[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 1998 Edition]
[From the U.S. Government Printing Office]


[[Page i]]

          26



          Internal Revenue



          PART 1 (Secs. 1.441 TO 1.500)

                         Revised as of April 1, 1998

          CONTAINING
          A CODIFICATION OF DOCUMENTS
          OF GENERAL APPLICABILITY
          AND FUTURE EFFECT
          AS OF APRIL 1, 1998

          With Ancillaries
          Published by
          the Office of the Federal Register
          National Archives and Records
          Administration
          as a Special Edition of
          the Federal Register



[[Page ii]]

                                      




                     U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 1998



               For sale by U.S. Government Printing Office
 Superintendent of Documents, Mail Stop: SSOP, Washington, DC 20402-9328



[[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..........................     579
    Alphabetical List of Agencies Appearing in the CFR........     595
    Table of OMB Control Numbers..............................     605
    List of CFR Sections Affected.............................     621



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   Cite this Code:  CFR

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

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[[Page v]]



                               EXPLANATION

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

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1
    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    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, 1998), 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 
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instances where the effective date is beyond the cut-off date for the 
Code a note has been inserted to reflect the future effective date. In 
those instances where a regulation published in the Federal Register 
states a date certain for expiration, an appropriate note will be 
inserted following the text.

OMB CONTROL NUMBERS

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

[[Page vi]]

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

OBSOLETE PROVISIONS

    Provisions that become obsolete before the revision date stated on 
the cover of each volume are not carried. Code users may find the text 
of provisions in effect on a given date in the past by using the 
appropriate numerical list of sections affected. For the period before 
January 1, 1986, consult either the List of CFR Sections Affected, 1949-
1963, 1964-1972, or 1973-1985, published in seven separate volumes. For 
the period beginning January 1, 1986, a ``List of CFR Sections 
Affected'' is published at the end of each CFR volume.

CFR INDEXES AND TABULAR GUIDES

    A subject index to the Code of Federal Regulations is contained in a 
separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of Statutory 
Authorities and Agency Rules (Table I), and Acts Requiring Publication 
in the Federal Register (Table II). A list of CFR titles, chapters, and 
parts and an alphabetical list of agencies publishing in the CFR are 
also included in this volume.
    An index to the text of ``Title 3--The President'' is carried within 
that volume.
    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
the daily Federal Register.
    A List of CFR Sections Affected (LSA) is published monthly, keyed to 
the revision dates of the 50 CFR titles.

REPUBLICATION OF MATERIAL

    There are no restrictions on the republication of material appearing 
in the Code of Federal Regulations.

INQUIRIES

    For a legal interpretation or explanation of any regulation in this 
volume, contact the issuing agency. The issuing agency's name appears at 
the top of odd-numbered pages.
    For inquiries concerning CFR reference assistance, call 202-523-5227 
or write to the Director, Office of the Federal Register, National 
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ELECTRONIC SERVICES

    The full text of the Code of Federal Regulations, The United States 
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of Presidential Documents and the Privacy Act Compilation are available 
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[[Page vii]]

    The Office of the Federal Register also offers a free service on the 
National Archives and Records Administration's (NARA) World Wide Web 
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site also contains links to GPO Access.

                              Raymond A. Mosley,
                                    Director,
                          Office of the Federal Register.

April 1, 1998.



[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of nineteen volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
1998. The first twelve volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Secs. 1.0-1-1.60; 
Secs. 1.61-1.169; Secs. 1.170-1.300; Secs. 1.301-1.400; Secs. 1.401-
1.440; Secs. 1.441-1.500; Secs. 1.501-1.640; Secs. 1.641-1.850; 
Secs. 1.851-1.907; Secs. 1.908-1.1000; Secs. 1.1001-1.1400 and 
Sec. 1.1401 to end. The thirteenth 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, Cheryl E. Sirofchuck was Chief Editor. The Code of 
Federal Regulations publication program is under the direction of 
Frances D. McDonald, assisted by Alomha S. Morris.

[[Page x]]




[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




            (This book contains part 1, Secs. 1.441 to 1.500)

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

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

[[Page 3]]



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




                     (Part 1, Secs. 1.441 to 1.500)

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

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

Supplementary Publication: Internal Revenue Service Looseleaf 
  Regulations System.

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

[[Page 5]]



                  SUBCHAPTER A--INCOME TAX (Continued)





PART 1--INCOME TAXES (Continued)--Table of Contents




                  Normal Taxes and Surtaxes (Continued)

                       DEFERRED COMPENSATION, ETC.

              Accounting Periods and Methods of Accounting

                           Accounting Periods

Sec.
1.441-1T  Period for computation of taxable income (temporary).
1.441-2T  Election of year consisting of 52-53 weeks (temporary).
1.441-3T  Special rules for certain adoptions of, retentions of, or 
          changes to or from a 52-53-week taxable year (temporary).
1.441-4T  Taxable year of a personal service corporation (temporary).
1.442-1  Change of annual accounting period.
1.442-2T  Special limitations on certain changes of annual accounting 
          period (temporary).
1.442-3T  Special limitations on certain adoptions and retentions of a 
          taxable year (temporary).
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).

                          Methods of Accounting

                    Methods of Accounting in General

1.446-1  General rule for methods of accounting.
1.446-2  Method of accounting for interest.
1.446-3  Notional principal contracts.
1.446-4  Hedging transactions.
1.448-1  Limitation on the use of the cash receipts and disbursements 
          method of accounting.
1.448-1T  Limitation on the use of the cash receipts and disbursements 
          method of accounting (temporary).
1.448-2T  Nonaccrual of certain amounts by service providers 
          (temporary).

          Taxable Year for Which Items of Gross Income Included

1.451-1  General rule for taxable year of inclusion.
1.451-2  Constructive receipt of income.
1.451-3  Long-term contracts.
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.
1.453A-0  Table of contents.
1.453A-1  Installment method of reporting income by dealers on personal 
          property.
1.453A-2  Treatment of revolving credit plans; taxable years beginning 
          on or before December 31, 1986.
1.453A-3  Requirements for adoption of or change to installment method 
          by dealers in personal property.
1.454-1  Obligations issued at discount.
1.455-1  Treatment of prepaid subscription income.
1.455-2  Scope of election under section 455.
1.455-3  Method of allocation.
1.455-4  Cessation of taxpayer's liability.
1.455-5  Definitions and other rules.
1.455-6  Time and manner of making election.
1.456-1  Treatment of prepaid dues income.
1.456-2  Scope of election under section 456.
1.456-3  Method of allocation.
1.456-4  Cessation of liability or existence.
1.456-5  Definitions and other rules.
1.456-6  Time and manner of making election.
1.456-7  Transitional rule.
1.457-1  Compensation deferred under eligible State deferred 
          compensation plans.
1.457-2  Eligible State deferred compensation plan defined.
1.457-3  Tax treatment of participants where plan is not an eligible 
          plan.
1.457-4  Transitional rules.
1.458-1  Exclusion for certain returned magazines, paperbacks, or 
          records.
1.458-2  Manner of and time for making election.
1.460-0  Outline of regulations under section 460.

[[Page 6]]

1.460-1  Accounting for long-term contracts in general. [Reserved]
1.460-2  Definition of long-term contract. [Reserved]
1.460-3  Percentage of completion method. [Reserved]
1.460-4  Methods of accounting for long-term contracts.
1.460-5  Cost allocation rules. [Reserved]
1.460-6  Look-back method.
1.460-6T  Look-back method (temporary).
1.460-7  Exempt long-term contracts. [Reserved]
1.460-8  Changes in method of accounting. [Reserved]

                 Taxable Year for Which Deductions Taken

1.461-0  Table of contents.
1.461-1  General rule for taxable year of deduction.
1.461-2  Contested liabilities.
1.461-3  Prepaid interest. [Reserved]
1.461-4  Economic performance.
1.461-5  Recurring item exception.
1.461-6  Economic performance when certain liabilities are assigned or 
          are extinguished by the establishment of a fund.
1.463-1T  Transitional rule for vested accrued vacation pay (temporary).
1.465-1T  Aggregation of certain activities (temporary).
1.466-1  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.
1.468A-0  Nuclear decommissioning costs; table of contents.
1.468A-1  Nuclear decommissioning costs; general rules.
1.468A-2  Treatment of electing taxpayer.
1.468A-3  Ruling amount.
1.468A-4  Treatment of nuclear decommissioning fund.
1.468A-5  Nuclear decommissioning fund qualification requirements; 
          prohibitions against self-dealing; disqualification of nuclear 
          decommissioning fund; termination of fund upon substantial 
          completion of decommissioning.
1.468A-6  Disposition of an interest in a nuclear power plant.
1.468A-7  Manner of and time for making election.
1.468A-8  Effective date and transitional rules.
1.468B  Designated settlement funds.
1.468B-0  Table of contents.
1.468B-1  Qualified settlement funds.
1.468B-2  Taxation of qualified settlement funds and related 
          administrative requirements.
1.468B-3  Rules applicable to the transferor.
1.468B-4  Taxability of distributions to claimants.
1.468B-5  Effective dates and transition rules.
1.469-0  Table of contents.
1.469-1  General rules.
1.469-1T  General rules (temporary).
1.469-2  Passive activity loss.
1.469-2T  Passive activity loss (temporary).
1.469-3  Passive activity credit.
1.469-3T  Passive activity credit (temporary).
1.469-4  Definition of activity.
1.469-4T  Definition of activity (temporary).
1.469-5  Material participation.
1.469-5T  Material participation (temporary).
1.469-6  Treatment of losses upon certain dispositions. [Reserved]
1.469-7  Treatment of self-charged items of income and expense. 
          [Reserved]
1.469-8  Application of section 469 to trust, estates, and their 
          beneficiaries. [Reserved]
1.469-9  Rules for certain rental real estate activities.
1.469-10  Application of section 469 to publicly traded partnerships. 
          [Reserved]
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(b)-1  Scope of exemptions from mark-

[[Page 7]]

          to-market requirement.
1.475(b)-2  Exemptions--identification requirements.
1.475(b)-3  [Reserved]
1.475(b)-4  Exemptions--transitional issues.
1.475(c)-1  Definitions--dealer in securities.
1.475(c)-2  Definitions--security.
1.475(d)-1  Character of gain or loss.
1.475(e)-1  Effective dates.

                               Adjustments

1.481-1  Adjustments in general.
1.481-2  Limitation on tax.
1.481-3  Adjustments attributable to pre-1954 years where change was not 
          initiated by taxpayer.
1.481-4  Adjustments taken into account with consent.
1.481-5  Effective dates.
1.482-0  Outline of regulations under 482.
1.482-1  Allocation of income and deductions among taxpayers.
1.482-2  Determination of taxable income in specific situations.
1.482-3  Methods to determine taxable income in connection with a 
          transfer of tangible property.
1.482-4  Methods to determine taxable income in connection with a 
          transfer of intangible property.
1.482-5  Comparable profits method.
1.482-6  Profit split method.
1.482-7  Sharing of costs.
1.482-8  Examples of the best method rule.
1.483-1  Interest on certain deferred payments.
1.483-2  Unstated interest.
1.483-3  Test rate of interest applicable to a contract.
1.483-4  Contingent payments.

 Regulations Applicable for Taxable Years Beginning on or Before April 
                                21, 1993

1.482-1A  Allocation of income and deductions among taxpayers.
1.482-2A  Determination of taxable income in specific situations.

    Authority:  26 U.S.C. 7805.
    Sec. 1.441-2T also issued under 26 U.S.C. 441(f).
Sec. 1.441-3T also issued under 26 U.S.C. 441.
Secs. 1.442-2T and 1.442-3T also issued under 26 U.S.C. 422, 706, and 
1378.
Secs. 1.444-0T through 1.444-3T and Sec. 1.706-3T are also issued under 
26 U.S.C. 444(f).
Sec. 1.446-1 also issued under 26 U.S.C. 446 and 461(h).
Sec. 1.446-4 also issued under 26 U.S.C. 1502.
Sec. 1.451-3 and 1.451-5 amended under 96 Stat. 324, 493.
Sec. 1.453-11 also issued under 26 U.S.C. 453(j)(1) and (k).
Sec. 1.453A-3 also issued under 26 U.S.C. 453A.
Sec. 1.458-1 also issued under 26 U.S.C. 458.
Sec. 1.460-4 also issued under 26 U.S.C. 460 and 1502.
Sec. 1.460-6 also issued under 26 U.S.C. 460(h).
Sec. 1.460-6T also issued under 26 U.S.C. 460(h).
Sec. 1.461-1 also issued under 26 U.S.C. 461(h).
Sec. 1.461-2 also issued under 26 U.S.C. 461(h).
Sec. 1.461-4 also issued under 26 U.S.C. 461(h).
Sec. 1.461-4(d) also issued under 26 U.S.C. 460 and 26 U.S.C. 461(h).
Sec. 1.461-5 also issued under 26 U.S.C. 461(h).
Sec. 1.461-6 also issued under 26 U.S.C. 461(h).
Secs. 1.466-1 through 1.466-4 also issued under 26 U.S.C. 466.
Sec. 1.468A-5 also issued under 26 U.S.C. 468A(e)(5).
Sec. 1.468B also issued under 26 U.S.C. 461(h) and 468B.
Secs. 1.468B-0 through 1.468B-5 also issued under 26 U.S.C. 461(h) and 
468B.
Sec. 1.469-1 also issued under 26 U.S.C. 469.
Sec. 1.469-1T also issued under 26 U.S.C. 469.
Sec. 1.469-2 also issued under 26 U.S.C. 469(l).
Sec. 1.469-2T also issued under 26 U.S.C. 469(l).
Sec. 1.469-3 also issued under 26 U.S.C. 469(l).
Sec. 1.469-3T also issued under 26 U.S.C. 469(l).
Sec. 1.469-4 also issued under 26 U.S.C. 469(l).
Sec. 1.469-5 also issued under 26 U.S.C. 469(l).
Sec. 1.469-5T also issued under 26 U.S.C. 469(l).
Sec. 1.469-9 also issued under 26 U.S.C. 469(c)(6), (h)(2), and (l)(1).
Sec. 1.469-11 also issued under 26 U.S.C. 469(l).
Sec. 1.471 also issued under 26 U.S.C. 471.
Sec. 1.471-4 also issued under 26 U.S.C. 263A.
Sec. 1.471-5 also issued under 26 U.S.C. 263A.
Sec. 1.475(a)-3 also issued under 26 U.S.C. 475(e).
Sec. 1.475(b)-1 also issued under 26 U.S.C. 475(b)(4) and 26 U.S.C. 
475(e).
Sec. 1.475(b)-2 also issued under 26 U.S.C. 475(b)(2) and 26 U.S.C. 
475(e).
Sec. 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.
Sec. 1.475(c)-1 also issued under 26 U.S.C. 475(e).
Sec. 1.475(c)-2 also issued under 26 U.S.C. 475(e) and 26 U.S.C. 
860G(e).
Sec. 1.475(d)-1 also issued under 26 U.S.C. 475(e).
Sec. 1.475(e)-1 also issued under 26 U.S.C. 475(e).
Sec. 1.481-1 also issued under 26 U.S.C. 481.
Sec. 1.481-2 also issued under 26 U.S.C. 481.
Sec. 1.481-3 also issued under 26 U.S.C. 481.
Sec. 1.481-4 also issued under 26 U.S.C. 481.
Sec. 1.481-5 also issued under 26 U.S.C. 481.
Sec. 1.482-1 also issued under 26 U.S.C. 482 and 936.
Sec. 1.482-2 also issued under 26 U.S.C. 482.
Sec. 1.482-3 also issued under 26 U.S.C. 482.
Sec. 1.482-4 also issued under 26 U.S.C. 482.
Sec. 1.482-5 also issued under 26 U.S.C. 482.
Sec. 1.482-7 is also issued under 26 U.S.C. 482.
Sec. 1.482-2A also issued under 26 U.S.C. 482.
Secs. 1.483-1 through 1.483-3 also issued under 26 U.S.C. 483(f).
Sec. 1.483-4 also issued under 26 U.S.C. 483(f).

[[Page 8]]

              Accounting Periods and Methods of Accounting

                           accounting periods



Sec. 1.441-1T  Period for computation of taxable income (temporary).

    (a) Computation of taxable income. Taxable income shall be computed 
and a return shall 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 Code, and the regulations 
thereunder.
    (b) Taxable year--(1) Definition of taxable year--(i) In general. 
Except as otherwise provided in this paragraph (b)(1), the term 
``taxable year'' means--
    (A) The taxpayer's annual accounting period if it is a calendar year 
or a fiscal year; or
    (B) The calendar year if section 441(g) (relating to taxpayers who 
keep no books or have no accounting period) applies. Except as provided 
in administrative provisions of the Internal Revenue laws, a taxable 
year may not cover a period of more than 12 calendar months. If a return 
is made under section 443 for a period of less than 12 months (a ``short 
period''), the taxable year is the short period for which the return is 
made.
    (ii) Special rules for certain entities. The general rule provided 
in paragraph (b)(1)(i) of this section may be modified by the Internal 
Revenue laws or regulations. For example, special rules are provided for 
the following taxpayers--
    (A) In the case of personal service corporations, the applicable 
rules are contained in Sec. 1.441-4T.
    (B) In the case of partnerships, the applicable rules are contained 
in Sec. 1.706-1T.
    (C) In the case of S corporations, the applicable rules are 
contained in section 1378.
    (D) In the case of members of an affiliated group which makes a 
consolidated return, the applicable rules are contained in Sec. 1.1502-
76 and paragraph (d) of Sec. 1.442-1.
    (E) In the case of trusts, the applicable rules are contained in 
section 645.
    (F) In the case of real estate investment trusts, the applicable 
rules are contained in section 859.
    (G) In the case of real estate mortgage investment conduits, the 
applicable rules are contained in section 860D(a)(5).
    (H) In the case of FSCs or DISCs, the applicable rules are contained 
in section 441(h).
    (2) Adoption of taxable year. A new taxpayer adopts a taxable year 
on or before the time prescribed by law (not including extensions) for 
the filing of the taxpayer's first return and may adopt, without prior 
approval, any taxable year that satisfies the requirements of section 
441 and this section.
    (3) Change in taxable year--(i) General rule. After a taxpayer has 
adopted a taxable year, such year must be used in computing taxable 
income and making returns for all subsequent years unless prior approval 
is obtained from the Commissioner to make a change or unless a change is 
otherwise permitted or required under the Internal Revenue laws or 
regulations. See section 442 and Sec. 1.442-1. Also see paragraph (b)(4) 
of this section.
    (ii) Change in taxable year required by the Tax Reform Act of 1986. 
Procedures for entities (certain personal service corporations, 
partnerships and S corporations) required to change their taxable year 
under section 806 of the Tax Reform Act of 1986, Pub. L. 99-5l4, 100 
Stat. 2362, are provided in Rev. Proc. 87-32, 1987-28 I.R.B. 14, or 
successor revenue procedures.
    (4) Retention of taxable year--(i) In general. In certain cases, 
taxpayers will be required under the Internal Revenue laws or 
regulations to change their taxable year unless they establish a 
business purpose for retaining their current taxable year. For example, 
corporations electing to be S corporations. corporations that are 
personal service corporations for the first time, and certain 
partnerships with new partners may be required to change their taxable 
year unless they establish a business purpose for retaining their 
current taxable year.
    (ii) Section 806 of the Tax Reform Act of 1986. Rev. Proc. 87-32 
provides (and any successor revenue procedure would provide) procedures 
for certain entities

[[Page 9]]

(i.e., personal service corporations, partnerships and S corporations) 
requesting the Commissioner's approval to retain a fiscal year when such 
entity would otherwise be required to change its taxable year under 
section 806 of the Tax Reform Act of 1986. In addition, personal service 
corporations should see Announcement 87-82, 1987-37 I.R.B. 30, for 
modifications to Rev. Proc. 87-32 extending the due date for personal 
service corporations requesting the Commissioner's approval to establish 
a business purpose.
    (c) Annual accounting period. The term ``annual accounting period'' 
means the annual period (calendar year or fiscal year) on the basis of 
which the taxpayer regularly computes his income in keeping his books.
    (d) Calendar year. The term ``calendar year'' means a period of 12 
months ending on December 31. A taxpayer who has not established a 
fiscal year must make his return on the basis of a calendar year.
    (e) Fiscal year. (1) The term ``fiscal year'' means--
    (i) A period of 12 months ending on the last day of any month other 
than December, or
    (ii) The 52-53-week annual accounting period, if such period has 
been elected by the taxpayer.
    (2) A fiscal year will be recognized only if it is established as 
the annual accounting period of the taxpayer and only if the books of 
the taxpayer are kept in accordance with such fiscal year.
    (f) Election of year consisting of 52-53 weeks. For rules relating 
to the 52-53-week taxable year, see Secs. 1.441-2T, 1.441-3T, and 1.441-
4T.
    (g) No books kept; no accounting period. Except as otherwise 
provided in the Internal Revenue laws or regulations, the taxpayer's 
taxable year shall be the calendar year if--
    (1) The taxpayer keeps no books;
    (2) The taxpayer does not have an annual accounting period (as 
defined in section 441(c) and paragraph (c) of this section); or
    (3) The taxpayer has an annual accounting period, but such period 
does not qualify as a fiscal year (as defined in section 441(e) and 
paragraph (e) of this section).

For the purposes of paragraph (g)(1) of this section, the keeping of 
books does not require that records be bound. Records which are 
sufficient to reflect income adequately and clearly on the basis of an 
annual accounting period will be regarded as the keeping of books. A 
taxpayer whose taxable year is required to be a calendar year under 
section 441(g) and this paragraph (g) may not adopt a fiscal year 
without obtaining prior approval from the Commissioner. See section 442 
and Sec. 1.442-1T(a)(2).
    (h) Effective date. This section is effective for taxable years 
beginning after December 31, 1986. See 26 CFR 1.441-1 (revised as of 
April 1, 1987) for rules applicable to taxable years beginning before 
January 1, 1987.

(Secs. 860(e), (92 Stat. 2849, 26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 
2850, 26 U.S.C. 860(g)); and sec. 7805 (68A Stat. 917, 26 U.S.C. 7805))
[T.D. 6500, 25 FR 11701, Nov. 26, 1960. Redesignated and amended by T.D. 
8167, 52 FR 48526, Dec. 23, 1987]



Sec. 1.441-2T  Election of year consisting of 52-53 weeks (temporary).

    (a) General rule. Section 441(f) provides, in general, that a 
taxpayer may elect to compute his taxable income on the basis of a 
fiscal year which--
    (1) Varies from 52 to 53 weeks,
    (2) Ends always on the same day of the week, and
    (3) Ends always on--
    (i) Whatever date this same day of the week last occurs in a 
calendar month, or
    (ii) Whatever date this same day of the week falls which is nearest 
to the last day of the calendar month.

For example, if the taxpayer elects a taxable year ending always on the 
last Saturday in November, then for the year 1956, the taxable year 
would end on November 24, 1956. 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 1956, the taxable year would end on 
December 1, 1956. Thus, in the case of a taxable year described in 
subparagraph (3)(i) of this paragraph, the year will always end within 
the month and may end on the last day of

[[Page 10]]

the month, or as many as six days before the end of the month. In the 
case of a taxable year described in subparagraph (3)(ii) of this 
paragraph, 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.
    (b) Application of effective dates. (1) For purposes of determining 
the effective date or the applicability of any provision of this title 
which 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 beginning 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 ending 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 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 (section 1561 and following), 
subchapter B, chapter 6, relating to surtax exemptions of certain 
controlled corporations. The provisions of this subparagraph do not 
apply to the computation of the tax if subparagraph (2) of this 
paragraph, relating to the computation under section 21 of the effect of 
changes in rates of tax during a taxable year, applies. The provisions 
of this subparagraph 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, 1957. For that purpose, a 
52-53-week taxable year beginning on any day within the period December 
26, 1956, to January 4, 1957, inclusive, shall be treated as beginning 
on January 1, 1957.
    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, shall be 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). X, a corporation created on January 1, 1966, elects a 
52-53-week taxable year ending on the Friday nearest the end of 
December. Thus, X's first taxable year begins on Saturday, January 1, 
1966, and ends on Friday, December 30, 1966; its next taxable year 
begins on Saturday, December 31, 1966, and ends on Friday, December 29, 
1967; and its next taxable year begins on Saturday, December 30, 1967, 
and ends on Friday, January 3, 1969. For purposes of applying the 
provisions of Part II, subchapter B, chapter 6 of the Code, X's first 
taxable year is deemed to begin on January 1, 1966, and end on December 
31, 1966; its next taxable year is deemed to begin on January 1, 1967, 
and end on December 31, 1967; and its next taxable year is deemed to 
begin on January 1, 1968, and end on December 31, 1968. Accordingly, 
each such taxable year is treated as including one and only one December 
31st.

    (2) 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 subparagraph (1) of this paragraph), the tax for the 52-53-week 
taxable year shall be computed in accordance with section 21, regulating 
to effect of changes, and the regulations thereunder. For the purpose of 
the computation under section 21, 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 subparagraph 
(1) of this paragraph. The provisions of this subparagraph 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, 1956. For a 52-53-week taxable 
year beginning on Wednesday, November 2, 1955, the tax must be computed 
on the basis of the old rates for the actual number of days, from 
November 2, 1955, to June 30, 1956, inclusive, and on the basis of the 
new rates for the actual number of days from July 1, 1956, to Tuesday, 
October 30, 1956, inclusive.
    Example (2). Assume a change in the rate of tax for taxable years 
beginning after June 30. 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 
21 will be required for such year because of the change in rate.


[[Page 11]]


    (c) Adoption of or change to or from 52-53-week taxable year. (1) A 
new taxpayer may adopt the 52-53-week taxable year for his first taxable 
year if he keeps his books and computes his income on that basis, or if 
he conforms his books accordingly in closing them. The taxpayer must 
thereafter keep his books and report his income on the basis of the 52-
53-week taxable year so adopted unless prior approval for a change is 
obtained from the Commissioner. See subparagraph (4) of this paragraph. 
The taxpayer shall file with his return for his first taxable year a 
statement containing the information required in subparagraph (3) of 
this paragraph. A newly-formed partnership may adopt a 52-53-week 
taxable year without the permission of the Commissioner only if such a 
year ends either with reference to the same month in which the taxable 
years of all its principal partners end or with reference to the month 
of December. See paragraph (b)(1) of Sec. 1.706-1.
    (2) A taxpayer, including a partnership, may change to a 52-53-week 
taxable year without the permission of the Commissioner if the 52-53-
week taxable year ends with reference to the end of the same calendar 
month as that in which the former taxable year ended, and if the 
taxpayer keeps his books and computes his income for the year of change 
on the basis of such 52-53-week taxable year, or if he conforms his 
books accordingly in closing them. The taxpayer must continue to keep 
his books and compute his income on the basis of such 52-53-week taxable 
year unless prior approval for a change is obtained. See subparagraph 
(4) of this paragraph. The taxpayer shall indicate his election to 
change to such 52-53-week taxable year by a statement filed with his 
return for the first taxable year for which the election is made. This 
statement shall contain the information required in subparagraph (3) of 
this paragraph.
    (3) The statement referred to in subparagraphs (1) and (2) of this 
paragraph shall contain the following information:
    (i) The calendar month with reference to which the new 52-53-week 
taxable year ends;
    (ii) The day of the week on which the 52-53-week taxable year always 
will end; and
    (iii) Whether the 52-53-week taxable year will always end on (a) the 
date on which such day of the week falls in the calendar month, or (b) 
on the date on which such day of the week last occurs which is nearest 
to the last day of such calendar month.
    (4) Where a taxpayer wishes to change to a 52-53-week taxable year 
and, in addition, wishes to change the month with reference to which the 
taxable year ends, or where a taxpayer wishes to change from a 52-53-
week taxable year, he must obtain prior approval from the Commissioner, 
as provided in section 442 and Sec. 1.442-1.
    (5) If a change from or to a 52-53-week taxable year results in a 
short period (within the meaning of section 443) of 359 days or more, or 
six days or less, the tax computation under section 443(b) shall not 
apply. If the short period is 359 days or more, it shall be 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 shall be added to and deemed a 
part of the following taxable year. (In the case of a change from or to 
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 
section 443(b) does not apply since 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, but less than 359 days, taxable income for the 
short period shall be placed on an annual basis for the purpose of 
section 443(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 shall be 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 section 443(b)(2) and paragraph (b)(2) of 
Sec. 1.443-1, relating to the alternative tax computation, apply). For 
adjustment in deduction for personal exemption, see section 443(c) and 
paragraph (b)(1)(v) of Sec. 1.443-1.

[[Page 12]]

    (6) The provisions of subparagraph (5) of this paragraph are 
illustrated by the following examples:
    Example (1). A taxpayer having a fiscal year ending April 30 elects 
for years beginning after April 30, 1955, a 52-53-week taxable year 
ending on the last Saturday in April. This election involves a short 
period of 364 days, from May 1, 1955, to April 28, 1956, inclusive. 
Since this short period is 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 in example (1), except 
that the taxpayer elects for years beginning after April 30, 1955, a 
taxable year ending on the Tuesday nearest to April 30. This election 
involves a short period of three days, from May 1 to May 3, 1955. Since 
this short period is less than seven days, tax is not separately 
computed for it. This short period is added to and deemed part of the 
following 52-week taxable year which would otherwise begin on May 4, 
1955, and end on May 1, 1956. Thus, that taxable year is deemed to begin 
on May 1, 1955, and end on May 1, 1956.

    (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, are 
generally applicable to 52-53-week taxable years. Thus, items of income 
and deductions are determined on the basis of a 52-53-week taxable year, 
except that such items may be determined as though the 52-53-week 
taxable year were a taxable year consisting of 12 calendar months if 
such practice is consistently followed by the taxpayer and if income is 
clearly reflected thereby. In the case of depreciation, unless some 
other practice is consistently followed, the allowance shall be 
determined as though the 52-53-week year were a taxable year consisting 
of 12 calendar months. Amortization deductions for the taxable year 
shall be determined as though the 52-53-week year were a taxable year 
consisting of 12 calendar months.
    (e) Partnerships, S corporations, and personal service 
corporations--(1) In general. Paragraph (e) of this section applies if a 
partnership, partner, S corporation, S corporation shareholder, personal 
service corporation (within the meaning of Sec. 1.441-4T(d)), or 
employee-owner (within the meaning of Sec. 1.441-4T(h)) uses a 52-53-
week taxable year.
    (2) Treatment of taxable years ending with reference to the same 
calendar month--(i) Timing of partners taking into account partnership 
items. If the taxable year of a partnership and a partner end with 
reference to the same ca!endar month, then for purposes of determining 
the taxable year in which a partner takes into account--
    (A) Items described in section 702, and
    (B) Items that are deductible by the partnership (including items 
described in section 707(c)) and includible in the income of the 
partner, the partner's taxable year will be deemed to end on the last 
day of the partnership's taxable year.
    (ii) Timing of S shareholders taking into account S corporation 
items. 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 a shareholder takes into account--
    (A) Items described in section 1366(a), and
    (B) Items that are deductible by the S corporation and includible in 
the income of the shareholder, the shareholder's taxable year will be 
deemed to end on the last day of the S corporation's taxable year.
    (iii) Personal service corporations and employee-owners. If the 
taxable year of a personal service corporation and an employee-owner 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 personal service corporation 
and includible in the income of the employee-owner, the employee-owner's 
taxable year will be deemed to end on the last day of the personal 
service corporation's taxable year.
    (3) Automatic approval for partnerships and S corporations. If a 
partnership or S corporation is required to use a taxable year ending 
with respect to the last day of a particular month and the partnership 
or S corporation desires to use a 52-53-week taxable year with reference 
to such month, the partnership or S corporation is granted automatic 
approval to use such 52-53-week taxable

[[Page 13]]

year. See Sec. 1.441-4T(b)(2)(ii) for a similar rule for personal 
service corporations.
    (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 Sunday 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, 1988, each partner's distributive share 
of ABC's taxable income is $10,000. Under section 706(a) and paragraph 
(e)(2)(i) of this section, for the taxable year ending December 31, 
1987, A, B, and C each must include $10,000 in income with respect to 
the ABC year ending January 3, 1988. Similarly, if ABC makes a 
guaranteed payment to A on January 2, 1988, A must include the payment 
in income for his or her taxable year ending December 31, 1987.
    Example (2). X, a personal service corporation, uses a 52-53-week 
taxable year that ends on the Sunday 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, 1988, X pays a bonus of 
$10,000 to each employee-owner. Under paragraph (e)(2)(iii) of this 
section, each employee-owner must include the bonus in income for the 
taxable year ending December 31, 1987.

    (5) Effective date. Paragraph (e) of this section applies to taxable 
years beginning after December 31, 1986.
    (f) Special rules for 1986 and subsequent years. For special rules 
relating to certain adoptions of, or changes to or from, a 52-53-week 
taxable year ending in 1986 or 1987, see Sec. 1.441-3T. For special 
rules relating to a 52-53-week taxable year beginning after December 31, 
1986, see Sec. 1.441-2T(e).
[T.D. 6500, 25 FR 11702, Nov. 26, 1960, as amended by T.D. 6845, 30 FR 
9739, Aug. 5, 1965. Redesignated and amended by T.D. 8167, 52 FR 48527, 
Dec. 23, 1987]



Sec. 1.441-3T  Special rules for certain adoptions of, retentions of, or changes to or from a 52-53-week taxable year (temporary).

    (a) Applicability. This section applies to any partnership, partner, 
S corporation, S corporation shareholder, personal service corporation, 
or employee-owner that wishes to adopt or change to or from a 52-53-week 
taxable year. This section also applies to a corporation seeking S 
status that wishes to adopt, retain, or change to or from a 52-53-week 
taxable year. This section applies in the case of a change to or from a 
52-53-week taxable year whether or not the taxpayer also wishes to 
change the month with reference to which its taxable year ends. 
Paragraph (c)(2) of this section applies to any taxpayer (including, for 
example, a corporation that is not seeking S status) that wishes to 
adopt or change to or from a 52-53-week taxable year.
    (b) Definitions--(1) Personal service corporation. For purposes of 
this section only, the term ``personal service corporation'' means any 
corporation (other than an S corporation) if--
    (i) The principal activity of that corporation is the performance of 
personal services, and
    (ii) Such services are substantially performed by employee-owners.

A corporation shall not be treated as a personal service corporation, 
however, unless more than 10 percent of the fair market value of the 
outstanding stock of the corporation is held by employee-owners.
    (2) Employee-owner. For purposes of this section, the term 
``employee-owner'' means an employee who owns, on any day of the 
corporation's taxable year, any outstanding stock of the personal 
service corporation. Section 318 will apply to determine stock ownership 
for purposes of this paragraph (b), except that ``any'' is to be 
substituted for ``50 percent or more in value'' in section 318(a)(2)(C).
    (3) Performance of a substantial portion of services. For purposes 
of paragraph (b)(1) of this section, personal services are substantially 
performed by employee-owners if the total time spent by employee-owners 
in performing those services is 10 percent or more of the total time 
spent by all employees (including employee-owners) in performing those 
services. In determining time spent in performing personal services of a 
corporation, time spent on matters that do not relate directly and 
intrinsically to the performance of services for or on behalf of clients 
or customers of the corporation shall not be taken into account. Thus, 
for example, in the case of a corporation performing accounting 
services, time

[[Page 14]]

spent in performing secretarial services, managerial work of a purely 
administrative nature, or janitorial services shall not be taken into 
account in determining either the time spent by employee-owners in 
performing accounting services or the total time spent by all employees 
in performing accounting services. Managerial time shall be taken into 
account, however, to the extent that it consists of the supervision of 
accounting services performed by employees for or on behalf of clients 
or customers of the corporation.
    (c) General rule--(1) Satisfaction of applicable conditions. A 
taxpayer to which this section applies may not adopt, retain, or change 
to or from a 52-53-week taxable year under Sec. 1.441-2(c) (1) or (2), 
Sec. 1.442-1, or 26 CFR 18.1378-1 unless each of the applicable 
conditions set forth in paragraph (d) of this section is satisfied with 
respect to the taxpayer seeking the adoption, retention, or change. For 
additional requirements applicable to certain taxpayers that wish to 
adopt, retain, or change to or from a 52-53-week taxable year, see 
Secs. 1.442-2T and 1.442-3T.
    (2) Evasion or avoidance of tax--(i) General rule. A taxpayer may 
not adopt or change to or from a 52-53-week taxable year if the 
principal purpose for such action is the evasion or avoidance of Federal 
income tax.
    (ii) Example. The provisions of this paragraph (c)(2) may be 
illustrated by the following example.

    Example.  Assume that X, a calendar year corporation, wishes to 
elect, for taxable years beginning after December 31, 1985, a 52-53-week 
taxable year that ends on the Tuesday nearest to December 31. Assume 
that such election allows the corporation to sell a substantial portion 
of its assets on Wednesday, December 31, 1986, and to report the income 
from such sale in the taxable year beginning on December 31, 1986, and 
ending on December 29, 1987. By electing the 52-53-week taxable year, 
the corporation obtains the advantages of the lower Federal income tax 
rates applicable for the period beginning December 31, 1986. Moreover, 
the sale of the assets on December 31 allows the buyer of the assets, a 
calendar year taxpayer, to obtain certain Federal income tax advantages 
that are not available with respect to purchases of assets in 1987 and 
later years. Given the above facts, it is presumed that the principal 
purpose for such action is the evasion or avoidance of Federal income 
tax. Thus, X may not adopt a 52-53-week taxable year.

    (d) Conditions applicable to certain taxpayers--(1) Conditions. (i) 
If the taxpayer seeking the adoption or change is a partnership, all of 
the partners (determined at the close of the first taxable year of the 
partnership for which the election to use the 52-53-week taxable year is 
made or, if applicable, the short period involved in the change) must 
agree to treat the current and all subsequent 52-53-week years of the 
partnership (and of any partner) as ending on the last day of the 
calendar month that ends nearest to the last day of the 52-53-week year 
for purposes of determining the taxable year in which the inclusions 
required by sections 702 and 707(c) are taken into account.
    (ii) If the taxpayer seeking the adoption or change is a partner, 
the partner must agree to treat the current and all subsequent 52-53-
week years of the partner (and the 52-53-week years of any partnership 
in which such taxpayer is a partner) as ending on the last day of the 
calendar month that ends nearest to the last day of the 52-53-week year 
for purposes of determining the taxable year in which the inclusions 
required by sections 702 and 707(c) are taken into account.
    (iii) If the taxpayer seeking the adoption, retention, or change is 
an S corporation or a corporation seeking S status, all of the 
shareholders (determined at the close of the first taxable year of the S 
corporation for which the election to use or retain the 52-53-week year 
is made or, if applicable, the short period involved in the change) must 
agree to treat the current and all subsequent 52-53-week taxable years 
of the corporation (and of any shareholder) as ending on the last day of 
the calendar month that ends nearest to the last day of the 52-53-week 
year for purposes of determining the taxable year in which the 
inclusions required by section 1366 are taken into account.
    (iv) If the taxpayer seeking the adoption or change is an S 
corporation shareholder, the shareholder must agree to treat the current 
and all subsequent 52-53-week taxable years of the shareholder (and the 
52-53-week years

[[Page 15]]

of any S corporation in which such taxpayer is a shareholder) as ending 
on the last day of the calendar month that ends nearest to the last day 
of the 52-53-week year for purposes of determining the taxable year in 
which the inclusions required by section 1366 are taken into account.
    (v) If the taxpayer seeking the adoption or change is a personal 
service corporation, all of the employee-owners (determined at the close 
of the first taxable year of the corporation for which the election to 
use the 52-53-week taxable year is made or, if applicable, the short 
period involved in the change) must agree to treat the current and all 
subsequent taxable years of an employee-owner and the corporation that 
end with or with reference to the same calendar month as if both such 
taxable years ended on the last day of the taxable year of the 
corporation for purposes of determining the taxable year in which 
payments (whether or not in cash) that are deductible by the corporation 
are taken into account by the employee-owner.
    (vi) If the taxpayer seeking the adoption or change is an employee-
owner of a personal service corporation, the employee-owner must agree 
to treat the current and all subsequent taxable years of the employee-
owner and the corporation that end with or with reference to the same 
calendar month as if both such taxable years ended on the last day of 
the taxable year of the corporation for purposes of determining the 
taxable year in which payments (whether or not in cash) that are 
deductible by the corporation are taken into account by the employee-
owner.
    (2) Examples. The provisions of paragraph (d)(1) of this section may 
be illustrated by the following examples.

    Example (1). Assume that ABC, a calendar year partnership, wishes to 
elect, for taxable years beginning after December 31, 1985, a 52-53-week 
taxable year that ends on the Friday nearest to December 31. Assume that 
A, B, and C, who are individual calendar year taxpayers, are equal 
partners in ABC. Assume also that A, B, and C agree to treat each of the 
52-53-week taxable years of ABC as ending on December 31 for purposes of 
determining the taxable year in which guaranteed payments and their 
distributive shares of income, gains, losses, deductions, and credits 
are taken into account. Assume that, for its taxable year ending January 
2, 1987, ABC has net income of $30,000, and that ABC has no other items 
of income, gain, loss, deduction, or credit for that taxable year. Under 
paragraph (d)(1)(i) of this section, A, B, and C each must include 
$10,000 in income for their taxable years ending on December 31, 1986. 
Similarly, if ABC makes a guaranteed payment to A on January 2, 1987, A 
must include the payment in income for the taxable year ending December 
31, 1986.
    Example (2). Assume that X, a calendar year personal service 
corporation, wishes to elect, for taxable years beginning after December 
31, 1985, a 52-53-week taxable year that ends on the Friday nearest to 
December 31. Assume that all of the employer-owners of X are individual 
calendar year taxpayers. Assume further that all of the employee-owners 
agree to treat their taxable year as ending on the last day of X's 
taxable year for purposes of determining the year in which payments by X 
are taken into income. Assume that on January 2, 1987, X makes a payment 
of bonuses of $10,000 to each employee-owner. Under paragraph (d)(1)(v) 
of this section, each employee-owner must include $10,000 in income for 
the taxable year ending December 31, 1986.

    (e) Procedural requirements. In the case of an adoption of or change 
to a 52-53-week taxable year under Sec. 1.441-2(c) (1) or (2), a 
taxpayer to which any condition in paragraph (d) of this section applies 
must indicate on the statement required under Sec. 1.441-2(c) (1) or 
(2), or on a separate statement that is attached to the income tax 
return for the year of adoption or change, that all of the applicable 
conditions are satisfied. If the due date for that return is before 
March 9, 1987, the statement required under Sec. 1.441-2(c) (1) or (2) 
(or an amended statement) indicating that the applicable conditions are 
satisfied must be filed by the later of March 9, 1987 or the due date 
for the return (determined with regard to extensions). If Sec. 1.442-2T 
or Sec. 1.442-3T applies to an adoption of, retention of, or change to 
or from a 52-53-week taxable year, the procedures set forth in 
Sec. 1.442-2T or Sec. 1.442-3T (whichever is applicable) must be 
followed and the rules set forth in Sec. 1.442-2T(f)(3) or Sec. 1.442-
3T(d) shall apply.
    (f) Effective date--(1) In general. This section shall apply to 
adoptions of, retentions of, or changes to or from a 52-53-week taxable 
year if--
    (i) The income tax return for the first taxable year for which the 
election to

[[Page 16]]

use or retain the 52-53-week year is made (or, if applicable, the income 
tax return for the short period involved in the change) is filed after 
September 29, 1986, and
    (ii) The first taxable year for which the election to use or retain 
the 52-53-week year is made (or the short period involved in the change) 
ends before January 5, 1987.
    (2) Exceptions. This section shall not apply if the application 
required to effect or request the adoption, retention, or change was 
timely filed before September 30, 1986. In the case of an adoption or 
change that is effected by filing an income tax return for the first 
taxable year for which the election is made, this section shall not 
apply if an application for extension of time for filing that return was 
filed before September 30, 1986, the application clearly stated the 
taxpayer's intention to adopt or change to a 52-53-week taxable year, 
and the income tax return for that taxable year is timely filed 
(determined with regard to extensions).
[T.D. 8123, 52 FR 3617, Feb. 5, 1987]



Sec. 1.441-4T  Taxable year of a personal service corporation (temporary).

    (a) Taxable year. The taxable year of a personal service corporation 
(as defined in paragraph (d) of this section) is--
    (1) The calendar year, or a ``short period'' (as provided in 
Sec. 1.441-1T(b)(1)(i)) ending December 31; or
    (2) A fiscal year, or a short period (other than a short period 
provided in paragraph (a)(1) of this section), if the corporation 
obtains the approval of the Commissioner (in accordance with paragraph 
(c) of this section) for using such fiscal year.
    (b) Change in taxable year required--(1) In general. For any taxable 
year beginning after December 31, 1986, a taxpayer that is a personal 
service corporation for such taxable year must--
    (i) Use a taxable year described in paragraph (a) of this section; 
or
    (ii) Change to such a taxable year by using a short taxable year 
that ends on the last day of a taxable year described in paragraph (a) 
of this section.
    (2) Approval not required for change to a calendar year--(i) In 
general. A personal service corporation may change its taxable year to 
the calendar year without the approval of the Commissioner. In such 
cases, however, the taxpayer should notify the Internal Revenue Service 
of the change in accordance with the provisions of the applicable 
revenue procedure. See, for example, section 5.02(1) of Rev. Proc. 87-
32, 1987-28 I.R.B. 14.
    (ii) Special rule for 52-53-week taxable year ending with reference 
to the month of December. For purposes of this section, a 52-53-week 
taxable year of a personal service corporation ending with reference to 
the month of December shall be treated as the calendar year. In order to 
assist in the processing of the retention or change in taxable year, 
taxpayers should refer to this special rule by either typing or legibly 
printing the following statement at the top of page 1 of the income tax 
return: ``FILED UNDER Sec. 1.441-4T(b)(2)(ii).'' See Sec. 1.441-2T(e) 
for special rules regarding 52-53-week taxable years for personal 
service corporations.
    (3) Examples. The provisions of paragraph (b) of this section may be 
illustrated by the following examples.

    Example (1). X corporation's last taxable year beginning before 
January 1, 1987, ends on January 31, 1987. In addition, X is a personal 
service corporation for its taxable year beginning February 1, 1987, and 
does not obtain the approval of the Commissioner for using a fiscal 
year. Thus, under paragraph (b)(1) of this section, X is required to 
change its taxable year to the calendar year by using a short taxable 
year that begins on February 1, 1987, and ends on December 31, 1987. 
Under paragraph (b)(2)(i) of this section, X may change its taxable year 
without the consent of the Commissioner, but should notify the Internal 
Revenue Service of the change in accordance with section 5.02(1) of Rev. 
Proc. 87-32.
    Example (2). Assume the same facts as in example (1), except that 
for its taxable year beginning February 1, 1987, X obtains the approval 
of the Commissioner to change its annual accounting period to a fiscal 
year ending September 30. Under paragraph (b)(1) of this section, X must 
file a tax return for the short period from February 1, 1987, through 
September 30, 1987.
    Example (3). Assume the same facts as in example (1), except that 
the first taxable year for which X is a personal service corporation is 
the taxable year that begins on February 1, 1990. Thus, for taxable 
years ending before that date, this section does not apply with respect 
to X. For its taxable year

[[Page 17]]

beginning on February 1, 1990, however, X will be required to comply 
with paragraph (b) of this section. If X does not obtain the approval of 
the Commissioner to use a fiscal year, X will be required to change its 
taxable year to the calendar year by using a short taxable year that 
ends on December 31, 1990.
    Example (4). 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. Pursuant to paragraphs (b)(2)(i) and (b)(2)(ii) 
of this section, X may change its taxable year to a 52-53-week taxable 
year ending with reference to the month of December without the consent 
of the Commissioner, but should notify the Internal Revenue Service of 
the change in accordance with paragraph (b)(2)(ii) of this section.

    (c) Approval of a fiscal year. A personal service corporation must 
establish to the satisfaction of the Commissioner a business purpose for 
using a fiscal year under paragraph (a)(2) of this section. Business 
purpose is established to the satisfaction of the Commissioner in the 
case of a personal service corporation that--
    (1) Requests to use, or is using, a fiscal year that coincides with 
its natural business year, as defined in section 4.01(1) of Rev. Proc. 
87-32, or successor revenue procedures, or
    (2) Receives permission from the Commissioner to use the fiscal year 
by establishing a business purpose for the fiscal year under section 
6.01 of Rev. Proc. 87-32, or successor revenue procedures. See also Rev. 
Rul. 87-57, 1987-28 I.R.B. 7. See Announcement 87-82 for modifications 
to Rev. Proc. 87-32 regarding due dates for personal service 
corporations filing applications and income tax returns for certain 
short taxable years beginning after December 31, 1986.
    (d) Personal service corporation for a taxable year--(1) In general. 
For purposes of this section, a taxpayer is a personal service 
corporation 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 for the taxable year is the performance of personal services;
    (iii) During the testing period for the taxable year, such services 
are substantially performed by employee-owners; and
    (iv) Employee-owners, as defined in paragraph (h) of this section, 
own (as determined under the attribution rules of section 318, except 
that ``any'' shall be substituted for ``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 
for the taxable year.
    (2) Testing period--(i) In general. Except as otherwise provided in 
paragraph (d)(2)(ii) of this section, the testing period for a taxable 
year is the taxable year preceding such taxable year.
    (ii) New corporations. The testing period for a taxpayer's first 
taxable year is the period beginning on the first day of such taxable 
year and ending on the earlier of--
    (A) The last day of such taxable year; or
    (B) The last day of the calendar year in which such taxable year 
begins.
    (3) Examples. The provisions of paragraph (d)(2) of this section may 
be illustrated by the following examples.

    Example (1). Corporation A has been in existence since 1980 and has 
used a January 31 taxable year for all taxable years beginning before 
1987. For purposes of determining whether A is a personal service 
corporation for the taxable year beginning February 1, 1987, A's testing 
period under paragraph (d)(2)(i) of this section is the taxable year 
ending January 31, 1987.
    Example (2). B corporation's first taxable year begins on June 1, 
1987, and B desires to use a September 30 taxable year. However, if B is 
a personal service corporation, it must obtain the Commissioner's 
approval to use a September 30 taxable year. Pursuant to paragraph 
(d)(2)(ii) of this section, B's testing period for its first taxable 
year beginning June 1, 1987, is the period June 1, 1987 through 
September 30, 1987. Thus, if, based upon such testing period, B is a 
personal service corporation, B must obtain the Commissioner's 
permission to use a September 30 taxable year.
    Example (3). The facts are the same as in Example (2), except that B 
desires to use a March 31 taxable year. Pursuant to paragraph (d)(2)(ii) 
of this section, B's testing period for its first taxable year beginning 
June 1, 1987, is the period June 1, 1987, through December 31, 1987. 
Thus, if, based upon such testing period, B is a personal service 
corporation, B must obtain the Commissioner's permission to use a March 
31 fiscal year.


[[Page 18]]


    (e) Determination of whether an activity during the testing period 
is treated as the 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 the regulations interpreting 
section 448) 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.
    (f) Principal activity--(1) General rule. For purposes of this 
section, the principal activity of a corporation for any testing period 
will be considered to 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 under paragraph (e) of 
this section exceeds 50 percent of the corporation's total compensation 
cost for such testing period.
    (2) Compensation cost. 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--
    (i) Wages and salaries, and
    (ii) 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 (h)(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.

However, for purposes 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 (e) of 
this section, or employees involved only in supporting the work of such 
employees, shall be 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 (e) of this section, or for 
employees involved only in supporting the work of such employees, shall 
not be 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 (f)(3)(i) or paragraph (f)(3)(ii) of 
this section (``a mixed activity employee'') shall be 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 such employee multiplied by the percentage of 
the total time worked for the corporation by such employee during the 
year that is attributable to activities of the corporation that are 
treated as the performance of personal services under paragraph (e) of 
this section. Such percentage shall be determined by the taxpayer in any 
reasonable and consistent manner. Time logs are not required unless 
maintained for other purposes;

[[Page 19]]

    (B) Compensation cost not attributable to personal service activity. 
That portion of the compensation cost for a mixed activity employee that 
shall not be considered to be attributable to the corporation's personal 
service activity is the compensation cost for such employee less the 
amount determined in paragraph (f)(3)(iii)(A) of this section.
    (g) 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 such period attributable to its 
activities that are treated as the performance of personal services 
(within the meaning of paragraph (e) of this section), is attributable 
to personal services performed by employee-owners.
    (2) Compensation cost attributable to personal services. For 
purposes of paragraph (g)(1) of this section--
    (i) The corporation's compensation cost attributable to its 
activities that are treated as the performance of personal services 
shall be determined under paragraph (f)(3) of this section; and
    (ii) The portion of the amount determined under paragraph (g)(2)(i) 
of this section that is attributable to personal services performed by 
employee-owners shall be determined by the taxpayer in any reasonable 
and consistent manner.
    (3) Examples. The provisions of paragraph (g) of this section may be 
illustrated by the following examples.

    Example (1). For its taxable year beginning February 1, 1987, 
Corporation A's testing period is the taxable year ending January 31, 
1987. During such 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 (g)(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). Corporation B has the same facts as corporation A in 
example (1), except that during the taxable year ending January 31, 
1987, 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 (g)(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).

    (h) 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 (h)(1)(ii) of this section and who performs personal services 
for or on behalf of the corporation shall be 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 he or she would be 
considered an independent contractor for other purposes.
    (i) Special rules for affiliated group filing consolidated return--
(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 shall be treated as a single 
corporation;
    (ii) The employees of the members of the affiliated group shall be 
treated as employees of such single corporation; and
    (iii) All of the stock, of the members of the affiliated group, that 
is not

[[Page 20]]

owned by any other member of the affiliated group shall be treated as 
the outstanding stock of such corporation.
    (2) Examples. The provisions of this paragraph (i) 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, 1987, and AB is 
attempting to determine whether it is affected by this section for its 
taxable year beginning February 1, 1987. During the testing period 
(i.e., the taxable year ending January 31, l987), A did not perform 
personal services while 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 while 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 (i)(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. 
Since the only employee-owners of AB are the employees of B and since 
B's employees do not own more than 10 percent of AB on the last day of 
the testing period, AB is not subject to the provisions of this section. 
Thus, AB is not required to determine on a consolidated basis whether, 
during the testing period, (a) its principal activity is the providing 
of personal services, or (b) 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 $5,000 as of 
the last day of the testing period. Pursuant to paragraph (d)(1)(iv) and 
paragraph (i)(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. Since the $14,000 [($100,000.09)+ $5,000] fair market 
value of the stock held by B's employees is greater than 10 percent of 
the $105,000 ($100,000+$5,000) aggregate fair market value of A and B as 
of the last day of the testing period, AB may be subject to this section 
if, on a consolidated basis during the testing period, (a) the principal 
activity of AB is the performance of personal services and (b) the 
personal services are substantially performed by employee-owners.

    (j) Effective date. This section applies to taxable years beginning 
after December 31, 1986.
[T.D. 8167, 52 FR 48528, Dec. 23, 1987]



Sec. 1.442-1  Change of annual accounting period.

    (a) Manner of effecting such change--(1) In general. If a taxpayer 
wishes to change his annual accounting period (as defined in section 
441(c)) and adopt a new taxable year (as defined in section 441(b)), he 
must obtain prior approval from the Commissioner by application, as 
provided in paragraph (b) of this section, or the change must be 
authorized under the Income Tax Regulations. A new taxpayer who adopts 
an annual accounting period as provided in section 441 and Secs. 1.441-1 
or 1.441-2 need not secure the permission of the Commissioner under 
section 442 and this section. However, see subparagraph (2) of this 
paragraph. For adoption of and changes to or from a 52-53-week taxable 
year, see section 441(f) and Sec. 1.441-2; for adoption of and changes 
in the taxable years of partners and partnerships, see paragraph (b)(2) 
of this section, section 706(b) and paragraph (b) of Sec. 1.706-1; for 
special rules relating to certain corporations, subsidiary corporations, 
and newly married couples, see paragraphs (c), (d), and (e), 
respectively, of this section. For special rules relating to real estate 
investment trusts, see section 859.
    (2) Taxpayers to whom section 441(g) applies. Section 441(g) 
provides that if a taxpayer keeps no books, does not have an annual 
accounting period, or has an accounting period which does not meet the 
requirements for a fiscal year, his taxable year shall be the calendar 
year. If section 441(g) applies to a taxpayer, the adoption of a fiscal 
year will be treated as a change in his annual accounting period under 
section 442. Therefore, such fiscal year can become the taxpayer's 
taxable year only with the approval of the Commissioner. Approval of any 
such change will be denied unless the taxpayer agrees in his application 
to establish and maintain accurate records of his taxable income for the 
short period involved in the

[[Page 21]]

change and for the fiscal year proposed. The keeping of records which 
adequately and clearly reflect income for the taxable year constitutes 
the keeping of books within the meaning of section 441(g) and paragraph 
(g) of Sec. 1.441-1.
    (b) Prior approval of the Commissioner--(1) In general. In order to 
secure prior approval of a change of a taxpayer's annual accounting 
period, the taxpayer must file an application on Form 1128 with the 
Commissioner of Internal Revenue, Washington, D.C. 20224, to effect the 
change of accounting period. If the short period involved in the change 
ends after December 31, 1973, such form shall be filed on or before the 
15th day of the second calendar month following the close of such short 
period; if such short period ends before January 1, 1974, such form 
shall be filed on or before the last day of the first calendar month 
following the close of such short period. Approval will not be granted 
unless the taxpayer and the Commissioner agree to the terms, conditions, 
and adjustments under which the change will be effected. In general, a 
change of annual accounting period will be approved where the taxpayer 
established a substantial business purpose for making the change. In 
determining whether a taxpayer has established a substantial business 
purpose for making the change, consideration will be given to all the 
facts and circumstances relating to the change, including the tax 
consequences resulting therefrom. Among the nontax factors that will be 
considered in determining whether a substantial business purpose has 
been established is the effect of the change on the taxpayer's annual 
cycle of business activity. The agreement between the taxpayer and the 
Commissioner under which the change will be effected shall, in 
appropriate cases, provide terms, conditions, and adjustments necessary 
to prevent a substantial distortion of income which otherwise would 
result from the change. The following are examples of effects of the 
change which would substantially distort income:
    (i) Deferral of a substantial portion of the taxpayer's income, or 
shifting of a substantial portion of deductions, from one year to 
another so as to reduce substantially the taxpayer's tax liability;
    (ii) Causing a similar deferral or shifting in the case of any other 
person, such as a partner, a beneficiary, or a shareholder in an 
electing small business corporation as defined in selection 1371(b); or
    (iii) Creating a short period in which there is either (a) a 
substantial net operating loss, or (b) in the case of an electing small 
business corporation, a substantial portion of amounts treated as long-
term capital gain.

    Even though a substantial business purpose is not established, the 
Commissioner in appropriate cases may permit a husband or wife to change 
his or her taxable year in order to secure the benefits of section 1(a) 
(relating to tax in case of a joint return). See paragraph (e) of this 
section for special rule for newly married couples.
    (2) Partnerships and partners. (i) A newly-formed partnership may 
adopt a taxable year which is the same as the taxable year of all its 
principal partners (or is the same taxable year to which its principal 
partners who do not have such taxable year concurrently change) without 
securing prior approval from the Commissioner. If all its principal 
partners are not on the same taxable year, a newly-formed partnership 
may adopt a calendar year without securing prior approval from the 
Commissioner. If a newly-formed partnership wishes to adopt a taxable 
year that does not qualify under the preceding two sentences, the 
adoption of such year requires the prior approval of the Commissioner in 
accordance with section 706(b)(1) and paragraph (b) of Sec. 1.706-1. An 
existing partnership may change its taxable year without securing prior 
approval from the Commissioner if all its principal partners have the 
same taxable year to which the partnership changes, or if all its 
principal partners who do not have such a taxable year concurrently 
change to such taxable year. In any other case, an existing partnership 
may not change its taxable year unless it secures the prior approval of 
the Commissioner in accordance with paragraph (b)(1) of this section and 
section 706(b)(1) and paragraph (b) of Sec. 1.706-1.

[[Page 22]]

    (ii) A partner may change his taxable year only if he secures the 
prior approval of the Commissioner in accordance with paragraph (b)(1) 
of this section.
    (3) Certain foreign corporations. Application for approval to change 
such taxable year of either a controlled foreign corporation (as defined 
in section 957 or a foreign corporation that meets the stock ownership 
requirements of a foreign personel holding company (as defined in 
section 552) shall be made by filing an application in accordance with 
paragraph (b)(1) of this section. The application shall be made by one 
or more of such controlled foreign corporation's United States 
shareholders (as defined in section 951(b)), by one or more individuals 
who comprise a foreign corporation's ``United States group''(as defined 
in section 552(a)(2)), or by the respective corporations. In general, a 
change of such a taxable year will be approved if the annual accounting 
period of such controlled foreign corporation or foreign corporation 
meeting the stock ownership requirements of a foreign personal holding 
company is changed to conform to the requirements of foreign law or 
because bona fide foreign business reasons make such a change necessary 
or desirable and the other applicable provisions of paragraph (b)(1) of 
this section are satisfied.
    (c) Special rule for certain corporations. (1) Except as otherwise 
provided in paragraph (c)(4) and (5) of this section and under section 
859, a corporation may change its annual accounting period without the 
prior approval of the commissioner if all the conditions in subparagraph 
(2) of this paragraph are met, and if the corporation files a statement 
with the district director with whom the returns of the corporation are 
filed at or before the time (including extension) for filing the return 
for the short period required by such change. This statement shall 
indicate that the corporation is changing its annual accounting period 
under paragraph (c) of this section and shall contain information 
indicating that all of the conditions in subparagraph (2) of this 
paragraph have been met.
    (2) The provisions of this paragraph do not apply unless all of the 
following conditions are met:
    (i) The corporation has not changed its annual accounting period at 
any time within the ten calendar years ending with the calendar year 
which includes the beginning of the short period required to effect the 
change of annual accounting period;
    (ii) The short period required to effect the change of annual 
accounting period is not a taxable year in which the corporation has a 
net operating loss as defined in section 172;
    (iii) The taxable income of the corporation for the short period 
required to effect the change of annual accounting period is, if placed 
on an annual basis (see paragraph (b)(1) (i) and (ii) of Sec. 1.443-1), 
80 percent or more of the taxable income of the corporation for the 
taxable year immediately preceding such short period;
    (iv) If a corporation had a special status either for the short 
period or for the taxable year immediately preceding such short period, 
it must have the same special status for both the short period and such 
taxable year (for the purpose of this subdivision, special status 
includes only: a personal holding company, a corporation that is an 
exempt organization, a foreign corporation not engaged in a trade or 
business within the United States, a Western Hemisphere trade 
corporation, and a China Trade Act corporation); and
    (v) The corporation does not attempt to make an election under 
section 1372(a) that purports to initially become effective with respect 
to a taxable year which (a) would immediately follow the short period 
required to effect the change of annual accounting period, and (b) would 
begin after August 23, 1972.
    (3) If the Commissioner finds upon examination of the returns that 
the corporation, because of subsequent adjustments in establishing tax 
liability, did not in fact meet all the conditions in subparagraph (2) 
of this paragraph, the statement filed under subparagraph (1) of this 
paragraph shall be considered as a timely application for permission to 
change the corporation's annual accounting period to the taxable year 
indicated in the statement.

[[Page 23]]

    (4) A corporation which is an electing small business corporation 
(as defined in section 1371(b)) or a DISC (as defined in section 
992(a)(1)) during the short period required to effect the change of 
annual accounting period may change its taxable year only if it secures 
the prior approval of the Commissioner in accordance with paragraph 
(b)(1) of this section. This subparagraph shall apply only if such short 
period ends after February 28, 1959. See subparagraphs (3)(ii) and (4) 
of Sec. 1.991-1(b) for special rules relating to the change of a DISC's 
annual accounting period during 1972.
    (5) A controlled foreign corporation (as defined in section 957) or 
a foreign corporation that meets the stock ownership requirements of a 
foreign personal holding company (as defined in section 552) may change 
its taxable year only if it secures the prior approval of the 
Commissioner in accordance with paragraph (b) (1) and (3) of this 
section. A controlled foreign corporation or a foreign corporation that 
meets the stock ownership requirements of a foreign personal holding 
company that is not subject to United States income tax shall be treated 
for the purposes of this section as a taxpayer within the meaning of 
section 7701(a)(14).
    (d) Special rule for change of annual accounting period by 
subsidiary corporation. A subsidiary corporation which is required to 
change its annual accounting period under Sec. 1.1502-76, relating to 
the taxable year of members of an affiliated group which file a 
consolidated return, need not file an application on Form 1128 with 
respect to such change.
    (e) Special rule for newly married couples. (1) A newly married 
husband or wife may change his or her annual accounting period in order 
to adopt the annual accounting period of the other spouse so that a 
joint return may be filed for the first or second taxable year of such 
spouse ending after the date of marriage, provided that the newly 
married husband or wife adopting the annual accounting period of the 
other spouse files a return for the short period required by such change 
on or before the 15th day of the 4th month following the close of such 
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.) The short-
period return shall contain a statement that it is filed under authority 
of this paragraph. For a change of annual accounting period by a husband 
or wife which does not qualify under this subparagraph, see paragraph 
(b) of this section.
    (2) The provisions of this paragraph may be illustrated by the 
following example:

    Example.  H & W marry on September 25, 1956. 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, 1956. H may not change to a 
calendar year for 1956 since, under paragraph (e) of Sec. 1.442-1, he 
would have had to file a return for the short period from July 1 to 
December 31, 1955, by April 15, 1956. Since the date of marriage 
occurred subsequent to this due date, the return could not be filed 
under paragraph (e) of Sec. 1.442-1. Therefore, H cannot change to a 
calendar year for 1956. However, H may change to a calendar year for 
1957 by filing a return under paragraph (e) of Sec. 1.442-1 by April 15, 
1957, for the short period from July 1 to December 31, 1956. If H files 
such a return, H and W may file a joint return for calendar year 1957 
(which is W's second taxable year ending after the date of marriage).

    (f) Effective date. The provisions of this section (other than 
paragraphs (c)(4) and (e) thereof) are effective for any change of 
annual accounting period where the last day of the short period required 
to effect the change ends on or after March 1, 1957. For special rules 
applicable to certain changes of annual accounting period that result in 
a short period ending in 1986 or 1987, see Sec. 1.442-2T. For special 
rules applicable to certain adoptions and retentions of

[[Page 24]]

a taxable year ending in 1986 or 1987, see Sec. 1.442-3T.

(Secs. 860(e), (92 Stat. 2849, 26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 
2850, 26 U.S.C. 860(g)); and sec. 7805 (68A Stat. 917, 26 U.S.C. 7805))
[T.D. 6500, 25 FR 11703, Nov. 26, 1960, as amended by T.D. 6614, 27 FR 
10098, Oct. 13, 1962; T.D. 7235, 37 FR 28624, Dec. 28, 1972; T.D. 7244, 
37 FR 28897, Dec. 30, 1972; T.D. 7286, 38 FR 26911, Sept. 27, 1973; T.D. 
7323, 39 FR 34409, Sept. 25, 1974; T.D. 7470, 42 FR 12178, Mar 3, 1977; 
T.D. 7767, 46 FR 11265, Feb. 6, 1981; T.D. 7936, 49 FR 2106, Jan. 18, 
1984; T.D. 8123, 52 FR 3619, Feb. 5, 1987]



Sec. 1.442-2T  Special limitations on certain changes of annual accounting period (temporary).

    (a) Applicability. This section applies to any taxpayer that wishes 
to change its annual accounting period, or that wishes to adopt an 
annual accounting period described in paragraph (h) of this section. 
This section shall not apply, however, to:
    (1) Any taxpayer to which the provisions of Sec. 1.1502-76 apply 
(other than a taxpayer to which the provisions of paragraph (h) of this 
section apply);
    (2) Any taxpayer to which the provisions of Sec. 1.442-1(e) apply;
    (3) Any taxpayer that wishes to change its annual accounting period 
to a calendar year (including a change under 26 CFR 18.1378-1(b)) or to 
a 52-53-week taxable year that ends with reference to the month of 
December (see, however, Sec. 1.441-3T);
    (4) Any partnership that wishes to change its annual accounting 
period under Sec. 1.706-1(b)(1) to the same taxable year as that of all 
of its principal partners or to which all of its principal partners are 
concurrently changing;
    (5) Any corporation seeking S status that wishes to change its 
annual accounting period under section 4.02 of Rev. Proc. 83-25, 1983-1 
C.B. 689, to the same taxable year as that of shareholders holding more 
than 50 percent of the shares of stock of the corporation or to which 
such shareholders are concurrently changing;
    (6) Any corporation seeking S status that wishes to change its 
annual accounting period under section 4.04 of Rev. Proc. 83-25, 1983-1 
C.B. 689;
    (7) Any taxpayer that wishes to change to a 52-53-week taxable year 
that ends with reference to the same calendar month as that in which the 
former taxable year ended (see, however, Sec. 1.441-3T); or
    (8) Any organization exempt under section 501(a), and any plan 
meeting the requirements for qualification under section 401(a) and 
which is exempt under section 501 (a), except those organizations and 
plans required to file a Form 990-T for the short period involved in the 
change of annual accounting period.
    (b) General rule. A taxpayer to which this section applies may not 
change its annual accounting period under the provisions of--
    (1) Paragraph (c) of Sec. 1.442-1,
    (2) Paragraph (b) of Sec. 1.706-1,
    (3) 26 CFR 18.1378-1(b),
    (4) Rev. Proc. 72-51, 1972-2 C.B. 832, or
    (5) Any revenue procedure issued before September 18, 1986, that, 
without regard to this section, would permit a taxpayer to change its 
taxable year either under a procedure that does not require the prior 
approval of the Commissioner or under expedited procedures for obtaining 
that approval.

Examples of procedures suspended by paragraph (b)(5) of this section 
include Rev. Proc. 84-34, 1984-1 C.B. 508, and those portions of Rev. 
Proc. 83-25, 1983-1 C.B. 689, that apply to changes of annual accounting 
period. In addition, the Commission will not consider a request by a 
taxpayer to which this section applies for approval of a change of 
annual accounting period under Sec. 1.442-1(b)(1) unless the 
requirements of paragraph (e) of this section are satisfied. A taxpayer 
to which this section applies may, however, change its annual accounting 
period without securing the prior approval of the Commissioner if the 
taxpayer can establish a substantial business purpose for the change 
under paragraph (c) of this section and agrees to all of the applicable 
conditions set forth in paragraph (d) of this section.
    (c) Substantial business purpose--(1) General rule. Except as 
provided in paragraph (c)(4) of this section, a taxpayer generally can 
establish a substantial business purpose under this paragraph (c) for a 
change of annual accounting period to any taxable year

[[Page 25]]

that meets the requirements of paragraph (c)(2) of this section. If more 
than one taxable year meets the requirements of paragraph (c)(2), 
however, a taxpayer can establish a substantial business purpose under 
this paragraph (c) only for a change to the year that yields the highest 
percentage when the percentages (rounded to the nearest 1/100 of a 
percent) obtained under paragraph (c)(2) of this section are averaged.
    (2) Mechanical test. A taxable year meets the requirements of this 
paragraph (c)(2) only if, for the most recent 12-month period 
(determined at the time the statement or application required to effect 
or request the change is filed) ending with the last month of the 
requested taxable year and for each of the two preceding 12-month 
periods ending with the corresponding month--
    (i) The gross receipts from sales or services for the last two 
months of such 12-month period equal or exceed 25 percent of--
    (ii) The gross receipts from sales or services for such 12-month 
period.
    (3) Special rules--(i) Gross receipts. For purposes of this section, 
gross receipts from sales or services shall be determined using the 
taxpayer's method of accounting.
    (ii) 52-53-week taxable year. If the requested year is a 52-53-week 
taxable year, the calendar month ending nearest to the last day of the 
52-53-week taxable year shall be treated for purposes of paragraph 
(c)(2) of this section as the last month of the requested year.
    (iii) Taxpayers not in existence for three 12-month periods. If a 
taxpayer has not been in existence for the three 12-month periods 
described in paragraph (c)(2) of this section, the requirements of 
paragraph (c)(2) of this section may be satisfied by taking into account 
the gross receipts from sales and services of a predecessor organization 
(within the meaning of section 4.04 of Rev. Proc. 83-25) that was 
actively engaged in a trade or business at all times during the portion 
of the three applicable 12-month periods prior to the inception of the 
taxpayer. Thus, a taxpayer in existence for only the most recent 
applicable 12-month period may use the gross receipts of a predecessor 
organization for the two preceding 12-month periods.
    (4) Exceptions. The following taxpayers cannot establish a 
substantial business purpose for a change of annual accounting period 
under this section solely by satisfying the requirements of this 
paragraph (c), and, thus, must secure the prior approval of the 
Commissioner to the change:
    (i) A partner of a partnership;
    (ii) A partnership in which any partner is a partnership or S 
corporation;
    (iii) A beneficiary of a trust or estate;
    (iv) A United States shareholder of a controlled foreign 
corporation; and
    (v) A shareholder of a DISC or former DISC.
    (5) Examples. The provisions of this paragraph (c) may be 
illustrated by the following examples.

    Example (1). Assume that X, a calendar year corporation that is not 
described in paragraph (c)(4) of this section, wishes to change its 
annual accounting period to a fiscal year that ends on November 30. If 
the change is permitted under this section, the short period involved in 
the change would end on November 30, 1986. Under paragraph (f) of this 
section, X must attach a statement to its income tax return for the 
short period ending November 30, 1986, in order to effect the change. 
For purposes of paragraph (c)(2) of this section, the most recent 12-
month period ending with the last month of the requested taxable year 
(November), determined as of the time the statement required to effect 
the change is filed, is the period that begins on December 1, 1985, and 
ends on November 30, 1986. The two preceding 12-month periods ending 
with the corresponding month are the periods from December 1, 1984, 
through November 30, 1985, and from December 1, 1983, through November 
30, 1984.
    Example (2). Assume that X, a calendar year corporation that is not 
described in paragraph (c)(4) of this section, wishes to change its 
annual accounting period to a fiscal year that ends on September 30. 
Assume that the most recent 12-month period determined under paragraph 
(c)(2) of this section is the period from October 1, 1985, through 
September 30, 1986, and that the two preceding 12-month periods are the 
periods from October 1, 1984, through September 30, 1985, and from 
October 1, 1983, through September 30, 1984.
    Assume that the gross receipts from sales or services for the last 
two months of the 12-month periods ending on September 30, 1986, 
September 30, 1985, and September 30, 1984,

[[Page 26]]

are $3,500, $3,125, and $2,500, respectively. Assume further that the 
total gross receipts for the 12-month periods ending on September 30, 
1986, September 30, 1985, and September 30, 1984, are $12,500, $12,000, 
and $10,000, respectively. The following percentages are obtained for 
the 12-month periods ending on September 30, 1986, September 30, 1985, 
and September 30, 1984, when the gross receipts for the last two months 
of each period are divided by the total gross receipts for that 12-month 
period: 28.00% ($3,500/$12,500), 26.04% ($3,125/$12,000), and 25.00% 
($2,500/$10,000). Thus, the requirements of paragraph (c)(2) of this 
section are satisfied since each of those percentages equals or exceeds 
25%.
    Example (3). Assume the same facts as in example (2) except that X 
wishes to change its annual accounting period to a fiscal year that ends 
on July 31. In addition, assume that the percentages obtained for 
purposes of paragraph (c)(2) of this section with respect to a fiscal 
year that ends on July 31 are 26.00%, 25.00%, and 25.00%. Under 
paragraph (c)(1) of this section, X can establish a substantial business 
purpose only for a fiscal year that ends on September 30 since the 
average of the percentages obtained under paragraph (c)(2) of this 
section with respect to that year (26.35%) exceeds the average of the 
percentages obtained with respect to a fiscal year that ends on July 31 
(25.33%).

    (d) Conditions. The requirements of this section are in addition to 
any applicable conditions under sections 441, 442, 443, 706, and 1378. 
Thus, for example, a taxpayer must annualize income for the short period 
involved in a change of annual accounting period to which this section 
applies if required to do so under section 443(b). The following 
additional conditions apply under this section to any change of annual 
accounting period made by a corporation (other than an S corporation) 
without the prior approval of the Commissioner:
    (1) If the taxpayer has a net operating loss as defined in section 
172 for the short period involved in the change, that net operating loss 
must be deducted ratably over a six-year period beginning with the first 
taxable year after the short period unless--
    (i) The net operating loss resulting from the short period is 
$10,000 or less, or
    (ii) The net operating loss results from a short period of nine 
months or longer and is less than the net operating loss for a full 12-
month period beginning with the first day of the short period.
    (2) If the taxpayer has an unused credit for the short period, the 
taxpayer must carry the unused credit forward. Unused credits from the 
short period may not be carried back.
    (3) The taxpayer may not make an election to be treated as an S 
corporation that would be effective for the taxable year immediately 
following the short period.
    (e) Prior approval of the Commissioner--(1) In general. The 
Commissioner will not consider a request for approval to a change of 
annual accounting period under this section unless--
    (i) The taxpayer is described in paragraph (c)(4) of this section 
and the taxable year to which the taxpayer wishes to change meets the 
requirements of paragraph (c)(1) of this section, or
    (ii) The taxpayer has experienced a substantial acquisition or 
diverstiture, as defined in paragraph (e)(2) of this section.
    (2) Substantial acquisition or diverstiture--(i) In general. For 
purposes of this paragraph (e), a taxpayer has not experienced a 
substantial acquisition or diverstiture unless--
    (A) The taxpayer has acquired or disposed of a block of assets on or 
after the first day of the taxable year immediately preceeding the short 
period involved in the change of annual accounting period,
    (B) At all times during the applicable 12-month periods (as defined 
in paragraph (e)(2)(iii) of this section), including any period during 
which the assets were not held by the taxpayer, the assets were 
segregated, whether in a separate branch or division or otherwise, so 
that the gross receipts attributable to those assets can be identified, 
and
    (C) The requirements of paragraph (e)(2)(ii) of this section are 
satisfied.

If a taxpayer has experienced a substantial acquisition or diverstiture 
it is anticipated that the Commissioner will usually approve a change of 
annual accounting period to a taxable year that would meet the 
requirements of paragraph (c)(1) of this section if pro-forma gross 
receipts (i.e., gross receipts that would have resulted if the 
acquistion or diverstiture had taken place at the

[[Page 27]]

beginning of the earliest applicable 12-month period) were substituted 
for the gross receipts described in paragraph (c)(2) of this section. 
The failure of a requested taxable year to meet the requirements of 
paragraph (c)(1) when pro-forma gross receipts are used, however, will 
not prevent the Commissioner from approving the change.
    (ii) Mechanical test. A taxpayer has experienced a substantial 
acquisition or diverstiture for purposes of this paragraph (e) only if--
    (A) The aggregate of the gross receipts from sales and services 
(within the meaning of paragraph (c)(3)(i) of this section) for the 
applicable 12-month periods attributable to the acquired or divested 
assets (including receipts for any period during which the assets were 
not held by the taxpayer), exceeds 80 percent of--
    (B) The aggregate of the gross receipts from sales and services 
(within the meaning of paragraph (c)(3)(i) of this section ) of the 
taxpayer for the applicable 12-month periods, determined without taking 
into account the gross receipts from sales and services attributable to 
the acquired or divested assets.
    (iii) Applicable 12-month periods. For purposes of this paragraph 
(e)(2), the term ``applicable 12-month periods'' means--
    (A) In the case of an acquisition, the 12-month periods described in 
paragraph (c)(2) of the section; and
    (B) In the case of divestiture, the 12-month periods described in 
paragraph (c)(2) of this section that end before the date of the 
divestiture.
    (iv) Example. The provisions of this paragraph (e) may be 
illustrated by the following example.

    Example.  Assume that X, a calendar year corporation, wishes to 
change its annual accounting period to a fiscal year ending October 31, 
1986. Assume that on January 1, 1986, X acquired from corporation Y a 
block of assets that Y held in a separate division and that X also holds 
in a separate division. Assume that the most recent 12-month period 
described in paragraph (c)(2) of this section is the period that begins 
on November 1, 1985, and ends on October 31, 1986, and that the two 
preceding 12-month periods are the periods from November 1, 1984 through 
October 31, 1985, and from November 1, 1983, through October 31, 1984. 
Assume that the gross receipts attributable to the assets acquired from 
Y for the 12-month period ending October 31, 1986 (including the 
receipts attributable to the period from November 1, 1985, through 
December 31, 1985, when the assets were held by Y, and the receipts 
attributable to the period from January 1, 1986, through October 31, 
1986, when the assets were held by X), are $8,000. In addition, assume 
that the gross receipts attributable to the assets acquired from Y for 
the 12-month periods ending October 31, 1985, and October 31, 1984, when 
the assets were held by Y, are $7,500, and $7,000, respectively. Assume 
further that X's gross receipts from sales and services for the 12-month 
period ending October 31, 1986, October 31, 1985, and October 31, 1984, 
without taking into account gross receipts attributable to the assets 
acquired from Y, are $10,000, $9,000, and $8,000, respectively. The 
requirements of paragraph (e)(2)(ii) of this section are satisfied since 
$22,500 ($8,000 + $7,500 + $7,000) exceeds 80 percent of $27,000 ($10,00 
+ $9,000 + $8,000). Thus, the Commissioner will consider X's request to 
change its taxable year to a fiscal year ending October 31, 1986.

    (f) Procedures--(1) Changes not requiring the prior approval of the 
Commissioner. In order to effect a change that does not require the 
prior approval of the Commissioner under this section, a taxpayer must 
indicate that the requirements of this section are satisfied in a 
statement setting forth the computations required to establish a 
substantial business purpose under paragraph (c) of this section. The 
statement also must indicate that the taxpayer has agreed to all of the 
applicable conditions to the change, including any applicable conditions 
contained in Sec. 1.441-3T. A taxpayer (other than a corporation seeking 
S status) must attach the statement to the income tax return for the 
short period involved in the change and, in addition, must type or 
legibly print the following caption at the top of page 1 of the return; 
``FILED UNDER Sec. 1.442-2T (f)(1).'' In the case of a corporation 
seeking S status, the statement must be attached to Form 2553 and the 
caption ``FILED UNDER Sec. 1.442-2T (f)(1)'' must be typed or printed 
legibly at the top of page 1 of Form 2553.
    (2) Changes requiring the prior approval of the Commissioner. In the 
case of a change of annual accounting period that requires the prior 
approval of the Commissioner under this section, a taxpayer must file 
Form 1128 or Form

[[Page 28]]

2553, whichever is applicable. (See paragraph (e)(1) of this section for 
situations in which a request for approval will be considered.) The 
taxpayer must indicate that the application is filed under this 
paragraph (f)(2) by typing or printing legibly the following caption at 
the top of page 1 of the Form 1128 or Form 2553: ``FILED UNDER 
Sec. 1.442-2T (f)(2).'' The taxpayer also must attach a statement to the 
applicable form setting forth the computations described in paragraph 
(c) of this section. In addition, a taxpayer described in paragraph 
(e)(1)(ii) of this section must attach a statement setting forth the 
computations described in paragraph (e)(2) of this section.
    (3) Time for filing. (i) Except as otherwise provided in paragraph 
(f)(3)(ii) of this section, a taxpayer cannot change its annual 
accounting period under this section unless the return or form required 
to effect or request the change is filed by its due date (with 
extensions if the change is effected by filing an income tax return for 
the short period involved in the change).
    (ii) A taxpayer may change its annual accounting period under this 
section if the due date (without regard to extensions) for the return or 
form required to effect or request the change is on or after September 
30, 1986, and before March 9, 1987 and the return or form is filed 
before March 9, 1987 (or, in the case of a change effected by filing an 
income tax return for the short period involved in the change, if an 
application for extension is filed before March 9, 1987. This paragraph 
only extends the time for changing an annual accounting period and does 
not extend the time for making an S election. An S election that is 
timely filed before March 9, 1987, however, will not be denied or 
rendered ineffective solely by reason of the need for the taxpayer to 
submit the information required by paragraph (f)(1) or (f)(2) of this 
section.
    (iii) In the case of a change of annual accounting period under this 
section that is effected by filing an income tax return for the short 
period involved in the change, any failure to file a return or to pay 
tax on or before the due date for the return or the date prescribed for 
payment will be treated as due to reasonable cause and will not give 
rise to any addition to tax under section 6651 if--
    (A) The due date for the return (without regard to extensions) or 
the date prescribed for payment is on or after September 30, 1986, and 
before March 9, 1987, and
    (B) The return (or application for extension) is filed and the tax 
is paid before March 9, 1987.
    (g) Effective date--(1) In general. This section shall apply to a 
change of annual accounting period (other than a change described in 
paragraph (g)(2) of this section) if--
    (i) The income tax return for the short period involved in the 
change is filed after September 29, 1986, and
    (ii) The short period involved in the change ends before January 5, 
1987.
    (2) Exceptions. This section shall not apply to a change of annual 
accounting period if the application required to effect or request the 
change was timely filed before September 30, 1986. In the case of a 
change that is effected by filing an income tax return for the short 
period involved in the change, this section shall not apply if an 
application for extension to file that return was filed before September 
30, 1986, the application clearly stated the year to which the taxpayer 
intended to change, and the income tax return for the short period is 
timely filed (determined with regard to extensions).
    (3) Hardship rule. A taxpayer can request a waiver from the 
provisions of this section if the taxpayer can demonstrate, to the 
satisfaction of the Commissioner, that the taxpayer would sustain a 
substantial hardship from the application of this section, and if the 
short period involved in the change ends on or before October 5, 1986. A 
waiver ordinarily will not be granted unless the taxpayer can show that, 
by October 5, 1986, the taxpayer had closed its books in a manner that 
indicates that the period in question was intended to be the end of the 
short period, taken a physical inventory (if applicable), and incurred 
substantial costs in modifying its accounting systems (including, for 
example, costs of reprogramming applicable computer systems) in order to 
change its year. A request for a waiver under this paragraph (g)(3) must 
be filed with the

[[Page 29]]

Commissioner of Internal Revenue, 1111 Constitution Avenue, NW, Room 
5040, Washington, DC 20224 by March 9, 1987. Any information submitted 
with the request for waiver shall be submitted under penalties of 
perjury.
    (h) Anti-abuse rule--(1) In general. A taxpayer may not adopt any 
taxable year that has the effect of circumventing the provisions of this 
section. The provisions of this section are deemed to be circumvented 
if, for example, a taxpayer that is unable to change its taxable year 
under this section transfers a substantial portion of its net assets to 
a related person and the related person purportedly adopts the desired 
taxable year. In that case, purported adoption of the desired taxable 
year will not be given effect and the related person must adopt the same 
taxable year as that of the taxpayer that is unable to change its 
taxable year under this section. For this purpose, the term ``related 
person'' has the same meaning as in section 168(e)(4)(D) (as in effect 
prior to the enactment of the Tax Reform Act of 1986), except that the 
second sentence thereof (relating to the substitution of 10 percent for 
50 percent in applying sections 267(b) and 707(b)(1)) shall be 
disregarded.
    (2) Example. The provisions of paragraph (h)(1) of this section may 
be illustrated with the following example.

    Example.  Assume that X, a calendar year corporation, is subject to 
the restrictions on changes in annual accounting period under this 
section. Assume that X wishes to change its taxable year to a fiscal 
year ending November 30, 1986, but cannot do so because it does not meet 
the requirements of this section. Assume further that X creates 
corporation Y, a wholly-owned subsidiary of X, which purportedly adopts 
a taxable year ending November 30, 1986. In addition, assume that X 
transfers a substantial portion of its net assets to Y before November 
30, 1986, in a transaction described in section 351 or 368. Under these 
facts, Y may not adopt a November 30 taxable year and instead must adopt 
a taxable year that ends on December 31, which is the taxable year of X.
[T.D. 8123, 52 FR 3619, Feb. 5, 1987]



Sec. 1.442-3T  Special limitations on certain adoptions and retentions of a taxable year (temporary).

    (a) Applicability. This section generally applies to--
    (1) Any partnership that wishes to adopt a taxable year other than 
the calendar year, the taxable year of its principal partners, or the 
taxable year to which all of its principal partners are concurrently 
changing, and
    (2) Any corporation seeking S status that wishes to adopt or retain 
a taxable year other than the calender year or a taxable year that meets 
the requirements of section 4.02 or 4.04 of Rev. Proc. 83-25, 1983-1 
C.B. 689.
    (b) General rule. A taxpayer to which this section applies may not 
adopt or retain a taxable year that results in any deferral of income to 
its partners or shareholders unless the taxpayer--
    (1) Secures the prior approval of the Commissioner by establishing a 
substantial business purpose under paragraph (c)(2) of this section for 
the adoption or retention, or
    (2) Is permitted to adopt or retain the taxable year without 
securing the prior approval of the Commissioner under paragraph (c)(1) 
of this section.

Thus, a taxpayer to which this section applies may not adopt or retain a 
taxable year that results in a deferral of income to its partners or 
shareholders under Rev. Proc. 72-51, 1972-2 C.B. 832, or section 4.03 of 
Rev. Proc. 83-25, 1983-1 C.B. 689.
    (c) Substantial business purpose--(1) Prior approval of the 
Commissioner not needed. Notwithstanding Sec. 1.706-1(b), Sec. 1.442-
1(b)(2), and 26 CFR 18.1378-1(a), a taxpayer to which this section 
applies may adopt or retain a taxable year that results in a deferral of 
income to its partners or shareholders without the prior approval of the 
Commissioner if the taxpayer can establish a substantial business 
purpose under Sec. 1.442-2T(c). Thus, a taxpayer described in 
Sec. 1.442-2T(c)(4) must secure the prior approval of the Commissioner 
to the adoption or retention even if the requirements of Sec. 1.442-
2T(c)(1) are satisfied. A taxpayer shall effect an adoption or retention 
permitted under this paragraph (c)(1) in the manner prescribed by 
Sec. 1.442-2T(f)(1), except that the taxpayer's first income tax return 
shall be treated as the return for the short period involved in a change 
of annual accounting period.
    (2) Prior approval of the Commissioner. In any case where the 
taxpayer was in

[[Page 30]]

existence for the three 12-month periods described in Sec. 1.442-
2T(c)(2), or where a predecessor organization (within the meaning of 
Sec. 4.04 of Rev. Proc. 83-25) was actively engaged in a trade or 
business at all times during the portion of those three 12-month periods 
prior to the inception of the taxpayer, the Commissioner will consider a 
request for prior approval of an adoption or retention of a taxable year 
that results in a deferral of income to its partners or shareholders 
only if the taxpayer is described in Sec. 1.442-2T(e). In such a case, 
the application for approval shall be filed in the manner prescribed by 
Sec. 1.442-2T(f)(2). In any other case, the taxpayer must establish a 
substantial business purpose in order to obtain the prior approval of 
the Commissioner, and must file an application for approval in 
accordance with Sec. 1.706-1(b) or 26 CFR 18.1378-1(a) (whichever is 
applicable) and Sec. 1.442-1T(b)(1). For this purpose, the following 
factors generally will not be sufficient to establish a substantial 
business purpose:
    (i) The use of a particular year for regulatory or financial 
accounting purposes;
    (ii) The hiring patterns of a particular business (e.g., the fact 
that a firm typically hires staff during certain times of the year);
    (iii) The use of a particular year for administrative purposes, such 
as for the admission or retirement of partners or shareholders, 
promotion of staff, and compensation or retirement arrangements with 
staff, partners, or shareholders; and
    (iv) The fact that a particular business involves the use of price 
lists, model year, or other items that change on an annual basis.
    (d) Time for filing. (1) Except as otherwise provided in paragraph 
(d)(2) of this section, a taxpayer cannot adopt or retain a taxable year 
under this section unless the return or form required to effect or 
request the adoption or retention is filed by its due date (with 
extensions if the adoption is effected by filing an income tax return 
for the taxpayer's first taxable year).
    (2) A taxpayer may adopt or retain a taxable year under this section 
if the due date (without regard to extensions) for the return or form 
required to effect or request the adoption or retention is on or after 
November 6, 1986, and before March 9, 1987, and the return or form is 
filed before March 9, 1987 (or, in the case of an adoption effected by 
filing an income tax return for the taxpayer's first taxable year, if an 
application for extension is filed before March 9, 1987). This paragraph 
(d)(2) only extends the time for adopting or retaining a taxable year 
and does not extend the time for making an S election. An S election 
that is timely filed before March 9, 1987, however, will not be denied 
or rendered ineffective solely by reason of the need for the taxpayer to 
submit the information required by paragraph (c) of this section.
    (3) In the case of an adoption or retention of a taxable year under 
this section that is effected by filing an income tax return for the 
taxpayer's first taxable year, any failure to file a return or to pay 
tax on or before the due date for the return or the date prescribed for 
payment will be treated as due to reasonable cause and will not give 
rise to any addition to tax under section 6651 if--
    (i) The due date for the return (without regard to extensions) or 
the date prescribed for payment is on or after November 6, 1986, and 
before March 9, 1987, and
    (ii) The return (or application for extension) is filed and the tax 
is paid before March 9, 1987.
    (e) Effective date. This section generally applies if the first 
taxable year of the partnership or the first taxable year for which the 
election to be an S corporation is effective begins before January 1, 
1987, unless the application necessary to effect or request the adoption 
or retention was timely filed before November 6, 1986. This section 
shall not apply, however, to an adoption by a partnership of a taxable 
year that begins before January 1, 1986.
[T.D. 8123, 52 FR 3622, Feb. 5, 1987]



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:

[[Page 31]]

    (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 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 paragraph (c)(5) of Sec. 1.441-2.
    (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

[[Page 32]]

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                                      
 respect to which a credit is allowable                                 
 under section 35......................  ........  .........      500.00
Dividends to which sections 34 and 116                                  
 are applicable........................  ........  .........      750.00
                                                             -----------
                                                               11,250.00
               Deductions                                               
Real estate taxes......................  ........  .........      200.00
2 personal exemptions at $600 on an                                     
 annual basis..........................  ........  .........    1,200.00
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 ($1,200 x \10/                                  
   12\)................................  ........   1,000.00            
  Real estate taxes....................  ........     200.00            
                                                    --------    1,250.00
                                                             -----------
    Taxable income for 10-month period                                  
     before annualizing................  ........  .........   10,000.00
Taxable income annualized (10,000 x \12/                                
 10\)..................................  ........  .........   12,000.00
Tax on $12,000 before credits..........  ........  .........    3,400.00
Deduct credits:                                                         
  Dividends received for 10-month                                       
   period..............................   $750.00                       
  Less: Excluded portion...............     50.00                       
                                        ----------                      
  Included in gross income.............    700.00                       
  Dividend income annualized ($700 x                                    
   \12/10\)............................    840.00                       
  Credit (4 percent of $840)...........  ........      33.60            
  Partially tax-exempt interest                                         
   included in gross income for 10-                                     
   month period........................    500.00                       
  Partially tax-exempt interest                                         
   (annualized) ($500 x \12/10\).......    600.00                       
  Credit (3 percent of $600)...........  ........      18.00            
                                                    --------       51.60
                                                             -----------
    Tax on $12,000 (after credits).....  ........  .........    3,348.40
                                                             -----------
Tax for 10-month period ($3,348.40 x                                    
 \10/12\)..............................  ........  .........    2,790.33
------------------------------------------------------------------------
                                                                        

    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 in excess of 85 percent of                            
 $26,000).........................................     22,100           
                                                   ------------         
  Taxable income for short period before                                
   annualizing....................................      3,900           
Taxable income annualized ($8,900 x 12)...........     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 ($18,836 x \1/12\)....................      1,570
                                                                        

    Example (3). The Y Corporation makes a re- turn for the six-month 
period ending June 30,

[[Page 33]]

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 ($50,000 x \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 ($46,500 x \6/12\)....................     23,250
                                                                        
                                                   ============         
            Alternative tax computation                                 
                                                                        
Taxable income annualized....................................   100,000 
Less annualized capital gain ($10,000 x \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 ($41,100 x \6/                       
 12\).............................................     20,550           
                                                                        

    Since the alternative tax of $20,550 is less than the tax computed 
in the regular manner ($23,250), the corporation's tax for the 6-month 
short period is $20,550.

    (2) Exception: computation based on 12-month period. (i) A taxpayer 
whose tax would otherwise be computed under section 443(b)(1) (or 
section 441(f)(2)(B)(iii) in the case of certain changes from or to a 
52-53-week taxable year) for the short period resulting from a change of 
annual accounting period may apply to the district director to have his 
tax computed under the provisions of section 443(b)(2) and this 
subparagraph. If such application is made, as provided in subdivision 
(v) of this subparagraph, and if the taxpayer establishes the amount of 
his taxable income for the 12-month period described in subdivision (ii) 
of this subparagraph, then the tax for the short period shall be the 
greater of the following--
    (a) An amount which bears the same ratio to the tax computed on the 
taxable income which the taxpayer has established for the 12-month 
period as the taxable income computed on the basis of the short period 
bears to the taxable income for such 12-month period; or
    (b) The tax computed on the taxable income for the short period 
without placing the taxable income on an annual basis.

However, if the tax computed under section 443(b)(2) and this 
subparagraph is not less than the tax for the short period computed 
under section 443(b)(1) (or section 441(f)(2)(B)(iii) in the case of 
certain changes from or to a 52-53-week taxable year), then section 
443(b)(2) and this subparagraph do not apply.
    (ii) The term ``12-month period'' referred to in subdivision (i) of 
this subparagraph means the 12-month period beginning on the first day 
of the short period. However, if the taxpayer is not in existence at the 
end of such 12-month period, or if the taxpayer is a corporation which 
has disposed of substantially all of its assets before the end of such 
12-month period, the term ``12-month period'' means the 12-month period 
ending at the close of the last day of the short period. For the 
purposes of the preceding sentence, a corporation which has ceased 
business and distributed so much of the assets used in its business that 
it cannot resume its customary operations with the remaining assets, 
will be considered to have disposed of substantially all of its assets. 
In the case of a change from a 52-53-week taxable year, the term ``12-
month period'' means the period of 52 or 53 weeks (depending on the 
taxpayer's 52-53-week taxable year) beginning on the first day of the 
short period.
    (iii)(a) The taxable income for the 12-month period is computed 
under the same provisions of law as are applicable to the short period 
and is computed as if the 12-month period were an actual annual 
accounting period of the taxpayer. All items which fall in such 12-month 
period must be included even if they are extraordinary in amount or of 
an unusual nature. If the taxpayer is a member of a partnership, his 
taxable income for the 12-month period shall include his distributive 
share of partnership income for any taxable year of the partnership 
ending within or with such 12-month period, but no amount

[[Page 34]]

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-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            
 is allowable under section 35................................       600
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                  
 $600)................................................      18          
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            
 paragraph (b)(1)(vii) of this section before annualizing.....    10,000
Tax for short period under section 443(b)(2)(A)(i) ($2,970 x            
 $10,000 (taxable income for short period)/$11,000 (taxable             
 income for 12-month period)).................................     2,700
                                                                        
        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               
   without proration of personal exemptions...................     9,800
Tax before credits............................................     2,572
Less credits:                                                           
  Partially tax-exempt interest (3 percent of $500)...      15          
  Dividends received (4 percent of ($750-50)).........      28          
                                                       --------         

[[Page 35]]

                                                                        
                                                                43rn,n,s
    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                          
 period.............................................     1,310          
                                                     ===========        
Tax for short period ($1,310 x  $10,000/$6,000)                         
 under section 443(b)(2)(A)(i)......................     2,183          
                                                                        
   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             
   without proration of personal exemptions...................     9,800
Tax before credits............................................     2,572
Less credits:                                                           
  Partially tax-exempt interest (3 percent of $500).        15          
  Dividends received (4 percent of $750-50))........        28          
                                                     -----------        
                                                                      43
                                                               ---------
Tax for short period under section 443(b)(2)(A)(ii)...........     2,529
                                                                        


The tax of $2,529, computed under section 443(b)(2)(A)(ii) is greater 
than the tax of $2,183 computed under section 443(b)(2)- (A)(i) and is, 
therefore, the tax under section 443(b)(2). Since this tax is less than 
the tax of $2,790.33, computed under section 443(b)(1) (see example (1) 
of paragraph (b)(1)(vii) of this section), the taxpayer's tax for the 
10-month short period is $2,529.

    (v)(a) A taxpayer who wishes to compute his tax for a short period 
resulting from a change of annual accounting period under section 
443(b)(2) must make an application therefor. Except as provided in (b) 
of this subdivision, the taxpayer shall first file his return for the 
short period and compute his tax under section 443(b)(1). The 
application for the benefits of section 443(b)(2) shall subsequently be 
made in the form of a claim for credit or refund. The claim shall set 
forth the computation of the taxable income and the tax thereon for the 
12-month period and must be filed not later than the time (including 
extensions) prescribed for filing the return for the taxpayer's first 
taxable year which ends on or after the day which is 12 months after the 
beginning of the short period. For example, assume that a taxpayer 
changes his annual accounting period from the calendar year to a fiscal 
year ending September 30, and files a return for the short period from 
January 1, 1956, to September 30, 1956. His application for the benefits 
of section 443(b)(2) must be filed not later than the time prescribed 
for filing his return for his first taxable year which ends on or after 
the last day of December 1956, the twelfth month after the beginning of 
the short period. Thus, the taxpayer must file his application not later 
than the time prescribed for filing the return for his fiscal year 
ending September 30, 1957. If he obtains an extension of time for filing 
the return for such fiscal year, he may file his application during the 
period of such extension. If the district director determines that the 
taxpayer has established the amount of his taxable income for the 12-
month period, any excess of the tax paid for the short period over the 
tax computed under section 443(b)(2) will be credited or refunded to the 
taxpayer in the same manner as in the case of an overpayment.
    (b) If at the time the return for the short period is filed, the 
taxpayer is able to determine that the 12-month period ending with the 
close of the short period (see section 443(b)(2)- (B)(ii) and 
subparagraph (2)(ii) of this

[[Page 36]]

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 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]



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.

[[Page 37]]

    (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.

     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-
4T(d)) 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

[[Page 38]]

election shall file returns and make payments as required by 
Secs. 1.7519-1T and 1.7519-2T. A personal service corporation that makes 
or continues a section 444 election is subject to the deduction 
limitation of Sec. 1.280H-1T.
    (ii) Duration of section 444 election. A section 444 election shall 
remain in effect until the election is terminated pursuant to paragraph 
(a)(5) of this section.
    (3) Section 444 election not required for certain years. A 
partnership, S corporation, or personal service corporation is not 
required to make a section 444 election to use--
    (i) A taxable year for which such entity establishes a business 
purpose to the satisfaction of the Commissioner (i.e., approved under 
section 4 or 6 of Rev. Proc. 87-32, 1987-28 I.R.B. 14, or any successor 
revenue ruling or revenue procedure), or
    (ii) A taxable year that is a ``grandfathered fiscal year,'' within 
the meaning of section 5.01(2) of Rev. Proc. 87-32 or any successor 
revenue ruling or revenue procedure.

Although a partnership, S corporation or personal service corporation 
qualifies to use a taxable year described in paragraph (a)(3) (i) or 
(ii) of this section, such entity may, if otherwise qualified, make a 
section 444 election to use a different taxable year. Thus, for example, 
assume that a personal service corporation that historically used a 
January 31 taxable year established to the satisfaction of the 
Commissioner, under section 6 of Rev. Proc. 87-32, a business purpose to 
use a September 30 taxable year for its taxable year beginning February 
1, 1987. Pursuant to this paragraph (a)(3), such personal service 
corporation may use a September 30 taxable year without making a section 
444 election. However, the corporation may, if otherwise qualified, make 
a section 444 election to use a year ending other than September 30 for 
its taxable year beginning February 1, 1987.
    (4) Required taxable year. For purposes of this section, the term 
``required taxable year'' means the taxable year determined under 
section 706(b), 1378, or 441(i) without taking into account any taxable 
year which is allowable either--
    (i) By reason of business purpose (i.e., approved under section 4 or 
6 of Rev. Proc. 87-32 or any successor revenue ruling or procedure), or
    (ii) As a ``grandfathered fiscal year'' within the meaning of 
section 5.01(2) of Rev. Proc. 87-32, or any successor revenue ruling or 
procedure.
    (5) Termination of section 444 election--(i) In general. A section 
444 election is terminated when--
    (A) A partnership, S corporation, or personal service corporation 
changes to its required taxable year; or
    (B) A partnership, S corporation, or personal service corporation 
liquidates (including a deemed liquidation of a partnership under 
Sec. 1.708-1 (b)(1)(iv)); or
    (C) A partnership, S corporation, or personal service corporation 
willfully fails to comply with the requirements of section 7519 or 280H, 
whichever is applicable; or
    (D) A partnership, S corporation, or personal service corporation 
becomes a member of a tiered structure (within the meaning of 
Sec. 1.444-2T), unless it is a partnership or S corporation that meets 
the same taxable year exception under Sec. 1.444-2T (e); or
    (E) An S corporation's S election is terminated; or
    (F) A personal service corporation ceases to be a personal service 
corporation.

However, if a personal service corporation, that has a section 444 
election in effect, elects to be an S corporation, the S corporation may 
continue the section 444 election of the personal service corporation. 
Similarly, if an S corporation that has a section 444 election in effect 
terminates its S election and immediately becomes a personal service 
corporation, the personal service corporation may continue the section 
444 election of the S corporation. If a section 444 election is 
terminated under this paragraph (a)(5), the partnership, S corporation, 
or personal service corporation may not make another section 444 
election for any taxable year.
    (ii) Effective date of termination. A termination of a section 444 
election shall be effective--
    (A) In the case of a change to the required year, on the first day 
of the short year caused by the change;

[[Page 39]]

    (B) In the case of a liquidating entity, on the date the liquidation 
is completed for tax purposes;
    (C) In the case of willful failure to comply, on the first day of 
the taxable year (determined as if a section 444 election had never been 
made) determined in the discretion of the District Director;
    (D) In the case of membership in a tiered structure, on the first 
day of the taxable year in which the entity is considered to be a member 
of a tiered structure, or such other taxable year determined in the 
discretion of the District Director;
    (E) In the case of termination of S status, on the first day of the 
taxable year for which S status no longer exists;
    (F) In the case of a personal service corporation that changes 
status, on the first day of the taxable year, for which the entity is no 
longer a personal service corporation.

In the case of a termination under this paragraph (a)(5) that results in 
a short taxable year, an income tax return is required for the short 
period. In order to allow the Service to process the affected income tax 
return in an efficient manner, a partnership, S corporation, or personal 
service corporation that files such a short period return should type or 
legibly print at the top of the first page of the income tax return for 
the short taxable year--``SECTION 444 ELECTION TERMINATED.'' In 
addition, a personal service corporation that changes its taxable year 
to the required taxable year is required to annualize its income for the 
short period.
    (iii) Example. The provisions of paragraph (a)(5)(ii) of this 
section may be illustrated by the following example.

    Example.  Assume a partnership that is 100 percent owned, at all 
times, by calendar year individuals has historically used a June 30 
taxable year. Also assume the partnership makes a valid section 444 
election to retain a year ending June 30 for its taxable year beginning 
July 1, 1987. However, for its taxable year beginning July 1, 1988, the 
partnership changes to a calendar year, its required year. Based on 
these facts, the partnership's section 444 election is terminated on 
July 1, 1988, and the partnership must file a short period return for 
the period July 1, 1988-December 31, 1988. Furthermore, pursuant to 
Sec. 1.702-3T(a)(1), the partners in such partnership are not entitled 
to a 4-year spread with respect to partnership items of income and 
expense for the taxable year beginning July 1, 1988 and ending December 
31, 1988.

    (iv) Special rule for entity that liquidates or is sold prior to 
making a section 444 election, required return, or required payment. A 
partnership, S corporation, or personal service corporation that is 
liquidated or sold for tax purposes before a section 444 election, 
required return, or required payment is made for a particular year may, 
nevertheless, make or continue a section 444 election, if otherwise 
qualified. (See Secs. 1.7519-2T (a)(2) and 1.7519-1T (a)(3), 
respectively, for a description of the required return and a definition 
of the term ``required payment.'') However, the partnership, S 
corporation, or personal service corporation (or a trustee or agent 
thereof) must comply with the requirements for making or continuing a 
section 444 election. Thus, if applicable, required payments must be 
made and a subsequent claim for refund must be made in accordance with 
Sec. 1.7519-2T(a)(6). The following examples illustrate the application 
of this paragraph (a)(5)(iv).

    Example (1). Assume an existing S corporation historically used a 
June 30 taxable year and desires to make a section 444 election for its 
taxable year beginning July 1, 1987. Assume further that the S 
corporation is liquidated for tax purposes on February 15, 1988. If 
otherwise qualified, the S corporation (or a trustee or agent thereof) 
may make a section 444 election to have a taxable year beginning July 1, 
1987, and ending February 15, 1988. However, if the S corporation makes 
a section 444 election, it must comply with the requirements for making 
a section 444 election, including making required payments.
    Example (2). The facts are the same as in example (1), except that 
instead of liquidating on February 15, 1988, the shareholders of the S 
corporation sell their stock to a corporation on February 15, 1988. 
Thus, the corporation's S election is terminated on February 15, 1988. 
If otherwise qualified, the corporation may make a section 444 election 
to have a taxable year beginning July 1, 1987, and ending February 14, 
1988.
    Example (3). The facts are the same as in example (2), except that 
the new shareholders are individuals. Furthermore, the corporation's S 
election is not terminated. Based on these facts, the S corporation, if 
otherwise qualified, may make a section 444 election to retain a year 
ending June 30 for

[[Page 40]]

its taxable year beginning July 1, 1987. Furthermore, the S corporation 
may, if otherwise qualified, continue its section 444 election for 
subsequent taxable years.

    (6) Re-activating certain S elections--(i) Certain corporations 
electing S status that did not make a back-up calendar year request. If 
a corporation that timely filed Form 2553, Election by a Small Business 
Corporation, effective for its first taxable year beginning in 1987--
    (A) Requested a fiscal year based on business purpose,
    (B) Did not agree to use a calendar year in the event its business 
purpose request was denied, and
    (C) Such business purpose request is denied or withdrawn,

such corporation may retroactively re-activate its S election by making 
a valid section 444 election for its first taxable year beginning in 
1987 and complying with the procedures in paragraph (a)(6)(iii) of this 
section.
    (ii) Certain corporations that revoked their S status. If a 
corporation that used a fiscal year revoked its S election (pursuant to 
section 1362(d)(1)) for its first taxable year beginning in 1987, such 
corporation may retroactively re-activate its S election (i.e. rescind 
its revocation) by making a valid section 444 election for its first 
taxable year beginning in 1987 and complying with the procedures in 
paragraph (a)(6)(iii) of this section.
    (iii) Procedures for re-activating an S election. A corporation re-
activating its S election pursuant to paragraph (a)(6) (i) or (ii) of 
this section must--
    (A) Obtain the consents of all shareholders who have owned stock in 
the corporation since the first day of the first taxable year of the 
corporation beginning after December 31, 1986,
    (B) Include the following statement at the top of the first page of 
the corporation's Form 1120S for its first taxable year beginning in 
1987--``SECTION 444 ELECTION--RE-ACTIVATES S STATUS,'' and
    (C) Include the following statement with Form 1120S--``RE-ACTIVATION 
CONSENTED TO BY ALL SHAREHOLDERS WHO HAVE OWNED STOCK AT ANY TIME SINCE 
THE FIRST DAY OF THE FIRST TAXABLE YEAR OF THIS CORPORATION BEGINNING 
AFTER DECEMBER 31, 1986.''
    (iv) Examples. The provisions of this paragraph (a)(6) may be 
illustrated by the following examples.

    Example (1). Assume a corporation historically used a June 30 
taxable year and such corporation timely filed Form 2553, Election by a 
Small Business Corporation, to be effective for its taxable year 
beginning July 1, 1987. On its Form 2553, the corporation requested 
permission to retain its June 30 taxable year based on business purpose. 
However, the corporation did not agree to use a calendar year in the 
event its business purpose request was denied. On April 1, 1988, the 
Internal Revenue Service notified the corporation that its business 
purpose request was denied and therefore the corporation's S election 
was not effective. Pursuant to paragraph (a)(6)(i) of this section, the 
corporation may re-activate its S election by making a valid section 444 
election and complying with the procedures in paragraph (a)(6)(iii) of 
this section.
    Example (2). The facts are the same as in example (1), except that 
as of July 26, 1988, the Internal Revenue Service has not yet determined 
whether the corporation has a valid business purpose to retain a June 30 
taxable year. Based on these facts, the corporation may, if otherwise 
qualified, make a back-up section 444 election as provided in 
Sec. 1.444-3T(b)(4). If the corporation's business purpose request is 
subsequently denied, the corporation should follow the procedures in 
Sec. 1.444-3T(b)(4)(iii) for activating a back-up section 444 election 
rather than the procedures provided in this paragraph (a)(6 for re-
activating an S election.
    Example (3) . Assume a corporation has historically been an S 
corporation with a March 31 taxable year. However, for its taxable year 
beginning April 1, 1987, the corporation revoked its S election pursuant 
to section 1362 (d)(1). Pursuant to paragraph (a)(6)(ii) of this 
section, such corporation may retroactively rescind its S election 
revocation by making a valid section 444 election for its taxable year 
beginning April 1, 1987, and complying with the procedures provided in 
paragraph (a)(6)(iii) of this section. If the corporation retroactively 
rescinds its S revocation, the corporation shall file a Form 1120S for 
its taxable year beginning April 1, 1987.

    (b) Limitation on taxable years that may be elected--(1) General 
rule. Except as provided in paragraphs (b)(2) and (3) of this section, a 
section 444 election may be made only if the deferral period (as defined 
in paragraph (b)(4) of this section) of the taxable year to be elected 
is not longer than three months.

[[Page 41]]

    (2) Changes in taxable year--(i) In general. In the case of a 
partnership, S corporation, or personal service corporation changing its 
taxable year, such entity may make a section 444 election only if the 
deferral period of the taxable year to be elected is not longer than the 
shorter of--
    (A) Three months, or
    (B) The deferral period of the taxable year that is being changed, 
as defined in paragraph (b)(2)(iii) of this section.
    (ii) Special rule for certain existing corporations electing S 
status. If a corporation with a taxable year other than the calendar 
year--
    (A) Elected after September 18, 1986, and before January 1, 1988, 
under section 1362 of the Code to be an S corporation, and
    (B) Elected to have the calendar year as the taxable year of the S 
corporation,

then, for taxable years beginning before 1989, paragraph (b)(2)(i) of 
this section shall be applied by taking into account the deferral period 
of the last taxable year of the corporation prior to electing to be an S 
corporation, rather than the deferral period of the taxable year that is 
being changed. Thus, the provisions of the preceding sentence do not 
apply to a corporation that elected to be an S corporation for its first 
taxable year.
    (iii) Deferral period of the taxable year that is being changed. For 
purposes of paragraph (b)(2)(i)(B) of this section, the phrase 
``deferral period of the taxable year that is being changed'' means the 
deferral period of the taxable year immediately preceding the taxable 
year for which the taxpayer desires to make a section 444 election. 
Furthermore, the deferral period of such year will be determined by 
using the required taxable year of the taxable year for which the 
taxpayer desires to make a section 444 election. For example, assume P, 
a partnership that has historically used a March 31 taxable year, 
desires to change to a September 30 taxable year by making a section 444 
election for its taxable year beginning April 1, 1987. Furthermore, 
assume that pursuant to paragraph (a)(4) of this section, P's required 
taxable year for the taxable year beginning April 1, 1987 is a year 
ending December 31. Based on these facts the deferral period of the 
taxable year being changed is nine months (the period from March 31 to 
December 31).
    (iv) Examples. See paragraph (d)(1) of this section for examples 
that illustrate the provisions of this paragraph (b)(2).
    (3) Special rule for entities retaining 1986 taxable year. 
Notwithstanding paragraph (b)(2) of this section, a partnership, S 
corporation, or personal service corporation may, for its first taxable 
year beginning after December 31, 1986, if otherwise qualified, make a 
section 444 election to have a taxable year that is the same as the 
entity's last taxable year beginning in 1986. See paragraph (d)(2) of 
this section for examples that illustrate the provisions of this 
paragraph (b)(3).
    (4) Deferral period--(i) Retentions of taxable year. For a 
partnership, S corporation, or personal service corporation that desires 
to retain its taxable year by making a section 444 election, the term 
``deferral period'' means the months between the beginning of such year 
and the close of the first required taxable year (as defined in 
paragraph (a)(4) of this section). The following example illustrates the 
application of this paragraph (b)(4)(i).

    Example.  AB partnership has historically used a taxable year ending 
July 31. AB desires to retain its July 31 taxable year by making a 
section 444 election for its taxable year beginning August 1, 1987. 
Calendar year individuals, A and B, each own 50 percent of the profits 
and capital of AB; thus, under paragraph (a)(4) of this section AB's 
required taxable year is the year ending December 31. Pursuant to this 
paragraph (b)(4)(i), if AB desires to retain its year ending July 31, 
the deferral period is five months (the months between July 31 and 
December 31).

    (ii) Adoptions of and changes in taxable year--(A) In general. For a 
partnership, S corporation, or personal service corporation that desires 
to adopt or change its taxable year by making a section 444 election, 
the term ``deferral period'' means the months that occur after the end 
of the taxable year desired under section 444 and before the close of 
the required taxable year.
    (B) Special rule. If a partnership, S corporation or personal 
service corporation is using the required taxable

[[Page 42]]

year as its taxable year, the deferral period is deemed to be zero.
    (C) Examples. The provisions of this paragraph (b)(4)(ii) may be 
illustrated by the following examples.

    Example (1). Assume that CD partnership has historically used the 
calendar year and that CD's required taxable year is the calendar year. 
Under the special rule provided in paragraph (b)(4)(ii)(B) of this 
section, CD's deferral period is zero. See paragraph (b)(2)(i) of this 
section for rules that preclude CD from making a section 444 election to 
change its taxable year.
    Example (2). E, a newly formed partnership, began operations on 
December 1, 1987, and is owned by calendar year individuals. E desires 
to make a section 444 election to adopt a September 30 taxable year. E's 
required taxable year is December 31. Pursuant to paragraph 
(b)(4)(ii)(A) of this section E's deferral period for the taxable year 
beginning December 1, 1987, is three months (the number of months 
between September 30 and December 31).
    Example (3). Assume that F, a personal service corporation, has 
historically used a June 30 taxable year. F desires to make a section 
444 election to change to an August 31 taxable year, effective for its 
taxable year beginning July 1, 1987. For purposes of determining the 
availability of a section 444 election for changing to the taxable year 
ending August 31, the deferral period of an August 31 taxable year is 
four months (the number of months between August 31 and December 31). 
The deferral period for F's existing June 30 taxable year is six months 
(the number of months between June 30 and December 31). Pursuant to 
Sec. 1.444-1T(b)(2)(i), F may not make a section 444 election to change 
to an August 31 taxable year.

    (5) Miscellaneous rules--(i) Special rule for determining the 
taxable year of a corporation electing S status. For purposes of this 
section, and only for purposes of this section, a corporation that 
elected to be an S corporation for a taxable year beginning in 1987 or 
1988 and which elected to be an S corporation prior to September 26, 
1988, will not be considered to have adopted or changed its taxable year 
by virtue of information included on Form 2553, Election by a Small 
Business Corporation. See example (8) in paragraph (d) of this section.
    (ii) Special procedure for cases where an income tax return is 
superseded--(A) In general. In the case of a partnership, S corporation, 
or personal service corporation that filed an income tax return for its 
first taxable year beginning after December 31, 1986, but subsequently 
makes a section 444 election that would result in a different year end 
for such taxable year, the income tax return filed pursuant to the 
section 444 election will supersede the original return. However, any 
payments of income tax made with respect to such superseded return will 
be credited to the taxpayer's superseding return and the taxpayer may 
file a claim for refund for such payments. See examples (5) and (7) in 
paragraph (d)(2) of this section.
    (B) Procedure for superseding return. In order to allow the Service 
to process the affected income tax returns in an efficient manner, a 
partnership, S corporation, or personal service corporation that desires 
to supersede an income tax return in accordance with paragraph 
(b)(5)(ii)(A) of this section, should type or legibly print at the top 
of the first page of the income tax return for the taxable year 
elected--``SECTION 444 ELECTION--SUPERSEDES PRIOR RETURN.''
    (iii) Anti-abuse rule-- If an existing partnership, S corporation or 
personal service corporation (``predecessor entities''), or the owners 
thereof, transfer assets to a related party and the principal purpose of 
such transfer is to--
    (A) Create a deferral period greater than the deferral period of the 
predecessor entity's taxable year, or
    (B) Make a section 444 election following the termination of the 
predecessor entity's section 444 election,

then such transfer will be disregarded for purposes of section 444 and 
this section, even if the deferral created by such change is effectively 
eliminated by a required payment (within the meaning of section 7519) or 
deferral of a deduction (to a personal service corporation under section 
280H). The following example illustrates the application of this 
paragraph (b)(5)(iii).

    Example. Assume that P1 is a partnership that historically used the 
calendar year and is owned by calendar year partners. Assume that P1 
desires to make a section 444 election to change to a September year for 
the taxable year beginning January 1, 1988. P1 may not make a section 
444 election to change taxable years under section 444(b)(2) because its 
current deferral period is zero.

[[Page 43]]

Assume further that P1 transfers a substantial portion of its assets to 
a newly-formed partnership (P2), which is owned by the partners of P1. 
Absent paragraph (b)(5)(iii) of this section, P2 could, if otherwise 
qualified, make a section 444 election under paragraph (b)(1) of this 
section to use a taxable year with a three month or less deferral period 
(i.e., a September 30, October 31, or November 30 taxable year). 
However, if the principal purpose of the asset transfer was to create a 
one-, two-, or three-month deferral period by P2 making a section 444 
election, the section 444 election shall not be given effect, even if 
the deferral would be effectively eliminated by P2 making a required 
payment under section 7519.

    (iv) Special rules for partial months and 52-53-week taxable years. 
Except as otherwise provided in Sec. 1.280H-1T(c)(2)(i)(A), for purposes 
of this section and Secs. 1.7519-1T, 1.7519-2T and 1.280H-1T--
    (A) A month of less than 16 days is disregarded, and a month of more 
than 15 days is treated as a full month; and
    (B) A 52-53-week taxable year with reference to the end of a 
particular month will be considered to be the same as a taxable year 
ending with reference to the last day of such month.
    (c) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.
    (d) Examples--(1) Changes in taxable year. The following examples 
illustrate the provisions of paragraph (b)(2) of this section.

    Example (1). A is a personal service corporation that historically 
used a June 30 taxable year. A desires to make a section 444 election to 
change to an August 31 taxable year, effective with its taxable year 
beginning July 1, 1987. Under paragraph (b)(4)(ii) of this section, the 
deferred period of the taxable year to be elected is four months (the 
number of months between August 31 and December 31). Furthermore, the 
deferral period of the taxable year that is being changed is six months 
(the number of months between June 30 and December 31). Pursuant to 
paragraph (b)(2)(i) of this section, a taxpayer may, if otherwise 
qualified, make a section 444 election to change to a taxable year only 
if the deferral period of the taxable year to be elected is not longer 
than the shorter of three months or the deferred period of the taxable 
year being changed. Since the deferral period of the taxable year to be 
elected (August 31) is greater than three months, A may not make a 
section 444 election to change to the taxable year ending August 31, 
However, since the deferral period of the taxable year that is being 
changed is three months or more, A may, if otherwise qualified, make a 
section 444 election to change to a year ending September 30, 1987 
(three-month deferral period), a year ending October 31, 1987 (two-month 
deferral period), or a year ending November 30, 1987 (one-month deferral 
period). In addition, instead of making a section 444 election to change 
its taxable year, A could, if otherwise qualified, make a section 444 
election to retain its June end, pursuant to paragraph (b)(3) of this 
section.
    Example (2). B, a corporation that historically used an August 31 
taxable year, elected on November 1, 1986 to be an S corporation for its 
taxable year beginning September 1, 1986. As a condition to having the S 
election accepted, B agreed on Form 2553 to use calendar year. Pursuant 
to the general effective date provided in paragraph (c) of this section, 
B may not make a section 444 election for its taxable year beginning in 
1986. Thus, B must file a short period income tax return for the period 
September 1 to December 31, 1986.
    Example (3). The facts are the same as in example (2), except that B 
desires to make a section 444 election for its taxable year beginning 
January 1, 1987. Absent paragraph (b)(2)(ii) of this section, B would 
not be allowed to change its taxable year because the deferral period of 
the taxable year being changed (i.e., the calendar year) is zero. 
However, pursuant to the special rule provided in paragraph (b)(2)(ii) 
of this section, B shall apply paragraph (b)(2)(i) of this section by 
taking into account the deferral period of the last taxable year of B 
prior to B's election to be an S corporation (four months), rather than 
the deferral period of B's taxable year that is being changed (zero 
months). Thus, if otherwise qualified, B may make a section 444 election 
to change to a taxable year ending September 30, October 31, or November 
30, for its taxable year beginning January 1, 1987.
    Example (4). The facts are the same as in example (3), except that B 
files a calendar year income tax return for 1987 rather than making a 
section 444 election. However, for its taxable year beginning January 1, 
1988, B desires to change its taxable year by making a section 444 
election. Given that the special rule provided in paragraph (b)(2)(ii) 
of this section applies to section 444 elections made in taxable years 
beginning before 1989, B may, if otherwise qualified, make a section 444 
election to change to a taxable year ending September 30, October 31, or 
November 30 for its taxable year beginning January 1, 1988.
    Example (5). C, a corporation that historically used a June 30 
taxable year, elected on December 15, 1986 to be an S corporation for 
its taxable year beginning July 1, 1987. As a condition to having the S 
election accepted,

[[Page 44]]

C agreed on Form 2553 to use a calendar year. Although pursuant to 
paragraph (b)(3) of this section, C would, if otherwise qualified, be 
allowed to retain its June 30 taxable year, C desires to change to a 
September 30 taxable year by making a section 444 election. Pursuant to 
paragraph (b)(2) of this section, a taxpayer may, if otherwise 
qualified, make a section 444 election to change to a taxable year only 
if the deferral period of the taxable year to be elected is not longer 
than the shorter of three months or the deferral period of the taxable 
year being changed. Given these facts, the deferral period of the 
taxable year to be elected is 3 months (September 30 to December 31) 
while the deferral period of the taxable year being changed is 6 months 
(June 30 to December 31). Thus, C may, if otherwise qualified, change to 
a September 30 taxable year for its taxable year beginning July 1, 1987, 
by making a section 444 election. The fact that C agreed on Form 2553 to 
use a calendar year is not relevant.
    Example (6). D, a corporation that historically used a March 31 
taxable year, elects on June 1, 1988 to be an S corporation for its 
taxable year beginning April 1, 1988. D desires to change to a June 30 
taxable year by making a section 444 election for its taxable year 
beginning April 1, 1988. Pursuant to paragraph (b)(2)(i) of this 
section, D may not change to a June 30 taxable year because such year 
would have a deferral period greater than 3 months. However, if 
otherwise qualified, D may make a section 444 election to change to a 
taxable year ending September 30, October 31, or November 30 for its 
taxable year beginning April 1, 1988.
    Example (7). E, a corporation that began operations on November 1, 
1986, elected to be an S corporation on December 15, 1986, for its 
taxable year beginning November 1, 1986. E filed a short period income 
tax return for the period November 1 to December 31, 1986. E desires to 
change to a September 30 taxable year by making a section 444 election 
for its taxable year beginning January 1, 1987. Although E elected to be 
an S corporation after September 18, 1986, and before January 1, 1988, 
paragraph (b)(2)(ii) of this section does not apply to E since E was not 
a C corporation prior to electing S status. Thus, E may not change its 
taxable year for the taxable year beginning January 1, 1987, by making a 
section 444 election.
    Example (8). The facts are the same as in example (7), except that E 
began operations on April 15, 1987, and elected to be an S corporation 
on June 1, 1987, for its taxable year beginning April 15, 1987. As a 
condition to being an S corporation, E agreed on Form 2553 to use a 
calendar year. E desires to make a section 444 election to use a year 
ending September 30 for its taxable year beginning April 15, 1987. 
Pursuant to paragraph (b)(5)(i) of this section, E's agreement to use a 
calendar year on Form 2553 does not mean that E has adopted a calendar 
year. Thus, E's desire to make a section 444 election to use a September 
30 taxable year will not be considered a change in taxable year and thus 
paragraph (b)(2) of this section will not apply. Instead, E will be 
subject to paragraph (b)(1) of this section. Since a September 30 
taxable year would result in only a three-month deferral period 
(September 30 to December 31), E may, if otherwise qualified, make a 
section 444 election to use a year ending September 30 for its taxable 
year beginning April 15, 1987.

    (2) Special rule for entities retaining their 1986 taxable year. The 
following examples illustrate the provisions of paragraph (b)(3) of this 
section.

    Example (1). F, an S corporation that elected to be an S corporation 
several years ago, has historically used a June 30 taxable year. F 
desires to retain its June 30 taxable year by making a section 444 
election for its taxable year beginning July 1, 1987. Pursuant to 
paragraph (b)(4)(i) of this section, the deferral period of the taxable 
year being retained is 6 months (June 30 to December 31, F's required 
taxable year). Absent the special rule provided in paragraph (b)(3) of 
this section, F would be subject to the general rule provided in 
paragraph (b)(1) of this section which limits the deferral period of the 
taxable year elected to three months or less. However, pursuant to 
paragraph (b)(3) of this section, F may, if otherwise qualified, make a 
section 444 election to retain its year ending June 30 for its taxable 
year beginning July 1, 1987.
    Example (2). The facts are the same as in example (1), except that F 
received permission from the Commissioner to change its taxable year to 
the calendar year, and filed a short period income tax return for the 
period July 1 to December 31, 1986. F desires to make a section 444 
election to use a year ending June 30 for its taxable year beginning 
January 1, 1987. Given that F had a December 31 taxable year for its 
last taxable year beginning in 1986, the special rule provided in 
paragraph (b)(3) of this section does not allow F to use a June 30 
taxable year for its taxable year beginning January 1, 1987. 
Furthermore, pursuant to paragraph (b)(2)(i) of this section, F is not 
allowed to change its taxable year from December 31 to June 30 because 
the deferral period of the taxable year being changed is zero months.
    Example (3). G, a corporation that historically used an August 31 
taxable year, elected be an S corporation on November 15, 1986, for its 
taxable year beginning September 1, 1986. As a condition to obtaining S 
status, G agreed to use a calendar year. Thus, G filed its first S 
corporation return for the period September 1 to December 31, 1986. G 
desires to make a section 444 election to use a year

[[Page 45]]

ending August 31 for its taxable year beginning January 1, 1987. Since 
G's last taxable year beginning in 1986 was a calendar year, G cannot 
use paragraph (b)(3) of this section, relating to retentions of taxable 
years, to elect an August 31 taxable year. Thus, G is subject to 
paragraph (b)(2)(i) of this section, relating to changes in taxable 
year. Although G, if otherwise qualified, may use the special rule 
provided in paragraph (b)(2)(ii) of this section, G may only change from 
its current taxable year (i.e., the calendar year) to a taxable year 
that has no more than a three-month deferral period (i.e., September 30, 
October 31, or November 30).
    Example (4). The facts are the same as in example (3), except that G 
elected to be an S corporation for its taxable year beginning September 
1, 1987, rather than its taxable year beginning September 1, 1986. As a 
condition to making its S election, G agreed, on Form 2553, to use the 
calendar year. However, G has not yet filed a short period income tax 
return for the period September 1 to December 31, 1987. Given these 
facts, paragraph (b)(3) of this section would allow G, if otherwise 
qualified, to make a section 444 election to retain an August 31 taxable 
year for its taxable year beginning September 1, 1987.
    Example (5). The facts are the same as in example (4), except that G 
has already filed a short period income tax return for the period 
September 1 to December 31, 1987. Pursuant to paragraph (b)(5)(ii)(A) of 
this section, G may supersede the return it filed for the period 
September 1 to December 31, 1987. Thus, pursuant to paragraph (b)(3) of 
this section, G may, if otherwise qualified, make a section 444 election 
to retain an August 31 taxable year for the taxable year beginning 
September 1, 1987. In addition, G should follow the special procedures 
set forth in paragraph (b)(5)(ii)(B) of this section.
    Example (6). H, a corporation that historically used a May 31 
taxable year, elects to be an S corporation on June 15, 1988 for its 
taxable year beginning June 1, 1988. H desires to make a section 444 
election to use a taxable year other than the calendar year. Since the 
taxable year in issue is not H's first taxable year beginning after 
December 31, 1986, H may not use the special rule provided in paragraph 
(b)(3)(i) and thus may not retain its May 31 year. However, H may, if 
otherwise qualified, make a section 444 election under paragraph 
(b)(2)(i) of this section, to change to a taxable year that has no more 
than a three-month deferral period (i.e., September 30, October 31, or 
November 30) for its taxable year beginning June 1, 1988.
    Example (7). I is a partnership that has historically used a 
calendar year. Sixty percent of the profits and capital of I are owned 
by Q, a corporation (that is neither an S corporation nor a personal 
service corporation) that has a June 30 taxable year, and 40 percent of 
the profits and capital are owned by R, a calendar year individual. 
Since the partner that has more than a fifty percent interest in I has a 
June 30 taxable year, I's required taxable year is June 30. Accordingly, 
I filed an income tax return for the period January 1 to June 30, 1987. 
Based on these facts, I may, pursuant to paragraph (b)(5)(ii)(A) of this 
section, disregard the income tax return filed for the period January 1 
to June 30, 1987. Thus, if otherwise qualified, I may make a section 444 
election under paragraph (b)(2)(i) of this section to use a calendar 
year for its taxable year beginning January 1, 1987. If I makes such a 
section 444 election, I should follow the special procedures set forth 
in paragraph (b)(5)(ii)(B) of this section.
[T.D. 8205, 53 FR 19694, May 27, 1988]



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. 1.441-4T (d).
    (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

[[Page 46]]

service corporation pursuant to Sec. 1.441-4T (i), such affiliated group 
is considered to be a single deferral entity.
    (ii) Grantor trusts. The term ``deferral entity'' does not include a 
trust (or a portion of a trust) which is treated as owned by the grantor 
or beneficiary under Subpart E, part I, subchapter J, chapter 1, of the 
Code (relating to grantor trusts), including a trust that is treated as 
a grantor trust pursuant to section 1361(d)(1)(A) of the Code (relating 
to qualified subchapter S trusts). Thus, any taxpayer treated under 
subpart E as owning a portion of a trust shall be treated as owning the 
assets of the trust attributable to that ownership. The following 
examples illustrate the provisions of this paragraph (b)(2)(ii).
    Example (1). A, an individual, is the sole beneficiary of T. T is a 
trust that owns 50 percent of the profits and capital of X, a 
partnership that desires to make a section 444 election. Furthermore, 
pursuant to Subpart E, Part I, subchapter J, chapter 1 of the Code, A is 
treated as an owner of X. Based upon these facts, T is not a deferral 
entity and 50 percent of X is considered to be directly owned by A.
    Example (2). The facts are the same as in example (1), except that A 
is a personal service corporation rather than an individual. Given these 
facts, 50 percent of X is considered to be directly owned by A, a 
deferral entity. Thus, X is considered to be a member of a tiered 
structure.

    (3) Anti-abuse rule. Notwithstanding paragraph (b)(1) of this 
section, a partnership, S corporation, or personal service corporation 
is considered a member of a tiered structure if the partnership, S 
corporation, personal service corporation, or related taxpayers have 
organized or reorganized their ownership structure or operations for the 
principal purpose of obtaining a significant unintended tax benefit from 
making or continuing a section 444 election. For purposes of the 
preceding sentence, a significant unintended tax benefit results when a 
partnership, S corporation, or personal service corporation makes a 
section 444 election and, as a result, a taxpayer (not limited to the 
entity making the election) obtains a significant deferral of income 
substantially all of which is not eliminated by a required payment under 
section 7519. See examples (15) through (19) in paragraph (f) of this 
section.
    (c) De minimis rules--(1) In general. For rules relating to a de 
minimis exception to paragraph (b)(1)(i) of this section (the 
``downstream de minimis rule''), see paragraph (c)(2) of this section. 
For rules relating to a de minimis exception to paragraph (b)(1)(ii) of 
this section (the ``upstream de minimis rule''), see paragraph (c)(3) of 
this section. For rules relating to the interaction of the de minimis 
rules provided in this paragraph (c) and the ``same taxable year 
exception'' provided in paragraph (e) of this section, see paragraph 
(e)(5) of this section.
    (2) Downstream de minimis rule--(i) General rule. If a partnership, 
S corporation, or personal service corporation directly owns any portion 
of one or more deferral entities as of the date specified in paragraph 
(d) of this section, such ownership is disregarded for purposes of 
paragraph (b)(1)(i) of this section if, in the aggregate, all such 
deferral entities accounted for--
    (A) Not more than 5 percent of the partnership's, S corporation's, 
or personal service corporation's adjusted taxable income for the 
testing period (``5 percent adjusted taxable income test''), or
    (B) Not more than 2 percent of the partnership's, S corporation's, 
or personal service corporation's gross income for the testing period 
(``2 percent gross income test''). See section 702 (c) for rules 
relating to the determination of gross income of a partner in a 
partnership.

See examples (3) through (5) in paragraph (f) of this section.
    (ii) Definition of testing period. For purposes of this paragraph 
(c)(2), the term ``testing period'' means the taxable year that ends 
immediately prior to the taxable year for which the partnership, S 
corporation, or personal service corporation desires to make or continue 
a section 444 election. However, see the special rules provided in 
paragraph (c)(2)(iv) of this section for certain special cases (e.g., 
the partnership, S corporation, personal service corporation or deferral 
entity was not in existence during the entire testing period). The 
following example illustrates the application of this paragraph 
(c)(2)(ii).


[[Page 47]]


    Example. A partnership desires to make a section 444 election for 
its taxable year beginning November 1, 1987. The testing period for 
purposes of determining whether deferral entities owned by such 
partnership are de minimis under paragraph (c)(2) of this section is the 
taxable year ending October 31, 1987. If either the partnership or the 
deferral entities were not in existence for the entire taxable year 
ending October 1, 1987, see the special rules provided in paragraph 
(c)(2)(iv) of this section.

    (iii) Definition of adjusted taxable income--(A) Partnership. In the 
case of a partnership, adjusted taxable income for purposes of paragraph 
(c)(2) of this section is an amount equal to the sum of the--
    (1) Aggregate amount of the partnership items described in section 
702(a) (other than credits and tax-exempt income),
    (2) Applicable payments defined in section 7519(d)(3) that are 
deducted in determining the amount described in paragraph 
(c)(2)(iii)(A)(1) of this section, and
    (3) Guaranteed payments defined in section 707(c) that are deducted 
in determining the amount described in paragraph (c)(2)(iii)(A)(1) of 
this section and are not otherwise included in paragraph 
(c)(2)(iii)(A)(2) of this section. For purposes of determining the 
aggregate amount of partnership items under paragraph (c)(2)(iii)(A)(1) 
of this section, deductions and losses are treated as negative income. 
Thus, for example, if under section 702(a) a partnership has $1,000 of 
ordinary taxable income, $500 of specially allocated deductions, and 
$300 of capital loss, the partnership's aggregate amount of partnership 
items under paragraph (c)(2)(iii)(A)(1) of this section is $200 ($1,000-
$500-$300).
    (B) S corporation. In the case of an S corporation, adjusted taxable 
income for purposes of paragraph (c)(2) of this section is an amount 
equal to the sum of the--
    (1) Aggregate amount of the S corporation items described in section 
1366(a) (other than credits and tax-exempt income), and
    (2) Applicable payments defined in section 7519(d)(3) that are 
deducted in determining the amount described in paragraph 
(c)(2)(iii)(B)(1) of this section.

For purposes of determining the aggregate amount of S corporation items 
under paragraph (c)(2)(iii)(B)(1) of this section, deductions and losses 
are treated as negative income. Thus, for example, if under section 
1366(a) an S corporation has $2,000 of ordinary taxable income, $1,000 
of deductions described in section 1366(a)(1)(A) of the Code, and $500 
of capital loss, the S corporation's aggregate amount of S corporation 
items under paragraph (c)(2)(iii)(B)(1) of this section is $500 ($2,000-
$1,000-$500).
    (C) Personal service corporation. In the case of a personal service 
corporation, adjusted taxable income for purposes of paragraph (c)(2) of 
this section is an amount equal to the sum of the--
    (1) Taxable income of the personal service corporation, and
    (2) Applicable amounts defined in section 280H(f)(1) that are 
deducted in determining the amount described in paragraph 
(c)(2)(iii)(C)(1) of this section.
    (iv) Special rules--(A) Pro-forma rule. Except as provided in 
paragraph (c)(iv)(C)(2) of this section, if a partnership, S 
corporation, or personal service corporation directly owns any interest 
in a deferral entity as of the date specified in paragraph (d) of this 
section and such ownership interest is different in amount from the 
partnership's, S corporation's, or personal service corporation's 
interest on any day during the testing period, the 5 percent adjusted 
taxable income test and the 2 percent gross income test must be applied 
on a pro-forma basis (i.e., adjusted taxable income and gross income 
must be calculated for the testing period assuming that the partnership, 
S corporation, or personal service corporation owned the same interest 
in the deferral entity that it owned as of the date specified in 
paragraph (d) of this section). The following example illustrates the 
application of this paragraph (c)(2)(iv)(A).
    Example.  A personal service corporation desiring to make a section 
444 election for its taxable year beginning October 1, 1987, acquires a 
25 percent ownership interest in a 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

[[Page 48]]

testing period ended September 30, 1987, by assuming that the personal 
service corporation owned 25 percent of the partnership during such 
testing period and the personal service corporation's adjusted taxable 
income and gross income were correspondingly adjusted.

    (B) Reasonable estimates allowed. If the information necessary to 
complete the pro-forma calculation described in paragraph (c)(2)(iv)(A) 
of this section is not readily available, the partnership, S 
corporation, or personal service corporation may make a reasonable 
estimate of such information.
    (C) Newly formed entities--(1) Newly formed deferral entities. If a 
partnership, S corporation, or personal service corporation owns any 
portion of a deferral entity on the date specified in paragraph (d) of 
this section and such deferral entity was not in existence during the 
entire testing period (hereinafter referred to as a ``newly formed 
deferral entity''), both the 5 percent adjusted taxable income test and 
the 2 percent gross income test are modified as follows. First, the 
partnership, S corporation, or personal service corporation shall 
calculate the percentage of its adjusted taxable income or gross income 
that is attributable to deferral entities, excluding newly formed 
deferral entities. Second, the partnership, S corporation, or personal 
service corporation shall calculate (on the date specified in paragraph 
(d) of this section) the percentage of the tax basis of its assets that 
are attributable to its tax basis with respect to its ownership 
interests in all newly formed deferral entities. If the sum of the two 
percentages is 5 percent or less, the deferral entities are considered 
de minimis and are disregarded for purposes of paragraph (b)(1)(i) of 
this section. If the sum of the two percentages is greater than 5 
percent, the deferral entities do not qualify for the de minimis rule 
provided in paragraph (c)(2) of this section and thus the partnership, S 
corporation, or personal service corporation is considered to be a 
member of a tiered structure for purposes of this section.
    (2) Newly formed partnership, S corporation, or personal service 
corporation desiring to make a section 444 election. If a partnership, S 
corporation, or personal service corporation desires to make a section 
444 election for the first taxable year of its existence, the 5 percent 
adjusted taxable income test and the 2 percent gross income test are 
replaced by a 5 percent of assets test. Thus, if on the date specified 
in paragraph (d) of this section, 5 percent or less of the assets 
(measured by reference to the tax basis of the assets) of the newly 
formed partnership, S corporation, or personal service corporation are 
attributable to the tax basis with respect to its ownership interests in 
the deferral entities, the deferral entities will be considered de 
minimis and will be disregarded for purposes of paragraph (b)(1)(i) of 
this section.
    (3) Upstream de minimis rule. If a partnership, S corporation, or 
personal service corporation is directly owned by one or more deferral 
entities as of the date specified in paragraph (d) of this section, such 
ownership is disregarded for purposes of paragraph (b)(1)(ii) of this 
section if on the date specified in paragraph (d) of this section the 
deferral entities directly own, in the aggregate, 5 percent or less of--
    (i) An interest in the current profits of the partnership, or
    (ii) The stock (measured by value) of the S corporation or personal 
service corporation.

See examples (6) and (7) in paragraph (f) of this section.
    (d) Date for determining the existence of a tiered structure--(1) 
General rule. For purposes of paragraph (a) of this section, a 
partnership, S corporation, or personal service corporation will be 
considered a member of a tiered structure for a particular taxable year 
if the partnership, S corporation, or personal service corporation is a 
member of a tiered structure on the last day of the required taxable 
year (as defined in section 444 (e) of the Code) ending within such 
year. If a particular taxable year does not include the last day of the 
required taxable year for such year, the partnership, S corporation, or 
personal service corporation will not be 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

[[Page 49]]

election. Furthermore, assume that for its taxable year beginning 
November 1, 1988, the partnership's required taxable year is December 
31. If the partnership is a member of a tiered structure on December 31, 
1988, it will not be eligible to make a section 444 election for a 
taxable year beginning November 1, 1988, and ending September 30, 1989.
    Example (2). Assume an S corporation that historically used a June 
30 taxable year desires to make a section 444 election to change to a 
year ending September 30 for its taxable year beginning July 1, 1987. If 
the S corporation can make the section 444 election, it will have a 
short taxable year beginning July 1, 1987, and ending September 30, 
1987. Given these facts, the short taxable year beginning July 1, 1987, 
does not include the last day of the S corporation's required taxable 
year for such year (i.e., December 31, 1987). Thus, pursuant to 
paragraph (d)(1) of this section, the S corporation will not be 
considered a member of a tiered structure for its taxable year beginning 
July 1, 1987, and ending September 30, 1987.

    (2) Special rule for taxable years beginning in 1987. For purposes 
of paragraph (a) of this section, a partnership, S corporation, or 
personal service corporation will not be considered a member of a tiered 
structure for a taxable year beginning in 1987 if the partnership, S 
corporation, or personal service corporation is not a member of a tiered 
structure on the day the partnership, S corporation, or personal service 
corporation timely files its section 444 election for such year. The 
following examples illustrate the application of this paragraph (d)(2).

    Example (1). Assume that a partnership desires to retain a June 30 
taxable year by making a section 444 election for its taxable year 
beginning July 1, 1987. Furthermore, assume that the partnership's 
required taxable year for such year is December 31 and that the 
partnership was a member of a tiered structure on such date. Also assume 
that the partnership was not a member of a tiered structure as of the 
date it timely filed its section 444 election for its taxable year 
beginning July 1, 1987. Based upon the special rule provided in this 
paragraph (d)(2), the partnership will not be considered a member of a 
tiered structure for its taxable year beginning July 1, 1987.
    Example (2). Assume the same facts as in example (1), except that 
the partnership was a member of a tiered structure on the date it filed 
its section 444 election for its taxable year beginning July 1, 1987, 
but was not a member of a tiered structure on December 31, 1987. 
Paragraph (d)(1) of this section would still apply and thus the 
partnership would not be considered part of a tiered structure for its 
taxable year beginning July 1, 1987. However, the partnership would be 
considered a member of a tiered structure for its taxable year beginning 
July 1, 1988, if the partnership was a member of a tiered structure on 
December 31, 1988.

    (e) Same taxable year exception--(1) In general. Although a 
partnership or S corporation is a member of a tiered structure as of the 
date specified in paragraph (d) of this section, the partnership, S 
corporation may make or continue a section 444 election if the tiered 
structure (as defined in paragraph (e)(2) of this section) consists 
entirely of partnerships or S corporations (or both), all of which have 
the same taxable year as determined under paragraph (e)(3) of this 
section. However, see paragraph (e)(5) of this section for the 
interaction of the de minimis rules provided in paragraph (c) of this 
section with the same taxable year exception. For purposes of this 
paragraph (e), two or more entities are considered to have the same 
taxable year if their taxable years end on the same day, even though 
they begin on different days. See examples (8) through (14) in paragraph 
(f) of this section.
    (2) Definition of tiered structure--(i) General rule. For purposes 
of the same taxable year exception, the members of a tiered structure 
are defined to include the following entities--
    (A) The partnership or S corporation that desires to qualify for the 
same taxable year exception,
    (B) A deferral entity (or entities) directly owned (in whole or in 
part) by the partnership or S corporation that desires to qualify for 
the same taxable year exception,
    (C) A deferral entity (or entities) directly owning any portion of 
the partnership or S corporation that desires to qualify for the same 
taxable year exception, and
    (D) A deferral entity (or entities) directly owned (in whole or in 
part) by a ``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

[[Page 50]]

qualify for the same taxable year exception, such owned partnership is 
considered a downstream controlled partnership for purposes of paragraph 
(e)(2)(i) of this section. Furthermore, if more than 50 percent of a 
partnership's profits and capital are owned by a downstream controlled 
partnership, such owned partnership is considered a downstream 
controlled partnership for purposes of paragraph (e)(2)(i) of this 
section.
    (3) Determining the taxable year of a partnership or S corporation. 
The taxable year of a partnership or S corporation to be taken into 
account for purposes of paragraph (e)(1) of this section is the taxable 
year ending with or prior to the date specified in paragraph (d) of this 
section. Furthermore, the determination of such taxable year will take 
into consideration any section 444 elections made by the partnership or 
S corporation. See examples (10) and (11) in paragraph (f) of this 
section.
    (4) Special rule for 52-53-week taxable years. For purposes of this 
paragraph (e), a 52-53-week taxable year with reference to the end of a 
particular month will be considered to be the same as a taxable year 
ending with reference to the last day of such month.
    (5) Interaction with de minimis rules--(i) Downstream de minimis 
rule--(A) In general. If a partnership or S corporation that desires to 
make or continue a section 444 election is a member of a tiered 
structure (as defined in paragraph (e)(2) of this section) and directly 
owns any member (or members) of the tiered structure with a taxable year 
different from the taxable year of the partnership or S corporation, 
such ownership is disregarded for purposes of the same taxable year 
exception of paragraph (e)(1) of this section provided that, in the 
aggregate, the de minimis rule of paragraph (c)(2) of this section is 
satisfied with respect to such owned member (or members). The following 
example illustrates the application of this paragraph (e)(5)(i)(A).

    Example.  P, a partnership with a June 30 taxable year, owns 60 
percent of P1, another partnership with a June 30 taxable year. P also 
owns 1 percent of P2 and P3, calendar year partnerships. If, in the 
aggregate, P's ownership interests in P2 and P3 are considered de 
minimis under paragraph (c)(2) of this section, P meets the same taxable 
year exception and may make a section 444 election to retain its June 30 
taxable year.

    (B) Special rule for members of a tiered structure directly owned by 
a downstream controlled partnership. For purposes of paragraph 
(e)(5)(i)(A) of this section, a partnership or S corporation desiring to 
make or continue a section 444 election is considered to directly own 
any member of the tiered structure (as defined in paragraph (e)(2) of 
this section) directly owned by a downstream controlled partnership (as 
defined in paragraph (e)(2)(ii) of this section). The adjusted taxable 
income or gross income of the partnership or S corporation that is 
attributable to a member of a tiered structure directly owned by a 
downstream controlled partnership equals the adjusted taxable income or 
gross income of such member multiplied by the partnership's or S 
corporation's indirect ownership percentage of such member. The 
following example illustrates the application of this paragraph 
(e)(5)(i)(B).

    Example.  P, a partnership, desires to retain its June 30 taxable 
year by making a section 444 election. However, as of the date specified 
in paragraph (d) of this section, P owns 75 percent of P1, a June 30 
partnership, and P1 owns 40 percent of P2, a calendar year partnership. 
P also owns 25 percent of P3, a calendar year partnership. Pursuant to 
paragraphs (e)(5)(i) (A) and (B) of this section, P may only qualify to 
use the same taxable year exception if, in the aggregate, P2 and P3 are 
de minimis with respect to P. Pursuant to paragraph (e)(5)(i)(B) of this 
section, P's adjusted taxable income or gross income attributable to P2 
equals 30 percent (75 percent times 40 percent) of P2's adjusted taxable 
income or gross income.

    (ii) Upstream de minimis rule. If a partnership or S corporation 
that desires to make or continue a section 444 election is a member of a 
tiered structure (as 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

[[Page 51]]

(or members). See example (12) of paragraph (f) of this section.
    (f) Examples. The provisions of this section may be illustrated by 
the following examples.

    Example (1). A, a partnership, desires to make or continue a section 
444 election. However, on the date specified in paragraph (d) of this 
section, A is owned by a combination of individuals and S corporations. 
The S corporations are deferral entities, as defined in paragraph (b)(2) 
of this section. Thus, pursuant to paragraph (b)(1)(ii) of this section, 
A will be a member of a tiered structure unless under paragraph (c)(3) 
of this section, the S corporations, in the aggregate, own a de minimis 
portion of A. If the S corporations' ownership in A is not considered de 
minimis under paragraph (c)(3) of this section, A is a member of a 
tiered structure and will be allowed to make or continue a section 444 
election only if it meets the same taxable year exception provided in 
paragraph (e) of this section.
    Example (2). B, a partnership, desires to make or continue a section 
444 election. However, on the date specified in paragraph (d) of this 
section, B is a partner in two partnerships, B1 and B2. B1 and B2 are 
deferral entities, as defined in paragraph (b)(2) of this section. Thus, 
under paragraph (b)(1)(i) of this section, B will be a member of a 
tiered structure unless B's aggregate ownership interests in B1 and B2 
are considered de minimis under paragraph (c)(2) of this section. If B 
is a member of a tiered structure on the date specified in paragraph (d) 
of this section, B will be allowed to make or continue a section 444 
election only if it meets the same taxable year exception provided in 
paragraph (e) of this section.
    Example (3). C, a partnership with a September 30 taxable year, is 
100 percent owned by calendar year individuals. C desires to make a 
section 444 election for its taxable year beginning October 1, 1987. 
However, on the date specified in paragraph (d) of this section, C owns 
a 1 percent interest in C1, a partnership. C does not own any other 
interest in a deferral entity. For the taxable year ended September 30, 
1987, 10 percent of C's adjusted taxable income (as defined in paragraph 
(c)(2)(iii) of this section) was attributable to C's partnership 
interest in C1. Furthermore, 4 percent of C's gross income for the 
taxable year ended September 30, 1987, was attributable to C's 
partnership interest in C1. Under paragraph (c)(2) of this section, C's 
partnership interest in C1 is not de minimis because during the testing 
period more than 5 percent of C's adjusted taxable income is 
attributable to C1 and more than 2 percent of C's gross income is 
attributable to C1. Thus, C is a member of a tiered structure for its 
taxable year beginning October 1, 1987.
    Example (4). The facts are the same as example (3), except that for 
the taxable year ended September 30, 1987, only 2 percent of C's 
adjusted taxable income was attributable to C1. Under paragraph (c)(2) 
of this section, C's partnership interest in C1 is considered de minimis 
for purposes of determining whether C is a member of a tiered structure 
because not more than 5 percent of C's adjusted taxable income during 
the testing period is attributable to C1. Thus, C is not a member of a 
tiered structure for its taxable year beginning October 1, 1987.

    Example (5). The facts are the same as example (4), except that in 
addition to owning C1, C also owns 15 percent of C2, another 
partnership. For the taxable year ended September 30, 1987, 2 percent of 
C's adjusted taxable income is attributable to C1 and an additional 4 
percent is attributable to C2. Furthermore, for the taxable year ended 
September 30, 1987, 4 percent of C's gross income is attributable to C1 
while 3 percent is attributable to C2. Under paragraph (c)(2) of this 
section, C1 and C2 must be aggregated for purposes of determining 
whether C meets either the 5 percent adjusted taxable income test or the 
2 percent gross income test. Since C's adjusted taxable income 
attributable to C1 and C2 is 6 percent (2 percent + 4 percent) and C's 
gross income attributable to C1 and C2 is 7 percent (4 percent + 3 
percent), C does not meet the downstream de minimis rule provided in 
paragraph (c)(2) of this section. Thus, C is a member of a tiered 
structure for its taxable year beginning October 1, 1987.
    Example (6). The facts are the same as example (3), except that 
instead of determining whether C is part of a tiered structure, the 
issue is whether C1 is part of a tiered structure. In addition, assume 
that on the date specified in paragraph (d) of this section, the 
remaining 99 percent of C1 is owned by calendar year individuals and C1 
does not own an interest in any deferral entity. Although C in Example 
(3) was considered to be a part of a tiered structure by virtue of its 
ownership interest in C1, C1 must be tested separately to determine 
whether it is part of a tiered structure. Since C's interest in C1 is 5 
percent or less, C's interest in C1 is de minimis with respect to C1. 
See paragraph (c)(3) of this section. Thus, based upon these facts, C1 
is not part of a tiered structure.
    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

[[Page 52]]

section 444 election for its taxable year beginning October 1, 1987. On 
December 31, 1987, and the date D plans to file its section 444 
election, D is 10 percent owned by D1, a personal service corporation 
with a September 30 taxable year, and 90 percent owned by calendar year 
individuals. Furthermore, D1 will retain its September 30 taxable year 
because it previously established a business purpose for such year. 
Since D is owned in part by D1, a personal service corporation, and the 
ownership interest is not de minimis under paragraph (c)(3) of this 
section, D is considered a member of a tiered structure for its taxable 
year beginning October 1, 1987. Furthermore, although D and D1 have the 
same taxable year, D does not qualify for the same taxable year 
exception provided in paragraph (e) of this section because D1 is a 
personal service corporation rather than a partnership or S corporation. 
Thus, pursuant to paragraph (a) of this section, D may not make a 
section 444 election for its taxable year beginning October 1, 1987.
    Example (9). The facts are the same as example (8), except that D1 
is a partnership rather than a personal service corporation. Based upon 
these facts, D qualifies for the same taxable year exception provided in 
paragraph (e) of this section. Thus, D may make a section 444 election 
for its taxable year beginning October 1, 1987.
    Example (10). The facts are the same as example (9), except that D1 
has not established a business purpose for a September 30 taxable year. 
In addition, D1 does not desire to make a section 444 election and, 
under section 706(b), D1 will be required to change to a calendar year 
for its taxable year beginning October 1, 1987. Pursuant to paragraph 
(e)(3) of this section, D and D1 do not have the same taxable year for 
purposes of the same taxable year exception provided in paragraph (e) of 
this section. Thus, D may not make a section 444 election for its 
taxable year beginning October 1, 1987.
    Example (11). The facts are the same as example (8), except that D1 
is a partnership with a March 31 taxable year. Furthermore, for its 
taxable year beginning April 1, 1987, D1 will change to a September 30 
taxable year by making a section 444 election. Pursuant to paragraph 
(e)(3) of this section, D1 is considered to have a September 30 taxable 
year for purposes of determining whether D qualifies for the same 
taxable year exception provided in paragraph (e) of this section. Since 
both D and D1 will have the same taxable year as of the date specified 
in paragraph (d) of this section, D may make a section 444 election for 
its taxable year beginning October 1, 1987.
    Example (12). The facts are the same as example (11), except that 
instead of the remaining 90 percent of D being owned by calendar year 
individuals, it is owned 86 percent by individuals and 4 percent by D2, 
a calendar year partnership. Thus, D, a September 30 partnership, is 10 
percent owned by D1, a September 30 partnership, 86 percent owned by 
calendar year individuals, and 4 percent owned by D2, a calendar year 
partnership. Under paragraph (e)(5)(ii) of this section, D2's ownership 
interest in D is considered de minimis for purposes of the same taxable 
year exception. Since D2's ownership interest in D is considered de 
minimis, it is disregarded for purposes of determining whether D 
qualifies for the same taxable year exception provided in paragraph (e) 
of this section. Thus, since both D and D1 will have the same taxable 
year as of the date specified in paragraph (d) of this section, D may 
make a section 444 election for its taxable year beginning October 1, 
1987.

    Example (13). E, a partnership with a June 30 taxable year, desires 
to make a section 444 election for its taxable year beginning July 1, 
1987. On the date specified in paragraph (d) of this section, E is 100 
percent owned by calendar year individuals; E owns 99 percent of the 
profits and capital of E1, a partnership with a June 30 taxable year; 
and E1 owns 30 percent of the profits and capital of E2, a partnership 
with a September 30 taxable year. E owns no other deferral entities. 
Pursuant to paragraph (b)(1)(i) of this section, E is considered to be a 
member of a tiered structure. Furthermore, pursuant to paragraph (e) of 
this section, E does not qualify for the same taxable year exception 
because E2 does not have the same taxable year as E and E1.
    Example (14). The facts are the same as example (13), except that E 
owns only 49 percent (rather than 99 percent) of the profits and capital 
of E1. Pursuant to paragraph (e) of this section, E qualifies for the 
same taxable year exception because E and E1 have the same taxable year. 
Pursuant to paragraph (e) of this section, E1's ownership interest in E2 
is disregarded since E does not own more than 50 percent of E1's profits 
and capital.
    Example (15). Prior to consideration of the anti-abuse rule provided 
in paragraph (b)(3) of this section, H, a partnership that commenced 
operations on October 1, 1987, is eligible to make a section 444 
election for its taxable year beginning October 1, 1987. Although H may 
obtain a significant deferral of income substantially all of which is 
not 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.

[[Page 53]]

    Example (16). F, a partnership with a January 31 taxable year, 
desires to make a section 444 election to retain its January 31 taxable 
year for the taxable year beginning February 1, 1987. F is 100 percent 
owned by calendar year individuals. Prior to the date specified in 
paragraph (d) of this section, F contributes substantially all of its 
assets to F1, a partnership, in exchange for a 51 percent interest in 
F1. The remaining 49 percent of F1 is owned by the calendar year 
individuals owning 100 percent of F. If F is allowed to make a section 
444 election to retain its January 31 taxable year, F1's required 
taxable year will be January 31 since a majority of F1's partners use a 
January 31 taxable year (see Sec. 1.706-3T). F's principal purpose for 
creating F1 and contributing its assets to F1 is to obtain an 11-month 
deferral on 49 percent of the income previously earned by F and now 
earned by F1. Pursuant to paragraph (b)(3) of this section, F is not 
allowed to make a section 444 election for its taxable year beginning 
February 1, 1987.
    Example (17). The facts are the same as in example (16), except that 
F does not create F1 and contribute its assets to F1 until immediately 
after F makes its section 444 election for the taxable year beginning 
February 1, 1987. Thus, F is allowed to make a section 444 election for 
its taxable year beginning February 1, 1987. However, pursuant to 
paragraph (b)(3) of this section, F will have its section 444 election 
terminated for subsequent years unless the tax deferral inherent in the 
structure is eliminated (e.g., F1 is liquidated or the individual owners 
of F contribute their interests in F1 to F) prior to the date specified 
in paragraph (d) of this section for subsequent taxable years beginning 
on or after February 1, 1988.
    Example (18). The facts are the same as in example (16), except that 
F1 is 99 percent owned by F and none of the individual owners of F own 
any portion of F1. Furthermore, F obtained no tax benefit from creating 
and contributing assets to F1. Given these facts paragraph (b)(3) of 
this section does not apply and thus, F may make a section 444 election 
for its taxable year beginning February 1, 1987.
    Example (19). G, a partnership with an October 31 taxable year, 
desires to retain its October 31 taxable year for its taxable year 
beginning November 1, 1987. However, as of December 31, 1987, G owns a 
30 percent interest in G1, a calendar year partnership. G owns no other 
deferral entity, and G is 100 percent owned by calendar year 
individuals. Furthermore, G's interest in G1 does not meet the de 
minimis rule provided in paragraph (c)(3) of this section. Thus, in 
order to avoid being a tiered structure, G sells its interest in G1 to 
an unrelated third party prior to the date G timely makes it section 444 
election for its taxable year beginning November 1, 1987. Although the 
sale of G1 allows G to qualify to make a section 444 election, and 
therefore to obtain a significant tax benefit, such benefit is not 
unintended. Thus, paragraph (b)(3) of this section does not apply, and G 
may make a section 444 election for its taxable year beginning November 
1, 1987.

    (g) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.
[T.D. 8205, 53 FR 19698, May 27, 1988]



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

[[Page 54]]

September 30, 1988 (i.e., January 15, 1989). Thus, A must file Form 8716 
by January 15, 1989.
    Example (2). The facts are the same as in example (1), except that A 
began operations on October 20, 1988. Based upon these facts, A must 
file Form 8716 by March 15, 1989, the 15th day of the fifth month 
following the month that includes the first day of the taxable year for 
which the election will first be effective.
    Example (3). B is a corporation that first becomes a personal 
service corporation for its taxable year beginning September 1, 1988. B 
qualifies to make a section 444 election to use a September 30 taxable 
year for its taxable year beginning September 1, 1988. Pursuant to this 
paragraph (b)(1), B must file Form 8716 by December 15, 1988, the due 
date of the income tax return for the short period September 1 to 
September 30, 1988.

    (2) Special extension of time for making an election. If, pursuant 
to paragraph (b)(1) of this section, the due date for filing Form 8716 
is prior to July 26, 1988, such date is extended to July 26, 1988. The 
provisions of this paragraph (b)(2) may be illustrated by the following 
examples.

    Example (1). B, a partnership that historically used a June 30 
taxable year, is qualified to make a section 444 election to retain a 
June 30 taxable year for its taxable year beginning July 1, 1987. Absent 
paragraph (b)(2) of this section, B would be required to file Form 8716 
by December 15, 1987. However, pursuant to paragraph (b)(2) of this 
section, B's due date for filing Form 8716 is extended to July 26, 1988.
    Example (2). C, a partnership that began operations on January 20, 
1988, is qualified to make a section 444 election to use a year ending 
September 30 for its taxable year beginning January 20, 1988. Absent 
paragraph (b)(2) of this section, C is required to file Form 8716 by 
June 15, 1988 (the 15th day of the fifth month following the month that 
includes the first day of the taxable year for which the election will 
first be effective). However, pursuant to paragraph (b)(2) of this 
section, the due date for filing Form 8716 is July 26, 1988.

    (3) Corporation electing to be an S corporation--(i) In general. A 
corporation electing to be an S corporation is subject to the same time 
and manner rules for filing Form 8716 as any other taxpayer making a 
section 444 election. Thus, a corporation electing to be an S 
corporation that desires to make a section 444 election is not required 
to file Form 8716 with its Form 2553, ``Election by a Small Business 
Corporation.'' However, a corporation electing to be an S corporation 
after September 26, 1988, is required to state on Form 2553 its 
intention to--

    (A) Make a section 444 election, if qualified, or
    (B) Make a ``back-up section 444 election'' as described in 
paragraph (b)(4) of this section.

If a corporation electing to be an S corporation fails to state either 
of the above intentions, the District Director may, at his discretion, 
disregard any section 444 election for such taxpayer.
    (ii) Examples. The provisions of this paragraph (b)(3) may be 
illustrated by the following examples.

    Example (1). D is a corporation that commences operations on October 
1, 1988, and elects to be an S corporation for its taxable year 
beginning October 1, 1988. All of D's shareholders use the calendar year 
as their taxable year. D desires to adopt a September 30 taxable year. D 
does not believe it has a business purpose for a September 30 taxable 
year and thus it must make a section 444 election to use such year. 
Based on these facts, D must, pursuant to the instructions to Form 2553, 
state on Form 2553 that, if qualified, it will make a section 444 
election to adopt a year ending September 30 for its taxable year 
beginning October 1, 1988. If D is qualified (i.e., D is not a member of 
a tiered structure on December 31, 1988) to make a section 444 election 
for its taxable year beginning October 1, 1988, D must file Form 8716 by 
March 15, 1989. If D ultimately is not qualified to make a section 444 
election for its taxable year beginning October 1, 1988, D's election to 
be an S corporation will not be effective unless, pursuant to the 
instructions to Form 2553, D made a back-up calendar year election 
(i.e., an election to adopt the calendar year in the event D ultimately 
is not qualified to make a section 444 election for such year).
    Example (2). The facts are the same as in example (1), except that D 
believes it can establish, to the satisfaction of the Commissioner, a 
business purpose for adopting a 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

[[Page 55]]

to make a section 444 election, D must make a back-up election in 
accordance with paragraph (b)(4) of this section.

    (4) Back-up section 444 election--(i) General rule. A taxpayer that 
has requested (or is planning to request) permission to use a particular 
taxable year based upon business purpose, may, if otherwise qualified, 
file a section 444 election (referred to as a ``back-up section 444 
election''). If the Commissioner subsequently denies the business 
purpose request, the taxpayer will, if otherwise qualified, be required 
to activate the back-up section 444 election. See examples (1) and (2) 
in paragraph (b)(4)(iv) of this section.
    (ii) Procedures for making a back-up section 444 election. In 
addition to following the general rules provided in this section, a 
taxpayer making a back-up section 444 election should, in order to allow 
the Service to process the affected returns in an efficient manner, type 
or legibly print the words ``BACK-UP ELECTION'' at the top of Form 8716, 
``Election to Have a Tax Year Other Than a Required Tax Year.'' However, 
if such Form 8716 is filed on or after the date a Form 1128, Application 
for Change in Accounting Period, is filed with respect to a period that 
begins on the same date, the words ``FORM 1128 BACK-UP ELECTION'' should 
be typed or legibly printed at the top of Form 8716.
    (iii) Procedures for activating a back-up section 444 election--(A) 
Partnerships and S corporations--(1) In general. A back-up section 444 
election made by a partnership or S corporation is activated by filing 
the return required in Sec. 1.7519-2T (a)(2)(i) and making the payment 
required in Sec. 1.7519-1T. The due date for filing such return and 
payment will be the later of--

    (i) The due dates provided in Sec. 1.7519-2T, or
    (ii) 60 days from the date the Commissioner denies the business 
purpose request.

However, interest will be assessed (at the rate provided in section 6621 
(a)(2)) on any required payment made after the due date (without regard 
to any extension for a back-up election) provided in Sec. 1.7519-2T 
(a)(4)(i) or (a)(4)(ii), whichever is applicable, for such payment. 
Interest will be calculated from such due date to the date such amount 
is actually paid. Interest assessed under this paragraph will be 
separate from any required payments. Thus, interest will not be subject 
to refund under Sec. 1.7519-2T.
    (2) Special rule if Form 720 used to satisfy return requirement. If, 
pursuant to Sec. 1.7519-2T (a)(3), a partnership or S corporation must 
use Form 720, ``Quarterly Federal Excise Tax Return,'' to satisfy the 
return requirement of Sec. 1.7519-2T (a)(2), then in addition to 
following the general rules provided in Sec. 1.7519-2T, the partnership 
or S corporation must type or legibly print the words ``ACTIVATING BACK-
UP ELECTION'' on the top of Form 720. A partnership or S corporation 
that would otherwise file a Form 720 on or before the date specified in 
paragraph (b)(4)(iii)(A)(1) of this section may satisfy the return 
requirement by including the necessary information on such Form 720. 
Alternatively, such partnership or S corporation may file an additional 
Form 720 (i.e., a Form 720 separate from the Form 720 it would otherwise 
file). Thus, for example, if the due date for activating an S 
corporation's back-up election is November 15, 1988, and the S 
corporation must file a Form 720 by October 31, 1988, to report 
manufacturers excise tax for the third quarter of 1988, the S 
corporation may use that Form 720 to activate its back-up election. 
Alternatively, the S corporation may file its regular Form 720 that is 
due October 31, 1988, and file an additional Form 720 by November 15, 
1988, activating its back-up election.
    (B) Personal service corporations. A back-up section 444 election 
made by a personal service corporation is activated by filing Form 8716 
with the personal service corporation's original or 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

[[Page 56]]

(pursuant to section 6 of Rev. Proc. 87-32, 1987-28 I.R.B. 14) 
permission from the Commissioner to retain a June 30 taxable year for 
its taxable year beginning July 1, 1987. Furthermore, E is qualified to 
make a section 444 election to retain a June 30 taxable year for its 
taxable year beginning July 1, 1987. However, as of the date specified 
in paragraph (b)(2) of this section, the Commissioner has not determined 
whether E has a valid business purpose for retaining its June 30 taxable 
year. Based on these facts, E may, by the date specified in paragraph 
(b)(2) of this section, make a back-up section 444 election to retain 
its June 30 taxable year.
    Example (2). The facts are the same as in example (1). In addition, 
on August 12, 1988, the Internal Revenue Service notifies E that its 
business purpose request is denied. E asks for reconsideration of the 
Service's decision, and the Service sustains the original denial on 
September 30, 1988. Based on these facts, E must activate its back-up 
section 444 election within 60 days after September 30, 1988.
    Example (3). The facts are the same as in example (1), except that E 
desires to make a section 444 election to use a year ending September 30 
for its taxable year beginning July 1, 1987. Although E qualifies to 
make a section 444 election to retain its June 30 taxable year, E may 
make a back-up section 444 election for a September 30 taxable year.

    (c) Administrative relief--(1) Extension of time to file income tax 
returns--(i) Automatic extension. If a partnership, S corporation, or 
personal service corporation makes a section 444 election (or does not 
make a section 444 election, either because it is ineligible or because 
it decides not to make the election, and therefore changes to its 
required taxable year) for its first taxable year beginning after 
December 31, 1986, the due date for filing its income tax return for 
such year shall be the later of--

    (A) The due date established under--

    (1) Section 6072, in the case of Form 1065,
    (2) Sec. 1.6037-1 (b), in the case of Form 1120S,
    (3) Section 6072 (b), in the case of other Form 1120 series form; or
    (B) August 15, 1988.

The words ``SECTION 444 RETURN'' should, in order to allow the Service 
to process the affected returns in an efficient manner, be typed or 
legibly printed at the top of the Form 1065 or Form 1120 series form, 
whichever is applicable, filed under this paragraph (c)(1)(i).
    (ii) Additional extensions. If the due date of the income tax return 
for the first taxable year beginning after December 31, 1986, extended 
as provided in paragraph (c)(1)(i)(B) of this section, occurs before the 
date that is 6 months after the date specified in paragraph (c)(1)(i)(A) 
of this section, the partnership, S corporation, or personal service 
corporation may request an additional extension or extensions of time 
(up to 6 months after the date specified in paragraph (c)(1)(i)(A) of 
this section) to file its income tax return for such first taxable year. 
The request must be made by the later of the date specified in paragraph 
(c)(1)(i)(A) or (c)(1)(i)(B) of this section and must be made on Form 
7004, ``Application for Automatic Extension of Time To File Corporation 
Income Tax Return'', or Form 2758, ``Application for Extension of Time 
to File U.S. Partnership, Fiduciary, and Certain Other Returns,'' 
whichever is applicable, in accordance with the form and its 
instructions. In addition, the following words should be typed or 
legibly printed at the top of the form--``SECTION 444 REQUEST FOR 
ADDITIONAL EXTENSION.''
    (iii) Examples. The provisions of paragraph (c)(1) of this section 
may be illustrated by the following examples.

    Example (1). G, a partnership that historically used a January 31 
taxable year, makes a section 444 election to retain such year for its 
taxable year beginning February 1, 1987. Absent paragraph (c)(1)(i) of 
this section, G's Form 1065 for the taxable year ending January 31, 
1988, is due on or before May 15, 1988. However, if G types or legibly 
prints ``SECTION 444 RETURN'' at the top of Form 1065 for such year, 
paragraph (c)(1)(i) of this section automatically extends the due date 
of such return to August 15, 1988.
    Example (2). The facts are the same as in example (1), except that G 
desires to extend the due date of its income tax return for the 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

[[Page 57]]

June 1, 1987. Absent paragraph (c)(1)(i) of this section, H's Form 1065 
for the taxable year beginning June 1, 1987, and ending September 30, 
1987, is due on or before January 15, 1988. However, if H types or 
legibly prints ``SECTION 444 RETURN'' at the top of Form 1065 for such 
year, paragraph (c)(1)(i) of this section automatically extends the due 
date of such return to August 15, 1988.
    Example (4). The facts are the same as in example (3), except H 
desires to further extend (i.e., extend beyond August 15, 1988) the due 
date of its income tax return for its taxable year beginning June 1, 
1987, and ending September 30, 1987. Since August 15, 1988, is 6 months 
or more after the due date (without extensions) of such return, 
paragraph (c)(1)(ii) of this section prevents H from further extending 
the time for filing such return.
    Example (5). I, a partnership that historically used a June 30 
taxable year, considered making a section 44 election to retain such 
taxable year, but eventually decided to change to a December 31, taxable 
year (I's required taxable year). Absent paragraph (c)(1)(i) of this 
section, I's Form 1065 for the taxable year beginning July 1, 1987, and 
ending December 31, 1987, is due on or before April 15, 1988. Pursuant 
to paragraph (c)(1)(i) of this section, if I types or legibly prints 
``SECTION 444 RETURN'' at the top of Form 1065 for such year, paragraph 
(c)(1)(i) of this section automatically extends the due date of such 
return to August 15, 1988. In addition, I may further extend such return 
pursuant to paragraph (c)(1)(ii) of this section.

    (2) No penalty for certain late payments--(i) In general. In the 
case of a personal service corporation or S corporation described in 
paragraph (c)(1)(i) of this section, no penalty under section 6651 
(a)(2) will be imposed for failure to pay income tax (if any) for the 
first taxable year beginning after December 31, 1986, but only for the 
period beginning with the last date for payment and ending with the 
later of the date specified in paragraph (c)(1)(i) or paragraph 
(c)(1)(ii) of this section.
    (ii) Example. The provisions of paragraph (c)(2)(i) of this section 
may be illustrated by the following example.

    Example.  J, a personal service corporation that historically used a 
January 31 taxable year, makes a section 444 election to retain such 
year for its taxable year beginning February 1, 1987. The last date 
(without extension) for payment of J's income tax (if any) for its 
taxable year beginning February 1, 1987, is April 15, 1988. However, 
under paragraph (c)(2)(i) of this section, no penalty under section 
6651(a)(2) will be imposed on any underpayment of income tax for the 
period beginning April 15, 1988 and ending August 15, 1988.

    (d) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.
[T.D. 8205, 53 FR 19703, May 27, 1988]

                          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

[[Page 58]]

in accordance with accepted conditions or practices in that trade or 
business will ordinarily be regarded as clearly reflecting income, 
provided all items of gross income and expense are treated consistently 
from year to year.
    (3) Items of gross income and expenditures which are elements in the 
computation of taxable income need not be in the form of cash. It is 
sufficient that such items can be valued in terms of money. For general 
rules relating to the taxable year for inclusion of income and for 
taking deductions, see sections 451 and 461, and the regulations 
thereunder.
    (4) Each taxpayer is required to make a return of his taxable income 
for each taxable year and must maintain such accounting records as will 
enable him to file a correct return. See section 6001 and the 
regulations thereunder. Accounting records include the taxpayer's 
regular books of account and such other records and data as may be 
necessary to support the entries on his books of account and on his 
return, as for example, a reconciliation of any differences between such 
books and his return. The following are among the essential features 
that must be considered in maintaining such records:
    (i) In all cases in which the production, purchase, or sale of 
merchandise of any kind is an income-producing factor, merchandise on 
hand (including finished goods, work in process, raw materials, and 
supplies) at the beginning and end of the year shall be taken into 
account in computing the taxable income of the year. (For rules relating 
to computation of inventories, see section 263A, 471, and 472 and the 
regulations thereunder.)
    (ii) Expenditures made during the year shall be properly classified 
as between capital and expense. For example, expenditures for such items 
as plant and equipment, which have a useful life extending substantially 
beyond the taxable year, shall be charged to a capital account and not 
to an expense account.
    (iii) In any case in which there is allowable with respect to an 
asset a deduction for depreciation, amortization, or depletion, any 
expenditures (other than ordinary repairs) made to restore the asset or 
prolong its useful life shall be added to the asset account or charged 
against the appropriate reserve.
    (b) Exceptions. (1) If the taxpayer does not regularly employ a 
method of accounting which clearly reflects his income, the computation 
of taxable income shall be made in a manner which, in the opinion of the 
Commissioner, does clearly reflect income.
    (2) A taxpayer whose sole source of income is wages need not keep 
formal books in order to have an accounting method. Tax returns, copies 
thereof, or other records may be sufficient to establish the use of the 
method of accounting used in the preparation of the taxpayer's income 
tax returns.
    (c) Permissible methods--(1) In general. Subject to the provisions 
of paragraphs (a) and (b) of this section, a taxpayer 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

[[Page 59]]

after the taxable year incurred, and see Secs. 1.461-4 through 1.461-6 
for rules relating to economic performance.) Applicable provisions of 
the Code, the Income Tax Regulations, and other guidance published by 
the Secretary prescribe the manner in which a liability that has been 
incurred is taken into account. For example, section 162 provides that a 
deductible liability generally is taken into account in the taxable year 
incurred through a deduction from gross income. As a further example, 
under section 263 or 263A, a liability that relates to the creation of 
an asset having a useful life extending substantially beyond the close 
of the taxable year is taken into account in the taxable year incurred 
through capitalization (within the meaning of Sec. 1.263A-1(c)(3)) and 
may later affect the computation of taxable income through depreciation 
or otherwise over a period including subsequent taxable years, in 
accordance with applicable Internal Revenue Code sections and related 
guidance.
    (B) The term ``liability'' includes any item allowable as a 
deduction, cost, or expense for Federal income tax purposes. In addition 
to allowable deductions, the term includes any amount otherwise 
allowable as a capitalized cost, as a cost taken into account in 
computing cost of goods sold, as a cost allocable to a long-term 
contract, or as any other cost or expense. Thus, for example, an amount 
that a taxpayer expends or will expend for capital improvements to 
property must be incurred before the taxpayer may take the amount into 
account in computing its basis in the property. The term ``liability'' 
is not limited to items for which a legal obligation to pay exists at 
the time of payment. Thus, for example, amounts prepaid for goods or 
services and amounts paid without a legal obligation to do so may not be 
taken into account by an accrual basis taxpayer any earlier than the 
taxable year in which those amounts are incurred.
    (C) No method of accounting is acceptable unless, in the opinion of 
the Commissioner, it clearly reflects income. The method used by the 
taxpayer in determining when income is to be accounted for will 
generally be acceptable if it accords with generally accepted accounting 
principles, is consistently used by the taxpayer from year to year, and 
is consistent with the Income Tax Regulations. For example, a taxpayer 
engaged in a manufacturing business may account for sales of the 
taxpayer's product when the goods are shipped, when the product is 
delivered or accepted, or when title to the goods passes to the 
customers, whether or not billed, depending on the method regularly 
employed in keeping the taxpayer's books.
    (iii) Other permissible methods. Special methods of accounting are 
described elsewhere in chapter 1 of the Code and the regulations 
thereunder. For example, see the following sections and the regulations 
thereunder: Sections 61 and 162, relating to the crop method of 
accounting; section 453, relating to the installment method; section 
451, 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

[[Page 60]]

gross income from his trade or business.
    (b) A taxpayer using one method of accounting in computing items of 
income and deductions of his trade or business may compute other items 
of income and deductions not connected with his trade or business under 
a different method of accounting.
    (2) Special rules. (i) In any case in which it is necessary to use 
an inventory the accrual method of accounting must be used with regard 
to purchases and sales unless otherwise authorized under subdivision 
(ii) of this subparagraph.
    (ii) No method of accounting will be regarded as clearly reflecting 
income unless all items of gross profit and deductions are treated with 
consistency from year to year. The Commissioner may authorize a taxpayer 
to adopt or change to a method of accounting permitted by this chapter 
although the method is not specifically described in the regulations in 
this part if, in the opinion of the Commissioner, income is clearly 
reflected by the use of such method. Further, the Commissioner may 
authorize a taxpayer to continue the use of a method of accounting 
consistently used by the taxpayer, even though not specifically 
authorized by the regulations in this part, if, in the opinion of the 
Commissioner, income is clearly reflected by the use of such method. See 
section 446(a) and paragraph (a) of this section, which require that 
taxable income shall be computed under the method of accounting on the 
basis of which the taxpayer regularly computes his income in keeping his 
books, and section 446(e) and paragraph (e) of this section, which 
require the prior approval of the Commissioner in the case of changes in 
accounting method.
    (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.

[[Page 61]]

    (ii)(a) A change in the method of accounting includes a change in 
the overall plan of accounting for gross income or deductions or a 
change in the treatment of any material item used in such overall plan. 
Although a method of accounting may exist under this definition without 
the necessity of a pattern of consistent treatment of an item, in most 
instances a method of accounting is not established for an item without 
such consistent treatment. A material item is any item which involves 
the proper time for the inclusion of the item in income or the taking of 
a deduction. Changes in method of accounting include a change from the 
cash receipts and disbursement method to an accrual method, or vice 
versa, a change involving the method or basis used in the valuation of 
inventories (see sections 471 and 472 and the regulations thereunder), a 
change from the cash or accrual method to a long-term contract method, 
or vice versa (see Sec. 1.451-3), a change involving the adoption, use 
or discontinuance of any other specialized method of computing taxable 
income, such as the crop method, and a change where the Internal Revenue 
Code and regulations thereunder specifically require that the consent of 
the Commissioner must be obtained before adopting such a change.
    (b) A change in method of accounting does not include correction of 
mathematical or posting errors, or errors in the computation of tax 
liability (such as errors in computation of the foreign tax credit, net 
operating loss, percentage depletion or investment credit). Also, a 
change in method of accounting does not include adjustment of any item 
of income or deduction which does not involve the proper time for the 
inclusion of the item of income or the taking of a deduction. For 
example, corrections of items that are deducted as interest or salary, 
but which are in fact payments of dividends, and of items that are 
deducted as business expenses, but which are in fact personal expenses, 
are not changes in method of accounting. In addition, a change in the 
method of accounting does not include an adjustment with respect to the 
addition to a reserve for bad debts or an adjustment in the useful life 
of a depreciable asset. Although such adjustments may involve the 
question of the proper time for the taking of a deduction, such items 
are traditionally corrected by adjustments in the current and future 
years. For the treatment of the adjustment of the addition to a bad debt 
reserve, see the regulations under section 166 of the Code; for the 
treatment of a change in the useful life of a depreciable asset, see the 
regulations under section 167(b) of the Code. A change in the method of 
accounting also does not include a change in treatment resulting from a 
change in underlying facts. On the other hand, for example, a correction 
to require depreciation in lieu of a deduction for the cost of a class 
of depreciable assets which has been consistently treated as an expense 
in the year of purchase involves the question of the proper timing of an 
item, and is to be treated as a change in method of accounting.
    (c) A change in an overall plan or system of identifying or valuing 
items in inventory is a change in method of accounting. Also a change in 
the treatment of any material item used in the overall plan for 
identifying or valuing items in inventory is a change in method of 
accounting.
    (iii) A change in the method of accounting may be illustrated by the 
following examples:

    Example (1). Although the sale of merchandise is an income producing 
factor, and therefore inventories are required, a taxpayer in the retail 
jewelry business reports his income on the cash receipts and 
disbursements method of accounting. A change from the cash receipts and 
disbursements method of accounting to the accrual method of accounting 
is a change in the overall plan of accounting and thus is a change in 
method of accounting.
    Example (2). A taxpayer in the wholesale dry goods business computes 
its income and expenses on the accrual method of accounting and files 
its Federal income tax returns on such basis except for real estate 
taxes which have been reported on the cash receipts and disbursements 
method of accounting. A change in the treatment of real estate taxes 
from the cash receipts and disbursements method to the accrual method is 
a change in method of accounting because such change is a change in the 
treatment of a material item within his overall accounting practice.
    Example (3). A taxpayer in the wholesale dry goods business computes 
its income and

[[Page 62]]

expenses on the accrual method of accounting and files its Federal 
income tax returns on such basis. Vacation pay has been deducted in the 
year in which paid because the taxpayer did not have a completely vested 
vacation pay plan, and, therefore, the liability for payment did not 
accrue until that year. Subsequently, the taxpayer adopts a completely 
vested vacation pay plan that changes its year for accruing the 
deduction from the year in which payment is made to the year in which 
the liability to make the payment now arises. The change for the year of 
deduction of the vacation pay plan is not a change in method of 
accounting but results, instead, because the underlying facts (that is, 
the type of vacation pay plan) have changed.
    Example (4). From 1968 through 1970, a taxpayer has fairly allocated 
indirect overhead costs to the value of inventories on a fixed 
percentage of direct costs. If the ratio of indirect overhead costs to 
direct costs increases in 1971, a change in the underlying facts has 
occurred. Accordingly, an increase in the percentage in 1971 to fairly 
reflect the increase in the relative level of indirect overhead costs is 
not a change in method of accounting but is a change in treatment 
resulting from a change in the underlying facts.
    Example (5). A taxpayer values inventories at cost. A change in the 
basis for valuation of inventories from cost to the lower of cost or 
market is a change in an overall practice of valuing items in inventory. 
The change, therefore, is a change of method of accounting for 
inventories.
    Example (6). A taxpayer in the manufacturing business has for many 
taxable years valued its inventories at cost. However, cost has been 
improperly computed since no overhead costs have been included in 
valuing the inventories at cost. The failure to allocate an appropriate 
portion of overhead to the value of inventories is contrary to the 
requirement of the Internal Revenue Code and the regulations thereunder. 
A change requiring appropriate allocation of overhead is a change in 
method of accounting because it involves a change in the treatment of a 
material item used in the overall practice of identifying or valuing 
items in inventory.
    Example (7). A taxpayer has for many taxable years valued certain 
inventories by a method which provides for deducting 20 percent of the 
cost of the inventory items in determining the final inventory 
valuation. The 20 percent adjustment is taken as a ``reserve for price 
changes.'' Although this method is not a proper method of valuing 
inventories under the Internal Revenue Code or the regulations 
thereunder, it involves the treatment of a material item used in the 
overall practice of valuing inventory. A change in such practice or 
procedure is a change of method of accounting for inventories.
    Example (8). A taxpayer has always used a base stock system of 
accounting for inventories. Under this system a constant price is 
applied to an assumed constant normal quantity of goods in stock. The 
base stock system is an overall plan of accounting for inventories which 
is not recognized as a proper method of accounting for inventories under 
the regulations. A change in this practice is, nevertheless, a change of 
method of accounting for inventories.

    (3)(i) Except as otherwise provided under the authority of paragraph 
(e)(3)(ii) of this section, to secure the Commissioner's consent to a 
taxpayer's change in method of accounting the taxpayer must file an 
application on Form 3115 with the Commissioner during the taxable year 
in which the taxpayer desires to make the change in method of 
accounting. To the extent applicable, the taxpayer must furnish all 
information requested on the Form 3115. This information includes all 
classes of items that will be treated differently under the new method 
of accounting, any amounts that will be duplicated or omitted as a 
result of the proposed change, and the taxpayer's computation of any 
adjustments necessary to prevent such duplications or omissions. The 
Commissioner may require such other information as may be necessary to 
determine whether the proposed change will be permitted. Permission to 
change a taxpayer's method of accounting will not be granted unless the 
taxpayer agrees to the Commissioner's prescribed terms and conditions 
for effecting the change, including the taxable year or years in which 
any adjustment necessary to prevent amounts from being duplicated or 
omitted is to be taken into account. See section 481 and the regulations 
thereunder, relating to certain adjustments resulting from accounting 
method changes, and section 472 and the regulations thereunder, relating 
to adjustments for changes to and from the last-in, first-out inventory 
method. For any Form 3115 filed on or after May 15, 1997, see 
Sec. 1.446-1T(e)(3)(i)(B).
    (ii) Notwithstanding the provisions of paragraph (e)(3)(i) of this 
section, the Commissioner may prescribe administrative procedures under 
which taxpayers will be permitted to change their method of accounting. 
The administrative procedures shall prescribe

[[Page 63]]

those terms and conditions necessary to obtain the Commissioner's 
consent to effect the change and to prevent amounts from being 
duplicated or omitted. The terms and conditions that may be prescribed 
by the Commissioner may include terms and conditions that require the 
change in method of accounting to be effected on a cut-off basis or by 
an adjustment under section 481(a) to be taken into account in the 
taxable year or years prescribed by the Commissioner.
    (iii) This paragraph (e)(3) applies to Forms 3115 filed on or after 
December 31, 1997. For other Forms 3115, see Sec. 1.446-1(e)(3) in 
effect prior to December 31, 1997 (Sec. 1.446-1(e)(3) as contained in 
the 26 CFR part 1 edition revised as of April 1, 1997).
[T.D. 6500, 25 FR 11708, Nov. 26, 1960, as amended by T.D. 7073, 35 FR 
17710, Nov. 18, 1970; T.D. 7285, 38 FR 26184, Sept. 19, 1973; T.D. 8067, 
51 FR 378, Jan. 6, 1986; T.D. 8131, 52 FR 10084, Mar. 30, 1987; T.D. 
8408, 57 FR 12419, Apr. 10, 1992; T.D. 8482, 58 FR 42233, Aug. 9, 1993; 
T.D. 8608, 60 FR 40078, Aug. 7, 1995; T.D. 8719, 62 FR 26741, May 15, 
1997; T.D. 8742, 62 FR 68169, Dec. 31, 1997]



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);
    (D) Sections 1281 through 1283 (discount on certain short-term 
obligations);
    (E) Section 7872(a) (certain loans with below-market interest 
rates); or
    (F) Section 1.1272-3 (an election by a holder to treat all interest 
on a debt instrument as original issue discount).
    (ii) De minimis original issue discount. This section does not apply 
to de minimis original issue discount (other than de minimis original 
issue discount treated as qualified stated interest) as determined under 
Sec. 1.1273-1(d). See Sec. 1.163-7 for the treatment of de minimis 
original issue discount by the issuer and Secs. 1.1273-1(d) and 1.1272-3 
for the treatment of de minimis original issue discount by the holder.
    (b) Accrual of qualified stated interest. Qualified stated interest 
(as defined in Sec. 1.1273-1(c)) accrues ratably over the accrual period 
(or periods) to which it is attributable and accrues at the stated rate 
for the period (or periods).
    (c) Accrual of interest other than qualified stated interest. 
Subject to the modifications in paragraph (d) of this section, the 
amount of interest (other than qualified stated interest) that accrues 
for any accrual period is determined under rules similar to those in the 
regulations under sections 1272 and 1275 for the accrual of original 
issue discount. The preceding sentence applies regardless of any 
contrary formula agreed to by the parties.
    (d) Modifications--(1) Issue price. The issue price of the loan or 
contract is equal to--
    (i) In the case of a contract for the sale or exchange of property 
to which section 483 applies, the amount described in Sec. 1.483-
2(a)(1)(i) or (ii), whichever is applicable;
    (ii) In the case of a contract for the sale or exchange of property 
to which section 483 does not apply, the stated principal amount; or
    (iii) In any other case, the amount loaned.

[[Page 64]]

    (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.

    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 ($1,000,000 x .092) and the amount 
of interest that accrues for the second accrual period is $100,464 
($1,092,000 x .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 ($543,892.17 x .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

[[Page 65]]

$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.
(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

[[Page 66]]

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 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

[[Page 67]]

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 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

[[Page 68]]

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 days x $8,000,000), and the ratable 
daily portion of the floating leg is $5,860,656 (275 days/366 days x 
$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 (0.5 
x 7.8% x $100,000,000) on October 1, 1995. In addition, D is obligated 
to pay C $3,730,000 (0.5 x 7.46% 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 days x $8,000,000), and the 
ratable daily portion of the floating leg is $5,765,000 ($3,900,000 + 
(90 days/180 days x $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 days x 8.25% x $100,000,000), while the ratable daily portion 
of the fixed leg is $6,010,929 (275 days/366 days x $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 days x ($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

[[Page 69]]

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 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

[[Page 70]]

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 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

[[Page 71]]

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 days x $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 
days x .25 x .001 x $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 (.25 x .0015 x $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 days x ($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 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

[[Page 72]]

                                                                                                                
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:

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

[[Page 73]]

                                                                                                                
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 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

[[Page 74]]

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 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

[[Page 75]]

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 $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

[[Page 76]]

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.
    (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-

[[Page 77]]

$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 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

[[Page 78]]

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(e), 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(e)(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 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(e). See Sec. 1.1221-2(a)(4)(i).
    (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.

[[Page 79]]

    (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:
    (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

[[Page 80]]

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(c)(2), 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 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(d)(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(d)(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.

[[Page 81]]

    (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]



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 section 481(a) adjustment into account ratably 
(beginning with the year of change) over the shorter of--
    (A) The number of taxable years the taxpayer used the cash method, 
or
    (B) 4 taxable years,

provided the taxpayer complies with the provisions of paragraph (h)(2) 
or (h)(3) of this section for its first section 448 year.
    (ii) Hospital timing rules--(A) In general. In the case of a 
hospital that is required by this section to change from the cash 
method, the section 481(a) adjustment shall be taken into account 
ratably (beginning with the year of change) over 10 years, provided the 
taxpayer complies with the provisions of paragraph (h)(2) or (h)(3) of 
this section for its first section 448 year.
    (B) Definition of hospital. For purposes of paragraph (g) of this 
section, a hospital is an institution--

[[Page 82]]

    (1) Accredited by the Joint Commission on Accreditation of 
Healthcare Organizations or its predecessor (the JCAHO) (or accredited 
or approved by a program of the qualified governmental unit in which 
such institution is located if the Secretary of Health and Human 
Services has found that the accreditation or comparable approval 
standards of such qualified governmental unit are essentially equivalent 
to those of the JCAHO);
    (2) Used primarily to provide, by or under the supervision of 
physicians, to inpatients diagnostic services and therapeutic services 
for medical diagnosis, treatment, and care of injured, disabled, or sick 
persons;
    (3) Requiring every patient to be under the care and supervision of 
a physician; and
    (4) Providing 24-hour nursing services rendered or supervised by a 
registered professional nurse and having a licensed practical nurse or 
registered nurse on duty at all times.

For purposes of this section, an entity need not be owned by or on 
behalf of a governmental unit or by a section 501(c)(3) organization, or 
operated by a section 501(c)(3) organization, in order to be considered 
a hospital. In addition, for purposes of this section, a hospital does 
not include a rest or nursing home, continuing care facility, daycare 
center, medical school facility, research laboratory, or ambulatory care 
facility.
    (C) Dual function facilities. With respect to any taxpayer whose 
operations consist both of a hospital, and other facilities not 
qualifying as a hospital, the portion of the adjustment required by 
section 481(a) that is attributable to the hospital shall be taken into 
account in accordance with the rules of paragraph (g)(2) of this section 
relating to hospitals. The portion of the adjustment required by section 
481(a) that is not attributable to the hospital shall be taken into 
account in accordance with the rules of paragraph (g)(2) of this section 
not relating to hospitals.
    (iii) Untimely change in method of accounting to comply with this 
section. Unless a taxpayer (including a hospital and a cooperative) 
required by this section to change from the cash method complies with 
the provisions of paragraph (h)(2) or (h)(3) of this section for its 
first section 448 year within the time prescribed by those paragraphs, 
the taxpayer must take the section 481 (a) adjustment into account under 
the provisions of any applicable administrative procedure that is 
prescribed by the Commissioner after January 7, 1991, specifically for 
purposes of complying with this section. Absent such an administrative 
procedure, a taxpayer must request a change under Sec. 1.446-1(e)(3) and 
shall be subject to any terms and conditions (including the year of 
change) as may be imposed by the Commissioner.
    (3) Special timing rules for section 481(a) adjustment--(i) One-
third rule. If, during the period the section 481(a) adjustment is to be 
taken into account, the balance of the taxpayer's accounts receivable as 
of the last day of each of two consecutive taxable years is less than 
66\2/3\ percent of the taxpayer's accounts receivable balance at the 
beginning of the first year of the section 481(a) adjustment, the 
balance of the section 481(a) adjustment (relating to accounts 
receivable) not previously taken into account shall be included in 
income in the second taxable year. This paragraph (g)(3)(i) shall not 
apply to any hospital (within the meaning of paragraph (g)(2)(ii) of 
this section).
    (ii) Cooperatives. Notwithstanding paragraph (g)(2)(i) of this 
section, in the case of a cooperative (within the meaning of section 
1381(a)) that is required by this section to change from the cash 
method, the entire section 481(a) adjustment may, at the cooperative's 
option, be taken into account in the year of change, provided the 
cooperative complies with the provisions of paragraph (h)(2) or (h)(3) 
of this section for its first section 448 year.
    (iii) Cessation of trade or business. If the taxpayer ceases to 
engage in the trade or business to which the section 481(a) adjustment 
relates, or if the taxpayer operating the trade or business terminates 
existence, and such cessation or termination occurs prior to the 
expiration of the adjustment period described in paragraph (g)(2) (i) or 
(ii) of this section, the taxpayer must take into account, in the 
taxable year of such cessation or termination, the balance of the 
adjustment not previously

[[Page 83]]

taken into account in computing taxable income. For purposes of this 
paragraph (g)(3)(iii), the determination as to whether a taxpayer has 
ceased to engage in the trade or business to which the section 481(a) 
adjustment relates, or has terminated its existence, is to be made under 
the principles of Sec. 1.446-1(e)(3)(ii) and its underlying 
administrative procedures.
    (iv) De minimis rule for a taxpayer other than a cooperative. 
Notwithstanding paragraph (g)(2)(i) and (ii) of this section, a taxpayer 
other than a cooperative (within the meaning of section 1381(a)) that is 
required to change from the cash method by this section may elect to 
use, in lieu of the adjustment period described in paragraph (g)(2)(i) 
and (ii) of this section, the adjustment period for de minimis section 
481(a) adjustments provided in the applicable administrative procedure 
issued under Sec. 1.446-1(e)(3)(ii) for obtaining the Commissioner's 
consent to a change in accounting method. A taxpayer may make an 
election under this paragraph (g)(3)(iv) only if--
    (A) The taxpayer's entire net section 481(a) adjustment (whether 
positive or negative) is a de minimis amount as determined under the 
applicable administrative procedure issued under Sec. 1.446-1(e)(3)(ii) 
for obtaining the Commissioner's consent to a change in accounting 
method,
    (B) The taxpayer complies with the provisions of paragraph (h)(2) or 
(3) of this section for its first section 448 year,
    (C) The return for such year is due (determined with regard to 
extensions) after December 27, 1993, and
    (D) The taxpayer complies with any applicable instructions to Form 
3115 that specify the manner of electing the adjustment period for de 
minimis section 481(a) adjustments.
    (4) Additional rules relating to section 481(a) adjustment. In 
addition to the rules set forth in paragraph (g) (2) and (3) of this 
section, the following rules shall apply in taking the section 481(a) 
adjustment into account--
    (i) Any net operating loss and tax credit carryforwards will be 
allowed to offset any positive section 481(a) adjustment,
    (ii) Any net operating loss arising in the year of change or in any 
subsequent year that is attributable to a negative section 481(a) 
adjustment may be carried back to earlier taxable years in accordance 
with section 172, and
    (iii) For purposes of determining estimated income tax payments 
under sections 6654 and 6655, the section 481(a) adjustment will be 
recognized in taxable income ratably throughout a taxable year.
    (5) Outstanding section 481(a) adjustment from previous change in 
method of accounting. If a taxpayer changed its method of accounting to 
the cash method for a taxable year prior to the year the taxpayer was 
required by this section to change from the cash method (the section 448 
year), any section 481(a) adjustment from such prior change in method of 
accounting that is outstanding as of the section 448 year shall be taken 
into account in accordance with the provisions of this paragraph (g)(5). 
A taxpayer shall account for any remaining portion of the prior section 
481(a) adjustment outstanding as of the section 448 year by continuing 
to take such remaining portion into account under the provisions and 
conditions of the prior change in method of accounting, or, at the 
taxpayer's option, combining or netting the remaining portion of the 
prior section 481(a) adjustment with the section 481(a) adjustment 
required under this section, and taking into account under the 
provisions of this section the resulting net amount of the adjustment. 
Any taxpayer choosing to combine or net the section 481(a) adjustments 
as described in the preceding sentence shall indicate such choice on the 
Form 3115 required to be filed by such taxpayer under the provisions of 
paragraph (h) of this section.
    (6) Examples. The following examples illustrate the provisions of 
paragraph (g) of this section.

    Example (1). Y is required by this section to change from the cash 
method of accounting for its taxable year beginning January 1, 1987. Y 
changes to an overall accrual method. The adjustment required by section 
481(a) to effect the change is $10,000. Y has been using the cash method 
for the 10-year period preceding the year of change. Y is required by 
paragraph (g)(2)(i) of this section to include

[[Page 84]]

the section 481(a) adjustment in taxable income ratably over four 
consecutive taxable years, beginning with 1987, i.e., $2,500 of the 
section 481(a) adjustment should be included in income for each of the 
four years.
    Example (2). The facts are the same as in example (1), except that Y 
is required to change from the cash method and changes to an overall 
accrual method of accounting for its taxable year beginning January 1, 
1989. The result is the same as in example (1), except that the four-
year period for ratably taking the section 481(a) adjustment into 
account begins with the 1989 taxable year.
    Example (3). Assume that X is required by this section to change 
from the cash method and that it changes to an overall accrual method 
for its taxable year beginning January 1, 1987. The adjustment required 
by section 481 (a) to effect the change is $10,000. X was formed on 
January 1, 1986, and began business operations during that year. Since X 
only used the cash method for one year, X is required by paragraph 
(g)(2)(i) of this section to include all ($10,000) of the section 481(a) 
adjustment in taxable income for the 1987 taxable year.
    Example (4). The facts are the same as in example (1). In addition, 
Y previously changed from an accrual method of accounting to the cash 
method for its taxable year beginning January 1, 1983. As a result of 
that prior change, Y was required to take into account a $5,000 negative 
section 481(a) adjustment ratably over a ten-year period, beginning with 
the 1983 taxable year.
    As of the beginning of the 1987 taxable year $3,000 of that 
adjustment had not been taken into account. Y may continue to take the 
remaining negative $3,000 section 481(a) adjustment into account ratably 
over the remaining adjustment period for the prior change in method of 
accounting (i.e., six remaining years). Alternatively, Y may combine or 
net the negative $3,000 adjustment with the positive $10,000 section 
481(a) adjustment required by this section, and include the resulting 
$7,000 amount in taxable income ratably over four consecutive taxable 
years, beginning with 1987. Y is not allowed to take the entire 
unamortized amount of the prior section 481(a) adjustment into account 
for its 1987 taxable year.

    (h) Procedures for change in method of accounting--(1) 
Applicability. Paragraph (h) of this section applies to taxpayers who 
change from the cash method as required by this section. Paragraph (h) 
of this section does not apply to a change in accounting method required 
by any Code section (or regulations thereunder) other than this section.
    (2) Automatic rule for changes to an overall accrual method--(i) 
Timely changes in method of accounting. Notwithstanding any other 
available procedures to change to the accrual method of accounting, a 
taxpayer to whom paragraph (h) of this section applies who desires to 
make a change to an overall accrual method for its first section 448 
year must make that change under the provisions of this paragraph 
(h)(2). A taxpayer changing to an overall accrual method under this 
paragraph (h)(2) must file a current Form 3115 by the time prescribed in 
paragraph (h)(2)(ii). In addition, the taxpayer must set forth on a 
statement accompanying the Form 3115 the period over which the section 
481(a) adjustment will be taken into account and the basis for such 
conclusion. Moreover, the taxpayer must type or legibly print the 
following statement at the top of page 1 of the Form 3115: ``Automatic 
Change to Accrual Method--Section 448.'' The consent of the Commissioner 
to the change in method of accounting is granted to taxpayers who change 
to an overall accrual method under this paragraph (h)(2). See paragraph 
(g)(2)(i), (g)(2)(ii), or (g)(3) of this section, whichever is 
applicable, for rules to account for the section 481(a) adjustment.
    (ii) Time and manner for filing Form 3115--(A) In general. Except as 
provided in paragraph (h)(2)(ii)(B) of this section, the Form 3115 
required by paragraph (h)(2)(i) must be filed no later than the due date 
(determined with regard to extensions) of the taxpayer's federal income 
tax return for the first section 448 year and must be attached to that 
return.
    (B) Extension of filing deadline. Notwithstanding paragraph 
(h)(2)(ii)(A) of this section, the filing of the Form 3115 required by 
paragraph (h)(2)(i) shall not be considered late if such Form 3115 is 
attached to a timely filed amended income tax return for the first 
section 448 year, provided that--
    (1) The taxpayer's first section 448 year is a taxable year that 
begins (or, pursuant to Sec. 1.441-2T (b)(1), 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

[[Page 85]]

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.
    (i) Effective date--(1) In general. Except as provided in paragraph 
(i)(2), (3), and (4) of this section, this section applies to any 
taxable year beginning after December 31, 1986.
    (2) Election out of section 448--(i) In general. A taxpayer may 
elect not to have this section apply to any (A) transaction with a 
related party (within the meaning of section 267(b) of the Internal 
Revenue Code of 1954, as in effect on October 21, 1986), (B) loan, or 
(C) lease, if such transaction, loan, or lease was entered into on or 
before September 25, 1985. Any such election described in the preceding 
sentence may

[[Page 86]]

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.
[T.D. 8514, 58 FR 68299, Dec. 27, 1993]



Sec. 1.448-1T  Limitation on the use of the cash receipts and disbursements method of accounting (temporary).

    (a) Limitation on accounting method--(1) In general. This section 
prescribes regulations under section 448 relating to the limitation on 
the use of the cash receipts and disbursements method of accounting (the 
cash method) by certain taxpayers.
    (2) Limitation rule. Except as otherwise provided in this section, 
the computation of taxable income using the cash method is prohibited in 
the case of a--
    (i) C corporation,
    (ii) Partnership with a C corporation as a partner, or
    (iii) Tax shelter.

A partnership is described in paragraph (a)(2)(ii) of this section, if 
the partnership has a C corporation as a partner at any time during the 
partnership's taxable year beginning after December 31, 1986.
    (3) Meaning of C corporation. For purposes of this section, the term 
``C corporation'' includes any corporation that is not an S corporation. 
For example, a regulated investment company (as defined in section 851) 
or a real estate investment trust (as defined in section 856) is a C 
corporation for purposes of this section. In addition, a trust subject 
to tax under section 511 (b) shall be treated, for purposes of this 
section, as a C corporation, but only with respect to the portion of its 
activities that constitute an unrelated trade or business. Similarly, 
for purposes of this section, a corporation that is exempt from federal 
income taxes under section 501 (a) shall be treated as a C corporation 
only with respect to the portion of its activities that constitute an 
unrelated trade or business. Moreover, for purposes of determining 
whether a partnership has a C corporation as a partner, any partnership 
described in paragraph (a)(2)(ii) of this section is treated as a C 
corporation. Thus, if partnership ABC has a partner that is a 
partnership with a C corporation, then, for purposes of this section, 
partnership ABC is treated as a partnership with a C corporation 
partner.
    (4) Treatment of a combination of methods. For purposes of this 
section, the

[[Page 87]]

use of a method of accounting that records some, but not all, items on 
the cash method shall be considered the use of the cash method. Thus, a 
C corporation that uses a combination of accounting methods including 
the use of the cash method is subject to this section.
    (b) Tax shelter defined--(1) In general. For purposes of this 
section, the term ``tax shelter'' means any--
    (i) Enterprise (other than a C corporation) if at any time 
(including taxable years beginning before January 1, 1987) interests in 
such enterprise have been offered for sale in any offering required to 
be registered with any federal or state agency having the authority to 
regulate the offering of securities for sale,
    (ii) Syndicate (within the meaning of paragraph (b)(3) of this 
section), or
    (iii) Tax shelter within the meaning of section 6661 (b)(2)(C)(ii) 
(relating to (A) a partnership or other entity, (B) any investment plan 
or arrangement, or (C) any other plan or arrangement, whose principal 
purpose is the avoidance or evasion of Federal income tax).
    (2) Requirement of registration. For purposes of paragraph (b)(1)(i) 
of this section, an offering is required to be registered with a federal 
or state agency if, under the applicable federal or state law, failure 
to register the offering would result in a violation of the applicable 
federal or state law (regardless of whether the offering is in fact 
registered). In addition, an offering is required to be registered with 
a federal or state agency if, under the applicable federal or state law, 
failure to file a notice of exemption from registration would result in 
a violation of the applicable federal or state law (regardless of 
whether the notice is in fact filed).
    (3) Meaning of syndicate. For purposes of paragraph (b)(1)(ii) of 
this section, the term ``syndicate'' means a partnership or other entity 
(other than a C corporation) if more than 35 percent of the losses of 
such entity during the taxable year (for taxable years beginning after 
December 31, 1986) are allocated to limited partners or limited 
entrepreneurs. For purposes of this paragraph (b)(3), the term ``limited 
entrepreneur'' has the same meaning given such term in section 464 
(e)(2). In addition, in determining whether an interest in a partnership 
is held by a limited partner, or an interest in an entity or enterprise 
is held by a limited entrepreneur, section 464 (c)(2) shall apply in the 
case of the trade or business of farming (as defined in paragraph (d)(2) 
of this section), and section 1256 (e)(3)(C) shall apply in any other 
case. Moreover, for purposes of this paragraph (b)(3), the losses of a 
partnership, entity, or enterprise (the enterprise) means the excess of 
the deductions allowable to the enterprise over the amount of income 
recognized by such enterprise under the enterprise's method of 
accounting used for federal income tax purposes (determined without 
regard to this section). For this purpose, gains or losses from the sale 
of capital assets or section 1221 (2) assets are not taken into account.
    (4) Presumed tax avoidance. For purposes of paragraph (b)(1)(iii) of 
this section, marketed arrangements in which persons carrying on farming 
activities using the services of a common managerial or administrative 
service will be presumed to have the principal purpose of tax avoidance 
if such persons use borrowed funds to prepay a substantial portion of 
their farming expenses (e.g., payment for farm supplies that will not be 
used or consumed until a taxable year subsequent to the taxable year of 
payment).
    (5) Taxable year tax shelter must change accounting method. A 
partnership, entity, or enterprise that is a tax shelter must change 
from the cash method for the later of (i) the first taxable year 
beginning after December 31, 1986, or (ii) the taxable year that such 
partnership, entity, or enterprise becomes a tax shelter.
    (c) Effect of section 448 on other provisions. Nothing in section 
448 shall have any effect on the application of any other provision of 
law that would otherwise limit the use of the cash method, and no 
inference shall be drawn from section 448 with respect to the 
application of any such provision. For example, nothing in section 448 
affects the requirement of section 447 that certain corporations must 
use an accrual method of accounting in computing taxable income from 
farming, or the

[[Page 88]]

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 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

[[Page 89]]

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 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

[[Page 90]]

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 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

[[Page 91]]

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 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

[[Page 92]]

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) 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,

[[Page 93]]

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 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,

[[Page 94]]

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 
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

[[Page 95]]

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 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

[[Page 96]]

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 
million3). Thus, for taxable year 1987, this section applies and 
X must change from the cash method for such year.
[T.D. 8143, 52 FR 22766, June 16, 1987, as amended by T.D. 8329, 56 FR 
485, Jan. 7, 1991; T.D. 8514, 58 FR 68299, Dec. 27, 1993]



Sec. 1.448-2T  Nonaccrual of certain amounts by service providers (temporary).

    (a) In general. Except as otherwise provided, this section applies 
to any person using an accrual method of accounting with respect to 
amounts to be received from the performance of services by such person. 
This section applies to such persons regardless of whether such persons 
changed their method of accounting from the cash method under section 
448. For example, this section applies to a taxpayer who used an overall 
accrual method of accounting in taxable years prior to 1987.
    (b) Nonaccrual-experience method; treatment as method of accounting. 
Any person to whom this section applies is not required to accrue any 
portion of amounts to be received from the performance of services 
which, on the basis of experience, will not be collected. This 
nonaccrual of amounts to be received for the performance of services 
shall be treated as a method of accounting under the Code (the 
nonaccrual-experience method).
    (c) Method not available if interest charged on amounts due--(1) In 
general. The nonaccrual-experience method of accounting may not be used 
with respect to amounts due for which interest is required to be paid, 
or for which there is any penalty for failure to timely pay any amounts 
due. For this purpose, interest or penalties for late payment will be 
deemed to be charged by a taxpayer if such treatment is in accordance 
with the economic substance of a transaction, regardless of the 
characterization of the transaction by the parties, or the treatment of 
the transaction under state or local law. However, the offering of a 
discount for early payment of an amount due will not be regarded as the 
charging of interest or penalties for late payment under this section, 
if (i) the full amount due is otherwise accrued as gross income by the 
taxpayer at the time the services are provided, and (ii) the discount 
for early payment is treated as an adjustment to gross income in the 
year of payment, if payment is received within the time required for 
allowance of such discount.

[[Page 97]]

    (2) Example. The provisions of this paragraph (c) may be illustrated 
by the following example:

    Example. X uses an accrual method of accounting for amounts to be 
received from the provision of services. For such amounts, X has two 
billing methods. Under one method, for amounts that are more than 90 
days past due, X charges interest at a market rate until such amounts 
(together with interest) are paid. Under the other billing method, X 
charges no interest for amounts past due. X cannot use the nonaccrual-
experience method of accounting with respect to any of the amounts 
billed under the method that charges interest on amounts that are more 
than 90 days past due. X may, however, use the nonaccrual-experience 
method with respect to the amounts billed under the method that does not 
charge interest for amounts past due.

    (d) Method not available for certain receivables. The nonaccrual-
experience method of accounting may be used only with respect to amounts 
earned by the taxpayer and otherwise recognized in income (an account 
receivable) through the performance of services by such taxpayer. For 
example, the nonaccrual-experience method may not be used with respect 
to amounts owed to the taxpayer by reason of the taxpayer's activities 
with respect to (1) lending money; (2) selling goods; or (3) acquiring 
receivables or other rights to receive payment from other persons 
(including persons related to the taxpayer) regardless of whether those 
other persons earned such amounts through the provision of services.
    (e) Use of experience to estimate uncollectible amounts--(1) In 
general. In determining the portion of any amount due which, on the 
basis of experience, will not be collected, the formula prescribed by 
paragraph (e)(2) of this section shall be used by the taxpayer with 
respect to each separate trade or business of the taxpayer. No other 
method or formula may be used by a taxpayer in determining the 
uncollectible amounts under this section.
    (2) Six-year moving average--(i) General rule. For any taxable year 
the uncollectible amount of a receivable is the amount of that 
receivable which bears the same ratio to the account receivable 
outstanding at the close of the taxable year as (A) the total bad debts 
(with respect to accounts receivable) sustained throughout the period 
consisting of the taxable year and the five preceding taxable years (or, 
with the approval of the Commissioner, a shorter period), adjusted for 
recoveries of bad debts during such period, bears to (B) the sum of the 
accounts receivable earned throughout the entire six (or fewer) taxable 
year period (i.e., the total amount of sales resulting in accounts 
receivable) throughout the period. Accounts receivable described in 
paragraphs (c) and (d) of this section are not taken into account in 
computing the ratio.
    (ii) Period of less than six years. A period shorter than six years 
generally will be appropriate only if there is a change in the type of a 
substantial portion of the outstanding accounts receivable such that the 
risk of loss is substantially increased. A decline in the general 
economic conditions in the area, which substantially increases the risk 
of loss, is a relevant factor in determining whether a shorter period is 
appropriate. However, approval to use a shorter period will not be 
granted unless the taxpayer supplies specific evidence that the loans 
outstanding at the close of the taxable years for the shorter period 
requested are not comparable in nature and risk to loans outstanding at 
the close of the six taxable years. A substantial increase in a 
taxpayer's bad debt experience, is not, by itself, sufficient to justify 
the use of a shorter period. If approval is granted to use a shorter 
period, the experience for the excluded taxable years shall not be used 
for any subsequent year. A request for approval to exclude the 
experience of a prior taxable year shall be made in accordance with the 
applicable procedures for requesting a letter ruling and shall include a 
statement of the reasons such experience should be excluded. A request 
will not be considered unless it is sent to the Commissioner at least 30 
days before the close of the first taxable year for which such approval 
is requested.
    (iii) Special rule for new taxpayers. In the case of any current 
taxable year which is preceded by less than 5 taxable years, paragraph 
(e)(2)(i) of this section shall be applied by using the experience of 
the current year and the actual number of preceding taxable

[[Page 98]]

years. However, for this purpose, experience from preceding taxable 
years of a predecessor trade or business may be used in applying 
paragraph (e)(2)(i) of this section.
    (3) Mechanics of nonaccrual-experience method. The nonaccrual-
experience method shall be applied with respect to each account 
receivable of the taxpayer which is eligible for such method. With 
respect to a particular account receivable, the taxpayer will determine, 
in the manner prescribed in paragraph (e) of this section, the amount of 
such account receivable that is not expected to be collected. Such 
determination shall be made only once with respect to each account 
receivable, regardless of the term of such receivable. The estimated 
uncollectible amount shall not be recognized as gross income. Thus, the 
amount recognized as gross income shall be the amount that would 
otherwise be recognized as gross income with respect to the account 
receivable, less the amount which is not expected to be collected. Upon 
the collection of the account receivable, additional gross income shall 
be recognized with respect to the collection of any amount not initially 
expected to be collected. Similarly, no bad debt deduction under section 
166 for a wholly or partially worthless account receivable shall be 
allowed for any amount not previously taken into income under the 
nonaccrual-experience method.
    (4) Examples. The following examples illustrate the provisions of 
paragraph (e) of this section:

    Example (1). X is a calendar year service provider that uses an 
accrual method of accounting with respect to the amounts (accounts 
receivable) to be received from the provision of services. X does not 
require the payment of interest or penalties with respect to past due 
accounts receivable. Assume that under this section, X adopts for 
taxable year 1987 the nonaccrual-experience method of accounting with 
respect to its accounts receivable. Further, assume that X's total 
accounts receivable and bad debt experience for the current and five 
preceding taxable years is as follows:

------------------------------------------------------------------------
                                    Total accounts    Bad debts adjusted
              Years                   receivable        for recoveries  
------------------------------------------------------------------------
1982............................         $30,000              $5,700    
1983............................          40,000               7,200    
1984............................          50,000              11,000    
1985............................          60,000              10,200    
1986............................          70,000              14,000    
1987............................          80,000              16,800    
                                                                        
                                 ---------------------------------------
                                         330,000              64,900    
------------------------------------------------------------------------

    Thus, the ratio of the bad debts (adjusted for recoveries) for the 
current and five preceding taxable years to the total accounts 
receivable over the same period is 19.67% ($64,900/$330,000). Assume 
that $49,300 of the total $80,000 of accounts receivable earned 
throughout the taxable year 1987 are outstanding as of the close of such 
year. Assume further that the $49,300 of the accounts receivable 
outstanding as of the close of the tax year 1987 consist of 10 separate 
accounts receivable. The uncollectible amount of each receivable is 
19.67%. The amount of these accounts receivable and the uncollectible 
amount of each is as follows:

------------------------------------------------------------------------
       Accounts receivable    Applicable ratio     Uncollectible amount 
------------------------------------------------------------------------
  1. $5,200                          .1967              $1,022.84       
  2. 7,300                           .1967               1,435.91       
  3. 3,200                           .1967                 629.44       
  4. 4,300                           .1967                 845.81       
  5. 1,700                           .1967                 334.39       
  6. 4,000                           .1967                 786.80       
  7. 6,300                           .1967               1,239.21       
  8. 8,000                           .1967               1,573.60       
  9. 3,200                           .1967                 629.44       
 10. 6,100                           .1967               1,199.87       
                                                                        
    ---------------------                      -------------------------
     49,300                                              9,697.31       
------------------------------------------------------------------------

    For taxable year 1987, X will not accrue as income $9,697.31 of its 
accounts receivable of $49,300 outstanding as of the close of the year.
    Example (2). The facts are the same as in example (1). In 1988 the 
entire amount of account receivable number 8 becomes wholly worthless. 
Since in 1987 X did not accrue as income under the nonaccrual-experience 
method $1,573.60 of that account receivable, no deduction under section 
166 is allowable with respect to that amount of the account receivable; 
a deduction of $6,426.40 under section 166 is allowable for 1988.
    Example (3). The facts are the same as in example (1). In 1988 X 
collects, in full, account receivable number 5. Accordingly, in 1988 X 
must recognize additional gross income of $334.39, the amount of the 
account receivable that was initially considered uncollectible.

    (5) Special rule for estimated tax. For purposes of section 6654 or 
6655 only (relating to the addition to tax for underpayment of estimated 
tax), a taxpayer's income does not include eligible income attributable 
to the period

[[Page 99]]

before May 16, 1988. A taxpayer's eligible income is the excess (if any) 
of--
    (i) Income (including the amount of any adjustment required under 
section 481(a)) computed with a bad debt experience ratio using accounts 
receivable earned throughout the period ending at the close of the six-
year period (or other shorter period) described in paragraph (e)(2)(i) 
of this section, over
    (ii) Income (including the amount of any adjustment required under 
section 481(a)) computed with a bad debt experience ratio using the 
year-end balances of accounts receivable over such six-year (or other 
shorter) period.

    (f) [Reserved]
    (g) Coordination of change in accounting method with section 481--
(1) Taxpayers required to change their method of accounting under 
section 448. The provisions of this paragraph (g)(1) apply to taxpayers 
who under Sec. 1.448-1T(h) change from the cash method as required by 
section 448 and who also change under paragraph (h) of this section to a 
method of accounting that includes the nonaccrual-experience method. 
With respect to such taxpayers, the section 481(a) adjustment resulting 
from the change in method of accounting to the nonaccrual-experience 
method shall be combined or netted with the section 481(a) adjustment 
applicable to the change in method of accounting required under section 
448. The resulting amount shall then be taken into account in accordance 
with the provisions of Sec. 1.448-1T(g) applicable to the change in 
method of accounting required by section 448.
    (2) Taxpayers not required to change their method of accounting 
under section 448. The provisions of this paragraph (g)(2) apply to 
taxpayers who are not required by section 448 to change their method of 
accounting (e.g., taxpayers who were using an accrual method of 
accounting for taxable years preceding 1987) and who change to the 
nonaccrual-experience method under paragraph (h)(3) of this section. 
With respect to such taxpayers, the section 481(a) adjustment resulting 
from the change in method of accounting to the nonaccrual-experience 
method shall be taken into account ratably over four taxable years. The 
provisions of this paragraph (g)(2) shall apply to any taxpayer 
regardless of whether such taxpayer was required to change its method of 
accounting for bad debts under section 805 of the Tax Reform Act of 
1986.
    (h) Changes in method of accounting to nonaccrual-experience 
method--(1) Automatic changes to overall accrual method. The provisions 
of this paragraph (h)(1) apply to taxpayers who change from the cash 
method as required by section 448, and change to an overall accrual 
method of accounting under the automatic change provisions of 
Sec. 1.448-1T(h)(2). Taxpayers to whom this paragraph (h)(1) applies may 
automatically change their method of accounting to the nonaccrual-
experience method under this paragraph (h)(1), if they otherwise qualify 
under this section for the use of such method. Taxpayers changing to the 
nonaccrual-experience method under this paragraph (h)(1) shall comply 
with the provisions of Sec. 1.448-1T(h)(2). Moreover, such taxpayers 
shall type or legibly print the following statement at the top of page 1 
of Form 315: ``Automatic Change to Nonaccrual Experience Method--Section 
448.'' The consent of the Commissioner to the change in method of 
accounting is granted to taxpayers changing to the nonaccrual-experience 
method under this paragraph (h)(1).
    (2) Changes to a method other than overall accrual method. The 
provisions of this paragraph (h)(2) apply to taxpayers who change from 
the cash method as required by section 448 and who also change to a 
permissible special method of accounting under Sec. 1.448-1T(h)(3). 
Taxpayers to whom this paragraph (h)(2) applies may change their method 
of accounting to the nonaccrual-experience method under this paragraph 
(h)(2). Taxpayers changing to the nonaccrual-experience method under 
this paragraph (h)(2) shall comply with the provisions of Sec. 1.448-
1T(h)(3). Moreover, such taxpayers shall type or legibly print the 
following statement on the top of page 1 of Form 3115: ``Change to 
Nonaccrual-Experience Method and Special Method of Accounting-Section 
448.'' The consent of the Commissioner to the change in method of 
accounting is granted to taxpayers changing to the nonaccrual-

[[Page 100]]

experience method under this paragraph (h)(2).
    (3) Taxpayers not required to change their method of accounting 
under section 448. The provisions of this paragraph (h)(3) apply to 
taxpayers who are not required by section 448 to change their method of 
accounting for the taxable year in which such taxpayers desire to adopt 
the nonaccrual-experience method (e.g., taxpayers who were using an 
accrual method of accounting for taxable years preceding 1987). Such 
taxpayers may automatically change their method of accounting to the 
nonaccrual-experience method under the provisions of this paragraph 
(h)(3), for their taxable year beginning in 1987, if they otherwise 
qualify under the provisions of this section for the use of such method. 
Taxpayers changing to the nonaccrual-experience method for their taxable 
year beginning in 1987 shall complete and file a current Form 3115. The 
Form 3115 shall be filed no later than the due date (including 
extension) of the taxpayer's federal income tax return for the year of 
change and shall be attached to that return, Moreover, the taxpayer 
shall type or legibly print the following statement at the top of page 1 
of Form 3115: ``Automatic Change to Nonaccrual Experience Method--
Taxpayer not Required to Change Method of Accounting Under Section 
448.'' The consent of the Commissioner to the change in method of 
accounting is granted to taxpayers changing to the nonaccrual-experience 
method for their taxable year beginning in 1987 under this paragraph 
(h)(3). With respect to taxpayers described in this paragraph (h)(3) who 
desire to change to the nonaccrual-experience method for a taxable year 
beginning after December 31, 1987, such taxpayers shall submit an 
application for change in accounting method under the administrative 
procedures applicable to taxpayers at the time of change, including the 
applicable procedures regarding the time and place of filing the 
application for change in method. Taxpayers described in the preceding 
sentence include taxpayers who were required to change their method of 
accounting under section 448 for an earlier taxable year, but who did 
not change to the nonaccrual-experience method at that time.
    (i) Effective date. This section applies to any taxable year 
beginning after December 31, 1986.
[T.D. 8143, 52 FR 22774, June 16, 1987, as amended by T.D. 8194, 53 FR 
12513, Apr. 15, 1988]

          taxable year for which items of gross income included



Sec. 1.451-1  General rule for taxable year of inclusion.

    (a) General rule. Gains, profits, and income are to be included in 
gross income for the taxable year in which they are actually or 
constructively received by the taxpayer unless includible for a 
different year in accordance with the taxpayer's method of accounting. 
Under an accrual method of accounting, income is includible in gross 
income when all the events have occurred which fix the right to receive 
such income and the amount thereof can be determined with reasonable 
accuracy. Therefore, under such a method of accounting if, in the case 
of compensation for services, no determination can be made as to the 
right to such compensation or the amount thereof until the services are 
completed, the amount of compensation is ordinarily income for the 
taxable year in which the determination can be made. Under the cash 
receipts and disbursements method of accounting, such an amount is 
includible in gross income when actually or constructively received. 
Where an amount of income is properly accrued on the basis of a 
reasonable estimate and the exact amount is subsequently determined, the 
difference, if any, shall be taken into account for the taxable year in 
which such determination is made. To the extent that income is 
attributable to the recovery of bad debts for accounts charged off in 
prior years, it is includible in the year of recovery in accordance with 
the taxpayer's method of accounting, regardless of the date when the 
amounts were charged off. For treatment of bad debts and bad debt 
recoveries, see sections 166 and 111 and the regulations thereunder. For 
rules relating to the treatment of amounts received in crop shares, see 
section 61 and the regulations thereunder. For

[[Page 101]]

the year in which a partner must include his distributive share of 
partnership income, see section 706(a) and paragraph (a) of Sec. 1.706-
1. If a taxpayer ascertains that an item should have been included in 
gross income in a prior taxable year, he should, if within the period of 
limitation, file an amended return and pay any additional tax due. 
Similarly, if a taxpayer ascertains that an item was improperly included 
in gross income in a prior taxable year, he should, if within the period 
of limitation, file claim for credit or refund of any overpayment of tax 
arising therefrom.
    (b) Special rule in case of death. (1) A taxpayer's taxable year 
ends on the date of his death. See section 443(a)(2) and paragraph 
(a)(2) of Sec. 1.443-1. In computing taxable income for such year, there 
shall be included only amounts properly includible under the method of 
accounting used by the taxpayer. However, if the taxpayer used an 
accrual method of accounting, amounts accrued only by reason of his 
death shall not be included in computing taxable income for such year. 
If the taxpayer uses no regular accounting method, only amounts actually 
or constructively received during such year shall be included. (For 
rules relating to the inclusion of partnership income in the return of a 
decedent partner, see subchapter K, chapter 1 of the Code, and the 
regulations thereunder.)
    (2) If the decedent owned an installment obligation the income from 
which was taxable to him under section 453, no income is required to be 
reported in the return of the decedent by reason of the transmission at 
death of such obligation. See section 453(d)(3). For the treatment of 
installment obligations acquired by the decedent's estate or by any 
person by bequest, devise, or inheritance from the decedent, see section 
691(a)(4) and the regulations thereunder.
    (c) Special rule for employee tips. Tips reported by an employee to 
his employer in a written statement furnished to the employer pursuant 
to section 6053(a) shall be included in gross income of the employee for 
the taxable year in which the written statement is furnished the 
employer. 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.
[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]



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

[[Page 102]]

and loan association, or similar institution, the following are not 
substantial limitations or restrictions on the taxpayer's control over 
the receipt of such earnings:
    (1) A requirement that the deposit or account, and the earnings 
thereon, must be withdrawn in multiples of even amounts;
    (2) The fact that the taxpayer would, by withdrawing the earnings 
during the taxable year, receive earnings that are not substantially 
less in comparison with the earnings for the corresponding period to 
which the taxpayer would be entitled had he left the account on deposit 
until a later date (for example, if an amount equal to three months' 
interest must be forfeited upon withdrawal or redemption before maturity 
of a one year or less certificate of deposit, time deposit, bonus plan, 
or other deposit arrangement then the earnings payable on premature 
withdrawal or redemption would be substantially less when compared with 
the earnings available at maturity);
    (3) A requirement that the earnings may be withdrawn only upon a 
withdrawal of all or part of the deposit or account. However, the mere 
fact that such institutions may pay earnings on withdrawals, total or 
partial, made during the last three business days of any calendar month 
ending a regular quarterly or semiannual earnings period at the 
applicable rate calculated to the end of such calendar month shall not 
constitute constructive receipt of income by any depositor or account 
holder in any such institution who has not made a withdrawal during such 
period;
    (4) A requirement that a notice of intention to withdraw must be 
given in advance of the withdrawal. In any case when the rate of 
earnings payable in respect of such a deposit or account depends on the 
amount of notice of intention to withdraw that is given, earnings at the 
maximum rate are constructively received during the taxable year 
regardless of how long the deposit 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

[[Page 103]]

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. 1.451-3  Long-term contracts.

    (a) Introduction and effective date--(1) In general. Income from a 
long-term contract (as defined in paragraph (b)(1) of this section) may 
be included in gross income in accordance with one of the two long-term 
contract methods, namely, the percentage of completion method (as 
described in paragraph (c) of this section) or the completed contract 
method (as described in paragraph (d) of this section), or any other 
method. Whichever method is chosen must, in the opinion of the 
Commissioner, clearly reflect income. See Sec. 1.446-1(a)(2) and (c). In 
addition, it must be applied consistently to all long-term contracts 
within the same trade or business except that a taxpayer who has long-
term contracts of substantial duration and long-term contracts of less 
than substantial duration in the same trade or business may report the 
income from all the contracts of substantial duration on the same long-
term contract method and report the income from the contracts of less 
than substantial duration pursuant to another proper method of 
accounting. For example, if a manufacturer of heavy machinery has 
special-order contracts of a type that generally take 15 months to 
complete and also has contracts of a type that generally take 3 months 
to complete, the manufacturer may use a long-term contract method for 
the 15-month contracts and a proper inventory method pursuant to section 
471 and the regulations thereunder for the 3-month contracts. Similarly, 
if a construction contractor has construction contracts of a type that 
generally take 15 calendar months to complete and other construction 
contracts that take only 5 months to complete but that are long-term 
contracts because they are not completed in the taxable years in which 
they are entered into (pursuant to paragraph (b)(1)(i) of this section), 
such contractor may either use a long-term contract method for all the 
contracts of both types or use a long-term contract method for the 15-
month contracts and another proper method of accounting for the 5-month 
contracts. If a taxpayer distinguishes between contracts of substantial 
duration and other long-term contracts of less than substantial 
duration, he must adhere to a consistently applied standard for 
determining substantial duration.
    (2) Reporting requirement. When a taxpayer reports income under the 
percentage of completion method or the completed contract method, a 
statement to that effect shall be attached to his income tax return.
    (3) Allocation among activities required. The percentage of 
completion method and the completed contract method apply only to the 
accounting for income and expenses attributable to long-term contracts. 
The term ``expenses attributable to long term contracts'' means all 
direct labor costs and direct material costs (within the meaning of 
paragraph (d)(5)(i) or (6)(i) of this section), and all indirect costs 
except those described in paragraph (d)(5)(iii) or, in the case of 
extended period long-term contracts, paragraph (d)(6)(iii). Other income 
and expense items, such as investment income, expenses not attributable 
to such contracts, and costs incurred with respect to any guarantee, 
warranty, maintenance, or other service agreement relating to the 
subject matter of such contracts, shall be acounted for under a proper 
method of accounting. See section 446(c) and Sec. 1.446-1(c).
    (4) Severing and aggregating contracts. In the case of income 
attributable to a long-term contract, whether or not a long-term 
contract method is used, for the purpose of clearly reflecting income it 
may be necessary in some instances for the Commissioner either to treat 
one agreement as several contracts or to treat several agreements as one 
contract. The rules of paragraph (e)(1) of this section shall apply to 
determine whether an agreement should be so severed or several 
agreements so aggregated.

[[Page 104]]

    (5) Certain taxpayers not using a long-term contract method. In the 
case of a taxpayer using a method of accounting that uses inventories 
(other than a long-term contract method) for any extended period long-
term contract entered into after December 31, 1982, see paragraphs 
(d)(6)(v) and (g) of this section.
    (6) Use of inventory methods in connection with the long-term 
contract method. Effective for taxable years beginning after December 
31, 1982, the taxpayer may use an inventory method to determine the 
costs attributable to a long-term contract accounted for under a long-
term contract method only in accordance with paragraph (d)(8) of this 
section.
    (7) Effective date. Except as otherwise provided, this section is 
effective for taxable years ending after December 31, 1982. For taxable 
years ending before January 1, 1983, see CFR Sec. 1.451-3, revised as of 
4/1/85.
    (8) Incurred. For purposes of this section, the term ``incurred'' 
has the same meaning as in Sec. 1.446-1(c)(1)(ii).
    (b) Definitions, and special rules relating to certain contracts--
(1) Long-term contract--(i) In general. Except as provided in paragraph 
(b)(1)(ii) of this section, the term ``long-term contract'' means a 
building, installation, construction or manufacturing contract which is 
not completed within the taxable year in which it is entered into.
    (ii) Manufacturing contracts. Notwithstanding paragraph (b)(1)(i) of 
this section, a manufacturing contract is a ``long-term contract'' only 
if such contract involves the manufacture of (A) unique items of a type 
which is not normally carried in the finished goods inventory of the 
taxpayer, or (B) items which normally require more than 12 calendar 
months to complete (regardless of the duration of the actual contract). 
Thus, for example, a contract to manufacture a unit of industrial 
machinery specifically designed for the needs of a customer and not 
normally carried in the taxpayer's inventory or a contract to 
manufacture machinery which will require more than 12 calendar months to 
complete are long term contracts[.] However, a contract to manufacture 
15,000 folding chairs which take 3 days each to manufacture is not a 
long-term contract even though it takes more than 12 calendar months to 
manufacture all 15,000 chairs and the contract is not completed within 
the taxable year it is entered into.
    (2) Completion--(i) Final completion and acceptance--(A) General 
rule. Except as otherwise provided in this paragraph (b)(2), and in 
paragraph (d) (2), (3), and (4) of this section (relating to disputes), 
a long-term contract shall not be considered ``completed'' until final 
completion and acceptance have occurred. Nevertheless, a taxpayer may 
not delay the completion of a contract for the principal purpose of 
deferring Federal income tax.
    (B) Completion determined on basis of all facts and circumstances. 
Final completion and acceptance of a contract for Federal income tax 
purposes is determined from an analysis of all the relevant facts and 
circumstances, including the manner in which the parties to the contract 
deal with each other and with the subject matter of the contract, the 
physical condition and state of readiness of the subject matter of the 
contract, and the nature of any work or costs remaining to be performed 
or incurred on the contract. In considering the manner in which the 
parties deal with the subject matter of the contract, any use of the 
primary subject matter of the contract by the purchaser (except for 
testing purposes that produce no gross revenue, cost savings, or other 
substantial benefits for the purchaser) will be considered.
    (C) Examples. The principles of paragraph (b)(2)(i) of this section 
are illustrated by the following examples:

    Example (1). In 1982, A, a calendar year contractor, contracts with 
B to construct a building. The initial completion date specified in the 
contract is October 1984. In November 1984, the building is completed in 
every respect necessary for the use for which the building is intended. 
Later in November 1984, B occupies the building and notifies A that 
certain minor deficiencies should be corrected. A agrees to correct the 
deficiencies. Under these circumstances, the contract is considered 
completed for Federal income tax purposes in A's taxable year ending 
December 31, 1984, without regard to when A corrects the deficiencies. 
The contract is considered completed because the parties have dealt with 
each other and with

[[Page 105]]

the subject matter of the contract in a manner that indicates that final 
completion and acceptance have occurred.
    Example (2). Assume the same facts as in example 1, except that 
there are no deficiencies in the building that require correction or 
repair. In addition, assume that the contract between A and B provides 
that none of the retainage under the contract may be released to A until 
A obtains an architect's certificate that the building has been 
completed according to the specifications of the contract. A obtains 
this certificate in February, 1985. Under these circumstances, the 
contract is considered completed for Federal income tax purposes in A's 
taxable year ending December 31, 1984, without regard to when A obtains 
the required architect's certificate, and without regard to when the 
retainage is released to A, because the parties have dealt with each 
other and with the subject matter of the contract in a manner that 
indicates that final completion and acceptance have occurred.
    Example (3). In 1982, X, a calendar year taxpayer who manufactures 
industrial machinery, contracts with F to build and install one large 
item of industrial machinery to be delivered in August 1983 and to be 
installed and tested by X in F's factory. The contract provides that the 
machinery will be accepted by F when the tests performed by X 
demonstrate that the machinery will perform within certain environmental 
standards required by a government agency, regardless of whether an 
operating permit has been obtained. Because of technical problems the 
machinery is not ready for delivery until December 1983. F accepts 
delivery of the machinery in December 1983 subject to installation and 
testing to determine if the assembled machinery meets the environmental 
standards. The machinery is installed and tested during December 1983 
through February 1984, and F accepts the machinery in February 1984. An 
operating permit required to operate the machinery under the 
environmental standards is issued by the governmental agency in 
February, 1985. Under these circumstances final completion and 
acceptance of the machinery for Federal income tax purposes occurs in 
February, 1984.
    Example (4). In 1983, D, a calendar year taxpayer, contracts with E 
to construct a shopping center and related parking areas. The shopping 
center is completed in October 1985. In December 1985, the shopping 
center and three-fourths of the parking area are opened to the general 
public. At that time, the entire parking area of the shopping center has 
been graded and three-fourths has been paved, but the final asphalt 
coating has not been laid due to general weather conditions. Under these 
circumstances, the contract to construct the shopping center and parking 
area is considered completed for Federal income tax purposes in December 
1985, because the shopping center and a major portion of the parking 
area were ready to be used and were used at that time.

    (ii) Contracts with more than one subject matter--(A) General rule. 
In the case of a long-term contract (which, after the application of the 
rules provided in paragraph (e) of this section, is treated as a single 
long-term contract for Federal income tax purposes) for one or more 
units (such as an aircraft or an item of industrial machinery) that 
represent the primary subject matter of the contract, and for other 
items (such as training manuals, or spare or replacement parts or 
components) that do not represent the primary subject matter of the 
contract, ``final completion and acceptance'' shall be determined 
without regard to the contractor's obligation to supply the other items 
that do not represent the primary subject matter of the contract. If at 
the end of the taxable year in which the long-term contract is completed 
there remain any other items that do not represent the primary subject 
matter of the contract and that have not been finally completed and 
accepted then the costs that have been incurred prior to the end of such 
year and that are properly allocable to such other items (determined 
pursuant to paragraph (d) (5) or (6) (as the case may be) of this 
section), and a portion of the gross contract price (if any) reasonably 
allocable to such other items shall be separated from the long-term 
contract, and such costs and such portion of the gross contract price 
shall be accounted for under a proper method of accounting. Such proper 
method of accounting includes a long-term contract method only if a 
separate contract for such other items would be a long-term contract (as 
defined in paragraph (b)(1) of this section).
    (B) Example. The principles of paragraph (b)(2)(ii)(A) of this 
section may be illustrated by the following example:

    Example. In 1982, X contracts with the Y Government to manufacture 
five aircraft and to manufacture 12 spare and replacement parts for the 
five aircraft and for certain other aircraft supplied to Y under prior 
contracts. Assume that under all the facts and circumstances it is 
determined that the portion of the contract relating to the 12 spare and 
replacement parts does not have to be

[[Page 106]]

severed from the portion of the contract relating to the five aircraft. 
Assume also that under all the facts and circumstances it is determined 
that the five aircraft represent the primary subject matter of the 
contract, and that the spare and replacement parts do not represent the 
primary subject matter of the contract. In 1984, X tenders the five 
aircraft and seven of the spare and replacement parts to Y. Y accepts 
the aircraft and the parts subject to X's delivery of the balance of the 
spare and replacement parts. For Federal income tax purposes the 
contract is deemed to have been completed in 1984. Accordingly, X must 
include in gross income in 1984 the entire contract price, less the 
portion of the gross contract price reasonably allocable (if any) to the 
parts not delivered in 1984. X must deduct from gross income in 1984 the 
entire costs properly allocable to the contract, less the entire costs 
incurred that are properly allocable to the parts not delivered in 1984. 
X will account for the income and costs allocable to the parts not 
delivered in 1984 under a proper method of accounting.

    (iii) Contingent compensation. In the case of a long-term contract, 
``final completion and acceptance'' shall be determined without regard 
to any term of the contract providing for additional compensation 
contingent upon the continued successful performance of the subject 
matter of the contract after the subject matter of the contract has been 
accepted by the purchaser (such as an incentive fee payable if a 
satellite remains in operation after it is placed in orbit). Such 
contingent compensation shall be included in gross income in the 
appropriate taxable year determined under the taxpayer's method of 
accounting other than a long-term contract method.
    (iv) Certain supervision of installation. In the case of a long-term 
contract, ``final completion and acceptance'' shall be determined 
without regard to any obligation on the part of the contractor to assist 
or to supervise installation or assembly of the subject matter of the 
contract where such installation or assembly is to be performed by the 
purchaser and, under applicable contract law, the subject matter of the 
contract may be accepted by the purchaser prior to such installation or 
assembly. If the preceding sentence applies to a contract, ``final 
completion and acceptance'' shall be determined without regard to such 
obligation [.] In addition, the entire gross contract price less the 
portion of the gross contract price (if any) reasonably allocable to 
such obligation, shall be included in gross income in the taxable year 
in which the contract is completed[.] Further, all costs properly 
allocable to the contract and which have been incurred prior to the end 
of the taxable year in which such contract is completed shall be 
deducted in such year[.] Finally, all other costs properly allocable to 
such contract and the portion of the gross contract price reasonably 
allocable to the obligation to assist or to supervise installation shall 
be accounted for under a proper method of accounting other than a long-
term contract method.
    (v) Subcontractors. In the case of a subcontractor who completes 
work on a long-term contract prior to the completion of the entire 
contract, ``final completion and acceptance'' of the contract with 
respect to such subcontractor shall be deemed to have occurred when the 
subcontractor's work has been completed and has been accepted by the 
party with whom the subcontractor has contracted.
    (vi) Disputes. Completion of a long-term contract is determined 
without regard to whether a dispute exists at the time the taxpayer 
tenders the subject matter of the contract to the party with whom the 
taxpayer has contracted. See paragraphs (d)(2), (3) and (4) of this 
section.
    (3) Extended period long-term contract--(i) General Rule. This 
paragraph (b)(3) does not apply to contracts accounted for under the 
percentage of completion method. Except as provided in paragraph 
(b)(3)(ii) of this section, the term ``extended period long-term 
contract'' means any long-term contract that the taxpayer estimates (at 
the time such contract is entered into) will not be completed (as 
defined in paragraph (b)(2) of this section) within the 2-year period 
beginning on the first date (hereinafter, ``the contract commencement 
date'') that the taxpayer incurs any costs (other than costs such as 
bidding expenses, or expenses incurred in connection with negotiating 
the contract) allocable to such contract (under the cost allocation 
rules of paragraph (d)(6) of this section). The preceding sentence shall 
be applied without regard to when costs allocable

[[Page 107]]

to a contract are recorded under the cost accounting procedures used by 
the taxpayer. In general, the contract commencement date will be the 
first date that any of the following activities occur; the taxpayer 
incurs design or engineering costs allocable to the contract other than 
design or engineering costs incurred solely for purposes of bidding for 
the contract; materials or equipment are shipped to the jobsite; or 
workers whose labor costs is treated as direct labor are sent to the 
jobsite. If the first date when any cost allocable to a contract are 
incurred is not determinable, the contract commencement date of a 
contract shall be the date such contract is entered into, unless the 
taxpayer establishes to the satisfaction of the district director that 
another date is a more appropriate contract commencement date. The 
contract commencement date shall not be earlier than the date the 
contract is entered into, unless the taxpayer delayed entering into the 
contract for a principal purpose of avoiding the rules of this section.
    (ii) Certain construction contracts. The term ``extended period 
long-term contract'' does not include any construction contract entered 
into by a taxpayer--
    (A) Who estimates (at the time such contract is entered into) that 
such contract will be completed within the 3-year period beginning on 
the contract commencement date of such contract, or
    (B) Whose average annual gross receipts (determined under paragraph 
(b)(3)(iii) of the this section) over the 3 taxable years preceding the 
taxable year the contract is entered into (or, if less, the number of 
preceding taxable years the taxpayer has been in existence) do not 
exceed $25 million.

For purposes of this paragraph (b)(3)(ii), the term ``construction 
contract'' means any contract for the building, construction, or 
erection of, or the installation of any integral component to, 
improvements to real property. For purposes of the preceding sentence, 
construction includes reconstruction and rehabilitation. An improvement 
to real property includes buildings or other structures intended to be 
permanently affixed to real property, roadways, dams, or bridges, but 
does not include such items as vessels or offshore drilling platforms. 
An integral component to an improvement to real property includes 
property not produced at the site of the real property but intended to 
be permanently affixed to an improvement to real property, for example, 
elevators and central heating and cooling systems. In the case of a 
contract that provides for the manufacture and the installation of an 
integral component to an improvement to real property (such as the 
pollution control equipment for a power plant), only the part of the 
overall gross contract price and the costs properly allocable to the 
work of installing the finished component is a construction contract. 
For example, in the case of a contract both to manufacture and to 
install an elevator in an office building, only the portion of the gross 
contract price and only the costs properly allocable to installing the 
elevator is a construction contract. However, in determining whether the 
installation portion of a contract is expected to be completed within 
three years, the time expected to complete both the manufacture and the 
installation of the contract subject matter must be taken into account. 
Similarly, in determining whether the manufacturing portion of a 
contract is expected to be completed within two years, the time expected 
to complete both the manufacture and the installation of the contract 
subject matter must be taken into account. Alternatively, the taxpayer 
may consistently account for the manufacturing portion and the 
installation portion of all such agreements as separate contracts if 
there is an appropriate allocation of the gross contract price between 
the manufacturing portion and the installation portion of the agreement. 
The preceding sentence applies without regard to paragraph (e)(1) of 
this section.
    (iii) Determination of gross receipts--(A) Aggregation and 
attribution of gross receipts. The following rules shall apply in 
determining the gross receipts of the taxpayer for purposes of paragraph 
(b)(3)(ii)(B) of this section, that is, for determining if the average 
annual gross receipts of the taxpayer over the 3 taxable years preceding 
the taxable

[[Page 108]]

year in which a construction contract is entered into (or, if less, the 
number of preceding taxable years the taxpayer has been in existence) 
exceed $25 million. Under paragraph (b)(3)(iii)(B) of this section, the 
average annual gross receipts of all trades or businesses (regardless of 
the nature of such trades or businesses) under common control with the 
taxpayer who enters into the construction contract are combined. Under 
paragraph (b)(3)(iii)(C), a portion of the average annual gross receipts 
from building, installation or construction contracts (hereinafter 
``construction gross receipts'') of trades or businesses not under 
common control with the taxpayer who enters into the contract, but which 
are related to the taxpayer through a chain of attribution (using 
indirect and constructive ownership), are attributed to the taxpayer who 
enters into the contract. Except as provided in paragraph 
(b)(3)(iii)(C)(4)(i), the rules of paragraph (b)(3)(iii) (B) and (C) are 
both applied. For purposes of paragraph (b)(3) of this section, ``gross 
receipts'' include the gross receipts realized from the active conduct 
of any trade or business, (e.g.,-- sales revenue), and shall be the 
gross receipts of the taxable year in which such receipts are recognized 
properly under the tax accounting method of the taxpayer. For this 
purpose ``gross receipts'' shall not include amounts that, under Federal 
income tax law, are interest, dividends, rents, royalties, annuities or 
the amount realized from the sale or exchange of property used in the 
trade or business or held for the production of income. Gross receipts 
of a contract includes the gross contract price (whether the contract is 
a general contract or a subcontract, and whether or not the contract is 
a long-term contract). If the taxpayer enters into a contract which 
provides that any direct materials (as described in paragraph (d)(5)(i) 
of this section) will be supplied by the party for whom the contract is 
being performed (and thus the cost of which is not represented in the 
gross contract price), gross receipts do not include the cost of such 
direct materials unless the contractual arrangement was entered into for 
a principal purpose of reducing the contractor's gross receipts.
    (B) Aggregation of all gross receipts of trades or businesses under 
common control. If, at any time during the calendar year in which the 
taxpayer enters into a construction contract, such taxpayer and any 
other trades or businesses (whether or not incorporated) are under 
common control, then the average annual gross receipts of each such 
trade or business (for the 3 taxable years of such trade or business 
preceding the taxable year of such trade or business in which the 
construction contract is entered into or, if less, the number of 
preceding taxable years such trade or business has been in existence) 
shall be combined with the average annual gross receipts of the taxpayer 
for taxpayer's 3 taxable years preceding the taxable year of the 
taxpayer in which the construction contract is entered into (or, if 
less, the number of preceding taxable years the taxpayer has been in 
existence). Gross receipts attributable to transactions between trades 
or businesses under common control shall be eliminated. For purposes of 
paragraph (b)(3) of this section, the term ``trades or businesses under 
common control'' means any group of trades or businesses that is 
either--
    (1) A ``parent-subsidiary group under common control'' as defined in 
Sec. 1.52-1(c),
    (2) A ``brother-sister group under common control'' as defined in 
Sec. 1.52-1(d), or
    (3) A ``combined group under common control'' as defined in 
Sec. 1.52-1(e).
    (C) Attribution of construction gross receipts to or from 
individuals, proprietorships, corporations, partnerships, trusts and 
estates not under common control--(1) Attribution of construction gross 
receipts to the contractor from persons owning an interest in the 
contractor. For purposes of paragraph (b)(3) of this section, if a 5 
percent or greater interest in the person who enters into a construction 
contract (hereinafter, ``the contractor'') is owned (at any time during 
the calendar year in which the construction contract is entered into), 
directly, or indirectly through the application of this paragraph 
(b)(3)(iii)(C), by or for any person, the average annual gross receipts 
of the contractor for the contractor's 3 taxable years

[[Page 109]]

preceding the taxable year of the contractor in which the contract was 
entered into (or, if less, the number of preceding taxable years the 
contractor has been in existence) shall include the average annual 
construction gross receipts of such person (for the 3 taxable years of 
such person preceding the taxable year of such person in which the 
contract was entered into or, if less, the number of preceding taxable 
years in which such person has been in existence) in proportion to the 
interest of such person in the contractor. If an interest is not owned 
for the entire calendar year, or if an interest varies during the 
calendar year, the amount of such interest for such year shall be the 
weighted average based on the number of days each interest is owned 
during such calendar year.
    (2) Attribution of construction gross receipts to the contractor 
from persons in which the contractor owns an interest. For purposes of 
paragraph (b)(3) of this section, if (at any time during the calendar 
year in which the contractor enters into a construction contract) a 5 
percent or greater interest in any person is owned, directly, or 
indirectly through the application of this paragraph (b)(3)(iii)(C), by 
or for the contractor, the average annual gross receipts of the 
contractor for the contractor's 3 taxable years preceding the taxable 
year of the contractor in which the contract was entered into (or, if 
less, the number of preceding taxable years the taxpayer has been in 
existence) shall include the average annual construction gross receipts 
of such person (for the 3 taxable years of such person preceding the 
taxable year of such person in which the contract was entered into or, 
if less, the number of preceding taxable years such person has been in 
existence) in proportion to the interest of the contractor in such 
person. If an interest is not owned for the entire calendar year, or if 
an interest varies during the calendar year, the amount of such interest 
for such year shall be the weighted average based on the number of days 
each interest is owned during such calendar year.
    (3) Rules for determining ownership--(i) In general. In determining 
the ownership of an interest in any person for purposes of paragraph 
(b)(3)(iii)(C) of this section, the indirect and constructive ownership 
rules of this paragraph (b)(3)(iii)(C)(3) shall apply, subject to the 
operating rules contained in paragraph (b)(3)(iii)(C)(4). For purposes 
of paragraph (b)(3)(iii)(C), an ``interest'' means: in the case of a 
corporation, stock; in the case of a trust or estate, an actuarial 
interest; in the case of a partnership, an interest in capital or 
profits; and in the case of a sole proprietorship, the proprietorship.
    (ii) Members of a family. An individual shall be considered as 
owning any interest in any person owned, directly or indirectly, by or 
for--
    (A) Such individual's spouse (other than a spouse who is legally 
separated from the individual under a decree of divorce or separate 
maintenance, whether final or interlocutory), and
    (B) Such individual's children, grandchildren, parents and 
grandparents. A legally adopted child of an individual shall be treated 
as the child of such individual.
    (iii) Attribution from partnerships, estates, trusts and 
corporations--(A) From partnerships. An interest in any person owned, 
directly or indirectly, by or for a partnership shall be considered as 
owned by any partner having a 5 percent or greater interest in either 
the profits or capital of the partnership, in proportion to such 
partner's interest in profits or capital, whichever is greater.
    (B) From estate and trusts. An interest in any person (hereinafter 
an ``organization interest'') owned, directly or indirectly, by or for 
an estate or trust shall be considered as owned by any beneficiary of 
such estate or trust who has an actuarial interest of 5 percent or 
greater in such organization interest, to the extent of such actuarial 
interest, as determined under Sec. 11.414(c)-4(b)(3).

An interest in any person owned, directly or indirectly, by or for any 
portion of a trust of which a person is considered the owner under 
subpart E of part I of subchapter J (relating to grantors and others 
treated as substantial owners) shall be considered as owned by such 
person.
    (C) From corporations. An interest in any person owned, directly or 
indirectly, by or for a corporation shall be

[[Page 110]]

considered as owned by any shareholder who owns (directly, and 
indirectly through the application of paragraph (b)(3)(iii)(C) of this 
section) 5 percent or more in value of such corporation's stock, in 
proportion to the value of the stock owned by such shareholder to the 
total value of all the outstanding stock in such corporation.
    (iv) Attribution to partnerships, estates, trusts and corporations--
(A) To partnerships. An interest in any person owned, directly or 
indirectly, by or for a partner having a 5 percent or greater interest 
in partnership profits or capital shall be considered as owned by the 
partnership in proportion to the partner's interest in profits or 
capital, whichever is greater.
    (B) To estates and trusts. An interest in any person owned, directly 
or indirectly, by or for a beneficiary having an actuarial interest of 5 
percent or greater in the value of property of an estate or trust shall 
be considered as owned by such estate or trust in proportion to the 
beneficiary's actuarial interest in the assets of the estate or trust. 
For purposes of this paragraph (b)(3) (iii)(C)(3)(iv)(B) the actuarial 
interest of a beneficiary shall be determined under the maximum exercise 
of discretion by the executor or trustee in favor of such beneficiary.

An interest in any person owned, directly or indirectly, by or for a 
person who is considered the owner of any portion of a trust under 
subpart E of part I of subchapter J (relating to grantors and others 
treated as substantial owners) shall be considered as owned by such 
trust.
    (C) To corporations. An interest in any person owned, directly or 
indirectly, by or for a shareholder who owns (directly and indirectly 
through the application of paragraph (b)(3)(iii)(C) of this section) 5 
percent or more in value of the stock in a corporation shall be 
considered as owned by such corporation in proportion to the value of 
the stock owned by such shareholder to the total value of all the 
outstanding stock in such corporation.
    (v) Options. If a person has an option to acquire any outstanding 
interest in any organization, such interest shall be considered as owned 
by such person. An option to acquire an option, and each one of a series 
of such options, shall be considered as an option to acquire such an 
interest.
    (4) Operating rules--(i) Common control. Paragraph (b)(3)(iii)(C) of 
this section shall not apply between two persons both of whom, under 
paragraph (b)(3)(iii)(B), are members of the group of trades or 
businesses under common control that includes the contractor. However, 
in applying paragraph (b)(3)(iii)(C) between two persons where one or 
both of such persons are not members of the group of trades or 
businesses under common control that includes the contractor, paragraph 
(b)(3)(iii)(C) shall be applied without regard to paragraph 
(b)(3)(iii)(B).
    (ii) Reattribution. Except as provided in paragraph 
(b)(3)(iii)(C)(4)(iii) (relating to no double family attribution) or 
(iv) (relating to no reattribution to certain co-owners), in applying 
paragraphs (b)(3)(iii)(C)(3) (ii), (iii), (iv), or (v), an interest 
constructively owned by a person shall, in applying paragraphs 
(b)(3)(iii)(C)(3), (ii), (iii), (iv) or (v), be considered as actually 
owned by such person, and such interest may be reattributed to another 
person.
    (iii) No double family attribution. An interest constructively owned 
by an individual by reason of paragraph (b)(3)(iii)(C)(3)(ii) shall not 
be considered as owned by such individual for purposes of again applying 
such paragraph to make another the constructive owner of such interest.
    (iv) No reattribution to certain co-owners. An interest 
constructively owned by a person by reason of paragraph 
(b)(3)(iii)(C)(3)(iv) shall not be considered as owned by such person 
for purposes of applying paragraph (b)(3)(iii)(C)(3)(iii) in order to 
make another person the constructive owner of such interest.
    (v) Option rule in lieu of family rule. If an interest may be 
considered as owned by an individual under paragraphs (b)(3)(iii)(C)(3) 
(ii) or (v), it shall be considered as owned by such individual under 
paragraph (b)(3)(iii)(C)(3)(v).
    (vi) Limitation. In applying paragraph (b)(3)(iii)(C)(3) to 
determine the ownership of an interest by any person for any one 
purpose--

[[Page 111]]

    (A) A corporation shall not be considered to own its own stock by 
reason of paragraph (b)(3)(iii)(C)(3)(iv)(C), and
    (B) If an interest owned by any person may be included in the 
computation more than one time, such interest shall be included only 
once, in the manner that will impute to the person concerned the largest 
total interest.
    (D) Short taxable years. For any taxpayer required to determine its 
average annual gross receipts over the three taxable year period of such 
person preceding the taxable year in which a construction contract is 
entered into, if such period includes a taxable year of less than 12 
full months, the taxpayer shall place the gross receipts of such taxable 
year on an annual basis by dividing the gross receipts of such taxable 
year by the number of full calendar months in such taxable year and 
multiplying the result by 12.
    (iv) Classification of contracts--(A) Initial classification by 
taxpayer. The taxpayer shall determine whether a contract is an extended 
period long-term contract at the time such contract is entered into. In 
estimating the time required to perform any contract, the taxpayer shall 
anticipate and provide a reasonable allowance for delay, rework, change 
orders, technology or design problems, and other problems. If the 
taxpayer determines that a contract is an extended period long-term 
contract, the cost allocation rules of paragraph (d)(6) of this section 
shall apply, and such contract shall be treated as an extended period 
long-term contract even if such contract is actually completed within 
the 2-year period (3 years in the case of certain construction 
contracts) beginning on the contract commencement date of such contract. 
Except as provided in paragraph (b)(3)(iv)(B) of this section, a long-
term contract that is not completed within the 2-year period (3 years in 
the case of certain construction contracts) beginning on the actual 
contract commencement date of such contract and which the taxpayer did 
not classify and account for as an extended period long-term contract 
will not be required to be reclassified (for any taxable year) and 
accounted for as an extended period long-term contract if, at the time 
the contract was entered into, the taxpayer reasonably could have 
expected the contract to be completed within that time. The taxpayer 
shall maintain contemporaneous written records setting forth the basis 
for classifying each contract, and such records shall be in sufficient 
detail to enable the district director readily to determine whether the 
taxpayer's estimate of the time required to complete a contract was made 
on a reasonable basis. A contract term specifying an expected completion 
or delivery date may be considered evidence that the parties expected 
completion or delivery to occur on or about the date specified, 
especially if there are actual bona fide penalties for not meeting the 
specified date. The taxpayer's estimate will not be considered 
unreasonable if a contract was not completed within the expected time 
primarily because of unforeseeable factors not within the control of the 
taxpayer. For purposes of the preceding sentence, ``unforeseeable 
factors'' are abnormal factors, such as prolonged third-party 
litigation, abnormal weather (considering the season and the jobsite), 
prolonged strikes, and prolonged delays in securing required permits or 
licenses, that could not reasonably be anticipated considering the 
nature of the contract and prior experience.
    (B) Exception for unreasonable classification, amended returns. If 
under all the facts and circumstances it is determined that a contract 
which the taxpayer did not classify and account for as an extended 
period long-term contract reasonably should have been so classified and 
accounted for, the taxpayer shall reclassify and account for such 
contract as an extended period long-term contract for the current 
taxable year and all subsequent taxable years. In addition, the taxpayer 
should file an amended return for each prior taxable year (assuming that 
the period for assessment has not run for such year) in which costs were 
incurred with respect to such contract, and such amended returns should 
reflect an allocation to the contract of costs incurred in such prior 
years using the cost allocation rules provided in paragraph (d)(6) of 
this section. If a contract is not an extended period long-term contract 
by reason of the $25 million gross receipts test of paragraph 
(b)(3)(ii)(B)

[[Page 112]]

of this section, such contract shall not be reclassified regardless of 
the taxpayer's gross receipts for any subsequent year and regardless of 
the time required to complete such contract.
    (v) Special rule for contract commencement date in case of 
components or subassemblies produced by the taxpayer. If the cost of 
components or subassemblies produced by the taxpayer represents a 
significant amount of the total costs allocable to a contract, the 
contract commencement date of such contract shall be the first date the 
taxpayer incurs any costs allocable either to (1) such type or category 
of components or subassemblies, or (2) any other subject matter of the 
contract. The contract commencement date shall not be earlier than the 
date the contract is entered into, unless the taxpayer delayed entering 
into the contract for a principal purpose of avoiding the rules for this 
section. For example, assume an airplane manufacturer who also 
manufactures a type of engine that represents a significant amount of 
the total costs of the airplanes produced enters into one or more 
contracts to manufacture airplanes containing such type of engine. For 
purposes of determining the contract commencement date with respect to 
each contract, the first date the manufacturer incurs any cost allocable 
to any of the engines is the first date that the taxpayer incurs any 
cost allocable to such type of engine, even if the manufacturer has not 
yet produced enough engines to satisfy all contracts.

See Sec. 1.451-3(d)(6)(iv) for the cost allocation rules required in the 
case of certain components or subassemblies.
    (c) Percentage of completion method. (1) Under the percentage of 
completion method, the portion of the gross contract price which 
corresponds to the percentage of the entire contract which has been 
completed during the taxable year must be included in gross income for 
such taxable year.
    (2) The determination of the percentage of completion of a contract 
generally may be made on either of the following methods:
    (i) By comparing, as of the end of the taxable year, the costs 
incurred with respect to the contract with the estimated total contract 
costs, or
    (ii) By comparing, as of the end of the taxable year, the work 
performed on the contract with the estimated total work to be performed.

In determining the percentage of completion pursuant to subdivision (i) 
of this subparagraph with respect to a long-term contract, a taxpayer 
may use any method of cost comparisons (such as comparisons of total 
direct and indirect costs incurred to date to estimated total direct and 
indirect costs, of total direct costs incurred to date to estimated 
total direct costs, or of direct labor costs incurred to date to 
estimated total direct labor costs) so long as such method is used 
consistently with respect to such contract and such method clearly 
reflects income. In determining the percentage of completion pursuant to 
subdivision (ii) of this subparagraph, 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. Thus, for example, in the case of a 
roadbuilder, a standard of completion based solely upon miles of roadway 
completed in a case where the terrain is substantially different with 
respect to roadway completed during one taxable year as compared with 
roadway completed during another taxable year may not clearly reflect 
the earning of income with respect to the contract. If the method 
described in subdivision (i) of this subparagraph is used and the 
taxpayer revises the estimated total costs as of the end of a taxable 
year, certificates of architects or engineers or other appropriate 
documentation showing the basis for such revision must be available at 
the principal place of business of the taxpayer for inspection in 
connection with an examination of the income tax return. If the method 
described in subdivision (ii) of this subparagraph is used, certificates 
of architects or engineers or other appropriate documentation showing 
the percentage of completion of each contract during the taxable year 
must be available at the principal place of business of the taxpayer for 
inspection in connection with an examination of the income tax return.

[[Page 113]]

    (3) Under the percentage of completion method, all costs incurred 
during the taxable year with respect to a long-term contract (account 
being taken of the material and supplies on hand at the beginning and 
the end of the taxable year for use in the contract) must be deducted. 
``Costs incurred during the taxable year with respect to a long-term 
contract'' do not include costs incurred with respect to any guarantee, 
warranty, maintenance, or other service agreement relating to the 
subject matter of the long-term contract. See paragraph (a)(3) of this 
section.
    (d) Completed contract method--(1) In general. Except as otherwise 
provided in paragraphs (d) (2), (3) or (4) (relating to disputes) of 
this section, under the completed contract method, gross income derived 
from long-term contracts must be reported by including the gross 
contract price of each contract in gross income for the taxable year in 
which such contract is completed (as defined in paragraph (b)(2) of this 
section). All costs properly allocable to a long-term contract 
(determined pursuant to paragraph (d) (5) or (6) of this section) must 
be deducted from gross income for the taxable year in which the contract 
is completed. In addition, account must be taken of any material and 
supplies charged to the contract but remaining on hand at the time of 
completion.
    (2) Contracts with disputes from buyer claims. (i) This subparagraph 
applies in any case where, on or after a taxpayer tenders the subject 
matter of a long-term contract to the party with whom he is contracting, 
there exists an amount reasonably in dispute because such party wishes 
to have the original contract price reduced or to have additional work 
performed on the contract. Any item of income or deduction with respect 
to an amount reasonably in dispute shall be taken into account in the 
taxable year in which such dispute is resolved. In addition, any item of 
income or deduction which is properly allocable to such contract and 
which is not included in or deducted from gross income in a prior 
taxable year pursuant to subdivisions (ii), (iii), (iv), or (v) of this 
subparagraph and which is not taken into account under the preceding 
sentence shall be included in or deducted from gross income in the 
taxable year in which the final dispute is resolved.
    (ii) If the amount reasonably in dispute affects so much of the 
contract price that it is not possible to determine whether a profit (an 
excess of the gross contract price over the costs properly allocable to 
such contract) or loss (an excess of the costs properly allocable to the 
long-term contract over the gross contract price) will ultimately be 
realized on such contract, then no item of income or deduction which is 
properly allocable to such contract shall be included in or deducted 
from gross income in the taxable year in which such contract is 
completed (without regard to such dispute).
    (iii) In all other cases, the entire amount of the gross contract 
price reduced (but not below zero) by an amount equal to the amount 
reasonably in dispute shall be included in gross income in the taxable 
year in which such contract is completed (without regard to the 
dispute).
    (iv) If the taxpayer is assured of a profit on such contract 
regardless of the outcome of the dispute, then all costs which are 
properly allocable to such contract and which have been incurred prior 
to the end of the taxable year in which such contract is completed 
(without regard to the dispute) shall be deducted in such year.
    (v) If the taxpayer is assured of a loss on such contract regardless 
of the outcome of the dispute, then there shall be deducted in the 
taxable year in which such contract is completed (without regard to the 
dispute) the total amount of costs properly allocable to such contract 
which are incurred prior to the end of such year reduced by the amount 
by which the gross contract price was reduced pursuant to subdivision 
(iii) of this subparagraph. All other costs which are properly allocable 
to such contract shall be deducted in the taxable year in which 
incurred.
    (vi) For purposes of this paragraph, where there is additional work 
to be performed with respect to a contract in dispute, the term 
``taxable year in which the dispute is resolved'' means the taxable year 
in which such work is completed rather than the taxable year in which 
the outcome of the dispute is

[[Page 114]]

determined by agreement, decision, or otherwise.
    (vii) The application of this subparagraph may be illustrated by the 
following examples:

    Example (1). X, a calendar year taxpayer utilizing the completed 
contract method of accounting, constructs a building for Y pursuant to a 
long-term contract. According to the terms of the contract, the gross 
contract price is $2,000,000. X finishes construction of the building in 
1972 at a cost of $1,900,000. Y examines the building and is 
dissatisfied with the construction. He demands either alterations or a 
reduction in the gross contract. The amount reasonably in dispute is 
$500,000. This dispute affects so much of the contract price that X is 
unable to determine whether a profit or a loss will ultimately be 
realized on such contract. Accordingly, pursuant to this subparagraph, X 
does not include any portion of the gross contract price in gross income 
and does not deduct any costs which are properly allocable to the 
contract until the taxable year in which the dispute is resolved.
    Example (2). A, a calendar year taxpayer utilizing the completed 
contract method of accounting, constructs a bridge for B pursuant to a 
long-term contract. The terms of the contract provide for a $10,000,000 
gross contract price. A finishes construction of the bridge in 1972 at a 
cost of $9,500,000. When B examines the bridge, he insists that either 
certain girders be repainted or that the contract price be reduced. The 
amount reasonably in dispute is $100,000. Since under the terms of the 
contract, A would be assured of a profit of at least $400,000 
($10,000,000--[$9,500,000+$100,000]) even if the dispute were resolved 
unfavorable to A, $9,900,000 ($10,000,000-$100,000 in dispute) of the 
gross contract price must be included in A's gross income in 1972 and 
$9,500,000 of costs must be deducted from A's gross income in 1972 
pursuant to this subparagraph. In 1973 A and B resolve the dispute, A 
repaints certain girders at a cost to A of $60,000, and A and B agree 
that the contract price is not to be reduced. In 1973 A must include 
$100,000 ($10,000,000- $9,000,000) in gross income and must deduct 
$60,000 from gross income.
    Example (3). M, a calendar year taxpayer utilizing the completed 
contract method of accounting, constructs a plant for N pursuant to a 
long-term contract. Under the terms of the contract M is entitled to 
receive $1,000,000 upon completion of the plant. M finishes construction 
of the plant in 1973 at a cost of $1,200,000. N examines the plant and 
determines that an elevator operates unsatisfactorily and insists that M 
either replace the elevator or that the contract price be reduced. The 
amount reasonably in dispute is $100,000. Under the terms of the 
contract M would be assured of a loss of at least $200,000 
($1,200,000-$1,000,000) even if the dispute were resolved in favor of M. 
Pursuant to this subparagraph M must include $900,000 
($1,000,000-$100,000) in gross income for 1973 and must deduct 
$1,100,000 ($1,200,000-$100,000) from gross income in 1973. In 1974 the 
dispute is resolved, and M replaces certain components of the elevator 
at a cost of $50,000. M must include $100,000 ($1,000,000-$900,000) in 
gross income for 1974, and must deduct $150,000 ($100,000 of previously 
undeducted costs plus $50,000 of additional costs) from gross income in 
1974.
    Example (4). Assume the same facts as in Example (3) except that N 
is insisting that the contract price be reduced because an elevator has 
insufficient capacity and that in 1974 the dispute is resolved by a 
reduction in the gross contract price of $40,000 (from $1,000,000 to 
$960,000). By the end of 1973, M is assured of a loss of at least 
$200,000 ($1,200,000-$1,000,000) under the terms of the contract even if 
the dispute were resolved in favor of M. Pursuant to this subparagraph, 
M must include in gross income for 1973 $900,000 ($1,000,000- $100,000) 
and must deduct from gross income in such year $1,100,000 
($1,200,000-$100,000). In 1974, when the dispute is resolved, M must 
include $60,000 ($960,000-$900,000) in gross income and must deduct 
$100,000 ($1,200,000- $1,100,000) from gross income.
    Example (5). Assume the same facts as in Example (3) except that N 
is also insisting that the contract price be reduced by an additional 
amount because an underground storage facility has insufficient 
capacity. M determines that the total amount reasonably in dispute is 
$160,000, $100,000 attributable to the elevator plus $60,000 
attributable to the underground storage facility. Under the terms of the 
contract, M would be assured of a loss of at least $200,000 
($1,200,000-$1,000,000) even if both disputes were resolved in favor of 
M. Pursuant to this subparagraph, M must include $840,000 
($1,000,000-$160,000) in gross income for 1973 and must deduct 
$1,040,000 (1,200,000-$160,000) from gross income in 1973. In 1974 the 
dispute relating to the elevator is resolved, and M replaces certain 
components of the elevator at a cost of $50,000. M must include $100,000 
(the amount of the gross contract price not included in gross income in 
1973 by reason of the elevator dispute) in gross income for 1974 and 
must deduct $150,000 ($100,000 of previously undeducted costs plus 
$50,000 of additional costs) from gross income in 1974. In 1975, the 
dispute relating to the underground storage facility is resolved by a 
reduction in the gross contract price of $20,000 (from $1,000,000 to 
$980,000). In 1975 M must include $40,000 ($60,000- $20,000) in gross 
income and must deduct $60,000 (his previously undeducted costs) from 
gross income.


[[Page 115]]


    (3) Contracts with disputes from taxpayer claims. (i) This 
subparagraph applies in any case where, on or after a taxpayer tenders 
the subject matter of a long-term contract to the party with whom he is 
contracting, a dispute exists because the taxpayer is requesting that 
the amount to be paid to him under such contract be increased.
    (ii) Except as provided in subparagraph (2) of this paragraph, in 
all cases described in subdivision (i) of this subparagraph, the entire 
amount of the gross contract price shall be included in gross income in 
the taxable year the contract is completed (without regard to the 
dispute), and all costs which are properly allocable to such contract 
and which have been incurred prior to the end of the taxable year in 
which such contract is completed (without regard to the dispute) shall 
be deducted in such year.
    (iii) Any item of income which is properly allocable to such 
contract and which is not included in gross income in a prior taxable 
year pursuant to subdivision (ii) of this subparagraph shall be included 
in gross income in the taxable year in which any such dispute (or part 
thereof) is resolved. Any item of deduction which is properly allocable 
to such contract and which is incurred in a taxable year subsequent to 
the year such contract is completed (without regard to the dispute) 
shall be deducted from gross income in the taxable year in which such 
item of deduction is incurred.
    (iv) For purposes of this paragraph, the term ``gross contract 
price'' means the original stated price of the contract with any 
modifications to which the parties have agreed as of the end of the 
taxable year. Thus, for example, such term includes any amount which the 
taxpayer is claiming by virtue of changes in the specifications of the 
contract which the other parties to the contract have agreed is proper, 
but it does not include any amount which the contractor is claiming 
which is disputed by the other parties to the contract. However, no 
amount is excluded from the term, ``gross contract price'' solely 
because a party refuses to pay such amount when due. Thus, for example, 
if the parties to a contract agree that the gross contract price is 
$100,000, but a party refuses to pay $60,000 of such amount when due, 
such refusal does not prevent the gross contract price from being 
$100,000.
    (v) The application of this subparagraph may be illustrated by the 
following examples:

    Example (1). S, a calendar year taxpayer utilizing the completed 
contract method of accounting, constructs a building for T pursuant to a 
long-term contract. Under the terms of the contract, S is entitled to 
receive $100,000 upon completion of the building. S finishes 
construction of the building in 1974 at a cost of $105,000. T examines 
the building in 1974 and agrees that it meets his specifications; 
however, as of the end of 1974, S and T are unable to agree as to the 
merits of S's claim for an additional $10,000 for certain items which S 
alleges are changes in contract specifications and T alleges are within 
the scope of the contract's original specifications. Under these 
circumstances, S must include in income in 1974 the gross contract price 
of $100,000 and must deduct from gross income in such year the $105,000 
of costs. In 1975 the dispute is resolved by a payment to S of $2,000 
with respect to his claim. S must include this $2,000 in gross income in 
1975.
    Example (2). Assume the same facts as in Example (1) except that S's 
claim for an additional $10,000 relates to two items which S alleges are 
changes in contract specifications, namely $7,000 for changes in the 
heating system and $3,000 for changes in the electrical system. In 1975 
the dispute with respect to the electrical system is resolved by a 
payment to S of $750, and in 1976 the dispute with respect to the 
heating system is resolved by a payment to S of $1,250 and by S's 
performance of additional work at a cost of $250. S must include the 
$750 in gross income for 1975 and the $1,250 in gross income for 1976, 
and S must deduct the $250 from gross income in 1976.

    (4) Contracts with disputes from both buyer and taxpayer claims. (i) 
This subparagraph applies in any case where, on or after a taxpayer 
tenders the subject matter of a long-term contract, a dispute exists 
involving both claims by the taxpayer for an increase in the contract 
price and claims by the other party to the contract either for a 
reduction in the contract price or for the performance of additional 
work under the contract. In any case described in the preceding 
sentence, principles similar to the principles of subparagraphs (2) and 
(3) of this paragraph shall be applied.

[[Page 116]]

    (ii) The application of this subparagraph may be illustrated by the 
following examples:

    Example (1). W, a calendar year taxpayer utilizing the completed 
contract method of accounting, constructs a factory for Z pursuant to a 
long-term contract. Under the terms of the contract, Z agrees to pay W a 
total of $100,000 for construction of the factory. W finishes 
construction of the factory in December 1974 at a cost of $110,000. When 
Z examines the factory in December 1974, Z is dissatisfied with the 
location and workmanship of certain heating ducts. As of the end of 
1974, W contends that the heating ducts as constructed are in accordance 
with contract specifications. The amount reasonably in dispute with 
respect to the heating ducts is $6,000. As of this time, W is claiming 
$14,000 in addition to the original contract price for certain changes 
in contract specifications which W alleges have increased his costs. Z 
denies that such changes have increased W's costs. In 1975 the disputes 
between W and Z are resolved by performance of additional work by W at a 
cost of $1,000 and by an agreement that the contract price would be 
revised downward to $96,000. Under these circumstances, W must include 
in his gross income for 1974, $94,000 (the gross contract price less the 
amount reasonably in dispute because of Z's claim, or $100,000-$6,000). 
In 1974, W must also deduct $104,000 (his costs incurred of $110,000 
less $6,000, an amount equal to the amount in dispute). In 1975, W must 
include in gross income an additional $2,000 ($96,000-$94,000) and must 
deduct $7,000 (the $1,000 of costs W incurs in such year plus the $6,000 
of previously undeducted costs).
    Example (2). R, a calendar year taxpayer utilizing the completed 
contract method of accounting, agrees to construct an office building 
for X for a total contract price of $10,000,000. R begins construction 
in 1973 and tenders the building to X in November 1975. As of November 
1975, R has incurred $15,000,000 of costs which are allocable to the 
contract. When X examines the building, X is dissatisfied with certain 
aspects of the construction and demands that a substantial amount of 
additional work be done. The amount reasonably in dispute with respect 
to X's demand is $4,000,000. R is claiming an additional $2,000,000 for 
certain changes in contract specifications which have allegedly 
increased his costs. As of the end of 1975, neither dispute has been 
resolved. In 1976, the dispute relating to X's claim is resolved by R's 
performance of additional work at a cost of $3,500,000 and X's agreement 
to pay R an additional $400,000. In 1977, the dispute relating to R's 
claim is resolved by X's agreement to increase the contract price by 
$1,800,000. Under these circumstances R must include in his gross income 
for 1975 $6,000,000 ($10,000,000- $4,000,000) and must deduct from gross 
income $11,000,000 ($15,000,000- $4,000,000). In 1976, when the dispute 
relating to X's claim is resolved, R must include in gross income 
$4,400,000 (the $4,000,000 of the gross contract price which was 
excluded from gross income in 1975 by reason of X's claim plus the 
$400,000 by which the contract price was increased) and must deduct 
$7,500,000 (the previously undeducted costs of $4,000,000 plus the costs 
of the work performed to resolve the dispute of $3,500,000). In 1977, 
when the dispute relating to R's claim is resolved, R must include in 
gross income the $1,800,000 by which the contract price was increased in 
settlement of R's claim.

    (5) General rule for allocation of costs to long-term contracts. The 
following rules shall apply in determining what costs are properly 
allocable to a long-term contract (other than an extended period long-
term contract to which the rules of paragraph (d)(6) of this section 
apply) in the case of a taxpayer using the completed contract method of 
accounting for tax purposes:
    (i) Direct costs. Direct material costs and direct labor costs must 
be treated as costs properly allocable to a long-term contract ``Direct 
material costs'' include the costs of those materials which become an 
integral part of the subject matter of the long-term contract and those 
materials which are consumed in the ordinary course of building, 
constructing, installing, or manufacturing the subject matter of a long-
term contract. See Sec. 1.471-3(b) for the elements of direct material 
costs. ``Direct labor costs'' include the cost of labor which can be 
identified or associated with a particular long-term contract. The 
elements of direct labor costs include such items as basic compensation, 
overtime pay, vacation and holiday pay, sick leave pay (other than 
payments pursuant to a wage continuation plan under section 105(d) as it 
existed prior to its repeal in 1983), shift differential, payroll taxes 
and payments to a supplemental unemployment benefit plan paid or 
incurred on behalf of employees engaged in direct labor.
    (ii) Indirect costs allocated to long-term contracts. The term 
``indirect costs'' includes all costs (other than direct material costs 
and direct labor costs) which are incident to and necessary for the 
performance of particular long-term contracts. Indirect costs which

[[Page 117]]

must be allocated to long-term contracts include:
    (A) Repair expenses of equipment or facilities used in the 
performance of particular long-term contracts,
    (B) Maintenance of equipment or facilities used in the performance 
of particular long-term contracts,
    (C) Utilities, such as heat, light, and power, relating to equipment 
or facilities used in the performance of particular long-term contracts,
    (D) Rent of equipment or facilities used in the performance of 
particular long-term contracts,
    (E) Indirect labor and contract supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay, 
(other than payments pursuant to a wage continuation plan under section 
105(d) as it existed prior to its repeal in 1983), shift differential 
payroll taxes and contributions to a supplemental unemployment benefit 
plan incurred in the performance of particular long-term contracts.
    (F) Indirect materials and supplies used in the performance of 
particular long-term contract,
    (G) Tools and equipment not capitalized used in the performance of 
particular long-term contracts,
    (H) Costs of quality control and inspection incurred in the 
performance of particular long-term contracts,
    (I) Taxes otherwise allowable as a deduction under section 164 
(other than State and local, and foreign income taxes) to the extent 
such taxes are attributable to labor, materials, supplies, equipment or 
facilities used in the performance of particular long-term contracts,
    (J) Depreciation, amortization and cost recovery allowances reported 
for the taxable year for financial purposes on equipment and facilities 
used in the performance of particular long-term contracts (but not in 
excess of the depreciation, amortization or cost recovery allowance 
allowable for the taxable year under Chapter I of the Code with respect 
to any item of equipment or facility).
    (K) Cost depletion incurred in the performance of particular long-
term contracts,
    (L) Administrative costs incurred in the performance of particular 
long-term contracts (but not including any costs of selling or any 
return on capital),
    (M) Compensation paid to officers attributable to services performed 
on particular long-term contracts (other than incidental or occasional 
services). and
    (N) Cost of insurance incurred in the performance of particular 
long-term contracts, such as insurance on machinery and equipment used 
in the construction of the subject matter of a long-term contract.
    (iii) Costs not allocated to long-term contracts. Costs which are 
not required to be included in costs attributable to a long-term 
contract include:
    (A) Marketing and selling expenses, including bidding expenses,
    (B) Advertising expenses,
    (C) Other distribution expenses,
    (D) Interest,
    (E) General and administrative expenses attributable to the 
performance of services which benefit the long-term contractor's 
activities as a whole (such as payroll expenses, legal and accounting 
expenses, etc.),
    (F) Research and experimental expenses (described in section 174 and 
the regulations thereunder),
    (G) Losses under section 165 and the regulations thereunder,
    (H) Percentage of depletion in excess of cost depletion,
    (I) Depreciation, amortization and cost recovery allowances on 
equipment and facilities that have been placed in service but are 
temporarily idle (for this purpose, an asset is not considered to be 
temporarily idle on non-working days, and an asset used in construction 
is considered to be idle when it is not enroute to or not located at a 
job-site), and depreciation, amortization and cost recovery allowances 
under Chapter I of the Code in excess of depreciation, amortization and 
cost recovery allowances reported by the taxpayer in the taxpayer's 
financial reports,
    (J) Income taxes attributable to income received from long-term 
contracts,
    (K) Contributions paid to or under a stock bonus, pension, profit-
sharing or annuity plan or other plan deferring

[[Page 118]]

the receipt of compensation whether or not the plan qualifies under 
section 401(a), and other employee benefit expenses paid or accrued on 
behalf of labor, to the extent such contributions or expenses are 
otherwise allowable as deductions under chapter 1 of the Code. ``Other 
employee benefit expenses'' include (but are not limited to): worker's 
compensation; amounts deductible or for whose payment reduction in 
earnings and profits is allowed under section 404A and the regulations 
thereunder; payments pursuant to a wage continuation plan under section 
105(d) as it existed prior to its repeal in 1983; amounts includible in 
the gross income of employees under a method or arrangement of employer 
contributions or compensation which has the effect of a stock bonus, 
pension, profit-sharing, or annuity plan, or other plan deferring the 
receipt of compensation or providing deferred benefits; premiums on life 
and health insurance; and miscellaneous benefits provided for employees 
such as safety, medical treatment, recreational and eating facilities, 
membership dues, etc.
    (L) Cost attributable to strikes, rework labor, scrap and spoilage, 
and
    (M) Compensation paid to officers attributable to the performance of 
services which benefit the long-term contractor's activities as a whole.
    (6) Allocation of costs to extended period long-term contracts. 
Except as provided in paragraph (g) of this section, this paragraph 
(d)(6) applies to taxable years beginning after December 31, 1982. The 
following rules shall apply in determining what costs are properly 
allocable to an extended period long-term contract (as defined in 
paragraph (b)(3) of this section) in the case of a taxpayer using the 
completed contract method of accounting for long-term contracts for tax 
purposes. These rules may also apply to certain extended period long-
term contracts accounted for under a method of accounting that uses 
inventories (other than a long-term contract method). See paragraph 
(d)(6)(v) of this section.
    (i) Direct costs. Direct material costs and direct labor costs must 
be treated as costs properly allocable to an extended period long-term 
contract. ``Direct material costs'' include the costs of those materials 
which become an integral part of the subject matter of the extended 
period long-term contract and those materials which are consumed in the 
ordinary course of building, constructing, installing or manufacturing 
the subject matter of an extended period long-term contract. See 
Sec. 1.471-3(b) for the elements of direct material costs. ``Direct 
labor costs'' include the cost of labor which can be identified or 
associated with a particular extended period long-term contract. The 
elements of direct labor costs include such items as basic compensation, 
overtime pay, vacation and holiday pay, sick leave pay (other than 
payments pursuant to a wage continuation plan under section 105(d) as it 
existed prior to its repeal in 1983), shift differential, payroll taxes 
and payments to a supplemental unemployment benefit plan paid or 
incurred on behalf of employees engaged in direct labor.
    (ii) Indirect costs allocated to extended period long-term 
contracts. The term ``indirect costs'' include all costs other than 
direct material costs and direct labor costs. In determining what 
indirect costs are properly allocable to an extended period long-term 
contract, all such costs that directly benefit the performance of 
extended period long-term contracts, or are incurred by reason of the 
performance of extended period long-term contracts must be allocated to 
extended period long-term contracts unless otherwise provided in 
paragraph (d)(6)(iii) of this section. Certain types of costs may 
directly benefit, or be incurred by reason of the performance of 
extended period long-term contracts of the taxpayer even though the same 
type of costs also benefits other activities of the taxpayer. 
Accordingly, such costs require a reasonable allocation between the 
portion of such costs that are attributable to extended period long-term 
contracts and the portion attributable to the other activities of the 
taxpayer. Indirect costs that must be allocated to extended period long-
term contracts include:
    (A) Repair expenses of equipment or facilities used in the 
performance of particular extended period long-term contracts,

[[Page 119]]

    (B) Maintenance of equipment or facilities used in the performance 
of particular extended period long-term contracts,
    (C) Utilities, such as heat, light, and power, relating to equipment 
or facilities used in the performance of particular extended period 
long-term contracts,
    (D) Rent of equipment or facilities used in the performance of 
particular extended period long-term contracts,
    (E) Indirect labor and contract supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d) as it existed prior to its repeal in 1983), shift differential, 
payroll taxes and contributions to a supplemental unemployment benefit 
plan incurred in the performance of particular extended period long-term 
contracts,
    (F) Indirect materials and supplies used in the performance of 
particular extended period long-term contracts,
    (G) Tools and equipment not capitalized used in the performance of 
particular extended period long-term contracts,
    (H) Costs of quality control and inspection incurred in the 
performance of particular extended period long-term contracts,
    (I) Taxes otherwise allowable as a deduction under section 164 
(other than State and local[,] and foreign income taxes) to the extent 
such taxes are attributable to labor, materials, supplies, equipment or 
facilities used in the performance of particular extended period long-
term contracts,
    (J) Depreciation, amortization and cost recovery allowances on 
equipment and facilities (to the extent allowable as deductions under 
Chapter I of the Code) used in the performance of particular extended 
period long-term contracts,
    (K) Depletion (whether or not in excess of cost) incurred in the 
performance of particular extended period long-term contracts,
    (L) Administrative costs (whether or not performed on a job-site) 
directly attributable to the performance of particular extended period 
long-term contracts (but not including any cost of selling, or any 
return on capital),
    (M) Direct and indirect costs incurred by any administrative, 
service, or support function or department to the extent such costs are 
allocable to particular extended period long-term contracts pursuant to 
paragraph (d)(9) of this section.
    (N) Compensation paid to officers attributable to services performed 
on particular extended period long-term contracts (but not including any 
cost of selling),
    (O) Costs of insurance incurred in the performance of particular 
extended period long-term contracts, such as insurance on machinery and 
equipment used in the construction of the subject matter of an extended 
period long-term contract.
    (P) Contributions paid to or under a stock bonus, pension, profit-
sharing or annuity plan or other plan deferring the receipt of 
compensation whether or not the plan qualifies under section 401(a) 
(except for amounts described in paragraph (d)(6)(iii)(I) of this 
section), and other employees benefit expenses paid or accrued on behalf 
of labor, to the extent such contributions or expenses are otherwise 
allowable as deductions under chapter 1 of the Code. ``Other employee 
benefit expenses'' include (but are not limited to): worker's 
compensation; amounts deductible or for whose payment reduction in 
earnings of profits is allowed under section 404A and the regulations 
thereunder; payments pursuant to a wage contribution plan under section 
105(d) as it existed prior to its repeal in 1983; amounts includible in 
the gross income of employees under a method or arrangement of employer 
contributions or compensation which has the effect of a stock bonus, 
pension, profit-sharing, or annuity plan, or other plan deferring the 
receipt of compensation or providing deferred benefits; premiums on life 
and health insurance; and miscellaneous benefits provided for employees 
such as safety, medical treatment, recreational and eating facilities, 
membership dues, etc.,
    (Q) Research and experimental expenses (described in section 174 and 
the regulations thereunder) directly attributable to particular extended 
period

[[Page 120]]

long-term contracts in existence at the time such expenses are incurred, 
or incurred under an agreement to perform research or experimentation,
    (R) Rework labor, scrap and spoilage to the extent incurred in the 
performance of particular extended period long-term contracts, and
    (S) Bidding expenses incurred in the solicitation of particular 
extended period long-term contracts ultimately awarded to the taxpayer. 
For purposes of this section, the term ``bidding expenses'' does not 
include any research and experimental expenses described in section 174 
and the regulations thereunder. The taxpayer shall defer all bidding 
expenses paid or incurred in the solicitation of a particular extended 
period long-term contract until the contract is awarded. If the contract 
is awarded to the taxpayer, the bidding costs become part of the 
indirect costs assigned to the contract. If the contract is not awarded 
to the taxpayer, bidding costs become deductible in the taxable year the 
contract is awarded, or the taxable year the taxpayer is notified in 
writing that no contract will be awarded and that the contract (or 
similar or related contract) will not be re-bid, or in the taxable year 
that the taxpayer abandons its bid or proposal, whichever occurs first. 
Abandoning a bid does not include modifying, supplementing, or changing 
the original bid or proposal. If the taxpayer is awarded only part of 
the bid (for example, the taxpayer submitted one bid to build each of 
two different types of bridges and the taxpayer was awarded a contract 
to build only one of the two bridges), the taxpayer shall deduct the 
portion of the bidding expenses related to the portion of the bid not 
awarded to the taxpayer; in the case of a bid or proposal for a multi-
unit contract, however, all the bidding expenses shall be allocated to a 
contract awarded to the taxpayer to produce any or such units (for 
example, where the taxpayer submitted one bid to produce three similar 
turbines and the taxpayer was awarded a contract to produce only two of 
the three turbines).
    (iii) Costs not allocated to extended period long-term contracts. 
Costs which are not required to be included in costs attributable to an 
extended period long-term contract include:
    (A) Marketing, selling and advertising expenses;
    (B) Bidding expenses incurred in the solicitation of contracts not 
awarded to the taxpayer (see paragraph (d)(6)(ii)(S) of this section),
    (C) Interest,
    (D) General and administrative expenses (but not including any cost 
described in paragraph (d)(6)(ii) (L) or (M) of this section) and 
compensation paid to officers attributable to the performance of 
services that do not directly benefit or are not incurred by reason of 
any extended period long-term contracts,
    (E) Research and experimental expenses (described in section 174 and 
the regulations thereunder) neither directly attributable to particular 
extended period long-term contracts in existence at the time such 
expenses are incurred nor incurred under any agreement to perform 
research or experimentation,
    (F) Losses under section 165 and the regulations thereunder,
    (G) Depreciation, amortization and cost recovery allowances on 
equipment and facilities that have been placed in service but are 
temporarily idle (for this purpose, an asset is not considered to be 
temporarily idle on non-working days, and an asset used in construction 
is considered to be idle when it is not en route to or not located at a 
job-site),
    (H) Income taxes attributable to income received from extended 
period long-term contracts,
    (I) Contributions paid to or under a pension or annuity plan 
allowable as a deduction under section 404 (and section 404A if 
applicable) to the extent such contributions represent past service 
costs, and
    (J) Costs attributable to strikes.
    (iv) Special rule for component parts or subassemblies produced by 
the taxpayer. In the case of any type of component or subassembly 
produced by the taxpayer, the taxpayer shall use the cost allocation 
rules prescribed in paragraph (d) (6) and (8) of this section to 
determine

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the unit cost of the components or subassemblies that reasonably can be 
expected to be incorporated into the subject matter of extended period 
long-term contracts of the taxpayer. The taxpayer may use other proper 
cost allocation rules (see Sec. 1.471-11) to determine the unit cost of 
the components or subassemblies other than those described in the 
preceding sentence. For each taxable year, the taxpayer's estimate of 
the number of components or subassemblies that can be expected to be 
incorporated into the subject matter of extended period long-term 
contracts shall be considered reasonable if the estimate is based upon 
facts known at the beginning of the taxable year.
    (v) Taxpayers not using a long-term contract method. Taxpayers who 
use a method of accounting that uses inventories (other than a long-term 
contract method) must use the cost allocation rules provided in 
paragraph (d)(6) of this section (rather than the cost allocation rules 
provided in Sec. 1.471-11) for any extended period long-term contract 
unless the taxpayer reasonably expects that:
    (A) 40% of the gross income from such contract will be recognized no 
later than the taxable year after the taxable year in which the contract 
is entered into;
    (B) 70% of the gross income from such contract will be recognized no 
later than the second taxable year after the taxable year in which the 
contract is entered into; and
    (C) 100% of the gross income from such contract will be recognized 
no later than the third taxable year after the taxable year in which the 
contract is entered into.

In determining whether the taxpayer meets the ``reasonably expected'' 
test of this paragraph (d)(6)(v), rules consistent with the rules of 
paragraph (b)(3)(iv) of this section will apply.
    (7) Guarantees, warranties, maintenance costs, etc. ``Costs which 
are properly allocable to a long-term contract'' do not include costs 
incurred with respect to any guarantee, warranty, maintenance, or other 
service agreement relating to the subject matter of the long-term 
contract. See paragraph (a)(3) of this section.
    (8) Separate accounts; annual cost allocation; use of inventory 
methods in connection with the completed contract method--(i) General 
rule. This paragraph (d)(8) is effective for taxable years beginning 
after December 31, 1982. For taxable years beginning before January 1, 
1983, see 26 CFR 1.451-3(d)(6) (revised as of April 1, 1985). The 
taxpayer shall maintain separate accounts for each long-term contract, 
and both the direct costs (as described in paragraph (d)(5)(i) or 
(d)(6)(i) of this section) and the indirect costs (as described in 
paragraph (d)(5)(ii) or (d)(6)(ii) of this section) incurred during the 
taxable year attributable to long-term contracts shall be allocated to 
particular long-term contracts for the taxable year such costs are 
incurred. Any change in the taxpayer's method of accounting for costs 
attributable to long-term contracts required by this paragraph (d)(8) is 
a change in method of accounting to which section 446(e) and the 
regulations and procedures thereunder apply.
    (ii) Direct labor. Direct labor costs incurred during the taxable 
year shall be allocated to particular long-term contracts using a 
specific identification (or ``tracing'') method. However, if direct 
labor costs attributable to more than one long-term contract are 
intermingled so that it is impractical to specifically identify (or 
``trace'') such costs to a particular long-term contract, such costs 
shall be allocated to particular long-term contracts using any 
reasonable method, provided that the method employed reasonably 
allocates direct labor costs among long-term contracts completed during 
the taxable year and long-term contracts that have not been completed as 
of the end of the taxable year. For the purpose of allocating elements 
of direct labor cost other than basic compensation to particular long-
term contracts, all such cost elements may be grouped together and then 
allocated to particular long-term contracts in proportion to the charge 
for basic compensation.
    (iii) Direct materials--(A) General rule. The cost of direct 
materials that are dedicated to a long-term contract in a taxable year 
shall be allocated to that long-term contract for that year. The cost 
that is allocated to the particular contract for the year of dedication

[[Page 122]]

shall be determined using the taxpayer's method of accounting for 
inventories (e.g., specific identification, FIFO, LIFO, etc.) of the 
material whose cost is being allocated. The costing rule in the 
preceding sentence applies both when materials are purchased 
specifically for a contract and when materials previously held by the 
taxpayer are dedicated to the contract. Examples of dedication of 
materials to a long-term contract include the following:
    (1) Delivery of materials to a job site (if only one contract is 
being performed at that site);
    (2) Association of materials with a specific contract (for example, 
by purchase order, entry on books and records, shipping instructions, 
etc.); and, if not previously assigned, the physical incorporation of 
the material into the subject matter of the contract or the consumption 
of the material in the production of the subject matter of the contract.
    (B) Alternative rule for taxable years beginning after December 31, 
1982 and before January 1, 1986. For taxable years beginning after 
December 31, 1982, and before January 1, 1986, taxpayers may, in lieu of 
applying the general rule of paragraph (d)(8)(iii)(A) of this section, 
allocate direct costs incurred during the taxable year to particular 
long-term contracts using the specific identification (or ``tracing'') 
method, and if direct costs attributable to more than one long-term 
contract are intermingled so that such costs cannot be identified (or 
``traced'') specifically to a particular long-term contract, such costs 
shall be allocated to particular long-term contracts using any 
reasonable method, provided that the method employed reasonably 
allocates direct costs among long-term contracts completed during the 
taxable year and long-term contracts that have not been completed as of 
the end of the taxable year. However, taxpayers utilizing the rule of 
this paragraph (d)(8)(iii)(B) may not use any LIFO or lower of cost or 
market method of identifying or allocating direct costs to any long-term 
contract.
    (iv) Indirect costs. The indirect costs-required to be allocated to 
a long-term contract under paragraph (d)(5)(ii) or (d)(6)(ii) of this 
section shall be allocated to particular contracts for the year such 
costs are incurred using either--
    (A) A specific identification (or ``tracing'') method, or
    (B) A method using burden rates, such as ratios based on direct 
costs, hours, or other items, or similar formulas, so long as the method 
employed for such allocation reasonably allocates indirect costs among 
long-term contracts completed during the taxable year and long-term 
contracts that have not been completed as of the end of the taxable 
year. Indirect costs may ordinarily be allocated to long-term contracts 
on the basis of direct labor and material costs, direct labor hours, or 
any other basis which results in a reasonable allocation of such 
indirect costs.
    (9) Allocation of administrative, service, or support costs to 
extended period long-term contracts--(i) Introduction. (A) If a function 
or department of the taxpayer incurs costs that directly benefit or are 
incurred by reason of the extended period long-term contract activities 
of the taxpayer, the costs of such function or department are allocable 
to such extended period long-term contracts. See paragraph (d)(6)(ii)(M) 
of this section. However, if a function or department incurs costs that 
do not directly benefit and are not incurred by reason of the taxpayer's 
extended period long-term contracts, but rather, for example, benefit 
only the overall management or policy guidance functions of the 
taxpayer, the costs incurred by such function or department are not 
allocable to any extended period long-term contract. In some cases, the 
costs incurred by a function or department may directly benefit or be 
incurred by reason of the taxpayer's extended period long-term contract 
activities as well as the taxpayer's overall management or policy 
guidance function. In such cases, the taxpayer shall reasonably allocate 
the costs of such function or department between the taxpayer's extended 
period long-term contract activities and the taxpayer's overall 
management or policy guidance functions. Paragraph (d)(9) of this 
section provides guidance in making these allocations.

[[Page 123]]

    (B) If the methods of allocation used by the taxpayer, or the 
taxpayer's selection of specific types of costs to be allocated differs 
from the allocation methods or the specific types of costs to be 
allocated described in this paragraph (d)(9), the taxpayer's allocation 
methods and selection of specific types of costs to be allocated shall 
generally not be changed if, with respect to the taxpayer's extended 
period long-term contracts taken as a whole--
    (1) The total amount of costs incurred during the taxable year of a 
type described in this paragraph (d)(9) that the taxpayer allocated to 
such contracts does not differ significantly from the total amount of 
costs that would be allocated to such contracts under this paragraph 
(d)(9); and
    (2) The taxpayer's selection of cost allocation methods and specific 
types of costs to be allocated are applied consistently and do not 
result in any disproportionate allocation of costs to contracts expected 
to be completed in the near future.
    (ii) General rule. The total amount of administrative, service, or 
support costs that directly benefit or are incurred by reason of only a 
particular extended period long-term contract shall be directly assigned 
to such contract. The direct and indirect cost (hereinafter ``service 
costs'') of administrative, service or support functions or departments 
(hereinafter ``service departments'') that directly benefit or are 
incurred by reason of more than one activity shall be allocated to 
particular extended period long-term contracts on the basis of a factor 
or relationship that reasonably relates the incurring of the service 
cost to the benefits received by the extended period long-term contract. 
In general, the direct costs of a service department include costs that 
can be identified specifically with the services provided by the 
department, and the indirect costs of a service department include costs 
not identified specifically with the services provided by the function 
or department, but incurred by reason of the direct costs of the 
function or department. Such direct and indirect costs include, but are 
not limited to, compensation (including compensation described in 
paragraph (d)(6)(ii) (E) and (P) of this section) of employees directly 
engaged in performing the services provided by the department, travel, 
materials and supplies consumed by the department, supervisory and 
clerical compensation, occupancy costs (rents or an allocable share of 
depreciation and property taxes), depreciation or rent of office 
machines, utilities, telephone, and other department overhead. The types 
of activities that are administrative, service or support functions or 
departments are not predetermined, but depend upon the facts and 
circumstances of each contractor's activities and business organization. 
In a decentralized business organization, all costs incurred at higher 
levels, for example, at a parent corporation or organization, or at the 
headquarters of a subsidiary corporation or division, are not 
necessarily general and administrative expenses (as described in 
paragraph (d)(5)(iii)(D) of this section) with respect to an extended 
period long-term contract.
    (iii) Rules for allocation of service costs. The taxpayer shall 
allocate the total direct and indirect costs of a service department to 
extended period long-term contracts by applying consistently any 
reasonable method of cost allocation authorized by cost accounting 
principles. Reasonable methods include:
    (A) The direct reallocation method, whereby the total costs (direct 
and indirect) of all service departments are allocated only to 
production departments, and then from the production departments to 
particular extended period long-term contracts and to other production 
activities that are not extended period long-term contracts. The service 
costs allocable to such other production activities shall be accounted 
for under a proper method of accounting. This direct reallocation method 
ignores benefits provided by one service department for other service 
departments, and also excludes such other service departments from the 
base used to make the allocation;
    (B) The step-allocation method, whereby a sequence of allocations is 
made beginning with the allocation to other service departments and to 
production departments of the total costs

[[Page 124]]

(direct and indirect) of the service department that provides benefits 
to the greatest number of other service departments, and ending with the 
allocation of the total costs (including the costs allocated to it from 
the other service departments) of the service department that provides 
benefits to the least number of other service departments. Under this 
allocation method, the cost of service departments allocated properly to 
functions or departments that are not service departments or production 
departments (for example, payroll costs allocated to a financial 
planning function or department) are not reallocated to any other 
service department or production department. The taxpayer shall then 
allocate the costs of the production departments (including the 
reallocated service department costs) to extended period long-term 
contracts and to other production activities that are not extended 
period long-term contracts. The service costs allocable to such other 
production activities shall be accounted for under a proper method of 
accounting, or
    (C) Other methods of cost allocation authorized by cost accounting 
principles. However, a reasonable method does not include allocating 
service department costs to other service departments without taking 
such allocation into account in allocating the costs of such other 
service departments.
    (iv) Relationship of service costs to benefits received. Factors or 
relationships that relate the incurring of service costs to the benefits 
received by an extended period long-term contract include measures based 
upon the total output of the service department (for example, the 
approximate number of service hours or the approximate number or the 
dollar volume of transactions provided to an extended period long-term 
contract as a fraction of the total number of service hours or the total 
number or the total dollar volume of transactions provided by the 
department), or measures based upon the relative size of the extended 
period long-term contract to the size of the taxpayer's other production 
activities (for example, the number of direct labor employees or direct 
labor hours or direct labor costs (as described in paragraph (d)(6)(i) 
of this section) incurred on an extended period long-term contract as a 
fraction of the total number of direct labor employees, direct labor 
hours, or direct labor costs incurred by the taxpayer in all production 
activities). In general, allocation methods prescribed in regulations of 
the Cost Accounting Standards Board, 4 CFR Chapter III, Subchapter G, as 
well as other allocation methods consistent with the principles or 
paragraph (d)(g) of this section are acceptable allocation methods, 
provided that the taxpayer applies such methods consistently.
    (v) Additional requirements. (A) If, pursuant to section 482 and the 
regulations thereunder, the district director makes an allocation of 
income or deductions between members of a group of controlled entities 
to reflect the performance of services or the provision of equipment or 
facilities at other than an arm's length charge, any taxpayer that has 
extended period long-term contracts and is affected by such allocation 
is required to take such allocation into account in making the 
taxpayer's allocation to extended period long-term contracts of the cost 
of administrative, service or support functions or departments.
    (B) If the taxpayer establishes to the satisfaction of the district 
director that all of a particular type of administrative, service or 
support function is performed only at the jobsite (that is, at the 
offices of a production plant or at a construction site), then all the 
direct and indirect costs of such function incurred at the jobsite shall 
be directly allocated to each particular extended period long-term 
contract and any other activities performed at that jobsite, and no 
further allocation of that type of cost shall be required .
    (C) For each taxable year that the taxpayer allocates costs service 
to an extended period long-term contract, the taxpayer shall maintain 
the records used to make such allocation so that the allocations may be 
readily examined and verified by the district director. The taxpayer 
shall also maintain records describing the types of costs that the 
taxpayer has deducted currently under paragraph (d)(6)(iii)(D) (general 
and administrative expenses),

[[Page 125]]

so that the amount, nature and allocation of such costs may be verified 
readily by the district director. A change in the method or base used in 
allocating such service costs (such as changing from an allocation base 
using direct labor cost to a base using direct labor hours), or a change 
in the taxpayer's determination of what functions or departments of the 
taxpayer are required or not required to be allocated to extended period 
long-term contracts is a change in method of accounting to which section 
446(e) and the regulations and procedures thereunder apply. See 
Sec. 1.446-1(e).
    (vi) Illustration of types of activities with respect to which costs 
ordinarily are required to be allocated. Costs incurred by the following 
types of functions or departments ordinarily are required to be 
allocated to extended period long-term contracts:
    (A) The administration and coordination of manufacturing or 
construction projects (wherever performed in the business organization 
of the taxpayer);
    (B) Personnel operations, including the cost of recruiting, hiring, 
relocating, assigning, and maintaining personnel records of employees 
whose labor cost is allocable to extended period long-term contracts;
    (C) Purchasing operations, including purchasing materials and 
equipment, scheduling and coordinating delivery and return of materials 
and equipment to or from factories or jobsites, and expediting and 
follow-up;
    (D) Materials handling and warehousing operations;
    (E) Accounting and data services operations related to contract 
activities, including cost accounting, accounts payable, disbursements, 
billing, accounts receivable and payroll;
    (F) Data processing;
    (G) Security services; and
    (H) Legal departments that provide legal services to contracts.
    (vii) Illustration of types of activities with respect to which 
costs ordinarily are not required to be allocated. Costs incurred by the 
following types of functions or departments ordinarily are not required 
to be allocated to extended period long-term contracts:
    (A) Functions or departments responsible for overall management of 
the taxpayer, or for setting overall policy for all of the taxpayer's 
activities or trades or businesses (such as, the board of directors 
(including their immediate staff), and the chief executive, financial, 
accounting and legal officers (including their immediate staffs) of the 
taxpayer, provided that no substantial part of the costs of such 
departments or functions directly benefit extended period long-term 
contracts);
    (B) General business planning;
    (C) Financial accounting (including the accounting services required 
to prepare consolidated reports, but not including any accounting for 
particular contracts);
    (D) General financial planning (including general budgeting) and 
financial management (including bank relations and cash management);
    (E) General economic analysis and forecasting;
    (F) Internal audit;
    (G) Shareholder, public and industrial relations;
    (H) Tax department; and
    (I) Other departments or functions that are not responsible for day-
to-day operations but are instead responsible for setting policy and 
establishing procedures to be used by all of the taxpayer's activities 
or trades or businesses.
    (viii) Policy and overall management services. Examples of such 
functions or departments that are responsible for setting policy and 
establishing procedures applicable to all of the taxpayer's activities 
or trades or businesses (see paragraph (d)(9)(vii)(I) of this section) 
are:
    (A) Purchasing policy (such as maintaining lists of approved 
suppliers, developing purchasing manuals and policy directives of 
general application, developing general quality standards for purchased 
materials and components, general auditing and review of purchasing 
activities to assure compliance with the taxpayer's purchasing policy 
and compliance with government purchasing requirements, and management 
of small business participation),
    (B) Personnel policy (such as establishing and managing personnel 
policy in general, developing general wage, salary and benefit policies, 
developing

[[Page 126]]

employee training programs unrelated to particular contracts, 
negotiations with labor unions and relations with retired workers),
    (C) Quality control policy,
    (D) Safety engineering policy,
    (E) Insurance or risk management policy (but not including bid or 
performance bonds or insurance related to particular contracts), and
    (F) Environmental management policy. However, the cost of 
establishing any system or procedure that will only benefit a particular 
extended period long-term contract shall be directly allocated to such 
contract.
    (ix) Costs not described. The costs of any administrative, service 
or support function or department of the taxpayer not described in 
paragraph (d)(9) (iv) or (vii) of this section are required to be 
allocated to extended period long-term contracts to the extent that the 
nature of the benefits provided by such function or department is more 
like the type of benefits described in paragraph (d)(9)(vi) than the 
type of benefits described in paragraph (d)(9)(vii).
    (x) Illustrations of the allocations required by this paragraph 
(d)(9). The following illustrate the types of considerations that are to 
be taken into account in making the allocations required by paragraph 
(d)(9) of this section. The taxpayer need not use the same method to 
allocate a particular type of administrative, service or support cost as 
the method described in these illustrations provided that the method 
used by the taxpayer is reasonable. See paragraph (d)(9)(iii) of this 
section. The allocation methods illustrated may be used to allocate 
other types of service costs not illustrated.
    (A) Security services. The cost of security or protection services 
benefits all areas covered by the service and should be allocated to 
each physical area that receives the service in proportion either to the 
size of the physical area, number of employees in the area, or in 
proportion to the relative fair market value of assets located in the 
area, or in any other reasonable basis applied consistently. That part 
of the total cost allocable to a factory or jobsite where the only work 
being performed is an extended period long-term contract shall be 
directly allocated to that contract. The treatment of the cost of 
security services allocable to other service departments depends upon 
the method of allocation adopted by the taxpayer under paragraph 
(d)(9)(iii) of this section.
    (B) Legal services. The cost of a legal department includes rent (or 
an allocation of building depreciation and occupancy costs), travel, 
office machines, supplies, telephone, library, and other overhead and 
the compensation of the attorneys and other employees assigned to the 
department. For this purpose compensation includes compensation 
described in paragraphs (d)(6)(ii) (E) and (P) of this section. These 
costs only benefit activities of the taxpayer requiring legal services. 
These costs are generally allocable directly to an extended period long-
term contract on the basis of the approximate number of hours of legal 
services (including research) performed in connection with the contract, 
including bidding, negotiating, drafting, or reviewing the contract 
(including subcontracts and supply contracts), obtaining necessary 
licenses and permits, and in resolving contract disputes, termination 
claims or disputes arising from the performance of the contract. 
Different hourly rates may be appropriate for different services. In 
determining the number of hours allocable to any contract, 
approximations are appropriate, detailed time records need not be kept, 
and insubstantial amounts of services provided to a contract by senior 
legal staff as administrators or as reviewers may be ignored. The 
taxpayer shall also allocate directly to a contract the cost of any 
outside legal services provided to the contract. Instead of an 
allocation based upon total hours of legal services provided to an 
activity, the taxpayer may choose to allocate the costs of a legal 
department to an extended period long-term contract and to other 
production activities on the basis of total direct costs (as described 
in paragraph (d)(6)(i) of this section) incurred on an extended period 
long-term contract as a fraction of the total direct costs incurred on 
all production activities. Legal costs may also be allocable to long-
term contracts of the taxpayer that are not extended period long-term 
contracts under paragraph (d)(5)(ii) of

[[Page 127]]

this section. Legal activities relating to general corporate functions, 
financing, securities law compliance, antitrust law compliance, tax 
compliance, industrial relations, compliance with laws and regulations 
not related to particular contracts, after the fact review of contracts 
to insure compliance with company policies, patents and licensing 
unrelated to particular contracts, and similar general legal functions 
are not required to be allocated to long-term contracts.
    (C) Centralized payroll department. The cost of a payroll department 
includes rent (or an allocation of building depreciation and occupancy 
costs), office machines, supplies, telephones and other overhead and 
compensation of employees assigned to the department. The department 
cost may also include the cost of data processing and file maintenance, 
or these costs may be incurred by a separate data processing or records 
department and allocated to the payroll department. Payroll service 
costs benefit any production department or other service department 
incurring labor costs. The cost of a payroll department is generally 
allocated on the basis of the gross amount of payroll processed.
    (D) Centralized data processing. The cost of a data processing 
department includes rent or depreciation of data processing machines, 
supplies, rent (or an allocation of building depreciation and occupancy 
costs), power, telephone and other overhead, and the compensation of 
employees assigned to the department. These costs benefit all production 
departments and all other service departments that require data 
processing services. Data processing costs are generally allocated based 
upon the number of data processing hours supplied. Other reasonable 
bases, such as an allocation based upon total direct costs, may also be 
used. The costs of data processing systems developed for particular 
long-term contract shall be directly allocated to such contract.
    (E) Engineering and design services. The cost of an engineering or 
design department includes rent (or an allocation of building 
depreciation and occupancy costs), travel, office machines, supplies, 
telephones, library, and other overhead, and compensation of employees 
assigned to the department. Unless the engineering and design services 
are properly accounted for separately, the cost of engineering or design 
service departments generally is directly allocable to a long-term 
contract (whether or not the contract is an extended period long-term 
contract) on the basis of the approximate number of hours of work 
performed on the contract as a fraction of the total hours of 
engineering or design work performed for all activities. Different 
services may be allocated at different hourly rates. Engineering and 
design services may also be treated as direct costs of the contract, 
provided that the taxpayer also treats all engineering and design 
overhead as a direct or indirect cost of the contract.
    (F) Safety engineering. The cost of a safety engineering department 
includes the compensation paid to employees assigned to the department, 
rent (or an allocation of building depreciation and occupancy costs), 
travel, office machines, supplies, telephones, library, and other 
overhead. These costs benefit all the production activities of the 
taxpayer and should be allocated to an extended period long-term 
contract on the basis of the approximate number of safety inspections 
made on the contract as a fraction of total inspections, or on the basis 
of the number of employees assigned to the contract as a fraction of 
total production employees or on the basis of total labor hours worked 
on the contract as a fraction of total production hours, whichever is 
most reasonable. The cost of a safety engineering department reponsible 
only for setting safety policy and establishing safety procedures to be 
used in all of the taxpayer's production activities or trades or 
businesses is not required to be allocated to extended period long-term 
contracts and other production activities. However, in determining the 
total costs of a safety engineering department to be allocated, costs 
attributable to providing a safety program only for a particular long-
term contract shall be directly assigned to the contract.
    (e) Severing and aggregating contracts--(1) In general. (i)(A) For 
the purpose of clearly reflecting income (e.g.,

[[Page 128]]

to prevent the unreasonable deferral of recognition of income or the 
premature recognition of loss), it may be necessary in some instances 
for the Commissioner either to treat one agreement as several contracts 
or to treat several agreements as one contract.
    (B) However, in the case of long-term contracts since the factors 
described in this paragraph are different from the factors for 
determining whether certain elements of an agreement are eligible for 
long-term contract treatment, the factors described in this paragraph do 
not apply in determining which elements of an agreement that are 
ineligible for long-term contract treatment must be separated from those 
elements that are eligible for long-term contract treatment.
    (C) In general only the Commissioner (and not the taxpayer) may take 
action under this paragraph. Thus, for example, if the taxpayer enters 
into one agreement, the taxpayer may not treat that agreement as several 
contracts for purposes of this section unless and until that agreement 
is changed into several agreements. See examples 3 and 5 for instances 
when one agreement is changed into several agreements.
    (ii) Whether an agreement should be so severed or several agreements 
so aggregated will depend on all the facts and circumstances. Such facts 
and circumstances may include whether there is separate delivery or 
separate acceptance of units representing a portion of the subject 
matter of the contract, whether such units are independently priced, 
whether there is no business purpose for one agreement rather than 
several agreements or several agreements rather than one agreement, and 
such other factors as customary commercial practice, the dealings 
between parties to the contract, the nature of the subject matter of the 
contract, the total number of units to be constructed, manufactured, or 
installed under the contract, and the contemplated time between the 
completion of each unit.
    (iii) Generally, one agreement will not be treated as several 
contracts unless such agreement contemplates separate delivery or 
separate acceptance of portions of the subject matter of the contract. 
However, separate delivery or separate acceptance of portions of the 
subject matter of a contract does not necessarily require severing of an 
agreement (see example (4) of paragraph (e)(2) of this section).
    (iv) One agreement may be severed, or several agreements may be 
aggregated, based upon the pricing formula of such agreements. For 
example, in the case of a multi-unit agreement for several similar 
items, if the price to be paid for similar units is determined under 
different terms or formulas (for example, if some units are priced under 
a cost-plus incentive fee arrangement, and later units are to be priced 
under a fixed-price arrangement), then the difference in the pricing 
terms or formulas may indicate that the agreement should be treated as 
several contracts.
    (v) An agreement generally will be treated as several contracts 
where there is no business purpose for entering into one agreement 
rather than several agreements.

A factor which may evidence that no such business purpose exists is that 
the agreement covers two or more subject matters, none of which readily 
can be determined to be the primary subject matter of the contract 
(within the meaning of paragraph (b)(2)(ii) of this section); such 
factor must be considered along with other factors indicating the 
presence or absence of business purpose.
    (vi) Several agreements generally will not be aggregated unless 
there is no business purpose for entering into several agreements rather 
than one agreement.
    (vii) An example of a factor which is evidence that two agreements 
entered into between the same parties should be aggregated is that 
(without regard to the order in which the agreements were entered into 
or performed, and without regard to whether one of the agreements could 
actually be performed without the prior or contemporaneous performance 
of the other agreement) a reasonable business-person would not have 
entered into one of the agreement for the terms agreed upon but for 
entering into the other agreement in such other agreement for

[[Page 129]]

the terms agreed upon (or for more favorable terms). See example (2) of 
paragraph (e)(2) of this section. An example of a factor which is not 
evidence that two agreements entered into between the same parties 
should be aggregated is that one of the agreements would not have been 
entered into containing the terms agreed upon but for the expectation 
that the parties would enter into the other agreement.
    (viii) If the number of items to be supplied is increased (as by the 
exercise of an option or the issuance of a ``change order''), the 
supplying of such additional items generally results in the agreement 
being changed into several agreements. See paragraph Sec. 1.451-
3(e)(1)(i).
    (ix) See paragraph (b)(2)(ii) of this section for special rules 
relating to the time for completion of certain contracts having more 
than one subject matter.
    (2) Examples. The application of paragraph (e) of this section may 
be illustrated by the following examples.

    Example (1). X, a calendar year taxpayer engaged in the construction 
business and using a long-term contract method, enters into one 
agreement in 1972 with A, a real estate developer, to build three houses 
of different designs in three different suburbs of a large city. The 
houses are to be completed, accepted, and put into service in 1973, 
1974, and 1975, respectively. The portion of the total contract price 
attributable to each house can reasonably be determined. In these 
circumstances it may be necessary for the Commissioner to sever and 
treat the agreement as separate contracts to build each house for 
purposes of applying X's long-term contract method.
    Example (2). Y, a calendar year shipbuilder using a long-term 
contract method, enters into two agreements at about the same time 
during 1982 with M. These agreements are the product of a single 
negotiation. Under each agreement the taxpayer is to construct for M a 
submarine of the same class. Although the specifications for each 
submarine are similar, it is anticipated that, since the taxpayer has 
never constructed this class of submarine before, the costs incurred in 
constructing the first submarine (to be delivered in 1983) will be 
substantially greater than the costs incurred in constructing the second 
submarine (to be delivered in 1984.) If the agreements are treated as 
separate contracts, it is estimated that the first contract could result 
in little or no gain, while the second contract would result in 
substantial profits. A reasonable business person would not have entered 
into the agreement to construct the first submarine for the price 
specified without entering into the agreement to construct the second 
submarine. In these circumstances, it may be necessary for the 
Commissioner to aggregate the two agreements for purposes of applying 
Y's long-term contract method.
    Example (3). Assume the same facts as in example (2) with the 
addition of the following facts: In 1983, M issues a ``change order'' 
providing for a third submarine of the same class to be constructed by Y 
and delivered to M in 1985. The portion of the total contract price 
attributable to the ``change order'' providing for the third submarine 
can reasonably be determined. A reasonable business person would have 
entered into the agreements to construct the first two submarines for 
the price specified without regard to whether M would issue the ``change 
order'' for the third submarine. In these circumstances the ``change 
order'' providing for the third submarine must be treated as a separate 
contract for purposes of applying Y's long-term contract method.
    Example (4). Z, a calendar year taxpayer engaged in the construction 
business and using a long-term contract method, enters into an agreement 
in 1983 to build a ten story office building for the Y Bank. In 1984, 
the structure is completed and the first three floors of the building 
are completed and accepted, and Y occupies these floors and uses them 
for the conduct of its banking business. Construction, however, 
continues on the remaining seven floors, which are completed and 
accepted in 1985. In these circumstances, it is clear that even though 
separate acceptance of portions of the subject matter of the agreement 
has occurred, the subject matter of the agreement was essentially a 
single unit, namely a building, and that there was a business purpose 
for entering into one contract rather than several contracts. 
Consequently, the agreement ordinarily will not be severed into separate 
contracts for purposes of applying Z's long-term contract method.
    Example (5). The facts are the same as in example (4), except that 
due to a change in business conditions, Y will not require (either for 
its own use or for rental) the remaining seven floors for at least two 
years and, pursuant to a separate agreement entered into in 1984 between 
the parties, substantially all work on completing the remaining seven 
floors is stopped. In these circumstances, due to the change in business 
conditions and the actions of the parties, the original agreement (as 
modified by the second agreement) is changed into two agreements, each 
of which is treated as a separate contract for purposes of this section, 
one contract (entered into in 1983) for the construction of a ten story 
building with the first three floors completed for occupancy,

[[Page 130]]

and a separate contract (or contracts) to finish work on the remaining 
seven floors on an ``as requested'' basis.
    Example (6). T, a calendar year taxpayer engaged in the business of 
manufacturing aircraft and related equipment, enters into an agreement 
in 1982 with the B government to manufacture 10 military aircraft for 
delivery in 1984. It is anticipated at the time the agreement is entered 
into that B may enter into an agreement with T for the production and 
sale of as many as 300 of these aircraft over the next 20 years. In 
negotiating the price for the agreement, B and T take into account the 
expected total cost of manufacturing the 10 aircraft, the risks and the 
opportunities associated with the agreement and all other factors that 
the parties consider relevant, in such a manner that T would have 
entered into the agreement with the terms agreed upon whether or not T 
would actually enter into one or more additional production agreements. 
However, it is unlikely that T would have entered into the agreements 
but for the expectation that T and B would enter into additional 
production agreements. In 1984, the 10 aircraft are completed by T and 
accepted by B. In 1984, T also enters into an agreement with B to 
manufacture 20 aircraft of the same type for delivery in 1986. In 
negotiating the price for these 20 aircraft, B and T take into account 
the fact that the expected unit costs for this production of 20 will be 
different than the unit costs of the 10 aircraft completed in 1984, but 
also that the expected unit costs of this production of 20 will be 
substantially higher than the costs of future production. Because the 
price awarded for each of the two agreements takes into account the 
expected total costs and the risks expected for each agreement standing 
alone, the terms agreed upon for any one of the agreements are 
independent of the terms agreed upon for the other agreements. Under the 
facts of this example, the two agreements may not be aggregated into one 
contract for purposes of applying T's long-term contract method.
    Example (7). R, a calendar year taxpayer engaged in the manufacture 
of industrial machinery, enters into one agreement in 1982 with Z to 
manufacture five specialized machines and to manufacture spare and 
replacement parts for the machines. The machines are to be delivered in 
1982 and 1983, and the spare and replacement parts are to be delivered 
in 1983 through 1985. The portion of the total contract price 
attributable to the five machines and to the spare and replacement parts 
reasonably can be determined. The portion of the total contract price 
reasonably attributable to the spare and replacement parts is more than 
an insignificant amount of the total contract price. Assume that, under 
all the facts and circumstance, it is determined that the portion of the 
agreement attributable to the five machines need not be severed as 
between the machines. In these circumstances, because the agreement 
contemplates separate delivery of the machines and the parts, because 
more than an insignificant amount of the total contract price is 
allocable to the spare and replacement parts, and because spare or 
replacement parts are items different than an entire machine, it may be 
necessary for the Commissioner to sever the agreement, treating the 
agreement to manufacture the five machines as a separate contract and 
the agreement to manufacture the spare and replacement parts as another 
separate contract (or as several separate contracts depending on the 
facts and circumstances) for purposes of applying R's long-term contract 
method.

    (3) Cross reference. See Sec. 1.6001-1 (a) regarding the duty of 
taxpayers to keep such records as are sufficient to establish the amount 
of gross income, deductions, etc.
    (f) Changing to or from a long-term method of accounting. A taxpayer 
may change to or from the percentage of completion method or the 
completed contract method only with the consent of the Commissioner. See 
section 446(e) and Sec. 1.446-1(e).
    (g) Effective date and transition to 1983 cost allocation rules; 
special rules--(1) In general. In the case of a taxpayer using the 
completed contract method or a method of accounting that uses 
inventories (other than a long-term contract method), the cost 
allocation rules prescribed in paragraph (d)(6) of this section 
(hereinafter ``the 1983 cost allocation method'') shall apply (with the 
phase-in described in paragraph (g)(2) of this section) to costs 
incurred by the taxpayer in taxable years beginning after December 31, 
1982, but only with respect to extended period long-term contracts (as 
defined in paragraph (b)(3) of this section) entered into after December 
31, 1982. No costs incurred with respect to any contract entered into 
before January 1, 1983 are required to be accounted for under the 1983 
cost allocation method. Such costs shall be accounted for under the cost 
allocation method prescribed in paragraph (d)(5) of this section. 
Because the transition to the 1983 cost allocation method is to be 
applied on a ``cut-off'' basis, sections 446(e) and 481 do not apply to 
the transition to the 1983 cost allocation method.
    (2) Phase-in. For costs required to be allocated to an extended 
period long-

[[Page 131]]

term contract under the 1983 cost allocation method that are not 
required to be allocated to the contract under the cost allocation 
method prescribed in paragraph (d)(5) of this section (or in paragraph 
(c) of Sec. 1.471-11 in the case of a taxpayer accounting for extended 
period long-term contracts under a method of accounting that uses 
inventories (other than a long-term contract method)), in lieu of 
allocating the full amount of such costs to the extended period long-
term contract, the taxpayer shall allocate to the contract only the 
applicable percentage of such costs incurred in taxable years beginning 
after December 31, 1982 and before January 1, 1986, with respect to 
extending period long-term contracts entered into after December 31, 
1982. The applicable percentage shall be determined as follows:

------------------------------------------------------------------------
                                                                  The   
                                                              applicable
       For taxable years beginning in calendar year--         percentage
                                                                 is--   
------------------------------------------------------------------------
1983........................................................     33\1/2\
1984........................................................     66\2/3\
1985 or thereafter..........................................         100
------------------------------------------------------------------------


In the case of a taxpayer whose taxable year does not begin on January 
1, costs incurred with respect to extended period long-term contracts 
entered into after December 31, 1982, shall be accounted for under the 
cost allocation method prescribed in paragraph (d)(5) of this section 
(or paragraph (c) of Sec. 1.471-11 in the case of a taxpayer using an 
inventory method) in the case of costs incurred in taxable years 
begininng before January 1, 1983, and under the 1983 cost allocation 
method (with the application of paragraph (g) of this section) in the 
case of taxable years beginning after December 31, 1982.
    (3) Special rule for completion of certain contracts in taxable 
years ending before January 1, 1983. Any contract that would (but for 
this paragraph (g)(3)) be considered to be completed in a taxable year 
ending before January 1, 1983, solely by reason of the application of 
paragraphs (b)(2)(i)(B), (ii), (iii), or (iv) of this section, shall be 
considered to be completed on the first day of the taxpayer's first 
taxable year ending after December 31, 1982. The application of this 
paragraph (g)(3) shall not be considered to be a change in method of 
accounting to which section 481 applies.
    (4) Special rule for severing and aggregating certain contracts in 
taxable years ending before January 1, 1983. Any contract of a taxpayer 
that would (but for this paragraph (g)(4)) be considered completed in a 
taxable year ending before January 1, 1983--
    (i) Solely by reason of the application of those provisions of 
paragraph (e)(1) of this section expressly made applicable to taxable 
years ending after December 31, 1982 (hereinafter, the ``severing/
aggregating modifications'') or,
    (ii) Solely by reason of the application of both the severing/
aggregating modifications and the application of paragraphs 
(b)(2)(i)(B), (ii), (iii) or (iv) of this section (hereinafter, the 
``completion modifications''), shall be treated as having been completed 
on the first day after December 31, 1982, on which any contract that was 
severed from such contract (by reason of the severing/aggregating 
modifications) is completed (determined with application of the 
completion modifications). The application of this paragraph (g)(4) 
shall not be considered to be a change in method of accounting to which 
section 481 applies.
    (5) Special rule for estimated tax payments. For purposes of the 
addition to the tax for underpayment of estimated tax under section 6654 
(relating to individuals) and section 6655 (relating to corporations), 
the gross income realized in the taxpayer's first taxable year ending 
after December 31, 1982, attributable to long-term contracts deemed to 
be completed in such taxable years solely by the application of 
paragraphs (b)(2)(i)(B), (ii), (iii), or (iv), (g)(3) or (g)(4) of this 
section or those portions of paragraph (e)(1) of this section made 
applicable to taxable years ending after December 31, 1982, shall be 
considered to be taxable income for such taxable year, but only with 
respect to installments of estimated tax required to be paid on or after 
April 13, 1983.
    (6) Taxpayer changing from a method more inclusive of indirect 
costs. Except as provided in paragraphs (g)(1) and (2) of this section, 
if a taxpayer wishes to

[[Page 132]]

change to a method of accounting for indirect costs prescribed under 
this section (or under Sec. 1.471-11 (c) in the case of a taxpayer using 
an inventory method of accounting for long-term contracts) from a method 
of accounting for indirect costs that is more inclusive of indirect 
costs, the taxpayer must secure the consent of the Commissioner prior to 
making the change in accordance with the regulations and procedures 
established under section 446(e).
[T.D. 7397, 41 FR 2637, Jan. 19, 1976, as amended by T.D. 8067, 51 FR 
378, Jan. 6, 1986; 51 FR 6520, Feb. 25, 1986; 51 FR 6914, Feb. 27, 1986; 
51 FR 16021, Apr. 30, 1986; T.D. 8408, 57 FR 12420, Apr. 10, 1992]



Sec. 1.451-4  Accounting for redemption of trading stamps and coupons.

    (a) In general--(1) Subtraction from receipts. If an accrual method 
taxpayer issues trading stamps or premium coupons with sales, or an 
accrual method taxpayer is engaged in the business of selling trading 
stamps or premium coupons, and such stamps or coupons are redeemable by 
such taxpayer in merchandise, cash, or other property, the taxpayer 
should, in computing the income from such sales, subtract from gross 
receipts with respect to sales of such stamps or coupons (or from gross 
receipts with respect to sales with which trading stamps or coupons are 
issued) an amount equal to--
    (i) The cost to the taxpayer of merchandise, cash, and other 
property used for redemptions in the taxable year,
    (ii) Plus the net addition to the provision for future redemptions 
during the taxable year (or less the net subtraction from the provision 
for future redemptions during the taxable year).
    (2) Trading stamp companies. For purposes of this section, a 
taxpayer will be considered as being in the business of selling trading 
stamps or premium coupons if--
    (i) The trading stamps or premium coupons sold by him are issued by 
purchasers to promote the sale of their merchandise or services,
    (ii) The principal activity of the trade or business is the sale of 
such stamps or coupons,
    (iii) Such stamps or coupons are redeemable by the taxpayer for a 
period of at least 1 year from the date of sale, and
    (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

[[Page 133]]

storing the merchandise or other property used to redeem stamps or 
coupons should not be included in costs of redeeming stamps or premium 
coupons, but rather should be accounted for in accordance with the 
provisions of sections 162 and 263.
    (2) Changes in provision for future redemptions. For purposes of 
this section, a ``net addition to'' or ``net subtraction from'' the 
provision for future redemptions for a taxable year is computed as 
follows:
    (i) Carry over the provision for future redemptions (if any) as of 
the end of the preceding taxable year,
    (ii) Compute the provision for future redemptions as of the end of 
the taxable year in accordance with subparagraph (1) of this paragraph, 
and
    (iii) If the amount referred to in subdivision (ii) of this 
subparagraph exceeds the amount referred to in subdivision (i) of this 
subparagraph, such excess is the net addition to the provision for 
future redemptions for the taxable year. On the other hand, if the 
amount referred to in such subdivision (i) exceeds the amount referred 
to in such subdivision (ii), such excess is the net subtraction from the 
provision for future redemptions for the taxable year.
    (3) Example. The provisions of this paragraph and paragraph (a)(1) 
of this section may be illustrated by the following example:

    Example. (a) X Company, a calendar year accrual method taxpayer, is 
engaged in the business of selling trading stamps to merchants. In 1971, 
its first year of operation, X sells 10 million stamps at $5 per 1,000; 
it redeems 3 million stamps for merchandise and cash of an average value 
of $3 per 1,000 stamps. At the end of 1971 it is estimated (pursuant to 
paragraph (c) of this section) that a total of 9 million stamps of the 
10 million stamps issued in 1971 will eventually be presented for 
redemption. At this time it is estimated that the average cost of 
redeeming stamps (as described in subparagraph (1)(iii) of this 
paragraph) would continue to be $3 per 1,000 stamps. Under these 
circumstances, X computes its gross income from sales of trading stamps 
as follows:

Gross receipts from sales (10 million stamps at $5                      
 per 1,000).........................................  ........   $50,000
Less:                                                                   
  Cost of actual redemptions (3 million stamps at $3                    
   per 1,000).......................................    $9,000  ........
  Provision for future redemptions on December 31,                      
   1971 (9 million stamps -- 3 million stamps  x  $3                    
   per 1,000).......................................    18,000  ........
                                                     ----------         
                                                                  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                       
   $3.01 per 1,000).................................   $21,070          
Plus:                                                                   
  Provision for future redemptions on Dec. 31, 1972                     
   (8 million stamps at $3.01 per 1,000)............    24,080          
Minus provision for future redemptions on Dec. 31,                      
 1971...............................................    18,000          
                                                     ----------         
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

[[Page 134]]

operation or other relevant factors the determination cannot reasonably 
be made completely on the basis of the taxpayer's own experience, the 
experiences of similarly situated taxpayers may be used to establish an 
experience factor.
    (3) One method of determining estimated future redemptions. One 
permissible method of determining the estimated future redemptions as of 
the end of the current taxable year is as follows:
    (i) Estimate for each preceding taxable year and the current taxable 
year the number of trading stamps or coupons issued for each such year 
which will ultimately be presented for redemption.
    (ii) Determine the sum of the estimates under subdivision (i) of 
this subparagraph for each taxable year prior to and including the 
current taxable year.
    (iii) The difference between the sum determined under subdivision 
(ii) of this subparagraph and the total number of trading stamps or 
coupons which have already been presented for redemption is the 
estimated future redemptions as of the end of the current taxable year.
    (4) Determination of an ``estimated redemption percentage.'' For 
purposes of applying subparagraph (3)(i) of this paragraph, one 
permissible method of estimating the number of trading stamps or coupons 
issued for a taxable year that will ultimately be presented for 
redemption is to multiply such number of stamps issued for such year by 
an ``estimated redemption percentage.'' For purposes of this section the 
term ``estimated redemption percentage'' for a taxable year means a 
fraction, the numerator of which is the number of trading stamps or 
coupons issued during a taxable year that it is reasonably estimated 
will ultimately be redeemed, and the denominator of which is the number 
of trading stamps or coupons issued during such year. Consequently, the 
product of such percentage and the number of stamps issued for such year 
equals the number of trading stamps or coupons issued for such year that 
it is estimated will ultimately be redeemed.
    (5) Five-year rule. (i) One permissible method of determining the 
``estimated redemption percentage'' for a taxable year is to--
    (a) Determine the percentage which the total number of stamps or 
coupons redeemed in the taxable year and the 4 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

[[Page 135]]

statistical principles. Ordinarily, samplings and recomputations of the 
estimated future redemptions will be required annually. However, the 
facts and circumstances in a particular case may justify such a 
recomputation being taken less frequently than annually. In addition, 
the Commissioner may prescribe procedures indicating that samples made 
to update the results of a sample of stamps redeemed in a prior year 
need not be the same size as the sample of such prior year.
    (d) Consistency with financial reporting--(1) Estimated future 
redemptions. For taxable years beginning after August 22, 1972, the 
estimated future redemptions must be no greater than the estimate that 
the taxpayer uses for purposes of all reports (including consolidated 
financial statements) to shareholders, partners, beneficiaries, other 
proprietors, and for credit purposes.
    (2) Average cost of redeeming stamps. For taxable years beginning 
after August 22, 1972, the estimated average cost of redeeming each 
stamp or coupon must be no greater than the average cost of redeeming 
each stamp or coupon (computed in accordance with paragraph (b)(1)(iii) 
of this section) that the taxpayer uses for purposes of all reports 
(including consolidated financial statements) to shareholders, partners, 
beneficiaries, other proprietors, and for credit purposes.
    (e) Information to be furnished with return--(1) In general. For 
taxable years beginning after August 22, 1972, a taxpayer described in 
paragraph (a) of this section who uses a method of determining the 
``estimated future redemptions'' other than that described in paragraph 
(c)(5)(i) of this section shall file a statement with his return showing 
such information as is necessary to establish the correctness of the 
amount subtracted from gross receipts in the taxable year.
    (2) Taxpayers using the 5-year rule. If a taxpayer uses the method 
of determining estimated future redemptions described in paragraph 
(c)(5)(i) of this section, he shall file a statement with his return 
showing, with respect to the taxable year and the 4 preceding taxable 
years--
    (i) The total number of stamps or coupons issued or sold during each 
year, and
    (ii) The total number of stamps or coupons redeemed in each such 
year.
    (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

[[Page 136]]

not only obligates the taxpayer to perform the activities described in 
subparagraph (1) (i) and (ii) of this paragraph, but also obligates the 
taxpayer to perform services that are not to be performed as an integral 
part of such activities, such amount will be treated as an ``advance 
payment'' (as defined in subparagraph (1) of this paragraph) only to the 
extent such amount is properly allocable to the obligation to perform 
the activities described in subparagraph (1) (i) and (ii) of this 
paragraph. The portion of the amount not so allocable will not be 
considered an ``advance payment'' to which this section applies. If, 
however, the amount not so allocable is less than 5 percent of the total 
contract price, such amount will be treated as so allocable except that 
such treatment cannot result in delaying the time at which the taxpayer 
would otherwise accrue the amounts attributable to the activities 
described in subparagraph (1) (i) and (ii) of this paragraph.
    (b) Taxable year of inclusion--(1) In general. Advance payments must 
be included in income either--
    (i) In the taxable year of receipt; or
    (ii) Except as provided in paragraph (c) of this section.
    (a) In the taxable year in which properly accruable under the 
taxpayer's method of accounting for tax purposes if such method results 
in including advance payments in gross receipts no later than the time 
such advance payments are included in gross receipts for purposes of all 
of his reports (including consolidated financial statements) to 
shareholders, partners, beneficiaries, other proprietors, and for credit 
purposes, or
    (b) If the taxpayer's method of accounting for purposes of such 
reports results in advance payments (or any portion of such payments) 
being included in gross receipts earlier than for tax purposes, in the 
taxable year in which includible in gross receipts pursuant to his 
method of accounting for purposes of such reports.
    (2) Examples. This paragraph may be illustrated by the following 
examples:

    Example (1). S, a retailer who uses for tax purposes and for 
purposes of the reports referred to in subparagraph (1)(ii)(a) of this 
paragraph, an accrual method of accounting under which it accounts for 
its sales of goods when the goods are shipped, receives advance payments 
for such goods. Such advance payments must be included in gross receipts 
for tax purposes either in the taxable year the payments are received or 
in the taxable year 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. 1.451-3, 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

[[Page 137]]

the installment method under section 453. See Sec. 1.446-1(c)(1)(ii).
    (c) Exception for inventoriable goods. (1)(i) If a taxpayer receives 
an advance payment in a taxable year with respect to an agreement for 
the sale of goods properly includible in his inventory, or with respect 
to an agreement (such as a gift certificate) which can be satisfied with 
goods or a type of goods that cannot be identified in such taxable year, 
and on the last day of such taxable year the taxpayer--
    (a) Is accounting for advance payments pursuant to a method 
described in paragraph (b)(1)(ii) of this section for tax purposes,
    (b) Has received ``substantial advance payments'' (as defined in 
subparagraph (3) of this paragraph) with respect to such agreement, and
    (c) Has on hand (or available to him in such year through his normal 
source of supply) goods of substantially similar kind and in sufficient 
quantity to satisfy the agreement in such year,

then all advance payments received with respect to such agreement by the 
last day of the second taxable year following the year in which such 
substantial advance payments are received, and not previously included 
in income in accordance with the taxpayer's accrual method of 
accounting, must be included in income in such second taxable year.
    (ii) If advance payments are required to be included in income in a 
taxable year solely by reason of subdivision (i) of this subparagraph, 
the taxpayer must take into account in such taxable year the costs and 
expenditures included in inventory at the end of such year with respect 
to such goods (or substantially similar goods) on hand or, if no such 
goods are on hand by the last day of such second taxable year, the 
estimated cost of goods necessary to satisfy the agreement.
    (iii) Subdivision (ii) of this subparagraph does not apply if the 
goods or type of goods with respect to which the advance payment is 
received are not identifiable in the year the advance payments are 
required to be included in income by reason of subdivision (i) of this 
subparagraph (for example, where an amount is received for a gift 
certificate).
    (2) If subparagraph (1)(i) of this paragraph is applicable to 
advance payments received with respect to an agreement, any advance 
payments received with respect to such agreement subsequent to such 
second taxable year must be included in gross income in 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

[[Page 138]]

                                                                        
1976.........................................................         10
                                                                        

    The goods are delivered pursuant to the customer's request in 1977. 
X's closing inventory for 1972 of the type of goods involved in the 
contract is sufficient to satisfy the contract. Since advance payments 
received by the end of 1972 exceed the inventoriable costs X estimates 
that he will incur, such payments constitute ``substantial advance 
payments''. Accordingly, all payments received by the end of 1974, the 
end of the second taxable year following the taxable year during which 
``substantial advance payments'' are received, are includible in gross 
income for 1974. Therefore, for taxable year 1974 X must include $80 in 
his gross income. X must include in his cost of goods sold for 1974 the 
cost of such goods (or similar goods) on hand or, if no such goods are 
on hand, the estimated inventoriable costs necessary to satisfy the 
contract. Since no further deferral is allowable for such contract, X 
must include in his gross income for the remaining years of the 
contract, the advance payment received each year. Any variance between 
estimated costs and the costs actually incurred in fulfilling the 
contract is to be taken into account in 1977, when the goods are 
delivered. See paragraph (c)(2) of this section.

    (d) Information schedule. If a taxpayer accounts for advance 
payments pursuant to paragraph (b)(1)(ii) of this section, he must 
attach to his income tax return for each taxable year to which such 
provision applies an annual information schedule reflecting the total 
amount of advance payments received in the taxable year, the total 
amount of advance payments received in prior taxable years which has not 
been included in gross income before the current taxable year, and the 
total amount of such payments received in prior taxable years which has 
been included in gross income for the current taxable year.
    (e) Adoption of method. (1) For taxable years ending on or after 
December 31, 1969, and before January 1, 1971, a taxpayer (even if he 
has already filed an income tax return for a taxable year ending within 
such period) may secure the consent of the Commissioner to change his 
method of accounting for such year to a method prescribed in paragraph 
(b)(1)(ii) of this section in the manner prescribed in section 446 and 
the regulations thereunder, if an application to secure such consent is 
filed on Form 3115 within 180 days after March 23, 1971.
    (2) A taxpayer who is already reporting his income in accordance 
with a method prescribed in paragraph (b)(1)(ii)(a) of this section need 
not secure the consent of the Commissioner to continue to utilize this 
method. However, such a taxpayer, for all taxable years ending after 
March 23, 1971, must comply with the requirements of paragraphs 
(b)(1)(ii)(a) (including the 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]



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

[[Page 139]]

year following the taxable year of the destruction or damage, if the 
taxpayer establishes that, under the taxpayer's normal business 
practice, the income from those crops would have been included in gross 
income for any taxable year following the taxable year of the 
destruction or damage. However, if the taxpayer receives the insurance 
proceeds in the taxable year following the taxable year of the 
destruction or damage, the taxpayer shall include the proceeds in gross 
income for the taxable year of receipt without having to make an 
election under section 451(d) and this section. For the purposes of this 
section only, federal payments received as a result of destruction or 
damage to crops caused by drought, flood, or any other natural disaster, 
or the inability to plant crops because of such a natural disaster, 
shall be treated as insurance proceeds received as a result of 
destruction or damage to crops. The preceding sentence shall apply to 
payments that are received by the taxpayer after December 31, 1973.
    (2) In the case of a taxpayer who receives insurance proceeds as a 
result of the destruction of, or damage to, two or more specific crops, 
if such proceeds may, under section 451(d) and this section, be included 
in gross income for the taxable year following the taxable year of such 
destruction or damage, and if such taxpayer makes an election under 
section 451(d) and this section with respect to any portion of such 
proceeds, then such election will be deemed to cover all of such 
proceeds which are attributable to crops representing a single trade or 
business under section 446(d). A separate election must be made with 
respect to insurance proceeds attributable to each crop which represents 
a separate trade or business under section 446(d).
    (b)(1) Time and manner of making election. The election to include 
in gross income insurance proceeds received as a result of destruction 
of, or damage to, the taxpayer's crops in the taxable year following the 
taxable year of such destruction or damage shall be made by means of a 
statement attached to the taxpayer's return (or an amended return) for 
the taxable year of destruction or damage. The statement shall include 
the name and address of the taxpayer (or his duly authorized 
representative), and shall set forth the following information:
    (i) A declaration that the taxpayer is making an election under 
section 451(d) and this section;
    (ii) Identification of the specific crop or crops destroyed or 
damaged;
    (iii) A declaration that under the taxpayer's normal business 
practice the income derived from the crops which 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

[[Page 140]]

that number of livestock sold or exchanged solely on account of a 
drought which caused an area to be designated as eligible for assistance 
by the Federal Government (regardless of whether the designation is made 
by the President or by an agency or department of the Federal 
Government). That number is equal to the excess of the number of 
livestock sold or exchanged over the number which would have been sold 
or exchanged had the taxpayer followed its usual business practices in 
the absence of such drought. For example, if in the past it has been a 
taxpayer's practice to sell or exchange annually 400 head of beef cattle 
but due to qualifying drought conditions 550 head were sold in a given 
taxable year, only income from the sale of 150 head may qualify for 
deferral under this section. The election is not available with respect 
to livestock described in section 1231(b)(3) (relating to cattle, horses 
(and other livestock) held by the taxpayer for 24 months (12 months) and 
used for draft, breeding, dairy, or sporting purposes).
    (b) Usual business. The determination of the number of animals which 
a taxpayer would have sold if it had followed its usual business 
practice in the absence of drought will be made in light of all facts 
and circumstances. In the case of taxpayers who have not established a 
usual business practice, reliance will be placed upon the usual business 
practice of similarly situated taxpayers in the same general region as 
the taxpayer.
    (c) Special rules--(1) Connection with drought area. To qualify 
under section 451(e) and this section, the livestock need not be raised, 
and the sale or exchange need not take place, in a drought area. 
However, the sale or exchange of the livestock must occur solely on 
account of drought conditions, the existence of which affected the 
water, grazing, or other requirements of the livestock so as to 
necessitate their sale or exchange.
    (2) Sale prior to designation of area as eligible for Federal 
assistance. The provisions of this section will apply regardless of 
whether all or a portion of the excess number of animals were sold or 
exchanged before an area becomes eligible for Federal assistance, so 
long as the drought which caused such dispositions also caused the area 
to be designated as eligible for Federal assistance.
    (d) Classifications of livestock with respect to which the election 
may be made. The election to have the provisions of section 451(e) apply 
must be made separately for each broad generic classification of animals 
(e.g., hogs, sheep, cattle) for which the taxpayer wishes the 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) x 35 (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.

[[Page 141]]

    (g) Time and manner of making election. The election provided for in 
this section must be made by the later of (1) the due date for filing 
the income tax return (determined with regard to any extensions of time 
granted the taxpayer for filing such return) for the taxable year in 
which the early sale of livestock occurs, or (2) (the 90th day after the 
date these regulations are published as a Treasury decision in the 
Federal Register). The election must be made separately for each taxable 
year to which it is to apply. It must be made by attaching a statement 
to the return or an amended return for such taxable year. The statement 
shall include the name and address of the taxpayer and shall set forth 
the following information for each classification of livestock for which 
the election is made:
    (1) A declaration that the taxpayer is making an election under 
section 451(e);
    (2) Evidence of the existence of the drought conditions which forced 
the early sale or exchange of the livestock and the date, if known, on 
which an area was designated as eligible for assistance by the Federal 
Government as a result of the drought conditions.
    (3) A statement explaining the relationship of the drought area to 
the taxpayer's early sale or exchange of the livestock;
    (4) The total number of animals sold in each of the three preceding 
years;
    (5) The number of animals which would have been sold in the taxable 
year had the taxpayer followed its normal business practice in the 
absence of drought;
    (6) The total number of animals sold, and the number sold on account 
of drought, during the taxable year; and
    (7) A computation, pursuant to paragraph (e) of this section, of the 
amount of income to be deferred for each such classification.
    (h) Revocation of election. Once an election under this section is 
made for a taxable year, it may be revoked only with the approval of the 
Commissioner.
    (i) Cross reference. For provisions relating to the involuntary 
conversion of livestock sold on account of drought see section 1033(e) 
and the regulations thereunder.
[T.D. 7526, 42 FR 64624, Dec. 27, 1977]



Secs. 1.453-1--1.453-2  [Reserved]



Sec. 1.453-3  Purchaser evidences of indebtedness payable on demand or readily tradable.

    (a) In general. A bond or other evidence of indebtedness 
(hereinafter in this section referred to as an obligation) issued by any 
person and payable 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

[[Page 142]]

    (2) For purposes of returning income on the installment method 
during the taxable year of the sale or disposition or in a subsequent 
taxable year,


the receipt by the seller of such obligation shall be treated as a 
payment. The rules stated in this paragraph may be illustrated by the 
following examples:


                                                                        
$250,000 payment (i.e., 250 of corporation                              
Y's registered bonds each with a principal                              
  amount and fair market value of $1,000)                               
-------------------------------------------  =         25 percent       
 $1 million selling price (i.e., $250,000                               
 of corporation Y's registered bonds plus                               
       promissory note of $750,000)                                     
                                                                        
                                                                        

    Example (1). On July 1, 1970, A, an individual on the cash method of 
accounting reporting on a calendar year basis, transferred all of his 
stock in corporation X (traded on an established securities market and 
having a fair market value of $1 million) to corporation Y in exchange 
for 250 of corporation Y's registered bonds (which are traded in an 
over-the-counter bond market) each with a principal amount and fair 
market value of $1,000 (with interest payable at the rate of 8 percent 
per year), and Y's unsecured promissory note, with a principal amount of 
$750,000. At the time of such exchange A's basis in the corporation X 
stock is $900,000. The promissory note is payable at the rate of $75,000 
annually, due on July 1, of each year following 1970, until the 
principal balance is paid. The note provides for the payment of interest 
at the rate of 10 percent per year also payable on July 1 of each year. 
Under the rule stated in subparagraph (1) of this paragraph, the 250 
registered bonds of corporation Y are treated as a payment for purposes 
of the 30 percent test described in section 453(b)(2)(A)(ii). The 
payment on account of the bonds equals 25 percent of the selling price 
determined as follows:
    Since the payments received in the taxable year of the sale do not 
exceed 30 percent of the selling price and the sales price exceeds 
$1,000, A may report the income received on the sale of his corporation 
X stock on the installment method. A elects to report the income on the 
installment method. The gross profit to be realized when the corporation 
X stock is fully paid for is 10 percent of the total contract price, 
computed as follows: $100,000 gross profit (i.e., $1 million contract 
price less $900,000 basis in corporation X stock) over $1 million 
contract price. However, since subparagraph (2) of this paragraph also 
treats the 250 corporation Y registered bonds as a payment for purposes 
of reporting income, A must include $25,000 (i.e., 10 percent times 
$250,000) in his gross income for calendar year 1970, the taxable year 
of sale.
    Example (2). Assume the same facts as in example (1). Assume further 
that on July 1, 1971, corporation Y makes its first installment payment 
to A under the terms of the unsecured promissory note with 75 more of 
its $1,000 registered bonds. A must include $7,500 (i.e., 10 percent 
gross profit percentage times $75,000) in his gross income for calendar 
year 1971. In addition, A includes the interest payment made by 
corporation Y on July 1, in his gross income for 1971.

    (c) Payable on demand. Under section 453(b)(3), an obligation shall 
be treated as payable on demand only if the obligation is treated as 
payable on demand under applicable state or local law.
    (d) Designed to be readily tradable in an established securities 
market--(1) In general. Obligations issued by a corporation or 
government or political subdivision thereof will be deemed to be in a 
form designed to render such obligations readily tradable in an 
established securities market if--
    (i) Steps necessary to create a market for them are taken at the 
time of issuance (or later, if taken pursuant to an expressed or implied 
agreement or understanding which existed at the time of issuance),
    (ii) If they are treated as readily tradable in an established 
securities market under subparagraph (2) of this paragraph, or
    (iii) If they are convertible obligations to which paragraph (e) of 
this section applies.
    (2) Readily tradable in an established securities market. An 
obligation will be treated as readily tradable in an established 
securities market if--
    (i) The obligation is part of an issue or series of issues which are 
readily tradable in an established securities market, or
    (ii) The corporation issuing the obligation has other obligations of 
a comparable character which are described in subdivision (i) of this 
subparagraph.

For purposes of subdivision (ii) of this subparagraph, the determination 
as to whether there exist obligations of a comparable character depends 
upon the particular facts and circumstances. Factors to be considered in 
making

[[Page 143]]

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 readily 
tradable in an established securities market unless such obligation is 
convertible only at a substantial discount. In determining whether the

[[Page 144]]

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 Secs. 1.453-1 through 
1.453-7, the amount of such mortgage shall be included only to the 
extent that it exceeds the basis of the property. The term ``payments'' 
does not include amounts received by the vendor in the year of sale from 
the disposition to a third person of notes given by the vendee as part 
of the purchase price which are due and payable in subsequent years. 
Commissions and other selling expenses paid or incurred by the vendor 
shall not reduce the amount of the payments, the total contract price, 
or the selling price.
[T.D. 6500, 25 FR 11715, Nov. 26, 1960]



Sec. 1.453-5  Sale of real property treated on installment method.

    (a) In general. In any transaction described in paragraph (b)(1) of 
Sec. 1.453-4, that is, sales of real property in which

[[Page 145]]

there are no payments during the year of sale or the payments in that 
year do not exceed 30 percent of the selling price, the vendor may 
return as income from each such transaction in any taxable year that 
proportion of the installment payments actually received in that year 
which the gross profit (as described in paragraph (b) of Sec. 1.453-1) 
realized or to be realized when the property is paid for bears to the 
total contract price. In any case, the sale of each lot or parcel of a 
subdivided tract must be treated as a separate transaction and gain or 
loss computed accordingly. (See paragraph (a) of Sec. 1.61-6.)
    (b) Defaults and repossessions--(1) Effective date. This paragraph 
shall apply only with respect to taxable years beginning before 
September 3, 1964, in respect of which an election has not been properly 
made to have the provisions of section 1038 apply. For rules applicable 
to taxable years beginning after September 2, 1964, and for taxable 
years beginning after December 31, 1957, to which such an election 
applies, see section 1038, and Secs. 1.1038-1 through 1.1038-3.
    (2) Gain or loss on reacquisition of property. If the purchaser of 
real property on the installment plan defaults in any of his payments, 
and the vendor returning income on the installment method reacquires the 
property sold, whether title thereto had been retained by the vendor or 
transferred to the purchaser, gain or loss for the year in which the 
reacquisition occurs is to be computed upon any installment obligations 
of the purchaser which are satisfied or discharged upon the 
reacquisition or are applied by the vendor to the purchase or bid price 
of the property. Such gain or loss is to be measured by the difference 
between the fair market value at the date of reacquisition of the 
property reacquired (including the fair market value of any fixed 
improvements placed on the property by the purchaser) and the basis in 
the hands of the vendor of the obligations of the purchaser which are so 
satisfied, discharged, or applied, with proper adjustment for any other 
amounts realized or costs incurred in connection with the reacquisition.
    (3) Fair market value of reacquired property. If the property 
reacquired is bid in by the vendor at a foreclosure sale, the fair 
market value of the property shall be presumed to be the purchase or bid 
price thereof in the absence of clear and convincing proof to the 
contrary.
    (4) Basis of obligations. The basis in the hands of the vendor of 
the obligations of the purchaser satisfied, discharged, or applied upon 
the reacquisition of the property will be the excess of the face value 
of such obligations over an amount equal to the income which would be 
returnable were the obligations paid in full. For definition of the 
basis of an installment obligation, see section 453(d)(2) and paragraph 
(b)(2) of Sec. 1.453-9.
    (5) Bad debt deduction. No deduction for a bad debt shall in any 
case be taken on account of any portion of the obligations of the 
purchaser which are treated by the vendor as not having been satisfied, 
discharged, or applied upon the reacquisition of the property, unless it 
is clearly shown that after the property was reacquired the purchaser 
remained liable for such portion; and in no event shall the amount of 
the deduction exceed the basis in the hands of the vendor of the portion 
of the obligations with respect to which the purchaser remained liable 
after the reacquisition. See section 166 and the regulations thereunder.
    (6) Basis of reacquired property. If the property reacquired is 
subsequently sold, the basis for determining gain or loss is the fair 
market value of the property at the date of reacquisition, including the 
fair market value of any fixed improvements placed on the property by 
the purchaser.
[T.D. 6500, 25 FR 11716, Nov. 26, 1960, as amended by T.D. 6916, 32 FR 
5923, Apr. 13, 1967]



Sec. 1.453-6  Deferred payment sale of real property not on installment method.

    (a) Value of obligations. (1) In transactions included in paragraph 
(b)(2) of Sec. 1.453-4, that is, sales of real property involving 
deferred payments in which the payments received during the year of sale 
exceed 30 percent of the selling price, the obligations of the purchaser

[[Page 146]]

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 
section 166 and the regulations thereunder with respect to property 
reacquired by the vendor in a foreclosure proceeding.

[[Page 147]]

    (d) Effective date. Paragraphs (b) and (c) of this section shall 
apply only with respect to taxable years beginning before September 3, 
1964, in respect of which an election has not been properly made to have 
the provisions of section 1038 apply. For rules applicable to taxable 
years beginning after September 2, 1964, and for taxable years beginning 
after December 31, 1957, to which such an election applies, see section 
1038, and Secs. 1.1038-1 through 1.1038-3.
[T.D. 6500, 25 FR 11716, Nov. 26, 1960, as amended by T.D. 6916, 32 FR 
5923, Apr. 13, 1967]



Secs. 1.453-7--1.453-8  [Reserved]



Sec. 1.453-9  Gain or loss on disposition of installment obligations.

    (a) In general. Subject to the exceptions contained in section 
453(d)(4) and paragraph (c) of this section, the entire amount of gain 
or loss resulting from any disposition or satisfaction of installment 
obligations, computed in accordance with section 453(d), is recognized 
in the taxable year of such disposition or satisfaction and shall be 
considered as resulting from the sale or exchange of the property in 
respect of which the installment obligation was received by the 
taxpayer.
    (b) Computation of gain or loss. (1) The amount of gain or loss 
resulting under paragraph (a) of this section is the difference between 
the basis of the obligation and (i) the amount realized, in the case of 
satisfaction at other than face value or in the case of a sale or 
exchange, or (ii) the fair market value of the obligation at the time of 
disposition, if such disposition is other than by sale or exchange.
    (2) The basis of an installment obligation shall be the excess of 
the face value of the obligation over an amount equal to the income 
which would be returnable were the obligation satisfied in full.
    (3) The application of subparagraphs (1) and (2) of this paragraph 
may be illustrated by the following examples:

    Example (1). In 1960 the M Corporation sold a piece of unimproved 
real estate to B for $20,000. The company acquired the property in 1948 
at a cost of $10,000. During 1960 the company received $5,000 cash and 
vendee's notes for the remainder of the selling price, or $15,000, 
payable in subsequent years. In 1962, before the vendee made any further 
payments, the company sold the notes for $13,000 in cash. The 
corporation makes its returns on the calendar year basis. The income to 
be reported for 1962 is $5,500, computed as follows:

Proceeds of sale of notes...........................  ........   $13,000
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                    
 in full, 50 percent of $15,000.....................     7,500          
                                                     ----------         
Basis of obligation--excess of face value of notes                      
 over amount of income returnable were the notes                        
 satisfied in full..................................     7,500          
                                                     ----------         
    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          
 of income returnable were the notes satisfied in full                  
 (computed as in example (1)).................................     7,500
                                                               =========
  Taxable income to be reported for 1962......................     6,500
                                                                        


    (c) Disposition from which no gain or loss is recognized. (1)(i) 
Under section 453(d)(4)(A), no gain or loss shall be recognized to a 
distributing corporation with respect to the distribution made after 
November 13, 1966, of installment obligations if (a) the distribution is 
made pursuant to a plan for the complete liquidation of a subsidiary 
under section 332, and (b) the basis of the such obligations in the 
hands of the distributee is determined under section 334(b)(1).
    (ii) Under section 453(d)(4)(B), no gain or loss shall be recognized 
to a distributing corporation with respect to the distribution of 
installment obligations if the distribution is made, pursuant to a plan 
for the complete liquidation of a corporation which meets the 
requirements of section 337, under conditions

[[Page 148]]

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 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.

[[Page 149]]

    (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 Secs. 1.453-1 through 1.453-9 shall apply to taxable years 
beginning after December 31, 1953, and ending after August 16, 1954.
    (b) The provisions of paragraphs (a) (2) and (3), (b), and (c) of 
Sec. 1.453-8 shall apply to taxable years ending after December 17, 
1958.
    (c) Under the provisions of sections 453(b) and 7851(a)(1)(C), 
section 453(b)(1) and the regulations with respect thereto shall also 
apply--
    (1) To a sale or other disposition during a taxable year beginning 
before January 1, 1954, only if the income was returnable (by reason of 
section 44(b) of the Internal Revenue Code of 1939) on the basis and in 
the manner prescribed in section 44(a) of such code.
    (2) To a sale or other disposition during a taxable year beginning 
after December 31, 1953, and ending before August 17, 1954, though such 
taxable year is subject to the provisions of the Internal Revenue Code 
of 1939.
    (d) Under the provisions of sections 453(c)(1)(B) and 7851(a)(1)(C) 
section 453(c) and the regulations with respect thereto shall also apply 
to taxable years beginning after December 31, 1953, and ending before 
August 17, 1954, though such taxable years are subject to the provisions 
of the Internal Revenue Code of 1939.
    (e) The provisions of paragraph (b)(3) of Sec. 1.453-6 shall apply 
to repossessions occurring after December 18, 1958.
    (f) The provisions of section 453(d)(5) and paragraph (g) of 
Sec. 1.453-9 shall apply to taxable years ending after December 31, 
1957, but only as to transfers or other dispositions of installment 
obligations occurring after such date.
[T.D. 6500, 25 FR 11718, Nov. 26, 1960, as amended by T.D. 6590, 27 FR 
1320, Feb. 13, 1962; T.D. 6682, 28 FR 11177, Oct. 18, 1963]

[[Page 150]]



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 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.

[[Page 151]]

    (5) Examples. The provisions of this paragraph (a) are illustrated 
by the following examples. Except as otherwise provided, assume in each 
example that A, an individual who is a calendar-year taxpayer, owns all 
of the stock of T corporation. A's adjusted tax basis in that stock is 
$100,000. On February 1, 1998, T, an accrual method taxpayer, adopts a 
plan of complete liquidation that satisfies section 453(h)(1)(A) and 
immediately sells all of its assets to unrelated B corporation in a 
single transaction. The examples are as follows:

    Example 1.  (i) The stated purchase price for T's assets is 
$3,500,000. In consideration for the sale, B makes a down payment of 
$500,000 and issues a 10-year installment obligation with a stated 
principal amount of $3,000,000. The obligation provides for interest 
payments of $150,000 on January 31 of each year, with the total 
principal amount due at maturity.
    (ii) Assume that for purposes of section 1274, the test rate on 
February 1, 1998, is 8 percent, compounded semi-annually. Also assume 
that a semi-annual accrual period is used. Under Sec. 1.1274-2, the 
issue price of the obligation on February 1, 1998, is $2,368,450. 
Accordingly, the obligation has $631,550 of original issue discount 
($3,000,000-$2,368,450). Between February 1 and July 31, $19,738 of 
original issue discount and $75,000 of qualified stated interest accrue 
with respect to the obligation and are taken into account by T.
    (iii) On July 31, 1998, T distributes the installment obligation to 
A in exchange for A's stock. No other property is ever distributed to A. 
On January 31, 1999, A receives the first annual payment of $150,000 
from B.
    (iv) When the obligation is distributed to A on July 31, 1998, it is 
treated as if the obligation is received by A in an installment sale of 
shares directly to B on that date. Under Sec. 1.1275-1(b), the adjusted 
issue price of the obligation on that date is $2,388,188 (original issue 
price of $2,368,450 plus accrued original issue discount of $19,738). 
Accordingly, the issue price of the obligation under paragraph 
(a)(2)(ii)(A) of this section is $2,463,188, the sum of the adjusted 
issue price of the obligation on that date ($2,388,188) and the amount 
of accrued but unpaid qualified stated interest ($75,000).
    (v) The selling price and contract price of A's stock in T is 
$2,463,188, and the gross profit is $2,363,188 ($2,463,188 selling price 
less A's adjusted tax basis of $100,000). A's gross profit ratio is thus 
96 percent (gross profit of $2,363,188 divided by total contract price 
of $2,463,188).
    (vi) Under Secs. 1.446-2(e)(1) and 1.1275-2(a), $98,527 of the 
$150,000 payment is treated as a payment of the interest and original 
issue discount that accrued on the obligation from July 31, 1998, to 
January 31, 1999 ($75,000 of qualified stated interest and $23,527 of 
original issue discount). The balance of the payment ($51,473) is 
treated as a payment of principal. A's gain recognized in 1999 is 
$49,414 (96 percent of $51,473).
    Example 2.  (i) T owns Blackacre, unimproved real property, with an 
adjusted tax basis of $700,000. Blackacre is subject to a mortgage 
(underlying mortgage) of $1,100,000. A is not personally liable on the 
underlying mortgage and the T shares held by A are not encumbered by the 
underlying mortgage. The other assets of T consist of $400,000 of cash 
and $600,000 of accounts receivable attributable to sales of inventory 
in the ordinary course of business. The unsecured liabilities of T total 
$900,000.
    (ii) On February 1, 1998, T adopts a plan of complete liquidation 
complying with section 453(h)(1)(A), and promptly sells Blackacre to B 
for a 4-year mortgage note (bearing adequate stated interest and 
otherwise meeting all of the requirements of section 453) in the face 
amount of $4 million. Under the agreement between T and B, T (or its 
successor) is to continue to make principal and interest payments on the 
underlying mortgage. Immediately thereafter, T completes its liquidation 
by distributing to A its remaining cash of $400,000 (after payment of 
T's tax liabilities), accounts receivable of $600,000, and the $4 
million B note. A assumes T's $900,000 of unsecured liabilities and 
receives the distributed property subject to the obligation to make 
payments on the $1,100,000 underlying mortgage. A receives no payments 
from B on the B note during 1998.
    (iii) Unless A elects otherwise, the transaction is reported by A on 
the installment method. The selling price is $5 million (cash of 
$400,000, accounts receivable of $600,000, and the B note of $4 
million). The total contract price also is $5 million. A's adjusted tax 
basis in the T shares, initially $100,000, is increased by the $900,000 
of unsecured T liabilities assumed by A and by the obligation (subject 
to which A takes the distributed property) to make payments on the 
$1,100,000 underlying mortgage on Blackacre, for an aggregate adjusted 
tax basis of $2,100,000. Accordingly, the gross profit is $2,900,000 
(selling price of $5 million less aggregate adjusted tax basis of 
$2,100,000). The gross profit ratio is 58 percent (gross profit of 
$2,900,000 divided by the total contract price of $5 million). The 1998 
payments to A are $1 million ($400,000 cash plus $600,000 receivables) 
and A recognizes gain in 1998 of $580,000 (58 percent of $1 million).

[[Page 152]]

    (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. 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.

[[Page 153]]

    (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 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

[[Page 154]]

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 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.

[[Page 155]]

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.

    (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,

[[Page 156]]

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. 1.453A-0  Table of contents.

    This section lists the paragraphs and subparagraphs contained in 
Secs. 1.453A-1 through 1.453A-3.

  Sec. 1.453A-1  Installment method of reporting income by dealers in 
                           personal property.

    (a) In general.
    (b) Effect of security.
    (c) Definition of dealer, sale, and sale on the installment plan.
    (d) Installment plans.
    (1) Traditional installment plans.
    (2) Revolving credit plans.
    (e) Installment income of dealers in personal property.
    (1) In general.
    (2) Gross profit and total contract price.
    (3) Carrying changes not included in total contract price.
    (f) Other accounting methods.
    (g) Records.
    (h) Effective date.

   Sec. 1.453A-2  Treatment of revolving credit plans; taxable years 
                beginning on or before December 31, 1986.

    (a) In general.
    (b) Coordination with traditional installment plan.
    (c) Revolving credit plans.
    (d) Effective date.

  Sec. 1.453A-3  Requirements for adoption of or change to installment 
                 method by dealers in personal property.

    (a) In general.
    (b) Time and manner of electing installment method reporting.
    (1) Time for election.
    (2) Adoption of installation method.
    (3) Change to installment method.
    (4) Deemed elections.
    (c) Consent.
    (d) Cut-off method for amounts previously accrued.
    (e) Effective date.
[T.D. 8270, 54 FR 46376, Nov. 3, 1989]



Sec. 1.453A-1  Installment method of reporting income by dealers on personal property.

    (a) In general. A dealer (as defined in paragraph (c)(1) of this 
section) may elect to return the income from the sale of personal 
property on the installment method if such sale is a sale on the 
installment plan (as defined in paragraphs (c)(3) and (d) of this 
section). Under the installment method of accounting, a taxpayer may 
return as income from installment sales in any taxable year that 
proportion of the installment payments actually received in that year 
which the gross profit realized or to be realized when the property is 
paid for bears to the total contract price. For this purpose, gross 
profit means sales less cost of goods sold. See paragraph (d) of this 
section for additional rules relating to the computation of income under 
the installment method of accounting. In addition, see Sec. 1.453A-2 for 
rules treating revolving credit plans as installment plans for taxable 
years beginning on or before December 31, 1986.
    (b) Effect of security. A dealer may adopt (but is not required to 
do so) one of the following four ways of protecting against loss in case 
of default by the purchaser:
    (1) An agreement that title is to remain in the vendor until 
performance of the purchaser's part of the transaction is completed;

[[Page 157]]

    (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 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

[[Page 158]]

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 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.

[[Page 159]]

    (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 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

[[Page 160]]

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 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

[[Page 161]]

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 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

[[Page 162]]

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


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
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

[[Page 163]]

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 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.

[[Page 164]]

    (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 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

[[Page 165]]

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]



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

[[Page 166]]

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]



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

[[Page 167]]

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 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

[[Page 168]]

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 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

[[Page 169]]

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 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

[[Page 170]]

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 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

[[Page 171]]

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 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.

[[Page 172]]

    (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 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

[[Page 173]]

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 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

[[Page 174]]

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]



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

[[Page 175]]

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 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

[[Page 176]]

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 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

[[Page 177]]

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 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

[[Page 178]]

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

    (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                                                                         
   456(d)(2)...........................       500      800      900      900      900      400      100         
----------------------------------------------------------------------------------------------------------------

    (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                                                                                 
 456(d)(1)..............................    2,500    1,500      500  .......  .......  .......  .......  .......
                                         -----------------------------------------------------------------------
    Total...............................    3,000    3,000    3,000    3,000    3,000    3,000    3,000    3,000
Amount deductible under section                                                                                 
 456(d)(2)..............................      500      800      900      900      900      400      100  .......
                                         -----------------------------------------------------------------------
    Net amount reportable under section                                                                         
   456..................................    2,500    2,200    2,100    2,100    2,100    2,600    2,900    3,000
----------------------------------------------------------------------------------------------------------------

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



Sec. 1.457-1  Compensation deferred under eligible State deferred compensation plans.

    (a) Year of inclusion in gross income--(1) In general. For taxable 
years beginning after December 31, 1978, section 457(a) provides that 
amounts deferred (within the meaning of Sec. 1.457-1(d)(3)) under an 
eligible State deferred compensation plan that satisfies the 
requirements of Sec. 1.457-2 (an ``eligible plan'') are includible in 
gross income only for the taxable year in which paid or otherwise made 
available to the participant or beneficiary under the plan.
    (2) Maximum deferral; in general. Under section 457(c)(1), the 
exclusion from gross income described in this paragraph (a) does not 
apply to compensation deferred under one or more eligible plans to the 
extent that the compensation so deferred during a participant's taxable 
year exceeds the greater of--
    (i) $7,500, or,
    (ii) As applicable, the sum of the plan ceilings determined under 
Sec. 1.457-2(f), to the extent such sum does not exceed $15,000.
    (3) Maximum deferral; exclusions under section 403(b) taken into 
account. Under

[[Page 179]]

section 457(c)(2), for a participant's taxable year for which an amount 
is contributed to an annuity contract described in section 403(b) 
(including a custodial account described in section 403(b)(7)) on behalf 
of the participant, subparagraph (2) of this paragraph (a) is applied by 
substituting--
    (i) For $7,500, an amount equal to $7,500, less the amount 
excludable from the participant's gross income under section 403(b) for 
the taxable year,
    (ii) For the sum of the plan ceilings determined under Sec. 1.457-
2(f), an amount equal to the sum of the plan ceilings determined under 
Sec. 1.457-2(f), less the amount excludable from the participant's gross 
income under section 403(b) for the taxable year, if such amount is not 
taken into account under such Sec. 1.457-2(f), and
    (iii) For $15,000, an amount equal to $15,000, less the amount 
excludable from the participant's gross income under section 403(b) for 
the taxable year.
    (b) Amounts made available to participant or beneficiary--(1) In 
general. For purposes of section 457(a) and this section, amounts 
deferred under an eligible plan will not be considered made available to 
the participant or beneficiary if under the plan the participant or 
beneficiary may irrevocably elect, prior to the time any such amounts 
become payable, to defer payment of some or all of such amounts to a 
fixed or determinable future time. In addition, amounts deferred 
(including amounts previously deferred) under an eligible plan will not 
be considered made available to the participant solely because the 
participant is permitted to choose among various investment modes under 
the plan for the investment of such amounts whether before or after 
payments have commenced under the plan.
    (2) Examples. Further examples of when amounts deferred will or will 
not be considered as being made available to the participant or 
beneficiary are provided below:

    Example (1). (i) C, an individual, is a participant in an eligible 
State deferred compensation plan that provides the following:
    (A) The total of the amounts deferred under the plan is payable to 
the participant in 120 substantially equal monthly installments 
commencing on the date 30 days after the participant attains normal 
retirement age under the plan (age 65), unless the participant elects, 
within the 90 day period ending on the date the participant attains 
normal retirement age, to receive a single sum payment of the deferred 
amounts. The single sum payment is payable to a participant on the date 
the first of the monthly payment would otherwise be payable to the 
participant.
    (B) If a participant separates from the service of the State before 
attaining normal retirement age, the total of the amounts deferred under 
the plan is payable to the participant in a single sum payment on the 
date 90 days after the date of the separation, unless, before the date 
30 days after the separation, the participant elects not to receive the 
single sum payment. The election is irrevocable. If the participant 
makes the election, the total of the amounts deferred under the plan is 
payable to the participant as described in (A), either in monthly 
installments or, at the election of the participant, in a single sum 
payment.
    (ii) On June 6, 1982, C, a calendar year taxpayer aged 59, separates 
from the service of the State. On June 18, 1982, C elects not to receive 
the single sum payment payable on account of the separation. Because of 
C's election, no amount deferred under the plan is considered made 
available in 1982 by reason of C's right to receive the single sum 
payment.
    (iii) On February 6, 1988, C attains age 65. C did not, within the 
90 day period elect the single sum payment that is payable in lieu of 
the monthly installments. Amounts deferred under the plan are includible 
in C's gross income as they are paid to C in the monthly installments. 
No amount is considered made available by reason of C's right to elect 
the single sum payment.
    Example (2). Assume the same facts as in example (1), except that 
the plan provides that notwithstanding that monthly installments have 
commenced under the plan, as described in (i)(A), the participant may, 
without restriction, elect to receive all or any portion of the amount 
remaining payable to the participant. The total of the amounts deferred 
under the plan is considered made available in 1988.
    Example (3). Assume the same facts as in example (1), except that 
the plan provides that once monthly installment payments have commenced 
under the plan, as described in (i)(A), the participant may accelerate 
the payment of the amount remaining payable to the participant upon the 
occurrence of an unforeseeable emergency as described in Sec. 1.457-
2(h)(4) in an amount not exceeding that described in Sec. 1.457-2(h)(5). 
No amount is considered made available to C on account of C's right to 
accelerate payments

[[Page 180]]

upon the occurrence of an unforeseeable emergency.
    Example (4). Under an eligible plan of which individual D is a 
participant, normal retirement age is age 65 at which time payments must 
begin. Payments may begin earlier upon a separation from the service. 
Under the plan, a participant who separates from the service before age 
65 or the participant's beneficiary (if the separation is due to the 
participant's death) may elect to defer the distribution of the amounts 
deferred until the year in which the participant attains or would have 
attained age 65. This election may be made only prior to the time any 
payments commence and once made may not be revoked. If such an election 
is made, the participant, former participant, or beneficary need not 
elect the method of payment, or if one is elected may change the method 
elected, until the date 30 days preceding the date upon which payments 
are to commence. No amount is considered made available by reason of D's 
right to defer the distribution of the amounts deferred until age 65, 
nor on account of D's right to delay the election of the method of 
payout. Similarly, if D dies at age 60, no amount is considered made 
available to D's beneficiary by reason of the beneficiary's right to 
defer the distribution of the amounts deferred until the year in which D 
would have attained age 65, nor on account of the beneficiary's right to 
delay the election of the method of payout.
    Example (5). Under an eligible plan of which individual E is a 
participant, the maximum that may be deferred in any taxable year is 
33\1/3\% of includible compensation, not to exceed $7,500. The plan does 
not provide for a catch-up deferral under section 457(b)(3). In one 
taxable year, E elects to have amounts deferred in excess of the 
limitation provided for under the plan. The amounts deferred in excess 
of the limitation will be considered to have been made available to E in 
the taxable year in which deferred.
    Example (6). Assume the same facts as in example (5), except that 
E's employer also contributes amounts for the purchase of an annuity 
contract under section 403(b). In one taxable year, E has amounts 
contributed for the annuity within the limitations of section 403(b)(2), 
and also has amounts deferred under the eligible plan for the same year. 
The aggregate of the amounts contributed for the annuity contract and 
the amounts deferred under the plan exceed the deferral limitations 
under the plan. The excess deferrals will be considered made available 
to E in the year in which the amounts were deferred.
    Example (7). Under an eligible plan of which F is a participant, 
amounts deferred have been invested in a money market investment fund. 
The plan then transfers the amounts deferred to a life insurance company 
for the purchase of life insurance contracts as an investment medium. 
However, the entity sponsoring the plan (1) retains all of the incidents 
of ownership of the contracts, (2) is the sole beneficiary under the 
contracts, and (3) is under no obligation to transfer the contracts or 
to pass through the proceeds of the contracts to any participant or a 
beneficiary of any participant. The movement of the amounts deferred to 
the life insurance company (whether or not made at the request of any 
plan participant) will not be considered to make the amounts available 
to the plan's participants. The cost of current life insurance 
protection under the life insurance contracts will not be considered 
made available to the plan's participants.

    (c) Life insurance proceeds and death benefits paid under eligible 
plan. No amount received or made available under an eligible plan is 
excludable from gross income under section 101(a) (relating to life 
insurance contracts) or section 101(b) (relating to employees' death 
benefits).
    (d) Definitions. For purposes of Secs. 1.457-1 through 1.457-4:
    (1) Participant. ``Participant'' means an individual who is eligible 
under Sec. 1.457-2(d) to defer compensation under the plan.
    (2) Beneficiary. ``Beneficiary'' means a beneficiary of a 
participant, a participant's estate, or any other person whose interest 
in the plan is derived from the participant.
    (3) Amounts deferred. ``Amount(s) deferred'' under an eligible plan 
means compensation deferred under the plan, plus income attributable to 
compensation so deferred. Income attributable to compensation deferred 
under an eligible plan includes gain from the disposition of property. 
The term ``amounts deferred'' includes amounts deferred in taxable years 
beginning before January 1, 1979, if such amounts were deferred under a 
plan described in Sec. 1.457-2(b), and such amounts were made a part of 
an eligible plan.
[T.D. 7836, 47 FR 42337, Sept. 27, 1982]



Sec. 1.457-2  Eligible State deferred compensation plan defined.

    (a) In general. For purposes of Secs. 1.457-1 through 1.457-4, an 
``eligible State deferred compensation plan'' (sometimes referred to as 
``eligible plan'') is a plan

[[Page 181]]

satisfying the requirements of paragraphs (c) through (k) of this 
section.
    (b) Plan. For purposes of this section and Sec. 1.457-3, the term 
``plan'' includes any agreement or arrangement between a State (within 
the meaning of paragraph (c) of this section) and a participant or 
participants, under which the payment of compensation is deferred, but 
only if such agreement or arrangement is not described in Sec. 1.457-
3(b).
    (c) State. The plan must be established and maintained by a State. 
For this purpose, the term ``State'' includes:
    (1) The 50 states of the United States and the District of Columbia;
    (2) A political subdivision of a State;
    (3) Any agency or instrumentality of a State or political 
subdivision of a State;
    (4) An organization that is exempt from tax under section 501(a) and 
engaged primarily in providing electrical service on a mutual or 
cooperative basis; and
    (5) An organization that is described in section 501(c)(4) or (6) 
and exempt from tax under section 501(a) and at least 80% of the members 
of which are organizations described in subparagraph (4).

Where it appears in this Sec. 1.457-2, the term ``State'' means the 
entity described in this paragraph (c) that sponsors the plan.
    (d) Participants. The plan must provide that only individuals who 
perform services for the State, either as an employee of the State or as 
an independent contractor, may defer compensation under the plan.
    (e) Maximum deferrals--(1) In general. The plan must provide that 
the amount of compensation that may be deferred under the plan for a 
taxable year of a participant shall not exceed an amount specifed in the 
plan (the ``plan ceiling''). Except as described in paragraph (f) of 
this section, a plan ceiling shall not exceed the lesser of:
    (i) $7,500, or
    (ii) 33\1/3\% of the participant's includible compensation for the 
taxable year, reduced by any amount excludable from the participant's 
gross income for the taxable year under section 403(b) on account of 
contributions made by the State.
    (2) Includible compensation. For purposes of this section, a 
participant's includible compensation for a taxable year includes only 
compensation from the State that is attributable to services performed 
for the State and that is includible in the participant's gross income 
for the taxable year. Accordingly, a participant's includible 
compensation for a taxable year does not include an amount payable by 
the State that is excludable from the employee's gross income under 
section 457(a) and Sec. 1.457-1 or under section 403(b) (relating to 
annuity contracts purchased by section 501(c)(3) organizations or public 
schools), section 105(d) (relating to wage continuation plans) or 
section 911 (relating to citizens or residents of the United States 
living abroad). A participant's includible compensation for a taxable 
year is determined without regard to any community property laws.
    (3) Compensation taken into account at its present value. For 
purposes of subparagraph (1) of this paragraph, compensation deferred 
under a plan shall be taken into account at its value in the plan year 
in which deferred. However, if the compensation deferred is subject to a 
substantial risk of forfeiture (as defined in section 457(e)(3)), such 
compensation shall be taken into account at its value in the plan year 
in which such compensation is no longer subject to a substantial risk of 
forfeiture.
    (f) Limited catch-up--(1) In general. The plan may provide that, for 
1 or more of the participant's last 3 taxable years ending before the 
participant attains normal retirement age, the plan ceiling is an amount 
not in excess of the lesser of:
    (i) $15,000, reduced by any amount excludable from the participant's 
gross income for the taxable year under section 403(b) on account of 
contributions made by the State, or
    (ii) The amount determined under subparagraph (2) of this paragraph.
    (2) Underutilized limitations. The amount determined under this 
subparagraph (2) is the sum of:
    (i) The plan ceiling established under paragraph (e)(1) of this 
section for the taxable year, plus

[[Page 182]]

    (ii) The plan ceiling established under paragraph (e)(1) of this 
section for any prior taxable year or years, less the amount of 
compensation deferred under the plan for such prior taxable year or 
years.

A prior taxable year shall be taken into account under subdivision (ii) 
of this subparagraph (2) only if (A) it begins after December 31, 1978, 
(B) the participant was eligible to participate in the plan during all 
or any portion of the taxable year, and (C) compensation deferred (if 
any) under the plan during the taxable year was subject to a plan 
ceiling established under paragraph (e)(1) of this section. A 
participant will be considered eligible to participate in the plan for a 
taxable year if the participant is described in paragraph (d) of this 
section for any part of that taxable year. A prior taxable year includes 
a taxable year in which the participant was eligible to participate in 
an eligible plan sponsored by a different entity, provided that the 
entities sponsoring the plans are located within the same State as that 
term is used in Sec. 1.457-2(c)(1).
    (3) Restriction on limited catch-up. The plan shall not provide that 
a participant may elect to have the limited catch-up provision of this 
paragraph (f) apply more than once, whether or not the limited catch-up 
is utilized in less than all of the three taxable years ending before 
the participant attains normal retirement age, and whether or not the 
participant or former participant rejoins the plan or participates in 
another eligible plan after retirement. For example, if the participant 
elects to utilize the limited catch-up only for the one taxable year 
ending before normal retirement age, and, after retirement at that age, 
the participant renders services for the State as an independent 
contractor or otherwise, the plan may not provide that the participant 
may utilize the limited catch-up for any of the taxable years subsequent 
to retirement.
    (4) Normal retirement age. For purposes of this paragraph (f), 
normal retirement age may be specified in the plan. If no normal 
retirement age is specified in the plan, then the normal retirement age 
is the later of the latest normal retirement age specified in the basic 
pension plan of the State, or age 65. A plan may define normal 
retirement age as any range of ages ending no later than age 70\1/2\ and 
beginning no earlier than the earliest age at which the participant has 
the right to retire under the State's basic pension plan without consent 
of the State and to receive immediate retirement benefits without 
actuarial or similar reduction because of retirement before some later 
specified age in the State's basic pension plan. The plan may further 
provide that in the case of a participant who continues to work beyond 
the ages specified in the preceding two sentences, the normal retirement 
age shall be that date or age designated by the participant, but such 
date or age shall not be later than the mandatory retirement age 
provided by the State, or the date or age at which the participant 
separates from the service with the State.
    (g) Agreement for deferral. The plan must provide that, in general, 
compensation is to be deferred for any calendar month only if an 
agreement providing for such deferral has been entered into before the 
first day of the month. However, a plan may provide that, with respect 
to a new employee, compensation is to be deferred for the calendar month 
during which the participant first becomes an employee, if an agreement 
providing for such deferral is entered into on or before the first day 
on which the participant becomes an employee.
    (h) Payments under the plan--(1) In general. The plan may not 
provide that amounts payable under the plan will be paid or made 
available to a participant or beneficiary before the participant 
separates from service with the State, or, if the plan provides for 
payment in the case of an unforeseeable emergency, before the 
participant incurs an unforeseeable emergency.
    (2) Separation from service; general rule. An employee is separated 
from service with the State if there is a separation from the service 
within the meaning of section 402(e)(4)(A)(iii), relating to lump sum 
distributions, and on account of the participant's death or retirement.

[[Page 183]]

    (3) Separation from service; independent contractor--(i) In general. 
An independent contractor is considered separated from service with the 
State upon the expiration of the contract (or in the case of more than 
one contract, all contracts) under which services are performed for the 
State, if the expiration constitutes a good-faith and complete 
termination of the contractual relationship. An expiration will not 
constitute a good faith and complete termination of the contractual 
relationship if the State anticipates a renewal of a contractual 
relationship or the independent contractor becoming an employee. For 
this purpose, a State is considered to anticipate the renewal of the 
contractual relationship with an independent contractor if it intends to 
again contract for the services provided under the expired contract, and 
neither the State nor the independent contractor has eliminated the 
independent contractor as a possible provider of services under any such 
new contract. Further, a State is considered to intend to again contract 
for the services provided under an expired contract, if the State's 
doing so is conditioned only upon the State's incurring a need for the 
services, or the availability of funds or both.
    (ii) Special rule. Notwithstanding subdivision (i), if, with respect 
to amounts payable to a participant who is an independent contractor, a 
plan provides that--
    (A) No amount shall be paid to the participant before a date at 
least 12 months after the day on which the contract expires under which 
services are performed for the State (or, in the case of more than one 
contract, all such contracts expire), and
    (B) No amount payable to the participant on that date shall be paid 
to the participant if, after the expiration of the contract (or 
contracts) and before that date, the participant performs services for 
the State as an independent contractor or an employee,

the plan is considered to satisfy the requirement described in 
subparagraph (1) that no amounts payable under the plan will be paid or 
made available to the participant before the participant separates from 
service with the State.
    (4) Unforeseeable emergency. For purposes of this paragraph (h), an 
unforeseeable emergency is, and if the plan provides for payment in the 
case of an unforeseeable emergency must be defined in the plan as, 
severe financial hardship to the participant resulting from a sudden and 
unexpected illness or accident of the participant or of a dependent (as 
defined in section 152(a)) of the participant, loss of the participant's 
property due to casualty, or other similar extraordinary and 
unforeseeable circumstances arising as a result of events beyond the 
control of the participant. The circumstances that will constitute an 
unforeseeable emergency will depend upon the facts of each case, but, in 
any case, payment may not be made to the extent that such hardship is or 
may be relieved--
    (i) Through reimbursement or compensation by insurance or otherwise,
    (ii) By liquidation of the participant's assets, to the extent the 
liquidation of such assets would not itself cause severe financial 
hardship, or
    (iii) By cessation of deferrals under the plan.

Examples of what are not considered to be unforeseeable emergencies 
include the need to send a participant's child to college or the desire 
to purchase a home.
    (5) Emergency withdrawals. Withdrawals of amounts because of an 
unforeseeable emergency must only be permitted to the extent reasonably 
needed to satisfy the emergency need.
    (i) Distributions of deferrals--(1) Commencement of distributions. A 
plan is not an eligible plan unless under the plan the payment of 
amounts deferred will commence not later than the later of--
    (i) 60 days after the close of the plan year in which the 
participant or former participant attains (or would have attained) 
normal retirement age (within the meaning of Sec. 1.457-2(f)(4)), or
    (ii) 60 days after the close of the plan year in which the 
participant separates from service (within the meaning of Secs. 1.457-
2(h) (2) and (3)) with the State.

A plan is not other than an eligible plan merely because, prior to 
October 27, 1982, the distribution of amounts deferred under the plan 
may commence

[[Page 184]]

no later than the close of the participant's taxable year in which the 
participant attains age 70\1/2\.
    (2) Limitations on distributions. Distributions must be made 
primarily for the benefit of participants (or former participants). 
Thus, the schedule selected by the participant for payments of benefits 
under the plan must be such that benefits payable to a beneficiary are 
not more than incidental. For example, if provision is made for payment 
of a portion of the amounts deferred to a beneficiary, the amounts 
payable to the participant or former participant (as determined by use 
of the expected return multiples in Sec. 1.72-9, or, in the case of 
payments under a contract issued by an insurance company, by use of the 
mortality tables of such company), must exceed one-half of the maximum 
that could have been payable to the participant if no provision were 
made for payment to a beneficiary.
    (3) Distributions to beneficiaries. A plan is not an eligible plan 
unless the plan provides that, if the participant dies before the entire 
amount deferred is paid to the participant, the entire amount deferred 
(or the remaining part of such deferrals if payment thereof has 
commenced) must be paid to a beneficiary over--
    (i) The life of the beneficiary (or any shorter period), if the 
beneficiary is the participant's surviving spouse, or
    (ii) A period not in excess of 15 years, if the beneficiary is not 
the participant's surviving spouse.
    (j) Administration of plan. A plan is not an eligible plan unless 
all amounts deferred under the plan, all property and rights to property 
(including rights as a beneficiary of a contract providing life 
insurance protection) purchased with the amounts, and all income 
attributable to the amounts, property, or rights to property, remain 
(until paid or made available to the participant or beneficiary under 
the plan) solely the property and rights of the State (without being 
restricted to the benefits under the plan) subject to the claims of the 
general creditors of the State only. However, nothing in this paragraph 
(j) prohibits a plan's permitting participants to direct, from among 
different modes under the plan, the investment of the above amounts (see 
Sec. 1.457-1(b)).
    (k) Plan-to-plan transfers. The plan may provide for the transfer of 
amounts deferred by a former participant to another eligible plan of 
which the former participant has become a participant if the following 
conditions are met--
    (1) The entities sponsoring the plans are located within the same 
State (as that term is used in Sec. 1.457-2(c)(1)),
    (2) The plan receiving such amounts provides for the acceptance of 
the amounts, and
    (3) The plan provides that if the participant separates from service 
in order to accept employment with another such entity, payout will not 
commence upon separation from service, regardless of any other provision 
of the plan, and amounts previously deferred will automatically be 
transferred.
    (l) Effect on plan when not administered in accordance with 
paragraphs (c) through (k). A plan that is administered in a manner 
which is inconsistent with one or more of the requirements of paragraphs 
(c) through (k) of this section ceases to be an eligible plan on the 
first day of the first plan year beginning more than 180 days after the 
date of written notification by the Internal Revenue Service that the 
requirements are not satisfied, unless the inconsistency is corrected 
before the first day of that plan year.
    (m) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1.  A, born on June 1, 1917, is a participant in an eligible 
State deferred compensation plan providing a normal retirement age of 
65. The plan provides limitations on deferrals up to the maximum 
permitted under Sec. 1.457-2 (e) and (f).
    For 1979, A, who will be 62, is scheduled to receive a salary of 
$20,000 from the State. A desires to defer the maximun amount possible 
in 1979. The maximum amount that A may defer under the plan is the 
lesser of $7,500, or 33\1/3\% of A's includible compensation (generally 
the equivalent of 25 percent of gross compensation). Accordingly, the 
maximum that A may defer for 1979 is $5,000 [$5,000=$20,000 x .25]. 
Although A's taxable year 1979 is one of A's last 3 taxable years before 
the year in which A attains normal retirement age under the plan, A is 
not able to utilize the catch-up provisions of Sec. 1.457-2(f) in 1979 
because only taxable years beginning

[[Page 185]]

after December 31, 1978, may be taken into account under those 
provisions.
    Example 2. Assume the same facts as in example 1. In A's taxable 
year 1980, A receives a salary of $20,000, and elects to defer only 
$1,000 under the plan. In A's taxable year 1981, A again receives a 
salary of $20,000 and elects to defer the maximum amount permissible 
under the plan's catch-up provisions prescribed under Sec. 1.457-2(f). 
The applicable limit on deferrals under the catch-up provision is the 
lesser of $15,000 or the sum of the normal plan ceiling for 1981, plus 
any underutilized deferrals for any taxable year before 1981. Thus, the 
maximum amount that A may defer in 1981 is $9,000, the normal plan 
ceiling for 1981, $5,000, plus the under-utilized deferrals for 1980, 
$4,000.
    Example 3. Assume the same facts as in examples 1 and 2. In A's 
taxable year 1982, the year in which A will attain age 65, normal 
retirement age under the plan, A desires to defer the maximum amount 
possible under the plan. For 1982 the normal limitations of Sec. 1.457-
2(e) are applicable, and the maximum amount that A may defer is $5,000, 
assuming that A's salary for 1982 was again $20,000. The plan's catch-up 
provisions prescribed under Sec. 1.457-2(f) are not applicable because 
1982 is not a year ending before the year in which A attains normal 
retirement age.
[T.D. 7836, 47 FR 42338, Sept. 27, 1982]



Sec. 1.457-3  Tax treatment of participants where plan is not an eligible plan.

    (a) In general. If a State (within the meaning of Sec. 1.457-2(c)) 
provides for a deferral of compensation (after the effective date 
described in paragraph (c)) under any agreement or arrangement described 
in Sec. 1.457-2(b) that is not an eligible plan within the meaning of 
Sec. 1.457-2--
    (1) Compensation deferred under the agreement or arrangement shall 
be includible in the gross income of the participant of beneficiary for 
the first taxable year in which there is no substantial risk of 
forfeiture (within the meaning of section 457(e)(3)) of the rights to 
such compensation,
    (2) Earnings credited on the compensation deferred under the 
agreement of arrangement shall be includible in the gross income of the 
participant or beneficiary only when paid or made available, provided 
that the interest of the participant or beneficiary in the assets 
(including amounts deferred under the plan) of the entity sponsoring the 
plan is not senior to the entity's general creditors, and
    (3) Amounts paid or made available under the plan to a participant 
or beneficiary shall be taxable to the participant or beneficiary under 
section 72, relating to annuities.
    (b) Exceptions. Paragraph (a) does not apply with respect to--
    (1) A plan described in section 401(a) which includes a trust exempt 
from tax under section 501(a),
    (2) An annuity plan or contract described in section 403,
    (3) A qualified bond purchase plan described in section 405(a),
    (4) That portion of any plan which consists of a transfer of 
property described in section 83, and
    (5) That portion of any plan which consists of a trust to which 
section 402(b) applies.
    (c) Effective date. This section is effective for taxable years 
beginning after December 31, 1981. For rules applicable in taxable years 
beginning after December 31, 1978, and before January 1, 1982, see 
Sec. 1.457-4.
[T.D. 7836, 47 FR 42341, Sept. 27, 1982; 47 FR 46497, Oct. 19, 1982]



Sec. 1.457-4  Transitional rules.

    (a) In general. Subject to the limitations described in paragraphs 
(b) and (c) of this section, amounts deferred (within the meaning of 
Sec. 1.457-1(d)(3)) in taxable years beginning after December 31, 1978, 
and before January 1, 1982 under a plan described in Sec. 1.457-2(b) 
(including an eligible plan within the meaning of Sec. 1.457-2, but not 
including a plan described in section 457(e)(2) and Sec. 1.457-3(b)) 
shall be includible in gross income only for the taxable year in which 
paid or otherwise made available to the participant or other 
beneficiary.
    (b) General limitation. Except as described in paragraph (c) of this 
section, and excluding amounts deferred in taxable years beginning 
before January 1, 1979, compensation deferred under one or more plans 
described in paragraph (a) of this section is excludable from a 
participant's gross income under this section for a taxable year only to 
the extent it does not exceed the lesser of--
    (1) $7,500, or
    (2) 33\1/3\% of the participant's includible compensation (within 
the meaning of Sec. 1.457-2(e)(2)) for the taxable year, reduced by any 
amount excludable

[[Page 186]]

from the participant's gross income for the taxable year under section 
403(b) on account of contributions made by the State (within the meaning 
of Sec. 1.457-2(c)). For purposes of this paragraph, compensation 
deferred under a plan shall be taken into account at its value in the 
plan year in which deferred. However, if the compensation deferred is 
subject to a substantial risk of forfeiture (as defined in section 
457(e)(3)), such compensation shall be taken into account at its value 
in the plan year in which such compensation is no longer subject to a 
substantial risk of forfeiture.
    (c) Limited catch-up. This paragraph (c) applies if all plans 
described in paragraph (a) of this section in which an individual is a 
participant are eligible plans within the meaning of Sec. 1.457-2, and 
the participant's taxable year is a taxable year described in section 
457(b)(3) and Sec. 1.457-2(f). In such a case, compensation deferred 
under the plans for the taxable year is excluded from gross income under 
paragraph (a) of this section to the extent it does not exceed the 
amount determined under Sec. 1.457-1(a)(2) or, as applicable, 
Sec. 1.457-1(a)(3).
    (d) Example. The provisions of this section may be illustrated by 
the following example:

    Example.  A is a participant in a State deferred compensation plan 
that is not an eligible plan within the meaning of Sec. 1.457-2. The 
plan provides no limitations on the amount of compensation that may be 
deferred during any taxable year. For the taxable years 1979, 1980, and 
1981 A has includible compensation of $40,000. In each of those years, A 
has deferred $10,000 of compensation. Under the transitional rules 
described in this section, $7,500 of A's deferrals in each year will be 
includible in gross income in the taxable year in which paid or made 
available to A or A's beneficiary. The remaining $2,500 of each year's 
deferrals ($10,000 - $7,500) are includible in A's gross income for the 
deferral year. Thus, $2,500 is includible in A's gross income for each 
of the taxable years 1979, 1980, and 1981. The tax treatment of amounts 
deferred by A in taxable years after 1981 is described in Sec. 1.457-3.
[T.D. 7836, 47 FR 42341, Sept. 27, 1982]



Sec. 1.458-1  Exclusion for certain returned magazines, paperbacks, or records.

    (a) In general--(1) Introduction. For taxable years beginning after 
September 30, 1979, section 458 allows accrual basis taxpayers to elect 
to use a method of accounting that excludes from gross income some or 
all of the income attributable to qualified sales during the taxable 
year of magazines, paperbacks, or records, that are returned before the 
close of the applicable merchandise return period for that taxable year. 
Any amount so excluded cannot be excluded or deducted from gross income 
for the taxable year in which the merchandise is returned to the 
taxpayer. For the taxable year in which the taxpayer first uses this 
method of accounting, the taxpayer is not allowed to exclude from gross 
income amounts attributable to merchandise returns received during the 
taxable year that would have been excluded from gross income for the 
prior taxable year had the taxpayer used this method of accounting for 
that prior year. (See paragraph (e) of this section for rules describing 
how this amount should be taken into account.) The election to use this 
method of accounting shall be made in accordance with the rules 
contained in section 458(c) and in Sec. 1.458-2 and this section. A 
taxpayer that does not elect to use this method of accounting can reduce 
income for returned merchandise only for the taxable year in which the 
merchandise is actually returned unsold by the purchaser.
    (2) Effective date. While this section is generally effective only 
for taxable years beginning after August 31, 1984, taxpayers may rely on 
the provisions of paragraphs (a) through (f) of this section in taxable 
years beginning after September 30, 1979.
    (b) Definitions--(1) Magazine. ``Magazine'' means a publication, 
usually paper-backed and sometimes illustrated, that is issued at 
regular intervals and contains stories, poems, articles, features, etc. 
This term includes

[[Page 187]]

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:
    (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

[[Page 188]]

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 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.

[[Page 189]]

    (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 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:

[[Page 190]]



----------------------------------------------------------------------------------------------------------------
                                                              Years Ending December 31                          
                                   -----------------------------------------------------------------------------
                                        1977         1978         1979       1980 \1\       1981         1982   
----------------------------------------------------------------------------------------------------------------
Facts:                                                                                                          
    Qualifying returns during                                                                                   
     merchandise return period for                                                                              
     the taxable year.............           $5           $8           $6           $5           $7          $10
                                   =============================================================================
Adjustment to suspense account:                                                                                 
    Opening balance...............  ...........  ...........  ...........           $8           $5           $7
    Addition to account \2\.......  ...........  ...........  ...........  ...........            2            1
    Reduction to account \3\......  ...........  ...........  ...........          (3)  ...........  ...........
                                   -----------------------------------------------------------------------------
      Opening balance for next                                                                                  
       year.......................  ...........  ...........  ...........           $5           $7           $8
                                   =============================================================================
Amount excludable from income:                                                                                  
    Initial year adjustment.......  ...........  ...........  ...........         $(2)  ...........  ...........
    Amount excludable as                                                                                        
     qualifying returns in                                                                                      
     merchandise return period....  ...........  ...........  ...........            5           $7          $10
    Adjustment for increase in                                                                                  
     suspense account.............  ...........  ...........  ...........  ...........          (2)          (1)
    Adjustment for decrease in                                                                                  
     suspense account.............  ...........  ...........  ...........            3  ...........  ...........
                                   -----------------------------------------------------------------------------
      Net amount excludable for                                                                                 
       the year...................  ...........  ...........  ...........           $6           $5           $9
----------------------------------------------------------------------------------------------------------------
\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

[[Page 191]]

taking into account both P's and S's experience for the 3 immediately 
preceding taxable years. Thus, the initial opening balance of S's 
suspense account is $170. S must also make an initial year adjustment of 
$10 ($170--$160), which S must include in income for S's taxable year 
ending December 31, 1983. P is not entitled to a deduction or exclusion 
for merchandise received after the date of the transfer (December 31, 
1982) attributable to sales made by the transferor before the date of 
transfer. Thus, P is not entitled to a deduction or exclusion for the 
$160 of merchandise received by S during the first 4 months and 15 days 
of 1983.

    (g) Adjustment to inventory and cost of goods sold. (1) If a 
taxpayer makes adjustments to gross receipts for a taxable year under 
the method of accounting described in section 458, the taxpayer, in 
determining excludable gross income, is also required to make 
appropriate correlative adjustments to purchases or closing inventory 
and to cost of goods sold for the same taxable year. Adjustments are 
appropriate, for example, where the taxpayer holds the merchandise 
returned for resale or where the taxpayer is entitled to receive a price 
adjustment from the person or entity that sold the merchandise to the 
taxpayer. Cost of goods sold must be properly adjusted in accordance 
with the provisions of Sec. 1.61-3 which provides, in pertinent part, 
that gross income derived from a manufacturing or merchandising business 
equals total sales less cost of goods sold.
    (2) The provisions of this paragraph (g) may be illustrated by the 
following examples. These examples do not, however, reflect any required 
adjustments under paragraph (e)(3) of this section.

    Example 1.  (i) In 1986, P, a publisher, properly elects under 
section 458 of the Code not to include in its gross income in the year 
of sale, income attributable to qualified sales 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 [(100 x $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

[[Page 192]]

sales of magazines, paperbacks, or records using an accrual method of 
accounting. In order to use the special method of accounting under 
section 458, a taxpayer must make an election in the manner prescribed 
in this section. The election does not require the prior consent of the 
Internal Revenue Service. The election is effective for the taxable year 
for which it is made and for all subsequent taxable years, unless the 
taxpayer secures the prior consent of the Internal Revenue Service to 
revoke such election.
    (b) Separate election for each trade or business. An election is 
made with respect to each trade or business of a taxpayer in connection 
with which qualified sales (as defined in section    458(b)(5)) of a 
category of merchandise were made. Magazines, paperbacks, and records 
are each treated as a separate category of merchandise. If qualified 
sales of two or more categories of merchandise are made in connection 
with the same trade or business, then solely for purposes of section 
458, each category is treated as a separate trade or business. For 
example, if a taxpayer makes qualified sales of both magazines and 
paperbacks in the same trade or business, then solely for purposes of 
section 458, the qualified sales relating to magazines are considered 
one trade or business and the qualified sales relating to paperbacks are 
considered a separate trade or business. Thus, if the taxpayer wishes to 
account under section 458 for the qualified sales of both magazines and 
paperbacks, such taxpayer must make a separate election for each 
category.
    (c) Manner of, and time for, making election. An election is made 
under section 458 and this section by filing a statement of election 
containing the 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 Secs. 1.460-1 through 
1.460-8.

 Sec. 1.460-1  Accounting for long-term contracts in general. [Reserved]

       Sec. 1.460-2  Definition of long-term contract. [Reserved]

        Sec. 1.460-3  Percentage of completion method. [Reserved]

      Sec. 1.460-4  Methods of accounting for long-term contracts.

    (a)-(i) [Reserved]
    (j) Consolidated groups and controlled groups.
    (1) Intercompany transactions.
    (i) In general.

[[Page 193]]

    (ii) Definitions and nomenclature.
    (2) Example.
    (3) Effective dates.
    (i) In general.
    (ii) Prior law.
    (4) Consent to change method of accounting.

             Sec. 1.460-5  Cost allocation rules. [Reserved]

                     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.
    (iv) Additional interest due on interest only after tax liability 
due.
    (d) Simplified marginal impact method.
    (1) Introduction.
    (2) Operation.
    (i) In general.
    (ii) Applicable tax rate.
    (iii) Overpayment ceiling.
    (iv) Example.
    (3) Anti-abuse rule.
    (4) Application.
    (i) Required use by certain pass-through entities.
    (A) General rule.
    (B) Closely held.
    (C) Examples.
    (D) Domestic contracts.
    (1) General rule.
    (2) Portion of contract income sourced.
    (E) Application to foreign contracts.
    (F) Effective date.
    (ii) Elective use.
    (A) General rule.
    (B) Election requirements.
    (C) Consolidated group consistency rule.
    (e) Delayed reapplication method.
    (1) In general.
    (2) Time and manner of making election.
    (3) Examples.
    (f) Look-back reporting.
    (1) Procedure.
    (2) Treatment of interest on return.
    (i) General rule.
    (ii) Timing of look-back interest.
    (g) Mid-contract change in taxpayer. [Reserved]
    (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.

              Sec. 1.460-6T  Look-back method (temporary).

    (a)-(i) [Reserved]
    (j) Election not to apply look-back method in de minimis cases.

          Sec. 1.460-7  Exempt long-term contracts. [Reserved]

        Sec. 1.460-8  Changes in method of accounting. [Reserved]

[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]

[[Page 194]]



Sec. 1.460-1  Accounting for long-term contracts in general. [Reserved]



Sec. 1.460-2  Definition of long-term contract. [Reserved]



Sec. 1.460-3  Percentage of completion method. [Reserved]



Sec. 1.460-4  Methods of accounting for long-term contracts.

    (a)-(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 
Secs. 1.267(f)-1T, 1.267(f)-2T, and 1.1502-13(n) (as contained in the 26 
CFR part 1 edition revised as of April 1, 1995).
    (4) Consent to change method of accounting. For transactions and 
sales to which this paragraph (j) applies, the Commissioner's consent 
under section 446(e) is hereby granted to the extent any changes in 
method of accounting are necessary solely to comply with this section, 
provided the changes are made in the first taxable year of the taxpayer 
to which the rules of this paragraph (j) apply. Changes in method of 
accounting for these transactions are to be effected on a cut-off basis.
[T.D. 8597, 60 FR 36684, July 18, 1995]



Sec. 1.460-5  Cost allocation rules. [Reserved]



Sec. 1.460-6  Look-back method.

    (a) In general--(1) Introduction. With respect to income from any 
long-term contract reported under the percentage of completion method, a 
taxpayer is required to pay or is entitled to receive interest under 
section 460(b) on the amount of tax liability that is deferred or 
accelerated as a result of overestimating or underestimating total 
contract price or contract costs. Under this look-back method, taxpayers 
are required to pay interest for any deferral of tax liability resulting 
from the underestimation of the total contract price or the 
overestimation of total contract costs. Conversely, if the total 
contract price is overestimated or the

[[Page 195]]

total contract costs are underestimated, taxpayers are entitled to 
receive interest for any resulting acceleration of tax liability. The 
computation of the amount of deferred or accelerated tax liability under 
the look-back method is hypothetical; application of the look-back 
method does not result in an adjustment to the taxpayer's tax liability 
as originally reported, as reported on an amended return, or as adjusted 
on examination. Thus, the look-back method does not correct for 
differences in tax liability that result from over- or under-estimation 
of contract price and costs and that are permanent because, for example, 
tax rates change during the term of the contract.
    (2) Overview. Paragraph (b) explains which situations require 
application of the look-back method to income from a long-term contract. 
Paragraph (c) explains the operation of the three computational steps 
for applying the look-back method. Paragraph (d) provides guidance 
concerning the simplified marginal impact method. Paragraph (e) provides 
an elective method to minimize the number of times the look-back method 
must be reapplied to a single long-term contract. Paragraph (f) 
describes the reporting requirements for the look-back method and the 
tax treatment of look-back interest. Paragraph (g) provides rules for 
applying the look-back method when there is a transaction that changes 
the taxpayer that reports income from a long-term contract prior to the 
completion of a contract. Paragraph (h) provides examples illustrating 
the three computational steps for applying the look-back method.
    (b) Scope of look-back method--(1) In general. The look-back method 
applies to any income from a long-term contract within the meaning of 
section 460(f) that is required to be reported under the percentage of 
completion method (as modified by section 460) for regular income tax 
purposes or for alternative minimum tax purposes. If a taxpayer uses the 
percentage of completion-capitalized cost method for long-term 
contracts, the look-back method applies for regular tax purposes only to 
the portion (40, 70, or 90 percent, whichever applies) of the income 
from the contract that is reported under the percentage of completion 
method. The requirements of section 460 also apply to income and 
expenses attributable to activities that benefit any long-term contract 
entered into by a party related to the taxpayer within the meaning of 
section 707(b) or 267(b), determined without regard to section 
267(f)(1)(A) and by substituting ``80 percent'' for ``50 percent'' with 
regard to the ownership of the stock of a C corporation. Therefore, to 
the extent that the percentage of completion method is required to be 
used with respect to income and expenses that are attributable to 
activities that benefit a related party's long-term contract, the look-
back method also applies to these amounts, even if those activities are 
not performed under a contract entered into directly by the taxpayer.
    (2) Exceptions from section 460. The look-back method generally does 
not apply to the regular taxable income from any long-term construction 
contract within the meaning of section 460(e)(4) that:
    (i) Is a home construction contract within the meaning of section 
460(e)(1)(A), or
    (ii) Is not a home construction contract but is estimated to be 
completed within a 2-year period by a taxpayer whose average annual 
gross receipts for the 3 tax years preceding the tax year the contract 
is entered into do not exceed $10,000,000 (as provided in section 
460(e)(1)(B)). These contracts are not subject to the look-back method 
for regular tax purposes, even if the taxpayer uses a version of the 
percentage of completion method permitted under Sec. 1.451-3, unless the 
taxpayer has properly changed its method of accounting for these 
contracts to the percentage of completion method as modified by section 
460(b). The look-back method, however, applies to the alternative 
minimum taxable income from a contract of this type, unless it is exempt 
from the required use of the percentage of completion method under 
section 56(a)(3).
    (3) De minimis exception. Notwithstanding that the percentage of 
completion method is otherwise required to be used, the look-back method 
does not apply to any long-term contract that:

[[Page 196]]

    (i) Is completed within 2 years of the contract commencement date, 
and
    (ii) Has a gross contract price (as of the completion of the 
contract) that does not exceed the lesser of $1,000,000 or 1 percent of 
the average annual gross receipts of the taxpayer for the 3 tax years 
preceding the tax year in which the contract is completed.

This de minimis exception is mandatory and, therefore, precludes 
application of the look-back method to any contract that meets the 
requirements of the exception. The de minimis exception applies for 
purposes of computing both regular taxable income and alternative 
minimum taxable income. Solely for this purpose, the determination of 
whether a long-term contract meets the gross receipts test for both 
alternative minimum tax and regular tax purposes is made based only on 
the taxpayer's regular taxable income.
    (4) Alternative minimum tax. For purposes of computing alternative 
minimum taxable income, section 56(a)(3) generally requires long-term 
contracts within the meaning of section 460(f) (generally without regard 
to the exceptions in section 460(e)) to be accounted for using only the 
percentage of completion method as defined in section 460(b), including 
the look-back method of section 460(b), with respect to tax years 
beginning after December 31, 1986. However, section 56(a)(3) (and thus 
the look-back method) does not apply to any long-term contract entered 
into after June 20, 1988, and before the beginning of the first tax year 
that begins after September 30, 1990, that meets the conditions of both 
section 460(e)(1)(A) and clauses (i) and (ii) of section 460(e)(1)(B), 
and does not apply to any long-term contract entered into in a tax year 
that begins after September 30, 1990, that meets the conditions of 
section 460(e)(1)(A). A taxpayer that applies the percentage of 
completion method (and thus the look-back method) to income from a long-
term contract only for purposes of determining alternative minimum 
taxable income, and not regular taxable income, must apply the look-back 
method to the alternative minimum taxable income in the year of contract 
completion and other filing years whether or not the taxpayer was liable 
for the alternative minimum tax for the filing year or for any prior 
year. Interest is computed under the look-back method to the extent that 
the taxpayer's total tax liability (including the alternative minimum 
tax liability) would have differed if the percentage of completion 
method had been applied using actual, rather than estimated, contract 
price and contract costs.
    (5) Effective date. The look-back method, including the de minimis 
exception, applies to long-term contracts entered into after February 
28, 1986. With respect to activities that are subject to section 460 
solely because they benefit a long-term contract of a related party, the 
look-back method generally applies only if the related party's long-term 
contract was entered into after June 20, 1988, unless a principal 
purpose of the related-party arrangement is to avoid the requirements of 
section 460.
    (c) Operation of the look-back method--(1) Overview--(i) In general. 
The amount of interest charged or credited to a taxpayer under the look-
back method is computed in three steps. This paragraph (c) describes the 
three steps for applying the look-back method. These steps are 
illustrated by the examples in paragraph (h). The first step is to 
hypothetically reapply the percentage of completion method to all long-
term contracts that are completed or adjusted in the current year (the 
``filing year''), using the actual, rather than estimated, total 
contract price and contract costs. Based on this reapplication, the 
taxpayer determines the amount of taxable income (and alternative 
minimum taxable income) that would have been reported for each year 
prior to the filing year that is affected by contracts completed or 
adjusted in the filing year if the actual, rather than estimated, total 
contract price and costs had been used in applying the percentage of 
completion method to these contracts, and to any other contracts 
completed or adjusted in a year preceding the filing year. If the 
percentage of completion method only applies to alternative minimum 
taxable income for contracts completed or adjusted in the filing year, 
only alternative minimum taxable income is recomputed in the first step. 
The second

[[Page 197]]

step is to compare what the tax liability would have been under the 
percentage of completion method (as reapplied in the first step) for 
each tax year for which the tax liability is affected by income from 
contracts completed or adjusted in the filing year (a ``redetermination 
year'') with the most recent determination of tax liability for that 
year to produce a hypothetical underpayments or overpayment of tax. The 
third step is to apply the rate of interest on overpayments designated 
under section 6621 of the Code, compounded daily, to the hypothetical 
underpayment or overpayment of tax for each redetermination year to 
compute interest that runs, generally, from the due date (determined 
without regard to extensions) of the return for the redetermination year 
to the due date (determined without regard to extensions) of the return 
for the filing year. The net amount of interest computed under the third 
step is paid by or credited to the taxpayer for the filing year. 
Paragraph (d) provides a simplified marginal impact method that 
simplifies the second step--the computation of hypothetical 
underpayments or overpayments of tax liability for redetermination 
years--and, in some cases, the third step--the determination of the time 
period for computing interest.
    (ii) Post-completion revenue and expenses--(A) In general. The look-
back method is applied upon the completion of any long-term contract and 
(unless the taxpayer elects the delayed reapplication method of this 
section) is applied in any subsequent tax year for which there are taken 
into account any increases or decreases in either total contract price 
or total contract costs allocable to the contract under section 460(c) 
(``allocable contract costs'') to the extent those increases or 
decreases were not previously taken into account under the percentage of 
completion method. Any year in which the look-back method must be 
reapplied is treated as a filing year. See Example (3) of paragraph 
(h)(4) for an illustration of how the look-back method is applied to 
post-completion adjustments.
    (B) Completion. A contract is considered to be completed for 
purposes of the look-back method no later than the year in which final 
completion and acceptance within the meaning of Sec. 1.451-3(b)(2) have 
occurred. Accordingly, determination of the completion year for any 
long-term contract is based on an analysis of all the relevant facts and 
circumstances, including the manner in which the parties to the contract 
deal with each other and with the subject matter of the contract and the 
nature of any work or costs remaining to be performed or incurred on the 
contract. Therefore, the first application of the look-back method must 
occur no later than the tax year in which the subject matter of the 
contract has been delivered and is available for use by the customer, 
even if the taxpayer reasonably expects at that time to incur additional 
allocable contract costs.
    (C) Discounting of contract price and contract cost adjustments 
subsequent to completion; election not to discount--(1) General rule. 
The amount of any post-completion adjustment to the total contract price 
or contract costs is discounted, solely for purposes of applying the 
look-back method, from its value at the time the amount is taken into 
account in computing taxable income to its value at the completion of 
the contract. The discount rate for this purpose is the Federal mid-term 
rate under section 1274(d) in effect at the time the amount is properly 
taken into account. For purposes of applying the look-back method for 
the completion year, no amounts are discounted, even if they are 
received after the completion year.
    (2) Election not to discount. Notwithstanding the general 
requirement to discount post-completion adjustments, a taxpayer may 
elect not to discount contract price and contract cost adjustments with 
respect to any contract. The election not to discount is to be made on a 
contract-by-contract basis and is binding with respect to all post-
completion adjustments that arise with respect to a contract for which 
an election has been made. An election not to discount with respect to 
any contract is made by stating that an election is being made on the 
taxpayer's timely filed Federal income tax return (determined with 
regard to extensions) for the first tax year after completion in which 
the taxpayer

[[Page 198]]

takes into account (i.e., includes in income or deducts) any adjustment 
to the contract price or contract costs. See Sec. 5h.6.
    (3) Year-end discounting convention. In the absence of an election 
not to discount, any revisions to the contract price and contract costs 
must be discounted to their value as of the completion of the contract 
in reapplying the look-back method. For this purpose, the period of 
discounting is the period between the completion date of the contract 
and the date that any adjustment is taken into account in computing 
taxable income. Although taxpayers may use the period between the months 
in which these two events actually occur, in many cases, these dates may 
not be readily identifiable. Therefore, for administrative convenience, 
taxpayers are permitted to use the period between the end of the tax 
years in which these events occur as the period of discounting provided 
that the convention is used consistently with respect to all post-
completion adjustments for all contracts of the taxpayer the adjustments 
to which are discounted. In that case, the taxpayer must use as the 
discount rate the Federal mid-term rate under section 1274(d) as of the 
end of the tax year in which any revision is taken into account in 
computing taxable income.
    (D) Revenue acceleration rule. Section 460(b)(1) imposes a special 
rule that requires a taxpayer to include in gross income, for the tax 
year immediately following the year of completion, any previously 
unreported portion of the total contract price (including amounts that 
the taxpayer expects to receive in the future) determined as of that 
year, even if the percentage of completion ratio is less than 100 
percent because the taxpayer expects to incur additional allocable 
contract costs in a later year. At the time any remaining portion of the 
contract price is includible in income under this rule, no offset 
against this income is permitted for estimated future contract costs. To 
achieve the requirement to report all remaining contract revenue without 
regard to additional estimated costs, a taxpayer must include only costs 
actually incurred through the end of the tax year in the denominator of 
the percentage of completion ratio in applying the percentage of 
completion method for any tax years after the year of completion. The 
look-back method also must be reapplied for the year immediately 
following the year of completion if any portion of the contract price is 
includible in income in that year by reason of section 460(b)(1). For 
purposes of reapplying the look-back method as a result of this 
inclusion in income, the taxpayer must only include in the denominator 
of the percentage of completion ratio the actual contract costs incurred 
as of the end of the year, even if the taxpayer reasonably expects to 
incur additional allocable contract costs. To the extent that costs are 
incurred in a subsequent tax year, the look-back method is reapplied in 
that year (or a later year if the delayed reapplication method is used), 
and the taxpayer is entitled to receive interest for the post-completion 
adjustment to contract costs. Because this reapplication occurs 
subsequent to the completion year, only the cumulative costs incurred as 
of the end of the reapplication year are includible in the denominator 
of the percentage of completion ratio.
    (2) Look-back Step One--(i) Hypothetical reallocation of income 
among prior tax years. For each filing year, a taxpayer must allocate 
total contract income among prior tax years, by hypothetically applying 
the percentage of completion method to all contracts that are completed 
or adjusted in the filing year using the rules of this paragraph (c)(2). 
The taxpayer must reallocate income from those contracts among all years 
preceding the filing year that are affected by those contracts using the 
total contract price and contract costs, as determined as of the end of 
the filing year (``actual contract price and costs''), rather than the 
estimated contract price and contract costs. The taxpayer then must 
determine the amount of taxable income and the amount of alternative 
minimum taxable income that would have been reported for each affected 
tax year preceding the filing year if the percentage of completion 
method had

[[Page 199]]

been applied on the basis of actual contract price and contract costs in 
reporting income from all contracts completed or adjusted in the filing 
year and in any preceding year. If the percentage of completion method 
only applies to alternative minimum taxable income from the contract, 
only alternative minimum taxable income is recomputed in the first step. 
For purposes of reallocating income (and costs if the 10-percent year 
changes for a taxpayer using the 10-percent method of section 460(b)(5)) 
under the look-back method, the method of computing the percentage of 
completion ratio is the same method used to report income from the 
contract on the taxpayer's return. (Thus, an election to use the 10-
percent method or the simplified cost-to-cost method is taken into 
account). See Example (1) of paragraph (h)(2) for an illustration of 
Step One.
    (ii) Treatment of estimated future costs in year of completion. If a 
taxpayer reasonably expects to incur additional allocable contract costs 
in a tax year subsequent to the year in which the contract is completed, 
the taxpayer includes the actual costs incurred as of the end of the 
completion year plus the additional allocable contract costs that are 
reasonably expected to be incurred (to the extent includible under the 
taxpayer's percentage of completion method) in the denominator of the 
percentage of completion ratio. The completion year is the only filing 
year for which the taxpayer may include additional estimated costs in 
the denominator of the percentage of completion ratio in applying the 
look-back method. If the look-back method is reapplied in any year after 
the completion year, only the cumulative costs incurred as of the end of 
the year of reapplication are includible in the denominator of the 
percentage of completion ratio in reapplying the look-back method.
    (iii) Interim reestimates not considered. The look-back method 
cannot be applied to a contract before it is completed. Accordingly, for 
purposes of applying Step One, the actual total contract price and 
contract costs are substituted for the previous estimates of total 
contract price and contract costs only with respect to contracts that 
have been completed in the filing year and in a tax year preceding the 
filing year. No adjustments are made under Step One for contracts that 
have not been completed prior to the end of the current filing year, 
even if, as of the end of this year, the estimated total contract price 
or contract costs for these uncompleted contracts is different from the 
estimated amount that was used during any tax year for which taxable 
income is recomputed with respect to completed contracts under the look-
back method for the current filing year.
    (iv) Tax years in which income is affected. In general, because 
income under the percentage of completion method is generally reported 
as costs are incurred, the taxable income and alternative minimum 
taxable income are recomputed only for each year in which allocable 
contract costs were incurred. However, there will be exceptions to this 
general rule. For example, a taxpayer may be required to cumulatively 
adjust the income from a contract in a year in which no allocable 
contract costs are incurred if the estimated total contract price or 
contract costs was revised in that year. However, in applying the look-
back method, no contract income is allocated to that year. Thus, there 
may be a difference between the amount of contract income originally 
reported for that year and the amount of contract income as reallocated. 
Similarly, because of the revenue acceleration rule of section 
460(b)(1), income may be reported in the year immediately following the 
completion year even though no costs were incurred during that year and, 
in applying the look-back method in that year or another year, if 
additional costs are incurred or the contract price is adjusted in a 
later year, no income is allocated to the year immediately following the 
completion year.
    (v) Costs incurred prior to contract execution; 10-percent method--
(A) General rule. There are two situations in which allocable contract 
costs may be incurred without causing contract income to be reported 
under the percentage of completion method. First, allocable contract 
costs that are incurred in tax years prior to the tax year the

[[Page 200]]

contract is entered into are deductible in the tax year the contract is 
entered into, and no contract income is required to be reported in any 
of these prior tax years. The look-back method does not require 
allocation of contract income to tax years before the contract was 
entered into. Costs incurred prior to the year a contract is entered 
into are similarly first taken into account in the numerator of the 
percentage of completion ratio in the year the contract is entered into. 
Second, under the elective 10-percent method of section 460(b)(5), a 
taxpayer takes no contract revenues or contract costs into account until 
the tax year as of the close of which at least 10 percent of the total 
estimated contract costs are incurred (the 10-percent year). Instead, 
contract costs incurred in a tax year preceding the 10-percent year are 
deferred until the 10-percent year, at which time they are included in 
the numerator of the percentage of completion ratio and deducted from 
gross income. A taxpayer using the 10-percent method must also use the 
10-percent method in applying the look-back method, using actual total 
contract costs to determine the 10-percent year. Thus, contract income 
is never reallocated to a year before the 10-percent year as determined 
on the basis of actual contract costs. If the 10-percent year is earlier 
as a result of applying Step One of the look-back method, contract costs 
incurred up to and including the new 10-percent year (as determined 
based on actual contract costs), are reallocated from the original 10-
percent year to the new 10-percent, and costs incurred in later years 
but before the old 10-percent year are reallocated to those years. If 
the 10-percent year is later as a result of applying Step One of the 
look-back method, contract costs incurred up to and including the new 
10-percent year are reallocated from all prior years to the new 10-
percent year. This is the only case in which costs are reallocated under 
the look-back method.
    (B) Example. The application of the look-back method by a taxpayer 
using the 10-percent method is illustrated by the following example:

    Example.  Z elected to use the 10-percent method of section 
460(b)(5) for reporting income under the percentage of completion 
method. Z entered into a contract in 1990 for a fixed price of $1,000x. 
During 1990, Z incurred allocable contract costs of $80x and estimated 
that it would incur a total of $900x for the entire contract. Since $80x 
is less than 10 percent of total estimated contract costs, Z reported no 
revenue from the contract in 1990 and deferred the $80x of costs 
incurred. In 1991, Z incurred an additional $620x of contract costs, and 
completed the contract. Accordingly, in its 1991 return, Z reported the 
entire contract price of $l,000x, and deducted the $620x of costs 
incurred in 1991 and the $80x of costs incurred in 1990.
    Under section 460(b)(5), the 10-percent method applies both for 
reporting contract income and the look-back method. Under the look-back 
method, since the costs incurred in 1990 ($80x) exceed 10 percent of the 
actual total contract costs ($700x), Z is required to allocate $114x of 
contract revenue ($80x/$700x x $1,000x) and the $80x of costs incurred 
to 1990. Thus, application of the 1ook-back method results in a net 
increase in taxable income for 1990 of $34x, solely for purposes of the 
look-back method.

    (vi) Amount treated as contract price--(A) General rule. The amount 
that is treated as total contract price for purposes of applying the 
percentage of completion method and reapplying the percentage of 
completion method under the look-back method under Step One includes all 
amounts that the taxpayer expects to receive from the customer. Thus, 
amounts are treated as part of the contract price as soon as it is 
reasonably estimated that they will be received, even if the all-events 
test has not yet been met.
    (B) Contingencies. Any amounts related to contingent rights or 
obligations, such as incentive fees or amounts in dispute, are not 
separated from the contract and accounted for under a non-long-term 
contract method of accounting, notwithstanding any provision in 
Sec. 1.451-3(b)(2) (ii), (iii), (iv), and Sec. 1.451-3(d) (2), (3), and 
(4), to the contrary. Instead, those amounts are treated as part of the 
total contract price in applying the percentage of completion method and 
the look-back method. For example, if an incentive fee under a contract 
to manufacture a satellite is payable to the taxpayer after a specified 
period of successful performance, the incentive fee is includible in the 
total contract price at the time and to the extent that it can 
reasonably be predicted that the performance objectives will be met, for

[[Page 201]]

purposes of both the percentage of completion method and the look-back 
method. Similarly, a portion of the contract price that is in dispute is 
included in the total contract price at the time and to the extent that 
the taxpayer can reasonably expect the dispute will be resolved in the 
taxpayer's favor (without regard to when the taxpayer receives payment 
for the amount in dispute or when the dispute is finally resolved).
    (C) Change orders. In applying the look-back method, a change order 
with respect to a contract is not treated as a separate contract unless 
the change order would be treated as a separate contract under the rules 
for severing and aggregating contracts provided in Sec. 1.451-3(e). 
Thus, if a change order is not treated as a separate contract, the 
contract price and contract costs attributable to the change order must 
be taken into account in allocating contract income to all tax years 
affected by the underlying contract.
    (3) Look-back Step Two: Computation of hypothetical overpayment or 
underpayment of tax--(i) In general. Step Two involves the computation 
of a hypothetical overpayment or underpayment of tax for each year in 
which the tax liability is affected by income from contracts that are 
completed or adjusted in the filing year (a ``redetermination year''). 
The application of Step Two depends on whether the taxpayer uses the 
simplified marginal impact method contained in paragraph (d) or the 
actual method described in this paragraph (c)(3). The remainder of this 
paragraph (c)(3) does not apply if a taxpayer uses the simplified 
marginal impact method.
    (ii) Redetermination of tax liability. Under the method described in 
this paragraph (c)(3) (the ``actual method''), a taxpayer, first, must 
determine what its regular and alternative minimum tax liability would 
have been for each redetermination year if the amounts of contract 
income allocated in Step One for all contracts completed or adjusted in 
the filing year and in any prior year were substituted for the amounts 
of contract income reported under the percentage of completion method on 
the taxpayer's original return (or as subsequently adjusted on 
examination, or by amended return). See Example (2) of paragraph (h)(3) 
for an illustration of Step Two.
    (iii) Hypothetical underpayment or overpayment. After redetermining 
the income tax liability for each tax year affected by the reallocation 
of contract income, the taxpayer then determines the amount, if any, of 
the hypothetical underpayment or overpayment of tax for each of these 
redetermination years. The hypothetical underpayment or overpayment for 
each affected year is the difference between the tax liability as 
redetermined under the look-back method for that year and the amount of 
tax liability determined as of the latest of the following:
    (A) The original return date;
    (B) The date of a subsequently amended or adjusted return (if, 
however, the amended return is due to a carryback described in section 
6611(f), see paragraph (c)(4)(iii)); or,
    (C) The last previous application of the look-back method (in which 
case, the previous hypothetical tax liability is used).
    (iv) Cumulative determination of tax liability. The redetermination 
of tax liability resulting from previous applications of the look-back 
method is cumulative. Thus, for example, in computing the amount of a 
hypothetical overpayment or underpayment of tax for a redetermination 
year, the current hypothetical tax liability is compared to the 
hypothetical tax liability for that year determined as of the last 
previous application of the look-back method.
    (v) Years affected by look-back only. A redetermination of income 
tax liability under Step Two is required for every tax year for which 
the tax liability would have been affected by a change in the amount of 
income or loss for any other year for which a redetermination is 
required. For example, if the allocation of contract income under Step 
One changed the amount of a net operating loss that was carried back to 
a year preceding the year the taxpayer entered into the contract, the 
tax liability for the earlier year must be redetermined.
    (vi) Definition of tax liability. For purposes of Step Two, the 
income tax liability must be redetermined by taking into account all 
applicable additions to

[[Page 202]]

tax, credits, and net operating loss carrybacks and carryovers. Thus, 
the tax, if any, imposed under section 55 (relating to alternative 
minimum tax) must be taken into account. For example, if the taxpayer 
did not pay alternative minimum tax, but would have paid alternative 
minimum tax for that year if actual rather than estimated contract price 
and costs had been used in determining contract income for the year, the 
amount of any hypothetical overpayment or underpayment of tax must be 
determined by comparing the hypothetical total tax liability (including 
hypothetical alternative minimum tax liability) with the actual tax 
liability for that year. The effect of taking these items into account 
in applying the look-back method is illustrated in Examples (4) through 
(7) of paragraphs (h)(5) through (h)(8) below.
    (4) Look-back Step Three: Calculation of interest on underpayment or 
overpayment--(i) In general. After determining a hypothetical 
underpayment or overpayment of tax for each redetermination year, the 
taxpayer must determine the interest charged or credited on each of 
these amounts. Interest on the amount determined under Step Two is 
determined by applying the overpayment rate designated under section 
6621, compounded daily. In general, the time period over which interest 
is charged on hypothetical underpayments or credited on hypothetical 
overpayments begins at the due date (not including extensions) of the 
return for the redetermination year for which the hypothetical 
underpayment or overpayment determined in Step Two is computed. This 
time period generally ends on the earlier of:
    (A) The due date (not including extensions) of the return for the 
filing year, and
    (B) The date both
    (1) The income tax return for the filing year is filed, and
    (2) The tax for that year has been paid in full. If a taxpayer uses 
the simplified marginal impact method contained in paragraph (d), the 
remainder of this paragraph (c)(4) does not apply.
    (ii) Changes in the amount of a loss or credit carryback or 
carryover. The time period for determining interest may be different in 
cases involving loss or credit carrybacks or carryovers in order to 
properly reflect the time period during which the taxpayer (in the case 
of an underpayment) or the Government (in the case of an overpayment) 
had the use of the amount determined to be a hypothetical underpayment 
or overpayment. Thus, if a reallocation of contract income under Step 
One results in an increase or decrease to a net operating loss carryback 
(but not a carryforward), the interest due or to be refunded must be 
computed on the increase or decrease in tax attributable to the change 
to the carryback only from the due date (not including extensions) of 
the return for the redetermination year that generated the carryback and 
not from the due date of the return for the redetermination year in 
which the carryback was absorbed. In the case of a change in the amount 
of a carryover as a result of applying the lookback method, interest is 
computed from the due date of the return for the year in which the 
carryover was absorbed. See Examples (8) and (9) of paragraph (h)(9) for 
an illustration of these rules.
    (iii) Changes in the amount of tax liability that generated a 
subsequent refund. If the amount of tax liability for a redetermination 
year (as reported on the taxpayer's original return, as subsequently 
adjusted on examination, as adjusted by amended return, or as 
redetermined by the last previous application of the look-back method) 
is decreased by the application of the look-back method, and any portion 
of the redetermination year tax liability was absorbed by a loss or 
credit carryback arising in a year subsequent to the redetermination 
year, the look-back method applies as follows to properly reflect the 
time period of the use of the tax overpayment. To the extent the amount 
of tax absorbed because of the carryback exceeds the total hypothetical 
tax liability for the year (as redetermined under the look-back method) 
the taxpayer is entitled to receive interest only until the due date 
(not including extensions) of the return for the year in which the 
carryback arose.

    Example.  Upon the completion of a long-term contract in 1990, the 
taxpayer redetermines its tax liability for 1988 under the

[[Page 203]]

look-back method. This redetermination results in a hypothetical 
reduction of tax liability from $1,500x (actual liability originally 
reported) to $1,200x (hypothetical liability). In addition, the taxpayer 
had already received a refund of some or all of the actual 1988 tax by 
carrying back a net operating loss (NOL) that arose in 1989. The time 
period over which interest would be computed on the hypothetical 
overpayment of $300x for 1988 would depend on the amount of the refund 
generated by the carryback, as illustrated by the following three 
alternative situations:
    (A) If the amount refunded because of the NOL is $1,500x: interest 
is credited to the taxpayer on the entire hypothetical overpayment of 
$300x from the due date of the 1988 return, when the hypothetical 
overpayment occurred, until the due date of the 1989 return, when the 
taxpayer received a refund for the entire amount of the 1988 tax, 
including the hypothetical overpayment.
    (B) If the amount refunded because of the NOL is $1,000x: interest 
is credited to the taxpayer on the entire amount of the hypothetical 
overpayment of $300x from the due date of the 1988 return, when the 
hypothetical overpayment occurred, until the due date of the 1990 
return. In this situation interest is credited until the due date of the 
return for the completion year of the contract, rather than the due date 
of the return for the year in which the carryback arose, because the 
amount refunded was less than the redetermined tax liability. Therefore, 
no portion of the hypothetical overpayment is treated as having been 
refunded to the taxpayer before the filing year.
    (C) If the amount refunded because of the NOL is $1,300x-: interest 
is credited to the taxpayer on $100x ($1,300x-$1,200x) from the due date 
of the 1988 return until the due date of the 1989 return because only 
this portion of the total hypothetical overpayment is treated as having 
been refunded to the taxpayer before the filing year. However, the 
taxpayer did not receive a refund for the remaining $200x of the 
overpayment at that time and, therefore, is credited with interest on 
$200x through the due date of the tax return for 1990, the filing year. 
See Examples (10) and (11) of paragraph (h)(9) for a further 
illustration of this rule.

    (iv) Additional interest due on interest only after tax liability 
due. For each filing year, taxpayers are required to file a Form 8697 
(Interest Computation Under the Look-back Method for Completed Long-term 
Contracts) at the time the return for that filing year is filed to 
report the interest due or to be refunded under the look-back method. 
Even if the taxpayer has received an extension to file its income tax 
return for the filing year, look-back interest is computed with respect 
to the hypothetical increase (or decrease) in the tax liability 
determined under the look-back method only until the initial due date of 
that return (without regard to the extension). Interest is charged, 
unless the taxpayer otherwise has a refund that fully offsets the amount 
of interest due, (or credited) with respect to the amount of look-back 
interest due (or to be refunded) under the look-back method from the 
initial due date of the return through the date the return is filed. No 
interest is charged (or credited) after the due date of the return with 
respect to the amount of the hypothetical increases (or decreases) in 
tax liability determined under the look-back method.
    (d) Simplified marginal impact method--(1) Introduction. This 
paragraph (d) provides a simplified method for calculating look-back 
interest. Any taxpayer may elect this simplified marginal impact method, 
except that pass-through entities described in paragraph (d)(4) of this 
section are required to apply the simplified marginal impact method at 
the entity level with respect to domestic contracts and the owners of 
those entities do not apply the look-back method to those contracts. 
Under the simplified marginal impact method, a taxpayer calculates the 
hypothetical underpayments or overpayments of tax for a prior year based 
on an assumed marginal tax rate. A taxpayer electing to use the 
simplified marginal impact method must use the method for each long-term 
contract for which it reports income (except with respect to domestic 
contracts if the taxpayer is an owner in a widely held pass-through 
entity that is required to use the simplified marginal impact method at 
the entity level for those contracts).
    (2) Operation--(i) In general. Under the simplified marginal impact 
method, income from those contracts that are completed or adjusted in 
the filing year is first reallocated in accordance with the procedures 
of Step One contained in paragraph (c)(2) of this section. Step Two is 
modified in the following manner. The hypothetical underpayment or 
overpayment of tax for

[[Page 204]]

each year of the contract (a ``redetermination year'') is determined by 
multiplying the applicable regular tax rate (as defined in paragraph 
(d)(2)(iii)) by the increase or decrease in regular taxable income (or, 
if it produces a greater amount, by multiplying the applicable 
alternative minimum tax rate by the increase or decrease in alternative 
minimum taxable income, whether or not the taxpayer would have been 
subject to the alternative minimum tax) that results from reallocating 
income to the tax year under Step One. Generally, the product of the 
alternative minimum tax rate and the increase or decrease in alternative 
minimum taxable income will be the greater of the two amounts described 
in the preceding sentence only with respect to contracts for which a 
taxpayer uses the full percentage of completion method only for 
alternative minimum tax purposes and uses the completed contract method, 
or the percentage of completion-capitalized cost method, for regular tax 
purposes. Step Three is then applied. Interest is credited to the 
taxpayer on the net overpayment and is charged to the taxpayer on the 
net underpayment for each redetermination year from the due date 
(determined without regard to extensions) of the return for the 
redetermination year until the earlier of
    (A) The due date (determined without regard to extensions) of the 
return for the filing year, and
    (B) The first date by which both the return is filed and the tax is 
fully paid.
    (ii) Applicable tax rate. For purposes of determining hypothetical 
underpayments or overpayments of tax under the simplified marginal 
impact method, the applicable regular tax rate is the highest rate of 
tax in effect for the redetermination year under section 1 in the case 
of an individual and under section 11 in the case of a corporation. The 
applicable alternative minimum tax rate is the rate of tax in effect for 
the taxpayer under section 55(b)(1). The highest rate is determined 
without regard to the taxpayer's actual rate bracket and without regard 
to any additional surtax imposed for the purpose of phasing out multiple 
tax brackets or exemptions.
    (iii) Overpayment ceiling. The net hypothetical overpayment of tax 
for any redetermination year is limited to the taxpayer's total federal 
income tax liability for the redetermination year reduced by the 
cumulative amount of net hypothetical overpayments of tax for that 
redetermination year resulting from earlier applications of the look-
back method. If the reallocation of contract income results in a net 
overpayment of tax and this amount exceeds the actual tax liability (as 
of the filing year) for the redetermination year, as adjusted for past 
applications of the look-back method and taking into account net 
operating loss, capital loss, or credit carryovers and carrybacks to 
that year, the actual tax so adjusted is treated as the overpayment for 
the redetermination year. This overpayment ceiling does not apply when 
the simplified marginal impact method is applied at the entity level by 
a widely held pass-through entity in accordance with paragraph (d)(4) of 
this section.
    (iv) Example. The application of the simplified marginal impact 
method is illustrated by the following example:

    Example.  Corporation X, a calendar-year taxpayer, reports income 
from long-term contracts and elected the simplified marginal impact 
method when it filed its income tax return for 1989. X uses only the 
percentage of completion method for both regular taxable income and 
alternative minimum taxable income. X completed contracts A, B, and C in 
1989 and, therefore, was required to apply the look-back method in 1989. 
Income was actually reported for these contracts in 1987, 1988, and 
1989. X's applicable tax rate, as determined under section 11, for the 
redetermination years 1987 and 1988 was 40 percent and 34 percent, 
respectively. The amount of contract income originally reported and 
reallocated for contracts A, B, and C, and the net overpayments and 
underpayments for the redetermination years are as follows:

------------------------------------------------------------------------
                                                     1987        1988   
------------------------------------------------------------------------
Contract A:                                                             
  Originally reported...........................    $5,000x     $4,000x 
  Reallocated...................................     3,000x      5,000x 
  Increase/(Decrease)...........................    (2,000x)     1,000x 
Contract B:                                                             
  Originally reported...........................     6,000x      2,000x 
  Reallocated...................................     7,000x      1,500x 
  Increase/(Decrease)...........................     1,000x       (500x)
Contract C:                                                             
  Originally reported...........................     8,000x      5,000x 
  Reallocated...................................     4,000x      7,000x 
  Increase/(Decrease)...........................    (4,000x)     2,000x 
Net Increase/(Decrease).........................    (5,000x)     2,500x 

[[Page 205]]

                                                                        
Tentative (Underpayment)/Overpayment:                                   
    @ .40.......................................     2,000x   ..........
    @ .34.......................................  ..........      (850x)
Ceiling:                                                                
  Actual Tax Liability (After Carryovers and                            
   Carrybacks)..................................     1,500x        500x 
Final (Underpayment)/Overpayment................     1,500x       (850x)
------------------------------------------------------------------------

    Under the simplified marginal impact method, X determined a 
tentative hypothetical net overpayment for 1987 and a net underpayment 
for 1988. X determined these amounts by first aggregating the difference 
for contracts A, B, and C between the amount of contract price 
originally reported and the amount of contract price as reallocated and, 
then, applying the highest regular tax rate to the aggregate decrease in 
income for 1987 and the aggregate increase in income for 1988.
    However, X's overpayment for 1987 is subject to a ceiling based on 
X's total tax liability. Because the tentative net overpayment of tax 
for 1987 exceeds the actual tax liability for that year after taking 
into account carryovers and carrybacks to that year, the final 
overpayment under the simplified marginal impact method is the amount of 
tax liability paid instead of the tentative net overpayment. Since 
application of the look-back method for 1988 results in a tentative 
underpayment of tax, it is not subject to a ceiling. If the look-back 
method is applied in 1991, the ceiling amount for 1987 will be zero and 
the ceiling amount for 1988 will be $1,350.
    X is entitled to receive interest on the hypothetical overpayment 
from March 15, 1988, to March 15, 1990. X is required to pay interest on 
the underpayment from March 15, 1989, to March 15, 1990.

    (3) Anti-abuse rule. If the simplified marginal impact method is 
used with respect to any long-term contract (including a contract of a 
widely held pass-through entity), the district director may recompute 
interest for the contract (including domestic contracts of widely held 
pass-through entities) under the look-back method using the actual 
method (and without regard to the simplified marginal impact method). 
The district director may make such a recomputation only if the amount 
of income originally reported with respect to the contract for any 
redetermination year exceeds the amount of income reallocated under the 
look-back method with respect to that contract for that year (using 
actual contract price and contract costs) by the lesser of $1,000,000 or 
20 percent of the amount of income as reallocated (i.e., based on actual 
contract price and contract costs) under the look-back method with 
respect to that contract for that year. In determining whether to 
exercise this authority upon examination of the Form 8697, the district 
director may take into account whether the taxpayer overreported income 
for a purpose of receiving interest under the look-back method on a 
hypothetical overpayment determined at the applicable tax rate. The 
district director also may take into account whether the taxpayer 
underreported income for the year in question with respect to other 
contracts. Notwithstanding the look-back method, the district director 
may require an adjustment to the tax liability for any open tax year if 
the taxpayer did not apply the percentage of completion method properly 
on its original return.
    (4) Application--(i) Required use by certain pass-through entities--
(A) General rule. The simplified marginal impact method is required to 
be used with respect to income reported from domestic contracts by a 
pass-through entity that is either a partnership, an S corporation, or a 
trust, and that is not closely held. With respect to contracts described 
in the preceding sentence, the simplified marginal impact method is 
applied by the pass-through entity at the entity level. For determining 
the amount of any hypothetical underpayment or overpayment, the 
applicable regular and alternative minimum tax rates, respectively, are 
generally the highest rates of tax in effect for corporations under 
section 11 and section 55 (b)(1). However, the applicable regular and 
alternative minimum tax rates are the highest rates of tax imposed on 
individuals under section 1 and section 55 (b)(1) if, at all times 
during the redetermination year involved (i.e., the year in which the 
hypothetical increase or decrease in income arises), more than 50 
percent of the interests in the entity were held by individuals directly 
or through 1 or more pass-through entities.
    (B) Closely held. A pass-through entity is closely held if, at any 
time during any redetermination year, 50 percent of more (by value) of 
the beneficial interests in that entity are held

[[Page 206]]

(directly or indirectly) by or for 5 or fewer persons. For this purpose, 
the term ``person'' has the same meaning as in section 7701(a)(1), 
except that a pass-through entity is not treated as a person. In 
addition, the constructive ownership rules of section 1563(e) apply by 
substituting the term ``beneficial interest'' for the term ``stock'' and 
by substituting the term ``pass-through entity'' for the term, 
``corporation'' used in that section, as appropriate, for purposes of 
determining whether a beneficial interest in a pass-through entity is 
indirectly owned by any person.
    (C) Examples. The following examples illustrate the application of 
the rules of paragraph (d)(4)(i):

    Example (1). P, a partnership, began a long-term contract on March 
1, 1986, and completed this contract in its tax year ending December 31, 
1989. P used the percentage of completion method for all contract 
income. Substantially all of the income from the contract arose from 
U.S. sources. At all times during all of the years for which income was 
required to be reported under the contract, exactly 25 percent of the 
value of P's interests was owned by Corporation M. The remaining 75 
percent of the value of P's interests was owned in equal shares by 15 
unrelated individuals, who are also unrelated to Corporation M. M's 
ownership of P represents less than 50 percent of the value of the 
beneficial interests in P, and, therefore, viewed alone, is insufficient 
to make P a closely held partnership. In addition, because no 4 of the 
individual owners together own 25 percent or more of the remaining value 
of P's beneficial interests, there is no group of 5 owners that together 
own, directly or indirectly, 50 percent or more by value of the 
beneficial interests in P. Therefore, P is not closely held pass-through 
entity.
    Because P is not a closely held pass-through entity, and because P 
completed the contract after the effective date of section 460(b)(4), P 
is required to use the simplified marginal impact method. Any interest 
computed under the look-back method will be paid to, or collected from, 
P, rather than its partners, and must be reported to each of the 
partners on Form 1065 as interest income or expense. Further, assume 
that, for the redetermination years, Corporation M is subject to 
alternative minimum tax at the rate of 20 percent and 3 of the 
individuals who own interests in P are subject to the highest marginal 
tax rate of 33 percent in 1988. Regardless of the actual marginal tax 
rates of its partners, P is required to determine the underpayment or 
overpayment of tax for each redetermination year at the entity level by 
applying a single rate to the increase or decrease in income resulting 
from the reallocation of contract income under the look-back method. 
Because more than 50 percent of the interests in P are held by 
individuals, P must use the highest rate specified in section 1 for each 
redetermination year. Thus, the rate applied by P is 50 percent for 
1986, 38.5 percent for 1987, and 28 percent for 1988.
    Example (2). Assume the same facts as in Example (1), except that 
one of the individuals, Individual I, who directly owns 5 percent of the 
value of the interests of P, also owns 100 percent of the stock of 
Corporation M. Section 1563(e)(4) of the Code provides that stock owned 
directly or indirectly by or for a corporation is considered to be owned 
by any person who owns 5 percent or more in value of its stock in that 
proportion which the value of the stock which that person so owns bears 
to the value of all the stock in that corporation. Because section 
460(b)(4)(C)(iii) and this paragraph (d)(4) provide that rules similar 
to the constructive ownership rules of section 1563(e) apply in 
determining whether a pass-through entity is closely held, all of M's 
interest in P is attributed to I because I owns 100 percent of the value 
of the stock in M. Accordingly, because I's direct 5 percent and 
constructive 25 percent ownership of P, plus the interests owned by any 
4 other individual partners, equals 50 percent or more of the value of 
the beneficial interests of P, P is a closely held pass-through entity 
within the meaning of section 460(b)(4)(C)(iii). Therefore, P cannot use 
the simplified marginal impact method at the entity level. Accordingly, 
each of the partners of P must separately apply the look-back method to 
their respective interests in the income and expenses attributable to 
the contract, but each partner may elect to use the simplified marginal 
impact method with respect to the partner's share of income from the 
contract.

    (D) Domestic contracts--(1) General rule. A domestic contract is any 
contract substantially all of the income of which is from sources in the 
United States. For this purpose, ``substantially all'' of the income 
from a long-term contract is considered to be from United States sources 
if 95 percent or more of the gross income from the contract is from 
sources within the United States as determined under the rules in 
sections 861 through 865.
    (2) Portion of contract income sourced. In determining whether 
substantially all of the gross income from a long-term contract is from 
United States sources, taxpayers must apply the allocation and 
apportionment principles of sections 861 through 865 only to the portion 
of the contract accounted for

[[Page 207]]

under the percentage of completion method. Under the percentage of 
completion method, gross income from a long-term contract includes all 
payments to be received under the contract (i.e., any amounts treated as 
contract price). Similarly, all costs taken into account in the 
computation of taxable income under the percentage of completion method 
are deducted from gross income rather than added to a cost of goods sold 
account that reduces gross income. Therefore, allocable contract costs 
are not considered in determining whether a long-term contract is a 
domestic contract or a foreign contract, even if, under the taxpayer's 
facts, the allocation of contract costs to any portion of a contract not 
accounted for under the percentage of completion method would affect the 
relative percentages of United States and foreign source gross income 
from the entire contract if this portion of the contract were taken into 
account in applying the 95-percent test.
    (E) Application to foreign contracts. If a widely held pass-through 
entity has some foreign contracts and some domestic contracts, the 
owners of the pass-through entity each apply the look-back method 
(using, if they elect, the simplified marginal impact method) to their 
respective share of the income and expense from foreign contracts. 
Moreover, in applying the look-back method to foreign contracts at the 
owner level, the owners do not take into account their share of 
increases or decreases in contract income resulting from the application 
of the simplified marginal impact method with respect to domestic 
contracts at the entity level.
    (F) Effective date. The simplified marginal impact method must be 
applied to pass-through entities described in paragraph (d)(4)(i) of 
this section with respect to domestic contracts completed or adjusted in 
tax years for which the due date of the return (determined with regard 
to extensions) of the pass-through entity is after November 9, 1988.
    (ii) Elective use--(A) General rule. As provided in paragraph 
(d)(4)(i) of this section, the simplified marginal impact method must be 
used by certain pass-through entities with respect to domestic 
contracts. C corporations, individuals, and owners of closely held pass-
through entities may elect the simplified marginal impact method. Owners 
of other pass-through entities may also elect the simplified marginal 
impact method with respect to all contracts other than those for which 
the simplified marginal impact method is required to be applied at the 
entity level. This rule applies to foreign contracts of widely held 
pass-through entities. In the case of an electing owner in a pass-
through entity, the simplified marginal impact method is applied at the 
owner level, instead of at the entity level, with respect to the owner's 
share of the long-term contract income and expense reported by the pass-
through entity.
    (B) Election requirements. A taxpayer elects the simplified marginal 
impact method by stating that the election is being made on a timely 
filed income tax return (determined with regard to extensions) for the 
first tax year the election is to apply. An election to use the 
simplified marginal impact method applies to all applications of the 
look-back method to all eligible long-term contracts for the tax year 
for which the election is made and for any subsequent tax year. The 
election may not be revoked without the consent of the Commissioner.
    (C) Consolidated group consistency rule. In the case of a 
consolidated group of corporations within the meaning of section 
1504(a), an election to use the simplified marginal impact method is 
made by the common parent of the group. The election is binding on all 
other affected members of the group (including members that join the 
group after the election is made with respect to all applications of the 
look-back method after joining). If a member subsequently leaves the 
group, the election remains binding as to that member unless the 
Commissioner consents to a revocation of the election. If a corporation 
using the simplified marginal impact method joins a group that does not 
use the method, the election is automatically revoked with respect to 
all applications of the look-back method after it joins the group.
    (e) Delayed reapplication method--(1) In general. For purposes of 
reapplying

[[Page 208]]

the look-back method after the year of contract completion, a taxpayer 
may elect the delayed reapplication method to minimize the number of 
required reapplications of the look-back method. Under this method, the 
look-back method is reapplied after the year of completion of a contract 
(or after a subsequent application of the look-back method) only when 
the first one of the following conditions is met with respect to the 
contract:
    (i) The net undiscounted value of increases or decreases in the 
contract price occurring since the time of the last application of the 
look-back method exceeds the lesser of $1,000,000 or 10 percent of the 
total contract price as of that time,
    (ii) The net undiscounted value of increases or decreases in the 
contract costs occurring since the time of the last application of the 
look-back method exceeds the lesser of $1,000,000 or 10 percent of the 
total contract price as of that time,
    (iii) The taxpayer goes out of existence,
    (iv) The taxpayer reasonably believes the contract is finally 
settled and closed, or
    (v) Neither condition (e)(1) (i), (ii), (iii), nor (iv) above is met 
by the end of the fifth tax year that begins after the last previous 
application of the look-back method.
    (2) Time and manner of making election. An election to use the 
delayed reapplication method may be made for any filing year for which 
the due date of the return (determined with regard to extensions) is 
after June 12, 1990. The election is made by a statement to that effect 
on the taxpayer's timely filed Federal income tax return (determined 
with regard to extensions) for the first tax year the election is to be 
effective. An election to use the delayed reapplication method is 
binding with respect to all long-term contracts for which the look-back 
method would be reapplied without regard to the election in the year of 
election and any subsequent year unless the Commissioner consents to a 
revocation of the election. In the case of a consolidated group of 
corporations within the meaning of section 1504(a), an election to use 
the delayed reapplication method is made by the common parent of the 
group. The election is binding on all other affected members of the 
group (including members that join the group after the election is made 
with respect to contracts adjusted after joining). If a member 
subsequently leaves the group, the election remains binding as to that 
member unless the Commissioner consents to a revocation of the election. 
If a corporation that has made the election joins a consolidated group 
that has not made the election, the election is treated as revoked with 
respect to contracts adjusted after joining.
    (3) Examples. The operation of this delayed reapplication method is 
illustrated by the following examples:

    Example (1). X completes a contract in 1987, and applies the look-
back method when its return for 1987 is filed. X properly uses $600,000 
as the actual contract price in applying the look-back method. In 1990, 
as a result of the settlement of a dispute with its customer, X 
redetermines total contract price to be $640,000, and includes $40,000 
in gross income. On its return for 1990, X states it is electing the 
delayed reapplication method. X is not required to reapply the look-back 
method at that time, because $40,000 does not exceed the lesser of 
$1,000,000 or 10 percent of the unadjusted contract price of $600,000, 
and 5 years have not passed since the last application of the look-back 
method.
    Example (2). Assume the same facts as in Example (1), except that at 
the end of 1992, the fifth year after completion of the contract, no 
other adjustments to contract price or contract costs have occurred. X 
is required to reapply the look-back method in 1992 and, accordingly, 
redetermine its tax liability for each redetermination year. After 
redetermining the underpayment of tax for those years, X must compute 
the amount of interest charged on the underpayments. Although 1992 is 
the filing year, interest is due on the amount of each underpayment 
resulting from the adjustment only from the due date of the return for 
each redetermination year to the due date of the return for 1990 because 
the tax liability for the adjustment was fully paid in 1990. However, 
from the due of the 1990 return until the due date of the 1992 return, 
when the look-back method is reapplied for the adjustment, interest is 
due on the amount of interest attributable to the underpayments.

    (f) Look-back reporting--(1) Procedure. The amount of any interest 
due or to be refunded as a result of applying the look-back method is 
computed and reported on Form 8697 for any filing year.

[[Page 209]]

In general, the look-back method is applied by and Form 8697 is filed by 
the taxpayer that reports income from a long-term contract. See 
paragraph (g) of this section to determine who is responsible for 
applying the look-back method when, prior to the completion of a long-
term contract, there is a transaction that changes the taxpayer that 
reports income from the contract.
    (2) Treatment of interest on return--(i) General rule. The amount of 
interest required to be paid by a taxpayer is treated as an income tax 
under subtitle A, but only for purposes of subtitle F of the Code (other 
than sections 6654 and 6655), which addresses tax procedures and 
administration.

Thus, a taxpayer that fails to file Form 8697 with respect to interest 
required to be paid or that fails to pay the amount of interest due is 
subject to any applicable penalties under subtitle F, including, for 
example, a penalty for failing to file Form 8697. However, interest 
required to be paid under the look-back method is treated as interest 
expense for purposes of computing taxable income under subtitle A, even 
though it is treated as income tax liability for penalty purposes. 
Interest received under the look-back method is treated as taxable 
interest income for all purposes, and is not treated as a reduction in 
tax liability. The determination of whether or not interest computed 
under the look-back method is treated as tax is determined on a ``net'' 
basis for each filing year. Thus, if a taxpayer computes for the current 
filing year both hypothetical overpayments and hypothetical 
underpayments for prior years, the taxpayer has an increase in tax only 
if the interest computed on the underpayments for all those prior years 
exceeds the interest computed on the overpayments for all those prior 
years, for all contracts completed or adjusted for the year.
    (ii) Timing of look-back interest. For purposes of determining 
taxable income under subtitle A of the Code, any amount of interest 
refunded to the taxpayer under the look-back method is includible in 
gross income as interest income in the tax year it is properly taken 
into account under the taxpayer's method of accounting for interest 
income. Any amount of interest required to be paid is taken into account 
as interest expense arising from an underpayment of income tax in the 
tax year it is properly taken into account under the taxpayer's method 
of accounting for interest expense. Thus, look-back interest required to 
be paid by an individual, or by a pass-through entity on behalf of an 
individual owner (or beneficiary) under the simplified marginal impact 
method, is personal interest and, therefore, is disallowed in accordance 
with Sec. 1.163-9T(b)(2). Interest determined at the entity level under 
the simplified marginal impact method is allocated among the owners (or 
beneficiaries) for reporting purposes in the same manner that interest 
income and interest expense are allocated to owners (or beneficiaries) 
and subject to the requirements of section 704 and any other applicable 
rules.
    (g) Mid-contract change in taxpayer. [Reserved]
    (h) Examples--(1) Overview. This paragraph provides computational 
examples of the rules of this section. Except as otherwise noted, the 
examples involve calendar-year taxpayers and involve long-term contracts 
subject to section 460 that are accounted for using the percentage of 
completion method, rather than the percentage of completion-capitalized 
cost method. If the percentage of completion-capitalized cost method 
were used by a taxpayer described in the examples, the amounts of 
contract income and expenses shown in the examples would be reduced, for 
purposes of determining regular taxable income, to the appropriate 
fraction (40, 70, or 90 percent) of contract items accounted for under 
the percentage of completion method. Tens of thousands of dollars ($ 
00,000's) are omitted from the figures in the examples. The contracts 
described in the examples are assumed to be the taxpayers' only 
contracts that are subject to the look-back method of section 460. 
Except as otherwise stated, the examples assume that the taxpayer has no 
adjustments and preferences for purposes of section 55, so that 
alternative minimum taxable income is the same as taxable income, and no 
alternative minimum tax is imposed for the years involved. The examples 
assume that

[[Page 210]]

the taxpayer does not elect the 10-percent method, the simplified 
marginal impact method, or the delayed reapplication method.
    (2) Step One. The following example illustrates the application of 
paragraph (c)(2):

    Example (1). In 1989, W completes three long-term contracts, A, B, 
and C, entered into on January 1 of 1986, 1987, and 1988, respectively. 
For Contract A, W used the completed contract method of accounting. For 
Contract B, W used the percentage of completion-capitalized cost method 
of accounting, taking into account 60 percent of contract income under 
W's normal method of accounting, which was the completed contract 
method. For Contract C, W used the percentage of completion method of 
accounting. The total price for each contract was $1,000. In computing 
alternative minimum taxable income, W is required to use the percentage 
of completion method for Contracts B and C. W used regular tax costs for 
purposes of determining the degree of contract completion under the 
alternative minimum tax.
    Contract A is not taken into account for purposes of applying the 
look-back method, because it is subject to neither section 460 nor 
section 56(a)(3). Thus, even if W had used the percentage of completion 
method as permitted under Sec. 1.451-3, instead of the completed 
contract method, the look-back method would not be applicable because 
the Contract A was entered into before the effective date of section 
460.
    The actual costs allocated to Contracts B and C under section 460(c) 
and incurred in each year of the contract were as follows:

------------------------------------------------------------------------
                 Contract                    1987   1988   1989   Total 
------------------------------------------------------------------------
B.........................................   $200   $400   $200     $800
C.........................................    100    300    400      800
------------------------------------------------------------------------

    In applying the look-back method, the first step is to allocate the 
contract price among tax years preceding and including the completion 
year. That allocation would produce the following amounts of gross 
income for purposes of the regular tax. Note that no income from 
Contract C is allocated to 1987, the year before the contract was 
entered into, even though contract costs were incurred in 1987:

----------------------------------------------------------------------------------------------------------------
              Contract                           1987                              1988                    1989 
----------------------------------------------------------------------------------------------------------------
B..................................              $100                              $200                     $700
                                            (40%X$200/$800X$1000)          ((40%X$600/$800X$1000)-$100)  .......
C..................................                0                                500                      500
                                     ............................                     ($400/$800X$1000)  .......
----------------------------------------------------------------------------------------------------------------

    Because the percentage of completion-capitalized cost method may not 
be used for alternative minimum tax purposes, the allocation of contract 
income would produce the following amounts of gross income for purposes 
of computing alternative minimum taxable income:

----------------------------------------------------------------------------------------------------------------
                     Contract                               1987                       1988                1989 
----------------------------------------------------------------------------------------------------------------
B.................................................          $250                       $500                 $250
                                                       ($200/$800X$1000)       (($600/$800X$1000)-$250)  .......
C.................................................            0                        500                   500
----------------------------------------------------------------------------------------------------------------


    (3) Step Two. The following example illustrates the application of 
paragraph (c)(3):

    Example (2). (i) X enters into two long-term contracts (D and E) in 
1988. X determines its tax liability for 1988 as follows:
    e=estimate
    a=amount originally reported (actual)
    h=hypothetical

------------------------------------------------------------------------
                                               1988                     
                                     ------------------------    Total  
                                           D           E                
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................     8,000e      8,000e   ..........
Total contract price................    10,000e     10,000e   ..........
1988 completion %...................      37.5e         25e   ..........
1988 gross income...................     3,750a      2,500a   ..........
Less, 1988 costs....................    (3,000a)    (2,000a)  ..........
                                     -----------------------------------
      1988 net contract income......       750a        500a     $1,250a 

[[Page 211]]

                                                                        
Other 1988 net income (loss)........  ..........  ..........    (2,000a)
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      (750a)
                                     -----------------------------------
      Tax...........................  ..........  ..........         0a 
Refund from NOL carryback fully                                         
 absorbed in 1985, at 46%...........  ..........  ..........       345a 
------------------------------------------------------------------------

    (ii) X completes Contract D during 1989. X determines its taxable 
income for 1989 as follows:

------------------------------------------------------------------------
                                               1989                     
                                     ------------------------    Total  
                                           D           E                
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................     6,000a     $9,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1989 completion %...................       100a       22.2e   ..........
1989 gross income/(loss)............     6,250a      (278a)   ..........
Less, 1989 costs....................   (3,000a)          0a   ..........
                                     -----------------------------------
      1989 net contract income......     3,250a      (278a)      $2,972a
Other 1989 net income (loss)........  ..........  ..........          0a
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      2,972a
Tax at 34%..........................  ..........  ..........      1,011a
------------------------------------------------------------------------

    (iii) For purposes of the look-back method, X must reallocate the 
actual total contract D price between 1988 and 1989 based on the actual 
total contract D costs. This results in the following hypothetical 
underpayment of tax for 1988 for purposes of the look-back method. Note 
that X does not reallocate the contract E price in applying the look-
back method in 1989 because contract E has not been completed, even 
though X's estimate of contract E costs has changed. The following 
computation is only for purposes of applying the look-back method, and 
does not result in the assessment of a tax deficiency.

------------------------------------------------------------------------
                                               1988                     
                                     ------------------------    Total  
                                           D           E                
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................     6,000a      8,000e   ..........
Total contract price................    10,000a     10,000e   ..........
1988 completion %...................        50a         25e   ..........
1988 gross income...................     5,000h      2,500a   ..........
Less, 1988 costs....................    (3,000a)    (2,000a)  ..........
                                     -----------------------------------
      1988 net contract income......     2,000h        500a     $2,500h 
Other 1988 net income (loss)........  ..........  ..........    (2,000a)
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........       500h 
Tax at 34%..........................  ..........  ..........       170h 
Less, previously computed tax.......  ..........  ..........        -0a 
Underpayment of 1988 tax............  ..........  ..........       170h 
Underpayment of 1985 tax from NOL                                       
 carryback refund in 1988...........  ..........  ..........       345h 
                                     -----------------------------------
      Total underpayment of tax.....  ..........  ..........       515h 
------------------------------------------------------------------------

    For purposes of any subsequent application of the look-back method 
for which 1989 is a redetermination year, because the reallocation of 
contract income and redetermination of tax liability are cumulative, X 
will use for 1989 the amount of contract D income and the amount of tax 
liability that would have been reported in 1989 if X had used actual 
contract costs instead of the amounts that were originally reported 
using the estimate of $8,000. Assuming no subsequent revisions (due to, 
for example, adjustments to contract D price and costs determined after 
the end of 1989), this amount would be determined as follows:

------------------------------------------------------------------------
                                               1989                     
                                     ------------------------    Total  
                                           D           E                
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................     6,000a     $9,000e   ..........
Total contract price................    10,000a     10,000e   ..........

[[Page 212]]

                                                                        
1989 completion %...................       100a       22.2e   ..........
1989 gross income...................     5,000h       (278a)  ..........
Less, 1989 costs....................    (3,000a)         0a   ..........
                                     -----------------------------------
      1989 net contract income......     2,000h       (278a)     $1,722h
Other 1989 net income (loss)........  ..........  ..........          0a
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      1,722h
Tax at 34%..........................  ..........  ..........        585h
------------------------------------------------------------------------

    (iv) X completes contract E during 1990. X determines its taxable 
income for 1990 as follows:

------------------------------------------------------------------------
                                               1990                     
                                     ------------------------    Total  
                                           D           E                
------------------------------------------------------------------------
1990 contract costs.................  ..........    $7,000a   ..........
Total contract costs................  ..........     9,000a   ..........
Total contract price................  ..........    10,000a   ..........
1990 completion %...................  ..........       100a   ..........
1990 gross income...................  ..........     7,778a   ..........
Less, 1990 costs....................  ..........    (7,000a)  ..........
                                     -----------------------------------
      1990 net contract income......  ..........       778a        $778a
Other 1990 net income (loss)........  ..........  ..........          0a
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........        778a
Tax at 34%..........................  ..........  ..........        265a
------------------------------------------------------------------------

    (v) For purposes of the look-back method, X must reallocate the 
actual total contract E price between the 1988, 1989, and 1990, based on 
the actual total contract E costs.
    This results in the following hypothetical overpayment of tax for 
1988. Note that X uses the amount of income for contract D determined in 
the last previous application of the look-back method, and not the 
amount of income actually reported:

------------------------------------------------------------------------
                                               1988                     
                                     ------------------------    Total  
                                           D           E                
------------------------------------------------------------------------
1988 contract costs.................    $3,000a     $2,000a   ..........
Total contract costs................    $6,000a     $9,000a   ..........
Total contract price................   $10,000a    $10,000a   ..........
1988 completion (%).................        50a       22.2a   ..........
1988 gross income...................    $5,000h     $2,222h   ..........
Less, 1988 costs....................   ($3,000a)   ($2,000a)  ..........
                                     -----------------------------------
      1988 net contract income......    $2,000h       $222h     $2,222h 
Other 1988 net income (loss)........  ..........  ..........   ($2,000a)
                                     -----------------------------------
      Taxable income (NOL)..........  ..........  ..........      $222h 
                                     -----------------------------------
      Tax at 34%....................  ..........  ..........       $75h 
Less, previously computed tax (based                                    
 on most recent application of the                                      
 look-back method)..................  ..........  ..........      $170h 
                                     -----------------------------------
      Overpayment of 1988 tax.......  ..........  ..........      ($95h)
------------------------------------------------------------------------

    In applying the look-back method to 1989, X again uses the amounts 
substituted as of the last previous application of the look-back method 
with respect to contract D. Thus, X computes its hypothetical 
underpayment for 1989 as follows:

------------------------------------------------------------------------
                                               1989                     
                                     ------------------------    Total  
                                           D           E                
------------------------------------------------------------------------
1989 contract costs.................    $3,000a          0a   ..........
Total contract costs................    $6,000a     $9,000a   ..........
Total contract price................   $10,000a    $10,000a   ..........
1989 completion (%).................       100a       22.2a   ..........
1989 gross income...................    $5,000h         $0h   ..........
Less, 1989 costs....................   ($3,000a)       ($0a)  ..........
                                     -----------------------------------

[[Page 213]]

                                                                        
      1989 net contract income......    $2,000h          0a     $2,000h 
Other 1989 net income (loss)........  ..........  ..........       ($0a)
                                     -----------------------------------
Taxable income (NOL)................  ..........  ..........    $2,000h 
Tax at 34%..........................  ..........  ..........      $680h 
Less, previously computed tax.......  ..........  ..........      $585h 
                                     -----------------------------------
      Underpayment of 1989 tax......  ..........  ..........       $95h 
------------------------------------------------------------------------

    For purposes of any subsequent application of the look-back method 
for which 1990 is a redetermination year, X will use for 1990 the amount 
of Contract E income, and the amount of tax liability, that was 
originally reported in 1990 because X's estimate of the total contract 
costs from $8,000 to $9,000 did not change after 1989. Without regard to 
any subsequent revisions, these amounts are the same as in the table in 
paragraph (h)(3)(iv) above.

    (4) Post-completion adjustments. The following example illustrates 
the application of paragraph (c)(1)(ii):

    Example (3). The facts are the same as in Example (2). In 1991, X 
settles a lawsuit against its customer in Contract E. The customer pays 
X an additional $3,000, without interest, in 1991. Applying the Federal 
mid-term rate then in effect, this $3,000 has a discounted value at the 
time of contract completion in 1990 of $2,700. X is required to apply 
the look-back method for 1991 even though no contract was completed in 
1991. X must include the full $3,000 adjustment (which was not 
previously includible in total contract price) in gross income for 1991. 
X does not elect not to discount adjustments to the contract price or 
costs. Thus, X adjusts the contract price by the discounted amount of 
the adjustment and, therefore, uses $12,700 (not $13,000) for total 
Contract E price, rather than $10,000, which was used when the look-back 
method was first applied with respect to Contract E.
    For purposes of the look-back method, X must allocate the revised 
total Contract E price of $12,700 between 1988, 1989 and 1990 based on 
the actual total Contract E costs, and compare the resulting revised tax 
liability with the tax liability determined for the last previous 
application of the look-back method involving those years. This results 
in the following hypothetical underpayments of tax for purposes of the 
look-back method:
    r=revised

------------------------------------------------------------------------
                                               1988                     
                                    -------------------------    Total  
                                          D           E                 
------------------------------------------------------------------------
1988 contract costs................     $3,000a     $2,000a   ..........
Total contract costs...............     $6,000a     $9,000a   ..........
Total contract price...............    $10,000a    $12,700r   ..........
1988 completion (%)................         50a       22.2a   ..........
1988 gross income..................     $5,000h    $2,822rh   ..........
Less, 1988 costs...................   ($3,000a)    ($2,000a)  ..........
                                    ------------------------------------
      1988 net contract income.....     $2,000h       822rh     $2,222rh
Other 1988 net income (loss).......  ..........  ...........   ($2,000a)
                                    ------------------------------------
      Taxable income...............  ..........  ...........      $822rh
      Tax at 34%...................  ..........  ...........      $279rh
Less, previously computed tax......  ..........  ...........        $75h
      Underpayment of 1988 tax.....  ..........  ...........      $204rh
                                                                        
------------------------------------------------------------------------

    No Contract E costs were incurred in 1989, and there is no 
hypothetical underpayment for 1989.

------------------------------------------------------------------------
                                                    1990                
                                  --------------------------------------
                                        D            E          Total   
------------------------------------------------------------------------
1990 contract costs..............  ...........     $7,000a   ...........
Total contract costs.............  ...........     $9,000a   ...........
Total contract price.............  ...........    $12,700r   ...........
1990 completion (%)..............  ...........        100a   ...........
1990 gross income................  ...........    $9,878rh   ...........

[[Page 214]]

                                                                        
Less 1990 costs..................  ...........    ($7,000a)  ...........
                                  --------------------------------------
      1990 net contract income...  ...........    $2,878rh     $2,878rh 
Other 1990 net income (loss).....  ...........  ...........          0a 
                                  --------------------------------------
Taxable income (NOL).............  ...........  ...........    $2,878rh 
Tax at 34%.......................  ...........  ...........      $978rh 
Less, previously computed tax....  ...........  ...........       $265h 
                                  --------------                        
      Underpayment of 1990 tax...  ...........  ...........      $713rh 
------------------------------------------------------------------------

    In 1992, X incurs an additional cost of $1,000 allocable to the 
contract, which was not previously includible in total contract costs. 
Applying the Federal mid-term rate then in effect, the $1,000 has a 
discounted value at the time of contract completion of $800. X deducts 
this additional $1,000 in expenses in 1992. Based on this increase to 
contract costs, X reapplies the look-back method, and determines the 
following hypothetical underpayments for 1988, 1989 and 1990 for 
purposes of the look-back method:

------------------------------------------------------------------------
                                             1988                       
                                  --------------------------    Total   
                                        D            E                  
------------------------------------------------------------------------
1988 contract costs..............     $3,000a      $2,000a   ...........
Total contract costs.............     $6,000a      $9,800r   ...........
Total contract price.............    $10,000a     $12,700r   ...........
1988 completion (%)..............         50a        20.4r   ...........
1988 gross income................     $5,000h     $2,592rh   ...........
Less, 1988 costs.................    ($3,000a)    ($2,000a)  ...........
                                  --------------------------------------
      1988 net contract income...     $2,000h        592rh     $2,592rh 
Other 1988 net income (loss).....  ...........  ...........    ($2,000a)
                                  --------------------------------------
      Taxable income (NOL).......  ...........  ...........      $592rh 
Tax at 34%.......................  ...........  ...........      $201rh 
Less, previously computed tax....  ...........  ...........      $279rh 
                                  --------------------------------------
      Overpayment of 1988 tax....  ...........  ...........      ($78rh)
------------------------------------------------------------------------

    No Contract E costs were incured in 1989, and there is no 
hypothetical underpayment for 1989.

------------------------------------------------------------------------
                                              1990                      
                                   -------------------------    Total   
                                         D           E                  
------------------------------------------------------------------------
1990 contract costs...............  ..........  ...........     $7,000a 
Total contract costs..............  ..........      9,800r   ...........
Total contract price..............  ..........     12,700r   ...........
1990 completion (%)...............  ..........         92a   ...........
1990 gross income.................  ..........     9,071rh   ...........
Less, 1990 costs..................  ..........     (7,000a)  ...........
                                   -------------------------------------
1990 Net contract income..........  ..........     2,071rh     $2,071rh 
Other 1990 net income (loss)......  ..........  ...........          0a 
                                   -------------------------------------
      Taxable income (NOL)........  ..........  ...........     2,071rh 
Tax at 34%........................  ..........  ...........       704rh 
Less, previously computed tax.....  ..........  ...........       978rh 
                                   -------------------------------------
      Overpayment of 1990 tax.....  ..........  ...........      (274rh)
------------------------------------------------------------------------

    (5) Alternative minimum tax. The operation of the look-back method 
in the case of a taxpayer liable for the alternative minimum tax as 
provided in paragraph (c)(3)(vi) is illustrated by the following 
examples:

    Example (4). Y enters into a long-term contract in 1988 that is 
completed in 1989. Y used regular tax costs for purposes of determining 
the degree of contract completion under the alternative minimum tax.

    (i) Y determines its tax liability for 1988 as follows:

[[Page 215]]



1988 contract costs........................................     $4,000a 
Total contract costs.......................................     $8,000e 
Total contract price.......................................    $20,000e 
1988 completion (%)........................................         50e 
1988 gross income..........................................    $10,000a 
Less, 1988 contract costs..................................    ($4,000a 
                                                            ------------
      1988 net contract income.............................     $6,000a 
Other 1988 net income/(loss)...............................    ($3,400a)
Taxable income.............................................     $2,600a 
Regular tax at 34%.........................................        884a 
Adjustments and preferences to produce alternative minimum              
 taxable income............................................       $600a 
Alternative minimum taxable income.........................     $3,200a 
Tentative minimum tax at 20%...............................        640a 
Tax liability..............................................       $884a 
                                                                        

    In 1989, Y determines the following amounts:

1989 contract costs..........................................    $6,000a
Total contract costs.........................................   $10,000a
Total contract price.........................................   $20,000a
                                                                        

    (ii) For purposes of applying the look-back method, Y redetermines 
its tax liability for 1988, which results in a hypothetical overpayment 
of tax. This hypothetical overpayment is determined by comparing Y's 
original regular tax liability for 1988 with the hypothetical total tax 
liability (including alternative minimum tax liability) for that year 
because Y would have paid the alternative minimum tax if Y had used its 
actual contract costs to report income:

1988 contract costs.........................................    $4,000a 
Total contract costs........................................   $10,000a 
Total contract price........................................   $20,000a 
1988 completion(%)..........................................        40a 
1988 gross income...........................................    $8,000h 
less, 1988 contract costs...................................   ($4,000a)
1988 net contract income....................................    $4,000h 
Other 1988 net income/(loss)................................   ($3,400a)
Taxable income..............................................      $600h 
Regular tax at 34%..........................................      $204h 
Adjustments and preferences to produce alternative minimum              
 taxable income.............................................      $600a 
Alternative minimum taxable income..........................    $1,200h 
Tentative minimum tax at 20%................................       240h 
Alternative minimum tax.....................................       $36h 
Total tax liability.........................................      $240h 
less, previously computed tax...............................      $884a 
Underpayment/(overpayment)..................................     ($644h)
                                                                        

    (6) Credit carryovers. The operation of the look-back method in the 
case of credit carryovers as provided in paragraph (c)(3)(v) is 
illustrated by the following example:

    Example (5). Z enters into a contract in 1986 that is completed in 
1987. Z determines its tax liability for 1986 as follows:

1986 contract costs..........................................     $400a 
Total contract costs.........................................   $1,000e 
Total contract price.........................................   $2,000e 
1986 completion (%)..........................................       40e 
1986 gross income............................................     $800a 
Less, 1986 costs.............................................    ($400a)
1986 net contract income.....................................     $400a 
Other 1986 net income........................................       $0a 
Taxable income...............................................     $400a 
Tax at 46%...................................................     $184a 
Unused tax credits carried forward from 1985 allowable in               
 1986........................................................     $350a 
Net tax due..................................................       $0a 
                                                                        

    Z determines the following amounts for 1987:

1987 contract costs..........................................      $400a
Total contract price.........................................    $2,000a
Total contract costs.........................................      $800a
                                                                        

    If Z had used actual rather than estimated contract costs in 
determining gross income for 1986, Z would have reported tax liability 
of $276 (46%x$600) rather than $184. However, Z would have paid no 
additional tax for 1986 because its unused tax credits carried forward 
from 1985 would have been sufficient to offset this increased tax 
liability. Therefore, there is no hypothetical underpayment for 1986 for 
purposes of the look-back method. However, this hypothetical earlier use 
of the credit may increase the hypothetical tax liability for 1987 (or 
another subsequent year) for purposes of subsequent applications of the 
look-back method.

    (7) Net operating losses. The operation of the look-back method in 
the case of net operating loss (``NOL'') carryovers as provided in 
paragraph (c)(3)(v) is illustrated by the following example:

    Example (6). A entered into a long-term contract in 1986, which was 
completed in 1987. A determined its tax liability for 1986 as follows:

1986 contract costs.........................................      $400a 
Total contract costs........................................    $1,000e 
Total contract price........................................    $2,000e 
1986 completion (%).........................................        40e 
1986 gross income...........................................      $800a 
Less, 1986 costs............................................     ($400a)
1986 net contract income....................................      $400a 
Other 1986 net income/(loss)................................   ($1,000a)
Taxable income/(NOL)........................................     ($600a)
Tax.........................................................        $0a 
                                                                        

    A elected to carry this loss forward to 1987 pursuant to section 
172(b)(3)(C).
    For 1987, A determined the following amounts:

1987 contract costs...........................................     $400a
Total contract costs..........................................     $800a
Total contract price..........................................   $2,000a

[[Page 216]]

                                                                        
                                                                        

    If actual rather than estimated contract costs had been used in 
determining gross income for 1986, A would have reported $1,000 of gross 
income from the contract rather than $800, and thus would have reported 
a loss of $400 rather than $600. However, since A would have paid no tax 
for 1986 regardless of whether actual or estimated contract costs had 
been used, A does not have an underpayment for 1986 for purposes of the 
look-back method. If A had, instead, carried back the 1986 NOL, and this 
NOL had been absorbed in the tax years 1983 through 1985, it would have 
resulted in refunds of tax for those years in 1986. When A applies the 
look-back method, a hypothetical underpayment of tax would have resulted 
for those years due to a hypothetical reduction in the amount that would 
have been refunded if income had been reported on the basis of actual 
contract costs. See Example (2)(iii).

    (8) Alternative minimum tax credit. The following example 
illustrates the application of the look-back method if affected by the 
alternative minimum tax credit as provided in paragraph (c)(3)(vi):
    (i) Example (4), above illustrates that the reallocation of contract 
income under the look-back method can result in a hypothetical 
underpayment or overpayment determined using the alternative minimum tax 
rate, even though the taxpayer actually paid only the regular tax for 
that year. However, application of the look-back method had no effect on 
the difference between the amount of alternative minimum taxable income 
and the amount of regular taxable income taken into account in that year 
because the taxpayer was required to use the percentage of completion 
method for both regular and alternative minimum tax purposes and used 
the same version of the percentage of completion method for both regular 
and alternative minimum tax purposes (i.e., the taxpayer had made an 
election to use regular tax costs in determining the percentage of 
completion for purposes of computing alternative minimum taxable 
income).
    (ii) The following example illustrates the application of the look-
back method in the case of a taxpayer that does not use the percentage 
of completion method of accounting for long-term contracts in computing 
taxable income for regular tax purposes and thus must make an adjustment 
to taxable income to determine alternative minimum taxable income. The 
example also shows how interest is computed under the look-back method 
when the taxpayer is entitled to a credit under section 53 for minimum 
tax paid because of this adjustment.

    Example (7). X is a taxpayer engaged in the construction of real 
property under contracts that are completed within a 24-month period and 
whose average annual gross receipts do not exceed $10,000,000. As 
permitted by section 460(e)(1)(B), X uses the completed contract method 
(``CCM'') for regular tax purposes. However, X is engaged in the 
construction of commercial real property and, therefore, is required to 
use the percentage of completion method (``PCM'') for alternative 
minimum tax (``AMT'') purposes.
    Assume that for 1988, 1989, and 1990, X has only one long-term 
contract, which is entered into in 1988 and completed in 1990. Assume 
further that X estimates gross income from the contract to be $2,000, 
total contract costs to be $1,000, and that the contract is 25 percent 
complete in 1988 and 75 percent complete in 1989. In 1990, the year of 
completion, the percentage of completion does not change but, upon 
completion, gross income from the contract is actually $3,000, instead 
of $2,000, and costs are actually $1,000.
    For 1988, 1989, and 1990, X's income and tax liability using 
estimated contract price and costs are as follows:

------------------------------------------------------------------------
            Estimates                  1988         1989         1990   
------------------------------------------------------------------------
Regular tax:                                                            
    Long-term:                                                          
        Contract-CCM.............           0            0       $2,000 
        Other Income.............           0       $5,000            0 
            Total Income.........           0       $5,000       $2,000 
Tax @ 34%........................           0       $1,700         $680 
AMT                                                                     
    Gross Income.................        $500       $1,000       $1,500 
    Deductions...................       $(250)       $(500)       $(250)
    Total long-term:                                                    
        Contract-PCM.............        $250         $500       $1,250 
        Other Income.............           0       $5,000            0 
            Total Income.........        $250       $5,500       $1,250 
Tax @ 20%........................         $50       $1,100         $250 
Tentative Minimum Tax............         $50       $1,100         $250 

[[Page 217]]

                                                                        
Regular Tax......................           0       $1,700         $680 
Minimum Tax Credit...............           0         $(50)           0 
    Net Tax Liability............         $50       $1,650         $680 
------------------------------------------------------------------------

    When X files its tax return for 1990, X applies the look-back method 
to the contract. For 1988, 1989, and 1990, X's income and tax liability 
using actual contract price and costs are as follows:

------------------------------------------------------------------------
              Actual                   1988         1989         1990   
------------------------------------------------------------------------
Regular tax:                                                            
    Long-term:                                                          
        Contract-CCM.............           0            0       $2,000 
        Other Income.............           0       $5,000            0 
            Total Income.........           0       $5,000       $2,000 
Tax @ 34%........................           0       $1,700         $680 
AMT                                                                     
    Gross Income.................        $750       $1,500         $750 
    Deductions...................       $(250)       $(500)       $(250)
    Total long-term:                                                    
        Contract-PCM.............        $500       $1,000         $500 
        Other Income.............           0       $5,000            0 
            Total Income.........        $500       $6,000         $500 
Tax @ 20%........................        $100       $1,200         $100 
Tentative Minimum Tax............        $100       $1,200         $100 
Regular Tax......................           0       $1,700         $680 
Minimum Tax Credit...............           0        $(100)           0 
    Net Tax Liability............        $100       $1,600         $680 
Underpayment.....................         $50                           
Overpayment......................                      $50              
                                                                        
------------------------------------------------------------------------

    As shown above, application of the look-back method results in a 
hypothetical underpayment of $50 for 1988 because X was subject to the 
alternative minimum tax for that year. Interest is charged to X on this 
$50 underpayment from the due date of X's 1988 return until the due date 
of X's 1990 return.
    In 1989, although X was required to compute alternative minimum 
taxable income using the percentage of completion method, X was not 
required to pay alternative minimum tax. Nevertheless, the look-back 
method must be applied to 1989 because use of actual rather than 
estimated contract price in computing alternative minimum taxable income 
for 1988 would have changed the amount of the alternative minimum tax 
credit carried to 1989. Interest is paid to X on the resulting $50 
overpayment from the due date of X's 1989 return until the due date of 
X's 1990 return.

    (9) Period for interest. The following Examples (8) through (11) 
illustrate how to determine the period for computing interest as 
provided in paragraph (c)(4):

    Example (8). The facts are the same as in Example (6), except that 
the contract is completed in 1988, and A determined the following 
amounts for 1987 and 1988:

For 1987:                                                               
  1987 contract costs.......................................          0 
  Total contract costs......................................    $1,000e 
  Total contract price......................................    $2,000e 
  1987 completion (%).......................................       $40e 
  1987 gross income.........................................         0a 
  Less, 1987 costs..........................................         0a 
  Other 1987 net income.....................................      $600a 
  Net operating loss carryforward from 1986.................     $(600a)
  Taxable income............................................         0a 
  Tax.......................................................         0a 
For 1988:                                                               
  1988 contract costs.......................................      $400a 
  Total contract costs......................................      $800a 
  Total contract price......................................    $2,000a 
                                                                        

    If actual rather than estimated contract costs had been used in 
determining gross income for 1986, A would have reported $1,000 of gross 
income from the contract for 1986 rather than $800, and would have 
reported a net operating loss carryforward to 1987 of $400 rather than 
$600. Therefore, A would have reported taxable income of $200, and would 
have paid tax of $80 (i.e., $200  x  40%) for 1987. The due date for 
filing A's Federal income tax return for its 1988 taxable year is March 
15. A obtains an extension and files its 1988 return on September 15, 
1989. Under the look-back method, A is required to pay interest on the 
amount of this hypothetical underpayment ($80) computed from the due 
date (determined without regard to extensions) for A's return for 1987 
(not 1986, even though 1986 was the year in which the net operating loss 
arose) until March 15 (not September

[[Page 218]]

15), the due date (without regard to extensions) of A's return for 1988. 
A is required to pay additional interest from March 15 until September 
15 on the amount of interest outstanding as of March 15 with respect to 
the hypothetical underpayment of $80.
    Example (9). The facts are the same as in Example (6), except that A 
carries the net operating loss of $600 back to 1983 rather than forward 
to 1987, and receives a refund of $276 ($600 reduction in 1983 taxable 
income  x  46% rate in effect in 1983). As in Example (6), if actual 
contract costs had been used, A would have reported a loss for 1986 of 
$400 rather than $600. Thus, A would have received a refund of 1983 tax 
of $184 ($400  x  46%) rather than $276. Under the look-back method A is 
required to pay interest on the difference in these two amounts ($92) 
computed from the due date (determined without regard to extensions) of 
A's return for 1986 (the year in which the carryback arose rather than 
1983, the year in which it was used) until the due date of A's return 
for 1988.
    Example (10). B enters into a long-term contract in 1986 that is 
completed in 1988. B determines its 1986 tax liability as follows:

1986 contract costs..........................................     $400a 
Total contract costs.........................................   $1,000e 
Total contract price.........................................   $2,000e 
1986 completion (%)..........................................       40e 
1986 gross income............................................     $800a 
Less, 1986 costs.............................................    ($400a)
1986 net contract income.....................................     $400a 
Other 1986 net income........................................   $2,000a 
Taxable income...............................................   $2,400a 
Tax at 46%...................................................   $1,104a 
     B determines its tax liability for 1987 as follows:                
1987 contract costs..........................................     $400a 
Total contract costs.........................................   $1,600e 
Total contract price.........................................   $2,000e 
1987 completion (%)..........................................       50e 
1987 gross income............................................     $200a 
(=(50%  x  $2,000)--$800 previously reported) less, 1987                
 costs.......................................................    ($400a)
1987 net contract income.....................................    ($200a)
Other 1987 net income/(loss).................................  ($2,200a)
Taxable income (NOL).........................................  ($2,400a)
Tax..........................................................        0a 
                                                                        

    Assume that B had no taxable income in either 1984 or 1985, so that 
the entire amount of the $2,400 net operating loss is carried back to 
1986, and B receives a refund, with interest from the due date of B's 
1987 return, of the entire $1,104 in tax that it paid for 1986.
    In 1988, B determines the following amounts:

1988 contract costs...........................................     $800a
Total contract costs..........................................   $1,600a
Total contract price..........................................   $2,000a
                                                                        

    If B had used actual contract costs rather than estimated costs in 
determining its gross income for 1986, B would have had gross income 
from the contract of $500 rather than $800, and thus would have had 
taxable income of $2,100 rather than $2,400, and would have paid tax of 
$966 rather than $1,104. B is entitled to receive interest on the 
difference between these two amounts, the hypothetical overpayment of 
tax of $138. Interest is computed from the due date (without regard to 
extensions) of B's return for 1986 until the due date for B's return for 
1987. Interest stops running at this date, because B's hypothetical 
overpayment of tax ended when B filed its original 1987 return and 
received a refund for the carryback to 1986, and interest on this refund 
began to run only from the due date of B's 1987 return. See section 
6611(f).
    Example (11). C enters into a long-term contract in 1986, its first 
year in business, which is completed in 1988. C determines its tax 
liability for 1986 as follows:

1986 contract costs.........................................      $400a 
Total contract costs........................................    $1,000e 
Total contract price........................................    $2,000e 
1986 completion (%).........................................        40e 
1986 gross income...........................................      $800a 
less, 1986 costs............................................     ($400a)
1986 net contract income....................................      $400a 
Other 1986 net income.......................................    $2,000a 
Taxable income (NOL)........................................    $2,400a 
Tax at 46%..................................................    $1,104a 
                                                                        

    C determines its tax liability for 1987 as follows:

1987 contract costs.........................................      $400a 
Total contract costs........................................    $1,066e 
Total contract price........................................    $2,000e 
1987 completion (%).........................................        75e 
1987 gross income...........................................      $700a 
Less, 1987 costs............................................     ($400a)
1987 net contract income....................................      $300a 
Other 1987 net income.......................................   ($2,450a)
Taxable income (NOL)........................................   ($2,150a)
Tax.........................................................       $10a 
                                                                        

    C carries back the net operating loss to 1986, and files an amended 
return for 1986, showing taxable income of $250, and receives a refund 
of $989 (46% x $2,150). Interest on this refund begins to run only as of 
the due date of C's 1987 return. See section 6611(f).
    In 1988, when the contract is completed, C determines the following 
amounts:

1988 contract costs.........................................      $800a 
Total contract costs........................................    $1,600a 
Total contract price........................................    $2,000a 
                                                                        

    If C had used actual contract price and contract costs in 
determining gross income for 1986, it would have reported gross income 
from the contract of $500 rather than $800, taxable income of $2,100 
rather than $2,400, and tax liability of $966 rather than $1,104.

[[Page 219]]

    If C had used actual contract price and contract costs in 
determining gross income for 1987, it would have reported gross income 
from the contract of $500 rather than $700, and would have reported a 
net operating loss of $2,350, rather than $2,150, which would have been 
carried back to 1986.
    Under the look-back method, C receives interest with respect to a 
total 1986 hypothetical overpayment of $138 ($1,104 minus $966). C is 
credited with interest on $23 of this amount only from the due date of 
C's 1986 return until the due date of C's 1987 tax return, because this 
portion of C's total hypothetical overpayment for 1986 was refunded to C 
with interest computed from the due date of C's 1987 return and, 
therefore, was no longer held by the government. However, because the 
remainder of the total hypothetical overpayment of $115 was not refunded 
to C, C is credited with interest on this amount from the due date of 
C's 1986 return until the due date of C's 1988 tax return.
    Under the look-back method, C receives no interest with respect to 
1987, because C had no tax liability for 1987 using either estimated or 
actual contract price and costs.
[T.D. 9315, 55 FR 41670, Oct. 15, 1990]



Sec. 1.460-6T  Look-back method (temporary).

    (a)-(h) [Reserved] For further guidance, see Sec. 1.460-6 (a)-(h).
    (i) [Reserved]
    (j) Election not to apply look-back method in de minimis cases. 
Section 460(b)(6) provides taxpayers with an election not to apply the 
look-back method to long-term contracts in de minimis cases, effective 
for contracts completed in taxable years ending after August 5, 1997. To 
make an election, a taxpayer must attach a statement to its timely filed 
original federal income tax return (including extensions) for the 
taxable year the election is to become effective or to an amended return 
for that year, provided the amended return is filed on or before March 
31, 1998. This statement must have the legend ``NOTIFICATION OF ELECTION 
UNDER SECTION 460(b)(6)''; provide the taxpayer's name and identifying 
number and the effective date of the election; and identify the trades 
or businesses that involve long-term contracts. An election applies to 
all long-term contracts completed during and after the taxable year for 
which the election is effective. An election may not be revoked without 
the Commissioner's consent. A consolidated group of corporations, as 
defined in Sec. 1.1502-1(h), is subject to consistency rules analogous 
to those in Sec. 1.460-6(e)(2) (concerning election to use delayed 
reapplication method) and in Sec. 1.460-6(d)(4)(ii)(C) (concerning 
election to use simplified marginal impact method).
[T.D. 8756, 63 FR 1919, Jan. 13, 1998]



Sec. 1.460-7  Exempt long-term contracts. [Reserved]



Sec. 1.460-8  Changes in method of accounting. [Reserved]

                 taxable year for which deductions taken



Sec. 1.461-0  Table of contents.

    This section lists the captions that appear in the regulations under 
section 461 of the Internal Revenue Code.

        Sec. 1.461-1  General rule for taxable year of deduction.

    (a) General rule.
    (1) Taxpayer using cash receipts and disbursements method.
    (2) Taxpayer using an accrual method.
    (3) Effect in current taxable year of improperly accounting for a 
liability in a prior taxable year.
    (4) Deductions attributable to certain foreign income.
    (b) Special rule in case of death.
    (c) Accrual of real property taxes.
    (1) In general.
    (2) Special rules.
    (3) When election may be made.
    (4) Binding effect of election.
    (5) Apportionment of taxes on real property between seller and 
purchaser.
    (6) Examples.
    (d) Limitation on acceleration of accrual of taxes.
    (e) Dividends or interest paid by certain savings institutions on 
certain deposits or withdrawable accounts.
    (1) Deduction not allowable.
    (2) Computation of amounts not allowed as a deduction.
    (3) When amounts allowable.

                  Sec. 1.461-2  Contested liabilities.

    (a) General rule.
    (1) Taxable year of deduction.
    (2) Exception.
    (3) Refunds includible in gross income.
    (4) Examples.
    (5) Liabilities described in paragraph (g) of Sec. 1.461-4. 
[Reserved]
    (b) Contest of asserted liability.
    (1) Asserted liability.

[[Page 220]]

    (2) Definition of the term ``contest.''
    (3) Example.
    (c) Transfer to provide for the satisfaction of an asserted 
liability.
    (1) In general.
    (2) Examples.
    (d) Contest exists after transfer.
    (e) Deduction otherwise allowed.
    (1) In general.
    (2) Example.
    (f) Treatment of mo