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Bulletin No. 1996–8

February 27, 1996

HIGHLIGHTS

OF THIS ISSUE

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be

relied upon as authoritative interpretations.

INCOME TAX

EXEMPT ORGANIZATIONS

PS–7–89, page 24.

Proposed regulations under section 1254 of the Code

relating to the treatment of gain from the disposition of

interest in certain natural resource recapture property

by S corporations and their shareholders.

Announcement 96–10, page 30.

A list is provided of organizations that no longer qualify

as organizations to which contributions are deductible

under section 170 of the Code.

EXCISE TAXES

T.D. 8645, page 4.

Final regulations under section 469 of the Code

providing rules for rental real estate activities of

taxpayers engaged in certain real property trades or

businesses.

Announcement 96–9, page 30.

Effective after December 31, 1995, the rates for fuel

taxes and the base amount not subject to the luxury tax

have changed. Also, excise taxes on transportation and

on the superfund expired December 31, 1995.

T.D. 8646, page 10.

Final regulations under section 861 of the Code

provides guidance concerning the allocation and apportionment of research and experimental expenditures for

purposes of determining taxable income from sources

inside and outside the U.S.

ADMINISTRATIVE

Rev. Proc. 96–25, page 19.

Automobile owners and lessees. This procedure provides

owners and lessees of passenger automobiles with

tables detailing the limitations on depreciation deductions for automobiles first placed in service during

calendar year 1996 and the amounts to be included in

income for automobiles first leased during calendar

year 1996.

EMPLOYEE PLANS

Notice 96–11, page 19.

Guidelines are set forth for determining for February

1996, the weighted average interest rate and the

resulting permissible range of interest rates used to

calculate current liability for purposes of the full funding

limitation of section 412(c)(7) of the Code as amended

by the Omnibus Budget Reconciliation Act of 1987 and

by the Uruguay Round Agreements Act (GATT).

Rev. Proc. 96–26, page 22.

Backup withholding; substitute Form W–9. The requirements for payors that want to use a substitute Form W–

9, Request for Taxpayer Identification Number and

Certification, are clarified.

Finding Lists begin on page 00.

Announcement of Disbarments and Suspensions begin on page 00.

Announcement of Declaratory Judgment Proceeding Under Section 7428 on page 00.

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Mission of the Service

The purpose of the Internal Revenue Service is to

collect the proper amount of tax revenue at the least

cost; serve the public by continually improving the

quality of our products and services; and perform in a

manner warranting the highest degree of public

confidence in our integrity, efficiency and fairness.

Statement of Principles

of Internal Revenue

Tax Administration

The function of the Internal Revenue Service is to

administer the Internal Revenue Code. Tax policy

for raising revenue is determined by Congress.

With this in mind, it is the duty of the Service to

carry out that policy by correctly applying the laws

enacted by Congress; to determine the reasonable

meaning of various Code provisions in light of the

Congressional purpose in enacting them; and to

perform this work in a fair and impartial manner,

with neither a government nor a taxpayer point of

view.

At the heart of administration is interpretation of the

Code. It is the responsibility of each person in the

Service, charged with the duty of interpreting the

law, to try to find the true meaning of the statutory

provision and not to adopt a strained construction in

the belief that he or she is ‘‘protecting the revenue.’’

The revenue is properly protected only when we ascertain and apply the true meaning of the statute.

The Service also has the responsibility of applying

and administering the law in a reasonable,

practical manner. Issues should only be raised by

examining officers when they have merit, never

arbitrarily or for trading purposes. At the same

time, the examining officer should never hesitate

to raise a meritorious issue. It is also important

that care be exercised not to raise an issue or to

ask a court to adopt a position inconsistent with

an established Service position.

Administration should be both reasonable and

vigorous. It should be conducted with as little

delay as possible and with great courtesy and

considerateness. It should never try to overreach,

and should be reasonable within the bounds of law

and sound administration. It should, however, be

vigorous in requiring compliance with law and it

should be relentless in its attack on unreal tax

devices and fraud.

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Introduction

The Internal Revenue Bulletin is the authoritative

instrument of the Commissioner of Internal Revenue for

announcing official rulings and procedures of the

Internal Revenue Service and for publishing Treasury

Decisions, Executive Orders, Tax Conventions, legislation, court decisions, and other items of general

interest. It is published weekly and may be obtained

from the Superintendent of Documents on a subscription basis. Bulletin contents of a permanent nature are

consolidated semiannually into Cumulative Bulletins,

which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin

all substantive rulings necessary to promote a uniform

application of the tax laws, including all rulings that

supersede, revoke, modify, or amend any of those

previously published in the Bulletin. All published

rulings apply retroactively unless otherwise indicated.

Procedures relating solely to matters of internal

management are not published; however, statements of

internal practices and procedures that affect the rights

and duties of taxpayers are published.

Revenue rulings represent the conclusions of the

Service on the application of the law to the pivotal facts

stated in the revenue ruling. In those based on

positions taken in rulings to taxpayers or technical

advice to Service field offices, identifying details and

information of a confidential nature are deleted to

prevent unwarranted invasions of privacy and to comply

with statutory requirements.

Rulings and procedures reported in the Bulletin do not

have the force and effect of Treasury Department

Regulations, but they may be used as precedents.

Unpublished rulings will not be relied on, used, or cited

as precedents by Service personnel in the disposition of

other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be

considered, and Service personnel and others concerned are cautioned against reaching the same

conclusions in other cases unless the facts and

circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on

provisions of the Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows:

Subpart A, Tax Conventions, and Subpart B, Legislation

and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellanous.

To the extent practicable, pertinent cross references to

these subjects are contained in the other Parts and

Subparts. Also included in this part are Bank Secrecy

Act Administrative Rulings. Bank Secrecy Act Administrative Rulings are issued by the Department of the

Treasury’s Office of the Assistant Secretary

(Enforcement).

Part IV.—Items of General Interest.

With the exception of the Notice of Proposed Rulemaking and the disbarment and suspension list included in

this part, none of these announcements are consolidated in the Cumulative Bulletins.

The first Bulletin for each month includes an index for

the matters published during the preceding month.

These monthly indexes are cumulated on a quarterly

and semiannual basis, and are published in the first

Bulletin of the succeeding quarterly and semi-annual

period, respectively.

The Bulletin Index-Digest System, a research and

reference service supplementing the Bulletin, may be

obtained from the Superintendent of Documents on a

subscription basis. It consists of four Services: Service

No. 1, Income Tax; Service No. 2, Estate and Gift

Taxes; Service No. 3, Employment Taxes; Service No.

4, Excise Taxes. Each Service consists of a basic

volume and a cumulative supplement that provides (1)

finding lists of items published in the Bulletin, (2)

digests of revenue rulings, revenue procedures, and

other published items, and (3) indexes of Public Laws,

Treasury Decisions, and Tax Conventions.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents U.S. Government Printing Office, Washington, D.C. 20402.

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Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Section 280F.—Limitation on

Depreciation for Luxury Automobiles;

Limitation where Certain Property

Used for Personal Purposes

26 CFR 280F–5T: Leased Property

(temporary).

This procedure provides owners and lessees of

passenger automobiles with tables detailing the

limitations on depreciation deductions for automobiles first placed in service during calendar

year 1996 and the amounts to be included in income for automobiles first leased during calendar

year 1996. See Rev. Proc. 96–25, page 19.

5228, Internal Revenue Service, POB

7604, Ben Franklin Station, Washington, DC 20044. In the alternative,

submissions may be hand delivered

between the hours of 8:00 a.m. and

5:00 p.m. to: CC:DOM:CORP:T:R (TD

8645), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue

NW, Washington, DC.

FOR FURTHER INFORMATION

CONTACT: William M. Kostak at

(202) 622-3080 (not a toll-free

number).

26 CFR 280F–7: Property leased after December

31, 1986.

SUPPLEMENTARY INFORMATION:

This procedure provides owners and lessees of

passenger automobiles with tables detailing the

limitations on depreciation deductions for automobiles first placed in service during calendar

year 1996 and the amounts to be included in income for automobiles first leased during calendar

year 1996. See Rev. Proc. 96–25, page 19.

Paperwork Reduction Act

Section 469.—Passive Activity

Losses and Credits Limited

26 CFR 1.469–4: Definition of activity.

T.D. 8645

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Rules for Certain Rental Real Estate

Activities

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations providing rules for

rental real estate activities of taxpayers

engaged in certain real property trades

or businesses. The regulations reflect

changes to the law made by the Omnibus Budget Reconciliation Act of 1993,

and affect taxpayers subject to the

limitations on passive activity losses

and passive activity credits.

DATES: These regulations are effective

on January 1, 1995. See §1.469–11 for

applicability.

ADDRESSES: Send submissions to:

CC:DOM:CORP:T:R (TD 8645), Room

The collection of information contained in these final regulations has

been reviewed and approved by the

Office of Management and Budget in

accordance with the Paperwork Reduction Act (44 U.S.C. 3504(h)) under

control number 1545–AS38. The estimated annual burden per respondent

varies from 0.10 hours to 0.25 hours,

depending on individual circumstances,

with an estimated average of 0.15

hours.

Comments concerning the accuracy

of this burden estimate and suggestions

for reducing this burden should be sent

to the Internal Revenue Service, Attn:

IRS Reports Clearance Officer, IT:FP,

Washington, DC 20224, and to the

Office of Management and Budget,

Attn: Desk Officer for the Department

of the Treasury, Office of Information

and Regulatory Affairs, Washington,

DC 20503.

Background

This document amends 26 CFR part

1 to provide rules relating to the

treatment of rental real estate activities

of certain taxpayers under the passive

activity loss and credit limitations of

section 469. Section 469 disallows

losses from passive activities to the

extent they exceed income from passive activities and similarly disallows

credits from passive activities to the

extent they exceed tax liability allocable to passive activities. In general,

passive activities are activities in which

the taxpayer does not materially participate. In addition, until the enactment of

the Omnibus Budget Reconciliation Act

of 1993 (OBRA 1993), all rental

activities (including those in which a

taxpayer materially participated) were

passive.

OBRA 1993 added section 469(c)(7),

which provides that rental real estate

activities of qualifying taxpayers are

not subject to the rule that treats all

rental activities as passive. Thus, a

rental real estate activity of a qualifying taxpayer is not passive if the

taxpayer materially participates in the

activity. Further, section 469(c)(7)

provides that each of a qualifying

taxpayer’s interests in rental real estate

is treated as a separate activity unless

the taxpayer elects to treat all interests

in rental real estate as a single activity.

On January 10, 1995, the IRS published in the Federal Register a notice

of proposed rulemaking (60 FR 2557

[PS–80–93, 1995–1 C.B. 1015]) to

provide guidance regarding section

469(c)(7). A number of public comments were received concerning the

proposed regulations, and a public

hearing was held on May 11, 1995.

After consideration of the comments

received, the proposed regulations are

adopted as revised by this Treasury

decision.

Explanation of provisions

I. General Background

The proposed regulations provide

rules for determining whether a taxpayer qualifies for treatment under

section 469(c)(7). The proposed regulations also provide rules for determining

the rental real estate activities of

qualifying taxpayers for purposes of

section 469. Except for modifications

in response to comments received on

the proposed regulations, the final

regulations generally adopt the rules

contained in the proposed regulations.

II. Public Comments

Several comments requested that the

Service reconsider the rule in the

proposed regulations prohibiting

qualifying taxpayers from grouping

rental real estate activities with other

activities in determining whether the

taxpayers materially participate in the

rental real estate activities. After care-

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ful consideration, the final regulations

adopt the rule in the proposed regulations because that position is consistent

with the statutory language and the

legislative history.

Several comments suggested that the

rule in the proposed regulations prohibiting the grouping of rental real

estate activities with other activities be

modified to allow qualifying taxpayers

to group the activities of development

or construction of rental real estate

with rental real estate activities. The

final regulations do not adopt this

modification because in most cases

development and construction activities

are separate and distinct from rental

activities. In addition, this modification

would introduce significant administrative difficulties in determining which

development activities or construction

activities qualify. However, the IRS

and Treasury Department invite comments concerning whether the material

participation tests in §1.469–5T(a)

should be amended to include a lookback material participation test for

taxpayers significantly involved in the

development or construction of their

rental real estate interests.

Several comments requested clarification regarding whether a qualifying

taxpayer’s participation in a management activity may count towards material participation in a rental real estate

activity if the management activity

includes the management of rental real

estate owned by the taxpayer. The final

regulations clarify that a qualifying

taxpayer may participate in a rental real

estate activity through participation in a

management activity. In determining

whether the taxpayer materially participates in the rental real estate activity,

however, work the taxpayer performs

in the management activity is taken

into account only to the extent it is

performed in managing the taxpayer’s

own rental real estate. The final regulations also clarify that a qualifying

taxpayer who owns rental real estate

through an entity, including a C corporation that is subject to section 469,

may count work performed by the taxpayer in managing the rental real estate

of the entity in establishing material

participation in the taxpayer’s rental

real estate activities. Thus, if a qualifying taxpayer owns some interests in

rental real estate through a closely held

C corporation and makes the election

to treat all interests in rental real estate

as a single activity, the aggregate rental

real estate activity will include those

interests held through the closely held

C corporation for purposes of material

participation.

One comment requested that the

regulations modify the definition of

trade or business to clarify that a

taxpayer’s real property trades or businesses are determined without regard to

the taxpayer’s grouping of activities

under §1.469–4. The final regulations

clarify that a taxpayer’s grouping of

activities under §1.469–4 does not

control the determination of the taxpayer’s real property trades or businesses for purposes of this section.

Several comments requested that the

regulations provide a detailed definition

of real property trades or businesses

beyond the cross-reference to section

469(c)(7)(C). However, to avoid complex and mechanical rules, the final

regulations do not adopt a detailed

definition of real property trades or

businesses. Instead, the regulations

provide that taxpayers may use any

reasonable method for determining

their real property trades or businesses.

Several comments requested that the

final regulations modify the rule in the

proposed regulations providing that

only employees who are five-percent

owners of their employer at all times

during the taxable year may treat

personal services performed as an

employee as services performed in a

real property trade or business. The

comments suggested that the regulations should take into account personal

services performed by employees that

are five-percent owners for a significant portion of a taxable year. In

response to these comments, the final

regulations are modified to provide that

an employee may count services performed in a real property trade or

business during the portion of the

taxable year that the employee is a

five-percent owner in the employer.

Several comments requested clarification concerning whether a qualifying taxpayer that makes an election to

treat all interests in rental real estate as

a single activity will be treated as

having a single rental real estate

activity for purposes of the former

passive activity rule under section

469(f). In addition, comments requested

that the regulations be modified to

provide that qualifying taxpayers that

make the aggregation election will be

treated as having separate activities for

purposes of the disposition rules under

section 469(g) and §1.469–4(g). In re-

sponse to these comments, the final

regulations clarify that a qualifying

taxpayer that makes the election to

treat all interests in rental real estate as

a single rental real estate activity will

be treated as having a single activity

for all purposes of section 469, including sections 469(f) and (g). The statutory language and the legislative history do not support a rule allowing a

qualifying taxpayer to treat all interests

in rental real estate as a single activity

for purposes of material participation

and section 469(f), but as separate

activities for purposes of section

469(g).

In addition, in response to comments,

the final regulations provide an example illustrating the operation of the

former passive activity rule for qualifying taxpayers that make the election to

treat all interests in rental real estate as

a single activity. This example illustrates that qualifying taxpayers that

make the aggregation election may use

current net income from the aggregate

rental real estate activity to offset the

prior-year disallowed passive losses of

the aggregate rental real estate activity,

regardless of which rental real estate

interests within that activity produced

the income or prior-year losses.

Some comments requested that the

regulations permit qualifying taxpayers

to make or revoke the aggregation

election on an amended income tax

return. After careful consideration of

this issue, the final regulations adopt

the rule in the proposed regulations that

aggregation elections must be made or

revoked on an original return. The final

regulations provide, however, that the

election may be revoked in any year in

which the facts are materially changed

from those in the taxable year for

which the election was made.

In addition, one comment requested

clarification as to what constitutes a

material change in the facts and circumstances that would allow a taxpayer

to revoke an aggregation election.

However, the final regulations do not

provide an example or bright-line rule

for determining when a material change

in the facts and circumstances has

occurred, because this determination is

intended to be a broad factual inquiry.

Providing an example or bright-line

rule may inappropriately restrict the

scope of that inquiry.

One comment requested the modification of the rule in the proposed

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regulations that the aggregation election

has no effect in years the taxpayer is

not a qualifying taxpayer. Instead, the

comment suggested that, for ease of

administration and compliance, the aggregation election should be binding

and irrevocable for all future years,

including years in which the taxpayer

is not a qualifying taxpayer. However,

the final regulations adopt the rule in

the proposed regulations because the

position advocated by the comment

would be unfavorable to many taxpayers and would not significantly

improve administration.

Several comments requested that the

regulations modify the rule in the

proposed regulations treating each

rental real estate interest of a passthrough entity as a separate interest of

a person owning a fifty-percent or

greater interest in the capital, gain,

loss, income, deduction, or credit of the

entity at any time during a taxable

year. A commentator stated that this

rule is burdensome on many passthrough entities and should be eliminated or modified. The final regulations

modify this rule so that it applies only

when a qualifying taxpayer owns a

fifty-percent or greater interest in the

capital, profits, or losses of a passthrough entity for a taxable year.

Accordingly, this rule will not apply if

a qualifying taxpayer owns a fiftypercent or greater interest in a single

item of income or deduction but does

not own a fifty-percent or greater

interest in the overall capital, profits, or

losses of the passthrough entity.

In response to one comment, the

final regulations also clarify the application of the fifty-percent ownership

rule to tiered passthrough entities. The

final regulations provide that if a

passthrough entity owns a fifty-percent

or greater interest in the capital, profits,

or losses of another passthrough entity

for a taxable year, each interest in

rental real estate of the lower-tier entity

will be a separate interest in rental real

estate of the upper-tier entity.

In response to another comment, the

final regulations clarify that section

469(i) applies after the rules of section

469(c)(7) are applied. Accordingly, the

$25,000 offset will be applied only

against passive losses from rental real

estate activities, and not against losses

that are allowable as a result of section

469(c)(7). In addition, the final regulations clarify that adjusted gross income

for purposes of section 469(i) is not

reduced by any losses from rental real

estate that are allowable as a result of

section 469(c)(7).

Several comments requested a modification to the effective date provision,

to provide that aggregation elections

made for taxable years beginning before January 1, 1995, are not binding

for future years. Because taxpayers had

sufficient notice of the rules of section

469(c)(7) and these regulations, this

modification is unnecessary and would

add administrative complexity. Accordingly, the final regulations adopt the

effective date provision of the proposed

regulations.

Finally, in response to a comment,

the activity regrouping rule of §1.469–

4(e)(2) is clarified to provide that a

taxpayer may not regroup activities

unless the taxpayer’s original grouping

was clearly inappropriate or there has

been a material change in the facts and

circumstances that makes the original

grouping clearly inappropriate.

III. Effective Dates

In general, section 469(c)(7) applies

for taxable years beginning after December 31, 1993. These regulations are

effective for taxable years beginning on

or after January 1, 1995. These regulations are also effective for elections

under section 469(c)(7)(A) and paragraph (g) of these regulations that are

made with returns filed on or after

January 1, 1995.

Special Analyses

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in EO

12866. Therefore, a regulatory assessment is not required. It also has been

determined that section 553(b) of the

Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not

apply to these regulations, and, therefore, a Regulatory Flexibility Analysis

is not required. Pursuant to section

7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking

preceding these regulations was submitted to the Small Business Administration for comment on its impact on

small business.

Drafting Information

The principal author of these regulations is William M. Kostak, Office of

Assistant Chief Counsel (Passthroughs

and Special Industries), IRS. However,

other personnel from the IRS and

Treasury Department participated in

their development.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is

amended as follows:

PART I—INCOME TAXES

Paragraph 1. The authority citation

for part 1 is amended by adding an

entry in numerical order to read as

follows:

Authority: 26 U.S.C. 7805. * * *

Section 1.469–9 also issued under 26

U.S.C. 469(c)(6), (h)(2), and (l)(1).

Par. 2. Section 1.469–0 is amended

by:

1. Revising the entry for §1.469–

4(h).

2. Revising the heading for §1.469–9

and adding entries for paragraphs (a)

through (j) of §1.469–9.

3. Revising the entry for §1.469–11(b)(2) and removing the entries for

§1.469–11(b)(2)(i) and (ii).

4. Revising the entry for §1.469–11(b)(3).

5. Adding an entry for §1.469–11(b)(4).

6. The revisions and additions read

as follows:

§1.469–0 Table of contents.

§1.469–4 Definition of Activity.

(h) Rules for grouping rental real

estate activities for taxpayers qualifying

under section 469(c)(7).

§1.469–9 Rules for certain rental

real estate activities.

(a) Scope and purpose.

(b) Definitions.

(1) Trade or business.

(2) Real property trade or

business.

(3) Rental real estate.

(4) Personal services.

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(c)

(d)

(e)

(f)

(g)

(h)

(i)

(j)

(5) Material participation.

(6) Qualifying taxpayer.

Requirements for qualifying

taxpayers.

(1) In general.

(2) Closely held C

corporations.

(3) Requirement of material

participation in the real

property trades or businesses.

(4) Treatment of spouses.

(5) Employees in real property trades or businesses.

General rule for determining

real property trades or

businesses.

(1) Facts and circumstances.

(2) Consistency requirement.

Treatment of rental real estate

activities of a qualifying

taxpayer.

(1) In general.

(2) Treatment as a former

passive activity.

(3) Grouping rental real estate

activities with other

activities.

(i) In general.

(ii) Special rule for certain

management activities.

(4) Example.

Limited partnership interests in

rental real estate activities.

(1) In general.

(2) De minimis exception.

Election to treat all interests

in rental real estate as a single

rental real estate activity.

(1) In general.

(2) Certain changes not material.

(3) Filing a statement to

make or revoke the

election.

Interests in rental real estate

held by certain passthrough

entities.

(1) General rule.

(2) Special rule if a qualifying taxpayer holds a fiftypercent or greater interest

in a passthrough entity.

(3) Special rule for interests

held in tiered passthrough

entities.

[Reserved].

$25,000 offset for rental real

estate activities of qualifying

taxpayers.

(1) In general.

(2) Example.

§1.469–11 Effective date and

transition rules.

(b) * * *

(2) Additional transition rule for

1992 amendments.

(3) Fresh starts under consistency

rules.

(i) Regrouping when tax liability is

first determined under Project PS–1–

89.

(ii) Regrouping when tax liability is

first determined under §1.469–4.

(iii) Regrouping when taxpayer is

first subject to section 469(c)(7).

(4) Certain investment credit

property.

Par. 3. Section 1.469–4 is amended

by revising paragraphs (e)(1) and (2)

and (h). The revisions read as follows:

§1.469–4 Definition of Activity.

(e) * * *

(1) Original groupings. Except as

provided in paragraph (e)(2) of this

section and §1.469–11, once a taxpayer

has grouped activities under this section, the taxpayer may not regroup

those activities in subsequent taxable

years. Taxpayers must comply with

disclosure requirements that the Commissioner may prescribe with respect to

both their original groupings and the

addition and disposition of specific

activities within those chosen groupings

in subsequent taxable years.

(2) Regroupings. If it is determined

that a taxpayer’s original grouping was

clearly inappropriate or a material

change in the facts and circumstances

has occurred that makes the original

grouping clearly inappropriate, the taxpayer must regroup the activities and

must comply with disclosure requirements that the Commissioner may

prescribe.

(h) Rules for grouping rental real

estate activities for taxpayers qualifying under section 469(c)(7). See

§1.469–9 for rules for certain rental

real estate activities.

Par. 4. Section 1.469-9 is revised to

read as follows:

§1.469–9 Rules for certain rental

real estate activities.

(a) Scope and purpose. This section

provides guidance to taxpayers engaged

in certain real property trades or businesses on applying section 469(c)(7) to

their rental real estate activities.

(b) Definitions. The following definitions apply for purposes of this

section:

(1) Trade or business. A trade or

business is any trade or business

determined by treating the types of

activities in §1.469–4(b)(1) as if they

involved the conduct of a trade or

business, and any interest in rental real

estate, including any interest in rental

real estate that gives rise to deductions

under section 212.

(2) Real property trade or business.

Real property trade or business is

defined in section 469(c)(7)(C).

(3) Rental real estate. Rental real

estate is any real property used by

customers or held for use by customers

in a rental activity within the meaning

of §1.469–1T(e)(3). However, any

rental real estate that the taxpayer

grouped with a trade or business

activity under §1.469–4(d)(1)(i)(A) or

estate for purposes of this section.

(4) Personal services. Personal services means any work performed by an

individual in connection with a trade or

business. However, personal services

do not include any work performed by

an individual in the individual’s capacity as an investor as described in

§1.469–5T(f)(2)(ii).

(5) Material participation. Material

participation has the same meaning as

under §1.469–5T. Paragraph (f) of this

section contains rules applicable to

limited partnership interests in rental

real estate that a qualifying taxpayer

elects to aggregate with other interests

in rental real estate of that taxpayer.

(6) Qualifying taxpayer. A qualifying taxpayer is a taxpayer that owns at

least one interest in rental real estate

and meets the requirements of paragraph (c) of this section.

taxpayer must meet the requirements of

section 469(c)(7)(B).

(2) Closely held C corporations. A

closely held C corporation meets the

requirements of paragraph (c)(1) of this

section by satisfying the requirements

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of section 469(c)(7)(D)(i). For purposes

of section 469(c)(7)(D)(i), gross receipts do not include items of portfolio

income within the meaning of §1.469–

2T(c)(3).

(3) Requirement of material participation in the real property trades or

businesses. A taxpayer must materially

participate in a real property trade or

business in order for the personal

services provided by the taxpayer in

that real property trade or business to

count towards meeting the requirements

of paragraph (c)(1) of this section.

(4) Treatment of spouses. Spouses

filing a joint return are qualifying

taxpayers only if one spouse separately

satisfies both requirements of section

469(c)(7)(B). In determining the real

property trades or businesses in which

a married taxpayer materially participates (but not for any other purpose

under this paragraph (c)), work performed by the taxpayer’s spouse in a

trade or business is treated as work

performed by the taxpayer under

§1.469–5T(f)(3), regardless of whether

the spouses file a joint return for the

year.

(5) Employees in real property

trades or businesses. For purposes of

paragraph (c)(1) of this section, personal services performed during a

taxable year as an employee generally

will be treated as performed in a trade

or business but will not be treated as

performed in a real property trade or

business, unless the taxpayer is a fivepercent owner (within the meaning of

section 416(i)(1)(B)) in the employer.

If an employee is not a five-percent

owner in the employer at all times

during the taxable year, only the

personal services performed by the

employee during the period the

employee is a five-percent owner in the

employer will be treated as performed

in a real property trade or business.

(d) General rule for determining

real property trades or businesses—(1)

Facts and circumstances. The determination of a taxpayer’s real property

trades or businesses for purposes of

paragraph (c) of this section is based

on all of the relevant facts and

circumstances. A taxpayer may use any

reasonable method of applying the facts

and circumstances in determining the

real property trades or businesses in

which the taxpayer provides personal

services. Depending on the facts and

circumstances, a real property trade or

business consists either of one or more

than one trade or business specifically

described in section 469(c)(7)(C). A

taxpayer’s grouping of activities under

§1.469–4 does not control the determination of the taxpayer’s real property

trades or businesses under this paragraph (d).

(2) Consistency requirement. Once a

taxpayer determines the real property

trades or businesses in which personal

services are provided for purposes of

paragraph (c) of this section, the

taxpayer may not redetermine those

real property trades or businesses in

subsequent taxable years unless the

original determination was clearly inappropriate or there has been a material

change in the facts and circumstances

that makes the original determination

clearly inappropriate.

(e) Treatment of rental real estate

activities of a qualifying taxpayer—(1)

In general. Section 469(c)(2) does not

apply to any rental real estate activity

of a taxpayer for a taxable year in

which the taxpayer is a qualifying

taxpayer under paragraph (c) of this

section. Instead, a rental real estate

activity of a qualifying taxpayer is a

passive activity under section 469 for

the taxable year unless the taxpayer

materially participates in the activity.

Each interest in rental real estate of a

qualifying taxpayer will be treated as a

separate rental real estate activity,

unless the taxpayer makes an election

under paragraph (g) of this section to

treat all interests in rental real estate as

a single rental real estate activity. Each

separate rental real estate activity, or

the single combined rental real estate

activity if the taxpayer makes an

election under paragraph (g), will be an

activity of the taxpayer for all purposes

of section 469, including the former

passive activity rules under section

469(f) and the disposition rules under

section 469(g). However, section 469

will continue to be applied separately

with respect to each publicly traded

partnership, as required under section

469(k), notwithstanding the rules of

this section.

(2) Treatment as a former passive

activity. For any taxable year in which

a qualifying taxpayer materially participates in a rental real estate activity,

that rental real estate activity will be

treated as a former passive activity

under section 469(f) if disallowed

deductions or credits are allocated to

the activity under §1.469–1(f)(4).

(3) Grouping rental real estate activities with other activities—(i) In

general. For purposes of this section, a

qualifying taxpayer may not group a

rental real estate activity with any other

activity of the taxpayer. For example, if

a qualifying taxpayer develops real

property, constructs buildings, and

owns an interest in rental real estate,

the taxpayer’s interest in rental real

estate may not be grouped with the

taxpayer’s development activity or construction activity. Thus, only the participation of the taxpayer with respect

to the rental real estate may be used to

determine if the taxpayer materially

participates in the rental real estate

activity under §1.469–5T.

(ii) Special rule for certain management activities. A qualifying taxpayer

may participate in a rental real estate

activity through participation, within

the meaning of §§1.469–5(f) and 5T(f),

in an activity involving the management of rental real estate (even if this

management activity is conducted

through a separate entity). In determining whether the taxpayer materially

participates in the rental real estate

activity, however, work the taxpayer

performs in the management activity is

taken into account only to the extent it

is performed in managing the taxpayer’s own rental real estate interests.

(4) Example. The following example

illustrates the application of this paragraph (e).

Example. (i) Taxpayer B owns interests in

three rental buildings, U, V and W. In 1995, B

has $30,000 of disallowed passive losses allocable to Building U and $10,000 of disallowed

passive losses allocable to Building V under

§1.469–1(f)(4). In 1996, B has $5,000 of net

income from building U, $5,000 of net losses

from building V, and $10,000 of net income from

building W. Also in 1996, B is a qualifying

taxpayer within the meaning of paragraph (c) of

this section. Each building is treated as a

separate activity of B under paragraph (e)(1) of

this section, unless B makes the election under

paragraph (g) to treat the three buildings as a

single rental real estate activity. If the buildings

are treated as separate activities, material participation is determined separately with respect

to each building. If B makes the election under

paragraph (g) to treat the buildings as a single

activity, all participation relating to the buildings

is aggregated in determining whether B materially participates in the combined activity.

(ii) Effective beginning in 1996, B makes the

election under paragraph (g) to treat the three

buildings as a single rental real estate activity. B

works full-time managing the three buildings and

thus materially participates in the combined

activity in 1996 (even if B conducts this

management function through a separate entity,

including a closely held C corporation). Accordingly, the combined activity is not a passive

activity of B in 1996. Moreover, as a result of

the election under paragraph (g), disallowed

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passive losses of $40,000 ($30,000 + $10,000)

are allocated to the combined activity. B’s net

income from the activity for 1996 is $10,000

($5,000 – $5,000 + $10,000). This net income is

nonpassive income for purposes of section 469.

However, under section 469(f), the net income

from a former passive activity may be offset

with the disallowed passive losses from the same

activity. Because Buildings U, V and W are

treated as one activity for all purposes of section

469 due to the election under paragraph (g), and

this activity is a former passive activity under

section 469(f), B may offset the $10,000 of net

income from the buildings with an equal amount

of disallowed passive losses allocable to the

buildings, regardless of which buildings produced the income or losses. As a result, B has

$30,000 ($40,000 – $10,000) of disallowed passive losses remaining from the buildings after

1996.

(f) Limited partnership interests in

rental real estate activities—(1) In

general. If a taxpayer elects under

paragraph (g) of this section to treat all

interests in rental real estate as a single

rental real estate activity, and at least

one interest in rental real estate is held

by the taxpayer as a limited partnership

interest (within the meaning of §1.469–

5T(e)(3)), the combined rental real

estate activity will be treated as a

limited partnership interest of the taxpayer for purposes of determining

material participation. Accordingly, the

taxpayer will not be treated under this

section as materially participating in

the combined rental real estate activity

unless the taxpayer materially participates in the activity under the tests

listed in §1.469–5T(e)(2) (dealing with

the tests for determining the material

participation of a limited partner).

(2) De minimis exception. If a

qualifying taxpayer elects under paragraph (g) of this section to treat all

interests in rental real estate as a single

rental real estate activity, and the

taxpayer’s share of gross rental income

from all of the taxpayer’s limited

partnership interests in rental real estate

is less than ten percent of the taxpayer’s share of gross rental income

from all of the taxpayer’s interests in

rental real estate for the taxable year,

paragraph (f)(1) of this section does not

apply. Thus the taxpayer may determine material participation under any

of the tests listed in §1.469–5T(a) that

apply to rental real estate activities.

(g) Election to treat all interests in

rental real estate as a single rental

real estate activity—(1) In general. A

qualifying taxpayer may make an election to treat all of the taxpayer’s

interests in rental real estate as a single

rental real estate activity. This election

is binding for the taxable year in which

it is made and for all future years in

which the taxpayer is a qualifying

taxpayer under paragraph (c) of this

section, even if there are intervening

years in which the taxpayer is not a

qualifying taxpayer. The election may

be made in any year in which the taxpayer is a qualifying taxpayer, and the

failure to make the election in one year

does not preclude the taxpayer from

making the election in a subsequent

year. In years in which the taxpayer is

not a qualifying taxpayer, the election

will not have effect and the taxpayer’s

activities will be those determined

under §1.469–4. If there is a material

change in the taxpayer’s facts and

circumstances, the taxpayer may revoke

the election using the procedure described in paragraph (g)(3) of this

section.

(2) Certain changes not material.

The fact that an election is less

advantageous to the taxpayer in a

particular taxable year is not, of itself,

a material change in the taxpayer’s

facts and circumstances. Similarly, a

break in the taxpayer’s status as a

qualifying taxpayer is not, of itself, a

material change in the taxpayer’s facts

and circumstances.

(3) Filing a statement to make or

revoke the election. A qualifying taxpayer makes the election to treat all

interests in rental real estate as a single

rental real estate activity by filing a

statement with the taxpayer’s original

income tax return for the taxable year.

This statement must contain a declaration that the taxpayer is a qualifying

taxpayer for the taxable year and is

making the election pursuant to section

469(c)(7)(A). The taxpayer may make

this election for any taxable year in

which section 469(c)(7) is applicable.

A taxpayer may revoke the election

only in the taxable year in which a

material change in the taxpayer’s facts

and circumstances occurs or in a

subsequent year in which the facts and

circumstances remain materially

changed from those in the taxable year

for which the election was made. To

revoke the election, the taxpayer must

file a statement with the taxpayer’s

original income tax return for the year

of revocation. This statement must

contain a declaration that the taxpayer

is revoking the election under section

469(c)(7)(A) and an explanation of the

nature of the material change.

(h) Interests in rental real estate

held by certain passthrough entities—

(1) General rule. Except as provided in

paragraph (h)(2) of this section, a

qualifying taxpayer’s interest in rental

real estate held by a partnership or an

S corporation (passthrough entity) is

treated as a single interest in rental real

estate if the passthrough entity grouped

its rental real estate as one rental

activity under §1.469–4(d)(5). If the

passthrough entity grouped its rental

real estate into separate rental activities

under §1.469–4(d)(5), each rental real

estate activity of the passthrough entity

will be treated as a separate interest in

rental real estate of the qualifying

taxpayer. However, the qualifying taxpayer may elect under paragraph (g) of

this section to treat all interests in

rental real estate, including the rental

real estate interests held through passthrough entities, as a single rental real

estate activity.

(2) Special rule if a qualifying taxpayer holds a fifty-percent or greater

interest in a passthrough entity. If a

qualifying taxpayer owns, directly or

indirectly, a fifty-percent or greater

interest in the capital, profits, or losses

of a passthrough entity for a taxable

year, each interest in rental real estate

held by the passthrough entity will be

treated as a separate interest in rental

real estate of the qualifying taxpayer,

regardless of the passthrough entity’s

grouping of activities under §1.469–

4(d)(5). However, the qualifying taxpayer may elect under paragraph (g) of

this section to treat all interests in

rental real estate, including the rental

real estate interests held through passthrough entities, as a single rental real

estate activity.

(3) Special rule for interests held in

tiered passthrough entities. If a passthrough entity owns a fifty-percent or

greater interest in the capital, profits, or

losses of another passthrough entity for

a taxable year, each interest in rental

real estate held by the lower-tier entity

will be treated as a separate interest in

rental real estate of the upper-tier

entity, regardless of the lower-tier

entity’s grouping of activities under

§1.469–4(d)(5).

(i) [Reserved].

(j) $25,000 offset for rental real

estate activities of qualifying taxpayers—(1) In general. A qualifying

taxpayer’s passive losses and credits

from rental real estate activities (including prior-year disallowed passive

activity losses and credits from rental

real estate activities in which the

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taxpayer materially participates) are

allowed to the extent permitted under

section 469(i). The amount of losses or

credits allowable under section 469(i)

is determined after the rules of this

section are applied. However, losses

allowable by reason of this section are

not taken into account in determining

adjusted gross income for purposes of

section 469(i)(3).

(2) Example. The following example

illustrates the application of this paragraph (j).

Example. (i) Taxpayer A owns building X and

building Y, both interests in rental real estate. In

1995, A is a qualifying taxpayer within the

meaning of paragraph (c) of this section. A does

not elect to treat X and Y as one activity under

section 469(c)(7)(A) and paragraph (g) of this

section. As a result, X and Y are treated as

separate activities pursuant to section 469(c)(7)(A)(ii). A materially participates in X which has

$100,000 of passive losses disallowed from prior

years and produces $20,000 of losses in 1995. A

does not materially participate in Y which

produces $40,000 of income in 1995. A also has

$50,000 of income from other nonpassive

sources in 1995. A otherwise meets the requirements of section 469(i).

(ii) Because X is not a passive activity in

1995, the $20,000 of losses produced by X in

1995 are nonpassive losses that may be used by

A to offset part of the $50,000 of nonpassive

income. Accordingly, A is left with $30,000

($50,000 – $20,000) of nonpassive income. In

addition, A may use the prior year disallowed

passive losses of X to offset any income from X

and passive income from other sources. Therefore, A may offset the $40,000 of passive income

from Y with $40,000 of passive losses from X.

(iii) Because A has $60,000 ($100,000 –

$40,000) of passive losses remaining from X and

meets all of the requirements of section 469(i), A

may offset up to $25,000 of nonpassive income

with passive losses from X pursuant to section

469(i). As a result, A has $5,000 ($30,000 –

$25,000) of nonpassive income remaining and

disallowed passive losses from X of $35,000

($60,000 – $25,000) in 1995.

Par. 5. Section 1.469–11 is amended

as follows:

1. Paragraph (a)(2) is amended by

removing ‘‘; and’’ and adding ‘‘;’’ in

its place.

2. Paragraph (a)(3) is redesignated

as paragraph (a)(4) and a new paragraph (a)(3) is added.

3. Paragraph (b)(1) is revised.

4. The heading for paragraph (b)(2)

is revised; the headings for paragraphs

(b)(2)(i) and (b)(2)(ii) are removed;

paragraph (b)(2)(ii) is removed, and

paragraph (b)(2)(i) is redesignated as

paragraph (b)(2).

5. Paragraph (b)(3) is redesignated

as paragraph (b)(4).

6. A new paragraph (b)(3) is added.

The added and revised provisions

read as follows:

§1.469–11 Effective date and

transition rules.

(a) * * *

(3) The rules contained in §1.469–9

apply for taxable years beginning on or

after January 1, 1995, and to elections

made under §1.469–9(g) with returns

filed on or after January 1, 1995; and

(b) * * * (1) Application of 1992

amendments for taxable years beginning before October 4, 1994. Except as

provided in paragraph (b)(2) of this

section, for taxable years that end after

May 10, 1992, and begin before

October 4, 1994, a taxpayer may

determine tax liability in accordance

with Project PS–1–89 published at

1992–1 C.B. 1219 (see §601.601(d)(2)(ii)(b) of this chapter).

(2) Additional transition rule for

1992 amendments. * * *

(3) Fresh starts under consistency

rules—(i) Regrouping when tax liability is first determined under Project

PS–1–89. For the first taxable year in

which a taxpayer determines its tax

liability under Project PS–1–89, the

taxpayer may regroup its activities

without regard to the manner in which

the activities were grouped in the

preceding taxable year and must regroup its activities if the grouping in

the preceding taxable year is inconsistent with the rules of Project PS–1–89.

(ii) Regrouping when tax liability is

first determined under §1.469–4. For

the first taxable year in which a

taxpayer determines its tax liability

under §1.469–4, rather than under the

rules of Project PS–1–89, the taxpayer

may regroup its activities without regard to the manner in which the

activities were grouped in the preceding taxable year and must regroup its

activities if the grouping in the preceding taxable year is inconsistent with the

rules of §1.469–4.

(iii) Regrouping when taxpayer is

first subject to section 469(c)(7). For

the first taxable year beginning after

December 31, 1993, a taxpayer may regroup its activities to the extent necessary or appropriate to avail itself of the

provisions of section 469(c)(7) and

without regard to the manner in which

the activities were grouped in the

preceding taxable year.

Margaret Milner Richardson,

Commissioner of

Internal Revenue.

Approved December 12, 1995.

Leslie Samuels,

Assistant Secretary of

the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on

December 21, 1995, 8:45 a.m., and published

in the issue of the Federal Register for

December 22, 1995, 60 F.R. 66496)

Section 861.—Income From Sources

Within the United States

26 CFR 1.861–8: Computation of taxable

income from sources within the United States

and from other sources and activities.

T.D. 8646

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Allocation and Apportionment of

Research and Experimental

Expenditures

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document provides

guidance concerning the allocation and

apportionment of research and experimental expenditures for purposes of

determining taxable income from

sources within and without the United

States. This document affects taxpayers

that have income from United States

and foreign sources and that have made

expenditures for research and experimentation that the taxpayer deducts

under section 174 of the Internal

Revenue Code of 1986.

EFFECTIVE DATE: January 1, 1996.

FOR FURTHER INFORMATION

CONTACT: Carl Cooper at (202)

622-3840 (not a toll-free number).

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SUPPLEMENTARY INFORMATION:

Background

Provisions

and

Explanation

On May 24, 1995, the IRS published

a notice of proposed rulemaking and

notice of public hearing in the Federal

1995–1 C.B. 987]) proposing amendments to the Income Tax Regulations

(26 CFR part 1) under section 861 of

the Internal Revenue Code of 1986.

Section 1.861–8(e)(3) of the Income

Tax Regulations provides rules regarding the allocation and apportionment of

research and experimental expenditures

for purposes of determining taxable

income from sources inside and outside

the United States.

The notice of proposed rulemaking

proposed three principal changes to the

existing regulations. First, allocation of

research and experimental expenditures

to three digit SIC code product categories of gross income would be permitted. Second, the percentage of research

and experimental expenditures that may

be exclusively apportioned to United

States source income under the sales

method of apportionment under

§1.861–8(e)(3)(ii) would be increased

from 30 percent to 50 percent. Third,

use of the optional gross income

methods of apportionment would constitute a binding election to use such

methods in subsequent years. The

election would not be revocable without the prior consent of the Commissioner. The three changes were proposed in part on the basis of an

economic study performed by the

Treasury Department pursuant to Rev.

Proc. 92–56 (1992–2 C.B. 409), ‘‘The

Relationship between U.S. Research

and Development and Foreign Income,’’ which was published by the

Treasury Department simultaneously

with the proposed regulations.

Written comments responding to the

notice were received, and a public

hearing was held on September 8,

1995.

Regarding the determination of product categories under §1.861–8(e)(3)(i)(B) of the proposed regulations,

commenters suggested that the rule

requiring a taxpayer to determine relevant product categories by reference to

the three digit classification of the

Standard Industrial Classification Manual should be modified to allow determinations by reference to the five digit

classifications of the Manual. This

suggestion was not adopted, because

such a rule would too narrowly restrict

the necessarily broad scope of the

deduction. The IRS continues to believe that research and experimentation

is an inherently speculative activity,

that findings may contribute unexpected benefits, and that gross income

derived from successful research and

experimentation must bear the cost of

unsuccessful research and experimentation.

Commenters suggested that the regulations permit taxpayers to determine

product categories by reference to two

or three digit categories at the annual

election of the taxpayer. This suggestion was not adopted. The regulations

provide that a taxpayer may determine

product categories by reference to two

or three digit categories. A taxpayer

may aggregate, disaggregate or change

a previously selected SIC code category if the taxpayer establishes to the

satisfaction of the Commissioner that,

due to changes in the relevant facts, a

change in product category is appropriate. This rule provides a simple and

workable format for balancing the need

for consistency with the desire for

flexibility.

Referring to current §1.861–8(g) Example 6 (which has been redesignated

§1.861–17(h) Example 4), commenters

suggested that the regulations allow the

use of the Wholesale Trade SIC code

category with respect to sales from any

other category. The current §1.861–8(g)

Example 6 was not correct on this point

and does not override the rule stated

parenthetically in the list of two digit

SIC code categories in present §1.861–

8(e)(3)(i)(A) that wholesale trade may

not be combined with other product

categories. The final regulations include this rule along with Example 6

corrected to conform to the rule.

Regarding the exclusive place of

performance apportionment rule under

§1.861–8(e)(3)(ii)(A) of the proposed

regulations, commenters suggested

adding a rule providing that if the ratio

of foreign research and experimental

expenditures in a three digit SIC code

category of all foreign affiliates of a

United States consolidated group over

foreign affiliate sales in that SIC code

category exceed fifty percent of the

ratio of United States consolidated

group research and experimental expenditures in that SIC code category over

United States consolidated group sales

in that SIC code category, then the

United States consolidated group research and experimental expenditures

should be exclusively apportioned to

United States source gross income.

This suggestion has not been adopted.

Although a foreign affiliate may incur

substantial research and experimental

expenditures in a given product category, the foreign affiliate may still

benefit from the research and experimental expenditures of the United

States consolidated group. See PerkinElmer Corporation v. Commissioner,

103 T.C. 464 (1994).

Regarding the optional gross income

methods of apportionment under

§1.861–8(e)(3)(iii) of the proposed regulations, commenters suggested that the

final regulations include a fifty percent

exclusive place of performance apportionment under the optional gross income methods to be parallel with

§1.861–8(e)(3)(ii)(A). This suggestion

has been adopted in part. Section

(b)(1)(ii) of the final regulations includes a twenty-five percent exclusive

place of performance apportionment

under the optional gross income

methods. This twenty-five percent exclusive apportionment ensures that taxpayers electing to use one of the

optional gross income methods also

obtain results comparable to those

obtained by taxpayers electing to use

the sales method, i.e., an overall

allocation that is twenty-five percent

lower on average than the allocation to

foreign source income resulting from

the current regulations. The Treasury

Department study does not support a

greater exclusive apportionment.

Commenters suggested that the proposed regulations should be modified

to reduce the floor on the amount of

research and experimental expenditures

that must be apportioned to foreign

source income under the optional gross

income methods from fifty percent to

thirty percent of the amount that would

have been apportioned under the sales

method. This suggestion has not been

adopted. The adoption of this suggested

rule in addition to the twenty-five

percent exclusive apportionment rule is

not supported by the Treasury Department study.

Commenters suggested the elimination of the binding election to use the

optional gross income methods under

§1.861–8(e)(3)(iii)(C) of the proposed

regulations. Commenters also suggested

that the binding election rule should be

modified to provide for a change of

method without the prior consent of the

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Commissioner after five years’ use of

one method. This suggestion, which

recognizes the need for consistency

while reducing the administrative burden on taxpayers, has been adopted.

Commenters suggested that the effective date election under §1.861–8(e)(3)(vi) of the proposed regulations

permit election by fiscal year taxpayers

whose taxable years begin after August

1, 1994, but before January 1, 1995.

This suggestion has been adopted.

Finally, these provisions, which were

previously published as §1.861–8(e)(3),

have been renumbered and will now be

published as §1.861–17. This change

has been made solely for the purpose

of achieving greater clarity in formatting and is not intended to result in any

additional substantive changes.

Special Analyses

It has been determined that these

final regulations are not a significant

regulatory action as defined in EO

12866. Therefore, a regulatory assessment is not required. It also has been

determined that section 553(b) of the

Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not

apply to these regulations, and therefore a Regulatory Flexibility Analysis

is not required. Pursuant to section

7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking

preceding these final regulations has

been submitted to the Chief Counsel

for Advocacy of the Small Business

Administration for comment on its

impact on small business.

Drafting Information

The principal author of these regulations is Carl Cooper, Office of the

Associate Chief Counsel (International). However, other personnel from

IRS and Treasury participated in their

development.

Amendments to the Regulations

Accordingly, 26 CFR part 1 is

amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation

continues to read as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.861–8 is amended

by:

1. Revising paragraph (e)(3) to

read as set forth below.

2. Removing and reserving paragraph (g), Examples 3 through 16 and

23.

§1.861–8 Computation of taxable

income from sources within the

United States and from other sources

and activities.

(e) * * *

(3) Research and experimental expenditures. For rules regarding the

allocation and apportionment of research and experimental expenditures,

see §1.861–17.

Par. 3. Section 1.861–17 is added to

read as follows:

§1.861–17 Allocation and apportionment of research and experimental

expenditures.

(a) Allocation—(1) In general. The

methods of allocation and apportionment of research and experimental

expenditures set forth in this section

recognize that research and experimentation is an inherently speculative activity, that findings may contribute

unexpected benefits, and that the gross

income derived from successful research and experimentation must bear

the cost of unsuccessful research and

experimentation. Expenditures for research and experimentation that a taxpayer deducts under section 174 ordinarily shall be considered deductions

that are definitely related to all income

reasonably connected with the relevant

broad product category (or categories)

of the taxpayer and therefore allocable

to all items of gross income as a class

(including income from sales, royalties,

and dividends) related to such product

category (or categories). For purposes

of this allocation, the product category

(or categories) that a taxpayer may be

considered to have shall be determined

in accordance with the provisions of

paragraph (a)(2) of this section.

(2) Product categories—(i) Allocation based on product categories. Ordinarily, a taxpayer’s research and

experimental expenditures may be divided between the relevant product

categories. Where research and experi-

mentation is conducted with respect to

more than one product category, the

taxpayer may aggregate the categories

for purposes of allocation and apportionment; however, the taxpayer may

not subdivide the categories. Where

research and experimentation is not

clearly identified with any product

category (or categories), it will be

considered conducted with respect to

all the taxpayer’s product categories.

(ii) Use of three digit standard

industrial classification codes. A taxpayer shall determine the relevant

product categories by reference to the

three digit classification of the Standard

Industrial Classification Manual (SIC

code). A copy may be purchased from

the Superintendent of Documents,

United States Government Printing Office, Washington, DC 20402. The

individual products included within

each category are enumerated in Executive Office of the President, Office

of Management and Budget, Standard

Industrial Classification Manual, 1987

(or later edition, as available).

(iii) Consistency. Once a taxpayer

selects a product category for the first

taxable year for which this section is

effective with respect to the taxpayer, it

must continue to use that product

category in following years, unless the

taxpayer establishes to the satisfaction

of the Commissioner that, due to

changes in the relevant facts, a change

in the product category is appropriate.

For this purpose, a change in the

taxpayer’s selection of a product category shall include a change from a

three digit SIC code category to a two

digit SIC code category, a change from

a two digit SIC code category to a

three digit SIC code category, or any

other aggregation, disaggregation or

change of a previously selected SIC

code category.

(iv) Wholesale trade category. The

two digit SIC code category ‘‘Wholesale trade’’ is not applicable with

respect to sales by the taxpayer of

goods and services from any other of

the taxpayer’s product categories and is

not applicable with respect to a domestic international sales corporation

(DISC) or foreign sales corporation

(FSC) for which the taxpayer is a

related supplier of goods and services

from any of the taxpayer’s product

categories.

(v) Retail trade category. The two

digit SIC code category ‘‘Retail trade’’

is not applicable with respect to sales

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by the taxpayer of goods and services

from any other of the taxpayer’s

product categories, except wholesale

trade, and is not applicable with respect

to a DISC or FSC for which the taxpayer is a related supplier of goods and

services from any other of the taxpayer’s product categories, except

wholesale trade.

(3) Affiliated Groups—(i) In general. Except as provided in paragraph

(a)(3)(ii) of this section, the allocation

and apportionment required by this

section shall be determined as if all

members of the affiliated group (as

defined in §1.861–14T(d)) were a

single corporation. See §1.861–14T.

(ii) Possessions corporations. (A)

For purposes of the allocation and

apportionment required by this section,

sales and gross income from products

produced in whole or in part in a

possession by an electing corporation

(within the meaning of section 936(h)(5)(E)), and dividends from an electing

corporation, shall not be taken into

account, except that this paragraph

(a)(3)(ii) shall not apply to sales of

(and gross income and dividends attributable to sales of) products with

respect to which an election under

section 936(h)(5)(F) is not in effect.

(B) The research and experimental

expenditures taken into account for

purposes of this section shall be

reduced by the amount of such expenditures included in computing the costsharing amount (determined under section 936(h)(5)(C)(i)).

(4) Legally mandated research and

experimentation. Where research and

experimentation is undertaken solely to

meet legal requirements imposed by a

political entity with respect to improvement or marketing of specific products

or processes, and the results cannot

reasonably be expected to generate

amounts of gross income (beyond de

minimis amounts) outside a single

geographic source, the deduction for

such research and experimentation shall

be considered definitely related and

therefore allocable only to the grouping

(or groupings) of gross income within

that geographic source as a class (and

apportioned, if necessary, between such

groupings as set forth in paragraphs (c)

and (d) of this section). For example,

where a taxpayer performs tests on a

product in response to a requirement

imposed by the U.S. Food and Drug

Administration, and the test results

cannot reasonably be expected to gen-

erate amounts of gross income (beyond

de minimis amounts) outside the United

States, the costs of testing shall be

allocated solely to gross income from

sources within the United States.

(b) Exclusive apportionment—(1) In

general. An exclusive apportionment

shall be made under this paragraph (b),

where an apportionment based upon

geographic sources of income of a

deduction for research and experimentation is necessary (after applying the

exception in paragraph (a)(4) of this

section).

(i) Exclusive apportionment under

the sales method. If the taxpayer

apportions on the sales method under

paragraph (c) of this section, an amount

equal to fifty percent of such deduction

for research and experimentation shall

be apportioned exclusively to the statutory grouping of gross income or the

residual grouping of gross income, as

the case may be, arising from the

geographic source where the research

and experimental activities which account for more than fifty percent of the

amount of such deduction were

performed.

(ii) Exclusive apportionment under

the optional gross income methods. If

the taxpayer apportions on the optional

gross income methods under paragraph

(d) of this section, an amount equal to

twenty-five percent of such deduction

for research and experimentation shall

be apportioned exclusively to the statutory grouping or the residual grouping

of gross income, as the case may be,

arising from the geographic source

where the research and experimental

activities which account for more than

fifty percent of the amount of such

deduction were performed.

(iii) Exception. If the applicable fifty

percent geographic source test of the

preceding paragraph (b)(1)(i) or (ii) is

not met, then no part of the deduction

shall be apportioned under this paragraph (b)(1).

(2) Facts and circumstances supporting an increased exclusive apportionment—(i) In general. The exclusive apportionment provided for in

paragraph (b)(1) of this section reflects

the view that research and experimentation is often most valuable in the

country where it is performed, for two

reasons. First, research and experimentation often benefits a broad product

category, consisting of many individual

products, all of which may be sold in

the nearest market but only some of

which may be sold in foreign markets.

Second, research and experimentation

often is utilized in the nearest market

before it is used in other markets, and

in such cases, has a lower value per

unit of sales when used in foreign

markets. The taxpayer may establish to

the satisfaction of the Commissioner

that, in its case, one or both of the

conditions mentioned in the preceding

sentences warrant a significantly

greater exclusive allocation percentage

than allowed by paragraph (b)(1) of

this section because the research and

experimentation is reasonably expected

to have very limited or long delayed

application outside the geographic

source where it was performed. Past

experience with research and experimentation may be considered in determining reasonable expectations.

(ii) Not all products sold in foreign

markets. For purposes of establishing

that only some products within the

product category (or categories) are

sold in foreign markets, the taxpayer

shall compare the commercial production of individual products in domestic

and foreign markets made by itself, by

uncontrolled parties (as defined under

paragraph (c)(2)(i) of this section) of

products involving intangible property

which was licensed or sold by the

taxpayer, and by those controlled corporations (as defined under paragraph

(c)(3)(ii) of this section) that can

reasonably be expected to benefit directly or indirectly from any of the

taxpayer’s research expense connected

with the product category (or categories). The individual products compared

for this purpose shall be limited, for

nonmanufactured categories, solely to

those enumerated in Executive Office

of the President, Office of Management

and Budget Standard Industrial Classification Manual, 1987 (or later edition,

as available), and, for manufactured

categories, solely to those enumerated

at a 7-digit level in the U.S. Bureau of

the Census, Census of Manufacturers:

1992, Numerical List of Manufactured

Products, 1993, (or later edition, as

available). Copies of both of these

documents may be purchased from the

Superintendent of Documents, United

States Government Printing Office,

Washington, DC 20402.

(iii) Delayed application of research

findings abroad. For purposes of

establishing the delayed application of

research findings abroad, the taxpayer

shall compare the commercial introduction of its own particular products and

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processes (not limited by those listed in

the Standard Industrial Classification

Manual or the Numerical List of Manufactured Products) in the United States

and foreign markets, made by itself, by

uncontrolled parties (as defined under

paragraph (c)(2)(i) of this section) of

products involving intangible property

that was licensed or sold by the

taxpayer, and by those controlled corporations (as defined under paragraph

(c)(3)(i) of this section) that can

reasonably be expected to benefit,

directly or indirectly, from the taxpayer’s research expense. For purposes

of evaluating the delay in the application of research findings in foreign

markets, the taxpayer shall use a safe

haven discount rate of 10 percent per

year of delay unless he is able to

establish to the satisfaction of the

Commissioner, by reference to the cost

of money and the number of years

during which economic benefit can be

directly attributable to the results of the

taxpayer’s research, that another discount rate is more appropriate.

The amount equal to the remaining

portion of such deduction for research

and experimentation, not apportioned

under paragraph (a)(4) or (b)(1)(i) of

this section, shall be apportioned between the statutory grouping (or among

the statutory groupings) within the

class of gross income and the residual

grouping within such class in the same

proportions that the amount of sales

from the product category (or categories) that resulted in such gross income

within the statutory grouping (or statutory groupings) and in the residual

grouping bear, respectively, to the total

amount of sales from the product

category (or categories).

(i) Apportionment in excess of gross

income. Amounts apportioned under

this section may exceed the amount of

gross income related to the product

category within the statutory grouping.

In such case, the excess shall be

applied against other gross income

within the statutory grouping. See

§1.861–8(d)(1) for instances where the

apportionment leads to an excess of

deductions over gross income within

the statutory grouping.

(ii) Leased property. For purposes of

this paragraph (c), amounts received

from the lease of equipment during a

taxable year shall be regarded as sales

receipts for such taxable year.

(2) Sales of uncontrolled parties. For

purposes of the apportionment under

paragraph (c)(1) of this section, the

sales from the product category (or

categories) by each party uncontrolled

by the taxpayer, of particular products

involving intangible property that was

licensed or sold by the taxpayer to such

uncontrolled party shall be taken fully

into account both for determining the

taxpayer’s apportionment and for determining the apportionment of any other

member of a controlled group of

corporations to which the taxpayer

belongs if the uncontrolled party can

reasonably be expected to benefit directly or indirectly (through any member of the controlled group of corporations to which the taxpayer belongs)

from the research expense connected

with the product category (or categories) of such other member. An uncontrolled party can reasonably be expected to benefit from the research

expense of a member of a controlled

group of corporations to which the

taxpayer belongs if such member can

reasonably be expected to license, sell,

or transfer intangible property to that

uncontrolled party or transfer secret

processes to that uncontrolled party,

directly or indirectly through a member

of the controlled group of corporations

to which the taxpayer belongs. Past

experience with research and experimentation shall be considered in determining reasonable expectations.

(i) Definition of uncontrolled party.

For purposes of this paragraph (c)(2)

the term uncontrolled party means a

party that is not a person with a

relationship to the taxpayer specified in

section 267(b), or is not a member of a

controlled group of corporations to

which the taxpayer belongs (within the

meaning of section 993(a)(3) or

927(d)(4)).

(ii) Licensed products. In the case of

licensed products, if the amount of

sales of such products is unknown (for

example, where the licensed product is

a component of a large machine), a

reasonable estimate based on the principles of section 482 should be made.

(iii) Sales of intangible property. In

the case of sales of intangible property,

regardless of whether the consideration

received in exchange for the intangible

is a fixed amount or is contingent on

the productivity, use, or disposition of

the intangible, if the amount of sales of

products utilizing the intangible property is unknown, a reasonable estimate

of sales shall be made annually. If

necessary, appropriate economic analyses shall be used to estimate sales.

(3) Sales of controlled parties. For

purposes of the apportionment under

paragraph (c)(1) of this section, the

sales from the product category (or

categories) of the taxpayer shall be

taken fully into account and the sales

from the product category (or categories) of a corporation controlled by the

taxpayer shall be taken into account to

the extent provided in this paragraph

(c)(3) for determining the taxpayer’s

apportionment, if such corporation can

reasonably be expected to benefit directly or indirectly (through another

member of the controlled group of

corporations to which the taxpayer

belongs) from the taxpayer’s research

expense connected with the product

category (or categories). A corporation

controlled by the taxpayer can reasonably be expected to benefit from the

taxpayer’s research expense if the

taxpayer can be expected to license,

sell, or transfer intangible property to

that corporation or transfer secret processes to that corporation, either directly

or indirectly through a member of the

controlled group of corporations to

which the taxpayer belongs. Past experience with research and experimentation shall be considered in determining reasonable expectations.

(i) Definition of a corporation controlled by the taxpayer. For purposes of

this paragraph (c)(3), the term a

corporation controlled by the taxpayer

means any corporation that has a

relationship to the taxpayer specified in

section 267(b) or is a member of a

controlled group of corporations to

which the taxpayer belongs (within the

meaning of section 993(a)(3) or

927(d)(4).

(ii) Sales to be taken into account.

The sales from the product category (or

categories) of a corporation controlled

by the taxpayer taken into account shall

be equal to the amount of sales that

bear the same proportion to the total

sales of the controlled corporation as

the total value of all classes of the

stock of such corporation owned directly or indirectly by the taxpayer,

within the meaning of section 1563,

bears to the total value of all classes of

stock of such corporation.

(iii) Sales not to be taken into

account more than once. Sales from the

product category (or categories) between or among such controlled corporations or the taxpayer shall not be

taken into account more than once; in

such a situation, the amount sold by the

selling corporation to the buying corpo-

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ration shall be subtracted from the sales

of the buying corporation.

(iv) Effect of cost-sharing arrangements. If the corporation controlled by

the taxpayer has entered into a bona

fide cost-sharing arrangement, in accordance with the provisions of

§1.482–7, with the taxpayer for the

purpose of developing intangible property, then that corporation shall not

reasonably be expected to benefit from

the taxpayer’s share of the research

expense.

(d) Gross income methods—(1)(i) In

general. In lieu of applying the sales

method of paragraph (c) of this section,

the remaining amount of the deduction

for research and experimentation, not

apportioned under paragraph (a)(4) or

(b)(1)(ii) of this section, shall be

apportioned as prescribed in paragraphs

(d)(2) and (3) of this section, between

the statutory grouping (or among the

statutory groupings) of gross income

and the residual grouping of gross

income.

(ii) Optional methods to be applied

to all research and experimental expenditures. These optional methods must

be applied to the taxpayer’s entire

deduction for research and experimental expense remaining after applying

the exception in paragraph (a)(4) of

this section, and may not be applied on

a product category basis. Thus, after

the allocation of the taxpayer’s entire

deduction for research and experimental expense under paragraph (a)(2) of

this section (by attribution to SIC code

categories), the taxpayer must then

apportion as necessary the entire deduction as allocated by separate

amounts to various product categories,

using only the sales method under

paragraph (c) of this section or only the

optional gross income methods under

this paragraph (d). The taxpayer may

not use the sales method for a portion

of the deduction and optional gross

income methods for the remainder of

the deduction separately allocated.

(2) Option one. The taxpayer may

apportion its research and experimental

expenditures ratably on the basis of

gross income between the statutory

grouping (or among the statutory

groupings) of gross income and the

residual grouping of gross income in

the same proportions that the amount

of gross income in the statutory grouping (or groupings) and the amount of

gross income in the residual grouping

bear, respectively, to the total amount

of gross income, if the conditions

described in paragraph (d)(2)(i) and (ii)

of this section are both met.

(i) The amount of research and

experimental expense ratably apportioned to the statutory grouping (or

groupings in the aggregate) is not less

than fifty percent of the amount that

would have been so apportioned if the

taxpayer had used the method described in paragraph (c) of this section;

and

(ii) The amount of research and

experimental expense ratably apportioned to the residual grouping is not

less than fifty percent of the amount

that would have been so apportioned if

the taxpayer had used the method

described in paragraph (c) of this

section.

(3) Option two. If, when the amount

of research and experimental expense is

apportioned ratably on the basis of

gross income, either of the conditions

described in paragraph (d)(2)(i) or (ii)

of this section is not met, the taxpayer

may either—

(i) Where the condition of paragraph

(d)(2)(i) of this section is not met,

apportion fifty percent of the amount of

research and experimental expense that

would have been apportioned to the

statutory grouping (or groupings in the

aggregate) under paragraph (c) of this

section to such statutory grouping (or

to such statutory groupings in the

aggregate and then among such groupings on the basis of gross income

within each grouping), and apportion

the balance of the amount of research

and experimental expenses to the residual grouping; or

(ii) Where the condition of paragraph (d)(2)(ii) of this section is not

met, apportion fifty percent of the

amount of research and experimental

expense that would have been apportioned to the residual grouping under

paragraph (c) of this section to such

residual grouping, and apportion the

balance of the amount of research and

experimental expenses to the statutory

grouping (or to the statutory groupings

in the aggregate and then among such

groupings ratably on the basis of gross

income within each grouping).

(e) Binding election—(1) In general.

A taxpayer may choose to use either

the sales method under paragraph (c) of

this section or the optional gross

income methods under paragraph (d) of

this section for its original return for its

first taxable year to which this section

applies. The taxpayer’s use of either

the sales method or the optional gross

income methods for its return filed for

its first taxable year to which this

section applies shall constitute a binding election to use the method chosen

for that year and for four taxable years

thereafter.

(2) Change of method. The taxpayer’s election of a method may not

be revoked during the period referred

to in paragraph (e)(1) of this section

without the prior consent of the Commissioner. After the expiration of that

period, the taxpayer may change

methods without the prior consent of

the Commissioner. However, the taxpayer’s use of the new method shall

constitute a binding election to use the

new method for its return filed for the

first year for which the taxpayer uses

the new method and for four taxable

years thereafter. The taxpayer’s election of the new method may not be

revoked during that period without the

prior consent of the Commissioner.

(i) Short taxable years. For purposes

of this paragraph (e), the term taxable

year includes a taxable year of less

than twelve months.

(ii) Affiliated groups. In the case of

an affiliated group, the period referred

to in paragraph (e)(1) of this section

shall commence as of the latest taxable

year in which any member of the group

has changed methods.

(f) Special rules for partnerships—

(1) Research and experimental expenditures. For purposes of applying this

section, if research and experimental

expenditures are incurred by a partnership in which the taxpayer is a

partner, the taxpayer’s research and

experimental expenditures shall include

the taxpayer’s distributive share of the

partnership’s research and experimental

expenditures.

(2) Purpose and location of expenditures. In applying the exception for

expenditures undertaken to meet legal

requirements under paragraph (a)(4) of

this section and the exclusive apportionment for the sales method and the

optional gross income methods under

paragraph (b) of this section, a partner’s distributive share of research and

experimental expenditures incurred by

a partnership shall be treated as incurred by the partner for the same

purpose and in the same location as

incurred by the partnership.

(3) Apportionment under the sales

method. In applying the remaining

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apportionment for the sales method

under paragraph (c) of this section, a

taxpayer’s sales from a product category shall include the taxpayer’s share

of any sales from the product category

of any partnership in which the taxpayer is a partner. For purposes of the

preceding sentence, a taxpayer’s share

of sales shall be proportionate to the

taxpayer’s distributive share of the

partnership’s gross income in the product category.

(g) Effective date. This section applies to taxable years beginning after

December 31, 1995. However, a taxpayer may at its option, apply this

section in its entirety to all taxable

years beginning after August 1, 1994.

(h) Examples. The following examples illustrate the application of this

section:

Example 1—(i) Facts. X, a domestic corporation, is a manufacturer and distributor of small

gasoline engines for lawn mowers. Gasoline

engines are a product within the category,

Engines and Turbines (SIC Industry Group 351).

Y, a wholly owned foreign subsidiary of X, also

manufactures and sells these engines abroad.

During 1996, X incurred expenditures of $60,000

on research and experimentation, which it

deducts as a current expense, to invent and

patent a new and improved gasoline engine. All

of the research and experimentation was performed in the United States. In 1996, the

domestic sales by X of the new engine total

$500,000 and foreign sales by Y total $300,000.

X provides technology for the manufacture of

engines to Y via a license that requires the

payment of an arm’s length royalty. In 1996, X’s

gross income is $160,000, of which $140,000 is

U.S. source income from domestic sales of

gasoline engines and $10,000 is foreign source

royalties from Y, and $10,000 is U.S. source

interest income.

(ii) Allocation. The research and experimental

expenditures were incurred in connection with

small gasoline engines and they are definitely

related to the items of gross income to which the

research gives rise, namely gross income from

the sale of small gasoline engines in the United

States and royalties received from subsidiary Y,

a foreign manufacturer of gasoline engines.

Accordingly, the expenses are allocable to this

class of gross income. The U.S. source interest

income is not within this class of gross income

and, therefore, is not taken into account.

(iii) Apportionment. (A) For purposes of applying the foreign tax credit limitation, the

statutory grouping is general limitation gross

income from sources without the United States

and the residual grouping is gross income from

sources within the United States. Since the

related class of gross income derived from the

use of engine technology consists of both gross

income from sources without the United States

(royalties from Y) and gross income from

sources within the United States (gross income

from engine sales), X’s deduction of $60,000 for

its research and experimental expenditure must

be apportioned between the statutory and residual

grouping before the foreign tax credit limitation

may be determined. Because more than 50

percent of X’s research and experimental activity

was performed in the United States, 50 percent

of that deduction can be apportioned exclusively

to the residual grouping of gross income, gross

income from sources within the United States.

The remaining 50 percent of the deduction can

then be apportioned between the residual and

statutory groupings on the basis of sales of small

gasoline engines by X and Y. Alternatively, X’s

deduction for research and experimentation can

be apportioned under the optional gross income

method. The apportionment for 1996 is as

follows:

(1) Tentative Apportionment on the Basis of

Sales.

(i) Research and experimental expense to be apportioned between residual and statutory groupings of gross

income:

$60,000

(ii) Less: Exclusive apportionment

of research and experimental expense

to the residual grouping of gross

income ($60,000 3 50 percent):

$30,000

(iii) Research and experimental expense to be apportioned between residual and statutory groupings of gross

income on the basis of sales:

$30,000

(iv) Apportionment of research and

experimental expense to the residual

grouping of gross income ($30,000 3

$500,000/($500,000 + $300,000)):

$18,750

(v) Apportionment of research and

experimental expense to the statutory

grouping of gross income ($30,000 3

$300,000/($500,000 + $300,000)):

$11,250

(vi) Total apportioned deduction for

research and experimentation:

$60,000

(vii) Amount apportioned to the

residual grouping ($30,000 + $18,750):

$48,750

(viii) Amount apportioned to the

statutory grouping:

$11,250

(2) Tentative Apportionment on the Basis of

Gross Income.

(i) Exclusive apportionment of research and experimental expense to the

residual grouping of gross income

($60,000 3 25 percent):

$15,000

(ii) Research and experimental expense apportioned to sources within

the United States (residual grouping)

($45,000 3 $140,000/($140,000 +

$10,000)):

$42,000

(iii) Research and experimental expense apportioned to sources within

country Y (statutory grouping)

($45,000 3 $10,000/($140,000 +

$10,000)):

$3,000

(iv) Amount apportioned to the

residual grouping:

$57,000

(v) Amount apportioned to the statutory grouping:

$3,000

(B) The total research and experimental expense apportioned to the statutory grouping

($3,000) under the gross income method is

approximately 26 percent of the amount apportioned to the statutory grouping under the sales

method. Thus, X may use option two of the

gross income method (paragraph (d)(3) of this

section) and apportion to the statutory grouping

fifty percent (50%) of the $11,250 apportioned to

that grouping under the sales method. Thus, X

apportions $5,625 of research and experimental

expense to the statutory grouping. X’s use of the

optional gross income methods will constitute a

binding election to use the optional gross income

methods for 1996 and four taxable years

thereafter.

Example 2—(i) Facts. Assume the same facts

as in Example 1 except that X also spends

$30,000 in 1996 for research on steam turbines,

all of which is performed in the United States,

and X has steam turbine sales in the United

States of $400,000. X’s foreign subsidiary Y

neither manufactures nor sells steam turbines.

The steam turbine research is in addition to the

$60,000 in research which X does on gasoline

engines for lawnmowers. X thus has a deduction

of $90,000 for its research activity. X’s gross

income is $200,000, of which $140,000 is U.S.

source income from domestic sales of gasoline

engines, $50,000 is U.S. source income from

domestic sales of steam turbines, and $10,000 is

foreign source royalties from Y.

(ii) Allocation. X’s research expenses generate

income from sales of small gasoline engines and

steam turbines. Both of these products are in the

same three digit SIC code category, Engines and

Turbines (SIC Industry Group 351). Therefore,

the deduction is definitely related to this product

category and allocable to all items of income

attributable to it. These items of X’s income are

gross income from the sale of small gasoline

engines and steam turbines in the United States

and royalties from foreign subsidiary Y, a

foreign manufacturer and seller of small gasoline

engines.

(iii) Apportionment. (A) For purposes of applying the foreign tax credit limitation, the

statutory grouping is general limitation gross

income from sources outside the United States

and the residual grouping is gross income from

sources within the United States. X’s deduction

of $90,000 must be apportioned between the

statutory and residual groupings. Because more

than 50 percent of X’s research and experimental

activity was performed in the United States, 50

percent of that deduction can be apportioned

exclusively to the residual grouping, gross

income from sources within the United States.

The remaining 50 percent of the deduction can

then be apportioned between the residual and

statutory groupings on the basis of total sales of

small gasoline engines and steam turbines by X

and Y. Alternatively, X’s deduction for research

and experimentation can be apportioned under

the optional gross income methods. The apportionment for 1996 is as follows:

(1) Tentative Apportionment on the Basis of

Sales.

(i) Research and experimental expense to be apportioned between residual and statutory groupings of gross

income:

(ii) Less: Exclusive apportionment

of the research and experimental expense to the residual grouping of gross

income ($90,000 3 50 percent):

(iii) Research and experimental expense to be apportioned between the

residual and statutory groupings of

gross income on the basis of sales:

(iv) Apportionment of research and

experimental expense to the residual

grouping of gross income ($45,000 3

($500,000 + $400,000)/($500,000 +

$400,000 + $300,000)):

$90,000

$45,000

$33,750

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(v) Apportionment of research and

experimental expense to the statutory

grouping of gross income ($45,000 3

$300,000/($500,000 + $400,000 +

$300,000)):

$11,250

(vi) Total apportioned deduction for

research and experimentation:

$90,000

(vii) Amount apportioned to the

residual grouping ($45,000 + $33,750):

$78,750

(viii) Amount apportioned to the

statutory

grouping:

$11,250

(2) Tentative Apportionment on the Basis of

Gross Income.

(i) Exclusive apportionment of research and experimental expense to the

residual grouping of gross income

($90,000 3 25 percent):

$22,500

(ii) Research and experimental expense apportioned to sources within

the United States (residual grouping)

($67,500 3 $190,000/($140,000 +

$50,000 + $10,000)):

$64,125

(iii) Research and experimental expense apportioned to sources within

country Y (statutory grouping)

($67,500 3 $10,000/($140,000 +

$50,000 + $10,000)):

$3,375

(iv) Amount apportioned to the

residual grouping:

$86,625

(v) Amount apportioned to the statutory grouping:

$3,375

(B) The total research and experimental expense apportioned to the statutory grouping

($3,375) under the gross income method is 30

percent of the amount apportioned to the

statutory grouping under the sales method. Thus,

X may use option two of the gross income

method (paragraph (d)(3) of this section) and

apportion to the statutory grouping fifty percent

(50%) of the $11,250 apportioned to that

grouping under the sales method. Thus, X

apportions $5,625 of research and experimental

expense to the statutory grouping. X’s use of the

optional gross income methods will constitute a

binding election to use the optional gross income

methods for 1996 and four taxable years

thereafter.

Example 3—(i) Facts. Assume the same facts

as in Example 1 except that in 1997 X continues

its sales of the new engines, with sales of

$600,000 in the United States and $400,000

abroad by subsidiary Y. X also acquires a 60

percent (by value) ownership interest in foreign

corporation Z and a 100 percent ownership

interest in foreign corporation C. X transfers its

engine technology to Z for a royalty equal to 5

percent of sales, and X enters into an arm’s

length cost-sharing arrangement with C to share

the funding of all of X’s research activity. In

1997, corporation Z has sales in country Z equal

to $1,000,000. X incurs expense of $80,000 on

research and experimentation in 1997, and in

addition, X performs $15,000 of research on

gasoline engines which was funded by the costsharing arrangement with C. All of Z’s sales are

from the product category, Engines and Turbines

(SIC Industry Group 351). X performs all of its

research in the United States and $20,000 of its

expenditure of $80,000 is made solely to meet

pollution standards mandated by law. X

establishes, to the satisfaction of the Commissioner, that the expenditure in response to

pollution standards is not expected to generate

gross income (beyond de minimis amounts)

outside the United States.

(ii) Allocation. The $20,000 of research expense which X incurred in connection with

pollution standards is definitely related and thus

allocable to the residual grouping, gross income

from sources within the United States. The

remaining $60,000 in research and experimental

expenditure incurred by X is definitely related to

all gasoline engines and is therefore allocable to

the class of gross income to which the engines

give rise, gross income from sales of gasoline

engines in the United States, royalties from

country Y, and royalties from country Z. No part

of the $60,000 research expense is allocable to

dividends from country C, because corporation C

has already paid, through its cost-sharing arrangement, for research activity performed by X

which may benefit C.

(iii) Apportionment. For purposes of applying

the foreign tax credit limitation, the statutory

grouping is general limitation gross income from

sources without the United States, and the

residual grouping is gross income from sources

within the United States. X’s deduction of

$60,000 for its research and experimental expenditure must be apportioned between these groupings. Because more than 50 percent of the

research and experimentation was performed in

the United States, 50 percent of the $60,000

deduction can be apportioned exclusively to the

residual grouping. The remaining 50 percent of

the deduction can then be apportioned between

the residual and the statutory grouping on the

basis of sales of gasoline engines by X, Y, and

Z. (If X utilized the optional gross income

methods in 1996, then its use of such methods

constituted a binding election to use the optional

gross income methods in 1996 and for four

taxable years thereafter. If X utilized the sales

method in 1996, then its use of such method

constituted a binding election to use the sales

method in 1996 and for four taxable years

thereafter.) The optional gross income methods

are not illustrated in this Example 3 (see instead

Examples 1 and 2). Since X has only a 60

percent ownership interest in corporation Z, only

60 percent of Z’s sales (60% of $1,000,000, or

$600,000) are included for purposes of apportionment. The allocation and apportionment for

1997 is as follows:

(A) X’s total research expense:

$80,000

(B) Less: Legally mandated research

directly allocated to the residual

grouping of gross income:

$20,000

basis of sales.

(1) Research and experimental expense to be apportioned between residual and statutory groupings of gross

income:

$60,000

(2) Less: Exclusive apportionment

of research and experimental expense

to the residual grouping of gross

income ($60,000 3 50 percent):

$30,000

(3) Research and experimental expense

to be apportioned between the residual

and the statutory groupings on the

basis of sales:

$30,000

(4) Apportionment of research and

experimental expense to gross income

from sources within the United States

(residual grouping) ($30,000 3

$600,000 / ($600,000 + $400,000 +

$600,000)):

$11,250

(5) Apportionment of research and

experimental expense to general limitation gross income from countries Y

and Z (statutory grouping) ($30,000 3

$400,000 + $600,000/($600,000 +

$400,000 +$600,000)):

$18,750

(6) Total apportioned deduction for

research and experimentation ($30,000

+ $30,000):

$60,000

(7) Amount apportioned to the residual grouping ($30,000 + $11,250):

$41,250

(8) Amount apportioned to the statutory grouping of gross income from

sources within countries Y and Z:

$18,750

Example 4—Research and Experimentation—

(i) Facts. X, a domestic corporation, manufactures and sells forklift trucks and other types of

materials handling equipment in the United

States. The manufacture and sale of forklift

trucks and other materials handling equipment

belongs to the product category, Construction,

Mining, and Materials Handling Machinery and

Equipment (SIC Industry Group 353). X also

sells its forklift trucks to a wholesaling subsidiary located in foreign country Y (but title passes

in the United States), and X manufactures

forklift trucks in foreign country Z. The wholesaling of forklift trucks to country Y also

belongs to X’s product category Transportation

equipment and, therefore, may not belong to the

product category, Wholesale trade (SIC Major

Group 50 and 51). In 1997, X sold $7,000,000 of

forklift trucks to purchasers in the United States,

$3,000,000 of forklift trucks to the wholesaling

subsidiary in Y, and transferred forklift truck

components with an FOB export value of

$2,000,000 to its branch in Z. The branch’s sales

of finished forklift trucks were $5,000,000. In

response to legally mandated emission control

requirements, X’s United States research department has been engaged in a research project to

improve the performance and quality of engine

exhaust systems used on its products in the

United States. It incurs expenses of $100,000 for

this purpose in 1997. In the past, X has

customarily adapted the product improvements

developed originally for the domestic market to

its forklift trucks manufactured abroad. During

the taxable year 1997, development of an

improved engine exhaust system is completed

and X begins installing the new system during

the latter part of the taxable year in products

manufactured and sold in the United States. X

continues to manufacture and sell forklift trucks

in foreign countries without the improved engine

exhaust systems.

(ii) Allocation. X’s deduction for its research

expense is definitely related to the income to

which it gives rise, namely income from the

manufacture and sale of forklift trucks within the

United States and in country Z. Although the

research is undertaken in response to a legal

mandate, it can reasonably be expected to

generate gross income from the manufacture and

sale of trucks by the branch in Z. Therefore, the

deduction is not allocable solely to income from

X’s domestic sales of forklift trucks. It is

allocable to income from such sales and income

from the sales of X’s branch in Z.

(iii) Apportionment. For the method of apportionment on the basis of either sales or gross

income, see Example 3. However, in determining

the amount of research apportioned to income

from foreign and domestic sources, the net sales

of the branch in Z are $3,000,000 ($5,000,000

less $2,000,000) and the sales within the United

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States are $12,000,000 ($7,000,000 plus

$3,000,000 plus $2,000,000). See §1.861–17(c)(3)(iii).

Example 5—(i) Facts. X, a domestic corporation, is a drug company that manufactures a wide

variety of pharmaceutical products for sale in the

United States. Pharmaceutical products belong to

the product category, Drugs (SIC Industry Group

283). X exports its pharmaceutical products

through a foreign sales corporation (FSC). X’s

wholly owned foreign subsidiary Y also manufactures pharmaceutical products. In 1997, X

has domestic sales of pharmaceutical products of

$10,000,000, the FSC has sales of pharmaceutical products of $3,000,000, and Y has sales of

pharmaceutical products of $5,000,000. In that

same year, 1997, X incurs expense of $200,000

on research to test a product in response to

requirements imposed by the United States Food

and Drug Administration (FDA). X is able to

show that, even though country Y imposes

certain testing requirements on pharmaceutical

products, the research performed in the United

States is not accepted by country Y for purposes

of its own licensing requirements, and the

research has minimal use abroad. X is further

able to show that FSC sells goods to countries

that do not accept or do not require research

performed in the United States for purposes of

their own licensing standards.

(ii) Allocation. Since X’s research expense of

$200,000 is undertaken to meet the requirements

of the United States Food and Drug Administration, and since it is reasonable to expect that the

expenditure will not generate gross income

(beyond de minimis amounts) outside the United

States, the deduction is definitely related and

thus allocable to the residual grouping.

(iii) Apportionment. No apportionment is necessary since the entire expense is allocated to the

residual grouping, gross income from sales

within the United States.

Example 6—(i) Facts. X, a domestic corporation, is engaged in continuous research and

experimentation to improve the quality of the

products that it manufactures and sells, which are

floodlights, flashlights, fuse boxes, and solderless

connectors. X incurs and deducts $100,000 of

expenditure for research and experimentation in

1997 that was performed exclusively in the

United States. As a result of this research

activity, X acquires patents that it uses in its own

manufacturing activity. X licenses its floodlight

patent to Y and Z, uncontrolled foreign corporations, for use in their own territories, countries Y

and Z, respectively. Corporation Y pays X an

arm’s length royalty of $3,000 plus $0.20 for

each floodlight sold. Sales of floodlights by Y

for the taxable year are $135,000 (at $4.50 per

unit) or 30,000 units, and the royalty is $9,000

($3,000 + $0.20 3 30,000). Y has sales of other

products of $500,000. Z pays X an arm’s length

royalty of $3,000 plus $0.30 for each unit sold. Z

manufactures 30,000 floodlights in the taxable

year, and the royalty is $12,000 ($3,000 + $0.30

3 30,000). The dollar value of Z’s floodlight

sales is not known and cannot be reasonably

estimated because, in this case, the floodlights

are not sold separately by Z but are instead used

as a component in Z’s manufacture of lighting

equipment for theaters. The sales of all Z’s

products, including the lighting equipment for

theaters, are $1,000,000. Y and Z each sell the

floodlights exclusively within their respective

countries. X’s sales of floodlights for the taxable

year are $500,000 and its sales of its other products, flashlights, fuse boxes, and solderless

connectors, are $400,000. X has gross income of

$500,000, consisting of gross income from domestic sources from sales of floodlights, flashlights, fuse boxes, and solderless connectors of

$479,000, and royalty income of $9,000 and

$12,000 from foreign corporations Y and Z respectively. X utilized the optional gross income

methods of apportionment for its return filed for

its first taxable year to which this section applies.

(ii) Allocation. X’s research and experimental

expenses are definitely related to all of the

products that it produces, which are floodlights,

flashlights, fuse boxes, and solderless connectors.

All of these products are in the same three digit

SIC Code category, Electric Lighting and Wiring

Equipment (SIC Industry Group 364). Thus, X’s

research and experimental expenses are allocable

to all items of income attributable to this product

category, domestic sales income and royalty

income from the foreign countries in which

corporations Y and Z operate.

(iii) Apportionment. (A) The statutory grouping of gross income is general limitation income

from sources without the United States. The

residual grouping is gross income from sources

within the United States. X’s deduction of

$100,000 for its research expenditures must be

apportioned between the groupings. For apportionment on the basis of sales in accordance with

paragraph (c) of this section, X is entitled to an

exclusive apportionment of 50 percent of its

research and experimental expense to the residual

grouping, gross income from sources within the

United States, since more than 50 percent of the

research activity was performed in the United

States. The remaining 50 percent of the deduction can then be apportioned between the

residual and statutory groupings on the basis of

sales. Since Y and Z are unrelated licensees of

X, only their sales of the licensed product,

floodlights, are included for purposes of apportionment. Floodlight sales of Z are unknown, but

are estimated at ten times royalties from Z, or

$120,000. All of X’s sales from the entire

product category are included for purposes of

apportionment on the basis of sales. Alternatively, X may apportion its deduction on the

basis of gross income, in accordance with

paragraph (d) of this section. The apportionment

is as follows:

(1) Tentative Apportionment on the basis of

sales.

(i) Research and experimental expense to be apportioned between statutory and residual groupings of gross

income:

$100,000

(ii) Less: Exclusive apportionment

of research and experimental expense

to the residual groupings of gross

income ($100,000 3 50 percent):

$50,000

(iii) Research and experimental expense to be apportioned between the

statutory and residual groupings of

gross income on the basis of sales:

$50,000

(iv) Apportionment of research and

experimental expense to the residual

groupings of gross income ($50,000 3

$900,000/($900,000 + $135,000 +

$120,000)):

$38,961

(v) Apportionment of research and

experimental expense to the statutory

grouping, royalty income from countries Y and Z ($50,000 3 $135,000 +

$120,000/($900,000 + $135,000 +

$120,000)):

$11,039

(vi) Total apportioned deduction for

research and experimentation:

$100,000

(vii) Amount apportioned to the

residual grouping ($50,000 + $38,961):

$88,961

(viii) Amount apportioned to the

statutory grouping of sources within

countries Y and Z:

$11,039

(2) Tentative apportionment on gross income

basis.

(i) Exclusive apportionment of research and experimental expense to the

residual grouping of gross income

($100,000 3 25 percent):

$25,000

(ii) Apportionment of research and

experimental expense to the residual

grouping of gross income ($75,000 3

$479,000/$500,000):

$71,850

(iii) Apportionment of research and

experimental expense to the statutory

grouping of gross income ($75,000 3

$9,000 + $12,000/$500,000):

$3,150

(iv) Amount apportioned to the

residual grouping:

$96,850

(v) Amount apportioned to the statutory grouping of general limitation

income from sources without the

United States:

$3,150

(B) Since X has elected to use the optional

gross income methods of apportionment and its

apportionment on the basis of gross income to

the statutory grouping, $3,150, is less than 50

percent of its apportionment on the basis of sales

to the statutory grouping, $11,039, it must use

Option two of paragraph (d)(3) of this section

and apportion $5,520 (50 percent of $11,039) to

the statutory grouping.

Margaret Milner Richardson,

Commissioner of

Internal Revenue.

Approved December 13, 1995.

Leslie Samuels,

Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on

December 21, 1995, 8:45 a.m., and published

in the issue of the Federal Register for

December 22, 1995, 60 F.R. 66502)

Section 3406.—Backup Withholding

26 CFR 31.3406(h)–3: Certificates.

When does a substitute Form W–9 that

contains a single signature line both for the

certifications under section 3406 of the Internal

Revenue Code and for unrelated account opening

provisions satisfy the requirement that the

certifications be clearly set forth? See Rev. Proc.

96–26, page 22.

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Part III. Administrative, Procedural, and Miscellaneous

Weighted Average Interest Rate Update

Notice 96–11

Notice 88–73 provides guidelines for

determining the weighted average interest rate and the resulting permissible

range of interest rates used to calculate

current liability for the purpose of

Month

February

Year

1996

Drafting Information

The principal author of this notice is

Donna Prestia of the Employee Plans

Division. For further information regarding this notice, call (202) 622-6076

between 2:30 and 4:00 p.m. Eastern

time (not a toll-free number). Ms.

Prestia’s number is (202) 622-7377

(also not a toll-free number).

26 CFR 601.105: Examination of returns and

claims for refund, credit, or abatement;

determination of correct tax liability.

(Also Part I, § 280F; 1.280F–7, 1.280F–5T.)

Rev. Proc. 96–25

SECTION 1. PURPOSE

This revenue procedure provides limitations on depreciation deductions for

owners of passenger automobiles first

placed in service during calendar year

1996, and the amounts to be included

in income by lessees of passenger

automobiles first leased during calendar

year 1996. The tables detailing these

amounts reflect the automobile price

inflation adjustments required by

§ 280F(d)(7) of the Internal Revenue

Code.

SECTION 2. BACKGROUND

For owners of automobiles,

§ 280F(a) imposes dollar limitations on

the depreciation deduction for both the

year that the automobile is placed in

the full funding limitation of

§ 412(c)(7) of the Internal Revenue

Code as amended by the Omnibus

Budget Reconciliation Act of 1987 and

as further amended by the Uruguay

Round Agreements Act, Pub. L. 103–

465 (GATT).

The average yield on the 30-year

Treasury Constant Maturities for January 1996 is 6.05 percent.

The following rates were determined

for the plan years beginning in the

month shown below.

90% to 108%

Permissible

Range

6.31 to 7.57

Weighted

Average

7.01

service and each succeeding year.

Section 280F(d)(7) requires the

amounts allowable as depreciation deductions to be increased by a price

inflation adjustment amount for passenger automobiles placed in service

after calendar year 1988.

For leased automobiles, § 280F(c)

requires a reduction in the deduction

allowed to the lessee of the automobile.

The reduction must be substantially

equivalent to the limitations on the

depreciation deductions imposed on

owners of automobiles. Under

§ 1.280F–7(a) of the Income Tax Regulations, this reduction requires the

lessees to include in gross income an

inclusion amount determined by applying a formula to the amount obtained

from a table. The table shows inclusion

amounts for a range of fair market

values for each tax year after the

automobile is first leased.

SECTION 3. SCOPE AND

OBJECTIVE

01. The limitations on depreciation

deductions in section 4.02 of this

revenue procedure apply to automobiles

(other than leased automobiles) that are

placed in service in calendar year 1996

and continue to apply for each tax year

that the automobile remains in service.

02. The table in section 4.03 of this

revenue procedure applies to leased

automobiles for which the lease term

begins in calendar year 1996. Lessees

of such automobiles must use this table

to determine the inclusion amount for

each tax year during which the auto-

90% to 110%

Permissible

Range

6.31 to 7.71

mobile is leased. See §§ 1.280F–5T(d)

and 1.280F–5T(e) of the temporary

Income Tax Regulations, § 1.280F–

7(a), Rev. Proc. 89–64, 1989–2 C.B.

783, Rev. Proc. 90–22, 1990–1 C.B.

504, Rev. Proc. 91–30, 1991–1 C.B.

563, Rev. Proc. 92–43, 1992–1 C.B.

873, Rev. Proc 93–35, 1993–2 C.B.

472, Rev. Proc 94–53, 1994–2 C.B.

712, and Rev. Proc. 95–9, 1995–1 C.B.

498, to determine inclusion amounts for

automobiles first leased before January

1, 1996.

SECTION 4. APPLICATION

01. A taxpayer placing an automobile in service for the first time

during calendar year 1996 is limited to

the depreciation deduction shown in

Table 1 of section 4.02(2). A taxpayer

first leasing an automobile in calendar

year 1996 must use Table 2 in section

4.03 to determine the inclusion amount

that is added to gross income. Otherwise, the procedures of § 1.280F–7(a)

must be followed.

02. Limitations on Depreciation Deductions for Certain Automobiles.

(1) Amount of the Inflation Adjustment. Under § 280F(d)(7)(B)(i), the

automobile price inflation adjustment

for any calendar year is the percentage

(if any) by which the CPI automobile

component for October of the preceding calendar year exceeds the CPI

automobile component for October

1987. The term ‘‘CPI automobile component’’ is defined in § 280F(d)(7)(B)(ii) as the ‘‘automobile component’’ of

the Consumer Price Index for all Urban

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Consumers published by the Department of Labor (the CPI). The new car

component of the CPI was 115.2 for

October 1987 and 138.6 for October

1995. The October 1995 index exceeded the October 1987 index by 23.4.

The Internal Revenue Service has,

therefore, determined that the auto-

mobile price inflation adjustment for

1996 is 20.31 percent (23.4/115.2 3

100%). This adjustment is applicable to

all automobiles that are first placed in

service in calendar year 1996. The

dollar limitations in § 280F(a) must

therefore be multiplied by a factor of

0.2031, and the resulting increases,

after rounding to the nearest $100, are

added to the 1988 limitations to give

the depreciation limitations for 1996.

(2) Amount of the Limitation. For

automobiles placed in service in calendar year 1996, Table 1 contains the

dollar amount of the depreciation limitations for each tax year.

REV. PROC. 96–25 TABLE 1

DEPRECIATION LIMITATIONS FOR AUTOMOBILES

FIRST PLACED IN SERVICE IN CALENDAR YEAR 1996

Tax Year

Amount

1st Tax Year

2nd Tax Year

3rd Tax Year

Each Succeeding Year

$3,060

$4,900

$2,950

$1,775

03. Inclusions in Income of Lessees of Automobiles.

The inclusion amounts for automobiles first leased in calendar year 1996 are calculated under the procedures described in

§ 1.280F–7(a). Table 2 of this revenue procedure is the applicable table to be used in applying those procedures.

REV. PROC. 96–25 TABLE 2

DOLLAR AMOUNTS FOR AUTOMOBILES

WITH A LEASE TERM BEGINNING IN CALENDAR YEAR 1996

Tax Year During Lease

Fair Market Value

of Automobile

Over

Not Over

1st

2nd

3rd

4th

5th and

Later

$15,500

15,800

16,100

16,400

16,700

17,000

17,500

18,000

18,500

19,000

19,500

20,000

20,500

21,000

21,500

22,000

23,000

24,000

25,000

26,000

27,000

28,000

$15,800

16,100

16,400

16,700

17,000

17,500

18,000

18,500

19,000

19,500

20,000

20,500

21,000

21,500

22,000

23,000

24,000

25,000

26,000

27,000

28,000

29,000

103

101

110

122

139

157

174

191

207

224

112

125

137

150

162

182

207

232

257

282

308

333

104

119

134

149

164

179

194

217

247

277

308

338

369

399

102

119

136

154

171

189

207

225

250

286

320

355

390

425

460

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REV. PROC. 96–25 TABLE 2

DOLLAR AMOUNTS FOR AUTOMOBILES

WITH A LEASE TERM BEGINNING IN CALENDAR YEAR 1996

Tax Year During Lease

Fair Market Value

of Automobile

Over

Not Over

1st

2nd

3rd

4th

5th and

Later

29,000

30,000

31,000

32,000

33,000

34,000

35,000

36,000

37,000

38,000

39,000

40,000

41,000

42,000

43,000

44,000

45,000

46,000

47,000

48,000

49,000

50,000

51,000

52,000

53,000

54,000

55,000

56,000

57,000

58,000

59,000

60,000

62,000

64,000

66,000

68,000

70,000

72,000

74,000

76,000

78,000

80,000

85,000

90,000

95,000

100,000

110,000

120,000

130,000

140,000

150,000

30,000

31,000

32,000

33,000

34,000

35,000

36,000

37,000

38,000

39,000

40,000

41,000

42,000

43,000

44,000

45,000

46,000

47,000

48,000

49,000

50,000

51,000

52,000

53,000

54,000

55,000

56,000

57,000

58,000

59,000

60,000

62,000

64,000

66,000

68,000

70,000

72,000

74,000

76,000

78,000

80,000

85,000

90,000

95,000

100,000

110,000

120,000

130,000

140,000

150,000

160,000

110

118

126

134

141

149

157

165

172

180

188

196

203

211

219

227

235

242

250

258

266

273

281

289

297

304

312

320

328

336

343

355

370

386

402

417

433

448

464

479

495

522

561

600

638

697

774

852

930

1,007

1,085

242

259

276

293

310

327

344

361

378

395

412

429

446

463

480

497

514

531

548

565

582

599

616

633

650

668

684

701

718

735

753

778

812

846

880

914

948

982

1,016

1,050

1,084

1,144

1,229

1,314

1,400

1,527

1,697

1,868

2,038

2,208

2,378

358

383

408

433

459

484

509

535

560

585

611

636

661

687

712

737

762

788

813

838

863

889

914

939

964

989

1,015

1,040

1,066

1,091

1,115

1,154

1,205

1,255

1,305

1,356

1,406

1,457

1,508

1,558

1,609

1,697

1,823

1,950

2,075

2,265

2,518

2,770

3,023

3,276

3,529

429

459

490

520

550

581

611

641

672

702

732

762

793

822

853

883

914

944

974

1,005

1,035

1,065

1,096

1,126

1,157

1,186

1,217

1,247

1,277

1,307

1,338

1,383

1,443

1,504

1,565

1,626

1,686

1,747

1,807

1,868

1,928

2,034

2,186

2,337

2,489

2,716

3,019

3,322

3,624

3,927

4,230

495

531

565

600

635

670

705

740

775

810

844

880

915

950

985

1,020

1,054

1,089

1,125

1,159

1,195

1,230

1,264

1,299

1,334

1,370

1,404

1,440

1,474

1,509

1,544

1,597

1,667

1,737

1,807

1,876

1,947

2,016

2,086

2,156

2,226

2,349

2,523

2,698

2,873

3,135

3,485

3,834

4,185

4,534

4,884

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REV. PROC. 96–25 TABLE 2

DOLLAR AMOUNTS FOR AUTOMOBILES

WITH A LEASE TERM BEGINNING IN CALENDAR YEAR 1996

Tax Year During Lease

Fair Market Value

of Automobile

Over

Not Over

1st

2nd

3rd

4th

5th and

Later

160,000

170,000

180,000

190,000

200,000

210,000

220,000

230,000

240,000

170,000

180,000

190,000

200,000

210,000

220,000

230,000

240,000

250,000

1,163

1,240

1,318

1,396

1,473

1,551

1,629

1,706

1,784

2,548

2,719

2,889

3,059

3,230

3,400

3,570

3,740

3,911

3,781

4,033

4,286

4,539

4,791

5,044

5,296

5,550

5,801

4,533

4,837

5,139

5,442

5,745

6,047

6,351

6,653

6,956

5,234

5,583

5,933

6,282

6,632

6,982

7,332

7,681

8,032

SECTION 5. EFFECTIVE DATE

This revenue procedure is effective

for automobiles (other than leased

automobiles) that are first placed in

service during calendar year 1996 and

to leased automobiles that are first

leased during calendar year 1996.

DRAFTING INFORMATION

The principal author of this revenue

procedure is Bernard P. Harvey of the

Office of Assistant Chief Counsel

Passthroughs and Special Industries).

For further information regarding this

revenue procedure contact Mr. Harvey

on (202) 622-3110 (not a toll-free call).

26 CFR 601.602: Forms and instructions.

(Also Part I, Section 3406; 31.3406(h)–3)

Rev. Proc. 96–26

SECTION 1. PURPOSE

This revenue procedure clarifies the

certification requirements for a substitute Form W–9, Request for Taxpayer Identification Number and Certification, and amplifies Rev. Proc. 83–

89, 1983–2 C.B. 613, which provides

guidelines for payors of interest, dividends, and patronage dividends and

brokers that want to design and provide

their own substitute Forms W–9.

SECTION 2. BACKGROUND

.01 Under §§ 6109(a)(2) and

3406(a)(1)(A) of the Internal Revenue

Code, a payee of a reportable payment

must provide its Taxpayer Identification Number (TIN) to a person who is

required to file an information return

with respect to the payment. In addition, under § 3406(a)(1)(A) the payee

of a reportable interest or dividend

payment generally must certify that its

TIN is correct and that it is not subject

to backup withholding under § 3406(a)(1)(C) for failure to include interest and

dividend income on its tax return

(required certifications). Section

3406(a)(1)(A) and (D) requires the

imposition of backup withholding on a

reportable interest or dividend payment

to a payee if the payee does not

provide its TIN or make the required

certifications.

.02 The Internal Revenue Service

provides an official Form W–9 for a

payee to provide the required certifications to the payor. A payor may use a

substitute Form W–9 to obtain the TIN

and the required certifications provided

the certification requirements in the

substitute Form W–9 comply with

section 4 of Rev. Proc. 83–89. A payor

may incorporate the required certifications into other business forms

customarily used, such as account

signature cards, provided the required

certifications are clearly set forth. See

section 5.01 of Rev. Proc. 83–89.

SECTION 3. SCOPE

This revenue procedure applies to

payors that choose to obtain the required certifications by using a substitute Form W–9 incorporated into

business forms the payor customarily

uses, as set forth in section 2.02 of this

revenue procedure.

SECTION 4. FORMAT FOR

MAKING THE REQUIRED

CERTIFICATIONS

.01 Required certifications clearly

set forth. For a payor to be treated as

having provided a taxpayer with a valid

substitute Form W–9, the required

certifications must be clearly set forth.

The Service will treat the required

certifications as being clearly set forth

only if they meet the provisions of

section 4.02 or 4.03 of this revenue

procedure.

.02 Separate signature for required

certifications. A substitute Form W–9

is valid if a separate signature line is

provided just for the required

certifications.

.03 Single signature for required

certifications and other provisions. A

substitute Form W–9 is valid if:

(1) a single signature line is provided for the required certifications as

well as other provisions unrelated to

the required certifications;

(2) the language of the required

certifications is highlighted, boxed,

printed in bold-face type, or presented

in some other manner that distinguishes

and causes the language to stand out

from all other information contained on

the substitute Form W–9; and

(3) the following statement is provided in the same manner prescribed in

section 4.03(2) and appears immediately above the single signature line

on the substitute Form W–9: ‘‘The

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Internal Revenue Service does not

require your consent to any provision

of this document other than the certifications required to avoid backup

withholding.’’

SECTION 5. IMPERMISSIBLE USE

OF THE CERTIFICATIONS

.01 A payor may not (1) require a

payee to agree to provisions included

on a substitute Form W–9 other than

the required certifications in order to

avoid backup withholding, or (2)

threaten backup withholding in order to

secure a payee’s acceptance of provisions included on a substitute Form W–

9 that are unrelated to the required

certifications.

.02 If a payor contravenes the provisions of section 5.01 of this revenue

procedure, the payor may be subject to

civil or criminal penalties under 31

U.S.C. § 333. That section generally

prohibits the use of any words, titles,

abbreviations, etc. in connection with a

business solicitation or activity in a

manner that could reasonably be interpreted to convey a false impression that

such activity is approved, endorsed,

sponsored, or authorized by the Service.

SECTION 6. EFFECT ON OTHER

DOCUMENTS

This revenue procedure amplifies

Rev. Proc. 83–89.

SECTION 7. EFFECTIVE DATE

Except for section 5, the provisions

of this revenue procedure apply to

substitute Forms W–9 completed by

payees after December 31, 1996. The

provisions of section 5.02 of this

revenue procedure apply to violations

occurring after March 31, 1995, the

effective date of 31 U.S.C. § 333.

DRAFTING INFORMATION

The principal author of this revenue

procedure is Renay France of the

Office of Assistant Chief Counsel

(Income Tax and Accounting). For

further information regarding this revenue procedure, contact Renay France

on (202) 622-4910 (not a toll-free call).

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Part IV. Items of General Interest

Notice of Proposed Rulemaking

SUPPLEMENTARY INFORMATION:

Background

Treatment of Gain From the

Disposition of Interest in Certain

Natural Resource Recapture Property

by S Corporations and Their

Shareholders

Paperwork Reduction Act

On June 11, 1980, proposed amendments to the Income Tax Regulations,

26 CFR part 1, under sections 170,

301, 312, 341, 453, 751, 1254, and

1502 of the Internal Revenue Code of

1954 (Code) were published in the

Federal Register (45 FR 39512). These

amendments were proposed to conform

the regulations to section 205(a), (b),

(c)(1) and (2) of the Tax Reform Act

of 1976, Public Law 94–455, 90 Stat.

1533, and section 402(c) of the Energy

Tax Act of 1978, Public Law 95–618,

92 Stat. 3202, and to make certain

other technical amendments to the

regulations to conform them to section

1(c) of the Act of September 12, 1966,

Public Law 89–570, 80 Stat. 762,

section 211(b)(6) of the Tax Reform

Act of 1969, Public Law 91–172, 83

Stat. 570, and sections 1042(c)(2),

1101(d)(2), 1901(a)(93), and 2110(a) of

the Tax Reform Act of 1976, 90 Stat.

1637, 1658, 1780, 1905. Section

1.1254–3 of the proposed regulations

provided rules relating to the sale or

exchange of stock in an electing small

business corporation (hereinafter referred to as an S corporation). Because

of the substantial changes in the tax

treatment of S corporations since the

proposed regulations were issued, the

proposed regulations contained in

§1.1254–3 needed to be completely

revised.

This document revises and reproposes §1.1254–3 of the abovereferenced notice of proposed rulemaking as amendments to the Income Tax

Regulations, 26 CFR part 1, under

section 1254 of the Code, relating to S

corporations (redesignated as §1.1254–

4). These amendments are proposed to

conform the regulations to section

5(a)(37) of the Subchapter S Revision

Act of 1982, Public Law 97–354, 96

Stat. 1669, and sections 411 and 413 of

the Tax Reform Act of 1986, Public

Law 99–514, 100 Stat. 2225, 2227. The

amendments are to be issued under the

authority contained in sections 1254(b)

and 7805 of the Code.

PS–7–89

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains

proposed regulations under section

1254 of the Internal Revenue Code

relating to the tax treatment by S

corporations and their shareholders of

gain from the disposition by an S

corporation (and a former S corporation) of certain natural resource recapture property (section 1254 property

after enactment of the Tax Reform Act

of 1986 and oil, gas, or geothermal

property before enactment of the Tax

Reform Act of 1986), and also rules

relating to the disposition of stock in

an S corporation that holds certain

natural resource recapture property.

Changes to the applicable tax law were

made by the Tax Reform Act of 1986,

and the Subchapter S Revision Act of

1982. The regulations provide the

public with guidance in complying with

the changed tax laws.

DATES: Written comments and requests for a public hearing must be

received by February 20, 1996.

ADDRESSES: Send comments and requests for a public hearing to:

CC:DOM:CORP:R (PS–7–89), Room

5228, Internal Revenue Service, P.O.

Box 7604, Ben Franklin Station, Washington, DC 20044. In the alternative,

submissions may be hand-delivered to

CC:DOM:CORP:R (PS–7–89), Room

5228, Internal Revenue Service Building, 1111 Constitution Avenue, NW.,

Washington, DC 20224.

FOR FURTHER INFORMATION

CONTACT: James A. Quinn,

202-622-3060 (not a toll-free number).

1996 – 23 I.R.B.

The collection of information contained in this notice of proposed

rulemaking has been submitted to the

Office of Management and Budget

(OMB) for review in accordance with

the Paperwork Reduction Act of 1995

(44 U.S.C 3507).

Comments on the collection of information should be sent to the Office of

Management and Budget, Attn: Desk

Officer for the Department of the

Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503, with copies to the Internal

Revenue Service, Attn: IRS Reports

Clearance Officer IT:FP, Washington,

DC 20224. Comments on the collection

of information should be received by

January 22, 1996.

An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information

displays a valid control number.

The collection of information is

contained in §1.1254–4(c) of the proposed regulations. This information is

required by the Internal Revenue Service to verify that taxpayers have reported the appropriate amount of gain

as ordinary income under section 1254

when a shareholder sells stock in an S

corporation that holds natural resource

recapture property. The likely respondents are individuals and businesses and

other for-profit institutions.

Books or records relating to a collection of information must be retained

as long as their contents may become

material in the administration of any

internal revenue law. Generally, tax

returns and tax return information are

confidential, as required by 26 U.S.C.

6103.

Estimated total annual reporting burden: 1,000 hours.

The estimated annual burden per respondent varies from .5 hours to 1.5

hours, depending on individual circumstances, with an estimated average of 1

hour.

Estimated number of respondents:

1,000.

Estimated annual frequency of responses: On occasion.

Explanation of Provisions

These proposed regulations contain

rules for applying the provisions of

section 1254 to the disposition of

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natural resource recapture property by

an S corporation (and a former S

corporation) and the disposition of S

corporation stock.

The proposed regulations provide

that the recognition of ordinary income

under section 1254 upon the disposition

of natural resource recapture property

by an S corporation is generally computed at the shareholder level. Determining the amount of ordinary income

to be recognized under section 1254 at

the shareholder level is appropriate

because the determination of section

1254 costs can be affected by shareholder elections and characteristics.

See, for example, sections 59(e) and

1363(c)(2)(A). Similarly, in the case of

oil and gas properties, gain on the

disposition of the property and depletion with respect to the property are

computed at the shareholder level. See

section 613A(c)(11).

The proposed regulations also contain rules relating to the recognition of

ordinary income under section 1254

upon a sale or exchange of S corporation stock. Under section 1254(b)(2),

rules similar to the rules of section 751

are to be applied to that portion of the

excess of the amount realized over the

adjusted basis of the stock that is

attributable to section 1254 costs. Pursuant to section 1254(b)(2), the proposed regulations provide that, as a

general rule, a shareholder must treat

any gain recognized on a sale or

exchange of S corporation stock as

ordinary income to the extent of the

shareholder’s section 1254 costs with

respect to the shares sold or exchanged.

The proposed regulations provide

two exceptions to the general rule for

determining the amount treated as

ordinary income under section 1254

upon a sale or exchange of stock. The

first exception is that the general rule

does not apply to the extent that the

shareholder establishes that the gain is

not attributable to the section 1254

costs. The portion of the gain recognized that is not attributable to section

1254 costs is that portion of the gain

recognized that exceeds the amount of

ordinary income that the shareholder

would have recognized under section

1254 (with respect to the shares sold or

exchanged) if, immediately prior to the

sale or exchange of the stock, the

corporation had sold at fair market

value all of the corporation’s property

the disposition of which would result in

the recognition by the shareholder of

ordinary income under section 1254.

To establish that a portion of the gain

recognized is not attributable to a

shareholder’s section 1254 costs, the

shareholder must attach to the shareholder’s tax return a statement detailing

the shareholder’s share of the fair

market value and basis, and the shareholder’s section 1254 costs, for each of

the S corporation’s natural resource

recapture properties held immediately

before the sale or exchange of stock.

The second exception to the general

rule for sales or exchanges of stock is

that, in the case of a contribution of

property to the S corporation prior to a

stock sale or exchange pursuant to a

plan a principal purpose of which is to

avoid the recognition of ordinary income under section 1254, the selling or

exchanging shareholder must recognize

as ordinary income under section 1254

the amount of ordinary income the

shareholder would have recognized under section 1254 (with respect to the

shares sold or exchanged) had the S

corporation sold all of its natural

resource recapture property the disposition of which would result in ordinary

income under section 1254. Section

1.1254–4(c)(3) Example 3 of the proposed regulations illustrates this

exception.

The proposed regulations also

provide rules for determining an S

corporation shareholder’s section 1254

costs. Generally, an S corporation

shareholder’s section 1254 costs with

respect to any natural resource recapture property held by the corporation

include all of the shareholder’s section

1254 costs with respect to the property

while in the hands of the S corporation.

In the case of a person (acquiring

shareholder) who acquires stock from

another shareholder, the proposed regulations provide that the acquiring

shareholder’s section 1254 costs are

zero if the acquiring shareholder’s basis

for the stock transferred is determined

by reference to its cost (within the

meaning of section 1012) or by reference to the fair market value of the

stock on the date of the decedent’s

death or on the applicable date provided in section 2032 (relating to

alternate valuation date). However, an

acquiring shareholder’s section 1254

costs include any section 1254 costs

paid or incurred before the decedent’s

death, to the extent that the basis of the

stock is reduced under section

1014(b)(9) (relating to adjustments to

basis if the property is acquired from a

decedent prior to death). For stock that

is acquired in a transfer that is a gift,

in a transfer that is part sale or

exchange and part gift, or a transfer

described in section 1041, the acquiring

shareholder generally acquires the section 1254 costs of the transferor but

reduces the section 1254 costs by the

amount of any gain treated as ordinary

income under section 1254 by the

transferor on the transfer.

The proposed regulations provide

rules for applying section 1254 to the

shareholders of an S corporation that

incurred section 1254 costs while it

was a C corporation (former C corporation). In the case of a C corporation

that holds natural resource recapture

property and that elects to be an S

corporation, each shareholder’s section

1254 costs as of the beginning of the

corporation’s first taxable year as an S

corporation include a pro rata share of

the section 1254 costs of the corporation as of the close of the last taxable

year that the corporation was a C

corporation.

The proposed regulations also provide rules for applying section 1254 to

a corporation that holds natural resource recapture property after the

termination of its S corporation election

(former S corporation). In the case of

an S corporation that becomes a C

corporation, the C corporation’s section

1254 costs with respect to any natural

resource recapture property held by the

corporation as of the beginning of the

corporation’s first taxable year as a C

corporation include the sum of its

shareholders’ section 1254 costs with

respect to the property as of the close

of the last taxable year for which the

corporation was an S corporation. In

the case of an S termination year as

defined in section 1362(e)(4), the

shareholders’ section 1254 costs are

determined as of the close of the S

short year as defined in section

1362(e)(1)(A).

Because certain transactions will

change the allocation to the shareholders of gain or amount realized

from the natural resource recapture

property if the S corporation disposes

of it subsequent to these transactions,

the proposed regulations require that

section 1254 costs be reallocated to

reflect the effects of these transactions.

Transactions requiring reallocation of

the section 1254 costs are transactions

involving the issuance of stock by an S

1996 – 23 I.R.B.

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corporation in a reorganization or otherwise, and transfers of natural resource recapture property to the S

corporation in exchange for stock of

the S corporation (for example, in a

section 351 transaction or in a

reorganization).

The rules for former S corporations

and the rules for allocating section

1254 costs upon certain transfers require the S corporation to determine

the aggregate of its shareholders’ section 1254 costs. The proposed regulations provide rules for the S corporation to apply in determining a

shareholder’s section 1254 costs with

respect to natural resource recapture

property held by the S corporation. In

general, the S corporation may determine a shareholder’s section 1254 costs

by using written data provided by the

shareholder or by applying certain

assumptions.

These regulations are proposed to

apply to dispositions of natural resource recapture property by an S

corporation (and a former S corporation) and dispositions of S corporation

stock occurring after publication of

these regulations as final regulations in

the Federal Register.

Comments and Requests for a Public

Hearing

Before the adoption of these proposed regulations, consideration will be

given to any written comments that are

timely submitted (preferably an original

and eight copies) to the IRS. All comments will be available for public

inspection and copying. A public hearing will be held upon written request to

the Internal Revenue Service by any

person who also submits written comments. If a public hearing is held,

notice of the time and place will be

published in the Federal Register.

Special Analyses

It has been determined that this proposed regulation is not a significant

regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also

has been determined that section 553(b)

of the Administrative Procedure Act (5

U.S.C. chapter 5) and the Regulatory

Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and,

therefore, a Regulatory Flexibility

Analysis is not required. Pursuant to

1996 – 23 I.R.B.

section 7805(f) of the Internal Revenue

Code, this notice of proposed rulemaking will be submitted to the Chief

Counsel for Advocacy of the Small

Business Administration for comment

on its impact on small business.

Drafting Information

The principal author of these regulations is James A. Quinn of the Office

of Assistant Chief Counsel (Passthroughs and Special Industries), IRS.

However, other personnel from the IRS

and Treasury Department participated

in their development.

Proposed Amendments to the

Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph. 1. The authority citation

for part 1 continues to read in part as

follows:

Authority: 26 U.S.C. 7805. * * *

Section 1.1254–4 also issued under 26

U.S.C. 1254(b). * * *

Par. 2. Section 1.1254–0 is amended

by revising the entry for §1.1254–4 to

read as follows:

§1.1254–0 Table of contents for

section 1254 recapture

rules. * * *

§1.1254–4 Special rules for S

corporations and their shareholders.

(a) In general.

(b) Determination of gain treated

as ordinary income under section 1254 upon a disposition

of natural resource recapture

property by an S corporation.

(1) General rule.

(2) Examples.

by a shareholder upon a sale

or exchange of S corporation

stock.

(1) General rule.

(2) Exceptions.

(3) Examples.

(d) Section 1254 costs of a shareholder.

(e) Section 1254 costs of an acquiring shareholder after certain acquisitions.

(1) Basis determined under section 1012.

(2) Basis determined by reason

of the application of section

1014(a).

(3) Basis determined by reason

of the application of section

1014(b)(9).

(4) Gifts and section 1041

transfers.

(f) Special rules for former S corporations and former C corporations.

(1) Section 1254 costs of an S

corporation that was formerly a C corporation.

(2) Examples.

(3) Section 1254 costs of a C

corporation that was formerly an S corporation.

(g) Determination of a shareholder’s section 1254 costs

upon certain stock transactions

(1) Issuance of stock.

(2) Natural resource recapture

property acquired in exchange for stock.

(3) Treatment of nonvested

stock.

(4) Exception.

(5) Aggregate of S corporation

shareholders’ section 1254

costs with respect to natural

resource recapture property

held by the S corporation

(6) Examples.

(h) Effective date.

Par. 3. Section 1.1254–4 is amended

by adding text to read as follows:

§1.1254–4 Special rules for S

corporations and their shareholders.

(a) In general. This section provides

rules for applying the provisions of

section 1254 to S corporations and

their shareholders upon the disposition

by an S corporation (or a former S

corporation) of natural resource recapture property and upon the disposition

by a shareholder of stock of an S

corporation that holds natural resource

recapture property.

(b) Determination of gain treated as

ordinary income under section 1254

upon a disposition of natural resource

recapture property by an S corporation—(1) General rule. Upon a disposi-

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tion of natural resource recapture property by an S corporation, the amount of

gain treated as ordinary income under

section 1254 is determined at the shareholder level. Each shareholder must

recognize as ordinary income under

section 1254 the lesser of—

(i) The shareholder’s section 1254

costs with respect to the property

disposed of; or

(ii) The shareholder’s share of the

amount, if any, by which the amount

realized on the sale, exchange, or

involuntary conversion, or the fair

market value of the property upon any

other disposition (including a distribution), exceeds the adjusted basis of the

property.

(2) Examples. The following examples illustrate the provisions of paragraph (b)(1) of this section:

Example 1. Disposition of natural resource

recapture property other than oil and gas

property. A and B are equal shareholders in X,

an S corporation. On January 1, 1995, X acquires

for $90,000 an undeveloped mineral property, its

sole property. During 1995, X expends and

deducts $100,000 in developing the property. On

January 15, 1996, X sells the property for

$250,000 when X’s basis in the property is

$90,000. Thus, X recognizes gain of $160,000 on

the sale. A and B’s share of the $160,000 gain

recognized is $80,000 each. Each shareholder has

$50,000 of section 1254 costs with respect to the

property. Under these circumstances, A and B

each are required to recognize $50,000 of the

$80,000 of gain on the sale of the property as

ordinary income under section 1254.

Example 2. Disposition of oil and gas property

the adjusted basis of which is allocated to the

shareholders under section 613A(c)(11). C and D

are equal shareholders in Y, an S corporation.

On January 1, 1995, Y acquires for $150,000 an

undeveloped oil and gas property, its sole

property. During 1995, Y expends in developing

the property $40,000 in intangible drilling costs

which it elects to expense under section 263(c).

On January 15, 1996, Y sells the property for

$200,000. C and D’s share of the $200,000

amount realized on the sale is $100,000 each. C

and D each have a basis of $75,000 in the

property and $20,000 of section 1254 costs with

respect to the property. Under these circumstances, C and D each are required to recognize

$20,000 of the $25,000 gain on the sale of the

property as ordinary income under section 1254.

a shareholder upon a sale or exchange

of S corporation stock—(1) General

rule. Except as provided in paragraph

(c)(2) of this section, if an S corporation shareholder recognizes gain upon a

sale or exchange of stock in the S

corporation (determined without regard

to section 1254), the gain is treated as

ordinary income under section 1254 to

the extent of the shareholder’s section

1254 costs (with respect to the shares

sold or exchanged).

(2) Exceptions—(i) Gain not attributable to section 1254 costs—(A) General rule. Paragraph (c)(1) of this

section does not apply to any portion

of the gain recognized on the sale or

exchange of the stock that the taxpayer

establishes is not attributable to section

1254 costs. The portion of the gain

recognized that is not attributable to

section 1254 costs is that portion of the

gain recognized that exceeds the

amount of ordinary income that the

shareholder would have recognized under section 1254 (with respect to the

shares sold or exchanged) if, immediately prior to the sale or exchange of

the stock, the corporation had sold at

fair market value all of the corporation’s property the disposition of which

would result in the recognition by the

shareholder of ordinary income under

section 1254.

(B) Substantiation. To establish that

a portion of the gain recognized is not

attributable to a shareholder’s section

1254 costs so as to qualify for the

exception contained in paragraph (c)(2)(i)(A) of this section, the shareholder must attach to the shareholder’s

tax return a statement detailing the

shareholder’s share of the fair market

value and basis, and the shareholder’s

section 1254 costs, for each of the S

corporation’s natural resource recapture

properties held immediately before the

sale or exchange of stock.

(ii) Transactions entered into as part

of a plan to avoid recognition of

ordinary income under section 1254. In

the case of a contribution of property

prior to a sale or exchange of stock

pursuant to a plan a principal purpose

of which is to avoid recognition of

ordinary income under section 1254,

paragraph (c)(1) of this section does

not apply. Instead, the amount recognized as ordinary income under section

1254 is the amount of ordinary income

the selling or exchanging shareholder

would have recognized under section

1254 (with respect to the shares sold or

exchanged) had the S corporation sold

its natural resource recapture property

the disposition of which would have

resulted in the recognition of ordinary

income under section 1254. The

amount recognized as ordinary income

under the preceding sentence reduces

the amount realized on the sale or

exchange of the stock. This reduced

amount realized is used in determining

any gain or loss on the sale or

exchange.

(3) Examples. The following examples illustrate the provisions of this

paragraph (c):

Example 1. Application of general rule upon a

sale of S corporation stock. C and D are equal

shareholders in Y, an S corporation. As of

January 1, 1995, Y holds two mining properties:

Blackacre, with an adjusted basis of $5,000 and

a fair market value of $35,000, and Whiteacre,

with an adjusted basis of $20,000 and a fair

market value of $15,000. Y also holds securities

with a basis of $5,000 and a fair market value of

$10,000. On January 1, 1995, D sells 50 percent

of D’s Y stock to E for $15,000. As of the date

of the sale, D’s adjusted basis in the Y stock

sold is $7,500, and D has $18,000 of section

1254 costs with respect to Blackacre and $12,000

of section 1254 costs with respect to Whiteacre.

Under this paragraph (c), the gain recognized by

D upon the sale of Y stock is treated as ordinary

income to the extent of D’s section 1254 costs

with respect to the stock sold, unless D

establishes that a portion of such excess is not

attributable to D’s section 1254 costs. However,

because D would recognize $7,500 in ordinary

income under section 1254 with respect to the

stock sold if Y sold Blackacre (the only asset the

disposition of which would result in ordinary

income to D under section 1254), the $7,500 of

gain recognized by D upon the sale of D’s Y

stock is attributable to D’s section 1254 costs.

Therefore, upon the sale of stock to E, D

recognizes $7,500 of ordinary income under this

paragraph (c).

Example 2. Sale of S corporation stock where

gain is not entirely attributable to section 1254

costs. Assume the same facts as in Example 1,

except that Blackacre has a fair market value of

$25,000, and the securities have a fair market

value of $20,000. Immediately prior to the sale

of stock to E, if Y had sold Blackacre (its only

asset the disposition of which would result in the

recognition of ordinary income to D under

section 1254), D would recognize $5,000 in

ordinary income with respect to the stock sold

under section 1254. D attaches a statement to

D’s tax return for 1995 detailing D’s share of the

fair market values and bases, and D’s section

1254 costs with respect to Blackacre and

Whiteacre. Therefore, upon the sale of stock to

E, of the $7,500 gain recognized by D, $5,000 is

ordinary income under this paragraph (c).

Example 3. Contribution of property prior to

sale of S corporation stock as part of a plan to

avoid recognition of ordinary income under

section 1254. H owns all of the stock of Z, an S

corporation. As of January 1, 1995, H has $3,000

of section 1254 costs with respect to property P,

which is natural resource recapture property and

Z’s only asset. Property P has an adjusted basis

of $5,000 and a fair market value of $8,000. H

has a basis of $5,000 in Z stock, which has a fair

market value of $8,000. On January 1, 1995, H

contributes securities to Z which have a basis of

$7,000 and a fair market value of $4,000. On

April 15, 1995, H sells all of the Z stock to J for

$12,000. On that date, H’s adjusted basis in the

Z stock is also $12,000. Based on all the facts

and circumstances, the sale of stock is part of a

plan (along with the contribution by H of the

securities to Z) that has a principal purpose to

avoid recognition of ordinary income under

section 1254. Con

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