[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2017 Edition]
[From the U.S. Government Publishing Office]



[[Page i]]

          
          
          Title 26

Internal Revenue


________________________

Part 1 (Secs. 1.0 to 1.60)

                         Revised as of April 1, 2017

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2017
                    Published by the Office of the Federal Register 
                    National Archives and Records Administration as a 
                    Special Edition of the Federal Register

[[Page ii]]

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                            Table of Contents



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

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury                                               3
  Findings Aids:
      Table of CFR Titles and Chapters........................     663
      Alphabetical List of Agencies Appearing in the CFR......     683
      Table of OMB Control Numbers............................     693
      List of CFR Sections Affected...........................     711

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

                     Cite this Code:  CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.0-1 refers 
                       to title 26, part 1, 
                       section 0-1.

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

[[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, 2017), 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.

PAST PROVISIONS OF THE CODE

    Provisions of the Code that are no longer in force and effect as of 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

``[RESERVED]'' TERMINOLOGY

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

INCORPORATION BY REFERENCE

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established by statute and allows Federal agencies to meet the 
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to materials already published elsewhere. For an incorporation to be 
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if it were published in full in the Federal Register (5 U.S.C. 552(a)). 
This material, like any other properly issued regulation, has the force 
of law.
    What is a proper incorporation by reference? The Director of the 
Federal Register will approve an incorporation by reference only when 
the requirements of 1 CFR part 51 are met. Some of the elements on which 
approval is based are:
    (a) The incorporation will substantially reduce the volume of 
material published in the Federal Register.
    (b) The matter incorporated is in fact available to the extent 
necessary to afford fairness and uniformity in the administrative 
process.
    (c) The incorporating document is drafted and submitted for 
publication in accordance with 1 CFR part 51.
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CFR INDEXES AND TABULAR GUIDES

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separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of Authorities 
and Rules. A list of CFR titles, chapters, subchapters, and parts and an 
alphabetical list of agencies publishing in the CFR are also included in 
this volume.

[[Page vii]]

    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

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in the Code of Federal Regulations.

INQUIRIES

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the top of odd-numbered pages.
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or write to the Director, Office of the Federal Register, National 
Archives and Records Administration, 8601 Adelphi Road, College Park, MD 
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ELECTRONIC SERVICES

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mail, [email protected]
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register.
    The e-CFR is a regularly updated, unofficial editorial compilation 
of CFR material and Federal Register amendments, produced by the Office 
of the Federal Register and the Government Publishing Office. It is 
available at www.ecfr.gov.

    Oliver A. Potts,
    Director,
    Office of the Federal Register.
    April 1, 2017.

                                
                                      
                            

  

[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty-two volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
2017. The first fifteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Secs. 1.0-1.60; 
Secs. 1.61-1.139; Secs. 1.140-1.169; Secs. 1.170-1.300; Secs. 1.301-
1.400; Secs. 1.401-1.409; Secs. 1.410-1.440; Secs. 1.441-1.500; 
Secs. 1.501-1.640; Secs. 1.641-1.850; Secs. 1.851-1.907; Secs. 1.908-
1.1000; Secs. 1.1001-1.1400; Secs. 1.1401-1.1550; and Sec. 1.1551 to end 
of part 1. The sixteenth volume containing parts 2-29, includes the 
remainder of subchapter A and all of Subchapter B--Estate and Gift 
Taxes. The last six volumes contain parts 30-39 (Subchapter C--
Employment Taxes and Collection of Income Tax at Source); parts 40-49; 
parts 50-299 (Subchapter D--Miscellaneous Excise Taxes); parts 300-499 
(Subchapter F--Procedure and Administration); parts 500-599 (Subchapter 
G--Regulations under Tax Conventions); and part 600 to end (Subchapter 
H--Internal Revenue Practice).

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

    For this volume, Cheryl E. Sirofchuck was Chief Editor. The Code of 
Federal Regulations publication program is under the direction of John 
Hyrum Martinez, assisted by Stephen J. Frattini.

[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




             (This book contains part 1, Secs. 1.0 to 1.60)

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

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

[[Page 3]]



     CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY




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


  Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980, 
deleting statutory sections from their regulations. In chapter I cross-
references to the deleted material have been changed to the 
corresponding sections of the IRS Code of 1954 or to the appropriate 
regulations sections. When either such change produced a redundancy, the 
cross-reference has been deleted. For further explanation, see 45 FR 
20795, Mar. 31, 1980.

                        SUBCHAPTER A--INCOME TAX
Part                                                                Page
1               Income taxes................................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System, Alcohol and Tobacco Tax Regulations, and 
  Regulations Under Tax Conventions.
  Editorial Note: Treasury Decision 6091, 19 FR 5167, Aug. 17, 1954, 
provides in part as follows:
  Paragraph 1. All regulations (including all Treasury decisions) 
prescribed by, or under authority duly delegated by, the Secretary of 
the Treasury, or jointly by the Secretary and the Commissioner of 
Internal Revenue, or by the Commissioner of Internal Revenue with the 
approval of the Secretary of the Treasury, or jointly by the 
Commissioner of Internal Revenue and the Commissioner of Customs or the 
Commissioner of Narcotics with the approval of the Secretary of the 
Treasury, applicable under any provision of law in effect on the date of 
enactment of the Code, to the extent such provision of law is repealed 
by the Code, are hereby prescribed under and made applicable to the 
provisions of the Code corresponding to the provision of law so repealed 
insofar as any such regulation is not inconsistent with the Code. Such 
regulations shall become effective as regulations under the various 
provisions of the Code as of the dates the corresponding provisions of 
law are repealed by the Code, until superseded by regulations issued 
under the Code.
  Par. 2. With respect to any provision of the Code which depends for 
its application upon the promulgation of regulations or which is to be 
applied in such manner as may be prescribed by regulations, all 
instructions or rules in effect immediately prior to the enactment of 
the Code, to the extent such instructions or rules could be prescribed 
as regulations under authority of such provision of the Code, shall be 
applied as regulations under such provision insofar as such instructions 
or rules are not inconsistent with the Code. Such instructions or rules 
shall be applied as regulations under the applicable provision of the 
Code as of the date such provision takes effect.
  Par. 3. If any election made or other act done pursuant to any 
provision of the Internal Revenue Code of 1939 or prior internal revenue 
laws would (except for the enactment of the Code) be effective for any 
period subsequent to such enactment, and if corresponding provisions are 
contained in the Code, such election or other act shall be given the 
same effect under the corresponding provisions of the Code to the extent 
not inconsistent therewith. The term ``act'' includes, but is not 
limited to, an allocation, identification, declaration, agreement, 
option, waiver, relinquishment, or renunciation.
  Par. 4. The limits of the various internal revenue districts have not 
been changed by the enactment of the Code. Furthermore, delegations of 
authority made pursuant to the provisions of Reorganization Plan No. 26 
of 1950 and Reorganization Plan No. 1 of 1952 (as well as redelegations 
thereunder), including those governing the authority of the Commissioner 
of Internal Revenue, the Regional Commissioners of Internal Revenue, or 
the District Directors of Internal Revenue, are applicable to the 
provisions of the Code to the extent consistent therewith.

[[Page 5]]



                         SUBCHAPTER A_INCOME TAX





PART 1_INCOME TAXES--Table of Contents



Sec.
1.0-1  Internal Revenue Code of 1954 and regulations.

                        Normal Taxes and Surtaxes

                     DETERMINATION OF TAX LIABILITY

                           Tax on Individuals

1.1-1  Income tax on individuals.
1.1-2  Limitation on tax.
1.1-3  Change in rates applicable to taxable year.
1.1(h)-1  Capital gains look-through rule for sales or exchanges of 
          interests in a partnership, S corporation, or trust.
1.1(i)-1T  Questions and answers relating to the tax on unearned income 
          certain minor children (Temporary).
1.2-1  Tax in case of joint return of husband and wife or the return of 
          a surviving spouse.
1.2-2  Definitions and special rules.
1.3-1  Application of optional tax.
1.4-1  Number of exemptions.
1.4-2  Elections.
1.4-3  Husband and wife filing separate returns.
1.4-4  Short taxable year caused by death.

                           Tax on Corporations

1.11-1  Tax on corporations.

                 Changes in Rates During a Taxable Year

1.15-1  Changes in rate during a taxable year.
1.21-1  Expenses for household and dependent care services necessary for 
          gainful employment.
1.21-2  Limitations on amount creditable.
1.21-3  Special rules applicable to married taxpayers.
1.21-4  Payments to certain related individuals.
1.23-1  Residential energy credit.
1.23-2  Definitions.
1.23-3  Special rules.
1.23-4  Performance and quality standards. [Reserved]
1.23-5  Certification procedures.
1.23-6  Procedure and criteria for additions to the approved list of 
          energy-conserving components or renewable energy sources.
1.25-1T  Credit for interest paid on certain home mortgages (Temporary).
1.25-2T  Amount of credit (Temporary).
1.25-3  Qualified mortgage credit certificate.
1.25-3T  Qualified mortgage credit certificate (Temporary).
1.25-4T  Qualified mortgage credit certificate program (Temporary).
1.25-5T  Limitation on aggregate amount of mortgage credit certificates 
          (Temporary).
1.25-6T  Form of qualified mortgage credit certificate (Temporary).
1.25-7T  Public notice (Temporary).
1.25-8T  Reporting requirements (Temporary).
1.25A-0  Table of contents.
1.25A-1  Calculation of education tax credit and general eligibility 
          requirements.
1.25A-2  Definitions.
1.25A-3  Hope Scholarship Credit.
1.25A-4  Lifetime Learning Credit.
1.25A-5  Special rules relating to characterization and timing of 
          payments.
1.28-0  Credit for clinical testing expenses for certain drugs for rare 
          diseases or conditions; table of contents.
1.28-1  Credit for clinical testing expenses for certain drugs for rare 
          diseases or conditions.

                           Credits Against Tax

             credits allowable under sections 30 through 45D

1.30-1  Definition of qualified electric vehicle and recapture of credit 
          for qualified electric vehicle.
1.31-1  Credit for tax withheld on wages.
1.31-2  Credit for ``special refunds'' of employee social security tax.
1.32-2  Earned income credit for taxable years beginning after December 
          31, 1978.
1.32-3  Eligibility requirements after denial of the earned income 
          credit.
1.34-1  Special rule for owners of certain business entities.
1.35-1  Partially tax-exempt interest received by individuals.
1.35-2  Taxpayers not entitled to credit.
1.36B-0  Table of contents.
1.36B-1  Premium tax credit definitions.
1.36B-2  Eligibility for premium tax credit.
1.36B-2T  Eligibility for premium tax credit (temporary).
1.36B-3  Computing the premium assistance credit amount.
1.36B-3T  Computing the premium assistance credit amount (temporary).
1.36B-4  Reconciling the premium tax credit with advance credit 
          payments.
1.36B-4T  Reconciling the premium tax credit with advance credit 
          payments (temporary).
1.36B-5  Information reporting by Exchanges.
1.36B-6  Minimum value.
1.37-1  General rules for the credit for the elderly.

[[Page 6]]

1.37-2  Credit for individuals age 65 or over.
1.37-3  Credit for individuals under age 65 who have public retirement 
          system income.
1.38-1  Investment in certain depreciable property.
1.40-1  Questions and answers relating to the meaning of the term 
          ``qualified mixture'' in section 40(b)(1).
1.41-0  Table of contents.
1.41-1  Credit for increasing research activities.
1.41-2  Qualified research expenses.
1.41-3  Base amount for taxable years beginning on or after January 3, 
          2001.
1.41-4  Qualified research for expenditures paid or incurred in taxable 
          years ending on or after December 31, 2003.
1.41-4A  Qualified research for taxable years beginning before January 
          1, 1986.
1.41-5  Basic research for taxable years beginning after December 31, 
          1986. [Reserved]
1.41-5A  Basic research for taxable years beginning before January 1, 
          1987.
1.41-6  Aggregation of expenditures.
1.41-6T  Aggregation of expenditures (temporary).
1.41-7  Special rules.
1.41-8  Alternative incremental credit applicable for taxable years 
          beginning on or before December 31, 2008.
1.41-9  Alternative simplified credit.
1.42-0  Table of contents.
1.42-0T  Table of contents.
1.42-1  Limitation on low-income housing credit allowed with respect to 
          qualified low-income buildings receiving housing credit 
          allocations from a State or local housing credit agency.
1.42-1T  Limitation on low-income housing credit allowed with respect to 
          qualified low-income buildings receiving housing credit 
          allocations from a State or local housing credit agency 
          (temporary).
1.42-2  Waiver of requirement that an existing building eligible for the 
          low-income housing credit was last placed in service more than 
          10 years prior to acquisition by the taxpayer.
1.42-3  Treatment of buildings financed with proceeds from a loan under 
          an Affordable Housing Program established pursuant to section 
          721 of the Financial Institutions Reform, Recovery, and 
          Enforcement Act of 1989 (FIRREA).
1.42-4  Application of not-for-profit rules of section 183 to low-income 
          housing credit activities.
1.42-5  Monitoring compliance with low-income housing credit 
          requirements.
1.42-5T  Monitoring compliance with low-income housing credit 
          requirements (temporary).
1.42-6  Buildings qualifying for carryover allocations.
1.42-7  Substantially bond-financed buildings. [Reserved]
1.42-8  Election of appropriate percentage month.
1.42-9  For use by the general public.
1.42-10  Utility allowances.
1.42-10T  Energy obtained directly from renewable sources (temporary).
1.42-11  Provision of services.
1.42-12  Effective dates and transitional rules.
1.42-13  Rules necessary and appropriate; housing credit agencies' 
          correction of administrative errors and omissions.
1.42-14  Allocation rules for post-2000 State housing credit ceiling 
          amount.
1.42-15  Available unit rule.
1.42-16  Eligible basis reduced by federal grants.
1.42-17  Qualified allocation plan.
1.42A-1  General tax credit for taxable years ending after December 31, 
          1975, and before January 1, 1979.
1.43-0  Table of contents.
1.43-1  The enhanced oil recovery credit--general rules.
1.43-2  Qualified enhanced oil recovery project.
1.43-3  Certification.
1.43-4  Qualified enhanced oil recovery costs.
1.43-5  At-risk limitation. [Reserved]
1.43-6  Election out of section 43.
1.43-7  Effective date of regulations.
1.44-1  Allowance of credit for purchase of new principal residence 
          after March 12, 1975, and before January 1, 1977.
1.44-2  Property to which credit for purchase of new principal residence 
          applies.
1.44-3  Certificate by seller.
1.44-4  Recapture for certain dispositions.
1.44-5  Definitions.
1.44B-1  Credit for employment of certain new employees.

   Research Credit--For Taxable Years Beginning Before January 1, 1990

1.41-0A  Table of contents.
1.41-3A  Base period research expense.

    rules for computing credit for investment in certain depreciable 
                                property

1.45D-0  Table of contents.
1.45D-1  New markets tax credit.
1.45G-0  Table of contents for the railroad track maintenance credit 
          rules.
1.45G-1  Railroad track maintenance credit.
1.45G-1T  Railroad track maintenance credit (temporary).
1.45R-0  Table of contents.
1.45R-1  Definitions.
1.45R-2  Eligibility for the credit.
1.45R-3  Uniform percentage of premium paid.
1.45R-4  Claiming the credit.
1.46-1  Determination of amount.
1.46-2  Carryback and carryover of unused credit.

[[Page 7]]

1.46-3  Qualified investment.
1.46-4  Limitations with respect to certain persons.
1.46-5  Qualified progress expenditures.
1.46-6  Limitation in case of certain regulated companies.
1.46-7  Statutory provisions; plan requirements for taxpayers electing 
          additional investment credit, etc.
1.46-8  Requirements for taxpayers electing additional one-percent 
          investment credit (TRASOP's).
1.46-9  Requirements for taxpayers electing an extra one-half percent 
          additional investment credit.
1.46-10  [Reserved]
1.46-11  Commuter highway vehicles.
1.47-1  Recomputation of credit allowed by section 38.
1.47-2  ``Disposition'' and ``cessation''.
1.47-3  Exceptions to the application of Sec. 1.47-1.
1.47-4  Electing small business corporation.
1.47-5  Estates and trusts.
1.47-6  Partnerships.
1.48-1  Definition of section 38 property.
1.48-2  New section 38 property.
1.48-3  Used section 38 property.
1.48-4  Election of lessor of new section 38 property to treat lessee as 
          purchaser.
1.48-5  Electing small business corporations.
1.48-6  Estates and trusts.
1.48-9  Definition of energy property.
1.48-10  Single purpose agricultural or horticultural structures.
1.48-11  Qualified rehabilitated building; expenditures incurred before 
          January 1, 1982.
1.48-12  Qualified rehabilitated building; expenditures incurred after 
          December 31, 1981.
1.50-1  Lessee's income inclusion following election of lessor of 
          investment credit property to treat lessee as acquirer.
1.50-1T  Lessee's income inclusion following election of lessor of 
          investment credit property to treat lessee as acquirer 
          (temporary).

   rules for computing credit for expenses of work incentive programs

1.50A-1  Determination of amount.
1.50A-2  Carryback and carryover of unused credit.
1.50A-3  Recomputation of credit allowed by section 40.
1.50A-4  Exceptions to the application of Sec. 1.50A-3.
1.50A-5  Electing small business corporations.
1.50A-6  Estates and trusts.
1.50A-7  Partnerships.
1.50B-1  Definitions of WIN expenses and WIN employees.
1.50B-2  Electing small business corporations.
1.50B-3  Estates and trusts.
1.50B-4  Partnerships.
1.50B-5  Limitations with respect to certain persons.
1.51-1  Amount of credit.

                              Tax Surcharge

1.52-1  Trades or businesses that are under common control.
1.52-2  Adjustments for acquisitions and dispositions.
1.52-3  Limitations with respect to certain persons.
1.53-1  Limitation based on amount of tax.
1.53-2  Carryback and carryover of unused credit.
1.53-3  Separate rule for pass-through of jobs credit.
1.55-1  Alternative minimum taxable income.
1.56-0  Table of contents to Sec. 1.56-1, adjustment for book income of 
          corporations.
1.56-1  Adjustment for the book income of corporations.

Regulations Applicable to Taxable Years Beginning in 1969 and Ending in 
                                  1970

1.56A-1  Imposition of tax.
1.56A-2  Deferral of tax liability in case of certain net operating 
          losses.
1.56A-3  Effective date.
1.56A-4  Certain taxpayers.
1.56A-5  Tax carryovers.
1.56(g)-0  Table of contents.
1.56(g)-1  Adjusted current earnings.

                       Tax Preference Regulations

1.57-0  Scope.
1.57-1  Items of tax preference defined.
1.57-2--1.57-3  [Reserved]
1.57-4  Limitation on amounts treated as items of tax preference for 
          taxable years beginning before January 1, 1976.
1.57-5  Records to be kept.
1.58-1  Minimum tax exemption.
1.58-2  General rules for conduit entities; partnerships and partners.
1.58-3  Estates and trusts.
1.58-3T  Treatment of non-alternative tax itemized deductions by trusts 
          and estates and their beneficiaries in taxable years beginning 
          after December 31, 1982 (temporary).
1.58-4  Electing small business corporations.
1.58-5  Common trust funds.
1.58-6  Regulated investment companies; real estate investment trusts.
1.58-7  Tax preferences attributable to foreign sources; preferences 
          other than capital gains and stock options.
1.58-8  Capital gains and stock options.
1.58-9  Application of the tax benefit rule to the minimum tax for 
          taxable years beginning prior to 1987.
1.59-1  Optional 10-year writeoff of certain tax preferences.
1.60  [Reserved]


[[Page 8]]


    Authority: 26 U.S.C 7805, unless otherwise noted.
    Section 1.1(h)-1 also issued under 26 U.S.C. 1(h);
    Section 1.21-1 also issued under 26 U.S.C. 21(f);
    Section 1.21-2 also issued under 26 U.S.C. 21(f);
    Section 1.21-3 also issued under 26 U.S.C. 21(f);
    Section 1.21-4 also issued under 26 U.S.C. 21(f);
    Sections 1.23-1--1.23-6 also issued under 26 U.S.C. 23;
    Section 1.25-1T also issued under 26 U.S.C. 25;
    Section 1.25-2T also issued under 26 U.S.C. 25;
    Section 1.25-3 also issued under 26 U.S.C. 25;
    Section 1.25-3T also issued under 26 U.S.C. 25;
    Section 1.25-4T also issued under 26 U.S.C. 25;
    Section 1.25-5T also issued under 26 U.S.C. 25;
    Section 1.25-6T also issued under 26 U.S.C. 25;
    Section 1.25-7T also issued under 26 U.S.C. 25;
    Section 1.25-8T also issued under 26 U.S.C. 25;
    Section 1.25A-1 also issued under section 26 U.S.C. 25A(i);
    Section 1.25A-2 also issued under section 26 U.S.C. 25A(i);
    Section 1.25A-3 also issued under section 26 U.S.C. 25A(i);
    Section 1.25A-4 also issued under section 26 U.S.C. 25A(i);
    Section 1.25A-5 also issued under section 26 U.S.C. 25A(i);
    Section 1.28-0 also issued under 26 U.S.C. 28(d)(5);
    Section 1.28-1 also issued under 26 U.S.C. 28(d)(5);
    Section 1.30-1 also issued under 26 U.S.C. 30(d)(2);
    Section 1.36B-0 also issued under 26 U.S.C. 36B(g);
    Section 1.36B-4 also issued under 26 U.S.C. 36B(g);
    Section 1.36B-5 also issued under 26 U.S.C. 36B(g);
    Section 1.41-4 also issued under 26 U.S.C. 41(d)(4)(E).
    Section 1.41-6 also issued under 26 U.S.C. 1502;
    Section 1.41-8 also issued under 26 U.S.C. 41(c)(4)(B);
    Section 1.41-8T also issued under 26 U.S.C. 41(c)(4)(B);
    Section 1.41-9 also issued under 26 U.S.C. 41(c)(5)(C);
    Section 1.41-9T also issued under 26 U.S.C. 41(c)(5)(C);
    Section 1.42-1 also issued under 26 U.S.C. 42(n);
    Section 1.42-1T also issued under 26 U.S.C. 42(n);
    Section 1.42-2 also issued under 26 U.S.C. 42(n);
    Section 1.42-3 also issued under 26 U.S.C. 42(n);
    Section 1.42-4 also issued under 26 U.S.C. 42(n);
    Section 1.42-5 also issued under 26 U.S.C. 42(n);
    Section 1.42-5T also issued under 26 U.S.C. 42(n);
    Sections 1.42-6, 1.42-8, 1.42-9, 1.42-10, 1.42-11, and 1.42-12, also 
issued under 26 U.S.C. 42(n);
    Section 1.42-10T also issued under 26 U.S.C. 42(n);
    Section 1.42-13 also issued under 26 U.S.C. 42(n);
    Section 1.42-14 also issued under 26 U.S.C. 42(n);
    Section 1.42-15 also issued under 26 U.S.C. 42(n);
    Section 1.42-16 also issued under 26 U.S.C. 42(n);
    Section 1.42-17 also issued under 26 U.S.C. 42(n);
    Section 1.42-18 also issued under 26 U.S.C. 42(h)(6)(F) and 
42(h)(6)(K);
    Sections 1.43-0--1.43-7 also issued under section 26 U.S.C. 43;
    Section 1.45D-1 also issued under 26 U.S.C. 45D(e)(2) and (i);
    Section 1.46-5 also issued under 26 U.S.C. 46(d)(6) and 26 U.S.C. 
47(a)(3)(C);
    Section 1.46-6 also issued under 26 U.S.C. 46(f)(7);
    Section 1.47-1 also issued under 26 U.S.C. 47(a);
    Section 1.48-9 also issued under 26 U.S.C. 38(b) (as in effect 
before the amendments made by subtitle F of the Tax Reform Act of 1984);
    Sections 1.50A--1.50B also issued under 85 Stat. 553 (26 U.S.C. 
40(b));
    Section 1.52-1 also issued under 26 U.S.C. 52(b);
    Section 1.56-1 also issued under 26 U.S.C. 56(f)(2)(H);
    Section 1.56(g)-1 also issued under section 7611(g)(3) of the 
Omnibus Budget Reconciliation Act of 1989 (Pub. L. 101-239, 103 Stat. 
2373); and
    Section 1.58-9 also issued under 26 U.S.C. 58(h).

    Source: T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 21, 
1960, unless otherwise noted.



Sec. 1.0-1  Internal Revenue Code of 1954 and regulations.

    (a) Enactment of law. The Internal Revenue Code of 1954 which became 
law upon enactment of Public Law 591, 83d

[[Page 9]]

Congress, approved August 16, 1954, provides in part as follows:

    Be it enacted by the Senate and House of Representatives of the 
United States of America in Congress assembled, That
    (a) Citation. (1) The provisions of this Act set forth under the 
heading ``Internal Revenue Title'' may be cited as the ``Internal 
Revenue Code of 1954''
    (2) The Internal Revenue Code enacted on February 10, 1939, as 
amended, may be cited as the ``Internal Revenue Code of 1939''.
    (b) Publication. This Act shall be published as volume 68A of the 
United States Statutes at Large, with a comprehensive table of contents 
and an appendix; but without an index or marginal references. The date 
of enactment, bill number, public law number, and chapter number, shall 
be printed as a headnote.
    (c) Cross reference. For saving provisions, effective date 
provisions, and other related provisions, see chapter 80 (sec. 7801 and 
following) of the Internal Revenue Code of 1954.
    (d) Enactment of Internal Revenue Title into law. The Internal 
Revenue Title referred to in subsection (a)(1) is as follows:

                                * * * * *

In general, the provisions of the Internal Revenue Code of 1954 are 
applicable with respect to taxable years beginning after December 31, 
1953, and ending after August 16, 1954. Certain provisions of that Code 
are deemed to be included in the Internal Revenue Code of 1939. See 
section 7851.
    (b) Scope of regulations. The regulations in this part deal with (1) 
the income taxes imposed under subtitle A of the Internal Revenue Code 
of 1954, and (2) certain administrative provisions contained in subtitle 
F of such Code relating to such taxes. In general, the applicability of 
such regulations is commensurate with the applicability of the 
respective provisions of the Internal Revenue Code of 1954 except that 
with respect to the provisions of the Internal Revenue Code of 1954 
which are deemed to be included in the Internal Revenue Code of 1939, 
the regulations relating to such provisions are applicable to certain 
fiscal years and short taxable years which are subject to the Internal 
Revenue Code of 1939. Those provisions of the regulations which are 
applicable to taxable years subject to the Internal Revenue Code of 1939 
and the specific taxable years to which such provisions are so 
applicable are identified in each instance. The regulations in 26 CFR 
(1939) part 39 (Regulations 118) are continued in effect until 
superseded by the regulations in this part. See Treasury Decision 6091, 
approved August 16, 1954 (19 FR 5167, C.B. 1954-2, 47).

                        Normal Taxes and Surtaxes

                     DETERMINATION OF TAX LIABILITY

                           Tax on Individuals



Sec. 1.1-1  Income tax on individuals.

    (a) General rule. (1) Section 1 of the Code imposes an income tax on 
the income of every individual who is a citizen or resident of the 
United States and, to the extent provided by section 871(b) or 877(b), 
on the income of a nonresident alien individual. For optional tax in the 
case of taxpayers with adjusted gross income of less than $10,000 (less 
than $5,000 for taxable years beginning before January 1, 1970) see 
section 3. The tax imposed is upon taxable income (determined by 
subtracting the allowable deductions from gross income). The tax is 
determined in accordance with the table contained in section 1. See 
subparagraph (2) of this paragraph for reference guides to the 
appropriate table for taxable years beginning on or after January 1, 
1964, and before January 1, 1965, taxable years beginning after December 
31, 1964, and before January 1, 1971, and taxable years beginning after 
December 31, 1970. In certain cases credits are allowed against the 
amount of the tax. See part IV (section 31 and following), subchapter A, 
chapter 1 of the Code. In general, the tax is payable upon the basis of 
returns rendered by persons liable therefor (subchapter A (sections 6001 
and following), chapter 61 of the Code) or at the source of the income 
by withholding. For the computation of tax in the case of a joint return 
of a husband and wife, or a return of a surviving spouse, for taxable 
years beginning before January 1, 1971, see section 2. The computation 
of tax in such a case for taxable years beginning after December 31, 
1970, is determined in accordance with the table contained in section 
1(a) as amended by the Tax Reform Act of 1969. For other rates of tax on 
individuals, see section 5(a). For the imposition of an additional tax 
for the calendar years 1968, 1969, and 1970, see section 51(a).
    (2)(i) For taxable years beginning on or after January 1, 1964, the 
tax imposed upon a single individual, a head of a household, a married 
individual filing a separate return, and estates

[[Page 10]]

and trusts is the tax imposed by section 1 determined in accordance with 
the appropriate table contained in the following subsection of section 
1:

----------------------------------------------------------------------------------------------------------------
                                                                                         Taxable years beginning
                                                                                           after Dec. 31, 1970
                                       Taxable years beginning  Taxable years beginning    (references in this
                                               in 1964           after 1964 but before    column are to the Code
                                                                          1971            as amended by the Tax
                                                                                           Reform Act of 1969)
----------------------------------------------------------------------------------------------------------------
Single individual....................  Sec. 1(a)(1)...........  Sec. 1(a)(2)...........  Sec. 1(c).
Head of a household..................  Sec. 1(b)(1)...........  Sec. 1(b)(2)...........  Sec. 1(b).
Married individual filing a separate   Sec. 1(a)(1)...........  Sec. 1(a)(2)...........  Sec. 1(d).
 return.
Estates and trusts...................  Sec. 1(a)(1)...........  Sec. 1(a)(2)...........  Sec. 1(d).
----------------------------------------------------------------------------------------------------------------

    (ii) For taxable years beginning after December 31, 1970, the tax 
imposed by section 1(d), as amended by the Tax Reform Act of 1969, shall 
apply to the income effectively connected with the conduct of a trade or 
business in the United States by a married alien individual who is a 
nonresident of the United States for all or part of the taxable year or 
by a foreign estate or trust. For such years the tax imposed by section 
1(c), as amended by such Act, shall apply to the income effectively 
connected with the conduct of a trade or business in the United States 
by an unmarried alien individual (other than a surviving spouse) who is 
a nonresident of the United States for all or part of the taxable year. 
See paragraph (b)(2) of Sec. 1.871-8.
    (3) The income tax imposed by section 1 upon any amount of taxable 
income is computed by adding to the income tax for the bracket in which 
that amount falls in the appropriate table in section 1 the income tax 
upon the excess of that amount over the bottom of the bracket at the 
rate indicated in such table.
    (4) The provisions of section 1 of the Code, as amended by the Tax 
Reform Act of 1969, and of this paragraph may be illustrated by the 
following examples:

    Example 1. A, an unmarried individual, had taxable income for the 
calendar year 1964 of $15,750. Accordingly, the tax upon such taxable 
income would be $4,507.50, computed as follows from the table in section 
1(a)(1):

Tax on $14,000 (from table).................................   $3,790.00
Tax on $1,750 (at 41 percent as determined from the table)..      717.50
                                                             -----------
    Total tax on $15,750....................................    4,507.50
 

    Example 2. Assume the same facts as in example (1), except the 
figures are for the calendar year 1965. The tax upon such taxable income 
would be $4,232.50, computed as follows from the table in section 
1(a)(2):

Tax on $14,000 (from table).................................   $3,550.00
Tax on $1,750 (at 39 percent as determined from the table)..      682.50
                                                             -----------
    Total tax on $15,750....................................    4,232.50
 

    Example 3. Assume the same facts as in example (1), except the 
figures are for the calendar year 1971. The tax upon such taxable income 
would be $3,752.50, computed as follows from the table in section 1(c), 
as amended:

Tax on $14,000 (from table).................................   $3,210.00
Tax on $1,750 (at 31 percent as determined from the table)..      542.50
                                                             -----------
    Total tax on $15,750....................................    3,752.50
 

    (b) Citizens or residents of the United States liable to tax. In 
general, all citizens of the United States, wherever resident, and all 
resident alien individuals are liable to the income taxes imposed by the 
Code whether the income is received from sources within or without the 
United States. Pursuant to section 876, a nonresident alien individual 
who is a bona fide resident of a section 931 possession (as defined in 
Sec. 1.931-1(c)(1) of this chapter) or Puerto Rico during the entire 
taxable year is, except as provided in section 931 or 933 with respect 
to income from sources within such possessions, subject to taxation in 
the same manner as a resident alien individual. As to tax on nonresident 
alien individuals, see sections 871 and 877.
    (c) Who is a citizen. Every person born or naturalized in the United 
States and subject to its jurisdiction is a citizen. For other rules 
governing the acquisition of citizenship, see chapters 1 and 2 of title 
III of the Immigration and Nationality Act (8 U.S.C. 1401-1459). For 
rules governing loss of citizenship, see sections 349 to 357, inclusive, 
of such Act (8 U.S.C. 1481-1489), Schneider v.

[[Page 11]]

Rusk, (1964) 377 U.S. 163, and Rev. Rul. 70-506, C.B. 1970-2, 1. For 
rules pertaining to persons who are nationals but not citizens at birth, 
e.g., a person born in American Samoa, see section 308 of such Act (8 
U.S.C. 1408). For special rules applicable to certain expatriates who 
have lost citizenship with a principal purpose of avoiding certain 
taxes, see section 877. A foreigner who has filed his declaration of 
intention of becoming a citizen but who has not yet been admitted to 
citizenship by a final order of a naturalization court is an alien.
    (d) Effective/applicability date. The second sentence of paragraph 
(b) of this section applies to taxable years ending after April 9, 2008.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7332, 39 FR 
44216, Dec. 23, 1974; T.D. 9391, 73 FR 19358, Apr. 9, 2008]



Sec. 1.1-2  Limitation on tax.

    (a) Taxable years ending before January 1, 1971. For taxable years 
ending before January 1, 1971, the tax imposed by section 1 (whether by 
subsection (a) or subsection (b) thereof) shall not exceed 87 percent of 
the taxable income for the taxable year. For purposes of determining 
this limitation the tax under section 1 (a) or (b) and the tax at the 
87-percent rate shall each be computed before the allowance of any 
credits against the tax. Where the alternative tax on capital gains is 
imposed under section 1201(b), the 87-percent limitation shall apply 
only to the partial tax computed on the taxable income reduced by 50 
percent of the excess of net long-term capital gains over net short-term 
capital losses. Where, for purposes of computations under the income 
averaging provisions, section 1201(b) is treated as imposing the 
alternative tax on capital gains computed under section 1304(e)(2), the 
87-percent limitation shall apply only to the tax equal to the tax 
imposed by section 1, reduced by the amount of the tax imposed by 
section 1 which is attributable to capital gain net income for the 
computation year.
    (b) Taxable years beginning after December 31, 1970. If, for any 
taxable year beginning after December 31, 1970, an individual has earned 
taxable income which exceeds his taxable income as defined by section 
1348, the tax imposed by section 1, as amended by the Tax Reform Act of 
1969, shall not exceed the sum computed under the provisions of section 
1348. For imposition of minimum tax for tax preferences see sections 56 
through 58.

[T.D. 7117, 36 FR 9397, May 25, 1971]



Sec. 1.1-3  Change in rates applicable to taxable year.

    For computation of the tax for a taxable year during which a change 
in the tax rates occurs, see section 21 and the regulations thereunder.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960. Redesignated by T.D. 7117, 36 FR 
9397, May 25, 1971]



Sec. 1.1(h)-1  Capital gains look-through rule for sales or exchanges of 
interests in a partnership, S corporation, or trust.

    (a) In general. When an interest in a partnership held for more than 
one year is sold or exchanged, the transferor may recognize ordinary 
income (e.g., under section 751(a)), collectibles gain, section 1250 
capital gain, and residual long-term capital gain or loss. When stock in 
an S corporation held for more than one year is sold or exchanged, the 
transferor may recognize ordinary income (e.g., under sections 304, 306, 
341, 1254), collectibles gain, and residual long-term capital gain or 
loss. When an interest in a trust held for more than one year is sold or 
exchanged, a transferor who is not treated as the owner of the portion 
of the trust attributable to the interest sold or exchanged (sections 
673 through 679) (a non-grantor transferor) may recognize collectibles 
gain and residual long-term capital gain or loss.
    (b) Look-through capital gain--(1) In general. Look-through capital 
gain is the share of collectibles gain allocable to an interest in a 
partnership, S corporation, or trust, plus the share of section 1250 
capital gain allocable to an interest in a partnership, determined under 
paragraphs (b)(2) and (3) of this section.
    (2) Collectibles gain--(i) Definition. For purposes of this section, 
collectibles gain shall be treated as gain from the sale or exchange of 
a collectible (as defined

[[Page 12]]

in section 408(m) without regard to section 408(m)(3)) that is a capital 
asset held for more than 1 year.
    (ii) Share of collectibles gain allocable to an interest in a 
partnership, S corporation, or a trust. When an interest in a 
partnership, S corporation, or trust held for more than one year is sold 
or exchanged in a transaction in which all realized gain is recognized, 
the transferor shall recognize as collectibles gain the amount of net 
gain (but not net loss) that would be allocated to that partner (taking 
into account any remedial allocation under Sec. 1.704-3(d)), 
shareholder, or beneficiary (to the extent attributable to the portion 
of the partnership interest, S corporation stock, or trust interest 
transferred that was held for more than one year) if the partnership, S 
corporation, or trust transferred all of its collectibles for cash equal 
to the fair market value of the assets in a fully taxable transaction 
immediately before the transfer of the interest in the partnership, S 
corporation, or trust. If less than all of the realized gain is 
recognized upon the sale or exchange of an interest in a partnership, S 
corporation, or trust, the same methodology shall apply to determine the 
collectibles gain recognized by the transferor, except that the 
partnership, S corporation, or trust shall be treated as transferring 
only a proportionate amount of each of its collectibles determined as a 
fraction that is the amount of gain recognized in the sale or exchange 
over the amount of gain realized in the sale or exchange. With respect 
to the transfer of an interest in a trust, this paragraph (b)(2) applies 
only to transfers by non-grantor transferors (as defined in paragraph 
(a) of this section). This paragraph (b)(2) does not apply to a 
transaction that is treated, for Federal income tax purposes, as a 
redemption of an interest in a partnership, S corporation, or trust.
    (3) Section 1250 capital gain--(i) Definition. For purposes of this 
section, section 1250 capital gain means the capital gain (not otherwise 
treated as ordinary income) that would be treated as ordinary income if 
section 1250(b)(1) included all depreciation and the applicable 
percentage under section 1250(a) were 100 percent.
    (ii) Share of section 1250 capital gain allocable to interest in 
partnership. When an interest in a partnership held for more than one 
year is sold or exchanged in a transaction in which all realized gain is 
recognized, there shall be taken into account under section 
1(h)(7)(A)(i) in determining the partner's unrecaptured section 1250 
gain the amount of section 1250 capital gain that would be allocated 
(taking into account any remedial allocation under Sec. 1.704-3(d)) to 
that partner (to the extent attributable to the portion of the 
partnership interest transferred that was held for more than one year) 
if the partnership transferred all of its section 1250 property in a 
fully taxable transaction for cash equal to the fair market value of the 
assets immediately before the transfer of the interest in the 
partnership. If less than all of the realized gain is recognized upon 
the sale or exchange of an interest in a partnership, the same 
methodology shall apply to determine the section 1250 capital gain 
recognized by the transferor, except that the partnership shall be 
treated as transferring only a proportionate amount of each section 1250 
property determined as a fraction that is the amount of gain recognized 
in the sale or exchange over the amount of gain realized in the sale or 
exchange. This paragraph (b)(3) does not apply to a transaction that is 
treated, for Federal income tax purposes, as a redemption of a 
partnership interest.
    (iii) Limitation with respect to net section 1231 gain. In 
determining a transferor partner's net section 1231 gain (as defined in 
section 1231(c)(3)) for purposes of section 1(h)(7)(B), the transferor 
partner's allocable share of section 1250 capital gain in partnership 
property shall not be treated as section 1231 gain, regardless of 
whether the partnership property is used in the trade or business (as 
defined in section 1231(b)).
    (c) Residual long-term capital gain or loss. The amount of residual 
long-term capital gain or loss recognized by a partner, shareholder of 
an S corporation, or beneficiary of a trust on account of the sale or 
exchange of an interest in a partnership, S corporation, or trust shall 
equal the amount of

[[Page 13]]

long-term capital gain or loss that the partner would recognize under 
section 741, that the shareholder would recognize upon the sale or 
exchange of stock of an S corporation, or that the beneficiary would 
recognize upon the sale or exchange of an interest in a trust (pre-look-
through long-term capital gain or loss) minus the amount of look-through 
capital gain determined under paragraph (b) of this section.
    (d) Special rule for tiered entities. In determining whether a 
partnership, S corporation, or trust has gain from collectibles, such 
partnership, S corporation, or trust shall be treated as owning its 
proportionate share of the collectibles of any partnership, S 
corporation, or trust in which it owns an interest either directly or 
indirectly through a chain of such entities. In determining whether a 
partnership has section 1250 capital gain, such partnership shall be 
treated as owning its proportionate share of the section 1250 property 
of any partnership in which it owns an interest, either directly or 
indirectly through a chain of partnerships.
    (e) Notification requirements. Reporting rules similar to those that 
apply to the partners and the partnership under section 751(a) shall 
apply in the case of sales or exchanges of interests in a partnership, S 
corporation, or trust that cause holders of such interests to recognize 
collectibles gain and in the case of sales or exchanges of interests in 
a partnership that cause holders of such interests to recognize section 
1250 capital gain. See Sec. 1.751-1(a)(3).
    (f) Examples. The following examples illustrate the requirements of 
this section:

    Example 1. Collectibles gain. (i) A and B are equal partners in a 
personal service partnership (PRS). B transfers B's interest in PRS to T 
for $15,000 when PRS's balance sheet (reflecting a cash receipts and 
disbursements method of accounting) is as follows:

------------------------------------------------------------------------
                                                            ASSETS
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Cash................................................    $3,000    $3,000
Loans Owed to Partnership...........................    10,000    10,000
  Collectibles......................................     1,000     3,000
  Other Capital Assets..............................     6,000     2,000
                                                     -------------------
Capital Assets......................................     7,000     5,000
Unrealized Receivables..............................         0    14,000
                                                     -------------------
    Total...........................................    20,000    32,000
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                        LIABILITIES AND
                                                            CAPITAL
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Liabilities.........................................     2,000     2,000
Capital:
  A.................................................     9,000    15,000
  B.................................................     9,000    15,000
                                                     -------------------
    Total...........................................    20,000    32,000
------------------------------------------------------------------------

    (ii) At the time of the transfer, B has held the interest in PRS for 
more than one year, and B's basis for the partnership interest is 
$10,000 ($9,000 plus $1,000, B's share of partnership liabilities). None 
of the property owned by PRS is section 704(c) property. The total 
amount realized by B is $16,000, consisting of the cash received, 
$15,000, plus $1,000, B's share of the partnership liabilities assumed 
by T. See section 752. B's undivided one-half interest in PRS includes a 
one-half interest in the partnership's unrealized receivables and a one-
half interest in the partnership's collectibles.
    (iii) If PRS were to sell all of its section 751 property in a fully 
taxable transaction for cash equal to the fair market value of the 
assets immediately prior to the transfer of B's partnership interest to 
T, B would be allocated $7,000 of ordinary income from the sale of PRS's 
unrealized receivables. Therefore, B will recognize $7,000 of ordinary 
income with respect to the unrealized receivables. The difference 
between the amount of capital gain or loss that the partner would 
realize in the absence of section 751 ($6,000) and the amount of 
ordinary income or loss determined under Sec. 1.751-1(a)(2) ($7,000) is 
the partner's capital gain or loss on the sale of the partnership 
interest under section 741. In this case, the transferor has a $1,000 
pre-look-through long-term capital loss.
    (iv) If PRS were to sell all of its collectibles in a fully taxable 
transaction for cash equal to the fair market value of the assets 
immediately prior to the transfer of B's partnership interest to T, B 
would be allocated $1,000 of gain from the sale of the collectibles. 
Therefore, B will recognize $1,000 of collectibles gain on account of 
the collectibles held by PRS.
    (v) The difference between the transferor's pre-look-through long-
term capital gain or loss (-$1,000) and the look-through capital gain 
determined under this section ($1,000) is the transferor's residual 
long-term capital gain or loss on the sale of the partnership interest. 
Under these facts, B will recognize a

[[Page 14]]

$2,000 residual long-term capital loss on account of the sale or 
exchange of the interest in PRS.
    Example 2. Special allocations. Assume the same facts as in Example 
1, except that under the partnership agreement, all gain from the sale 
of the collectibles is specially allocated to B, and B transfers B's 
interest to T for $16,000. All items of income, gain, loss, or deduction 
of PRS, other than the gain from the collectibles, are divided equally 
between A and B. Under these facts, B's amount realized is $17,000, 
consisting of the cash received, $16,000, plus $1,000, B's share of the 
partnership liabilities assumed by T. See section 752. B will recognize 
$7,000 of ordinary income with respect to the unrealized receivables 
(determined under Sec. 1.751-1(a)(2)). Accordingly, B's pre-look-through 
long-term capital gain would be $0. If PRS were to sell all of its 
collectibles in a fully taxable transaction for cash equal to the fair 
market value of the assets immediately prior to the transfer of B's 
partnership interest to T, B would be allocated $2,000 of gain from the 
sale of the collectibles. Therefore, B will recognize $2,000 of 
collectibles gain on account of the collectibles held by PRS. B will 
recognize a $2,000 residual long-term capital loss on account of the 
sale of B's interest in PRS.
    Example 3. Net collectibles loss ignored. Assume the same facts as 
in Example 1, except that the collectibles held by PRS have an adjusted 
basis of $3,000 and a fair market value of $1,000, and the other capital 
assets have an adjusted basis of $4,000 and a fair market value of 
$4,000. (The total adjusted basis and fair market value of the 
partnership's capital assets are the same as in Example 1.) If PRS were 
to sell all of its collectibles in a fully taxable transaction for cash 
equal to the fair market value of the assets immediately prior to the 
transfer of B's partnership interest to T, B would be allocated $1,000 
of loss from the sale of the collectibles. Because none of the gain from 
the sale of the interest in PRS is attributable to unrealized 
appreciation in the value of collectibles held by PRS, the net loss in 
collectibles held by PRS is not recognized at the time B transfers the 
interest in PRS. B will recognize $7,000 of ordinary income (determined 
under Sec. 1.751-1(a)(2)) and a $1,000 long-term capital loss on account 
of the sale of B's interest in PRS.
    Example 4. Collectibles gain in an S corporation. (i) A corporation 
(X) has always been an S corporation and is owned by individuals A, B, 
and C. In 1996, X invested in antiques. Subsequent to their purchase, 
the antiques appreciated in value by $300. A owns one-third of the 
shares of X stock and has held that stock for more than one year. A's 
adjusted basis in the X stock is $100. If A were to sell all of A's X 
stock to T for $150, A would realize $50 of pre-look-through long-term 
capital gain.
    (ii) If X were to sell its antiques in a fully taxable transaction 
for cash equal to the fair market value of the assets immediately before 
the transfer to T, A would be allocated $100 of gain on account of the 
sale. Therefore, A will recognize $100 of collectibles gain (look-
through capital gain) on account of the collectibles held by X.
    (iii) The difference between the transferor's pre-look-through long-
term capital gain or loss ($50) and the look-through capital gain 
determined under this section ($100) is the transferor's residual long-
term capital gain or loss on the sale of the S corporation stock. Under 
these facts, A will recognize $100 of collectibles gain and a $50 
residual long-term capital loss on account of the sale of A's interest 
in X.
    Example 5. Sale or exchange of partnership interest where part of 
the interest has a short-term holding period. (i) A, B, and C form an 
equal partnership (PRS). In connection with the formation, A contributes 
$5,000 in cash and a capital asset with a fair market value of $5,000 
and a basis of $2,000; B contributes $7,000 in cash and a collectible 
with a fair market value of $3,000 and a basis of $3,000; and C 
contributes $10,000 in cash. At the time of the contribution, A had held 
the contributed property for two years. Six months later, when A's basis 
in PRS is $7,000, A transfers A's interest in PRS to T for $14,000 at a 
time when PRS's balance sheet (reflecting a cash receipts and 
disbursements method of accounting) is as follows:

------------------------------------------------------------------------
                                                            ASSETS
                                                     -------------------
                                                      Adjusted   Market
                                                        basis     value
------------------------------------------------------------------------
Cash................................................   $22,000   $22,000
Unrealized Receivables..............................         0     6,000
  Capital Asset.....................................     2,000     5,000
  Collectible.......................................     3,000     9,000
Capital Assets......................................     5,000    14,000
                                                     -------------------
    Total...........................................    27,000    42,000
------------------------------------------------------------------------

    (ii) Although at the time of the transfer A has not held A's 
interest in PRS for more than one year, 50 percent of the fair market 
value of A's interest in PRS was received in exchange for a capital 
asset with a long-term holding period. Therefore, 50 percent of A's 
interest in PRS has a long-term holding period. See Sec. 1.1223-3(b)(1).
    (iii) If PRS were to sell all of its section 751 property in a fully 
taxable transaction immediately before A's transfer of the partnership 
interest, A would be allocated $2,000 of ordinary income. Accordingly, A 
will recognize $2,000 ordinary income and $5,000 ($7,000-$2,000) of 
capital gain on account of the transfer to T of A's interest in PRS. 
Fifty percent ($2,500) of that gain is long-term capital gain and 50 
percent ($2,500) is short-term capital gain. See Sec. 1.1223-3(c)(1).

[[Page 15]]

    (iv) If the collectible were sold or exchanged in a fully taxable 
transaction immediately before A's transfer of the partnership interest, 
A would be allocated $2,000 of gain attributable to the collectible. The 
gain attributable to the collectible that is allocable to the portion of 
the transferred interest in PRS with a long-term holding period is 
$1,000 (50 percent of $2,000). Accordingly, A will recognize $1,000 of 
collectibles gain on account of the transfer of A's interest in PRS.
    (v) The difference between the amount of pre-look-through long-term 
capital gain or loss ($2,500) and the look-through capital gain ($1,000) 
is the amount of residual long-term capital gain or loss that A will 
recognize on account of the transfer of A's interest in PRS. Under these 
facts, A will recognize a residual long-term capital gain of $1,500 and 
a short-term capital gain of $2,500.

    (g) Effective date. This section applies to transfers of interests 
in partnerships, S corporations, and trusts that occur on or after 
September 21, 2000.

[T.D. 8902, 65 FR 57096, Sept. 21, 2000]



Sec. 1.1(i)-1T  Questions and answers relating to the tax on unearned 
income certain minor children (Temporary).

                               In General

    Q-1. To whom does section 1(i) apply?
    A-1. Section 1(i) applies to any child who is under 14 years of age 
at the close of the taxable year, who has at least one living parent at 
the close of the taxable year, and who recognizes over $1,000 of 
unearned income during the taxable year.
    Q-2. What is the effective date of section 1(i)?
    A-2. Section 1(i) applies to taxable years of the child beginning 
after December 31, 1986.

                           Computation of Tax

    Q-3. What is the amount of tax imposed by section 1 on a child to 
whom section 1(i) applies?
    A-3. In the case of a child to whom section 1(i) applies, the amount 
of tax imposed by section 1 equals the greater of (A) the tax imposed by 
section 1 without regard to section 1(i) or (B) the sum of the tax that 
would be imposed by section 1 if the child's taxable income was reduced 
by the child's net unearned income, plus the child's share of the 
allocable parental tax.
    Q-4. What is the allocable parental tax?
    A-4. The allocable parental tax is the excess of (A) the tax that 
would be imposed by section 1 on the sum of the parent's taxable income 
plus the net unearned income of all children of such parent to whom 
section 1(i) applies, over (B) the tax imposed by section 1 on the 
parent's taxable income. Thus, the allocable parental tax is not 
computed with reference to unearned income of a child over 14 or a child 
under 14 with less than $1,000 of unearned income. See A-10 through A-13 
for rules regarding the determination of the parent(s) whose taxable 
income is taken into account under section 1(i). See A-14 for rules 
regarding the determination of children of the parent whose net unearned 
income is taken into account under section 1(i).
    Q-5. What is the child's share of the allocable parental tax?
    A-5. The child's share of the allocable parental tax is an amount 
that bears the same ratio to the total allocable parental tax as the 
child's net unearned income bears to the total net unearned income of 
all children of such parent to whom section 1(i) applies. See A-14.

    Example 1. During 1988, D, and a 12 year old, receives $5,000 of 
unearned income and no earned income. D has no itemized deductions and 
is not eligible for a personal exemption. D's parents have two other 
children, E, a 15 year old, and F, a 10 year old. E has $10,000 of 
unearned income and F has $100 of unearned income. D's parents file a 
joint return for 1988 and report taxable income of $70,000. Neither D's 
nor his parent's taxable income is attributable to net capital gain. D's 
tax liability for 1988, determined without regard to section 1(i), is 
$675 on $4,500 of taxable income ($5,000 less $500 allowable standard 
deduction). In applying section 1(i), D's tax would be equal to the sum 
of (A) the tax that would be imposed on D's taxable income if it were 
reduced by any net unearned income, plus (B) D's share of the allocable 
parental tax. Only D's unearned income is taken into account in 
determining the allocable parental tax because E is over 14 and F has 
less than $1,000 of unearned income. See A-4. D's net unearned income is 
$4,000 ($4,500 taxable unearned income less $500). The tax imposed on 
D's taxable income as reduced by D's net unearned income is $75 ($500 
x  15%). The allocable parental tax is $1,225, the excess of $16,957.50 
(the tax on $74,000, the parent's taxable income plus D's net unearned 
income) over $15,732.50 (the tax on $70,000, the parent's taxable 
income). See A-4. Thus, D's tax

[[Page 16]]

under section 1(i)(1)(B) is $1,300 ($1,225 + $75). Since this amount is 
greater than the amount of D's tax liability as determined without 
regard to section 1(i), the amount of tax imposed on D for 1988 is 
$1,300. See A-3.
    Example 2. H and W have 3 children, A, B, and C, who are all under 
14 years of age. For the taxable year 1988, H and W file a joint return 
and report taxable income of $129,750. The tax imposed by section 1 on H 
and W is $35,355. A has $5,000 of net unearned income and B and C each 
have $2,500 of net unearned income during 1988. The allocable parental 
tax imposed on A, B, and C's combined net unearned income of $10,000 is 
$3,300. This tax is the excess of $38,655, which is the tax imposed by 
section 1 on $139,750 ($129,750 + 10,000), over $35,355 (the tax imposed 
by section 1 on H and W's taxable income of $129,750). See A-4. Each 
child's share of the allocable parental tax is an amount that bears the 
same ratio to the total allocable parental tax as the child's net 
unearned income bears to the total net unearned income of A, B, and C. 
Thus, A's share of the allocable parental tax is $1,650 (5,000  10,000 
x  3,300) and B and C's share of the tax is $825 (2,500  10,000  x  
3,300) each. See A-5.

                    Definition of Net Unearned Income

    Q-6. What is net unearned income?
    A-6. Net unearned income is the excess of the portion of adjusted 
gross income for the taxable year that is not ``earned income'' as 
defined in section 911(d)(2) (income that is not attributable to wages, 
salaries, or other amounts received as compensation for personal 
services), over the sum of the standard deduction amount provided for 
under section 63 (c)(5)(A) ($500 for 1987 and 1988; adjusted for 
inflation thereafter), plus the greater of (A) $500 (adjusted for 
inflation after 1988) or (B) the amount of allowable itemized deductions 
that are directly connected with the production of unearned income. A 
child's net unearned income for any taxable year shall not exceed the 
child's taxable income for such year.

    Example 3. A is a child who is under 14 years of age at the end of 
the taxable year 1987. Both of A's parents are alive at this time. 
During 1987, A receives $3,000 of interest from a bank savings account 
and earns $1,000 from a paper route and performing odd jobs. A has no 
itemized deductions for 1987. A's standard deduction is $1,000, which is 
an amount equal to A's earned income for 1987. Of this amount, $500 is 
applied against A's unearned income and the remaining $500 is applied 
against A's earned income. Thus, A's $500 of taxable earned income 
($1,000 less the remaining $500 of the standard deduction) is taxed 
without regard to section 1 (i); A has $2,500 of taxable unearned income 
($3,000 gross unearned income less $500 of the standard deduction) of 
which $500 is taxed without regard to section 1(i). The remaining $2,000 
of taxable unearned income is A's net unearned income and is taxed under 
section 1(i).
    Example 4. B is a child who is subject to tax under section 1(i). B 
has $400 of earned income and $2,000 of unearned income. B has itemized 
deductions of $800 (net of the 2 percent of adjusted gross income (AGI) 
floor on miscellaneous itemized deductions under section 67) of which 
$200 are directly connected with the production of unearned income. The 
amount of itemized deductions that B may apply against unearned income 
is equal to the greater of $500 or the deductions directly connected 
with the production of unearned income. See A-6. Thus, $500 of B's 
itemized deductions are applied against the $2,000 of unearned income 
and the remaining $300 of deductions are applied against earned income. 
As a result, B has taxable earned income of $100 and taxable unearned 
income of $1,500. Of these amounts, all of the earned income and $500 of 
the unearned income are taxed without regard to section 1(i). The 
remaining $1,000 of unearned income is net unearned income and is taxed 
under section 1(i).

            Unearned Income Subject to tax Under Section 1(i)

    Q-7. Will a child be subject to tax under section 1(i) on net 
unearned income (as defined in section 1(i) (4) and A-6 of this section) 
that is attributable to property transferred to the child prior to 1987?
    A-7. Yes. The tax imposed by section 1(i) on a child's net unearned 
income applies to any net unearned income of the child for taxable years 
beginning after December 31, 1986, regardless of when the underlying 
assets were transferred to the child.
    Q-8. Will a child be subject to tax under section 1(i) on net 
unearned income that is attributable to gifts from persons other than 
the child's parents or attributable to assets resulting from the child's 
earned income?
    A-8. Yes. The tax imposed by section 1(i) applies to all net 
unearned income of the child, regardless of the source of the assets 
that produced such income. Thus, the rules of section 1(i) apply to 
income attributable to gifts not only from the parents but also from any

[[Page 17]]

other source, such as the child's grandparents. Section 1(i) also 
applies to unearned income derived with respect to assets resulting from 
earned income of the child, such as interest earned on bank deposits.

    Example 5. A is a child who is under 14 years of age at the end of 
the taxable year beginning on January 1, 1987. Both of A's parents are 
alive at the end of the taxable year. During 1987, A receives $2,000 in 
interest from his bank account and $1,500 from a paper route. Some of 
the interest earned by A from the bank account is attributable to A's 
paper route earnings that were deposited in the account. The balance of 
the account is attributable to cash gifts from A's parents and 
grandparents and interest earned prior to 1987. Some cash gifts were 
received by A prior to 1987. A has no itemized deductions and is 
eligible to be claimed as a dependent on his parent's return. Therefore, 
for the taxable year 1987, A's standard deduction is $1,500, the amount 
of A's earned income. Of this standard deduction amount, $500 is 
allocated against unearned income and $1,000 is allocated against earned 
income. A's taxable unearned income is $1,500 of which $500 is taxed 
without regard to section 1(i). The remaining taxable unearned income of 
$1,000 is net unearned income and is taxed under section 1(i). The fact 
that some of A's unearned income is attributable to interest on 
principal created by earned income and gifts from persons other than A's 
parents or that some of the unearned income is attributable to property 
transferred to A prior to 1987, will not affect the tax treatment of 
this income under section 1(i). See A-8.

    Q-9. For purposes of section 1(i), does income which is not earned 
income (as defined in section 911(d)(2)) include social security 
benefits or pension benefits that are paid to the child?
    A-9. Yes. For purposes of section 1(i), earned income (as defined in 
section 911(d)(2)) does not include any social security or pension 
benefits paid to the child. Thus, such amounts are included in unearned 
income to the extent they are includible in the child's gross income.

              Determination of the Parent's Taxable Income

    Q-10. If a child's parents file a joint return, what is the taxable 
income that must be taken into account by the child in determining tax 
liability under section 1(i)?
    A-10. In the case of parents who file a joint return, the parental 
taxable income to be taken into account in determining the tax liability 
of a child is the total taxable income shown on the joint return.
    Q-11. If a child's parents are married and file separate tax 
returns, which parent's taxable income must be taken into account by the 
child in determining tax liability under section 1(i)?
    A-11. For purposes of determining the tax liability of a child under 
section 1(i), where such child's parents are married and file separate 
tax returns, the parent whose taxable income is the greater of the two 
for the taxable year shall be taken into account.
    Q-12. If the parents of a child are divorced, legally separated, or 
treated as not married under section 7703(b), which parent's taxable 
income is taken into account in computing the child's tax liability?
    A-12. If the child's parents are divorced, legally separated, or 
treated as not married under section 7703(b), the taxable income of the 
custodial parent (within the meaning of section 152(e)) of the child is 
taken into account under section 1(i) in determining the child's tax 
liability.
    Q-13. If a parent whose taxable income must be taken into account in 
determining a child's tax liability under section 1(i) files a joint 
return with a spouse who is not a parent of the child, what taxable 
income must the child take into account?
    A-13. The amount of a parent's taxable income that a child must take 
into account for purposes of section 1(i) where the parent files a joint 
return with a spouse who is not a parent of the child is the total 
taxable income shown on such joint return.

                         Children of the Parent

    Q-14. In determining a child's share of the allocable parental tax, 
is the net unearned income of legally adopted children, children related 
to such child by half-blood, or children from a prior marriage of the 
spouse of such child's parent taken into account in addition to the 
natural children of such child's parent?
    A-14. Yes. In determining a child's share of the allocable parental 
tax, the net unearned income of all children subject to tax under 
section 1(i) and who use the same parent's taxable income as such child 
to determine their

[[Page 18]]

tax liability under section 1(i) must be taken into account. Such 
children are taken into account regardless of whether they are adopted 
by the parent, related to such child by half-blood, or are children from 
a prior marriage of the spouse of such child's parent.

        Rules Regarding Income From a Trust or Similar Instrument

    Q-15. Will the unearned income of a child who is subject to section 
1(i) that is attributable to gifts given to the child under the Uniform 
Gift to Minors Act (UGMA) be subject to tax under section 1(i)?
    A-15. Yes. A gift under the UGMA vests legal title to the property 
in the child although an adult custodian is given certain rights to deal 
with the property until the child attains majority. Any unearned income 
attributable to such a gift is the child's unearned income and is 
subject to tax under section 1(i), whether distributed to the child or 
not.
    Q-16. Will a child who is a beneficiary of a trust be required to 
take into account the income of a trust in determining the child's tax 
liability under section 1(i)?
    A-16. The income of a trust must be taken into account for purposes 
of determining the tax liability of a beneficiary who is subject to 
section 1(i) only to the extent it is included in the child's gross 
income for the taxable year under sections 652(a) or 662(a). Thus, 
income from a trust for the fiscal taxable year of a trust ending during 
1987, that is included in the gross income of a child who is subject to 
section 1(i) and who has a calendar taxable year, will be subject to tax 
under section 1(i) for the child's 1987 taxable year.

                         Subsequent Adjustments

    Q-17. What effect will a subsequent adjustment to a parent's taxable 
income have on the child's tax liability if such parent's taxable income 
was used to determine the child's tax liability under section 1(i) for 
the same taxable year?
    A-17. If the parent's taxable income is adjusted and if, for the 
same taxable year as the adjustment, the child paid tax determined under 
section 1(i) with reference to that parent's taxable income, then the 
child's tax liability under section 1(i) must be recomputed using the 
parent's taxable income as adjusted.
    Q-18. In the case where more than one child who is subject to 
section 1(i) uses the same parent's taxable income to determine their 
allocable parental tax, what effect will a subsequent adjustment to the 
net unearned income of one child have on the other child's share of the 
allocable parental tax?
    A-18. If, for the same taxable year, more than one child uses the 
same parent's taxable income to determine their share of the allocable 
parental tax and a subsequent adjustment is made to one or more of such 
children's net unearned income, each child's share of the allocable 
parental tax must be recomputed using the combined net unearned income 
of all such children as adjusted.
    Q-19. If a recomputation of a child's tax under section 1(i), as a 
result of an adjustment to the taxable income of the child's parents or 
another child's net unearned income, results in additional tax being 
imposed by section 1(i) on the child, is the child subject to interest 
and penalties on such additional tax?
    A-19. Any additional tax resulting from an adjustment to the taxable 
income of the child's parents or the net unearned income of another 
child shall be treated as an underpayment of tax and interest shall be 
imposed on such underpayment as provided in section 6601. However, the 
child shall not be liable for any penalties on the underpayment 
resulting from additional tax being imposed under section 1(i) due to 
such an adjustment.

    Example 6. D and M are the parents of C, a child under the age of 
14. D and M file a joint return for 1988 and report taxable income of 
$69,900. C has unearned income of $3,000 and no itemized deductions for 
1988. C properly reports a total tax liability of $635 for 1988. This 
amount is the sum of the allocable parental tax of $560 on C's net 
unearned income of $2,000 (the excess of $3,000 over the sum of $500 
standard deduction and the first $500 of taxable unearned income) plus 
$75 (the tax imposed on C's first $500 of taxable unearned income). See 
A-3. One year later, D and M's 1988 tax return is adjusted on audit by 
adding an additional $1,000 of taxable income. No adjustment is made to 
the amount reported as C's net unearned income for 1988. However, the 
adjustment to D and M's taxable income causes C's tax liability under 
section 1(i) for

[[Page 19]]

1988 to be increased by $50 as a result of the phase-out of the 15 
percent rate bracket. See A-20. In addition to this further tax 
liability, C will be liable for interest on the $50. However, C will not 
have to pay any penalty on the delinquent amount.

                           Miscellaneous Rules

    Q-20. Does the phase-out of the parent's 15 percent rate bracket and 
personal exemptions under section 1(g), if applicable, have any effect 
on the calculation of the allocable parental tax imposed on a child's 
net unearned income under section 1(i)?
    A-20. Yes. Any phase-out of the parent's 15 percent rate bracket or 
personal exemptions under section 1(g) is given full effect in 
determining the tax that would be imposed on the sum of the parent's 
taxable income and the total net unearned income of all children of the 
parent. Thus, any additional tax on a child's net unearned income 
resulting from the phase-out of the 15 percent rate bracket and the 
personal exemptions is reflected in the tax liability of the child.
    Q-21. For purposes of calculating a parent's tax liability or the 
allocable parental tax imposed on a child, are other phase-outs, 
limitations, or floors on deductions or credits, such as the phase-out 
of the $25,000 passive loss allowance for rental real estate activities 
under section 469(i)(3) or the 2 percent of AGI floor on miscellaneous 
itemized deductions under section 67, affected by the addition of a 
child's net unearned income to the parent's taxable income?
    A-21. No. A child's net unearned income is not taken into account in 
computing any deduction or credit for purposes of determining the 
parent's tax liability or the child's allocable parental tax. Thus, for 
example, although the amounts allowable to the parent as a charitable 
contribution deduction, medical expense deduction, section 212 
deduction, or a miscellaneous itemized deduction are affected by the 
amount of the parent's adjusted gross income, the amount of these 
deductions that is allowed does not change as a result of the 
application of section 1(i) because the amount of the parent's adjusted 
gross income does not include the child's net unearned income. 
Similarly, the amount of itemized deductions that is allowed to a child 
does not change as a result of section 1(i) because section 1(i) only 
affects the amount of tax liability and not the child's adjusted gross 
income.
    Q-22. If a child is unable to obtain information concerning the tax 
return of the child's parents directly from such parents, how may the 
child obtain information from the parent's tax return which is necessary 
to determine the child's tax liability under section 1(i)?
    A-22. Under section 6103(e)(1)(A)(iv), a return of a parent shall, 
upon written request, be open to inspection or disclosure to a child of 
that individual (or the child's legal representative) to the extent 
necessary to comply with section 1(i). Thus, a child may request the 
Internal Revenue Service to disclose sufficient tax information about 
the parent to the child so that the child can properly file his or her 
return.

[T.D. 8158, 52 FR 33579, Sept. 4, 1987; 52 FR 36133, Sept. 25, 1987]



Sec. 1.2-1  Tax in case of joint return of husband and wife or the 
return of a surviving spouse.

    (a) Taxable year ending before January 1, 1971. (1) For taxable 
years ending before January 1, 1971, in the case of a joint return of 
husband and wife, or the return of a surviving spouse as defined in 
section 2(b), the tax imposed by section 1 shall be twice the tax that 
would be imposed if the taxable income were reduced by one-half. For 
rules relating to the filing of joint returns of husband and wife, see 
section 6013 and the regulations thereunder.
    (2) The method of computing, under section 2(a), the tax of husband 
and wife in the case of a joint return, or the tax of a surviving 
spouse, is as follows:
    (i) First, the taxable income is reduced by one-half. Second, the 
tax is determined as provided by section 1 by using the taxable income 
so reduced. Third, the tax so determined, which is the tax that would be 
determined if the taxable income were reduced by one-half, is then 
multiplied by two to produce the tax imposed in the case of the joint 
return or the return of a surviving spouse, subject, however, to the 
allowance of any credits against the tax under the provisions of 
sections 31 through 38 and the regulations thereunder.

[[Page 20]]

    (ii) The limitation under section 1(c) of the tax to an amount not 
in excess of a specified percent of the taxable income for the taxable 
year is to be applied before the third step above, that is, the 
limitation to be applied upon the tax is determined as the applicable 
specified percent of one-half of the taxable income for the taxable year 
(such one-half of the taxable income being the actual aggregate taxable 
income of the spouses, or the total taxable income of the surviving 
spouse, as the case may be, reduced by one-half). For the percent 
applicable in determining the limitation of the tax under section 1(c), 
see Sec. 1.1-2(a). After such limitation is applied, then the tax so 
limited is multiplied by two as provided in section 2(a) (the third step 
above).
    (iii) The following computation illustrates the method of 
application of section 2(a) in the determination of the tax of a husband 
and wife filing a joint return for the calendar year 1965. If the 
combined gross income is $8,200, and the only deductions are the two 
exemptions of the taxpayers under section 151(b) and the standard 
deduction under section 141, the tax on the joint return for 1965, 
without regard to any credits against the tax, is $1,034.20 determined 
as follows:

1. Gross income.................................   $8,200.00
2. Less:
    Standard deduction, section 141.............        $820
    Deduction for personal exemption, section          1,200    2,020.00
     151........................................
                                                 -----------------------
3. Taxable income...............................    6,180.00
4. Taxable income reduced by one-half...........    3,090.00
5. Tax computed by the tax table provided under       517.10
 section 1(a)(2) ($310 plus 19 percent of excess
 over $2,000)...................................
6. Twice the tax in item 5......................    1,034.20
 

    (b) Taxable years beginning after December 31, 1970. (1) For taxable 
years beginning after December 31, 1970, in the case of a joint return 
of husband and wife, or the return of a surviving spouse as defined in 
section 2(a) of the Code as amended by the Tax Reform Act of 1969, the 
tax shall be determined in accordance with the table contained in 
section 1(a) of the Code as so amended. For rules relating to the filing 
of joint returns of husband and wife see section 6013 as amended and the 
regulations thereunder.
    (2) The following computation illustrates the method of computing 
the tax of a husband and wife filing a joint return for calendar year 
1971. If the combined gross income is $8,200, and the only deductions 
are the two exemptions of the taxpayers under section 151(b), as 
amended, and the standard deduction under section 141, as amended, the 
tax on the joint return for 1971, without regard to any credits against 
the tax, is $968.46, determined as follows:

1. Gross income.................................   $8,200.00
2. Less:
  Standard deduction, section 141...............   $1,066.00
  Deduction for personal exemption, section 151.    1,300.00    2,366.00
                                                 -----------------------
3. Taxable income...............................    5,834.00
4. Tax computed by the tax table provided under       968.46
 section 1(a) ($620 plus 19 percent of excess
 over $4,000)...................................
 

    (3) The limitation under section 1348 with respect to the maximum 
rate of tax on earned income shall apply to a married individual only if 
such individual and his spouse file a joint return for the taxable year.
    (c) Death of a spouse. If a joint return of a husband and wife is 
filed under the provisions of section 6013 and if the husband and wife 
have different taxable years solely because of the death of either 
spouse, the taxable year of the deceased spouse covered by the joint 
return shall, for the purpose of the computation of the tax in respect 
of such joint return, be deemed to have ended on the date of the closing 
of the surviving spouse's taxable year.
    (d) Computation of optional tax. For computation of optional tax in 
the case of a joint return or the return of a surviving spouse, see 
section 3 and the regulations thereunder.
    (e) Change in rates. For treatment of taxable years during which a 
change in the tax rates occurs see section 21 and the regulations 
thereunder.

[T.D. 7117, 36 FR 9398, May 25, 1971]



Sec. 1.2-2  Definitions and special rules.

    (a) Surviving spouse. (1) If a taxpayer is eligible to file a joint 
return under the Internal Revenue Code of 1954 without regard to section 
6013(a) (3) thereof for the taxable year in which his spouse dies, his 
return for each of the

[[Page 21]]

next 2 taxable years following the year of the death of the spouse shall 
be treated as a joint return for all purposes if all three of the 
following requirements are satisfied:
    (i) He has not remarried before the close of the taxable year the 
return for which is sought to be treated as a joint return, and
    (ii) He maintains as his home a household which constitutes for the 
taxable year the principal place of abode as a member of such household 
of a person who is (whether by blood or adoption) a son, stepson, 
daughter, or stepdaughter of the taxpayer, and
    (iii) He is entitled for the taxable year to a deduction under 
section 151 (relating to deductions for dependents) with respect to such 
son, stepson, daughter, or stepdaughter.
    (2) See paragraphs (c)(1) and (d) of this section for rules for the 
determination of when the taxpayer maintains as his home a household 
which constitutes for the taxable year the principal place of abode, as 
a member of such household, of another person.
    (3) If the taxpayer does not qualify as a surviving spouse he may 
nevertheless qualify as a head of a household if he meets the 
requirements of Sec. 1.2-2(b).
    (4) The following example illustrates the provisions relating to a 
surviving spouse:

    Example: Assume that the taxpayer meets the requirements of this 
paragraph for the years 1967 through 1971, and that the taxpayer, whose 
wife died during 1966 while married to him, remarried in 1968. In 1969, 
the taxpayer's second wife died while married to him, and he remained 
single thereafter. For 1967 the taxpayer will qualify as a surviving 
spouse, provided that neither the taxpayer nor the first wife was a 
nonresident alien at any time during 1966 and that she (immediately 
prior to her death) did not have a taxable year different from that of 
the taxpayer. For 1968 the taxpayer does not qualify as a surviving 
spouse because he remarried before the close of the taxable year. The 
taxpayer will qualify as a surviving spouse for 1970 and 1971, provided 
that neither the taxpayer nor the second wife was a nonresident alien at 
any time during 1969 and that she (immediately prior to her death) did 
not have a taxable year different from that of the taxpayer. On the 
other hand, if the taxpayer, in 1969, was divorced or legally separated 
from his second wife, the taxpayer will not qualify as a surviving 
spouse for 1970 or 1971, since he could not have filed a joint return 
for 1969 (the year in which his second wife died).

    (b) Head of household. (1) A taxpayer shall be considered the head 
of a household if, and only if, he is not married at the close of his 
taxable year, is not a surviving spouse (as defined in paragraph (a) of 
this section, and (i) maintains as his home a household which 
constitutes for such taxable year the principal place of abode, as a 
member of such household, of at least one of the individuals described 
in subparagraph (3), or (ii) maintains (whether or not as his home) a 
household which constitutes for such taxable year the principal place of 
abode of one of the individuals described in subparagraph (4).
    (2) Under no circumstances shall the same person be used to qualify 
more than one taxpayer as the head of a household for the same taxable 
year.
    (3) Any of the following persons may qualify the taxpayer as a head 
of a household:
    (i) A son, stepson, daughter, or stepdaughter of the taxpayer, or a 
descendant of a son or daughter of the taxpayer. For the purpose of 
determining whether any of the stated relationships exist, a legally 
adopted child of a person is considered a child of such person by blood. 
If any such person is not married at the close of the taxable year of 
the taxpayer, the taxpayer may qualify as the head of a household by 
reason of such person even though the taxpayer may not claim a deduction 
for such person under section 151, for example, because the taxpayer 
does not furnish more than half of the support of such person. However, 
if any such person is married at the close of the taxable year of the 
taxpayer, the taxpayer may qualify as the head of a household by reason 
of such person only if the taxpayer is entitled to a deduction for such 
person under section 151 and the regulations thereunder. In applying the 
preceding sentence there shall be disregarded any such person for whom a 
deduction is allowed under section 151 only by reason of section 152(c) 
(relating to persons covered by a multiple support agreement).
    (ii) Any other person who is a dependent of the taxpayer, if the 
taxpayer is entitled to a deduction for the

[[Page 22]]

taxable year for such person under section 151 and paragraphs (3) 
through (8) of section 152(a) and the regulations thereunder. Under 
section 151 the taxpayer may be entitled to a deduction for any of the 
following persons:
    (a) His brother, sister, stepbrother, or stepsister;
    (b) His father or mother, or an ancestor of either;
    (c) His stepfather or stepmother;
    (d) A son or a daughter of his brother or sister;
    (e) A brother or sister of his father or mother; or
    (f) His son-in-law, daughter-in-law, father-in-law, mother-in-law, 
brother- in-law, or sister-in-law;


if such person has a gross income of less than the amount determined 
pursuant to Sec. 1.151-2 applicable to the calendar year in which the 
taxable year of the taxpayer begins, if the taxpayer supplies more than 
one-half of the support of such person for such calendar year and if 
such person does not make a joint return with his spouse for the taxable 
year beginning in such calendar year. The taxpayer may not be considered 
to be a head of a household by reason of any person for whom a deduction 
is allowed under section 151 only by reason of sections 152 (a)(9), 152 
(a)(10), or 152(c) (relating to persons not related to the taxpayer, 
persons receiving institutional care, and persons covered by multiple 
support agreements).
    (4) The father or mother of the taxpayer may qualify the taxpayer as 
a head of a household, but only if the taxpayer is entitled to a 
deduction for the taxable year for such father or mother under section 
151 (determined without regard to section 152(c)). For example, an 
unmarried taxpayer who maintains a home for his widowed mother may not 
qualify as the head of a household by reason of his maintenance of a 
home for his mother if his mother has gross income equal to or in excess 
of the amount determined pursuant to Sec. 1.151-2 applicable to the 
calendar year in which the taxable year of the taxpayer begins, or if he 
does not furnish more than one-half of the support of his mother for 
such calendar year. For this purpose, a person who legally adopted the 
taxpayer is considered the father or mother of the taxpayer.
    (5) For the purpose of this paragraph, the status of the taxpayer 
shall be determined as of the close of the taxpayer's taxable year. A 
taxpayer shall be considered as not married if at the close of his 
taxable year he is legally separated from his spouse under a decree of 
divorce or separate maintenance, or if at any time during the taxable 
year the spouse to whom the taxpayer is married at the close of his 
taxable year was a nonresident alien. A taxpayer shall be considered 
married at the close of his taxable year if his spouse (other than a 
spouse who is a nonresident alien) dies during such year.
    (6) If the taxpayer is a nonresident alien during any part of the 
taxable year he may not qualify as a head of a household even though he 
may comply with the other provisions of this paragraph. See the 
regulations prescribed under section 871 for a definition of nonresident 
alien.
    (c) Household. (1) In order for a taxpayer to be considered as 
maintaining a household by reason of any individual described in 
paragraph (a)(1) or (b)(3) of this section, the household must actually 
constitute the home of the taxpayer for his taxable year. A physical 
change in the location of such home will not prevent a taxpayer from 
qualifying as a head of a household. Such home must also constitute the 
principal place of abode of at least one of the persons specified in 
such paragraph (a)(1) or (b)(3) of this section. It is not sufficient 
that the taxpayer maintain the household without being its occupant. The 
taxpayer and such other person must occupy the household for the entire 
taxable year of the taxpayer. However, the fact that such other person 
is born or dies within the taxable year will not prevent the taxpayer 
from qualifying as a head of household if the household constitutes the 
principal place of abode of such other person for the remaining or 
preceding part of such taxable year. The taxpayer and such other person 
will be considered as occupying the household for such entire taxable 
year notwithstanding temporary absences from the household

[[Page 23]]

due to special circumstances. A nonpermanent failure to occupy the 
common abode by reason of illness, education, business, vacation, 
military service, or a custody agreement under which a child or 
stepchild is absent for less than 6 months in the taxable year of the 
taxpayer, shall be considered temporary absence due to special 
circumstances. Such absence will not prevent the taxpayer from being 
considered as maintaining a household if (i) it is reasonable to assume 
that the taxpayer or such other person will return to the household, and 
(ii) the taxpayer continues to maintain such household or a 
substantially equivalent household in anticipation of such return.
    (2) In order for a taxpayer to be considered as maintaining a 
household by reason of any individual described in paragraph (b)(4) of 
this section, the household must actually constitute the principal place 
of abode of the taxpayer's dependent father or mother, or both of them. 
It is not, however, necessary for the purposes of such subparagraph for 
the taxpayer also to reside in such place of abode. A physical change in 
the location of such home will not prevent a taxpayer from qualifying as 
a head of a household. The father or mother of the taxpayer, however, 
must occupy the household for the entire taxable year of the taxpayer. 
They will be considered as occupying the household for such entire year 
notwithstanding temporary absences from the household due to special 
circumstances. For example, a nonpermanent failure to occupy the 
household by reason of illness or vacation shall be considered temporary 
absence due to special circumstances. Such absence will not prevent the 
taxpayer from qualifying as the head of a household if (i) it is 
reasonable to assume that such person will return to the household, and 
(ii) the taxpayer continues to maintain such household or a 
substantially equivalent household in anticipation of such return. 
However, the fact that the father or mother of the taxpayer dies within 
the year will not prevent the taxpayer from qualifying as a head of a 
household if the household constitutes the principal place of abode of 
the father or mother for the preceding part of such taxable year.
    (d) Cost of maintaining a household. A taxpayer shall be considered 
as maintaining a household only if he pays more than one-half the cost 
thereof for his taxable year. The cost of maintaining a household shall 
be the expenses incurred for the mutual benefit of the occupants thereof 
by reason of its operation as the principal place of abode of such 
occupants for such taxable year. The cost of maintaining a household 
shall not include expenses otherwise incurred. The expenses of 
maintaining a household include property taxes, mortgage interest, rent, 
utility charges, upkeep and repairs, property insurance, and food 
consumed on the premises. Such expenses do not include the cost of 
clothing, education, medical treatment, vacations, life insurance, and 
transportation. In addition, the cost of maintaining a household shall 
not include any amount which represents the value of services rendered 
in the household by the taxpayer or by a person qualifying the taxpayer 
as a head of a household or as a surviving spouse.
    (e) Certain married individuals living apart. For taxable years 
beginning after December 31, 1969, an individual who is considered as 
not married under section 143(b) shall be considered as not married for 
purposes of determining whether he or she qualifies as a single 
individual, a married individual, a head of household or a surviving 
spouse under sections 1 and 2 of the Code.

[T.D. 7117, 36 FR 9398, May 25, 1971]



Sec. 1.3-1  Application of optional tax.

    (a) General rules. (1) For taxable years ending before January 1, 
1970, an individual whose adjusted gross income is less than $5,000 (or 
a husband and wife filing a joint return whose combined adjusted gross 
income is less than $5,000) may elect to pay the tax imposed by section 
3 in place of the tax imposed by section 1 (a) or (b). For taxable years 
beginning after December 31, 1969 and before January 1, 1971 an 
individual whose adjusted gross income is less than $10,000 (or a 
husband and wife filing a joint return whose combined adjusted gross 
income is less than $10,000) may elect to pay the tax imposed by section 
3 as amended by the Tax Reform Act of 1969 in place of the

[[Page 24]]

tax imposed by section 1 (a) or (b). For taxable years beginning after 
December 31, 1970 an individual whose adjusted gross income is less than 
$10,000 (or a husband and wife filing a joint return whose combined 
adjusted gross income is less than $10,000) may elect to pay the tax 
imposed by section 3 as amended in place of the tax imposed by section 1 
as amended. See Sec. 1.4-2 for the manner of making such election. A 
taxpayer may make such election regardless of the sources from which his 
income is derived and regardless of whether his income is computed by 
the cash method or the accrual method. See section 62 and the 
regulations thereunder for the determination of adjusted gross income. 
For the purpose of determining whether a taxpayer may elect to pay the 
tax under section 3, the amount of the adjusted gross income is 
controlling, without reference to the number of exemptions to which the 
taxpayer may be entitled. See section 4 and the regulations thereunder 
for additional rules applicable to section 3.
    (2) The following examples illustrate the rule that section 3 
applies only if the adjusted gross income is less than $10,000 ($5,000 
for taxable years ending before January 1, 1970).

    Example 1. A is employed at a salary of $9,200 for the calendar year 
1970. In the course of such employment, he incurred travel expenses of 
$1,500 for which he was reimbursed during the year. Such items 
constitute his sole income for 1970. In such case the gross income is 
$10,700 but the amount of $1,500 is deducted from gross income in the 
determination of adjusted gross income and thus A's adjusted gross 
income for 1970 is $9,200. Hence, the adjusted gross income being less 
than $10,000, he may elect to pay his tax for 1970 under section 3. 
Similarly, in the case of an individual engaged in trade or business 
(excluding from the term ``engaged in trade or business'' the 
performance of personal services as an employee), there may be deducted 
from gross income in ascertaining adjusted gross income those expenses 
directly relating to the carrying on of such trade or business.
    Example 2. If B has, as his only income for 1970, a salary of 
$11,600 and his spouse has no gross income, then B's adjusted gross 
income is $11,600 (not $11,600 reduced by exemptions of $1,250) and he 
is not for such year, entitled to pay his tax under section 3. If, 
however, B has for 1970 a salary of $13,000 and incident to his 
employment he incurs expenses in the amount of $3,400 for travel, meals, 
and lodging while away from home, for which he is not reimbursed, the 
adjusted gross income is $13,000 minus $3,400 or $9,600. In such case 
his adjusted gross income being less than $10,000, B may elect to pay 
the tax under section 3. However, if B's wife has adjusted gross income 
of $400, the total adjusted gross income is $10,000. In such case, if B 
and his wife file a joint return, they may not elect to pay the optional 
tax since the combined adjusted gross income is not less than $10,000. B 
may nevertheless elect to pay the optional tax, but if he makes this 
election he must file a separate return and, since his wife has gross 
income, he may not claim an exemption for her in computing the optional 
tax.

    (b) Surviving spouse. The return of a surviving spouse is treated as 
a joint return for purposes of section 3. See section 2, and the 
regulations thereunder, with respect to the qualifications of a taxpayer 
as a surviving spouse. Accordingly, if the taxpayer qualifies as a 
surviving spouse and elects to pay the optional tax, he shall use the 
column in the tax table, appropriate to his number of exemptions, 
provided for cases in which a joint return is filed.
    (c) Use of tax table. (1) To determine the amount of the tax, the 
individual ascertains the amount of his adjusted gross income, refers to 
the appropriate table set forth in section 3 or the regulations 
thereunder, ascertains the income bracket into which such income falls, 
and, using the number of exemptions applicable to his case, finds the 
tax in the vertical column having at the top thereof a number 
corresponding to the number of exemptions to which the taxpayer is 
entitled.
    (2) Section 3(b) (relating to taxable years beginning after Dec. 31, 
1964 and ending before Jan. 1, 1970) contains 5 tables for use in 
computing the tax. Table I is to be used by a single person who is not a 
head of household. Table II is to be used by a head of household. Table 
III is to be used by married persons filing joint returns and by a 
surviving spouse. Table IV is to be used by married persons filing 
separate returns using the 10 percent standard deduction. Table V is to 
be used by married persons filing separate returns using the minimum 
standard deduction. For an explanation of the standard deduction see 
section 141 and the regulations thereunder.

[[Page 25]]

    (3) 30 tables are provided for use in computing the tax under the 
Tax Reform Act of 1969. Tables I through XV apply for taxable years 
beginning after December 31, 1969 and ending before January 1, 1971. 
Tables XVI through XXX apply for taxable years beginning after December 
31, 1970. The standard deduction for Tables I through XV, applicable to 
taxable years beginning in 1970, is 10 percent. The standard deduction 
for Tables XVI through XXX, applicable to taxable years beginning in 
1971, is 13 percent. For an explanation of the standard deduction and 
the low income allowance see section 141 as amended by the Tax Reform 
Act of 1969.
    (4) In the case of married persons filing separate returns who 
qualify to use the optional tax imposed by section 3, such persons shall 
use the tax imposed by the table for the applicable year in accordance 
with the rules prescribed by sections 4(c) and 141 and the regulations 
thereunder governing the use and application of the standard deduction 
and the low income allowance.
    (5) The tax shown in the tax tables set forth in section 3 or the 
regulations thereunder reflects full income splitting in the case of a 
joint return (including the return of a surviving spouse) and lesser 
income splitting in the case of a head of household. Therefore, it is 
possible for the tax shown in the tables relating to joint returns, or 
relating to a return of a head of a household, to be lower than that 
shown in the table for separate returns even though the amounts of 
adjusted gross income and the number of exemptions are the same.

[T.D. 7117, 36 FR 9420, May 25, 1971]



Sec. 1.4-1  Number of exemptions.

    (a) For the purpose of determining the optional tax imposed under 
section 3, the taxpayer shall use the number of exemptions allowable to 
him as deductions under section 151. See sections 151, 152, and 153, and 
the regulations thereunder. In general, one exemption is allowed for the 
taxpayer; one exemption for his spouse if a joint return is made, or if 
a separate return is made by the taxpayer and his spouse has no gross 
income for the calendar year in which the taxable year of the taxpayer 
begins and is not the dependent of another taxpayer for such calendar 
year; and one exemption for each dependent whose gross income for the 
calendar year in which the taxable year of the taxpayer begins is less 
than the applicable amount determined pursuant to Sec. 1.151-2. No 
exemption is allowed for any dependent who has made a joint return with 
his spouse for the taxable year beginning in the calendar year in which 
the taxable year of the taxpayer begins. The taxpayer may, in certain 
cases, be allowed an exemption for a dependent child of the taxpayer 
notwithstanding the fact that such child has gross income equal to or in 
excess of the amount determined pursuant to Sec. 1.151-2 applicable to 
the calendar year in which the taxable year of the taxpayer begins. The 
requirements for the allowance of such an exemption are set forth in 
paragraph (c) of Sec. 1.152-1. See paragraphs (c) and (d) of Sec. 1.151-
1 with respect to additional exemptions for a taxpayer or spouse who has 
attained the age 65 years and for a blind taxpayer or blind spouse
    (b) The application of this section may be illustrated by the 
following examples:

    Example 1. A, a married man whose duties as an employee require 
traveling away from his home, has as his sole gross income a salary of 
$5,600 for the calendar year 1954. His traveling expenses, including 
cost of meals and lodging, amount in such year to $750, and hence, his 
adjusted gross income is $4,850. His wife, B, has as her sole income 
interest in the amount of $85, and thus the aggregate adjusted gross 
income of A and B is $4,935. A has two dependent children neither of 
whom has any income. A and B file a joint return for 1954 on Form 1040. 
In such case four exemptions are allowable. The adjusted gross income 
falls within the tax bracket $4,900-4,950. By referring to such tax 
bracket in the tax table in section 3 and to the column headed ``4'' 
therein, the tax is found to be $407.
    Example 2. C, a married man, has as his sole income in 1954 wages of 
$4,600, and has two dependent children neither of whom has any income. 
His wife, D, has adjusted gross income of $400. C files a separate 
return for 1954 and is entitled to claim three exemptions. C's income 
falls within the tax bracket $4,600-4,650 and hence, with three 
exemptions his tax is $480. No exemption is allowed with respect to 
since D has gross income and a joint return was not filed.

[[Page 26]]

    Example 3. D, a married man with no dependents, attains the age of 
65 on September 1, 1954. The aggregate adjusted gross income of D and 
his wife for 1954 is $4,840. D and his wife file a joint return for 1954 
and are entitled to three exemptions, one for each taxpayer and one 
additional exemption for D because of his age. Since the adjusted gross 
income of D and his wife falls within the tax bracket $4,800-4,850, the 
tax on a joint return is $509.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7114, 36 FR 
9018, May 18, 1971]



Sec. 1.4-2  Elections.

    (a) Making of election. The election to pay the optional tax imposed 
under section 3 shall be made by (1) filing a return on Form 1040A, or 
(2) filing a return on Form 1040 and electing in such return, in 
accordance with the provisions of section 144 and the regulations 
thereunder, to take the standard deduction provided by section 141.
    (b) Election under section 3 and election of standard deduction. 
Section 144 (a) and the regulations thereunder provide rules for 
treating an election to pay the tax under section 3 as an election to 
take the standard deduction, and for treating an election to take the 
standard deduction as an election to pay the tax under section 3. For 
example, if the taxpayer's return shows $5,000 or more of adjusted gross 
income and he elects to take the standard deduction, he will be deemed 
to have elected to pay the tax under section 3 if it is subsequently 
determined that his correct adjusted gross income is less than $5,000.
    (c) [Reserved]
    (d) Change of election. For rules relating to a change of election 
to pay, or not to pay, the optional tax imposed under section 3, see 
section 144 (b) and the regulations thereunder.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6581, 26 FR 
11677, Dec. 6, 1961; T.D. 7269, 38 FR 9295, Apr. 13, 1973]



Sec. 1.4-3  Husband and wife filing separate returns.

    (a) In general. If the separate adjusted gross income of a husband 
is less than $5,000 and the separate adjusted gross income of his wife 
is less than $5,000, and if each is required to file a return, the 
husband and the wife must each elect to pay the optional tax imposed 
under section 3 or neither may so elect. If the separate adjusted gross 
income of each spouse is $5,000 or more, then neither spouse can elect 
to pay the optional tax imposed under section 3. If the adjusted gross 
income of one spouse is $5,000 or more and that of the other spouse is 
less than $5,000, the election to pay the optional tax imposed under 
section 3 may be exercised by the spouse having adjusted gross income of 
less than $5,000 only if the spouse having adjusted gross income of 
$5,000 or more, in computing taxable income, uses the standard deduction 
provided by section 141. If the spouse having adjusted gross income of 
$5,000 or more does not use the standard deduction, then the spouse 
having adjusted gross income of less than $5,000 may not elect to pay 
the optional tax and must compute taxable income without regard to the 
standard deduction. Accordingly, if the spouse having adjusted gross 
income of $5,000 or more itemizes the deductions allowed by sections 161 
and 211 in computing taxable income, the spouse having adjusted gross 
income of less than $5,000 must also compute taxable income by itemizing 
the deductions allowed by sections 161 and 211, and must pay the tax 
imposed by section 1. For rules relative to the election to take the 
standard deduction by husband and wife, see part IV (section 141 and 
following), subchapter B, chapter 1 of the Code, and the regulations 
thereunder.
    (b) Taxable years beginning after December 31, 1963, and before 
January 1, 1970. (1) In the case of a husband and wife filing a separate 
return for a taxable year beginning after December 31, 1963, and before 
January 1, 1970, the optional tax imposed by section 3 shall be--
    (i) For taxable years beginning in 1964, the lesser of the tax shown 
in Table IV (relating to the 10-percent standard deduction for married 
persons filing separate returns) or Table V (relating to the minimum 
standard deduction for married persons filing separate returns) of 
section 3(a), and
    (ii) For a taxable year beginning after December 31, 1964, and 
before January 1, 1970, the lesser of the tax shown in Table IV 
(relating to the 10-percent standard deduction for married persons

[[Page 27]]

filing separate returns) or Table V (relating to minimum standard 
deduction for married persons filing separate returns) of section 3(b).
    (2) If the tax of one spouse is determined with regard to the 10-
percent standard deduction provided for in Table IV of section 3(a) or 
3(b) or if such spouse in computing taxable income uses the 10-percent 
standard deduction provided for in section 141(b), then the minimum 
standard deduction provided for in Table V of section 3(a) or 3(b) shall 
not apply in the case of the other spouse, if such spouse elects to pay 
the optional tax imposed under section (3). Thus, if a husband and wife 
compute their tax with reference to the standard deduction, one cannot 
elect to use the 10-percent standard deduction and the other elect to 
use the minimum standard deduction. However, an individual described in 
section 141(d)(2) may elect pursuant to such section and the regulations 
thereunder to pay the tax shown in Table V of section 3(a) or 3(b) in 
lieu of the tax shown in Table IV of section 3(a) or 3(b). See section 
141(d) and the regulations thereunder for rules relating to the standard 
deduction in the case of married individuals filing separate returns.
    (c) Taxable years beginning after December 31, 1969. (1) In the case 
of a husband and wife filing a separate return for a taxable year 
beginning after December 31, 1969, the optional tax imposed by section 3 
shall be the lesser of the tax shown in--
    (i) The table prescribed under section 3 applicable to such taxable 
year in the case of married persons filing separate returns which 
applies the percentage standard deduction, or
    (ii) The table prescribed under section 3 applicable to such taxable 
year in the case of married persons filing separate returns which 
applies the low income allowance.
    (2) If the tax of one spouse is determined by the table described in 
subparagraph (1)(i) of this paragraph or if such spouse in computing 
taxable income uses the percentage standard deduction provided for in 
section 141(b), then the table described in subparagraph (1)(ii) of this 
paragraph shall not apply in the case of the other spouse, if such other 
spouse elects to pay the optional tax imposed under section 3. Thus, if 
a husband and wife compute the tax with reference to the standard 
deduction, one cannot elect to use the percentage standard deduction and 
the other elect to use the low income allowance. A married individual 
described in section 141(d)(2) may elect pursuant to such section and 
the regulations thereunder to pay the tax shown in the table described 
by subparagraph (1)(ii) of this paragraph in lieu of the tax shown in 
the table described by subparagraph (1)(i) of this paragraph. See 
section 141(d) and the regulations thereunder for rules relating to the 
standard deduction in the case of married individuals filing separate 
returns.
    (d) Determination of marital status. For the purpose of applying the 
restrictions upon the right of a married person to elect to pay the tax 
under section 3, (1) the determination of marital status is made as of 
the close of the taxpayer's taxable year or, if his spouse died during 
such year, as of the date of death; (2) a person legally separated from 
his spouse under a decree of divorce or separate maintenance on the last 
day of his taxable year (or the date of death of his spouse, whichever 
is applicable) is not considered as married; and (3) with respect to 
taxable years beginning after December 31, 1969, a person, although 
considered as married within the meaning of section 143(a), is 
considered as not married if he lives apart from his spouse and 
satisfies the requirements set forth in section 143(b). See section 143 
and the regulations thereunder.

[T.D. 6792, 30 FR 529, Jan. 15, 1965, as amended by T.D. 7123, 36 FR 
11084, June 9, 1971]



Sec. 1.4-4  Short taxable year caused by death.

    An individual making a return for a period of less than 12 months on 
account of a change in his accounting period may not elect to pay the 
optional tax under section 3. However, the fact that the taxable year is 
less than 12 months does not prevent the determination of the tax for 
the taxable year under section 3 if the short taxable year results from 
the death of the taxpayer.

[[Page 28]]

                           Tax on Corporations



Sec. 1.11-1  Tax on corporations.

    (a) Every corporation, foreign or domestic, is liable to the tax 
imposed under section 11 except (1) corporations specifically excepted 
under such section from such tax; (2) corporations expressly exempt from 
all taxation under subtitle A of the Code (see section 501); and (3) 
corporations subject to tax under section 511(a). For taxable years 
beginning after December 31, 1966, foreign corporations engaged in trade 
or business in the United States shall be taxable under section 11 only 
on their taxable income which is effectively connected with the conduct 
of a trade or business in the United States (see section 882(a)(1)). For 
definition of the terms ``corporations,'' ``domestic,'' and ``foreign,'' 
see section 7701(a) (3), (4), and (5), respectively. It is immaterial 
that a domestic corporation, and for taxable years beginning after 
December 31, 1966, a foreign corporation engaged in trade or business in 
the United States, which is subject to the tax imposed by section 11 may 
derive no income from sources within the United States. The tax imposed 
by section 11 is payable upon the basis of the returns rendered by the 
corporations liable thereto, except that in some cases a tax is to be 
paid at the source of the income. See subchapter A (sections 6001 and 
following), chapter 61 of the Code, and section 1442.
    (b) The tax imposed by section 11 consists of a normal tax and a 
surtax. The normal tax and the surtax are both computed upon the taxable 
income of the corporation for the taxable year, that is, upon the gross 
income of the corporation minus the deductions allowed by chapter 1 of 
the Code. However, the deduction provided in section 242 for partially 
tax-exempt interest is not allowed in computing the taxable income 
subject to the surtax.
    (c) The normal tax is at the rate of 22 percent and is applied to 
the taxable income for the taxable year. However, in the case of a 
taxable year ending after December 31, 1974, and before January 1, 1976, 
the normal tax is at the rate of 20 percent of so much of the taxable 
income as does not exceed $25,000 and at the rate of 22 percent of so 
much of the taxable income as does exceed $25,000 and is applied to the 
taxable income for the taxable year.
    (d) The surtax is at the rate of 26 percent and is upon the taxable 
income (computed without regard to the deduction, if any, provided in 
section 242 for partially tax-exempt interest) in excess of $25,000. 
However, in the case of a taxable year ending after December 31, 1974, 
and before January 1, 1976, the surtax is upon the taxable income 
(computed as provided in the preceding sentence) in excess of $50,000. 
In certain circumstances the exemption from surtax may be disallowed in 
whole or in part. See sections 269, 1551, 1561, and 1564 and the 
regulations thereunder. For purposes of sections 244, 247, 804, 907, 922 
and Secs. 1.51-1 and 1.815-4, when the phrase ``the sum of the normal 
tax rate and the surtax rate for the taxable year'' is used in any such 
section, the normal tax rate for all taxable years beginning after 
December 31, 1963, and ending before January 1, 1976, shall be 
considered to be 22 percent.
    (e) The computation of the tax on corporations imposed under section 
11 may be illustrated by the following example:

    Example. The X Corporation, a domestic corporation, has gross income 
of $86,000 for the calendar year 1964. The gross income includes 
interest of $5,000 on United States obligations for which a deduction 
under section 242 is allowable in determining taxable income subject to 
the normal tax. It has other deductions of $11,000. The tax of the X 
Corporation under section 11 for the calendar year is $28,400 ($15,400 
normal tax and $13,000 surtax) computed as follows:

                        Computation of Normal Tax
Gross income....................................     $86,000
Deductions:
  Partially tax-exempt interest.................      $5,000
  Other.........................................      11,000      16,000
                                                 -----------------------
Taxable income..................................      70,000
Normal tax (22 percent of $70,000)..............      15,400
 
                          Computation of Surtax
Taxable income..................................      70,000
Add: Amount of partially tax-exempt interest           5,000
 deducted in computing taxable income...........
                                                 -------------
Taxable income subject to surtax................      75,000
Less: Exemption from surtax.....................      25,000
                                                 -------------
Excess of taxable income subject to surtax over       50,000
 exemption......................................
Surtax (26 percent of $50,000)..................      13,000
 

    (f) For special rules applicable to foreign corporations engaged in 
trade or

[[Page 29]]

business within the United States, see section 882 and the regulations 
thereunder. For additional tax on personal holding companies, see part 
II (section 541 and following), subchapter G, chapter 1 of the Code, and 
the regulations thereunder. For additional tax on corporations 
improperly accumulating surplus, see part I (section 531 and following), 
subchapter G, chapter 1 of the Code, and the regulations thereunder. For 
treatment of China Trade Act corporations, see sections 941 and 942 and 
the regulations thereunder. For treatment of Western Hemisphere trade 
corporations, see sections 921 and 922 and the regulations thereunder. 
For treatment of capital gains and losses, see subchapter P (section 
1201 and following), chapter 1 of the Code. For computation of the tax 
for a taxable year during which a change in the tax rates occurs, see 
section 21 and the regulations thereunder.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 7293, 38 FR 
32792, Nov. 28, 1973; T.D. 74-13, 41 FR 12639, Mar. 26, 1976]

                 Changes in Rates During a Taxable Year



Sec. 1.15-1  Changes in rate during a taxable year.

    (a) Section 21 applies to all taxpayers, including individuals and 
corporations. It provides a general rule applicable in any case where 
(1) any rate of tax imposed by chapter 1 of the Code upon the taxpayer 
is increased or decreased, or any such tax is repealed, and (2) the 
taxable year includes the effective date of the change, except where 
that date is the first day of the taxable year. For example, the normal 
tax on corporations under section 11(b) was decreased from 30 percent to 
22 percent in the case of a taxable year beginning after December 31, 
1963. Accordingly, the tax for a taxable year of a corporation beginning 
on January 1, 1964, would be computed under section 11(b) at the new 
rate without regard to section 21. However, for any taxable year 
beginning before January 1, 1964, and ending on or after that date, the 
tax would be computed under section 21. For additional circumstances 
under which section 21 is not applicable, see paragraph (k) of this 
section.
    (b) In any case in which section 21 is applicable, a tentative tax 
shall be computed by applying to the taxable income for the entire 
taxable year the rate for the period within the taxable year before the 
effective date of change, and another tentative tax shall be computed by 
applying to the taxable income for the entire taxable year the rate for 
the period within the taxable year on or after such effective date. The 
tax imposed on the taxpayer is the sum of--
    (1) An amount which bears the same ratio to the tentative tax 
computed at the rate applicable to the period within the taxable year 
before the effective date of the change that the number of days in such 
period bears to the number of days in the taxable year, and
    (2) An amount which bears the same ratio to the tentative tax 
computed at the rate applicable to the period within the taxable year on 
and after the effective date of the change that the number of days in 
such period bears to the number of days in the taxable year.
    (c) If the rate of tax is changed for taxable years ``beginning 
after'' or ``ending after'' a certain date, the following day is 
considered the effective date of the change for purposes of section 21. 
If the rate is changed for taxable years ``beginning on or after'' a 
certain date, that date is considered the effective date of the change 
for purposes of section 21. This rule may be illustrated by the 
following examples:

    Example 1. Assume that the law provides that a change in a certain 
rate of tax shall be effective only with respect to taxable years 
beginning after December 31, 1969. The effective date of change for 
purposes of section 21 is January 1, 1970, and section 21 must be 
applied to any taxable year which begins before and ends on or after 
January 1, 1970.
    Example 2. Assume that the law provides that a change in a certain 
rate of tax shall be applicable only with respect to taxable years 
ending after December 31, 1970. For purposes of section 21, the 
effective date of change is January 1, 1971, and section 21 must be 
applied to any taxable year which begins before and ends on or after 
January 1, 1971.
    Example 3. Assume that the law provides that a change in a certain 
rate of tax shall be effective only with respect to taxable years 
beginning on or after January 1, 1971. The effective date of change for 
purposes of section 21 is January 1, 1971, and section 21

[[Page 30]]

must be applied to any taxable year which begins before and ends on or 
after January 1, 1971.

    (d) If a tax is repealed, the repeal will be treated as a change of 
rate for purposes of section 21, and the rate for the period after the 
repeal (for purposes of computing the tentative tax with respect to that 
period) will be considered zero. For example, the Tax Reform Act of 1969 
repealed section 1562, which imposed a 6 percent additional tax on 
controlled corporations electing multiple surtax exemptions, effective 
for taxable years beginning after December 31, 1974. For such controlled 
corporations having taxable years beginning in 1974 and ending in 1975, 
the rate for the period ending before January 1, 1975, would be 6 
percent; the rate for the period beginning after December 31, 1974, 
would be zero. However, subject to the rules stated in this section, 
section 21 does not apply to the imposition of a new tax. For example, 
if a new tax is imposed for taxable years beginning on or after July 1, 
1972, a computation under section 21 would not be required with respect 
to such new tax in the case of taxable years beginning before July 1, 
1972, and ending on or after that date. If the effective date of the 
imposition of a new tax and the effective date of a change in rate of 
such tax fall in the same taxable year, section 21 is not applicable in 
computing the taxpayer's liability for such tax for such year unless the 
new tax is expressly imposed upon the taxpayer for a portion of his 
taxable year prior to the change in rate.
    (e) If a husband and wife have different taxable years because of 
the death of either spouse, and if a joint return is filed with respect 
to the taxable year of each, then, for purposes of section 21, the joint 
return shall be treated as if the taxable years of both spouses ended on 
the date of the closing of the surviving spouse's taxable year. See 
section 6013 (c), relating to treatment of joint return after death of 
either spouse. Accordingly, if a change in the rate of tax is effective 
during the taxable year of the surviving spouse, the tentative taxes 
with respect to the joint return shall be computed on the basis of the 
number of days during which each rate of tax was in effect for the 
taxable year of the surviving spouse.
    (f) Section 21 applies whether or not the taxpayer has a taxable 
year of less than 12 months. Moreover, section 21 applies whether or not 
the taxable income for a taxable year of less than 12 months is required 
to be placed on an annual basis under section 443. If the taxable income 
is required to be computed under section 443(b) then the tentative taxes 
under section 21 are computed as provided in paragraph (1) or (2) of 
section 443(b) and are reduced as provided in those paragraphs. The 
tentative taxes so computed and reduced are then apportioned as provided 
in section 21(a)(2) to determine the tax for such taxable year as 
computed under section 21.
    (g) If a taxpayer has made the election under section 441(f) 
(relating to computation of taxable income on the basis of an annual 
accounting period varying from 52 to 53 weeks), the rules provided in 
section 441(f)(2) shall be applicable for purposes of determining 
whether section 21 applies to the taxable year of the taxpayer. Where a 
taxpayer has made the election under section 441(f) and where section 21 
applies to the taxable year of the taxpayer the computation under 
section 21(a)(2) shall be made upon the basis of the actual number of 
days in the taxable year and in each period thereof.
    (h)(1) Section 21 is applicable only if the rate of tax imposed by 
chapter 1 changes. Sections in which rates of tax are specified or 
incorporated by reference include the following: 1, 2, 3, 11, 511, 531, 
541, 821, 831, 871, 881, 1201, and 1348 (for taxable years beginning 
after December 31, 1970). Except as provided in subparagraph (3) of this 
paragraph, section 21 is not applicable with respect to changes in the 
law relating to deductions from gross income, exclusions from or 
inclusions in gross income, or other items taken into account in 
determining the amount or character of income subject to tax. Moreover, 
section 21 is not applicable with respect to changes in the law relating 
to credits against the tax or with respect to changes in the law 
relating to limitations on the amount of tax. Section 21 is applicable, 
however, to all those computations specified in

[[Page 31]]

the section providing the rate of tax which are implicit in determining 
the rate. For example, if one of the tax brackets in the tax tables 
under section 3 were to be changed, section 21 would be applicable to 
that change. Thus, if the bracket relating to ``at least $4,200 but not 
less than $4,250'' for heads of households should be changed to increase 
or decrease the last sum specified, with corresponding changes being 
made in subsequent brackets, section 21 would be applicable. The 
enactment of sections 1561 and 1562 is considered a change in section 
11(d) which constitutes a change in rate for the period ending after 
December 31, 1963. The amendment of section 1561 and the repeal of 
section 1562 by the Tax Reform Act of 1969 is considered a change in 
section 11(d) which constitutes a change in rate for the period ending 
after December 31, 1974. The repeal of the 2 percent additional tax 
imposed under section 1503 on corporations filing consolidated returns 
constitutes a change in rate for the period ending after December 31, 
1963. The addition to the Code of section 1348 (relating to 50 percent 
maximum rate on earned income) is a change in rate to which section 
21(a) is applicable. The amendment of section 11(d) by the Tax Reduction 
Act of 1975 which increases to $50,000 the surtax exemption for a 
taxable year ending during 1975 constitutes a change in rate for such 
portion of the taxable year (if less than the entire taxable year) as 
follows December 31, 1974. Similarly, the return of the surtax exemption 
to $25,000 for a taxable year ending during 1976 constitutes a change in 
rate for such portion of the taxable year (if less than the entire 
taxable year) as follows December 31, 1975.
    (2) Ordinarily, both the old and the new rates are applied to the 
same amount of taxable income. However, where the rate of tax is itself 
taken into account in determining taxable income (for example, the 
special deduction for Western Hemisphere trade corporations under 
section 922), the taxable income used in determining the tentative tax 
employing the rate before the effective date of change shall be 
determined by reference to that rate of tax, and the taxable income for 
the purpose of determining the tentative tax employing the rate for the 
period on and after the effective date of the change shall be determined 
by reference to the new tax rate.
    (3) Section 21 is applicable with respect to changes in the law 
relating to the standard deduction for individuals provided in part IV 
of subchapter B and to the deduction for personal exemptions for 
individuals provided in part V of subchapter B.
    (i) If the rate of tax changes more than once during the taxable 
year, section 21 is applicable to each change in rate. For example, if 
the rate of normal tax changed for taxable years beginning on or after 
March 1, 1954, and changed again for taxable years beginning on or after 
June 1, 1954, section 21 requires computation of 3 tentative taxes for 
any taxable year which began before March 1, 1954, and ended on or after 
June 1, 1954: One tentative tax at the rate in effect before the March 1 
change; another tentative tax at the rate in effect from March 1 to May 
31; and a third tentative tax at the rate in effect from June 1 to the 
end of the taxable year. The proportion of each such tentative tax taken 
into account in determining the tax imposed on the taxpayer is computed 
by reference to the portion of the taxable year before March 1, 1954, by 
reference to the portion of the taxable year from March 1, 1954, through 
May 31, 1954, and by reference to the portion of the taxable year from 
June 1, 1954, to the end of the taxable year, respectively.
    (j)(1) If a change in the rate of one tax imposed by chapter 1 of 
the Code does not affect the amount of other taxes imposed by chapter 1 
of the Code the other taxes may be determined without regard to section 
21 and section 21 will be applied only to the tax for which a change in 
rate is made. However, if the change of rate of one tax does affect the 
amount of other taxes imposed under chapter 1 of the Code, then the 
computation of the taxes under chapter 1 of the Code so affected shall 
be made by applying section 21. For example, if section 1201 applies to 
an individual taxpayer for a taxable year containing the effective date 
of a change in a rate of tax provided in section 1, then under section

[[Page 32]]

21 the taxpayer must compute a tentative tax for each period for which a 
different rate of tax is effective under section 1. The tentative tax 
for each such period as computed under section 1201 will reflect the 
rate of tax provided by section 1 for such period.
    (2) In certain cases chapter 1 of the Code provides that the 
particular tax to be imposed upon the taxpayer shall be one of several 
taxes, the basis of selection being the tax that is greater or lesser. 
See, for example, sections 821 and 1201. If in any such case the rate of 
any one of these taxes changes, then the tentative taxes computed as 
provided by section 21 for each period shall be computed employing the 
tax selected in accordance with the general rule of selection for such a 
case, at the rate of tax in effect for such period. Thus, if a change in 
the rate of the alternative tax under section 1201 is such that the 
alternative tax under section 1201 is applicable if the old rate is used 
and is not applicable if the new rate is used, one tentative tax will 
consist of the alternative tax under section 1201 and the other 
tentative tax will consist of the tax imposed by the other applicable 
sections of chapter 1 of the Code. The two tentative taxes so computed 
are then prorated in accordance with section 21(a)(2) and the sum of the 
proportionate amounts is the tax imposed for the taxable year under 
chapter 1 of the Code. See the examples in paragraph (n) of this 
section.
    (k) Section 21 does not apply in the following situations:
    (1) The provisions of section 21 do not apply to the imposition of 
the tax surcharge by section 51. The proration rules of section 51(a) 
apply in the case of a taxable year ending on or after the effective 
date of the surcharge and beginning before July 1, 1970.
    (2) The provisions of section 21 do not apply to the imposition of 
the minimum tax for tax preferences by section 56. The proration rules 
of section 301(c) of the Tax Reform Act of 1969 (83 Stat. 586) apply in 
the case of a taxable year beginning in 1969 and ending in 1970.
    (l) In computing the number of days each rate of tax is in effect 
during the taxable year for purposes of section 21(a)(2), the effective 
date of the change in rate shall be counted in the period for which the 
new rate is in effect.
    (m) Any credits against tax, and any limitation in any credit 
against tax, shall be based upon the tax computed under section 21. For 
credits against tax, see part IV (section 31 and following), subchapter 
A, chapter 1 of the Code.
    (n) The application of section 21 may be illustrated by the 
following examples: (See also the examples in Sec. 1.1561-2A(a)(3).)

    Example 1. A, a married taxpayer filing a joint return, reports his 
income on the basis of a fiscal year ending June 30. For his fiscal year 
ending June 30, 1970, A reports taxable income (exclusive of capital 
gains and losses) of $50,000 and net long-term capital gain (section 
1201 gain (net capital gain for taxable years beginning after December 
31, 1976)) of $75,000. The rate of tax on capital gains under section 
1201(b) relating to the alternative tax has been increased from 25 
percent to a maximum rate of 29\1/2\ percent with respect to gain in 
excess of $50,000 and the effective date of the change in rate is 
January 1, 1970. The income tax for the taxable year ended June 30, 
1970, would be computed under section 21 as follows:

                              Tentative Tax
Taxable income exclusive of capital      $50,000
 gains and losses...................
Long-term capital gain..............      75,000
                                     -------------
                                         125,000
Deduct 50% of long-term capital gain      37,500
                                     -------------
      Taxable income................      87,500
                                     =============
Tax under section 1 (1969 and 1970        37,690
 rates).............................
                                     =============
           Alternative Tax Under Section 1201(b) (1969 Rates)
Taxable income ($50,000 + 50% of         $87,500
 $75,000)...........................
Less 50% of long-term capital gain..      37,500
                                     -------------
Taxable income exclusive of capital       50,000
 gains..............................
                                     =============
Partial tax (tax on $50,000)........      17,060
Plus 25% of $75,000.................      18,750
                                     -------------
Alternative tax under section             35,810
 1201(b) at 1969 rates..............

[[Page 33]]

 
           Alternative Tax Under Section 1201(b) (1970 Rates)
                                 step i
Taxable income ($50,000 + 50% of         $87,500
 $75,000)...........................
Deduct 50% of net section 1201 gain       37,500
 (net capital gain for taxable years
 beginning after December 31, 1976).
                                     ------------
                                          50,000
                                     ============
Tax on $50,000 (taxable income        ..........     $17,060
 exclusive of capital gains)........
                                 step ii
(a) Net section 1201 gain (net            75,000
 capital gain for taxable years
 beginning after December 31, 1976).
(b) Subsection (d) gain.............      50,000
25% of $50,000 (lesser of (a) or      ..........      12,500
 (b))...............................
                                step iii
(c) 29\1/2\% of $25,000 (excess of         7,375
 (a) over (b))......................
                                     ============
(d) Ordinary income.................     $50,000
50% of net section 1201 gain (net         37,500
 capital gain for taxable years
 beginning after December 31, 1976).
                                     ------------
                                          87,500
                                     ============
Tax on $87,500......................     $37,690
Ordinary income.....................     $50,000
50% of subsection (d) gain..........      25,000
                                     ------------
                                          75,000
                                     ============
Tax on $75,000......................      30,470
                                     ------------
Difference..........................       7,220
                                     ============
Lesser of (c) or (d)................      $7,220
                                     -------------
Alternative tax (total of 3 steps)        36,780
 at rates effective on and after
 January 1, 1970....................
                                     =============
 


Since the alternative tax is less than the tax imposed under section 1 
for both the period in 1969 and the period in 1970, the alternative tax 
applies for both periods. Thus, since the effective date of the change 
in the rate of tax on capital gains is January 1, 1970, the old rate of 
alternative tax is effective for 184 days of the taxable year and the 
new rate of alternative tax is effective for 181 days of the taxable 
year. The alternative taxes are apportioned as follows:

1969--184/365 of $35,810....................................  $18,052.16
1970--181/365 of $36,780....................................   18,238.85
                                                             -----------
                                                               36,291.01
Tax surcharge (See Sec.  1.51-1(d)(1)(i))...................    2,729.28
                                                             -----------
      Total tax for the taxable year........................   39,020.29
 

    Example 2. B, a single individual not a head of a household, has a 
taxable year ending March 31. For the taxable year ending March 31, 
1971, B has adjusted gross income of $18,500. His computation of the tax 
imposed is as follows:

                           1970 Tentative Tax
Adjusted gross income...........................  $18,500.00
  Less:
    Standard deduction..........................   $1,000.00
    Personal exemption..........................      625.00    1,625.00
                                                 -----------------------
Taxable income under 1970 deduction provisions..   16,875.00
                                                 =============
Tax on $16,875 (1970 rates):
  Tax on first $16,000..........................    4,330.00
  42 percent of $875............................      367.50
                                                 ------------
Tentative tax at rates and deduction provisions     4,697.50
 effective on or after January 1, 1970..........
                                                 =============
 
                           1971 Tentative Tax
Adjusted gross income...........................  $18,500.00
  Less:
    Standard deduction..........................      $1,500
    Personal exemption..........................         650    2,150.00
                                                 -----------------------
Taxable income under 1971 deduction provisions..   16,350.00
                                                 =============
Tax on $16,350 (1971 rates):
  Tax on first $16,000..........................       3,830
  34 percent of $350............................         119
                                                 ------------
Tentative tax at rates and deduction provisions     3,949.00
 effective on or after Januray 1, 1971..........
                                                 =============
The 1970 and 1971 tentative taxes are
 apportioned as follows:
  1970--275/365 of $4,697.50....................    3,539.21
  1971--90/365 of $3,949.00.....................      973.73
                                                 -------------
                                                    4,512.94
Tax surcharge (see Sec.  1.51-1(d)(1)(i)).......       56.26
                                                 -------------
      Total tax for the taxable year............    4,569.20
                                                 =============
 

    Example 3. H and W, husband and wife, have a foster child, C, who 
qualifies as a dependent under section 152(b)(2) for the period 
beginning after December 31, 1969. H and W file a joint return on the 
basis of a taxable year ending August 31. For the taxable year ending 
August 31, 1970, H and W have adjusted gross income of $12,500. Their 
computation of the tax imposed is as follows:

                           1969 Tentative Tax
Adjusted gross income...........................  $12,500.00

[[Page 34]]

 
  Less:
        Standard deduction......................   $1,000.00
        Personal exemption (2)..................    1,200.00    2,200.00
                                                 -----------------------
Taxable income under 1969 deduction provisions..   10,300.00
                                                 =============
Taxable income reduced by one-half..............  ..........    5,150.00
                                                             ===========
Tax on $5,150 (1969 rates):
  Tax on first $4,000...........................     $690.00
  22 percent of $1,150..........................      253.00      943.00
                                                 -----------------------
Twice the tax on $5,150.........................   $1,886.00
                                                 ============
Tentative tax at rates and deduction provisions     1,886.00
 effective on or after January 1, 1969..........
                                                 =============
                           1970 Tentative Tax
Adjusted gross income...........................  $12,500.00
  Less:
    Standard deduction..........................   $1,000.00
    Personal exemption (3)......................    1,875.00    2,875.00
                                                 -----------------------
Taxable income under 1970 deduction provisions..   $9,625.00
                                                 =============
Tax on $9,625 (1970 rates):
  Tax on first $8,000...........................   $1,380.00
  22 percent of $1,625..........................      357.50
                                                 ------------
Tentative tax at rates and deduction provisions     1,737.50
 effective on or after January 1, 1970..........
                                                 =============
The 1969 and 1970 tentative taxes are
 apportioned as follows:
  1969--122/365 of $1,886.......................     $630.39
  1970--243/365 of $1,737.50....................    1,156.75
                                                 -------------
                                                    1,787.14
Tax surcharge (see Sec.  1.51-1(d)(1)(i)).......      104.05
                                                 -------------
  Total tax for the taxable year................    1,891.19
                                                 =============
 

    Example 4. B, a single individual with one exemption, reports his 
income on the basis of a fiscal year ending June 30. For fiscal year 
ending June 30, 1971, B reports adjusted gross income of $250,000, 
consisting of earned net income of $240,000 and investment income of 
$10,000. In addition, on April 24, 1971, stock was transferred to B 
pursuant to his exercise of a qualified stock option, and the fair 
market value of such stock at that time exceeded the option price by 
$175,000. This $175,000 constitutes an item of tax preference described 
in section 57(a)(6). B claims itemized deductions in the amount of 
$34,000. By reason of section 1348, the maximum rate of tax on earned 
taxable income for a taxable year beginning after 1970 but before 1972 
is 60 percent. The income tax for the taxable year ending June 30, 1971, 
would be computed under section 21 as follows:

                           1970 Tentative Tax
Adjusted gross income...................     $250,000.00
  Less:
    Itemized deductions.................      $34,000.00
    Personal exemption..................          625.00       34,625.00
                                         -------------------------------
Taxable income under 1970 deduction           215,375.00
 provisions.............................
                                         =================
Tax on $215,375 (1970 rates)
Tax on first $100,000...................      $55,490.00
70 percent of $115,375..................       80,762.50
                                         ----------------
Tentative tax at rates and deduction          136,252.50
 provisions effective on or after
 January 1, 1970........................
                                         =================
Minimum tax:
  Total tax preference items............      175,000.00
  Less:
    Exemption...........................      $30,000.00
    Income tax..........................      136,252.50      166,252.50
                                         -------------------------------
Subject to 10 percent tax...............        8,747.50
                                         =================
10 percent tax..........................          874.75
                                         =================
      Total tentative tax ($136,252.50 +      137,127.25
       $874.75).........................
                                         =================
                           1971 Tentative Tax
Adjusted gross income...................     $250,000.00
  Less:
    Itemized deductions.................      $34,000.00
    Personal exemption..................          650.00       34,650.00
                                         -------------------------------
Taxable income under 1971 deduction           215,350.00
 provisions.............................
                                         =================
(a) Tax on highest amount of taxable           20,190.00
 income on which rate does not exceed 60
 percent ($50,000) (1971 rates).........
(b) Earned taxable
  income:
  ($215,350  x
  $240,000/
  $250,000).............................     $206,736.00
Less: Tax
  preference offset:
  ($175,000
-$30,000)...............................      145,000.00
                                         -----------------
                                               61,736.00
                                         ================
(c) 60% of the amount by which $61,736          7,041.60
 exceeds $50,000........................
(d) Tax on $215,350 (1971 rates)
  Tax on first $100,000.................       53,090.00
  70% of $115,350.......................       80,745.00
                                         ----------------
      Total.............................      133,835.00
                                         ================
(e) Tax on $61,736 (1971 rates)
  Tax on first $60,000..................       26,390.00
  64% of $1,736.........................        1,111.04
                                         ----------------
      Total.............................       27,501.04
                                         ================
(f) Excess of $133,835 over $27,501.04..      106,333.96
                                         -----------------

[[Page 35]]

 
Tentative tax (total of Steps (a), (c),       133,565.56
 and (f)) at rates and deduction
 provisions effective on or after
 January 1, 1971........................
                                         =================
Minimum tax:
  Total tax preference items............      175,000.00
  Less:
    Exemption...........................      $30,000.00
    Income tax..........................      133,565.56      163,565.56
                                         -------------------------------
  Subject to 10 percent tax.............      $11,434.44
                                         =================
  10 percent tax........................        1,143.44
                                         =================
    Total tentative tax ($133,565.56 +        134,709.00
     $1,143.44).........................
                                         =================
The 1970 and 1971 tentative taxes are
 apportioned as follows:
  1970--184/365 of $137,127.25..........       69,127.16
  1971--181/365 of $134,709.............       66,800.90
                                         =================
    Total tax for the taxable year......      135,928.06
                                         =================
 

    Example 5. The surtax exemption of corporation M (one of 4 
subsidiary corporations of W corporation), which files its income tax 
returns on the basis of a fiscal year ending March 31, 1964, is less 
than $25,000, by reason of section 1561 of the Code applicable to 
taxable years ending after December 31, 1963, and beginning before 
January 1, 1975. The taxable income of corporation M is $100,000, and 
the amount of the surtax exemption determined under the new rule for the 
1964 taxable year is $5,000 ($25,000  5). M's income tax liability for 
the taxable year ending March 31, 1964, is computed as follows:

                           1963 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1963 rates) 30           $30,000
 percent of $100,000....................
Surtax on $75,000 (1963 rates and                 16,500
 $25,000 surtax exemption) 22 percent of
 $75,000................................
                                         -----------------
      Total tentative tax at rates and            46,500
       surtax exemption effective before
       January 1, 1964..................
                                         =================
                           1964 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1964 rates) 22           $22,000
 percent of $100,000....................
Surtax on $95,000 (1964 rates and a               26,600
 $5,000 surtax exemption) 28 percent of
 $95,000................................
                                         ----------------
      Total tentative tax at rates and            48,600
       surtax exemption effective after
       January 1, 1964..................
                                         =================
The 1963 and 1964 tentative taxes are
 apportioned as follows:
  1963--275/366 of $46,500..............       34,938.52
  1964--91/366 of $48,600...............       12,083.61
                                         -----------------
      Total tax for the taxable year....       47,022.13
                                         =================
     M has the same amount of taxable income in 1965. Its income tax
   liability for the fiscal year ending March 31, 1965, is computed as
                                follows:
                           1964 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1964 rates) 22           $22,000
 percent of $100,000....................
Surtax on $95,000 (1964 rates and a               26,600
 $5,000 surtax exemption) 28 percent of
 $95,000................................
                                         -----------------
      Total tentative tax at the 1964             48,600
       rates............................
                                         =================
                           1965 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1965 rates) 22           $22,000
 percent of $100,000....................
Surtax on $95,000 (1965 rates and a               24,700
 $5,000 surtax exemption) 26 percent of
 $95,000................................
                                         ----------------
      Total tentative tax at the 1965             46,700
       rates............................
                                         =================
The 1964 and 1965 tentative taxes are
 apportioned as follows:
  1964--275/365 of $48,600..............      $36,616.44
  1965--90/365 of $46,700...............       11,515.07
                                         -----------------
      Total tax for the taxable year....       48,131.51
                                         =================
 

    Example 6. Assume the same facts as in example (5), except that M 
elected the additional tax under section 1562 for its fiscal year ending 
March 31, 1964. M's tax liability is completed as follows:

                           1963 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1963 rates) 30           $30,000
 percent of $100,000....................
Surtax on $75,000 (1963 rates and                 16,500
 $25,000 surtax exemption) 22 percent of
 $75,000................................
                                         ----------------

[[Page 36]]

 
      Total tentative tax at rates and            46,500
       surtax exemption effective before
       January 1, 1964..................
                                         =================
                           1964 Tentative Tax
Taxable income..........................        $100,000
                                         =================
Normal tax on $100,000 (1964 rates) 22           $22,000
 percent of $100,000....................
Surtax on $75,000 (1964 rates and                 21,000
 $25,000 surtax exemption) 28 percent of
 $75,000................................
Additional tax on $25,000 6 percent of             1,500
 $25,000................................
                                         ----------------
      Total tentative tax at rates and            44,500
       surtax exemption effective on and
       after January 1, 1964............
                                         =================
The 1963 and 1964 tentative taxes are
 apportioned as follows:
  1963--275/366 of $46,500..............      $34,938.52
  1964--91/366 of $44,500...............       11,064.21
                                         -----------------
      Total tax for the taxable year....       46,002.73
                                         =================
 

    Example 7. Corporation N files its income tax returns on the basis 
of a fiscal year ending June 30. For its taxable year ending in 1976, 
the taxable income of N is $100,000. N's income tax liability is 
determined for the period July 1, 1975, through December 31, 1975, by 
taking into account two rates of normal tax under section 11(b)(2) (A) 
and (B) and the increase to $50,000 in the surtax exemption under 
section 11(d). For the period January 1, 1976, through June 30, 1976, 
N's income tax liability is determined by taking into account the single 
normal tax rate under section 11(b)(1) and the $25,000 surtax exemption 
under section 11(d). N's tax liability for the taxable year ending June 
30, 1976, is computed as follows:

                           1975 Tentative Tax
Taxable income..........................        $100,000
                                         =================
  Normal tax on $100,000 (1975 rates) 20          $5,000
   percent of $25,000...................
  22 percent of $75,000.................          16,500
  Surtax on $50,000 (1975 rates and               13,000
   $50,000 surtax exemption) 26 percent
   of $50,000...........................
                                         ----------------
      Total tentative tax at rates and            34,500
       surtax exemption effective on and
       after January 1, 1975............
                                         =================
                           1976 Tentative Tax
Taxable income..........................        $100,000
                                         =================
  Normal tax on $100,000 (1976 rates) 22         $22,000
   percent of $100,000..................
  Surtax on $75,000 (1976 rates and               19,500
   $25,000 surtax exemption) 26 percent
   of $75,000...........................
                                         ----------------
      Total tentative tax at rates and            41,500
       surtax exemption effective on and
       after January 1, 1976............
                                         =================
The 1975 and 1976 tentative taxes are
 apportioned as follows:
  1975--184/366 of $34,500..............         $17,344
  1976--182/366 of $41,500..............          20,637
                                         -----------------
      Total tax for the taxable year....          37,981
 


(Secs. 1561(a) (83 Stat. 599; 26 U.S.C. 1561(a)) of the Internal Revenue 
Code)

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7164, 37 FR 4190, Feb. 29, 1972; T.D. 74-13, 41 FR 
12639, Mar. 26, 1976; T.D. 7528, 42 FR 64694, Dec. 28, 1977; T.D. 7728, 
45 FR 72651, Nov. 3, 1980. Redesignated by T.D. 9354, 72 FR 45341, Aug. 
14, 2007]



Sec. 1.21-1  Expenses for household and dependent care services 
necessary for gainful employment.

    (a) In general. (1) Section 21 allows a credit to a taxpayer against 
the tax imposed by chapter 1 for employment-related expenses for 
household services and care (as defined in paragraph (d) of this 
section) of a qualifying individual (as defined in paragraph (b) of this 
section). The purpose of the expenses must be to enable the taxpayer to 
be gainfully employed (as defined in paragraph (c) of this section). For 
taxable years beginning after December 31, 2004, a qualifying individual 
must have the same principal place of abode (as defined in paragraph (g) 
of this section) as the taxpayer for more than one-half of the taxable 
year. For taxable years beginning before January 1, 2005, the taxpayer 
must maintain a household (as defined in paragraph (h) of this section) 
that includes one or more qualifying individuals.
    (2) The amount of the credit is equal to the applicable percentage 
of the employment-related expenses that may be taken into account by the 
taxpayer during the taxable year (but subject to

[[Page 37]]

the limits prescribed in Sec. 1.21-2). Applicable percentage means 35 
percent reduced by 1 percentage point for each $2,000 (or fraction 
thereof) by which the taxpayer's adjusted gross income for the taxable 
year exceeds $15,000, but not less than 20 percent. For example, if a 
taxpayer's adjusted gross income is $31,850, the applicable percentage 
is 26 percent.
    (3) Expenses may be taken as a credit under section 21, regardless 
of the taxpayer's method of accounting, only in the taxable year the 
services are performed or the taxable year the expenses are paid, 
whichever is later.
    (4) The requirements of section 21 and Secs. 1.21-1 through 1.21-4 
are applied at the time the services are performed, regardless of when 
the expenses are paid.
    (5) Examples. The provisions of this paragraph (a) are illustrated 
by the following examples.

    Example 1. In December 2007, B pays for the care of her child for 
January 2008. Under paragraph (a)(3) of this section, B may claim the 
credit in 2008, the later of the years in which the expenses are paid 
and the services are performed.
    Example 2. The facts are the same as in Example 1, except that B's 
child turns 13 on February 1, 2008, and B pays for the care provided in 
January 2008 on February 3, 2008. Under paragraph (a)(4) of this 
section, the determination of whether the expenses are employment-
related expenses is made when the services are performed. Assuming other 
requirements are met, the amount B pays will be an employment-related 
expense under section 21, because B's child is a qualifying individual 
when the services are performed, even though the child is not a 
qualifying individual when B pays the expenses.

    (b) Qualifying individual--(1) In general. For taxable years 
beginning after December 31, 2004, a qualifying individual is--
    (i) The taxpayer's dependent (who is a qualifying child within the 
meaning of section 152) who has not attained age 13;
    (ii) The taxpayer's dependent (as defined in section 152, determined 
without regard to subsections (b)(1), (b)(2), and (d)(1)(B)) who is 
physically or mentally incapable of self-care and who has the same 
principal place of abode as the taxpayer for more than one-half of the 
taxable year; or
    (iii) The taxpayer's spouse who is physically or mentally incapable 
of self-care and who has the same principal place of abode as the 
taxpayer for more than one-half of the taxable year.
    (2) Taxable years beginning before January 1, 2005. For taxable 
years beginning before January 1, 2005, a qualifying individual is--
    (i) The taxpayer's dependent for whom the taxpayer is entitled to a 
deduction for a personal exemption under section 151(c) and who is under 
age 13;
    (ii) The taxpayer's dependent who is physically or mentally 
incapable of self-care; or
    (iii) The taxpayer's spouse who is physically or mentally incapable 
of self-care.
    (3) Qualification on a daily basis. The status of an individual as a 
qualifying individual is determined on a daily basis. An individual is 
not a qualifying individual on the day the status terminates.
    (4) Physical or mental incapacity. An individual is physically or 
mentally incapable of self-care if, as a result of a physical or mental 
defect, the individual is incapable of caring for the individual's 
hygiene or nutritional needs, or requires full-time attention of another 
person for the individual's own safety or the safety of others. The 
inability of an individual to engage in any substantial gainful activity 
or to perform the normal household functions of a homemaker or care for 
minor children by reason of a physical or mental condition does not of 
itself establish that the individual is physically or mentally incapable 
of self-care.
    (5) Special test for divorced or separated parents or parents living 
apart--(i) Scope. This paragraph (b)(5) applies to a child (as defined 
in section 152(f)(1) for taxable years beginning after December 31, 
2004, and in section 151(c)(3) for taxable years beginning before 
January 1, 2005) who--
    (A) Is under age 13 or is physically or mentally incapable of self-
care;
    (B) Receives over one-half of his or her support during the calendar 
year from one or both parents who are divorced or legally separated 
under a decree of divorce or separate maintenance, are separated under a 
written

[[Page 38]]

separation agreement, or live apart at all times during the last 6 
months of the calendar year; and
    (C) Is in the custody of one or both parents for more than one-half 
of the calendar year.
    (ii) Custodial parent allowed the credit. A child to whom this 
paragraph (b)(5) applies is the qualifying individual of only one parent 
in any taxable year and is the qualifying child of the custodial parent 
even if the noncustodial parent may claim the dependency exemption for 
that child for that taxable year. See section 21(e)(5). The custodial 
parent is the parent having custody for the greater portion of the 
calendar year. See section 152(e)(4)(A).
    (6) Example. The provisions of this paragraph (b) are illustrated by 
the following examples.

    Example. C pays $420 for the care of her child, a qualifying 
individual, to be provided from January 2 through January 31, 2008 (21 
days of care). On January 20, 2008, C's child turns 13 years old. Under 
paragraph (b)(3) of this section, C's child is a qualifying individual 
from January 2 through January 19, 2008 (13 days of care). C may take 
into account $260, the pro rata amount C pays for the care of her child 
for 13 days, under section 21. See Sec. 1.21-2(a)(4).

    (c) Gainful employment--(1) In general. Expenses are employment-
related expenses only if they are for the purpose of enabling the 
taxpayer to be gainfully employed. The expenses must be for the care of 
a qualifying individual or household services performed during periods 
in which the taxpayer is gainfully employed or is in active search of 
gainful employment. Employment may consist of service within or outside 
the taxpayer's home and includes self-employment. An expense is not 
employment-related merely because it is paid or incurred while the 
taxpayer is gainfully employed. The purpose of the expense must be to 
enable the taxpayer to be gainfully employed. Whether the purpose of an 
expense is to enable the taxpayer to be gainfully employed depends on 
the facts and circumstances of the particular case. Work as a volunteer 
or for a nominal consideration is not gainful employment.
    (2) Determination of period of employment on a daily basis--(i) In 
general. Expenses paid for a period during only part of which the 
taxpayer is gainfully employed or in active search of gainful employment 
must be allocated on a daily basis.
    (ii) Exception for short, temporary absences. A taxpayer who is 
gainfully employed is not required to allocate expenses during a short, 
temporary absence from work, such as for vacation or minor illness, 
provided that the care-giving arrangement requires the taxpayer to pay 
for care during the absence. An absence of 2 consecutive calendar weeks 
is a short, temporary absence. Whether an absence longer than 2 
consecutive calendar weeks is a short, temporary absence is determined 
based on all the facts and circumstances.
    (iii) Part-time employment. A taxpayer who is employed part-time 
generally must allocate expenses for dependent care between days worked 
and days not worked. However, if a taxpayer employed part-time is 
required to pay for dependent care on a periodic basis (such as weekly 
or monthly) that includes both days worked and days not worked, the 
taxpayer is not required to allocate the expenses. A day on which the 
taxpayer works at least 1 hour is a day of work.
    (3) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. D works during the day and her husband, E, works at night 
and sleeps during the day. D and E pay for care for a qualifying 
individual during the hours when D is working and E is sleeping. Under 
paragraph (c)(1) of this section, the amount paid by D and E for care 
may be for the purpose of allowing D and E to be gainfully employed and 
may be an employment-related expense under section 21.
    Example 2. F works at night and pays for care for a qualifying 
individual during the hours when F is working. Under paragraph (c)(1) of 
this section, the amount paid by F for care may be for the purpose of 
allowing F to be gainfully employed and may be an employment-related 
expense under section 21.
    Example 3. G, the custodial parent of two children who are 
qualifying individuals, hires a housekeeper for a monthly salary to care 
for the children while G is gainfully employed. G becomes ill and as a 
result is absent from work for 4 months. G continues to pay the 
housekeeper to care for the children while G is absent from work. During 
this 4-month period, G performs no employment

[[Page 39]]

services, but receives payments under her employer's wage continuation 
plan. Although G may be considered to be gainfully employed during her 
absence from work, the absence is not a short, temporary absence within 
the meaning of paragraph (c)(2)(ii) of this section, and her payments 
for household and dependent care services during the period of illness 
are not for the purpose of enabling her to be gainfully employed. G's 
expenses are not employment-related expenses, and she may not take the 
expenses into account under section 21.
    Example 4. To be gainfully employed, H sends his child to a 
dependent care center that complies with all state and local 
requirements. The dependent care center requires payment for days when a 
child is absent from the center. H takes 8 days off from work as 
vacation days. Because the absence is less than 2 consecutive calendar 
weeks, under paragraph (c)(2)(ii) of this section, H's absence is a 
short, temporary absence. H is not required to allocate expenses between 
days worked and days not worked. The entire fee for the period that 
includes the 8 vacation days may be an employment-related expense under 
section 21.
    Example 5. J works 3 days per week and her child attends a dependent 
care center (that complies with all state and local requirements) to 
enable her to be gainfully employed. The dependent care center allows 
payment for any 3 days per week for $150 or 5 days per week for $250. J 
enrolls her child for 5 days per week, and her child attends the care 
center for 5 days per week. Under paragraph (c)(2)(iii) of this section, 
J must allocate her expenses for dependent care between days worked and 
days not worked. Three-fifths of the $250, or $150 per week, may be an 
employment-related expense under section 21.
    Example 6. The facts are the same as in Example 5, except that the 
dependent care center does not offer a 3-day option. The entire $250 
weekly fee may be an employment-related expense under section 21.

    (d) Care of qualifying individual and household services--(1) In 
general. To qualify for the dependent care credit, expenses must be for 
the care of a qualifying individual. Expenses are for the care of a 
qualifying individual if the primary function is to assure the 
individual's well-being and protection. Not all expenses relating to a 
qualifying individual are for the individual's care. Amounts paid for 
food, lodging, clothing, or education are not for the care of a 
qualifying individual. If, however, the care is provided in such a 
manner that the expenses cover other goods or services that are 
incidental to and inseparably a part of the care, the full amount is for 
care.
    (2) Allocation of expenses. If an expense is partly for household 
services or for the care of a qualifying individual and partly for other 
goods or services, a reasonable allocation must be made. Only so much of 
the expense that is allocable to the household services or care of a 
qualifying individual is an employment-related expense. An allocation 
must be made if a housekeeper or other domestic employee performs 
household duties and cares for the qualifying children of the taxpayer 
and also performs other services for the taxpayer. No allocation is 
required, however, if the expense for the other purpose is minimal or 
insignificant or if an expense is partly attributable to the care of a 
qualifying individual and partly to household services.
    (3) Household services. Expenses for household services may be 
employment-related expenses if the services are performed in connection 
with the care of a qualifying individual. The household services must be 
the performance in and about the taxpayer's home of ordinary and usual 
services necessary to the maintenance of the household and attributable 
to the care of the qualifying individual. Services of a housekeeper are 
household services within the meaning of this paragraph (d)(3) if the 
services are provided, at least in part, to the qualifying individual. 
Such services as are performed by chauffeurs, bartenders, or gardeners 
are not household services.
    (4) Manner of providing care. The manner of providing care need not 
be the least expensive alternative available to the taxpayer. The cost 
of a paid caregiver may be an expense for the care of a qualifying 
individual even if another caregiver is available at no cost.
    (5) School or similar program. Expenses for a child in nursery 
school, pre-school, or similar programs for children below the level of 
kindergarten are for the care of a qualifying individual and may be 
employment-related expenses. Expenses for a child in kindergarten or a 
higher grade are not for the care of a qualifying individual. However, 
expenses for before- or after-school care of a child in kindergarten

[[Page 40]]

or a higher grade may be for the care of a qualifying individual.
    (6) Overnight camps. Expenses for overnight camps are not 
employment-related expenses.
    (7) Day camps. (i) The cost of a day camp or similar program may be 
for the care of a qualifying individual and an employment-related 
expense, without allocation under paragraph (d)(2) of this section, even 
if the day camp specializes in a particular activity. Summer school and 
tutoring programs are not for the care of a qualifying individual and 
the costs are not employment-related expenses.
    (ii) A day camp that meets the definition of dependent care center 
in section 21(b)(2)(D) and paragraph (e)(2) of this section must comply 
with the requirements of section 21(b)(2)(C) and paragraph (e)(2) of 
this section.
    (8) Transportation. The cost of transportation by a dependent care 
provider of a qualifying individual to or from a place where care of 
that qualifying individual is provided may be for the care of the 
qualifying individual. The cost of transportation not provided by a 
dependent care provider is not for the care of the qualifying 
individual.
    (9) Employment taxes. Taxes under sections 3111 (relating to the 
Federal Insurance Contributions Act) and 3301 (relating to the Federal 
Unemployment Tax Act) and similar state payroll taxes are employment-
related expenses if paid in respect of wages that are employment-related 
expenses.
    (10) Room and board. The additional cost of providing room and board 
for a caregiver over usual household expenditures may be an employment-
related expense.
    (11) Indirect expenses. Expenses that relate to, but are not 
directly for, the care of a qualifying individual, such as application 
fees, agency fees, and deposits, may be for the care of a qualifying 
individual and may be employment-related expenses if the taxpayer is 
required to pay the expenses to obtain the related care. However, 
forfeited deposits and other payments are not for the care of a 
qualifying individual if care is not provided.
    (12) Examples. The provisions of this paragraph (d) are illustrated 
by the following examples:

    Example 1. To be gainfully employed, K sends his 3-year old child to 
a pre-school. The pre-school provides lunch and snacks. Under paragraph 
(d)(1) of this section, K is not required to allocate expenses between 
care and the lunch and snacks, because the lunch and snacks are 
incidental to and inseparably a part of the care. Therefore, K may treat 
the full amount paid to the pre-school as for the care of his child.
    Example 2. L, a member of the armed forces, is ordered to a combat 
zone. To be able to comply with the orders, L places her 10-year old 
child in boarding school. The school provides education, meals, and 
housing to L's child in addition to care. Under paragraph (d)(2) of this 
section, L must allocate the cost of the boarding school between 
expenses for care and expenses for education and other services not 
constituting care. Only the part of the cost of the boarding school that 
is for the care of L's child is an employment-related expense under 
section 21.
    Example 3. To be gainfully employed, M employs a full-time 
housekeeper to care for M's two children, aged 9 and 13 years. The 
housekeeper regularly performs household services of cleaning and 
cooking and drives M to and from M's place of employment, a trip of 15 
minutes each way. Under paragraph (d)(3) of this section, the chauffeur 
services are not household services. M is not required to allocate a 
portion of the expense of the housekeeper to the chauffeur services 
under paragraph (d)(2) of this section, however, because the chauffeur 
services are minimal and insignificant. Further, no allocation under 
paragraph (d)(2) of this section is required to determine the portion of 
the expenses attributable to the care of the 13-year old child (not a 
qualifying individual) because the household expenses are in part 
attributable to the care of the 9-year-old child. Accordingly, the 
entire expense of employing the housekeeper is an employment-related 
expense. The amount that M may take into account as an employment-
related expense under section 21, however, is limited to the amount 
allowable for one qualifying individual.
    Example 4. To be gainfully employed, N sends her 9-year-old child to 
a summer day camp that offers computer activities and recreational 
activities such as swimming and arts and crafts. Under paragraph 
(d)(7)(i) of this section, the full cost of the summer day camp may be 
for care.
    Example 5. To be gainfully employed, O sends her 9-year-old child to 
a math tutoring program for two hours per day during the summer. Under 
paragraph (d)(7)(i) of this section, the cost of the tutoring program is 
not for care.
    Example 6. To be gainfully employed, P hires a full-time housekeeper 
to care for her 8-year old child. In order to accommodate

[[Page 41]]

the housekeeper, P moves from a 2-bedroom apartment to a 3-bedroom 
apartment that otherwise is comparable to the 2-bedroom apartment. Under 
paragraph (d)(10) of this section, the additional cost to rent the 3-
bedroom apartment over the cost of the 2-bedroom apartment and any 
additional utilities attributable to the housekeeper's residence in the 
household may be employment-related expenses under section 21.
    Example 7. Q pays a fee to an agency to obtain the services of an au 
pair to care for Q's children, qualifying individuals, to enable Q to be 
gainfully employed. An au pair from the agency subsequently provides 
care for Q's children. Under paragraph (d)(11) of this section, the fee 
may be an employment-related expense.
    Example 8. R places a deposit with a pre-school to reserve a place 
for her child. R sends the child to a different pre-school and forfeits 
the deposit. Under paragraph (d)(11) of this section, the forfeited 
deposit is not an employment-related expense.

    (e) Services outside the taxpayer's household--(1) In general. The 
credit is allowable for expenses for services performed outside the 
taxpayer's household only if the care is for one or more qualifying 
individuals who are described in this section at--
    (i) Paragraph (b)(1)(i) or (b)(2)(i); or
    (ii) Paragraph (b)(1)(ii), (b)(2)(ii), (b)(1)(iii), or (b)(2)(iii) 
and regularly spend at least 8 hours each day in the taxpayer's 
household.
    (2) Dependent care centers--(i) In general. The credit is allowable 
for services performed by a dependent care center only if--
    (A) The center complies with all applicable laws and regulations, if 
any, of a state or local government, such as state or local licensing 
requirements and building and fire code regulations; and
    (B) The requirements provided in this paragraph (e) are met.
    (ii) Definition. The term dependent care center means any facility 
that provides full-time or part-time care for more than six individuals 
(other than individuals who reside at the facility) on a regular basis 
during the taxpayer's taxable year, and receives a fee, payment, or 
grant for providing services for the individuals (regardless of whether 
the facility is operated for profit). For purposes of the preceding 
sentence, a facility is presumed to provide full-time or part-time care 
for six or fewer individuals on a regular basis during the taxpayer's 
taxable year if the facility has six or fewer individuals (including the 
taxpayer's qualifying individual) enrolled for full-time or part-time 
care on the day the qualifying individual is enrolled in the facility 
(or on the first day of the taxable year the qualifying individual 
attends the facility if the qualifying individual was enrolled in the 
facility in the preceding taxable year) unless the Internal Revenue 
Service demonstrates that the facility provides full-time or part-time 
care for more than six individuals on a regular basis during the 
taxpayer's taxable year.
    (f) Reimbursed expenses. Employment-related expenses for which the 
taxpayer is reimbursed (for example, under a dependent care assistance 
program) may not be taken into account for purposes of the credit.
    (g) Principal place of abode. For purposes of this section, the term 
principal place of abode has the same meaning as in section 152.
    (h) Maintenance of a household--(1) In general. For taxable years 
beginning before January 1, 2005, the credit is available only to a 
taxpayer who maintains a household that includes one or more qualifying 
individuals. A taxpayer maintains a household for the taxable year (or 
lesser period) only if the taxpayer (and spouse, if applicable) occupies 
the household and furnishes over one-half of the cost for the taxable 
year (or lesser period) of maintaining the household. The household must 
be the principal place of abode for the taxable year of the taxpayer and 
the qualifying individual or individuals.
    (2) Cost of maintaining a household. (i) Except as provided in 
paragraph (h)(2)(ii) of this section, for purposes of this section, the 
term cost of maintaining a household has the same meaning as in 
Sec. 1.2-2(d) without regard to the last sentence thereof.
    (ii) The cost of maintaining a household does not include the value 
of services performed in the household by the taxpayer or by a 
qualifying individual described in paragraph (b) of this section or any 
expense paid or reimbursed by another person.
    (3) Monthly proration of annual costs. In determining the cost of 
maintaining a household for a period of less than a

[[Page 42]]

taxable year, the cost for the entire taxable year must be prorated on 
the basis of the number of calendar months within that period. A period 
of less than a calendar month is treated as a full calendar month.
    (4) Two or more families. If two or more families occupy living 
quarters in common, each of the families is treated as maintaining a 
separate household. A taxpayer is maintaining a household if the 
taxpayer provides more than one-half of the cost of maintaining the 
separate household. For example, if two unrelated taxpayers with their 
respective children occupy living quarters in common and each taxpayer 
pays more than one-half of the household costs for each respective 
family, each taxpayer is treated as maintaining a household.
    (i) Reserved.
    (j) Expenses qualifying as medical expenses--(1) In general. A 
taxpayer may not take an amount into account as both an employment-
related expense under section 21 and an expense for medical care under 
section 213.
    (2) Examples. The provisions of this paragraph (j) are illustrated 
by the following examples:

    Example 1. S has $6,500 of employment-related expenses for the care 
of his child who is physically incapable of self-care. The expenses are 
for services performed in S's household that also qualify as expenses 
for medical care under section 213. Of the total expenses, S may take 
into account $3,000 under section 21. S may deduct the balance of the 
expenses, or $3,500, as expenses for medical care under section 213 to 
the extent the expenses exceed 7.5 percent of S's adjusted gross income.
    Example 2. The facts are the same as in Example 1, however, S first 
takes into account the $6,500 of expenses under section 213. S deducts 
$500 as an expense for medical care, which is the amount by which the 
expenses exceed 7.5 percent of his adjusted gross income. S may not take 
into account the $6,000 balance as employment-related expenses under 
section 21, because he has taken the full amount of the expenses into 
account in computing the amount deductible under section 213.

    (k) Substantiation. A taxpayer claiming a credit for employment-
related expenses must maintain adequate records or other sufficient 
evidence to substantiate the expenses in accordance with section 6001 
and the regulations thereunder.
    (l) Effective/applicability date. This section and Secs. 1.21-2 
through 1.21-4 apply to taxable years ending after August 14, 2007.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec. 1.21-2  Limitations on amount creditable.

    (a) Annual dollar limitation. (1) The amount of employment-related 
expenses that may be taken into account under Sec. 1.21-1(a) for any 
taxable year cannot exceed--
    (i) $2,400 ($3,000 for taxable years beginning after December 31, 
2002, and before January 1, 2011) if there is one qualifying individual 
with respect to the taxpayer at any time during the taxable year; or
    (ii) $4,800 ($6,000 for taxable years beginning after December 31, 
2002, and before January 1, 2011) if there are two or more qualifying 
individuals with respect to the taxpayer at any time during the taxable 
year.
    (2) The amount determined under paragraph (a)(1) of this section is 
reduced by the aggregate amount excludable from gross income under 
section 129 for the taxable year.
    (3) A taxpayer may take into account the total amount of employment-
related expenses that do not exceed the annual dollar limitation 
although the amount of employment-related expenses attributable to one 
qualifying individual is disproportionate to the total employment-
related expenses. For example, a taxpayer with expenses in 2007 of 
$4,000 for one qualifying individual and $1,500 for a second qualifying 
individual may take into account the full $5,500.
    (4) A taxpayer is not required to prorate the annual dollar 
limitation if a qualifying individual ceases to qualify (for example, by 
turning age 13) during the taxable year. However, the taxpayer may take 
into account only amounts that qualify as employment-related expenses 
before the disqualifying event. See also Sec. 1.21-1(b)(6).
    (b) Earned income limitation--(1) In general. The amount of 
employment-related expenses that may be taken into account under section 
21 for any taxable year cannot exceed--
    (i) For a taxpayer who is not married at the close of the taxable 
year, the

[[Page 43]]

taxpayer's earned income for the taxable year; or
    (ii) For a taxpayer who is married at the close of the taxable year, 
the lesser of the taxpayer's earned income or the earned income of the 
taxpayer's spouse for the taxable year.
    (2) Determination of spouse. For purposes of this paragraph (b), a 
taxpayer must take into account only the earned income of a spouse to 
whom the taxpayer is married at the close of the taxable year. The 
spouse's earned income for the entire taxable year is taken into 
account, however, even though the taxpayer and the spouse were married 
for only part of the taxable year. The taxpayer is not required to take 
into account the earned income of a spouse who died or was divorced or 
separated from the taxpayer during the taxable year. See Sec. 1.21-3(b) 
for rules providing that certain married taxpayers legally separated or 
living apart are treated as not married.
    (3) Definition of earned income. For purposes of this section, the 
term earned income has the same meaning as in section 32(c)(2) and the 
regulations thereunder.
    (4) Attribution of earned income to student or incapacitated spouse. 
(i) For purposes of this section, a spouse is deemed, for each month 
during which the spouse is a full-time student or is a qualifying 
individual described in Sec. 1.21-1(b)(1)(iii) or (b)(2)(iii), to be 
gainfully employed and to have earned income of not less than--
    (A) $200 ($250 for taxable years beginning after December 31, 2002, 
and before January 1, 2011) if there is one qualifying individual with 
respect to the taxpayer at any time during the taxable year; or
    (B) $400 ($500 for taxable years beginning after December 31, 2002, 
and before January 1, 2011) if there are two or more qualifying 
individuals with respect to the taxpayer at any time during the taxable 
year.
    (ii) For purposes of this paragraph (b)(4), a full-time student is 
an individual who, during each of 5 calendar months of the taxpayer's 
taxable year, is enrolled as a student for the number of course hours 
considered to be a full-time course of study at an educational 
organization as defined in section 170(b)(1)(A)(ii). The enrollment for 
5 calendar months need not be consecutive.
    (iii) Earned income may be attributed under this paragraph (b)(4), 
in the case of any husband and wife, to only one spouse in any month.
    (c) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. In 2007, T, who is married to U, pays employment-related 
expenses of $5,000 for the care of one qualifying individual. T's earned 
income for the taxable year is $40,000 and her husband's earned income 
is $2,000. T did not exclude any dependent care assistance under section 
129. Under paragraph (b)(1) of this section, T may take into account 
under section 21 only the amount of employment-related expenses that 
does not exceed the lesser of her earned income or the earned income of 
U, or $2,000.
    Example 2. The facts are the same as in Example 1 except that U is a 
full-time student at an educational organization within the meaning of 
section 170(b)(1)(A)(ii) for 9 months of the taxable year and has no 
earned income. Under paragraph (b)(4) of this section, U is deemed to 
have earned income of $2,250. T may take into account $2,250 of 
employment-related expenses under section 21.
    Example 3. For all of 2007, V is a full-time student and W, V's 
husband, is an individual who is incapable of self-care (as defined in 
Sec. 1.21-1(b)(1)(iii)). V and W have no earned income and pay expenses 
of $5,000 for W's care. Under paragraph (b)(4) of this section, either V 
or W may be deemed to have $3,000 of earned income. However, earned 
income may be attributed to only one spouse under paragraph (b)(4)(iii) 
of this section. Under the limitation in paragraph (b)(1)(ii) of this 
section, the lesser of V's and W's earned income is zero. V and W may 
not take the expenses into account under section 21.

    (d) Cross-reference. For an additional limitation on the credit 
under section 21, see section 26.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec. 1.21-3  Special rules applicable to married taxpayers.

    (a) Joint return requirement. No credit is allowed under section 21 
for taxpayers who are married (within the meaning of section 7703 and 
the regulations thereunder) at the close of the taxable year unless the 
taxpayer and spouse file a joint return for the taxable year. See 
section 6013 and the regulations thereunder relating to joint

[[Page 44]]

returns of income tax by husband and wife.
    (b) Taxpayers treated as not married. The requirements of paragraph 
(a) of this section do not apply to a taxpayer who is legally separated 
under a decree of divorce or separate maintenance or who is treated as 
not married under section 7703(b) and the regulations thereunder 
(relating to certain married taxpayers living apart). A taxpayer who is 
treated as not married under this paragraph (b) is not required to take 
into account the earned income of the taxpayer's spouse for purposes of 
applying the earned income limitation on the amount of employment-
related expenses under Sec. 1.21-2(b).
    (c) Death of married taxpayer. If a married taxpayer dies during the 
taxable year and the survivor may make a joint return with respect to 
the deceased spouse under section 6013(a)(3), the credit is allowed for 
the year only if a joint return is made. If, however, the surviving 
spouse remarries before the end of the taxable year in which the 
deceased spouse dies, a credit may be allowed on the decedent spouse(s 
separate return.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec. 1.21-4  Payments to certain related individuals.

    (a) In general. A credit is not allowed under section 21 for any 
amount paid by the taxpayer to an individual--
    (1) For whom a deduction under section 151(c) (relating to 
deductions for personal exemptions for dependents) is allowable either 
to the taxpayer or the taxpayer's spouse for the taxable year;
    (2) Who is a child of the taxpayer (within the meaning of section 
152(f)(1) for taxable years beginning after December 31, 2004, and 
section 151(c)(3) for taxable years beginning before January 1, 2005) 
and is under age 19 at the close of the taxable year;
    (3) Who is the spouse of the taxpayer at any time during the taxable 
year; or
    (4) Who is the parent of the taxpayer's child who is a qualifying 
individual described in Sec. 1.21-1(b)(1)(i) or (b)(2)(i).
    (b) Payments to partnerships or other entities. In general, 
paragraph (a) of this section does not apply to services performed by 
partnerships or other entities. If, however, the partnership or other 
entity is established or maintained primarily to avoid the application 
of paragraph (a) of this section to permit the taxpayer to claim the 
credit, for purposes of section 21, the payments of employment-related 
expenses are treated as made directly to each partner or owner in 
proportion to that partner's or owner's ownership interest. Whether a 
partnership or other entity is established or maintained to avoid the 
application of paragraph (a) of this section is determined based on the 
facts and circumstances, including whether the partnership or other 
entity is established for the primary purpose of caring for the 
taxpayer's qualifying individual or providing household services to the 
taxpayer.
    (c) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. During 2007, X pays $5,000 to her mother for the care of 
X's 5-year old child who is a qualifying individual. The expenses 
otherwise qualify as employment-related expenses. X's mother is not her 
dependent. X may take into account under section 21 the amounts paid to 
her mother for the care of X's child.
    Example 2. Y is divorced and has custody of his 5-year old child, 
who is a qualifying individual. Y pays $6,000 during 2007 to Z, who is 
his ex-wife and the child's mother, for the care of the child. The 
expenses otherwise qualify as employment-related expenses. Under 
paragraph (a)(4) of this section, Y may not take into account under 
section 21 the amounts paid to Z because Z is the child's mother.
    Example 3. The facts are the same as in Example 2, except that Z is 
not the mother of Y's child. Y may take into account under section 21 
the amounts paid to Z.

[T.D. 9354, 72 FR 45341, Aug. 14, 2007]



Sec. 1.23-1  Residential energy credit.

    (a) General rule. Section 23 or former section 44C provides a 
residential energy credit against the tax imposed by chapter 1 of the 
Internal Revenue Code. The credit is an amount equal to the individual's 
qualified energy conservation expenditures (set out in paragraph (b)) 
plus the individual's qualified renewable energy source expenditures 
(set out in paragraph (c)) for the taxable year. However, the credit is 
subject to the limitations described in

[[Page 45]]

paragraph (d) and the special rules contained in Sec. 1.23-3. The credit 
is nonrefundable (that is, the credit may not exceed an individual's tax 
liability for the taxable year). However, any unused credit may be 
carried over to succeeding years to the extent permitted under paragraph 
(e). Renters as well as owners of a dwelling unit may qualify for the 
credit. See Sec. 1.23-3(h) for the rules relating to the allocation of 
the credit in the case of joint occupants of a dwelling unit.
    (b) Qualified energy conservation expenditures. In the case of any 
dwelling unit, the qualified energy conservation expenditures are 15 
percent of the energy conservation expenditures made by the taxpayer 
with respect to the dwelling unit during the taxable year, but not in 
excess of $2,000 of such expenditures. See Sec. 1.23-2(a) for the 
definition of energy conservation expenditures.
    (c) Qualified renewable energy source expenditures. In the case of 
taxable years beginning after December 31, 1979, the qualified renewable 
energy source expenditures are 40 percent of the renewable energy source 
expenditures made by the taxpayer during the taxable year (and before 
January 1, 1986) with respect to the dwelling units that do not exceed 
$10,000. In the case of taxable years beginning before January 1, 1980, 
the qualified renewable energy source expenditures are the renewable 
energy source expenditures made by the taxpayer with respect to the 
dwelling unit during the taxable year, but not in excess of--
    (1) 30 percent of the expenditures up to $2,000, plus
    (2) 20 percent of the expenditures over $2,000, but not more than 
$10,000.

See Sec. 1.23-2(b) for the definition of renewable energy source 
expenditures.
    (d) Limitations--(1) Minimum dollar amount. No residential energy 
credit shall be allowed with respect to any return (whether joint or 
separate) for any taxable year if the amount of the credit otherwise 
allowable (determined without regard to the tax liability limitation 
imposed by paragraph (d)(3) of this section) is less than $10.
    (2) Prior expenditures taken into account--(i) In general. For 
purposes of determining the credit for expenditures made during a 
taxable year, the taxpayer must reduce the maximum amount of allowable 
expenditures with respect to the dwelling until in computing qualified 
energy conservation expenditures (under paragraph (b)) or qualified 
renewable energy conservation expenditures (under paragraph (c)) by 
prior expenditures which were made by the taxpayer or by joint occupants 
(see Sec. 1.23-3(h)) with respect to the same dwelling unit, and which 
were taken into account in computing the credit for prior taxable years. 
In the case of expenditures made during taxable years beginning before 
January 1, 1980, the reduction of the maximum amount under paragraph (c) 
must first be made with respect to the first $2,000 of expenditures (to 
which a 30 percent rate applies) and then with respect to the next 
$8,000 of expenditures (to which a 20 percent rate applies). This 
reduction must be made if all or any part of the credit was allowed in 
or was carried over from a prior taxable year.
    (ii) Change of principal residence. A taxpayer is eligible for the 
maximum credit for qualifying expenditures made with respect to a new 
principal residence notwithstanding the allowance of a credit for 
qualifying expenditures made with respect to the taxpayer's previous 
principal residence. Furthermore, except in certain cases involving 
joint occupancy (see Sec. 1.23-3(h)), a taxpayer is eligible for the 
maximum credit notwithstanding the allowance of a credit to a prior 
owner of the taxpayer's new principal residence.
    (iii) Example. The rules with respect to the reduction for prior 
expenditures are illustrated by the following example:

    Example. In 1978, A has $1,000 of energy conservation expenditures 
and $5,000 of renewable energy source expenditures in connection with 
A's principal residence. A's residential energy credit for 1978 is 
$1,350, made up of $150 of qualified energy conservation expenditures 
(15 percent of $1,000) plus $1,200 of qualified renewable energy source 
expenditures (30 percent of the first $2,000 plus 20 percent of the next 
$3,000). In 1979 A has an additional $2,000 of energy conservation 
expenditures and $3,000 of renewable energy source expenditures in 
connection with the same principal residence. A's residential energy 
credit for 1979 is $750, made up of $150 of qualified energy 
conservation expenditures (15 percent of the new maximum $1,000,

[[Page 46]]

which was reduced from $2,000 by $1,000 of energy conservation 
expenditures taken into account in 1978) plus $600 of qualified 
renewable energy source expenditures (20 percent of $3,000, which 
reflects the reduction of the maximum allowable expenditures by the 
$5,000 of renewable energy source expenditures taken into account in 
1978). The maximum residential energy credit allowable to A with respect 
to the same principal residence in subsequent years in which the credit 
is allowable is $400 (20 percent of the new maximum of $2,000 for 
renewable energy source expenditures and none for energy conservation 
expenditures).

    (3) Effects of grants and subsidized energy financing--(i) In 
general. Qualified expenditures financed with Federal, State, or local 
grants shall be taken into account for purposes of computing the 
residential energy credit only if the amount of such grants is taxable 
as gross income to the taxpayer under section 61 (relating to the 
definition of gross income) and the regulations thereunder. In the case 
of taxable years beginning after December 31, 1980, qualified 
expenditures made from subsidized energy financing (as defined in 
Sec. 1.23-2(i)) shall not be taken into account (except as provided in 
the following sentence) for purposes of computing the residential energy 
credit. In addition, the taxpayer must reduce the maximum amount 
allowable expenditures (reduced as provided in paragraph (d)(2) of this 
section) with respect to the dwelling unit in computing qualified energy 
conservation expenditures (under paragraph (b) of this section) or 
qualified renewable energy source expenditures (under paragraph (c) of 
this section), whichever is appropriate, by an amount equal to the sum 
of--
    (A) The amount of expenditures from subsidized energy financing (as 
defined in Sec. 1.23-2(i)) that were made by the taxpayer during the 
taxable year or any prior taxable year beginning after December 31, 
1980, with respect to the same dwelling unit, and
    (B) The amount of any funds received by the taxpayer during the 
taxable year or any prior taxable year beginning after December 31, 
1980, as a Federal, State, or local government grant made in taxable 
years beginning after December 31, 1980, that were used to make 
qualified expenditures with respect to the same dwelling unit and that 
were not included in the gross income of the taxpayer.
    (ii) Example. The provisions of this paragraph (d)(3) may be 
illustrated by the following example:

    Example. A had in 1979 made a renewable energy source expenditure of 
$2,000 in connection with A's residence for which he took the then 
allowed credit of $600. In 1981 A made additional renewable energy 
source expenditures of $9,000 with respect to which he received a loan 
of $5,000 from the Federal Solar-Energy and Energy Conservation Bank. 
Assume that the loan is subsidized energy financing. A computes the 
credit as follows: The initial maximum allowable dollar limit is $10,000 
which is reduced by the sum of the prior year expenditures of $2,000 and 
the subsidized energy financing loan of $5,000 leaving a dollar limit of 
$3,000 ($10,000-($2,000 + $5,000)). The $5,000 portion of the $9,000 
funded by the subsidized energy financing loan is not allowed as a 
renewable energy source expenditure. The remaining expenditures in 1981 
are $4,000 ($9,000-$5,000). However, this amount exceeds the allowed 
maximum dollar limit of $3,000. Therefore, A's creditable expenses for 
1981 are only $3,000 on which the credit is $1,200 (40 percent of 
$3,000).

    (4) Tax liability limitation--(i) For taxable years beginning after 
December 31, 1983. For taxable years beginning after December 31, 1983, 
the credit allowed by this section shall not exceed the amount of tax 
imposed by chapter 1 of the Internal Revenue Code of 1954 for the 
taxable year, reduced by the sum of credits allowable under--
    (A) Section 21 (relating to expenses for household and dependent 
care services necessary for gainful employment),
    (B) Section 22 (relating to credit for the elderly and the 
permanently and totally disabled), and
    (C) Section 24 (relating to contributions to candidates for public 
office).

See section 26 (b) and (c) for certain taxes that are not treated as 
imposed by chapter 1.
    (ii) For taxable years beginning before January 1, 1984. For taxable 
years beginning before January 1, 1984, the credit allowed by this 
section shall not exceed the amount of the tax imposed by chapter 1 of 
the Internal Revenue Code of 1954 for the taxable year, reduced by the 
sum of the credits allowable under--

[[Page 47]]

    (A) Section 32 (relating to tax withheld at source on nonresident 
aliens and foreign corporations and on tax-free covenant bonds),
    (B) Section 33 (relating to the taxes of foreign countries and 
possessions of the United States),
    (C) Section 37 (relating to retirement income),
    (D) Section 38 (relating to investment in certain depreciable 
property),
    (E) Section 40 (relating to expenses of work incentive programs),
    (F) Section 41 (relating to contributions to candidates for public 
office),
    (G) Section 42 (relating to the general tax credit),
    (H) Section 44 (relating to purchase of new personal residence),
    (I) Section 44A (relating to expenses for household and dependent 
care services), and
    (J) Section 44B (relating to employment of certain new employees).
    (e) Carryforward of unused credit. If the credit allowable by this 
section exceeds the tax liability limitation imposed by section 23(b)(5) 
(or former section 44C(b)(5)) and paragraph (d)(4) of this section, the 
excess credit shall be carried forward to the succeeding taxable year 
and added to the credit allowable under this section for the succeeding 
taxable year. A carryforward that is not used in the succeeding year 
because it exceeds the tax liability limitation shall be carried forward 
to later taxable years until used, except that no excess credit may be 
carried forward to any taxable year beginning after December 31, 1987.

[T.D. 7717, 45 FR 57715, Aug. 29, 1980. Redesignated and amended by T.D. 
8146, 52 FR 26669, July 16, 1987]



Sec. 1.23-2  Definitions.

    For purposes of section 23 or former section 44C and regulations 
thereunder--
    (a) Energy conservation expenditures--(1) In general. The term 
``energy conservation expenditure'' means an expenditure made on or 
after April 20, 1977, and before January 1, 1986, by a taxpayer for 
insulation or any other energy-conserving component, or for labor costs 
allocable to the original installation of such insulation or other 
component, if all of the following conditions are satisfied:
    (i) The insulation (as defined in paragraph (c)) or other energy-
conserving component (as defined in paragraph (d)) is installed in or on 
a dwelling unit that is used as the taxpayer's principal residence when 
the installation is completed. See Sec. 1.23-3(e) for the definition of 
principal residence.
    (ii) The dwelling unit is located in the United States (as defined 
in section 7701(a)(9)).
    (iii) The construction of the dwelling unit was substantially 
completed before April 20, 1977. See Sec. 1.23-3(f) for the definition 
of the terms ``construction'' and ``substantially completed''. In the 
case of expenditures made with respect to the enlargement of a dwelling 
unit, the construction of the enlargement must have been substantially 
completed before April 20, 1977.
    (2) Examples. The application of this paragraph may be illustrated 
by the following examples:

    Example 1. In 1978, A spent $500 for the purchase and installation 
of new storm windows to replace old storm windows, $100 to reinstall old 
storm windows, and $150 to transfer a A's house insulation which had 
been installed in A's garage. Only the $500 spent for new storm windows 
qualifies as an energy conservation expenditure. The $100 spent to 
reinstall storm windows and the $150 spent to transfer insulation to A's 
house do not qualify since the only installation costs that qualify are 
those for the original installation of energy conservation property the 
original use of which commences with the taxpayer.
    Example 2. In June 1977, B purchased for B's principal residence a 
new house that was substantially completed before April 20, 1977. 
Pursuant to B's request the builder installed storm windows on May 1, 
1977, the cost of this option being included in the purchase price of 
the house. The portion of the purchase price of the residence allocable 
to the storm windows constitutes an energy conservation expenditure. 
However, no other part of the purchase price may be allocated to energy 
conservation property (insulation and other energy conserving 
components) installed before April 20, 1977. To qualify as an energy 
conservation expenditure, an expenditure must be made (i.e., 
installation of the energy conservation property must be completed) on 
or after April 20, 1977.

    (b) Renewable energy source expenditures. The term ``renewable 
energy source expenditures'' means an expenditure made on or after April 
20, 1977,

[[Page 48]]

and before January 1, 1986, by a taxpayer for renewable energy source 
property (as defined in paragraph (e)), or for labor costs properly 
allocable to the on-site preparation, assembly, or original installation 
such property, if both of the following conditions are satisfied:
    (1) The renewable energy source property is installed in connection 
with a dwelling unit that is used as the taxpayer's principal residence 
when the installation is completed. See Sec. 1.23-3(e).
    (2) The dwelling unit is located in the United States (as defined in 
section 7701(a)(9)).

Additionally, the term ``renewable energy source expenditures'' includes 
expenditures made after December 31, 1979, and before January 1, 1986, 
for an onsite well drilled for any geothermal deposit (as defined in 
paragraph (h)), or for labor costs properly allocable to onsite 
preparation, assembly, or original installation of such well, but only 
if the requirements of paragraphs (b) (1) and (2) of this section are 
met and the taxpayer has not elected under section 263(c) to deduct any 
portion of such expenditures or allocable labor costs.

Eligibility as a renewable energy source expenditure does not depend on 
the date of construction of the dwelling unit. Thus, such an expenditure 
may be made in connection with either a new or an existing dwelling 
unit. Renewable energy source expenditures need only be made in 
connection with a dwelling, rather than in or on a dwelling unit. For 
example, a solar collector that otherwise constitutes renewable energy 
source property is not ineligible merely because it is installed 
separately from the dwelling unit. The term ``renewable energy source 
expenditure'' does not include any expenditure allocable to a swimming 
pool even when used as an energy storage medium or to any other energy 
storage medium whose primary function is other than the storage of 
energy. It also does not include the cost of maintenance of an installed 
system or the cost of leasing renewable energy source property.
    (c) Insulation. The term ``insulation'' means any item that 
satisfies all of the following conditions:
    (1) The item is specifically and primarily designed to reduce, when 
installed in or on a dwelling or on a water heater, the heat loss or 
gain of such dwelling or water heater. To qualify as insulation the item 
must be installed between a conditioned area and a nonconditioned area 
(except when installed on a water heater, water pipe, or heating/cooling 
duct). Thus for example, awnings do not qualify as insulation. For 
purposes of this section the term ``conditioned area'' means an area 
that has been heated or cooled by conventional or renewable energy 
source means. Insulation includes materials made of fiberglass, rock 
wool, cellulose, urea based foam, urethane, vermiculite, perlite, 
polystyrene, and extruded polystyrene foam.
    (2) The original use of the item begins with the taxpayer.
    (3) The item can reasonably be expected to remain in operation at 
least 3 years.
    (4) The item meets the applicable performance and quality standards 
prescribed in Sec. 1.23-4 (if any) that are in effect at the time the 
taxpayer acquires the item. The term ``insulation'' shall not include 
items whose primary purpose is not insulation (e.g., whose function is 
primarily structural, decorative, or safety-related). For example, 
carpeting, drapes (including linings), shades, wood paneling, fireplace 
screens (including those made of glass), new or replacement walls 
(except for qualifying insulation therein) and exterior siding do not 
qualify although they may have been designed in part to have an 
insulating effect.
    (d) Other energy-conserving components. The term ``other energy-
conserving component'' means any item (other than insulation) that 
satisfies all of the following conditions:
    (1) The original use of the item begins with the taxpayer.
    (2) The item can reasonably be expected to remain in operation for 
at least 3 years.
    (3) The item meets the applicable performance and quality standards 
prescribed in Sec. 1.23-4 (if any) that are in effect at the time of the 
taxpayer's acquisition of the item.
    (4) The item is one of the following items:

[[Page 49]]

    (i) A furnace replacement burner. The term ``furnace replacement 
burner'' means a device (for oil and gas-fired furnaces or boilers) that 
is designed to achieve a reduction in the amount of fuel consumed as a 
result of increased combustion efficiency. The burner must replace an 
existing burner. It does not qualify if it is acquired as a component 
of, or for use in, a new furnace or boiler.
    (ii) A device for modifying flue openings. The term ``device for 
modifying flue openings'' means an automatically operated damper that--
    (A) Is designed for installation in the flue, between the barometric 
damper or draft hood and the chimney, of a furnace; and
    (B) Conserves energy by substantially reducing the flow of 
conditioned air through the chimney when the furnace is not in 
operation. Conditioned air is air that has been heated or cooled by 
conventional or renewable energy source means.
    (iii) A furnace ignition system. The term ``furnace ignition 
system'' means an electrical or mechanical device, designed for 
installation in a gas-fired furnace or boiler that automatically ignites 
the gas burner. In order to qualify, the device must replace a gas pilot 
light. Furthermore, it does not qualify if it is acquired as a component 
of, or for use in, a new furnace or boiler.
    (iv) A storm or thermal window or door. The terms ``storm or thermal 
window'' and ``storm or thermal door'' mean the following:
    (A)(1) A window placed outside or inside an ordinary or prime 
window, creating an insulating air space.
    (2) A window with enhanced resistance to heat flow through the 
glazed area by multi-glazing.
    (3) A window that consists of glass or other glazing materials that 
have exceptional heat-absorbing or heat-reflecting properties. For 
purposes of this subdivision (iv), the term ``glazing material'' does 
not include films and coatings applied on the surface of a window.
    (B)(1) A second door, installed outside or inside a prime exterior 
door, creating an insulating air space.
    (2) A door with enhanced resistance to heat flow through the glazed 
area by multi-glazing.
    (3) A prime exterior door that has an R-value (a measurement of the 
ability of insulation to resist the flow of heat) of at least 2 
throughout.

For purposes of this subdivision, ``multi-glazing'' is an arrangement in 
which two or more sheets of glazing material are affixed in a window or 
door frame to create one or more insulating air spaces. Multi-glazing 
can be achieved by installing a preassembled, sealed insulating glass 
unit or by affixing one or more additional sheets of glazing onto an 
existing window (or sash) or door. For purposes of this subdivision, a 
storm or thermal window or door does not include any film applied on or 
over the surface of a window or door.
    (v) Automatic energy-saving setback thermostat. The term ``automatic 
energy-saving setback thermostat'' means a device that is designed to 
reduce energy consumption by regulating the demand on the heating or 
cooling system in which it is installed, and uses--
    (A) A temperature control device for interior spaces incorporating 
more than one temperature control level, and
    (B) A clock or other automatic mechanism for switching from one 
control level to another.
    (vi) Caulking and weatherstripping. The term ``caulking'' means 
pliable materials used to fill small gaps at fixed joints on buildings 
to reduce the passage of air and moisture. Caulking includes, but is not 
limited to, materials commonly known as ``sealants'', ``putty'', and 
``glazing compounds''. The term ``weatherstripping'' means narrow strips 
of material placed over or in movable joints of windows and doors to 
reduce the passage of air and moisture.
    (vii) Energy usage display meter. The term ``energy usage display 
meter'' means a device the sole purpose of which is to display the cost 
(in money) of energy usage in the dwelling. It may show cost information 
for electricity usage, gas usage, oil usage, or any combination thereof. 
The device may measure energy usage of the whole dwelling,

[[Page 50]]

or individual appliances or systems on an instantaneous or cumulative 
basis.
    (viii) Components specified by the Secretary. The Secretary (or his 
delegate) may, in his discretion, after consultation with the Secretary 
of Energy and the Secretary of Housing and Urban Development (or their 
delegates), and any other appropriate Federal officers, specify by 
regulation other energy-conserving components for addition to the list 
of qualified items. See Sec. 1.23-6 for the procedures and criteria to 
be used in determining whether an item will be considered for addition 
to the list of qualified items by the Secretary.

The term ``other energy-conserving component'' is limited to items in a 
category specifically listed in section 44(c)(4)(A) (i) through (vii) or 
added by the Secretary.
    (e) Renewable energy source property--(1) In general. The term 
``renewable energy source property'' includes any solar energy property, 
wind energy property, geothermal energy property, or property referred 
to in subparagraph (2), which meets the following conditions:
    (i) The original use of the property begins with the taxpayer.
    (ii) The property can reasonably be expected to remain in operation 
for at least 5 years.
    (iii) The property meets the applicable performance and quality 
standards prescribed in Sec. 1.23-4 (if any) that are in effect at the 
time of the taxpayer's acquisition of the property.

Renewable energy source property does not include heating or cooling 
systems, nor systems to provide hot water or electricity, which serve to 
supplement renewable energy source equipment in heating, cooling, or 
providing hot water or electricity to a dwelling unit, and which employ 
a form of energy (such as oil or gas) other than solar, wind, or 
geothermal energy (or other forms of renewable energy provided in 
paragraph (e)(2) of this section. Thus, heat pumps or oil or gas 
furnaces, used in connection with renewable energy source property, are 
not eligible for the credit. In order to be eligible for the credit for 
renewable energy source property, the property (as well as labor costs 
properly allocable to onsite preparation, assembly or installation of 
equipment) must be clearly identifiable. See Sec. 1.23-3(l) for 
recordkeeping rules.
    (2) Renewable energy source specified by the Secretary. In addition 
to solar, wind, and geothermal energy property, renewable energy source 
property includes property that transmits or uses another renewable 
energy source that the Secretary (or his delegate) specifies by 
regulations, after consultation with the Secretary of Energy and the 
Secretary of Housing and Urban Development (or their delegates), and any 
other appropriate Federal officers, to be of a kind that is appropriate 
for the purpose of heating or cooling the dwelling or providing hot 
water or (in the case of expenditures made after December 31, 1979) 
electricity for use within the dwelling. For purposes of this section, 
references to the transmission or use of energy include its collection 
and storage. See Sec. 1.23-6 for the procedures and criteria to be used 
in determining when another energy source will be considered for 
addition to the list of qualified renewable energy sources.
    (f) Solar energy property--(1) In general. The term ``solar energy 
property'' means equipment and materials of a solar energy system as 
defined in this paragraph (and parts solely related to the functioning 
of such equipment) which, when installed in connection with a dwelling, 
transmits or uses solar energy to heat or cool the dwelling or to 
provide hot water or (in the case of expenditures made after December 
31, 1979) electricity for use within the dwelling. For this purpose, 
solar energy is energy derived directly from sunlight (solar radiation). 
Property which uses, as an energy source, fuel or energy which is 
indirectly derived from sunlight (solar radiation), such as fossil fuel 
or wood or heat in underground water, is not considered solar energy 
property. Materials and components of ``passive solar systems'' as well 
as ``active solar systems'', or a combination of both types of systems 
may qualify as solar energy property.
    (2) Active solar system. An active solar system is based on the use 
of mechanically forced energy transfer, such as the use of fans or pumps 
to circulate solar generated energy, or thermal energy transfer, such as 
systems utilizing

[[Page 51]]

thermal siphon principles. Generally, this is accomplished through the 
use of equipment such as collectors (to absorb sunlight and create hot 
liquids or air), storage tanks (to store hot liquids), rockbeds (to 
store hot air), thermostats (to activate pumps or fans which circulate 
the hot liquids or air), and heat exchangers (to utilize hot liquids or 
air to heat air or water).
    (3) Passive solar system. A passive solar system is based on the use 
of conductive, convective, or radiant energy transfer. In order to 
qualify as a passive solar system, a solar system used for heating 
purposes must contain all of the following: a solar collection area, an 
absorber, a storage mass, a heat distribution method, and heat 
regulation devices. The term ``solar collection area'' means an expanse 
of transparent or translucent material, such as glass which is 
positioned in such a manner that the rays of the sun directly strike an 
absorber. The term ``absorber'' means a surface, such as a floor, that 
is exposed to the rays of the sun admitted through the solar collection 
area, which converts solar radiation into heat, and then transfers the 
heat to a storage mass. The term ``storage mass'' means material, such 
as masonry, that receives and holds heat from the absorber and later 
releases the heat to the interior of the dwelling. The storage mass must 
be of sufficient volume, depth, and thermal energy capacity to store and 
deliver adequate amounts of solar heat for the relative size of the 
dwelling. In addition, the storage mass must be located so that it is 
capable of distributing the stored heat directly to the habitable areas 
of the dwelling through a heat distribution method. The term ``heat 
distribution method'' means the release of radiant heating from the 
storage mass within the habitable areas of the dwelling, or convective 
heating from the storage mass through airflow paths provided by openings 
or by ducts in the storage mass, to habitable areas of the dwelling. The 
term ``heat regulations devices'' means shading or venting mechanisms 
(such as awnings or insulated drapes) to control the amount of solar 
heat admitted through the solar collection areas and nighttime 
insulation or its equivalent to control the amount of heat permitted to 
escape from the interior of the dwelling.
    (4) Components with dual function. To the extent that a passive or 
active solar system utilizes portions of the structure of a residence, 
only the materials and components whose sole purpose is to transmit or 
use solar radiation (and labor costs associated with installing such 
materials and components) are included within the term ``solar energy 
property''. Accordingly, materials and components that serve a dual 
purpose, e.g., they have a significant structural function or are 
structural components of the dwelling (and labor costs associated with 
installing such materials and components) are not included within the 
term ``solar energy property''. For example, roof ponds that form part 
of a roof (including additional structural components to support the 
roof), windows (including clerestories and skylights), and greenhouses 
do not qualify as solar energy property. However, with respect to 
expenditures made after December 31, 1979, a solar collector panel 
installed as a roof or portion thereof (including additional structural 
components to support the roof attributable to the collector) does not 
fail to qualify as solar energy property solely because it constitutes a 
structural component of the dwelling on which it is installed. For this 
purpose, the term ``solar collector panel'' does not include a skylight 
or other type of window. In the case of a trombe wall (a south facing 
wall composed of a mass wall and exterior glazing), the mass wall (and 
labor costs associated with installing the mass wall) will not qualify. 
However, the exterior (non-window) glazing will qualify. Any shading, 
venting and heat distribution mechanisms or storage systems that do not 
have a dual function will also qualify.
    (g) Wind energy property. The term ``wind energy property'' means 
equipment (and parts solely related to the functioning of such 
equipment) which, when installed in connection with a dwelling, 
transmits or uses wind energy to produce energy in a useful form for 
personal residential purposes. Examples of equipment using wind energy 
to produce energy in a useful form are windmills, wind-driven 
generators,

[[Page 52]]

power conditioning and storage devices that use wind to generate 
electricity or mechanical forms of energy. Devices that use wind merely 
to ventilate do not qualify as wind energy property.
    (h) Geothermal energy property. The term ``geothermal energy 
property'' means equipment (and parts solely related to the functioning 
of such equipment) necessary to transmit or use energy from a geothermal 
deposit to heat or cool a dwelling or provide hot water for use within 
the dwelling. With respect to expenditures made after December 31, 1979, 
the term ``geothermal energy property'' also means equipment (and parts 
solely related to the functioning of such equipment) necessary to 
transmit or use energy from a geothermal deposit to produce electricity 
for use within the dwelling. Equipment such as a pipe that serves both a 
geothermal function (by transmitting hot geothermal water within a 
dwelling) and a non-geothermal function (by transmitting hot water from 
a water heater within a dwelling) does not qualify as geothermal 
property. A geothermal deposit is a geothermal reservoir consisting of 
natural heat which is from an underground source and is stored in rocks 
or in an aqueous liquid or vapor (whether or not under pressure), having 
a temperature exceeding 50 degrees Celsius as measured at the wellhead 
or, in the case of a natural hot spring (where no well is drilled), at 
the intake to the distribution system.
    (i) Subsidized energy financing--(1) In general. The term 
``subsidized energy financing'' means financing (e.g., a loan) made 
directly or indirectly (such as in association with, or through the 
facilities of, a bank or other lender) during a taxable year beginning 
after December 31, 1980, under a Federal, State, or local program, a 
principal purpose of which is to provide subsidized financing for 
projects designed to conserve or produce energy. For purposes of this 
paragraph (i), financing is made when funds that constitute subsidized 
energy financing are disbursed. Subsidized energy financing includes 
financing under a Federal, State, or local program having two or more 
principal purposes (provided that at least one of the principal purposes 
is to provide subsidized financing for projects designed to conserve or 
produce energy), but only to the extent that the financing--
    (i) Is to be used for energy production or conservation purposes, or
    (ii) Is provided out of funds designated specifically for energy 
production or conservation.

Loan proceeds meet the use test of paragraph (i)(l)(i) of this section 
only to the extent that the loan application, the loan instrument, or 
any other loan-related documents indicate that the funds are intended 
for such use. However, loan proceeds designated for the purchase either 
of property that contains ``insulation'' or any ``other energy-
conserving component'' or of ``renewable energy source property'' as 
defined in paragraphs (c), (d), and (e), respectively, of this section 
meet the test of paragraph (i)(l)(i) of this section. Financing is 
subsidized if the interest rate or other terms of the financing 
(including any special tax treatment) provided to the taxpayer in 
connection with the program or used to raise funds for the program are 
more favorable than the terms generally available commercially. In 
addition, financing is subsidized if the principal obligation of the 
financing provided to the taxpayer is reduced by funds provided under 
the program. The source from which the funds for the program are derived 
is not a factor to be taken into account in determining whether the 
financing is subsidized. If a public utility disburses funds for the 
financing of energy conservation or renewable energy source property 
under a program that obtains the funds through sales to the utility's 
ratepayers, the program is not considered to be a Federal, State or 
local program even though the utility is a governmental agency, and, 
thus, the funds are not subsidized energy financing. Subsidized energy 
financing does not include a grant includible in gross income under 
section 61, nontaxable grants, a credit against State or local taxes 
made directly to the taxpayer claiming the credit provided for in 
section 23, or a loan guarantee made directly to the taxpayer claiming 
the credit provided for in section 23.
    (2) Examples. The provisions of this paragraph (i) may be 
illustrated by the following examples:


[[Page 53]]


    Example 1. State A has a farm and home loan program. The program is 
used to provide low interest mortgage loans. In 1984 State A's 
legislature enacted statutory amendments to its farm and home loan 
program in an effort to encourage energy conservation-type measures. Low 
interest loans for such improvements were made available to qualified 
purchasers and owners under the farm and home loan program. The energy 
conservation measures subsidized by the program include energy 
conserving components and renewable energy source devices. State A's tax 
exempt bonds are the source of funds for loans under the program. 
Although the 1984 legislation authorizing loans for energy conserving 
components and renewable energy source improvements did not diminish the 
original purpose of the farm and home loan program, the 1984 legislation 
added another principal purpose to the program. Therefore, State A's 
program which has two principal purposes, one of which is the 
conservation or production of energy, is considered as providing 
subsidized energy financing for purposes of section 23 (c)(10) of the 
Code, to the extent that financing is provided by State A out of funds 
designated specifically for energy production or conservation. State A's 
program will also be considered as providing subsidized energy financing 
to the extent that the loan proceeds are to be used for energy 
production or conservation purposes. Loan proceeds meet the use test of 
the preceding sentence only to the extent that loan application, the 
loan instruments, or any other loan-related documents indicate that the 
funds are intended for such use.
    Example 2. The United States Department of Energy disburses funds to 
State B that the Department received from settlements from alleged 
petroleum pricing and allocation violations. State B establishes a 
program under which B will use the funds to make loans at below market 
interest rates directly to qualified applicants for the purchase of 
renewable energy source property. B's loans are subsidized energy 
financing.
    Example 3. State C establishes a program under which C will make 
loans at below market interest rates directly to qualified applicants 
for the purchases of renewable energy source property. The program is 
funded with money that State C was able to borrow after it obtained a 
loan guarantee from a Federal agency. C's loans provided under the 
program are subsidized energy financing.
    Example 4. Company D is an electric utility that is a Federal 
agency. D purchases its electricity from another federal agency, 
transmits the electricity over its own distribution system, and sells 
the electricity to numerous local public utilities that in turn sell the 
electricity to their customers. D wishes to start a program under which 
D will make loans at below market interest rates directly to customers 
of the local utilities for the purchase of renewable energy source 
property from D. The local public utility will act as the collection 
agent for repayment of the loans. The loans will be repayable over a 
period of time not in excess of 15 years. Under law, D must cover its 
full costs through its own revenues derived from the sale of power and 
other services. While D may borrow by sale of bonds to the United States 
Treasury, D must borrow at rates comparable to the rates prevailing in 
the market for similar bonds. Thus, the subsidized loans made under D's 
program will be financed by the profits from the sale of electricity to 
consumers and not by the federal government. D's program, which is 
substantially the same as that carried out by private (investor-owned) 
utilities, is not considered to be a Federal, State or local 
governmental program. Therefore, D's loans are not subsidized energy 
financing.
    Example 5. The Solar Energy and Energy Conservation Bank (Bank) 
disburses funds to State E. E disburses a portion of the funds to 
Financial Institution F. Both the Bank and State E make these 
disbursements under a program the principal purpose of which is to 
provide subsidized financing for projects designed to conserve or 
produce energy. F uses the funds to reduce a portion of the principal 
obligation on loans it issues to finance energy conservation or solar 
energy expenditures. Taxpayer G borrows $3,000 from F in order to 
purchase a solar water heating system. F uses $500 of the funds it 
received from the Bank to reduce the principal obligation of the loan to 
G to $2,500. The amount of subsidized energy financing to G is $3,000.
    Example 6. State H allows a tax credit to Financial Institution J 
under a program the principal purpose of which is to provide loans at 
below market interest rates directly to qualified applicants for the 
purchase of renewable energy source property. J receives a credit each 
year in the amount of the excess of the interest that would have been 
paid at private market rates over the actual interest paid on such 
loans. The State H tax credit arrangement is an interest subsidy. Thus, 
any low-interest loans made pursuant to this credit arrangement are 
subsidized energy financing.

[T.D. 7717, 45 FR 57716, Aug. 29, 1980. Redesignated and amended by T.D. 
8146, 52 FR 26670, July 16, 1987]



Sec. 1.23-3  Special rules.

    (a) When expenditures are treated as made--(1) Timeliness of an 
expenditure for the energy credit. In general, for the purpose of 
determining whether an expenditure qualifies as being timely for the 
residential energy credit under section 23 or former section 44C (i.e., 
is made after April 19, 1977, and before

[[Page 54]]

January 1, 1986), the expenditure is treated as made when original 
installation of the item is completed. Thus, solely for that purpose, 
the time of payment or accrual is irrelevant.
    (2) Special rule for renewable energy source expenditures in the 
case of construction or reconstruction of a dwelling. In the case of 
renewable energy source expenditures in connection with the construction 
or reconstruction of a dwelling that becomes the taxpayer's new 
principal residence, the expenditures are to be treated as made (for the 
purpose of determining the timeliness of an expenditure for the 
residential energy credit) when the taxpayer commences use of the 
dwelling as his or her principal residence following its construction or 
reconstruction. The term ``reconstruction'' means the replacement of 
most of a dwelling's major structural components such as floors, walls, 
and ceiling. When a taxpayer reoccupies a reconstructed dwelling that 
was the taxpayer's principal residence prior to reconstruction, a 
renewable energy source expenditure is considered made when the original 
installation of the renewable energy source property is completed.
    (3) Taxable year in which credit is allowable. For the purpose of 
determining the taxable year in which the credit for an expenditure is 
allowable (once it has qualified as timely under subparagraph (1) or 
(2)), an expenditure is treated as made on the later of (i) the date on 
which it qualifies as timely; or (ii) the date on which it is paid or 
incurred by the taxpayer.
    (b) Expenditures in 1977. No credit under section 23 or former 
section 44C shall be allowed for any taxable year beginning before 1978. 
However, the amount of any credit under section 23 or former section 44C 
for the taxpayer's first taxable year beginning after December 31, 1977, 
shall take into account qualified energy conservation expenditures and 
qualified renewable energy source expenditures made during the period 
beginning April 20, 1977, and ending on the last day of such first 
taxable year.
    (c) Cross reference. For rules relating to expenditures financed 
with Federal, State, or local government grants or subsidized financing 
see paragraph (d)(3) of Sec. 1.23-1 and paragraph (i) of Sec. 1.23-2.
    (d) Expenditures qualifying both as energy conservation expenditures 
and renewable source expenditures. In the case of an expenditure which 
meets both the definition of an energy conservation expenditure (as 
defined in Sec. 1.23-2(a)) and a renewable energy source expenditure (as 
defined in Sec. 1.23-2(b)), the taxpayer may claim either a credit under 
Sec. 1.23-1(b) (relating to qualified energy conservation expenditures) 
or Sec. 1.23-1(c) (relating to qualified renewable energy source 
expenditures) but may not claim both credits with respect to the same 
expenditure.
    (e) Principal residence. For purposes of section 23 or former 
section 44C the determination of whether a dwelling unit is the 
taxpayer's principal residence shall be made under principles similar to 
those applicable to section 1034 and the regulations thereunder 
(relating to sale or exchange of a principal residence) except that 
ownership of the dwelling unit is not required. In making this 
determination, the period for which a dwelling is treated as a 
taxpayer's principal residence includes the 30-day period ending on the 
first day on which the dwelling unit would (but for this sentence) be 
treated as being used as the taxpayer's principal residence under 
principles similar to those applicable to section 1034. Thus, 
installation that are completed within that 30-day period may be 
eligible for the credit although, in the absence of the 30-day rule, the 
date of habitation of the dwelling unit by the taxpayer would mark the 
beginning of the taxpayer's use of the unit as a principal residence.
    (f) Construction substantially completed. Construction of a dwelling 
unit is substantially completed when construction has progressed to the 
point where the unit could be put to use as a personal residence, even 
though comparatively minor items remain to be finished or performed in 
order to conform to the plans or specifications of the completed 
building. For this purpose, construction includes reconstruction as 
defined in paragraph (a)(2). This rule may be illustrated by the 
following example:


[[Page 55]]


    Example. On January 1, 1979, A purchases a dwelling that is to 
become A's principal residence. The dwelling unit was originally 
constructed in 1950. A spends $50,000 to reconstruct the dwelling by 
replacing most of the dwelling's major structural components such as 
floors, walls, and ceilings. Included in the cost is $3,000 attributable 
to energy-conserving components. Reconstruction is substantially 
completed on April 1, 1979, and A moves into the reconstructed residence 
on May 1, 1979. Since construction includes reconstruction, A's 
reconstructed residence is not considered substantially completed before 
April 20, 1977. Thus, amounts spent with respect to A's reconstructed 
residence for energy-conserving components do not qualify as energy 
conservation expenditures.

    (g) Residential use of property. To be eligible for the residential 
energy credit, expenditures must be made for personal residential 
purposes. If at least 80 percent of the use of a component or item of 
property is for personal residential purposes, the entire amount of the 
energy conservation expenditure or the renewable energy source 
expenditure is taken into account in computing the credit under this 
section. If less than 80 percent of the use of a component or item of 
property is for personal residential purposes, the amount of an 
expenditure taken into account is the amount that bears the same ratio 
to the amount of the expenditure as the amount of personal residential 
use of the component or item bears to its total use. For purposes of 
this paragraph, use of a component or an item of property with respect 
to a swimming pool is not a use for a personal residential purpose. The 
rules with respect to residential use of property are illustrated by the 
following examples:

    Example 1. In 1978 A makes an expenditure of $3,000 for the 
installation of storm windows of which 50 percent is on the portion of 
A's dwelling used as the principal family residence and 50 percent is on 
the portion of the dwelling used as an office. A has made no other 
energy conservation expenditures for the residence. The allowable energy 
conservation expenditure is $1,500 (50 percent of $3,000), the portion 
attributable to residential use. Therefore, the residential energy 
credit is $225 (the qualified conservation expenditure of 15 percent of 
$1.500).
    Example 2. During 1979, B makes $10,000 of renewable energy source 
expenditures on solar energy property for B's principal residence. 
Approximately 60 percent of the use of the solar energy property will be 
for heating B's swimming pool; the other 40 percent will be for heating 
the dwelling unit. B had not previously made renewable energy source 
expenditures with respect to the residence. Since use for a swimming 
pool is not considered a residential use, less than 80 percent of the 
use of B's solar energy property is considered used for personal 
residential purposes. Therefore, only $4,000 (40 percent of $10,000), 
the proportionate part of B's expenditures representing personal 
residential use, is treated as a renewable energy source expenditure. B 
is allowed a $1,000 residential energy credit (30 percent of $2,000 plus 
20 percent of $2,000) for 1979.

    (h) Joint occupancy--(1) In general. If two or more individuals 
jointly occupied and used a dwelling unit as their principal residence 
during any portion of a calendar year--
    (i) The amount of the credit allowable under section 23 or former 
section 44C by reason of energy conservation expenditures or by reason 
of renewable energy source expenditures shall be determined by treating 
all of the joint occupants as one taxpayer whose taxable year is such 
calendar year; and
    (ii) The credit under section 23 or former section 44C allowable to 
each joint occupant for the taxable year with which or in which such 
calendar year ends shall be an amount which bears the same ratio to the 
amount determined under paragraph (h)(1)(i) of this section as the 
amount of energy conservation expenditures or renewable energy source 
expenditures made by that occupant bears to the total amount of each 
type of such expenditures made by all joint occupants during such 
calendar year.

The provisions of this subparagraph may be illustrated by the following 
example:

    Example. A, a calendar year taxpayer, and B, a June 1 fiscal year 
taxpayer, make energy conservation exenditures of $2,000 (A making 
expenditures of $500 and B making expenditures of $1,500) on their 
principal and jointly occupied residence in 1978. A and B have not 
previously make energy conservation expenditures with respect to this 
residence. Of the $300 credit (15 percent of $2,000), $75 will be 
allocated to A ($500 / $2,000  x  $300) and $225 to B ($1,500 / $2,000 
x  300). A will claim the allocable share of the credit on A's 1978 tax 
return and B will claim the allocable share of the credit on B's tax 
return for the fiscal year ending May 31, 1979.


[[Page 56]]


    (2) Minimum credit. The fact that one joint occupant may be unable 
to claim all or part of the credit under section 23 of former section 
44C because of insufficient tax liability or because that occupant's 
allowable credit does not exceed the $10 minimum credit (as set forth in 
paragraph (d)(1) of Sec. 1.23-1) shall have no effect upon the 
computation of the amount of the allowable credits for the other joint 
occupants.
    (3) Prior expenditures. Because joint occupants are treated as one 
taxpayer for purposes of determining the residential energy credit, the 
maximum amount of energy conservation expenditures or renewable energy 
source expenditures must be reduced by the total amount of such 
expenditures made in connection with the dwelling unit during prior 
calendar years in which any one of the residents of the unit during the 
current calendar year was a resident (whether made by the current 
resident or by an individual previously occupying the dwelling with the 
current resident). However, the preceding sentence shall not apply to 
prior expenditures no part of which was taken into account in computing 
the credits under section 23 of former section 44C for such years. Prior 
years' expenditures are not to be allocated among joint occupants to 
take into account the specific expenditures of each of the occupants in 
prior years.
    (4) The rules of this paragraph may be illustrated by the following 
examples:

    Example 1. Assume A and B have together made prior years' energy 
conservation expenditures of $1,600 (A having made $1,200 of 
expenditures and B having made $400) on their principal and jointly 
occupied residence. In the current year, each makes energy conservation 
expenditures of $300 with respect to the same residence. The maximum 
qualified expenditure with respect to the residence is reduced by the 
$1,600 of prior expenditures made by A and B. Therefore, only $400 of 
the $600 current expenditures are eligible as energy conservation 
expenditures. The resulting residential energy credit is $60 (15 percent 
of $400) of which $30 apiece will be allocated to A and B ($300/$600  x  
$60). The fact that A had previously computed the credit in prior years 
with respect to $1,200 of the total $1,600 of expenditures is irrelevant 
to the apportionment of the credit in the current year.
    Example 2. In 1978, spouses C and D make $10,000 of renewable energy 
source expenditures with respect to their principal residence, half of 
which is paid by each spouse. No prior renewable energy source 
expenditures have been taken into account with respect to that residence 
by either C or D. C and D file separate returns for the calendar year. 
Under the joint occupancy rule, the maximum allowable renewable energy 
source credit with respect to C and D's principal residence is $2,200 
(30 percent of the first $2,000, and 20 percent of the next $8,000 of 
expenditures). Half of this amount or $1,100, will be allowed to each 
spouse. If either spouse makes renewable energy source expenditures with 
respect to the same principal residence in future years, none of those 
expenditures would be qualified renewable energy source expenditures for 
which a credit can be claimed. That is, not more than $2,200 may be 
taken in the aggregate by C and D as a renewable energy source credit 
with respect to their principal residence.
    Example 3. In 1978, E and F make energy conservation expenditures of 
$1,500 on their principal and jointly occupied residence. In 1979, E 
moves away and G becomes the other joint occupant of the residence. F 
and G make energy conservation expenditures of $1,000 in 1979. In 1980 F 
moves away and H moves in with G. G and H make energy conservation 
expenditures of $500. The maximum qualified expenditure made by F and G 
with respect to the residence is reduced by the $1,500 of prior 
expenditures made in 1978 by E and F. The maximum qualified expenditures 
made by G and H with respect to the residence is reduced only by the 
expenditures in prior years in connection with the residence during 
which either G or H was a joint occupant. Accordingly, the maximum 
qualified expenditures made by G and H with respect to the residence is 
reduced only by the $1,000 of prior expenditures made in 1979 by F and 
G.

    (i) Condominiums and cooperative housing corporations. An individual 
who is a tenant stockholder in a cooperative housing corporation (as 
defined in section 216) or who is a member of a condominium management 
association with respect to a condominium which he or she owns shall be 
treated as having made a proportionate share of the energy conservation 
expenditures or renewable energy source expenditures of such corporation 
or association. The cooperative stockholder's allocable share of the 
expenditures is to be the same as his or her proportionate share of the 
cooperative's total outstanding stock (including any stock held by the 
corporation). However, in the case

[[Page 57]]

where only certain cooperative stockholders are assessed for the 
expenditures made by the cooperative housing corporation, only those 
cooperative stockholders that are assessed shall be treated as having 
made a share of the expenditures of such corporation. In such case, the 
cooperative stockholder's share of the expenditures is the amount that 
the stockholder is assessed. The allocable share of a condominium 
management association member's energy conservation of renewable energy 
source expenditures is the amount that the member is assessed (or would 
be assessed in the case where expenditures are from general funds) by 
the association as a result of such expenditures. The residential energy 
credit for a qualified expenditure is allowable for the year in which 
the association or corporation has completed original installation of 
the item (or has paid or incurred the expenditure, if later). For 
purposes of this paragraph, the term ``condominium management 
association'' means an organization meeting the requirements of section 
528(c)(1) of the Code (other than subparagraph (E) of that section), 
with respect to a condominium project substantially all the units of 
which are used as residences.
    (j) Joint ownership of energy conservation property or renewable 
energy source property--(1) In general. Energy conservation property 
renewable energy source property include property which is jointly owned 
by the taxpayer and another person (or persons) and installed in 
connection with two or more dwelling units. For example, the fact that a 
windmill, solar collector, or geothermal well and distribution system is 
owned by two or more individuals does not preclude its qualification as 
renewable energy source property. The amount of the credit allowable 
under section 23 shall be computed separately with respect to the amount 
of the expenditures made by each individual, subject to the limitations 
of $2,000 imposed by section 23(b)(1) and $10,000 imposed by section 
23(b)(2), per dwelling units of jointly owned property. For example, in 
1982, A, B, and C purchased as joint owners renewable energy source 
property that serviced two houses. One of the houses is jointly owned 
and occupied by A and B and the other is owned and occupied by C alone. 
The renewable energy source property cost $30,000 of which A paid 
$9,000, B paid $6,000, and C paid $15,000. A and B must share the $4,000 
credit (40% of $10,000 maximum) with respect to the expenditures for the 
jointly owned house. Therefore, A is allowed a $2,400 credit ($4,000 
times $9,000 divided by $9,000 plus $6,000) and B is allowed a $1,600 
credit ($4,000 times $6,000 divided by $9,000 plus $6,000) with respect 
to the expenditures attributable to the jointly owned house. C is 
entitled to a credit of $4,000 with respect to the expenditures 
attributable to the other house.
    (2) Example. The application of this subparagraph may be illustrated 
by the following example:

    Example. A, B, and C each has a separate principal residence. They 
agree to finance jointly the construction of a solar collector, each 
providing one-third of the costs and taking one-third of the output of 
the collector. Each will separately pay for the costs of connecting the 
solar collector with his or her principal residence. Provided the solar 
collector and connection equipment otherwise qualify as renewable energy 
source property, A, B, and C will each be considered to have made 
renewable energy source expenditures equal to one-third of the cost of 
the collector plus his or her separate connection costs. Such 
expenditures will be subject to the limitations and other rules 
separately applicable to A, B, and C with respect to each principal 
residence, such as those with respect to the $10 minimum (Sec. 1.23-
1(d)(1)), prior expenditures (Sec. 1.23-1(d)(2)), residential use 
(paragraph (g) of this section), and joint occupancy (paragraph (h) of 
this section).

    (k) Basic adjustments. If a credit is allowed under section 23 or 
former section 44C for any expenditure with respect to any property, the 
increase in the basis of that property which would (but for this 
paragraph) result from such expenditure shall be reduced by the amount 
of the credit allowed.
    (l) Recordkeeping--(1) In general. No residential energy credit is 
allowable unless the taxpayer maintains the records described in 
paragraph (l)(2) of this section. The records shall be retained so long 
as the contents thereof may become material in the administration of any 
internal revenue law.
    (2) Records. The taxpayer must maintain records that clearly 
identify the

[[Page 58]]

energy-conserving components and renewable energy source property with 
respect to which a residential energy credit is claimed, and 
substantiate their cost to the taxpayer, any labor costs properly 
allocable to them paid for by the taxpayer, and the method used for 
allocating such labor costs.

[T.D. 7717, 45 FR 57719, Aug. 29, 1980. Redesignated and amended by T.D. 
8146, 52 FR 26672, July 16, 1987]



Sec. 1.23-4  Performance and quality standards. [Reserved]

[T.D. 7717, 45 FR 57721, Aug. 29, 1980. Redesignated by T.D. 8146, 52 FR 
26672, July 16, 1987]



Sec. 1.23-5  Certification procedures.

    (a) Certification that an item meets the definition of an energy-
conserving component or renewable energy source property. Upon the 
request of a manufacturer of an item pursuant to paragraph (b) of this 
section which is supported by proof that the item is entitled to be 
certified, the Assistant Commissioner (Technical) shall certify (or 
shall notify the manufacturer that the request is denied) that:
    (1) The item meets the definition of insulation (see Sec. 1.23-
2(c)(1)).
    (2) The item meets the definition of an other energy-conserving 
component specified in section 23(c)(4) or former section 44C(c)(4) see 
(Sec. 1.23-2(d)(4)).
    (3) The item meets the definition of solar energy property (see 
Sec. 1.23-2(f)), wind energy property (see Sec. 1.23-2(g)), or 
geothermal energy property (see Sec. 1.23-2(h)).
    (4) The item meets the definition of a category of energy-conserving 
component that has been added to the list of approved items pursuant to 
paragraph (d)(4)(viii) of Sec. 1.23-2.
    (5) The item meets the definition of renewable energy source 
property that transmits or uses a renewable energy source that has been 
added to the list of approved renewable energy sources pursuant to 
paragraph (e)(2) of Sec. 1.23-2.
    (b) Procedure--(1) In general. A manufacturer of an item desiring to 
apply under paragraph (a) shall submit the application to the 
Commissioner of Internal Revenue, Attention: Associate Chief Counsel 
(Technical), CC:C:E, 1111 Constitution Avenue NW., Washington, DC 20224. 
Upon being advised by the National Office, orally or in writing, that an 
adverse decision is contemplated a manufacturer may request a 
conference. The conference must be held within 21 calendar days from the 
date of that advice. Procedures for requesting an extension of the 21-
day period and notifying the manufacturer of the Service's decision on 
that request are the same as those applicable to conferences on ruling 
requests by taxpayers (see section 9.05 of Rev. Proc. 80-20).
    (2) Contents of application. The application shall include a 
description of the item (including appropriate design drawings and 
specifications) and an explanation of the purpose and function of the 
item. There shall accompany the application a declaration in the 
following form: ``Under penalties of perjury, I declare that I have 
examined this application, including accompanying documents and, to the 
best of my knowledge and belief, the facts presented in support of the 
application are true, correct, and complete.'' The statement must be 
signed by the person or persons making the application.
    (c) Effect of certification under paragraph (a). Certifications 
granted under paragraph (a)(1), (2), or (3) will be applied 
retroactively to April 20, 1977. However, certifications granted under 
paragraph (a) (4) or (5) will be applied retroactively only to the date 
the applicable energy-conserving component or renewable energy source 
was added by Treasury decision to the list of qualifying components or 
sources. Certification of an item under this section means that the 
applicable definitional requirement of Sec. 1.23-2 is considered 
satisfied in the case of any person claiming a residential energy credit 
with respect to such item. However, it does not relieve manufacturers of 
the need to establish that their items conform to performance and 
quality standards (if any) provided under Sec. 1.23-4 and that their 
items can reasonably be expected to remain in operation at least 3 
years, in the case of insulation and other energy-conserving components, 
or at least 5 years, in the case of renewable energy source property.

[T.D. 7717, 45 FR 57721, Aug. 29, 1980. Redesignated and amended by T.D. 
8146, 52 FR 26672, July 16, 1987]

[[Page 59]]



Sec. 1.23-6  Procedure and criteria for additions to the approved list 
of energy-conserving components or renewable energy sources.

    (a) Procedures for additions to the list of energy-conserving 
components or renewable energy sources--(1) In general. A manufacturer 
of an item (or a group of manufacturers) desiring to apply for addition 
to the approved list of energy-conserving components or renewable energy 
sources pursuant to paragraph (d)(4)(viii) or (e)(2) of Sec. 1.23-2 
shall submit an application to the Internal Revenue Service, Attention: 
Associate Chief Counsel (Technical), CC:C:E, 1111 Constitution Avenue, 
NW., Washington, DC 20224. The term ``manufacturer'' includes a person 
who assembles an item or a system from components manufactured by other 
persons. The application shall provide the information required under 
paragraph (b) of this section. An application may request that more than 
one item be added to the approved list. It will be the responsibility of 
the Office of the Associate Chief Counsel (Technical) upon receipt of 
the application to determine whether all the information required under 
paragraph (b) of this section has been furnished with the application. 
If an application lacks essential information, the applicant will be 
advised of the additional information required. If the information (or a 
reasonable explanation of the reason why the information cannot be made 
available) is not forthcoming within 30 days of the date of that advice, 
the application will be closed and the applicant will be so informed. 
Any resubmission of information beyond the 30-day period will be treated 
as a new application. If the Office of the Associate Chief Counsel 
(Technical) already is considering an application with respect to the 
same or a similar item, it may consolidate applications. The Office of 
the Associate Chief Counsel will make a report and recommendation to the 
ad hoc advisory board as to whether each item that is the subject to an 
application should be added in accordance with the manufacturer's 
request to the approved list of energy-conserving components or 
renewable energy sources in light of the applicable criteria provided in 
paragraph (c) and the standards for Secretarial determination provided 
in paragraph (d) of this section. In making this recommendation, the 
Office of the Associate Chief Counsel shall consult with the Secretary 
of Energy and the Secretary of Housing and Urban Development (or their 
delegates) and any other appropriate Federal officers to obtain their 
views concerning the item in question. In addition, the Office of the 
Associate Chief Counsel may request from the manufacturer clarification 
of information submitted with the application. The Office of the 
Associate Chief Counsel shall report its recommendation and forward the 
application to the ad hoc advisory board for further consideration.
    (2) Ad hoc advisory board. The Commissioner of Internal Revenue and 
the Assistant Secretary (Tax Policy) shall establish an ad hoc advisory 
board to consider applications and recommendations forwarded by the 
Office of the Associate Chief Counsel (Technical). If a finding in favor 
of addition of any item is made, the board shall report its 
recommendation and forward the application to the Commissioner for 
further consideration. If the item is approved by the Commissioner, the 
application will be forwarded to the Secretary (or his delegate) for 
further consideration. The application will be closed with respect to an 
item if the board, the Commissioner, or the Secretary (or his delegate) 
determines that, under the applicable criteria or the standards for 
Secretarial determination, the item should not be added to the list of 
energy-conserving components or renewable energy sources.
    (3) Action on application. (i) A final decision to grant or deny any 
application filed under paragraph (a)(1) shall be made within 1 year 
after the application and all information required to be filed with such 
request under paragraph (b) have been received by the Office of the 
Associate Chief Counsel (Technical). The applicant manufacturer shall be 
notified in writing of the final decision. In the event of a favorable 
determination, a regulation will be issued in accordance with the 
procedures contained in Sec. 601.601 to include the item as an energy-
conserving component or as a renewable energy

[[Page 60]]

source. A final decision to grant approval of an application is made 
when a Treasury decision adding the item (that is subject of the 
application) as an energy-conserving component or as a renewable energy 
source is published in the Federal Register.
    (ii) The applicant manufacturer shall be entitled to a conference 
and be so notified anytime an adverse action is contemplated by the 
Office of the Associate Chief Counsel, the ad hoc advisory board, the 
Commissioner of Internal Revenue, or the Secretary (or his delegate) and 
no conference was previously conducted. Upon being advised in writing 
that an adverse recommendation or decision as to any item that is the 
subject of an application is contemplated, a manufacturer may request a 
conference. The conference must be held within 21 calendar days from the 
mailing of that advice. Procedures for requesting an extension of the 
21-day period and notifying the manufacturer of the recommendation or 
decision with respect to that request are the same as those applicable 
to conferences on ruling requests by taxpayers. The applicant is 
entitled to only one conference. There is no right to another conference 
when a favorable recommendation or decision is reversed at a higher 
level.
    (iii) A report of any application which has been denied during the 
preceding month and the reasons for the denial shall be published each 
month.
    (b) Contents of application. The application by the manufacturer 
shall include the following information:
    (1) A description of the item and the generic class to which it 
belongs, including any features relating to safe installation and use of 
the item. This description shall include appropriate design drawings and 
technical specifications (or representative drawings and specifications 
when application by a group of manufacturers).
    (2) An explanation of the purpose, function, and each recommended 
use of the item.
    (3) An estimate (and explanation of the estimation methods employed 
and the assumptions made) of the total number of units that would be 
sold for each recommended use during the first 4 years following the 
addition of the item to the approved list and of the total number that 
would be sold for each recommended use during that period in the absence 
of addition. If the item is sold in more than one size, the estimate 
shall indicate the projected sales for each size. This estimate shall 
reflect total industry sales of the item. Past industry sales 
information for each recommended use for the previous two years shall 
also be provided.
    (4) Whether sufficient capacity is available to increase production 
to meet any increase in demand for the item, or for associated fuels and 
materials, caused by such addition. This determination shall be based on 
industry-wide data and not just the manufacturing capability of the 
applicant. If the applicant has the exclusive right to manufacture the 
item, this information shall also be provided in the application.
    (5) An estimate (including estimation methods and assumptions) of 
the energy in Btu's of oil and natural gas used directly or indirectly 
per unit by the applicant in the manufacture of the item and other items 
necessary for its use, the type of energy source (e.g., oil, natural 
gas, coal, electricity), and the extent of its use in the manufacturing 
process of the item. The applicant must also provide a list of the major 
components of the item and their composition and weight.
    (6) Test data and experience data (where experience data is 
available) to substantiate for each recommended use the energy savings 
in Btu's that are claimed will be achieved by one unit during a period 
of one year. The data shall be obtained by controlled tests in which, if 
possible, the addition of the item is the only variable. If the item may 
be sold in various configurations, data shall be provided with respect 
to energy savings from each configuration with significantly different 
energy use characteristics. Test methods are to conform to recognized 
industry or government standards. This determination shall take into 
account the seasonal use of the item. If the energy savings of the item 
varies with climatic conditions, data shall be provided with respect to 
each climate zone. The applicant may use the Department of Energy's 
climatic zones for heating and

[[Page 61]]

cooling (see Sec. 450.35 of 10 CFR part 450 (1980)).
    (7) The impact of increased demand on the price of the item and the 
energy source used by the item.
    (8) The energy source which will be replaced or conserved by the 
item, and, in the case of a request for addition to the approved list of 
renewable energy sources, data establishing that the energy source is 
inexhaustible.
    (9) Data to show the total estimated savings of energy in Btu's 
attributable to reduced consumption of oil or natural gas whether 
directly or indirectly from use of the item, including assumptions 
underlying this estimate. If the consumption of both oil and natural gas 
will be reduced, data to show the energy savings in Btu's attributable 
to each shall be provided. The estimate is to be based on energy savings 
in Btu's per unit determined under paragraph (b)(6) of this section for 
the first four years of the useful life of the item and is to take into 
account only the additional units of the item estimated to be placed in 
service as a result of the addition using data obtained under paragraph 
(b)(3) of this section. If the item will result in reduction of oil or 
natural gas consumption by replacing an item which uses such an energy 
source, the application shall indicate the item replaced and the extent 
to which this reduction will occur.
    (10) Geographical information if required under paragraph (b)(6) of 
this section to show the climatic zones of the country where the item is 
expected to be used, including an estimate of the total number of 
additional units to be placed in service during the first 4 years 
following the addition of the item in the area as a result of the 
addition of the item to the list of qualifying items.
    (11) The retail cost of the item (or items if the item is sold in 
more than one size) including all installation costs necessary for safe 
and effective use.
    (12) Whether the item is designed for residential use.
    (13) The estimated useful life of the item and associated equipment 
necessary for its use.
    (14) The type and amount of waste and emissions in weight per unit 
of energy saved resulting from use of the item.
    (15) If the item might reasonably be suspected of presenting any 
health or safety hazard, test data to show that the item does not 
present such hazard.

With respect to applications for addition to the approved list of 
renewable energy sources, the term ``item'' as used in this paragraph 
refers to the property which uses the energy source and not the energy 
source itself. The application should clearly indicate whether the 
request is for addition to the approved list of energy-conserving 
components or renewable energy sources, identify the provisions for 
which data is being submitted, and present the data in the order 
requested. The tests required under this paragraph may be conducted by 
independent laboratories but the underlying data must be submitted along 
with the test results. There shall accompany the request a declaration 
in the following form: ``Under penalties of perjury, I declare that I 
have examined this application, including accompanying documents, and, 
to the best of my knowledge and belief, the facts presented in support 
of the application are true, correct and complete.'' The statement must 
be signed by the person or persons making the application. The 
declaration shall not be made by the taxpayer's representative.
    (c) Criteria for additions--(1) Additions to the approved list of 
energy-conserving components. For an item to be considered for addition 
to the approved list of energy-conserving components, the manufacturer 
must show that the item increases the energy efficiency of a dwelling. 
For an item to be considered as increasing the energy efficiency of a 
dwelling, all of the following criteria must be met:
    (i) The use of the item must improve the energy efficiency of the 
dwelling structure, structural components of the dwelling, hot water 
heating, or heating or cooling systems.
    (ii) The use of the item must result, directly or indirectly, in a 
significant reduction in the consumption of oil or natural gas.
    (iii) The increase in energy efficiency must be established by test 
data and in

[[Page 62]]

accordance with accepted testing standards.
    (iv) The item must not present a safety, fire, environmental, or 
health hazard when properly installed.
    (2) Additions to the approved list of renewable energy sources. For 
an energy source to be considered for addition to the approved list of 
renewable energy sources, the manufacturer must show that the following 
criteria are met:
    (i) As in the case of solar, wind, and geothermal energy, the energy 
source must be an inexhaustible energy supply. Accordingly, wood and 
agricultural products and by-products are not considered renewable 
energy sources. Similarly, no exhaustible or depletable energy source 
(such as sources that are depletable under 611) will be considered.
    (ii) The energy source must be capable of being used for heating or 
cooling a residential dwelling or providing hot water or electricity for 
use in such a dwelling.
    (iii) A practical working device, machine, or mechanism, etc., must 
exist and be commercially available to use such renewable energy source.
    (iv) The use of the renewable energy source must not present a 
significant safety, fire, environmental, or health hazard.
    (d) Standards for Secretarial determination--(1) In general. The 
Secretary will not make any addition to the approved list of energy-
conserving components or renewable energy sources unless the Secretary 
determines that--
    (i) There will be a reduction in the total consumption of oil or 
natural gas as a result of the addition, and that reduction is 
sufficient to justify any resulting decrease in Federal revenues.
    (ii) The addition will not result in an increased use of any item 
which is known to be, or reasonably suspected to be, environmentally 
hazardous or a threat to public health or safety, and
    (iii) Available Federal subsidies do not make the addition 
unnecessary or inappropriate (in the light of the most advantageous 
allocation of economic resources).
    (2) Factors taken into account. In making any determination under 
paragraph (d)(1)(i) of this section, the Secretary will--
    (i) Make an estimate of the amount by which the addition will reduce 
oil and natural gas consumption, and
    (ii) Determine whether the addition compares favorably, on the basis 
of the reduction in oil and natural gas consumption per dollar of cost 
to the Federal Government (including revenue loss), with other Federal 
programs in existence or being proposed.
    (3) Factors taken into account in making estimates. In making any 
estimate under subparagraph (2)(i), the Secretary will take into account 
(among other factors)--
    (i) The extent to which the use of any item will be increased as a 
result of the addition,
    (ii) Whether sufficient capacity is available to increase production 
to meet any increase in demand for the item or associated fuels and 
materials caused by the addition,
    (iii) The amount of oil and natural gas used directly or indirectly 
in the manufacture of the item and other items necessary for its use,
    (iv) The estimated useful life of the item, and
    (v) The extent additional use of the item leads, directly or 
indirectly, to the reduced use of oil or natural gas. Indirect uses of 
oil or natural gas include use of electricity derived from oil or 
natural gas.
    (e) Effective date of addition to approved lists. In the case of 
additions to the approved list of energy-conserving components or 
renewable energy sources, the credit allowable by Sec. 1.23-1 shall 
apply with respect to expenditures which are made on or after the date a 
Treasury decision amending the regulations pursuant to the application 
is published in the Federal Register. However, the Secretary may 
prescribe by regulations that expenditures for additions made on or 
after the date referred to in the preceding sentence and before the 
close of the taxable year in which such date occurs shall be taken into 
account in the following taxable year. Additions to the list will be 
subject to the performance and quality standards (if any) provided under 
Sec. 1.23-4 which are in effect at the time of the addition. 
Furthermore, any addition made to the approved list will be subject to 
reevaluation by the Secretary

[[Page 63]]

for the purpose of determining whether the item still meets the 
requisite criteria and standards for addition to the list. If it is 
determined by the Secretary that an item no longer meets the requisite 
criteria, the Secretary will amend the regulations to delete the item 
from the approved list. Removal of an item from the list will be 
prospective from the date a Treasury decision amending the regulations 
is published in the Federal Register.

(Secs. 44C and 7805 of the Internal Revenue Code of 1954 (92 Stat. 3175, 
26 U.S.C. 44C; 68A Stat. 917, 26 U.S.C. 7805). The amendments to the 
Statement of Procedural Rules are issued under the authority contained 
in 5 U.S.C. 301 and 552)

[T.D. 7861, 47 FR 56331, Dec. 16, 1982. Redesignated and amended by T.D. 
8146, 52 FR 26673, July 16, 1987]



Sec. 1.25-1T  Credit for interest paid on certain home mortgages (Temporary).

    (a) In general. Section 25 permits States and political subdivisions 
to elect to issue mortgage credit certificates in lieu of qualified 
mortgage bonds. An individual who holds a qualified mortgage credit 
certificate (as defined in Sec. 1.25-3T) is entitled to a credit against 
his Federal income taxes. The amount of the credit depends upon (1) the 
amount of mortgage interest paid or accrued during the year and (2) the 
applicable certificate credit rate. See Sec. 1.25-2T. The amount of the 
deduction under section 163 for interest paid or accrued during any 
taxable year is reduced by the amount of the credit allowable under 
section 25 for such year. See Sec. 1.163-6T. The holder of a qualified 
mortgage credit certificate may be entitled to additional withholding 
allowances. See section 3402 (m) and the regulations thereunder.
    (b) Definitions. For purposes of Secs. 1.25-2T through 1.25-8T and 
this section, the following definitions apply:
    (1) Mortgage. The term ``mortgage'' includes deeds of trust, 
conditional sales contracts, pledges, agreements to hold title in 
escrow, and any other form of owner financing.
    (2) State. (i) The term ``State'' includes a possession of the 
United States and the District of Columbia.
    (ii) Mortgage credit certificates issued by or on behalf of any 
State or political subdivision (``governmental unit'') by constituted 
authorities empowered to issue such certificates are the certificates of 
such governmental unit.
    (3) Qualified home improvement loan. The term ``qualified home 
improvement loan'' has the meaning given that term under section 103A 
(1)(6) and the regulations thereunder.
    (4) Qualified rehabilitation loan. The term ``qualified 
rehabilitation loan'' has the meaning given that term under section 103A 
(1)(7)(A) and the regulations thereunder.
    (5) Single-family and owner-occupied residences. The terms ``single-
family'' and ``owner-occupied'' have the meaning given those terms under 
section 103A (1)(9) and the regulations thereunder.
    (6) Constitutional home rule city. The term ``constitutional home 
rule city'' means, with respect to any calendar year, any political 
subdivision of a State which, under a State constitution which was 
adopted in 1970 and effective on July 1, 1971, had home rule powers on 
the 1st day of the calendar year.
    (7) Targeted area residence. The term ``targeted area residence'' 
has the meaning given that term under section 103A (k) and the 
regulations thereunder.
    (8) Acquisition cost. The term ``acquisition cost'' has the meaning 
given that term under section 103A (1)(5) and the regulations 
thereunder.
    (9) Average area purchase price. The term ``average area purchase 
price'' has the meaning given that term under subparagraphs (2), (3), 
and (4) of section 103A (f) and the regulations thereunder. For purposes 
of this paragraph (b)(9), all determinations of average area purchase 
price shall be made with respect to residences as that term is defined 
in section 103A and the regulations thereunder.
    (10) Total proceeds. The ``total proceeds'' of an issue is the sum 
of the products determined by multiplying--
    (i) The certified indebtedness amount of each mortgage credit 
certificate issued pursuant to such issue, by

[[Page 64]]

    (ii) The certificate credit rate specified in such certificate.

Each qualified mortgage credit certificate program shall be treated as a 
separate issue of mortgage credit certificates.
    (11) Residence. The term ``residence'' includes stock held by a 
tenant-stockholder in a cooperative housing corporation (as those terms 
are defined in section 216(b) (1) and (2)). It does not include property 
such as an appliance, a piece of furniture, a radio, etc., which, under 
applicable local law, is not a fixture. The term also includes any 
manufactured home which has a minimum of 400 square feet of living space 
and a minimum width in excess of 102 inches and which is of a kind 
customarily used at a fixed location. The preceding sentence shall not 
apply for purposes of determining the average area purchase price for 
single-family residences, nor shall it apply for purposes of determining 
the State ceiling amount. The term ``residence'' does not, however, 
include recreational vehicles, campers, and other similar vehicles.
    (12) Related person. The term ``related person'' has the meaning 
given that term under section 103(b)(6)(C)(i) and Sec. 1.103-10(e)(1).
    (13) Date of issue. A mortgage credit certificate is considered 
issued on the date on which a closing agreement is signed with respect 
to the certified indebtedness amount.
    (c) Affidavits. For purposes of Secs. 1.25-1T through 1.25-8T, an 
affidavit filed in connection with the requirements of Secs. 1.25-1T 
through 1.25-8T shall be made under penalties of perjury. Applicants for 
mortgage credit certificates who are required by a lender or the issuer 
to sign affidavits must be informed that any fraudulent statement will 
result in (1) the revocation of the individual's mortgage credit 
certificate, and (2) a $10,000 penalty under section 6709. Other persons 
required by a lender or an issuer to provide affidavits must receive 
similar notice. A person may not rely on an affidavit where that person 
knows or has reason to know that the information contained in the 
affidavit is false.

[T.D. 8023, 50 FR 19346, May 8, 1985]



Sec. 1.25-2T  Amount of credit (Temporary).

    (a) In general. Except as otherwise provided, the amount of the 
credit allowable for any taxable year to an individual who holds a 
qualified mortgage credit certificate is equal to the product of the 
certificate credit rate (as defined in paragraph (b)) and the amount of 
the interest paid or accrued by the taxpayer during the taxable year on 
the certified indebtedness amount (as defined in paragraph (c)).
    (b) Certificate credit rate--(1) In general. For purposes of 
Secs. 1.25-1T through 1.25-8T, the term ``certificate credit rate'' 
means the rate specified by the issuer on the mortgage credit 
certificate. The certificate credit rate shall not be less than 10 
percent nor more than 50 percent.
    (2) Limitation in certain States. (i) In the case of a State which--
    (A) Has a State ceiling for the calendar year in which an election 
is made that exceeds 20 percent of the average annual aggregate 
principal amount of mortgages executed during the immediately preceding 
3 calendar years for single-family owner-occupied residences located 
within the jurisdiction of such State, or
    (B) Issued qualified mortgage bonds in an aggregate amount less than 
$150 million for calendar year 1983.

the certificate credit rate for any mortgage credit certificate issued 
under such program shall not exceed 20 percent unless the issuing 
authority submits a plan to the Commissioner to ensure that the weighted 
average of the certificate credit rates in such mortgage credit 
certificate program does not exceed 20 percent and the Commissioner 
approves such plan. For purposes of determining the average annual 
aggregate principal amount of mortgages executed during the immediately 
preceding 3 calendar years for single-family owner-occupied residences 
located within the jurisdiction of such State, an issuer may rely upon 
the amount published by the Treasury Department for such calendar years. 
An issuer may rely on a different amount from that safe-harbor 
limitation where the issuer has made a more accurate and comprehensive 
determination of that amount. The weighted

[[Page 65]]

average of the certificate credit rates in a mortgage credit certificate 
program is determined by dividing the sum of the products obtained by 
multiplying the certificate credit rate of each certificate by the 
certified indebtedness amount with respect to that certificate by the 
sum of the certified indebtedness amounts of the certificates issued. 
See section 103A(g) and the regulations thereunder for the definition of 
the term ``State ceiling''.
    (ii) The following example illustrates the application of this 
paragraph (b)(2):

    Example. City Z issues four qualified mortgage credit certificates 
pursuant to its qualified mortgage credit certificate program. H 
receives a certificate with a certificate credit rate of 30 percent and 
a certified indebtedness amount of $50,000. I receives a certificate 
with a certificate credit rate of 25 percent and a certified 
indebtedness amount of $100,000. J and K each receive certificates with 
certificate credit rates of 10 percent; their certified indebtedness 
amounts are $50,000 and $100,000, respectively. The weighted average of 
the certificate credit rates is determined by dividing the sum of the 
products obtained by multiplying the certificate credit rate of each 
certificate by the certified indebtedness amount with respect to that 
certificate ((.3  x  $50,000) + (.25  x  $100,000) + (.1  x  $50,000) + 
(.1  x  $100,000)) by the sum of the certified indebtedness amounts of 
the certificates issued ($50,000 + $100,000 + $50,000 + $100,000). Thus, 
the weighted average of the certificate credit rates is 18.33 percent 
($55,000/$300,000).

    (c) Certified indebtedness amount--(1) In general. The term 
``certified indebtedness amount'' means the amount of indebtedness which 
is--
    (i) Incurred by the taxpayer--
    (A) To acquire his principal residence, Sec. 1.25-2T(c)(1)(i),
    (B) As a qualified home improvement loan, or
    (C) As a qualified rehabilitation loan, and
    (ii) Specified in the mortgage credit certificate.
    (2) Example. The following example illustrates the application of 
this paragraph:

    Example. On March 1, 1986, State X, pursuant to its qualified 
mortgage credit certificate program, provides a mortgage credit 
certificate to B. State X specifies that the maximum amount of the 
mortgage loan for which B may claim a credit is $65,000. On March 15, B 
purchases for $67,000 a single-family dwelling for use as his principal 
residence. B obtains from Bank M a mortgage loan for $60,000. State X, 
or Bank M acting on behalf of State X, indicates on B's mortgage credit 
certificate that the certified indebtedness amount of B's loan is 
$60,000. B may claim a credit under section 25 (e) based on this amount.

    (d) Limitation on credit--(1) Limitation where certificate credit 
rate exceeds 20 percent. (i) If the certificate credit rate of any 
mortgage credit certificate exceeds 20 percent, the amount of the credit 
allowed to the taxpayer by section 25(a)(1) for any year shall not 
exceed $2,000. Any amount denied under this paragraph (d)(1) may not be 
carried forward under section 25(e)(1) and paragraph (d)(2) of this 
section.
    (ii) If two or more persons hold interests in any residence, the 
limitation of paragraph (d)(1)(i) shall be allocated among such persons 
in proporation to their respective interests in the residence.
    (2) Carryforward of unused credit. (i) If the credit allowable under 
section 25 (a) and Sec. 1.25-2T for any taxable year exceeds the 
applicable tax limit for that year, the excess (the ``unused credit'') 
will be a carryover to each of the 3 succeeding taxable years and, 
subject to the limitations of paragraph (d)(2)(ii), will be added to the 
credit allowable by section 25 (a) and Sec. 1.25-2T for that succeeding 
year.
    (ii) The amount of the unused credit for any taxable year (the 
``unused credit year'') which may be taken into account under this 
paragraph (d)(2) for any subsequent taxable year may not exceed the 
amount by which the applicable tax limit for that subsequent taxable 
year exceeds the sum of (A) the amount of the credit allowable under 
section 25 (a) and Sec. 1.25-1T for the current taxable year, and (B) 
the sum of the unused credits which, by reason of this paragraph (d)(2), 
are carried to that subsequent taxable year and are attributable to 
taxable years before the unused credit year. Thus, if by reason of this 
paragraph (d)(2), unused credits from 2 prior taxable years are carried 
forward to a subsequent taxable year, the unused credit from the earlier 
of those 2 prior years must be taken into account before the unused 
credit from the later of those 2 years is taken into account.

[[Page 66]]

    (iii) For purposes of this paragraph (d)(2) the term ``applicable 
tax limit'' means the limitation imposed by section 26 (a) for the 
taxable year reduced by the sum of the credits allowable for that year 
under section 21, relating to expenses for household and dependent care 
services necessary for gainful employment, section 22, relating to the 
credit for the elderly and the permanently disabled, section 23, 
relating to the residential energy credit, and section 24, relating to 
contributions to candidates for public office. The limitation imposed by 
section 26 (a) for any taxable year is equal to the taxpayer's tax 
liability (as defined in section 26 (b)) for that year.
    (iv) The following examples illustrate the application of this 
paragraph (d)(2):

    Example 1. (i) B, a calendar year taxpayer, holds a qualified 
mortgage credit certificate. For 1986 B's applicable tax limit (i.e., 
tax liability) is $1,100. The amount of the credit under section 25 (a) 
and Sec. 1.25-2T for 1986 is $1,700. For 1986 B is not entitled to any 
of the credits described in sections 21 through 24. Under Sec. 1.25-2T 
(d)(2), B's unused credit for 1986 is $600, and B is entitled to carry 
forward that amount to the 3 succeeding years.
    (ii) For 1987 B's applicable tax limit is $1,500, the amount of the 
credit under section 25 (a) and Sec. 1.25-2T is $1,700, and the unused 
credit is $200. For 1988 B's applicable tax limit is $2,000, the amount 
of the credit under section 25 (a) and Sec. 1.25-2T is $1,300, and there 
is no unused credit. For 1987 and 1988 B is not entitled to any of the 
credits described in sections 21 through 24. No portion of the unused 
credit for 1986 my be used in 1987. For 1988 B is entitled to claim a 
credit of $2,000 under section 25 (a) and Sec. 1.25-2T, consisting of a 
$1,300 credit for 1988, the $600 unused credit for 1986, and $100 of the 
$200 unused credit for 1987. In addition, B may carry forward the 
remaining unused credit for 1987 ($100) to 1989 and 1990.
    Example 2. The facts are the same as in Example (1) except that for 
1988 B is entitled to a credit of $400 under section 23. B's applicable 
tax limit for 1988 is $1,600 ($2,000 less $400). For 1988 B is entitled 
to claim a credit of $1,600 under section 25 (a) and Sec. 1.25-2T, 
consisting of a $1,300 credit for 1988 and $300 of the unused credit for 
1986. In addition, B may carry forward the remaining unused credits of 
$300 for 1986 to 1989 and of $200 for 1987 to 1989 and 1990.

[T.D. 8023, 50 FR 19346, May 8, 1985]



Sec. 1.25-3  Qualified mortgage credit certificate.

    (a)-(g)(1)(ii) [Reserved]. For further guidance, see Sec. 1.25-3T(a) 
through (g)(1)(ii).
    (g)(1)(iii) Reissued certificate exception. See paragraph (p) of 
this section for rules regarding the exception in the case of 
refinancing existing mortgages.
    (g)(2)-(o) [Reserved]. For further guidance, see Sec. 1.25-3T(g)(2) 
through (o).
    (p) Reissued certificates for certain refinancings--(1) In general. 
If the issuer of a qualified mortgage credit certificate reissues a 
certificate in place of an existing mortgage credit certificate to the 
holder of that existing certificate, the reissued certificate is treated 
as satisfying the requirements of this section. The period for which the 
reissued certificate is in effect begins with the date of the 
refinancing (that is, the date on which interest begins accruing on the 
refinancing loan).
    (2) Meaning of existing certificate. For purposes of this paragraph 
(p), a mortgage credit certificate is an existing certificate only if it 
satisfies the requirements of this section. An existing certificate may 
be the original certificate, a certificate issued to a transferee under 
Sec. 1.25-3T(h)(2)(ii), or a certificate previously reissued under this 
paragraph (p).
    (3) Limitations on reissued certificate. An issuer may reissue a 
mortgage credit certificate only if all of the following requirements 
are satisfied:
    (i) The reissued certificate is issued to the holder of an existing 
certificate with respect to the same property to which the existing 
certificate relates.
    (ii) The reissued certificate entirely replaces the existing 
certificate (that is, the holder cannot retain the existing certificate 
with respect to any portion of the outstanding balance of the certified 
mortgage indebtedness specified on the existing certificate).
    (iii) The certified mortgage indebtedness specified on the reissued 
certificate does not exceed the remaining outstanding balance of the 
certified mortgage indebtedness specified on the existing certificate.
    (iv) The reissued certificate does not increase the certificate 
credit rate specified in the existing certificate.

[[Page 67]]

    (v) The reissued certificate does not result in an increase in the 
tax credit that would otherwise have been allowable to the holder under 
the existing certificate for any taxable year. The holder of a reissued 
certificate determines the amount of tax credit that would otherwise 
have been allowable by multiplying the interest that was scheduled to 
have been paid on the refinanced loan by the certificate rate of the 
existing certificate. In the case of a series of refinancings, the tax 
credit that would otherwise have been allowable is determined from the 
amount of interest that was scheduled to have been paid on the original 
loan and the certificate rate of the original certificate.
    (A) In the case of a refinanced loan that is a fixed interest rate 
loan, the interest that was scheduled to be paid on the refinanced loan 
is determined using the scheduled interest method described in paragraph 
(p)(3)(v)(C) of this section.
    (B) In the case of a refinanced loan that is not a fixed interest 
rate loan, the interest that was scheduled to be paid on the refinanced 
loan is determined using either the scheduled interest method described 
in paragraph (p)(3)(v)(C) of this section or the hypothetical interest 
method described in paragraph (p)(3)(v)(D) of this section.
    (C) The scheduled interest method determines the amount of interest 
for each taxable year that was scheduled to have been paid in the 
taxable year based on the terms of the refinanced loan including any 
changes in the interest rate that would have been required by the terms 
of the refinanced loan and any payments of principal that would have 
been required by the terms of the refinanced loan (other than repayments 
required as a result of any refinancing of the loan).
    (D) The hypothetical interest method (which is available only for 
refinanced loans that are not fixed interest rate loans) determines the 
amount of interest treated as having been scheduled to be paid for a 
taxable year by constructing an amortization schedule for a hypothetical 
self-amortizing loan with level payments. The hypothetical loan must 
have a principal amount equal to the remaining outstanding balance of 
the certified mortgage indebtedness specified on the existing 
certificate, a maturity equal to that of the refinanced loan, and 
interest equal to the annual percentage rate (APR) of the refinancing 
loan that is required to be calculated for the Federal Truth in Lending 
Act.
    (E) A holder must consistently apply the scheduled interest method 
or the hypothetical interest method for all taxable years beginning with 
the first taxable year the tax credit is claimed by the holder based 
upon the reissued certificate.
    (4) Examples. The following examples illustrate the application of 
paragraph (p)(3)(v) of this section:

    Example 1. A holder of an existing certificate that meets the 
requirements of this section seeks to refinance the mortgage on the 
property to which the existing certificate relates. The final payment on 
the holder's existing mortgage is due on December 31, 2000; the final 
payment on the new mortgage would not be due until January 31, 2004. The 
holder requests that the issuer provide to the holder a reissued 
mortgage credit certificate in place of the existing certificate. The 
requested certificate would have the same certificate credit rate as the 
existing certificate. For each calendar year through the year 2000, the 
credit that would be allowable to the holder with respect to the new 
mortgage under the requested certificate would not exceed the credit 
allowable for that year under the existing certificate. The requested 
certificate, however, would allow the holder credits for the years 2001 
through 2004, years for which, due to the earlier scheduled retirement 
of the existing mortgage, no credit would be allowable under the 
existing certificate. Under paragraph (p)(3)(v) of this section, the 
issuer may not reissue the certificate as requested because, under the 
existing certificate, no credit would be allowable for the years 2001 
through 2004. The issuer may, however, provide a reissued certificate 
that limits the amount of the credit allowable in each year to the 
amount allowable under the existing certificate. Because the existing 
certificate would allow no credit after December 31, 2000, the reissued 
certificate could expire on December 31, 2000.
    Example 2. (a) The facts are the same as Example 1 except that the 
existing mortgage loan has a variable rate of interest and the 
refinancing loan will have a fixed rate of interest. To determine 
whether the limit under paragraph (p)(3)(v) of this section is met for 
any taxable year, the holder must calculate the amount of credit that 
otherwise would have been allowable absent the refinancing. This 
requires a determination of the amount

[[Page 68]]

of interest that would have been payable on the refinanced loan for the 
taxable year. The holder may determine this amount by--
    (1) Applying the terms of the refinanced loan, including the 
variable interest rate or rates, for the taxable year as though the 
refinanced loan continued to exist; or
    (2) Obtaining the amount of interest, and calculating the amount of 
credit that would have been available, from the schedule of equal 
payments that fully amortize a hypothetical loan with the principal 
amount equal to the remaining outstanding balance of the certified 
mortgage indebtedness specified on the existing certificate, the 
interest equal to the annual percentage rate (APR) of the refinancing 
loan, and the maturity equal to that of the refinanced loan.
    (b) The holder must apply the same method for each taxable year the 
tax credit is claimed based upon the reissued mortgage credit 
certificate.

    (5) Coordination with Section 143(m)(3). A refinancing loan 
underlying a reissued mortgage credit certificate that replaces a 
mortgage credit certificate issued on or before December 31, 1990, is 
not a federally subsidized indebtedness for the purposes of section 
143(m)(3) of the Internal Revenue Code.

[T.D. 8692, 61 FR 66214, Dec. 17, 1996]



Sec. 1.25-3T  Qualified mortgage credit certificate (Temporary).

    (a) Definition of qualified mortgage credit certificate. For 
purposes of Secs. 1.25-1T through 1.25-8T, the term ``qualified mortgage 
credit certificate'' means a certificate that meets all of the 
requirements of this section.
    (b) Qualified mortgage credit certificate program. A certificate 
meets the requirements of this paragraph if it is issued under a 
qualified mortgage credit certificate program (as defined in Sec. 1.25-
4T).
    (c) Required form and information. A certificate meets the 
requirements of this paragraph if it is in the form specified in 
Sec. 1.25-6T and if all the information required by the form is 
specified on the form.
    (d) Residence requirement--(1) In general. A certificate meets the 
requirements of this paragraph only if it is provided in connection with 
the acquisition, qualified rehabilitation, or qualified home improvement 
of a residence, that is--
    (i) A single-family residence (as defined in Sec. 1.25-1T(b)(5)) 
which, at the time the financing on the residence is executed or 
assumed, can reasonably be expected by the issuer to become (or, in the 
case of a qualified home improvement loan, to continue to be) the 
principal residence (as defined in section 1034 and the regulations 
thereunder) of the holder of the certificate within a reasonable time 
after the financing is executed or assumed, and
    (ii) Located within the jurisdiction of the governmental unit 
issuing the certificate.

See section 103a(d) and the regulations thereunder for further 
definitions and requirements.
    (2) Certification procedure. The requirements of this paragraph will 
be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating his intent to use (or, in the case of a 
qualified home improvement loan, that he is currently using and intends 
to continue to use) the residence as his principal residence within a 
reasonable time (e.g., 60 days) after the mortgage credit certificate is 
issued and stating that the holder will notify the issuer of the 
mortgage credit certificate if the residence ceases to be his principal 
residence. The affidavit must also state facts that are sufficient for 
the issuer or his agent to determine whether the residence is located 
within the jurisdiction of the issuer that issued the mortgage credit 
certificate.
    (e) 3-year requirement--(1) In general. A certificate meets the 
requirements of this paragraph only if the holder of the certificate had 
no present ownership interest in a principal residence at any time 
during the 3-year period prior to the date on which the mortgage on the 
residence in connection with which the certificate is provided is 
executed. For purposes of the preceding sentence, the holder's interest 
in the residence with respect to which the certificate is being provided 
shall not be taken into account. See section 103A(e) and the regulations 
thereunder for further definitions and requirements.
    (2) Exceptions. Paragraph (e)(1) shall not apply with respect to--
    (i) Any certificate provided with respect to a targeted area 
residence (as defined in Sec. 1.25-1T(b)(7)),

[[Page 69]]

    (ii) Any qualified home improvement loan (as defined in Sec. 1.25-
1T(b)(3)), and
    (iii) Any qualified rehabilitation loan (as defined in Sec. 1.25-
1T(b)(4)).
    (3) Certification procedure. The requirements of paragraph (e)(1) 
will be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that he had no present ownership 
interest in a principal residence at any time during the 3-year period 
prior to the date of which the certificate is issued and the issuer or 
its agent obtains from the applicant copies of the applicant's Federal 
tax returns for the preceding 3 years and examines each statement to 
determine whether the applicant has claimed a deduction for taxes on 
property which was the applicant's principal residence pursuant to 
section 164(a)(1) or a deduction pursuant to section 163 for interest 
paid on a mortgage secured by property which was the applicant's 
principal residence. Where the mortgage is executed during the period 
between January 1 and February 15 and the applicant has not yet filed 
has Federal income tax return with the Internal Revenue Service, the 
issuer may, with respect to such year, rely on an affidavit of the 
applicant that the applicant is not entitled to claim deductions for 
taxes or interest on indebtedness with respect to property constituting 
his principal residence for the preceding calendar year. In the 
alternative, when applicable, the holder may provide an affidavit 
stating that one of the exceptions provided in paragraph (e)(2) applies.
    (4) Special rule. An issuer may submit a plan to the Commissioner 
for distributing certificates, in an amount not to exceed 10 percent of 
the proceeds of the issue, to individuals who do not meet the 
requirements of this paragraph. Such plan must describe a procedure for 
ensuring that no more than 10 percent of the proceeds of a such issue 
will be used to provide certificates to such individuals. If the 
Commissioner approves the issuer's plan, certificates issued in 
accordance with the terms of the plan to holders who do not meet the 3-
year requirement do not fail to satisfy the requirements of this 
paragraph.
    (f) Purchase price requirement--(1) In general. A certificate meets 
the requirements of this paragraph only if the acquisition cost (as 
defined in Sec. 1.25-1T(b)(8)) of the residence, other than a targeted 
area residence, in connection with which the certificate is provided 
does not exceed 110 percent of the average area purchase price (as 
defined in Sec. 1.25-1T(b)(9)) applicable to that residence. In the case 
of a targeted area residence (as defined in Sec. 1.251T(b)(7)) the 
acquisition cost may not exceed 120 percent of the average area purchase 
price applicable to such residence. See section 1093A(f) and the 
regulations thereunder for further definitions and requirements.
    (2) Certification procedure. The requirements of paragraph (f)(1) 
will be met if the issuer or its agent obtains affidavits executed by 
the seller and the buyer that state these requirements have been met. 
Such affidavits must include an itemized list of--
    (i) Any payments made by the buyer (or a related person) or for the 
benefit of the buyer,
    (ii) If the residence is incomplete, an estimate of the reasonable 
cost of completing the residence, and
    (iii) If the residence is purchased subject to a ground rent, the 
capitalized value of the ground rent.

The issuer or his agent must examine such affidavits and determine 
whether, on the basis of information contained therein, the purchase 
price requirement is met.
    (g) New mortgage requirement--(1) In general. (i) A certificate 
meets the requirements of this paragraph only if the certificate is not 
issued in connection with the acquisition or replacement of an existing 
mortgage. Except in the case of a qualified home improvement loan, the 
certificate must be issued to an individual who did not have a mortgage 
(whether or not paid off) on the residence with respect to which the 
certificate is issued at any time prior to the execution of the 
mortgage.
    (ii) Exceptions. For purposes of this paragraph, a certificate used 
in connection with the replacement of--
    (A) Construction period loans,
    (B) Bridge loans or similar temporary initial financing, and
    (C) In the case of a qualified rehabilitation loan, an existing 
mortgage,

[[Page 70]]


shall not be treated as being used to acquire or replace an existing 
mortgage. Generally, temporary initial financing is any financing which 
has a term of 24 months or less. See section 103A(j)(1) and the 
regulations thereunder for examples illustrating the application of 
these requirements.
    (2) Certification procedure. The requirements of paragraph (g)(1) 
will be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that the mortage being acquired in 
connection with the certificate will not be used to acquire or replace 
an existing mortgage (other than one that falls within the exceptions 
described in paragraph (g)(1)(ii)).
    (h) Transfer of mortgage credit certificates--(1) In general. A 
certificate meets the requirements of this paragraph only if it is (i) 
not transferable or (ii) transferable only with the approval of the 
issuer.
    (2) Transfer procedure. A certificate that is transferred with the 
approval of the issuer is a qualified mortgage credit certificate in the 
hands of the transferee only if each of the following requirements is 
met:
    (i) The transferee assumed liability for the remaining balance of 
the certified indebtedness amount in connection with the acquisition of 
the residence from the transferor,
    (ii) The issuer issues a new certificate to the transferee, and
    (iii) The new certificate meets each of the requirements of 
paragraphs (d), (e), (f), and (i) of this section based on the facts as 
they exist at the time of the transfer as if the mortgage credit 
certificate were being issued for the first time. For example, the 
purchase price requirement is to be determined by reference to the 
average area purchase price at the time of the assumption and not when 
the mortgage credit certificate was originally issued.
    (3) Statement on certificate. The requirements of paragraph (h)(1) 
will be met if the mortgage credit certificate states that the 
certificate may not be transferred or states that the certificate may 
not be transferred unless the issuer issues a new certificate in place 
of the original certificate.
    (i) Prohibited mortgages--(1) In general. A certificate meets the 
requirements of this paragraph only if it is issued in connection with 
the acquisition of a residence none of the financing of which is 
provided from the proceeds of--
    (i) A qualified mortgage bond (as defined under section 103A(c)(1) 
and the regulations thereunder), or
    (ii) A qualified veterans' mortgage bond (as defined under section 
103A(c)(3) and the regulations thereunder).

Thus, for example, if a mortgagor has a mortgage on his principal 
residence that was obtained from the proceeds of a qualified mortgage 
bond, a mortgage credit certificate issued to such mortgagor in 
connection with a qualified home improvement loan with respect to such 
residence is not a qualified mortgage credit certificate. If, however, 
the financing provided from the proceeds of the qualified mortgage bond 
had been paid off in full, the certificate would be a qualified mortgage 
credit certificate (assuming all the requirements of this paragraph are 
met).
    (2) Certification procedure. The requirements of paragraph (i)(1) 
will be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that no portion of the financing of the 
residence in connection with which the certificate is issued is provided 
from the proceeds of a qualified mortgage bond or a qualified veterans' 
mortgage bond.
    (j) Particular lenders--(1) In general. Except as otherwise provided 
in paragraph (j)(2), a certificate meets the requirements of this 
paragraph only if the certificate is not limited to indebtedness 
incurred from particular lenders. A certificate is limited to 
indebtedness from particular lenders if the issuer, directly or 
indirectly, prohibits the holder of a certificate from obtaining 
financing from one or more lenders or requires the holder of a 
certificate to obtain financing from one or more lenders. For purposes 
of this paragraph, a lender is any person, including an issuer of 
mortgage credit certificates, that provides financing for the 
acquisition, qualified rehabilitation, or qualified home improvement of 
a residence.
    (2) Exception. A mortgage credit certificate that is limited to 
indebtedness

[[Page 71]]

incurred from particular lenders will not cease to meet the requirements 
of this paragraph if the Commissioner approves the basis for such 
limitation. The Commissioner may approve the basis for such limitation 
if the issuer establishes to the satisfaction of the Commissioner that 
it will result in a significant economic benefit to the holders of 
mortgage credit certificates (e.g., substantially lower financing costs) 
compared to the result without such limitation.
    (3) Taxable bonds. The requirements of this paragraph do not prevent 
an issuer of mortgage credit certificates from issuing mortgage subsidy 
bonds (other than obligations described in section 103 (a)) the proceeds 
of which are to be used to provide mortgages to holders of mortgage 
credit certificates provided that the holders of such certificates are 
not required to obtain financing from the proceeds of the bond issue. 
See Sec. 1.25-4T (h) with respect to permissible fees.
    (4) Lists of participating lenders. The requirements of this 
paragraph do not prohibit an issuer from maintaining a list of lenders 
that have stated that they will make loans to qualified holders of 
mortgage credit certificates, provided that (i) the issuer solicits such 
statements in a public notice similar to the notice described in 
Sec. 1.25-7T, (ii) lenders are provided a reasonable period of time in 
which to express their interest in being included in such a list, and 
(iii) holders of mortgage credit certificates are not required to obtain 
financing from the lenders on the list. If an issuer maintains such a 
list, it must update the list at least annually.
    (5) Certification procedure. The requirements of this paragraph will 
be met if (i) the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that the certificate was not limited to 
indebtedness incurred from particular lenders or (ii) the issuer obtains 
a ruling from the Commissioner under paragraph (j)(2).
    (6) Examples. The following examples illustrate the application of 
this paragraph:

    Example 1. Under its mortgage credit certificate program, County Z 
distributes all the certificates to be issued to a group of 60 
participating lenders. Residents of County Z may obtain mortgage credit 
certificates only from the participating lenders and only in connection 
with the acquisition of mortgage financing from that lender or one of 
the other participating lenders. Certificates issued under this program 
do not meet the requirements of this paragraph since the certificates 
are limited to indebtedness incurred from particular lenders. The 
certificates, therefore, are not qualified mortgage credit certificates.
    Example 2. In connection with its mortgage credit certificate 
program, County Y arranges with Bank P for a line of credit to be used 
to provide mortgage financing to holders of mortgage credit 
certificates. County Y, pursuant to paragraph (j)(4), maintains a list 
of lenders participating in the mortgage credit certificate program. 
County Y distributes the certificates directly to applicants. Holders of 
the certificates are not required to obtain mortgage financing through 
the line of credit or through a lender on the list of participating 
lenders. Certificates issued pursuant to County Y's program satisfy the 
requirements of this paragraph.

    (k) Developer certification--(1) In general. A mortgage credit 
certificate that is allocated by the issuer to any particular 
development meets the requirements of this paragraph only if the 
developer provides a certification to the purchaser of the residence and 
the issuer stating that the purchase price of that residence is not 
higher than the price would be if the issuer had not allocated mortgage 
credit certificates to the development. The certification must be made 
by the developer if a natural person or, if not, by a duly authorized 
official of the developer.
    (2) Certification procedure. The requirements of this paragraph will 
be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that he has received from the developer 
the certification described in this paragraph.
    (l) Expiration--(1) In general. A certificate meets the requirements 
of this paragraph if the certified indebtedness amount is incurred prior 
to the close of the second calendar year following the calendar year for 
which the issuer elected not to issue qualified mortgage bonds under 
Sec. 1.25-4T with respect to that issue of mortgage credit certificates. 
Thus, for example, if on October 1, 1984, an issuing authority elects 
under Sec. 1.25-4T not to issue qualified

[[Page 72]]

mortgage bonds, a mortgage credit certificate provided under that 
program does not meet the requirements of this paragraph unless the 
indebtedness is incurred on or before December 31, 1986.
    (2) Issuer-imposed expiration dates. An issuer of mortgage credit 
certificates may provide that a certificate shall expire if the holder 
of the certificate does not incure certified indebtedness by a date that 
is prior to the expiration date provided in paragraph (l)(1). A 
certificate that expires prior to the date provided in paragraph (l)(1) 
may be reissued provided that the requirements of this paragraph are 
met.
    (m) Revocation. A certificate meets the requirements of this 
paragraph only if it has not been revoked. Thus, the credit provided by 
section 25 and Sec. 1.25-1T does not apply to interest paid or accrued 
following the revocation of a certificate. A certificate is treated as 
revoked when the residence to which the certificate relates ceases to be 
the holder's principal residence. An issuer may revoke a mortgage credit 
certificate if the certificate does not meet all the requirements of 
Sec. 1.25-3T (d), (e), (f), (g), (h), (i), (j), (k), and (n). The 
certificate is revoked by the issure's notifying the holder of the 
certificate and the Internal Revenue Service that the certificate is 
revoked. The notice to the Internal Revenue Service shall be made as 
part of the report requred by Sec. 1.25-8T (b)(2).
    (n) Interest paid to related person--(1) In general. A certificate 
does not meet the requirements of this paragraph if interest on the 
certified indebtedness amount is paid to a person who is a related 
person to the holder of the certificate.
    (2) Certification procedure. The requirements of this paragraph will 
be met if the issuer or its agent obtains from the holder of the 
certificate an affidavit stating that a related person does not have, 
and is not expected to have, an interest as a creditor in the certified 
indebtedness amount.
    (o) Fraud. Notwithstanding any other provision of this section, a 
mortgage credit certificate does not meet the requirements of this 
section and, therefore, the certificate is not a qualified mortgage 
credit certificate for any calendar year, if the holder of the 
certificate provides a certification or any other information to the 
lender providing the mortgage or to the issuer of the certificate 
containing a material misstatement and such misstatement is due to 
fraud. In determining whether any misstatement is due to fraud, the 
rules generally applicable to underpayments of tax due to fraud 
(including rules relating to the statute of limitations) shall apply. 
See Sec. 1.6709-1T with respect to the penalty for filing negligent or 
fraudulent statements.

[T.D. 8023, 50 FR 19348, May 8, 1985, as amended at T.D. 8502, 58 FR 
67689, Dec. 22, 1993; T.D. 8692, 61 FR 66215, Dec. 17, 1996]



Sec. 1.25-4T  Qualified mortgage credit certificate program (Temporary).

    (a) In general--(1) Definition of qualified mortgage credit 
certificate program. For purposes of Secs. 1.25-1T through 1.25-8T, the 
term ``qualified mortgage credit certificate program'' means a program 
to issue qualified mortgage credit certificates which meets all of the 
requirements of paragraphs (b) through (i) of this section.
    (2) Requirements are a minimum. Except as otherwise provided in this 
section, the requirements of this section are minimum requirements. 
Issuers may establish more stringent criteria for participation in a 
qualified mortgage credit certificate program. Thus, for example, an 
issuer may target 30 percent of the proceeds of an issue of mortgage 
credit certificates to targeted areas. Further, issuers may establish 
additional eligibility criteria for participation in a qualified 
mortgage credit certificate program. Thus, for example, issuers may 
impose an income limitation designed to ensure that only those 
individuals who could not otherwise purchase a residence will benefit 
from the credit.
    (3) Except as otherwise provided in this section and Sec. 1.25-3T, 
issuers may use mortgage credit certificates in connection with other 
Federal, State, and local programs provided that such use complies with 
the requirements of Sec. 1.25-3T(j). Thus, for example, a mortgage 
credit certificate may be issued in connection with the qualified 
rehabilitation of a residence part of the cost of which will be paid 
from the proceeds of a State grant.

[[Page 73]]

    (b) Establishment of program. A program meets the requirements of 
this paragraph only if it is established by a State or political 
subdivision thereof for any calendar year for which it has the authority 
to issue qualified mortgage bonds.
    (c) Election not to issue qualified mortgage bonds--(1) In general. 
A program meets the requirements of this paragraph only if the issuer 
elects, in the time and manner specified in this paragraph, not to issue 
an amount of qualified mortgage bonds that it may otherwise issue during 
the calendar year under section 103A and the regulations thereunder.
    (2) Manner of making election. On or before the earlier of the date 
of distribution of mortgage credit certificates under a program or 
December 31, 1987, the issuer must file an election not to issue an 
amount of qualified mortgage bonds. The election (and the certification 
(or affidavit) described in paragraph (d)) shall be filed with the 
Internal Revenue Service Center, Philadelphia, Pennsylvania 19255. The 
election should be titled ``Mortgage Credit Certificate Election'' and 
must include--
    (i) The name, address, and TIN of the issuer,
    (ii) The issuer's applicable limit, as defined in section 103A (g) 
and the regulations thereunder,
    (iii) The aggregate amount of qualified mortgage bonds issued by the 
issuing authority during the calendar year,
    (iv) The amount of the issuer's applicable limit that it has 
surrendered to other issuers during the calendar year,
    (v) The date and amount of any previous elections under this 
paragraph for the calendar year, and
    (vi) The amount of qualfied mortgage bonds that the issuer elects 
not to issue.
    (3) Revocation of election. Any election made under this paragraph 
may be revoked, in whole or in part, at any time during the calendar 
year in which the election was made. The revocation, however, may not be 
made with respect to any part of the nonissued bond amount that has been 
used to issue mortgage credit certificates pursuant to the election. The 
revocation shall be filed with the Internal Revenue Service Center, 
Philadelphia, Pennsylvania 19255. The revocation should be titled 
``Revocation of Mortgage Credit Certificate Election'' and must 
include--
    (i) The name, address, and TIN of the issuer,
    (ii) The nonissued bond amount as originally elected, and
    (iii) The portion of the nonissued bond amount with respect to which 
the election is being revoked.
    (4) Special rule. If at the time that an issuer makes an election 
under this paragraph it does not know its applicable limit, the issuer 
may elect not to use all of its remaining authority to issue qualified 
mortgage bonds; this form of election will be treated as meeting the 
requirements of paragraph (c)(2) if, prior to the later of the end of 
the calendar year and December 31, 1985, the issuer amends its election 
so as to indicate the exact amount of qualified mortgage bond authority 
that it elected not to issue.
    (5) Limitation on nonissued bond amount. The amount of qualified 
mortgage bonds which an issuer elects not to issue may not exceed the 
issuer's applicable limit (as determined under section 103A (g) and the 
regulations thereunder). For example, a governmental unit that, pursuant 
to section 103A (g)(3), may issue $10 million of qualified mortgage 
bonds that elects to trade in $11 million in qualified mortgage bond 
authority has not met the requirements of this paragraph, and mortgage 
credit certificates issued pursuant to such election are not qualified 
mortgage credit certificates.
    (d) State certification requirement--(1) In general. A program meets 
the requirements of this paragraph only if the State official designated 
by law (or, where there is no State official, the Governor) certifies, 
based on facts and circumstances as of the date on which the 
certification is requested, following a request for such certification, 
that the issue meets the requirements of section 103A(g) (relating to 
volume limitation) and the regulations thereunder. A copy of the State 
certification must be attached to the issuer's election not to issue 
qualified mortgage bonds, except that, in the case of elections made 
during calendar year 1984,

[[Page 74]]

the certification may be filed with the Service prior to July 8, 1985 
provided that mortgage credit certificates may not be distributed until 
the certification is filed. In the case of any constitutional home rule 
city, the certification shall be made by the chief executive officer of 
the city.
    (2) Certification procedure. The official making the certification 
described in this paragraph (d) need not perform an independent 
investigation to determine whether the issuer has met the requirements 
of section 103A(g). In determining the aggregate amount of qualified 
mortgage bonds previously issued by that issuer during the calendar year 
the official may rely on copies of prior elections under paragraph (c) 
of this section made by the issuer for that year, together with an 
affidavit executed by an official of the issuer who is responsible for 
issuing bonds stating that the issuer has not, to date, issued any other 
issues of qualified mortgage bonds during the calendar year and stating 
the amount, if any, of the issuer's applicable limit that it has 
surrendered to other issuers during the calendar year; for any calendar 
year prior to 1985, the official may rely on an affidavit executed by a 
duly authorized official of the issuer who states the aggregate amount 
of qualified mortgage bonds issued by the issuer during the year. In 
determining the aggregate amount of qualified mortgage bonds that the 
issuer has previously elected not to issue during that calendar year, 
the official may rely on copies of any elections not to issue qualified 
mortgage bonds filed by the issuer for that calendar year, together with 
an affidavit executed by an official of the issuer responsible for 
issuing mortgage credit certificates stating that the issuer has not, to 
date, made any other elections not to issue qualified mortgage bonds. 
If, based on such information, the certifying official determines that 
the issuer has not, as of the date on which the certification is 
provided, exceeded its applicable limit for the year, the official may 
certify that the issue meets the requirements of section 103A(g). The 
fact that the certification described in this paragraph (d) is provided 
does not ensure that the issuer has met the requirements of section 
103A(g) and the regulations thereunder, nor does it preclude the 
application of the penalty for over-issuance of mortgage credit 
certificates if such over-issuance actually occurs. See Sec. 1.25-5T.
    (3) Special rule. If within 30 days after the issuer files a proper 
request for the certification described in this paragraph (d) the issuer 
has not received from the State official designated by law (or, if there 
is no State official, the Governor) certification that the issue meets 
the requirements of section 103A(g) or, in the alternative, a statement 
that the issue does not meet such requirements, the issuer may submit, 
in lieu of the certification required by this paragraph (d), an 
affidavit executed by an officer of the issuer responsible for issuing 
mortgage credit certificates stating that--
    (i) The issue meets the requirements of section 103A(g) and the 
regulations thereunder,
    (ii) At least 30 days before the execution of the affidavit the 
issuer filed a proper request for the certification described in this 
paragraph (d), and
    (iii) The State official designated by law (or, if there is no State 
official, the Governor) has not provided the certification described in 
this paragraph (d) or a statement that the issue does not meet such 
requirements.

For purposes of this paragraph, a request for certification is proper if 
the request includes the reports and affidavits described in paragraph 
(d)(2).
    (e) Information reporting requirement--(1) Reports. With respect to 
mortgage credit certificates issued after September 30, 1985, a program 
meets the requirements of this paragraph only if the issuer submits a 
report containing the information concerning the holders of certificates 
issued during the preceding reporting period required by this paragraph. 
The report must be filed for each reporting period in which certificates 
(other than transferred certificates) are issued under the program. The 
issuer is not responsible for false information provided by a holder if 
the issuer did not know or have reason to know that the information was 
false. The report must be filed on the form prescribed by the Internal 
Revenue Service. If no form is prescribed,

[[Page 75]]

or if the form prescribed is not readily available, the issuer may use 
its own form provided that such form is in the format set forth in this 
paragraph and contains the information required by this paragraph. The 
report must be titled ``Mortgage Credit Certificate Information Report'' 
and must include the name, address, and TIN of the issuer, the reporting 
period for which the information is provided, and the following tables 
containing information concerning the holders of certificates issued 
during the reporting period for which the report is filed:
    (i) A table titled ``Number of Mortgage Credit Certificates by 
Income and Acquisition Cost'' showing the number of mortgage credit 
certificates issued (other than those issued in connection with 
qualified home improvement and rehabilitation loans) according to the 
annualized gross income of the holders (categorized in the following 
intervals of income:

$0-$9,999;
$10,000-$19,999;
$20,000-$29,999;
$30,000-$39,999;
$40,000-$49,999;
$50,000-$74,999; and
$75,000 or more)


and according to the acquisition cost of the residences acquired in 
connection with the mortgage credit certificates (categorized in the 
following intervals of acquisition cost:

$0-$19,999;
$20,000-$39,999;
$40,000-$59,999;
$60,000-$79,999;
$80,000-$99,999;
$100,000-$119,999;
$120,000-$149,999;
$150,000-$199,999; and
$200,000 or more).


For each interval of income and acquisition cost the table must also be 
categorized according to--
    (A) The aggregate amount of fees charged to holders to cover any 
administrative costs incurred by the issuer in issuing mortgage credit 
certificates, and
    (B) The number of holders that--
    (1) Did not have a present ownership interest in a principal 
residence at any time during the 3-year period ending on the date the 
mortgage credit certificate is executed (i.e., satisfied the 3-year 
requirement) and purchased residences in targeted areas,
    (2) Satisfied the 3-year requirement and purchased residences not 
located in targeted areas,
    (3) Did have a present ownership interest in a principal residence 
at any time during the 3-year period ending on the date the mortgage 
credit certificate is executed (i.e., did not satisfy the 3-year 
requirement) and purchased residences in targeted areas, and
    (4) Did not satisfy the 3-year requirement and purchased residences 
not located in targeted areas.
    (ii) A table titled ``Volume of Mortgage Credit Certificates by 
Income and Acquisition Cost'' containing data on--
    (A) The total of the certified indebtedness amounts of the 
certificates issued (other than those issued in connection with 
qualified home improvement and rehabilitation loans);
    (B) The sum of the products of the certified indebtedness amount and 
the certificate credit rate for each certificate (other than those 
issued in connection with qualified home improvement and rehabilitation 
loans) according to annualized gross income (categorized in the same 
intervals of income as the preceding table) and according to the 
acquisition cost of the residences acquired in connection with mortgage 
credit certificates (categorized in the same intervals of acquisition 
cost as the preceding table); and
    (C) For each interval of income and acquisition cost, the 
information described in paragraph (e)(1)(ii) (A) and (B) categorized 
according to the holders that--
    (1) Satisfied the 3-year requirement and purchased residences in 
targeted areas,
    (2) Satisfied the 3-year requirement and purchased residences not 
located in targeted areas,
    (3) Did not satisfy the 3-year requirement and purchased residences 
in targeted areas, and
    (4) Did not satisfy the 3-year requirement and purchased residences 
not located in targeted areas.
    (iii) A table titled ``Mortgage Credit Certificates for Qualified 
Home Improvement and Rehabilitation Loans'' showing the number of 
mortgage credit

[[Page 76]]

certificates issued in connection with qualified home improvement loans 
and qualified rehabilitation loans, the total of the certified 
indebtedness amount with respect to such certificates, and the sum of 
the products of the certified indebtedness amount and the certificate 
credit rate for each certificate; the information contained in the table 
must also be categorized according to whether the residences with 
respect to which the certificates were provided are located in targeted 
areas.
    (2) Format. If no form is prescribed by the Internal Revenue 
Service, or if the prescribed form is not readily available, the issuer 
must submit the report in the format specified in this paragraph (e)(2). 
The specified format of the report is the following:

             Mortgage Credit Certificate Information Report

Name of issuer:
Address of issuer:
TIN of issuer:
Reporting period:

                                          Number of Mortgage Credit Certificates by Income and Acquisition Cost
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         Satisfied                           Not satisfied
  3-year requirement: Annualized gross monthly income of  ----------------------------------------------------------------------------    Totals fees
                        borrowers                           Nontargeted area    Targeted area     Nontargeted area    Targeted area
--------------------------------------------------------------------------------------------------------------------------------------------------------
$0 to $9,999.............................................
$10,000 to $19,999.......................................
$20,000 to $29,999.......................................
$30,000 to $39,999.......................................
$40,000 to $49,999.......................................
$50,000 to $74,999.......................................
$75,000 or more..........................................
                                                          ----------------------------------------------------------------------------------------------
  Total..................................................
 
                     Acquisition Cost
 
0 to $19,999.............................................
$20,000 to $39,999.......................................
$40,000 to $59,999.......................................
$60,000 to $79,999.......................................
$80,000 to $99,999.......................................
$100,000 to $119,999.....................................
$120,000 to $149,999.....................................
$150,000 to $199,999.....................................
$200,000 or more.........................................
                                                          ----------------------------------------------------------------------------------------------
    Total................................................
--------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 77]]


                                                              Volume of Mortgage Credit Certificates by Income and Acouisition Cost
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                             Holders satisfying the 3-year requirement                   3-year requirement not satisfied                       Totals
                                                     -------------------------------------------------------------------------------------------------------------------------------------------
                                                           Nontargeted area              Targeted area             Nontargeted area              Targeted area
                                                     ----------------------------------------------------------------------------------------------------------------               Total sum of
                                                                       Sum of                      Sum of                      Sum of                      Sum of     Total of the   products of
     Annualized gross monthly income of holders       Total of the   products of  Total of the   products of  Total of the   products of  Total of the   products of    certified     certified
                                                        certified     certified     certified     certified     certified     certified     certified     certified   indebtedness  indebtedness
                                                      indebtedness  indebtedness  indebtedness  indebtedness  indebtedness  indebtedness  indebtedness  indebtedness     amounts     amounts and
                                                         amounts     amounts and     amounts     amounts and     amounts     amounts and     amounts     amounts and                credit rates
                                                                    credit rates                credit rates                credit rates                credit rates
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
$0 to $9,999........................................
$10,000 to $19,999..................................
$20,000 to $29,999..................................
$30,000 to $39,999..................................
$40,000 to $49,999..................................
$50,000 to $74,999..................................
$75,000 to more.....................................
                                                     -------------------------------------------------------------------------------------------------------------------------------------------
    Total...........................................
 
                  Acquisition Cost
 
$0 to $19,999.......................................
$20,000 to $39,999..................................
$40,000 to $59,999..................................
$60,000 to $79,999..................................
$80,000 to $99,999..................................
$100,000 to $119,999................................
$120,000 to $149,999................................
$150,000 to $199,999................................
$200,000 or more....................................
                                                     -------------------------------------------------------------------------------------------------------------------------------------------
    Total...........................................
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 78]]


     Mortgage Credit Certificates for Qualified Home Improvement and
                          Rehabilitation Loans
------------------------------------------------------------------------
                                          Nontargeted  Targeted
                                              area       area     Totals
------------------------------------------------------------------------
         Home Improvement Loans
 
Number of mortgage credit certificates..
Total of the certified indebtedness
 amounts................................
Product of certified indebtedness
 amounts and credit rates...............
 
          Rehabilitation Loans
 
Number of mortgage credit certificates..
Total of the certified indebtedness
 amounts................................
Product of certified indebtedness
 amounts and credit rates...............
------------------------------------------------------------------------

    (3) Definitions and special rules. (i) For purposes of this 
paragraph the term ``annualized gross income'' means the borrower's 
gross monthly income multiplied by 12. Gross monthly income is the sum 
of monthly gross pay, any additional income from investments, pensions, 
Veterans Administration (VA) compensation, part-time employment, 
bonuses, dividends, interest, current overtime pay, net rental income, 
etc., and other income (such as alimony and child support, if the 
borrower chooses to disclose such income). Information with respect to 
gross monthly income may be obtained from available loan documents, 
e.g., the sum of lines 23D and 23E on the Application for VA or FmHA 
Home Loan Guaranty or for HUD/FHA Insured Mortgage (VA Form 26-1802a, 
HUD 92900, Jan. 1982), or the total line from the Gross Monthly Income 
section of FHLMC Residential Loan Application form (FHLMC 65 Rev. 8/78).
    (ii) For purposes of this paragraph, the term ``reporting period'' 
means each one year period beginning July 1 and ending June 30, except 
that issuers need not provide data with respect to the period prior to 
October 1, 1985.
    (iii) For purposes of this paragraph, verification of information 
concerning a holder's gross monthly income by utilizing other available 
information concerning the holder's income (e.g., Federal income tax 
returns) is not required. In determining whether the holder of a 
mortgage credit certificate acquiring a residence in a targeted area 
satisfies the 3-year requirement, the issuer may rely on a statement 
signed by the holder.
    (4) Time for filing. The report required by this paragraph shall be 
filed not later than the 15th day of the second calendar month after the 
close of the reporting period. The Commissioner may grant an extension 
of time for the filing of a report required by this paragraph if there 
is reasonable cause for the failure to file such report in a timely 
fashion. The report may be filed at any time before such date but must 
be complete based on facts and reasonable expectations as of the date 
the report is filed. The report need not be amended to reflect 
information learned subsequent to the date of filing, or to reflect 
changed circumstances with respect to any holder.
    (5) Place for filing. The report required by this paragraph is to be 
filed at the Internal Revenue Service Center, Philadelphia, Pennsylvania 
19255.
    (f) Policy statement. A program established pursuant to an election 
under paragraph (c) made after 1984 meets the requirements of this 
paragraph only if the applicable elected representative of the 
governmental unit--
    (1) Which is the issuer, or
    (2) On whose behalf the certificates were issued,

has published (after a public hearing following reasonable public 
notice) a policy statement described in Sec. 1.103A-2(1) by the last day 
of the year preceding the year in which the election under paragraph (c) 
is made, and a copy of such report has been submitted to the 
Commissioner on or before such last day. See Sec. 1.103A-2(1) for 
further definitions and requirements.
    (g) Targeted areas requirement--(1) In general. A program meets the 
requirements of this paragraph only if--
    (i) The portion of the total proceeds of the issue specified in 
paragraph (g)(2) is made available to provide mortgage credit 
certificates in connection with owner financing of targeted area 
residents for at least 1 year after the date on which mortgage credit 
certificates are first made available with respect to targeted area 
residences, and

[[Page 79]]

    (ii) The issuer attempts with reasonable diligence to place such 
proceeds with qualified persons.


Mortgage credit certificates are considered first made available with 
respect to targeted area residences on the date on which the issuer 
first begins to accept applications for mortgage credit certificates 
provided under that issue.
    (2) Specified portion. (i) The specified portion of the total 
proceeds of an issue is the lesser of--
    (A) 20 percent of the total proceeds, or
    (B) 8 percent of the average annual aggregate principal amount of 
mortgages executed during the immediately preceding 3 calendar years for 
single-family, owner-occupied residences in targeted areas within the 
jurisdiction of the issuing authority.

For purposes of computing the required portion of the total proceeds 
specified in paragraph (g)(2)(i)(B) where such provision is applicable, 
an issuer may rely upon the safe-harbor formula provided in the 
regulations under section 103A(h).
    (ii) See Sec. 1.25-1T(b)(10)(ii) for the definition of ``total 
proceeds''.
    (h) Fees--(1) In general. A program meets the requirements of this 
paragraph only if each applicant is required to pay, directly or 
indirectly, no fee other than those fees permitted under this paragraph.
    (2) Permissible fees. Applicants may be required to pay the 
following fees provided that they are reasonable:
    (i) Points, origination fees, servicing fees, and other fees in 
amounts that are customarily charged with respect to mortgages not 
provided in connection with mortgage credit certificates,
    (ii) Application fees, survey fees, credit report fees, insurance 
fees, or similar settlement or financing costs to the extent such 
amounts do not exceed the amounts charged in the area in cases where 
mortgages are not provided in connection with mortgage credit 
certificates. For example, amounts charged for FHA, VA, or similar 
private mortgage insurance on an individual's mortgage are permissible 
so long as such amounts do not exceed the amounts charged in the area 
with respect to a similar mortgage that is not provided in connection 
with a mortgage credit certificate, and
    (iii) Other fees that, taking into account all the facts and 
circumstances, are reasonably necessary to cover any administrative 
costs incurred by the issuer or its agent in issuing mortgage credit 
certificates.
    (i) Qualified mortgage credit certificate. A program meets the 
requirements of this paragraph only if each mortgage credit certificate 
issued under the program meets each of the requirements of paragraphs 
(c) through (o) of Sec. 1.25-3T.
    (j) Good faith compliance efforts--(1) Eligibility requirements. (i) 
A program under which each of the mortgage credit certificates issued 
does not meet each of the requirements of paragraphs (c) through (o) of 
Sec. 1.25-3T shall be treated as meeting the requirements of paragraph 
(i) of this section if each of the requirements of this paragraph (j)(1) 
is satisfied. A mortgage credit certificate program meets the 
requirements of this paragraph (j)(1) only if each of the following 
provisions is met:
    (A) The issuer in good faith attempted to issue mortgage credit 
certificates only to individuals meeting each of the requirements of 
paragraphs (c) through (o) of Sec. 1.25-3T. Good faith requires that 
agreements with lenders and agents and other relevant instruments 
contain restrictions that permit the approval of mortgage credit 
certificates only in accordance with the requirements of paragraphs (c) 
through (o) of Sec. 1.25-3T. In addition, the issuer must establish 
reasonable procedures to ensure compliance with those requirements. 
Reasonable procedures include reasonable investigations by the issuer to 
determine whether individuals satisfy the requirements of paragraphs (c) 
through (o) of Sec. 1.25-3T.
    (B) 95 percent or more of the total proceeds of the issue were 
devoted to individuals with respect to whom, at the time that the 
certificate was issued, all the requirements of paragraphs (c) through 
(o) of Sec. 1.25-3T were met. If a holder of a mortgage credit 
certificate fails to meet more than one of these requirements, the 
amount of the certificate (i.e., the certificate credit rate multiplied 
by the certified

[[Page 80]]

indebtedness amount) issued to that individual will be taken into 
account only once in determining whether the 95-percent requirement is 
met. However, all of the defects in that individual's certificate must 
be corrected pursuant to paragraph (j)(1)(i)(C).
    (C) Any failure to meet the requirements of paragraphs (c) through 
(o) of Sec. 1.25-3T is corrected within a reasonable period after that 
failure is discovered. For example, if an individual fails to meet one 
or more of such requirements those failures can be corrected by revoking 
that individual's certificate.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (j)(1):

    Example 1. County X only distributes mortgage credit certificates to 
individuals who have contracted to purchase a principal residence. 
County X requires that applicants for mortgage credit certificates 
present the following information:
    (i) An affidavit stating that the applicant intends to use the 
residence in connection with which the mortgage credit certificate is 
issued as his principal residence within a reasonable time after the 
certificate is issued by County X, that the applicant will notify the 
County if the residence ceases to be his principal residence, and facts 
that are sufficient for County X to determine whether the residence is 
located within the jurisdiction of County X,
    (ii) An affidavit stating that the applicant had no present 
ownership interest in a principal residence at any time during the 3-
year period prior to the date on which the certificate is issued,
    (iii) Copies of the applicant's Federal tax returns for the 
preceding 3 years,
    (iv) Affidavits from the seller of the residence with respect to 
which the certificate is issued and the applicant stating the purchase 
price of the residence, including an itemized list of (A) payments made 
by or for the benefit of the applicant, (B) if the residence is 
incomplete, an estimate of the reasonable cost of completing the 
residence, and (C) if the residence is subject to a ground rent, the 
capitalized value of the ground rent,
    (v) An affidavit executed by the applicant stating that the mortgage 
being acquired in connection with the certificate will not be used to 
acquire or replace an existing mortgage,
    (vi) An affidavit executed by the applicant stating that no portion 
of the financing for the residence in connection with which the 
certificate is issued is provided from the proceeds of a qualified 
mortgage bond or qualified veterans' mortgage bond and that no portion 
of the mortgage for the residence is provided by a person related to the 
applicant (as defined in Sec. 1.25-3T(n)),
    (vii) An affidavit executed by the applicant stating that the 
certificate was not limited to indebtedness incurred from particular 
lenders, and
    (viii) In the case of a mortgate credit certificate allocated for 
use in connection with a particular development, and affidavit executed 
by the applicant stating that the applicant received from the developer 
a certification stating that the price of the residence with respect to 
which the certificate was issued is no higher than it would be without 
the use of a mortgage credit certificate.

County X examines the information submitted by the applicant to 
determine whether the requirements of paragraphs (c), (d), (e), (f), 
(g), (i), (j), (k), and (n) of Sec. 1.25-3T are met. County X determines 
that the certificate has not expired. The mortgage credit certificates 
issued by County X are in the form prescribed by Sec. 1.25-6T and County 
X provides all the required information and statements. After 
determining that the applicant meets all these requirements County X 
issues a mortgage credit certificate to the applicant. This procedure 
for issuing mortgage credit certificates is sufficient evidence of the 
good faith of County X to meet the requirements of Sec. 1.25-
4T(j)(1)(i)(A).
    Example 2. County W distributes preliminary mortgage credit 
certificates to individuals who have not entered into contracts to 
purchase a principal residence. County W issues preliminary certificates 
in the form prescribed by Sec. 1.25-6T to those applicants that have 
submitted statements that they (i) intend to purchase a single-family 
residence located within the jurisdiction of County W which they will 
occupy as a principal residence, (ii) have had no present ownership 
interest in a principal residence within the preceding 3-year period, 
and (iii) will not use the certificate in connection with the 
acquisition or replacement of an existing mortgage. The certificates 
contain a maximum purchase price, the certificate credit rate, and a 
statement that the certificate will expire if the applicant does not 
enter into a closing agreement with respect to a loan within 6 months 
from the date of preliminary issuance. Holders of these certificates may 
apply for a mortgage loan from any lender. When the holder of the 
certificate applies for a loan the lender requires that he submit the 
following:
    (i) An affidavit stating that the applicant intends to use the 
residence in connection with which the mortgage credit certificate is 
issued as his principal residence within a reasonable time after the 
certificate is issued by County W, that the applicant will notify the 
County if the residence ceases to be his principal residence, and facts 
that are

[[Page 81]]

sufficient for County W to determine whether the residence is located 
within the jurisdication of County W,
    (ii) An affidavit stating that the applicant had no present 
ownership interest in a principal residence at any time during the 3-
year period prior to the date on which the certificate is issued,
    (iii) Copies of the applicant's Federal tax returns for the 
preceding 3 years,
    (iv) Affidavits from the seller of the residence with respect to 
which the certificate is issued and the applicant stating the purchase 
price of the residence, including an itemized list of (A) payments made 
by or for the benefit of the applicant, (B) if the residence is 
incomplete, an estimate of the reasonable cost of completing the 
residence, and (C) if the residence is subject to a ground rent, the 
capitalized value of the ground rent,
    (v) An affidavit executed by the applicant stating that the mortgage 
being acquired in connection with the certificate will not be used to 
acquire or replace an existing mortgage,
    (vi) An affidavit executed by the applicant stating that no portion 
of the financing for the residence in connection with which the 
certificate is issued in provided from the proceeds of a qualified 
mortgage bond or qualified veterans' mortgage bond and that no portion 
of the mortgage for the residence is provided by a person related to the 
applicant (as defined in Sec. 1.25-3T(n)),
    (vii) An affidavit executed by the applicant stating that the 
certificate was not limited to indebtedness incurred from particular 
lenders, and
    (viii) In the case of a mortgage credit certificate allocated for 
use in connection with a particular development, an affidavit executed 
by the applicant stating that the applicant received from the developer 
a certification stating that the price of the residence with respect to 
which the certificate was issued is no higher than it would be without 
the use of a mortgage credit certificate.

The lender then submits those affidavits, together with its statement as 
to the amount of the indebtedness incurred, to County W. After 
determining that the requirements of paragraphs (c), (d), (e), (f), (g), 
(i), (j), (k) and (n) of Sec. 1.25-3T are met and determining that the 
certificate has not expired, County W completes the mortgage credit 
certificate. This procedure for issuing mortgage credit certificates is 
sufficient evidence of the good faith of County W to meet the 
requirements of Sec. 1.25-4T(j)(1)(i)(A).

    (2) Program requirements. (i) A mortgage credit certificate program 
which fails to meet one or more of the requirements of paragraphs (b) 
through (h) of this section shall be treated as meeting such 
requirements if the requirements of this paragraph (j)(2) are satisfied. 
A mortgage credit certificate program meets the requirements of this 
paragraph (j)(2) only if each of the following provisions is met:
    (A) The issuer in good faith attempted to meet all of the 
requirements of paragraphs (b) through (h) of this section. This good 
faith requirement will be met if all reasonable steps are taken by the 
issuer to ensure that the program complies with these requirements.
    (B) Any failure to meet such requirements is due to inadvertent 
error, e.g., mathematical error, after taking reasonable steps to comply 
with such requirements.
    (ii) The following example illustrate the application of this 
paragraph (j)(2):

    Example. City X issues an issue of mortgage credit certificates. 
However, despite taking all reasonable steps to determine accurately the 
size of the applicable limit, as provided in section 103A (g)(3) and the 
regulations thereunder, the limit is exceeded because the amount of the 
mortgages, originated in the area during the past 3 years is incorrectly 
computed as a result of mathematical error. Such facts are sufficient 
evidence of the good faith of the issuer to meet the requirements of 
paragraph (j)(2).

[T.D. 8023, 50 FR 19350, May 8, 1985, as amended by T.D. 8048, 50 FR 
35538, Sept. 3, 1985]



Sec. 1.25-5T  Limitation on aggregate amount of mortgage credit 
certificates (Temporary).

    (a) In general. If the aggregate amount of qualified mortgage credit 
certificates (as defined in paragraph (b)) issued by an issuer under a 
qualified mortgage credit certificate program exceeds 20 percent of the 
nonissued bond amount (as defined in paragraph (c)), the provisions of 
paragraph (d) shall apply.
    (b) Aggregate amount of mortgage credit certificates--(1) In 
general. The aggregate amount of qualified mortgage credit certificates 
issued under a qualified mortgage credit certificate program is the sum 
of the products determined by multiplying--
    (i) The certified indebtedness amount of each qualified mortgage 
credit certificate issued under that program, by
    (ii) The certificate credit rate with respect to such certificate.

[[Page 82]]

    (2) Examples. The following examples illustrate the application of 
this paragraph (b):

    Example 1. For 1986 City Q has a nonissued bond amount of $100 
million. After making a proper election, Q issues 2,000 qualified 
mortgage credit certificates each with a certificate credit rate of 20 
percent and a certified indebtedness amount of $50,000. The aggregate 
amount of qualified mortgage credit certificates is $20 million (2,000 
x  (.2  x  $50,000)). Since this amount does not exceed 20 percent of 
the nonissued bond amount (.2  x  $100 million = $20 million), Q has 
complied with the limitation on the aggregate amount of mortgage credit 
certificates, provided that it does not issue any additional 
certificates.
    Example 2. The facts are the same as in example (1) except that 
instead of issuing all its certificates at the 20 percent rate, Q issues 
(i) qualified mortgage credit certificates with a certificate credit 
rate of 10 percent and an aggregate principal amount of $25 million, 
(ii) qualified mortgage credit certificates with a certificate credit 
rate of 40 percent and an aggregate principal amount of $25 million, and 
(iii) qualified mortgage credit certificates with a certificate credit 
rate of 30 percent and an aggregate principal amount of $25 million. The 
aggregate amount of qualified mortgage credit certificates is $20 
million ((10 percent of $25 million) plus (40 percent of $25 million) 
plus (30 percent of $25 million)). Q has complied with the limitation on 
the aggregate amount of qualified mortgage credit certificates, provided 
that it does not issue any additional certificates pursuant to the same 
program.

    (c) Nonissued bond amount. The term ``nonissued bond amount'' means, 
with respect to any qualified mortgage credit certificate program, the 
amount of qualified mortgage bonds (as defined in section 103A(c)(1) and 
the regulations thereunder) which the issuer is otherwise authorized to 
issue and elects not to issue under section 25(c)(2) and Sec. 1.25-
4T(b). The amount of qualified mortgage bonds which an issuing authority 
is authorized to issue is determined under section 103A(g) and the 
regulations thereunder; such determination shall take into account any 
prior elections by the issuer not to issue qualified mortgage bonds, the 
amount of any reduction in the State ceiling under paragraph (d) of this 
section, and the aggregate amount of qualified mortgage bonds issued by 
the issuer prior to its election not to issue qualified mortgage bonds.
    (d) Noncompliance with limitation on aggregate amount of mortgage 
credit certificates--(1) In general. If the provisions of this paragraph 
apply, the State ceiling under section 103A(g)(4) and the regulations 
thereunder for the calendar year following the calendar year in which 
the Commissioner determines the correction amount for the State in which 
the issuer which exceeded the limitation on the aggregate amount of 
mortgage credit certificates is located shall be reduced by 1.25 times 
the correction amount with respect to such failure.
    (2) Correction amount. (i) The term ``correction amount'' means an 
amount equal to the excess credit amount divided by .20.
    (ii) The term ``excess credit amount'' means the excess of--
    (A) The credit amount for any mortgage credit certificate program, 
over
    (B) The amount which would have been the credit amount for such 
program had such program met the requirements of section 25(d)(2) and 
paragraph (a) of this section.
    (iii) The term ``credit amount'' means the sum of the products 
determined by multiplying--
    (A) The certified indebtedness amount of each qualified mortgage 
credit certificate issued under the program, by
    (B) The certificate credit rate with respect to such certificate.
    (3) Example. The following example illustrates the application of 
this paragraph:

    Example. For 1987 City R has a nonissued bond amount of $100 
million. City R issues all of its mortgage credit certificates with a 
certificate credit rate of 20 percent. City R issues certificates with 
an aggregate certified indebtedness amount of $120 million. The 
aggregate amount of mortgage credit certificates issued by City R is $24 
million, which exceeds 20 percent of the nonissued bond amount. The 
State ceiling for the calendar year following the calendar year in which 
the Commissioner determines the correction amount is reduced by $25 
million (the correction amount multiplied by 1.25). The correction 
amount is determined as follows: The credit amount is $24 million (.2 
x  $120 million); the amount which would have been the credit amount for 
the program had it met the requirements of section 25(d)(2) is $20 
million (.2  x  $100 million); the excess credit amount is $4 million 
($24 million--$20

[[Page 83]]

million); therefore, the correction amount is $20 million ($4 
million/.2).

    (4) Cross-references. See section 103A(g)(4) and the regulations 
thereunder with respect to the reduction of the applicable State 
ceiling.

[T.D. 8023, 50 FR 19353, May 8, 1985]



Sec. 1.25-6T  Form of qualified mortgage credit certificate (Temporary).

    (a) In general. Qualified mortgage credit certificates are to be 
issued on the form prescribed by the Internal Revenue Service. If no 
form is prescribed by the Internal Revenue Service, or if the form 
prescribed by the Internal Revenue Service is not readily available, the 
issuer may use its own form provided that such form contains the 
information required by this section. Each mortgage credit certificate 
must be issued in a form such that there are at least three copies of 
the form. One copy of the certificate shall be retained by the issuer; 
one copy shall be retained by the lender; and one copy shall be 
forwarded to the State official who issued the certification required by 
Sec. 1.25-4T(d), unless that State official has stated in writing that 
he does not want to receive such copies.
    (b) Required information. Each qualified mortgage credit certificate 
must include the following information:
    (1) The name, address, and TIN of the issuer,
    (2) The date of the issuer's election not to issue qualified 
mortgage bonds pursuant to which the certificate is being issued,
    (3) The number assigned to the certificate,
    (4) The name, address, and TIN of the holder of the certificate,
    (5) The certificate credit rate,
    (6) The certified indebtness amount,
    (7) The acquisition cost of the residence being acquired in 
connection with the certificate,
    (8) The average area purchase price applicable to the residence,
    (9) Whether the certificate meets the requirements of Sec. 1.25-
3T(d), relating to residence requirement,
    (10) Whether the certificate meets the requirements of Sec. 1.25-
3T(e), relating to 3-year requirement,
    (11) Whether the certificate meets the requirements of Sec. 1.25-
3T(g), relating to new mortgage requirement,
    (12) Whether the certificate meets the requirements of Sec. 1.25-
3T(i), relating to prohibited mortgages,
    (13) Whether the certificate meets the requirements of Sec. 1.25-
3T(j), relating to particular lenders,
    (14) Whether the certificate meets the requirements of Sec. 1.25-
3T(k), relating to allocations to particular developments,
    (15) Whether the certificate meets the requirements of Sec. 1.25-
3T(n), relating to interest paid to related persons,
    (16) Whether the residence in connection with which the certificate 
is issued is a targeted area residence,
    (17) The date on which a closing agreement is signed with respect to 
the certified indebtness amount,
    (18) The expiration date of the certificate,
    (19) A statement that the certificate is not transferable or a 
statement that the certificate may be transferred only if the issuer 
issues a new certificate, and
    (20) A statement, signed under penalties of perjury by an authorized 
official of the issuer or its agent, that such person has made the 
determinations specified in paragraph (b) (9) through (16).

[T.D. 8023, 50 FR 19354, May 8, 1985]



Sec. 1.25-7T  Public notice (Temporary).

    (a) In general. At least 90 days prior to the issuance of any 
mortgage credit certificate under a qualified mortgage credit 
certificate program, the issuer shall provide reasonable public notice 
of--
    (1) The eligibility requirements for such certificate,
    (2) The methods by which such certificates are to be issued, and
    (3) The other information required by this section.
    (b) Reasonable public notice--(1) In general. Reasonable public 
notice means published notice which is reasonably designed to inform 
individuals who would be eligible to receive mortgage credit 
certificates of the proposed issuance. Reasonable public notice may be 
provided through newspapers of general circulation.

[[Page 84]]

    (2) Contents of notice. The public notice required by paragraph (a) 
must include a brief description of the principal residence requirement, 
3-year requirement, purchase price requirement, and new mortgage 
requirement. The notice must also provide a brief description of the 
methods by which the certificates are to be issued and the address and 
telephone number for obtaining further information.

[T.D. 8023, 50 FR 19354, May 8, 1985]



Sec. 1.25-8T  Reporting requirements (Temporary).

    (a) Lender--(1) In general. Each person who makes a loan that is a 
certified indebtedness amount with respect to any mortgage credit 
certificate must file the report described in paragraph (a)(2) and must 
retain on its books and records the information described in paragraph 
(a)(3). The report described in paragraph (a)(2) is an annual report and 
must be filed on or before January 31 of the year following the calendar 
year to which the report relates. See section 6709(c) and the 
regulations thereunder for the applicable penalties with respect to 
failure to file reports.
    (2) Information required. The report shall be submitted on Form 8329 
and shall contain the information required therein. A separate Form 8329 
shall be filed for each issue of mortgage credit certificates with 
respect to which the lender made mortgage loans during the preceding 
calendar year. Thus, for example, if during 1986 Bank M makes three 
mortgage loans which are certified indebtedness amounts with respect to 
State Z's January 15, 1986, issue of mortgage credit certificates, and 
two mortgage loans which are certified indebtedness amounts with respect 
to State Z's April 15, 1986, issue of mortgage credit certificates, and 
fifty mortgage loans which are certified indebtedness amounts with 
respect to County X's December 31, 1985, issue of mortgage credit 
certificates, Bank M must file three separate reports for calendar year 
1986. The lender must submit the Form 8329 with the information required 
therein, including--
    (i) The name, address, and TIN of the issuer of the mortgage credit 
certificates,
    (ii) The date on which the election not to issue qualified mortgage 
bonds with respect to that mortgage credit certificate was made,
    (iii) The name, address, and TIN of the lender, and
    (iv) The sum of the products determined by multiplying--
    (A) The certified indebtedness amount of each mortgage credit 
certificate issued under such program, by
    (B) The certificate credit rate with respect to such certificate.
    (3) Recordkeeping requirements. Each person who makes a loan that is 
a certified indebtedness amount with respect to any mortgage credit 
certificate must retain the information specified in this paragraph 
(a)(3) on its books and records for 6 years following the year in which 
the loan was made. With respect to each loan the lender must retain the 
following information:
    (i) The name, address, and TIN of each holder of a qualified 
mortgage credit certificate with respect to which a loan is made,
    (ii) The name, address, and TIN of the issuer of such certificate, 
and
    (iii) The date the loan for the certified indebtedness amount is 
closed, the certified indebtedness amount, and the certificate credit 
rate of such certificate.
    (b) Issuers--(1) In general. Each issuer of mortgage credit 
certificates shall file the report described in paragraph (b)(2) of this 
section.
    (2) Quarterly reports. (i) Each issuer which elects to issue 
mortgage credit certificates shall file reports on Form 8330. These 
reports shall be filed on a quarterly basis, beginning with the quarter 
in which the election is made, and are due on the following dates: April 
30 (for the quarter ending March 31), July 31 (for the quarter ending 
June 30), October 31 (for the quarter ending September 30), and January 
31 (for the quarter ending December 31). For elections made prior to May 
8, 1985, the first report need not be filed until July 31, 1985. An 
issuer shall file a separate report for each issue of mortgage credit 
certificates. In the quarter in which the last qualified mortgage credit 
certificate that may be issued under a program is issued, the issuer 
must state that fact on the report to be filed

[[Page 85]]

for that quarter; the issuer is not required to file any subsequent 
reports with respect to that program. See section 6709(c) for the 
penalties with respect to failure to file a report.
    (ii) The report shall be submitted on Form 8330 and shall contain 
the information required therein, including--
    (A) The name, address, and TIN of the issuer of the mortgage credit 
certificates,
    (B) The date of the issuer's election not to issue qualified 
mortgage bonds with respect to the mortgage credit certificate program 
and the nonissued bond amount of the program,
    (C) The sum of the products determined by multiplying--
    (1) The certified indebtedness amount of each qualified mortgage 
credit certificate issued under that program during the calendar 
quarter, by
    (2) The certificate credit rate with respect to such certificate, 
and
    (D) A listing of the name, address, and TIN of each holder of a 
qualified mortgage credit certificate which has been revoked during the 
calendar quarter.
    (c) Extensions of time for filing reports. The Commissioner may 
grant an extension of time for the filing of a report required by this 
section if there is reasonable cause for the failure to file such report 
in a timely fashion.
    (d) Place for filing. The reports required by this section are to be 
filed at the Internal Revenue Service Center, Philadelphia, Pennsylvania 
19225.
    (e) Cross reference. See section 6709 and the regulations thereunder 
with respect to the penalty for failure to file a report required by 
this section.

[T.D. 8023, 50 FR 19354, May 8, 1985]



Sec. 1.25A-0  Table of contents.

    This section lists captions contained in Secs. 1.25A-1, 1.25A-2, 
1.25A-3, 1.25A-4, and 1.25A-5.

     Sec. 1.25A-1  Calculation of Education Tax Credit and General 
                        Eligibility Requirements

    (a) Amount of education tax credit.
    (b) Coordination of Hope Scholarship Credit and Lifetime Learning 
Credit.
    (1) In general.
    (2) Hope Scholarship Credit.
    (3) Lifetime Learning Credit.
    (4) Examples.
    (c) Limitation based on modified adjusted gross income.
    (1) In general.
    (2) Modified adjusted gross income defined.
    (3) Inflation adjustment.
    (d) Election.
    (e) Identification requirement.
    (f) Claiming the credit in the case of a dependent.
    (1) In general.
    (2) Examples.
    (g) Married taxpayers.
    (h) Nonresident alien taxpayers and dependents.

                        Sec. 1.25A-2  Definitions

    (a) Claimed dependent.
    (b) Eligible educational institution.
    (1) In general.
    (2) Rules on Federal financial aid programs.
    (c) Academic period.
    (d) Qualified tuition and related expenses.
    (1) In general.
    (2) Required fees.
    (i) In general.
    (ii) Books, supplies, and equipment.
    (iii) Nonacademic fees.
    (3) Personal expenses.
    (4) Treatment of a comprehensive or bundled fee.
    (5) Hobby courses.
    (6) Examples.

                  Sec. 1.25A-3  Hope Scholarship Credit

    (a) Amount of the credit.
    (1) In general.
    (2) Maximum credit.
    (b) Per student credit.
    (1) In general.
    (2) Example.
    (c) Credit allowed for only two taxable years.
    (d) Eligible student.
    (1) Eligible student defined.
    (i) Degree requirement.
    (ii) Work load requirement.
    (iii) Year of study requirement.
    (iv) No felony drug conviction.
    (2) Examples.
    (e) Academic period for prepayments.
    (1) In general.
    (2) Example.
    (f) Effective date.

                 Sec. 1.25A-4  Lifetime Learning Credit

    (a) Amount of the credit.
    (1) Taxable years beginning before January 1, 2003.
    (2) Taxable years beginning after December 31, 2002.
    (3) Coordination with the Hope Scholarship Credit.
    (4) Examples.
    (b) Credit allowed for unlimited number of taxable years.

[[Page 86]]

    (c) Both degree and nondegree courses are eligible for the credit.
    (1) In general.
    (2) Examples.
    (d) Effective date.

 Sec. 1.25A-5  Special Rules Relating to Characterization and Timing of 
                                Payments

    (a) Educational expenses paid by claimed dependent.
    (b) Educational expenses paid by a third party.
    (1) In general.
    (2) Special rule for tuition reduction included in gross income of 
employee.
    (3) Examples.
    (c) Adjustment to qualified tuition and related expenses for certain 
excludable educational assistance.
    (1) In general.
    (2) No adjustment for excludable educational assistance attributable 
to expenses paid in a prior year.
    (3) Scholarships and fellowship grants.
    (4) Examples.
    (d) No double benefit.
    (e) Timing rules.
    (1) In general.
    (2) Prepayment rule.
    (i) In general.
    (ii) Example.
    (3) Expenses paid with loan proceeds.
    (4) Expenses paid through third party installment payment plans.
    (i) In general.
    (ii) Example.
    (f) Refund of qualified tuition and related expenses.
    (1) Payment and refund of qualified tuition and related expenses in 
the same taxable year.
    (2) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year before return filed for prior 
taxable year.
    (3) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year.
    (i) In general.
    (ii) Recapture amount.
    (4) Refund of loan proceeds treated as refund of qualified tuition 
and related expenses.
    (5) Excludable educational assistance received in a subsequent 
taxable year treated as a refund.
    (6) Examples.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec. 1.25A-1  Calculation of education tax credit and general eligibility 
requirements.

    (a) Amount of education tax credit. An individual taxpayer is 
allowed a nonrefundable education tax credit against income tax imposed 
by chapter 1 of the Internal Revenue Code for the taxable year. The 
amount of the education tax credit is the total of the Hope Scholarship 
Credit (as described in Sec. 1.25A-3) plus the Lifetime Learning Credit 
(as described in Sec. 1.25A-4). For limitations on the credits allowed 
by subpart A of part IV of subchapter A of chapter 1 of the Internal 
Revenue Code, see section 26.
    (b) Coordination of Hope Scholarship Credit and Lifetime Learning 
Credit--(1) In general. In the same taxable year, a taxpayer may claim a 
Hope Scholarship Credit for each eligible student's qualified tuition 
and related expenses (as defined in Sec. 1.25A-2(d)) and a Lifetime 
Learning Credit for one or more other students' qualified tuition and 
related expenses. However, a taxpayer may not claim both a Hope 
Scholarship Credit and a Lifetime Learning Credit with respect to the 
same student in the same taxable year.
    (2) Hope Scholarship Credit. Subject to certain limitations, a Hope 
Scholarship Credit may be claimed for the qualified tuition and related 
expenses paid during a taxable year with respect to each eligible 
student (as defined in Sec. 1.25A-3(d)). Qualified tuition and related 
expenses paid during a taxable year with respect to one student may not 
be taken into account in computing the amount of the Hope Scholarship 
Credit with respect to any other student. In addition, qualified tuition 
and related expenses paid during a taxable year with respect to any 
student for whom a Hope Scholarship Credit is claimed may not be taken 
into account in computing the amount of the Lifetime Learning Credit.
    (3) Lifetime Learning Credit. Subject to certain limitations, a 
Lifetime Learning Credit may be claimed for the aggregate amount of 
qualified tuition and related expenses paid during a taxable year with 
respect to students for whom no Hope Scholarship Credit is claimed.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. In 1999, Taxpayer A pays qualified tuition and related 
expenses for his dependent, B, to attend College Y during 1999. Assuming 
all other relevant requirements are met, Taxpayer A may claim either a

[[Page 87]]

Hope Scholarship Credit or a Lifetime Learning Credit with respect to 
dependent B, but not both. See Sec. 1.25A-3(a) and Sec. 1.25A-4(a).
    Example 2. In 1999, Taxpayer C pays $2,000 in qualified tuition and 
related expenses for her dependent, D, to attend College Z during 1999. 
In 1999, Taxpayer C also pays $500 in qualified tuition and related 
expenses to attend a computer course during 1999 to improve Taxpayer C's 
job skills. Assuming all other relevant requirements are met, Taxpayer C 
may claim a Hope Scholarship Credit for the $2,000 of qualified tuition 
and related expenses attributable to dependent D (see Sec. 1.25A-3(a)) 
and a Lifetime Learning Credit (see Sec. 1.25A-4(a)) for the $500 of 
qualified tuition and related expenses incurred to improve her job 
skills.
    Example 3. The facts are the same as in Example 2, except that 
Taxpayer C pays $3,000 in qualified tuition and related expenses for her 
dependent, D, to attend College Z during 1999. Although a Hope 
Scholarship Credit is available only with respect to the first $2,000 of 
qualified tuition and related expenses paid with respect to D (see 
Sec. 1.25A-3(a)), Taxpayer C may not add the $1,000 of excess expenses 
to her $500 of qualified tuition and related expenses in computing the 
amount of the Lifetime Learning Credit.

    (c) Limitation based on modified adjusted gross income--(1) In 
general. The education tax credit that a taxpayer may otherwise claim is 
phased out ratably for taxpayers with modified adjusted gross income 
between $40,000 and $50,000 ($80,000 and $100,000 for married 
individuals who file a joint return). Thus, taxpayers with modified 
adjusted gross income above $50,000 (or $100,000 for joint filers) may 
not claim an education tax credit.
    (2) Modified adjusted gross income defined. The term modified 
adjusted gross income means the adjusted gross income (as defined in 
section 62) of the taxpayer for the taxable year increased by any amount 
excluded from gross income under section 911, 931, or 933 (relating to 
income earned abroad or from certain U.S. possessions or Puerto Rico).
    (3) Inflation adjustment. For taxable years beginning after 2001, 
the amounts in paragraph (c)(1) of this section will be increased for 
inflation occurring after 2000 in accordance with section 1(f)(3). If 
any amount adjusted under this paragraph (c)(3) is not a multiple of 
$1,000, the amount will be rounded to the next lowest multiple of 
$1,000.
    (d) Election. No education tax credit is allowed unless a taxpayer 
elects to claim the credit on the taxpayer's federal income tax return 
for the taxable year in which the credit is claimed. The election is 
made by attaching Form 8863, ``Education Credits (Hope and Lifetime 
Learning Credits),'' to the federal income tax return.
    (e) Identification requirement. No education tax credit is allowed 
unless a taxpayer includes on the federal income tax return claiming the 
credit the name and the taxpayer identification number of the student 
for whom the credit is claimed. For rules relating to assessment for an 
omission of a correct taxpayer identification number, see section 
6213(b) and (g)(2)(J).
    (f) Claiming the credit in the case of a dependent--(1) In general. 
If a student is a claimed dependent of another taxpayer, only that 
taxpayer may claim the education tax credit for the student's qualified 
tuition and related expenses. However, if another taxpayer is eligible 
to, but does not, claim the student as a dependent, only the student may 
claim the education tax credit for the student's qualified tuition and 
related expenses.
    (2) Examples. The following examples illustrate the rules of this 
paragraph (f):

    Example 1. In 1999, Taxpayer A pays qualified tuition and related 
expenses for his dependent, B, to attend University Y during 1999. 
Taxpayer A claims B as a dependent on his federal income tax return. 
Therefore, assuming all other relevant requirements are met, Taxpayer A 
is allowed an education tax credit on his federal income tax return, and 
B is not allowed an education tax credit on B's federal income tax 
return. The result would be the same if B paid the qualified tuition and 
related expenses. See Sec. 1.25A-5(a).
    Example 2. In 1999, Taxpayer C has one dependent, D. In 1999, D pays 
qualified tuition and related expenses to attend University Z during 
1999. Although Taxpayer C is eligible to claim D as a dependent on her 
federal income tax return, she does not do so. Therefore, assuming all 
other relevant requirements are met, D is allowed an education tax 
credit on D's federal income tax return, and Taxpayer C is not allowed 
an education tax credit on her federal income tax return, with respect 
to D's education expenses. The result would be the same if C paid the 
qualified tuition and related expenses on behalf of D. See Sec. 1.25A-
5(b).


[[Page 88]]


    (g) Married taxpayers. If a taxpayer is married (within the meaning 
of section 7703), no education tax credit is allowed to the taxpayer 
unless the taxpayer and the taxpayer's spouse file a joint Federal 
income tax return for the taxable year.
    (h) Nonresident alien taxpayers and dependents. If a taxpayer or the 
taxpayer's spouse is a nonresident alien for any portion of the taxable 
year, no education tax credit is allowed unless the nonresident alien is 
treated as a resident alien by reason of an election under section 
6013(g) or (h). In addition, if a student is a nonresident alien, a 
taxpayer may not claim an education tax credit with respect to the 
qualified tuition and related expenses of the student unless the student 
is a claimed dependent (as defined in Sec. 1.25A-2(a)).

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec. 1.25A-2  Definitions.

    (a) Claimed dependent. A claimed dependent means a dependent (as 
defined in section 152) for whom a deduction under section 151 is 
allowed on a taxpayer's federal income tax return for the taxable year. 
Among other requirements under section 152, a nonresident alien student 
must be a resident of a country contiguous to the United States in order 
to be treated as a dependent.
    (b) Eligible educational institution--(1) In general. In general, an 
eligible educational institution means a college, university, vocational 
school, or other postsecondary educational institution that is--
    (i) Described in section 481 of the Higher Education Act of 1965 (20 
U.S.C. 1088) as in effect on August 5, 1997, (generally all accredited 
public, nonprofit, and proprietary postsecondary institutions); and
    (ii) Participating in a Federal financial aid program under title IV 
of the Higher Education Act of 1965 or is certified by the Department of 
Education as eligible to participate in such a program but chooses not 
to participate.
    (2) Rules on Federal financial aid programs. For rules governing an 
educational institution's eligibility to participate in Federal 
financial aid programs, see 20 U.S.C. 1070; 20 U.S.C. 1094; and 34 CFR 
600 and 668.
    (c) Academic period. Academic period means a quarter, semester, 
trimester, or other period of study as reasonably determined by an 
eligible educational institution. In the case of an eligible educational 
institution that uses credit hours or clock hours, and does not have 
academic terms, each payment period (as defined in 34 CFR 668.4, revised 
as of July 1, 2002) may be treated as an academic period.
    (d) Qualified tuition and related expenses--(1) In general. 
Qualified tuition and related expenses means tuition and fees required 
for the enrollment or attendance of a student for courses of instruction 
at an eligible educational institution.
    (2) Required fees--(i) In general. Except as provided in paragraph 
(d)(3) of this section, the test for determining whether any fee is a 
qualified tuition and related expense is whether the fee is required to 
be paid to the eligible educational institution as a condition of the 
student's enrollment or attendance at the institution.
    (ii) Books, supplies, and equipment. Qualified tuition and related 
expenses include fees for books, supplies, and equipment used in a 
course of study only if the fees must be paid to the eligible 
educational institution for the enrollment or attendance of the student 
at the institution.
    (iii) Nonacademic fees. Except as provided in paragraph (d)(3) of 
this section, qualified tuition and related expenses include fees 
charged by an eligible educational institution that are not used 
directly for, or allocated to, an academic course of instruction only if 
the fee must be paid to the eligible educational institution for the 
enrollment or attendance of the student at the institution.
    (3) Personal expenses. Qualified tuition and related expenses do not 
include the costs of room and board, insurance, medical expenses 
(including student health fees), transportation, and similar personal, 
living, or family expenses, regardless of whether the fee must be paid 
to the eligible educational institution for the enrollment or attendance 
of the student at the institution.
    (4) Treatment of a comprehensive or bundled fee. If a student is 
required to

[[Page 89]]

pay a fee (such as a comprehensive fee or a bundled fee) to an eligible 
educational institution that combines charges for qualified tuition and 
related expenses with charges for personal expenses described in 
paragraph (d)(3) of this section, the portion of the fee that is 
allocable to personal expenses is not included in qualified tuition and 
related expenses. The determination of what portion of the fee relates 
to qualified tuition and related expenses and what portion relates to 
personal expenses must be made by the institution using a reasonable 
method of allocation.
    (5) Hobby courses. Qualified tuition and related expenses do not 
include expenses that relate to any course of instruction or other 
education that involves sports, games, or hobbies, or any noncredit 
course, unless the course or other education is part of the student's 
degree program, or in the case of the Lifetime Learning Credit, the 
student takes the course to acquire or improve job skills.
    (6) Examples. The following examples illustrate the rules of this 
paragraph (d). In each example, assume that the institution is an 
eligible educational institution and that all other relevant 
requirements to claim an education tax credit are met. The examples are 
as follows:

    Example 1. University V offers a degree program in dentistry. In 
addition to tuition, all students enrolled in the program are required 
to pay a fee to University V for the rental of dental equipment. Because 
the equipment rental fee must be paid to University V for enrollment and 
attendance, the tuition and the equipment rental fee are qualified 
tuition and related expenses.
    Example 2. First-year students at College W are required to obtain 
books and other reading materials used in its mandatory first-year 
curriculum. The books and other reading materials are not required to be 
purchased from College W and may be borrowed from other students or 
purchased from off-campus bookstores, as well as from College W's 
bookstore. College W bills students for any books and materials 
purchased from College W's bookstore. The fee that College W charges for 
the first-year books and materials purchased at its bookstore is not a 
qualified tuition and related expense because the books and materials 
are not required to be purchased from College W for enrollment or 
attendance at the institution.
    Example 3. All students who attend College X are required to pay a 
separate student activity fee in addition to their tuition. The student 
activity fee is used solely to fund on-campus organizations and 
activities run by students, such as the student newspaper and the 
student government (no portion of the fee covers personal expenses). 
Although labeled as a student activity fee, the fee is required for 
enrollment or attendance at College X. Therefore, the fee is a qualified 
tuition and related expense.
    Example 4. The facts are the same as in Example 3, except that 
College X offers an optional athletic fee that students may pay to 
receive discounted tickets to sports events. The athletic fee is not 
required for enrollment or attendance at College X. Therefore, the fee 
is not a qualified tuition and related expense.
    Example 5. College Y requires all students to live on campus. It 
charges a single comprehensive fee to cover tuition, required fees, and 
room and board. Based on College Y's reasonable allocation, sixty 
percent of the comprehensive fee is allocable to tuition and other 
required fees not allocable to personal expenses, and the remaining 
forty percent of the comprehensive fee is allocable to charges for room 
and board and other personal expenses. Therefore, only sixty percent of 
College Y's comprehensive fee is a qualified tuition and related 
expense.
    Example 6. As a degree student at College Z, Student A is required 
to take a certain number of courses outside of her chosen major in 
Economics. To fulfill this requirement, Student A enrolls in a square 
dancing class offered by the Physical Education Department. Because 
Student A receives credit toward her degree program for the square 
dancing class, the tuition for the square dancing class is included in 
qualified tuition and related expenses.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec. 1.25A-3  Hope Scholarship Credit.

    (a) Amount of the credit--(1) In general. Subject to the phaseout of 
the education tax credit described in Sec. 1.25A-1(c), the Hope 
Scholarship Credit amount is the total of--
    (i) 100 percent of the first $1,000 of qualified tuition and related 
expenses paid during the taxable year for education furnished to an 
eligible student (as defined in paragraph (d) of this section) who is 
the taxpayer, the taxpayer's spouse, or any claimed dependent during any 
academic period beginning in the taxable year (or treated as beginning 
in the taxable year, see Sec. 1.25A-5(e)(2)); plus

[[Page 90]]

    (ii) 50 percent of the next $1,000 of such expenses paid with 
respect to that student.
    (2) Maximum credit. For taxable years beginning before 2002, the 
maximum Hope Scholarship Credit allowed for each eligible student is 
$1,500. For taxable years beginning after 2001, the amounts used in 
paragraph (a)(1) of this section to determine the maximum credit will be 
increased for inflation occurring after 2000 in accordance with section 
1(f)(3). If any amount adjusted under this paragraph (a)(2) is not a 
multiple of $100, the amount will be rounded to the next lowest multiple 
of $100.
    (b) Per student credit--(1) In general. A Hope Scholarship Credit 
may be claimed for the qualified tuition and related expenses of each 
eligible student (as defined in paragraph (d) of this section).
    (2) Example. The following example illustrates the rule of this 
paragraph (b). In the example, assume that all the requirements to claim 
an education tax credit are met. The example is as follows:

    Example. In 1999, Taxpayer A has two dependents, B and C, both of 
whom are eligible students. Taxpayer A pays $1,600 in qualified tuition 
and related expenses for dependent B to attend a community college. 
Taxpayer A pays $5,000 in qualified tuition and related expenses for 
dependent C to attend University X. Taxpayer A may claim a Hope 
Scholarship Credit of $1,300 ($1,000 + (.50  x  $600)) for dependent B, 
and the maximum $1,500 Hope Scholarship Credit for dependent C, for a 
total Hope Scholarship Credit of $2,800.

    (c) Credit allowed for only two taxable years. For each eligible 
student, the Hope Scholarship Credit may be claimed for no more than two 
taxable years.
    (d) Eligible student--(1) Eligible student defined. For purposes of 
the Hope Scholarship Credit, the term eligible student means a student 
who satisfies all of the following requirements--
    (i) Degree requirement. For at least one academic period that begins 
during the taxable year, the student enrolls at an eligible educational 
institution in a program leading toward a postsecondary degree, 
certificate, or other recognized postsecondary educational credential;
    (ii) Work load requirement. For at least one academic period that 
begins during the taxable year, the student enrolls for at least one-
half of the normal full-time work load for the course of study the 
student is pursuing. The standard for what is half of the normal full-
time work load is determined by each eligible educational institution. 
However, the standard for half-time may not be lower than the applicable 
standard for half-time established by the Department of Education under 
the Higher Education Act of 1965 and set forth in 34 CFR 674.2(b) 
(revised as of July 1, 2002) for a half-time undergraduate student;
    (iii) Year of study requirement. As of the beginning of the taxable 
year, the student has not completed the first two years of postsecondary 
education at an eligible educational institution. Whether a student has 
completed the first two years of postsecondary education at an eligible 
educational institution as of the beginning of a taxable year is 
determined based on whether the institution in which the student is 
enrolled in a degree program (as described in paragraph (d)(1)(i) of 
this section) awards the student two years of academic credit at that 
institution for postsecondary course work completed by the student prior 
to the beginning of the taxable year. Any academic credit awarded by the 
eligible educational institution solely on the basis of the student's 
performance on proficiency examinations is disregarded in determining 
whether the student has completed two years of postsecondary education; 
and
    (iv) No felony drug conviction. The student has not been convicted 
of a Federal or State felony offense for possession or distribution of a 
controlled substance as of the end of the taxable year for which the 
credit is claimed.
    (2) Examples. The following examples illustrate the rules of this 
paragraph (d). In each example, assume that the student has not been 
convicted of a felony drug offense, that the institution is an eligible 
educational institution unless otherwise stated, that the qualified 
tuition and related expenses are paid during the same taxable year that 
the academic period begins, and that a

[[Page 91]]

Hope Scholarship Credit has not previously been claimed for the student 
(see paragraph (c) of this section). The examples are as follows:

    Example 1. Student A graduates from high school in June 1998 and is 
enrolled in an undergraduate degree program at College U for the 1998 
Fall semester on a full-time basis. For the 1999 Spring semester, 
Student A again is enrolled at College U on a full-time basis. For the 
1999 Fall semester, Student A is enrolled in less than half the normal 
full-time course work for her degree program. Because Student A is 
enrolled in an undergraduate degree program on at least a half-time 
basis for at least one academic period that begins during 1998 and at 
least one academic period that begins during 1999, Student A is an 
eligible student for taxable years 1998 and 1999 (including the 1999 
Fall semester when Student A enrolls at College U on less than a half-
time basis).
    Example 2. Prior to 1998, Student B attended college for several 
years on a full-time basis. Student B transfers to College V for the 
1998 Spring semester. College V awards Student B credit for some (but 
not all) of the courses he previously completed, and College V 
classifies Student B as a first-semester sophomore. During both the 
Spring and Fall semesters of 1998, Student B is enrolled in at least 
one-half the normal full-time work load for his degree program at 
College V. Because College V does not classify Student B as having 
completed the first two years of postsecondary education as of the 
beginning of 1998, Student B is an eligible student for taxable year 
1998.
    Example 3. The facts are the same as in Example 2. After taking 
classes on a half-time basis for the 1998 Spring and Fall semesters, 
Student B is enrolled at College V for the 1999 Spring semester on a 
full-time basis. College V classifies Student B as a second-semester 
sophomore for the 1999 Spring semester and as a first-semester junior 
for the 1999 Fall semester. Because College V does not classify Student 
B as having completed the first two years of postsecondary education as 
of the beginning of 1999, Student B is an eligible student for taxable 
year 1999. Therefore, the qualified expenses and required fees paid for 
the 1999 Spring semester and the 1999 Fall semester are taken into 
account in calculating any Hope Scholarship Credit.
    Example 4. Prior to 1998, Student C was not enrolled at another 
eligible educational institution. At the time that Student C enrolls in 
a degree program at College W for the 1998 Fall semester, Student C 
takes examinations to demonstrate her proficiency in several subjects. 
On the basis of Student C's performance on these examinations, College W 
classifies Student C as a second-semester sophomore as of the beginning 
of the 1998 Fall semester. Student C is enrolled at College W during the 
1998 Fall semester and during the 1999 Spring and Fall semesters on a 
full-time basis and is classified as a first-semester junior as of the 
beginning of the 1999 Spring semester. Because Student C was not 
enrolled in a college or other eligible educational institution prior to 
1998 (but rather was awarded three semesters of academic credit solely 
because of proficiency examinations), Student C is not treated as having 
completed the first two years of postsecondary education at an eligible 
educational institution as of the beginning of 1998 or as of the 
beginning of 1999. Therefore, Student C is an eligible student for both 
taxable years 1998 and 1999.
    Example 5. During the 1998 Fall semester, Student D is a high school 
student who takes classes on a half-time basis at College X. Student D 
is not enrolled as part of a degree program at College X because College 
X does not admit students to a degree program unless the student has a 
high school diploma or equivalent. Because Student D is not enrolled in 
a degree program at College X during 1998, Student D is not an eligible 
student for taxable year 1998.
    Example 6. The facts are the same as in Example 5. In addition, 
during the 1999 Spring semester, Student D again attends College X but 
not as part of a degree program. Student D graduates from high school in 
June 1999. For the 1999 Fall semester, Student D enrolls in College X as 
part of a degree program, and College X awards Student D credit for her 
prior course work at College X. During the 1999 Fall semester, Student D 
is enrolled in more than one-half the normal full-time work load of 
courses for her degree program at College X. Because Student D is 
enrolled in a degree program at College X for the 1999 Fall term on at 
least a half-time basis, Student D is an eligible student for all of 
taxable year 1999. Therefore, the qualified tuition and required fees 
paid for classes taken at College X during both the 1999 Spring semester 
(during which Student D was not enrolled in a degree program) and the 
1999 Fall semester are taken into account in computing any Hope 
Scholarship Credit.
    Example 7. Student E completed two years of undergraduate study at 
College S. College S is not an eligible educational institution for 
purposes of the education tax credit. At the end of 1998, Student E 
enrolls in an undergraduate degree program at College Z, an eligible 
educational institution, for the 1999 Spring semester on a full-time 
basis. College Z awards Student E two years of academic credit for his 
previous course work at College S and classifies Student E as a first-
semester junior for the 1999 Spring semester. Student E is treated as 
having completed the first two years of postsecondary education at an 
eligible educational institution as of the beginning of 1999. Therefore, 
Student E is not an eligible student for taxable year 1999.

[[Page 92]]

    Example 8. Student F received a degree in 1998 from College R. 
College R is not an eligible educational institution for purposes of the 
education tax credit. During 1999, Student F is enrolled in a graduate-
degree program at College Y, an eligible educational institution, for 
the 1999 Fall semester on a full-time basis. By admitting Student F to 
its graduate degree program, College Y treats Student F as having 
completed the first two years of postsecondary education as of the 
beginning of 1999. Therefore, Student F is not an eligible student for 
taxable year 1999.
    Example 9. Student G graduates from high school in June 2001. In 
January 2002, Student G is enrolled in a one-year postsecondary 
certificate program on a full-time basis to obtain a certificate as a 
travel agent. Student G completes the program in December 2002 and is 
awarded a certificate. In January 2003, Student G enrolls in a one-year 
postsecondary certificate program on a full-time basis to obtain a 
certificate as a computer programer. Student G meets the degree 
requirement, the work load requirement, and the year of study 
requirement for the taxable years 2002 and 2003. Therefore, Student G is 
an eligible student for both taxable years 2002 and 2003.

    (e) Academic period for prepayments--(1) In general. For purposes of 
determining whether a student meets the requirements in paragraph (d) of 
this section for a taxable year, if qualified tuition and related 
expenses are paid during one taxable year for an academic period that 
begins during January, February or March of the next taxable year (for 
taxpayers on a fiscal taxable year, use the first three months of the 
next taxable year), the academic period is treated as beginning during 
the taxable year in which the payment is made.
    (2) Example. The following example illustrates the rule of this 
paragraph (e). In the example, assume that all the requirements to claim 
a Hope Scholarship Credit are met. The example is as follows:

    Example. Student G graduates from high school in June 1998. After 
graduation, Student G works full-time for several months to earn money 
for college. Student G is enrolled on a full-time basis in an 
undergraduate degree program at University W, an eligible educational 
institution, for the 1999 Spring semester, which begins in January 1999. 
Student G pays tuition to University W for the 1999 Spring semester in 
December 1998. Because the tuition paid by Student G in 1998 relates to 
an academic period that begins during the first three months of 1999, 
Student G's eligibility to claim a Hope Scholarship Credit in 1998 is 
determined as if the 1999 Spring semester began in 1998. Thus, assuming 
Student G has not been convicted of a felony drug offense as of December 
31, 1998, Student G is an eligible student for 1998.

    (f) Effective date. The Hope Scholarship Credit is applicable for 
qualified tuition and related expenses paid after December 31, 1997, for 
education furnished in academic periods beginning after December 31, 
1997.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002; 68 FR 15940, Apr. 2, 2003]



Sec. 1.25A-4  Lifetime Learning Credit.

    (a) Amount of the credit--(1) Taxable years beginning before January 
1, 2003. Subject to the phaseout of the education tax credit described 
in Sec. 1.25A-1(c), for taxable years beginning before 2003, the 
Lifetime Learning Credit amount is 20 percent of up to $5,000 of 
qualified tuition and related expenses paid during the taxable year for 
education furnished to the taxpayer, the taxpayer's spouse, and any 
claimed dependent during any academic period beginning in the taxable 
year (or treated as beginning in the taxable year, see Sec. 1.25A-
5(e)(2)).
    (2) Taxable years beginning after December 31, 2002. Subject to the 
phaseout of the education tax credit described in Sec. 1.25A-1(c), for 
taxable years beginning after 2002, the Lifetime Learning Credit amount 
is 20 percent of up to $10,000 of qualified tuition and related expenses 
paid during the taxable year for education furnished to the taxpayer, 
the taxpayer's spouse, and any claimed dependent during any academic 
period beginning in the taxable year (or treated as beginning in the 
taxable year, see Sec. 1.25A-5(e)(2)).
    (3) Coordination with the Hope Scholarship Credit. Expenses paid 
with respect to a student for whom the Hope Scholarship Credit is 
claimed are not eligible for the Lifetime Learning Credit.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (a). In each example, assume that all the requirements to 
claim a Lifetime Learning Credit or a Hope Scholarship Credit, as 
applicable, are met. The examples are as follows:


[[Page 93]]


    Example 1. In 1999, Taxpayer A pays qualified tuition and related 
expenses of $3,000 for dependent B to attend an eligible educational 
institution, and Taxpayer A pays qualified tuition and related expenses 
of $4,000 for dependent C to attend an eligible educational institution. 
Taxpayer A does not claim a Hope Scholarship Credit with respect to 
either B or C. Although Taxpayer A paid $7,000 of qualified tuition and 
related expenses during the taxable year, Taxpayer A may claim the 
Lifetime Learning Credit with respect to only $5,000 of such expenses. 
Therefore, the maximum Lifetime Learning Credit Taxpayer A may claim for 
1999 is $1,000 (.20  x  $5,000).
    Example 2. In 1999, Taxpayer D pays $6,000 of qualified tuition and 
related expenses for dependent E, and $2,000 of qualified tuition and 
related expenses for dependent F, to attend eligible educational 
institutions. Dependent F has already completed the first two years of 
postsecondary education. For 1999, Taxpayer D claims the maximum $1,500 
Hope Scholarship Credit with respect to dependent E. In computing the 
amount of the Lifetime Learning Credit, Taxpayer D may not include any 
of the $6,000 of qualified tuition and related expenses paid on behalf 
of dependent E but may include the $2,000 of qualified tuition and 
related expenses of dependent F.

    (b) Credit allowed for unlimited number of taxable years. There is 
no limit to the number of taxable years that a taxpayer may claim a 
Lifetime Learning Credit with respect to any student.
    (c) Both degree and nondegree courses are eligible for the credit--
(1) In general. For purposes of the Lifetime Learning Credit, amounts 
paid for a course at an eligible educational institution are qualified 
tuition and related expenses if the course is either part of a 
postsecondary degree program or is not part of a postsecondary degree 
program but is taken by the student to acquire or improve job skills.
    (2) Examples. The following examples illustrate the rule of this 
paragraph (c). In each example, assume that all the requirements to 
claim a Lifetime Learning Credit are met. The examples are as follows:

    Example 1. Taxpayer A, a professional photographer, enrolls in an 
advanced photography course at a local community college. Although the 
course is not part of a degree program, Taxpayer A enrolls in the course 
to improve her job skills. The course fee paid by Taxpayer A is a 
qualified tuition and related expense for purposes of the Lifetime 
Learning Credit.
    Example 2. Taxpayer B, a stockbroker, plans to travel abroad on a 
``photo-safari'' for his next vacation. In preparation for the trip, 
Taxpayer B enrolls in a noncredit photography class at a local community 
college. Because Taxpayer B is not taking the photography course as part 
of a degree program or to acquire or improve his job skills, amounts 
paid by Taxpayer B for the course are not qualified tuition and related 
expenses for purposes of the Lifetime Learning Credit.

    (d) Effective date. The Lifetime Learning Credit is applicable for 
qualified tuition and related expenses paid after June 30, 1998, for 
education furnished in academic periods beginning after June 30, 1998.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002]



Sec. 1.25A-5  Special rules relating to characterization and 
timing of payments.

    (a) Educational expenses paid by claimed dependent. For any taxable 
year for which the student is a claimed dependent of another taxpayer, 
qualified tuition and related expenses paid by the student are treated 
as paid by the taxpayer to whom the deduction under section 151 is 
allowed.
    (b) Educational expenses paid by a third party--(1) In general. 
Solely for purposes of section 25A, if a third party (someone other than 
the taxpayer, the taxpayer's spouse if the taxpayer is treated as 
married within the meaning of section 7703, or a claimed dependent) 
makes a payment directly to an eligible educational institution to pay 
for a student's qualified tuition and related expenses, the student is 
treated as receiving the payment from the third party and, in turn, 
paying the qualified tuition and related expenses to the institution.
    (2) Special rule for tuition reduction included in gross income of 
employee. Solely for purposes of section 25A, if an eligible educational 
institution provides a reduction in tuition to an employee of the 
institution (or to the spouse or dependent child of an employee, as 
described in section 132(h)(2)) and the amount of the tuition reduction 
is included in the employee's gross income, the employee is treated as 
receiving payment of an amount equal to the tuition reduction and, in 
turn, paying such amount to the institution.

[[Page 94]]

    (3) Examples. The following examples illustrate the rules of this 
paragraph (b). In each example, assume that all the requirements to 
claim an education tax credit are met. The examples are as follows:

    Example 1. Grandparent D makes a direct payment to an eligible 
educational institution for Student E's qualified tuition and related 
expenses. Student E is not a claimed dependent in 1999. For purposes of 
claiming an education tax credit, Student E is treated as receiving the 
money from her grandparent and, in turn, paying her qualified tuition 
and related expenses.
    Example 2. Under a court-approved divorce decree, Parent A is 
required to pay Student C's college tuition. Parent A makes a direct 
payment to an eligible educational institution for Student C's 1999 
tuition. Under paragraph (b)(1) of this section, Student C is treated as 
receiving the money from Parent A and, in turn, paying the qualified 
tuition and related expenses. Under the divorce decree, Parent B has 
custody of Student C for 1999. Parent B properly claims Student C as a 
dependent on Parent B's 1999 federal income tax return. Under paragraph 
(a) of this section, expenses paid by Student C are treated as paid by 
Parent B. Thus, Parent B may claim an education tax credit for the 
qualified tuition and related expenses paid directly to the institution 
by Parent A.
    Example 3. University A, an eligible educational institution, offers 
reduced tuition charges to its employees and their dependent children. F 
is an employee of University A. F's dependent child, G, enrolls in a 
graduate-level course at University A. Section 117(d) does not apply, 
because it is limited to tuition reductions provided for education below 
the graduate level. Therefore, the amount of the tuition reduction 
received by G is treated as additional compensation from University A to 
F and is included in F's gross income. For purposes of claiming a 
Lifetime Learning Credit, F is treated as receiving payment of an amount 
equal to the tuition reduction from University A and, in turn, paying 
such amount to University A on behalf of F's child, G.

    (c) Adjustment to qualified tuition and related expenses for certain 
excludable educational assistance--(1) In general. In determining the 
amount of an education tax credit, qualified tuition and related 
expenses for any academic period must be reduced by the amount of any 
tax-free educational assistance allocable to such period. For this 
purpose, tax-free educational assistance means--
    (i) A qualified scholarship that is excludable from income under 
section 117;
    (ii) A veterans' or member of the armed forces' educational 
assistance allowance under chapter 30, 31, 32, 34 or 35 of title 38, 
United States Code, or under chapter 1606 of title 10, United States 
Code;
    (iii) Employer-provided educational assistance that is excludable 
from income under section 127; or
    (iv) Any other educational assistance that is excludable from gross 
income (other than as a gift, bequest, devise, or inheritance within the 
meaning of section 102(a)).
    (2) No adjustment for excludable educational assistance attributable 
to expenses paid in a prior year. A reduction is not required under 
paragraph (c)(1) of this section if the amount of excludable educational 
assistance received during the taxable year is treated as a refund of 
qualified tuition and related expenses paid in a prior taxable year. See 
paragraph (f)(5) of this section.
    (3) Scholarships and fellowship grants. For purposes of paragraph 
(c)(1)(i) of this section, a scholarship or fellowship grant is treated 
as a qualified scholarship excludable under section 117 except to the 
extent--
    (i) The scholarship or fellowship grant (or any portion thereof) may 
be applied, by its terms, to expenses other than qualified tuition and 
related expenses within the meaning of section 117(b)(2) (such as room 
and board) and the student reports the grant (or the appropriate portion 
thereof) as income on the student's federal income tax return if the 
student is required to file a return; or
    (ii) The scholarship or fellowship grant (or any portion thereof) 
must be applied, by its terms, to expenses other than qualified tuition 
and related expenses within the meaning of section 117(b)(2) (such as 
room and board) and the student reports the grant (or the appropriate 
portion thereof) as income on the student's federal income tax return if 
the student is required to file a return.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (c). In each example, assume that all the requirements to 
claim an education

[[Page 95]]

tax credit are met. The examples are as follows:

    Example 1. University X charges Student A, who lives on University 
X's campus, $3,000 for tuition and $5,000 for room and board. University 
X awards Student A a $2,000 scholarship. The terms of the scholarship 
permit it to be used to pay any of a student's costs of attendance at 
University X, including tuition, room and board, and other incidental 
expenses. University X applies the $2,000 scholarship against Student 
A's $8,000 total bill, and Student A pays the $6,000 balance of her bill 
from University X with a combination of savings and amounts she earns 
from a summer job. University X does not require A to pay any additional 
fees beyond the $3,000 in tuition in order to enroll in or attend 
classes. Student A does not report any portion of the scholarship as 
income on her federal income tax return. Since Student A does not report 
the scholarship as income, the scholarship is treated under paragraph 
(c)(3) of this section as a qualified scholarship that is excludable 
under section 117. Therefore, for purposes of calculating an education 
tax credit, Student A is treated as having paid only $1,000 ($3,000 
tuition-$2,000 scholarship) in qualified tuition and related expenses to 
University X.
    Example 2. The facts are the same as in Example 1, except that 
Student A reports the entire scholarship as income on the student's 
federal income tax return. Since the full amount of the scholarship may 
be applied to expenses other than qualified expenses (room and board) 
and Student A reports the scholarship as income, the exception in 
paragraph (c)(3) of this section applies and the scholarship is not 
treated as a qualified scholarship excludable under section 117. 
Therefore, for purposes of calculating an education tax credit, Student 
A is treated as having paid $3,000 of qualified tuition and related 
expenses to University X.
    Example 3. The facts are the same as in Example 1, except that the 
terms of the scholarship require it to be used to pay tuition. Under 
paragraph (c)(3) of this section, the scholarship is treated as a 
qualified scholarship excludable under section 117. Therefore, for 
purposes of calculating an education tax credit, Student A is treated as 
having paid only $1,000 ($3,000 tuition-$2,000 scholarship) in qualified 
tuition and related expenses to University X.
    Example 4. The facts are the same as in Example 1, except that the 
terms of the scholarship require it to be used to pay tuition or room 
and board charged by University X, and the scholarship amount is $6,000. 
Under the terms of the scholarship, Student A may allocate the 
scholarship between tuition and room and board in any manner. However, 
because room and board totals $5,000, that is the maximum amount that 
can be applied under the terms of the scholarship to expenses other than 
qualified expenses and at least $1,000 of the scholarship must be 
applied to tuition. Therefore, the maximum amount of the exception under 
paragraph (c)(3) of this section is $5,000 and at least $1,000 is 
treated as a qualified scholarship excludable under section 117 ($6,000 
scholarship-$5,000 room and board). If Student A reports $5,000 of the 
scholarship as income on the student's federal income tax return, then 
Student A will be treated as having paid $2,000 ($3,000 tuition-$1,000 
qualified scholarship excludable under section 117) in qualified tuition 
and related expenses to University X.
    Example 5. The facts are the same as in Example 1, except that in 
addition to the scholarship that University X awards to Student A, 
University X also provides Student A with an education loan and pays 
Student A for working in a work/study job in the campus dining hall. The 
loan is not excludable educational assistance within the meaning of 
paragraph (c) of this section. In addition, wages paid to a student who 
is performing services for the payor are neither a qualified scholarship 
nor otherwise excludable from gross income. Therefore, Student A is not 
required to reduce her qualified tuition and related expenses by the 
amounts she receives from the student loan or as wages from her work/
study job.
    Example 6. In 1999, Student B pays University Y $1,000 in tuition 
for the 1999 Spring semester. University Y does not require Student B to 
pay any additional fees beyond the $1,000 in tuition in order to enroll 
in classes. Student B is an employee of Company Z. At the end of the 
academic period and during the same taxable year that Student B paid 
tuition to University Y, Student B provides Company Z with proof that he 
has satisfactorily completed his courses at University Y. Pursuant to an 
educational assistance program described in section 127(b), Company Z 
reimburses Student B for all of the tuition paid to University Y. 
Because the reimbursement from Company Z is employer-provided 
educational assistance that is excludable from Student B's gross income 
under section 127, the reimbursement reduces Student B's qualified 
tuition and related expenses. Therefore, for purposes of calculating an 
education tax credit, Student B is treated as having paid no qualified 
tuition and related expenses to University Y during 1999.

    Example 7. The facts are the same as in Example 6 except that the 
reimbursement from Company Z is not pursuant to an educational 
assistance program described in section 127(b), is not otherwise 
excludable from Student B's gross income, and is taxed as additional 
compensation to Student B. Because the reimbursement is not excludable 
educational assistance within the meaning of

[[Page 96]]

paragraph (c)(1) of this section, Student B is not required to reduce 
his qualified tuition and related expenses by the $1,000 reimbursement 
he received from his employer. Therefore, for purposes of calculating an 
education tax credit, Student B is treated as paying $1,000 in qualified 
tuition and related expenses to University Y during 1999.

    (d) No double benefit. Qualified tuition and related expenses do not 
include any expense for which a deduction is allowed under section 162, 
section 222, or any other provision of chapter 1 of the Internal Revenue 
Code.
    (e) Timing rules--(1) In general. Except as provided in paragraph 
(e)(2) of this section, an education tax credit is allowed only for 
payments of qualified tuition and related expenses for an academic 
period beginning in the same taxable year as the year the payment is 
made. Except for certain individuals who do not use the cash receipts 
and disbursements method of accounting, qualified tuition and related 
expenses are treated as paid in the year in which the expenses are 
actually paid. See Sec. 1.461-1(a)(1).
    (2) Prepayment rule--(i) In general. If qualified tuition and 
related expenses are paid during one taxable year for an academic period 
that begins during the first three months of the taxpayer's next taxable 
year (i.e., in January, February, or March of the next taxable year for 
calendar year taxpayers), an education tax credit is allowed with 
respect to the qualified tuition and related expenses only in the 
taxable year in which the expenses are paid.
    (ii) Example. The following example illustrates the rule of this 
paragraph (e)(2). In the example, assume that all the requirements to 
claim an education tax credit are met. The example is as follows:

    Example. In December 1998, Taxpayer A, a calendar year taxpayer, 
pays College Z $1,000 in qualified tuition and related expenses to 
attend classes during the 1999 Spring semester, which begins in January 
1999. Taxpayer A may claim an education tax credit only in 1998 for 
payments made in 1998 for the 1999 Spring semester.

    (3) Expenses paid with loan proceeds. An education tax credit may be 
claimed for qualified tuition and related expenses paid with the 
proceeds of a loan only in the taxable year in which the expenses are 
paid, and may not be claimed in the taxable year in which the loan is 
repaid. Loan proceeds disbursed directly to an eligible educational 
institution will be treated as paid on the date the institution credits 
the proceeds to the student's account. For example, in the case of any 
loan issued or guaranteed as part of a Federal student loan program 
under title IV of the Higher Education Act of 1965, loan proceeds will 
be treated as paid on the date of disbursement (as defined in 34 CFR 
668.164(a), revised as of July 1, 2002) by the eligible educational 
institution. If a taxpayer does not know the date the institution 
credits the student's account, the taxpayer must treat the qualified 
tuition and related expenses as paid on the last date for payment 
prescribed by the institution.
    (4) Expenses paid through third party installment payment plans--(i) 
In general. A taxpayer, an eligible educational institution, and a third 
party installment payment company may enter into an agreement in which 
the company agrees to collect installment payments of qualified tuition 
and related expenses from the taxpayer and to remit the installment 
payments to the institution. If the third party installment payment 
company is the taxpayer's agent for purposes of paying qualified tuition 
and related expenses to the eligible educational institution, the 
taxpayer is treated as paying the qualified expenses on the date the 
company pays the institution. However, if the third party installment 
payment company is the eligible educational institution's agent for 
purposes of collecting payments of qualified tuition and related 
expenses from the taxpayer, the taxpayer is treated as paying the 
qualified expenses on the date the taxpayer pays the company.
    (ii) Example. The following example illustrates the rule of this 
paragraph (e)(4). The example is as follows:

    Example. Student A, Company B, and College C enter into a written 
agreement in which Student A agrees to pay the tuition required to 
attend College C in 10 equal monthly installments to Company B. Under 
the written agreement, Student A is not relieved of her obligation to 
pay College C until Company B remits the payments to College C. Under 
the written agreement, Company B agrees to disburse the monthly 
installment payments to College C within 30

[[Page 97]]

days of receipt. Because Company B acts as Student A's agent for 
purposes of paying qualified expenses to College C, Student A is treated 
as paying qualified expenses on the date Company B disburses payments to 
College C.

    (f) Refund of qualified tuition and related expenses--(1) Payment 
and refund of qualified tuition and related expenses in the same taxable 
year. With respect to any student, the amount of qualified tuition and 
related expenses for a taxable year is calculated by adding all 
qualified tuition and related expenses paid for the taxable year, and 
subtracting any refund of such expenses received from the eligible 
educational institution during the same taxable year (including refunds 
of loan proceeds described in paragraph (f)(4) of this section).
    (2) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year before return filed for prior 
taxable year. If, in a taxable year, a taxpayer or someone other than 
the taxpayer receives a refund (including refunds of loan proceeds 
described in paragraph (f)(4) of this section) of qualified tuition and 
related expenses paid on behalf of a student in a prior taxable year and 
the refund is received before the taxpayer files a federal income tax 
return for the prior taxable year, the amount of the qualified tuition 
and related expenses for the prior taxable year is reduced by the amount 
of the refund.
    (3) Payment of qualified tuition and related expenses in one taxable 
year and refund in subsequent taxable year--(i) In general. If, in a 
taxable year (refund year), a taxpayer or someone other than the 
taxpayer receives a refund (including refunds of loan proceeds described 
in paragraph (f)(4) of this section) of qualified tuition and related 
expenses paid on behalf of a student for which the taxpayer claimed an 
education tax credit in a prior taxable year, the tax imposed by chapter 
1 of the Internal Revenue Code for the refund year is increased by the 
recapture amount.
    (ii) Recapture amount. The recapture amount is the difference in tax 
liability for the prior taxable year (taking into account any 
redetermination of such tax liability by audit or amended return) that 
results when the tax liability for the prior year is calculated using 
the taxpayer's redetermined credit. The redetermined credit is computed 
by reducing the amount of the qualified tuition and related expenses 
taken into account in determining any credit claimed in the prior 
taxable year by the amount of the refund of the qualified tuition and 
related expenses (redetermined qualified expenses), and computing the 
allowable credit using the redetermined qualified expenses and the 
relevant facts and circumstances of the prior taxable year, such as 
modified adjusted gross income (redetermined credit).
    (4) Refund of loan proceeds treated as refund of qualified tuition 
and related expenses. If loan proceeds used to pay qualified tuition and 
related expenses (as described in paragraph (e)(3) of this section) 
during a taxable year are refunded by an eligible educational 
institution to a lender on behalf of the borrower, the refund is treated 
as a refund of qualified tuition and related expenses for purposes of 
paragraphs (f)(1), (2), and (3) of this section.
    (5) Excludable educational assistance received in a subsequent 
taxable year treated as a refund. If, in a taxable year, a taxpayer or 
someone other than the taxpayer receives any excludable educational 
assistance (described in paragraph (c)(1) of this section) for the 
qualified tuition and related expenses paid on behalf of a student 
during a prior taxable year (or attributable to enrollment at an 
eligible educational institution during a prior taxable year), the 
educational assistance is treated as a refund of qualified tuition and 
related expenses for purposes of paragraphs (f)(2) and (3) of this 
section. If the excludable educational assistance is received before the 
taxpayer files a federal income tax return for the prior taxable year, 
the amount of the qualified tuition and related expenses for the prior 
taxable year is reduced by the amount of the excludable educational 
assistance as provided in paragraph (f)(2) of this section. If the 
excludable educational assistance is received after the taxpayer has 
filed a federal income tax return for the prior taxable year, any 
education tax credit claimed for the prior taxable year is

[[Page 98]]

subject to recapture as provided in paragraph (f)(3) of this section.
    (6) Examples. The following examples illustrate the rules of this 
paragraph (f). In each example, assume that all the requirements to 
claim an education tax credit are met. The examples are as follows:

    Example 1. In January 1998, Student A, a full-time freshman at 
University X, pays $2,000 for qualified tuition and related expenses for 
a 16-hour work load for the 1998 Spring semester. Prior to beginning 
classes, Student A withdraws from 6 course hours. On February 15, 1998, 
Student A receives a $750 refund from University X. In September 1998, 
Student A pays University X $1,000 to enroll half-time for the 1998 Fall 
semester. Prior to beginning classes, Student A withdraws from a 2-hour 
course, and she receives a $250 refund in October 1998. Student A 
computes the amount of qualified tuition and related expenses she may 
claim for 1998 by:
    (i) Adding all qualified expenses paid during the taxable year 
($2,000 + 1,000 = $3,000);
    (ii) Adding all refunds of qualified tuition and related expenses 
received during the taxable year ($750 + $250 = $1,000); and, then
    (iii) Subtracting paragraph (ii) of this Example 1 from paragraph 
(i) of this Example 1 ($3,000 -$1,000 = $2,000). Therefore, Student A's 
qualified tuition and related expenses for 1998 are $2,000.
    Example 2. (i) In December 1998, Student B, a senior at College Y, 
pays $2,000 for qualified tuition and related expenses for a 16-hour 
work load for the 1999 Spring semester. Prior to beginning classes, 
Student B withdraws from a 4-hour course. On January 15, 1999, Student B 
files her 1998 income tax return and claims a $400 Lifetime Learning 
Credit for the $2,000 qualified expenses paid in 1998, which reduces her 
tax liability for 1998 by $400. On February 15, 1999, Student B receives 
a $500 refund from College Y.
    (ii) Student B calculates the increase in tax for 1999 by--
    (A) Calculating the redetermined qualified expenses for 1998 ($2,000 
- $500 = $1,500);
    (B) Calculating the redetermined credit for the redetermined 
qualified expenses ($1,500  x  .20 = $300); and
    (C) Calculating the difference in tax liability for 1998 resulting 
from the redetermined credit. Because Student B's tax liability for 1998 
was reduced by the full amount of the $400 education tax credit claimed 
on her 1998 income tax return, the difference in tax liability can be 
determined by subtracting the redetermined credit from the credit 
claimed in 1998 ($400-$300 = $100).
    (iii) Therefore, Student B must increase the tax on her 1999 federal 
income tax return by $100.
    Example 3. In September 1998, Student C pays College Z $1,200 in 
qualified tuition and related expenses to attend evening classes during 
the 1998 Fall semester. Student C is an employee of Company R. On 
January 15, 1999, Student C files a federal income tax return for 1998 
claiming a Lifetime Learning Credit of $240 (.20  x  $1,200), which 
reduces Student C's tax liability for 1998 by $240. Pursuant to an 
educational assistance program described in section 127(b), Company R 
reimburses Student C in February 1999 for the $1,200 of qualified 
tuition and related expenses paid by Student C in 1998. The $240 
education tax credit claimed by Student C for 1998 is subject to 
recapture. Because Student C paid no net qualified tuition and related 
expenses for 1998, the redetermined credit for 1998 is zero. Student C 
must increase the amount of Student C's 1999 tax by the recapture 
amount, which is $240 (the difference in tax liability for 1998 
resulting from the redetermined credit for 1998 ($0)). Because the 
$1,200 reimbursement relates to expenses for which the taxpayer claimed 
an education tax credit in a prior year, the reimbursement does not 
reduce the amount of any qualified tuition and related expenses that 
Student C paid in 1999.

[T.D. 9034, 67 FR 78691, Dec. 26, 2002; 68 FR 15940, Apr. 2, 2003]



Sec. 1.28-0  Credit for clinical testing expenses for certain drugs 
for rare diseases or conditions; table of contents.

    In order to facilitate use of Sec. 1.28-1, this section lists the 
paragraphs, subparagraphs, and subdivisions contained in Sec. 1.28-1.

    (a) General rule.
    (b) Qualified clinical testing expenses.
    (1) In general.
    (2) Modification of section 41(b).
    (3) Exclusion for amounts funded by another person.
    (i) In general.
    (ii) Clinical testing in which taxpayer retains no rights.
    (iii) Clinical testing in which taxpayer retains substantial rights.
    (A) In general.
    (B) Drug by drug determination.
    (iv) Funding for qualified clinical testing expenses determinable 
only in subsequent taxable years.
    (4) Special rule governing the application of section 41(b) beyond 
its expiration date.
    (c) Clinical testing.
    (1) In general.
    (2) Definition of ``human clinical testing''.
    (3) Definition of ``carried out under'' section 505(i).
    (d) Definition and special rules.

[[Page 99]]

    (1) Definition of ``rare disease or condition''.
    (i) In general.
    (ii) Cost of developing and making available the designated drug.
    (A) In general.
    (B) Exclusion of costs funded by another person.
    (C) Computation of cost.
    (D) Allocation of common costs. Costs for developing and making 
available the designated drug for both the disease or condition for 
which it is designated and one or more other diseases or conditions.
    (iii) Recovery from sales.
    (iv) Recordkeeping requirements.
    (2) Tax liability limitation.
    (i) Taxable years beginning after December 31, 1986.
    (ii) Taxable years beginning before January 1, 1987, and after 
December 31, 1983.
    (iii) Taxable years beginning before January 1, 1984.
    (3) Special limitations on foreign testing.
    (i) Clinical testing conducted outside the United States--In 
general.
    (ii) Insufficient testing population in the United States.
    (A) In general.
    (B) ``Insufficient testing population''.
    (C) ``Unrelated to the taxpayer''.
    (4) Special limitations for certain corporations.
    (i) Corporations to which section 936 applies.
    (ii) Corporations to which section 934(b) applies.
    (5) Aggregation of expenditures.
    (i) Controlled group of corporations: organizations under common 
control.
    (A) In general.
    (B) Definition of controlled group of corporations.
    (C) Definition of organization.
    (D) Determination of common control.
    (ii) Tax accounting periods used.
    (A) In general.
    (B) Special rule where the timing of clinical testing is 
manipulated.
    (iii) Membership during taxable year in more than one group.
    (iv) Intra-group transactions.
    (A) In general.
    (B) In-house research expenses.
    (C) Contract research expenses.
    (D) Lease payments.
    (E) Payments for supplies.
    (6) Allocations.
    (i) Pass-through in the case of an S corporation
    (ii) Pass-through in the case of an estate or a trust.
    (iii) Pass-through in the case of a partnership.
    (A) In general.
    (B) Certain partnership non-business expenditures.
    (C) Apportionment.
    (iv) Year in which taken into account.
    (v) Credit allowed subject to limitation.
    (7) Manner of making an election.

[T.D. 8232, 53 FR 38710, Oct. 3, 1988; 53 FR 40879, Oct. 19, 1988]



Sec. 1.28-1  Credit for clinical testing expenses for certain drugs 
for rare diseases or conditions.

    (a) General rule. Section 28 provides a credit against the tax 
imposed by chapter 1 of the Internal Revenue Code. The amount of the 
credit is equal to 50 percent of the qualified clinical testing expenses 
(as defined in paragraph (b) of this section) for the taxable year. The 
credit applies to qualified clinical testing expenses paid or incurred 
by the taxpayer after December 31, 1982, and before January 1, 1991. The 
credit may not exceed the taxpayer's tax liability for the taxable year 
(as determined under paragraph (d)(2) of this section).
    (b) Qualified clinical testing expenses--(1) In general. Except as 
otherwise provided in paragraph (b)(3) of this section, the term 
``qualified clinical testing expenses'' means the amounts which are paid 
or incurred during the taxable year which would constitute ``qualified 
research expenses'' within the meaning of section 41(b) (relating to the 
credit for increasing research activities) as modified by section 
28(b)(1)(B) and paragraph (b)(2) of this section. For example, amounts 
paid or incurred for the acquisition of depreciable property used in the 
conduct of clinical testing (as defined in paragraph (c) of this 
section) are not qualified clinical testing expenses.
    (2) Modification of section 41(b). For purposes of paragraph (b)(1) 
of this section, section 41(b) is modified by substituting ``clinical 
testing'' for ``qualified research'' each place it appears in paragraph 
(2) of section 41(b) (relating to in-house research expenses) and 
paragraph (3) of section 41(b) (relating to contract research expenses). 
In addition, ``100 percent'' is substituted for ``65 percent'' in 
paragraph (3)(A) of section 41(b).
    (3) Exclusion for amounts funded by another person--(i) In general. 
The term ``qualified clinical testing expenses'' shall not include any 
amount which would otherwise constitute qualified clinical testing 
expenses, to the extent

[[Page 100]]

such amount is funded by a grant, contract, or otherwise by another 
person (or any governmental entity). The determination of the extent to 
which an amount is funded shall be made in light of all the facts and 
circumstances. For a special rule regarding funding between commonly 
controlled businesses, see paragraph (d)(5)(iv) of Sec. 1.28-1.
    (ii) Clinical testing in which taxpayer retains no rights. If a 
taxpayer conducting clinical testing with respect to the designated drug 
for another person retains no substantial rights in the clinical testing 
under the agreement providing for the clinical testing the taxpayer's 
clinical testing expenses are treated as fully funded for purposes of 
section 28(b)(1)(C). Thus, for example, if the taxpayer incurs clinical 
testing expenses under an agreement that confers on another person the 
exclusive right to exploit the results of the clinical testing, those 
expenses do not constitute qualified clinical testing expenses because 
they are fully funded under this paragraph (b)(3)(ii). Incidental 
benefits to the taxpayer from the conduct of the clinical testing (for 
example, increased experience in the field of human clinical testing) do 
not constitute substantial rights in the clinical testing.
    (iii) Clinical testing in which taxpayer retains substantial 
rights--(A) In general. If a taxpayer conducting clinical testing with 
respect to the designated drug for another person retains substantial 
rights in the clinical testing under the agreement providing for the 
clinical testing, the clinical testing expenses are funded to the extent 
of the payments (and fair market value of any property at the time of 
transfer) to which the taxpayer becomes entitled by conducting the 
clinical testing. The taxpayer shall reduce the amount paid or incurred 
by the taxpayer for the clinical testing expenses that would, but for 
section 28(b)(1)(C) constitute qualified clinical testing expenses of 
the taxpayer by the amount of the funding determined under the preceding 
sentence. Rights retained in the clinical testing are not treated as 
property for purposes of this paragraph (b)(3)(iii)(A). If the property 
that is transferred to the taxpayer is to be consumed in the clinical 
testing (for example, supplies), the taxpayer should exclude the value 
of that property from both the payments received and the expenses paid 
or incurred for the clinical testing.
    (B) Drug by drug determination. The provisions of this paragraph 
(b)(3) shall be applied separately to each designated drug tested by the 
taxpayer.
    (iv) Funding for qualified clinical testing expenses determinable 
only in subsequent taxable years. If, at the time the taxpayer files its 
return for a taxable year, it is impossible to determine to what extent 
some or all of the qualified clinical testing expenses may be funded, 
the taxpayer shall treat the clinical testing expenses as fully funded 
for purposes of that return. When the amount of funding for qualified 
clinical testing expenses is finally determined, the taxpayer should 
amend the return and any interim returns to reflect the amount of 
funding for qualified clinical testing expenses.
    (4) Special rule governing the application of section 41(b) beyond 
its expiration date. For purposes of section 28 and this section, 
section 41(b), as amended, and the regulations thereunder shall be 
deemed to remain in effect after December 31, 1988.
    (c) Clinical testing--(1) In general. The term ``clinical testing'' 
means any human clinical testing which--
    (i) Is carried out under an exemption under section 505(i) of the 
Federal Food, Drug, and Cosmetic Act (21 U.S.C. 355(i)) and the 
regulations relating thereto (21 CFR part 312) for the purpose of 
testing a drug for a rare disease or condition as defined in paragraph 
(d)(1) of this section,
    (ii) Occurs after the date the drug is designated as a drug for a 
rare disease or condition under section 526 of the Federal Food, Drug, 
and Cosmetic Act (21 U.S.C. 360bb),
    (iii) Occurs before the date on which an application for the 
designated drug is approved under section 505(b) of the Federal Food, 
Drug, and Cosmetic Act (21 U.S.C. 355(b)) or, if the drug is a 
biological product (other than a radioactive biological product intended 
for human use), before the date on which a license for such drug is 
issued under section 351 of the Public Health Services Act (42 U.S.C. 
262), and

[[Page 101]]

    (iv) Is conducted by or on behalf of the taxpayer to whom the 
designation under section 526 of the Federal Food, Drug, and Cosmetic 
Act applies.

Human clinical testing shall be taken into account under this paragraph 
(c)(1) only to the extent that the testing relates to the use of a drug 
for the rare disease or condition for which the drug was designated 
under section 526 of the Federal Food, Drug, and Cosmetic Act. For 
purposes of paragraph (c)(1)(i) of this section the testing under 
section 505(i) exemption procedures (21 CFR part 312) of a biological 
product (other than a radioactive biological product intended for human 
use) pursuant to 21 CFR Sec. 601.21 is deemed to be carried out under an 
exemption under section 505(i) of the Federal Food, Drug, and Cosmetic 
Act.
    (2) Definition of ``human clinical testing.'' Testing is considered 
to be human clinical testing only to the extent that it uses human 
subjects to determine the effect of the designated drug on humans and is 
necessary for the designated drug either to be approved under section 
505(b) of the Federal Food, Drug, and Cosmetic Act and the regulations 
thereunder (21 CFR part 314), or if the designated drug is a biological 
product (other than a radioactive biological product intended for human 
use), to be licensed under section 351 of the Public Health Services Act 
and the regulations thereunder (21 CFR part 601). For purposes of this 
paragraph (c)(2), a human subject is an individual who is a participant 
in research, either as a recipient of the drug or as a control. A 
subject may be either a healthy individual or a patient.
    (3) Definition of ``carried out under'' section 505(i). Human 
clinical testing is not carried out under section 505(i) of the Federal 
Food, Drug, and Cosmetic Act and the regulations thereunder (21 CFR part 
312) unless the primary purpose of the human clinical testing is to 
ascertain the data necessary to qualify the designated drug for sale in 
the United States, and not to ascertain data unrelated or only 
incidentally related to that needed to qualify the designated drug. 
Whether or not this primary purpose test is met shall be determined in 
light of all of the facts and circumstances.
    (d) Definition and special rules--(1) Definition of ``rare disease 
or condition''--(i) In general. The term ``rare disease or condition'' 
means any disease or condition which--
    (A) Afflicts 200,000 or fewer persons in the United States, or
    (B) Afflicts more than 200,000 persons in the United States but for 
which there is no reasonable expectation that the cost of developing and 
making available in the United States (as defined in section 7701(a)(9)) 
a drug for such disease or condition will be recovered from sales in the 
United States (as so defined) of such drug.

Determinations under paragraph (d)(1)(i)(B) of this section with respect 
to any drug shall be made on the basis of the facts and circumstances as 
of the date such drug is designated under section 526 of the Federal 
Food, Drug, and Cosmetic Act. Examples of diseases or conditions which 
in 1987 afflicted 200,000 or fewer persons in the United States are 
Duchenne dystrophy, one of the muscular dystrophies; Huntington's 
disease, a hereditary chorea; myoclonus; Tourette's syndrome; and 
amyotrophic lateral sclerosis (ALS or Lou Gehrig's disease).
    (ii) Cost of developing and making available the designated drug--
(A) In general. Except as otherwise provided in this paragraph 
(d)(1)(ii), the taxpayer's computation of the cost of developing and 
making available in the United States the designated drug shall include 
only the costs that the taxpayer (or any person whose right to make 
sales of the drug is directly or indirectly derived from the taxpayer, 
e.g., a licensee or transferee) has incurred or reasonably expects to 
incur in developing and making available in the United States the 
designated drug for the disease or condition for which it is designated. 
For example, if, prior to designation under section 526, the taxpayer 
incurred costs of $125,000 to test the drug for the rare disease or 
condition for which it is subsequently designated and incurred $500,000 
to test the same drug for other diseases, and if, on the date of 
designation, the taxpayer expects to incur costs of $1.2 million to test 
the drug for the rare disease or condition for which it is designated, 
the taxpayer shall include in

[[Page 102]]

its cost computation both the $125,000 incurred prior to designation and 
the $1.2 million expected to be incurred after designation to test the 
drug for the rare disease or condition for which it is designated. The 
taxpayer shall not include the $500,000 incurred to test the drug for 
other diseases.
    (B) Exclusion of costs funded by another person. In computing the 
cost of developing and making available in the United States the 
designated drug, the taxpayer shall not include any cost incurred or 
expected to be incurred by the taxpayer to the extent that the cost is 
funded or is reasonably expected to be funded (determined under the 
principles of paragraph (b)(3)) by a grant, contract, or otherwise by 
another person (or any governmental entity).
    (C) Computation of cost. The cost computation shall use only 
reasonable costs incurred after the first indication of an orphan 
application for the designated drug. Such costs shall include the costs 
of obtaining data needed, and of meetings to be held, in connection with 
a request for FDA assistance under section 525 of the Federal, Food, 
Drug, and Cosmetic Act (21 U.S.C. 360aa) or a request for orphan 
designation under section 526 of that Act; costs of determining 
patentability of the drug; costs of screening, animal and clinical 
studies; costs associated with preparation of a Notice of Claimed 
Investigational Exemption for a New Drug (IND) and a New Drug 
Application (NDA); costs of possible distribution of drug under a 
``treatment'' protocol; costs of development of a dosage form; 
manufacturing costs; distribution costs; promotion costs; costs to 
maintain required records and reports; and costs of the taxpayer in 
acquiring the right to market a drug from the owner of that right prior 
to designation. The taxpayer shall also include general overhead, 
depreciation costs and premiums for insurance against liability losses 
to the extent that the taxpayer can demonstrate that these costs are 
properly allocable to the designated drug under the established 
standards of financial accounting and reporting of research and 
development costs.
    (D) Allocation of common costs. Costs for developing and making 
available the designated drug for both the disease or condition for 
which it is designated and one or more other diseases or conditions. In 
the case where the costs incurred or expected to be incurred in 
developing and making available the designated drug for the disease or 
condition for which it is designated are also incurred or expected to be 
incurred in developing and making available in the United States the 
same drug for one or more other diseases or conditions (whether or not 
they are also designated or expected to be designated), the costs shall 
be allocated between the cost of developing and making available the 
designated drug for the disease or condition for which the drug is 
designated and the cost of developing and making available the 
designated drug for the other diseases or conditions. The amount of the 
common costs to be allocated to the cost of developing and making 
available the designated drug for the disease or condition for which it 
is designated is determined by multiplying the common costs by a 
fraction the numerator of which is the sum of the expected amount of 
sales in the United States of the designated drug for the disease or 
condition for which the drug is designated and the denominator of which 
is the total expected amount of sales in the United States of the 
designated drug. For example, if prior to designation, the taxpayer 
incurs (among other costs) costs of $100,000 in testing the designated 
drug for its toxic effect on animals (without reference to any disease 
or condition), and if the taxpayer expects to recover $500,000 from 
sales in the United States of the designated drug for disease X, the 
disease for which the drug is designated, and further expects to recover 
another $1.5 million from the sales in the United States of the 
designated drug for disease Y, the taxpayer must allocate a 
proportionate amount of the common costs of $100,000 to the cost of 
developing and making available the designated drug for both disease X 
and disease Y. Since the ratio of the expected amount of sales in the 
United States of the designated drug for disease X to the total of both 
the expected amount

[[Page 103]]

of sales in the United States of the designated drug for disease X and 
the expected amount of sales in the United States of the designated drug 
for disease Y is $500,000/$2,000,000, 25% of the common costs of 
$100,000 (i.e., $25,000) is allocated to the cost of developing and 
making available the designated drug for disease X.
    (iii) Recovery from sales. In determining whether the taxpayer's 
cost described in paragraph (d)(1)(ii) of this section will be recovered 
from sales in the United States of the designated drug for the disease 
or condition for which the drug is designated, the taxpayer shall 
include anticipated sales by the taxpayer or any person whose right to 
make such sales is directly or indirectly derived from the taxpayer 
(such as a licensee or transferee). The anticipated sales shall be based 
upon the size of the anticipated patient population for which the 
designated drug would be useful, including the following factors: the 
degree of effectiveness and safety of the designated drug, if known: the 
projected fraction of the anticipated patient population expected to be 
given the designated drug and to continue to take it; other available 
agents and other types of therapy; the likelihood that superior agents 
will become available within a few years; and the number of years during 
which the designated drug would be exclusively available, e.g., under a 
patent.
    (iv) Recordkeeping requirements. The taxpayer shall keep records 
sufficient to substantiate the cost and sales estimates made pursuant to 
this paragraph (d)(1). The records required by this paragraph (d)(1)(iv) 
shall be retained so long as the contents thereof may become material in 
the administration of section 28.
    (2) Tax liability limitation--(i) Taxable years beginning after 
December 31, 1986. The credit allowed by section 28 shall not exceed the 
excess (if any) of--
    (A) The taxpayer's regular tax liability for the taxable year (as 
defined in section 26(b)), reduced by the sum of the credits allowable 
under--
    (1) Section 21 (relating to expenses for household and dependent 
care services necessary for gainful employment),
    (2) Section 22 (relating to the elderly and permanently and totally 
disabled),
    (3) Section 23 (relating to residential energy),
    (4) Section 25 (relating to interest on certain home mortgages), and
    (5) Section 27 (relating to taxes on foreign countries and 
possessions of the United States), over
    (B) The tentative minimum tax for the taxable year (as determined 
under section 55(b)(1)).
    (ii) Taxable years beginning before January 1, 1987, and after 
December 31, 1983. The credit allowed by section 28 shall not exceed the 
taxpayer's tax liability for the taxable year (as defined in section 26 
(b) prior to its amendment by the Tax Reform Act of 1986 (Pub. L. 99-
514)), reduced by the sum of the credits allowable under--
    (A) Section 21 (relating to expenses for household dependent care 
services necessary for gainful employment),
    (B) Section 22 (relating to the elderly and permanently and totally 
disabled),
    (C) Section 23 (relating to residential energy),
    (D) Section 24 (relating to contributions to candidates for public 
office),
    (E) Section 25 (relating to interest on certain home mortgages), and
    (F) Section 27 (relating to the taxes on foreign countries and 
possessions of the United States).
    (iii) Taxable years beginning before January 1, 1984. The credit 
allowed by section 28 shall not exceed the amount of the tax imposed by 
chapter 1 of the Internal Revenue Code for the taxable year, reduced by 
the sum of the credits allowable under the following sections as 
designated prior to the enactment of the Tax Reform Act of 1984 (Pub. 
Law 98-369):
    (A) Section 32 (relating to tax withheld at source on nonresident 
aliens and foreign corporations and on tax-free convenant bonds),
    (B) Sections 33 (relating to taxes of foreign countries and 
possessions of the United States),
    (C) Section 37 (relating to the retirement income),
    (D) Section 38 (relating to investment in certain depreciable 
property),
    (E) Section 40 (relating to expenses of work incentive programs).

[[Page 104]]

    (F) Section 41 (relating to contributions to candidates for public 
office).
    (G) Section 44 (relating to purchase of new principal residence).
    (H) Section 44A (relating to expenses for household and dependent 
care services necessary for gainful employment).
    (I) Section 44B (relating to employment of certain new employees).
    (J) Section 44C (relating to residential energy).
    (K) Section 44D (relating to producing fuel from a nonconventional 
source).
    (L) Section 44E (relating to alcohol used as fuel).
    (M) Section 44F (relating to increasing research activities), and
    (N) Section 44G (relating to employee stock ownership).

The term ``tax imposed by chapter 1'' as used in this paragraph 
(d)(2)(iii) does not include any tax treated as not imposed by chapter 1 
of the Internal Revenue Code under the last sentence of section 53(a).
    (3) Special limitations on foreign testing--(i) Clinical testing 
conducted outside of the United States--In general. Except as otherwise 
provided in this paragraph (d)(3), expenses paid or incurred with 
respect to clinical testing conducted outside the United States (as 
defined in section 7701(a)(9)) are not eligible for credit under this 
section. Thus, for example, wages paid an employee clinical investigator 
for clinical testing conducted in medical facilities in the United 
States and Mexico generally must be apportioned between the clinical 
testing conducted within the United States and the clinical testing 
conducted outside the United States, and only the wages apportioned to 
the clinical testing conducted within the United States are qualified 
clinical testing expenses.
    (ii) Insufficient testing population in the United States--(A) In 
general. If clinical testing is conducted outside of the United States 
because there is an insufficient testing population in the United 
States, and if the clinical testing is conducted by a United States 
person (as defined in section 7701(a)(30)) or is conducted by any other 
person unrelated to the taxpayer to whom the designation under section 
526 of the Federal Food, Drug, and Cosmetic Act applies, then the 
expenses paid or incurred for clinical testing conducted outside of the 
United States are eligible for the credit provided by section 28.
    (B) ``Insufficient testing population.'' The testing population in 
the United States is insufficient if there are not within the United 
States the number of available and appropriate human subjects needed to 
produce reliable data from the clinical investigation.
    (C) ``Unrelated to the taxpayer.'' For the purpose of determining 
whether a person is unrelated to the taxpayer to whom the designation 
under section 526 of the Federal Food, Drug, and Cosmetic Act and the 
regulations thereunder applies, the rules of section 613A(d)(3) shall 
apply except that the number ``5'' in section 613A(d)(3) (A), (B), and 
(C) shall be deleted and the number ``10'' inserted in lieu thereof.
    (4) Special limitations for certain corporations--(i) Corporations 
to which section 936 applies. Expenses paid or incurred for clinical 
testing conducted either inside or outside the United States by a 
corporation to which section 936 (relating to Puerto Rico and 
possessions tax credit) applies are not eligible for the credit under 
section 28.
    (ii) Corporations to which section 934(b) applies. For taxable years 
beginning before January 1, 1987, expenses paid or incurred for clinical 
testing conducted either inside or outside the United States by a 
corporation to which section 934(b) (relating to the limitation on 
reduction in income tax liability incurred to the Virgin Islands), as in 
effect prior to its amendment by the Tax Reform Act of 1986, applies are 
not eligible for the credit under section 28. For taxable years 
beginning after December 31, 1986, see section 1277(c)(1) of the Tax 
Reform Act of 1986 (100 Stat. 2600) which makes the rule set forth in 
the preceding sentence inapplicable with respect to corporations created 
or organized in the Virgin Islands only if (and so long as) an 
implementing agreement described in that section is in effect between 
the United States and the Virgin Islands.
    (5) Aggregation of expenditures--(i) Controlled group of 
corporations; organizations under common control--(A) In

[[Page 105]]

general. In determining the amount of the credit allowable with respect 
to an organization that at the end of its taxable year is a member of a 
controlled group of corporations or a member of a group of organizations 
under common control, all members of the group are treated as a single 
taxpayer and the credit (if any) allowable to the member is determined 
on the basis of its proportionate share of the qualified clinical 
testing expenses of the aggregated group.
    (B) Definition of controlled group of corporations. For purposes of 
this section, the term ``controlled group of corporations'' shall have 
the meaning given to the term by section 41(f)(5).
    (C) Definition of organization. For purposes of this section, an 
organization is a sole proprietorship, a partnership, a trust, an 
estate, or a corporation, that is carrying on a trade or business 
(within the meaning of section 162). For purposes of this section, any 
corporation that is a member of a commonly controlled group shall be 
deemed to be carrying on a trade or business if any other member of that 
group is carrying on any trade or business.
    (D) Determination of common control. Whether organizations are under 
common control shall be determined under the principles set forth in 
paragraphs (b) through (g) of 26 CFR 1.52-1.
    (ii) Tax accounting periods used--(A) In general. The credit 
allowable to a member of a controlled group of corporations or a group 
of organizations under common control is that member's share of the 
aggregate credit computed as of the end of such member's taxable year.
    (B) Special rule where the timing of clinical testing is 
manipulated. If the timing of clinical testing by members using 
different tax accounting periods is manipulated to generate a credit in 
excess of the amount that would be allowable if all members of the group 
used the same tax accounting period, the district director may require 
all members of the group to calculate the credit in the current taxable 
year and all future years by using the ``conformed years'' method. Each 
member computing a credit under the ``conformed years'' method shall 
compute the credit as if all members of the group had the same taxable 
year as the computing member.
    (iii) Membership during taxable year in more than one group. An 
organization may be a member of only one group for a taxable year. If, 
without application of this paragraph (d)(5)(iii), an organization would 
be a member of more than one group at the end of its taxable year, the 
organization shall be treated as a member of the group in which it was 
included for its preceding taxable year. If the organization was not 
included for its preceding taxable year in any group in which it could 
be included as of the end of its taxable year, the organization shall 
designate in its timely filed return the group in which it is being 
included. If the return for a taxable year is due before May 1, 1985, 
the organization may designate its group membership through an amended 
return for that year filed on or before April 30, 1985. If the 
organization does not so designate, then the district director with 
audit jurisdiction of the return will determine the group in which the 
business is to be included.
    (iv) Intra-group transactions--(A) In general. Because all members 
of a group under common control are treated as a single taxpayer for 
purposes of determining the credit, transactions between members of the 
group are generally disregarded.
    (B) In-house research expenses. If one member of a group conducts 
clinical testing on behalf of another member, the member conducting the 
clinical testing shall include in its qualified clinical testing 
expenses any in-house research expenses for that work and shall not 
treat any amount received or accrued from the other member as funding 
the clinical testing. Conversely, the member for whom the clinical 
testing is conducted shall not treat any part of any amount paid or 
incurred as a contract research expense. For purposes of determining 
whether the in-house research for that work is clinical testing, the 
member performing the clinical testing shall be treated as carrying on 
any trade or business carried on by the member on whose behalf the 
clinical testing is performed.

[[Page 106]]

    (C) Contract research expenses. If a member of a group pays or 
incurs contract research expenses to a person outside the group in 
carrying on the member's trade or business, that member shall include 
those expenses as qualified clinical testing expenses. However, if the 
expenses are not paid or incurred in carrying on any trade or business 
of that member, those expenses may be taken into account as contract 
research expenses by another member of the group provided that the other 
member--
    (1) Reimburses the member paying or incurring the expenses, and
    (2) Carries on a trade or business to which the clinical testing 
relates.
    (D) Lease payments. Amounts paid or incurred to another member of 
the group for the lease of personal property owned by a person outside 
the group shall be taken into account as in-house research expenses for 
purposes of section 28 only to the extent of the lesser of--
    (1) The amount paid or incurred to the other member, or
    (2) The amount of the lease expense paid to a person outside the 
group.
    The amount paid or incurred to another member of the group for the 
lease of personal property owned by a member of the group is not taken 
into account for purposes of section 28.
    (E) Payment for supplies. Amounts paid or incurred to another member 
of the group for supplies shall be taken into account as in-house 
research expenses for purposes of section 28 only to the extent of the 
lesser of--
    (1) The amount paid or incurred to the other member, or
    (2) The amount of the other member's basis in the supplies.
    (6) Allocations--(i) Pass-through in the case of an S corporation. 
In the case of an S corporation (as defined in section 1361), the amount 
of the credit for qualified clinical testing expenses computed for the 
corporation for any taxable year shall be allocated among the persons 
who are shareholders of the corporation during the taxable year 
according to the provisions of section 1366 and section 1377.
    (ii) Pass-through in the case of an estate or a trust. In the case 
of an estate or a trust, the amount of the credit for qualified clinical 
testing expenses computed for the estate or trust for any taxable year 
shall be apportioned between the estate or trust and the beneficiaries 
on the basis of the income of the estate or trust allocable to each.
    (iii) Pass-through in the case of a partnership--(A) In general. In 
the case of a partnership, the credit for qualified clinical testing 
expenses computed for the partnership for any taxable year shall be 
apportioned among the persons who are partners during the taxable year 
in accordance with section 704 and the regulations thereunder.
    (B) Certain partnership non-business expenditures. A partner's share 
of an in-house research expense or contract research expense paid or 
incurred by a partnership other than in carrying on a trade or business 
of the partnership constitutes a qualified clinical testing expense of 
the partner if--
    (1) The partner is entitled to make independent use of the result of 
the clinical testing, and
    (2) The clinical testing expense paid or incurred in carrying on the 
clinical testing would have been paid or incurred by the partner in 
carrying on a trade or business of the partner if the partner had 
carried on the clinical testing that was in fact carried on by the 
partnership.
    (C) Apportionment. Qualified clinical testing expenses to which 
paragraph (d)(6)(iii)(B) of this section applies shall be apportioned 
among the persons who are partners during the taxable year in accordance 
with section 704 and the regulations thereunder. For purposes of section 
28, these expenses shall be treated as paid or incurred directly by the 
partners rather than by the partnership. Thus, the partnership shall 
disregard these expenses in computing the credit to be apportioned under 
paragraph (d)(6)(iii)(A) of this section, and each partner shall 
aggregate the portion of these expenses allocated to the partner with 
other qualified clinical testing expenses of the partner in making the 
computations under section 28.
    (iv) Year in which taken into account. An amount apportioned to a 
person under paragraph (d)(6) of this section shall be taken into 
account by the person in the taxable year of such person

[[Page 107]]

in which or with which the taxable year of the corporation, estate, 
trust, or partnership (as the case may be) ends.
    (v) Credit allowed subject to limitation. Any person to whom any 
amount has been apportioned under paragraph (d)(6)(i), (ii), or (iii) of 
this section is allowed, subject to the limitation provided in section 
28(d)(2), a credit for that amount.
    (7) Manner of making an election. To make an election to have 
section 28 apply for its taxable year, the taxpayer shall file Form 6765 
(Credit for Increasing Research Activities (or for claiming the orphan 
drugs credit)) containing all the information required by that form.

[T.D. 8232, 53 FR 38711, Oct. 3, 1988; 53 FR 40879, Oct. 19, 1988; 53 FR 
41013, Oct. 19, 1988]

                           Credits Against Tax

             credits allowable under sections 30 through 45D



Sec. 1.30-1  Definition of qualified electric vehicle and recapture 
of credit for qualified electric vehicle.

    (a) Definition of qualified electric vehicle. A qualified electric 
vehicle is a motor vehicle that meets the requirements of section 30(c). 
Accordingly, a qualified electric vehicle does not include any motor 
vehicle that has ever been used (for either personal or business use) as 
a non-electric vehicle.
    (b) Recapture of credit for qualified electric vehicle--(1) In 
general--(i) Addition to tax. If a recapture event occurs with respect 
to a taxpayer's qualified electric vehicle, the taxpayer must add the 
recapture amount to the amount of tax due in the taxable year in which 
the recapture event occurs. The recapture amount is not treated as 
income tax imposed on the taxpayer by chapter 1 of the Internal Revenue 
Code for purposes of computing the alternative minimum tax or 
determining the amount of any other allowable credits for the taxable 
year in which the recapture event occurs.
    (ii) Reduction of carryover. If a recapture event occurs with 
respect to a taxpayer's qualified electric vehicle, and if a portion of 
the section 30 credit for the cost of that vehicle was disallowed under 
section 30(b)(3)(B) and consequently added to the taxpayer's minimum tax 
credit pursuant to section 53(d)(1)(B)(iii), the taxpayer must reduce 
its minimum tax credit carryover by an amount equal to the portion of 
any minimum tax credit carryover attributable to the disallowed section 
30 credit, multiplied by the recapture percentage for the taxable year 
of recapture. Similarly, the taxpayer must reduce any other credit 
carryover amounts (such as under section 469) by the portion of the 
carryover attributable to section 30, multiplied by the recapture 
percentage.
    (2) Recapture event--(i) In general. A recapture event occurs if, 
within 3 full years from the date a qualified electric vehicle is placed 
in service, the vehicle ceases to be a qualified electric vehicle. A 
vehicle ceases to be a qualified electric vehicle if--
    (A) The vehicle is modified so that it is no longer primarily 
powered by electricity;
    (B) The vehicle is used in a manner described in section 50(b); or
    (C) The taxpayer receiving the credit under section 30 sells or 
disposes of the vehicle and knows or has reason to know that the vehicle 
will be used in a manner described in paragraph (b)(2)(i)(A) or (B) of 
this section.
    (ii) Exception for disposition. Except as provided in paragraph 
(b)(2)(i)(C) of this section, a sale or other disposition (including a 
disposition by reason of an accident or other casualty) of a qualified 
electric vehicle is not a recapture event.
    (3) Recapture amount. The recapture amount is equal to the recapture 
percentage times the decrease in the credits allowed under section 30 
for all prior taxable years that would have resulted solely from 
reducing to zero the cost taken into account under section 30 with 
respect to such vehicle, including any credits allowed attributable to 
section 30 (such as under sections 53 and 469).
    (4) Recapture date. The recapture date is the actual date of the 
recapture event unless a recapture event described in paragraph 
(b)(2)(i)(B) of this section occurs, in which case the recapture date is 
the first day of the recapture year.

[[Page 108]]

    (5) Recapture percentage. For purposes of this section, the 
recapture percentage is--
    (i) 100, if the recapture date is within the first full year after 
the date the vehicle is placed in service;
    (ii) 66\2/3\, if the recapture date is within the second full year 
after the date the vehicle is placed in service; or
    (iii) 33\1/3\, if the recapture date is within the third full year 
after the date the vehicle is placed in service.
    (6) Basis adjustment. As of the first day of the taxable year in 
which the recapture event occurs, the basis of the qualified electric 
vehicle is increased by the recapture amount and the carryover 
reductions taken into account under paragraphs (b)(1)(i) and (ii) of 
this section, respectively. For a vehicle that is of a character that is 
subject to an allowance for depreciation, this increase in basis is 
recoverable over the remaining recovery period for the vehicle beginning 
as of the first day of the taxable year of recapture.
    (7) Application of section 1245 for sales and other dispositions. 
For purposes of section 1245, the amount of the credit allowable under 
section 30(a) with respect to any qualified electric vehicle that is (or 
has been) of a character subject to an allowance for depreciation is 
treated as a deduction allowed for depreciation under section 167. 
Therefore, upon a sale or other disposition of a depreciable qualified 
electric vehicle, section 1245 will apply to any gain recognized to the 
extent the basis of the depreciable vehicle was reduced under section 
30(d)(1) net of any basis increase described in paragraph (b)(6) of this 
section.
    (8) Examples. The following examples illustrate the provisions of 
this section:

    Example 1. A, a calendar-year taxpayer, purchases and places in 
service for personal use on January 1, 1995, a qualified electric 
vehicle costing $25,000. On A's 1995 federal income tax return, A claims 
a credit of $2,500. On January 2, 1996, A sells the vehicle to an 
unrelated third party who subsequently converts the vehicle into a non-
electric vehicle on October 15, 1996. There is no recapture upon the 
sale of the vehicle by A provided A did not know or have reason to know 
that the purchaser intended to convert the vehicle to non-electric use.
    Example 2. B, a calendar-year taxpayer, purchases and places in 
service for personal use on October 11, 1994, a qualified electric 
vehicle costing $20,000. On B's 1994 federal income tax return, B claims 
a credit of $2,000, which reduces B's tax by $2,000. The basis of the 
vehicle is reduced to $18,000 ($20,000-$2,000). On March 8, 1996, B 
sells the vehicle to a tax-exempt entity. Because B knowingly sold the 
vehicle to a tax-exempt entity described in section 50(b) in the second 
full year from the date the vehicle was placed in service, B must 
recapture $1,333 ($2,000  x  66\2/3\ percent). This recapture amount 
increases B's tax by $1,333 on B's 1996 federal income tax return and is 
added to the basis of the vehicle as of January 1, 1996, the beginning 
of the taxable year in which the recapture event occurred.
    Example 3. X, a calendar-year taxpayer, purchases and places in 
service for business use on January 1, 1994, a qualified electric 
vehicle costing $30,000. On X's 1994 federal income tax return, X claims 
a credit of $3,000, which reduces X's tax by $3,000. The basis of the 
vehicle is reduced to $27,000 ($30,000-$3,000) prior to any adjustments 
for depreciation. On March 8, 1995, X converts the qualified electric 
vehicle into a gasoline-propelled vehicle. Because X modified the 
vehicle so that it is no longer primarily powered by electricity in the 
second full year from the date the vehicle was placed in service, X must 
recapture $2,000 ($3,000  x  66\2/3\ percent). This recapture amount 
increases X's tax by $2,000 on X's 1995 federal income tax return. The 
recapture amount of $2,000 is added to the basis of the vehicle as of 
January 1, 1995, the beginning of the taxable year of recapture, and to 
the extent the property remains depreciable, the adjusted basis is 
recoverable over the remaining recovery period.
    Example 4. The facts are the same as in Example 3. In 1996, X sells 
the vehicle for $31,000, recognizing a gain from this sale. Under 
paragraph (b)(7) of this section, section 1245 will apply to any gain 
recognized on the sale of a depreciable vehicle to the extent the basis 
of the vehicle was reduced by the section 30 credit net of any basis 
increase from recapture of the section 30 credit. Accordingly, the gain 
from the sale of the vehicle is subject to section 1245 to the extent of 
the depreciation allowance for the vehicle plus the credit allowed under 
section 30 ($3,000), less the previous recapture amount ($2,000). Any 
remaining amount of gain may be subject to other applicable provisions 
of the Internal Revenue Code.

    (c) Effective date. This section is effective on October 14, 1994. 
If the recapture date is before the effective date of this section, a 
taxpayer may use any reasonable method to recapture the

[[Page 109]]

benefit of any credit allowable under section 30(a) consistent with 
section 30 and its legislative history. For this purpose, the recapture 
date is defined in paragraph (b)(4) of this section.

[60 FR 39649, Aug. 3, 1995]



Sec. 1.31-1  Credit for tax withheld on wages.

    (a) The tax deducted and withheld at the source upon wages under 
chapter 24 of the Internal Revenue Code of 1954 (or in the case of 
amounts withheld in 1954, under subchapter D, chapter 9 of the Internal 
Revenue Code of 1939) is allowable as a credit against the tax imposed 
by Subtitle A of the Internal Revenue Code of 1954, upon the recipient 
of the income. If the tax has actually been withheld at the source, 
credit or refund shall be made to the recipient of the income even 
though such tax has not been paid over to the Government by the 
employer. For the purpose of the credit, the recipient of the income is 
the person subject to tax imposed under Subtitle A upon the wages from 
which the tax was withheld. For instance, if a husband and wife 
domiciled in a State recognized as a community property State for 
Federal tax purposes make separate returns, each reporting for income 
tax purposes one- half of the wages received by the husband, each spouse 
is entitled to one-half of the credit allowable for the tax withheld at 
source with respect to such wages.
    (b) The tax withheld during any calendar year shall be allowed as a 
credit against the tax imposed by Subtitle A for the taxable year of the 
recipient of the income which begins in that calendar year. If such 
recipient has more than one taxable year beginning in that calendar 
year, the credit shall be allowed against the tax for the last taxable 
year so beginning.



Sec. 1.31-2  Credit for ``special refunds'' of employee social security tax.

    (a) In general. (1) In the case of an employee receiving wages from 
more than one employer during the calendar year, amounts may be deducted 
and withheld as employee social security tax with respect to more than 
$3,600 of wages received during the calendar year 1954, and with respect 
to more than $4,200 of wages received during a calendar year after 1954. 
For example, employee social security tax may be deducted and withheld 
on $5,000 of wages received by an employee during a particular calendar 
year if the employee is paid wages in such year in the amount of $3,000 
by one employer and in the amount of $2,000 by another employer. Section 
6413(c) (as amended by section 202 of the Social Security Amendments of 
1954 (68 Stat. 1089)), permits, under certain conditions, a so-called 
``special refund'' of the amount of employee social security tax 
deducted and withheld with respect to wages paid to an employee in a 
calendar year after 1954 in excess of $4,200 ($3,600 for the calendar 
year 1954) by reason of the employee receiving wages from more than one 
employer during the calendar year. For provisions relating to the 
imposition of the employee tax and the limitation on wages, see with 
respect to the calendar year 1954, sections 1400 and 1426(a)(1) of the 
Internal Revenue Code of 1939 and, with respect to calendar years after 
1954, sections 3101 and 3121(a)(1) of the Internal Revenue Code of 1954, 
as amended by sections 208(b) and 204(a), respectively, of the Social 
Security Amendments of 1954 (68 Stat. 1094, 1091).
    (2) An employee who is entitled to a special refund of employee tax 
with respect to wages received during a calendar year and who is also 
required to file an income tax return for such calendar year (or for his 
last taxable year beginning in such calendar year) may obtain the 
benefits of such special refund only by claiming credit for such special 
refund in the same manner as if such special refund were an amount 
deducted and withheld as income tax at the source. For provisions for 
claiming special refunds for 1955 and subsequent years in the case of 
employees not required to file income tax returns, see section 6413(c) 
and the regulations thereunder. For provisions relating to such refunds 
for 1954, see 26 CFR (1939) 408.802 (regulations 128).
    (3) The amount of the special refund allowed as a credit shall be 
considered as an amount deducted and withheld as income tax at the 
source under chapter 24 of the Internal Revenue Code of 1954 (or, in the 
case of a special refund for

[[Page 110]]

1954, subchapter D, chapter 9 of the Internal Revenue Code of 1939). If 
the amount of such special refund when added to amounts deducted and 
withheld as income tax exceeds the taxes imposed by subtitle A of the 
Internal Revenue Code of 1954, the amount of the excess constitutes an 
overpayment of income tax under Subtitle A, and interest on such 
overpayment is allowed to the extent provided under section 6611 upon an 
overpayment of income tax resulting from a credit for income tax 
withheld at source. See section 6401(b).
    (b) Federal and State employees and employees of certain foreign 
corporations. The provisions of this section shall apply to the amount 
of a special refund allowable to an employee of a Federal agency or a 
wholly owned instrumentality of the United States, to the amount of a 
special refund allowable to an employee of any State or political 
subdivision thereof (or any instrumentality of any one or more of the 
foregoing), and to the amount of a special refund allowable to employees 
of certain foreign corporations. See, with respect to such special 
refunds for 1954, section 1401(d)(4) of the Internal Revenue Code of 
1939, and with respect to such special refunds for 1955 and subsequent 
years, section 6413(c)(2) of the Internal Revenue Code of 1954, as 
amended by section 202 of the Social Security amendments of 1954.



Sec. 1.32-2  Earned income credit for taxable years beginning after
December 31, 1978.

    (a) [Reserved]
    (b) Limitations. (1) [Reserved]
    (2) Married individuals. No credit is allowed by section 32 in the 
case of an eligible individual who is married (within the meaning of 
section 7703 and the regulations thereunder) unless the individual and 
spouse file a single return jointly (a joint return) for the taxable 
year (see section 6013 and the regulations thereunder relating to joint 
returns of income tax by husband and wife). The requirements of the 
preceding sentence do not apply to an eligible individual who is not 
considered as married under section 7703(b) and the regulations 
thereunder (relating to certain married individuals living apart).
    (3) Length of taxable year. No credit is allowed by section 32 in 
the case of a taxable year covering a period of less than 12 months. 
However, the rule of the preceding sentence does not apply to a taxable 
year closed by reason of the death of the eligible individual.
    (c) Definitions. (1) [Reserved]
    (2) Earned income. For purposes of this section, earned income is 
computed without regard to any community property laws which may 
otherwise be applicable. Earned income is reduced by any net loss in 
earnings from self-employment. Earned income does not include amounts 
received as a pension, an annuity, unemployment compensation, or 
workmen's compensation, or an amount to which section 871(a) and the 
regulations thereunder apply (relating to income of nonresident alien 
individuals not connected with United States business).
    (d) [Reserved]
    (e) Coordination of credit with advance payments--(1) Recapture of 
excess advance payments. If any advance payment of earned income credit 
under section 3507 is made to an individual by an employer during any 
calendar year, then the total amount of these advance payments to the 
individual in that calendar year is treated as an additional amount of 
tax imposed (by chapter 1 of the Code) upon the individual on the tax 
return for the individual's last taxable year beginning in that calendar 
year.
    (2) Reconciliation of payments advanced and credit allowed. Any 
additional amount of tax under paragraph (e)(1) of this section is not 
treated as a tax imposed by chapter 1 of the Internal Revenue Code for 
purposes of determining the amount of any credit (other than the earned 
income credit) allowable under part IV, subchapter A, chapter 1 of the 
Internal Revenue Code.

[T.D. 7683, 45 FR 16175, Mar. 13, 1980. Redesignated by T.D. 8448, 57 FR 
54923, Nov. 23, 1992; T.D. 9045, 68 FR 10656, Mar. 6, 2003]



Sec. 1.32-3  Eligibility requirements after denial of the earned income credit.

    (a) In general. A taxpayer who has been denied the earned income 
credit (EIC), in whole or in part, as a result of

[[Page 111]]

the deficiency procedures under subchapter B of chapter 63 (deficiency 
procedures) is ineligible to file a return claiming the EIC subsequent 
to the denial until the taxpayer demonstrates eligibility for the EIC in 
accordance with paragraph (c) of this section. If a taxpayer 
demonstrates eligibility for a taxable year in accordance with paragraph 
(c) of this section, the taxpayer need not comply with those 
requirements for any subsequent taxable year unless the Service again 
denies the EIC as a result of the deficiency procedures.
    (b) Denial of the EIC as a result of the deficiency procedures. For 
purposes of this section, denial of the EIC as a result of the 
deficiency procedures occurs when a tax on account of the EIC is 
assessed as a deficiency (other than as a mathematical or clerical error 
under section 6213(b)(1)).
    (c) Demonstration of eligibility. In the case of a taxpayer to whom 
paragraph (a) of this section applies, and except as otherwise provided 
by the Commissioner in the instructions for Form 8862, ``Information To 
Claim Earned Income Credit After Disallowance,'' no claim for the EIC 
filed subsequent to the denial is allowed unless the taxpayer properly 
completes Form 8862, demonstrating eligibility for the EIC, and 
otherwise is eligible for the EIC. If any item of information on Form 
8862 is incorrect or inconsistent with any item on the return, the 
taxpayer will be treated as not demonstrating eligibility for the EIC. 
The taxpayer must follow the instructions for Form 8862 to determine the 
income tax return to which Form 8862 must be attached. If the taxpayer 
attaches Form 8862 to an incorrect tax return, the taxpayer will not be 
relieved of the requirement that the taxpayer attach Form 8862 to the 
correct tax return and will, therefore, not be treated as meeting the 
taxpayer's obligation under paragraph (a) of this section.
    (d) Failure to demonstrate eligibility. If a taxpayer to whom 
paragraph (a) of this section applies fails to satisfy the requirements 
of paragraph (c) of this section with respect to a particular taxable 
year, the IRS can deny the EIC as a mathematical or clerical error under 
section 6213(g)(2)(K).
    (e) Special rule where one spouse denied EIC. The eligibility 
requirements set forth in this section apply to taxpayers filing a joint 
return where one spouse was denied the EIC for a taxable year prior to 
marriage and has not established eligibility as either an unmarried or 
married taxpayer for a subsequent taxable year.
    (f) Effective date. This section applies to returns claiming the EIC 
for taxable years beginning after December 31, 1997, where the EIC was 
denied for a taxable year beginning after December 31, 1996.

[T.D. 8953, 66 FR 33637, June 25, 2001]



Sec. 1.34-1  Special rule for owners of certain business entities.

    Amounts payable under sections 6420, 6421, and 6427 to a business 
entity that is treated as separate from its owner under Sec. 1.1361-
4(a)(8) (relating to certain qualified subchapter S subsidiaries) or 
Sec. 301.7701-2(c)(2)(v) of this chapter (relating to certain wholly-
owned entities) are, for purposes of section 34, treated as payable to 
the owner of that entity.

[T.D. 9356, 72 FR 45893, Aug. 16, 2007]



Sec. 1.35-1  Partially tax-exempt interest received by individuals.

    (a) The credit against tax under section 35 shall be allowed only to 
individuals and if the requirements of both paragraphs (1) and (2) of 
section 35(a) are met. Where the alternative tax on capital gains is 
imposed under section 1201(b), the taxable income for such taxable year 
is the taxable income as defined in section 63, which includes 50 
percent of the excess of net long-term capital gain over net short-term 
capital loss.
    (b) For the treatment of partially tax-exempt interest in the case 
of amounts not allocable to any beneficiary of an estate or trust, see 
section 642(a)(1), and for treatment of amounts allocable to a 
beneficiary, see sections 652 and 662. For treatment of partially tax-
exempt interest received by a partnership, see section 702(a)(7). For 
treatment of such interest received by a common trust fund, see section 
584(c)(2).

[[Page 112]]

    (c) The application of section 35 may be illustrated by the 
following example:

    Example. In his taxable year, 1955, A received $4,500 of partially 
tax-exempt interest. A's taxable income is $4,000 upon which the tax 
prior to any credits against tax is $840. His foreign tax credit under 
section 33 is $610, and his dividends received credit under section 34 
is $120. A's credit under section 35 for partially tax-exempt interest 
is $110, determined as follows:

                              Section 35(a)
 
Partially tax-exempt interest................................     $4,500
Credit computed under section 35(a); 3 percent of $4,500.....        135
                            Section 35(b)(1)
Tax imposed by chapter 1.....................................        840
Less:
  Credit allowed under section 33.................       $610
  Credit allowed under section 34.................        120
                                                         ____       $730
                                                              ----------
Limitation on credit under section 35(b)(1)..................        110
 
                            Section 35(b)(2)
 
Taxable income...............................................      4,000
Limitation on credit under section 35(b)(2); 3 percent of            120
 $4,000......................................................
 


Since of the three figures ($135, $110, and $120), the lesser is $110, 
A's credit under section 35 is limited to $110.



Sec. 1.35-2  Taxpayers not entitled to credit.

    For taxable years beginning after December 31, 1957, no credit shall 
be allowed under section 35 to a nonresident alien individual with 
respect to whom a tax is imposed for such taxable year under section 
871(a).



Sec. 1.36B-0  Table of contents.

    This section lists the captions contained in Secs. 1.36B-1 through 
1.36B-6.

              Sec. 1.36B-1  Premium tax credit definitions.

(a) In general.
(b) Affordable Care Act.
(c) Qualified health plan.
(d) Family and family size.
(e) Household income.
(1) In general.
(2) Modified adjusted gross income.
(f) Dependent.
(g) Lawfully present.
(h) Federal poverty line.
(i) [Reserved]
(j) Advance credit payment.
(k) Exchange.
(l) Self-only coverage.
(m) Family coverage.
(n) Rating area.
(o) Effective/applicability date.

            Sec. 1.36B-2  Eligibility for premium tax credit.

(a) In general.
(b) Applicable taxpayer.
(1) In general.
(2) Married taxpayers must file joint return.
(3) Dependents.
(4) Individuals not lawfully present or incarcerated.
(5) Individuals lawfully present.
(6) Special rule for taxpayers with household income below 100 percent 
of the Federal poverty line for the taxable year.
(i) In general.
(ii) Exceptions.
(7) Computation of premium assistance amounts for taxpayers with 
household income below 100 percent of the Federal poverty line.
(c) Minimum essential coverage.
(1) In general.
(2) Government-sponsored minimum essential coverage.
(i) In general.
(ii) Obligation to complete administrative requirements to obtain 
coverage.
(iii) Special rule for coverage for veterans and other individuals under 
chapter 17 or 18 of title 38, U.S.C.
(iv) Retroactive effect of eligibility determination.
(v) Determination of Medicaid or Children's Health Insurance Program 
(CHIP) ineligibility.
(vi) Examples.
(3) Employer-sponsored minimum essential coverage.
(i) In general.
(ii) Plan year.
(iii) Eligibility for months during a plan year.
(A) Failure to enroll in plan.
(B) Waiting periods.
(C) Example.
(iv) Post employment coverage.
(v) Affordable coverage.
(A) In general.
(1) Affordability for employee.
(2) Affordability for related individual.
(3) Employee safe harbor.
(4) Wellness program incentives.
(5) Employer contributions to health reimbursement arrangements.
(6) Employer contributions to cafeteria plans.
(7) Opt-out arrangements.
(B) Affordability for part-year period.
(C) Required contribution percentage.
(D) Examples.
(vi) Minimum value.
(vii) Enrollment in eligible employer-sponsored plan.
(A) In general.
(B) Automatic enrollment.
(C) Examples.
(4) Special eligibility rules.
(i) Related individual not claimed as a personal exemption deduction.

[[Page 113]]

(ii) Exchange unable to discontinue advance credit payments.
(A) In general.
(B) Medicaid or CHIP.
(5) Related individuals not claimed as a personal exemption deduction.
(d) [Reserved]
(e) Effective/applicability dates.

      Sec. 1.36B-3  Computing the premium assistance credit amount.

(a) In general.
(b) Definitions.
(c) Coverage month.
(1) In general.
(2) Certain individuals enrolled during a month.
(3) Premiums paid for a taxpayer.
(4) Appeals of coverage eligibility.
(5) Examples.
(d) Premium assistance amount.
(1) Premium assistance amount.
(2) Examples.
(i) In general.
(ii) Examples.
(e) Adjusted monthly premium.
(f) Applicable benchmark plan.
(1) In general.
(2) Family coverage.
(3) Silver-level plan not covering pediatric dental benefits.
(4) Family members residing in different locations.
(5) Single or multiple policies needed to cover the family.
(i) Policy covering a taxpayer's family.
(ii) Policy not covering a taxpayer's family.
(6) Plan not available for enrollment.
(7) Benchmark plan terminates or closes to enrollment during the year.
(8) Only one silver-level plan offered to the coverage family.
(9) Examples.
(g) Applicable percentage.
(1) In general.
(2) Applicable percentage table.
(3) Examples.
(h) Plan covering more than one family.
(1) In general.
(2) Example.
(i) [Reserved]
(j) Additional benefits.
(1) In general.
(2) Method of allocation.
(3) Examples.
(k) Pediatric dental coverage.
(1) In general.
(2) Method of allocation.
(3) Example.
(l) Families including individuals not lawfully present.
(1) In general.
(2) Revised household income computation.
(i) Statutory method.
(ii) Comparable method.
(m) [Reserved]
(n) Effective/applicability date.

  Sec. 1.36B-4  Reconciling the premium tax credit with advance credit 
                                payments.

(a) Reconciliation.
(1) Coordination of premium tax credit with advance credit payments.
(i) In general.
(ii) Responsibility for advance credit payments.
(iii) Advance credit payment for a month in which an issuer does not 
provide coverage.
(2) Credit computation.
(3) Limitation on additional tax.
(i) In general.
(ii) Additional tax limitation table.
(4) Examples.
(b) Changes in filing status.
(1) In general.
(2) Taxpayers who marry during the taxable year.
(i) In general.
(ii) Alternative computation of additional tax liability.
(A) In general.
(B) Alternative premium assistance amounts for pre-marriage months.
(C) Premium assistance amounts for marriage months.
(3) Taxpayers not married to each other at the end of the taxable year.
(4) Married taxpayers filing separate returns.
(5) Taxpayers filing returns as head of household and married filing 
separately.
(6) Examples.

            Sec. 1.36B-5  Information reporting by Exchanges.

(a) In general.
(b) Individual filing a return.
(c) Information required to be reported.
(1) Information reported annually.
(2) Information reported monthly.
(3) Special rules for information reported.
(i) Multiple families enrolled in a single qualified health plan.
(ii) Alternative to reporting applicable benchmark plan.
(iii) Partial month of coverage.
(A) In general.
(B) Certain mid-month enrollments.
(4) Exemptions.
(d) Time for reporting.
(1) Annual reporting.
(2) Monthly reporting.
(i) In general.
(ii) Initial monthly reporting in 2014.
(3) Corrections to information reported.
(e) Electronic reporting.
(f) Annual statement to be furnished to individuals.
(1) In general.
(2) Form of statements.
(3) Time and manner for furnishing statements.
(g) Electronic furnishing of statements.
(1) In general.
(2) Consent.
(i) In general.

[[Page 114]]

(ii) Withdrawal of consent.
(iii) Change in hardware or software requirements.
(iv) Examples.
(3) Required disclosures.
(i) In general.
(ii) Paper statement.
(iii) Scope and duration of consent.
(iv) Post-consent request for a paper statement.
(v) Withdrawal of consent.
(vi) Notice of termination.
(vii) Updating information.
(viii) Hardware and software requirements.
(4) Format.
(5) Notice.
(i) In general.
(ii) Undeliverable electronic address.
(iii) Corrected statement.
(6) Access period.
(7) Paper statements after withdrawal of consent.

                      Sec. 1.36B-6  Minimum value.

    (a) In general.
    (b) MV standard population.
    (c) MV percentage.
    (1) In general.
    (2) Wellness program incentives.
    (i) In general.
    (ii) Example.
    (3) Employer contributions to health savings accounts.
    (4) Employer contributions to health reimbursement arrangements.
    (5) Expected spending adjustments for health savings accounts and 
health reimbursement arrangements.
    (d) Methods for determining MV.
    (e) Scope of essential health benefits and adjustment for benefits 
not included in MV Calculator.
    (f) Actuarial certification.
    (1) In general.
    (2) Membership in American Academy of Actuaries.
    (3) Actuarial analysis.
    (4) Use of MV Calculator.
    (g) Effective/applicability date.
    (1) In general.
    (2) Exception.

[T.D. 9590, 77 FR 30385, May 23, 2012, as amended by T.D. 9663, 79 FR 
26117, May 7, 2014; T.D. 9745, 80 FR 78974, Dec. 18, 2015; T.D. 9604, 81 
FR 91763, Dec. 19, 2016]



Sec. 1.36B-1  Premium tax credit definitions.

    (a) In general. Section 36B allows a refundable premium tax credit 
for taxable years ending after December 31, 2013. The definitions in 
this section apply to this section and Secs. 1.36B-2 through 1.36B-5.
    (b) Affordable Care Act. The term Affordable Care Act refers to the 
Patient Protection and Affordable Care Act, Public Law 111-148 (124 
Stat. 119 (2010)), and the Health Care and Education Reconciliation Act 
of 2010, Public Law 111-152 (124 Stat. 1029 (2010)), as amended by the 
Medicare and Medicaid Extenders Act of 2010, Public Law 111-309 (124 
Stat. 3285 (2010)), the Comprehensive 1099 Taxpayer Protection and 
Repayment of Exchange Subsidy Overpayments Act of 2011, Public Law 112-9 
(125 Stat. 36 (2011)), the Department of Defense and Full-Year 
Continuing Appropriations Act, 2011, Public Law 112-10 (125 Stat. 38 
(2011)), and the 3% Withholding Repeal and Job Creation Act, Public Law 
112-56 (125 Stat. 711 (2011)).
    (c) Qualified health plan. The term qualified health plan has the 
same meaning as in section 1301(a) of the Affordable Care Act (42 U.S.C. 
18021(a)) but does not include a catastrophic plan described in section 
1302(e) of the Affordable Care Act (42 U.S.C. 18022(e)).
    (d) Family and family size. A taxpayer's family means the 
individuals for whom a taxpayer properly claims a deduction for a 
personal exemption under section 151 for the taxable year. Family size 
means the number of individuals in the family. Family and family size 
may include individuals who are not subject to or are exempt from the 
penalty under section 5000A for failing to maintain minimum essential 
coverage.
    (e) Household income--(1) In general. Household income means the sum 
of--
    (i) A taxpayer's modified adjusted gross income (including the 
modified adjusted gross income of a child for whom an election under 
section 1(g)(7) is made for the taxable year);
    (ii) The aggregate modified adjusted gross income of all other 
individuals who--
    (A) Are included in the taxpayer's family under paragraph (d) of 
this section; and
    (B) Are required to file a return of tax imposed by section 1 for 
the taxable year.
    (2) Modified adjusted gross income. Modified adjusted gross income 
means adjusted gross income (within the meaning of section 62) increased 
by--

[[Page 115]]

    (i) Amounts excluded from gross income under section 911;
    (ii) Tax-exempt interest the taxpayer receives or accrues during the 
taxable year; and
    (iii) Social security benefits (within the meaning of section 86(d)) 
not included in gross income under section 86.
    (f) Dependent. Dependent has the same meaning as in section 152.
    (g) Lawfully present. Lawfully present has the same meaning as in 45 
CFR 155.20.
    (h) Federal poverty line. The Federal poverty line means the most 
recently published poverty guidelines (updated periodically in the 
Federal Register by the Secretary of Health and Human Services under the 
authority of 42 U.S.C. 9902(2)) as of the first day of the regular 
enrollment period for coverage by a qualified health plan offered 
through an Exchange for a calendar year. Thus, the Federal poverty line 
for computing the premium tax credit for a taxable year is the Federal 
poverty line in effect on the first day of the initial or annual open 
enrollment period preceding that taxable year. See 45 CFR 155.410. If a 
taxpayer's primary residence changes during a taxable year from one 
state to a state with different Federal poverty guidelines or married 
taxpayers reside in separate states with different Federal poverty 
guidelines (for example, Alaska or Hawaii and another state), the 
Federal poverty line that applies for purposes of section 36B and the 
associated regulations is the higher Federal poverty guideline 
(resulting in a lower percentage of the Federal poverty line for the 
taxpayers' household income and family size).
    (i) [Reserved]
    (j) Advance credit payment. Advance credit payment means an advance 
payment of the premium tax credit as provided in section 1412 of the 
Affordable Care Act (42 U.S.C. 18082).
    (k) Exchange. Exchange has the same meaning as in 45 CFR 155.20.
    (l) Self-only coverage. Self-only coverage means health insurance 
that covers one individual and provides coverage for the essential 
health benefits as defined in section 1302(b)(1) of the Affordable Care 
Act (42 U.S.C. 18022).
    (m) Family coverage. Family coverage means health insurance that 
covers more than one individual and provides coverage for the essential 
health benefits as defined in section 1302(b)(1) of the Affordable Care 
Act (42 U.S.C. 18022).
    (n) Rating area. The term rating area has the same meaning as used 
in section 2701(a)(2) of the Public Health Service Act (42 U.S.C. 
300gg(a)(2)) and 45 CFR 147.102(b).
    (o) Effective/applicability date. Except for paragraphs (l) and (m), 
this section applies to taxable years ending after December 31, 2013. 
Paragraphs (l) and (m) of this section apply to taxable years beginning 
after December 31, 2018. Paragraphs (l) and (m) of Sec. 1.36B-1 as 
contained in 26 CFR part I edition revised as of April 1, 2016, apply to 
taxable years ending after December 31, 2013, and beginning before 
January 1, 2019.

[T.D. 9590, 77 FR 30385, May 23, 2012, as amended by T.D. 9745, 80 FR 
78974, Dec. 18, 2015; T.D. 9804, 81 FR 91763, Dec. 19, 2016]



Sec. 1.36B-2  Eligibility for premium tax credit.

    (a) In general. An applicable taxpayer (within the meaning of 
paragraph (b) of this section) is allowed a premium assistance amount 
only for any month that one or more members of the applicable taxpayer's 
family (the applicable taxpayer or the applicable taxpayer's spouse or 
dependent)--
    (1) Is enrolled in one or more qualified health plans through an 
Exchange; and
    (2) Is not eligible for minimum essential coverage (within the 
meaning of paragraph (c) of this section) other than coverage described 
in section 5000A(f)(1)(C) (relating to coverage in the individual 
market).
    (b) Applicable taxpayer--(1) In general. Except as otherwise 
provided in this paragraph (b), an applicable taxpayer is a taxpayer 
whose household income is at least 100 percent but not more than 400 
percent of the Federal poverty line for the taxpayer's family size for 
the taxable year.
    (2) [Reserved]. For further guidance, see Sec. 1.36B-2T(b)(2).

[[Page 116]]

    (3) Dependents. An individual is not an applicable taxpayer if 
another taxpayer may claim a deduction under section 151 for the 
individual for a taxable year beginning in the calendar year in which 
the individual's taxable year begins.
    (4) Individuals not lawfully present or incarcerated. An individual 
who is not lawfully present in the United States or is incarcerated 
(other than incarceration pending disposition of charges) is not 
eligible to enroll in a qualified health plan through an Exchange. 
However, the individual may be an applicable taxpayer if a family member 
is eligible to enroll in a qualified health plan. See sections 
1312(f)(1)(B) and 1312(f)(3) of the Affordable Care Act (42 U.S.C. 
18032(f)(1)(B) and (f)(3)) and Sec. 1.36B-3(b)(2).
    (5) Individuals lawfully present. If a taxpayer's household income 
is less than 100 percent of the Federal poverty line for the taxpayer's 
family size and the taxpayer or a member of the taxpayer's family is an 
alien lawfully present in the United States, the taxpayer is treated as 
an applicable taxpayer if--
    (i) The lawfully present taxpayer or family member is not eligible 
for the Medicaid program; and
    (ii) The taxpayer would be an applicable taxpayer if the taxpayer's 
household income for the taxable year was between 100 and 400 percent of 
the Federal poverty line for the taxpayer's family size.
    (6) Special rule for taxpayers with household income below 100 
percent of the Federal poverty line for the taxable year--(i) In 
general. A taxpayer (other than a taxpayer described in paragraph (b)(5) 
of this section) whose household income for a taxable year is less than 
100 percent of the Federal poverty line for the taxpayer's family size 
is treated as an applicable taxpayer for the taxable year if--
    (A) The taxpayer or a family member enrolls in a qualified health 
plan through an Exchange for one or more months during the taxable year;
    (B) An Exchange estimates at the time of enrollment that the 
taxpayer's household income will be at least 100 percent but not more 
than 400 percent of the Federal poverty line for the taxable year;
    (C) Advance credit payments are authorized and paid for one or more 
months during the taxable year; and
    (D) The taxpayer would be an applicable taxpayer if the taxpayer's 
household income for the taxable year was at least 100 but not more than 
400 percent of the Federal poverty line for the taxpayer's family size.
    (ii) Exceptions. This paragraph (b)(6) does not apply for an 
individual who, with intentional or reckless disregard for the facts, 
provides incorrect information to an Exchange for the year of coverage. 
A reckless disregard of the facts occurs if the taxpayer makes little or 
no effort to determine whether the information provided to the Exchange 
is accurate under circumstances that demonstrate a substantial deviation 
from the standard of conduct a reasonable person would observe. A 
disregard of the facts is intentional if the taxpayer knows the 
information provided to the Exchange is inaccurate.
    (iii) Advance credit payments are authorized and paid for one or 
more months during the taxable year; and
    (iv) The taxpayer would be an applicable taxpayer if the taxpayer's 
household income for the taxable year was between 100 and 400 percent of 
the Federal poverty line for the taxpayer's family size.
    (7) Computation of premium assistance amounts for taxpayers with 
household income below 100 percent of the Federal poverty line. If a 
taxpayer is treated as an applicable taxpayer under paragraph (b)(5) or 
(b)(6) of this section, the taxpayer's actual household income for the 
taxable year is used to compute the premium assistance amounts under 
Sec. 1.36B-3(d).
    (c) Minimum essential coverage--(1) In general. Minimum essential 
coverage is defined in section 5000A(f) and regulations issued under 
that section. As described in section 5000A(f), government-sponsored 
programs, eligible employer-sponsored plans, grandfathered health plans, 
and certain other health benefits coverage are minimum essential 
coverage.

[[Page 117]]

    (2) Government-sponsored minimum essential coverage--(i) In general. 
An individual is eligible for government-sponsored minimum essential 
coverage if the individual meets the criteria for coverage under a 
government-sponsored program described in section 5000A(f)(1)(A) as of 
the first day of the first full month the individual may receive 
benefits under the program, subject to the limitation in paragraph 
(c)(2)(ii) of this section. The Commissioner may define eligibility for 
specific government-sponsored programs further in additional published 
guidance, see Sec. 601.601(d)(2) of this chapter.
    (ii) Obligation to complete administrative requirements to obtain 
coverage. An individual who meets the criteria for eligibility for 
government-sponsored minimum essential coverage must complete the 
requirements necessary to receive benefits. An individual who fails by 
the last day of the third full calendar month following the event that 
establishes eligibility under paragraph (c)(2)(i) of this section to 
complete the requirements to obtain government-sponsored minimum 
essential coverage (other than a veteran's health care program) is 
treated as eligible for government-sponsored minimum essential coverage 
as of the first day of the fourth calendar month following the event 
that establishes eligibility.
    (iii) Special rule for coverage for veterans and other individuals 
under chapter 17 or 18 of title 38, U.S.C. An individual is eligible for 
minimum essential coverage under a health care program under chapter 17 
or 18 of title 38, U.S.C. only if the individual is enrolled in a health 
care program under chapter 17 or 18 of title 38, U.S.C. identified as 
minimum essential coverage in regulations issued under section 5000A.
    (iv) Retroactive effect of eligibility determination. If an 
individual receiving advance credit payments is determined to be 
eligible for government-sponsored minimum essential coverage that is 
effective retroactively (such as Medicaid), the individual is treated as 
eligible for minimum essential coverage under that program no earlier 
than the first day of the first calendar month beginning after the 
approval.
    (v) Determination of Medicaid or Children's Health Insurance Program 
(CHIP) ineligibility. An individual is treated as not eligible for 
Medicaid, CHIP, or a similar program for a period of coverage under a 
qualified health plan if, when the individual enrolls in the qualified 
health plan, an Exchange determines or considers (within the meaning of 
45 CFR 155.302(b)) the individual to be not eligible for Medicaid or 
CHIP. This paragraph (c)(2)(v) does not apply for an individual who, 
with intentional or reckless disregard for the facts, provides incorrect 
information to an Exchange for the year of coverage. A reckless 
disregard of the facts occurs if the taxpayer makes little or no effort 
to determine whether the information provided to the Exchange is 
accurate under circumstances that demonstrate a substantial deviation 
from the standard of conduct a reasonable person would observe. A 
disregard of the facts is intentional if the taxpayer knows that 
information provided to the Exchange is inaccurate.
    (vi) Examples. The following examples illustrate the provisions of 
this paragraph (c)(2):

    Example 1. Delay in coverage effectiveness. On April 10, 2015, 
Taxpayer D applies for coverage under a government-sponsored health care 
program. D's application is approved on July 12, 2015, but her coverage 
is not effective until September 1, 2015. Under paragraph (c)(2)(i) of 
this section, D is eligible for government-sponsored minimum essential 
coverage on September 1, 2015.
    Example 2. Time of eligibility. Taxpayer E turns 65 on June 3, 2015, 
and becomes eligible for Medicare. Under section 5000A(f)(1)(A)(i), 
Medicare is minimum essential coverage. However, E must enroll in 
Medicare to receive benefits. E enrolls in Medicare in September, which 
is the last month of E's initial enrollment period. Thus, E may receive 
Medicare benefits on December 1, 2015. Because E completed the 
requirements necessary to receive Medicare benefits by the last day of 
the third full calendar month after the event that establishes E's 
eligibility (E turning 65), under paragraph (c)(2)(i) and (c)(2)(ii) of 
this section E is eligible for government-sponsored minimum essential 
coverage on December 1, 2015, the first day of the first full month that 
E may receive benefits under the program.
    Example 3. Time of eligibility, individual fails to complete 
necessary requirements. The facts are the same as in Example 2, except 
that E fails to enroll in the Medicare coverage during E's initial 
enrollment period. E is treated

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as eligible for government-sponsored minimum essential coverage under 
paragraph (c)(2)(ii) of this section as of October 1, 2015, the first 
day of the fourth month following the event that establishes E's 
eligibility (E turning 65).
    Example 4. Retroactive effect of eligibility. In November 2014, 
Taxpayer F enrolls in a qualified health plan for 2015 and receives 
advance credit payments. F loses her part-time employment and on April 
10, 2015 applies for coverage under the Medicaid program. F's 
application is approved on May 15, 2015, and her Medicaid coverage is 
effective as of April 1, 2015. Under paragraph (c)(2)(iv) of this 
section, F is eligible for government-sponsored minimum essential 
coverage on June 1, 2015, the first day of the first calendar month 
after approval.
    Example 5. Determination of Medicaid ineligibility. In November 
2014, Taxpayer G applies through the Exchange to enroll in health 
coverage for 2015. The Exchange determines that G is not eligible for 
Medicaid and estimates that G's household income will be 140 percent of 
the Federal poverty line for G's family size for purposes of determining 
advance credit payments. G enrolls in a qualified health plan and begins 
receiving advance credit payments. G experiences a reduction in 
household income during the year and his household income for 2015 is 
130 percent of the Federal poverty line (within the Medicaid income 
threshold). However, under paragraph (c)(2)(v) of this section, G is 
treated as not eligible for Medicaid for 2015.
    Example 6. Mid-year Medicaid eligibility redetermination. The facts 
are the same as in Example 5, except that G returns to the Exchange in 
July 2015 and the Exchange determines that G is eligible for Medicaid. 
Medicaid approves G for coverage and the Exchange discontinues G's 
advance credit payments effective August 1. Under paragraphs (c)(2)(iv) 
and (c)(2)(v) of this section, G is treated as not eligible for Medicaid 
for the months when G is covered by a qualified health plan. G is 
eligible for government-sponsored minimum essential coverage for the 
months after G is approved for Medicaid and can receive benefits, August 
through December 2015.

    (3) Employer-sponsored minimum essential coverage--(i) In general. 
For purposes of section 36B, an employee who may enroll in an eligible 
employer-sponsored plan (as defined in section 5000A(f)(2) and the 
regulations under that section) that is minimum essential coverage, and 
an individual who may enroll in the plan because of a relationship to 
the employee (a related individual), are eligible for minimum essential 
coverage under the plan for any month only if the plan is affordable and 
provides minimum value. Except for the Nonappropriated Fund Health 
Benefits Program of the Department of Defense, established under section 
349 of the National Defense Authorization Act for Fiscal Year 1995 
(Public Law 103-337; 10 U.S.C. 1587 note), government-sponsored minimum 
essential coverage is not an eligible employer-sponsored plan. The 
Nonappropriated Fund Health Benefits Program of the Department of 
Defense is considered eligible employer-sponsored coverage, but not 
government-sponsored coverage, for purposes of determining if an 
individual is eligible for minimum essential coverage under this 
section.
    (ii) Plan year. For purposes of this paragraph (c)(3), a plan year 
is an eligible employer-sponsored plan's regular 12-month coverage 
period (or the remainder of a 12-month coverage period for a new 
employee or an individual who enrolls during a special enrollment 
period).
    (iii) Eligibility for months during a plan year--(A) Failure to 
enroll in plan. An employee or related individual may be eligible for 
minimum essential coverage under an eligible employer-sponsored plan for 
a month during a plan year if the employee or related individual could 
have enrolled in the plan for that month during an open or special 
enrollment period for the plan year. If an enrollment period relates to 
coverage for not only the upcoming plan year (or the current plan year 
in the case of an enrollment period other than an open enrollment 
period), but also coverage in one or more succeeding plan years, this 
paragraph (c)(3)(iii)(A) applies only to eligibility for the coverage in 
the upcoming plan year (or the current plan year in the case of an 
enrollment period other than an open enrollment period).
    (B) Waiting periods. An employee or related individual is not 
eligible for minimum essential coverage under an eligible employer-
sponsored plan during a required waiting period before the coverage 
becomes effective.
    (C) Example. The following example illustrates the provisions of 
this paragraph (c)(3)(iii):

    Example. (i) Taxpayer B is an employee of Employer X. X offers its 
employees a health

[[Page 119]]

insurance plan that has a plan year (within the meaning of paragraph 
(c)(3)(ii) of this section) from October 1 through September 30. 
Employees may enroll during an open season from August 1 to September 
15. B does not enroll in X's plan for the plan year October 1, 2014, to 
September 30, 2015. In November 2014, B enrolls in a qualified health 
plan through an Exchange for calendar year 2015.
    (ii) B could have enrolled in X's plan during the August 1 to 
September 15 enrollment period. Therefore, unless X's plan is not 
affordable for B or does not provide minimum value, B is eligible for 
minimum essential coverage under X's plan for the months that B is 
enrolled in the qualified health plan during X's plan year (January 
through September 2015).

    (iv) Post-employment coverage. A former employee (including a 
retiree), or an individual related (within the meaning of paragraph 
(c)(3)(i) of this section) to a former employee, who may enroll in 
eligible employer-sponsored coverage or in continuation coverage 
required under Federal law or a State law that provides comparable 
continuation coverage is eligible for minimum essential coverage under 
this coverage only for months that the former employee or related 
individual is enrolled in the coverage.
    (v) Affordable coverage--(A) In general--(1) Affordability for 
employee. Except as provided in paragraph (c)(3)(v)(A)(3) of this 
section, an eligible employer-sponsored plan is affordable for an 
employee if the portion of the annual premium the employee must pay, 
whether by salary reduction or otherwise (required contribution), for 
self-only coverage does not exceed the required contribution percentage 
(as defined in paragraph (c)(3)(v)(C) of this section) of the applicable 
taxpayer's household income for the taxable year.
    (2) Affordability for related individual. Except as provided in 
paragraph (c)(3)(v)(A)(3) of this section, an eligible employer-
sponsored plan is affordable for a related individual if the portion of 
the annual premium the employee must pay for self-only coverage does not 
exceed the required contribution percentage, as described in paragraph 
(c)(3)(v)(A)(1) of this section.
    (3) Employee safe harbor. An employer-sponsored plan is not 
affordable for an employee or a related individual for a plan year if, 
when the employee or a related individual enrolls in a qualified health 
plan for a period coinciding with the plan year (in whole or in part), 
an Exchange determines that the eligible employer-sponsored plan is not 
affordable for that plan year. This paragraph (c)(3)(v)(A)(3) does not 
apply to a determination made as part of the redetermination process 
described in 45 CFR 155.335 unless the individual receiving an Exchange 
redetermination notification affirmatively responds and provides current 
information on affordability. This paragraph (c)(3)(v)(A)(3) does not 
apply for an individual who, with intentional or reckless disregard for 
the facts, provides incorrect information to an Exchange concerning the 
portion of the annual premium for coverage for the employee or related 
individual under the plan. A reckless disregard of the facts occurs if 
the taxpayer makes little or no effort to determine whether the 
information provided to the Exchange is accurate under circumstances 
that demonstrate a substantial deviation from the standard of conduct a 
reasonable person would observe. A disregard of the facts is intentional 
if the taxpayer knows that the information provided to the Exchange is 
inaccurate.
    (4) Wellness program incentives. Nondiscriminatory wellness program 
incentives offered by an eligible employer-sponsored plan that affect 
premiums are treated as earned in determining an employee's required 
contribution for purposes of affordability of an eligible employer-
sponsored plan to the extent the incentives relate exclusively to 
tobacco use. Wellness program incentives that do not relate to tobacco 
use or that include a component unrelated to tobacco use are treated as 
not earned for this purpose. For purposes of this section, the term 
wellness program incentive has the same meaning as the term reward in 
Sec. 54.9802-1(f)(1)(i) of this chapter.
    (5) Employer contributions to health reimbursement arrangements. 
Amounts newly made available for the current plan year under a health 
reimbursement arrangement that an employee may use to pay premiums, or 
may use to pay cost-sharing or benefits not covered by the primary plan 
in addition to

[[Page 120]]

premiums, reduce the employee's required contribution if the health 
reimbursement arrangement would be integrated, as that term is used in 
Notice 2013-54 (2013-40 IRB 287) (see Sec. 601.601(d) of this chapter), 
with an eligible employer-sponsored plan for an employee enrolled in the 
plan. The eligible employer-sponsored plan and the health reimbursement 
arrangement must be offered by the same employer. Employer contributions 
to a health reimbursement arrangement reduce an employee's required 
contribution only to the extent the amount of the annual contribution is 
required under the terms of the plan or otherwise determinable within a 
reasonable time before the employee must decide whether to enroll in the 
eligible employer-sponsored plan.
    (6) Employer contributions to cafeteria plans. Amounts made 
available for the current plan year under a cafeteria plan, within the 
meaning of section 125, reduce an employee's or a related individual's 
required contribution if--
    (i) The employee may not opt to receive the amount as a taxable 
benefit;
    (ii) The employee may use the amount to pay for minimum essential 
coverage; and
    (iii) The employee may use the amount exclusively to pay for medical 
care, within the meaning of section 213.
    (7) Opt-out arrangements. [Reserved]
    (B) Affordability for part-year period. Affordability under 
paragraph (c)(3)(v)(A) of this section is determined separately for each 
employment period that is less than a full calendar year or for the 
portions of an employer's plan year that fall in different taxable years 
of an applicable taxpayer (a part-year period). An eligible employer-
sponsored plan is affordable for a part-year period if the employee's 
annualized required contribution for self-only coverage under the plan 
for the part-year period does not exceed the required contribution 
percentage of the applicable taxpayer's household income for the taxable 
year. The employee's annualized required contribution is the employee's 
required contribution for the part-year period times a fraction, the 
numerator of which is 12 and the denominator of which is the number of 
months in the part-year period during the applicable taxpayer's taxable 
year. Only full calendar months are included in the computation under 
this paragraph (c)(3)(v)(B).
    (C) [Reserved]. For further guidance, see Sec. 1.36B-2T(c)(3)(v)(C).
    (D) Examples. The following examples illustrate the provisions of 
this paragraph (c)(3)(v). Unless stated otherwise, in each example the 
taxpayer is single and has no dependents, the employer's plan is an 
eligible employer-sponsored plan and provides minimum value, the 
employee is not eligible for other minimum essential coverage, and the 
taxpayer, related individual, and employer-sponsored plan have a 
calendar taxable year:

    Example 1. Basic determination of affordability. In 2014 Taxpayer C 
has household income of $47,000. C is an employee of Employer X, which 
offers its employees a health insurance plan that requires C to 
contribute $3,450 for self-only coverage for 2014 (7.3 percent of C's 
household income). Because C's required contribution for self-only 
coverage does not exceed 9.5 percent of household income, under 
paragraph (c)(3)(v)(A)(1) of this section, X's plan is affordable for C, 
and C is eligible for minimum essential coverage for all months in 2014.
    Example 2. Basic determination of affordability for a related 
individual. The facts are the same as in Example 1, except that C is 
married to J and X's plan requires C to contribute $5,300 for coverage 
for C and J for 2014 (11.3 percent of C's household income). Because C's 
required contribution for self-only coverage ($3,450) does not exceed 
9.5 percent of household income, under paragraph (c)(3)(v)(A)(2) of this 
section, X's plan is affordable for C and J, and C and J are eligible 
for minimum essential coverage for all months in 2014.
    Example 3. Determination of unaffordability at enrollment. (i) 
Taxpayer D is an employee of Employer X. In November 2013 the Exchange 
for D's rating area projects that D's 2014 household income will be 
$37,000. It also verifies that D's required contribution for self-only 
coverage under X's health insurance plan will be $3,700 (10 percent of 
household income). Consequently, the Exchange determines that X's plan 
is unaffordable. D enrolls in a qualified health plan and not in X's 
plan. In December 2014, X pays D a $2,500 bonus. Thus, D's actual 2014 
household income is $39,500 and D's required contribution for coverage 
under X's plan is 9.4 percent of D's household income.
    (ii) Based on D's actual 2014 household income, D's required 
contribution does not exceed 9.5 percent of household income and X's 
health plan is affordable for D. However,

[[Page 121]]

when D enrolled in a qualified health plan for 2014, the Exchange 
determined that X's plan was not affordable for D for 2014. 
Consequently, under paragraph (c)(3)(v)(A)(3) of this section, X's plan 
is not affordable for D and D is not eligible for minimum essential 
coverage under X's plan for 2014.
    Example 4. Determination of unaffordability for plan year. The facts 
are the same as in Example 3, except that X's employee health insurance 
plan year is September 1 to August 31. The Exchange for D's rating area 
determines in August 2014 that X's plan is unaffordable for D based on 
D's projected household income for 2014. D enrolls in a qualified health 
plan as of September 1, 2014. Under paragraph (c)(3)(v)(A)(3) of this 
section, X's plan is not affordable for D and D is not eligible for 
minimum essential coverage under X's plan for the coverage months 
September to December 2014 and January through August 2015.
    Example 5. No affordability information affirmatively provided for 
annual redetermination. (i) The facts are the same as in Example 3, 
except the Exchange redetermines D's eligibility for advance credit 
payments for 2015. D does not affirmatively provide the Exchange with 
current information regarding affordability and the Exchange determines 
that D's coverage is not affordable for 2015 and approves advance credit 
payments based on information from the previous enrollment period. In 
2015, D's required contribution for coverage under X's plan is 9.4 
percent of D's household income.
    (ii) Because D does not respond to the Exchange notification and the 
Exchange makes an affordability determination based on information from 
an earlier year, the employee safe harbor in paragraph (c)(3)(v)(A)(3) 
of this section does not apply. D's required contribution for 2015 does 
not exceed 9.5 percent of D's household income. Thus, X's plan is 
affordable for D for 2015 and D is eligible for minimum essential 
coverage for all months in 2015.
    Example 6. Determination of unaffordability for part of plan year 
(part-year period). (i) Taxpayer E is an employee of Employer X 
beginning in May 2015. X's employee health insurance plan year is 
September 1 to August 31. E's required contribution for self-only 
coverage for May through August is $150 per month ($1,800 for the full 
plan year). The Exchange for E's rating area projects E's household 
income for purposes of eligibility for advance credit payments as 
$18,000. E's actual household income for the 2015 taxable year is 
$20,000.
    (ii) Under paragraph (c)(3)(v)(B) of this section, whether coverage 
under X's plan is affordable for E is determined for the remainder of 
X's plan year (May through August). E's required contribution for a full 
plan year ($1,800) exceeds 9.5 percent of E's household income (1,800/
18,000 = 10 percent). Therefore, the Exchange determines that X's 
coverage is unaffordable for May through August. Although E's actual 
household income for 2015 is $20,000 (and E's required contribution of 
$1,800 does not exceed 9.5 percent of E's household income), under 
paragraph (c)(3)(v)(A)(3) of this section, X's plan is unaffordable for 
E for the part of the plan year May through August 2015. Consequently, E 
is not eligible for minimum essential coverage under X's plan for the 
period May through August 2015.
    Example 7. Affordability determined for part of a taxable year 
(part-year period). (i) Taxpayer F is an employee of Employer X. X's 
employee health insurance plan year is September 1 to August 31. F's 
required contribution for self-only coverage for the period September 
2014 through August 2015 is $150 per month or $1,800 for the plan year. 
F does not enroll in X's plan during X's open season but enrolls in a 
qualified health plan for September through December 2014. F does not 
request advance credit payments and does not ask the Exchange for his 
rating area to determine whether X's coverage is affordable for F. F's 
household income in 2014 is $18,000.
    (ii) Because F is a calendar year taxpayer and Employer X's plan is 
not a calendar year plan, F must determine the affordability of X's 
coverage for the part-year period in 2014 (September-December) under 
paragraph (c)(3)(v)(B) of this section. F determines the affordability 
of X's plan for the September through December 2014 period by comparing 
the annual premiums ($1,800) to F's 2014 household income. F's required 
contribution of $1,800 is 10 percent of F's 2014 household income. 
Because F's required contribution exceeds 9.5 percent of F's 2014 
household income, X's plan is not affordable for F for the part-year 
period September through December 2014 and F is not eligible for minimum 
essential coverage under X's plan for that period.
    (iii) F enrolls in Exchange coverage for 2015 and does not ask the 
Exchange to approve advance credit payments or determine whether X's 
coverage is affordable. F's 2015 household income is $20,000.
    (iv) F must determine if X's plan is affordable for the part-year 
period January 2015 through August 2015. F's annual required 
contribution ($1,800) is 9 percent of F's 2015 household income. Because 
F's required contribution does not exceed 9.5 percent of F's 2015 
household income, X's plan is affordable for F for the part-year period 
January through August 2015 and F is eligible for minimum essential 
coverage for that period.
    Example 8. Coverage unaffordable at year end. Taxpayer G is employed 
by Employer X. In November 2014, the Exchange for G's rating area 
determines that G is eligible for affordable employer-sponsored coverage 
for 2015. G nonetheless enrolls in a qualified

[[Page 122]]

health plan for 2015 but does not receive advance credit payments. G's 
2015 household income is less than expected and G's required 
contribution for employer-sponsored coverage for 2015 exceeds 9.5 
percent of G's actual 2015 household income. Under paragraph 
(c)(3)(v)(A)(1) of this section, G is not eligible for minimum essential 
coverage under X's plan for 2015.
    Example 9. Wellness program incentives. (i) Employer X offers an 
eligible employer-sponsored plan with a nondiscriminatory wellness 
program that reduces premiums by $300 for employees who do not use 
tobacco products or who complete a smoking cessation course. Premiums 
are reduced by $200 if an employee completes cholesterol screening 
within the first six months of the plan year. Employee B does not use 
tobacco and the cost of his premiums is $3,700. Employee C uses tobacco 
and the cost of her premiums is $4,000.
    (ii) Under paragraph (c)(3)(v)(A)(4) of this section, only the 
incentives related to tobacco use are counted toward the premium amount 
used to determine the affordability of X's plan. C is treated as having 
earned the $300 incentive for attending a smoking cessation course 
regardless of whether C actually attends the course. Thus, the required 
contribution for determining affordability for both Employee B and 
Employee C is $3,700. The $200 incentive for completing cholesterol 
screening is treated as not earned and does not reduce their required 
contribution.

    (vi) Minimum value. See Sec. 1.36B-6 for rules for determining 
whether an eligible employer-sponsored plan provides minimum value.
    (vii) Enrollment in eligible employer-sponsored plan--(A) In 
general. Except as provided in paragraph (c)(3)(vii)(B) of this section, 
the requirements of affordability and minimum value do not apply for 
months that an individual is enrolled in an eligible employer-sponsored 
plan.
    (B) Automatic enrollment. An employee or related individual is 
treated as not enrolled in an eligible employer-sponsored plan for a 
month in a plan year or other period for which the employee or related 
individual is automatically enrolled if the employee or related 
individual terminates the coverage before the later of the first day of 
the second full calendar month of that plan year or other period or the 
last day of any permissible opt-out period provided by the employer-
sponsored plan or in regulations to be issued by the Department of 
Labor, for that plan year or other period.
    (C) Examples. The following examples illustrate the provisions of 
this paragraph (c)(3)(vii):

    Example 1. Taxpayer H is employed by Employer X in 2014. H's 
required contribution for self-only employer coverage exceeds 9.5 
percent of H's 2014 household income. H enrolls in X's calendar year 
plan for 2014. Under paragraph (c)(3)(vii)(A) of this section, H is 
eligible for minimum essential coverage for 2014 because H is enrolled 
in an eligible employer-sponsored plan for 2014.
    Example 2. The facts are the same as in Example 1, except that H 
terminates plan coverage on June 30, 2014. Under paragraph 
(c)(3)(vii)(A) of this section, H is eligible for minimum essential 
coverage under X's plan for January through June 2014 but is not 
eligible for minimum essential coverage under X's plan for July through 
December 2014.
    Example 3. The facts are the same as in Example 1, except that 
Employer X automatically enrolls H in the plan for calendar year 2015. H 
terminates the coverage on January 20, 2015. Under paragraph 
(c)(3)(vii)(B) of this section, H is not eligible for minimum essential 
coverage under X's plan for January 2015.

    (4) Special eligibility rules--(i) Related individual not claimed as 
a personal exemption deduction. An individual who may enroll in minimum 
essential coverage because of a relationship to another person eligible 
for the coverage, but for whom the other eligible person does not claim 
a personal exemption deduction under section 151, is treated as eligible 
for minimum essential coverage under the coverage only for months that 
the related individual is enrolled in the coverage.
    (ii) Exchange unable to discontinue advance credit payments--(A) In 
general. If an individual who is enrolled in a qualified health plan for 
which advance credit payments are made informs the Exchange that the 
individual is or will soon be eligible for other minimum essential 
coverage and that advance credit payments should be discontinued, but 
the Exchange does not discontinue advance credit payments for the first 
calendar month beginning after the month the individual informs the 
Exchange, the individual is treated as eligible for the other minimum 
essential coverage no earlier than the first day

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of the second calendar month beginning after the first month the 
individual may enroll in the other minimum essential coverage.
    (B) Medicaid or CHIP. If a determination is made that an individual 
who is enrolled in a qualified health plan for which advance credit 
payments are made is eligible for Medicaid or CHIP but the advance 
credit payments are not discontinued for the first calendar month 
beginning after the eligibility determination, the individual is treated 
as eligible for the Medicaid or CHIP no earlier than the first day of 
the second calendar month beginning after the eligibility determination.
    (d) [Reserved].
    (e) Effective/applicability date. (1) Except as provided in 
paragraph (e)(2) of this section, this section applies to taxable years 
ending after December 31, 2013.
    (2) Paragraph (b)(6)(ii), the last three sentences of paragraph 
(c)(2)(v), paragraph (c)(3)(i), paragraph (c)(3)(iii)(A), the last three 
sentences of paragraph (c)(3)(v)(A)(3), and paragraph (c)(4) of this 
section apply to taxable years beginning after December 31, 2016. 
Paragraphs (b)(6), (c)(3)(i), (c)(3)(iii)(A), and (c)(4) of Sec. 1.36B-2 
as contained in 26 CFR part I edition revised as of April 1, 2016, apply 
to taxable years ending after December 31, 2013, and beginning before 
January 1, 2017.

[T.D. 9590, 77 FR 30385, May 23, 2012, as amended by T.D. 9611, 78 FR 
7265, Feb. 1, 2013; T.D. 9683, 79 FR 43626, July 28, 2014; 80 fr 78974, 
Dec. 18, 2015; T.D. 9804, 81 FR 91764, Dec. 19, 2016]



Sec. 1.36B-2T  Eligibility for premium tax credit (temporary).

    (a) through (b)(1) [Reserved]. For further guidance, see Sec. 1.36B-
2(a) through (b)(1).
    (2) Married taxpayers must file joint return--(i) In general. Except 
as provided in paragraph (b)(2)(ii) of this section, a taxpayer who is 
married (within the meaning of section 7703) at the close of the taxable 
year is an applicable taxpayer only if the taxpayer and the taxpayer's 
spouse file a joint return for the taxable year.
    (ii) Victims of domestic abuse and abandonment. Except as provided 
in paragraph (b)(2)(v) of this section, a married taxpayer satisfies the 
joint filing requirement of paragraph (b)(2)(i) of this section if the 
taxpayer files a tax return using a filing status of married filing 
separately and the taxpayer--
    (A) Is living apart from the taxpayer's spouse at the time the 
taxpayer files the tax return;
    (B) Is unable to file a joint return because the taxpayer is a 
victim of domestic abuse, as described in paragraph (b)(2)(iii) of this 
section, or spousal abandonment, as described in paragraph (b)(2)(iv) of 
this section; and
    (C) Certifies on the return, in accordance with the relevant 
instructions, that the taxpayer meets the criteria of this paragraph 
(b)(2)(ii).
    (iii) Domestic abuse. For purposes of paragraph (b)(2)(ii) of this 
section, domestic abuse includes physical, psychological, sexual, or 
emotional abuse, including efforts to control, isolate, humiliate, and 
intimidate, or to undermine the victim's ability to reason 
independently. All the facts and circumstances are considered in 
determining whether an individual is abused, including the effects of 
alcohol or drug abuse by the victim's spouse. Depending on the facts and 
circumstances, abuse of the victim's child or another family member 
living in the household may constitute abuse of the victim.
    (iv) Abandonment. For purposes of paragraph (b)(2)(ii) of this 
section, a taxpayer is a victim of spousal abandonment for a taxable 
year if, taking into account all facts and circumstances, the taxpayer 
is unable to locate his or her spouse after reasonable diligence.
    (v) Three-year rule. Paragraph (b)(2)(ii) of this section does not 
apply if the taxpayer met the requirements of paragraph (b)(2)(ii) of 
this section for each of the three preceding taxable years.
    (b)(3) through (c)(3)(v)(B) [Reserved]. For further guidance, see 
Sec. 1.36B-2(b)(3) through (c)(3)(v)(B).
    (C) Required contribution percentage. The required contribution 
percentage is 9.5 percent. For plan years beginning in a calendar year 
after 2014, the percentage will be adjusted by the ratio of premium 
growth to income growth for the preceding calendar year and may

[[Page 124]]

be further adjusted to reflect changes to the data used to compute the 
ratio of premium growth to income growth for the 2014 calendar year or 
the data sources used to compute the ratio of premium growth to income 
growth. Premium growth and income growth will be determined under 
published guidance, see Sec. 601.601(d)(2) of this chapter. In addition, 
the percentage may be adjusted for plan years beginning in a calendar 
year after 2018 to reflect rates of premium growth relative to growth in 
the consumer price index.
    (c)(3)(v)(D) through (c)(4) [Reserved]. For further guidance, see 
Sec. 1.36B-2(c)(3)(v)(D) through (c)(4).
    (d) Effective/applicability date. Paragraphs (b)(2) and (c)(3)(v)(C) 
of this section apply to taxable years beginning after December 31, 
2013.
    (e) Expiration date. Paragraphs (b)(2) and (c)(3)(v)(C) of this 
section expire on July 24, 2017.

[T.D. 9683, 79 FR 43627, July 28, 2014]



Sec. 1.36B-3  Computing the premium assistance credit amount.

    (a) In general. A taxpayer's premium assistance credit amount for a 
taxable year is the sum of the premium assistance amounts determined 
under paragraph (d) of this section for all coverage months for 
individuals in the taxpayer's family.
    (b) Definitions. For purposes of this section--
    (1) The cost of a qualified health plan is the premium the plan 
charges; and
    (2) The term coverage family means, in each month, the members of a 
taxpayer's family for whom the month is a coverage month.
    (c) Coverage month--(1) In general. A month is a coverage month for 
an individual if--
    (i) As of the first day of the month, the individual is enrolled in 
a qualified health plan through an Exchange;
    (ii) The taxpayer pays the taxpayer's share of the premium for the 
individual's coverage under the plan for the month by the unextended due 
date for filing the taxpayer's income tax return for that taxable year, 
or the full premium for the month is paid by advance credit payments; 
and
    (iii) The individual is not eligible for the full calendar month for 
minimum essential coverage (within the meaning of Sec. 1.36B-2(c)) other 
than coverage described in section 5000A(f)(1)(C) (relating to coverage 
in the individual market).
    (2) Certain individuals enrolled during a month. If an individual 
enrolls in a qualified health plan and the enrollment is effective on 
the date of the individual's birth, adoption, or placement for adoption 
or in foster care, or on the effective date of a court order, the 
individual is treated as enrolled as of the first day of that month for 
purposes of this paragraph (c).
    (3) Premiums paid for a taxpayer. Premiums another person pays for 
coverage of the taxpayer, taxpayer's spouse, or dependent are treated as 
paid by the taxpayer.
    (4) Appeals of coverage eligibility. A taxpayer who is eligible for 
advance credit payments pursuant to an eligibility appeal decision 
implemented under 45 CFR 155.545(c)(1)(ii) for coverage of a member of 
the taxpayer's coverage family who, based on the appeal decision, 
retroactively enrolls in a qualified health plan is considered to have 
met the requirement in paragraph (c)(1)(ii) of this section for a month 
if the taxpayer pays the taxpayer's share of the premiums for coverage 
under the plan for the month on or before the 120th day following the 
date of the appeals decision.
    (5) Examples. The following examples illustrate the provisions of 
this paragraph (c):

    Example 1. (i) Taxpayer M is single with no dependents. In December 
2013, M enrolls in a qualified health plan for 2014 and the Exchange 
approves advance credit payments. M pays M's share of the premiums. On 
May 15, 2014, M enlists in the U.S. Army and is eligible immediately for 
government-sponsored minimum essential coverage.
    (ii) Under paragraph (c)(1) of this section, January through May 
2014 are coverage months for M. June through December 2014 are not 
coverage months because M is eligible for minimum essential coverage for 
those months. Thus, under paragraph (a) of this section, M's premium 
assistance credit amount for 2014 is the sum of the premium assistance 
amounts for the months January through May.
    Example 2. (i) Taxpayer N has one dependent, S. S is eligible for 
government-sponsored minimum essential coverage. N is not eligible for 
minimum essential coverage. N

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enrolls in a qualified health plan for 2014 and the Exchange approves 
advance credit payments. On August 1, 2014, S loses eligibility for 
minimum essential coverage. N terminates enrollment in the qualified 
health plan that covers only N and enrolls in a qualified health plan 
that covers N and S for August through December 2014. N pays all 
premiums not covered by advance credit payments.
    (ii) Under paragraph (c)(1) of this section, January through 
December of 2014 are coverage months for N and August through December 
are coverage months for N and S. N's premium assistance credit amount 
for 2014 is the sum of the premium assistance amounts for these coverage 
months.
    Example 3. (i) O and P are the divorced parents of T. Under the 
divorce agreement between O and P, T resides with P and P claims T as a 
dependent. However, O must pay premiums for health insurance for T. P 
enrolls T in a qualified health plan for 2014. O pays the portion of T's 
qualified health plan premiums not covered by advance credit payments.
    (ii) Because P claims T as a dependent, P (and not O) may claim a 
premium tax credit for coverage for T. See Sec. 1.36B-2(a). Under 
paragraph (c)(2) of this section, the premiums that O pays for coverage 
for T are treated as paid by P. Thus, the months when T is covered by a 
qualified health plan and not eligible for other minimum essential 
coverage are coverage months under paragraph (c)(1) of this section in 
computing P's premium tax credit under paragraph (a) of this section.
    Example 4. Q, an American Indian, enrolls in a qualified health plan 
for 2014. Q's tribe pays the portion of Q's qualified health plan 
premiums not covered by advance credit payments. Under paragraph (c)(2) 
of this section, the premiums that Q's tribe pays for Q are treated as 
paid by Q. Thus, the months when Q is covered by a qualified health plan 
and not eligible for other minimum essential coverage are coverage 
months under paragraph (c)(1) of this section in computing Q's premium 
tax credit under paragraph (a) of this section.

    (d) Premium assistance amount--(1) Premium assistance amount. The 
premium assistance amount for a coverage month is the lesser of--
    (i) The premiums for the month, reduced by any amounts that were 
refunded, for one or more qualified health plans in which a taxpayer or 
a member of the taxpayer's family enrolls (enrollment premiums); or
    (ii) The excess of the adjusted monthly premium for the applicable 
benchmark plan (benchmark plan premium) over \1/12\ of the product of a 
taxpayer's household income and the applicable percentage for the 
taxable year (the taxpayer's contribution amount).
    (2) Examples. The following examples illustrate the rules of 
paragraph (d)(1) of this section.

    Example 1. Taxpayer Q is single and has no dependents. Q enrolls in 
a qualified health plan with a monthly premium of $400. Q's monthly 
benchmark plan premium is $500, and his monthly contribution amount is 
$80. Q's premium assistance amount for a coverage month is $400 (the 
lesser of $400, Q's monthly enrollment premium, and $420, the difference 
between Q's monthly benchmark plan premium and Q's contribution amount).
    Example 2. (i) Taxpayer R is single and has no dependents. R enrolls 
in a qualified health plan with a monthly premium of $450. The 
difference between R's benchmark plan premium and contribution amount 
for the month is $420.
    (ii) The issuer of R's qualified health plan is notified that R died 
on September 20. The issuer terminates coverage as of that date and 
refunds the remaining portion of the September enrollment premiums 
($150) for R's coverage.
    (iii) R's premium assistance amount for each coverage month from 
January through August is $420 (the lesser of $450 and $420). Under 
paragraph (d)(1) of this section, R's premium assistance amount for 
September is the lesser of the enrollment premiums for the month, 
reduced by any amounts that were refunded ($300 ($450-$150)) or the 
difference between the benchmark plan premium and the contribution 
amount for the month ($420). R's premium assistance amount for September 
is $300, the lesser of $420 and $300.
    Example 3. The facts are the same as in Example 2 of this paragraph 
(d)(2), except that the qualified health plan issuer does not refund any 
enrollment premiums for September. Under paragraph (d)(1) of this 
section, R's premium assistance amount for September is $420, the lesser 
of $450 and $420.

    (e) Adjusted monthly premium. The adjusted monthly premium is the 
premium an issuer would charge for the applicable benchmark plan to 
cover all members of the taxpayer's coverage family, adjusted only for 
the age of each member of the coverage family as allowed under section 
2701 of the Public Health Service Act (42 U.S.C. 300gg). The adjusted 
monthly premium is determined without regard to any premium discount or 
rebate under the wellness discount demonstration project under section 
2705(d) of the Public Health Service Act (42 U.S.C.

[[Page 126]]

300gg-4(d)) and may not include any adjustments for tobacco use. The 
adjusted monthly premium for a coverage month is determined as of the 
first day of the month.
    (f) Applicable benchmark plan--(1) In general. Except as otherwise 
provided in this paragraph (f), the applicable benchmark plan for each 
coverage month is the second-lowest-cost silver plan (as described in 
section 1302(d)(1)(B) of the Affordable Care Act (42 U.S.C. 
18022(d)(1)(B))) offered to the taxpayer's coverage family through the 
Exchange for the rating area where the taxpayer resides for--
    (i) Self-only coverage for a taxpayer--
    (A) Who computes tax under section 1(c) (unmarried individuals other 
than surviving spouses and heads of household) and is not allowed a 
deduction under section 151 for a dependent for the taxable year;
    (B) Who purchases only self-only coverage for one individual; or
    (C) Whose coverage family includes only one individual; and
    (ii) Family coverage for all other taxpayers.
    (2) Family coverage. The applicable benchmark plan for family 
coverage is the second lowest-cost silver plan that would cover the 
members of the taxpayer's coverage family (such as a plan covering two 
adults if the members of a taxpayer's coverage family are two adults).
    (3) Silver-level plan not covering pediatric dental benefits. If one 
or more silver-level qualified health plans offered through an Exchange 
do not cover pediatric dental benefits, the premium for the applicable 
benchmark plan is determined based on the second lowest-cost option 
among--
    (i) The silver-level qualified health plans that are offered by the 
Exchange to the members of the coverage family and that provide 
pediatric dental benefits; and
    (ii) The silver-level qualified health plans that are offered by the 
Exchange to the members of the coverage family that do not provide 
pediatric dental benefits in conjunction with the second lowest-cost 
portion of the premium for a stand-alone dental plan (within the meaning 
of section 1311(d)(2)(B)(ii) of the Affordable Care Act (42 U.S.C. 
18031(d)(2)(B)(ii)) offered by the Exchange to the members of the 
coverage family that is properly allocable to pediatric dental benefits 
determined under guidance issued by the Secretary of Health and Human 
Services.
    (4) Family members residing in different locations. If members of a 
taxpayer's coverage family reside in different locations, the taxpayer's 
benchmark plan premium is the sum of the premiums for the applicable 
benchmark plans for each group of coverage family members residing in 
different locations, based on the plans offered to the group through the 
Exchange where the group resides. If all members of a taxpayer's 
coverage family reside in a single location that is different from where 
the taxpayer resides, the taxpayer's benchmark plan premium is the 
premium for the applicable benchmark plan for the coverage family, based 
on the plans offered through the Exchange to the taxpayer's coverage 
family for the rating area where the coverage family resides.
    (5) Single or multiple policies needed to cover the family--(i) 
Policy covering a taxpayer's family. If a silver-level plan or a stand-
alone dental plan offers coverage to all members of a taxpayer's 
coverage family who reside in the same location under a single policy, 
the premium (or allocable portion thereof, in the case of a stand-alone 
dental plan) taken into account for the plan for purposes of determining 
the applicable benchmark plan under paragraphs (f)(1), (f)(2), and 
(f)(3) of this section is the premium for this single policy.
    (ii) Policy not covering a taxpayer's family. If a silver-level 
qualified health plan or a stand-alone dental plan would require 
multiple policies to cover all members of a taxpayer's coverage family 
who reside in the same location (for example, because of the 
relationships within the family), the premium (or allocable portion 
thereof, in the case of a standalone dental plan) taken into account for 
the plan for purposes of determining the applicable benchmark plan under 
paragraphs (f)(1), (f)(2), and (f)(3) of this section is the sum of the 
premiums (or allocable portion thereof, in the case of a stand-alone 
dental plan) for self-only policies under the plan for each member of 
the coverage

[[Page 127]]

family who resides in the same location.
    (6) Plan not available for enrollment. A silver-level qualified 
health plan or a stand-alone dental plan that is not open to enrollment 
by a taxpayer or family member at the time the taxpayer or family member 
enrolls in a qualified health plan is disregarded in determining the 
applicable benchmark plan.
    (7) Benchmark plan terminates or closes to enrollment during the 
year. A silver-level qualified health plan or a stand-alone dental plan 
that is used for purposes of determining the applicable benchmark plan 
under this paragraph (f) for a taxpayer does not cease to be the 
applicable benchmark plan for a taxable year solely because the plan or 
a lower cost plan terminates or closes to enrollment during the taxable 
year.
    (8) Only one silver-level plan offered to the coverage family. If 
there is only one silver-level qualified health plan or one stand-alone 
dental plan offered through an Exchange that would cover all members of 
a taxpayer's coverage family who reside in the same location (whether 
under one policy or multiple policies), that plan is used for purposes 
of determining the taxpayer's applicable benchmark plan.
    (9) Examples. The following examples illustrate the rules of this 
paragraph (f). Unless otherwise stated, in each example the plans are 
open to enrollment to a taxpayer or family member at the time of 
enrollment and are offered through the Exchange for the rating area 
where the taxpayer resides:
    Example 1. Single taxpayer enrolls in Exchange coverage. Taxpayer A 
is single, has no dependents, and enrolls in a qualified health plan. 
The Exchange in the rating area in which A resides offers only silver-
level qualified health plans that provide pediatric dental benefits. 
Under paragraphs (f)(1) and (f)(2) of this section, A's applicable 
benchmark plan is the second lowest cost silver plan providing self-only 
coverage for A.
    Example 2. Single taxpayer enrolls with dependent child through an 
Exchange where all qualified health plans provide pediatric dental 
benefits. Taxpayer B is single and claims her 12-year old daughter, C, 
as a dependent. B purchases family coverage for herself and C. The 
Exchange in the rating area in which B and C reside offers qualified 
health plans that provide pediatric dental benefits but does not offer 
qualified health plans without pediatric dental benefits. Under 
paragraphs (f)(1) and (f)(2) of this section, B's applicable benchmark 
plan is the second lowest-cost silver plan providing family coverage to 
B and C.
    Example 3. Single taxpayer enrolls with dependent child through an 
Exchange where one or more qualified health plans do not provide 
pediatric dental benefits. (i) Taxpayer D is single and claims his 10-
year old son, E, as a dependent. The Exchange in the rating area in 
which D and E reside offers three silver-level qualified health plans, 
one of which provides pediatric dental benefits (S1) and two of which do 
not (S2 and S3), in which D and E may enroll. The Exchange also offers 
two stand-alone dental plans (DP1 and DP2) available to D and E. The 
monthly premiums allocable to essential health benefits for the silver-
level plans are as follows:
S1--$650
S2--$620
S3--$590
    (ii) The monthly premiums, and the portion of the premium allocable 
to pediatric dental benefits, for the two dental plans are as follows:
DP1--$50 ($20 allocable to pediatric dental benefits)
DP2--$40 ($15 allocable to pediatric dental benefits).
    (iii) Under paragraph (f)(3) of this section, D's applicable 
benchmark plan is the second lowest cost option among the following 
offered by the rating area in which D resides: Silver-level qualified 
health plans providing pediatric dental benefits ($650 for S1) and the 
silver-level qualified health plans not providing pediatric dental 
benefits, in conjunction with the second lowest-cost portion of the 
premium for a stand-alone dental plan properly allocable to pediatric 
dental benefits ($590 for S3 in conjunction with $20 for DP1 = $610 and 
$620 for S2 in conjunction with $20 for DP1 = $640). Under paragraph (e) 
of this section, the adjusted monthly premium for D's applicable 
benchmark plan is $640.
    Example 4. Single taxpayer enrolls with dependent adult through an 
Exchange where one or more qualified health plans do not provide 
pediatric dental benefits. (i) The facts are the same as in Example 3, 
except Taxpayer D's coverage family consists of D and D's 22-year old 
son, F, who is a dependent of D. The monthly premiums allocable to 
essential health benefits for the silver-level plans are as follows:
S1--$630
S2--$590
S3--$580
    (ii) Because no one in D's coverage family is eligible for pediatric 
dental benefits, $0 of the premium for a stand-alone dental plan is 
allocable to pediatric dental benefits in determining A's applicable 
benchmark plan. Consequently, under paragraphs (f)(1), (f)(2),

[[Page 128]]

and (f)(3) of this section, D's applicable benchmark plan is the second 
lowest-cost option among the following options offered by the rating 
area in which D resides: Silver-level qualified health plans providing 
pediatric dental benefits ($630 for S1) and the silver-level qualified 
health plans not providing pediatric dental benefits, in conjunction 
with the second lowest-cost portion of the premium for a stand-alone 
dental plan properly allocable to pediatric dental benefits ($580 for S3 
in conjunction with $0 for DP1 = $580 and $590 for S2 in conjunction 
with $0 for DP1 = $590). Under paragraph (e) of this section, the 
adjusted monthly premium for D's applicable benchmark plan is $590.
    Example 5. Single taxpayer enrolls with dependent and nondependent. 
Taxpayer G is single and resides with his 25-year old daughter, H, and 
with his 14-year old son, I. G may claim I, but not H, as a dependent. 
G, H, and I enroll in coverage through the Exchange in the rating area 
in which they all reside. The Exchange offers only silver-level plans 
providing pediatric dental benefits. Under paragraphs (f)(1) and (f)(2) 
of this section, G's applicable benchmark plan is the second lowest-cost 
silver plan covering G and I. However, H may qualify for a premium tax 
credit if H is otherwise eligible. See paragraph (h) of this section.
    Example 6. Change in coverage family. Taxpayer J is single and has 
no dependents when she enrolls in a qualified health plan. The Exchange 
in the rating area in which she resides offers only silver-level plans 
that provide pediatric dental benefits. On August 1, J has a child, K, 
whom she claims as a dependent. J enrolls in a qualified health plan 
covering J and K effective August 1. Under paragraphs (f)(1) and (f)(2) 
of this section, J's applicable benchmark plan for January through July 
is the second lowest-cost silver plan providing self-only coverage for 
J, and J's applicable benchmark plan for the months August through 
December is the second lowest-cost silver plan covering J and K.
    Example 7. Minimum essential coverage for some coverage months. 
Taxpayer L claims his 6-year old daughter, M, as a dependent. L and M 
are enrolled for the entire year in a qualified health plan that offers 
only silver-level plans that provide pediatric dental benefits. L, but 
not M, is eligible for government-sponsored minimum essential coverage 
for September to December. Thus, under paragraph (c)(1)(iii) of this 
section, January through December are coverage months for M, and January 
through August are coverage months for L. Because, under paragraphs (d) 
and (f)(1) of this section, the premium assistance amount for a coverage 
month is computed based on the applicable benchmark plan for that 
coverage month, L's applicable benchmark plan for January through August 
is the second lowest-cost option covering L and M. Under paragraph 
(f)(1)(i)(C) of this section, L's applicable benchmark plan for 
September through December is the second lowest-cost silver plan 
providing self-only coverage for M.
    Example 8. Family member eligible for minimum essential coverage for 
the taxable year. The facts are the same as in Example 7, except that L 
is not eligible for government-sponsored minimum essential coverage for 
any months and M is eligible for government sponsored minimum essential 
coverage for the entire year. Under paragraph (f)(1)(i)(C) of this 
section, L's applicable benchmark plan is the second lowest-cost silver 
plan providing self-only coverage for L.
    Example 9. Benchmark plan premium for a coverage family with family 
members who reside in different locations. (i) Taxpayer N's coverage 
family consists of N and her three dependents O, P, and Q. N, O, and P 
reside together but Q resides in a different location. The monthly 
applicable benchmark plan premium for N, O, and P is $1,000 and the 
monthly applicable benchmark plan premium for Q is $220.
    (ii) Under paragraph (f)(4) of this section, because the members of 
N's coverage family reside in different locations, the monthly premium 
for N's applicable benchmark plan is the sum of $1,000, the monthly 
premiums for the applicable benchmark plan for N, O, and P, who reside 
together, and $220, the monthly applicable benchmark plan premium for Q, 
who resides in a different location than N, O, and P. Consequently, the 
premium for N's applicable benchmark plan is $1,220.
    Example 10. Aggregation of silver-level policies for plans not 
covering a family under a single policy. (i) Taxpayers R and S are 
married and live with S's mother, T, whom they claim as a dependent. The 
Exchange for their rating area offers self-only and family coverage at 
the silver level through Issuers A, B, and C, which each offer only one 
silver-level plan. The silver-level plans offered by Issuers A and B do 
not cover R, S, and T under a single policy. The silver-level plan 
offered by Issuer A costs the following monthly amounts for self-only 
coverage of R, S, and T, respectively: $400, $450, and $600. The silver-
level plan offered by Issuer B costs the following monthly amounts for 
self-only coverage of R, S, and T, respectively: $250, $300, and $450. 
The silver-level plan offered by Issuer C provides coverage for R, S, 
and T under one policy for a $1,200 monthly premium.
    (ii) Under paragraph (f)(5) of this section, Issuer C's silver-level 
plan that covers R, S, and T under one policy ($1,200 monthly premium) 
and Issuer A's and Issuer B's silver-level plans that do not cover R, S 
and T under one policy are considered in determining R's and S's 
applicable benchmark plan. In addition, under paragraph (f)(5)(ii) of 
this section, in determining R's and S's applicable benchmark plan, the 
premium taken

[[Page 129]]

into account for Issuer A's plan is $1,450 (the aggregate premiums for 
self-only policies covering R ($400), S ($450), and T ($600) and the 
premium taken into account for Issuer B's plan is $1,000 (the aggregate 
premiums for self-only policies covering R ($250), S ($300), and T 
($450). Consequently, R's and S's applicable benchmark plan is the 
Issuer C silver-level plan covering R's and S's coverage family and the 
premium for their applicable benchmark plan is $1,200.
    Example 11. Benchmark plan premium for a taxpayer with family 
members who cannot enroll in one policy and who reside in different 
locations. (i) Taxpayer U's coverage family consists of U, U's mother, 
V, and U's two daughters, W and X. U and V reside together in Location 1 
and W and X reside together in Location 2. The Exchange in the rating 
area in which U and V reside does not offer a silver-level plan that 
covers U and V under a single policy, whereas all the silver-level plans 
offered through the Exchange in the rating area in which W and X reside 
cover W and X under a single policy. Both Exchanges offer only silver-
level plans that provide pediatric dental benefits. The silver plan 
offered by the Exchange for the rating area in which U and V reside that 
would cover U and V under self-only policies with the second-lowest 
aggregate premium costs $400 a month for self-only coverage for U and 
$600 a month for self-only coverage for V. The monthly premium for the 
second-lowest cost silver plan covering W and X that is offered by the 
Exchange for the rating area in which W and X reside is $500.
    (ii) Under paragraph (f)(5)(ii) of this section, because multiple 
policies are required to cover U and V, the members of U's coverage 
family who reside together in Location 1, the premium taken into account 
in determining U's benchmark plan is $1,000, the sum of the premiums for 
the second-lowest aggregate cost of self-only policies covering U ($400) 
and V ($600) offered by the Exchange to U and V for the rating area in 
which U and V reside. Under paragraph (f)(5)(i) of this section, because 
all silver-level plans offered by the Exchange in which W and X reside 
cover W and X under a single policy, the premium for W and X's coverage 
that is taken into account in determining U's benchmark plan is $500, 
the second-lowest cost silver policy covering W and X that is offered by 
the Exchange for the rating area in which W and X reside. Under 
paragraph (f)(4) of this section, because the members of U's coverage 
family reside in different locations, U's monthly benchmark plan premium 
is $1,500, the sum of the premiums for the applicable benchmark plans 
for each group of family members residing in different locations ($1,000 
for U and V, who reside in Location 1, plus $500 for W and X, who reside 
in Location 2).
    Example 12. Qualified health plan closed to enrollment. Taxpayer Y 
has two dependents, Z and AA. Y, Z, and AA enroll in a qualified health 
plan through the Exchange for the rating area where the family resides. 
The Exchange, which offers only qualified health plans that include 
pediatric dental benefits, offers silver-level plans J, K, L, and M, 
which are, respectively, the first, second, third, and fourth lowest 
cost silver plans covering Y's family. When Y's family enrolls, Plan J 
is closed to enrollment. Under paragraph (f)(6) of this section, Plan J 
is disregarded in determining Y's applicable benchmark plan, and Plan L 
is used in determining Y's applicable benchmark plan.
    Example 13. Benchmark plan closes to new enrollees during the year. 
(i) Taxpayers BB, CC, and DD each have coverage families consisting of 
two adults. In that rating area, Plan 2 is the second lowest cost silver 
plan and Plan 3 is the third lowest cost silver plan covering the two 
adults in each coverage family offered through the Exchange. The BB and 
CC families each enroll in a qualified health plan that is not the 
applicable benchmark plan (Plan 4) in November during the annual open 
enrollment period. Plan 2 closes to new enrollees the following June. 
Thus, on July 1, Plan 3 is the second lowest cost silver plan available 
to new enrollees through the Exchange. The DD family enrolls in a 
qualified health plan in July.
    (ii) Under paragraphs (f)(1), (f)(2), (f)(3), and (f)(7) of this 
section, the silver-level plan that BB and CC use to determine their 
applicable benchmark plan for all coverage months during the year is 
Plan 2. The applicable benchmark plan that DD uses to determine DD's 
applicable benchmark plan is Plan 3, because Plan 2 is not open to 
enrollment through the Exchange when the DD family enrolls.
    Example 14. Benchmark plan terminates for all enrollees during the 
year. The facts are the same as in Example 13, except that Plan 2 
terminates for all enrollees on June 30. Under paragraphs (f)(1), 
(f)(2), (f)(3), and (f)(7) of this section, Plan 2 is the silver-level 
plan that BB and CC use to determine their applicable benchmark plan for 
all coverage months during the year, and Plan 3 is the applicable 
benchmark plan that DD uses.
    Example 15. Exchange offers only one silver-level plan. Taxpayer 
EE's coverage family consists of EE, his spouse FF, and their two 
dependent children GG and HH, who all reside together. The Exchange for 
the rating area in which they reside offers only one silver-level plan 
that EE's family may enroll in and the plan does not provide pediatric 
dental benefits. The Exchange also offers one stand-alone dental plan in 
which the family may enroll. Under paragraph (f)(8) of this section, the 
silver-level plan and the stand-alone dental plan offered by the 
Exchange are used for purposes of determining EE's applicable benchmark 
plan under paragraph

[[Page 130]]

(f)(3) of this section. Moreover, the lone silver-level plan and the 
lone stand-alone dental plan offered by the Exchange are used for 
purposes of determining EE's applicable benchmark plan regardless of 
whether these plans cover EE's family under a single policy or multiples 
policies.

    (g) Applicable percentage--(1) [Reserved]. For further guidance, see 
Sec. 1.36B-3T(g)(1).
    (2) Applicable percentage table.

------------------------------------------------------------------------
 Household income percentage of Federal       Initial          Final
              poverty line                  percentage      percentage
------------------------------------------------------------------------
Less than 133%..........................             2.0             2.0
At least 133% but less than 150%........             3.0             4.0
At least 150% but less than 200%........             4.0             6.3
At least 200% but less than 250%........             6.3            8.05
At least 250% but less than 300%........            8.05             9.5
At least 300% but not more than 400%....             9.5             9.5
------------------------------------------------------------------------

    (3) Examples. The following examples illustrate the rules of this 
paragraph (g):

    Example 1. A's household income is 275 percent of the Federal 
Poverty line for A's family size for that taxable year. In the table in 
paragraph (g)(2) of this section, the initial percentage for a taxpayer 
with household income of 250 to 300 percent of the Federal poverty line 
is 8.05 and the final percentage is 9.5. A's Federal poverty line 
percentage of 275 percent is halfway between 250 percent and 300 
percent. Thus, rounded to the nearest one-hundredth of one percent, A's 
applicable percentage is 8.78, which is halfway between the initial 
percentage of 8.05 and the final percentage of 9.5.
    Example 2. (i) B's household income is 210 percent of the Federal 
poverty line for B's family size. In the table in paragraph (g)(2) of 
this section, the initial percentage for a taxpayer with household 
income of 200 to 250 percent of the Federal poverty line is 6.3 and the 
final percentage is 8.05. B's applicable percentage is 6.65, computed as 
follows.
    (ii) Determine the excess of B's Federal poverty line percentage 
(210) over the initial household income percentage in B's range (200), 
which is 10. Determine the difference between the initial household 
income percentage in the taxpayer's range (200) and the ending household 
income percentage in the taxpayer's range (250), which is 50. Divide the 
first amount by the second amount:


210 - 200 = 10
250 - 200 = 50
10 / 50 = .20

    (iii) Compute the difference between the initial premium percentage 
(6.3) and the second premium percentage (8.05) in the taxpayer's range; 
8.05-6.3 = 1.75.
    (iv) Multiply the amount in the first calculation (.20) by the 
amount in the second calculation (1.75) and add the product (.35) to the 
initial premium percentage in B's range (6.3), resulting in B's 
applicable percentage of 6.65:

.20  x  1.75 = .35
6.3 + .35 = 6.65.

    (h) Plan covering more than one family--(1) In general. If a 
qualified health plan covers more than one family under a single policy, 
each applicable taxpayer covered by the plan may claim a premium tax 
credit, if otherwise allowable. Each taxpayer computes the credit using 
that taxpayer's applicable percentage, household income, and the 
benchmark plan that applies to the taxpayer under paragraph (f) of this 
section. In determining whether the amount computed under paragraph 
(d)(1)(i) of this section (the premiums for the qualified health plan in 
which the taxpayer enrolls) is less than the amount computed under 
paragraph (d)(1)(ii) of this section (the benchmark plan premium minus 
the product of household income and the applicable percentage), the 
premiums paid are allocated to each taxpayer in proportion to the 
premiums for each taxpayer's applicable benchmark plan.
    (2) Example. The following example illustrates the rules of this 
paragraph (h):

    Example. (i) Taxpayers A and B enroll in a single policy under a 
qualified health plan. B is A's 25-year old child who is not A's 
dependent. B has no dependents. The plan covers A, B, and A's two 
additional children who are A's dependents. The premium for the plan in 
which A and B enroll is $15,000. The premium for the second lowest cost 
silver family plan covering only A and A's dependents is $12,000 and the 
premium for the second lowest cost silver plan providing self-only 
coverage to B is $6,000. A and B are applicable taxpayers and otherwise 
eligible to claim the premium tax credit.

[[Page 131]]

    (ii) Under paragraph (h)(1) of this section, both A and B may claim 
premium tax credits. A computes her credit using her household income, a 
family size of three, and a benchmark plan premium of $12,000. B 
computes his credit using his household income, a family size of one, 
and a benchmark plan premium of $6,000.
    (iii) In determining whether the amount in paragraph (d)(1)(i) of 
this section (the premiums for the qualified health plan A and B 
purchase) is less than the amount in paragraph (d)(1)(ii) of this 
section (the benchmark plan premium minus the product of household 
income and the applicable percentage), the $15,000 premiums paid are 
allocated to A and B in proportion to the premiums for their applicable 
benchmark plans. Thus, the portion of the premium allocated to A is 
$10,000 ($15,000  x  $12,000/$18,000) and the portion allocated to B is 
$5,000 ($15,000  x  $6,000/$18,000).

    (i) [Reserved]
    (j) Additional benefits--(1) In general. If a qualified health plan 
offers benefits in addition to the essential health benefits a qualified 
health plan must provide under section 1302 of the Affordable Care Act 
(42 U.S.C. 18022), or a State requires a qualified health plan to cover 
benefits in addition to these essential health benefits, the portion of 
the premium for the plan properly allocable to the additional benefits 
is excluded from the monthly premiums under paragraph (d)(1)(i) or (ii) 
of this section. Premiums are allocated to additional benefits before 
determining the applicable benchmark plan under paragraph (f) of this 
section.
    (2) Method of allocation. The portion of the premium properly 
allocable to additional benefits is determined under guidance issued by 
the Secretary of Health and Human Services. See section 36B(b)(3)(D).
    (3) Examples. The following examples illustrate the rules of this 
paragraph (j):

    Example 1. (i) Taxpayer B enrolls in a qualified health plan that 
provides benefits in addition to essential health benefits (additional 
benefits). The monthly premiums for the plan in which B enrolls are 
$370, of which $35 is allocable to additional benefits. B's benchmark 
plan premium (determined after allocating premiums to additional 
benefits for all silver level plans) is $440, of which $40 is allocable 
to additional benefits. B's monthly contribution amount, which is the 
product of B's household income and the applicable percentage, is $60.
    (ii) Under this paragraph (j), B's enrollment premiums and the 
benchmark plan premium are reduced by the portion of the premium that is 
allocable to the additional benefits provided under that plan. 
Therefore, B's monthly enrollment premiums are reduced to $335 ($370 - 
$35) and B's benchmark plan premium is reduced to $400 ($440 - $40). B's 
premium assistance amount for a coverage month is $335, the lesser of 
$335 (B's enrollment premiums, reduced by the portion of the premium 
allocable to additional benefits) and $340 (B's benchmark plan premium, 
reduced by the portion of the premium allocable to additional benefits 
($400), minus B's $60 contribution amount).
    Example 2. The facts are the same as in Example 1 of this paragraph 
(j)(3), except that the plan in which B enrolls provides no benefits in 
addition to the essential health benefits required to be provided by the 
plan. Thus, under paragraph (j) of this section, B's benchmark plan 
premium ($440) is reduced by the portion of the premium allocable to 
additional benefits provided under that plan ($40). B's enrollment 
premiums ($370) are not reduced under this paragraph (j). B's premium 
assistance amount for a coverage month is $340, the lesser of $370 (B's 
enrollment premiums) and $340 (B's benchmark plan premium, reduced by 
the portion of the premium allocable to additional benefits ($400), 
minus B's $60 contribution amount).

    (k) Pediatric dental coverage--(1) In general. For purposes of 
determining the amount of the monthly premium a taxpayer pays for 
coverage under paragraph (d)(1)(i) of this section, if an individual 
enrolls in both a qualified health plan and a plan described in section 
1311(d)(2)(B)(ii) of the Affordable Care Act (42 U.S.C. 
13031(d)(2)(B)(ii)) (a stand-alone dental plan), the portion of the 
premium for the stand-alone dental plan that is properly allocable to 
pediatric dental benefits that are essential benefits required to be 
provided by a qualified health plan is treated as a premium payable for 
the individual's qualified health plan.
    (2) Method of allocation. The portion of the premium for a stand-
alone dental plan properly allocable to pediatric dental benefits is 
determined under guidance issued by the Secretary of Health and Human 
Services.
    (3) Example. The following example illustrates the rules of this 
paragraph (k):

    Example. (i) Taxpayer C and C's dependent, R, enroll in a qualified 
health plan. The premium for the plan in which C and R enroll is

[[Page 132]]

$7,200 ($600/month) (Amount 1). The plan does not provide dental 
coverage. C also enrolls in a stand-alone dental plan covering C and R. 
The portion of the premium for the dental plan allocable to pediatric 
dental benefits that are essential health benefits is $240 ($20 per 
month). The excess of the premium for C's applicable benchmark plan over 
C's contribution amount (the product of C's household income and the 
applicable percentage) is $7,260 ($605/month) (Amount 2).
    (ii) Under this paragraph (k), the amount C pays for premiums 
(Amount 1) for purposes of computing the premium assistance amount is 
increased by the portion of the premium for the stand-alone dental plan 
allocable to pediatric dental benefits that are essential health 
benefits. Thus, the amount of the premiums for the plan in which C 
enrolls is treated as $620 for purposes of computing the amount of the 
premium tax credit. C's premium assistance amount for each coverage 
month is $605 (Amount 2), the lesser of Amount 1 (increased by the 
premiums allocable to pediatric dental benefits) and Amount 2.

    (l) Families including individuals not lawfully present--(1) In 
general. If one or more individuals for whom a taxpayer is allowed a 
deduction under section 151 are not lawfully present (within the meaning 
of Sec. 1.36B-1(g)), the percentage a taxpayer's household income bears 
to the Federal poverty line for the taxpayer's family size for purposes 
of determining the applicable percentage under paragraph (g) of this 
section is determined by excluding individuals who are not lawfully 
present from family size and by determining household income in 
accordance with paragraph (l)(2) of this section.
    (2) Revised household income computation--(i) Statutory method. For 
purposes of paragraph (l)(1) of this section, household income is equal 
to the product of the taxpayer's household income (determined without 
regard to this paragraph (l)(2)) and a fraction--
    (A) The numerator of which is the Federal poverty line for the 
taxpayer's family size determined by excluding individuals who are not 
lawfully present; and
    (B) The denominator of which is the Federal poverty line for the 
taxpayer's family size determined by including individuals who are not 
lawfully present.
    (ii) Comparable method. The Commissioner may describe a comparable 
method in additional published guidance, see Sec. 601.601(d)(2) of this 
chapter.
    (m) [Reserved]. For further guidance, see Sec. 1.36B-3T(m).
    (n) Effective/applicability date. (1) Except as provided in 
paragraph (n)(2) of this section, this section applies to taxable years 
ending after December 31, 2013.
    (2) Paragraphs (c)(4), (d)(1) and (d)(2) of this section apply to 
taxable years beginning after December 31, 2016. Paragraph (f) of this 
section applies to taxable years beginning after December 31, 2018. 
Paragraphs (d)(1) and (d)(2) of Sec. 1.36B-3, as contained in 26 CFR 
part I edition revised as of April 1, 2016, applies to taxable years 
ending after December 31, 2013, and beginning before January 1, 2017. 
Paragraph (f) of Sec. 1.36B-3, as contained in 26 CFR part I edition 
revised as of April 1, 2016, applies to taxable years ending after 
December 31, 2013, and beginning before January 1, 2019.

[T.D. 9590, 77 FR 30385, May 23, 2012; 77 FR 41048, July 12, 2012; T.D. 
9683, 79 FR 43627, July 28, 2014; T.D. 9745, 80 FR 78975, Dec. 18, 2015; 
81 FR 2088, Jan. 15, 2016; T.D. 9804, 81 FR 91765, Dec. 19, 2016]



Sec. 1.36B-3T  Computing the premium assistance credit amount (temporary).

    (a) through (f) [Reserved]. For further guidance, see Sec. 1.36B-
3(a) through (f).
    (g) Applicable percentage--(1) In general. The applicable percentage 
multiplied by a taxpayer's household income determines the taxpayer's 
annual required share of premiums for the benchmark plan. The required 
share is divided by 12 and this monthly amount is subtracted from the 
adjusted monthly premium for the applicable benchmark plan when 
computing the premium assistance amount. The applicable percentage is 
computed by first determining the percentage that the taxpayer's 
household income bears to the Federal poverty line for the taxpayer's 
family size. The resulting Federal poverty line percentage is then 
compared to the income categories described in the table in paragraph 
(g)(2) of this section (or successor tables). An applicable percentage 
within an income category increases on a sliding scale in a linear 
manner and is rounded to the nearest one-hundredth of one percent.

[[Page 133]]

For taxable years beginning after December 31, 2014, the applicable 
percentages in the table will be adjusted by the ratio of premium growth 
to income growth for the preceding calendar year and may be further 
adjusted to reflect changes to the data used to compute the ratio of 
premium growth to income growth for the 2014 calendar year or the data 
sources used to compute the ratio of premium growth to income growth. 
Premium growth and income growth will be determined in accordance with 
published guidance, see Sec. 601.601(d)(2) of this chapter. In addition, 
the applicable percentages in the table may be adjusted for taxable 
years beginning after December 31, 2018, to reflect rates of premium 
growth relative to growth in the consumer price index.
    (g)(2) through (l) [Reserved]. For further guidance, see Sec. 1.36B-
3(g)(2) through (l).
    (m) Effective/applicability date. Paragraph (g)(1) of this section 
applies to taxable years beginning after December 31, 2013.
    (n) Expiration date. Paragraph (g)(1) of this section expires on 
July 24, 2017.

[T.D. 9683, 79 FR 43627, July 28, 2014]



Sec. 1.36B-4  Reconciling the premium tax credit with advance credit payments.

    (a) Reconciliation--(1) Coordination of premium tax credit with 
advance credit payments--(i) In general. A taxpayer must reconcile the 
amount of credit allowed under section 36B with advance credit payments 
on the taxpayer's income tax return for a taxable year. A taxpayer whose 
premium tax credit for the taxable year exceeds the taxpayer's advance 
credit payments may receive the excess as an income tax refund. A 
taxpayer whose advance credit payments for the taxable year exceed the 
taxpayer's premium tax credit owes the excess as an additional income 
tax liability.
    (ii) [Reserved]. For further guidance, see Sec. 1.36B-4T(a)(1)(ii).
    (iii) Advance credit payment for a month in which an issuer does not 
provide coverage. For purposes of reconciliation, a taxpayer does not 
have an advance credit payment for a month if the issuer of the 
qualified health plan in which the taxpayer or a family member is 
enrolled does not provide coverage for that month.
    (2) Credit computation. The premium assistance credit amount is 
computed on the taxpayer's return using the taxpayer's household income 
and family size for the taxable year. Thus, the taxpayer's contribution 
amount (household income for the taxable year times the applicable 
percentage) is determined using the taxpayer's household income and 
family size at the end of the taxable year. The applicable benchmark 
plan for each coverage month is determined under Sec. 1.36B-3(f).
    (3) Limitation on additional tax--(i) In general. The additional tax 
imposed under paragraph (a)(1) of this section on a taxpayer whose 
household income is less than 400 percent of the Federal poverty line is 
limited to the amounts provided in the table in paragraph (a)(3)(ii) of 
this section (or successor tables). For taxable years beginning after 
December 31, 2014, the limitation amounts may be adjusted in published 
guidance, see Sec. 601.601(d)(2) of this chapter, to reflect changes in 
the consumer price index.
    (ii) Additional tax limitation table.

----------------------------------------------------------------------------------------------------------------
                                                                 Limitation amount for
                                                                 taxpayers whose tax is   Limitation amount for
      Household income percentage of Federal poverty line           determined under       all other taxpayers
                                                                      section 1(c)
----------------------------------------------------------------------------------------------------------------
Less than 200%................................................                     $300                     $600
At least 200% but less than 300%..............................                      750                    1,500
At least 300% but less than 400%..............................                    1,250                    2,500
----------------------------------------------------------------------------------------------------------------

    (iii) [Reserved]. For further guidance, see Sec. 1.36B-
4T(a)(3)(iii).
    (4) Examples. The following examples illustrate the rules of this 
paragraph (a). In each example the taxpayer enrolls in a higher cost 
qualified health plan than the applicable benchmark plan:


[[Page 134]]


    Example 1. Household income increases. (i) Taxpayer A is single and 
has no dependents. The Exchange for A's rating area projects A's 2014 
household income to be $27,925 (250 percent of the Federal poverty line 
for a family of one, applicable percentage 8.05). A enrolls in a 
qualified health plan. The annual premium for the applicable benchmark 
plan is $5,200. A's advance credit payments are $2,952, computed as 
follows: benchmark plan premium of $5,200 less contribution amount of 
$2,248 (projected household income of $27,925  x  .0805) = $2,952.
    (ii) A's household income for 2014 is $33,622, which is 301 percent 
of the Federal poverty line for a family of one (applicable percentage 
9.5). Consequently, A's premium tax credit for 2014 is $2,006 (benchmark 
plan premium of $5,200 less contribution amount of $3,194 (household 
income of $33,622  x  .095)). Because A's advance credit payments for 
2014 are $2,952 and A's 2014 credit is $2,006, A has excess advance 
payments of $946. Under paragraph (a)(1) of this section, A's tax 
liability for 2014 is increased by $946. Because A's household income is 
between 300 percent and 400 percent of the Federal poverty line, if A's 
excess advance payments exceeded $1,250, under the limitation of 
paragraph (a)(3) of this section, A's additional tax liability would be 
limited to that amount.
    Example 2. Household income increases, repayment limitation applies. 
The facts are the same as in Example 1, except that A's household income 
for 2014 is $43,560 (390 percent of the Federal poverty line for a 
family of one, applicable percentage 9.5). Consequently, A's premium tax 
credit for 2014 is $1,062 ($5,200 benchmark plan premium less 
contribution amount of $4,138 (household income of $43,560  x  .095)). 
A's advance credit payments for 2014 are $2,952; therefore, A has excess 
advance payments of $1,890. Because A's household income is between 300 
percent and 400 percent of the Federal poverty line, A's additional tax 
liability for the taxable year is $1,250 under the repayment limitation 
of paragraph (a)(3) of this section.
    Example 3. Household income decreases. The facts are the same as in 
Example 1, except that A's actual household income for 2014 is $22,340 
(200 percent of the Federal poverty line for a family of one, applicable 
percentage 6.3). Consequently, A's premium tax credit for 2014 is $3,793 
($5,200 benchmark plan premium less contribution amount of $1,407 
(household income of $22,340  x  .063)). Because A's advance credit 
payments for 2014 are $2,952, A is allowed an additional credit of $841 
($3,793 less $2,952).
    Example 4. [Reserved]. For further guidance, see Sec. 1.36B-
4T(a)(4), Example 4.
    Example 5. Repayment limitation does not apply. (i) Taxpayer D is 
single and has no dependents. The Exchange for D's rating area approves 
advance credit payments for D based on 2014 household income of $39,095 
(350 percent of the Federal poverty line for a family of one, applicable 
percentage 9.5). D enrolls in a qualified health plan. The annual 
premium for the applicable benchmark plan is $5,200. D's advance credit 
payments are $1,486, computed as follows: benchmark plan premium of 
$5,200 less contribution amount of $3,714 (projected household income of 
$39,095  x  .095) = $1,486.
    (ii) D's actual household income for 2014 is $44,903, which is 402 
percent of the Federal poverty line for a family of one. D is not an 
applicable taxpayer and may not claim a premium tax credit. 
Additionally, the repayment limitation of paragraph (a)(3) of this 
section does not apply. Consequently, D has excess advance payments of 
$1,486 (the total amount of the advance credit payments in 2014). Under 
paragraph (a)(1) of this section, D's tax liability for 2014 is 
increased by $1,486.
    Example 6. Coverage for less than a full taxable year. (i) Taxpayer 
F is single and has no dependents. In November 2013, the Exchange for 
F's rating area projects F's 2014 household income to be $27,925 (250 
percent of the Federal poverty line for a family of one, applicable 
percentage 8.05). F enrolls in a qualified health plan. The annual 
premium for the applicable benchmark plan is $5,200. F's monthly advance 
credit payment is $246, computed as follows: benchmark plan premium of 
$5,200 less contribution amount of $2,248 (projected household income of 
$27,925  x  .0805) = $2,952; $2,952/12 = $246.
    (ii) F begins a new job in August 2014 and is eligible for employer-
sponsored minimum essential coverage for the period September through 
December 2014. F discontinues her Exchange coverage effective November 
1, 2014. F's household income for 2014 is $28,707 (257 percent of the 
Federal poverty line for a family size of one, applicable percentage 
8.25).
    (iii) Under Sec. 1.36B-3(a), F's premium assistance credit amount is 
the sum of the premium assistance amounts for the coverage months. Under 
Sec. 1.36B-3(c)(1)(iii), a month in which an individual is eligible for 
minimum essential coverage other than coverage in the individual market 
is not a coverage month. Because F is eligible for employer-sponsored 
minimum essential coverage as of September 1, only the months January 
through August of 2014 are coverage months.
    (iv) If F had 12 coverage months in 2014, F's premium tax credit 
would be $2,832 (benchmark plan premium of $5,200 less contribution 
amount of $2,368 (household income of $28,707  x  .0825)). Because F has 
only eight coverage months in 2014, F's credit is $1,888 ($2,832/12  x  
8). Because F does not discontinue her Exchange coverage until November 
1, 2014, F's advance credit payments for 2014 are $2,460 ($246  x  10). 
Consequently, F has excess

[[Page 135]]

advance payments of $572 ($2,460 less $1,888) and F's tax liability for 
2014 is increased by $572 under paragraph (a)(1) of this section.
    Example 7. Changes in coverage months and applicable benchmark plan. 
(i) Taxpayer E claims one dependent, F. E is eligible for government-
sponsored minimum essential coverage. E enrolls F in a qualified health 
plan for 2014. The Exchange for E's rating area projects E's 2014 
household income to be $30,260 (200 percent of the Federal poverty line 
for a family of two, applicable percentage 6.3). The annual premium for 
E's applicable benchmark plan is $5,200. E's monthly advance credit 
payment is $275, computed as follows: benchmark plan premium of $5,200 
less contribution amount of $1,906 (projected household income of 
$30,260  x  .063) = $3,294; $3,294/12 = $275.
    (ii) On August 1, 2014, E loses her eligibility for government-
sponsored minimum essential coverage. E enrolls in the qualified health 
plan that covers F for August through December 2014. The annual premium 
for the applicable benchmark plan is $10,000. The Exchange computes E's 
monthly advance credit payments for the period September through 
December to be $675 as follows: benchmark plan premium of $10,000 less 
contribution amount of $1,906 (projected household income of $30,260  x  
.063) = $8,094; $8,094/12 = $675. E's household income for 2014 is 
$28,747 (190 percent of the Federal poverty line, applicable percentage 
5.84).
    (iii) Under Sec. 1.36B-3(c)(1), January through July of 2014 are 
coverage months for F and August through December are coverage months 
for E and F. Under paragraph (a)(2) of this section, E must compute her 
premium tax credit using the premium for the applicable benchmark plan 
for each coverage month. E's premium assistance credit amount for 2014 
is the sum of the premium assistance amounts for all coverage months. E 
reconciles her premium tax credit with advance credit payments as 
follows:

Advance credit payments (Jan. to July).......          $1,925  ($275  x  7)
Advance credit payments (Aug. to Dec.).......           3,375  ($675  x  5)
                                              ----------------
    Total advance credit payments............           5,300
 
Benchmark plan premium (Jan. to July)........           3,033  (($5,200/12)  x  7)
Benchmark plan premium (Aug. to Dec.)........           4,167  (($10,000/12)  x  5)
                                              ----------------
    Total benchmark plan premium.............           7,200
Contribution amount (taxable year household             1,679  ($28,747  x  .0584)
 income  x  applicable percentage).
                                              ----------------
    Credit (total benchmark plan premium less           5,521
     contribution amount).
 

    (iv) E's advance credit payments for 2014 are $5,300. E's premium 
tax credit is $5,521. Thus, E is allowed an additional credit of $221.
    Example 8. Part-year coverage and changes in coverage months and 
applicable benchmark plan. (i) The facts are the same as in Example 7, 
except that F is eligible for government-sponsored minimum essential 
coverage for January and February 2014, and E enrolls F in a qualified 
health plan beginning in March 2014. Thus, March through July are 
coverage months for F and August through December are coverage months 
for E and F.
    (ii) E reconciles her premium tax credit with advance credit 
payments as follows:

Advance credit payments (March to July)......          $1,375  ($275  x  5)
Advance credit payments (Aug. to Dec.).......           3,375  ($675  x  5)
                                              ----------------
    Total advance credit payments............           4,750
 
Benchmark plan premium (March to July).......           2,167  (($5,200/12)  x  5)
Benchmark plan premium (Aug. to Dec.)........           4,167  (($10,000/12)  x  5)
                                              ----------------
    Total benchmark plan premium.............           6,334
Contribution amount for 10 coverage months              1,399  ($28,747  x  .0584  x  10/12)
 (taxable year household income  x
 applicable percentage  x  10/12).
                                              ----------------
    Credit (total benchmark plan premium less           4,935
     contribution amount).
 


[[Page 136]]

    (iii) E's advance credit payments for 2014 are $4,750. E's premium 
tax credit is $4,935. Thus, E is allowed an additional credit of $185.
    Example 9. Advance credit payments for months an issuer does not 
provide coverage. (i) Taxpayer F enrolls in a qualified health plan for 
2014 and the Exchange approves advance credit payments. F pays the 
portion of the premium not covered by advance credit payments for 
January through April of 2014 but fails to make payments in May, June, 
and July. As a result, the issuer of the qualified health plan initiates 
the 3-month grace period under section 1412(c)(2)(B)(iv)(II) of the 
Affordable Care Act and 45 CFR 156.270(d). During the grace period the 
issuer continues to receive advance credit payments on behalf of F. On 
July 1 the issuer rescinds F's coverage retroactive to the end of the 
first month of the grace period, May 31.
    (ii) Under paragraph (a)(1)(iii) of this section, F does not take 
into account advance credit payments for June or July of 2014 when 
reconciling the premium tax credit with advance credit payments under 
paragraph (a)(1) of this section.
    Example 10. [Reserved]. For further guidance, see Sec. 1.36B-
4T(a)(4), Example 10.
    Example 11. [Reserved]. For further guidance, see Sec. 1.36B-
4T(a)(4), Example 11.
    Example 12. [Reserved]. For further guidance, see Sec. 1.36B-
4T(a)(4), Example 12.
    Example 13. [Reserved]. For further guidance, see Sec. 1.36B-
4T(a)(4), Example 13.
    Example 14. [Reserved]. For further guidance, see Sec. 1.36B-
4T(a)(4), Example 14.

    (b) Changes in filing status--(1) In general. Except as provided in 
paragraph (b)(2) or (b)(3) of this section, a taxpayer whose marital 
status changes during the taxable year computes the premium tax credit 
by using the applicable benchmark plan or plans for the taxpayer's 
marital status as of the first day of each coverage month. The 
taxpayer's contribution amount (household income for the taxable year 
times the applicable percentage) is determined using the taxpayer's 
household income and family size at the end of the taxable year.
    (2) Taxpayers who marry during the taxable year--(i) In general. 
Taxpayers who marry during and file a joint return for the taxable year 
may compute the additional tax imposed under paragraph (a)(1) of this 
section under paragraph (b)(2)(ii) of this section. Only taxpayers who 
are unmarried at the beginning of the taxable year and are married 
(within the meaning of section 7703) at the end of the taxable year, at 
least one of whom receives advance credit payments, may use this 
alternative computation.
    (ii) Alternative computation of additional tax liability--(A) In 
general. The additional tax liability determined under this paragraph 
(b)(2)(ii) is equal to the excess of the taxpayers' advance credit 
payments for the taxable year over the amount of the alternative 
marriage-year credit. The alternative marriage-year credit is the sum of 
both taxpayers' alternative premium assistance amounts for the pre-
marriage months and the premium assistance amounts for the marriage 
months. This paragraph (b)(2)(ii) may not be used to increase the 
additional premium tax credit computed under paragraph (a)(1)(i) of this 
section.
    (B) Alternative premium assistance amounts for pre-marriage months. 
Taxpayers compute the alternative premium assistance amounts for each 
taxpayer for each full or partial month the taxpayers are unmarried as 
described in paragraph (a)(2) of this section, except that each taxpayer 
treats the amount of household income as one-half of the actual 
household income for the taxable year and treats family size as the 
number of individuals in the taxpayer's family prior to the marriage. 
The taxpayers may include a dependent of the taxpayers for the taxable 
year in either taxpayer's family size for the pre-marriage months.
    (C) Premium assistance amounts for marriage months. Taxpayers 
compute the premium assistance amounts for each full month the taxpayers 
are married as described in paragraph (a)(2) of this section.
    (3) [Reserved]. For further guidance, see Sec. 1.36B-4T(b)(3).
    (4) [Reserved]. For further guidance, see Sec. 1.36B-4T(b)(4).
    (5) Examples. The following examples illustrate the provisions of 
this paragraph (b). In each example the taxpayer enrolls in a higher 
cost qualified health plan than the applicable benchmark plan:


[[Page 137]]


    Example 1. Taxpayers marry during the taxable year, general rule for 
computing additional tax. (i) P is a single taxpayer with no dependents. 
In 2013 the Exchange for the rating area where P resides determines that 
P's 2014 household income will be $40,000 (358 percent of the Federal 
poverty line, applicable percentage 9.5). P enrolls in a qualified 
health plan. The premium for the applicable benchmark plan is $5,200. 
P's monthly advance credit payment is $117, computed as follows: $5,200 
benchmark plan premium minus contribution amount of $3,800 ($40,000  x  
.095) equals $1,400 (total advance credit payment); $1,400/12 = $117.
    (ii) Q is a single taxpayer with two dependents. In 2013 the 
Exchange for the rating area where Q resides determines that Q's 2014 
household income will be $35,000 (183 percent of the Federal poverty 
line, applicable percentage 5.52). Q enrolls in a qualified health plan. 
The premium for the applicable benchmark plan is $10,000. Q's monthly 
advance credit payment is $672, computed as follows: $10,000 benchmark 
plan premium minus contribution amount of $1,932 ($35,000  x  .0552) 
equals $8,068 (total advance credit); $8,068/12 = $672.
    (iii) P and Q marry on July 17, 2014 and enroll in a single policy 
for a qualified health plan covering four family members, effective 
August 1, 2014. The premium for the applicable benchmark plan is 
$14,000. Based on household income of $75,000 and a family size of four 
(325 percent of the Federal poverty line, applicable percentage 9.5), 
the Exchange approves advance credit payments of $573 per month, 
computed as follows: $14,000 benchmark plan premium minus contribution 
amount of $7,125 ($75,000  x  .095) equals $6,875 (total advance 
credit); $6,875/12 = $573.
    (iv) P and Q file a joint return for 2014 and report $75,000 in 
household income and a family size of four. P and Q compute their credit 
at reconciliation under paragraph (b)(1) of this section. They use the 
premiums for the applicable benchmark plans that apply for the months 
married and the months not married, and their contribution amount is 
based on their Federal poverty line percentage at the end of the taxable 
year. P and Q reconcile their premium tax credit with advance credit 
payments as follows:

Advance payments for P (Jan. to July)...................            $819
Advance payments for Q (Jan. to July)...................           4,704
Advance payments for P and Q (Aug. to Dec.).............           2,865
                                                         ---------------
    Total advance payments..............................           8,388
                                                         ===============
Benchmark plan premium for P (Jan. to July).............           3,033
Benchmark plan premium for Q (Jan. to July).............           5,833
Benchmark plan premium for P and Q (Aug. to Dec.).......           5,833
                                                         ---------------
    Total benchmark plan premium........................          14,699
                                                         ===============
Contribution amount (taxable year household income  x              7,125
 applicable percentage).................................
                                                         ---------------
    Credit (total benchmark plan premium less                      7,574
     contribution amount)...............................
Additional tax..........................................             814
 

    (v) P's and Q's tax liability for 2014 is increased by $814 under 
paragraph (a)(1) of this section.
    Example 2. Taxpayers marry during the taxable year, alternative 
computation of additional tax. (i) The facts are the same as in Example 
1, except that P and Q compute their additional tax liability under 
paragraph (b)(2)(ii) of this section. P's and Q's additional tax is the 
excess of their advance credit payments for the taxable year ($8,388) 
over their alternative marriage-year credit, which is the sum of the 
alternative premium assistance amounts for the pre-marriage months and 
the premium assistance amounts for the marriage months.
    (ii) P and Q compute the alternative marriage-year credit as 
follows:

Alternative premium assistance amounts for
 pre-marriage months:
    Benchmark plan premium for P (Jan. to              $3,033  (($5,200/12)  x  7)
     July).
    Contribution amount (\1/2\ taxable year             2,078  ($37,500  x  .095  x  7/12)
     household income  x  applicable
     percentage)  x  7/12).
    Alternative premium assistance amount for             955  ($3,033-$2,078)
     P's pre-marriage months.

[[Page 138]]

 
    Benchmark plan premium for Q (Jan. to               5,833  (($10,000/12)  x  7)
     July).
    Contribution amount (\1/2\ taxable year             1,339  ($37,500  x  .0612  x  7/12)
     household income  x  applicable
     percentage  x  7/12).
    Alternative premium assistance amount for           4,494  ($5,833-$1,339)
     Q's pre-marriage months.
Premium assistance amount for marriage
 months:
    Benchmark plan premium for P and Q (Aug.            5,833  (($14,000/12  x  5)
     to Dec.).
    Contribution amount (taxable year                   2,969  ($75,000  x  .095  x  5/12)
     household income  x  applicable
     percentage  x  5/12).
    Premium assistance amount for marriage              2,864  ($5,833-$2,969)
     months.
 

    Alternative marriage-year credit (sum of premium assistance amounts 
for pre-marriage months and marriage months): $955 + $4,494 + $2,864 = 
$8,313.
    (iii) P and Q reconcile their premium tax credit with advance credit 
payments by determining the excess of their advance credit payments 
($8,388) over their alternative marriage-year credit ($8,313). P and Q 
must increase their tax liability by $75 under paragraph (a)(1) of this 
section.
    Example 3. Taxpayers marry during the taxable year, alternative 
computation of additional tax, alternative marriage-year tax credit 
exceeds advance credit payments. The facts are the same as in Example 2, 
except that the amount of P's and Q's advance credit payments is $8,301. 
Thus, their alternative marriage-year credit ($8,313) exceeds the amount 
of their advance credit payments ($8,301). Under paragraph (b)(2)(ii)(A) 
of this section, the amount of additional tax liability and additional 
tax credit that P and Q report on their tax return is $0.
    Example 4. Taxpayers marry during the taxable year, alternative 
computation of additional tax. (i) Taxpayer R is single and has no 
dependents. In 2013, the Exchange for the rating area where R resides 
determines that R's 2014 household income will be $40,000 (358 percent 
of the Federal poverty line, applicable percentage 9.5). R enrolls in a 
qualified health plan. The premium for the applicable benchmark plan is 
$5,200. R's monthly advance credit payment is $117, computed as follows: 
$5,200 benchmark plan premium minus contribution amount of $3,800 
($40,000  x  .095) = $1,400 (total advance credit); $1,400/12 = $117.
    (ii) Taxpayer S is single with no dependents. In 2013, the Exchange 
for the rating area where S resides determines that S's 2014 household 
income will be $20,000 (179 percent of the Federal poverty line, 
applicable percentage 5.33). S enrolls in a qualified health plan. The 
premium for the applicable benchmark plan is $5,200. S's monthly advance 
credit payment is $345, computed as follows: $5,200 benchmark plan 
premium minus contribution amount of $1,066 ($20,000  x  .0533) = $4,134 
(total advance credit); $4,134/12 = $345.
    (iii) R and S marry in September 2014 and enroll in a single policy 
for a qualified health plan covering them both, beginning October 1, 
2014. The premium for the applicable benchmark plan is $10,000. Based on 
household income of $60,000 and a family size of two (397 percent of the 
Federal poverty line, applicable percentage 9.5), R's and S's monthly 
advance credit payment is $358, computed as follows: $10,000 benchmark 
plan premium minus contribution amount of $5,700 ($60,000  x  .095) = 
$4,300; $4,300/12 = $358. R's and S's advance credit payments for 2014 
are $5,232, computed as follows:

Advance payments for R (Jan. to Sept.).......          $1,053  ($117  x  9)
Advance payments for S (Jan. to Sept.).......           3,105  ($345  x  9)
Advance payments for R and S (Oct. to Dec.)..           1,074  ($358  x  3)
                                              ----------------
    Total advance payments...................           5,232
 

    (iv) R and S file a joint return for 2014 and report $62,000 in 
household income and a family size of two (410 percent of the FPL for a 
family of 2). Thus, under Sec. 1.36B-2(b)(2), R and S are not applicable 
taxpayers for 2014 and may not claim a premium tax credit for 2014. 
However, they compute their additional tax liability under paragraph 
(b)(2)(ii) of this section. R's and S's additional tax is the excess of 
their advance credit payments for the taxable year ($5,232) over their 
alternative marriage-year credit, which is the sum of the alternative 
premium assistance amounts for the pre-marriage months and the premium 
assistance amounts for the marriage months.

[[Page 139]]

In this case, R and S have no premium assistance amounts for the married 
months because their household income is over 400 percent of the Federal 
poverty line for a family of 2.
    (v) R and S compute their alternative marriage-year credit as 
follows:

Premium assistance amount for pre-marriage
 months:
    Benchmark plan premium for R (Jan. to              $3,900  (($5,200/12)  x  9)
     Sept.).
    Contribution amount ((\1/2\  taxable year           2,053  ($31,000  x  .0883  x  9/12)
     household income  x  applicable
     percentage)  x  9/12).
    Premium assistance amount for R's pre-              1,847  ($3,900 - $2,053)
     marriage months.
    Benchmark plan premium for S (Jan. to               3,900  (($5,200/12)  x  9)
     Sept.).
    Contribution amount ((\1/2\  taxable year           2,053  ($31,000  x  .0883  x  9/12)
     household income  x  applicable
     percentage)  x  9/12).
    Premium assistance amount for S's pre-              1,847  ($3,900-$2,053)
     marriage months.
Premium assistance amount for marriage months               0
 

    Alternative marriage-year credit (sum of premium assistance amounts 
for pre-marriage months and marriage months): $1,847 + 1,847 + 0 = 
$3,694.
    (vi) R and S reconcile their premium tax credit with advance credit 
payments by determining the excess of their advance credit payments 
($5,232) over their alternative marriage-year credit ($3,694). R and S 
must increase their tax liability by $1,538 under paragraph (a)(1) of 
this section.
    Example 5. (i) Taxpayers marry during the taxable year, no 
additional tax liability. The facts are the same as in Example 4, except 
that S has no income and is enrolled in Medicaid for January through 
September 2014 and R's and S's household income for 2014 is $37,000 (245 
percent of the Federal poverty line, applicable percentage 7.88). Their 
advance credit payments for 2014 are $2,707 ($1,053 for R for January to 
September and $1,654 for R and S for October to December). Their premium 
tax credit for 2014 is $3,484 (total benchmark premium of $6,400 less 
contribution amount of $2,916).
    (ii) Because R's and S's premium tax credit of $3,484 exceeds their 
advance credit payments of $2,707, R and S are allowed an additional 
credit of $777. Although R and S marry in 2014, paragraph (b)(2) of this 
section (the alternative computation of additional tax for taxpayers who 
marry during the taxable year) does not apply because they do not owe 
additional tax for 2014.
    Example 6. Taxpayers divorce during the taxable year, 50 percent 
allocation. (i) Taxpayers V and W are married and have two dependents. 
In 2013, the Exchange for the rating area where the family resides 
determines that their 2014 household income will be $76,000 (330 percent 
of the Federal poverty line for a family of 4, applicable percentage 
9.5). V and W enroll in a qualified health plan for 2014. The premium 
for the applicable benchmark plan is $14,100. The Exchange approves 
advance credit payments of $573 per month, computed as follows: $14,100 
benchmark plan premium minus V and W's contribution amount of $7,220 
($76,000  x  .095) equals $6,880 (total advance credit); $6,880/12 = 
$573.
    (ii) V and W divorce on June 17, 2014, and obtain separate qualified 
health plans beginning July 1, 2014. V enrolls based on household income 
of $60,000 and a family size of three (314 percent of the Federal 
poverty line, applicable percentage 9.5). The premium for the applicable 
benchmark plan is $10,000. The Exchange approves advance credit payments 
of $358 per month, computed as follows: $10,000 benchmark plan premium 
minus V's contribution amount of $5,700 ($60,000  x  .095) equals $4,300 
(total advance credit); $4,300/12 = $358.
    (iii) W enrolls based on household income of $16,420 and a family 
size of one (147 percent of the Federal poverty line, applicable 
percentage 3.82). The premium for the applicable benchmark plan is 
$5,200. The Exchange approves advance credit payments of $381 per month, 
computed as follows: $5,200 benchmark plan premium minus W's 
contribution amount of $627 ($16,420  x  .0382) equals $4,573 (total 
advance credit); $4,573/12 = $381. V and W do not agree on an allocation 
of the premium for the applicable benchmark plan, the premiums for the 
plan in which they enroll, and the advance credit payments for the 
period they were married in the taxable year.
    (iv) V and W each compute their credit at reconciliation under 
paragraph (b)(1) of this section, using the premiums for the applicable 
benchmark plans that apply to them for the months married and the months 
not married, and the contribution amount based on their Federal poverty 
line percentages at

[[Page 140]]

the end of the taxable year. Under paragraph (b)(3) of this section, 
because V and W do not agree on an allocation, V and W must equally 
allocate the benchmark plan premium ($7,050) and the advance credit 
payments ($3,438) for the six-month period January through June 2014 
when they are married and enrolled in the same qualified health plan. 
Thus, V and W each are allocated $3,525 of the benchmark plan premium 
($7,050/2) and $1,719 of the advance credit payments ($3,438/2) for 
January through June.
    (v) V reports on his 2014 tax return $60,000 in household income and 
family size of three. W reports on her 2014 tax return $16,420 in 
household income and family size of one. V and W reconcile their premium 
tax credit with advance credit payments as follows:

------------------------------------------------------------------------
                                                     V            W
------------------------------------------------------------------------
Allocated advance payments (Jan. to June).....       $1,719       $1,719
Actual advance payments (July to Dec.)........        2,148        2,286
                                               -------------------------
    Total advance payments....................        3,867        4,005
 
Allocated benchmark plan premium (Jan. to             3,525        3,525
 June)........................................
Actual benchmark plan premium (July to Dec.)..        5,000        2,600
                                               -------------------------
    Total benchmark plan premium..............        8,525        6,125
 
Contribution amount (taxable year household           5,700          627
 income  x  applicable percentage)............
                                               -------------------------
    Credit (total benchmark plan premium less         2,825        5,498
     contribution amount).....................
Additional credit.............................  ...........        1,493
Additional tax................................        1,042  ...........
------------------------------------------------------------------------

    (vi) Under paragraph (a)(1) of this section, on their tax returns 
V's tax liability is increased by $1,042 and W is allowed $1,493 as 
additional credit.
    Example 7. Taxpayers divorce during the taxable year, allocation in 
proportion to household income. (i) The facts are the same as in Example 
6, except that V and W decide to allocate the benchmark plan premium 
($7,050) and the advance credit payments ($3,438) for January through 
June 2014 in proportion to their household incomes (79 percent and 21 
percent). Thus, V is allocated $5,570 of the benchmark plan premiums 
($7,050  x  .79) and $2,716 of the advance credit payments ($3,438  x  
.79), and W is allocated $1,481 of the benchmark plan premiums ($7,050 
x  .21) and $722 of the advance credit payments ($3,438  x  .21). V and 
W reconcile their premium tax credit with advance credit payments as 
follows:

------------------------------------------------------------------------
                                                     V            W
------------------------------------------------------------------------
Allocated advance payments (Jan. to June).....       $2,716         $722
Actual advance payments (July to Dec.)........        2,148        2,286
                                               -------------------------
    Total advance payments....................        4,864        3,008
 
Allocated benchmark plan premium (Jan. to             5,570        1,481
 June)........................................
Actual benchmark plan premium (July to Dec.)..        5,000        2,600
                                               -------------------------
    Total benchmark plan premium..............       10,570        4,081
 
Contribution amount (taxable year household           5,700          627
 income  x  applicable percentage)............
                                               -------------------------
    Credit (total benchmark plan premium less         4,870        3,454
     contribution amount).....................
Additional credit.............................            6          446
------------------------------------------------------------------------

    (ii) Under paragraph (a)(1) of this section, on their tax returns V 
is allowed an additional credit of $6 and W is allowed an additional 
credit of $446.
    Example 8. Married taxpayers filing separate tax returns. (i) 
Taxpayers X and Y are married and have two dependents. In 2013, the 
Exchange for the rating area where the family resides determines that 
their 2014 household income will be $76,000 (330 percent of the Federal 
poverty line for a family of 4, applicable percentage 9.5). W and Y 
enroll in a qualified health plan for 2014. The premium for the 
applicable benchmark plan is $14,100. X's and Y's monthly advance credit 
payment is $573, computed as follows: $14,100 benchmark plan premium 
minus X's and Y's contribution amount of $7,220 ($76,000  x  .095) 
equals $6,880 (total advance credit); $6,880/12 = $573.
    (ii) X and Y file income tax returns for 2014 using a married filing 
separately filing status. X reports household income of $60,000 and a 
family size of three (314 percent of the Federal poverty line). Y 
reports household income of $16,420 and a family size of one (147 
percent of the Federal poverty line).

[[Page 141]]

    (iii) Because X and Y are married but do not file a joint return for 
2014, X and Y are not applicable taxpayers and are not allowed a premium 
tax credit for 2014. See Sec. 1.36B-2(b)(2). Under paragraph (b)(4) of 
this section, half of the advance credit payments ($6,880/2 = $3,440) is 
allocated to X and half is allocated to Y for purposes of determining 
their excess advance payments. The repayment limitation described in 
paragraph (a)(3) of this section applies to X and Y based on the 
household income and family size reported on each return. Consequently, 
X's tax liability for 2014 is increased by $2,500 and Y's tax liability 
for 2014 is increased by $600.
    Example 9. [Reserved]. For further guidance, see Sec. 1.36B-
4T(b)(5), Example 9.
    Example 10. [Reserved]. For further guidance, see Sec. 1.36B-
4T(b)(5), Example 10.
    (c) [Reserved]. For further guidance, see Sec. 1.36B-4T(c).

[T.D. 9590, 77 FR 30385, May 23, 2012; 77 FR 41048, July 12, 2012; 77 FR 
41270, July 13, 2012, as amended by T.D. 9683, 79 FR 43627, July 28, 
2014]



Sec. 1.36B-4T  Reconciling the premium tax credit with advance credit payments (temporary).

    (a)(1)(i) [Reserved]. For further guidance, see Sec. 1.36B-
4(a)(1)(i).
    (ii) Allocation rules and responsibility for advance credit 
payments--(A) In general. A taxpayer must reconcile all advance credit 
payments for coverage of any member of the taxpayer's family.
    (B) Individuals enrolled by a taxpayer and claimed as a personal 
exemption deduction by another taxpayer--(1) In general. If a taxpayer 
(the enrolling taxpayer) enrolls an individual in a qualified health 
plan and another taxpayer (the claiming taxpayer) claims a personal 
exemption deduction for the individual (the shifting enrollee), then for 
purposes of computing each taxpayer's premium tax credit and reconciling 
any advance credit payments, the premiums and advance credit payments 
for the plan in which the shifting enrollee was enrolled are allocated 
under this paragraph (a)(1)(ii)(B) according to the allocation 
percentage described in paragraph (a)(1)(ii)(B)(2) of this section. If 
advance credit payments are allocated under paragraph (a)(1)(ii)(B)(4) 
of this section, the claiming taxpayer and enrolling taxpayer must use 
this same allocation percentage to calculate their Sec. 1.36B-3(d)(2) 
adjusted monthly premiums for the applicable benchmark plan (benchmark 
plan premiums). This paragraph (a)(1)(ii)(B) does not apply to amounts 
allocated under Sec. 1.36B-3(h) (qualified health plan covering more 
than one family) or if the shifting enrollee or enrollees are the only 
individuals enrolled in the qualified health plan. For purposes of this 
paragraph (a)(1)(ii)(B)(1), a taxpayer who is expected at enrollment in 
a qualified health plan to be the taxpayer filing an income tax return 
for the year of coverage with respect to an individual enrolling in the 
plan has enrolled that individual.
    (2) Allocation percentage. The enrolling taxpayer and claiming 
taxpayer may agree on any allocation percentage between zero and one 
hundred percent. If the enrolling taxpayer and claiming taxpayer do not 
agree on an allocation percentage, the percentage is equal to the number 
of shifting enrollees claimed as a personal exemption deduction by the 
claiming taxpayer divided by the number of individuals enrolled by the 
enrolling taxpayer in the same qualified health plan as the shifting 
enrollee.
    (3) Allocating premiums. In computing the premium tax credit, the 
claiming taxpayer is allocated a portion of the premiums for the plan in 
which the shifting enrollee was enrolled equal to the premiums for the 
plan times the allocation percentage. The enrolling taxpayer is 
allocated the remainder of the premiums not allocated to one or more 
claiming taxpayers.
    (4) Allocating advance credit payments. In reconciling any advance 
credit payments, the claiming taxpayer is allocated a portion of the 
advance credit payments for the plan in which the shifting enrollee was 
enrolled equal to the enrolling taxpayer's advance credit payments for 
the plan times the allocation percentage. The enrolling taxpayer is 
allocated the remainder of the advance credit payments not allocated to 
one or more claiming taxpayers. This paragraph (a)(1)(ii)(B)(4) only 
applies in situations in which advance credit payments are made for 
coverage of a shifting enrollee.
    (5) Premiums for the applicable benchmark plan. If paragraph 
(a)(1)(ii)(B)(4)

[[Page 142]]

of this section applies, the claiming taxpayer's benchmark plan premium 
is the sum of the benchmark plan premium for the claiming taxpayer's 
coverage family, excluding the shifting enrollee or enrollees, and the 
allocable portion. The allocable portion for purposes of this paragraph 
(a)(1)(ii)(B)(5) is the product of the benchmark plan premium for the 
enrolling taxpayer's coverage family if the shifting enrollee was a 
member of the enrolling taxpayer's coverage family and the allocation 
percentage. If the enrolling taxpayer's coverage family is enrolled in 
more than one qualified health plan, the allocable portion is determined 
as if the enrolling taxpayer's coverage family includes only the 
coverage family members who enrolled in the same plan as the shifting 
enrollee or enrollees. The enrolling taxpayer's benchmark plan premium 
is the benchmark plan premium for the enrolling taxpayer's coverage 
family had the shifting enrollee or enrollees remained a part of the 
enrolling taxpayer's coverage family, minus the allocable portion.
    (C) Responsibility for advance credit payments for an individual for 
whom no personal exemption deduction is claimed. If advance credit 
payments are made for coverage of an individual for whom no taxpayer 
claims a personal exemption deduction, the taxpayer who attested to the 
Exchange to the intention to claim a personal exemption deduction for 
the individual as part of the advance credit payment eligibility 
determination for coverage of the individual must reconcile the advance 
credit payments.
    (a)(1)(iii) through (a)(3)(ii) [Reserved]. For further guidance, see 
Sec. 1.36B-4(a)(1)(iii) through (a)(3)(ii).
    (iii) Limitation on additional tax for taxpayers who claim a section 
162(l) deduction for a qualified health plan--(A) In general. A taxpayer 
who receives advance credit payments and deducts premiums for a 
qualified health plan under section 162(l) must use paragraphs 
(a)(3)(iii)(B) and (C) of this section to determine the limitation on 
additional tax in this paragraph (a)(3) (limitation amount). Taxpayers 
must make this determination before calculating their section 162(l) 
deduction and premium tax credit. For additional rules for taxpayers who 
may claim a deduction under section 162(l) for a qualified health plan 
for which advance credit payments are made, see Sec. 1.162(l)-1T.
    (B) Determining the limitation amount. A taxpayer described in 
paragraph (a)(3)(iii)(A) of this section must use the limitation amount 
for which the taxpayer qualifies under the requirements of paragraph 
(a)(3)(iii)(C) of this section. The limitation amount determined under 
this paragraph (a)(3)(iii) replaces the limitation amount that would 
otherwise be determined under the additional tax limitation table in 
paragraph (a)(3)(ii) of this section. In applying paragraph 
(a)(3)(iii)(C) of this section, a taxpayer must first determine whether 
he or she qualifies for the limitation amount applicable to taxpayers 
with household income of less than 200 percent of the Federal poverty 
line for the taxpayer's family size. If the taxpayer is unable to meet 
the requirements of paragraph (a)(3)(iii)(C) of this section for that 
limitation amount, the taxpayer must next determine whether he or she 
qualifies for the limitation applicable to taxpayers with household 
income of less than 300 percent of the Federal poverty line for the 
taxpayer's family size. If the taxpayer is unable to meet the 
requirements of paragraph (a)(3)(iii)(C) of this section for taxpayers 
with household income of less than 300 percent of the Federal poverty 
line for the taxpayer's family size, the taxpayer must next determine 
whether he or she qualifies for the limitation applicable to taxpayers 
with household income of less than 400 percent of the Federal poverty 
line for the taxpayer's family size. If the taxpayer is unable to meet 
the requirements of paragraph (a)(3)(iii)(C) of this section for any 
limitation amount, the limitation on additional tax under section 
36B(f)(2)(B) does not apply to the taxpayer.
    (C) Requirements. A taxpayer meets the requirements of this 
paragraph (a)(3)(iii)(C) for a limitation amount if the taxpayer's 
household income as a percentage of the Federal poverty line is less 
than or equal to the maximum household income as a percentage of the 
Federal poverty line for which that

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limitation is available. Household income for this purpose is determined 
by using a section 162(l) deduction equal to the sum of the specified 
premiums for the plan not paid through advance credit payments and the 
limitation amount in addition to any deduction allowable under section 
162(l) for premiums other than specified premiums. For purposes of this 
paragraph (a)(3)(iii)(C), specified premiums not paid through advance 
credit payments means specified premiums, as defined in Sec. 1.162(l)-
1T(a)(2), minus advance credit payments made with respect to the 
specified premiums.
    (D) Examples. For examples illustrating the rules of this paragraph 
(a)(3)(iii), see Examples 13 and 14 of paragraph (a)(4) of this section.
    (a)(4), Example 1, through Example 3 [Reserved]. For further 
guidance, see Sec. 1.36B-4(a)(4), Example 1 through Example 3.

    Example 4. Family size decreases. (i) Taxpayers B and C are married 
and have two children, K and L (ages 17 and 20), whom they claim as 
dependents in 2013. The Exchange for their rating area projects their 
2014 household income to be $63,388 (275 percent of the Federal poverty 
line for a family of four, applicable percentage 8.78). B and C enroll 
in a qualified health plan for 2014 that covers the four family members. 
The annual premium for the applicable benchmark plan is $14,100. B's and 
C's advance credit payments for 2014 are $8,535, computed as follows: 
benchmark plan premium of $14,100 less contribution amount of $5,565 
(projected household income of $63,388  x  .0878) = $8,535.
    (ii) In 2014, B and C do not claim L as their dependent (and no 
taxpayer claims a personal exemption deduction for L). Consequently, B's 
and C's family size for 2014 is three, their household income of $63,388 
is 332 percent of the Federal poverty line for a family of three 
(applicable percentage 9.5), and the annual premium for their applicable 
benchmark plan is $12,000. Their premium tax credit for 2014 is $5,978 
($12,000 benchmark plan premium less $6,022 contribution amount 
(household income of $63,388  x  .095)). Because B's and C's advance 
credit payments for 2014 are $8,535 and their 2014 credit is $5,978, B 
and C have excess advance payments of $2,557. B's and C's additional tax 
liability for 2014 under paragraph (a)(1) of this section, however, is 
limited to $2,500 under paragraph (a)(3) of this section.

    Example 5 through Example 9 [Reserved]. For further guidance, see 
1.36B-4(a)(4), Example 5 through Example 9.

    Example 10. Allocation percentage, agreement on allocation. (i) 
Taxpayers G and H are divorced and have two children, J and K. G enrolls 
herself and J and K in a qualified health plan for 2014. The premium for 
the plan in which G enrolls is $13,000. The Exchange in G's rating area 
approves advance credit payments for G based on a family size of three, 
an annual benchmark plan premium of $12,000 and projected 2014 household 
income of $58,590 (300 percent of the Federal poverty line for a family 
of three, applicable percentage 9.5). G's advance credit payments for 
2014 are $6,434 ($12,000 benchmark plan premium less $5,566 contribution 
amount (household income of $58,590  x  .095)). G's actual household 
income for 2014 is $58,900.
    (ii) K lives with H for more than half of 2014 and H claims K as a 
dependent for 2014. G and H agree to an allocation percentage, as 
described in paragraph (a)(1)(ii)(B)(2) of this section, of 20 percent. 
Under the agreement, H is allocated 20 percent of the items to be 
allocated and G is allocated the remainder of those items.
    (iii) If H is eligible for a premium tax credit, H takes into 
account $2,600 of the premiums for the plan in which K was enrolled 
($13,000  x  .20) and $2,400 of G's benchmark plan premium ($12,000  x  
.20). In addition, H is responsible for reconciling $1,287 ($6,434  x  
.20) of the advance credit payments for K's coverage.
    (iv) G's family size for 2014 includes only G and J and G's 
household income of $58,900 is 380 percent of the Federal poverty line 
for a family of two (applicable percentage 9.5). G's benchmark plan 
premium for 2014 is $9,600 (the benchmark premium for the plan covering 
G, J and K ($12,000), minus the amount allocated to H ($2,400). 
Consequently, G's premium tax credit is $4,004 (G's benchmark plan 
premium of $9,600 minus G's contribution amount of $5,596 ($58,900  x  
.095)). G has an excess advance payment of $1,143 (the excess of the 
advance credit payments of $5,147 ($6,434 - $1,287 allocated to H) over 
the premium tax credit of $4,004).
    Example 11. Allocation percentage, no agreement on allocation. (i) 
The facts are the same as in Example 10, except that G and H do not 
agree on an allocation percentage. Under paragraph (a)(1)(ii)(B)(2) of 
this section, the allocation percentage is 33 percent, computed as 
follows: The number of shifting enrollees, 1 (K), divided by the number 
of individuals enrolled by the enrolling taxpayer on the same qualified 
health plan as the shifting enrollee, 3 (G,J, and K). Thus, H is 
allocated 33 percent of the items to be allocated and G is allocated the 
remainder of those items.

[[Page 144]]

    (ii) If H is eligible for a premium tax credit, H takes into account 
$4,290 of the premiums for the plan in which K was enrolled ($13,000  x  
.33). H, in computing H's benchmark plan premium must include $3,960 of 
G's benchmark plan premium ($12,000  x  .33). In addition, H is 
responsible for reconciling $2,123 ($6,434  x  .33) of the advance 
credit payments for K's coverage.
    (iii) G's benchmark plan premium for 2014 is $8,040 (the benchmark 
premium for the plan covering G, J, and K ($12,000), minus the amount 
allocated to H ($3,960). Consequently, G's premium tax credit is $2,444 
(G's benchmark plan premium of $8,040 minus G's contribution amount of 
$5,596 ($58,900  x  .095)). G has an excess advance credit payment of 
$1,867 (the excess of the advance credit payments of $4,311 ($6,434 - 
$2,123 allocated to H) over the premium tax credit of $2,444).
    Example 12. Allocations for an emancipated child. Spouses L and M 
enroll in a qualified health plan with their child, N. L and M attest 
that they will claim N as a dependent and advance credit payments are 
made for the coverage of all three family members. However, N files his 
own return and claims a personal exemption deduction for himself for the 
taxable year. Under paragraph (a)(1)(ii)(B)(1) of this section, L and M 
are enrolling taxpayers, N is a claiming taxpayer and all are subject to 
the allocation rules in paragraph (a)(1)(ii)(B) of this section.
    Example 13. Taxpayer with advance credit payments allowed a section 
162(l) deduction but not a limitation on additional tax. (i) In 2014, B, 
B's spouse, and their two dependents enroll in the applicable second 
lowest cost silver plan with an annual premium of $14,000. B's advance 
credit payments attributable to the premiums are $8,000. B is self-
employed for all of 2014 and derives $75,000 of earnings from B's trade 
or business. B's household income without including a deduction under 
section 162(l) for specified premiums is $103,700. The Federal poverty 
line for a family the size of B's family is $23,550.
    (ii) Because B received advance credit payments and deducts premiums 
for a qualified health plan under section 162(l), B must determine 
whether B is allowed a limitation on additional tax under paragraph 
(a)(3)(iii) of this section. B begins by testing eligibility for the 
$600 limitation amount for taxpayers with household income at less than 
200 percent of the Federal poverty line for the taxpayer's family size. 
B determines household income as a percentage of the Federal poverty 
line by taking a section 162(l) deduction equal to the sum of the amount 
of premiums not paid through advance credit payments, $6,000 
($14,000-$8,000), and the limitation amount, $600. The result is $97,100 
($103,700-$6,600) or 412 percent of the Federal poverty line for B's 
family size. Since 412 percent is not less than 200 percent, B may not 
use a $600 limitation amount.
    (iii) B performs the same calculation for the $1,500 
($103,700-$7,500 = $96,200 or 408 percent of the Federal poverty line) 
and $2,500 limitation amounts ($103,700-$8,500 = $95,200 or 404 percent 
of the Federal poverty line), the amounts for taxpayers with household 
income of less than 300 percent or 400 percent, respectively, of the 
Federal poverty line for the taxpayer's family size, and determines that 
B may not use either of those limitation amounts. Because B does not 
meet the requirements of paragraph (a)(3)(iii) of this section for any 
of the limitation amounts in section 36B(f)(2)(B), B is not eligible for 
the limitation on additional tax for excess advance credit payments.
    (iv) Although B may not claim a limitation on additional tax for 
excess advance credit payments, B may still be eligible for a premium 
tax credit. B would determine eligibility for the premium tax credit and 
the amounts of the premium tax credit and the section 162(l) deduction 
using other rules, including the regulations under section 36B and 
section 162(l), applying no limitation on additional tax.
    Example 14. Taxpayer with advance credit payments allowed a section 
162(l) deduction and a limitation on additional tax. (i) Same facts as 
Example 13, except that B's household income without including a 
deduction under section 162(l) for specified premiums is $78,802.
    (ii) Because B received advance credit payments and deducts premiums 
for a qualified health plan under section 162(l), B must determine 
whether B is allowed a limitation on additional tax under paragraph 
(a)(3)(iii) of this section. B first determines that B does not meet the 
requirements of paragraph (a)(3)(iii)(C) of this section for using the 
$600 or $1,500 limitation amounts, the amounts for taxpayers with 
household income of less than 200 percent or 300 percent, respectively, 
of the Federal poverty line for the taxpayer's family size. That is 
because B's household income as a percentage of the Federal poverty 
line, determined by using a section 162(l) deduction for premiums for 
the qualified health plan equal to the sum of the premiums for the plan 
not paid through advance credit payments and the limitation amount, is 
more than the maximum household income as a percentage of the Federal 
poverty line for which that limitation is available (using the $600 
limitation, B's household income would be $72,202 ($78,802-($6,000 + 
$600)), which is 307 percent of the Federal poverty line for B's family 
size; and using the $1,500 limitation, B's household income would be 
$71,302 ($78,802-($6,000 + $1,500)), which is 303 percent of the Federal 
poverty line for B's family size).
    (iii) However, B meets the requirements of paragraph (a)(3)(iii)(C) 
of this section using the $2,500 limitation amount for taxpayers

[[Page 145]]

with household income of less than 400 percent of the Federal poverty 
line for the taxpayer's family size. This is because B's household 
income as a percentage of the Federal poverty line by taking a section 
162(l) deduction equal to the sum of the amount of premiums not paid 
through advance credit payments, $6,000, and the limitation amount, 
$2,500, is $70,302 (299 percent of the Federal poverty line), which is 
below 400 percent of the Federal poverty line for B's family size, and 
is less than the maximum amount for which that limitation is available. 
Thus, B uses a limitation amount of $2,500 in computing B's additional 
tax on excess advance credit payments.
    (iv) B may then determine the amount of the premium tax credit and 
section 162(l) deduction using the rules under section 36B and section 
162(l), applying the $2,500 limitation amount determined above.

    (b)(1) through (b)(2) [Reserved]. For further guidance, see 
Sec. 1.36B-4(b)(1) through (b)(2).
    (3) Taxpayers not married to each other at the end of the taxable 
year. Taxpayers who are married (within the meaning of section 7703) to 
each other during a taxable year but legally separate under a decree of 
divorce or of separate maintenance during the taxable year, and who are 
enrolled in the same qualified health plan at any time during the 
taxable year must allocate the benchmark plan premium, the premium for 
the plan in which the taxpayers enroll, and the advance credit payments 
for the period the taxpayers are married during the taxable year. 
Taxpayers must also allocate these items if one of the taxpayers has a 
dependent enrolled in the same plan as the taxpayer's former spouse or 
enrolled in the same plan as a dependent of the taxpayer's former 
spouse. The taxpayers may allocate these items to each former spouse in 
any proportion but must allocate all items in the same proportion. If 
the taxpayers do not agree on an allocation that is reported to the IRS 
in accordance with the relevant forms and instructions, 50 percent of 
the premium for the applicable benchmark plan, the premium for the plan 
in which the taxpayers enroll, and the advance credit payments for the 
married period are allocated to each taxpayer. If for a period a plan 
covers only one of the taxpayers and no dependents, only one of the 
taxpayers and one or more dependents of that same taxpayer, or only one 
or more dependents of one of the taxpayers, then the benchmark plan 
premium, the premium for the plan in which the taxpayers enroll, and the 
advance credit payments for that period are allocated entirely to that 
taxpayer.
    (4) Taxpayers filing returns as married filing separately or head of 
household--(i) Allocation of advance credit payments. Except as provided 
in Sec. 1.36B-2(b)(2)(ii), the premium tax credit is allowed to married 
(within the meaning of section 7703) taxpayers only if they file joint 
returns. See Sec. 1.36B-2(b)(2)(i). Taxpayers who receive advance credit 
payments as married taxpayers and do not file a joint return must 
allocate the advance credit payments for coverage under a qualified 
health plan equally to each taxpayer for any period the plan covers and 
advance credit payments are made for both taxpayers, only one of the 
taxpayers and one or more dependents of the other taxpayer, or one or 
more dependents of both taxpayers. If for a period a plan covers or 
advance credit payments are made for only one of the taxpayers and no 
dependents, only one of the taxpayers and one or more dependents of that 
same taxpayer, or only one or more dependents of one of the taxpayers, 
the advance credit payments for that period are allocated entirely to 
that taxpayer. If one or both of the taxpayers is an applicable taxpayer 
eligible for a premium tax credit for the taxable year, the premium tax 
credit is computed by allocating the premiums for the plan in which the 
taxpayers or their family members enroll under paragraph (b)(4)(ii) of 
this section. The repayment limitation described in paragraph (a)(3) of 
this section applies to each taxpayer based on the household income and 
family size reported on that taxpayer's return. This paragraph (b)(4) 
also applies to taxpayers who receive advance credit payments as married 
taxpayers and file a tax return using the head of household filing 
status.
    (ii) Allocation of premiums. If taxpayers who are married within the 
meaning of section 7703, without regard to section 7703(b), do not file 
a joint return, 50 percent of the premiums for a period of coverage in a 
qualified health plan are allocated to each taxpayer.

[[Page 146]]

However, all of the premiums are allocated to only one of the taxpayers 
for a period in which a qualified health plan covers only that taxpayer, 
only that taxpayer and one or more dependents of that taxpayer, or only 
one or more dependents of that taxpayer.
    (b)(5), Example 1 through Example 8 [Reserved]. For further 
guidance, see Sec. 1.36B-4(b)(5), Example 1 through Example 8.

    Example 9. (i) The facts are the same as in Example 8, except that X 
and Y live apart for over 6 months of the year and X properly files an 
income tax return as head of household. Under section 7703(b), X is 
treated as unmarried and therefore is not required to file a joint 
return. If X otherwise qualifies as an applicable taxpayer, X may claim 
the premium tax credit based on the household income and family size X 
reports on the return. Y is not an applicable taxpayer and is not 
eligible to claim the premium tax credit.
    (ii) X must reconcile the amount of credit with advance credit 
payments under paragraph (a) of this section. The premium for the 
applicable benchmark plan covering X and his two dependents is $9,800. 
X's premium tax credit is computed as follows: $9,800 benchmark plan 
premium minus X's contribution amount of $5,700 ($60,000  x  .095) 
equals $4,100.
    (iii) Under paragraph (b)(4) of this section, half of the advance 
payments ($6,880/2 = $3,440) is allocated to X and half is allocated to 
Y. Thus, X is entitled to $660 additional premium tax credit 
($4,100-$3,440). Y has $3,440 excess advance payments, which is limited 
to $600 under paragraph (a)(3) of this section.
    Example 10. (i) A is married to B at the close of 2014 and they have 
no dependents. A and B are enrolled in a qualified health plan for 2014 
with an annual premium of $10,000 and advance credit payments of $6,500. 
A is not eligible for minimum essential coverage (other than coverage 
described in section 5000A(f)(1)(C)) for any month in 2014. A is a 
victim of domestic abuse as described in Sec. 1.36B-2(b)(2)(iii). At the 
time A files her tax return for 2014, A is unable to file a joint return 
with B for 2014 because of the domestic abuse. A certifies on her 2014 
return, in accordance with relevant instructions, that she is living 
apart from B and is unable to file a joint return because of domestic 
abuse. Thus, under Sec. 1.36B-2(b)(2)(ii), A satisfies the joint return 
filing requirement in section 36B(c)(1)(C) for 2014.
    (ii) A's family size for 2014 for purposes of computing the premium 
tax credit is one and A is the only member of her coverage family. Thus, 
A's benchmark plan for all months of 2014 is the second lowest cost 
silver plan offered by the Exchange for A's rating area that covers A. 
A's household income includes only A's modified adjusted gross income. 
Under paragraph (b)(4)(ii) of this section, A takes into account $5,000 
($10,000  x  .50) of the premiums for the plan in which she was enrolled 
in determining her premium tax credit. Further, A must reconcile $3,250 
($6,500  x  .50) of the advance credit payments for her coverage under 
paragraph (b)(4)(i) of this section.

    (c) Effective/applicability date. Paragraphs (a)(1)(ii), 
(a)(3)(iii), (a)(4), Examples 4, 10, 11, 12, 13, and 14, (b)(3), (b)(4), 
and (b)(5), Examples 9 and 10 apply to taxable years beginning after 
December 31, 2013.
    (d) Expiration date. Paragraphs (a)(1)(ii), (a)(3)(iii), (a)(4), 
Examples 4, 10, 11, 12, 13, and 14, (b)(3), (b)(4), and (b)(5), Examples 
9 and 10 expire on July 24, 2017.

[T.D. 9683, 79 FR 43628, July 28, 2014]



Sec. 1.36B-5  Information reporting by Exchanges.

    (a) In general. An Exchange must report to the Internal Revenue 
Service (IRS) information required by section 36B(f)(3) and this section 
relating to individual market qualified health plans in which 
individuals enroll through the Exchange. No reporting is required under 
this section for enrollment in plans through the Small Business Health 
Options Exchange.
    (b) Individual filing a return. For purposes of this section, the 
terms tax filer and responsible adult describe the individual who is 
expected to be the taxpayer filing an income tax return for the year of 
coverage with respect to individuals enrolling in a qualified health 
plan. A tax filer is an individual on behalf of whom advance payments of 
the premium tax credit are made. A responsible adult is an individual on 
behalf of whom advance payments of the premium tax credit are not made. 
An individual may be a tax filer or responsible adult whether or not 
enrolled in coverage. If more than one family (within the meaning of 
Sec. 1.36B-1(d)) enrolls in the same qualified health plan, there is a 
tax filer or responsible adult for each family.
    (c) Information required to be reported--(1) Information reported 
annually. An Exchange must report to the

[[Page 147]]

IRS the following information for each qualified health plan--
    (i) The name, address, and taxpayer identification number (TIN), or 
date of birth if a TIN is not available, of the tax filer or responsible 
adult;
    (ii) The name and TIN, or date of birth if a TIN is not available, 
of a tax filer's spouse;
    (iii) The amount of the advance credit payments paid for coverage 
under the plan each month;
    (iv) For plans for which advance credit payments are made, the 
premium (excluding the premium allocated to benefits in excess of 
essential health benefits, see Sec. 1.36B-3(j)) for the applicable 
benchmark plan for purposes of computing advance credit payments;
    (v) Except as provided in paragraph (c)(3)(ii) of this section, for 
plans for which advance credit payments are not made, the premium 
(excluding the premium allocated to benefits in excess of essential 
health benefits, see Sec. 1.36B-3(j)) for the applicable benchmark plan 
that would apply to all individuals enrolled in the qualified health 
plan if advance credit payments were made for the coverage;
    (vi) The name and TIN, or date of birth if a TIN is not available, 
and dates of coverage for each individual covered under the plan;
    (vii) The coverage start and end dates of the qualified health plan;
    (viii) The monthly premium for the plan in which the individuals 
enroll, however--
    (A) The premium allocated to benefits in excess of essential health 
benefits is excluded, see Sec. 1.36B-3(j);
    (B) The premium for a stand-alone dental plan allocated to pediatric 
dental benefits is added, see Sec. 1.36B-3(k), but if a family (within 
the meaning of Sec. 1.36B-1(d)) is enrolled in more than one qualified 
health plan, the pediatric dental premium is added to the premium for 
only one qualified health plan; and
    (C) The amount is not reduced for advance credit payments;
    (ix) The name of the qualified health plan issuer;
    (x) The Exchange-assigned policy identification number;
    (xi) The Exchange's unique identifier; and
    (xii) Any other information specified by forms or instructions or in 
published guidance, see Sec. 601.601(d) of this chapter.
    (2) Information reported monthly. For each calendar month, an 
Exchange must report to the IRS for each qualified health plan, the 
information described in paragraph (c)(1) of this section and the 
following information--
    (i) For plans for which advance credit payments are made--
    (A) The names, TINs, or dates of birth if no TIN is available, of 
the individuals enrolled in the qualified health plan who are expected 
to be the tax filer's dependent; and
    (B) Information on employment (to the extent this information is 
provided to the Exchange) consisting of--
    (1) The name, address, and EIN of each employer of the tax filer, 
the tax filer's spouse, and each individual covered by the plan; and
    (2) An indication of whether an employer offered affordable minimum 
essential coverage that provided minimum value, and, if so, the amount 
of the employee's required contribution for self-only coverage;
    (ii) The unique identifying number the Exchange uses to report data 
that enables the IRS to associate the data with the proper account from 
month to month;
    (iii) The issuer's employer identification number (EIN); and
    (iv) Any other information specified by forms or instructions or in 
published guidance, see Sec. 601.601(d) of this chapter.
    (3) Special rules for information reported--(i) Multiple families 
enrolled in a single qualified health plan. An Exchange must report the 
information specified in paragraphs (c)(1) and (c)(2) of this section 
for each family (within the meaning of Sec. 1.36B-1(d)) enrolled in a 
qualified health plan, including families submitting a single 
application or enrolled in a single qualified health plan. If advance 
credit payments are made for coverage under the plan, the enrollment 
premiums reported to each family under paragraph (c)(1)(viii) of this 
section are the premiums allocated to the family under Sec. 1.36B-3(h) 
(allocating enrollment premiums to

[[Page 148]]

each taxpayer in proportion to the premiums for each taxpayer's 
applicable benchmark plan).
    (ii) Alternative to reporting applicable benchmark plan. An Exchange 
satisfies the requirement in paragraph (c)(1)(v) of this section if, on 
or before January 1 of each year after 2014, the Exchange provides a 
reasonable method that a responsible adult may use to determine the 
premium (after adjusting for benefits in excess of essential health 
benefits) for the applicable benchmark plan that applies to the 
responsible adult's coverage family for the prior calendar year for 
purposes of determining the premium tax credit on the tax return.
    (iii) Partial month of coverage.--(A) In general. Except as provided 
in paragraph (c)(3)(iii)(B) of this section, if an individual is 
enrolled in a qualified health plan after the first day of a month, the 
amount reported for that month under paragraphs (c)(1)(iv), (c)(1)(v), 
and (c)(1)(viii) of this section is $0.
    (B) Certain mid-month enrollments. For information reporting that is 
due on or after January 1, 2019, if an individual's qualified health 
plan is terminated before the last day of a month, or if an individual 
is enrolled in coverage after the first day of a month and the coverage 
is effective on the date of the individual's birth, adoption, or 
placement for adoption or in foster care, or on the effective date of a 
court order, the amount reported under paragraphs (c)(1)(iv) and 
(c)(1)(v) of this section is the premium for the applicable benchmark 
plan for a full month of coverage (excluding the premium allocated to 
benefits in excess of essential health benefits), and the amount 
reported under paragraph (c)(1)(viii) of this section is the enrollment 
premium for the month, reduced by any amounts that were refunded.
    (4) Exemptions. For each calendar month, an Exchange must report to 
the IRS the name and TIN, or date of birth if a TIN is not available, of 
each individual for whom the Exchange has granted an exemption from 
coverage under section 5000A(e) and the related regulations, the months 
for which the exemption is in effect, and the exemption certificate 
number.
    (d) Time for reporting--(1) Annual reporting. An Exchange must 
submit to the IRS the annual report required under paragraph (c)(1) of 
this section on or before January 31 of the year following the calendar 
year of coverage.
    (2) Monthly reporting--(i) In general. Except as provided in 
paragraph (d)(2)(ii) of this section, an Exchange must submit to the IRS 
the monthly reports required under paragraphs (c)(2) and (c)(4) of this 
section on or before the 15th day following each month of coverage.
    (ii) Initial monthly reporting in 2014. Exchanges must submit to the 
IRS the initial monthly report required under paragraphs (c)(2) and 
(c)(4) of this section on a date that the Commissioner may establish in 
other guidance, see Sec. 601.601(d) of this section, but no earlier than 
June 15, 2014. The initial report must include cumulative information 
for enrollments for the period January 1, 2014, through the last day of 
the month preceding the month for submitting the initial monthly report.
    (3) Corrections to information reported. In general, an Exchange 
must correct erroneous or outdated monthly-reported information in the 
next monthly report. If the information must be corrected after the 
final monthly submission on January 15 following the coverage year, 
corrections should be submitted by the 15th day of the month following 
the month in which the incorrect information is identified. However, no 
monthly report correction is permitted after April 15 following the year 
of coverage. Errors on the annual report must be corrected and reported 
to the IRS and to the individual recipient identified in paragraph (f) 
of this section as soon as possible.
    (e) Electronic reporting. An Exchange must submit the reports to the 
IRS required under this section in electronic format. The information 
reported monthly will be submitted to the IRS through the Department of 
Health and Human Services.
    (f) Annual statement to be furnished to individuals--(1) In general. 
An Exchange must furnish to each tax filer or responsible adult (the 
recipient for purposes of paragraphs (f) and (g) of this section) a 
written statement showing--

[[Page 149]]

    (i) The name and address of the recipient and
    (ii) The information described in paragraph (c)(1) of this section 
for the previous calendar year.
    (2) Form of statements. A statement required under this paragraph 
(f) may be made by furnishing to the recipient identified in the annual 
report either a copy of the report filed with the IRS or a substitute 
statement. A substitute statement must include the information required 
to be shown on the report filed with the IRS and must comply with 
requirements in published guidance (see Sec. 601.601(d)(2) of this 
chapter) relating to substitute statements. A reporting entity may use 
an IRS truncated taxpayer identification number as the identification 
number for an individual in lieu of the identification number appearing 
on the corresponding information report filed with the IRS.
    (3) Time and manner for furnishing statements. An Exchange must 
furnish the statements required under this paragraph (f) on or before 
January 31 of the year following the calendar year of coverage. If 
mailed, the statement must be sent to the recipient's last known 
permanent address or, if no permanent address is known, to the 
recipient's temporary address. For purposes of this paragraph (f)(3), an 
Exchange's first class mailing to the last known permanent address, or 
if no permanent address is known, the temporary address, discharges the 
Exchange's requirement to furnish the statement. An Exchange may furnish 
the statement electronically in accordance with paragraph (g) of this 
section.
    (g) Electronic furnishing of statements--(1) In general. An Exchange 
required to furnish a statement under paragraph (f) of this section may 
furnish the statement to the recipient in an electronic format in lieu 
of a paper format. An Exchange that meets the requirements of paragraphs 
(g)(2) through (g)(7) of this section is treated as furnishing the 
statement in a timely manner.
    (2) Consent--(i) In general. A recipient must have affirmatively 
consented to receive the statement in an electronic format. The consent 
may be made electronically in any manner that reasonably demonstrates 
that the recipient is able to access the statement in the electronic 
format in which it will be furnished. Alternatively, the consent may be 
made in a paper document that is confirmed electronically.
    (ii) Withdrawal of consent. The consent requirement of this 
paragraph (g)(2) is not satisfied if the recipient withdraws the consent 
and the withdrawal takes effect before the statement is furnished. An 
Exchange may provide that the withdrawal of consent takes effect either 
on the date the Exchange receives it or on another date no more than 60 
days later. The Exchange may provide that a request by the recipient for 
a paper statement will be treated as a withdrawal of consent to receive 
the statement in an electronic format. If the Exchange furnishes a 
statement after the withdrawal of consent takes effect, the recipient 
has not consented to receive the statement in electronic format.
    (iii) Change in hardware or software requirements. If a change in 
the hardware or software required to access the statement creates a 
material risk that a recipient will not be able to access a statement, 
an Exchange must, prior to changing the hardware or software, notify the 
recipient. The notice must describe the revised hardware and software 
required to access the statement and inform the recipient that a new 
consent to receive the statement in the revised electronic format must 
be provided to the Exchange. After implementing the revised hardware and 
software, the Exchange must obtain a new consent or confirmation of 
consent from the recipient to receive the statement electronically.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (g)(2):
    Example 1. Furnisher F sends Recipient R a letter stating that R may 
consent to receive the statement required under section 36B 
electronically on a Web site instead of in a paper format. The letter 
contains instructions explaining how to consent to receive the statement 
electronically by accessing the Web site, downloading and completing the 
consent document, and emailing the completed consent to F. The consent 
document posted on the Web site uses the same electronic format that F 
will use for the electronically furnished statement. R reads the 
instructions and submits the consent in the manner provided in the 
instructions. R

[[Page 150]]

has consented to receive the statement required under section 36B 
electronically in the manner described in paragraph (g)(2)(i) of this 
section.
    Example 2. Furnisher F sends Recipient R an email stating that R may 
consent to receive the statement required under section 36B 
electronically instead of in a paper format. The email contains an 
attachment instructing R how to consent to receive the statement 
required under section 36B electronically. The email attachment uses the 
same electronic format that F will use for the electronically furnished 
statement. R opens the attachment, reads the instructions, and submits 
the consent in the manner provided in the instructions. R has consented 
to receive the statement required under section 36B electronically in 
the manner described in paragraph (g)(2)(i) of this section.
    Example 3. Furnisher F posts a notice on its Web site stating that 
Recipient R may receive the statement required under section 36B 
electronically instead of in a paper format. The Web site contains 
instructions on how R may access a secure Web page and consent to 
receive the statements electronically. R accesses the secure Web page 
and follows the instructions for giving consent. R has consented to 
receive the statement required under section 36B electronically in the 
manner described in paragraph (g)(2)(i) of this section.
    (3) Required disclosures--(i) In general. Prior to, or at the time 
of, a recipient's consent, an Exchange must provide to the recipient a 
clear and conspicuous disclosure statement containing each of the 
disclosures described in paragraphs (g)(3)(ii) through (g)(3)(viii) of 
this section.
    (ii) Paper statement. An Exchange must inform the recipient that the 
statement will be furnished on paper if the recipient does not consent 
to receive it electronically.
    (iii) Scope and duration of consent. An Exchange must inform the 
recipient of the scope and duration of the consent. For example, the 
Exchange must inform the recipient whether the consent applies to each 
statement required to be furnished after the consent is given until it 
is withdrawn or only to the first statement required to be furnished 
following the consent.
    (iv) Post-consent request for a paper statement. An Exchange must 
inform the recipient of any procedure for obtaining a paper copy of the 
recipient's statement after giving the consent described in paragraph 
(g)(2)(i) of this section and whether a request for a paper statement 
will be treated as a withdrawal of consent.
    (v) Withdrawal of consent. An Exchange must inform the recipient 
that--
    (A) The recipient may withdraw consent by writing (electronically or 
on paper) to the person or department whose name, mailing address, 
telephone number, and email address is provided in the disclosure 
statement;
    (B) An Exchange will confirm the withdrawal and the date on which it 
takes effect in writing (either electronically or on paper); and
    (C) A withdrawal of consent does not apply to a statement that was 
furnished electronically in the manner described in this paragraph (g) 
before the date on which the withdrawal of consent takes effect.
    (vi) Notice of termination. An Exchange must inform the recipient of 
the conditions under which the Exchange will cease furnishing statements 
electronically to the recipient.
    (vii) Updating information. An Exchange must inform the recipient of 
the procedures for updating the information needed to contact the 
recipient and notify the recipient of any change in the Exchange's 
contact information.
    (viii) Hardware and software requirements. An Exchange must provide 
the recipient with a description of the hardware and software required 
to access, print, and retain the statement, and the date when the 
statement will no longer be available on the Web site. The Exchange must 
advise the recipient that the statement may be required to be printed 
and attached to a Federal, State, or local income tax return.
    (4) Format. The electronic version of the statement must contain all 
required information and comply with applicable published guidance (see 
Sec. 601.601(d) of this chapter) relating to substitute statements to 
recipients.
    (5) Notice--(i) In general. If a statement is furnished on a Web 
site, the Exchange must notify the recipient. The notice may be 
delivered by mail, electronic mail, or in person. The notice must 
provide instructions on how to access and print the statement and

[[Page 151]]

include the following statement in capital letters, ``IMPORTANT TAX 
RETURN DOCUMENT AVAILABLE.'' If the notice is provided by electronic 
mail, this statement must be on the subject line of the electronic mail.
    (ii) Undeliverable electronic address. If an electronic notice 
described in paragraph (g)(5)(i) of this section is returned as 
undeliverable, and the Exchange cannot obtain the correct electronic 
address from the Exchange's records or from the recipient, the Exchange 
must furnish the notice by mail or in person within 30 days after the 
electronic notice is returned.
    (iii) Corrected statement. An Exchange must furnish a corrected 
statement to the recipient electronically if the original statement was 
furnished electronically. If the original statement was furnished 
through a Web site posting, the Exchange must notify the recipient that 
it has posted the corrected statement on the Web site in the manner 
described in paragraph (g)(5)(i) of this section within 30 days of the 
posting. The corrected statement or the notice must be furnished by mail 
or in person if--
    (A) An electronic notice of the Web site posting of an original 
statement or the corrected statement was returned as undeliverable; and
    (B) The recipient has not provided a new email address.
    (6) Access period. Statements furnished on a Web site must be 
retained on the Web site through October 15 of the year following the 
calendar year to which the statements relate (or the first business day 
after October 15, if October 15 falls on a Saturday, Sunday, or legal 
holiday). The furnisher must maintain access to corrected statements 
that are posted on the Web site through October 15 of the year following 
the calendar year to which the statements relate (or the first business 
day after October 15, if October 15 falls on a Saturday, Sunday, or 
legal holiday) or the date 90 days after the corrected forms are posted, 
whichever is later.
    (7) Paper statements after withdrawal of consent. An Exchange must 
furnish a paper statement if a recipient withdraws consent to receive a 
statement electronically and the withdrawal takes effect before the 
statement is furnished. A paper statement furnished under this paragraph 
(g)(7) after the statement due date is timely if furnished within 30 
days after the date the Exchange receives the withdrawal of consent.
    (h) Effective/applicability date. Except for the last sentence of 
paragraph (c)(3)(i) of this section and paragraph (c)(3)(iii) of this 
section, this section applies to taxable years ending after December 31, 
2013. The last sentence of paragraph (c)(3)(i) of this section and 
paragraph (c)(3)(iii) of this section apply to taxable years beginning 
after December 31, 2018. Paragraph (c)(3) of Sec. 1.36B-5 as contained 
in 26 CFR part I edition revised as of April 1, 2016, applies to 
information reporting for taxable years ending after December 31, 2013, 
and beginning before January 1, 2019.

[T.D. 9663, 79 FR 26117, May 7, 2014, as amended at 81 FR 91768, Dec. 
19, 2016]



Sec. 1.36B-6  Minimum value.

    (a) In general. An eligible employer-sponsored plan provides minimum 
value (MV) only if--
    (1) The plan's share of the total allowed costs of benefits provided 
to an employee (the MV percentage) is at least 60 percent; and
    (2) [Reserved]
    (b) MV standard population. [Reserved]
    (c) MV percentage--(1) In general. [Reserved]
    (2) Wellness program incentives--(i) In general. Nondiscriminatory 
wellness program incentives offered by an eligible employer-sponsored 
plan that affect deductibles, copayments, or other cost-sharing are 
treated as earned in determining the plan's MV percentage if the 
incentives relate exclusively to tobacco use. Wellness program 
incentives that do not relate to tobacco use or that include a component 
unrelated to tobacco use are treated as not earned for this purpose. For 
purposes of this section, the term wellness program incentive has the 
same meaning as the term reward in Sec. 54.9802-1(f)(1)(i) of this 
chapter.
    (ii) Example. The following example illustrates the rules of this 
paragraph (c)(2):


[[Page 152]]


    Example. (i) Employer X offers an eligible employer-sponsored plan 
that reduces the deductible by $300 for employees who do not use tobacco 
products or who complete a smoking cessation course. The deductible is 
reduced by $200 if an employee completes cholesterol screening within 
the first six months of the plan year. Employee B does not use tobacco 
and his deductible is $3,700. Employee C uses tobacco and her deductible 
is $4,000.
    (ii) Under paragraph (c)(2)(i) of this section, only the incentives 
related to tobacco use are considered in determining the plan's MV 
percentage. C is treated as having earned the $300 incentive for 
attending a smoking cessation course regardless of whether C actually 
attends the course. Thus, the deductible for determining for the MV 
percentage for both Employees B and C is $3,700. The $200 incentive for 
completing cholesterol screening is disregarded.

    (3) Employer contributions to health savings accounts. Employer 
contributions for the current plan year to health savings accounts that 
are offered with an eligible employer-sponsored plan are taken into 
account for that plan year towards the plan's MV percentage.
    (4) Employer contributions to health reimbursement arrangements. 
Amounts newly made available for the current plan year under a health 
reimbursement arrangement that would be integrated within the meaning of 
Notice 2013-54 (2013-40 IRB 287), see Sec. 601.601(d) of this chapter, 
with an eligible employer-sponsored plan for an employee enrolled in the 
plan are taken into account for that plan year towards the plan's MV 
percentage if the amounts may be used to reduce only cost-sharing for 
covered medical expenses. A health reimbursement arrangement counts 
toward a plan's MV percentage only if the health reimbursement 
arrangement and the eligible employer-sponsored plan are offered by the 
same employer. Employer contributions to a health reimbursement 
arrangement count for a plan year towards the plan's MV percentage only 
to the extent the amount of the annual contribution is required under 
the terms of the plan or otherwise determinable within a reasonable time 
before the employee must decide whether to enroll in the eligible 
employer-sponsored plan.
    (5) Expected spending adjustments for health savings accounts and 
health reimbursement arrangements. [Reserved]
    (d) Methods for determining MV. [Reserved]
    (e) Scope of essential health benefits and adjustment for benefits 
not included in MV Calculator. [Reserved]
    (f) Actuarial certification. [Reserved]
    (1) In general. [Reserved]
    (2) Membership in American Academy of Actuaries. [Reserved]
    (3) Actuarial analysis. [Reserved]
    (4) Use of MV Calculator. [Reserved]
    (g) Effective/applicability date--in general. (1) Except as provided 
in paragraph (g)(2) of this section, this section applies for taxable 
years ending after December 31, 2013.
    (2) Exception. [Reserved]

[T.D. 9745, 80 FR 78976, Dec. 18, 2015]



Sec. 1.37-1  General rules for the credit for the elderly.

    (a) In general. In the case of an individual, section 37 provides a 
credit against the tax imposed by chapter 1 of the Internal Revenue Code 
of 1954. This section and Secs. 1.37-2 and 1.37-3 provide guidance in 
the computation of the credit for the elderly provided under section 37 
for taxable years beginning after 1975. For rules relating to the 
computation of the retirement income credit provided under section 37 
for taxable years beginning before 1976, see 26 CFR 1.37-1 through 1.37-
5 (Rev. as of April 1, 1980). Note that section 403 of the Tax Reduction 
and Simplification Act of 1977 provides that a taxpayer may elect to 
compute the credit under section 37 for the taxpayer's first taxable 
year beginning in 1976 in accordance with the rules applicable to 
taxable years beginning before 1976.
    (b) Limitation on the amount of the credit. The credit allowed by 
section 37 for a taxable year shall not exceed the tax imposed by 
chapter 1 of the Code for the taxable year (reduced, in the case of a 
taxable year beginning before 1979, by the general tax credit allowed by 
section 42).
    (c) Married couples must file joint returns. If the taxpayer is 
married at the close of the taxable year, the credit provided by section 
37 shall be allowed only if the taxpayer and the taxpayer's

[[Page 153]]

spouse file a joint return for the taxable year. The preceding sentence 
shall not apply in the case of a husband and wife who are not members of 
the same household at any time during the taxable year. For the 
determination of marital status, see Secs. 143 and 1.143-1.
    (d) Nonresident aliens ineligible. No credit is allowed under 
section 37 to any individual for any taxable year during which that 
individual is at any time a nonresident alien unless the individual is 
treated, by reason of an election under section 6013 (g) or (h), as a 
resident of the United States for that taxable year.

[T.D. 7743, 45 FR 84049, Dec. 22, 1980]



Sec. 1.37-2  Credit for individuals age 65 or over.

    (a) In general. This section illustrates the computation of the 
credit for the elderly in the case of an individual who has attained the 
age of 65 before the close of the taxable year. This section shall not 
apply to an individual for any taxable year for which the individual 
makes the election described in section 37(e)(2) and paragraph (b) of 
Sec. 1.37-3.
    (b) Computation of credit. The credit for the elderly for an 
individual to whom this section applies equals 15 percent of the 
individual's ``section 37 amount'' for the taxable year. An individual's 
``section 37 amount'' for a taxable year is the initial amount 
determined under section 37(b)(2), reduced as provided in section 
37(b)(3) and (c)(1).
    (c) Examples. The computation of the credit for the elderly for 
individuals to whom this section applies may be illustrated by the 
following examples:

    Example 1. A, a single individual who is 67 years old, has adjusted 
gross income of $8,000 for the calendar year 1977. A also receives 
social security payments of $1,450 during 1977. A does not itemize 
deductions. A's credit for the elderly is $120, computed as follows:

Initial amount under section 37(b)(2).........................    $2,500
Reductions required by section 37 (b)(3) and (c)(1):
    Social security payments........................    $1,450
    One-half the excess of adjusted gross income           250     1,700
     over $7,500....................................
                                                     ----------
Section 37 amount.............................................       800
                                                               =========
15 pct. of $800...............................................      $120
 


A's tax from the tax tables, which reflect the allowance of the general 
tax credit, is $662. Accordingly, the limitation of section 37(c)(2) and 
paragraph (b) of Sec. 1.37-1 does not reduce A's credit for the elderly.
    Example 2. H and W, who have both attained the age of 65, file a 
joint return for calendar year 1977. For that year H and W have adjusted 
gross income of $8,120; H also receives a railroad retirement pension of 
$1,550, and W receives social security payments of $1,200. H and W do 
not itemize deductions. The credit for the elderly allowed to H and W 
for 1977 is $139, computed as follows:

Initial amount under section 37(b)(2).........................    $3,750
Reductions required by section 37 (b)(3):
    Railroad retirement pension.....................    $1,550
    Social Security payments........................     1,200     2,750
                                                     ----------
Section 37 amount.............................................     1,000
                                                               =========
15 pct. of $1,000.............................................       150
Limitation based upon amount of tax (derived from table             $139
 reflecting allowance of general tax credit)..................
 


Since the adjusted gross income of H and W is not greater than $10,000, 
no reduction of the initial amount is required under section 37 (c)(1).

[T.D. 7743, 45 FR 84050, Dec. 22, 1980]



Sec. 1.37-3  Credit for individuals under age 65 who have public retirement 
system income.

    (a) In general. This section provides rules for the computation of 
the credit for the elderly under section 37(e) in the case of an 
individual who has not attained the age of 65 before the close of the 
taxable year and whose gross income for the taxable year includes 
retirement income within the meaning of paragraph (d)(1)(ii) of this 
section (i.e., under a public retirement system). If such an individual 
is married within the meaning of section 143 at the close of the taxable 
year and the spouse of the individual has attained the age of 65 before 
the close of the taxable year, this section shall apply to the 
individual for the taxable year only if both spouses make the election 
described in paragraph (b) of this section. If both spouses make the 
election described in paragraph (b) of this section for the taxable 
year, the credit of each spouse shall be determined under the rules of 
this section. See paragraph (f)(2) of this section for a limitation on 
the effects of community property laws in making determinations and 
computations under section 37(e) and this section.
    (b) Election by certain married taxpayers. If a married individual 
under

[[Page 154]]

age 65 at the close of the taxable year has retirement income and the 
spouse of that individual has attained the age of 65 before the close of 
the taxable year, both spouses may elect to compute the credit provided 
by section 37 under the rules of section 37(e) and this section. The 
spouses shall signify the election on the return (or amended return) for 
the taxable year in the manner prescribed in the instructions 
accompanying the return. The election may be made at any time before the 
expiration of the period of limitation for filing claim for credit or 
return for the taxable year. The election may be revoked without the 
consent of the Commissioner at any time before the expiration of that 
period by filing an amended return.
    (c) Computation of credit. The credit of an individual under section 
37(e) and this section equals 15 percent of the individual's credit base 
for the taxable year. The credit base of an individual for a taxable 
year is the lesser of--
    (1) The retirement income of the individual for the taxable year, or
    (2) The amount determined under section 37(e)(5), as modified by 
section 37(e) (6) and (7).
    (d) Retirement income--(1) General rule--(i) For individuals 65 or 
over. Section 37(e)(4)(A) enumerates the kinds of income which may be 
treated as the retirement income of an individual who has attained the 
age of 65 before the close of the taxable year. They include income from 
pensions and annuities, interest, rents, dividends, certain bonds 
received under a qualified bond purchase plan, and certain individual 
retirement accounts or annuities.
    (ii) For individuals under 65. In the case of an individual who has 
not attained the age of 65 before the close of the taxable year, 
retirement income consists only of income from pensions and annuities 
(including disability annuity payments) under a public retirement system 
which arises from services performed by that individual or by a present 
or former spouse of that individual. The term ``public retirement 
system'' means a pension, annuity, or retirement, or similar fund or 
system established by the United States, a State, a possession of the 
United States, any political subdivision of any of the foregoing, or the 
District of Columbia.
    (2) Rents. For purposes of section 37(e)(4)(A)(iii), income from 
rents shall be the gross amount received, not reduced by depreciation or 
other expenses, except that beneficiaries of a trust or estate shall 
treat as retirement income only their proportionate shares, of the 
taxable rents of the trust or estate. In the case of an amount received 
for board and lodging, only the portion of the amount received for 
lodging is income from rents.
    (3) Disability annuity payments received by individual under age 65. 
Disability annuity payments received under a public retirement system by 
an individual under age 65 at the close of the taxable year shall not be 
treated as retirement income unless the payments are for periods after 
the date on which the individual reached minimum retirement age, that 
is, the age at which the individual would be eligible to receive a 
pension or annuity without regard to disability, and any of the 
following conditions is satisfied--
    (i) The individual is precluded from seeking the benefits of section 
105(d) (relating to certain disability payments) for that taxable year 
by reason of an irrevocable election;
    (ii) The individual was not permanently and totally disabled at the 
time of retirement (and was not permanently and totally disabled either 
on January 1, 1976, or on January 1, 1977, if the individual retired 
before the later date on disability or under circumstances which 
entitled the individual to retire on disability); or
    (iii) The payments are for periods after the individual reached 
mandatory retirement age.

For purposes of this paragraph, disability annuity payments include 
payments to an individual who retired on partial or temporary 
disability.
    (4) Compensation of personal services rendered during taxable year. 
Retirement income does not include any amount representing compensation 
for personal services rendered during the taxable year. For this 
purpose, amounts received as a pension shall

[[Page 155]]

not be treated as representing compensation for personal services 
rendered during the taxable year if the period of service during the 
taxable year is not substantial when compared with the total years of 
service. For example, an individual on the calendar year basis retires 
on November 30 after 5 years of service and receives a pension during 
the remainder of his taxable year. The pension is not treated as 
representing compensation for personal services rendered during such 
taxable year merely because it is paid by reason of the services of the 
individual for a period of 5 years which includes a portion of the 
taxable year.
    (5) Amounts not includible in gross income. Retirement income does 
not include any amount not includible in the gross income of the 
individual for the taxable year. For example, if a portion of an annuity 
is excluded from gross income under section 72, relating to annuities, 
that portion of the annuity is not retirement income; similarly, the 
portion of dividend income excluded from gross income under section 116, 
relating to the partial exclusion of dividends received by individuals 
is not retirement income.
    (e) Earned income--(1) In general. The term ``earned income'' in 
section 37(e)(5)(B) generally has the same meaning as in section 911(b), 
except that earned income does not include any amount received as a 
pension or annuity. See section 911(b) and the regulations thereunder. 
Section 911(b) provides, in general, that earned income includes wages, 
salaries, professional fees, and other amounts received as compensation 
for personal services rendered.
    (2) Earned income from self-employment. For purposes of section 
37(e)(5)(B), the earned income of a taxpayer from self-employment in a 
trade or business shall not exceed--
    (i) The taxpayer's share of the net profits from the trade or 
business if capital is not a material income-producing factor in that 
trade or business; or
    (ii) Thirty percent of the taxpayer's share of the net profits from 
the trade or business if capital is a material income-producing factor 
in that trade or business.

For other rules relating to the determination of earned income from 
self-employment in a trade or business, see section 911(b) and the 
regulations thereunder.
    (3) Disability annuity payments received by individuals under age 
65. Disability annuity payments received under a public retirement 
system by an individual under age 65 at the close of the taxable year 
shall be treated as earned income for purposes of section 37(e)(5)(B) 
unless the payments are treated as retirement income under paragraph 
(d)(3) of this section.
    (f) Computation of credit under section 37(e) in the case of joint 
returns--(1) In general. In the case of a joint return of husband and 
wife, the credit base of each spouse under section 37(e) is computed 
separately. The spouses then combine their credit bases and compute a 
single credit. The limitation in section 37(c)(2) and paragraph (b) of 
Sec. 1.37-1 on the amount of the credit is determined by reference to 
the joint tax liability of the spouses. Thus, regardless of whether a 
spouse would be liable for the tax imposed by chapter 1 of the Code if 
the joint return had not been filed, the credit base of that spouse is 
taken into account in computing the credit.
    (2) Community property laws. For taxable years beginning after 1977, 
married individuals filing joint returns shall disregard community 
property laws in making any determination or computation required under 
section 37(e) or this section. Each item of income is attributed in full 
to the spouse whose income it would have been in the absence of 
community property laws. Thus, if a 67-year old individual files a joint 
return with a 62-year old spouse for 1979 and the only income of the 
couple is from a public pension of the older spouse, that public pension 
is attributed in full to the older spouse for purposes of section 37(e) 
even though the applicable community property law may treat one-half of 
the pension as the income of the 62-year old spouse. Since the younger 
spouse consequently has no retirement income within the meaning of 
paragraph (d) of this section, the couple may not make the election 
described in paragraph (b) of this section.

[[Page 156]]

    (g) Examples. The computation of the credit for the elderly under 
section 37(e) and this section is illustrated by the following examples:

    Example 1. B, who is 62 years old and single, receives a fully 
taxable pension of $2,400 from a public retirement system during 1977. B 
performed the services giving rise to the pension. During that year, B 
also earns $2,650 from a part-time job. B receives no tax-exempt pension 
or annuity in 1977. Subject to the limitation of section 37(c)(2) and 
paragraph (b) of Sec. 1.37-1, B's credit for the elderly for 1977 under 
section 37(e) is $195, computed as follows:

Maximum retirement income level under section 37(e)(5)......      $2,500
Earned income offset under section
 37(e)(5)(B)(ii):
    Earned income in excess of $1,700...........        $950
    One-half of earned income in excess of               250       1,200
     $1,200, but not in excess of $1,700........
                                                 ------------
Amount determined under section 37(e)(5)....................       1,300
                                                             ===========
Retirement income...........................................       2,400
                                                             ===========
Credit for the elderly (15 pct. of $1,300)..................         195
 

    Example 2. During 1978 H, who is 67 years old, has earnings of 
$1,300 and retirement income (rents, interest, etc.) of $6,000. H also 
receives social security payments totalling $1,400. During 1978 W, who 
is 63 years old, earns $1,600 and receives a fully taxable pension of 
$1,400 from a public retirement system that constitutes retirement 
income. W performed the services giving rise to the pension. H and W 
file a joint return for 1978 and elect to compute the credit for the 
elderly under section 37(e). Under the applicable law these items of 
income are community income, and both spouses share equally in each 
item. Because H and W are filing a joint return, they disregard 
community property laws in computing their credit under section 37(e). 
The couple allocates $1,600 of the $3,750 referred to in section 
37(e)(6) to W and $2,150 to H. Subject to the limitation of section 
37(c)(2) and paragraph (b) of Sec. 1.37-1, their credit for the elderly 
is $315, computed as follows:

Credit base of H:
  Amount allocated to H under section 37(e)(6)..............      $2,150
  Reductions required by section 37(e)(5):
      Social Security payments..................      $1,400
      One-half of excess of earnings over $1,200          50       1,450
                                                 ------------
  Amount determined under section 37(e)(5)..................         700
                                                             ===========
  Retirement income.........................................       6,000
                                                             ===========
  Credit base of H..........................................         700
Credit base of W:
  Amount allocated to W under section 37(e)(6)..............      $1,600
  Reduction required by section 37(e)(5)(B):
      One-half of excess of earnings over $1,200............        $200
                                                             -----------
      Amount determined under section 37(e)(5)..............       1,400
                                                             ===========
  Retirement income.........................................       1,400
                                                             ===========
  Credit base of W..........................................       1,400
                                                             ===========
  Computation of credit:
      Credit base of H......................................         700
      Credit base of W......................................       1,400
                                                             -----------
      Combined credit base..................................       2,100
                                                             ===========
  Credit for the elderly (15 pct. of $2,100)................         315
 

    Example 3. (a) Assume the same facts as in example (2) of this 
paragraph, except that H and W live apart at all times during 1978 and 
file separate returns. Under these circumstances, H and W must give 
effect to the applicable community property law in determining their 
credits under section 37(e). Thus, each spouse must take into account 
one-half of each item of income.
    (b) Subject to the limitation of section 37(c)(2) and paragraph (b) 
of Sec. 1.37-1, H's credit for the elderly is $157.50, computed as 
follows:

Maximum retirement income level under section 37(e)(7)......      $1,875
Reductions required by section 37(e)(5):
    Social security payments....................        $700
    One-half of excess of earnings over $1,200           125         825
     (taking into account one-half of combined
     earnings of $2,900)........................
                                                 ------------
Amount determined under section 37(e)(5)....................       1,050
                                                             ===========
Retirement income...........................................       3,700
                                                             ===========
Credit of H (15 pct. of $1,050).............................      157.50
 

    (c) Subject to the limitation of section 37(c)(2) and paragraph (b) 
of Sec. 1.37-1, W's credit for the elderly is computed as follows:

Maximum retirement income level under section         $1,875
 37(e)(7).......................................
Reductions required by section 37(e)(5):
    Social security payments....................        $700
    One-half of excess of earnings over $1,200..         125         825
                                                 ------------
Amount determined under section 37(e)(5)........       1,050
                                                 =============
Retirement income (limited to W's share of               700
 public pension)................................
                                                 =============
Credit of W (15 pct. of $700)...................         105
 


[T.D. 7743, 45 FR 84050, Dec. 22, 1980]

[[Page 157]]



Sec. 1.38-1  Investment in certain depreciable property.

    Regulations under sections 46 through 50 are prescribed under the 
authority granted the Secretary by section 38(b) to prescribe 
regulations as may be necessary to carry out the purposes of section 38 
and subpart B, part IV, subchapter A, chapter 1 of the Code.

[44 FR 20417, Apr. 5, 1979]



Sec. 1.40-1  Questions and answers relating to the meaning of the 
term ``qualified mixture'' in section 40(b)(1).

    Q-1. What is a ``qualified mixture'' within the meaning of section 
40(b)(1)?
    A-1. A ``qualified mixture'' is a mixture of alcohol and gasoline or 
of alcohol and special fuel which (1) is sold by the taxpayer producing 
such mixture to any person for use as a fuel, or (2) is used as a fuel 
by the taxpayer producing such mixture.
    Q-2. Must alcohol be present in a product in order for that product 
to be considered a mixture of alcohol and either gasoline or a special 
fuel?
    A-2. No. A product is considered to be a mixture of alcohol and 
gasoline or of alcohol and a special fuel if the product is derived from 
alcohol and either gasoline or a special fuel even if the alcohol is 
chemically transformed in producing the product so that the alcohol is 
no longer present as a separate chemical in the final product, provided 
that there is no significant loss in the energy content of the alcohol. 
Thus, a product may be considered to be ``mixture of alcohol and 
gasoline or of alcohol and a special fuel'' within the meaning of 
section 40(b)(1)(B) if such product is produced in a chemical reaction 
between alcohol and either gasoline or a special fuel. Similarly a 
product may be considered to be a ``mixture of alcohol and gasoline or 
of alcohol and a special fuel'' if such product is produced by blending 
a chemical compound derived from alcohol with either gasoline or a 
special fuel.
    Thus, for example, a blend of gasoline and ethyl tertiary butyl 
ether (ETBE), a compound derived from ethanol (a qualified alcohol), in 
a chemical reaction in which there is no significant loss in the energy 
content of the ethanol, is considered for purposes of section 
40(b)(1)(B) to be a mixture of gasoline and the ethanol used to produce 
the ETBE, even though the ethanol is chemically transformed in the 
production of ETBE and is not present in the final product.

[T.D. 8291, 55 FR 8948, Mar. 9, 1990]



Sec. 1.41-0  Table of contents.

    This section lists the table of contents for Secs. 1.41-1 through 
1.41-9.

         Sec. 1.41-1  Credit for increasing research activities.

    (a) Amount of credit.
    (b) Introduction to regulations under section 41.

                Sec. 1.41-2  Qualified research expenses.

    (a) Trade or business requirement.
    (1) In general.
    (2) New business.
    (3) Research performed for others.
    (i) Taxpayer not entitled to results.
    (ii) Taxpayer entitled to results.
    (4) Partnerships.
    (i) In general.
    (ii) Special rule for certain partnerships and joint ventures.
    (b) Supplies and personal property used in the conduct of qualified 
research.
    (1) In general.
    (2) Certain utility charges.
    (i) In general.
    (ii) Extraordinary expenditures.
    (3) Right to use personal property.
    (4) Use of personal property in taxable years beginning after 
December 31, 1985.
    (c) Qualified services.
    (1) Engaging in qualified research.
    (2) Direct supervision.
    (3) Direct support.
    (d) Wages paid for qualified services.
    (1) In general.
    (2) ``Substantially all.''
    (e) Contract research expenses.
    (1) In general.
    (2) Performance of qualified research.
    (3) ``On behalf of.''
    (4) Prepaid amounts.
    (5) Examples.

Sec. 1.41-3  Base amount for taxable years beginning on or after January 
                                3, 2001.

    (a) New taxpayers.
    (b) Special rules for short taxable years.
    (1) Short credit year.
    (2) Short taxable year preceding credit year.
    (3) Short taxable year in determining fixed-base percentage.
    (c) Definition of gross receipts.
    (1) In general.

[[Page 158]]

    (2) Amounts excluded.
    (3) Foreign corporations.
    (d) Consistency requirement.
    (1) In general.
    (2) Illustrations.
    (e) Effective date.

  Sec. 1.41-4  Qualified research for expenditures paid or incurred in 
           taxable years ending on or after December 31, 2003.

    (a) Qualified research.
    (1) General rule.
    (2) Requirements of section 41(d)(1).
    (3) Undertaken for the purpose of discovering information.
    (i) In general.
    (ii) Application of the discovering information requirement.
    (iii) Patent safe harbor.
    (4) Technological in nature.
    (5) Process of experimentation.
    (i) In general.
    (ii) Qualified purpose.
    (6) Substantially all requirement.
    (7) Use of computers and information technology.
    (8) Illustrations.
    (b) Application of requirements for qualified research.
    (1) In general.
    (2) Shrinking-back rule.
    (3) Illustration.
    (c) Excluded activities.
    (1) In general.
    (2) Research after commercial production.
    (i) In general.
    (ii) Certain additional activities related to the business 
component.
    (iii) Activities related to production process or technique.
    (iv) Clinical testing.
    (3) Adaptation of existing business components.
    (4) Duplication of existing business component.
    (5) Surveys, studies, research relating to management functions, 
etc.
    (6) Internal use software.
    (i) General rule.
    (ii) Inapplicability of the high threshold of innovation test.
    (iii) Software developed primarily for internal use.
    (iv) Software not developed primarily for internal use.
    (v) Time and manner of determination.
    (vi) Software developed for both internal use and to enable 
interaction with third parties (dual function software).
    (vii) High threshold of innovation test.
    (viii) Illustrations.
    (7) Activities outside the United States, Puerto Rico, and other 
possessions.
    (i) In general.
    (ii) Apportionment of in-house research expenses.
    (iii) Apportionment of contract research expenses.
    (8) Research in the social sciences, etc.
    (9) Research funded by any grant, contract, or otherwise.
    (10) Illustrations.
    (d) Recordkeeping for the research credit.
    (e) Effective dates.

 Sec. 1.41-5  Basic research for taxable years beginning after December 
                          31, 1986. [Reserved]

                Sec. 1.41-6  Aggregation of expenditures.

    (a) Controlled groups of corporations; trades or businesses under 
common control.
    (1) In general.
    (2) Consolidated groups.
    (3) Definitions.
    (b) Computation of the group credit.
    (1) In general.
    (2) Start-up companies.
    (c) Allocation of the group credit.
    (d) Special rules for consolidated groups.
    (1) In general.
    (2) Start-up company status.
    (3) Special rule for allocation of group credit among consolidated 
group members.
    (e) Examples.
    (f) For taxable years beginning before January 1, 1990.
    (g) Tax accounting periods used.
    (1) In general.
    (2) Special rule when timing of research is manipulated.
    (h) Membership during taxable year in more than one group.
    (i) Intra-group transactions.
    (1) In general.
    (2) In-house research expenses.
    (3) Contract research expenses.
    (4) Lease payments.
    (5) Payment for supplies.
    (j) Effective/applicability dates.
    (1) In general.
    (2) Consolidated group rule.
    (3) Taxable years ending after June 9, 2011.
    (4) Taxable years beginning after December 31, 2011.
    (5) Taxable years ending before January 1, 2012.

                       Sec. 1.41-7  Special rules.

    (a) Allocations.
    (1) Corporation making an election under subchapter S.
    (i) Pass-through, for taxable years beginning after December 31, 
1982, in the case of an S corporation.
    (ii) Pass-through, for taxable years beginning before January 1, 
1983, in the case of a subchapter S corporation.
    (2) Pass-through in the case of an estate or trust.
    (3) Pass-through in the case of a partnership.
    (i) In general.
    (ii) Certain expenditures by joint ventures.

[[Page 159]]

    (4) Year in which taken into account.
    (5) Credit allowed subject to limitation.
    (b) Adjustments for certain acquisitions and dispositions--Meaning 
of terms.
    (c) Special rule for pass-through of credit.
    (d) Carryback and carryover of unused credits.

Sec. 1.41-8  Alternative incremental credit applicable for taxable years 
                beginning on or before December 31, 2008.

    (a) Determination of credit.
    (b) Election.
    (1) In general.
    (2) Time and manner of election.
    (3) Revocation.
    (4) Special rules for controlled groups.
    (i) In general.
    (ii) Designated member.
    (5) Effective/applicability dates.

               Sec. 1.41-9  Alternative simplified credit.

    (a) Determination of credit.
    (b) Election.
    (1) In general.
    (2) Time and manner of election.
    (3) Revocation.
    (4) Special rules for controlled groups.
    (i) In general.
    (ii) Designated member.
    (c) Special rules.
    (1) Qualified research expenditures (QREs) required in all years.
    (2) Section 41(c)(6) applicability.
    (3) Short taxable years.
    (i) General rule.
    (ii) Limited exception.
    (4) Controlled groups.
    (d) Effective/applicability dates.

[T.D. 8930, 65 FR 287, Jan. 3, 2001, as amended by T.D. 9104, 69 FR 26, 
Jan. 2, 2004; T.D. 9205, 70 FR 29601, May 24, 2005; T.D. 9296, 71 FR 
65725, Nov. 9, 2006; T.D. 9401, 73 FR 34187, June 17, 2008; T.D. 9528, 
76 FR 33995, June 10, 2011; 80 FR 18098, Apr. 3, 2015; T.D. 9786, 81 FR 
68306, Oct. 4, 2016]



Sec. 1.41-1  Credit for increasing research activities.

    (a) Amount of credit. The amount of a taxpayer's credit is 
determined under section 41(a). For taxable years beginning after June 
30, 1996, and at the election of the taxpayer, the portion of the credit 
determined under section 41(a)(1) may be calculated using the 
alternative incremental credit set forth in section 41(c)(4). For 
taxable years ending after December 31, 2006, and at the election of the 
taxpayer, the portion of the credit determined under section 41(a)(1) 
may be calculated using either the alternative incremental credit set 
forth in section 41(c)(4), or the alternative simplified credit set 
forth in section 41(c)(5).
    (b) Introduction to regulations under section 41. (1) Sections 1.41-
2 through 1.41-8 and 1.41-3A through 1.41-5A address only certain 
provisions of section 41. The following table identifies the provisions 
of section 41 that are addressed, and lists each provision with the 
section of the regulations in which it is covered.

------------------------------------------------------------------------
                                               Section of the Internal
         Section of the regulation                  Revenue Code
------------------------------------------------------------------------
Sec.  1.41-2..............................  41(b).
Sec.  1.41-3..............................  41(c).
Sec.  1.41-4..............................  41(d).
Sec.  1.41-5..............................  41(e).
Sec.  1.41-6..............................  41(f).
Sec.  1.41-7..............................  41(f).
                                            41(g).
Sec.  1.41-8..............................  41(c).
Sec.  1.41-3A.............................  41(c) (taxable years
                                             beginning before January 1,
                                             1990).
Sec.  1.41-4A.............................  41(d) (taxable years
                                             beginning before January 1,
                                             1986).
Sec.  1.41-5A.............................  41(e) (taxable years
                                             beginning before January 1,
                                             1987).
------------------------------------------------------------------------

    (2) Section 1.41-3A also addresses the special rule in section 
221(d)(2) of the Economic Recovery Tax Act of 1981 relating to taxable 
years overlapping the effective dates of section 41. Section 41 was 
formerly designated as sections 30 and 44F. Sections 1.41-0 through 
1.41-8 and 1.41-0A through 1.41-5A refer to these sections as section 41 
for conformity purposes. Whether section 41, former section 30, or 
former section 44F applies to a particular expenditure depends upon when 
the expenditure was paid or incurred.

[T.D. 8930, 65 FR 288, Jan. 3, 2001, as amended by T.D. 9401, 73 FR 
34187, June 17, 2008]



Sec. 1.41-2  Qualified research expenses.

    (a) Trade or business requirement--(1) In general. An in-house 
research expense of the taxpayer or a contract research expense of the 
taxpayer is a qualified research expense only if the expense is paid or 
incurred by the taxpayer in carrying on a trade or business of the 
taxpayer. The phrase ``in carrying on a trade or business'' has the same 
meaning for purposes of section 41(b)(1) as it has for purposes of 
section 162; thus, expenses paid or incurred in connection with a trade 
or

[[Page 160]]

business within the meaning of section 174(a) (relating to the deduction 
for research and experimental expenses) are not necessarily paid or 
incurred in carrying on a trade or business for purposes of section 41. 
A research expense must relate to a particular trade or business being 
carried on by the taxpayer at the time the expense is paid or incurred 
in order to be a qualified research expense. For purposes of section 41, 
a contract research expense of the taxpayer is not a qualified research 
expense if the product or result of the research is intended to be 
transferred to another in return for license or royalty payments and the 
taxpayer does not use the product of the research in the taxpayer's 
trade or business.
    (2) New business. Expenses paid or incurred prior to commencing a 
new business (as distinguished from expanding an existing business) may 
be paid or incurred in connection with a trade or business but are not 
paid or incurred in carrying on a trade or business. Thus, research 
expenses paid or incurred by a taxpayer in developing a product the sale 
of which would constitute a new trade or business for the taxpayer are 
not paid or incurred in carrying on a trade or business.
    (3) Research performed for others--(i) Taxpayer not entitled to 
results. If the taxpayer performs research on behalf of another person 
and retains no substantial rights in the research, that research shall 
not be taken into account by the taxpayer for purposes of section 41. 
See Sec. 1.41-4A(d)(2).
    (ii) Taxpayer entitled to results. If the taxpayer in carrying on a 
trade or business performs research on behalf of other persons but 
retains substantial rights in the research, the taxpayer shall take 
otherwise qualified expenses for that research into account for purposes 
of section 41 to the extent provided in Sec. 1.41-4A(d)(3).
    (4) Partnerships--(i) In general. An in-house research expense or a 
contract research expense paid or incurred by a partnership is a 
qualified research expense of the partnership if the expense is paid or 
incurred by the partnership in carrying on a trade or business of the 
partnership, determined at the partnership level without regard to the 
trade or business of any partner.
    (ii) Special rule for certain partnerships and joint ventures. (A) 
If a partnership or a joint venture (taxable as a partnership) is not 
carrying on the trade or business to which the research relates, then 
the general rule in paragraph (a)(4)(i) of this section would not allow 
any of such expenditures to qualify as qualified research expenses.
    (B) Notwithstanding paragraph (a)(4)(ii)(A) of this section, if all 
the partners or venturers are entitled to make independent use of the 
results of the research, this paragraph (a)(4)(ii) may allow a portion 
of such expenditures to be treated as qualified research expenditures by 
certain partners or venturers.
    (C) First, in order to determine the amount of credit that may be 
claimed by certain partners or venturers, the amount of qualified 
research expenditures of the partnership or joint venture is determined 
(assuming for this purpose that the partnership or joint venture is 
carrying on the trade or business to which the research relates).
    (D) Second, this amount is reduced by the proportionate share of 
such expenses allocable to those partners or venturers who would not be 
able to claim such expenses as qualified research expenditures if they 
had paid or incurred such expenses directly. For this purpose such 
partners' or venturers' proportionate share of such expenses shall be 
determined on the basis of such partners' or venturers' share of 
partnership items of income or gain (excluding gain allocated under 
section 704(c)) which results in the largest proportionate share. Where 
a partner's or venturer's share of partnership items of income or gain 
(excluding gain allocated under section 704(c)) may vary during the 
period such partner or venturer is a partner or venturer in such 
partnership or joint venture, such share shall be the highest share such 
partner or venturer may receive.
    (E) Third, the remaining amount of qualified research expenses is 
allocated among those partners or venturers who would have been entitled 
to claim a credit for such expenses if they had paid or incurred the 
research expenses in their own trade or business, in the relative 
proportions that such partners

[[Page 161]]

or venturers share deductions for expenses under section 174 for the 
taxable year that such expenses are paid or incurred.
    (F) For purposes of section 41, research expenditures to which this 
paragraph (a)(4)(ii) applies shall be treated as paid or incurred 
directly by such partners or venturers. See Sec. 1.41-7(a)(3)(ii) for 
special rules regarding these expenses.
    (iii) The following examples illustrate the application of the 
principles contained in paragraph (a)(4)(ii) of this section.

    Example 1. A joint venture (taxable as a partnership) is formed by 
corporations A, B, and C to develop and market a supercomputer. A and B 
are in the business of developing computers, and each has a 30 percent 
distributive share of each item of income, gain, loss, deduction, credit 
and basis of the joint venture. C, which is an investment banking firm, 
has a 40 percent distributive share of each item of income, gain, loss, 
deduction, credit and basis of the joint venture. The joint venture 
agreement provides that A's, B's and C's distributive shares will not 
vary during the life of the joint venture, liquidation proceeds are to 
be distributed in accordance with the partners' capital account 
balances, and any partner with a deficit in its capital account 
following the distribution of liquidation proceeds is required to 
restore the amount of such deficit to the joint venture. Assume in Year 
1 that the joint venture incurs $100x of ``qualified research 
expenses.'' Assume further that the joint venture cannot claim the 
research credit for such expenses because it is not carrying on the 
trade or business to which the research relates. In addition A, B, and C 
are all entitled to make independent use of the results of the research. 
First, the amount of qualified research expenses of the joint venture is 
$l00x. Second, this amount is reduced by the proportionate share of such 
expenses allocable to C, the venturer which would not have been able to 
claim such expenses as qualified research expenditures if it had paid or 
incurred them directly, C's proportionate share of such expenses is $40x 
(40% of $100x). The reduced amount is $60x. Third, the remaining $60x of 
qualified research expenses is allocated between A and B in the relative 
proportions that A and B share deductions for expenses under section 
174. A is entitled to treat $30x ((30%/(30% + 30%)) $60x) as a qualified 
research expense. B is also entitled to treat $30x ((30%/(30% + 30%)) 
$60x) as a qualified research expense.
    Example 2. Assume the same facts as in example (1) except that the 
joint venture agreement provides that during the first 2 years of the 
joint venture, A and B are each allocated 10 percent of each item of 
income, gain, loss, deduction, credit and basis, and C is allocated 80 
percent of each item of income, gain, loss, deduction, credit and basis. 
Thereafter the allocations are the same as in example (1). Assume for 
purposes of this example that such allocations have substantial economic 
effect for purposes of section 704 (b). C's highest share of such items 
during the life of the joint venture is 80 percent. Therefore C's 
proportionate share of the joint venture's qualified research expenses 
is $80x (80% of $100x). The reduced amount of qualified research 
expenses is $20x ($100x-$80x). A is entitled to treat $10x ((10%/(10% + 
10%)) $20x) as a qualified research expense in Year 1. B is also 
entitled to treat $10x ((10%/(10% + 10%)) $20x) as a qualified research 
expense in Year 1.

    (b) Supplies and personal property used in the conduct of qualified 
research--(1) In general. Supplies and personal property (except to the 
extent provided in paragraph (b)(4) of this section) are used in the 
conduct of qualified research if they are used in the performance of 
qualified services (as defined in section 41(b)(2)(B), but without 
regard to the last sentence thereof) by an employee of the taxpayer (or 
by a person acting in a capacity similar to that of an employee of the 
taxpayer; see example (6) of Sec. 1.41-2(e)(5)). Expenditures for 
supplies or for the use of personal property that are indirect research 
expenditures or general and administrative expenses do not qualify as 
inhouse research expenses.
    (2) Certain utility charges--(i) In general. In general, amounts 
paid or incurred for utilities such as water, electricity, and natural 
gas used in the building in which qualified research is performed are 
treated as expenditures for general and administrative expenses.
    (ii) Extraordinary expenditures. To the extent the taxpayer can 
establish that the special character of the qualified research required 
additional extraordinary expenditures for utilities, the additional 
expenditures shall be treated as amounts paid or incurred for supplies 
used in the conduct of qualified research. For example, amounts paid for 
electricity used for general laboratory lighting are treated as general 
and administrative expenses, but amounts paid for electricity used in 
operating

[[Page 162]]

high energy equipment for qualified research (such as laser or nuclear 
research) may be treated as expenditures for supplies used in the 
conduct of qualified research to the extent the taxpayer can establish 
that the special character of the research required an extraordinary 
additional expenditure for electricity.
    (3) Right to use personal property. The determination of whether an 
amount is paid to or incurred for another person for the right to use 
personal property in the conduct of qualified research shall be made 
without regard to the characterization of the transaction as a lease 
under section 168(f)(8) (as that section read before it was repealed by 
the Tax Reform Act of 1986). See Sec. 5c.168(f)(8)-1(b).
    (4) Use of personal property in taxable years beginning after 
December 31, 1985. For taxable years beginning after December 31, 1985, 
amounts paid or incurred for the use of personal property are not 
qualified research expenses, except for any amount paid or incurred to 
another person for the right to use (time-sharing) computers in the 
conduct of qualified research. The computer must be owned and operated 
by someone other than the taxpayer, located off the taxpayer's premises, 
and the taxpayer must not be the primary user of the computer.
    (c) Qualified services--(1) Engaging in qualified research. The term 
``engaging in qualified research'' as used in section 41(b)(2)(B) means 
the actual conduct of qualified research (as in the case of a scientist 
conducting laboratory experiments).
    (2) Direct supervision. The term ``direct supervision'' as used in 
section 41(b)(2)(B) means the immediate supervision (first-line 
management) of qualified research (as in the case of a research 
scientist who directly supervises laboratory experiments, but who may 
not actually perform experiments). ``Direct supervision'' does not 
include supervision by a higher-level manager to whom first-line 
managers report, even if that manager is a qualified research scientist.
    (3) Direct support. The term ``direct support'' as used in section 
41(b)(2)(B) means services in the direct support of either--
    (i) Persons engaging in actual conduct of qualified research, or
    (ii) Persons who are directly supervising persons engaging in the 
actual conduct of qualified research. For example, direct support of 
research includes the services of a secretary for typing reports 
describing laboratory results derived from qualified research, of a 
laboratory worker for cleaning equipment used in qualified research, of 
a clerk for compiling research data, and of a machinist for machining a 
part of an experimental model used in qualified research. Direct support 
of research activities does not include general administrative services, 
or other services only indirectly of benefit to research activities. For 
example, services of payroll personnel in preparing salary checks of 
laboratory scientists, of an accountant for accounting for research 
expenses, of a janitor for general cleaning of a research laboratory, or 
of officers engaged in supervising financial or personnel matters do not 
qualify as direct support of research. This is true whether general 
administrative personnel are part of the research department or in a 
separate department. Direct support does not include supervision. 
Supervisory services constitute ``qualified services'' only to the 
extent provided in paragraph (c)(2) of this section.
    (d) Wages paid for qualified services--(1) In general. Wages paid to 
or incurred for an employee constitute in-house research expenses only 
to the extent the wages were paid or incurred for qualified services 
performed by the employee. If an employee has performed both qualified 
services and nonqualified services, only the amount of wages allocated 
to the performance of qualified services constitutes an in-house 
research expense. In the absence of another method of allocation that 
the taxpayer can demonstrate to be more appropriate, the amount of in-
house research expense shall be determined by multiplying the total 
amount of wages paid to or incurred for the employee during the taxable 
year by the ratio of the total time actually spent by the employee in 
the performance of qualified services for the taxpayer to the total time 
spent by the employee

[[Page 163]]

in the performance of all services for the taxpayer during the taxable 
year.
    (2) ``Substantially all.'' Notwithstanding paragraph (d)(1) of this 
section, if substantially all of the services performed by an employee 
for the taxpayer during the taxable year consist of services meeting the 
requirements of section 41(b)(2)(B) (i) or (ii), then the term 
``qualified services'' means all of the services performed by the 
employee for the taxpayer during the taxable year. Services meeting the 
requirements of section 41(b)(2)(B) (i) or (ii) constitute substantially 
all of the services performed by the employee during a taxable year only 
if the wages allocated (on the basis used for purposes of paragraph 
(d)(1) of this section) to services meeting the requirements of section 
41(b)(2)(B) (i) or (ii) constitute at least 80 percent of the wages paid 
to or incurred by the taxpayer for the employee during the taxable year.
    (e) Contract research expenses--(1) In general. A contract research 
expense is 65 percent of any expense paid or incurred in carrying on a 
trade or business to any person other than an employee of the taxpayer 
for the performance on behalf of the taxpayer of--
    (i) Qualified research as defined in Sec. 1.41-4 or 1.41-4A, 
whichever is applicable, or
    (ii) Services which, if performed by employees of the taxpayer, 
would constitute qualified services within the meaning of section 
41(b)(2)(B).

Where the contract calls for services other than services described in 
this paragraph (e)(1), only 65 percent of the portion of the amount paid 
or incurred that is attributable to the services described in this 
paragraph (e)(1) is a contract research expense.
    (2) Performance of qualified research. An expense is paid or 
incurred for the performance of qualified research only to the extent 
that it is paid or incurred pursuant to an agreement that--
    (i) Is entered into prior to the performance of the qualified 
research,
    (ii) Provides that research be performed on behalf of the taxpayer, 
and
    (iii) Requires the taxpayer to bear the expense even if the research 
is not successful.

If an expense is paid or incurred pursuant to an agreement under which 
payment is contingent on the success of the research, then the expense 
is considered paid for the product or result rather than the performance 
of the research, and the payment is not a contract research expense. The 
previous sentence applies only to that portion of a payment which is 
contingent on the success of the research.
    (3) ``On behalf of.'' Qualified research is performed on behalf of 
the taxpayer if the taxpayer has a right to the research results. 
Qualified research can be performed on behalf of the taxpayer 
notwithstanding the fact that the taxpayer does not have exclusive 
rights to the results.
    (4) Prepaid amounts. Notwithstanding paragraph (e)(1) of this 
section, if any contract research expense paid or incurred during any 
taxable year is attributable to qualified research to be conducted after 
the close of such taxable year, the expense so attributable shall be 
treated for purposes of section 41(b)(1)(B) as paid or incurred during 
the period during which the qualified research is conducted.
    (5) Examples. The following examples illustrate provisions contained 
in paragraphs (e) (1) through (4) of this section.

    Example 1. A, a cash-method taxpayer using the calendar year as the 
taxable year, enters into a contract with B Corporation under which B is 
to perform qualified research on behalf of A. The contract requires A to 
pay B $300x, regardless of the success of the research. In 1982, B 
performs all of the research, and A makes full payment of $300x under 
the contract. Accordingly, during the taxable year 1982, $195x (65 
percent of the payment of $300x) constitutes a contract research expense 
of A.
    Example 2. The facts are the same as in example (1), except that B 
performs 50 percent of the research in 1983. Of the $195x of contract 
research expense paid in 1982, paragraph (e)(4) of this section provides 
that $97.5x (50 percent of $195x) is a contract research expense for 
1982 and the remaining $97.5x is contract research expense for 1983.
    Example 3. The facts are the same as in example (1), except that 
instead of calling for a flat payment of $300x, the contract requires A 
to reimburse B for all expenses plus pay B $l00x. B incurs expenses 
attributable to the research as follows:

Labor..........................................................     $90x
Supplies.......................................................      20x
Depreciation on equipment......................................      50x

[[Page 164]]

 
Overhead.......................................................      40x
                                                                --------
 
      Total....................................................     200x
 


Under this agreement A pays B $300x during 1982. Accordingly, during 
taxable year 1982, $195x (65 percent of $300x) of the payment 
constitutes a contract research expense of A.
    Example 4. The facts are the same as in example (3), except that A 
agrees to reimburse B for all expenses and agrees to pay B an additional 
amount of $100x, but the additional $100x is payable only if the 
research is successful. The research is successful and A pays B $300x 
during 1982. Paragraph (e)(2) of this section provides that the 
contingent portion of the payment is not an expense incurred for the 
performance of qualified research. Thus, for taxable year 1982, $130x 
(65 percent of the payment of $200x) constitutes a contract research 
expense of A.
    Example 5. C conducts in-house qualified research in carrying on a 
trade or business. In addition, C pays D Corporation, a provider of 
computer services, $100x to develop software to be used in analyzing the 
results C derives from its research. Because the software services, if 
performed by an employee of C, would constitute qualified services, $65x 
of the $100x constitutes a contract research expense of C.
    Example 6. C conducts in-house qualified research in carrying on C's 
trade or business. In addition, C contracts with E Corporation, a 
provider of temporary secretarial services, for the services of a 
secretary for a week. The secretary spends the entire week typing 
reports describing laboratory results derived from C's qualified 
research. C pays E $400 for the secretarial service, none of which 
constitutes wages within the meaning of section 41(b)(2)(D). These 
services, if performed by employees of C, would constitute qualified 
services within the meaning of section 41(b)(2)(B). Thus, pursuant to 
paragraph (e)(1) of this section, $260 (65 percent of $400) constitutes 
a contract research expense of C.
    Example 7. C conducts in-house qualified research in carrying on C's 
trade or business. In addition, C pays F, an outside accountant, $100x 
to keep C's books and records pertaining to the research project. The 
activity carried on by the accountant does not constitute qualified 
research as defined in section 41(d). The services performed by the 
accountant, if performed by an employee of C, would not constitute 
qualified services (as defined in section 41(b)(2)(B)). Thus, under 
paragraph (e)(1) of this section, no portion of the $100x constitutes a 
contract research expense.

[T.D. 8251, 54 FR 21204, May 17, 1989, as amended by T.D. 8930, 65 FR 
287, Jan. 3, 2001]



Sec. 1.41-3  Base amount for taxable years beginning on or after 
January 3, 2001.

    (a) New taxpayers. If, with respect to any credit year, the taxpayer 
has not been in existence for any previous taxable year, the average 
annual gross receipts of the taxpayer for the four taxable years 
preceding the credit year shall be zero. If, with respect to any credit 
year, the taxpayer has been in existence for at least one previous 
taxable year, but has not been in existence for four taxable years 
preceding the taxable year, then the average annual gross receipts of 
the taxpayer for the four taxable years preceding the credit year shall 
be the average annual gross receipts for the number of taxable years 
preceding the credit year for which the taxpayer has been in existence.
    (b) Special rules for short taxable years--(1) Short credit year. If 
a credit year is a short taxable year, then the base amount determined 
under section 41(c)(1) (but not section 41(c)(2)) shall be modified by 
multiplying that amount by the number of months in the short taxable 
year and dividing the result by 12.
    (2) Short taxable year preceding credit year. If one or more of the 
four taxable years preceding the credit year is a short taxable year, 
then the gross receipts for such year are deemed to be equal to the 
gross receipts actually derived in that year multiplied by 12 and 
divided by the number of months in that year.
    (3) Short taxable year in determining fixed-base percentage. No 
adjustment shall be made on account of a short taxable year to the 
computation of a taxpayer's fixed-base percentage.
    (c) Definition of gross receipts--(1) In general. For purposes of 
section 41, gross receipts means the total amount, as determined under 
the taxpayer's method of accounting, derived by the taxpayer from all 
its activities and from all sources (e.g., revenues derived from the 
sale of inventory before reduction for cost of goods sold).
    (2) Amounts excluded. For purposes of this paragraph (c), gross 
receipts do not include amounts representing--
    (i) Returns or allowances;

[[Page 165]]

    (ii) Receipts from the sale or exchange of capital assets, as 
defined in section 1221;
    (iii) Repayments of loans or similar instruments (e.g., a repayment 
of the principal amount of a loan held by a commercial lender);
    (iv) Receipts from a sale or exchange not in the ordinary course of 
business, such as the sale of an entire trade or business or the sale of 
property used in a trade or business as defined under section 1221(2);
    (v) Amounts received 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; and
    (vi) Amounts received by a taxpayer in a taxable year that precedes 
the first taxable year in which the taxpayer derives more than $25,000 
in gross receipts other than investment income. For purposes of this 
paragraph (c)(2)(vi), investment income is interest or distributions 
with respect to stock (other than the stock of a 20-percent owned 
corporation as defined in section 243(c)(2).
    (3) Foreign corporations. For purposes of section 41, in the case of 
a foreign corporation, gross receipts include only gross receipts that 
are effectively connected with the conduct of a trade or business within 
the United States, the Commonwealth of Puerto Rico, or other possessions 
of the United States. See section 864(c) and applicable regulations 
thereunder for the definition of effectively connected income.
    (d) Consistency requirement--(1) In general. In computing the credit 
for increasing research activities for taxable years beginning after 
December 31, 1989, qualified research expenses and gross receipts taken 
into account in computing a taxpayer's fixed-base percentage and a 
taxpayer's base amount must be determined on a basis consistent with the 
definition of qualified research expenses and gross receipts for the 
credit year, without regard to the law in effect for the taxable years 
taken into account in computing the fixed-base percentage or the base 
amount. This consistency requirement applies even if the period for 
filing a claim for credit or refund has expired for any taxable year 
taken into account in computing the fixed-base percentage or the base 
amount.
    (2) Illustrations. The following examples illustrate the application 
of the consistency rule of paragraph (d)(1) of this section:

    Example 1. (i) X, an accrual method taxpayer using the calendar year 
as its taxable year, incurs qualified research expenses in 2001. X wants 
to compute its research credit under section 41 for the tax year ending 
December 31, 2001. As part of the computation, X must determine its 
fixed-base percentage, which depends in part on X's qualified research 
expenses incurred during the fixed-base period, the taxable years 
beginning after December 31, 1983, and before January 1, 1989.
    (ii) During the fixed-base period, X reported the following amounts 
as qualified research expenses on its Form 6765:

1984...........................................................    $100x
1985...........................................................     120x
1986...........................................................     150x
1987...........................................................     180x
1988...........................................................     170x
                                                                --------
    Total......................................................     720x
 

    (iii) For the taxable years ending December 31, 1984, and December 
31, 1985, X based the amounts reported as qualified research expenses on 
the definition of qualified research in effect for those taxable years. 
The definition of qualified research changed for taxable years beginning 
after December 31, 1985. If X used the definition of qualified research 
applicable to its taxable year ending December 31, 2001, the credit 
year, its qualified research expenses for the taxable years ending 
December 31, 1984, and December 31, 1985, would be reduced to $ 80x and 
$ 100x, respectively. Under the consistency rule in section 41(c)(5) and 
paragraph (d)(1) of this section, to compute the research credit for the 
tax year ending December 31, 2001, X must reduce its qualified research 
expenses for 1984 and 1985 to reflect the change in the definition of 
qualified research for taxable years beginning after December 31, 1985. 
Thus, X's total qualified research expenses for the fixed-base period 
(1984-1988) to be used in computing the fixed-base percentage is $80 + 
100 + 150 + 180 + 170 = $680x.
    Example 2. The facts are the same as in Example 1, except that, in 
computing its qualified research expenses for the taxable year ending 
December 31, 2001, X claimed that a certain type of expenditure incurred 
in 2001 was a qualified research expense. X's claim reflected a change 
in X's position, because X

[[Page 166]]

had not previously claimed that similar expenditures were qualified 
research expenses. The consistency rule requires X to adjust its 
qualified research expenses in computing the fixed-base percentage to 
include any similar expenditures not treated as qualified research 
expenses during the fixed-base period, regardless of whether the period 
for filing a claim for credit or refund has expired for any year taken 
into account in computing the fixed-base percentage.

    (e) Effective date. The rules in paragraphs (c) and (d) of this 
section are applicable for taxable years beginning on or after the date 
final regulations are published in the Federal Register.

[T.D. 8930, 66 FR 289, Jan. 3, 2001]



Sec. 1.41-4  Qualified research for expenditures paid or incurred in taxable 
years ending on or after December 31, 2003.

    (a) Qualified research--(1) General rule. Research activities 
related to the development or improvement of a business component 
constitute qualified research only if the research activities meet all 
of the requirements of section 41(d)(1) and this section, and are not 
otherwise excluded under section 41(d)(3)(B) or (d)(4), or this section.
    (2) Requirements of section 41(d)(1). Research constitutes qualified 
research only if it is research--
    (i) With respect to which expenditures may be treated as expenses 
under section 174, see Sec. 1.174-2;
    (ii) That is undertaken for the purpose of discovering information 
that is technological in nature, and the application of which is 
intended to be useful in the development of a new or improved business 
component of the taxpayer; and
    (iii) Substantially all of the activities of which constitute 
elements of a process of experimentation that relates to a qualified 
purpose.
    (3) Undertaken for the purpose of discovering information--(i) In 
general. For purposes of section 41(d) and this section, research must 
be undertaken for the purpose of discovering information that is 
technological in nature. Research is undertaken for the purpose of 
discovering information if it is intended to eliminate uncertainty 
concerning the development or improvement of a business component. 
Uncertainty exists if the information available to the taxpayer does not 
establish the capability or method for developing or improving the 
business component, or the appropriate design of the business component.
    (ii) Application of the discovering information requirement. A 
determination that research is undertaken for the purpose of discovering 
information that is technological in nature does not require the 
taxpayer be seeking to obtain information that exceeds, expands or 
refines the common knowledge of skilled professionals in the particular 
field of science or engineering in which the taxpayer is performing the 
research. In addition, a determination that research is undertaken for 
the purpose of discovering information that is technological in nature 
does not require that the taxpayer succeed in developing a new or 
improved business component.
    (iii) Patent safe harbor. For purposes of section 41(d) and 
paragraph (a)(3)(i) of this section, the issuance of a patent by the 
Patent and Trademark Office under the provisions of 35 U.S.C. 151 (other 
than a patent for design issued under the provisions of 35 U.S.C. 171) 
is conclusive evidence that a taxpayer has discovered information that 
is technological in nature that is intended to eliminate uncertainty 
concerning the development or improvement of a business component. 
However, the issuance of such a patent is not a precondition for credit 
availability.
    (4) Technological in nature. For purposes of section 41(d) and this 
section, information is technological in nature if the process of 
experimentation used to discover such information fundamentally relies 
on principles of the physical or biological sciences, engineering, or 
computer science. A taxpayer may employ existing technologies and may 
rely on existing principles of the physical or biological sciences, 
engineering, or computer science to satisfy this requirement.
    (5) Process of experimentation--(i) In general. For purposes of 
section 41(d) and this section, a process of experimentation is a 
process designed to evaluate one or more alternatives to achieve a 
result where the capability or the method of achieving that result,

[[Page 167]]

or the appropriate design of that result, is uncertain as of the 
beginning of the taxpayer's research activities. A process of 
experimentation must fundamentally rely on the principles of the 
physical or biological sciences, engineering, or computer science and 
involves the identification of uncertainty concerning the development or 
improvement of a business component, the identification of one or more 
alternatives intended to eliminate that uncertainty, and the 
identification and the conduct of a process of evaluating the 
alternatives (through, for example, modeling, simulation, or a 
systematic trial and error methodology). A process of experimentation 
must be an evaluative process and generally should be capable of 
evaluating more than one alternative. A taxpayer may undertake a process 
of experimentation if there is no uncertainty concerning the taxpayer's 
capability or method of achieving the desired result so long as the 
appropriate design of the desired result is uncertain as of the 
beginning of the taxpayer's research activities. Uncertainty concerning 
the development or improvement of the business component (e.g., its 
appropriate design) does not establish that all activities undertaken to 
achieve that new or improved business component constitute a process of 
experimentation.
    (ii) Qualified purpose. For purposes of section 41(d) and this 
section, a process of experimentation is undertaken for a qualified 
purpose if it relates to a new or improved function, performance, 
reliability or quality of the business component. Research will not be 
treated as conducted for a qualified purpose if it relates to style, 
taste, cosmetic, or seasonal design factors.
    (6) Substantially all requirement. In order for activities to 
constitute qualified research under section 41(d)(1), substantially all 
of the activities must constitute elements of a process of 
experimentation that relates to a qualified purpose. The substantially 
all requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this 
section is satisfied only if 80 percent or more of a taxpayer's research 
activities, measured on a cost or other consistently applied reasonable 
basis (and without regard to section 1.41-2(d)(2)), constitute elements 
of a process of experimentation for a purpose described in section 
41(d)(3). Accordingly, if 80 percent (or more) of a taxpayer's research 
activities with respect to a business component constitute elements of a 
process of experimentation for a purpose described in section 41(d)(3), 
the substantially all requirement is satisfied even if the remaining 20 
percent (or less) of a taxpayer's research activities with respect to 
the business component do not constitute elements of a process of 
experimentation for a purpose described in section 41(d)(3), so long as 
these remaining research activities satisfy the requirements of section 
41(d)(1)(A) and are not otherwise excluded under section 41(d)(4). The 
substantially all requirement is applied separately to each business 
component.
    (7) Use of computers and information technology. The employment of 
computers or information technology, or the reliance on principles of 
computer science or information technology to store, collect, 
manipulate, translate, disseminate, produce, distribute, or process data 
or information, and similar uses of computers and information technology 
does not itself establish that qualified research has been undertaken.
    (8) Illustrations. The following examples illustrate the application 
of paragraph (a)(5) of this section:

    Example 1. (i) Facts. X is engaged in the business of developing and 
manufacturing widgets. X wants to change the color of its blue widget to 
green. X obtains from various suppliers several different shades of 
green paint. X paints several sample widgets, and surveys X's customers 
to determine which shade of green X's customers prefer.
    (ii) Conclusion. X's activities to change the color of its blue 
widget to green are not qualified research under section 41(d)(1) and 
paragraph (a)(5) of this section because substantially all of X's 
activities are not undertaken for a qualified purpose. All of X's 
research activities are related to style, taste, cosmetic, or seasonal 
design factors.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that X chooses one of the green paints. X obtains samples of the green 
paint from a supplier and determines that X must modify its painting 
process to accommodate the green paint because the green paint has 
different characteristics from other paints X has used. X obtains 
detailed data on the green paint from X's paint

[[Page 168]]

supplier. X also consults with the manufacturer of X's paint spraying 
machines. The manufacturer informs X that X must acquire a new nozzle 
that operates with the green paint X wants to use. X tests the nozzles 
to ensure that they work as specified by the manufacturer of the paint 
spraying machines.
    (ii) Conclusion. X's activities to modify its painting process are a 
separate business component under section 41(d)(2)(A). X's activities to 
modify its painting process to change the color of its blue widget to 
green are not qualified research under section 41(d)(1) and paragraph 
(a)(5) of this section. X did not conduct a process of evaluating 
alternatives in order to eliminate uncertainty regarding the 
modification of its painting process. Rather, the manufacturer of the 
paint machines eliminated X's uncertainty regarding the modification of 
its painting process. X's activities to test the nozzles to determine if 
the nozzles work as specified by the manufacturer of the paint spraying 
machines are in the nature of routine or ordinary testing or inspection 
for quality control.
    Example 3. (i) Facts. X is engaged in the business of manufacturing 
food products and currently manufactures a large-shred version of a 
product. X seeks to modify its current production line to permit it to 
manufacture both a large-shred version and a fine-shred version of one 
of its food products. A smaller, thinner shredding blade capable of 
producing a fine-shred version of the food product, however, is not 
commercially available. Thus, X must develop a new shredding blade that 
can be fitted onto its current production line. X is uncertain 
concerning the design of the new shredding blade, because the material 
used in its existing blade breaks when machined into smaller, thinner 
blades. X engages in a systematic trial and error process of analyzing 
various blade designs and materials to determine whether the new 
shredding blade must be constructed of a different material from that of 
its existing shredding blade and, if so, what material will best meet 
X's functional requirements.
    (ii) Conclusion. X's activities to modify its current production 
line by developing the new shredding blade meet the requirements of 
qualified research as set forth in paragraph (a)(2) of this section. 
Substantially all of X's activities constitute elements of a process of 
experimentation because X evaluated alternatives to achieve a result 
where the method of achieving that result, and the appropriate design of 
that result, were uncertain as of the beginning of the taxpayer's 
research activities. X identified uncertainties related to the 
development of a business component, and identified alternatives 
intended to eliminate these uncertainties. Furthermore, X's process of 
evaluating identified alternatives was technological in nature, and was 
undertaken to eliminate the uncertainties.
    Example 4. (i) Facts. X is in the business of designing, developing 
and manufacturing automobiles. In response to government-mandated fuel 
economy requirements, X seeks to update its current model vehicle and 
undertakes to improve aerodynamics by lowering the hood of its current 
model vehicle. X determines, however, that lowering the hood changes the 
air flow under the hood, which changes the rate at which air enters the 
engine through the air intake system, and which reduces the 
functionality of the cooling system. X's engineers are uncertain how to 
design a lower hood to obtain the increased fuel economy, while 
maintaining the necessary air flow under the hood. X designs, models, 
simulates, tests, refines, and re-tests several alternative designs for 
the hood and associated proposed modifications to both the air intake 
system and cooling system. This process enables X to eliminate the 
uncertainties related to the integrated design of the hood, air intake 
system, and cooling system, and such activities constitute eighty-five 
percent of X's total activities to update its current model vehicle. X 
then engages in additional activities that do not involve a process of 
evaluating alternatives in order to eliminate uncertainties. The 
additional activities constitute only fifteen percent of X's total 
activities to update its current model vehicle.
    (ii) Conclusion. In general, if eighty percent or more of a 
taxpayer's research activities measured on a cost or other consistently 
applied reasonable basis constitute elements of a process of 
experimentation for a qualified purpose under section 41(d)(3)(A) and 
paragraph (a)(5)(ii) of this section, then the substantially all 
requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this 
section is satisfied. Substantially all of X's activities constitute 
elements of a process of experimentation because X evaluated 
alternatives to achieve a result where the method of achieving that 
result, and the appropriate design of that result, were uncertain as of 
the beginning of X's research activities. X identified uncertainties 
related to the improvement of a business component and identified 
alternatives intended to eliminate these uncertainties. Furthermore, X's 
process of evaluating the identified alternatives was technological in 
nature and was undertaken to eliminate the uncertainties. Because 
substantially all (in this example, eighty-five percent) of X's 
activities to update its current model vehicle constitute elements of a 
process of experimentation for a qualified purpose described in section 
41(d)(3)(A), all of X's activities to update its current model vehicle 
meet the requirements of qualified research as set forth in paragraph 
(a)(2) of this section, provided that X's remaining activities (in this 
example, fifteen

[[Page 169]]

percent of X's total activities) satisfy the requirements of section 
41(d)(1)(A) and are not otherwise excluded under section 41(d)(4).
    Example 5. (i) Facts. X, a retail and distribution company, wants to 
upgrade its warehouse management software. X evaluates several of the 
alternative warehouse management software products available from 
vendors in the marketplace to determine which product will best serve 
X's technical requirements. X selects vendor V's software.
    (ii) Conclusion. X's activities to select the software are not 
qualified research under section 41(d)(1) and paragraph (a)(5) of this 
section. X did not conduct a process of evaluating alternatives in order 
to eliminate uncertainty regarding the development of a business 
component. X's evaluation of products available from vendors is not a 
process of experimentation.
    Example 6. (i) Facts. X wants to develop a new web application to 
allow customers to purchase its products online. X, after reviewing 
commercial software offered by various vendors, purchases a commercial 
software package of object-oriented functions from vendor Z that X can 
use in its web application (for example, a shopping cart). X evaluates 
the various object-oriented functions included in vendor Z's software 
package to determine which functions it can use. X then incorporates the 
selected software functions in its new web application software.
    (ii) Conclusion. X's activities related to selecting the commercial 
software vendor with the object-oriented functions it wanted, and then 
selecting which functions to use, are not qualified research under 
section 41(d)(1) and paragraph (a)(5) of this section. In addition, 
incorporating the selected object-oriented functions into the new web 
application software being developed by X did not involve conducting a 
process of evaluating alternatives in order to eliminate uncertainty 
regarding the development of software. X's evaluation of products 
available from vendors and selection of software functions are not a 
process of experimentation.
    Example 7. (i) Facts. In order to be more responsive to user online 
requests, X wants to develop software to balance the incoming processing 
requests across multiple web servers that run the same set of software 
applications. Without evaluating or testing any alternatives, X decides 
that a separate server will be used to distribute the workload across 
each of the web servers and that a round robin workload distribution 
algorithm is appropriate for its needs.
    (ii) Conclusion. X's activities to develop the software are 
activities relating to the development of a separate business component 
under section 41(d)(2)(A). X's activities to develop the load 
distribution function are not qualified research under section 41(d)(1) 
and paragraph (a)(5) of this section. X did not conduct a process of 
evaluating different load distribution alternatives in order to 
eliminate uncertainty regarding the development of software. X's 
selection of a separate server and a round robin distribution algorithm 
is not a process of experimentation.
    Example 8. (i) Facts. X must develop load balancing software across 
a server cluster supporting multiple web applications. X's web 
applications have high concurrency demands because of a dynamic, highly 
volatile environment. X is uncertain of the appropriate design of the 
load balancing algorithm, given that the existing evolutionary 
algorithms did not meet the demands of their highly volatile web 
environment. Therefore, X designs and systematically tests and evaluates 
several different algorithms that perform the load distribution 
functions.
    (ii) Conclusion. X's activities to develop software are activities 
to develop a separate business component under section 41(d)(2)(A). X's 
activities involving the design, evaluation, and systematic testing of 
several new load balancing algorithms meet the requirements as set forth 
in paragraph (a)(5) of this section. X's activities constitute elements 
of a process of experimentation because X identified uncertainties 
related to the development of a business component, identified 
alternatives intended to eliminate those uncertainties, and evaluated 
one or more alternatives to achieve a result where the appropriate 
design was uncertain at the beginning of X's research activities.
    Example 9. (i) Facts. X, a multinational manufacturer, wants to 
install an enterprise resource planning (ERP) system that runs off a 
single database so that X can track orders more easily, and coordinate 
manufacturing, inventory, and shipping among many different locations at 
the same time. In order to successfully install and implement ERP 
software, X evaluates its business needs and the technical requirements 
of the software, such as processing power, memory, storage, and network 
resources. X devotes the majority of its resources in implementing the 
ERP system to evaluating the available templates, reports, and other 
standard programs and choosing among these alternatives in configuring 
the system to match its business process and reengineering its business 
process to match the available alternatives in the ERP system. X also 
performs some data transfer from its old system, involving routine 
programming and one-to-one mapping of data to be exchanged between each 
system.
    (ii) Conclusion. X's activities related to the ERP software 
including the data transfer are not qualified research under section 
41(d)(1) and paragraph (a)(5) of this section. X did

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not conduct a process of evaluating alternatives in order to eliminate 
uncertainty regarding the development of software. X's activities in 
choosing between available templates, reports, and other standard 
programs and conducting data transfer are not elements of a process of 
experimentation.
    Example 10. (i) Facts. Same facts as Example 9 except that X 
determines that it must interface part of its legacy software with the 
new ERP software because the ERP software does not provide a particular 
function that X requires for its business. As a result, X must develop 
an interface between its legacy software and the ERP software, and X 
evaluates several data exchange software applications and chooses one of 
the available alternatives. X is uncertain as to how to keep the data 
synchronized between the legacy and ERP systems. Thus, X engages in 
systematic trial and error testing of several newly designed data 
caching algorithms to eliminate synchronization problems.
    (ii) Conclusion. Substantially all of X's activities with respect to 
this ERP project do not satisfy the requirements for a process of 
experimentation. However, when the shrinking-back rule is applied, a 
subset of X's activities do satisfy the requirements for a process of 
experimentation. X's activities to develop the data caching software and 
keeping the data on the legacy and ERP systems synchronized meet the 
requirements of qualified research as set forth in paragraph (a)(2) of 
this section. Substantially all of X's activities to develop the 
specialized data caching and synchronization software constitute 
elements of a process of experimentation because X identified 
uncertainties related to the development of a business component, 
identified alternatives intended to eliminate those uncertainties, and 
evaluated alternatives to achieve a result where the appropriate design 
of that result was uncertain as of the beginning of the taxpayer's 
research activities.

    (b) Application of requirements for qualified research--(1) In 
general. The requirements for qualified research in section 41(d)(1) and 
paragraph (a) of this section, must be applied separately to each 
business component, as defined in section 41(d)(2)(B). In cases 
involving development of both a product and a manufacturing or other 
commercial production process for the product, research activities 
relating to development of the process are not qualified research unless 
the requirements of section 41(d) and this section are met for the 
research activities relating to the process without taking into account 
the research activities relating to development of the product. 
Similarly, research activities relating to development of the product 
are not qualified research unless the requirements of section 41(d) and 
this section are met for the research activities relating to the product 
without taking into account the research activities relating to 
development of the manufacturing or other commercial production process.
    (2) Shrinking-back rule. The requirements of section 41(d) and 
paragraph (a) of this section are to be applied first at the level of 
the discrete business component, that is, the product, process, computer 
software, technique, formula, or invention to be held for sale, lease, 
or license, or used by the taxpayer in a trade or business of the 
taxpayer. If these requirements are not met at that level, then they 
apply at the most significant subset of elements of the product, 
process, computer software, technique, formula, or invention to be held 
for sale, lease, or license. This shrinking back of the product is to 
continue until either a subset of elements of the product that satisfies 
the requirements is reached, or the most basic element of the product is 
reached and such element fails to satisfy the test. This shrinking-back 
rule is applied only if a taxpayer does not satisfy the requirements of 
section 41(d)(1) and paragraph (a)(2) of this section with respect to 
the overall business component. The shrinking-back rule is not itself 
applied as a reason to exclude research activities from credit 
eligibility.
    (3) Illustration. The following example illustrates the application 
of this paragraph (b):

    Example. X, a motorcycle engine builder, develops a new carburetor 
for use in a motorcycle engine. X also modifies an existing engine 
design for use with the new carburetor. Under the shrinking-back rule, 
the requirements of section 41(d)(1) and paragraph (a) of this section 
are applied first to the engine. If the modifications to the engine when 
viewed as a whole, including the development of the new carburetor, do 
not satisfy the requirements of section 41(d)(1) and paragraph (a) of 
this section, those requirements are applied to the next most 
significant subset of elements of the business component. Assuming that 
the next most significant subset of elements of the engine is the 
carburetor, the research activities in developing the new carburetor may 
constitute qualified research

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within the meaning of section 41(d)(1) and paragraph (a) of this 
section.

    (c) Excluded activities--(1) In general. Qualified research does not 
include any activity described in section 41(d)(4) and paragraph (c) of 
this section.
    (2) Research after commercial production--(i) In general. Activities 
conducted after the beginning of commercial production of a business 
component are not qualified research. Activities are conducted after the 
beginning of commercial production of a business component if such 
activities are conducted after the component is developed to the point 
where it is ready for commercial sale or use, or meets the basic 
functional and economic requirements of the taxpayer for the component's 
sale or use.
    (ii) Certain additional activities related to the business 
component. The following activities are deemed to occur after the 
beginning of commercial production of a business component--
    (A) Preproduction planning for a finished business component;
    (B) Tooling-up for production;
    (C) Trial production runs;
    (D) Trouble shooting involving detecting faults in production 
equipment or processes;
    (E) Accumulating data relating to production processes; and
    (F) Debugging flaws in a business component.
    (iii) Activities related to production process or technique. In 
cases involving development of both a product and a manufacturing or 
other commercial production process for the product, the exclusion 
described in section 41(d)(4)(A) and paragraphs (c)(2)(i) and (ii) of 
this section applies separately for the activities relating to the 
development of the product and the activities relating to the 
development of the process. For example, even after a product meets the 
taxpayer's basic functional and economic requirements, activities 
relating to the development of the manufacturing process still may 
constitute qualified research, provided that the development of the 
process itself separately satisfies the requirements of section 41(d) 
and this section, and the activities are conducted before the process 
meets the taxpayer's basic functional and economic requirements or is 
ready for commercial use.
    (iv) Clinical testing. Clinical testing of a pharmaceutical product 
prior to its commercial production in the United States is not treated 
as occurring after the beginning of commercial production even if the 
product is commercially available in other countries. Additional 
clinical testing of a pharmaceutical product after a product has been 
approved for a specific therapeutic use by the Food and Drug 
Administration and is ready for commercial production and sale is not 
treated as occurring after the beginning of commercial production if 
such clinical testing is undertaken to establish new functional uses, 
characteristics, indications, combinations, dosages, or delivery forms 
for the product. A functional use, characteristic, indication, 
combination, dosage, or delivery form shall be considered new only if 
such functional use, characteristic, indication, combination, dosage, or 
delivery form must be approved by the Food and Drug Administration.
    (3) Adaptation of existing business components. Activities relating 
to adapting an existing business component to a particular customer's 
requirement or need are not qualified research. This exclusion does not 
apply merely because a business component is intended for a specific 
customer.
    (4) Duplication of existing business component. Activities relating 
to reproducing an existing business component (in whole or in part) from 
a physical examination of the business component itself or from plans, 
blueprints, detailed specifications, or publicly available information 
about the business component are not qualified research. This exclusion 
does not apply merely because the taxpayer examines an existing business 
component in the course of developing its own business component.
    (5) Surveys, studies, research relating to management functions, 
etc. Qualified research does not include activities relating to--
    (i) Efficiency surveys;
    (ii) Management functions or techniques, including such items as 
preparation of financial data and analysis,

[[Page 172]]

development of employee training programs and management organization 
plans, and management-based changes in production processes (such as 
rearranging work stations on an assembly line);
    (iii) Market research, testing, or development (including 
advertising or promotions);
    (iv) Routine data collections; or
    (v) Routine or ordinary testing or inspections for quality control.
    (6) Internal use software--(i) General rule. Research with respect 
to software that is developed by (or for the benefit of) the taxpayer 
primarily for the taxpayer's internal use is eligible for the research 
credit only if--
    (A) The research with respect to the software satisfies the 
requirements of section 41(d)(1);
    (B) The research with respect to the software is not otherwise 
excluded under section 41(d)(4) (other than section 41(d)(4)(E)); and
    (C) The software satisfies the high threshold of innovation test of 
paragraph (c)(6)(vii) of this section.
    (ii) Inapplicability of the high threshold of innovation test. This 
paragraph (c)(6) does not apply to the following:
    (A) Software developed by (or for the benefit of) the taxpayer 
primarily for internal use by the taxpayer for use in an activity that 
constitutes qualified research (other than the development of the 
internal use software itself);
    (B) Software developed by (or for the benefit of) the taxpayer 
primarily for internal use by the taxpayer for use in a production 
process to which the requirements of section 41(d)(1) are met; and
    (C) A new or improved package of software and hardware developed 
together by the taxpayer as a single product (or to the costs to modify 
an acquired software and hardware package), of which the software is an 
integral part, that is used directly by the taxpayer in providing 
services in its trade or business. In these cases, eligibility for the 
research credit is to be determined by examining the combined hardware-
software product as a single product.
    (iii) Software developed primarily for internal use--(A) In general. 
Except as otherwise provided in paragraph (c)(6)(vi) of this section, 
software is developed by (or for the benefit of) the taxpayer primarily 
for the taxpayer's internal use if the software is developed for use in 
general and administrative functions that facilitate or support the 
conduct of the taxpayer's trade or business. Software that the taxpayer 
develops primarily for a related party's internal use will be considered 
internal use software. A related party is any corporation, trade or 
business, or other person that is treated as a single taxpayer with the 
taxpayer pursuant to section 41(f).
    (B) General and administrative functions. General and administrative 
functions are:
    (1) Financial management. Financial management functions are 
functions that involve the financial management of the taxpayer and the 
supporting recordkeeping. Financial management functions include, but 
are not limited to, functions such as accounts payable, accounts 
receivable, inventory management, budgeting, cash management, cost 
accounting, disbursements, economic analysis and forecasting, financial 
reporting, finance, fixed asset accounting, general ledger bookkeeping, 
internal audit, management accounting, risk management, strategic 
business planning, and tax.
    (2) Human resources management. Human resources management functions 
are functions that manage the taxpayer's workforce. Human resources 
management functions include, but are not limited to, functions such as 
recruiting, hiring, training, assigning personnel, and maintaining 
personnel records, payroll, and benefits.
    (3) Support services. Support services are other functions that 
support the day- to-day operations of the taxpayer. Support services 
include, but are not limited to, functions such as data processing, 
facility services (for example, grounds keeping, housekeeping, 
janitorial, and logistics), graphic services, marketing, legal services, 
government compliance services, printing and publication services, and 
security services (for example, video surveillance and physical asset 
protection from fire and theft).

[[Page 173]]

    (iv) Software not developed primarily for internal use. Software is 
not developed primarily for the taxpayer's internal use if it is not 
developed for use in general and administrative functions that 
facilitate or support the conduct of the taxpayer's trade or business, 
such as--
    (A) Software developed to be commercially sold, leased, licensed, or 
otherwise marketed to third parties; or
    (B) Software developed to enable a taxpayer to interact with third 
parties or to allow third parties to initiate functions or review data 
on the taxpayer's system.
    (v) Time and manner of determination. For purposes of paragraphs 
(c)(6)(iii) and (iv) of this section, whether software is developed 
primarily for internal use or not developed primarily for internal use 
depends on the intent of the taxpayer and the facts and circumstances at 
the beginning of the software development. For example, software will 
not be considered internal use software solely because it is used 
internally for purposes of testing prior to commercial sale, lease, or 
license. If a taxpayer originally develops software primarily for 
internal use, but later makes improvements to the software with the 
intent to hold the improved software to be sold, leased, licensed, or 
otherwise marketed to third parties, or to interact with third parties 
or to allow third parties to initiate functions or review data on the 
taxpayer's system using the improved software, the improvements will be 
considered separate from the existing software and will not be 
considered developed primarily for internal use. Alternatively, if a 
taxpayer originally develops software to be sold, leased, licensed, or 
otherwise marketed to third parties, or to interact with third parties 
or to allow third parties to initiate functions or review data on the 
taxpayer's system, but later makes improvements to the software with the 
intent to use the software in general and administrative functions, the 
improvements will be considered separate from the existing software and 
will be considered developed primarily for internal use.
    (vi) Software developed for both internal use and to enable 
interaction with third parties (dual function software)--(A) Presumption 
of development primarily for internal use. Unless paragraph 
(c)(6)(vi)(B) or (C) of this section applies, software developed by (or 
for the benefit of) the taxpayer both for use in general and 
administrative functions that facilitate or support the conduct of the 
taxpayer's trade or business and to enable a taxpayer to interact with 
third parties or to allow third parties to initiate functions or review 
data on the taxpayer's system (dual function software) is presumed to be 
developed primarily for a taxpayer's internal use.
    (B) Identification of a subset of elements of software that only 
enables interaction with third parties. To the extent that a taxpayer 
can identify a subset of elements of dual function software that only 
enables a taxpayer to interact with third parties or allows third 
parties to initiate functions or review data (third party subset), the 
presumption under paragraph (c)(6)(vi)(A) of this section does not apply 
to such third party subset, and such third party subset is not developed 
primarily for internal use as described under paragraph (c)(6)(iv)(B) of 
this section.
    (C) Safe harbor for expenditures related to software developed for 
both internal use and to enable interaction with third parties. If, 
after the application of paragraph (c)(6)(vi)(B) of this section, there 
remains dual function software or a subset of elements of dual function 
software (dual function subset), a taxpayer may include 25 percent of 
the qualified research expenditures of such dual function software or 
dual function subset in computing the amount of the taxpayer's credit. 
This paragraph (c)(6)(vi)(C) applies only if the taxpayer's research 
activities related to the development or improvement of the dual 
function software or dual function subset constitute qualified research 
under section 41(d), without regard to section 41(d)(4)(E), and the dual 
function software or dual function subset's use by third parties or by 
the taxpayer to interact with third parties is reasonably anticipated to 
constitute at least 10 percent of the dual function software or the dual 
function subset's use. An objective, reasonable method within the 
taxpayer's industry must be

[[Page 174]]

used to estimate the dual function software or dual function subset's 
use by third parties or by the taxpayer to interact with third parties. 
An objective, reasonable method may include, but is not limited to, 
processing time, amount of data transfer, and number of software user 
interface screens.
    (D) Time and manner of determination. A taxpayer must apply this 
paragraph (c)(6)(vi) based on the intent of the taxpayer and the facts 
and circumstances at the beginning of the software development.
    (E) Third party. For purposes of paragraphs (c)(6)(iv), (v), and 
(vi) of this section, the term third party means any corporation, trade 
or business, or other person that is not treated as a single taxpayer 
with the taxpayer pursuant to section 41(f). Additionally, for purposes 
of paragraph (c)(6)(iv)(B) of this section, third parties do not include 
any persons that use the software to support the general and 
administrative functions of the taxpayer.
    (vii) High threshold of innovation test--(A) In general. Software 
satisfies this paragraph (c)(6)(vii) only if the taxpayer can establish 
that--
    (1) The software is innovative;
    (2) The software development involves significant economic risk; and
    (3) The software is not commercially available for use by the 
taxpayer in that the software cannot be purchased, leased, or licensed 
and used for the intended purpose without modifications that would 
satisfy the requirements of paragraphs (c)(6)(vii)(A)(1) and (2) of this 
section.
    (B) Innovative. Software is innovative if the software would result 
in a reduction in cost or improvement in speed or other measurable 
improvement, that is substantial and economically significant, if the 
development is or would have been successful. This is a measurable 
objective standard, not a determination of the unique or novel nature of 
the software or the software development process.
    (C) Significant economic risk. The software development involves 
significant economic risk if the taxpayer commits substantial resources 
to the development and if there is substantial uncertainty, because of 
technical risk, that such resources would be recovered within a 
reasonable period. The term ``substantial uncertainty'' requires a 
higher level of uncertainty and technical risk than that required for 
business components that are not internal use software. This standard 
does not require technical uncertainty regarding whether the final 
result can ever be achieved, but rather whether the final result can be 
achieved within a timeframe that will allow the substantial resources 
committed to the development to be recovered within a reasonable period. 
Technical risk arises from uncertainty that is technological in nature, 
as defined in paragraph (a)(4) of this section, and substantial 
uncertainty must exist at the beginning of the taxpayer's activities.
    (D) Application of high threshold of innovation test. The high 
threshold of innovation test of paragraph (c)(6)(vii) of this section 
takes into account only the results anticipated to be attributable to 
the development of new or improved software at the beginning of the 
software development independent of the effect of any modifications to 
related hardware or other software. The implementation of existing 
technology by itself is not evidence of innovation, but the use of 
existing technology in new ways could be evidence of a high threshold of 
innovation if it resolves substantial uncertainty as defined in 
paragraph (c)(6)(vii)(C) of this section.
    (viii) Illustrations. The following examples illustrate provisions 
contained in this paragraph (c)(6). No inference should be drawn from 
these examples concerning the application of section 41(d)(1) and 
paragraph (a) of this section to these facts.

    Example 1. Computer hardware and software developed as a single 
product--(i) Facts. X is a telecommunications company that developed 
high technology telephone switching hardware. In addition, X developed 
software that interfaces directly with the hardware to initiate and 
terminate a call, along with other functions. X designed and developed 
the hardware and software together.
    (ii) Conclusion. The telecommunications software that interfaces 
directly with the hardware is part of a package of software and hardware 
developed together by the taxpayer that is used by the taxpayer in 
providing services in its trade or business. Accordingly, this paragraph 
(c)(6) does not apply to the software that interfaces directly with the 
hardware as described in paragraph

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(c)(6)(ii)(C) of this section, and eligibility for the research credit 
is determined by examining the combined software-hardware product as a 
single product.
    Example 2. Internal use software; financial management--(i) Facts. 
X, a manufacturer, self-insures its liabilities for employee health 
benefits. X develops its own software to administer its self-insurance 
reserves related to employee health benefits. At the beginning of the 
development, X does not intend to develop the software for commercial 
sale, lease, license, or to be otherwise marketed to third parties or to 
enable X to interact with third parties or to allow third parties to 
initiate functions or review data on X's system.
    (ii) Conclusion. The software is developed for use in a general and 
administrative function because reserve valuation is a financial 
management function under paragraph (c)(6)(iii)(B)(1) of this section. 
Accordingly, the software is internal use software because it is 
developed for use in a general and administrative function.
    Example 3. Internal use software; human resources management--(i) 
Facts. X, a manufacturer, develops a software module that interacts with 
X's existing payroll software to allow X's employees to print pay stubs 
and make certain changes related to payroll deductions over the 
internet. At the beginning of the development, X does not intend to 
develop the software module for commercial sale, lease, license, or to 
be otherwise marketed to third parties or to enable X to interact with 
third parties or to allow third parties to initiate functions or review 
data on X's system.
    (ii) Conclusion. The employee access software module is developed 
for use in a general and administrative function because employee access 
software is a human resources management function under paragraph 
(c)(6)(iii)(B)(2) of this section. Accordingly, the software module is 
internal use software because it is developed for use in a general and 
administrative function.
    Example 4. Internal use software; support services--(i) Facts. X, a 
restaurant, develops software for a Web site that provides information, 
such as items served, price, location, phone number, and hours of 
operation for purposes of advertising. At the beginning of the 
development, X does not intend to develop the Web site software for 
commercial sale, lease, license, or to be otherwise marketed to third 
parties or to enable X to interact with third parties or to allow third 
parties to initiate functions or review data on X's system. X intends to 
use the software for marketing by allowing third parties to review 
general information on X's Web site.
    (ii) Conclusion. The software is developed for use in a general and 
administrative function because the software was developed to be used by 
X for marketing which is a support services function under paragraph 
(c)(6)(iii)(B)(3) of this section. Accordingly, the software is internal 
use software because it is developed for use in a general and 
administrative function.
    Example 5. Internal use software--(i) Facts. X, a multinational 
manufacturer with different business and financial systems in each of 
its divisions, undertakes a software development project aimed at 
integrating the majority of the functional areas of its major software 
systems (Existing Software) into a single enterprise resource management 
system supporting centralized financial systems, human resources, 
inventory, and sales. X purchases software (New Software) upon which to 
base its enterprise-wide system. X has to develop software (Developed 
Software) that transfers data from X's legacy financial, human 
resources, inventory, and sales systems to the New Software. At the 
beginning of the development, X does not intend to develop the software 
for commercial sale, lease, license, or to be otherwise marketed to 
third parties or to enable X to interact with third parties or to allow 
third parties to initiate functions or review data on X's system.
    (ii) Conclusion. The financial systems, human resource systems, 
inventory and sales systems are general and administrative functions 
under paragraph (c)(6)(iii)(B) of this section. Accordingly, the 
Developed Software is internal use software because it is developed for 
use in general and administrative functions.
    Example 6. Internal use software; definition of third party--(i) 
Facts. X develops software to interact electronically with its vendors 
to improve X's inventory management. X develops the software to enable X 
to interact with vendors and to allow vendors to initiate functions or 
review data on the taxpayer's system. X defines the electronic messages 
that will be exchanged between X and the vendors. X's software allows a 
vendor to request X's current inventory of the vendor's product, and 
allows a vendor to send a message to X which informs X that the vendor 
has just made a new shipment of the vendor's product to replenish X's 
inventory. At the beginning of development, X does not intend to develop 
the software for commercial sale, lease, license, or to be otherwise 
marketed to third parties.
    (ii) Conclusion. Under paragraph (c)(6)(vi)(E) of this section, X's 
vendors are not third parties for purposes of paragraph (c)(6)(iv) of 
this section. While X's software was developed to allow vendors to 
initiate functions or review data on the taxpayer's system, the software 
is not excluded from internal use software as set forth in paragraph 
(c)(6)(iv)(B) of this section because the software was developed to 
allow vendors to use the software to support X's inventory management, 
which is a general and administrative function of X.

[[Page 176]]

    Example 7. Not internal use software; third party interaction--(i) 
Facts. X, a manufacturer of various products, develops software for a 
Web site with the intent to allow third parties to access data on X's 
database, to order X's products and track the status of their orders 
online. At the beginning of the development, X does not intend to 
develop the Web site software for commercial sale, lease, license, or to 
be otherwise marketed to third parties.
    (ii) Conclusion. The software is not developed primarily for 
internal use because it is not developed for use in a general and 
administrative function. X developed the software to allow third parties 
to initiate functions or review data on the taxpayer's system as 
provided under paragraph (c)(6)(iv)(B) of this section.
    Example 8. Not internal use software; third party interaction--(i) 
Facts. X developed software that allows its users to upload and modify 
photographs at no charge. X earns revenue by selling advertisements that 
are displayed while users enjoy the software that X offers for free. X 
also developed software that has interfaces through which advertisers 
can bid for the best position in placing their ads, set prices for the 
ads, or develop advertisement campaign budgets. At the beginning of the 
development, X intended to develop the software to enable X to interact 
with third parties or to allow third parties to initiate functions on 
X's system.
    (ii) Conclusion. The software for uploading and modifying 
photographs is not developed primarily for internal use because it is 
not developed for use in X's general and administrative functions under 
paragraph (c)(6)(iii)(A) of this section. The users and the advertisers 
are third parties for purposes of paragraph (c)(6)(iv) of this section. 
Furthermore, both the software for uploading and modifying photographs 
and the advertising software are not internal use software under 
paragraph (c)(6)(iv)(B) of this section because at the beginning of the 
development X developed the software with the intention of enabling X to 
interact with third parties or to allow third parties to initiate 
functions on X's system.
    Example 9. Not internal use software; commercially sold, leased, 
licensed, or otherwise marketed--(i) Facts. X is a provider of cloud-
based software. X develops enterprise application software (including 
customer relationship management, sales automation, and accounting 
software) to be accessed online and used by X's customers. At the 
beginning of development, X intended to develop the software for 
commercial sale, lease, license, or to be otherwise marketed to third 
parties.
    (ii) Conclusion. The software is not developed primarily for 
internal use because it is not developed for use in a general and 
administrative function. X developed the software to be commercially 
sold, leased, licensed, or otherwise marketed to third parties under 
paragraph (c)(6)(iv)(A) of this section.
    Example 10. Improvements to existing internal use software--(i) 
Facts. X has branches throughout the country and develops its own 
facilities services software to coordinate moves and to track 
maintenance requests for all locations. At the beginning of the 
development, X does not intend to develop the software for commercial 
sale, lease, license, or to be otherwise marketed to third parties or to 
enable X to interact with third parties or to allow third parties to 
initiate functions or review data on X's system. Several years after 
completing the development and using the software, X consults its 
business development department, which assesses the market for the 
software. X determines that the software could be sold at a profit if 
certain technical and functional enhancements are made. X develops the 
improvements to the software, and sells the improved software to third 
parties.
    (ii) Conclusion. Support services, which include facility services, 
are general and administrative functions under paragraph (c)(6)(iii)(B) 
of this section. Accordingly, the original software is developed for use 
in general and administrative functions and is, therefore, developed 
primarily for internal use. However, the improvements to the software 
are not developed primarily for internal use because the improved 
software was not developed for use in a general and administrative 
function. X developed the improved software to be commercially sold, 
leased, licensed, or otherwise marketed to third parties under 
paragraphs (c)(6)(iv)(A) and (c)(6)(v) of this section.
    Example 11. Dual function software; identification of a third party 
subset--(i) Facts. X develops software for use in general and 
administrative functions that facilitate or support the conduct of X's 
trade or business and to allow third parties to initiate functions. X is 
able to identify a third party subset. X incurs $50,000 of research 
expenditures for the software, 50% of which is allocable to the third 
party subset.
    (ii) Conclusion. The software developed by X is dual function 
software. Because X is able to identify a third party subset, the third 
party subset is not presumed to be internal use software under paragraph 
(c)(6)(vi)(A) of this section. If X's research activities related to the 
third party subset constitute qualified research under section 41(d), 
and the allocable expenditures are qualified research expenditures under 
section 41(b), $25,000 of the software research expenditures allocable 
to the third party subset may be included in computing the amount of X's 
credit, pursuant to paragraph (c)(6)(vi)(B) of this section. If, after 
the application of paragraph (c)(6)(vi)(B) of this

[[Page 177]]

section, there remains a dual function subset, X may determine whether 
paragraph (c)(6)(vi)(C) of this section applies.
    Example 12. Dual function software; application of the safe harbor--
(i) Facts. The facts are the same as in Example 11, except that X is 
unable to identify a third party subset. X uses an objective, reasonable 
method at the beginning of the software development to determine that 
the dual function software's use by third parties to initiate functions 
is reasonably anticipated to constitute 15% of the dual function 
software's use.
    (ii) Conclusion. The software developed by X is dual function 
software. The software is presumed to be developed primarily for 
internal use under paragraph (c)(6)(vi)(A) of this section. Although X 
is unable to identify a third party subset, X reasonably anticipates 
that the dual function software's use by third parties will be at least 
10% of the dual function software's use. If X's research activities 
related to the development or improvement of the dual function software 
constitute qualified research under section 41(d), without regard to 
section 41(d)(4)(E), and the allocable expenditures are qualified 
research expenditures under section 41(b), X may include $12,500 (25% of 
$50,000) of the software research expenditures of the dual function 
software in computing the amount of X's credit pursuant to paragraph 
(c)(6)(vi)(C) of this section.
    Example 13. Dual function software; safe harbor inapplicable--(i) 
Facts. The facts are the same as in Example 11, except X is unable to 
identify a third party subset. X uses an objective, reasonable method at 
the beginning of the software development to determine that the dual 
function software's use by third parties to initiate functions is 
reasonably anticipated to constitute 5% of the dual function software's 
use.
    (ii) Conclusion. The software developed by X is dual function 
software. The software is presumed to be developed primarily for X's 
internal use under paragraph (c)(6)(vi)(A) of this section. X is unable 
to identify a third party subset, and X reasonably anticipates that the 
dual function software's use by third parties will be less than 10% of 
the dual function software's use. X may only include the software 
research expenditures of the dual function software in computing the 
amount of X's credit if the software satisfies the high threshold of 
innovation test of paragraph (c)(6)(vii) of this section and X's 
research activities related to the development or improvement of the 
dual function software constitute qualified research under section 
41(d), without regard to section 41(d)(4)(E), and the allocable 
expenditures are qualified research expenditures under section 41(b).
    Example 14. Dual function software; identification of a third party 
subset and the safe harbor--(i) Facts. X develops software for use in 
general and administrative functions that facilitate or support the 
conduct of X's trade or business and to allow third parties to initiate 
functions and review data. X is able to identify a third party subset 
(Subset A). The remaining dual function subset of the software (Subset 
B) allows third parties to review data and provides X with data used in 
its general and administrative functions. X is unable to identify a 
third party subset of Subset B. X incurs $50,000 of research 
expenditures for the software, 50% of which is allocable to Subset A and 
50% of which is allocable to Subset B. X determines, at the beginning of 
the software development, that the processing time of the third party 
use of Subset B is reasonably anticipated to account for 15% of the 
total processing time of Subset B.
    (ii) Conclusion. The software developed by X is dual function 
software. Because X is able to identify a third party subset, such third 
party subset (Subset A) is not presumed to be internal use software 
under paragraph (c)(6)(vi)(A) of this section. If X's research 
activities related to the development or improvement of Subset A 
constitute qualified research under section 41(d), and the allocable 
expenditures are qualified research expenditures under section 41(b), 
the $25,000 of the software research expenditures allocable to Subset A 
may be included in computing the amount of X's credit pursuant to 
paragraph (c)(6)(vi)(B) of this section. Although X is unable to 
identify a third party subset of Subset B, 15% of Subset B's use is 
reasonably anticipated to be attributable to the use of Subset B by 
third parties. If X's research activities related to the development or 
improvement of Subset B constitute qualified research under section 
41(d), without regard to section 41(d)(4)(E), and the allocable 
expenditures are qualified research expenditures under section 41(b), X 
may include $6,250 (25%  x  $25,000) of the software research 
expenditures of Subset B in computing the amount of X's credit, pursuant 
to paragraph (c)(6)(vi)(C) of this section.
    Example 15. Internal use software; application of the high threshold 
of innovation test--(i) Facts. X maintained separate software 
applications for tracking a variety of human resource (HR) functions, 
including employee reviews, salary information, location within the 
hierarchy and physical location of employees, 401(k) plans, and 
insurance coverage information. X determined that improved HR efficiency 
could be achieved by redesigning its disparate software applications 
into one employee-centric system, and worked to develop that system. X 
also determined that commercially available database management systems 
did not meet all of the requirements of the proposed system. Rather than 
waiting several years for vendor offerings to mature and become viable 
for its purpose, X embarked upon the project utilizing

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older technology that was severely challenged with respect to data 
modeling capabilities. The improvements, if successful, would provide a 
reduction in cost and improvement in speed that is substantial and 
economically significant. For example, having one employee-centric 
system would remove the duplicative time and cost of manually entering 
basic employee information separately in each application because the 
information would only have to be entered once to be available across 
all applications. The limitations of the technology X was attempting to 
utilize required that X attempt to develop a new database architecture. 
X committed substantial resources to the project, but could not predict, 
because of technical risk, whether it could develop the database 
software in the timeframe necessary so that X could recover its 
resources in a reasonable period. Specifically, X was uncertain 
regarding the capability of developing, within a reasonable period, a 
new database architecture using the old technology that would resolve 
its technological issues regarding the data modeling capabilities and 
the integration of the disparate systems into one system. At the 
beginning of the development, X did not intend to develop the software 
for commercial sale, lease, license, or to be otherwise marketed to 
third parties or to enable X to interact with third parties or to allow 
third parties to initiate functions or review data on X's system.
    (ii) Conclusion. The software is internal use software because it is 
developed for use in a general and administrative function. However, the 
software satisfies the high threshold of innovation test set forth in 
paragraph (c)(6)(vii) of this section. The software was intended to be 
innovative in that it would provide a reduction in cost or improvement 
in speed that is substantial and economically significant. In addition, 
X's development activities involved significant economic risk in that X 
committed substantial resources to the development and there was 
substantial uncertainty, because of technical risk, that the resources 
would be recovered within a reasonable period. Finally, at the time X 
undertook the development of the system, software meeting X's 
requirements was not commercially available for use by X.
    Example 16. Internal use software; application of the high threshold 
of innovation test--(i) Facts. X undertook a software project to rewrite 
a legacy mainframe application using an object-oriented programming 
language, and to move the new application off the mainframe to a client/
server environment. Both the object-oriented language and client/server 
technologies were new to X. This project was undertaken to develop a 
more maintainable application, which X expected would significantly 
reduce the cost of maintenance, and implement new features more quickly, 
which X expected would provide both significant improvements in speed 
and reduction in cost. Thus, the improvements, if successful, would 
provide a reduction in cost and improvement in speed that is substantial 
and economically significant. X also determined that commercially 
available systems did not meet the requirements of the proposed system. 
X was certain that it would be able to overcome any technological 
uncertainties and implement the improvements within a reasonable period. 
However, X was unsure of the appropriate methodology to achieve the 
improvements. At the beginning of the development, X does not intend to 
develop the software for commercial sale, lease, license, or to be 
otherwise marketed to third parties or to enable X to interact with 
third parties or to allow third parties to initiate functions or review 
data on X's system.
    (ii) Conclusion. The software is internal use software because it is 
developed for use in a general and administrative function. X's 
activities do not satisfy the high threshold of innovation test of 
paragraph (c)(6)(vii) of this section. Although the software meets the 
requirements of paragraphs (c)(6)(vii)(A)(1) and (3) of this section, 
X's development activities did not involve significant economic risk 
under paragraph (c)(6)(vii)(A)(2) of this section. X did not have 
substantial uncertainty, because of technical risk, that the resources 
committed to the project would be recovered within a reasonable period.
    Example 17. Internal use software; application of the high threshold 
of innovation test--(i) Facts. X wants to expand its internal computing 
power, and is aware that its PCs and workstations are idle at night, on 
the weekends, and for a significant part of any business day. Because 
the general and administrative computations that X needs to make could 
be done on workstations as well as PCs, X develops a screen-saver-like 
application that runs on employee computers. When employees' computers 
have been idle for an amount of time set by each employee, X's 
application goes back to a central server to get a new job to execute. 
This job will execute on the idle employee's computer until it has 
either finished, or the employee resumes working on his computer. The 
ability to use the idle employees' computers would save X significant 
costs because X would not have to buy new hardware to expand the 
computing power. The improvements, if successful, would provide a 
reduction in cost that is substantial and economically significant. At 
the time X undertook the software development project, there was no 
commercial application available with such a capability. In addition, at 
the time X undertook the software development project, X was uncertain 
regarding the capability of developing a server application that could 
schedule and distribute the jobs across thousands of PCs and 
workstations, as well as handle all the

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error conditions that occur on a user's machine. X commits substantial 
resources to the project. X undertakes a process of experimentation to 
attempt to eliminate its uncertainty. At the beginning of the 
development, X does not intend to develop the software for commercial 
sale, lease, license, or to be otherwise marketed to third parties or to 
enable X to interact with third parties or to allow third parties to 
initiate functions or review data on X's system.
    (ii) Conclusion. The software is internal use software because it is 
developed for use in a general and administrative function. However, the 
software satisfies the high threshold of innovation test as set forth in 
paragraph (c)(6)(vii) of this section. The software was intended to be 
innovative because it would provide a reduction in cost or improvement 
in speed that is substantial and economically significant. In addition, 
X's development activities involved significant economic risk in that X 
committed substantial resources to the development and there was 
substantial uncertainty that because of technical risk, such resources 
would be recovered within a reasonable period. Finally, at the time X 
undertook the development of the system, software meeting X's 
requirements was not commercially available for use by X.
    Example 18. Internal use software; application of the high threshold 
of innovation test--(i) Facts. X, a multinational manufacturer, wants to 
install an enterprise resource planning (ERP) system that runs off a 
single database. However, to implement the ERP system, X determines that 
it must integrate part of its old system with the new because the ERP 
system does not have a particular function that X requires for its 
business. The two systems are general and administrative software 
systems. The systems have mutual incompatibilities. The integration, if 
successful, would provide a reduction in cost and improvement in speed 
that is substantial and economically significant. At the time X 
undertook this project, there was no commercial application available 
with such a capability. X is uncertain regarding the appropriate design 
of the interface software. However, X knows that given a reasonable 
period of time to experiment with various designs, X would be able to 
determine the appropriate design necessary to meet X's technical 
requirements and would recover the substantial resources that X commits 
to the development of the system within a reasonable period. At the 
beginning of the development, X does not intend to develop the software 
for commercial sale, lease, license, or to be otherwise marketed to 
third parties or to enable X to interact with third parties or to allow 
third parties to initiate functions or review data on X's system.
    (ii) Conclusion. The software is internal use software because it is 
developed for use in a general and administrative function. X's 
activities do not satisfy the high threshold of innovation test of 
paragraph (c)(6)(vii) of this section. Although the software meets the 
requirements of paragraphs (c)(6)(vii)(A)(1) and (3) of this section, 
X's development activities did not involve significant economic risk 
under paragraph (c)(6)(vii)(A)(2) of this section. X did not have 
substantial uncertainty, because of technical risk, that the resources 
committed to the project would be recovered within a reasonable period.

    (7) Activities outside the United States, Puerto Rico, and other 
possessions--(i) In general. Research conducted outside the United 
States, as defined in section 7701(a)(9), the Commonwealth of Puerto 
Rico and other possessions of the United States does not constitute 
qualified research.
    (ii) Apportionment of in-house research expenses. In-house research 
expenses paid or incurred for qualified services performed both in the 
United States, the Commonwealth of Puerto Rico and other possessions of 
the United States and outside the United States, the Commonwealth of 
Puerto Rico and other possessions of the United States must be 
apportioned between the services performed in the United States, the 
Commonwealth of Puerto Rico and other possessions of the United States 
and the services performed outside the United States, the Commonwealth 
of Puerto Rico and other possessions of the United States. Only those 
in-house research expenses apportioned to the services performed within 
the United States, the Commonwealth of Puerto Rico and other possessions 
of the United States are eligible to be treated as qualified research 
expenses, unless the in-house research expenses are wages and the 80 
percent rule of Sec. 1.41-2(d)(2) applies.
    (iii) Apportionment of contract research expenses. If contract 
research is performed partly in the United States, the Commonwealth of 
Puerto Rico and other possessions of the United States and partly 
outside the United States, the Commonwealth of Puerto Rico and other 
possessions of the United States, only 65 percent (or 75 percent in the 
case of amounts paid to qualified research consortia) of the portion of 
the contract amount that is attributable to the research activity 
performed in

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the United States, the Commonwealth of Puerto Rico and other possessions 
of the United States may qualify as a contract research expense (even if 
80 percent or more of the contract amount is for research performed in 
the United States, the Commonwealth of Puerto Rico and other possessions 
of the United States).
    (8) Research in the social sciences, etc. Qualified research does 
not include research in the social sciences (including economics, 
business management, and behavioral sciences), arts, or humanities.
    (9) Research funded by any grant, contract, or otherwise. Qualified 
research does not include any research to the extent funded by any 
grant, contract, or otherwise by another person (or governmental 
entity). To determine the extent to which research is so funded, 
Sec. 1.41-4A(d) applies.
    (10) Illustrations. The following examples illustrate provisions 
contained in paragraphs (c)(1) through (9) (excepting paragraphs (c)(6) 
of this section) of this section. No inference should be drawn from 
these examples concerning the application of section 41(d)(1) and 
paragraph (a) of this section to these facts. The examples are as 
follows:

    Example 1. (i) Facts. X, a tire manufacturer, develops a new 
material to use in its tires. X conducts research to determine the 
changes that will be necessary for X to modify its existing 
manufacturing processes to manufacture the new tire. X determines that 
the new tire material retains heat for a longer period of time than the 
materials X currently uses for tires, and, as a result, the new tire 
material adheres to the manufacturing equipment during tread cooling. X 
evaluates several alternatives for processing the treads at cooler 
temperatures to address this problem, including a new type of belt for 
its manufacturing equipment to be used in tread cooling. Such a belt is 
not commercially available. Because X is uncertain of the belt design, X 
develops and conducts sophisticated engineering tests on several 
alternative designs for a new type of belt to be used in tread cooling 
until X successfully achieves a design that meets X's requirements. X 
then manufactures a set of belts for its production equipment, installs 
the belts, and tests the belts to make sure they were manufactured 
correctly.
    (ii) Conclusion. X's research with respect to the design of the new 
belts to be used in its manufacturing of the new tire may be qualified 
research under section 41(d)(1) and paragraph (a) of this section. 
However, X's expenses to implement the new belts, including the costs to 
manufacture, install, and test the belts were incurred after the belts 
met the taxpayer's functional and economic requirements and are excluded 
as research after commercial production under section 41(d)(4)(A) and 
paragraph (c)(2) of this section.
    Example 2. (i) Facts. For several years, X has manufactured and sold 
a particular kind of widget. X initiates a new research project to 
develop a new or improved widget.
    (ii) Conclusion. X's activities to develop a new or improved widget 
are not excluded from the definition of qualified research under section 
41(d)(4)(A) and paragraph (c)(2) of this section. X's activities 
relating to the development of a new or improved widget constitute a new 
research project to develop a new business component. X's research 
activities relating to the development of the new or improved widget, a 
new business component, are not considered to be activities conducted 
after the beginning of commercial production under section 41(d)(4)(A) 
and paragraph (c)(2) of this section.
    Example 3. (i) Facts. X, a computer software development firm, owns 
all substantial rights in a general ledger accounting software core 
program that X markets and licenses to customers. X incurs expenditures 
in adapting the core software program to the requirements of C, one of 
X's customers.
    (ii) Conclusion. Because X's activities represent activities to 
adapt an existing software program to a particular customer's 
requirement or need, X's activities are excluded from the definition of 
qualified research under section 41(d)(4)(B) and paragraph (c)(3) of 
this section.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that C pays X to adapt the core software program to C's requirements.
    (ii) Conclusion. Because X's activities are excluded from the 
definition of qualified research under section 41(d)(4)(B) and paragraph 
(c)(3) of this section, C's payments to X are not for qualified research 
and are not considered to be contract research expenses under section 
41(b)(3)(A).
    Example 5. (i) Facts. The facts are the same as in Example 3, except 
that C's own employees adapt the core software program to C's 
requirements.
    (ii) Conclusion. Because C's employees' activities to adapt the core 
software program to C's requirements are excluded from the definition of 
qualified research under section 41(d)(4)(B) and paragraph (c)(3) of 
this section, the wages C paid to its employees do not constitute in-
house research expenses under section 41(b)(2)(A).

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    Example 6. (i) Facts. X manufacturers and sells rail cars. Because 
rail cars have numerous specifications related to performance, 
reliability and quality, rail car designs are subject to extensive, 
complex testing in the scientific or laboratory sense. B orders 
passenger rail cars from X. B's rail car requirements differ from those 
of X's other existing customers only in that B wants fewer seats in its 
passenger cars and a higher quality seating material and carpet that are 
commercially available. X manufactures rail cars meeting B's 
requirements.
    (ii) Conclusion. X's activities to manufacture rail cars for B are 
excluded from the definition of qualified research. The rail car sold to 
B was not a new business component, but merely an adaptation of an 
existing business component that did not require a process of 
experimentation. Thus, X's activities to manufacture rail cars for B are 
excluded from the definition of qualified research under section 
41(d)(4)(B) and paragraph (c)(3) of this section because X's activities 
represent activities to adapt an existing business component to a 
particular customer's requirement or need.
    Example 7. (i) Facts. X, a manufacturer, undertakes to create a 
manufacturing process for a new valve design. X determines that it 
requires a specialized type of robotic equipment to use in the 
manufacturing process for its new valves. Such robotic equipment is not 
commercially available, and X, therefore, purchases the existing robotic 
equipment for the purpose of modifying it to meet its needs. X's 
engineers identify uncertainty that is technological in nature 
concerning how to modify the existing robotic equipment to meet its 
needs. X's engineers develop several alternative designs, and conduct 
experiments using modeling and simulation in modifying the robotic 
equipment and conduct extensive scientific and laboratory testing of 
design alternatives. As a result of this process, X's engineers develop 
a design for the robotic equipment that meets X's needs. X constructs 
and installs the modified robotic equipment on its manufacturing 
process.
    (ii) Conclusion. X's research activities to determine how to modify 
X's robotic equipment for its manufacturing process are not excluded 
from the definition of qualified research under section 41(d)(4)(B) and 
paragraph (c)(3) of this section, provided that X's research activities 
satisfy the requirements of section 41(d)(1).
    Example 8. (i) Facts. An existing gasoline additive is manufactured 
by Y using three ingredients, A, B, and C. X seeks to develop and 
manufacture its own gasoline additive that appears and functions in a 
manner similar to Y's additive. To develop its own additive, X first 
inspects the composition of Y's additive, and uses knowledge gained from 
the inspection to reproduce A and B in the laboratory. Any differences 
between ingredients A and B that are used in Y's additive and those 
reproduced by X are insignificant and are not material to the viability, 
effectiveness, or cost of A and B. X desires to use with A and B an 
ingredient that has a materially lower cost than ingredient C. 
Accordingly, X engages in a process of experimentation to develop, 
analyze and test potential alternative formulations of the additive.
    (ii) Conclusion. X's activities in analyzing and reproducing 
ingredients A and B involve duplication of existing business components 
and are excluded from the definition of qualified research under section 
41(d)(4)(C) and paragraph (c)(4) of this section. X's experimentation 
activities to develop potential alternative formulations of the additive 
do not involve duplication of an existing business component and are not 
excluded from the definition of qualified research under section 
41(d)(4)(C) and paragraph (c)(4) of this section.
    Example 9. (i) Facts. X, a manufacturing corporation, undertakes to 
restructure its manufacturing organization. X organizes a team to design 
an organizational structure that will improve X's business operations. 
The team includes X's employees as well as outside management 
consultants. The team studies current operations, interviews X's 
employees, and studies the structure of other manufacturing facilities 
to determine appropriate modifications to X's current business 
operations. The team develops a recommendation of proposed modifications 
which it presents to X's management. X's management approves the team's 
recommendation and begins to implement the proposed modifications.
    (ii) Conclusion. X's activities in developing and implementing the 
new management structure are excluded from the definition of qualified 
research under section 41(d)(4)(D) and paragraph (c)(5) of this section. 
Qualified research does not include activities relating to management 
functions or techniques including management organization plans and 
management-based changes in production processes.
    Example 10. (i) Facts. X, an insurance company, develops a new life 
insurance product. In the course of developing the product, X engages in 
research with respect to the effect of pricing and tax consequences on 
demand for the product, the expected volatility of interest rates, and 
the expected mortality rates (based on published data and prior 
insurance claims).
    (ii) Conclusion. X's activities related to the new product represent 
research in the social sciences (including economics and business 
management) and are thus excluded from the definition of qualified 
research under section 41(d)(4)(G) and paragraph (c)(8) of this section.


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    (d) Recordkeeping for the research credit. A taxpayer claiming a 
credit under section 41 must retain records in sufficiently usable form 
and detail to substantiate that the expenditures claimed are eligible 
for the credit. For the rules governing record retention, see 
Sec. 1.6001-1. To facilitate compliance and administration, the IRS and 
taxpayers may agree to guidelines for the keeping of specific records 
for purposes of substantiating research credits.
    (e) Effective/applicability dates. Other than paragraph (c)(6) of 
this section, this section is applicable for taxable years ending on or 
after December 31, 2003. Paragraph (c)(6) of this section is applicable 
for taxable years beginning on or after October 4, 2016. For any taxable 
year that both ends on or after January 20, 2015 and begins before 
October 4, 2016, the IRS will not challenge return positions consistent 
with all of paragraph (c)(6) of this section or all of paragraph (c)(6) 
of this section as contained in the Internal Revenue Bulletin (IRB) 
2015-5 (see www.irs.gov/pub/irs-irbs/irb15-05.pdf). For taxable years 
ending before January 20, 2015, taxpayers may choose to follow either 
all of Sec. 1.41-4(c)(6) as contained in 26 CFR part 1 (revised as of 
April 1, 2003) and IRB 2001-5 (see www.irs.gov/pub/irs-irbs/irb01-
05.pdf) or all of Sec. 1.41-4(c)(6) as contained in IRB 2002-4 (see 
www.irs.gov/pub/irs-irbs/irb02-04.pdf).

[T.D. 8930, 66 FR 290, Jan. 3, 2001, as amended by T.D. 9104, 69 FR 26, 
Jan. 2, 2004; T.D. 9786, 81 FR 68307, Oct. 4, 2016; 81 FR 76496, Nov. 3, 
2016]



Sec. 1.41-4A  Qualified research for taxable years beginning before
January 1, 1986.

    (a) General rule. Except as otherwise provided in section 30(d) (as 
that section read before amendment by the Tax Reform Act of 1986) and in 
this section, the term ``qualified research'' means research, 
expenditures for which would be research and experimental expenditures 
within the meaning of section 174. Expenditures that are ineligible for 
the section 174 deduction elections are not expenditures for qualified 
research. For example, expenditures for the acquisition of land or 
depreciable property used in research, and mineral exploration costs 
described in section 174(d), are not expenditures for qualified 
research.
    (b) Activities outside the United States--(1) In-house research. In-
house research conducted outside the United States (as defined in 
section 7701(a)(9)) cannot constitute qualified research. Thus, wages 
paid to an employee scientist for services performed in a laboratory in 
the United States and in a test station in Antarctica must be 
apportioned between the services performed within the United States and 
the services performed outside the United States, and only the wages 
apportioned to the services conducted within the United States are 
qualified research expenses unless the 80 percent rule of Sec. 1.41-
2(d)(2) applies.
    (2) Contract research. If contract research is performed partly 
within the United States and partly without, only 65 percent of the 
portion of the contract amount that is attributable to the research 
performed within the United States can qualify as contract research 
expense (even if 80 percent or more of the contract amount was for 
research performed in the United States).
    (c) Social sciences or humanities. Qualified research does not 
include research in the social sciences or humanities. For purposes of 
section 30(d)(2) (as that section read before amendment by the Tax 
Reform Act of 1986) and of this section, the phrase ``research in the 
social sciences or humanities'' encompasses all areas of research other 
than research in a field of laboratory science (such as physics or 
biochemistry), engineering or technology. Examples of research in the 
social sciences or humanities include the development of a new life 
insurance contract, a new economic model or theory, a new accounting 
procedure or a new cookbook.
    (d) Research funded by any grant, contract, or otherwise--(1) In 
general. Research does not constitute qualified research to the extent 
it is funded by any grant, contract, or otherwise by another person 
(including any governmental entity). All agreements (not only research 
contracts) entered into between the taxpayer performing the research and 
other persons shall be considered in determining the extent to which the 
research is funded.

[[Page 183]]

Amounts payable under any agreement that are contingent on the success 
of the research and thus considered to be paid for the product or result 
of the research (see Sec. 1.41-2(e)(2)) are not treated as funding. For 
special rules regarding funding between commonly controlled businesses, 
see Sec. 1.41-6(e).
    (2) Research in which taxpayer retains no rights. If a taxpayer 
performing research for another person retains no substantial rights in 
research under the agreement providing for the research, the research is 
treated as fully funded for purposes of section 41(d)(4)(H), and no 
expenses paid or incurred by the taxpayer in performing the research are 
qualified research expenses. For example, if the taxpayer performs 
research under an agreement that confers on another person the exclusive 
right to exploit the results of the research, the taxpayer is not 
performing qualified research because the research is treated as fully 
funded under this paragraph (d)(2). Incidental benefits to the taxpayer 
from performance of the research (for example, increased experience in a 
field of research) do not constitute substantial rights in the research. 
If a taxpayer performing research for another person retains no 
substantial rights in the research and if the payments to the researcher 
are contingent upon the success of the research, neither the performer 
nor the person paying for the research is entitled to treat any portion 
of the expenditures as qualified research expenditures.
    (3) Research in which the taxpayer retains substantial rights--(i) 
In general. If a taxpayer performing research for another person retains 
substantial rights in the research under the agreement providing for the 
research, the research is funded to the extent of the payments (and fair 
market value of any property) to which the taxpayer becomes entitled by 
performing the research. A taxpayer does not retain substantial rights 
in the research if the taxpayer must pay for the right to use the 
results of the research. Except as otherwise provided in paragraph 
(d)(3)(ii) of this section, the taxpayer shall reduce the amount paid or 
incurred by the taxpayer for the research that would, but for section 
41(d)(4)(H), constitute qualified research expenses of the taxpayer by 
the amount of funding determined under the preceding sentence.
    (ii) Pro rata allocation. If the taxpayer can establish to the 
satisfaction of the district director--
    (A) The total amount of research expenses,
    (B) That the total amount of research expenses exceed the funding, 
and
    (C) That the otherwise qualified research expenses (that is, the 
expenses which would be qualified research expenses if there were no 
funding) exceed 65 percent of the funding, then the taxpayer may 
allocate the funding pro rata to nonqualified and otherwise qualified 
research expenses, rather than allocating it 100 percent to otherwise 
qualified research expenses (as provided in paragraph (d)(3)(i) of this 
section). In no event, however, shall less than 65 percent of the 
funding be applied against the otherwise qualified research expenses.
    (iii) Project-by-project determination. The provisions of this 
paragraph (d)(3) shall be applied separately to each research project 
undertaken by the taxpayer.
    (4) Independent research and development under the Federal 
Acquisition Regulations System and similar provisions. The Federal 
Acquisition Regulations System and similar rules and regulations 
relating to contracts (fixed price, cost plus, etc.) with government 
entities provide for allocation of certain ``independent research and 
development costs'' and ``bid and proposal costs'' of a contractor to 
contracts entered into with that contractor. In general, any 
``independent research and development costs'' and ``bid and proposal 
costs'' paid to a taxpayer by reason of such a contract shall not be 
treated as funding the underlying research activities except to the 
extent the ``independent research and development costs'' and ``bid and 
proposal costs'' are properly severable from the contract. See 
Sec. 1.451-3(e); see also section 804(d)(2) of the Tax Reform Act of 
1986.
    (5) Funding determinable only in subsequent taxable year. If at the 
time the taxpayer files its return for a taxable year, it is impossible 
to determine to

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what extent particular research performed by the taxpayer during that 
year may be funded, then the taxpayer shall treat the research as 
completely funded for purposes of completing that return. When the 
amount of funding is finally determined, the taxpayer should amend the 
return and any interim returns to reflect the proper amount of funding.
    (6) Examples. The following examples illustrate the application of 
the principles contained in this paragraph.

    Example 1. A enters into a contract with B Corporation, a cash-
method taxpayer using the calendar year as its taxable year, under which 
B is to perform research that would, but for section 41(d)(3)(H), be 
qualified research of B. The agreement calls for A to pay B $120x, 
regardless of the outcome of the research. In 1982, A makes full payment 
of $120x under the contract, B performs all the research, and B pays all 
the expenses connected with the research, as follows:

In-house research expenses.....................................    $100x
Outside research:
  (Amount B paid to third parties for research, 65 percent of        40x
   which ($26x) is treated as a contract research expense of B)
Overhead and other expenses....................................      10x
                                                                --------
    Total......................................................     150x
 

    If B has no rights to the research, B is fully funded. 
Alternatively, assume that B retains the right to use the results of the 
research in carrying on B's business. Of B's otherwise qualified 
research expenses of $126x + $26x), $120x is treated as funded by A. 
Thus $6x ($126x - $120x) is treated as a qualified research expense of 
B. However, if B establishes the facts required under paragraph (d)(3) 
of this section, B can allocate the funding pro rata to nonqualified and 
otherwise qualified research expenses. Thus $100.8x ($120x ($126x/
$150x)) would be allocated to otherwise qualified research expenses. B's 
qualified research expenses would be $25.2x ($126x - $100.8x). For 
purposes of the following examples (2), (3) and (4) assume that B 
retains substantial rights to use the results of the research in 
carrying on B's business.
    Example 2. The facts are the same as in example (1) (assuming that B 
retains the right to use the results of the research in carrying on B's 
business) except that, although A makes full payment of $120x during 
1982, B does not perform the research or pay the associated expenses 
until 1983. The computations are unchanged. However, B's qualified 
research expenses determined in example (1) are qualified research 
expenses during 1983.
    Example 3. The facts are the same as in example (1) (assuming that B 
retains the right to use the results of the research in carrying on B's 
business) except that, although B performs the research and pays the 
associated expenses during 1982, A does not pay the $120x until 1983. 
The computations are unchanged and the amount determined in example (1) 
is a qualified research expense of B during 1982.
    Example 4. The facts are the same as in example (1) (assuming that B 
retains the right to use the results of the research in carrying on B's 
business) except that, instead of agreeing to pay B $120x, A agrees to 
pay $100x regardless of the outcome and an additional $20x only if B's 
research produces a useful product. B's research produces a useful 
product and A pays B $120x during 1982. The $20x payment that is 
conditional on the success of the research is not treated as funding. 
Assuming that B establishes to the satisfaction of the district director 
the actual research expenses, B can allocate the funding to nonqualified 
and otherwise qualified research expenses. Thus $84x ($100x ($126x/
$150x)) would be allocated to otherwise qualified research expenses. B's 
qualified research expenses would be $42x ($126x - $84x).
    Example 5. C enters into a contract with D, a cash-method taxpayer 
using the calendar year as its taxable year, under which D is to perform 
research in which both C and D will have substantial rights. C agrees to 
reimburse D for 80 percent of D's expenses for the research. D performs 
part of the research in 1982 and the rest in 1983. At the time that D 
files its return for 1982, D is unable to determine the extent to which 
the research is funded under the provisions of this paragraph. Under 
these circumstances, D may not treat any of the expenses paid by D for 
this research during 1982 as qualified research expenses on its 1982 
return. When the project is complete and D can determine the extent of 
funding, D should file an amended return for 1982 to take into account 
any qualified research expense for 1982.

[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated and amended by T.D. 
8930, 66 FR 295, Jan. 3, 2001]



Sec. 1.41-5  Basic research for taxable years beginning after 
December 31, 1986. [Reserved]



Sec. 1.41-5A  Basic research for taxable years beginning before 
January 1, 1987.

    (a) In general. The amount expended for basic research within the 
meaning of section 30(e) (before amended by the Tax Reform Act of 1986) 
equals the sum of money plus the taxpayer's basis in tangible property 
(other than land)

[[Page 185]]

transferred for use in the performance of basic research.
    (b) Trade or business requirement. Any amount treated as a contract 
research expense under section 30(e) (before amendment by the Tax Reform 
Act of 1986) shall be deemed to have been paid or incurred in carrying 
on a trade or business, if the corporation that paid or incurred the 
expenses is actually engaged in carrying on some trade or business.
    (c) Prepaid amounts--(1) In general. If any basic research expense 
paid or incurred during any taxable year is attributable to research to 
be conducted after the close of such taxable year, the expense so 
attributable shall be treated for purposes of section 30(b)(1)(B) 
(before amendment by the Tax Reform Act of 1986) as paid or incurred 
during the period in which the basic research is conducted.
    (2) Transfers of property. In the case of transfers of property to 
be used in the performance of basic research, the research in which that 
property is to be used shall be considered to be conducted ratably over 
a period beginning on the day the property is first so used and 
continuing for the number of years provided with respect to property of 
that class under section 168(c)(2) (before amendment by the Tax Reform 
Act of 1986). For example, if an item of property which is 3-year 
property under section 168(c) is transferred to a university for basic 
research on January 12, 1983, and is first so used by the university on 
March 1, 1983, then the research in which that property is used is 
considered to be conducted ratably from March 1, 1983, through February 
28, 1986.
    (d) Written research agreement--(1) In general. A written research 
agreement must be entered into prior to the performance of the basic 
research.
    (2) Agreement between a corporation and a qualified organization 
after June 30, 1983--(i) In general. A written research agreement 
between a corporation and a qualified organization (including a 
qualified fund) entered into after June 30, 1983, shall provide that the 
organization shall inform the corporation within 60 days after the close 
of each taxable year of the corporation what amount of funds provided by 
the corporation pursuant to the agreement was expended on basic research 
during the taxable year of the corporation. In determining amounts 
expended on basic research, the qualified organization shall take into 
account the exclusions specified in section 30(e)(3) (before amendment 
by the Tax Reform Act of 1986) and in paragraph (e) of this section.
    (ii) Transfers of property. In the case of transfers of property to 
be used in basic research, the agreement shall provide that 
substantially all use of the property is to be for basic research, as 
defined in section 30(e)(3) (before amendment by the Tax Reform Act of 
1986).
    (3) Agreement between a qualified fund and a qualified educational 
organization after June 30, 1983. A written research agreement between a 
qualified fund and a qualified educational organization (see section 
30(e)(4)(B)(iii) (before amendment by the Tax Reform Act of 1986)) 
entered into after June 30, 1983, shall provide that the qualified 
educational organization shall furnish sufficient information to the 
qualified fund to enable the qualified fund to comply with the written 
research agreements it has entered into with grantor corporations, 
including the requirement set forth in paragraph (d)(2) of this section.
    (e) Exclusions--(1) Research conducted outside the United States. If 
a taxpayer pays or incurs an amount for basic research to be performed 
partly within the United States and partly without, only 65 percent of 
the portion of the amount attributable to research performed within the 
United States can be treated as a contract research expense (even if 80 
percent or more of the contract amount was for basic research performed 
in the United States).
    (2) Research in the social sciences or humanities. Basic research 
does not include research in the social sciences or humanities, within 
the meaning of Sec. 1.41-4A(c).
    (f) Procedure for making an election to be treated as a qualified 
fund. In order to make an election to be treated as a qualified fund 
within the meaning of section 30(e)(4)(B)(iii) (before amendment by the 
Tax Reform Act of 1986) or as an organization described in section

[[Page 186]]

41(e)(6)(D), the organization shall file with the Internal Revenue 
Service center with which it files its annual return a statement that--
    (1) Sets out the name, address, and taxpayer identification number 
of the electing organization (the ``taxpayer'') and of the organization 
that established and maintains the electing organization (the 
``controlling organization''),
    (2) Identifies the election as an election under section 41(e)(6)(D) 
of the Code,
    (3) Affirms that the controlling organization and the taxpayer are 
section 501(c)(3) organizations,
    (4) Provides that the taxpayer elects to be treated as a private 
foundation for all Code purposes other than section 4940,
    (5) Affirms that the taxpayer satisfies the requirement of section 
41(e)(6)(D)(iii), and
    (6) Specifies the date on which the election is to become effective.

If an election to be treated as a qualified fund is filed before 
February 1, 1982, the election may be made effective as of any date 
after June 30, 1981, and before January 1, 1986. If an election is filed 
on or after February 1, 1982, the election may be made effective as of 
any date on or after the date on which the election is filed.

[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated and amended by T.D. 
8930, 66 FR 295, Jan. 3, 2001]



Sec. 1.41-6  Aggregation of expenditures.

    (a) Controlled group of corporations; trades or businesses under 
common control--(1) In general. To determine the amount of research 
credit (if any) allowable to a trade or business that at the end of its 
taxable year is a member of a controlled group, a taxpayer must--
    (i) Compute the group credit in the manner described in paragraph 
(b) of this section; and
    (ii) Allocate the group credit among the members of the group in the 
manner described in paragraph (c) of this section.
    (2) Consolidated groups. For special rules relating to consolidated 
groups, see paragraph (d) of this section.
    (3) Definitions. For purposes of this section--
    (i) Consolidated group has the meaning set forth in Sec. 1.1502-
1(h).
    (ii) Controlled group and group mean a controlled group of 
corporations, as defined in section 41(f)(5), or a group of trades or 
businesses under common control. For rules for determining whether 
trades or businesses are under common control, see Sec. 1.52-1 (b) 
through (g).
    (iii) Credit year means the taxable year for which the member is 
computing the credit.
    (iv) Group credit means the research credit (if any) allowable to a 
controlled group.
    (v) Trade or business means a sole proprietorship, a partnership, a 
trust, an estate, or a corporation that is carrying on a trade or 
business (within the meaning of section 162). Any corporation that is a 
member of a commonly controlled group shall be deemed to be carrying on 
a trade or business if any other member of that group is carrying on any 
trade or business.
    (b) Computation of the group credit--(1) In general. All members of 
a controlled group are treated as a single taxpayer for purposes of 
computing the research credit. The group credit is compute2d by applying 
all of the section 41 computational rules on an aggregate basis. All 
members of a controlled group must use the same method of computation: 
The method described in section 41(a)(1), the alternative incremental 
credit (AIRC) method described in section 41(c)(4) (available for years 
beginning on or before December 31, 2008), or the alternative simplified 
credit (ASC) method described in section 41(c)(5), in computing the 
group credit for a credit year.
    (2) Start-up companies--(i) In general. For purposes of computing 
the group credit, a controlled group is treated as a start-up company 
for purposes of section 41(c)(3)(B)(i) if--
    (A) There was no taxable year beginning before January 1, 1984, in 
which a member of the group had gross receipts and either the same 
member or another member also had qualified research expenditures 
(QREs); or
    (B) There were fewer than three taxable years beginning after 
December 31,

[[Page 187]]

1983, and before January 1, 1989, in which a member of the group had 
gross receipts and either the same member or another member also had 
QREs.
    (ii) Example. The following example illustrates the principles of 
paragraph (b)(2)(i) of this section:

    Example. A, B, and C, all of which are calendar year taxpayers, are 
members of a controlled group. During the 1983 taxable year, A had QREs, 
but no gross receipts; B had gross receipts, but no QREs; and C had no 
QREs or gross receipts. The 1984 taxable year was the first taxable year 
for which each of A, B, and C had both QREs and gross receipts. A, B, 
and C had both QREs and gross receipts in 1985, 1986, 1987, and 1988. 
Because the first taxable year for which each of A, B, and C had both 
QREs and gross receipts began after December 31, 1983, each of A, B, and 
C is a start-up company under section 41(c)(3)(B)(i) and each is a 
start-up company for purposes of computing the stand-alone entity 
credit. During the 1983 taxable year, at least one member of the group, 
A, had QREs and at least one member of the group, B, had gross receipts, 
thus, the group had both QREs and gross receipts in 1983. Therefore, the 
controlled group is not a start-up company because the first taxable 
year for which the group had both QREs and gross receipts did not begin 
after December 31, 1983, and there were not fewer than three taxable 
years beginning after December 31, 1983, and before January 1, 1989, in 
which a member of the group had gross receipts and QREs.

    (iii) First taxable year after December 31, 1993, for which the 
controlled group had QREs. In the case of a controlled group that is 
treated as a start-up company under section 41(c)(3)(B)(i) and paragraph 
(b)(2)(i) of this section, for purposes of determining the group's 
fixed-base percentage under section 41(c)(3)(B)(ii), the first taxable 
year after December 31, 1993, for which the group has QREs is the first 
taxable year in which at least one member of the group has QREs.
    (iv) Example. The following example illustrates the principles of 
paragraph (b)(2)(iii) of this section:

    Example. D, E, and F, all of which are calendar year taxpayers, are 
members of a controlled group. The group is treated as a start-up 
company under section 41(c)(3)(B)(i) and paragraph (b)(2)(i) of this 
section. The first taxable year after December 31, 1993, for which D had 
QREs was 1994. The first taxable year after December 31, 1993, for which 
E had QREs was 1995. The first taxable year after December 31, 1993, for 
which F had QREs was 1996. Because the 1994 taxable year was the first 
taxable year after December 31, 1993, for which at least one member of 
the group, D, had QREs, for purposes of determining the group's fixed-
based percentage under section 41(c)(3)(B)(ii), the 1994 taxable year 
was the first taxable year after December 31, 1993, for which the group 
had QREs.

    (c) [Reserved]. For further guidance, see Sec. 1.41-6T(c).
    (d) Special rules for consolidated groups--(1) [Reserved]. For 
further guidance, see Sec. 1.41-6T(d)(1).
    (2) Start-up company status. A consolidated group's status as a 
start-up company and the first taxable year after December 31, 1993, for 
which a consolidated group has QREs are determined in accordance with 
the principles of paragraph (b)(2) of this section.
    (3) [Reserved]. For further guidance, see Sec. 1.41-6T(d)(3).
    (e) [Reserved]. For further guidance, see Sec. 1.41-6T(e).
    (f) For taxable years beginning before January 1, 1990. For taxable 
years beginning before January 1, 1990, see Sec. 1.41-6 as contained in 
26 CFR part 1, revised April 1, 2005.
    (g) Tax accounting periods used--(1) In general. The credit 
allowable to a member of a controlled group is that member's share of 
the group credit computed as of the end of that member's taxable year. 
In computing the group credit for a group whose members have different 
taxable years, a member generally should treat the taxable year of 
another member that ends with or within the credit year of the computing 
member as the credit year of that other member. For example, Q, R, and S 
are members of a controlled group of corporations. Both Q and R are 
calendar year taxpayers. S files a return using a fiscal year ending 
June 30. For purposes of computing the group credit at the end of Q's 
and R's taxable year on December 31, S's fiscal year ending June 30, 
which ends within Q's and R's taxable year, is treated as S's credit 
year.
    (2) Special rule when timing of research is manipulated. If the 
timing of research by members using different tax accounting periods is 
manipulated to generate a credit in excess of the amount that would be 
allowable if all members of the group used the same

[[Page 188]]

tax accounting period, then the appropriate Internal Revenue Service 
official in the operating division that has examination jurisdiction of 
the return may require each member of the group to calculate the credit 
in the current taxable year and all future years as if all members of 
the group had the same taxable year and base period as the computing 
member.
    (h) Membership during taxable year in more than one group. A trade 
or business may be a member of only one group for a taxable year. If, 
without application of this paragraph, a business would be a member of 
more than one group at the end of its taxable year, the business shall 
be treated as a member of the group in which it was included for its 
preceding taxable year. If the business was not included for its 
preceding taxable year in any group in which it could be included as of 
the end of its taxable year, the business shall designate in its timely 
filed (including extensions) return the group in which it is being 
included. If the return for a taxable year is due before July 1, 1983, 
the business may designate its group membership through an amended 
return for that year filed on or before June 30, 1983. If the business 
does not so designate, then the appropriate Internal Revenue Service 
official in the operating division that has examination jurisdiction of 
the return will determine the group in which the business is to be 
included.
    (i) Intra-group transactions--(1) In general. Because all members of 
a group under common control are treated as a single taxpayer for 
purposes of determining the research credit, transfers between members 
of the group are generally disregarded.
    (2) In-house research expenses. If one member of a group performs 
qualified research on behalf of another member, the member performing 
the research shall include in its QREs any in-house research expenses 
for that work and shall not treat any amount received or accrued as 
funding the research. Conversely, the member for whom the research is 
performed shall not treat any part of any amount paid or incurred as a 
contract research expense. For purposes of determining whether the in-
house research for that work is qualified research, the member 
performing the research shall be treated as carrying on any trade or 
business carried on by the member on whose behalf the research is 
performed.
    (3) Contract research expenses. If a member of a group pays or 
incurs contract research expenses to a person outside the group in 
carrying on the member's trade or business, that member shall include 
those expenses as QREs. However, if the expenses are not paid or 
incurred in carrying on any trade or business of that member, those 
expenses may be taken into account as contract research expenses by 
another member of the group provided that the other member--
    (i) Reimburses the member paying or incurring the expenses; and
    (ii) Carries on a trade or business to which the research relates.
    (4) Lease payments. The amount paid or incurred to another member of 
the group for the lease of personal property owned by a member of the 
group is not taken into account for purposes of section 41. Amounts paid 
or incurred to another member of the group for the lease of personal 
property owned by a person outside the group shall be taken into account 
as in-house research expenses for purposes of section 41 only to the 
extent of the lesser of--
    (i) The amount paid or incurred to the other member; or
    (ii) The amount of the lease expenses paid to the person outside the 
group.
    (5) Payment for supplies. Amounts paid or incurred to another member 
of the group for supplies shall be taken into account as in-house 
research expenses for purposes of section 41 only to the extent of the 
lesser of--
    (i) The amount paid or incurred to the other member; or
    (ii) The amount of the other member's basis in the supplies.
    (j) Effective/applicability dates--(1) In general. Except for 
paragraph (d) of this section, these regulations are applicable for 
taxable years ending on or after May 24, 2005. Generally, a taxpayer may 
use any reasonable method of computing and allocating the credit 
(including use of the consolidated group rule contained in paragraph (d)

[[Page 189]]

of this section) for taxable years ending before May 24, 2005. However, 
paragraph (b) of this section, relating to the computation of the group 
credit, and paragraph (c) of this section, relating to the allocation of 
the group credit, (applied without regard to paragraph (d) of this 
section) will apply to taxable years ending on or after December 29, 
1999, if the members of a controlled group, as a whole, claimed more 
than 100 percent of the amount that would be allowable under paragraph 
(b) of this section. In the case of a controlled group whose members 
have different taxable years and whose members use inconsistent methods 
of allocation, the members of the controlled group shall be deemed to 
have, as a whole, claimed more than 100 percent of the amount that would 
be allowable under paragraph (b) of this section.
    (2) Consolidated group rule. Paragraph (d) of this section is 
applicable for taxable years ending on or after November 9, 2006. For 
taxable years ending on or after May 24, 2005, and before November 9, 
2006, see Sec. 1.41-6T(d) as contained in 26 CFR part 1, revised April 
1, 2006.
    (3) Taxable years ending after June 9, 2011. Paragraphs (b)(1), 
(c)(2), and (e) of this section are applicable for taxable years ending 
after June 9, 2011. For taxable years ending on or before June 9, 2011, 
see Secs. 1.41-6T and 1.41-6 as contained in 26 CFR part 1, revised 
April 1, 2011.
    (4) Taxable years beginning after December 31, 2011. [Reserved]. For 
further guidance, see Sec. 1.41-6T(j)(4).
    (5) Taxable years ending before January 1, 2012. [Reserved]. For 
further guidance, see Sec. 1.41-6T(j)(5).

[T.D. 9296, 71 FR 65725, Nov. 9, 2006; 71 FR 70875, Dec. 7, 2006; 71 FR 
75614, Dec. 15, 2006; T.D. 9401, 73 FR 34188, June 17, 2008; T.D. 9528, 
76 FR 33995, June 10, 2011; T.D. 9717, 80 FR 18098, Apr. 3, 2015]



Sec. 1.41-6T.  Aggregation of expenditures (temporary).

    (a) through (b) [Reserved]. For further guidance, see Sec. 1.41-6(a) 
through (b).
    (c) Allocation of the group credit. The group credit is allocated to 
each member of the controlled group on a proportionate basis to its 
share of the aggregate of the qualified research expenses, basic 
research payments, and amounts paid or incurred to energy research 
consortiums (collectively ``QREs'' for purposes of paragraphs (c), (d), 
and (e) of this section) taken into account for the taxable year by such 
controlled group for purposes of the credit.
    (d) Special rules for consolidated groups--(1) In general. For 
purposes of applying paragraph (c) of this section, members of a 
consolidated group who are members of a controlled group are treated as 
a single member of the controlled group.
    (2) [Reserved]. For further guidance, see Sec. 1.41-6(d)(2).
    (3) Special rule for allocation of group credit among consolidated 
group members. The portion of the group credit that is allocated to a 
consolidated group is allocated to each member of the consolidated group 
on a proportionate basis to its share of the aggregate of the QREs taken 
into account for the taxable year by such consolidated group for 
purposes of the credit.
    (e) Examples. The following examples illustrate the provisions of 
paragraphs (c) and (d) of this section.

    Example 1. Controlled group. A, B, and C are a controlled group. A 
had $100x, B $300x, and C $500x of qualified research expenses for the 
year, totaling $900x for the group. A, in the course of its trade or 
business, also made a payment of $100x to an energy research consortium 
for energy research. The group's QREs total 1000x and the group 
calculated its total research credit to be $60x for the year. Based on 
each member's proportionate share of the controlled group's aggregate 
QREs, A is allocated $12x, B $18x, and C $30x of the credit.
    Example 2. Consolidated group is a member of controlled group. The 
controlled group's members are D, E, F, G, and H. F, G, and H file a 
consolidated return and are treated as a single member (FGH) of the 
controlled group. D had $240x, E $360x, and FGH $600x of qualified 
research expenses for the year ($1,200x aggregate). The group calculated 
its research credit to be $100x for the year. Based on the proportion of 
each member's share of QREs to the controlled group's aggregate QREs for 
the taxable year D is allocated $20x, E $30x, and FGH $50x of the 
credit. The $50x of credit allocated to FGH is then allocated to the 
consolidated group members based on the proportion of each consolidated 
group member's share of QREs to the consolidated group's aggregate QREs. 
F had $120x, G $240x, and H $240x of QREs for

[[Page 190]]

the year. Therefore, F is allocated $10x, G is allocated $20x, and H is 
allocated $20x.

    (f) through (i) [Reserved]. For further guidance, see Sec. 1.41-6(f) 
through (i).
    (j)(1) through (3) [Reserved]. For further guidance, see Sec. 1.41-
6(j)(1) through (3).
    (4) Taxable years beginning after December 31, 2011. Section 1.41-6T 
is applicable for taxable years beginning on or after April 3, 2015. 
Taxpayers may apply Sec. 1.41-6T to taxable years beginning after 
December 31, 2011, but before April 3, 2015. For a taxpayer that does 
not apply Sec. 1.41-6T to a taxable year beginning after December 31, 
2011, but before April 3, 2015, the guidance that applies to such 
taxable year is contained in Notice 2013-20 (2013-15 IRB 902).
    (5) Taxable years beginning before January 1, 2012. See Sec. 1.41-6 
as contained in 26 CFR part 1, revised April 1, 2014.
    (6) Expiration date. The applicability of Sec. 1.41-6T expires on 
April 2, 2018.

[T.D. 9717, 80 FR 18098, Apr. 3, 2015]



Sec. 1.41-7  Special rules.

    (a) Allocations--(1) Corporation making an election under subchapter 
S--(i) Pass-through, for taxable years beginning after December 31, 
1982, in the case of an S corporation. In the case of an S corporation 
(as defined in section 1361) the amount of research credit computed for 
the corporation shall be allocated to the shareholders according to the 
provisions of section 1366 and section 1377.
    (ii) Pass-through, for taxable years beginning before January 1, 
1983, in the case of a subchapter S corporation. In the case of an 
electing small business corporation (as defined in section 1371 as that 
section read before the amendments made by the subchapter S Revision Act 
of 1982), the amount of the research credit computed for the corporation 
for any taxable year shall be apportioned pro rata among the persons who 
are shareholders of the corporation on the last day of the corporation's 
taxable year.
    (2) Pass-through in the case of an estate or trust. In the case of 
an estate or trust, the amount of the research credit computed for the 
estate or trust for any taxable year shall be apportioned among the 
estate or trust and the beneficiaries on the basis of the income of the 
estate or trust allocable to each.
    (3) Pass-through in the case of a partnership--(i) In general. In 
the case of a partnership, the research credit computed for the 
partnership for any taxable year shall be apportioned among the persons 
who are partners during the taxable year in accordance with section 704 
and the regulations thereunder. See, for example, Sec. 1.704-
1(b)(4)(ii). Because the research credit is an expenditure-based credit, 
the credit is to be allocated among the partners in the same proportion 
as section 174 expenditures are allocated for the year.
    (ii) Certain expenditures by joint ventures. Research expenses to 
which Sec. 1.41-2(a)(4)(ii) applies shall be apportioned among the 
persons who are partners during the taxable year in accordance with the 
provisions of that section. For purposes of section 41, these expenses 
shall be treated as paid or incurred directly by the partners rather 
than by the partnership. Thus, the partnership shall disregard these 
expenses in computing the credit to be apportioned under paragraph 
(a)(3)(i) of this section, and in making the computations under section 
41 each partner shall aggregate its distributive share of these expenses 
with other research expenses of the partner. The limitation on the 
amount of the credit set out in section 41(g) and in paragraph (c) of 
this section shall not apply because the credit is computed by the 
partner, not the partnership.
    (4) Year in which taken into account. An amount apportioned to a 
person under this paragraph shall be taken into account by the person in 
the taxable year of such person which or within which the taxable year 
of the corporation, estate, trust, or partnership (as the case may be) 
ends.
    (5) Credit allowed subject to limitation. The credit allowable to 
any person to whom any amount has been apportioned under paragraph 
(a)(1), (2) or (3)(i) of this section is subject to section 41(g) and 
sections 38 and 39 of the Code, if applicable.
    (b) Adjustments for certain acquisitions and dispositions--Meaning 
of terms. For the meaning of ``acquisition,'' ``separate unit,'' and 
``major portion,'' see

[[Page 191]]

paragraph (b) of Sec. 1.52-2. An ``acquisition'' includes an 
incorporation or a liquidation.
    (c) Special rule for pass-through of credit. The special rule 
contained in section 41(g) for the pass-through of the credit in the 
case of an individual who owns an interest in an unincorporated trade or 
business, is a partner in a partnership, is a beneficiary of an estate 
or trust, or is a shareholder in an S corporation shall be applied in 
accordance with the principles set forth in Sec. 1.53-3.
    (d) Carryback and carryover of unused credits. The taxpayer to whom 
the credit is passed through under paragraph (c) of this section shall 
not be prevented from applying the unused portion in a carryback or 
carryover year merely because the entity that earned the credit changes 
its form of conducting business.

[T.D. 8251, 54 FR 21204, May 17, 1989. Redesignated by T.D. 8930, 66 FR 
295, Jan. 3, 2001]



Sec. 1.41-8  Alternative incremental credit applicable for taxable years 
beginning on or before December 31, 2008.

    (a) Determination of credit. At the election of the taxpayer, the 
credit determined under section 41(a)(1) equals the amount determined 
under section 41(c)(4).
    (b) Election--(1) In general. A taxpayer may elect to apply the 
provisions of the alternative incremental research credit (AIRC) in 
section 41(c)(4) for any taxable year of the taxpayer beginning after 
June 30, 1996. If a taxpayer makes an election under section 41(c)(4), 
the election applies to the taxable year for which made and all 
subsequent taxable years unless revoked in the manner prescribed in 
paragraph (b)(3) of this section.
    (2) Time and manner of election. An election under section 41(c)(4) 
is made by completing the portion of Form 6765, ``Credit for Increasing 
Research Activities,'' (or successor form) relating to the election of 
the AIRC, and attaching the completed form to the taxpayer's timely 
filed (including extensions) original return for the taxable year to 
which the election applies. An election under section 41(c)(4) may not 
be made on an amended return. An extension of time to make an election 
under section 41(c)(4) will not be granted under Sec. 301.9100-3 of this 
chapter.
    (3) Revocation. An election under this section may not be revoked 
except with the consent of the Commissioner. A taxpayer is deemed to 
have requested, and to have been granted, the consent of the 
Commissioner to revoke an election under section 41(c)(4) if the 
taxpayer completes the portion of Form 6765, ``Credit For Increasing 
Research Activities,'' (or successor form) relating to the amount 
determined under section 41(a)(1) (the regular credit) or the 
alternative simplified credit (ASC) and attaches the completed form to 
the taxpayer's timely filed (including extensions) original return for 
the year to which the revocation applies. An election under section 
41(c)(4) may not be revoked on an amended return. An extension of time 
to revoke an election under section 41(c)(4) will not be granted under 
Sec. 301.9100-3 of this chapter.
    (4) Special rules for controlled groups--(i) In general. In the case 
of a controlled group of corporations, all the members of which are not 
included on a single consolidated return, an election (or revocation) 
must be made by the designated member by satisfying the requirements of 
paragraph (b)(2) or (b)(3) of this section (whichever applies), and such 
election (or revocation) by the designated member shall be binding on 
all the members of the group for the credit year to which the election 
(or revocation) relates. If the designated member fails to timely make 
(or revoke) an election, each member of the group must compute the group 
credit using the method used to compute the group credit for the 
immediately preceding credit year.
    (ii) Designated member. For purposes of this paragraph (b)(4), for 
any credit year, the term designated member means that member of the 
group that is allocated the greatest amount of the group credit under 
Sec. 1.41-6(c) based on the amount of credit reported on the taxpayer's 
timely filed (including extensions) original Federal income tax return 
(even if that member subsequently is determined not to be the designated 
member). If the members of a group compute the group credit using

[[Page 192]]

different methods (the method described in section 41(a)(1), the AIRC 
method of section 41(c)(4) (available for years beginning on or before 
December 31, 2008), or the ASC method of section 41(c)(5)) and at least 
two members of the group qualify as the designated member, then the term 
designated member means that member that computes the group credit using 
the method that yields the greatest group credit. For example, A, B, C, 
and D are members of a controlled group but are not members of a 
consolidated group. For the 2008 taxable year (the credit year), the 
group credit using the method described in section 41(a)(1) is $10x. 
Under this method, A would be allocated $5x of the group credit, which 
would be the largest share of the group credit under this method. For 
the credit year, the group credit using the AIRC method is $15x. Under 
the AIRC method, B would be allocated $5x of the group credit, which is 
the largest share of the group credit computed using the AIRC method. 
For the credit year, the group credit using the ASC method is $10x. 
Under the ASC method, C would be allocated $5x of the group credit, 
which is the largest share of the group credit computed using the ASC 
method. Because the group credit is greatest using the AIRC method and B 
is allocated the greatest amount of credit under that method, B is the 
designated member. Therefore, if B makes a section 41(c)(4) election on 
its original timely filed return for the credit year, that election is 
binding on all members of the group for the credit year.
    (5) Effective/applicability dates. This section is applicable for 
taxable years ending after June 9, 2011. For taxable years ending on or 
before June 9, 2011, see Secs. 1.41-8 and 1.41-8T, as contained in 26 
CFR part 1, revised April 1, 2011.

[T.D. 9296, 71 FR 65732, Nov. 9, 2006; 71 FR 70875, Dec. 7, 2006, as 
amended by T.D. 9401, 73 FR 34189, June 17, 2008; T.D. 9528, 76 FR 
33996, June 10, 2011]



Sec. 1.41-9  Alternative simplified credit.

    (a) Determination of credit. At the election of the taxpayer, the 
credit determined under section 41(a)(1) equals the amount determined 
under section 41(c)(5).
    (b) Election--(1) In general. A taxpayer may elect to apply the 
provisions of the alternative simplified credit (ASC) in section 
41(c)(5) for any taxable year of the taxpayer ending after December 31, 
2006. If a taxpayer makes an election under section 41(c)(5), the 
election applies to the taxable year for which made and all subsequent 
taxable years unless revoked in the manner prescribed in paragraph 
(b)(3) of this section.
    (2) Time and manner of election. A taxpayer makes an election under 
section 41(c)(5) by completing the portion of Form 6765, ``Credit for 
Increasing Research Activities,'' (or successor form) relating to the 
election of the ASC, and attaching the completed form to the taxpayer's 
timely filed (including extensions) original return for the taxable year 
to which the election applies. A taxpayer may make an election under 
section 41(c)(5) for a tax year on an amended return, but only if the 
taxpayer has not previously claimed a section 41(a)(1) credit on its 
original return or an amended return for that tax year, and only if that 
tax year is not closed by the period of limitations on assessment under 
section 6501(a). An extension of time to make an election under section 
41(c)(5) will not be granted under Sec. 301.9100-3 of this chapter. A 
taxpayer that is a member of a controlled group in a tax year may not 
make an election under section 41(c)(5) for that tax year on an amended 
return if any member of the controlled group for that tax year 
previously claimed the research credit under section 41(a)(1) using a 
method other than the ASC on an original or amended return for that tax 
year. See paragraph (b)(4) of this section for additional rules 
concerning controlled groups. See also Sec. 1.41-6(b)(1) requiring that 
all members of the controlled group use the same method of computation.
    (3) Revocation. An election under this section may not be revoked 
except with the consent of the Commissioner. A taxpayer is deemed to 
have requested, and to have been granted, the consent of the 
Commissioner to revoke an election under section 41(c)(5) if the 
taxpayer completes the portion of Form 6765 (or successor form) relating 
to the credit determined under section

[[Page 193]]

41(a)(1) (the regular credit) or the alternative incremental credit 
(AIRC) and attaches the completed form to the taxpayer's timely filed 
(including extensions) original return for the year to which the 
revocation applies. An election under section 41(c)(5) may not be 
revoked on an amended return. An extension of time to revoke an election 
under section 41(c)(5) will not be granted under Sec. 301.9100-3 of this 
chapter.
    (4) Special rules for controlled groups--(i) In general. In the case 
of a controlled group of corporations, all the members of which are not 
included on a single consolidated return, an election (or revocation) 
must be made by the designated member by satisfying the requirements of 
paragraphs (b)(2) or (b)(3) of this section (whichever applies), and 
such election (or revocation) by the designated member shall be binding 
on all the members of the group for the credit year to which the 
election (or revocation) relates. If the designated member fails to 
timely make (or revoke) an election, each member of the group must 
compute the group credit using the method used to compute the group 
credit for the immediately preceding credit year.
    (ii) Designated member. For purposes of this paragraph (b)(4), for 
any credit year, the term designated member means that member of the 
group that is allocated the greatest amount of the group credit under 
Sec. 1.41-6(c) based on the amount of credit reported on the taxpayer's 
timely filed (including extensions) original Federal income tax return 
(even if that member subsequently is determined not to be the designated 
member). If the members of a group compute the group credit using 
different methods (the method described in section 41(a)(1), the AIRC 
method of section 41(c)(4), or the ASC method of section 41(c)(5)) and 
at least two members of the group qualify as the designated member, then 
the term designated member means that member that computes the group 
credit using the method that yields the greatest group credit. For 
example, A, B, C, and D are members of a controlled group but are not 
members of a consolidated group. For the 2011 taxable year (the credit 
year), the group credit using the method described in section 41(a)(1) 
is $10x. Under this method, A would be allocated $5x of the group 
credit, which would be the largest share of the group credit under this 
method. For the credit year, the group credit using the ASC method is 
$15x. Under the ASC method, C would be allocated $5x of the group 
credit, which is the largest share of the group credit computed using 
the ASC method. Because the group credit is greatest using the ASC 
method and C is allocated the greatest amount of credit under that 
method, C is the designated member. Therefore, if C makes a section 
41(c)(5) election on its timely filed (including extensions) original 
return for the credit year, that election is binding on all members of 
the group for the credit year.
    (c) Special rules--(1) Qualified research expenses (QREs) required 
in all years. Unless a taxpayer has QREs in each of the three taxable 
years preceding the taxable year for which the credit is being 
determined, the credit equals that percentage of the QREs for the 
taxable year provided by section 41(c)(5)(B)(ii).
    (2) Section 41(c)(6) applicability. QREs for the three taxable years 
preceding the credit year must be determined on a basis consistent with 
the definition of QREs for the credit year, without regard to the law in 
effect for the three taxable years preceding the credit year. This 
consistency requirement applies even if the period for filing a claim 
for credit or refund has expired for any of the three taxable years 
preceding the credit year.
    (3) Short taxable years--(i) General rule. If one or more of the 
three taxable years preceding the credit year is a short taxable year, 
then the QREs for such year are deemed to be equal to the QREs actually 
paid or incurred in that year multiplied by 365 and divided by the 
number of days in that year. If a credit year is a short taxable year, 
then the average QREs for the three taxable years preceding the credit 
year are modified by multiplying that amount by the number of days in 
the short taxable year and dividing the result by 365.
    (ii) Limited exception. Returns filed for taxable years ending after 
December 31, 2006, and before June 9, 2011, and for which the period of 
limitations has

[[Page 194]]

not expired, may be amended to apply the daily calculation for short 
taxable years provided in paragraph (3)(i) of this section in lieu of 
the monthly calculation for short taxable years provided in Sec. 1.41-
9T(c)(4).
    (4) Controlled groups. For purposes of computing the group credit 
under Sec. 1.41-6, a controlled group must apply the rules of this 
paragraph (c) on an aggregate basis. For example, if the controlled 
group has QREs in each of the three taxable years preceding the taxable 
year for which the credit is being determined, the controlled group 
applies the credit computation provided by section 41(c)(5)(A) rather 
than section 41(c)(5)(B)(ii).
    (d) Effective/applicability dates. This section is applicable for 
taxable years ending after June 9, 2011. For taxable years ending on or 
before June 9, 2011, see Sec. 1.41-9T as contained in 26 CFR part 1, 
revised April 1, 2011. Paragraph (b)(2) of this section applies to 
elections with respect to taxable years ending on or after February 27, 
2015. For taxable years ending before February 27, 2015, see Sec. 1.41-
9T as contained in 26 CFR part 1, revised April 1, 2015.

[T.D. 9528, 76 FR 33996, June 10, 2011, as amended by T.D. 9666, 79 FR 
31864, June 3, 2014; T.D. 9712, 80 FR 10589, Feb. 27, 2015]



Sec. 1.42-0  Table of contents.

    This section lists the paragraphs contained in Secs. 1.42-1 through 
1.42-18 and Sec. 1.42-1T.
Sec. 1.42-1  Limitation on low-income housing credit allowed with 
          respect to qualified low-income buildings receiving housing 
          credit allocations from a State or local housing credit 
          agency.

    (a) through (g) [Reserved]
    (h) Filing of forms.
    (i) [Reserved]
    (j) Effective dates.

Sec. 1.42-1T  Limitation on low-income housing credit allowed with 
          respect to qualified low income buildings receiving housing 
          credit allocations from a State or local housing credit agency 
          (temporary).

    (a) In general.
    (1) Determination of amount of low-income housing credit.
    (2) Limitation on low-income housing credit allowed.
    (b) The State housing credit ceiling.
    (c) Apportionment of State housing credit ceiling among State and 
local housing credit agencies.
    (1) In general.
    (2) Primary apportionment.
    (3) States with 1 or more constitutional home rule cities.
    (i) In general.
    (ii) Amount of apportionment to a constitutional home rule city.
    (iii) Effect of apportionment to constitutional home rule cities on 
apportionment to other housing credit agencies.
    (iv) Treatment of governmental authority within constitutional home 
rule city.
    (4) Apportionment to local housing credit agencies.
    (i) In general.
    (ii) Change in apportionment during a calendar year.
    (iii) Exchanges of apportionments.
    (iv) Written records of apportionments.
    (5) Set-aside apportionments for projects involving a qualified 
nonprofit organization.
    (i) In general.
    (ii) Projects involving a qualified nonprofit organization.
    (6) Expiration of unused apportionments.
    (d) Housing credit allocation made by State and local housing credit 
agencies.
    (1) In general.
    (2) Amount of a housing credit allocation.
    (3) Counting housing credit allocations against an agency's 
aggregate housing credit dollar amount.
    (4) Rules for when applications for housing credit allocations 
exceed an agency's aggregate housing credit dollar amount.
    (5) Reduced or additional housing credit allocations.
    (i) In general.
    (ii) Examples.
    (6) No carryover of unused aggregate housing credit dollar amount.
    (7) Effect of housing credit allocations in excess of an agency's 
aggregate housing credit dollar amount.
    (8) Time and manner for making housing credit allocations.
    (i) Time.
    (ii) Manner.
    (iii) Certification.
    (iv) Fee.
    (v) No continuing agency responsibility.
    (e) Housing credit allocation taken into account by owner of a 
qualified low-income building.
    (1) Time and manner for taking housing credit allocation into 
account.
    (2) First-year convention limitation on housing credit allocation 
taken into account.
    (3) Use of excess housing credit allocation for increases in 
qualified basis.
    (i) In general.
    (ii) Example.
    (4) Separate housing credit allocations for new buildings and 
increases in qualified basis.

[[Page 195]]

    (5) Acquisition of building for which a prior housing credit 
allocation has been made.
    (6) Multiple housing credit allocations.
    (f) Exception to housing credit allocation requirement.
    (1) Tax-exempt bond financing.
    (i) In general.
    (ii) Determining use of bond proceeds.
    (iii) Example.
    (g) Termination of authority to make housing credit allocation.
    (1) In general.
    (2) Carryover of unused 1989 apportionment.
    (3) Expiration of exception for tax-exempt bond financed projects.
    (h) [Reserved]
    (i) Transitional rules.

 Sec. 1.42-2  Waiver of requirement that an existing building eligible 
 for the low-income housing credit was last placed in service more than 
             10 years prior to acquisition by the taxpayer.

    (a) Low-income housing credit for existing building
    (b) Waiver of 10-year holding period requirement
    (c) Waiver requirements
    (1) Federally-assisted building
    (2) Federal mortgage funds at risk
    (3) Statement by the Department of Housing and Urban Development or 
the Farmers' Home Administration
    (4) No prior credit allowed
    (d) Application for waiver
    (1) Time and manner
    (2) Information required
    (3) Other rules
    (4) Effective date of waiver
    (5) Attachment to return
    (e) Effective date of regulations
Sec. 1.42-3  Treatment of buildings financed with proceeds from a loan 
          under an Affordable Housing Program established pursuant to 
          section 721 of the Financial Institutions Reform, Recovery, 
          and Enforcement Act of 1989 (FIRREA).

    (a) Treatment under sections 42(i) and 42(b).
    (b) Effective date.

Sec. 1.42-4  Application of not-for-profit rules of section 183 to low-
          income housing credit activities.

    (a) Inapplicability to section 42.
    (b) Limitation.
    (c) Effective date.

Sec. 1.42-5  Monitoring compliance with low-income housing credit 
          requirements.

    (a) Compliance monitoring requirement.
    (1) In general.
    (2) Requirements for a monitoring procedure.
    (i) In general.
    (ii) Order and form.
    (iii) [Reserved]
    (b) Recordkeeping and record retention provisions.
    (1) Recordkeeping provision.
    (2) Record retention provision.
    (3) Inspection record retention provision.
    (c) Certification and review provisions.
    (1) Certification.
    (2) Review.
    (ii)-(iii) [Reserved]
    (3) [Reserved]
    (4) Exception for certain buildings.
    (i) In general.
    (ii) Agreement and review.
    (iii) Example.
    (5) Agency reports of compliance monitoring activities.
    (d) Inspection provision.
    (1) In general.
    (2) Inspection standard.
    (3) Exception from inspection provision.
    (4) Delegation.
    (e) Notification-of-noncompliance provisions.
    (1) In general.
    (2) Notice to owner.
    (3) Notice to Internal Revenue Service.
    (i) In general.
    (ii) Agency retention of records.
    (4) Correction period.
    (f) Delegation of authority.
    (1) Agencies permitted to delegate compliance monitoring functions.
    (i) In general.
    (ii) Limitations.
    (2) Agencies permitted to delegate compliance monitoring functions 
to another Agency.
    (g) Liability.
    (h) Effective/applicability dates.
    (1) In general.
    (2) [Reserved]

Sec. 1.42-6  Buildings qualifying for carryover allocations.

    (a) Carryover allocations.
    (1) In general.
    (2) 10 percent basis requirement.
    (i) Allocation made before July 1.
    (ii) Allocation made after June 30.
    (b) Carryover-allocation basis.
    (1) In general.
    (2) Limitations.
    (i) Taxpayer must have basis in land or depreciable property related 
to the project.
    (ii) High cost areas.
    (iii) Amounts not treated as paid or incurred.
    (iv) Fees.
    (3) Reasonably expected basis.
    (4) Examples.
    (c) Verification of basis by Agency.
    (1) Verification requirement.
    (2) Manner of verification.
    (3) Time of verification.
    (i) Allocations made before July 1.
    (ii) Allocations made after June 30.
    (d) Requirements for making carryover allocations.

[[Page 196]]

    (1) In general.
    (2) Requirements for allocation.
    (3) Special rules for project-based allocations.
    (i) In general.
    (ii) Requirement of section 42(h)(1)(F)(1)(III).
    (4) Recordkeeping requirements.
    (i) Taxpayer.
    (ii) Agency.
    (5) Separate procedure for election of appropriate percentage month.
    (e) Special rules.
    (1) Treatment of partnerships and other flow-through entities.
    (2) Transferees.

Sec. 1.42-7  Substantially bond-financed buildings. [Reserved]

Sec. 1.42-8  Election of appropriate percentage month.

    (a) Election under section 42(b)(2)(A)(ii)(I) to use the appropriate 
percentage for the month of a binding agreement.
    (1) In general.
    (2) Effect on state housing credit ceiling.
    (3) Time and manner of making election.
    (4) Multiple agreements.
    (i) Rescinded agreements.
    (ii) Increases in credit.
    (5) Amount allocated.
    (6) Procedures.
    (i) Taxpayer.
    (ii) Agency.
    (7) Examples.
    (b) Election under section 42(b)(2)(A)(ii)(II) to use the 
appropriate percentage for the month tax-exempt bonds are issued.
    (1) Time and manner of making election.
    (2) Bonds issued in more than one month.
    (3) Limitations on appropriate percentage.
    (4) Procedures.
    (i) Taxpayer.
    (ii) Agency.

Sec. 1.42-9  For use by the general public.

    (a) General rule.
    (b) Limitations.
    (c) Treatment of units not for use by the general public.

Sec. 1.42-10  Utility allowances.

    (a) Inclusion of utility allowances in gross rent.
    (b) Applicable utility allowances.
    (1) Buildings assisted by the Rural Housing Service.
    (2) Buildings with Rural Housing Service assisted tenants.
    (3) Buildings regulated by the Department of Housing and Urban 
Development.
    (4) Other buildings.
    (i) Tenants receiving HUD rental assistance.
    (ii) Other tenants.
    (A) General rule.
    (B) Utility company estimate.
    (C) Agency estimate.
    (D) HUD Utility Schedule Model.
    (E) Energy consumption model.
    (c) Changes in applicable utility allowance.
    (1) In general.
    (2) Annual review.
    (d) Record retention.
    (e) Actual consumption submetering arrangements.
    (1) Definition.
    (2) Administrative fees.

Sec. 1.42-11  Provision of services.

    (a) General rule.
    (b) Services that are optional.
    (1) General rule.
    (2) Continual or frequent services.
    (3) Required services.
    (i) General rule.
    (ii) Exceptions.
    (A) Supportive services.
    (B) Specific project exception.

Sec. 1.42-12  Effective dates and transitional rules.

    (a) Effective dates.
    (1) In general.
    (2) Community Renewal Tax Relief Act of 2000.
    (i) In general.
    (3) Electronic filing simplification changes.
    (4) Utility allowances.
    (5) Additional effective dates affecting utility allowances.
    (b) Prior periods.
    (c) Carryover allocations.

Sec. 1.42-13  Rules necessary and appropriate; housing credit agencies' 
          correction of administrative errors and omissions.

    (a) Publication of guidance.
    (b) Correcting administrative errors and omissions.
    (1) In general.
    (2) Administrative errors and omissions described.
    (3) Procedures for correcting administrative errors or omissions.
    (i) In general.
    (ii) Specific procedures.
    (iii) Secretary's prior approval required.
    (iv) Requesting the Secretary's approval.
    (v) Agreement to conditions.
    (vi) Secretary's automatic approval.
    (vii) How Agency corrects errors or omissions subject to automatic 
approval.
    (viii) Other approval procedures.
    (c) Examples.
    (d) Effective date.

Sec. 1.42-14  Allocation rules for post-2000 State housing credit 
          ceiling amount.

    (a) State housing credit ceiling.
    (1) In general.
    (2) Cost-of-living adjustment.
    (i) General rule.
    (ii) Rounding.
    (b) The unused carryforward component.
    (c) The population component.
    (d) The returned credit component.
    (1) In general.

[[Page 197]]

    (2) Limitations and special rules.
    (i) General limitations.
    (ii) Credit period limitation.
    (iii) Three-month rule for returned credit.
    (iv) Returns of credit.
    (A) Building not qualified within required time period.
    (B) Noncompliance with terms of the allocation.
    (C) Mutual consent.
    (D) Amount not necessary for financial feasibility.
    (3) Manner of returning credit.
    (i) Taxpayer notification.
    (ii) Internal Revenue Service notification.
    (e) The national pool component.
    (f) When the State housing credit ceiling is determined.
    (g) Stacking order.
    (h) Nonprofit set-aside.
    (1) Determination of set-aside.
    (2) Allocation rules.
    (i) National Pool.
    (1) In general.
    (2) Unused housing credit carryover.
    (3) Qualified State.
    (i) In general.
    (ii) Exceptions.
    (A) De minimis amount.
    (B) Other circumstances.
    (iii) Time and manner for making request.
    (4) Formula for determining the National Pool.
    (j) Coordination between Agencies.
    (k) Example.
    (l) Effective dates.
    (1) In general.
    (2) Community Renewal Tax Relief Act of 2000 changes.

Sec. 1.42-15  Available unit rule.

    (a) Definitions.
    (b) General section 42(g)(2)(D)(i) rule.
    (c) Exception.
    (d) Effect of current resident moving within building.
    (e) Available unit rule applies separately to each building in a 
project.
    (f) Result of noncompliance with available unit rule.
    (g) Relationship to tax-exempt bond provisions.
    (h) Examples.
    (i) Effective date.

Sec. 1.42-16  Eligible basis reduced by federal grants.

    (a) In general.
    (b) Grants do not include certain rental assistance payments.
    (c) Qualifying rental assistance program.
    (d) Effective date.

Sec. 1.42-17  Qualified allocation plan.

    (a) Requirements.
    (1) In general [Reserved].
    (2) Selection criteria [Reserved].
    (3) Agency evaluation.
    (4) Timing of Agency evaluation.
    (i) In general.
    (ii) Time limit for placed-in-service evaluation.
    (5) Special rule for final determinations and certifications.
    (6) Bond-financed projects.
    (b) Effective date.

Sec. 1.42-18  Qualified Contracts.

    (a) Extended low-income housing commitment.
    (1) In general.
    (i) Extended use period.
    (ii) Termination of extended use period.
    (iii) Other non-acceptance.
    (iv) Eviction, gross rent increase concerning existing low-income 
tenants not permitted.
    (2) Exception.
    (b) Definitions.
    (c) Qualified contract purchase price formula.
    (1) In general.
    (i) Initial determination.
    (ii) Mandatory adjustment by the buyer and owner.
    (iii) Optional adjustment by the Agency and owner.
    (2) Low-income portion amount.
    (3) Outstanding indebtedness.
    (4) Adjusted investor equity.
    (i) Application of cost-of-living factor.
    (ii) Unadjusted investor equity.
    (iii) Qualified-contract cost-of-living adjustment.
    (iv) General rule.
    (v) Provision by the Commissioner of the qualified-contract cost-of-
living adjustment.
    (vi) Methodology.
    (vii) Example.
    (5) Other capital contributions.
    (6) Cash distributions.
    (i) In general.
    (ii) Excess proceeds.
    (iii) Anti-abuse rule.
    (d) Administrative discretion and responsibilities of the Agency.
    (1) In general.
    (2) Actual offer.
    (3) Debarment of certain appraisers.
    (e) Effective/applicability date.

[T.D. 8302, 55 FR 21189, May 23, 1990, as amended by T.D. 9755, 81 FR 
11107, Mar. 3, 2016]



Sec. 1.42-0T  Table of contents.

    This section lists the paragraphs contained in Secs. 1.42-5T and 
1.42-10T.

Sec. 1.42-5T  Monitoring compliance with low-income housing credit 
          requirements (temporary).

    (a)(1) through (a)(2)(ii) [Reserved]
    (iii) Effect of guidance published in the Internal Revenue Bulletin.

[[Page 198]]

    (b) through (c)(2)(i) [Reserved]
    (3) Frequency and form of certification.
    (c)(4) through (g) [Reserved]
    (h) Effective/applicability dates.
    (1) [Reserved]
    (2) Effective/applicability dates of the REAC inspection protocol.

Sec. 1.42-10T  Energy obtained directly from renewable sources 
          (temporary).

    (a) through (e)(1)(i)(A) [Reserved]
    (B) Utility not purchased from or through a local utility company.
    (C) Renewable source.
    (2) [Reserved]
    (f) Date of applicability.
    (g) Expiration date.

[T.D. 9755, 81 FR 11109, Mar. 3, 2016]



Sec. 1.42-1  Limitation on low-income housing credit allowed with respect 
to qualified low-income buildings receiving housing credit allocations from 
a State or local housing credit agency.

    (a)-(g) [Reserved]. For further guidance, see Sec. 1.42-1T(a) 
through (g).
    (h) Filing of forms. Unless otherwise provided in forms or 
instructions, a completed Form 8586, ``Low-Income Housing Credit,'' (or 
any successor form) must be filed with the owner's Federal income tax 
return for each taxable year the owner of a qualified low-income 
building is claiming the low-income housing credit under section 42(a). 
Unless otherwise provided in forms or instructions, a completed Form 
8609, ``Low-Income Housing Credit Allocation and Certification,'' (or 
any successor form) must be filed by the building owner with the IRS. 
The requirements for completing and filing Forms 8586 and 8609 are 
addressed in the instructions to the forms.
    (i) [Reserved]. For further guidance, see Sec. 1.42-1T(i).
    (j) Effective dates. Section 1.42-1(h) applies to forms filed on or 
after November 7, 2005. The rules that apply for forms filed before 
November 7, 2005 are contained in Sec. 1.42-1T(h) and Sec. 1.42-1(h) 
(see 26 CFR part 1 revised as of April 1, 2003, and April 1, 2005).

[T.D. 9112, 69 FR 3827, Jan. 27, 2004, as amended by T.D. 9228, 70 FR 
67356, Nov. 7, 2005]



Sec. 1.42-1T  Limitation on low-income housing credit allowed with respect 
to qualified low-income buildings receiving housing credit allocations 
from a State or local housing credit agency (temporary).

    (a) In general--(1) Determination of amount of low-income housing 
credit. Section 42 provides that, for purposes of section 38, a low-
income housing credit is determined for a building in an amount equal to 
the applicable percentage of the qualified basis of the qualified low-
income building. In general, the credit may be claimed annually for a 
10-year credit period, beginning with the taxable year in which the 
building is placed in service or, at the election of the taxpayer, the 
succeeding taxable year. If, after the first year of the credit period, 
the qualified basis of a building is increased in excess of the 
qualified basis upon which the credit was initially determined, the 
allowable credit with respect to such additional qualified basis is 
determined using a credit percentage equal to two-thirds of the 
applicable percentage for the initial qualified basis. The credit for 
additions to qualified basis is generally allowable for the remaining 
years in the 15-year compliance period which begins with the first 
taxable year of the credit period for the building. In general, the low-
income housing credit is available with respect to buildings placed in 
service after December 31, 1986, in taxable years ending after that 
date. See section 42 for the definitions of ``qualified low-income 
building'', ``applicable percentage'', ``qualified basis'', ``credit 
period'', ``compliance period'', and for other rules relating to 
determination of the amount of the low-income housing credit.
    (2) Limitation on low-income housing credit allowed. Generally, the 
low-income housing credit determined under section 42 is allowed and may 
be claimed for any taxable year if, and to the extent that, the owner of 
a qualified low-income building receives a housing credit allocation 
from a State or local housing credit agency. The aggregate amount of 
housing credit allocations that may be made in any calendar year by all 
housing credit agencies within a State is limited by a

[[Page 199]]

State housing credit ceiling, or volume cap, described in paragraph (b) 
of this section. The authority to make housing credit allocations within 
the State housing credit ceiling may be apportioned among the State and 
local housing credit agencies, under the rules prescribed in paragraph 
(c) of this section. Upon apportionment of the State housing credit 
volume cap, each State or local housing credit agency receives an 
aggregate housing credit dollar amount that may be used to make housing 
credit allocations among qualified low-income buildings located within 
an agency's geographic jurisdiction. The rules governing the making of 
housing credit allocations by any state or local housing credit agency 
are provided in paragraph (d) of this section. Housing credit 
allocations are required to be taken into account by owners of qualified 
low-income buildings under the rules prescribed in paragraph (e) of this 
section. Exceptions to the requirement that a qualified low-income 
building receive a housing credit allocation from a State or local 
housing credit agency are provided in paragraph (f) of this section. 
Rules regarding termination of the authority of State and local housing 
credit agencies to make housing credit allocations after December 31, 
1989, are specified in paragraph (g) of this section. Rules concerning 
information reporting by State and local housing credit agencies and 
owners of qualified low-income buildings are provided in paragraph (h) 
of this section. Special statutory transitional rules are incorporated 
into this section of the regulations as described in paragraph (i) of 
this section.
    (b) The State housing credit ceiling. The aggregate amount of 
housing credit allocations that may be made in any calendar year by all 
State and local housing credit agencies within a State may not exceed 
the State's housing credit ceiling for such calendar year. The State 
housing credit ceiling for each State for any calendar year is equal to 
$1.25 multiplied by the State's population. A State's population for any 
calendar year is determined by reference to the most recent census 
estimate (whether final or provisional) of the resident population of 
the State released by the Bureau of the Census before the beginning of 
the calendar year for which the State's housing credit ceiling is set. 
Unless otherwise prescribed by applicable revenue procedure, 
determinations of population are based on the most recent estimates of 
population contained in the Bureau of the Census publication, ``Current 
Population Reports, Series P-25: Population Estimates and Projections, 
Estimates of the Population of States''. For purposes of this section, 
the District of Columbia and United States possessions are treated as 
States.
    (c) Apportionment of State housing credit ceiling among State and 
local housing credit agencies--(1) In general. A State's housing credit 
ceiling for any calendar year is apportioned among the State and local 
housing credit agencies within such State under the rules prescribed in 
this paragraph. A ``State housing credit agency'' is any State agency 
specifically authorized by gubernatorial act or State statute to make 
housing credit allocations on behalf of the State and to carry out the 
provisions of section 42(h). A ``local housing credit agency'' is any 
agency of a political subdivision of the State that is specifically 
authorized by a State enabling act to make housing credit allocations on 
behalf of the State or political subdivision and to carry out the 
provisions of section 42(h). A ``State enabling act'' is any 
gubernatorial act, State statute, or State housing credit agency 
regulation (if authorized by gubernatorial act or State statute). A 
State enabling act enacted on or before October 22, 1986, the date of 
enactment of the Tax Reform Act of 1986, shall be given effect for 
purposes of this paragraph if such State enabling act expressly carries 
out the provisions of section 42(h).
    (2) Primary apportionment. Except as otherwise provided in 
paragraphs (c) (3) and (4) of this section, a State's housing credit 
ceiling is apportioned in its entirety to the State housing credit 
agency. Such an apportionment is the ``primary apportionment'' of a 
State's housing credit ceiling. There shall be no primary apportionment 
of the State housing credit ceiling and no grants of housing credit 
allocations in such State until a State housing credit agency is 
authorized by gubernatorial

[[Page 200]]

act or State statute. If a State has more than one State housing credit 
agency, such agencies shall be treated as a single agency for purposes 
of the primary apportionment. In such a case, the State housing credit 
ceiling may be divided among the multiple State housing credit agencies 
pursuant to gubernatorial act or State statute.
    (3) States with 1 or more constitutional home rule cities--(i) In 
general. Notwithstanding paragraph (c)(2) of this section, in any State 
with 1 or more constitutional home rule cities, a portion of the State 
housing credit ceiling is apportioned to each constitutional home rule 
city. In such a State, except as provided in paragraph (c)(4) of this 
section, the remainder of the State housing credit ceiling is 
apportioned to the State housing credit agency under paragraph (c)(2) of 
this section. See paragraph (c)(3)(iii) of this section. The term 
``constitutional home rule city'' means, with respect to any calendar 
year, any political subdivision of a State that, under a State 
constitution that was adopted in 1970 and effective on July 1, 1971, had 
home rule powers on the first day of the calendar year.
    (ii) Amount of apportionment to a constitutional home rule city. The 
amount of the State housing credit ceiling apportioned to a 
constitutional home rule city for any calendar year is an amount that 
bears the same ratio to the State housing credit ceiling for that year 
as the population of the constitutional home rule city bears to the 
population of the entire State. The population of any constitutional 
home rule city for any calendar year is determined by reference to the 
most recent census estimate (whether final or provisional) of the 
resident population of the constitutional home rule city released by the 
Bureau of the Census before the beginning of the calendar year for which 
the State housing credit ceiling is apportioned. However, determinations 
of the population of a constitutional home rule city may not be based on 
Bureau of the Census estimates that do not contain estimates for all of 
the constitutional home rule cities within the State. If no Bureau of 
the Census estimate is available for all such constitutional home rule 
cities, the most recent decennial census of population shall be relied 
on. Unless otherwise prescribed by applicable revenue procedure, 
determinations of population for constitutional home rule cities are 
based on estimates of population contained in the Bureau of the Census 
publication, ``Current Population Reports, Series P-26: Local Population 
Estimates''.
    (iii) Effect of apportionments to constitutional home rule cities on 
apportionments to other housing credit agencies. The aggregate amounts 
of the State housing credit ceiling apportioned to constitutional home 
rule cities under this paragraph (c)(3) reduce the State housing credit 
ceiling available for apportionment under paragraph (c) (2) or (4) of 
this section. Unless otherwise provided in a State constitutional 
amendment or by law changing the home rule provisions adopted in a 
manner provided by the State constitution, the power of the governor or 
State legislature to apportion the State housing credit ceiling among 
local housing credit agencies under paragraph (c)(4) of this section 
shall not be construed as allowing any reduction of the portion of the 
State housing credit ceiling apportioned to a constitutional home rule 
city under this paragraph (c)(3). However, any constitutional home rule 
city may agree to a reduction in its apportionment of the State housing 
credit ceiling under this paragraph (c)(3), in which case the amount of 
the State housing credit ceiling not apportioned to the constitutional 
home rule city shall be available for apportionment under paragraph (c) 
(2) or (4) of this section.
    (iv) Treatment of governmental authority within constitutional home 
rule city. For purposes of determining which agency within a 
constitutional home rule city receives the apportionment of the State 
housing credit ceiling under this paragraph (c)(3), the rules of this 
paragraph (c) shall be applied by treating the constitutional home rule 
city as a ``State'', the chief executive officer of a constitutional 
home rule city as a ``governor'', and a city council as a ``State 
legislature''. A constitutional home rule city is also treated as a 
``State'' for purposes of the set-aside requirement for housing credit 
allocations to projects involving a qualified

[[Page 201]]

nonprofit organization. See paragraph (c)(5) of this section for rules 
governing set-aside requirements. In this connection, a constitutional 
home rule city may agree with the State housing credit agency to 
exchange an apportionment set aside for projects involving a qualified 
nonprofit organization for an apportionment that is not so restricted. 
In such a case, the authorizing gubernatorial act, State statute, or 
State housing credit agency regulation (if authorized by gubernatorial 
act or State statute) must ensure that the set-aside apportionment 
transferred to the State housing credit agency be used for the purposes 
described in paragraph (c)(5) of this section.
    (4) Apportionment to local housing credit agencies--(i) In general. 
In lieu of the primary apportionment under paragraph (c)(2) of this 
section, all or a portion of the State housing credit ceiling may be 
apportioned among housing credit agencies of governmental subdivisions. 
Apportionments of the State housing credit ceiling to local housing 
credit agencies must be made pursuant to a State enabling act as defined 
in paragraph (c)(1) of this section. Apportionments of the State housing 
credit ceiling may be made to housing credit agencies of constitutional 
home rule cities under this paragraph (c)(4), in addition to 
apportionments made under paragraph (c)(3) of this section. 
Apportionments of the State housing credit ceiling under this paragraph 
(c)(4) need not be based on the population of political subdivisions and 
may, but are not required to, give balanced consideration to the low-
income housing needs of the entire State.
    (ii) Change in apportionments during a calendar year. The 
apportionment of the State housing credit ceiling among State and local 
housing credit agencies under this paragraph (c)(4) may be changed after 
the beginning of a calendar year, pursuant to a State enabling act. No 
change in apportionments shall retroactively reduce the housing credit 
allocations made by any agency during such year. Any change in the 
apportionment of the State housing credit ceiling under this paragraph 
(c)(4) that occurs during a calendar year is effective only to the 
extent housing credit agencies have not previously made housing credit 
allocations during such year from their original apportionments of the 
State housing credit ceiling for such year. To the extent apportionments 
of the State housing credit ceiling to local housing credit agencies 
made pursuant to this paragraph (c)(4) for any calendar year are not 
used by such local agencies before a certain date (e.g., November 1) to 
make housing credit allocations in such year, the amount of unused 
apportionments may revert back to the State housing credit agency for 
reapportionment. Such reversion must be specifically authorized by the 
State enabling act.
    (iii) Exchanges of apportionments. Any State or local housing credit 
agency that receives an apportionment of the State housing credit 
ceiling for any calendar year under this paragraph (c)(4) may exchange 
part or all of such apportionment with another State or local housing 
credit agency to the extent no housing credit allocations have been made 
in such year from the exchanged portions. Such exchanges must be made 
with another housing credit agency in the same State and must be 
consistent with the State enabling act. If an apportionment set aside 
for projects involving a qualified nonprofit organization is transferred 
or exchanged, the transferee housing credit agency shall be required to 
use the set-aside apportionment for the purposes described in paragraph 
(c)(5) of this section.
    (iv) Written records of apportionments. All apportionments, 
exchanges of apportionments, and reapportionments of the State housing 
credit ceiling which are authorized by this paragraph (c)(4) must be 
evidenced in the written records maintained by each State and local 
housing credit agency.
    (5) Set-aside apportionments for projects involving a qualified 
nonprofit organization--(i) In general. Ten percent of the State housing 
credit ceiling for a calendar year must be set aside exclusively for 
projects involving a qualified nonprofit organization (as defined in 
paragraph (c)(5)(ii) of this section). Thus, at least 10 percent of 
apportionments of the State housing credit ceiling under paragraphs (c) 
(2) and (3) of this section must be used only to make

[[Page 202]]

housing credit allocations to buildings that are part of projects 
involving a qualified nonprofit organization. In the case of 
apportionments of the State housing credit ceiling under paragraph 
(c)(4) of this section, the State enabling act must ensure that the 
apportionment of at least 10 percent of the State housing credit ceiling 
be used exclusively to make housing credit allocations to buildings that 
are part of projects involving a qualified nonprofit organization. The 
State enabling act shall prescribe which housing credit agencies in the 
State receive apportionments that must be set aside for making housing 
credit allocations to buildings that are part of projects involving a 
qualified nonprofit organization. These set-aside apportionments may be 
distributed disproportionately among the State or local housing credit 
agencies receiving apportionments under paragraph (c)(4) of this 
section. The 10-percent set-aside requirement of this paragraph (c)(4) 
is a minimum requirement, and the State enabling act may set aside more 
than 10 percent of the State housing credit ceiling for apportionment to 
housing credit agencies for exclusive use in making housing credit 
allocations to buildings that are part of projects involving a qualified 
nonprofit organization.
    (ii) Projects involving a qualified nonprofit organization. The term 
``projects involving a qualified nonprofit organization'' means projects 
with respect to which a qualified nonprofit organization is to 
materially participate (within the meaning of section 469(h)) in the 
development and continuing operation of the project throughout the 15-
year compliance period. The term ``qualified nonprofit organization'' 
means any organization that is described in section 501(c) (3) or (4), 
is exempt from tax under section 501(a), and includes as one of its 
exempt purposes the fostering of low-income housing.
    (6) Expiration of unused apportionments. Apportionments of the State 
housing credit ceiling under this paragraph (c) for any calendar year 
may be used by housing credit agencies to make housing credit 
allocations only in such calendar year. Any part of an apportionment of 
the State housing credit ceiling for any calendar year that is not used 
for housing credit allocations in such year expires as of the end of 
such year and does not carry over to any other year. However, any part 
of an apportionment for 1989 that is not used to make a housing credit 
allocation in 1989 may be carried over to 1990 and used to make a 
housing credit allocation to a qualified low-income building described 
in section 42(n)(2)(B). See paragraph (g)(2) of this section.
    (d) Housing credit allocations made by State and local housing 
credit agencies--(1) In general. This paragraph governs State and local 
housing credit agencies in making housing credit allocations to 
qualified low-income buildings. The amount of the apportionment of the 
State housing credit ceiling for any calendar year received by any State 
or local housing credit agency under paragraph (c) of this section 
constitutes the agency's aggregate housing credit dollar amount for such 
year. The aggregate amount of housing credit allocations made in any 
calendar year by a State or local housing credit agency may not exceed 
such agency's aggregate housing credit dollar amount for such year. A 
State or local housing credit agency may make housing credit allocations 
only to qualified low-income buildings located within the agency's 
geographic jurisdiction.
    (2) Amount of a housing credit allocation. In making a housing 
credit allocation, a State or local housing credit agency must specify a 
credit percentage, not to exceed the building's applicable percentage 
determined under section 42(b), and a qualified basis amount. The amount 
of the housing credit allocation for any building is the product of the 
specified credit percentage and the specified qualified basis amount. In 
specifying the credit percentage and qualified basis amount, the State 
or local housing credit agency shall not take account of the first-year 
conventions described in section 42(f) (2)(A) and (3)(B). A State or 
local housing credit agency may adopt rules or regulations governing 
conditions for specification of less than the maximum credit percentage 
and qualified basis amount allowable under section 42 (b) and (c), 
respectively. For example, an agency may specify a credit percentage

[[Page 203]]

and a qualified basis amount of less than the maximum credit percentage 
and qualified basis amount allowable under section 42 (b) and (c), 
respectively, when the financing and rental assistance from all sources 
for the project of which the building is a part is sufficient to provide 
the continuing operation of the building without the maximum credit 
amount allowable under section 42.
    (3) Counting housing credit allocations against an agency's 
aggregate housing credit dollar amount. The aggregate amount of housing 
credit allocations made in any calendar year by a State or local housing 
credit agency may not exceed such agency's aggregate housing credit 
dollar amount (i.e., the agency's apportionment of the State housing 
credit ceiling for such year). This limitation on the aggregate dollar 
amount of housing credit allocations shall be computed separately for 
set-aside apportionments received pursuant to paragraph (c)(5) of this 
section. Housing credit allocations count against an agency's aggregate 
housing credit dollar amount without regard to the amount of credit 
allowable to or claimed by an owner of a building in the taxable year in 
which the allocation is made or in any subsequent year. Thus, housing 
credit allocations (which are computed without regard to the first-year 
conventions as provided in paragraph (d)(2) of this section) count in 
full against an agency's aggregate housing credit dollar amount, even 
though the first-year conventions described in section 42(f) (2)(A) and 
(3)(B) may reduce the amount of credit claimed by a taxpayer in the 
first year in which a credit is allowable. See also paragraph (e)(2) of 
this section. Housing credit allocations count against an agency's 
aggregate housing credit dollar amount only in the calendar year in 
which made and not in subsequent taxable years in the credit period or 
compliance period during which a taxpayer may claim a credit based on 
the original housing credit allocation. Since the aggregate amount of 
housing credit allocations made in any calendar year by a State or local 
housing credit agency may not exceed such agency's aggregate housing 
credit dollar amount, an agency shall at all times during a calendar 
year maintain a record of its cumulative allocations made during such 
year and its remaining unused aggregate housing credit dollar amount.
    (4) Rules for when applications for housing credit allocations 
exceed an agency's aggregate housing credit dollar amount. A State or 
local housing credit agency may adopt rules or regulations governing the 
awarding of housing credit allocations when an agency expects that 
applicants during a calendar year will seek aggregate allocations in 
excess of the agency's aggregate housing credit dollar amount. The State 
enabling act may provide uniform standards for the awarding of housing 
credit allocations when there is actual or anticipated excess demand 
from applicants in any calendar year.
    (5) Reduced or additional housing credit allocations--(i) In 
general. A State or local housing credit agency may not reduce or 
rescind a housing credit allocation made to a qualified low-income 
building in the manner prescribed in paragraph (d)(8) of this section. 
Thus, a housing credit agency may not reduce or rescind a housing credit 
allocation made to a qualified low-income building which is acquired by 
a new owner who is entitled to a carryover of the allowable credit for 
such building under section 42(d)(7). A housing credit agency may make 
additional housing credit allocations to a building in any year in the 
building's compliance period, whether or not there are additions to 
qualified basis for which an increased credit is allowable under section 
42(f)(3). Each additional housing credit allocation made to a building 
is treated as a separate allocation and is subject to the rules and 
requirements of this section. However, in the case of an additional 
housing credit allocation made with respect to additions to qualified 
basis for which an increased credit is allowable under section 42(f)(3), 
the amount of the allocation that counts against the agency's aggregate 
housing credit dollar amount shall be computed as if the specified 
credit percentage were unreduced in the manner prescribed in section 
42(f)(3)(A) and the specified qualified basis amount were unreduced by 
the first-year convention prescribed in section 42(f)(3)(B).

[[Page 204]]

    (ii) Examples. The rules of paragraph (d)(5)(i) of this section may 
be illustrated by the following examples:

    Example 1. For 1987, the County L Housing Credit Agency has an 
aggregate housing credit dollar amount of $2 million. D, an individual, 
places in service on July 1, 1987, a new qualified low-income building. 
As of the close of each month in 1987 in which the building is in 
service, the building consists of 100 residential rental units, of which 
20 units are both rent-restricted and occupied by individuals whose 
income is 50 percent or less of area median gross income. The total 
floor space of the residential rental units is 120,000 square feet, and 
the total floor space of the low-income units is 20,000 square feet. The 
building is not Federally subsidized within the meaning of section 
42(i)(2). As of the end of 1987, the building has eligible basis under 
section 42(d) of $1 million. Thus, the qualified basis of the building 
determined without regard to the first-year convention provided in 
section 42(f) is $166,666.67 (i.e., $1 million eligible basis times \1/
6\, the floor space fraction which is required to be used instead of the 
larger unit fraction). However, the amount of the low-income housing 
credit determined for 1987 under section 42 reflects the first-year 
convention provided in section 42(f)(2). Since the building has the same 
floor space and unit fractions as of the close of each of the six months 
in 1987 during which it is in service, upon applying the first-year 
convention in section 42(f)(2), the qualified basis of the building in 
1987 is $83,333.33 (i.e., $1 million eligible basis times \1/12\, the 
fraction determined under section 42(f)(2)(A)). Under paragraph (d)(2) 
of this section, the County L Housing Credit Agency may make a housing 
credit allocation by specifying a credit percentage, not to exceed 9 
percent, and a qualified basis amount, which may be greater or less than 
the qualified basis of the building in 1987 as determined under section 
42(c), without regard to the first-year convention provided in section 
42(f)(2). If the County L Housing Credit Agency specifies a credit 
percentage of 8 percent and a qualified basis amount of $100,000, the 
amount of the housing credit allocation is $8,000. Under paragraph 
(d)(3) of this section, the County L Housing Credit Agency's aggregate 
housing credit dollar amount for 1987 is reduced by $8,000, 
notwithstanding that D is entitled to claim less than $8,000 of the 
credit in 1987 under the rules in paragraph (e) of this section. Under 
paragraph (e)(2) of this section, in 1987 D is entitled to claim only 
$4,000 of the credit, determined by applying the first-year convention 
of \6/12\ to the specified qualified basis amount contained in the 
housing credit allocation (i.e., .08  x  $100,000  x  (\6/12\)).
    Example 2. The facts are the same as in Example 1 except that on 
July 1, 1988, the number of occupied low-income units increases to 50 
units and the floor space of the occupied low-income units increases to 
48,000 square feet. These occupancy fractions remain unchanged as of the 
close of each month remaining in 1988. Under section 42(c), the 
qualified basis of the building in 1988, without regard to the first-
year convention in section 42(f)(3)(B), is $400,000 (i.e., $1 million 
eligible basis times .4, the floor space fraction which is required to 
be used instead of the larger unit fraction). D's 1987 housing credit 
allocation from the County L Housing Credit Agency remains effective in 
1988 and entitles D to a credit of $8,000 (i.e., .08, the specified 
credit percentage, times $100,000, the specified qualified basis 
amount). With respect to the additional $300,000 of qualified basis 
which the 1987 housing credit allocation does not cover, D must apply to 
the County L Housing Credit Agency for an additional housing credit 
allocation. Assume that the County L Housing Credit Agency has a 
sufficient aggregate housing credit dollar amount for 1988 to make a 
housing credit allocation to D in 1988 by specifying a credit percentage 
of 9 percent and a qualified basis amount of $300,000. The amount of the 
housing credit allocation that counts against the County L Housing 
Credit Agency's aggregate housing credit dollar amount is $27,000 (i.e., 
the amount counted (.09 times $300,000) is unreduced in the manner 
prescribed in section 42(f)(3) (A) and (B)). Since D's qualified basis 
in 1987 was $166,666.67, D is entitled to claim a credit in 1988 with 
respect to such basis of $14,000 (i.e., .08  x  $100,000, the 1987 
credit allocation, + .09  x  $66,666.67, the 1988 credit allocation). In 
addition, D is entitled to claim a credit in 1988 and subsequent years 
in the 15-year compliance period with respect to the additional 
$233,333.33 of qualified basis covered by the 1988 housing credit 
allocation. However, the allowable credit for 1988 with respect to this 
amount of additional qualified basis is subject to reductions prescribed 
in section 42(f)(3) (A) and (B). Thus, D is entitled in 1988 to a credit 
at a 6-percent rate applied to $116,666.67 of additional qualified 
basis, which is reduced to reflect the first-year convention. D's total 
allowable low-income housing credit in 1988 is $21,000 (i.e., $14,000 
with respect to original qualified basis + $7,000 with respect to 1988 
additions to qualified basis). If the County L Housing Credit Agency had 
specified an 8-percent credit percentage in 1988 with respect to the 
qualified basis not covered by the 1987 housing credit allocation to D, 
D's allowable credit with respect to the $233,333.33 of additions to 
qualified basis would not exceed, in 1988 and subsequent years, an 
amount determined by applying a specified credit percentage of 5.33 
percent (i.e., two-thirds of 8 percent). In 1988, D's specified 
qualified basis amount would be adjusted for the first-year convention.


[[Page 205]]


    (6) No carryover of unused aggregate housing credit dollar amount. 
Any portion of a State or local housing credit agency's aggregate 
housing credit dollar amount for any calendar year that is not used to 
make a housing credit allocation in such year may not be carried over to 
any other year, except as provided in paragraph (g) of this section. An 
agency may not permit owners of qualified low-income buildings to 
transfer housing credit allocations to other buildings. However, an 
agency may provide a procedure whereby owners may return to the agency, 
prior to the end of the calendar year in which housing credit 
allocations are made, unusable portions of such allocations. In such a 
case, an owner's housing credit allocation is deemed reduced by the 
amount of the allocation returned to the agency, and the agency may 
reallocate such amount to other qualified low-income buildings prior to 
the end of the year.
    (7) Effect of housing credit allocations in excess of an agency's 
aggregate housing credit dollar amount. In the event that a State or 
local housing credit agency makes housing credit allocations in excess 
of its aggregate housing credit dollar amount for any calendar year, the 
allocations shall be deemed reduced (to the extent of such excess) for 
buildings in the reverse order in which such allocations were made 
during such year.
    (8) Time and manner for making housing credit allocations--(i) Time. 
Housing credit allocations are effective for the calendar year in which 
made in the manner prescribed in paragraph (d)(8)(ii) of this section. A 
State or local housing credit agency may not make a housing credit 
allocation to a qualified low-income building prior to the calendar year 
in which such building is placed in service. An agency may adopt its own 
procedures for receiving applications for housing credit allocations 
from owners of qualified low-income buildings. An agency may provide a 
procedure for making, in advance of a building's being placed in 
service, a binding commitment (e.g., by contract, inducement, 
resolution, or other means) to make a housing credit allocation in the 
calendar year in which a qualified low-income building is placed in 
service or in a subsequent calendar year. Any advance commitment shall 
not constitute a housing credit allocation for purposes of this section.
    (ii) Manner. Housing credit allocations are deemed made when part I 
of IRS Form 8609, Low-Income Housing Credit Allocation Certification, is 
completed and signed by an authorized official of the housing credit 
agency and mailed to the owner of the qualified low-income building. A 
copy of all completed (as to part I) Form 8609 allocations along with a 
single completed Form 8610, Annual Low-Income Housing Credit Agencies 
Report, must also be mailed to the Internal Revenue Service not later 
than the 28th day of the second calendar month after the close of the 
calendar year in which the housing credit was allocated to the qualified 
low-income building. Housing credit allocations to a qualified low-
income building must be made on Form 8609 and must include--
    (A) The address of the building;
    (B) The name, address, and taxpayer identification number of the 
housing credit agency making the housing credit allocation;
    (C) The name, address, and taxpayer identification number of the 
owner of the qualified low-income building;
    (D) The date of the allocation of housing credit;
    (E) The housing credit dollar amount allocated to the building on 
such date;
    (F) The specified maximum applicable credit percentage allocated to 
the building on such date;
    (G) The specified maximum qualified basis amount;
    (H) The percentage of the aggregate basis financed by tax-exempt 
bonds taken into account for purposes of the volume cap under section 
146;
    (I) A certification under penalties of perjury by an authorized 
State or local housing credit agency official that the allocation is 
made in compliance with the requirements of section 42(h); and
    (J) Any additional information that may be required by Form 8609 or 
by an applicable revenue procedure.

See paragraph (h) of this section for additional rules concerning filing 
of forms.

[[Page 206]]

    (iii) Certification. The certifying official for the State or local 
housing credit agency need not perform an independent investigation of 
the qualified low-income building in order to certify on part I of Form 
8609 that the housing credit allocation meets the requirements of 
section 42(h). For example, the certifying official may rely on 
information contained in an application for a low-income housing credit 
allocation submitted by the building owner which sets forth facts 
necessary to determine that the building is eligible for the low-income 
housing credit under section 42.
    (iv) Fee. A State or local housing credit agency may charge building 
owners applying for housing credit allocations a reasonable fee to cover 
the agency's administrative expenses for processing applications.
    (v) No continuing agency responsibility. The State or local housing 
credit agency need not monitor or investigate the continued compliance 
of a qualified low-income building with the requirements of section 42 
throughout the applicable compliance period.
    (e) Housing credit allocation taken into account by owner of a 
qualified low-income building--(1) Time and manner for taking housing 
credit allocation into account. An owner of a qualified low-income 
building may not claim a low-income housing credit determined under 
section 42 in any year in excess of an effective housing credit 
allocation received from a State or local housing credit agency. A 
housing credit allocation made to a qualified low-income building is 
effective with respect to any owner of the building beginning with the 
owner's taxable year in which the housing credit allocation is received. 
A housing credit allocation is deemed received in a taxable year, except 
as modified in the succeeding sentence, if that allocation is made (in 
the manner described in paragraph (d)(8) of this section) not later than 
the earlier of (i) the 60th day after the close of the taxable year, or 
(ii) the close of the calendar year in which such taxable year ends. A 
housing credit allocation is deemed received in a taxable year ending in 
1987, if such allocation is made (in the manner described in paragraph 
(d)(8) of this section) on or before December 31, 1987. A housing credit 
allocation is not effective for any taxable year if received in a 
calendar year which ends prior to when the qualified low-income building 
is placed in service. A housing credit allocation made to a qualified 
low-income building remains effective for all taxable years in the 
compliance period.
    (2) First-year convention limitation on housing credit allocation 
taken into account. For purposes of the limitation that the allowable 
low-income housing credit may not exceed the effective housing credit 
allocation received from a State or local housing credit agency, as 
provided in paragraph (e)(1) of this section, the amount of the 
effective housing credit allocation shall be adjusted by applying the 
first-year convention provided in section 42(f)(2)(A) and (3)(B) and the 
percentage credit reduction provided in section 42(f)(3)(A). Under 
paragraphs (d) (2) and (5) of this section, the State or local housing 
credit agency must specify the credit percentage and qualified basis 
amount, the product of which is the amount of the housing credit 
allocation, without taking account of the first-year convention 
described in section 42(f)(2)(A) and (3)(B) or the percentage credit 
reduction prescribed in section 42(f)(3)(A). However, for purposes of 
the limitation on the amount of the allowable low-income housing credit, 
as provided in paragraph (e)(1) of this section, in a taxable year in 
which the first-year convention applies to the amount of credit 
determined under section 42(a), the specified qualified basis amount 
shall be adjusted by the first-year convention fraction which is equal 
to the number of full months (during the first taxable year) in which 
the building was in service divided by 12. In addition, for purposes of 
the limitation on the amount of the allowable low-income housing credit, 
as provided in paragraph (e)(1) of this section, in a taxable year in 
which the reduction in credit percentage applies to additions to 
qualified basis, as prescribed in section 42(f)(3), the specified credit 
percentage shall be reduced by one-third. See examples in paragraphs 
(d)(5)(ii) and (e)(3)(ii) of this section.
    (3) Use of excess housing credit allocation for increases in 
qualified basis--(i) In

[[Page 207]]

general. If the housing credit allocation made to a qualified low-income 
building exceeds the amount of credit allowable with respect to such 
building in any taxable year (without regard to the first-year 
conventions under section 42(f)), such excess is not transferable to 
another qualified low-income building. However, if in a subsequent year 
there are increases in the qualified basis for which an increased credit 
is allowable under section 42(f)(3) at a reduced credit percentage, the 
original housing credit allocation (including the specified credit 
percentage and qualified basis amount) would be effective with respect 
to such increased credit.
    (ii) Example. The provisions of this paragraph (e)(3) may be 
illustrated by the following example:

    Example. In 1987, a newly-constructed qualified low-income building 
receives a housing credit allocation of $90,000 based on a specified 
credit percentage of 9 percent and a specified qualified basis amount of 
$1,000,000. The building is placed in service in 1987, but the qualified 
basis in such year is only $800,000, resulting in an allowable credit in 
1987 (determined without regard to the first-year conventions) of 
$72,000. In 1988, the qualified basis is increased to $1,100,000, 
resulting in an additional credit allowable under section 42(f)(3) 
(without regard to the first-year conventions) of $18,000 (i.e., 
$300,000  x  .06, or \2/3\ of .09). The unused portion of the 1987 
housing credit allocation ($18,000) is effective in 1988 and in each 
subsequent year in the compliance period only with respect to the 
specified qualified basis for the 1987 housing credit allocation 
($1,000,000). Thus, the owner is allowed to claim a credit in 1988 and 
in each subsequent year (without regard to the first-year conventions), 
based on the effective housing credit allocation from 1987, of $84,000 
(i.e., $72,000 + ($200,000  x  .06)). The owner of the qualified low-
income building must obtain a new housing credit allocation in 1988 with 
respect to the additional $100,000 of qualified basis in order to claim 
a credit on such basis in 1988 and in each subsequent year. If the 
applicable first-year convention under section 42(f)(3)(B) entitled the 
owner in 1988 to only \1/2\ of the otherwise applicable credit for the 
additions to qualified basis, under paragraph (e)(2) of this section the 
owner is allowed to claim a credit in 1988, based on the effective 
housing credit allocation from 1987, of $78,000 (i.e., $72,000 + 
($200,000  x  .06  x  .5)).

    (4) Separate housing credit allocations for new buildings and 
increases in qualified basis. Separate housing credit allocations must 
be received for each building with respect to which a housing credit may 
be claimed. Rehabilitation expenditures with respect to a qualified low-
income building are treated as a separate new building under section 
42(e) and must receive a separate housing credit allocation. Increases 
in qualified basis in a qualified low-income building are not generally 
treated as a new building for purposes of section 42. To the extent that 
a prior housing credit allocation received with respect to a qualified 
low-income building does not allow an increased credit with respect to 
an increase in the qualified basis of such building, an additional 
housing credit allocation must be received in order to claim a credit 
with respect to that portion of increase in qualified basis. See 
paragraph (e)(3) of this section. The amount of credit allowable with 
respect to an increase in qualified basis is subject to the credit 
percentage limitation of section 42(f)(3)(A) and the first-year 
convention of section 42(f)(3)(B). See paragraph (d)(5) of this section 
for a rule requiring that the State or local housing credit agency count 
a housing credit allocation made with respect to an increase in 
qualified basis as if the specified credit percentage were unreduced in 
the manner prescribed in section 42(f)(3) and the specified basis amount 
were unreduced by the first-year convention prescribed in section 
42(f)(3)(B).
    (5) Acquisition of building for which a prior housing credit 
allocation has been made. If a carryover credit would be allowable to an 
acquirer of a qualified low-income building under section 42(d)(7), such 
acquirer need not obtain a new housing credit allocation with respect to 
such building. Under section 42(d)(7), the acquirer would be entitled to 
claim only such credits as would have been allowable to the prior owner 
of the building.
    (6) Multiple housing credit allocations. A qualified low-income 
building may receive multiple housing credit allocations from different 
housing credit agencies having overlapping jurisdictions. A qualified 
low-income building that receives a housing credit allocation set aside 
exclusively for projects

[[Page 208]]

involving a qualified nonprofit organization may also receive a housing 
credit allocation from a housing credit agency's aggregate housing 
credit dollar amount that is not so set aside.
    (f) Exception to housing credit allocation requirement--(1) Tax-
exempt bond financing--(i) In general. No housing credit allocation is 
required in order to claim a credit under section 42 with respect to 
that portion of the eligible basis (as defined in section 42(d)) of a 
qualified low-income building that is financed with the proceeds of an 
obligation described in section 103(a) (``tax-exempt bond'') which is 
taken into account for purposes of the volume cap under section 146. In 
addition, no housing credit allocation is required in order to claim a 
credit under section 42 with respect to the entire qualified basis (as 
defined in section 42(c)) of a qualified low-income building if 70 
percent or more of the aggregate basis of the building and the land on 
which the building is located is financed with the proceeds of tax-
exempt bonds which are taken into account for purposes of the volume cap 
under section 146. For purposes of this paragraph, ``land on which the 
building is located'' includes only land that is functionally related 
and subordinate to the qualified low-income building. See Sec. 1.103-
8(b)(4)(iii) for the meaning of the term ``functionally related and 
subordinate''. For purposes of this paragraph, the basis of the land 
shall be determined using principles that are consistent with the rules 
contained in section 42(d).
    (ii) Determining use of bond proceeds. For purposes of determining 
the portion of proceeds of an issue of tax-exempt bonds used to finance 
(A) the eligible basis of a qualified low-income building, and (B) the 
aggregate basis of the building and the land on which the building is 
located, the proceeds of the issue must be allocated in the bond 
indenture or a related document (as defined in Sec. 1.103-13(b)(8)) in a 
manner consistent with the method used to allocate the net proceeds of 
the issue for purposes of determining whether 95 percent or more of the 
net proceeds of the issue are to be used for the exempt purpose of the 
issue. If the issuer is not consistent in making this allocation 
throughout the bond indenture and related documents, or if neither the 
bond indenture nor a related document provides an allocation, the 
proceeds of the issue will be allocated on a pro rata basis to all of 
the property financed by the issue, based on the relative cost of the 
property.
    (iii) Example. The provisions of this paragraph may be illustrated 
by the following example:

    Example. In 1987, County K assigns $500,000 of its volume cap for 
private activity bonds under section 146 to a $500,000 issue of exempt 
facility bonds to provide a qualified residential rental project to be 
owned by A, an individual. The aggregate basis of the building and the 
land on which the building is located is $700,000. Under the terms of 
the bond indenture, the net proceeds of the issue are to be used to 
finance $490,000 of the eligible basis of the building. More than 70 
percent of the aggregate basis of the qualified low-income building and 
the land on which the building is located is financed with the proceeds 
of tax-exempt bonds to which a portion of the volume cap under section 
146 was allocated. Accordingly, A may claim a credit under section 42 
without regard to whether any housing credit dollar amount was allocated 
to that building. If, instead, the aggregate basis of the building and 
land were $800,000, A would be able to claim the credit under section 42 
without receiving a housing credit allocation for the building only to 
the extent that the credit was attributable to eligible basis of the 
building financed with tax-exempt bonds.

    (g) Termination of authority to make housing credit allocation--(1) 
In general. No State or local housing credit agency shall receive an 
apportionment of a State housing credit ceiling for calendar years after 
1989. Consequently, no housing credit allocations may be made after 
1989, except as provided in paragraph (g)(2) of this section. Housing 
credit allocations made prior to January 1, 1990, remain effective after 
such date.
    (2) Carryover of unused 1989 apportionment. Any State or local 
housing credit agency that has an unused portion of its apportionment of 
the State housing credit ceiling for 1989 from which housing credit 
allocations have not been made in 1989 may carry over such unused 
portion into 1990. Such carryover portion of the 1989 apportionment 
shall be treated as the agency's apportionment for 1990. From this 1990 
apportionment, the State or local housing

[[Page 209]]

credit agency may make housing credit allocations only to a qualified 
low-income building meeting the following requirements:
    (i) The building must be constructed, reconstructed, or 
rehabilitated by the taxpayer seeking the allocation;
    (ii) More than 10 percent of the reasonably anticipated cost of such 
construction, reconstruction, or rehabilitation must have been incurred 
as of January 1, 1989; and
    (iii) The building must be placed in service before January 1, 1991.
    (3) Expiration of exception for tax-exempt bond financed projects. 
The exception to the requirement that a housing credit allocation be 
received with respect to any portion of the eligible basis of a 
qualified low-income building, as provided in paragraph (f) of this 
section, shall not apply to any building placed in service after 1989, 
unless such building is described in paragraphs (g)(2) (i), (ii), and 
(iii) of this section.
    (h) Filing of forms. For further guidance, see Sec. 1.42-1(h).
    (i) Transitional rules. The transitional rules contained in section 
252(f)(1) of the Tax Reform Act of 1986 are incorporated into this 
section of the regulations for purposes of determining whether a 
qualified low-income building is entitled to receive a housing credit 
allocation or is excepted from the requirement that a housing credit 
allocation be received. Housing credit allocations made to qualified 
low-income buildings described in section 252(f)(1) shall not count 
against the State or local housing credit agency's aggregate housing 
credit dollar amount. The transitional rules contained in section 
252(f)(2) of the Tax Reform Act of 1986 are incorporated into this 
section of the regulations for purposes of determining amounts available 
to certain State or local housing credit agencies for the making of 
housing credit allocations to certain qualified low-income housing 
projects. Amounts available to housing credit agencies under section 
252(f)(2) shall be treated as special apportionments unavailable for 
housing credit allocations to qualified low-income buildings not 
described in section 252(f)(2). Housing credit allocations made from the 
special apportionments shall not count against the State or local credit 
agency's aggregate housing credit dollar amount. The set-aside 
requirements shall not apply to these special apportionments. The 
transitional rules contained in section 252(f)(3) of the Tax Reform Act 
1986 are incorporated in this section of the regulations for purposes of 
determining the amount of housing credit allocations received by certain 
qualified low-income buildings. Housing credit allocations deemed 
received under section 252(f)(3) shall not count against the State or 
local housing credit agency's aggregate housing credit dollar amount.

[T.D. 8144, 52 FR 23433, June 22, 1987; 52 FR 24583, July 1, 1987, as 
amended by T.D. 9112, 69 FR 3827, Jan. 27, 2004]



Sec. 1.42-2  Waiver of requirement that an existing building eligible 
for the low-income housing credit was last placed in service more 
than 10 years prior to acquisition by the taxpayer.

    (a) Low-income housing credit for existing building. Section 42 
provides that, for purposes of section 38, new and existing qualified 
low-income buildings are eligible for a low-income housing credit. The 
eligibility rules for new and existing buildings differ. Under section 
42(d)(2), an existing building may be eligible for the low-income 
housing credit based upon the acquisition cost and amounts chargeable to 
capital account (to the extent properly included in eligible basis) if--
    (1) The taxpayer acquires the building by purchase (as defined in 
section 179(d)(2), as applicable under section 42(d)(2)(D)(iii)(I)),
    (2) There is a period of at least 10 years between the date of the 
building's acquisition by the taxpayer and the later of--(i) The date 
the building was last placed in service, or
    (ii) The date of the most recent nonqualified substantial 
improvement of the building, and
    (3) The building was not previously placed in service by the 
taxpayer, or by a person who was a related person (as defined in section 
42(d)(2)(D)(iii)(II)) with respect to the taxpayer as of the time the 
building was last previously placed in service.

[[Page 210]]

    (b) Waiver of 10-year holding period requirement. Section 42(d)(6) 
provides that a taxpayer may apply for a waiver of the 10-year holding 
period requirement specified in paragraph (a)(2) of this section. The 
Internal Revenue Service will grant a waiver only if--
    (1) The existing building satisfies all of the requirements in 
paragraph (c) of this section, and
    (2) The taxpayer makes an application in conformity with the 
requirements in paragraph (d) of this section.
    (c) Waiver requirements--(1) Federally-assisted building. To satisfy 
the requirement of this paragraph, a building must be a Federally-
assisted building. The term ``Federally assisted building'' means any 
building which is substantially assisted, financed, or operated under 
section 8 of the United States Housing Act of 1937, section 221(d)(3) or 
236 of the National Housing Act, or section 515 of the Housing Act of 
1949, as such acts were in effect on October 22, 1986.
    (2) Federal mortgage funds at risk. To satisfy the requirement of 
this paragraph, Federal mortgage funds must be at risk with respect to a 
mortgage that is secured by the building or a project of which the 
building is a part. For purposes of this paragraph, Federal mortgage 
funds are at risk if, in the event of a default by the mortgagor on the 
mortgage secured by the building or the project of which the building is 
a part--
    (i) The mortgage could be assigned to the Department of Housing and 
Urban Development or the Farmers' Home Administration, or
    (ii) There could arise a claim against a Federal mortgage insurance 
fund (or such Department or Administration).
    (3) Statement by the Department of Housing and Urban Development or 
the Farmers' Home Administration. (i) To satisfy the requirement of this 
paragraph, a letter or other written statement must be made or received 
and approved by the national office of the Department of Housing and 
Urban Development or the Farmers' Home Administration (``the Federal 
agency''). This letter or statement shall include the following:
    (A) A statement that, as of the earlier of the time of the 
taxpayer's acquisition of the building or the taxpayer's application for 
a waiver, the building is a Federally-assisted building within the 
meaning of paragraph (c)(1) of this section and identifies the source of 
Federal assistance;
    (B) A statement that a waiver of the 10-year holding period 
requirement is necessary to avert Federal mortgage funds being at risk 
within the meaning of paragraph (c)(2) of this section; and
    (C) A statement that the Federal agency has taken a Federal agency 
action as described in paragraph (c)(3)(ii) of this section.
    (ii) The following specified Federal agency actions shall be the 
only means of satisfying the requirement of this paragraph:
    (A) The Federal agency intends to accept an assignment of a mortgage 
secured by the building or the project of which the building is a part, 
and such assignment requires payments by the agency or a mortgage 
insurance fund maintained by the agency to the prior mortgagee;
    (B) The Federal agency or a mortgage insurance fund maintained by 
the agency intends to accept, as a consequence of foreclosure 
proceedings or otherwise, conveyance of the building or the project of 
which the building is a part;
    (C) The Federal agency or a mortgage insurance fund maintained by 
the agency intends, as a consequence of default, to take possession of, 
hold title to, or otherwise assume ownership of the building or the 
project of which the building is a part; or
    (D) The Federal agency has designated the building or the project of 
which the building is a part as a troubled building or project. A 
designation of a troubled building or project must satisfy the following 
requirements:
    (1) Designation of troubled status must be based on a review by the 
Federal agency of the financial condition of the building or project and 
on a determination by the Federal agency of a history of financial 
distress or mortgage defaults;
    (2) Designation of troubled status must be made or received and 
approved by the national office of the Federal agency; and

[[Page 211]]

    (3) Federal agency regulations or procedures must provide that, in 
the event of transfer of the ownership of a designated troubled building 
or project, the building or project may be subject to continued review 
by the Federal agency. Each Federal agency may prescribe its own 
standards and procedures for designating a troubled building or project 
so long as such standards are consistent with the requirements of this 
paragraph (c)(3)(ii)(D).
    (4) No prior credit allowed. The requirement of this paragraph is 
satisfied only if no prior owner was allowed a low-income housing credit 
under section 42 for the building.
    (d) Application for waiver--(1) Time and manner. In order to receive 
a waiver of the 10-year holding period requirement specified in 
paragraph (a)(2) of this section, a taxpayer must file an application 
(including the applicable user fee) that complies with the requirements 
of this paragraph (d) and Rev. Proc. 90-1, 1990-1 I.R.B. 8 (or any 
subsequent applicable revenue procedure). The application must be filed 
by a taxpayer who has acquired the building by purchase or who has a 
binding contract to purchase the building. Such binding contract may be 
conditioned upon the granting of a waiver under this section. The 
application may be filed at any time after a binding contract has been 
entered into, but no later than 12 months after the taxpayer's 
acquisition of the building. An application for a waiver of the 10-year 
holding period requirement must not contain a request for a ruling on 
any other issue arising under section 42 or other sections of the 
Internal Revenue Code. An application for a waiver of the 10-year 
holding period requirement must be mailed or delivered to the address 
listed in section 3.01 of Rev. Proc. 90-1 (or any subsequent applicable 
revenue procedure).
    (2) Information required. An application for a waiver of the 10-year 
holding period requirement must contain the following information:
    (i) The taxpayer's name, address and taxpayer identification number;
    (ii) The name (if any) and address of the acquired building and the 
project (if any) of which it is a part;
    (iii) The date of acquisition or the date of the binding contract 
for acquisition of the building by the taxpayer and the expected date of 
acquisition, the amount of consideration paid or to be paid for the 
acquisition (including the value of any liabilities assumed by the 
taxpayer), and the taxpayer's certification that such acquisition is by 
purchase (as defined in section 179(d)(2), as applicable under section 
42 (d)(2)(D)(iii)(I));
    (iv) The identity of the person from whom the building is acquired, 
and whether such person is a Federal agency, a mortgagee holding title 
to the building, or the mortgagor or prior owner;
    (v) The date the building was last placed in service and the date of 
the most recent (if any) nonqualified substantial improvement of the 
building (as defined in section 42 (d)(2)(D)(i));
    (vi) The taxpayer's certification that the building was not 
previously placed in service by the taxpayer, or by a person who was a 
related person (as defined in section 42(d)(2)(D)(iii)(II)) with respect 
to the taxpayer as of the time the building was last placed in service;
    (vii) The amount and disposition (e.g., discharge, assignment, 
assumption, or refinance) of the outstanding mortgage at the time of 
acquisition and the identities of the mortgagee and mortgagor;
    (viii) The taxpayer's certification that no prior owner was allowed 
a low-income housing credit under section 42 for the building (made to 
the best of the taxpayer's knowledge, with no documentation from other 
persons needed to be submitted); and
    (ix) The statement from the Federal agency required by paragraph 
(c)(3)(i) of this section.
    (3) Other rules. (i) In the event that an acquired building will be 
owned by more than one taxpayer, a single application for waiver may be 
filed by one taxpayer on behalf of the co-owners if the application 
contains the names, addresses and taxpayer identification numbers of the 
other owners. A general partner or a designated limited partner may file 
an application for waiver on behalf of a partnership.
    (ii) In the event that multiple Federally-assisted buildings in a 
project are

[[Page 212]]

being acquired by the taxpayer, a single application for waiver with 
respect to such buildings may be filed if the application contains the 
required information set out for the address of each Federally-assisted 
building involved.
    (iii) In the event that specific Federally-assisted buildings are 
being acquired by the taxpayer in a project consisting of multiple 
buildings that may or may not be Federally-assisted, a single 
application for waiver with respect to the Federally-assisted buildings 
being acquired may be filed if the application contains the required 
information set out for the address of each Federally-assisted building 
being acquired.
    (4) Effective date of waiver. A waiver will be effective when 
granted in writing by the Internal Revenue Service after submission of a 
completed application for waiver filed under this paragraph (d).
    (5) Attachment to return. A waiver letter granted by the Internal 
Revenue Service shall be filed with the taxpayer's Federal income tax 
return for the first taxable year the low-income housing credit is 
claimed by the taxpayer.
    (e) Effective date of regulations. The provisions of Sec. 1.42-2 are 
effective for buildings placed in service by the taxpayer after December 
31, 1986.

[T.D. 8302, 55 FR 21189, May 23, 1990; 55 FR 25973, June 26, 1990]



Sec. 1.42-3  Treatment of buildings financed with proceeds from a loan 
under an Affordable Housing Program established pursuant to section 
721 of the Financial Institutions Reform, Recovery, and Enforcement 
Act of 1989 (FIRREA).

    (a) Treatment under sections 42(i) and 42(b). A below market loan 
funded in whole or in part with funds from an Affordable Housing Program 
established under section 721 of FIRREA is not, solely by reason of the 
Affordable Housing Program funds, a below market Federal loan as defined 
in section 42(i)(2)(D). Thus, any building with respect to which the 
proceeds of the loan are used during the tax year is not, solely by 
reason of the Affordable Housing Program funds, treated as a federally 
subsidized building for that tax year and subsequent tax years for 
purposes of determining the applicable percentage for the building under 
section 42(b).
    (b) Effective date. The rules set forth in paragraph (a) of this 
section are effective for loans made after August 8, 1989.

[56 FR 48734, Sept. 26, 1991]



Sec. 1.42-4  Application of not-for-profit rules of section 183 
to low-income housing credit activities.

    (a) Inapplicability to section 42. In the case of a qualified low-
income building with respect to which the low-income housing credit 
under section 42 is allowable, section 183 does not apply to disallow 
losses, deductions, or credits attributable to the ownership and 
operation of the building.
    (b) Limitation. Notwithstanding paragraph (a) of this section, 
losses, deductions, or credits attributable to the ownership and 
operation of a qualified low-income building with respect to which the 
low-income housing credit under section 42 is allowable may be limited 
or disallowed under other provisions of the Code or principles of tax 
law. See, e.g., sections 38(c), 163(d), 465, 469; Knetsch v. United 
States, 364 U.S. 361 (1960), 1961-1 C.B. 34 (``sham'' or ``economic 
substance'' analysis); and Frank Lyon Co. v. Commissioner, 435 U.S. 561 
(1978), 1978-1 C.B. 46 (``ownership'' analysis).
    (c) Effective date. The rules set forth in paragraphs (a) and (b) of 
this section are effective with respect to buildings placed in service 
after December 31, 1986.

[T.D. 8420, 57 FR 24729, June 11, 1992]



Sec. 1.42-5  Monitoring compliance with low-income housing credit requirements.

    (a) Compliance monitoring requirement--(1) In general. Under section 
42(m)(1)(B)(iii), an allocation plan is not qualified unless it contains 
a procedure that the State or local housing credit agency (``Agency'') 
(or an agent of, or other private contractor hired by, the Agency) will 
follow in monitoring for noncompliance with the provisions of section 42 
and in notifying the Internal Revenue Service of any

[[Page 213]]

noncompliance of which the Agency becomes aware. These regulations only 
address compliance monitoring procedures required of Agencies. The 
regulations do not address forms and other records that may be required 
by the Service on examination or audit. For example, if a building is 
sold or otherwise transferred by the owner, the transferee should obtain 
from the transferor information related to the first year of the credit 
period so that the transferee can substantiate credits claimed.
    (2) Requirements for a monitoring procedure--(i) In general. A 
procedure for monitoring for noncompliance under section 
42(m)(1)(B)(iii) must include--
    (A) The recordkeeping and record retention provisions of paragraph 
(b) of this section;
    (B) The certification and review provisions of paragraph (c) of this 
section;
    (C) The inspection provision of paragraph (d) of this section; and
    (D) The notification-of-noncompliance provisions of paragraph (e) of 
this section.
    (ii) Order and form. A monitoring procedure will meet the 
requirements of section 42 (m)(1)(B)(iii) if it contains the substance 
of these provisions. The particular order and form of the provisions in 
the allocation plan is not material. A monitoring procedure may contain 
additional provisions or requirements.
    (iii) [Reserved]. For further guidance, see Sec. 1.42-5T(a)(2)(iii).
    (b) Recordkeeping and record retention provisions--(1) Recordkeeping 
provision. Under the recordkeeping provision, the owner of a low-income 
housing project must be required to keep records for each qualified low-
income building in the project that show for each year in the compliance 
period--
    (i) The total number of residential rental units in the building 
(including the number of bedrooms and the size in square feet of each 
residential rental unit);
    (ii) The percentage of residential rental units in the building that 
are low-income units;
    (iii) The rent charged on each residential rental unit in the 
building (including any utility allowances);
    (iv) The number of occupants in each low-income unit, but only if 
rent is determined by the number of occupants in each unit under section 
42(g)(2) (as in effect before the amendments made by the Omnibus Budget 
Reconciliation Act of 1989);
    (v) The low-income unit vacancies in the building and information 
that shows when, and to whom, the next available units were rented;
    (vi) The annual income certification of each low-income tenant per 
unit. For an exception to this requirement, see section 42(g)(8)(B) 
(which provides a special rule for a 100 percent low-income building);
    (vii) Documentation to support each low-income tenant's income 
certification (for example, a copy of the tenant's federal income tax 
return, Forms W-2, or verifications of income from third parties such as 
employers or state agencies paying unemployment compensation). For an 
exception to this requirement, see section 42(g)(8)(B) (which provides a 
special rule for a 100 percent low-income building). Tenant income is 
calculated in a manner consistent with the determination of annual 
income under section 8 of the United States Housing Act of 1937 
(``Section 8''), not in accordance with the determination of gross 
income for federal income tax liability. In the case of a tenant 
receiving housing assistance payments under Section 8, the documentation 
requirement of this paragraph (b)(1)(vii) is satisfied if the public 
housing authority provides a statement to the building owner declaring 
that the tenant's income does not exceed the applicable income limit 
under section 42 (g);
    (viii) The eligible basis and qualified basis of the building at the 
end of the first year of the credit period; and
    (ix) The character and use of the nonresidential portion of the 
building included in the building's eligible basis under section 42 (d) 
(e.g., tenant facilities that are available on a comparable basis to all 
tenants and for which no separate fee is charged for use of the 
facilities, or facilities reasonably required by the project).
    (2) Record retention provision. Under the record retention 
provision, the owner of a low-income housing project

[[Page 214]]

must be required to retain the records described in paragraph (b)(1) of 
this section for at least 6 years after the due date (with extensions) 
for filing the federal income tax return for that year. The records for 
the first year of the credit period, however, must be retained for at 
least 6 years beyond the due date (with extensions) for filing the 
federal income tax return for the last year of the compliance period of 
the building.
    (3) Inspection record retention provision. Under the inspection 
record retention provision, the owner of a low-income housing project 
must be required to retain the original local health, safety, or 
building code violation reports or notices that were issued by the State 
or local government unit (as described in paragraph (c)(1)(vi) of this 
section) for the Agency's inspection under paragraph (d) of this 
section. Retention of the original violation reports or notices is not 
required once the Agency reviews the violation reports or notices and 
completes its inspection, unless the violation remains uncorrected.
    (c) Certification and review provisions--(1) Certification. Under 
the certification provision, the owner of a low-income housing project 
must be required to certify at least annually to the Agency that, for 
the preceding 12-month period--
    (i) The project met the requirements of:
    (A) The 20-50 test under section 42 (g)(1)(A), the 40-60 test under 
section 42 (g)(1)(B), or the 25-60 test under sections 42 (g)(4) and 142 
(d)(6) for New York City, whichever minimum set-aside test was 
applicable to the project; and
    (B) If applicable to the project, the 15-40 test under sections 
42(g)(4) and 142 (d)(4)(B) for ``deep rent skewed'' projects;
    (ii) There was no change in the applicable fraction (as defined in 
section 42(c)(1)(B)) of any building in the project, or that there was a 
change, and a description of the change;
    (iii) The owner has received an annual income certification from 
each low-income tenant, and documentation to support that certification; 
or, in the case of a tenant receiving Section 8 housing assistance 
payments, the statement from a public housing authority described in 
paragraph (b)(1)(vii) of this section. For an exception to this 
requirement, see section 42(g)(8)(B) (which provides a special rule for 
a 100 percent low-income building);
    (iv) Each low-income unit in the project was rent-restricted under 
section 42(g)(2);
    (v) All units in the project were for use by the general public (as 
defined in Sec. 1.42-9), including the requirement that no finding of 
discrimination under the Fair Housing Act, 42 U.S.C. 3601-3619, occurred 
for the project. A finding of discrimination includes an adverse final 
decision by the Secretary of the Department of Housing and Urban 
Development (HUD), 24 CFR 180.680, an adverse final decision by a 
substantially equivalent state or local fair housing agency, 42 U.S.C. 
3616a(a)(1), or an adverse judgment from a federal court;
    (vi) The buildings and low-income units in the project were suitable 
for occupancy, taking into account local health, safety, and building 
codes (or other habitability standards), and the State or local 
government unit responsible for making local health, safety, or building 
code inspections did not issue a violation report for any building or 
low-income unit in the project. If a violation report or notice was 
issued by the governmental unit, the owner must attach a statement 
summarizing the violation report or notice or a copy of the violation 
report or notice to the annual certification submitted to the Agency 
under paragraph (c)(1) of this section. In addition, the owner must 
state whether the violation has been corrected;
    (vii) There was no change in the eligible basis (as defined in 
section 42(d)) of any building in the project, or if there was a change, 
the nature of the change (e.g., a common area has become commercial 
space, or a fee is now charged for a tenant facility formerly provided 
without charge);
    (viii) All tenant facilities included in the eligible basis under 
section 42(d) of any building in the project, such as

[[Page 215]]

swimming pools, other recreational facilities, and parking areas, were 
provided on a comparable basis without charge to all tenants in the 
building;
    (ix) If a low-income unit in the project became vacant during the 
year, that reasonable attempts were or are being made to rent that unit 
or the next available unit of comparable or smaller size to tenants 
having a qualifying income before any units in the project were or will 
be rented to tenants not having a qualifying income;
    (x) If the income of tenants of a low-income unit in the building 
increased above the limit allowed in section 42(g)(2)(D)(ii), the next 
available unit of comparable or smaller size in the building was or will 
be rented to tenants having a qualifying income;
    (xi) An extended low-income housing commitment as described in 
section 42(h)(6) was in effect (for buildings subject to section 
7108(c)(1) of the Omnibus Budget Reconciliation Act of 1989, 103 Stat. 
2106, 2308-2311), including the requirement under section 
42(h)(6)(B)(iv) that an owner cannot refuse to lease a unit in the 
project to an applicant because the applicant holds a voucher or 
certificate of eligibility under section 8 of the United States Housing 
Act of 1937, 42 U.S.C. 1437f (for buildings subject to section 
13142(b)(4) of the Omnibus Budget Reconciliation Act of 1993, 107 Stat. 
312, 438-439); and
    (xii) All low-income units in the project were used on a 
nontransient basis (except for transitional housing for the homeless 
provided under section 42(i)(3)(B)(iii) or single-room-occupancy units 
rented on a month-by-month basis under section 42(i)(3)(B)(iv)).
    (2) Review. The review provision must--
    (i) Require that the Agency review the certifications submitted 
under paragraph (c)(1) of this section for compliance with the 
requirements of section 42;
    (ii) [Reserved]. For further guidance, see Sec. 1.42-5T(c)(2)(ii).
    (iii) [Reserved]. For further guidance, see Sec. 1.42-5T(c)(2)(iii).
    (3) [Reserved]. For further guidance, see Sec. 1.42-5T(c)(3).
    (4) Exception for certain buildings--(i) In general. The review 
requirements under paragraph (c)(2)(ii) of this section may provide that 
owners are not required to submit, and the Agency is not required to 
review, the tenant income certifications, supporting documentation, and 
rent records for buildings financed by the Rural Housing Service (RHS), 
formerly known as Farmers Home Administration, under the section 515 
program, or buildings of which 50 percent or more of the aggregate basis 
(taking into account the building and the land) is financed with the 
proceeds of obligations the interest on which is exempt from tax under 
section 103 (tax-exempt bonds). In order for a monitoring procedure to 
except these buildings, the Agency must meet the requirements of 
paragraph (c)(4)(ii) of this section.
    (ii) Agreement and review. The Agency must enter into an agreement 
with the RHS or tax-exempt bond issuer. Under the agreement, the RHS or 
tax-exempt bond issuer must agree to provide information concerning the 
income and rent of the tenants in the building to the Agency. The Agency 
may assume the accuracy of the information provided by RHS or the tax-
exempt bond issuer without verification. The Agency must review the 
information and determine that the income limitation and rent 
restriction of section 42 (g)(1) and (2) are met. However, if the 
information provided by the RHS or tax-exempt bond issuer is not 
sufficient for the Agency to make this determination, the Agency must 
request the necessary additional income or rent information from the 
owner of the buildings. For example, because RHS determines tenant 
eligibility based on its definition of ``adjusted annual income,'' 
rather than ``annual income'' as defined under Section 8, the Agency may 
have to calculate the tenant's income for section 42 purposes and may 
need to request additional income information from the owner.
    (iii) Example. The exception permitted under paragraph (c)(4)(i) and 
(ii) of this section is illustrated by the following example.

    Example. An Agency selects for review buildings financed by the RHS. 
The Agency has entered into an agreement described in paragraph 
(c)(4)(ii) of this section with the

[[Page 216]]

RHS with respect to those buildings. In reviewing the RHS-financed 
buildings, the Agency obtains the tenant income and rent information 
from the RHS for 20 percent of the low-income units in each of those 
buildings. The Agency calculates the tenant income and rent to determine 
whether the tenants meet the income and rent limitation of section 42 
(g)(1) and (2). In order to make this determination, the Agency may need 
to request additional income or rent information from the owners of the 
RHS buildings if the information provided by the RHS is not sufficient.

    (5) Agency reports of compliance monitoring activities. The Agency 
must report its compliance monitoring activities annually on Form 8610, 
``Annual Low-Income Housing Credit Agencies Report.''
    (d) Inspection provision--(1) In general. Under the inspection 
provision, the Agency must have the right to perform an on-site 
inspection of any low-income housing project at least through the end of 
the compliance period of the buildings in the project. The inspection 
provision of this paragraph (d) is a separate requirement from any 
tenant file review under paragraph (c)(2)(ii) of this section.
    (2) Inspection standard. For the on-site inspections of buildings 
and low-income units required by paragraph (c)(2)(ii) of this section, 
the Agency must review any local health, safety, or building code 
violations reports or notices retained by the owner under paragraph 
(b)(3) of this section and must determine--
    (i) Whether the buildings and units are suitable for occupancy, 
taking into account local health, safety, and building codes (or other 
habitability standards); or
    (ii) Whether the buildings and units satisfy, as determined by the 
Agency, the uniform physical condition standards for public housing 
established by HUD (24 CFR 5.703). The HUD physical condition standards 
do not supersede or preempt local health, safety, and building codes. A 
low-income housing project under section 42 must continue to satisfy 
these codes and, if the Agency becomes aware of any violation of these 
codes, the Agency must report the violation to the Service. However, 
provided the Agency determines by inspection that the HUD standards are 
met, the Agency is not required under this paragraph (d)(2)(ii) to 
determine by inspection whether the project meets local health, safety, 
and building codes.
    (3) Exception from inspection provision. An Agency is not required 
to inspect a building under this paragraph (d) if the building is 
financed by the RHS under the section 515 program, the RHS inspects the 
building (under 7 CFR part 1930), and the RHS and Agency enter into a 
memorandum of understanding, or other similar arrangement, under which 
the RHS agrees to notify the Agency of the inspection results.
    (4) Delegation. An Agency may delegate inspection under this 
paragraph (d) to an Authorized Delegate retained under paragraph (f) of 
this section. Such Authorized Delegate, which may include HUD or a HUD-
approved inspector, must notify the Agency of the inspection results.
    (e) Notification-of-noncompliance provision--(1) In general. Under 
the notification-of-noncompliance provisions, the Agency must be 
required to give the notice described in paragraph (e)(2) of this 
section to the owner of a low-income housing project and the notice 
described in paragraph (e)(3) of this section to the Service.
    (2) Notice to owner. The Agency must be required to provide prompt 
written notice to the owner of a low-income housing project if the 
Agency does not receive the certification described in paragraph (c)(1) 
of this section, or does not receive or is not permitted to inspect the 
tenant income certifications, supporting documentation, and rent records 
described in paragraph (c)(2)(ii) of this section, or discovers by 
inspection, review, or in some other manner, that the project is not in 
compliance with the provisions of section 42.
    (3) Notice to Internal Revenue Service--(i) In general. The Agency 
must be required to file Form 8823, ``Low-Income Housing Credit Agencies 
Report of Noncompliance,'' with the Service no later than 45 days after 
the end of the correction period (as described in paragraph (e)(4) of 
this section, including extensions permitted under that paragraph) and 
no earlier than the end of the correction period, whether or not the 
noncompliance or failure to certify

[[Page 217]]

is corrected. The Agency must explain on Form 8823 the nature of the 
noncompliance or failure to certify and indicate whether the owner has 
corrected the noncompliance or failure to certify. Any change in either 
the applicable fraction or eligible basis under paragraph (c)(1)(ii) and 
(vii) of this section, respectively, that results in a decrease in the 
qualified basis of the project under section 42 (c)(1)(A) is 
noncompliance that must be reported to the Service under this paragraph 
(e)(3). If an Agency reports on Form 8823 that a building is entirely 
out of compliance and will not be in compliance at any time in the 
future, the Agency need not file Form 8823 in subsequent years to report 
that building's noncompliance. If the noncompliance or failure to 
certify is corrected within 3 years after the end of the correction 
period, the Agency is required to file Form 8823 with the Service 
reporting the correction of the noncompliance or failure to certify.
    (ii) Agency retention of records. An Agency must retain records of 
noncompliance or failure to certify for 6 years beyond the Agency's 
filing of the respective Form 8823. In all other cases, the Agency must 
retain the certifications and records described in paragraph (c) of this 
section for 3 years from the end of the calendar year the Agency 
receives the certifications and records.
    (4) Correction period. The correction period shall be that period 
specified in the monitoring procedure during which an owner must supply 
any missing certifications and bring the project into compliance with 
the provisions of section 42. The correction period is not to exceed 90 
days from the date of the notice to the owner described in paragraph 
(e)(2) of this section. An Agency may extend the correction period for 
up to 6 months, but only if the Agency determines there is good cause 
for granting the extension.
    (f) Delegation of Authority--(1) Agencies permitted to delegate 
compliance monitoring functions--(i) In general. An Agency may retain an 
agent or other private contractor (``Authorized Delegate'') to perform 
compliance monitoring. The Authorized Delegate must be unrelated to the 
owner of any building that the Authorized Delegate monitors. The 
Authorized Delegate may be delegated all of the functions of the Agency, 
except for the responsibility of notifying the Service under paragraphs 
(c)(5) and (e)(3) of this section. For example, the Authorized Delegate 
may be delegated the responsibility of reviewing tenant certifications 
and documentation under paragraph (c) (1) and (2) of this section, the 
right to inspect buildings and records as described in paragraph (d) of 
this section, and the responsibility of notifying building owners of 
lack of certification or noncompliance under paragraph (e)(2) of this 
section. The Authorized Delegate must notify the Agency of any 
noncompliance or failure to certify.
    (ii) Limitations. An Agency that delegates compliance monitoring to 
an Authorized Delegate under paragraph (f)(1)(i) of this section must 
use reasonable diligence to ensure that the Authorized Delegate properly 
performs the delegated monitoring functions. Delegation by an Agency of 
compliance monitoring functions to an Authorized Delegate does not 
relieve the Agency of its obligation to notify the Service of any 
noncompliance of which the Agency becomes aware.
    (2) Agencies permitted to delegate compliance monitoring functions 
to another Agency. An Agency may delegate all or some of its compliance 
monitoring responsibilities for a building to another Agency within the 
State. This delegation may include the responsibility of notifying the 
Service under paragraph (e)(3) of this section.
    (g) Liability. Compliance with the requirements of section 42 is the 
responsibility of the owner of the building for which the credit is 
allowable. The Agency's obligation to monitor for compliance with the 
requirements of section 42 does not make the Agency liable for an 
owner's noncompliance.
    (h) Effective/applicability dates--(1) In general. Allocation plans 
must comply with these regulations by June 30, 1993. The requirement of 
section 42 (m)(1)(B)(iii) that allocation plans contain a procedure for 
monitoring for noncompliance becomes effective on January 1, 1992, and 
applies to buildings for which a low-income housing credit is, or has 
been, allowable at any

[[Page 218]]

time. Thus, allocation plans must comply with section 42(m)(1)(B)(iii) 
prior to June 30, 1993, the effective date of these regulations. An 
allocation plan that complies with these regulations, with the notice of 
proposed rulemaking published in the Federal Register on December 27, 
1991, or with a reasonable interpretation of section 42(m)(1)(B)(iii) 
will satisfy the requirements of section 42(m)(1)(B)(iii) for periods 
before June 30, 1993. Section 42(m)(1)(B)(iii) and these regulations do 
not require monitoring for whether a building or project is in 
compliance with the requirements of section 42 prior to January 1, 1992. 
However, if an Agency becomes aware of noncompliance that occurred prior 
to January 1, 1992, the Agency is required to notify the Service of that 
noncompliance. In addition, the requirements in paragraphs (b)(3) and 
(c)(1)(v), (vi), and (xi) of this section (involving recordkeeping and 
annual owner certifications) and paragraphs (c)(2)(ii)(B), (c)(2)(iii), 
and (d) of this section (involving tenant file reviews and physical 
inspections of existing projects, and the physical inspection standard) 
are applicable January 1, 2001. The requirement in paragraph 
(c)(2)(ii)(A) of this section (involving tenant file reviews and 
physical inspections of new projects) is applicable for buildings placed 
in service on or after January 1, 2001. The requirements in paragraph 
(c)(5) of this section (involving Agency reporting of compliance 
monitoring activities to the Service) and paragraph (e)(3)(i) of this 
section (involving Agency reporting of corrected noncompliance or 
failure to certify within 3 years after the end of the correction 
period) are applicable January 14, 2000.
    (2) [Reserved]. For further guidance, see Sec. 1.42-5T(h)(2).
    (i) [Reserved]. For further guidance, see Sec. 1.42-5T(i).

[T.D. 8430, 57 FR 40121, Sept. 2, 1992; 57 FR 57280, Dec. 3, 1992; 58 FR 
7748, Feb. 9, 1993; T.D. 8563, 59 FR 50163, Oct. 3, 1994; T.D. 8859, 65 
FR 2326, Jan. 14, 2000; 65 FR 16317, Mar. 28, 2000; T.D. 9753, 81 FR 
9336, Feb. 25, 2016]



Sec. 1.42-5T  Monitoring compliance with low-income housing credit 
requirements (temporary).

    (a)(1) through (a)(2)(ii) [Reserved]. For further guidance, see 
Sec. 1.42-5(a)(1) through (a)(2)(ii).
    (iii) Effect of guidance published in the Internal Revenue Bulletin. 
Guidance published in the Internal Revenue Bulletin (see 
Sec. 601.601(d)(2)(ii)(b) of this chapter) may provide--
    (A) Exceptions to the requirements referred to in Sec. 1.42-
5(a)(2)(i) and the requirements described in this section; or
    (B) Alternative means of satisfying those requirements.
    (b) through (c)(2)(i) [Reserved]. For further guidance, see 
Sec. 1.42-5(b) through (c)(2)(i).
    (ii) Require that, with respect to each low-income housing project, 
the Agency conduct on-site inspections and review low-income 
certifications (including in that term the documentation supporting the 
low-income certifications and the rent records for tenants).
    (iii) Require that the on-site inspections that the Agency must 
conduct satisfy both the requirements of Sec. 1.42-5(d) and the 
requirements in paragraph (c)(2)(iii)(A) through (D) of this section, 
and require that the low-income certification review that the Agency 
must perform satisfies the requirements in paragraphs (c)(2)(iii)(A) 
through (D) of this section. Paragraph (c)(2)(iii)(A) through (D) of 
this section provides rules determining how these on-site inspection 
requirements and how these low-income certification review requirements 
may be satisfied by an inspection or review, as the case may be, that 
includes only a sample of the low-income units.
    (A) Timing. The Agency must conduct on-site inspections of all 
buildings in the low-income housing project and must review low-income 
certifications of the low-income housing project--
    (1) By the end of the second calendar year following the year the 
last building in the low-income housing project is placed in service; 
and
    (2) At least once every 3 years thereafter.

[[Page 219]]

    (B) Number of low-income units. The Agency must conduct on-site 
inspections and low-income certification review of not fewer than the 
minimum number of low-income units required by guidance published in the 
Internal Revenue Bulletin. See Sec. 601.601(d)(2)(ii)(b) of this 
chapter.
    (C) Selection of low-income units for inspection and low-income 
certifications for review--(1) Random selection. The Agency must select 
in a random manner the low-income units to be inspected and the units 
whose low-income certifications are to be reviewed. The Agency is not 
required to select the same low-income units of a low-income housing 
project for on-site inspections and low-income certification review, and 
an Agency may choose a different number of units for on-site inspections 
and for low-income certification review, provided the Agency chooses at 
least the minimum number of low-income units in each case. If the Agency 
chooses to select different low-income units for on-site inspections and 
low-income certification review, the Agency must select the units for 
on-site inspections or low-income certification review separately and in 
a random manner.
    (2) Advance notification limited to reasonable notice. The Agency 
must select the low-income units to inspect and low-income 
certifications to review in a manner that will not give advance notice 
that a particular low-income unit (or low-income certifications for a 
particular low-income unit) for a particular year will or will not be 
inspected (or reviewed). However, the Agency may give an owner 
reasonable notice that an inspection of the building and low-income 
units or review of low-income certifications will occur. The notice is 
to enable the owner to notify tenants of the inspection or to assemble 
low-income certifications for review.
    (3) Meaning of reasonable notice. For purposes of paragraph 
(c)(2)(iii)(C)(ii) of this section, reasonable notice is generally no 
more than 30 days. The notice period begins on the date the Agency 
informs the owner of the identity of the units for which on-site 
inspections or low-income certification review will or will not occur. 
Notice of more than 30 days, however, may be reasonable in extraordinary 
circumstances that are beyond an Agency's control and that prevent an 
Agency from carrying out within 30 days an on-site inspection or low-
income certification review. Extraordinary circumstances include, but 
are not limited to, natural disasters and severe weather conditions. In 
the event of extraordinary circumstances that result in a reasonable-
notice period longer than 30 days, an Agency must conduct the on-site 
inspection or low-income certification review as soon as practicable.
    (4) Applicability of reasonable notice limitation when the same 
units are chosen for inspection and file review. If the Agency chooses 
to select the same units for on-site inspections and low-income 
certification review, the Agency may conduct on-site inspections and 
low-income certification review either at the same time or separately. 
The Agency, however, must conduct both the inspections and review within 
the reasonable-notice period described in paragraph (c)(2)(iii)(C)(2) 
and (3) of this section.
    (D) Method of low-income certification review. The Agency may review 
the low-income certifications wherever the owner maintains or stores the 
records (either on-site or off-site).
    (3) Frequency and form of certification. A monitoring procedure must 
require that the certifications and reviews of Sec. 1.42-5(c)(1) and 
(c)(2)(i) be made at least annually covering each year of the 15-year 
compliance period under section 42(i)(1). The certifications must be 
made under penalty of perjury. A monitoring procedure may require 
certifications and reviews more frequently than every 12 months, 
provided that all months within each 12-month period are subject to 
certification.
    (c)(4) through (h)(1) [Reserved]. For further guidance, see 
Sec. 1.42-5(c)(4) through (h)(1).
    (2) Effective/applicability dates of the REAC inspection protocol. 
The requirements in paragraphs (a)(2)(iii), (c)(2)(ii) and (iii), and 
(c)(3) of this section apply beginning on February 25, 2016. Agencies 
using the REAC inspection protocol of the Department of Housing and 
Urban Development as part of the Physical Inspections Pilot Program may 
rely on these provisions for on-

[[Page 220]]

site inspections and low-income certification review occurring between 
January 1, 2015 and February 25, 2016. Otherwise, for the rules that 
apply before February 25, 2016, see Sec. 1.42-5 as contained in 26 CFR 
part 1 revised as of April 1, 2015.
    (i) Expiration date. The applicability of this section expires on 
February 22, 2019.

[T.D. 9753, 81 FR 9337, Feb. 25, 2016]



Sec. 1.42-6  Buildings qualifying for carryover allocations.

    (a) Carryover allocations--(1) In general. A carryover allocation is 
an allocation that meets the requirements of section 42(h)(1)(E) or (F). 
If the requirements of section Sec. 42(h)(1)(E) or (F) that are required 
to be satisfied by the close of a calendar year are not satisfied, the 
allocation is not valid and is treated as if it had not been made for 
that calendar year. For example, if a carryover allocation fails to 
satisfy a requirement in Sec. 1.42-6(d) for making an allocation, such 
as failing to be signed or dated by an authorized official of an 
allocating agency by the close of a calendar year, the allocation is not 
valid and is treated as if it had not been made for that calendar year.
    (2) 10 percent basis requirement. A carryover allocation may only be 
made with respect to a qualified building. A qualified building is any 
building which is part of a project if, by the date specified under 
paragraph (a)(2)(i) or (ii) of this section, a taxpayer's basis in the 
project is more than 10 percent of the taxpayer's reasonably expected 
basis in the project as of the close of the second calendar year 
following the calendar year the allocation is made. For purposes of 
meeting the 10 percent basis requirement, the determination of whether a 
building is part of a single-building project or multi-building project 
is based on whether the carryover allocation is made under section 
42(h)(1)(E) (building-based allocation) or section 42(h)(1)(F) (project-
based allocation). In the case of a multi-building project that receives 
an allocation under section 42(h)(1)(F), the 10 percent basis 
requirement is satisfied by reference to the entire project.
    (i) Allocation made before July 1. If a carryover allocation is made 
before July 1 of a calendar year, a taxpayer must meet the 10 percent 
basis requirement by the close of that calendar year. If a taxpayer does 
not meet the 10 percent basis requirement by the close of the calendar 
year, the carryover allocation is not valid and is treated as if it had 
not been made.
    (ii) Allocation made after June 30. If a carryover allocation is 
made after June 30 of a calendar year, a taxpayer must meet the 10 
percent basis requirement by the close of the date that is 6 months 
after the date the allocation was made. If a taxpayer does not meet the 
10 percent basis requirement by the close of the required date, the 
carryover allocation must be returned to the Agency. Unlike a carryover 
allocation made before July 1, if a taxpayer does not meet the 10 
percent basis requirement by the close of the required date, the 
carryover allocation is treated as a valid allocation for the calendar 
year of allocation, but is included in the ``returned credit component'' 
for purposes of determining the State housing credit ceiling under 
section 42(h)(3)(C) for the calendar year following the calendar year of 
the allocation. See Sec. 1.42-14(d)(1).
    (b) Carryover-allocation basis--(1) In general. Subject to the 
limitations of paragraph (b)(2) of this section, a taxpayer's basis in a 
project for purposes of section 42(h)(1) (E)(ii) or (F) (carryover-
allocation basis) is the taxpayer's adjusted basis in land or 
depreciable property that is reasonably expected to be part of the 
project, whether or not these amounts are includible in eligible basis 
under section 42(d). Thus, for example, if the project is to include 
property that is not residential rental property, such as commercial 
space, the basis attributable to the commercial space, although not 
includible in eligible basis, is includible in carryover-allocation 
basis. The adjusted basis of land and depreciable property is determined 
under sections 1012 and 1016, and generally includes the direct and 
indirect costs of acquiring, constructing, and rehabilitating the 
property. Costs otherwise includible in carryover-allocation basis are 
not excluded by reason of having been incurred prior to the calendar 
year in which the carryover allocation is made.

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    (2) Limitations--For purposes of determining carryover-allocation 
basis under paragraph (b)(1) of this section, the following limitations 
apply.
    (i) Taxpayer must have basis in land or depreciable property related 
to the project. A taxpayer has carryover-allocation basis to the extent 
that it has basis in land or depreciable property and the land or 
depreciable property is reasonably expected to be part of the project 
for which the carryover allocation is made. This basis includes all 
items that are properly capitalizable with respect to the land or 
depreciable property. For example, a nonrefundable downpayment for, or 
an amount paid to acquire an option to purchase, land or depreciable 
property may be included in carryover-allocation basis if properly 
capitalizable into the basis of land or depreciable property that is 
reasonably expected to be part of a project.
    (ii) High cost areas. Any increase in eligible basis that may result 
under section 42(d)(5)(C) from a building's location in a qualified 
census tract or difficult development area is not taken into account in 
determining carryover-allocation basis or reasonably expected basis.
    (iii) Amounts not treated as paid or incurred. An amount is not 
includible in carryover-allocation basis unless it is treated as paid or 
incurred under the method of accounting used by the taxpayer. For 
example, a cash method taxpayer cannot include construction costs in 
carryover-allocation basis unless the costs have been paid, and an 
accrual method taxpayer cannot include construction costs in carryover- 
allocation basis unless they have been properly accrued. See paragraph 
(b)(2)(iv) of this section for a special rule for fees.
    (iv) Fees. A fee is includible in carryover-allocation basis only to 
the extent the requirements of paragraph (b)(2)(iii) of this section are 
met and--
    (A) The fee is reasonable;
    (B) The taxpayer is legally obligated to pay the fee;
    (C) The fee is capitalizable as part of the taxpayer's basis in land 
or depreciable property that is reasonably expected to be part of the 
project;
    (D) The fee is not paid (or to be paid) by the taxpayer to itself; 
and
    (E) If the fee is paid (or to be paid) by the taxpayer to a related 
person, and the taxpayer uses the cash method of accounting, the 
taxpayer could properly accrue the fee under the accrual method of 
accounting (considering, for example, the rules of section 461(h)). A 
person is a related person if the person bears a relationship to the 
taxpayer specified in sections 267(b) or 707(b)(1), or if the person and 
the taxpayer are engaged in trades or businesses under common control 
(within the meaning of subsections (a) and (b) of section 52).
    (3) Reasonably expected basis. Rules similar to the rules of 
paragraphs (a) and (b) of this section apply in determining the 
taxpayer's reasonably expected basis in a project (land and depreciable 
basis) as of the close of the second calendar year following the 
calendar year of the allocation.
    (4) Examples. The following examples illustrate the rules of 
paragraphs (a) and (b) of this section.

    Example 1. (i) Facts. C, an accrual-method taxpayer, receives a 
carryover allocation from Agency, the state housing credit agency, in 
May of 2003. As of that date, C has not begun construction of the low-
income housing building C plans to build. However, C has owned the land 
on which C plans to build the building since 1985. C's basis in the land 
is $100,000. C reasonably expects that by the end of 2005, C's basis in 
the project of which the building is to be a part will be $2,000,000. C 
also expects that because the project is located in a qualified census 
tract, C will be able to increase its basis in the project to 
$2,600,000. Before the close of 2003, C incurs $150,000 of costs for 
architects' fees and site preparation. C properly accrues these costs 
under its method of accounting and capitalizes the costs.
    (ii) Determination of carryover-allocation basis. C's $100,000 basis 
in the land is includible in carryover-allocation basis even though C 
has owned the land since 1985. The $150,000 of costs C has incurred for 
architects' fees and site preparation are also includible in carryover-
allocation basis. The expected increase in basis due to the project's 
location in a qualified census tract is not taken into account in 
determining C's carryover-allocation basis. Accordingly, C's carryover-
allocation basis in the project of which the building is a part is 
$250,000.
    (iii) Determination of whether building is qualified. C's reasonably 
expected basis in the project at the close of the second calendar

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year following the calendar year of allocation is $2,000,000. The 
expected increase in eligible basis due to the project's location in a 
qualified census tract is not taken into account in determining this 
amount. Because C's carryover-allocation basis is more than 10 percent 
of C's reasonably expected basis in the project of which the building is 
a part, the building for which C received the carryover allocation is a 
qualified building for purposes of section 42(h)(1)(E)(ii) and paragraph 
(a) of this section.
    Example 2. (i) Facts. D, an accrual-method taxpayer, received a 
carryover allocation from Agency, the state housing credit agency of 
State X, on September 12, 2003. As of that date, D has not begun 
construction of the low-income housing building D plans to build and D 
does not have basis in the land on which D plans to build the building. 
From September 12, 2003, to the close of March 12, 2004, D incurs some 
costs related to the planned building, including architects' fees. As of 
the close of March 12, 2004, these costs do not exceed 10 percent of D's 
reasonably expected basis in the single-building project as of the close 
of 2005.
    (ii) Determination of whether building is qualified. Because D's 
carryover-allocation basis as of the close of March 12, 2004, is not 
more than 10 percent of D's reasonably expected basis in the single-
building project, the building is not a qualified building for purposes 
of section 42(h)(1)(E)(ii) and paragraph (a) of this section. 
Accordingly, the carryover allocation to D must be returned to the 
Agency. The allocation is valid for purposes of determining the amount 
of credit allocated by Agency from State X's 2003 State housing credit 
ceiling, but is included in the returned credit component of State X's 
2004 housing credit ceiling.

    (c) Verification of basis by Agency--(1) Verification requirement. 
An Agency that makes a carryover allocation to a taxpayer must verify 
that the taxpayer has met the 10 percent basis requirement of paragraph 
(a)(2) of this section.
    (2) Manner of verification. An Agency may verify that a taxpayer has 
incurred more than 10 percent of its reasonably expected basis in a 
project by obtaining a certification from the taxpayer, in writing and 
under penalty of perjury, that the taxpayer has incurred by the close of 
the calendar year of the allocation (for allocations made before July 1) 
or by the close of the date that is 6 months after the date the 
allocation is made (for allocations made after June 30) more than 10 
percent of the reasonably expected basis in the project. The 
certification must be accompanied by supporting documentation that the 
Agency must review. Supporting documentation may include, for example, 
copies of checks or other records of payments. Alternatively, an Agency 
may verify that the taxpayer has incurred adequate basis by requiring 
that the taxpayer obtain from an attorney or certified public accountant 
a written certification to the Agency, that the attorney or accountant 
has examined all eligible costs incurred with respect to the project and 
that, based upon this examination, it is the attorney's or accountant's 
belief that the taxpayer has incurred more than 10 percent of its 
reasonably expected basis in the project by the close of the calendar 
year of the allocation (for allocations made before July 1) or by the 
close of the date that is 6 months after the date the allocation is made 
(for allocations made after June 30).
    (3) Time of verification--(i) Allocations made before July 1. For a 
carryover allocation made before July 1, an Agency may require that the 
basis certification be submitted to or received by the Agency prior to 
the close of the calendar year of allocation or within a reasonable time 
following the close of the calendar year of allocation. The Agency will 
need to verify basis as provided in paragraph (c)(2) of this section to 
accurately complete the Form 8610, ``Annual Low-Income Housing Credit 
Agencies Report,'' and the Schedule A (Form 8610), ``Carryover 
Allocation of Low-Income Housing Credit,'' for the calendar year of the 
allocation. If the basis certification is not timely made, or supporting 
documentation is lacking, inadequate, or does not actually support the 
certification, the Agency should notify the taxpayer and try to get 
adequate documentation. If the Agency cannot verify before the Form 8610 
is filed that the taxpayer has satisfied the 10 percent basis 
requirement for a carryover allocation made before July 1, the 
allocation is not valid and is treated as if it had not been made and 
the carryover allocation should not be reported on the Schedule A (Form 
8610).
    (ii) Allocations made after June 30. An Agency may require that the 
basis certification be submitted to or received by the Agency prior to 
the close of the

[[Page 223]]

date that is 6 months after the date the allocation was made or within a 
reasonable period of time following the close of the date that is 6 
months after the date the allocation was made. The Agency will need to 
verify basis as provided in paragraph (c)(2) of this section. If the 
basis certification is not timely made, or supporting documentation is 
lacking, inadequate, or does not actually support the certification, the 
Agency should notify the taxpayer and try to get adequate documentation. 
If the Agency cannot verify that the taxpayer has satisfied the 10 
percent basis requirement for a carryover allocation made after June 30, 
the allocation must be returned to the Agency. The carryover allocation 
is a valid allocation for the calendar year of the allocation, but is 
included in the returned credit component of the State housing credit 
ceiling for the calendar year following the calendar year of the 
allocation.
    (d) Requirements for making carryover allocations--(1) In general. 
Generally, an allocation is made when an Agency issues the Form 8609, 
`Low-Income Housing Credit Allocation Certification,' for a building. 
See Sec. 1.42-1T(d)(8)(ii). An Agency does not issue the Form 8609 for a 
building until the building is placed in service. However, in cases 
where allocations of credit are made pursuant to section 42(h)(1)(E) 
(relating to carryover allocations for buildings) or section 42(h)(1)(F) 
(relating to carryover allocations for multiple-building projects), Form 
8609 is not used as the allocating document because the buildings are 
not yet in service. When an allocation is made pursuant to section 
42(h)(1) (E) or (F), the allocating document is the document meeting the 
requirements of paragraph (d)(2) of this section. In addition, when an 
allocation is made pursuant to section 42(h)(1)(F), the requirements of 
paragraph (d)(3) of this section must be met for the allocation to be 
valid. An allocation pursuant to section 42(h)(1) (E) or (F) reduces the 
state housing credit ceiling for the year in which the allocation is 
made, whether or not the Form 8609 is also issued in that year.
    (2) Requirements for allocation. An allocation pursuant to section 
42(h)(1) (E) or (F) is made when an allocation document containing the 
following information is completed, signed, and dated by an authorized 
official of the Agency--
    (i) The address of each building in the project, or if none exists, 
a specific description of the location of each building;
    (ii) The name, address, and taxpayer identification number of the 
taxpayer receiving the allocation;
    (iii) The name and address of the Agency;
    (iv) The taxpayer identification number of the Agency;
    (v) The date of the allocation;
    (vi) The housing credit dollar amount allocated to the building or 
project, as applicable;
    (vii) The taxpayer's reasonably expected basis in the project (land 
and depreciable basis) as of the close of the second calendar year 
following the calendar year in which the allocation is made;
    (viii) For carryover allocations made before July 1, the taxpayer's 
basis in the project (land and depreciable basis) as of the close of the 
calendar year of the allocation and the percentage that basis bears to 
the reasonably expected basis in the project (land and depreciable 
basis) as of the close of the second calendar year following the 
calendar year of allocation;
    (ix) The date that each building in the project is expected to be 
placed in service; and
    (x) The Building Identification Number (B.I.N.) to be assigned to 
each building in the project. The B.I.N. must reflect the year an 
allocation is first made to the building, regardless of the year that 
the building is placed in service. This B.I.N. must be used for all 
allocations of credit for the building. For example, rehabilitation 
expenditures treated as a separate new building under section 42(e) 
should not have a separate B.I.N. if the building to which the 
rehabilitation expenditures are made has a B.I.N. In this case, the 
B.I.N. used for the rehabilitation expenditures shall be the B.I.N. 
previously assigned to the building, although the rehabilitation 
expenditures must have a separate Form 8609 for the

[[Page 224]]

allocation. Similarly, a newly constructed building that receives an 
allocation of credit in different calendar years must have a separate 
Form 8609 for each allocation. The B.I.N. assigned to the building for 
the first allocation must be used for the subsequent allocation.
    (3) Special rules for project-based allocations--(i) In general. An 
allocation pursuant to section 42(h)(1)(F) (a project-based allocation) 
must meet the requirements of this section as well as the requirements 
of section 42(h)(1)(F), including the minimum basis requirement of 
section 42(h)(1)(E)(ii).
    (ii) Requirement of section 42(h)(1)(F)(i)(III). An allocation 
satisfies the requirement of section 42(h)(1)(F)(i)(III) if the Form 
8609 that is issued for each building that is placed in service in the 
project states the portion of the project-based allocation that is 
applied to that building.
    (4) Recordkeeping requirements--(i) Taxpayer. When an allocation is 
made pursuant to section 42(h)(1)(E) or (F), the taxpayer must retain a 
copy of the allocation document. The Form 8609 that reflects the 
allocation must be filed for the first taxable year that the credit is 
claimed and for each taxable year thereafter throughout the compliance 
period, whether or not a credit is claimed for the taxable year.
    (ii) Agency. The Agency must retain the original carryover 
allocation document made under paragraph (d)(2) of this section and file 
Schedule A (Form 8610) with the Agency's Form 8610 for the year the 
allocation is made. The Agency must also retain a copy of the Form 8609 
that is issued to the taxpayer and file the original with the Agency's 
Form 8610 that reflects the year the form is issued.
    (5) Separate procedure for election of appropriate percentage month. 
If a taxpayer receives an allocation under section 42(h)(1) (E) or (F) 
and wishes to elect under section 42(b)(2)(A)(ii) to use the appropriate 
percentage for a month other than the month in which a building is 
placed in service, the requirements specified in Sec. 1.42-8 must be met 
for the election to be effective.
    (e) Special rules. The following rules apply for purposes of this 
section.
    (1) Treatment of partnerships and other flow-through entities. With 
respect to taxpayers that own projects through partnerships or other 
flow-through entities (e.g., S corporations, estates, or trusts), 
carryover-allocation basis is determined at the entity level using the 
rules provided by this section. In addition, the entity is responsible 
for providing to the Agency the certification and documentation required 
under the basis verification requirement in paragraph (c) of this 
section.
    (2) Transferees. If land or depreciable property that is expected to 
be part of a project is transferred after a carryover allocation has 
been made for a building that is reasonably expected to be part of the 
project, but before the close of the calendar year of the allocation 
(for allocations made before July 1) or by the close of the date that is 
6 months after the date