These synopses are intended only as aids to the reader in

Bulletin No. 1997–2

January 13, 1997

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

Rev. Rul. 97–1, page 10.

Federal rates; adjusted federal rates; adjusted federal long-term rate, and the long-term exempt rate.

For purposes of sections 1274, 1288, 382, and other

sections of the Code, tables set forth the rates for

January 1997.

Rev. Rul. 97–2, page 8.

Insurance companies; interest rate tables. Prevailing

state assumed interest rates are provided for the

determination of reserves under section 807 of the

Code for contracts issued in 1996 and 1997. Rev. Rul.

92–19 supplemented in part.

Rev. Rul. 97–3, page 5.

SBA guaranteed payment rights; participating securities. The Small Business Administration (SBA) is the

primary obligor of the guaranteed payment rights that

are created under its participating security program and

investors in those rights are treated as owning SBA

debt.

T.D. 8697, page 11.

Final regulations under section 7701 of the Code

classify certain business organizations under an elective

regime.

Notice 97–1, page 22.

Revenue rulings and revenue procedures under T.D.

8697 obsoleted. Revenue rulings and revenue procedures that use the prior classification regulations to

differentiate between partnerships and associations are

obsolete to the extent that they rely on those prior

regulations.

Notice 97–4, page 24.

S corporation subsidiaries. This notice requests comments concerning issues raised by section 1308 of the

Small Business Job Protection Act of 1996 which

permits an S corporation (1) to own 80 percent or more

Finding Lists begin on page 63.

of the stock of a C corporation, and (2) to elect to own a

qualified subchapter S subsidiary (QSSS). This notice

also provides temporary guidance on the manner in

which a QSSS election must be made and the effective

date of the election.

Notice 97–5, page 25.

Electing small business corporations and banks. This

notice provides guidance on the effect of the qualified

subchapter S subsidiary (QSSS) election under section

1361(b)(3) on banks affiliated with nonbanks; the application of the S corporation passive investment income

rule of section 1362(d)(3); the application of the interest

expense disallowance rules of section 265; and an

automatic change in method of accounting for bad debts.

EMPLOYEE PLANS

Rev. Proc. 97–9, page 55.

Cash or deferred arrangements; amendments;

SIMPLEs. This procedure describes how an employer

that maintains a qualified cash or deferred arrangement

may make the necessary amendment for its qualified

cash or deferred arrangement to meet the provision for

a savings incentive match plan pursuant to section

1422 of the Small Business Job Protection Act of 1996.

Announcement 97–2, page 62.

Schedule Q; determination letter requests; section

401(a)(26). The instructions for completing Schedule Q

for plan years beginning after December 31, 1996, are

being changed.

Notice 97–2, page 22.

Cash or deferred arrangements; nondiscrimination.

With respect to cash or deferred arrangements, the notice

gives transitional relief for certain nondiscrimination tests

for the 1997 plan year and describes methods for the

determination and distribution of excess contributions.

(Continued on page 4)

HIGHLIGHTS

OF THIS ISSUE—Continued

EMPLOYEE PLANS—Continued

Protection Act of 1996 to treat retail motor fuels outlets

placed in service before August 20, 1996, as 15-year

property under section 168 of the Code. Rev. Proc.

92–20 modified.

Notice 97–6, page 26.

Questions and answers; SIMPLE IRAs. A notice, in

question and answer format, pertaining to simple IRAs

described in section 408(p) of the Code as added by the

Small Business Job Protection Act of 1996, is set forth.

Notice 97–9, page 35.

Adoption assistance. This notice provides general guidance concerning the tax credit under section 23 for

“qualified adoption expenses” paid or incurred by an

individual and the exclusion from gross income under

section 137 for amounts paid or expenses incurred by

an employer for “qualified adoption expenses” under an

adoption assistance program.

Notice 97–10, page 41.

Spousal consent; qualified joint and survivor annuities, etc.; sample language. The Service has developed sample language for inclusion in a form providing

spousal consent to a participant’s election to waive a

qualified joint and survivor annuity or a qualified preretirement survivor annuity, in accordance with section 1457 of

the Small Business Job Protection Act of 1996.

ADMINISTRATIVE

Announcement 97–1, page 62.

Extension of test of mediation procedure for appeals.

This announcement extends the test of the mediation

procedure set forth in Announcement 95–86, 1995–44

I.R.B. 27, for an additional one-year period beginning on

January 13, 1997. The procedure will allow taxpayers,

whose cases are not docketed in any court and already

in the Appeals administrative process, to request mediation as a dispute resolution technique.

Rev. Proc. 97–10, page 59.

Change in computing depreciation for retail motor

fuels outlets. This procedure is provided for making the

election under section 1120 of the Small Business Job

Announcement 97–3, page 62.

A list is provided of organizations that no longer qualify

as organizations to which contributions are deductible

under section 170 of the Code.

Notice 97–11, page 49.

Qualified domestic relations orders; sample language. The Service has developed sample language for

qualified domestic relations orders within the meaning of

section 414(p) of the Code in accordance with section

1457 of the Small Business Job Protection Act of 1996.

4

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 Service also has the responsibility of applying

and administering the law in a reasonable,

practical manner. Issues should only be raised by

examining of ficers 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.

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.

Administration should be both reasonable and

vigorous. It should be conducted with as little

delay as possible and with great cour tesy 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.

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.

2

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.

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.

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.

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 Miscellaneous.

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).

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.

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.

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,

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 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.

3

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

Section 42.—Low-Income Housing

Credit

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the

month of January 1997. See Rev. Rul. 97–1, page

10.

Section 56.—Adjustments in

Computing Alternative Minimum

Taxable Income

If a taxpayer elects to treat a retail motor fuels

outlet placed in service before August 20, 1996, as

15-year property for computing depreciation for

regular tax purposes, how is the depreciation

computed for alternative minimum taxable income

purposes? See Rev. Proc. 97–10, page 59.

Section 61.—Gross Income Defined

26 C.F.R. 1.61–1: Gross Income. (Also §§ 851,

856, 895, 7701; 1.851–2, 1.856–2, 1.895–1,

301.7701–13A.)

SBA guaranteed payment rights; participating securities. The Small Business Administration (SBA) is the primary obligor of the guaranteed payment

rights that are created under its participating security program and investors in

those rights are treated as owning SBA

debt.

Rev. Rul. 97–3

ISSUE

For federal tax purposes, is the Small

Business Administration (SBA) the primary obligor of certain guaranteed payment rights that are created under its

participating security program?

FACTS

The SBA is an independent agency of

the United States. Its activities include

regulating and providing financial assistance to small business investment companies (SBICs), which furnish venture

capital to small business concerns. One

way SBICs raise money for investment

is by issuing participating securities to

the SBA. See 15 U.S.C. §§ 683 and

687(l) (1994). Participating securities

may take the form of preferred stock,

preferred limited partnership interests, or

similar instruments. 15 U.S.C. § 683(g)

(1994).

Regardless of their form, or the rights

they may provide under state and local

law, all participating securities share the

following characteristics. Every participating security entitles the SBA to both

a return of capital (Redemption Pay-

ments) and priority distributions that

equal a fixed percentage of the

unreturned capital (Prioritized Payments). Redemption Payments have to

be made by the final due date, which in

most cases, is approximately 10 years

from the day the participating security is

issued. Before the final due date, a

SBIC may make Redemption Payments

at its discretion, or may be required to

make Redemption Payments for reasons

such as its insolvency. Prioritized Payments are scheduled to be made at least

annually, but are due only to the extent

that the SBIC has sufficient profits. Any

scheduled amount that goes unpaid accumulates. Every participating security

also entitles the SBA to receive a portion of the SBIC’s remaining profits

(Profit Participation Payments) and

gives the SBA the right to bar any

changes affecting its interests.

Once every quarter, the SBA acquires

new participating securities and assembles them into a pool to be

securitized. Every security in a newly

formed pool has the same final due date

for making Redemption Payments and

uses the same percentage for calculating

Prioritized Payments. The percentage

used to calculate the Prioritized Payments is established with reference to

current interest rates.

To securitize a pool, the SBA assigns

the Redemption Payments and Prioritized Payments to a group of underwriters and simultaneously enters into a

guarantee relating to the assigned payments (the Payment Guarantee). All

rights in the participating securities,

other than the Redemption Payments

and Prioritized Payments, are retained

by the SBA, and the SBA has no duty

to exercise them for anyone else’s benefit. The underwriters transfer the assigned payments and the Payment Guarantee to a trust. In exchange, the

underwriters receive a single class of

marketable trust certificates that in form

evidence beneficial ownership of the

transferred assets. Proceeds from the

underwriters’ sale of the trust certificates

are paid to the SBICs whose participating securities make up the pool.

Under the Payment Guarantee, the

SBA must disburse quarterly the amount

by which (1) the Prioritized Payments

made by the SBICs and available to the

trust fall short of (2) the Prioritized

Payments that would be due if Prioritized Payments had to be made regardless of financial condition and were paid

5

in quarterly installments rather than annually. 15 U.S.C. § 683(g) (1994).

Thus, if a SBIC’s profits are so low that

the SBIC has no obligation to make a

Prioritized Payment, the SBA nevertheless has to pay, in quarterly installments,

the amount that would be owed if the

SBIC’s profits were unlimited. Making a

payment in this case does not entitle the

SBA to seek immediate restitution from

the SBIC. Instead, the SBA has to

recover the payment from whatever future Prioritized Payments the SBIC may

generate.

The Payment Guarantee also obligates

the SBA to pay any shortfall in a pool’s

Redemption Payments. The SBA, therefore, has to make up any Redemption

Payment that a SBIC fails to pay on the

final due date or cannot pay when

forced to redeem a participating security

(for instance, in the case of insolvency

or commencement of receivership proceedings). Under these circumstances,

the right to receive the Redemption

Payment from the SBIC is released by

the trust in favor of the SBA.

By the terms of the Payment Guarantee, the obligations of the SBA are

unconditional and must be performed

despite any legal or equitable defense.

Each time a new pool is created, the

SBA will reasonably expect to disburse

and not recover, during the pool’s first

three years, an amount exceeding 15

percent of the Prioritized Payments that

would be due on the participating securities in the pool if Prioritized Payments

had to be made regardless of financial

condition and were paid in quarterly

installments rather than annually. The

Payment Guarantee cannot be transferred separately from the rights to the

Redemption Payments and Prioritized

Payments.

The trust that holds the Payment

Guarantee and the rights to the Redemption Payments and Prioritized Payments

is authorized by statute, 15 U.S.C.

§ 687l(a) (1994), and governed by an

agreement among the SBA, the SBA’s

fiscal agent, and an independent trustee.

These parties may amend the agreement

without the consent of the certificate

holders, provided the amendment does

not adversely affect payments on the

certificates.

In form, each trust certificate represents a fractional undivided ownership

interest in the transferred assets. The

SBA guarantees (the Passthrough Guarantee) that the certificate holders will

receive timely an amount equal to their

proportionate share of all amounts received by the trust. 15 U.S.C. § 687l(b)

(1994). The Passthrough Guarantee is

enforceable regardless of the defenses

available to the SBICs or the trustee.

Although the certificate holders can enforce the Passthrough Guarantee, they

cannot enforce any obligation of the

SBICs. Specifically, the certificate holders have no right to enforce the Prioritized Payments or Redemption Payments, and the underlying SBICs owe

no duty to the certificate holders.

The trustee has no duty or authority

to enforce collection of the trust assets

other than the Payment Guarantee. Instead, the SBA services (at its expense)

the Redemption Payments and Prioritized Payments and has the sole right to

take action and assert claims with respect to the Redemption Payments and

Prioritized Payments. As servicer, the

SBA can waive or agree to amend any

term of any participating security; those

modifications, however, cannot decrease

or defer the aggregate payments to the

trust. No federal or state law may limit

the exercise by the SBA of its ownership rights in the participating securities.

15 U.S.C. § 687l(e)(2) (1994).

Because the SBA forms a new pool

of participating securities each quarter,

several pools may exist at any time. The

SBA has the right (but not the obligation) to replace Redemption Payments

and Prioritized Payments due on one

pool with Redemption Payments and

Prioritized Payments due on another.

Specifically, if the SBA believes a participating security in a pool is about to

make a Redemption Payment, the SBA

can exchange the rights to all or part of

that Redemption Payment (and related

Prioritized Payments) for the rights to

all or part of the Redemption Payments

and Prioritized Payments due on participating securities in other pools.

The SBA can exercise the right of

substitution at any time provided three

conditions are met. These conditions ensure an adequate match between the

payments relinquished on a redeeming

security and the payments to be received

in exchange from any ‘‘replacement’’

securities. First, the sum of the Redemption Payments to be received with respect to the replacement securities must

equal the amount of the Redemption

Payment relinquished with respect to the

redeeming security. Second, the final due

date for each replacement security must

be no later than the final due date for the

redeeming security. Third, the percentage

used for calculating the Prioritized Payments on each replacement security must

be no less than the percentage used for

calculating the Prioritized Payments on

the redeeming security.

There are common situations in which

the SBA can benefit from using the

substitution power. For example, if a

pool holds a 6 percent security that is

about to be redeemed, the SBA can

replace it with an 8 percent security

from an older pool. Certificate holders

in the older pool, after receiving the

Redemption Payment from the 6 percent

security, will no longer be entitled to

Prioritized Payments on the redeemed

amount. Certificate holders in the 6

percent pool will receive Prioritized

Payments from the 8 percent security,

but only at a 6 percent rate. Consequently, the exchange will advance the

termination of the older, higher interest

rate pool, and allow the SBA to retain

the extra 2 percent of Prioritized Payments that are not required to service

the 6 percent pool.

LAW

The economic substance of a transaction generally governs its federal tax

consequences. Gregory v. Helvering, 293

U.S. 465 (1935), XIV–1 C.B. 193. Affixing a label to an undertaking (for

example, referring to an arrangement as

a ‘‘guarantee’’) does not alone decide its

character. Sun Oil Co. v. Commissioner,

562 F. 2d 258, 263 (3d Cir. 1977);

Oesterreich v. Commissioner, 226 F. 2d

798, 801–02 (9th Cir. 1955); Boulez v.

Commissioner, 83 T.C. 584, 591 (1984);

see also Commissioner v. P.G. Lake,

Inc., 356 U.S. 260 (1958), 1958–1 C.B.

516.

A guarantee of an instrument is a

secondary and collateral promise to pay

the amounts due under the instrument in

the event the primary obligor (ordinarily

the issuer) defaults. Zappo v. Commissioner, 81 T.C. 87–88 (1983); Perry v.

Commissioner, 47 T.C. 159, 163 (1966).

The Commissioner may recharacterize

any transaction that has the preceding

attributes in appearance but not in substance. See Estate of Durkin v. Commissioner, 99 T.C. 561, 571 (1992). How

the transaction may be rechacterized depends on the facts, including the terms

of the ‘‘guarantee’’ and any related

agreements and the circumstances existing at the time the ‘‘guarantee’’ is made.

For example, at the time a taxpayer

‘‘guarantees’’ an instrument, the finances

of the issuer may be so precarious that

6

the taxpayer (rather than the issuer) is

expected to pay the instrument. Under

such facts, the taxpayer may be, in

substance, accepting primary (rather

than secondary) responsibility for the

instrument. Lang v. Commissioner, 32

B.T.A. 522 (1935); see Rev. Rul. 94–42,

1994–2 C.B. 15. As another example,

under the terms of a ‘‘guarantee’’ and

any related agreements, a taxpayer may

have to pay regardless of any default on

the ‘‘guaranteed’’ instrument and may

enjoy beneficial ownership of the instrument. Beneficial ownership may be evidenced by, among other things, a power

in the taxpayer to replace the instrument

or to exercise for its own advantage any

privileges inherent in the instrument. See

Schoellkopf v. Commissioner, 32 B.T.A.

88 (1935); cf. Rev. Rul. 77–137, 1977–1

C.B. 178. Under such facts, the taxpayer

may be, in substance, issuing its own

primary obligation and using the ‘‘guaranteed’’ instrument to secure that obligation. Rev. Rul. 78–118, 1978–1 C.B.

219; see Schoellkopf v. Commissioner.

Different facts may support other characterizations. No single fact is conclusive, and all aspects of a transaction

must be considered to determine its

substance.

ANALYSIS

The trust holds a group of inseparable

rights consisting of the rights to the

Redemption Payments, the Prioritized

Payments, and the amounts paid under

the Payment Guarantee. Based on all of

the facts and circumstances, this group

of rights (the Guaranteed Payment

Rights) constitutes, in substance, a primary obligation of the SBA. It does not

represent an ownership interest in SBIC

securities backed by an SBA guarantee.

Among the reasons for this conclusion

are not only the differences between the

payment obligations of the SBA and the

payment obligations of the SBICs but

also the continuing interest of the SBA

in the participating securities.

The payment obligations of the SBA

and the SBICs differ in that the SBA

has to make payments even if the SBICs

are not in default. A SBIC has to make

a Prioritized Payment only if it has

sufficient profits, but the SBA must

disburse an amount equivalent to that

Prioritized Payment in all events. Also,

a SBIC has to make Prioritized Payments only on an annual basis, but the

SBA must make payments quarterly.

These differences are more than a matter of form. Each time a new pool is

created, the SBA will reasonably expect

to disburse and not recover, during the

pool’s first three years, an amount exceeding 15 percent of the Prioritized

Payments that would be due on the

participating securities in the pool if

Prioritized Payments had to be made

regardless of financial condition and

were paid in quarterly installments

rather than annually.

In addition, the SBA retains beneficial

ownership of the participating securities.

Although, in form, the rights to the

Redemption Payments and Prioritized

Payments are transferred to the trust,

neither the trust nor the certificate holders enjoy any rights of beneficial ownership in the participating securities. No

federal or state law can limit the exercise of the SBA’s ownership rights in

the participating securities, and the SBA

makes no promise to exercise these

rights for the trust’s benefit. 15 U.S.C.

§ 687l(e)(2) (1994). The SBA never

transfers its interests in the Profit Participation Payments and continues to

service (at its expense) the Redemption

Payments and Prioritized Payments.

Moreover, neither the trustee nor the

certificate holders can force the SBICs

to make these payments. The SBA enjoys a right to replace Redemption Payments and Prioritized Payments due on

one pool with Redemption Payments

and Prioritized Payments due on another. This right allows the SBA to

exercise control over a participating security for its own rather than the certificate holders’ benefit. It also demonstrates that a certificate does not

represent an interest in any identifiable

participating security.

HOLDING

For federal tax purposes, the SBA is

the primary obligor of the Guaranteed

Payment Rights created under its participating security program, and the trust

certificate holders are treated as owning

indebtedness of the SBA.

This revenue ruling is predicated on

the law governing the SBA participating

security program as of December 24,

1996. Therefore, before relying on this

revenue ruling, taxpayers, Service personnel, and others are cautioned to determine whether the law referred to has

materially changed since that date. See

§ 7.01(6), Rev. Proc. 89–14, 1989–1

C.B. 814.

DRAFTING INFORMATION

The principal author of this revenue

ruling is Kenneth Christman of the

Office of Assistant Chief Counsel (Financial Institutions & Products). For

further information regarding this revenue ruling contact Mr. Christman on

(202) 622–3950 (not a toll-free call).

Section 168.—Accelerated Cost

Recovery System

How does a taxpayer elect to treat a retail motor

fuels outlet placed in service before August 20,

1996, as 15-year property for depreciation purposes? See Rev. Proc. 97–10, page 59.

Section 265.—Expenses and

Interest Relating to Tax-exempt

Income

26 CFR 1.265–2: Interest relating to tax-exempt

income.

In an S corporation context, to the extent

indebtedness and tax-exempt obligations are taken

into account in applying § 265(b) at the bank

level, are they taken into account again in applying § 265(a) at the shareholder level? See Notice

97–5, page 25.

Section 280G.—Golden Parachute

Payments

Federal short-term, mid-term, and long-term

rates are set forth for the month of January 1997.

See Rev. Rul. 97–1, page 10.

Section 382.—Limitation on Net

Operating Loss Carryforwards and

Certain Built-In Losses Following

Ownership Change

The adjusted federal long-term rate is set forth

for the month of January 1997. See Rev. Rul.

97–1, page 10.

Section 412.—Minimum Funding

Standards

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the

month of January 1997. See Rev. Rul. 97–1, page

10.

Section 446.—General Rule for

Methods of Accounting

If a taxpayer elects to treat a retail motor fuels

outlet placed in service before August 20, 1996, as

15-year property for depreciation purposes, is this

election a change in method of accounting? See

Rev. Proc. 97–10, page 59.

7

Section 446.—General Rule for

Methods of Accounting

26 CFR 1.446–1: General rule for methods of

accounting.

If a taxpayer elects to treat a retail motor fuels

outlet place in service before August 20, 1996, as

15-year property for depreciation purposes, is this

election a change in method of accounting? See

Rev. Proc. 97–10, page 59.

Section 467.—Certain Payments

for the Use of Property or Services

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the

month of January 1997. See Rev. Rul. 97–1, page

10.

Section 468.—Special Rules for

Mining and Solid Waste

Reclamation and Closing Costs

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the

month of January 1997. See Rev. Rul. 97–1, page

10.

Section 481.—Adjustments

Required by Changes in Methods of

Accounting

If a taxpayer elects to treat a retail motor fuels

outlet placed in service before August 20, 1996, as

15-year property for depreciation purposes, is an

adjustment to taxable income required by this

change in method of accounting? See Rev. Proc.

97–10, page 59.

Section 483.—Interest on Certain

Deferred Payments

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the

month of January 1997. See Rev. Rul. 97–1, page

10.

Section 807.—Rules for Certain

Reserves

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the

month of January 1997. See Rev. Rul. 97–1, page

10.

Insurance companies; interest rate

tables. Prevailing state assumed interest

rates are provided for the determination

of reserves under section 807 of the

Code for contracts issued in 1996 and

1997. Rev. Rul. 92–19 supplemented in

part. See Rev. Rul. 97–2 on page 8.

Rev. Rul. 97–2

For purposes of § 807(d)(4) of the

Internal Revenue Code, for taxable years

beginning after December 31, 1995, this

ruling supplements the schedules of prevailing state assumed interest rates set

forth in Rev. Rul. 92–19, 1992–1 C.B.

227. This information is to be used by

insurance companies in computing their

reserves for (1) life insurance and

supplementary total and permanent disability benefits, (2) individual annuities

and pure endowments, and (3) group

annuities and pure endowments. As

§ 807(d)(2)(B) requires that the interest

rate used to compute these reserves be

the greater of (1) the applicable federal

interest rate, or (2) the prevailing state

assumed interest rate, the table of applicable federal interest rates in Rev. Rul.

92–19 is also supplemented.

Following are supplements to schedules A, B, C, and D to Part III of Rev.

Rul. 92–19, providing prevailing state

assumed interest rates for insurance

products with different features issued in

1996 and 1997, and a supplement to the

table in Part IV of Rev. Rul. 92–19,

providing the applicable federal interest

rate under § 807(d) for 1996 and 1997.

This ruling does not supplement Parts I

and II of Rev. Rul. 92–19.

This is the fifth supplement to the

interest rates provided in Rev. Rul.

92–19. Earlier supplements were published in Rev. Rul. 93–58, 1993–2 C.B.

241 (interest rates for insurance products

issued in 1992 and 1993), Rev. Rul.

94–11, 1994–1 C.B. 196 (1993 and

1994), Rev. Rul. 95–4, 1995–1 C.B. 141

(1994 and 1995), and Rev. Rul. 96–2,

1996–1 C.B. 141 (1995 and 1996).

Part III. Prevailing State Assumed

Interest Rates — Products Issued in

Years After 1982.*

Schedule A

STATUTORY VALUATION INTEREST

RATES BASED ON THE 1980

AMENDMENTS TO THE

NAIC STANDARD VALUATION LAW

A. Life insurance valuation:

Guarantee

Duration

Calendar Year

(years)

of Issue

1997

10 or fewer

More than 10

but not more

than 20

More than 20

5.50**

5.25**

4.50**

Source: Rates calculated from the

monthly averages, ending June 30, 1996,

of Moody’s Corporate Bond Yield Average — Monthly Average Corporates.

** As the applicable federal interest rate

for 1997 of 6.33 percent exceeds this

prevailing state assumed interest rate,

the interest rate to be used for this

product under § 807 is 6.33 percent.

* The terms used in the schedules in

this ruling and in Part III of Rev. Rul.

92–19 are those used in the Standard

Valuation Law; the terms are defined in

Rev. Rul. 92–19.

Part III, Schedule B

STATUTORY VALUATION INTEREST

RATES BASED ON THE 1980

AMENDMENTS TO THE

NAIC STANDARD VALUATION LAW

B. Single premium immediate annuities

and annuity benefits involving life contingencies arising from other annuities

with cash settlement options and from

guaranteed interest contracts with cash

settlement options:

Calendar Year of

Valuation Interest

Issue

Rate

1996

6.75*

Source: Rates calculated from the

monthly averages, ending June 30, 1996,

of Moody’s Corporate Bond Yield Average — Monthly Average Corporates.

The terms used in this schedule are

those used in the Standard Valuation

Law as defined in Rev. Rul. 92–19.

*As this prevailing state assumed interest rate exceeds the applicable federal

interest rate for 1996 of 6.63 percent,

the interest rate to be used for this

product under § 807 is 6.75 percent.

Part III, Schedule C14—1996

STATUTORY VALUATION INTEREST RATES

BASED ON NAIC STANDARD VALUATION LAW

FOR 1996 CALENDAR YEAR BUSINESS

GOVERNED BY THE 1980 AMENDMENTS

C. Valuation interest rates for other annuities and guaranteed interest contracts that are valued on an issue year basis:

Cash

Future

Valuation Interest Rate

Settlement

Interest

Guarantee Duration

For Plan Type

Options?

Guarantee?

(years)

A

B

C

Yes

Yes

Yes

No

5 or fewer

6.75

5.75*

5.25*

More than 5, but not

more than 10

More than 10, but not

more than 20

More than 20

5 or fewer

More than 5, but not

more than 10

More than 10, but not

more than 20

6.50*

5.75*

5.25*

6.00*

5.25*

5.00*

5.00*

6.75

6.75

4.50*

6.00*

6.00*

4.50*

5.50*

5.50*

6.25*

5.50*

5.25*

8

Valuation Interest Rate

For Plan Type

No

Yes or No

More than 20

5 or fewer

More than 5, but not

more than 10

More than 10, but not

more than 20

More than 20

5.25*

6.75

6.50*

4.75*

NOT

4.75*

APPLICABLE

6.00*

5.00*

Source: Rates calculated from the monthly averages, ending June 30, 1996 of Moody’s Corporate Bond Yield Average —

Monthly Average Corporates.

*As the applicable federal interest rate for 1996 of 6.63 percent exceeds this prevailing state assumed interest rate, the interest

rate to be used for this product under § 807 is 6.63 percent.

Part III, Schedule D14—1996

STATUTORY VALUATION INTEREST RATES

BASED ON NAIC STANDARD VALUATION LAW

FOR 1996 CALENDAR YEAR BUSINESS

GOVERNED BY THE 1980 AMENDMENTS

D. Valuation interest rates for other annuities and guaranteed interest contracts that are contracts with cash settlement options

and that are valued on a change in fund basis:

Valuation Interest Rate

Cash

Future

For Plan Type

Settlement

Interest

Guarantee Duration

Options?

Guarantee?

(years)

A

B

C

Yes

Yes

5 or fewer

7.25

6.75

5.50*

More than 5, but not

7.00

6.75

5.50*

more than 10

More than 10, but not

6.75

6.50*

5.25*

more than 20

More than 20

5.75*

5.75*

4.75*

Yes

No

5 or fewer

7.50

7.00

5.75*

More than 5, but not

7.25

7.00

5.75*

more than 10

More than 10, but not

6.75

6.75

5.50*

more than 20

More than 20

6.00*

6.00*

5.00*

Source: Rates calculated from the monthly averages, ending June 30, 1996, of Moody’s Corporate Bond Yield Average —

Monthly Average Corporates.

*As the applicable federal interest rate for 1996 of 6.63 percent exceeds this prevailing state assumed interest rate, the interest

rate to be used for this product under § 807 is 6.63 percent.

Part IV. Applicable Federal

Interest Rates.

96–57, 1996–50 I.R.B. C.B. 5 for the

1997 rate.

TABLE OF APPLICABLE

FEDERAL INTEREST RATES

FOR PURPOSES OF § 807

Year

Interest Rate

EFFECT ON OTHER REVENUE

RULINGS

DRAFTING INFORMATION

Rev. Rul. 92–19 is supplemented by

the addition to Part III of that ruling of

prevailing state assumed interest rates

under § 807 for certain insurance products issued in 1996 and 1997 and is

further supplemented by an addition to

the table in Part IV of Rev. Rul. 92–19

The principal author of this revenue

ruling is Ann H. Logan of the Office of

Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling

contact her on (202) 622–3970 (not a

toll-free call).

1996

1997

6.63

6.33

Sources: Rev. Rul. 95–79, 1995–2 C.B.

134 for the 1996 rate and Rev. Rul.

9

listing applicable federal interest rates.

Parts I and II of Rev. Rul. 92–19 are not

affected by this ruling.

Section 846.—Discounted Unpaid

Losses Defined

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the

month of January 1997. See Rev. Rul. 97–1, this

page.

Section 895.—Income Derived by a

Foreign Central Bank of Issue From

Obligations of the United States or

From Bank Deposits

26 CFR 1.895–1: Income derived by a foreign

central bank of issue, or by Bank for International

Settlements, from obligations of the United States

or from bank deposits.

Are holders of the guaranteed payment rights

that are created by the Small Business Administration (SBA) under its participating security program

treated as owning SBA debt? See Rev. Rul. 97–3,

page 5.

Section 851.—Definition of

Regulated Investment Company

26 CFR 1.851–2: Limitations.

Are holders of the guaranteed payment rights

that are created by the Small Business Administration (SBA) under its participating security program

treated as owning SBA debt? See Rev. Rul. 97–3,

page 5.

Section 856.—Definition of Real

Estate Investment Trusts

Section 1274.—Determination of

Issue Price in the Case of Certain

Debt Instruments Issued for

Property

(Also Sections 42, 280G, 382, 412, 467, 468, 482,

483, 642, 807, 846, 1288, 7520, 7872.)

26 CFR 1.856–2: Limitations.

Are holders of the guaranteed payment rights

that are created by the Small Business Administration (SBA) under its participating security program

treated as owning SBA debt? See Rev. Rul. 97–3,

page 5.

Federal rates; adjusted federal

rates; adjusted federal long-term rate,

and the long-term exempt rate. For

purposes of sections 1274, 1288, 382,

and other sections of the Code, tables

set forth the rates for January 1997.

Rev. Rul. 97–1

This revenue ruling provides various

prescribed rates for federal income tax

purposes for January 1997 (the current

month.) Table 1 contains the short-term,

mid-term, and long-term applicable federal rates (AFR) for the current month

for purposes of section 1274(d) of the

Internal Revenue Code. Table 2 contains

the short-term, mid-term, and long-term

adjusted applicable federal rates (adjusted AFR) for the current month for

purposes of section 1288(b). Table 3

sets forth the adjusted federal long-term

rate and the long-term tax-exempt rate

described in section 382(f). Table 4

contains the appropriate percentages for

determining the low-income housing

credit described in section 42(b)(2) for

buildings placed in service during the

current month. Table 5 contains the

federal rate for determining the present

value of an annuity, an interest for life

or for a term of years, or a remainder or

a reversionary interest for purposes of

section 7520. Finally, Table 6 contains

the deemed rate of return for transfers

made during calendar year 1997 to

pooled income funds described in section 642(c)(5) that have been in existence for less than 3 taxable years immediately preceding the taxable year in

which the transfer is made.

REV. RUL. 97–1 TABLE 1

Applicable Federal Rates (AFR) for January 1997

Period for Compounding

Annual

Semiannual

Quarterly

Monthly

5.63%

6.20%

6.77%

7.35%

5.55%

6.11%

6.66%

7.22%

5.51%

6.06%

6.61%

7.16%

5.49%

6.03%

6.57%

7.11%

6.10%

6.72%

7.34%

7.96%

9.22%

10.80%

6.01%

6.61%

7.21%

7.81%

9.02%

10.52%

5.97%

6.56%

7.15%

7.74%

8.92%

10.39%

5.94%

6.52%

7.10%

7.69%

8.86%

10.30%

6.54%

7.21%

7.88%

8.55%

6.44%

7.08%

7.73%

8.37%

6.39%

7.02%

7.66%

8.28%

6.36%

6.98%

7.61%

8.23%

Short-Term

AFR

110% AFR

120% AFR

130% AFR

Mid-Term

AFR

110% AFR

120% AFR

130% AFR

150% AFR

175% AFR

Long-Term

AFR

110% AFR

120% AFR

130% AFR

10

REV. RUL. 97–1 TABLE 2

Adjusted AFR for January 1997

Period for Compounding

Annual

Semiannual

Quarterly

Monthly

Short-term

adjusted AFR

3.64%

3.61%

3.59%

3.58%

Mid-term

adjusted AFR

4.45%

4.40%

4.38%

4.36%

Long-term

adjusted AFR

5.35%

5.28%

5.25%

5.22%

REV. RUL. 97–1 TABLE 3

Rates Under Section 382 for January 1997

Adjusted federal long-term rate for the current month

Long-term tax-exempt rate for ownership changes during the current month (the highest of the

adjusted federal long-term rates for the current month and the prior two months.)

5.35%

5.60%

REV. RUL. 97–1 TABLE 4

Appropriate Percentages Under Section 42(b)(2) for January 1997

Appropriate percentage for the 70% present value low-income housing credit

Appropriate percentage for the 30% present value low-income housing credit

8.48%

3.64%

REV. RUL. 97–1 TABLE 5

Rate Under Section 7520 for January 1997

Applicable federal rate for determining the present value of an annuity, an interest for life or a

term of years, or a remainder or reversionary interest

7.4%

REV. RUL. 97–1 TABLE 6

Deemed Rate for Transfers to New Pooled Income Funds During 1997

Deemed rate of return for transfers during 1997 to pooled income funds that have been in existence for less than 3 taxable years.

Section 1288.—Treatment of

Original Issue Discount on

Tax-Exempt Obligations

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the

month of January 1997. See Rev. Rul. 97–1, page

10.

26 CFR 301.7701–3: Classification of certain

business entities.

T.D. 8697

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 301, and 602

Section 7701.—Definitions

26 CFR 301.7701–13A: Post-1969 domestic building and loan association.

Are holders of the guaranteed payment rights

that are created by the Small Business Administration (SBA) under its participating security program

treated as owning SBA debt? See Rev. Rul. 97–3,

page 5.

Simplification of Entity

Classification Rules

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

11

7.2%

SUMMARY: This document contains final regulations that classify certain business organizations under an elective regime. These regulations replace the

existing classification rules.

DATES: These regulations are effective

as of January 1, 1997. For dates of

applicability of these regulations, see

Effective Dates under Supplementary Information.

FOR FURTHER INFORMATION

CONTACT: Concerning the regulations,

Mark D. Harris, (202) 622–3050; concerning foreign organizations, William

H. Morris or Ronald M. Gootzeit, (202)

622–3880 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations have

been reviewed and approved by the

Office of Management and Budget in

accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control

number 1545–1486. Responses to these

collections of information are required

to obtain a benefit (to choose an entity’s

classification by election).

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 estimates of the reporting burden

in these final regulations are reflected in

the burden estimates in Form 8832

(Entity Classification Election).

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, T: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.

Books or records relating to these

collections 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.

Background

On April 3, 1995, Notice 95–14

(1995–1 C.B. 297), relating to classification of business organizations under section 7701 of the Code, was published in

the Internal Revenue Bulletin. A notice

of public hearing was published in the

Federal Register on May 10, 1995 (60

FR 24813). Written comments were received and a public hearing was held on

July 20, 1995.

On May 13, 1996, the IRS and Treasury issued a notice of proposed

rulemaking (61 FR 21989 [PS–43–95,

1996–24 I.R.B. 20]) under section 7701.

The regulations proposed to replace the

existing regulations for classifying certain business organizations with an elective regime. Comments responding to

the notice were received, and a public

hearing was held on August 21, 1996.

After considering the comments that

were received in response to the notice

of proposed rulemaking and the statements made at the public hearing, the

proposed regulations are adopted as revised by this Treasury decision. The

revisions are discussed below.

Explanation of Provisions

Section 7701(a)(2) of the Code defines a partnership to include a syndicate, group, pool, joint venture, or other

unincorporated organization, through or

by means of which any business, financial operation, or venture is carried on,

and that is not a trust or estate or a

corporation. Section 7701(a)(3) defines a

corporation to include associations,

joint-stock companies, and insurance

companies.

The existing regulations for classifying business organizations as associations (which are taxable as corporations

under section 7701(a)(3)) or as partnerships under section 7701(a)(2) are based

on the historical differences under local

law between partnerships and corporations. Treasury and the IRS believe that

those rules have become increasingly

formalistic. This document replaces

those rules with a much simpler approach that generally is elective.

As stated in the preamble to the

proposed regulations, in light of the

increased flexibility under an elective

regime for the creation of organizations

classified as partnerships, Treasury and

the IRS will continue to monitor carefully the uses of partnerships in the

international context and will take appropriate action when partnerships are

used to achieve results that are inconsistent with the policies and rules of

particular Code provisions or of U.S. tax

treaties.

A. Summary of the Regulations

Section 301.7701–1 provides an overview of the rules applicable in determining an organization’s classification for

federal tax purposes. The first step in

the classification process is to determine

whether there is a separate entity for

federal tax purposes. The regulations

explain that certain joint undertakings

that are not entities under local law may

nonetheless constitute separate entities

for federal tax purposes; however, not

all entities formed under local law are

recognized as separate entities for federal tax purposes. Whether an organization is treated as an entity for federal

12

tax purposes is a matter of federal tax

law, and does not affect the rights and

obligations of its owners under local

law. For example, if a domestic limited

liability company with a single individual owner is disregarded as an entity

separate from its owner under

§ 301.7701–3, its individual owner is

subject to federal income tax as if the

company’s business was operated as a

sole proprietorship.

An organization that is recognized as

a separate entity for federal tax purposes

is either a trust or a business entity

(unless a provision of the Code expressly provides for special treatment,

such as the Qualified Settlement Fund

rules (§ 1.468B) or the Real Estate

Mortgage Investment Conduit (REMIC)

rules, see section 860A(a)). The regulations provide that trusts generally do not

have associates or an objective to carry

on business for profit. The distinctions

between trusts and business entities, although restated, are not changed by

these regulations.

Section 301.7701–2 clarifies that business entities that are classified as corporations for federal tax purposes include

corporations denominated as such under

applicable law, as well as associations,

joint-stock companies, insurance companies, organizations that conduct certain

banking activities, organizations wholly

owned by a State, organizations that are

taxable as corporations under a provision of the Code other than section

7701(a)(3), and certain organizations

formed under the laws of a foreign

jurisdiction (including a U.S. possession,

territory, or commonwealth).

The regulations in § 301.7701–2 include a special grandfather rule, under

which an entity described in the list of

foreign entities treated as per se corporations will nevertheless be classified as

other than a corporation. The regulations

also list certain situations where a

grandfathered entity would lose its

grandfathered status.

Any business entity that is not required to be treated as a corporation for

federal tax purposes (referred to in the

regulation as an eligible entity) may

choose its classification under the rules

of § 301.7701–3. Those rules provide

that an eligible entity with at least two

members can be classified as either a

partnership or an association, and that

an eligible entity with a single member

can be classified as an association or

can be disregarded as an entity separate

from its owner. However, if the single

owner of a business entity is a bank (as

defined in section 581), then the special

rules applicable to banks will continue

to apply to the single owner as if the

wholly owned entity were a separate

entity.

In order to provide most eligible

entities with the classification they

would choose without requiring them to

file an election, the regulations provide

default classification rules that aim to

match taxpayers’ expectations (and thus

reduce the number of elections that will

be needed). The regulations adopt a

passthrough default for domestic entities, under which a newly formed eligible entity will be classified as a

partnership if it has at least two members, or will be disregarded as an entity

separate from its owner if it has a single

owner. The default for foreign entities is

based on whether the members have

limited liability. Thus a foreign eligible

entity will be classified as an association

if all members have limited liability. A

foreign eligible entity will be classified

as a partnership if it has two or more

members and at least one member does

not have limited liability; the entity will

be disregarded as an entity separate

from its owner if it has a single owner

and that owner does not have limited

liability. Finally, the default classification for an existing entity is the classification that the entity claimed immediately prior to the effective date of these

regulations. An entity’s default classification continues until the entity elects to

change its classification by means of an

affirmative election.

An eligible entity may affirmatively

elect its classification on Form 8832,

Entity Classification Election. The regulations require that the election be

signed by each member of the entity or

any officer, manager, or member of the

entity who is authorized to make the

election and who represents to having

such authorization under penalties of

perjury. An election will not be accepted

unless it includes all of the required

information, including the entity’s taxpayer identifying number (TIN).

Taxpayers are reminded that a change

in classification, no matter how

achieved, will have certain tax consequences that must be reported. For example, if an organization classified as an

association elects to be classified as a

partnership, the organization and its

owners must recognize gain, if any,

under the rules applicable to liquidations

of corporations.a

B. Discussion of Comments on the

General Approach and Scope of the

Regulations

Several comments requested clarification with regard to the rules for determining when an owner of an interest in

an organization will be respected as a

bona fide owner for federal tax purposes. Some commentators were concerned, for example, that certain owners

would be required to maintain certain

net worth requirements. Other commentators, relying on Rev. Rul. 93–4,

1993–1 C.B. 225, suggested that if two

wholly-owned subsidiaries of a common

parent were the owners of an organization, those owners would not be respected as bona fide owners and the

organization would be treated as having

only one owner (the common parent).

Although the determination of whether

an organization has more than one

owner is based on all the facts and

circumstances, the fact that some or all

of the owners of an organization are

under common control does not require

the common parent to be treated as the

sole owner. Consistent with this approach, Rev. Rul. 93–4 treated two

wholly owned subsidiaries as associates

and then classified the foreign entity

based on the four corporate characteristics under section 7701. While these

four factors will no longer apply with

the adoption of the regulations, determining whether the subsidiaries are associates continues to be an issue.

The IRS has received a number of

comments asking for clarification of the

tax treatment of entities that are wholly

owned by an Indian tribe and incorporated under tribal law. Treasury and the

IRS are currently studying this issue and

will, if necessary, issue separate guidance regarding this issue.

Most commentators agreed that inclusion of the list of foreign business

entities treated as corporations per se

was appropriate. However, several commentators requested clarification about

certain foreign business entities on the

per se list. Other commentators requested clarification whether and how

the list of such corporations might be

updated in the future. The regulations

are clarified with respect to entities

formed in the following jurisdictions:

Aruba, Canada, People’s Republic of

China, Republic of China (Taiwan), India, Indonesia, Netherlands Antilles, and

Sweden. Any further modifications will

be announced in a notice of proposed

rulemaking and will be prospective only.

13

Commentators also raised the issue of

how to determine if a joint venture or

other contractual arrangement that is

considered a separate entity under these

regulations is considered a foreign or

domestic entity. This issue is outside the

scope of these regulations and thus is

not addressed in the final regulations.

Some commentators raised issues relating to the application of the grandfather rule for certain existing entities

organized under foreign statutes included on the list of per se corporations.

In particular, commentators requested

clarification regarding existing entities

that would be listed on the per se list.

Commentators have asked whether an

existing entity on the per se list which

had claimed non-corporate status could

retain that status, and, if so, whether it

could subsequently elect to be treated as

a corporation. Commentators also asked

for clarification as to the effect of a

deemed termination under section

708(b)(1)(B) or a division under section

708(b)(2)(B) on a grandfathered per se

entity.

In response to these comments, the

grandfather rules clarify that an entity

on the list which was previously disregarded as a separate entity (i.e., treated

as a branch) or was treated as a partnership may continue to be treated as such

when the regulations become effective.

Moreover, entities on the list which

continue to treat themselves as branches

or partnerships after the effective date of

the regulations may subsequently elect

to be treated as corporations. However,

after such election they may not subsequently elect to be treated as a partnership or a branch. Finally, any termination under section 708(b)(1)(B) (except

in the case of a sale or exchange of

interests in an entity described in

§ 301.7701–2(d)(2) where the sale or

exchange is to a related person within

the meaning of sections 267(b) and

707(b) and occurs no later than 12

months after the date the entity is

formed) or division under section

708(b)(2)(B) will end the grandfathered

status of any entity on the per se list,

and therefore the successor entity (or

entities) will thereafter be permanently

treated as a corporation.

Other commentators suggested that

the requirement that an existing entity

included on the per se list must have

claimed passthrough treatment for all

prior periods is burdensome and precludes grandfather treatment for entities

that restructured in the past and recognized the resulting tax consequences. In

response to these comments, the regulations are modified to indicate that an

existing entity can continue to be treated

as a non-corporate entity if it was in

existence on May 8, 1996, and was

reasonably treated as a non-corporate

entity on that date (or formed thereafter

pursuant to a written binding contract in

effect on May 8, 1996, in which the

parties agreed to engage (directly or

indirectly) in an active and substantial

business operation in the jurisdiction in

which the entity is formed, and which

would otherwise meet the grandfather

rules if the date the entity is formed is

substituted for May 8, 1996). If the

entity changed its claimed tax status

within the sixty months prior to May 8,

1996, the entity and its members must

have recognized the tax consequences

that resulted from that change in tax

status. Moreover, the regulations clarify

that the grandfather treatment applies if

no person for whom the entity’s classification was relevant on May 8, 1996,

treats the entity as a corporation for

purposes of filing such person’s federal

income tax returns, information returns,

and withholding documents for the period including May 8, 1996.

One commentator suggested that it

was unclear when the classification of a

foreign entity is ‘‘relevant’’ for federal

tax purposes. This determination is important, as it affects whether the grandfather rule, the default rule for existing

entities, or the default rule for a newly

formed foreign entity applies. In general, an entity’s classification is relevant

when its classification affects the liability of any person for federal tax or

information purposes. The date that the

classification of a foreign entity is relevant is the date an event occurs that

causes an obligation to file a return or

statement for which the classification of

the entity must be determined.

C. Discussion of Comments Relating to

the Elective Regime

Most of the commentators agreed that

the default rules included in the proposed regulations generally would match

taxpayers’ expectations. However, some

commentators expressed concern over

the application of the default rule for

newly formed foreign eligible entities

which would treat such entities as associations if no member had unlimited

liability. Specifically, certain commentators noted that under the definition of

unlimited liability in the proposed regulations, certain contractual joint ventures

which, under current law, would generally be classified as partnerships, would

be treated as associations under the

default rule. The members of these

contractual joint ventures are not jointly

and severally liable for all debts of the

entity; rather, each member has unlimited liability for a certain proportion of

the debts of the entity. To simplify the

default rules, the regulations are modified to provide that a newly formed

foreign eligible entity will— (1) be

treated as a partnership if it has at least

two members and at least one member

does not have limited liability; (2) be

treated as an association if all members

of the entity have limited liability; and

(3) be disregarded as an entity separate

from its owner if it has a single owner

that does not have limited liability.

The regulations are modified to provide that a member does not have

limited liability if the member, by virtue

of being a member, has personal liability for all or any portion of the debts of

the entity.

Certain commentators asked for clarification of the default rule in the case

where the relevant statute or law of a

particular country provides for limited

or unlimited liability. Generally, the

regulations specify that only the statute

or law is relevant. Where, however, the

underlying statute allows the entity to

specify in its organizational documents

whether the members will have limited

liability, the organizational documents

may be relevant.

Some commentators requested that

taxpayers be allowed to make classification elections with their first tax returns.

The regulations retain the requirement

that elections be made at the beginning

of the taxable year. Treasury and the

IRS continue to believe that it is appropriate to determine an entity’s classification at the time that it begins its operations. Taxpayers can specify the date on

which an election will be effective,

provided that date is not more than 75

days prior to the date on which the

election is filed (irrespective of when

the interest was acquired) and not more

than 12 months after the date the election was filed. If a taxpayer specifies an

effective date more than 75 days prior

to the date on which the election is

filed, the election will be effective 75

days prior to the date on which the

election was filed. If a taxpayer specifies an effective date more than 12

months from the filing date, the election

will be effective 12 months after the

14

date the election was filed. No election,

whenever filed, will be effective before

January 1, 1997.

One commentator expressed concern

about the ability to make protective

elections where there is uncertainty, for

example, about an entity’s status as a

business entity. Such protective elections

are not prohibited under the regulations.

The regulations limit the ability of an

entity to make multiple classification

elections by prohibiting more than one

election to change an entity’s classification during any sixty month period. One

commentator suggested that the regulations be amended to waive application

of this rule in certain circumstances,

particularly when there has been a substantial change in ownership of the

entity. In response to this comment, the

regulations permit the Commissioner to

waive the application of the sixty month

limitation by letter ruling. However,

waivers will not be granted unless there

has been more than a fifty percent

ownership change. The sixty month

limitation only applies to a change in

classification by election; the limitation

does not apply if the organization’s

business is actually transferred to another entity.

Several commentators requested clarification concerning the classification of

a foreign entity when the classification

of the entity becomes relevant for federal tax purposes after a period during

which the classification of the entity

was not relevant. Generally, such an

entity will retain its prior classification.

However, if the classification of a foreign eligible entity which was previously relevant for federal tax purposes

ceases to be relevant for sixty consecutive months, the entity’s classification

will be determined initially under the

default classification when the classification of the foreign eligible entity

again becomes relevant.

Some commentators requested clarification regarding the rule permitting

elections to be signed by any authorized

officer, manager, or member of the

electing entity. The regulations retain

this rule, as it provides taxpayers with

flexibility in complying with the election requirements. The determination of

whether a person is authorized to make

an election is based on local law. Thus,

the election can be made by anyone

authorized to act on behalf of the entity.

Several commentators asked for guidance regarding the necessary signatures

on the classification election. The regulations are modified to provide that if

the election is made by all of the

members, each person who is an owner

at the time the election is made must

consent to the election. However, if an

election is to be effective for any period

prior to the date it is filed, each person

who was an owner between the date the

election is to be effective and the date

the election is filed (even if by an

authorized person), and who is not an

owner at the time the election is filed,

must also consent to the election.

Several commentators requested that

the classification election be coordinated

with the election under section 856(c)(1)

to be a real estate investment trust

(REIT). Because the latter election is

required to be made with the REIT’s

first tax return, the regulations are modified to provide that an election by an

eligible entity to be a REIT will be

treated as a deemed election to be

classified as an association, effective for

the entire period during which REIT

status is claimed.

Some commentators suggested that

the regulations should not require an

entity or its direct or indirect owners to

attach a copy of the entity’s election to

their federal tax returns. Specifically,

some commentators were concerned that

the failure of one owner to attach a

copy of the election to the owner’s

return would void an otherwise valid

election. The regulations retain the requirement that taxpayers must attach a

copy of the election to their returns, but

clarify that failure to do so will not

invalidate an otherwise valid election.

Although the failure to attach a copy

will not adversely affect an otherwise

valid election, taxpayers are reminded

that each member of the entity is required to file returns that are consistent

with the entity’s election. Failure to

attach the election form to a federal tax

or information return as directed in the

regulations may give rise to penalties

against the non-filing party. Other applicable penalties may also apply to parties

who file federal tax or information returns inconsistent with the entity’s election.

One commentator asked for guidance

on the treatment of conversions by election from partnership to corporation and

from corporation to partnership. This

issue is outside the scope of these

classification rules and thus is not addressed in these regulations. Treasury

and the IRS, however, are actively considering issuing guidance on the treatment of such conversions.

D. Effective Dates

The regulations are effective as of

January 1, 1997.

The regulations provide a special

transition rule for existing entities. The

IRS will not challenge the prior classification of an existing eligible entity, or

an existing entity described on the per

se list, for periods prior to January 1,

1997, if— (1) the entity had a reasonable basis (within the meaning of section 6662) for its claimed classification;

(2) the entity and all members of the

entity recognized the federal tax consequences of any change in the entity’s

classification within the sixty months

prior to January 1, 1997; and (3) neither

the entity nor any member had been

notified in writing on or before May 8,

1996, that the classification of the entity

was under examination (in which case

the entity’s classification will be determined in the examination).

Some commentators were concerned

that an entity organized after May 8,

1996, would be excluded from this

transition rule for existing entities. Because § 301.7701–3(f)(2) applies to entities that were in existence prior to

January 1, 1997, no change is necessary

to provide relief for entities organized

after May 8, 1996.

Some commentators were concerned

about entities that claimed to be trusts

for the period prior to January 1, 1997,

but are subsequently determined to be

business entities. In that case, the entity’s claimed classification for purposes

of applying the provisions of the special

transition rule will be the business entity

classification claimed by the entity after

it has been determined to be a business

entity.

Effect on other documents

The Service has published a number

of revenue rulings and revenue procedures interpreting the section 7701 regulations. The Service is currently reviewing these revenue rulings and revenue

procedures to determine which are affected by the publication of these regulations. See accompanying Notice 97–1.

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) does

not apply to these regulations. It is

hereby certified that these regulations do

15

not have a significant economic impact

on a substantial number of small entities. This certification is based upon the

fact that the automatic classification

rules of § 301.7701–2(b) and the default

classification rules of § 301.7701–3(b)

will operate in such a manner that only

a limited number of entities will need to

make an election under § 301.7701–3(c)

to determine their classification. Therefore, a Regulatory Flexibility Analysis

under the Regulatory Flexibility Act (5

U.S.C. chapter 6) 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 authors of these regulations are Armando Gomez and Mark D.

Harris of the Office of Assistant Chief

Counsel (Passthroughs and Special Industries) and William H. Morris and

Ronald M. Gootzeit of the Office of

Associate Chief Counsel (International).

However, other personnel from the IRS

and Treasury Department participated in

their development.

*

*

*

*

*

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1, 301,

and 602 are 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 * * *

Par. 2. Section 1.581–1 is revised to

read as follows:

§ 1.581–1 Banks.

(a) In order to be a bank as defined

in section 581, an institution must be a

corporation for federal tax purposes. See

§ 301.7701–2(b) of this chapter for the

definition of a corporation.

(b) This section is effective as of

January 1, 1997.

Par. 3. Section 1.581–2 is amended as

follows:

1. Paragraph (a) is removed.

2. Paragraphs (b) and (c) are redesignated as paragraphs (a) and (b), respectively.

3. Newly designated paragraph (a) is

amended by revising the second and last

sentences.

The revisions read as follows:

to change its federal tax classification

will retain that employer identification

number.

§ 1.581–2 Mutual savings banks, building and loan associations, and cooperative banks.

Par.

7. Sections

301.7701–1,

301.7701–2, and 301.7701–3 are revised

to read as follows:

(a) * * * See section 593 for special

rules concerning reserves for bad debts.

* * * See also section 594 and

§ 1.594–1 for special rules governing

the taxation of a mutual savings bank

conducting a life insurance business.

§ 301.7701–1 Classification of organizations for federal tax purposes.

(a) Organizations for federal tax purposes—(1) In general. The Internal Revenue Code prescribes the classification

of various organizations for federal tax

purposes. Whether an organization is an

entity separate from its owners for federal tax purposes is a matter of federal

tax law and does not depend on whether

the organization is recognized as an

entity under local law.

(2) Certain joint undertakings give

rise to entities for federal tax purposes.

A joint venture or other contractual

arrangement may create a separate entity

for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the

profits therefrom. For example, a separate entity exists for federal tax purposes

if co-owners of an apartment building

lease space and in addition provide

services to the occupants either directly

or through an agent. Nevertheless, a

joint undertaking merely to share expenses does not create a separate entity

for federal tax purposes. For example, if

two or more persons jointly construct a

ditch merely to drain surface water from

their properties, they have not created a

separate entity for federal tax purposes.

Similarly, mere co-ownership of property that is maintained, kept in repair,

and rented or leased does not constitute

a separate entity for federal tax purposes. For example, if an individual

owner, or tenants in common, of farm

property lease it to a farmer for a cash

rental or a share of the crops, they do

not necessarily create a separate entity

for federal tax purposes.

(3) Certain local law entities not recognized. An entity formed under local

law is not always recognized as a

separate entity for federal tax purposes.

For example, an organization wholly

owned by a State is not recognized as a

separate entity for federal tax purposes

if it is an integral part of the State.

Similarly, tribes incorporated under section 17 of the Indian Reorganization Act

of 1934, as amended, 25 U.S.C. 477, or

under section 3 of the Oklahoma Indian

Welfare Act, as amended, 25 U.S.C.

*

*

*

*

*

*

Par. 4. In § 1.761–1, paragraph (a) is

revised to read as follows:

§ 1.761–1 Terms defined.

(a) Partnership. The term partnership

means a partnership as determined under

§§ 301.7701–1, 301.7701–2, and

301.7701–3 of this chapter.

*

*

*

*

*

PART 301—PROCEDURE AND

ADMINISTRATION

Par. 5. The authority citation for part

301 continues to read in part as follows:

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

Par. 6. Section 301.6109–1 is

amended as follows:

1. Paragraph (b)(2)(iii) is amended by

removing the language ‘‘and’’ at the end

of the paragraph.

2. Paragraph (b)(2)(iv) is amended by

removing the period at the end of the

paragraph, and replacing it with the

language ‘‘; and’’.

3. Paragraph (b)(2)(v) is added.

4. The text of paragraph (d)(2) is

redesignated as paragraph (d)(2)(i).

5. A paragraph heading is added for

newly designated paragraph (d)(2)(i).

6. Paragraph (d)(2)(ii) is added.

The revisions and additions read as

follows:

§ 301.6109–1 Identifying numbers.

*

*

*

*

*

(b) * * *

(2) * * *

(v) A foreign person that makes an

election under § 301.7701–3(c).

*

*

*

*

*

(d) * * *

(2) Employer identification number—

(i) In general. * * *

(ii) Special rule for entities electing

to change their federal tax classification

under § 301.7701–3(c). Any entity that

has an employer identification number

and then elects under § 301.7701–3(c)

*

*

16

*

*

503, are not recognized as separate

entities for federal tax purposes.

(4) Single owner organizations. Under §§ 301.7701–2 and 301.7701–3,

certain organizations that have a single

owner can choose to be recognized or

disregarded as entities separate from

their owners.

(b) Classification of organizations.

The classification of organizations that

are recognized as separate entities is

determined under §§ 301.7701–2,

301.7701–3, and 301.7701–4 unless a

provision of the Internal Revenue Code

(such as section 860A addressing Real

Estate Mortgage Investment Conduits

(REMICs)) provides for special treatment of that organization. For the classification of organizations as trusts, see

§ 301.7701–4. That section provides

that trusts generally do not have associates or an objective to carry on business

for profit. Sections 301.7701–2 and

301.7701–3 provide rules for classifying

organizations that are not classified as

trusts.

(c) Qualified cost sharing arrangements. A qualified cost sharing arrangement that is described in § 1.482–7 of

this chapter and any arrangement that is

treated by the Commissioner as a qualified cost sharing arrangement under

§ 1.482–7 of this chapter is not recognized as a separate entity for purposes

of the Internal Revenue Code. See

§ 1.482–7 of this chapter for the proper

treatment of qualified cost sharing arrangements.

(d) Domestic and foreign entities. For

purposes of this section and

§§ 301.7701–2 and 301.7701–3, an entity is a domestic entity if it is created

or organized in the United States or

under the law of the United States or of

any State; an entity is foreign if it is not

domestic. See sections 7701(a)(4) and

(a)(5).

(e) State. For purposes of this section

and § 301.7701–2, the term State includes the District of Columbia.

(f) Effective date. The rules of this

section are effective as of January 1,

1997.

§ 301.7701–2 Business entities; definitions.

(a) Business entities. For purposes of

this section and § 301.7701–3, a business entity is any entity recognized for

federal tax purposes (including an entity

with a single owner that may be disregarded as an entity separate from its

owner under § 301.7701–3) that is not

properly classified as a trust under

§ 301.7701–4 or otherwise subject to

special treatment under the Internal Revenue Code. A business entity with two

or more members is classified for federal tax purposes as either a corporation

or a partnership. A business entity with

only one owner is classified as a corporation or is disregarded; if the entity is

disregarded, its activities are treated in

the same manner as a sole proprietorship, branch, or division of the owner.

(b) Corporations. For federal tax purposes, the term corporation means—

(1) A business entity organized under

a Federal or State statute, or under a

statute of a federally recognized Indian

tribe, if the statute describes or refers to

the entity as incorporated or as a corporation, body corporate, or body politic;

(2) An association (as determined under § 301.7701–3);

(3) A business entity organized under

a State statute, if the statute describes or

refers to the entity as a joint-stock

company or joint-stock association;

(4) An insurance company;

(5) A State-chartered business entity

conducting banking activities, if any of

its deposits are insured under the Federal Deposit Insurance Act, as amended,

12 U.S.C. 1811 et seq., or a similar

federal statute;

(6) A business entity wholly owned

by a State or any political subdivision

thereof;

(7) A business entity that is taxable

as a corporation under a provision of the

Internal Revenue Code other than section 7701(a)(3); and

(8) Certain foreign entities—(i) In

general. Except as provided in paragraphs (b)(8)(ii) and (d) of this section,

the following business entities formed in

the following jurisdictions:

American Samoa, Corporation

Argentina, Sociedad Anonima

Australia, Public Limited Company

Austria, Aktiengesellschaft

Barbados, Limited Company

Belgium, Societe Anonyme

Belize, Public Limited Company

Bolivia, Sociedad Anonima

Brazil, Sociedade Anonima

Canada, Corporation and Company

Chile, Sociedad Anonima

People’s Republic of China, Gufen

Youxian Gongsi

Republic of China (Taiwan), Ku-fen

Yu-hsien Kung-szu

Colombia, Sociedad Anonima

Costa Rica, Sociedad Anonima

Cyprus, Public Limited Company

Czech Republic, Akciova Spolecnost

Denmark, Aktieselskab

Ecuador, Sociedad Anonima or

Compania Anonima

Egypt, Sharikat Al-Mossahamah

El Salvador, Sociedad Anonima

Finland, Osakeyhtio/Aktiebolag

France, Societe Anonyme

Germany, Aktiengesellschaft

Greece, Anonymos Etairia

Guam, Corporation

Guatemala, Sociedad Anonima

Guyana, Public Limited Company

Honduras, Sociedad Anonima

Hong Kong, Public Limited Company

Hungary, Reszvenytarsasag

Iceland, Hlutafelag

India, Public Limited Company

Indonesia, Perseroan Terbuka

Ireland, Public Limited Company

Israel, Public Limited Company

Italy, Societa per Azioni

Jamaica, Public Limited Company

Japan, Kabushiki Kaisha

Kazakstan, Ashyk Aktsionerlik

Kogham

Republic of Korea, Chusik Hoesa

Liberia, Corporation

Luxembourg, Societe Anonyme

Malaysia, Berhad

Malta, Partnership Anonyme

Mexico, Sociedad Anonima

Morocco, Societe Anonyme

Netherlands, Naamloze Vennootschap

New Zealand, Limited Company

Nicaragua, Compania Anonima

Nigeria, Public Limited Company

Northern Mariana Islands, Corporation

Norway, Aksjeselskap

Pakistan, Public Limited Company

Panama, Sociedad Anonima

Paraguay, Sociedad Anonima

Peru, Sociedad Anonima

Philippines, Stock Corporation

Poland, Spolka Akcyjna

Portugal, Sociedade Anonima

Puerto Rico, Corporation

Romania, Societe pe Actiuni

Russia, Otkrytoye Aktsionernoy

Obshchestvo

Saudi

Arabia,

Sharikat

AlMossahamah

Singapore, Public Limited Company

Slovak Republic, Akciova Spolocnost

South Africa, Public Limited Company

Spain, Sociedad Anonima

Surinam, Naamloze Vennootschap

Sweden, Publika Aktiebolag

Switzerland, Aktiengesellschaft

Thailand,

Borisat

Chamkad

(Mahachon)

Trinidad and Tobago, Public Limited

Company

17

Tunisia, Societe Anonyme

Turkey, Anonim Sirket

Ukraine, Aktsionerne Tovaristvo

Vidkritogo Tipu

United Kingdom, Public Limited

Company

United States Virgin Islands, Corporation

Uruguay, Sociedad Anonima

Venezuela, Sociedad Anonima or

Compania Anonima

(ii) Exceptions in certain cases. The

following entities will not be treated as

corporations under paragraph (b)(8)(i) of

this section:

(A) With regard to Canada, any corporation or company formed under any

federal or provincial law which provides

that the liability of all of the members

of such corporation or company will be

unlimited; and

(B) With regard to India, a company

deemed to be a public limited company

solely by operation of Section 43A(1)

(relating to corporate ownership of the

company), section 43A(1A) (relating to

annual average turnover), or section

43A(1B) (relating to ownership interests

in other companies) of the Companies

Act, 1956 (or any combination of these),

provided that the organizational documents of such deemed public limited

company continue to meet the requirements of section 3(1)(iii) of the Companies Act, 1956.

(iii) Public companies. With regard to

Cyprus, Hong Kong, Jamaica, and

Trinidad and Tobago, the term public

limited company includes any limited

company which is not a private limited

company under the laws of those jurisdictions.

(iv) Limited companies. Any reference to a limited company (whether

public or private) in paragraph (b)(8)(i)

of this section includes, as the case may

be, companies limited by shares and

companies limited by guarantee.

(v) Multilingual countries. Different

linguistic renderings of the name of an

entity listed in paragraph (b)(8)(i) of this

section shall be disregarded. For example, an entity formed under the laws

of Switzerland as a Societe Anonyme

will be a corporation and treated in the

same manner as an Aktiengesellschaft.

(c) Other business entities. For federal tax purposes—

(1) The term partnership means a

business entity that is not a corporation

under paragraph (b) of this section and

that has at least two members.

(2) Wholly owned entities—(i) In

general. A business entity that has a

single owner and is not a corporation

under paragraph (b) of this section is

disregarded as an entity separate from

its owner.

(ii) Special rule for certain business

entities. If the single owner of a business entity is a bank (as defined in

section 581), then the special rules applicable to banks will continue to apply

to the single owner as if the wholly

owned entity were a separate entity.

(d) Special rule for certain foreign

business entities—(1) In general. Except

as provided in paragraph (d)(3) of this

section, a foreign business entity described in paragraph (b)(8)(i) of this

section will not be treated as a corporation under paragraph (b)(8)(i) of this

section if—

(i) The entity was in existence on

May 8, 1996;

(ii) The entity’s classification was relevant (as defined in § 301.7701–3(d))

on May 8, 1996;

(iii) No person (including the entity)

for whom the entity’s classification was

relevant on May 8, 1996, treats the

entity as a corporation for purposes of

filing such person’s federal income tax

returns, information returns, and withholding documents for the taxable year

including May 8, 1996;

(iv) Any change in the entity’s

claimed classification within the sixty

months prior to May 8, 1996, occurred

solely as a result of a change in the

organizational documents of the entity,

and the entity and all members of the

entity recognized the federal tax consequences of any change in the entity’s

classification within the sixty months

prior to May 8, 1996;

(v) A reasonable basis (within the

meaning of section 6662) existed on

May 8, 1996, for treating the entity as

other than a corporation; and

(vi) Neither the entity nor any member was notified in writing on or before

May 8, 1996, that the classification of

the entity was under examination (in

which case the entity’s classification

will be determined in the examination).

(2) Binding contract rule. If a foreign

business entity described in paragraph

(b)(8)(i) of this section is formed after

May 8, 1996, pursuant to a written

binding contract (including an accepted

bid to develop a project) in effect on

May 8, 1996, and all times thereafter, in

which the parties agreed to engage (directly or indirectly) in an active and

substantial business operation in the jurisdiction in which the entity is formed,

paragraph (d)(1) of this section will be

applied to that entity by substituting the

date of the entity’s formation for May 8,

1996.

(3) Termination of grandfather status—(i) In general. An entity that is not

treated as a corporation under paragraph

(b)(8)(i) of this section by reason of

paragraph (d)(1) or (d)(2) of this section

will be treated permanently as a corporation under paragraph (b)(8)(i) of this

section from the earliest of:

(A) The effective date of an election

to be treated as an association under

§ 301.7701–3;

(B) A termination of the partnership

under section 708(b)(1)(B) (regarding

sale or exchange of 50 percent or more

of the total interest in an entity’s capital

or profits within a twelve month period); or

(C) A division of the partnership under section 708(b)(2)(B).

(ii) Special rule for certain entities.

For purposes of paragraph (d)(2) of this

section, paragraph (d)(3)(i)(B) of this

section shall not apply if the sale or

exchange of interests in the entity is to a

related person (within the meaning of

sections 267(b) and 707(b)) and occurs

no later than twelve months after the

date of the formation of the entity.

(e) Effective date. The rules of this

section are effective as of January 1,

1997.

§ 301.7701–3 Classification of certain

business entities.

(a) In general. A business entity that

is not classified as a corporation under

§ 301.7701–2(b)(1), (3), (4), (5), (6),

(7), or (8) (an eligible entity) can elect

its classification for federal tax purposes

as provided in this section. An eligible

entity with at least two members can

elect to be classified as either an association (and thus a corporation under

§ 301.7701–2(b)(2)) or a partnership,

and an eligible entity with a single

owner can elect to be classified as an

association or to be disregarded as an

entity separate from its owner. Paragraph (b) of this section provides a

default classification for an eligible entity that does not make an election.

Thus, elections are necessary only when

an eligible entity chooses to be classified initially as other than the default

classification or when an eligible entity

chooses to change its classification. An

entity whose classification is determined

under the default classification retains

that classification (regardless of any

changes in the members’ liability that

18

occurs at any time during the time that

the entity’s classification is relevant as

defined in paragraph (d) of this section)

until the entity makes an election to

change that classification under paragraph (c)(1) of this section. Paragraph

(c) of this section provides rules for

making express elections. Paragraph (d)

of this section provides special rules for

foreign eligible entities. Paragraph (e) of

this section provides special rules for

classifying entities resulting from partnership terminations and divisions under

section 708(b). Paragraph (f) of this

section sets forth the effective date of

this section and a special rule relating to

prior periods.

(b) Classification of eligible entities

that do not file an election—(1) Domestic eligible entities. Except as provided

in paragraph (b)(3) of this section, unless the entity elects otherwise, a domestic eligible entity is—

(i) A partnership if it has two or

more members; or

(ii) Disregarded as an entity separate

from its owner if it has a single owner.

(2) Foreign eligible entities—(i) In

general. Except as provided in paragraph (b)(3) of this section, unless the

entity elects otherwise, a foreign eligible

entity is—

(A) A partnership if it has two or

more members and at least one member

does not have limited liability;

(B) An association if all members

have limited liability; or

(C) Disregarded as an entity separate

from its owner if it has a single owner

that does not have limited liability.

(ii) Definition of limited liability. For

purposes of paragraph (b)(2)(i) of this

section, a member of a foreign eligible

entity has limited liability if the member

has no personal liability for the debts of

or claims against the entity by reason of

being a member. This determination is

based solely on the statute or law pursuant to which the entity is organized,

except that if the underlying statute or

law allows the entity to specify in its

organizational documents whether the

members will have limited liability, the

organizational documents may also be

relevant. For purposes of this section, a

member has personal liability if the

creditors of the entity may seek satisfaction of all or any portion of the debts or

claims against the entity from the member as such. A member has personal

liability for purposes of this paragraph

even if the member makes an agreement

under which another person (whether or

not a member of the entity) assumes

such liability or agrees to indemnify that

member for any such liability.

(3) Existing eligible entities—(i) In

general. Unless the entity elects otherwise, an eligible entity in existence prior

to the effective date of this section will

have the same classification that the

entity claimed under §§ 301.7701–1

through 301.7701–3 as in effect on the

date prior to the effective date of this

section; except that if an eligible entity

with a single owner claimed to be a

partnership under those regulations, the

entity will be disregarded as an entity

separate from its owner under this paragraph (b)(3)(i). For special rules regarding the classification of such entities for

periods prior to the effective date of this

section, see paragraph (f)(2) of this

section.

(ii) Special rules. For purposes of

paragraph (b)(3)(i) of this section, a

foreign eligible entity is treated as being

in existence prior to the effective date of

this section only if the entity’s classification was relevant (as defined in paragraph (d) of this section) at any time

during the sixty months prior to the

effective date of this section. If an entity

claimed different classifications prior to

the effective date of this section, the

entity’s classification for purposes of

paragraph (b)(3)(i) of this section is the

last classification claimed by the entity.

If a foreign eligible entity’s classification is relevant prior to the effective

date of this section, but no federal tax or

information return is filed or the federal

tax or information return does not indicate the classification of the entity, the

entity’s classification for the period prior

to the effective date of this section is

determined under the regulations in effect on the date prior to the effective

date of this section.

(c) Elections—(1) Time and place for

filing—(i) In general. Except as provided in paragraphs (c)(1)(iv) and (v) of

this section, an eligible entity may elect

to be classified other than as provided

under paragraph (b) of this section, or to

change its classification, by filing Form

8832, Entity Classification Election,

with the service center designated on

Form 8832. An election will not be

accepted unless all of the information

required by the form and instructions,

including the taxpayer identifying number of the entity, is provided on Form

8832. See § 301.6109–1 for rules on

applying for and displaying Employer

Identification Numbers.

(ii) Further notification of elections.

An eligible entity required to file a

federal tax or information return for the

taxable year for which an election is

made under paragraph (c)(1)(i) of this

section must attach a copy of its Form

8832 to its federal tax or information

return for that year. If the entity is not

required to file a return for that year, a

copy of its Form 8832 must be attached

to the federal income tax or information

return of any direct or indirect owner of

the entity for the taxable year of the

owner that includes the date on which

the election was effective. An indirect

owner of the entity does not have to

attach a copy of the Form 8832 to its

return if an entity in which it has an

interest is already filing a copy of the

Form 8832 with its return. If an entity,

or one of its direct or indirect owners,

fails to attach a copy of a Form 8832 to

its return as directed in this section, an

otherwise valid election under paragraph

(c)(1)(i) of this section will not be

invalidated, but the non-filing party may

be subject to penalties, including any

applicable penalties if the federal tax or

information returns are inconsistent with

the entity’s election under paragraph

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

(iii) Effective date of election. An

election made under paragraph (c)(1)(i)

of this section will be effective on the

date specified by the entity on Form

8832 or on the date filed if no such date

is specified on the election form. The

effective date specified on Form 8832

can not be more than 75 days prior to

the date on which the election is filed

and can not be more than 12 months

after the date on which the election is

filed. If an election specifies an effective

date more than 75 days prior to the date

on which the election is filed, it will be

effective 75 days prior to the date it was

filed. If an election specifies an effective

date more than 12 months from the date

on which the election is filed, it will be

effective 12 months after the date it was

filed. If an election specifies an effective

date before January 1, 1997, it will be

effective as of January 1, 1997.

(iv) Limitation. If an eligible entity

makes an election under paragraph

(c)(1)(i) of this section to change its

classification (other than an election

made by an existing entity to change its

classification as of the effective date of

this section), the entity cannot change its

classification by election again during

the sixty months succeeding the effective date of the election. However, the

Commissioner may permit the entity to

change its classification by election

within the sixty months if more than

19

fifty percent of the ownership interests

in the entity as of the effective date of

the subsequent election are owned by

persons that did not own any interests in

the entity on the filing date or on the

effective date of the entity’s prior election.

(v) Deemed elections—(A) Exempt

organizations. An eligible entity that has

been determined to be, or claims to be,

exempt from taxation under section

501(a) is treated as having made an

election under this section to be classified as an association. Such election will

be effective as of the first day for which

exemption is claimed or determined to

apply, regardless of when the claim or

determination is made, and will remain

in effect unless an election is made

under paragraph (c)(1)(i) of this section

after the date the claim for exempt

status is withdrawn or rejected or the

date the determination of exempt status

is revoked.

(B) Real estate investment trusts. An

eligible entity that files an election under section 856(c)(1) to be treated as a

real estate investment trust is treated as

having made an election under this

section to be classified as an association.

Such election will be effective as of the

first day the entity is treated as a real

estate investment trust.

(vi) Examples. The following examples illustrate the rules of this paragraph (c)(1):

Example 1. On July 1, 1998, X, a domestic

corporation, purchases a 10% interest in Y, an

eligible entity formed under Country A law in

1990. The entity’s classification was not relevant

to any person for federal tax or information

purposes prior to X’s acquisition of an interest in

Y. Thus, Y is not considered to be in existence on

the effective date of this section for purposes of

paragraph (b)(3) of this section. Under the applicable Country A statute, all members of Y have

limited liability as defined in paragraph (b)(2)(ii)

of this section. Accordingly, Y is classified as an

association under paragraph (b)(2)(i)(B) of this

section unless it elects under this paragraph (c) to

be classified as a partnership. To be classified as a

partnership as of July 1, 1998, Y must file a Form

8832 by September 13, 1998. See paragraph

(c)(1)(i) of this section. Because an election

cannot be effective more than 75 days prior to the

date on which it is filed, if Y files its Form 8832

after September 13, 1998, it will be classified as

an association from July 1, 1998, until the effective date of the election. In that case, it could not

change its classification by election under this

paragraph (c) during the sixty months succeeding

the effective date of the election.

Example 2. (i) Z is an eligible entity formed

under Country B law and is in existence on the

effective date of this section within the meaning of

paragraph (b)(3) of this section. Prior to the

effective date of this section, Z claimed to be

classified as an association. Unless Z files an

election under this paragraph (c), it will continue

to be classified as an association under paragraph

(b)(3) of this section.

(ii) Z files a Form 8832 pursuant to this

paragraph (c) to be classified as a partnership,

effective as of the effective date of this section. Z

can file an election to be classified as an association at any time thereafter, but then would not be

permitted to change its classification by election

during the sixty months succeeding the effective

date of that subsequent election.

(2) Authorized signatures—(i) In general. An election made under paragraph

(c)(1)(i) of this section must be signed

by—

(A) Each member of the electing entity who is an owner at the time the

election is filed; or

(B) Any officer, manager, or member

of the electing entity who is authorized

(under local law or the entity’s organizational documents) to make the election

and who represents to having such authorization under penalties of perjury.

(ii) Retroactive elections. For purposes of paragraph (c)(2)(i) of this section, if an election under paragraph

(c)(1)(i) of this section is to be effective

for any period prior to the time that it is

filed, each person who was an owner

between the date the election is to be

effective and the date the election is

filed, and who is not an owner at the

time the election is filed, must also sign

the election.

(d) Special rules for foreign eligible

entities—(1) For purposes of this section, a foreign eligible entity’s classification is relevant when its classification

affects the liability of any person for

federal tax or information purposes. For

example, a foreign entity’s classification

would be relevant if U.S. income was

paid to the entity and the determination

by the withholding agent of the amount

to be withheld under chapter 3 of the

Internal Revenue Code (if any) would

vary depending upon whether the entity

is classified as a partnership or as an

association. Thus, the classification

might affect the documentation that the

withholding agent must receive from the

entity, the type of tax or information

return to file, or how the return must be

prepared. The date that the classification

of a foreign eligible entity is relevant is

the date an event occurs that creates an

obligation to file a federal tax return,

information return, or statement for

which the classification of the entity

must be determined. Thus, the classification of a foreign entity is relevant, for

example, on the date that an interest in

the entity is acquired which will require

a U.S. person to file an information

return on Form 5471.

(2) Special rule when classification is

no longer relevant. If the classification

of a foreign eligible entity which was

previously relevant for federal tax purposes ceases to be relevant for sixty

consecutive months, the entity’s classification will initially be determined under

the default classification when the classification of the foreign eligible entity

again becomes relevant. The date that

the classification of a foreign entity

ceases to be relevant is the date an

event occurs that causes the classification to no longer be relevant, or, if no

event occurs in a taxable year that

causes the classification to be relevant,

then the date is the first day of that

taxable year.

(e) Coordination with section 708(b).

Except as provided in § 301.7701–

2(d)(3) (regarding termination of grandfather status for certain foreign business

entities), an entity resulting from a

transaction described in section

708(b)(1)(B) (partnership termination

due to sales or exchanges) or section

708(b)(2)(B) (partnership division) is a

partnership.

(f) Effective date—(1) In general.

The rules of this section are effective as

of January 1, 1997.

(2) Prior treatment of existing entities. In the case of a business entity that

is not described in § 301.7701–2(b)(1),

(3), (4), (5), (6), or (7), and that was in

existence prior to January 1, 1997, the

entity’s claimed classification(s) will be

respected for all periods prior to January

1, 1997, if—

(i) The entity had a reasonable basis

(within the meaning of section 6662) for

its claimed classification;

(ii) The entity and all members of the

entity recognized the federal tax consequences of any change in the entity’s

classification within the sixty months

prior to January 1, 1997; and

(iii) Neither the entity nor any member was notified in writing on or before

May 8, 1996, that the classification of

the entity was under examination (in

which case the entity’s classification

will be determined in the examination).

Par. 8. Section 301.7701–4 is

amended as follows:

1. The last sentence of paragraphs

(b), (c)(1), (c)(2) Example 1, and (c)(2)

Example 3 are revised.

2. Paragraph (f) is added.

20

The revisions and addition read as

follows:

§ 301.7701–4 Trusts.

*

*

*

*

*

(b) Business trusts. * * * The fact

that any organization is technically cast

in the trust form, by conveying title to

property to trustees for the benefit of

persons designated as beneficiaries, will

not change the real character of the

organization if the organization is more

properly classified as a business entity

under § 301.7701–2.

(c) * * * (1) * * * An investment

trust with multiple classes of ownership

interests ordinarily will be classified as

a business entity under § 301.7701–2;

however, an investment trust with multiple classes of ownership interests, in

which there is no power under the trust

agreement to vary the investment of the

certificate holders, will be classified as a

trust if the trust is formed to facilitate

direct investment in the assets of the

trust and the existence of multiple

classes of ownership interests is incidental to that purpose.

(2) * * *

Example 1. * * * As a consequence,

the existence of multiple classes of trust

ownership is not incidental to any purpose of the trust to facilitate direct

investment, and, accordingly, the trust is

classified as a business entity under

§ 301.7701–2.

*

*

*

*

*

Example 3. * * * Accordingly, the

trust is classified as a business entity

under § 301.7701–2.

*

*

*

*

*

(f) Effective date. The rules of this

section generally apply to taxable years

beginning after December 31, 1960.

Paragraph (e)(5) of this section contains

rules of applicability for paragraph (e)

of this section. In addition, the last

sentences of paragraphs (b), (c)(1), and

(c)(2) Example 1 and Example 3 of this

section are effective as of January 1,

1997.

Par. 9. Section 301.7701–6 is revised

to read as follows:

§ 301.7701–6 Definitions; person, fiduciary.

(a) Person. The term person includes

an individual, a corporation, a partnership, a trust or estate, a joint-stock

company, an association, or a syndicate,

group, pool, joint venture, or other unincorporated organization or group. The

term also includes a guardian, commit-

tee, trustee, executor, administrator,

trustee in bankruptcy, receiver, assignee

for the benefit of creditors, conservator,

or any person acting in a fiduciary

capacity.

(b) Fiduciary—(1) In general. Fiduciary is a term that applies to persons

who occupy positions of peculiar confidence toward others, such as trustees,

executors, and administrators. A fiduciary is a person who holds in trust an

estate to which another has a beneficial

interest, or receives and controls income

of another, as in the case of receivers. A

committee or guardian of the property

of an incompetent person is a fiduciary.

(2) Fiduciary distinguished from

agent. There may be a fiduciary relationship between an agent and a principal, but the word agent does not denote

a fiduciary. An agent having entire

charge of property, with authority to

effect and execute leases with tenants

entirely on his own responsibility and

without consulting his principal, merely

turning over the net profits from the

property periodically to his principal by

virtue of authority conferred upon him

by a power of attorney, is not a fiduciary within the meaning of the Internal

Revenue Code. In cases when no legal

trust has been created in the estate

controlled by the agent and attorney, the

liability to make a return rests with the

principal. (c) Effective date. The rules

of this section are effective as of January 1, 1997.

§ 301.7701–7 [Removed]

Par. 10. Section 301.7701–7 is removed.

PART 602—OMB CONTROL

NUMBERS UNDER THE

PAPERWORK REDUCTION ACT

Par. 11. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

§ 602.101 [Amended]

Par. 12. In § 602.101, paragraph (c)

is amended by adding a new entry in

numerical order to the table to read as

follows:

§ 602.101 OMB Control numbers.

*

*

*

(c) * * *

21

*

*

CFR part or section where

identified or described

Current OMB

control No.

*

*

*

*

*

301.7701–3 . . . . . . . . . . . . . . . . 1545–1486

*

*

*

*

*

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved December 10, 1996.

Donald C. Lubick,

Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on

December 17, 1996, 8:45 a.m., and published in

the issue of the Federal Register for December 18,

1996, 61 F.R. 66584)

Section 7520.—Valuation Tables

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the

month of January 1997. See Rev. Rul. 97–1, page

10.

Section 7872.—Treatment of Loans

With Below-Market Interest Rates

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the

month of January 1997. See Rev. Rul. 97–1, page

10.

Part III. Administrative, Procedural, and Miscellaneous

Obsolescence of Revenue Rulings

and Revenue Procedures Under TD

8697, Simplification of Entity

Classification Regulations (Check

the Box)

Notice 97–1

This notice accompanies TD 8697,

Simplification of Entity Classification

Regulations (published in the Federal

Register on December 18, 1996). The

purpose of this notice is to alert taxpayers to the effect of the regulations on

existing revenue rulings and revenue

procedures that apply the prior classification regulations under § 7701 of the

Internal Revenue Code. Effective January 1, 1997, such revenue rulings and

revenue procedures are obsolete to the

extent that they use the prior classification regulations to distinguish between

partnerships and associations.

The Internal Revenue Service is compiling a list of these obsolete documents

that will be published in the Internal

Revenue Bulletin.

The principal author of this notice is

Mark D. Harris of the Office of Assistant Chief Counsel (Passthroughs and

Special Industries). For further information regarding this notice contact Mr.

Harris at (202) 622-3050 (not a toll-free

call).

Cash or Deferred Arrangements;

Nondiscrimination

Notice 97–2

This notice provides guidance and

transition relief relating to the revised

nondiscrimination rules under § 401(k)

and § 401(m) of the Internal Revenue

Code. The rules applicable to qualified

cash or deferred arrangements under

§ 401(k) and matching and employee

contributions under § 401(m) were

changed by the Small Business Job

Protection Act of 1996 (SBJPA), Pub. L.

104–188.

Under § 401(k) and § 401(m) of the

Code, the actual deferral percentage

(ADP) and the actual contribution percentage (ACP) of highly compensated

employees (HCEs) are compared with

those of nonhighly compensated employees (NHCEs). Section 1433(c) of

the SBJPA amends § 401(k)(3)(A) and

§ 401(m)(2)(A), effective for plan years

beginning after December 31, 1996, to

provide for the use of prior year data in

determining the ADP and ACP of

NHCEs, while current year data is used

for HCEs. Alternatively, an employer

may elect to use current year data for

determining the ADP and ACP for both

HCEs and NHCEs, but this election may

only be changed as provided by the

Secretary. Prior to the effective date of

these amendments, plans must use current year data in determining the ADP

and ACP for both HCEs and NHCEs.

Section 1433(e) of the SBJPA amends

§ 401(k)(8)(C) and § 401(m)(6)(C), effective for plan years beginning after

December 31, 1996, to provide that the

distribution of excess contributions and

excess aggregate contributions will be

made on the basis of the amount of

contributions by, or on behalf of, each

HCE. Prior to the effective date of these

amendments, plans must distribute excess contributions and excess aggregate

contributions using a method based on

the actual deferral ratio or actual contribution ratio of each HCE.

This notice provides guidance regarding the determination of the ADP and

ACP for NHCEs under § 401(k)(3)(A)(ii) and § 401(m)(2)(A) for plan

years beginning after December 31,

1996; transition relief for plans that

elect to use current year ADP or ACP

data for the 1997 plan year; and guidance regarding the distribution of excess

contributions and excess aggregate contributions under § 401(k)(8)(C) and

§ 401(m)(6)(C) for plan years beginning

after December 31, 1996.

I. DETERMINATION OF ADP AND

ACP FOR NHCEs USING PRIOR

YEAR DATA

Section 401(k)(3)(A)(ii), as amended,

provides that a cash or deferred arrangement will not be treated as a qualified

cash or deferred arrangement unless the

actual deferral percentage for eligible

HCEs for the plan year meets a nondiscrimination test when compared to the

actual deferral percentage for all other

eligible employees for the preceding

plan year. Thus, as amended,

§ 401(k)(3)(A)(ii) generally requires the

comparison of the current year’s ADP

for HCEs to the prior year’s ADP for

NHCEs.

For purposes of § 401(k)(3)(A)(ii),

the actual deferral percentage for all

other eligible employees for the preceding plan year is the ADP for the preceding plan year for the group of employees who were NHCEs in the preceding

22

plan year, using the definition of HCE

in effect for the preceding plan year.

Thus, for purposes of § 401(k)(3)(A)(ii), the individuals taken into account in determining the prior year’s

ADP for NHCEs are those individuals

who were NHCEs during the preceding

year, without regard to the individuals’

status in the current year. For example,

an individual who was an NHCE for the

preceding plan year is included in this

calculation even if the individual is no

longer employed by the employer or has

become an HCE in the current plan

year.

As a result, the prior year’s ADP for

NHCEs can be calculated as soon as the

necessary data on prior year status,

contributions and compensation become

available. For example, for the 1997

plan year, if a plan does not provide for

matching contributions described in

§ 401(m)(4)(A) or qualified nonelective

contributions described in § 401(m)(4)(C), the ADP for the 1997 plan year

of HCEs will be compared with the

ADP for the 1996 plan year of NHCEs

in 1996, i.e., with the same ADP used in

nondiscrimination testing for the 1996

plan year under prior law. Future guidance will address the conditions under

which and the extent to which matching

contributions described in § 401(m)(4)(A) and qualified nonelective contributions described in § 401(m)(4)(C)

may be taken into account in determining the current or prior year’s ADP or

ACP for NHCEs in nondiscrimination

testing for the 1997 plan year and future

plan years.

For purposes of determining the prior

year’s ACP for NHCEs under

§ 401(m)(2)(A), as amended, rules similar to those used in determining the

prior year’s ADP for NHCEs under

§ 401(k)(3)(A)(ii) will apply.

II. TRANSITION RELIEF FOR PLANS

USING CURRENT YEAR ADP OR

ACP DATA FOR THE 1997 PLAN

YEAR

Under

§ 401(k)(3)(A)(ii)

and

§ 401(m)(2)(A), as amended, an employer that elects to use current year

data in determining the ADP or ACP of

NHCEs for the 1997 plan year or for

later plan years must continue to use

current year data for all future plan

years, unless the election is changed in a

manner provided by the Secretary.

Under the transition relief provided

by this notice, a plan that uses current

year data in determining the ADP or

ACP of NHCEs for the 1997 plan year

will be permitted to use prior year data

for the 1998 plan year without receiving

approval from the Service. For the 1997

plan year, no plan amendment or formal

election is required to be made in 1996

or 1997 in order to continue to use

current year data in determining the

ADP of NHCEs. The Treasury and the

Service intend to issue guidance regarding the conditions under which employers that elect to use current year data for

the 1998 or a later plan year may switch

to using prior year data for subsequent

plan years.

III. DISTRIBUTION OF EXCESS

CONTRIBUTIONS AND EXCESS AGGREGATE CONTRIBUTIONS

Section 401(k)(8), as amended, provides a new procedure for correcting a

plan’s failure to meet the nondiscrimination test of § 401(k)(3). Under

§ 401(k)(8)(B), which was not amended

by the SBJPA, an excess contribution is

determined for each HCE. Section

401(k)(8)(C), prior to amendment, and

§ 1.401(k)-1(f)(2) of the Income Tax

Regulations provided for the distribution

of this amount to each HCE. Parallel

rules applied to correction of failure to

satisfy the nondiscrimination test of

§ 401(m).

The SBJPA amended § 401(k)(8)(C)

to provide that distributions of excess

contributions for any plan year are made

to HCEs on the basis of the amount of

contributions by, or on behalf of, each

HCE. This amendment does not affect

the total amount of the excess contributions to be distributed, but merely reallocates the distributions among the

HCEs.

Accordingly, in order to distribute

excess contributions under § 401(k)(8),

as amended, the following procedure is

used:

1. Calculate the dollar amount of

excess contributions for each affected HCE in a manner described

in § 401(k)(8)(B) and § 1.401(k)1(f)(2). However, in applying these

rules, rather than distributing the

amount necessary to reduce the

actual deferral ratio (ADR) of each

affected HCE in order of these

employees’ ADRs, beginning with

the highest ADR, the plan uses

these amounts in step 2.

2. Determine the total of the dollar

amounts calculated in step 1.

This total amount in step 2 (total

excess contributions) should be distributed in accordance with steps 3 and 4

below:

3. The elective contributions of the

HCE with the highest dollar

amount of elective contributions are

reduced by the amount required to

cause that HCE’s elective contributions to equal the dollar amount of

the elective contributions of the

HCE with the next highest dollar

amount of elective contributions.

This amount is then distributed to

the HCE with the highest dollar

amount. However, if a lesser reduction, when added to the total dollar

amount already distributed under

this step, would equal the total

excess contributions, the lesser reduction amount is distributed.

4. If the total amount distributed is

less than the total excess contributions, step 3 is repeated.

If these distributions are made, the

cash or deferred arrangement is treated

as meeting the nondiscrimination test of

§ 401(k)(3) regardless of whether the

ADP, if recalculated after distributions,

would satisfy § 401(k)(3).

A parallel method is used for the

purpose of recharacterizing excess contributions under § 401(k)(8)(A)(ii) and

for distributing excess aggregate contributions under § 401(m)(6)(C), as

amended.

After excess and excess aggregate

contributions, if any, have been distributed using the method described above,

the multiple use test of § 401(m)(9) is

applied. For purposes of § 401(m)(9), if

a corrective distribution of excess contributions has been made, or a

recharacterization has occurred, the ADP

for HCEs is deemed to be the largest

amount permitted under § 401(k)(3).

Similarly, if a corrective distribution of

excess aggregate contributions has been

made, the ACP for HCEs is deemed to

be the largest amount permitted under

§ 401(m)(2).

The method described above for distributing excess contributions is illustrated by the following example:

For the 1997 plan year, HCE 1 has

elective contributions of $8,500 and

$85,000 in compensation, for an ADR

of 10%, and HCE 2 has elective contributions of $9,500 and compensation of

$158,333, for an ADR of 6%. As a

result, the ADP for the 2 HCEs under

the plan (HCE 1 and HCE 2) is 8%.

The ADP for the NHCEs is 3%. Under

the ADP test of § 401(k)(3)(A)(ii), the

23

ADP of the two HCEs under the plan

may not exceed 5% (i.e., 2 percentage

points more than the ADP of the

NHCEs under the plan).

Pursuant to § 401(k)(8)(B), § 1.401(k)-1(f)(2), and this notice, the total

excess contributions for the HCEs is

determined as follows:

Step 1. The elective contributions of

HCE 1 (the HCE with the highest

ADR) are reduced by $3,400 in order

to reduce the ADR of HCE 1 to 6%

($5,100/$85,000), which is the ADR

of HCE 2. Because the ADP of the

HCEs still exceeds 5%, the ADP test

of § 401(k)(3)(A)(ii) is not satisfied

and further reductions in elective contributions are necessary. The elective

contributions of HCE 1 and HCE 2

are each reduced by one percent of

compensation ($850 and $1,583 respectively). Because the ADP of the

HCEs now equals 5%, the ADP test

of § 401(k)(3)(A)(ii) is satisfied, and

no further reductions in elective contributions are necessary.

Step 2. The total excess contributions

for the HCEs that must be distributed

equal $5,833, the total reductions in

elective contributions under step 1

($3,400 + $850 + $1,583).

Pursuant to § 401(k)(8)(C), the $5,833

in total excess contributions for the 1997

plan year would then be distributed as

follows:

Step 3. The plan distributes $1,000 in

elective contributions to HCE 2 (the

HCE with the highest dollar amount

of elective contributions) in order to

reduce the dollar amount of the elective contributions of HCE 2 to

$8,500, which is the dollar amount of

the elective contributions of HCE 1.

Step 4. Because the total amount distributed ($1,000) is less than the total

excess contributions ($5,833), step 3

must be repeated. As the dollar

amounts of remaining elective contributions for both HCE 1 and HCE 2

are equal, the remaining $4,833 of

excess contributions is then distributed equally to HCE 1 and HCE 2 in

the amount of $2,416.50 each.

Under this example, HCE 1 must

receive a total distribution of $2,416.50

of excess contributions, and HCE 2

must receive a total distribution of

$3,416.50 of excess contributions. This

is true even though the ADR of HCE 1

exceeded the ADR of HCE 2. The plan

is now treated as satisfying the nondiscrimination test of § 401(k)(3) even

though the ADP would fail to satisfy

§ 401(k)(3), if recalculated after distributions.

COMMENTS REQUESTED

The Treasury and the Service invite

comments and suggestions regarding the

matters discussed in this notice. Comments are specifically requested concerning:

—The use of qualified matching and

qualified nonelective contributions in

computing the prior year’s ADP for

NHCEs, including methods of preventing inappropriate double counting.

—The appropriate determination of

the prior year’s ADP for NHCEs when

the group of employees tested is significantly different in the current year than

in the prior year.

Comments can be addressed to

CC:DOM:CORP:R (Notice 97–2), room

5228, Internal Revenue Service, POB

7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, comments

may be hand delivered between the

hours of 8 a.m. and 5 p.m. to

CC:DOM:CORP:R (Notice 97–2), Courier’s Desk, Internal Revenue Service,

1111 Constitution Avenue NW., Washington, DC. Alternatively, taxpayers may

transmit comments electronically

via the IRS Internet site at http://

www.irs.ustreas.gov/prod/tax_regs/

comments/html.

DRAFTING INFORMATION

The principal authors of this notice

are Kenneth Conn of the Employee

Plans Division and Catherine Fernandez

of the Office of the Associate Chief

Counsel (Employee Benefits and Exempt Organizations). For further information regarding this notice, contact the

Employee Plans Division’s telephone assistance service between 1:30 and 4:00

p.m., Eastern Time, Monday through

Thursday at (202) 622–6074/75 or Kenneth Conn at (202) 622–6214. (These

telephone numbers are not toll-free

numbers.)

Subchapter S Corporation

Subsidiaries

Notice 97–4

PURPOSE

Section 1308 of the Small Business

Job Protection Act of 1996, Pub. L. No.

104–188, 110 Stat. 1755 (the Act) modified § 1361 of the Internal Revenue

Code to permit an S corporation (1) to

own 80 percent or more of the stock of

a C corporation, and (2) to elect to own

a qualified subchapter S subsidiary

(QSSS).

To help taxpayers comply with the

law, the Department of the Treasury and

the Internal Revenue Service intend to

issue regulations interpreting § 1308 of

the Act. This notice solicits comments

from taxpayers and practitioners regarding the issues listed below. However,

any other comments concerning the

changes made by § 1308 of the Act will

be considered in developing regulatory

guidance. This notice also provides temporary guidance on the manner in which

a QSSS election must be made and the

effective date of the election.

BACKGROUND

Prior law prohibited a subchapter S

corporation from owning 80 percent or

more of the stock of another corporation. Furthermore, an S corporation

could not have a corporation as a shareholder. Congress modified these constraints by enacting § 1308 of the Act,

effective for taxable years beginning

after December 31, 1996. The Act added

new §§ 1361(b)(3), 1362(d)(3)(F), and

1504(b)(8) to the Code, while removing

§ 1361(b)(2)(A) and 1361(c)(6).

By removing § 1361(b)(2)(A), the

Act permits an S corporation to own 80

percent or more of a C corporation. At

the same time, new § 1504(b)(8) prevents an S corporation from joining in

the filing of a consolidated return with

its affiliated C corporations, but does

not prevent the C corporation subsidiary

from filing a consolidated return with its

affiliated C corporations. See H.R. Conf.

Rep. No. 737, 104th Cong., 2d Sess.

224 (1996).

Under prior law, the S election of a

corporation with C earnings and profits

terminated if that S corporation received

passive income, including dividends, in

excess of 25 percent of gross receipts

for 3 consecutive years. Section

1363(d)(3)(F) modifies that general rule

by excluding dividends from passive

investment income to the extent that the

dividends are attributable to the active

conduct of a trade or business of a C

corporation in which the S corporation

has an 80 percent or greater ownership

interest. However, neither the Act nor

the legislative history provides rules for

determining the attribution of dividends

to an active trade or business.

24

New § 1361(b)(3)(B) defines the

term ‘‘qualified subchapter S subsidiary’’ as a domestic corporation that is

not an ineligible corporation, if (1) an S

corporation holds 100 percent of the

stock of the corporation, and (2) that S

corporation elects to treat the subsidiary

as a QSSS. Section 1361(b)(3)(A) provides that a corporation that is a QSSS

is not treated as a separate corporation,

and all assets, liabilities, and items of

income, deduction, and credit of the

QSSS are treated as assets, liabilities,

and items of income, deduction, and

credit of the parent S corporation.

The statutory provisions do not provide guidance on how the corporation

makes the election, the effective date of

the election, or how the commingling of

assets, liabilities, and other items occurs

after the election is made. The legislative history, however, indicates that

when the parent corporation makes the

election, the subsidiary will be deemed

to have liquidated under §§ 332 and

337 immediately before the election is

effective. See S. Rep. No. 281, 104th

Cong., 2d Sess. 53 (1996)(Senate Report); H.R. Rep. No. 586, 104th Cong.,

2d Sess. 89 (1996)(House Report).

Where the S corporation acquires the

stock of the subsidiary in a qualified

stock purchase, the corporation may

make an election under § 338 with

respect to the subsidiary.

Section 1361(b)(3)(C) provides that

any QSSS that ceases to meet the

requirements of § 1361(b)(3)(B) will be

treated as a new corporation acquiring

all of its assets (and assuming all of its

liabilities) immediately before the cessation from its S corporation parent in a

deemed exchange for the subsidiary’s

stock.

Upon

the

termination,

§ 1361(b)(3)(D) provides that the

former QSSS (and any successor corporation) is not eligible to make either a

QSSS election or an election to be

treated as an S corporation before its

fifth taxable year that begins after the

first taxable year for which the termination is effective, unless the Secretary

consents to the election.

REQUEST FOR COMMENTS

The Service and Treasury invite comments from the public on issues that

should be addressed in proposed regulations implementing § 1308 of the Act.

The Service is particularly interested in

receiving comments on the following:

1) The attribution of dividends received by an S corporation from an 80

percent or greater owned C corporation

between earnings and profits attributable

to the active conduct of a trade or

business or to passive investments of the

C corporation, particularly in situations

where the C corporation is a member of

an affiliated group that files a consolidated return;

2) Issues arising upon the formation

of a QSSS, including those arising from

the operation of §§ 332 and 337 or

§ 338;

3) Issues arising upon the termination

of a QSSS; and

4) Issues arising when a QSSS election is made for a subsidiary that is a

member of a consolidated group. Written comments should be sent to the

following address:

Internal Revenue Service

CC:DOM:CORP (NT 97–4;

CC:DOM:P&SI:1)

P.O. Box 7604, Ben Franklin Station

Washington, DC 20044

In the alternative, comments may be

hand delivered between the hours of

8:00 a.m. and 5:00 p.m. to the courier’s

desk at 1111 Constitution Avenue, NW.,

Washington, DC, or submitted electronically via the IRS internet site at http://

www.irs.ustreas.gov/prod/tax_regs/

comments.html.

TEMPORARY QSSS ELECTION

PROCEDURE

The legislative history supporting

§ 1308 of the Act indicates that when a

parent corporation makes an election to

treat a subsidiary as a QSSS, the subsidiary will be deemed to have liquidated

under §§ 332 and 337 immediately before the election is effective. See Senate

Report at 53; House Report at 89. When

a corporation liquidates under § 332,

that corporation must file a Corporate

Dissolution or Liquidation Form 966

within 30 days of the adoption of a

liquidating plan or resolution. In addition, that corporation must file a return

for the short period ending on the date

that it goes out of existence.

The Service and Treasury intend to

issue regulations describing the manner

in which a QSSS election must be made

and the effective date of the election.

Until regulations are issued, however,

taxpayers should follow the procedures

listed in this notice to satisfy the election requirements.

To make the QSSS election, the parent corporation should file a Form 966

with the Service Center. When completing the form, the parent corporation

should follow the instructions applicable

to that form with the following modifications:

1. At the top of the Form 966, print

‘‘FILED PURSUANT TO NOTICE 97–4.’’

2. In the box labeled ‘‘Employer

identification number’’ (EIN), enter

the subsidiary’s EIN (if applicable). If the subsidiary was not in

existence prior to the time of election and does not have an EIN,

there will be no need to obtain a

taxpayer identification number for

the subsidiary. In this case, insert

‘‘QSSS’’ in the box. (If the parent

corporation chooses to obtain an

EIN for the newly-formed QSSS,

the parent should check ‘‘Other’’

when asked the ‘‘Type of entity’’

on the SS–4, and specify that the

entity is a QSSS.)

3. In Box 4 on Form 966, enter the

desired effective date for the election. The election may be effective

on the date Form 966 is filed or up

to 75 days prior to the filing of

Form 966, provided that date is

not before the effective date of

§ 1308 of the Act and that the

subsidiary otherwise qualified as a

QSSS for the entire period for

which the retroactive election is in

effect. For these purposes, the requirement that Form 966 be filed

within 30 days of the date in Box

4 is ignored.

4. In Box 7c on Form 966, enter the

name of the parent. The parent’s

EIN should be included in Box 7d.

5. In Box 10 on Form 966, enter

‘‘§ 1361(b)(3)(B).’’

6. Form 966 must be signed by a

corporate officer authorized to sign

the PARENT’s tax return.

Banks and bank holding companies

should consult Notice 97–5, 1997–2

I.R.B., before filing an election under

the procedures listed above.

DRAFTING INFORMATION

The principal author of this notice is

Deanna L. Walton of the Office of

Assistant Chief Counsel (Passthroughs

and Special Industries). For further information regarding this notice contact

Ms. Walton at (202) 622–3050 (not a

toll-free call).

25

Subchapter S Banks — Sections

1362 and 265

Notice 97–5

BACKGROUND

Section 1315 of the Small Business

Job Protection Act of 1996 (the Act),

P.L. 104–188, amended § 1361(b)(2) of

the Internal Revenue Code to allow

banks (as defined in § 581) that do not

use the reserve method of accounting

for bad debts to qualify as small business corporations (and therefore qualify

to elect S corporation status), effective

for tax years beginning after December

31, 1996.

Section 1308(b) of the Act added new

§ 1361(b)(3) to allow an S corporation

to own a qualified subchapter S subsidiary (QSSS). A subsidiary qualifies as a

QSSS if (1) the subsidiary would be

eligible to elect subchapter S status if its

stock were owned directly by the shareholders of its S corporation parent; (2)

the S corporation parent owns 100 percent of the subsidiary’s stock; and (3)

the parent elects to treat the subsidiary

as a QSSS. If the QSSS election is

made, the subsidiary is not treated as a

separate corporation, and all the assets,

liabilities, and items of income, deduction, and credit of the subsidiary are

treated as the assets, liabilities, and

items of income, deduction, and credit

of the parent S corporation.

This notice provides guidance on the

effect of the QSSS election under

§ 1361(b)(3) on banks affiliated with

nonbanks; the application of the S corporation passive investment income

rules of § 1362(d)(3); the application of

the interest expense disallowance rules

of § 265; and an automatic change in

method of accounting for bad debts.

BANKS AFFILIATED WITH

NONBANKS

The Department of the Treasury and

the Internal Revenue Service are concerned that the interaction of § 1315

and § 1308(b) of the Act creates unintended and inappropriate results for

banks that are affiliated with nonbank

entities. Treasury and the IRS believe

that the special provisions of the Code

that apply to banks should apply only to

the specific state-law entity that qualifies as a bank under § 581 of the Code;

such special bank treatment should not

apply to nonbanks, even if the nonbank

is affiliated with a bank and the parent

elects to treat the subsidiary as a QSSS.

Treasury intends to work with Congress

on appropriate technical corrections to

the Act to clarify the tax treatment of

banks affiliated with nonbanks. It is

anticipated that any technical corrections

will be effective as of the effective date

of the Act. In the interim, banks (including banks for which QSSS elections are

made) should continue to comply with

applicable information reporting and filing requirements of the Code (e.g.,

§ 6049 (Returns Regarding Payments of

Interest)).

PASSIVE INVESTMENT INCOME

Under § 1362(d)(3)(A), the S election

of a corporation with accumulated earnings and profits terminates if the passive

investment income of the corporation

constitutes more than 25 percent of its

gross receipts for each of three consecutive tax years. In general, § 1362(d)(3)

defines ‘‘passive investment income’’ as

gross receipts derived from royalties,

rents, dividends, interest, annuities, and

sales or exchanges of stock or securities.

Passive investment income does not include gross receipts directly derived

from the active and regular conduct of a

lending or finance business, provided

the corporation meets the requirements

of § 542(c)(6) (lending or finance company excluded from the definition of

personal holding company).

Similarly, § 1.1362–2(c)(5)(iii)(B)(1)(i) provides that passive investment income does not include gross receipts

directly derived in the ordinary course

of a trade or business of lending or

financing. Under § 1.1362–2(c)(5)(iii)(B)(2), gross receipts directly derived in

the ordinary course of a trade or business of lending or financing include

gain (as well as interest income) from

loans originated in a lending business;

however, interest earned from the investment of idle funds in short-term

securities does not constitute gross receipts directly derived in the ordinary

course of business.

The Service will treat income earned

by an S corporation on the following

banking assets as gross receipts directly

derived from the active and regular

conduct of a banking business—

* All loans and REMIC regular interests owned, or considered to be

owned, by the bank regardless of

whether the loan originated in the

bank’s business. For these purposes, securities described in

§ 165(g)(2)(C) are not considered

loans.

* Assets required to be held to conduct a banking business (such as

Federal Reserve Bank, Federal

Home Loan Bank, or Federal Agricultural Mortgage Bank stock or

participation certificates issued by a

Federal Intermediate Credit Bank

which represent nonvoting stock in

the bank).

* Assets pledged to a third party to

secure deposits or business for the

bank (such as assets pledged to

qualify as a depository for federal

taxes or state funds).

* Investment assets (other than assets

specified in the preceding paragraphs) that are held by the bank to

satisfy reasonable liquidity needs

(including funds needed to meet

anticipated loan demands).

As a result, income and gain from

these assets will not be considered subject to the passive investment income

limitation applicable to S corporations.

INTEREST EXPENSE

DISALLOWANCE

Section 265(a)(2) denies taxpayers

(including banks) a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the

interest on which is wholly exempt from

federal income taxes.

Section 265(b) denies banks and other

financial institutions a deduction for the

portion of a bank’s interest expense that

is allocable to tax-exempt interest and

not otherwise disallowed by § 265(a).

The portion of a bank’s interest expense

that is allocable to tax-exempt interest is

an amount that bears the same ratio to

the interest expense as (1) the bank’s

average adjusted bases of tax-exempt

obligations acquired after August 7,

1986, bears to (2) the average adjusted

bases for all assets of the bank.

Section 1366(a)(1) requires S corporation shareholders to determine their tax

liability by taking into account their pro

rata share of the corporation’s

nonseparately computed income or loss

and their share of the items of income

(including tax-exempt income), loss, deduction, or credit the separate treatment

of which could affect the liability for

tax of any shareholder.

Because § 265(b) provides a special

disallowance rule for banks, the Service

will apply § 265(b) only at the bank

level in determining the amount, if any,

of the bank’s interest expense that is

disallowed. To the extent indebtedness

and tax-exempt obligations are taken

26

into account in applying § 265(b) at the

bank level, they are not taken into

account again in applying § 265(a) at

the shareholder level.

AUTOMATIC CHANGE IN METHOD

OF ACCOUNTING

The Service will issue further guidance granting permission for an automatic change in method of accounting

for banks that change from the reserve

method of accounting for bad debts.

This guidance will permit changes to be

effective as of the bank’s first taxable

year beginning after December 31,

1996. A bank that wishes to be an S

corporation effective January 1, 1997,

must file the change in method of

accounting and the S election by March

15, 1997.

The principal authors of this notice

are Martin Schäffer and Deane Burke of

the Office of Assistant Chief Counsel

(Passthroughs and Special Industries).

For further information regarding this

notice, contact Martin Schäffer or Deane

Burke at (202) 622–3080 (not a toll-free

call).

SIMPLE IRAs; Questions and

Answers

Notice 97–6

PURPOSE

The purpose of this notice is to

provide guidance, in the form of questions and answers, with respect to the

SIMPLE plan provisions that are part of

the Small Business Job Protection Act

of 1996 (‘‘SBJPA’’), Pub. Law. 104–

188.

Section 1421 of the SBJPA established a simplified tax-favored retirement plan for small employers

(‘‘SIMPLE plan’’) under section 408(p)

of the Internal Revenue Code. Contributions under a SIMPLE plan are made to

individual retirement accounts or annuities (‘‘SIMPLE IRAs’’) that are established pursuant to the SIMPLE plan

adopted by the employer.

This notice provides guidance solely

with respect to certain issues relating to

SIMPLE plans under section 1421 of

the SBJPA. No inference should be

drawn, however, regarding issues not

specifically addressed in this notice that

may be suggested by a particular question and answer or as to why certain

questions, and not others, are included.

This notice does not provide guidance

with respect to section 1422 of the

SBJPA, which provides for a simplified

401(k) arrangement within a qualified

plan that shares many characteristics

with the SIMPLE plans described in this

notice.

TABLE OF CONTENTS

A. SIMPLE PLANS IN GENERAL

B. EMPLOYERS THAT CAN ESTABLISH SIMPLE PLANS

C. EMPLOYEE ELIGIBILITY TO

PARTICIPATE IN A SIMPLE PLAN

D. SIMPLE PLAN CONTRIBUTIONS

E. EMPLOYEE ELECTIONS

F. VESTING REQUIREMENTS

G. EMPLOYER ADMINISTRATIVE

AND NOTIFICATION REQUIREMENTS

H. TRUSTEE ADMINISTRATIVE REQUIREMENTS

I. TAX TREATMENT OF SIMPLE

PLANS

J. EXCEPTION FOR USE OF DESIGNATED FINANCIAL INSTITUTION

K. SIMPLE PLAN ESTABLISHMENT

QUESTIONS AND ANSWERS

A. SIMPLE PLANS IN GENERAL

Q. A–1: What is a SIMPLE plan?

A. A–1: A SIMPLE plan is a written

arrangement established under section

408(p) of the Code that provides a

simplified tax-favored retirement plan

for small employers. If an employer

establishes a SIMPLE plan, each employee may choose whether to have the

employer make payments as contributions under the SIMPLE plan or to

receive these payments directly in cash.

An employer that chooses to establish a

SIMPLE plan must make either matching contributions or nonelective contributions. All contributions under a

SIMPLE plan are made to SIMPLE

IRAs.

Q. A–2: Can contributions made under a SIMPLE plan be made to any type

of IRA?

A. A–2: Contributions under a

SIMPLE plan may only be made to a

SIMPLE IRA, not to any other type of

IRA. A SIMPLE IRA is an individual

retirement account described in section

408(a), or an individual retirement annuity described in section 408(b), to which

the only contributions that can be made

are contributions under a SIMPLE plan

and rollovers or transfers from another

SIMPLE IRA.

Q. A–3: Can a SIMPLE plan be

maintained on a fiscal year basis?

A. A–3: A SIMPLE plan may only

be maintained on a calendar year basis.

Thus, for example, employer eligibility

to establish a SIMPLE plan (see Q&As

B–1 through B–5) and SIMPLE plan

contributions (see Q&As D–1 through

D–6) are determined on a calendar year

basis.

B. EMPLOYERS THAT CAN

ESTABLISH SIMPLE PLANS

Q. B–1: Can any employer establish

a SIMPLE plan?

A. B–1: SIMPLE plans may be established only by employers that had no

more than 100 employees who earned

$5,000 or more in compensation during

the preceding calendar year (the ‘‘100–

employee limitation’’). See Q&As C–4

and C–5 for the definition of compensation. For purposes of the 100-employee

limitation, all employees employed at

any time during the calendar year are

taken into account, regardless of

whether they are eligible to participate

in the SIMPLE plan. Thus, employees

who are excludable under the rules of

section 410(b)(3) or who have not met

the plan’s minimum eligibility requirements must be taken into account. Employees also include self-employed individuals described in section 401(c)(1)

who received earned income from the

employer during the year.

Q. B–2: Is there a grace period that

can be used by an employer that ceases

to satisfy the 100-employee limitation?

A. B–2: An employer that previously

maintained a SIMPLE plan is treated as

satisfying the 100-employee limitation

for the two calendar years immediately

following the calendar year for which it

last satisfied the 100-employee limitation. However, if the failure to satisfy

the 100-employee limitation is due to an

acquisition, disposition or similar transaction involving the employer, then the

two-year grace period will apply only in

accordance with rules similar to the

rules of section 410(b)(6)(C)(i).

Q. B–3: Can an employer make contributions under a SIMPLE plan for a

calendar year if it maintains another

qualified plan?

A. B–3: An employer cannot make

contributions under a SIMPLE plan for

a calendar year if the employer, or a

predecessor employer, maintains a qualified plan under which any of its employees receives an allocation of contributions (in the case of a defined

contribution plan) or has an increase in

a benefit accrued or treated as an ac-

27

crued benefit under section 411(d)(6) (in

the case of a defined benefit plan) for

any plan year beginning or ending in

that calendar year. For this purpose, a

‘‘qualified plan’’ means a plan, contract,

pension or trust described in section

219(g)(5) and includes a qualified plan

(described in section 401(a)), a qualified

annuity plan (described in section

403(a)), an annuity contract (described

in section 403(b)), a plan established for

employees of a state, a political subdivision or by an agency or instrumentality

of any state or political subdivision

(other than an eligible deferred compensation plan described in section 457(b)),

a simplified employee pension (‘‘SEP’’)

(described in section 408(k)) and a trust

described in section 501(c)(18). In applying these rules, transfers, rollovers or

forfeitures are disregarded, except to the

extent forfeitures replace otherwise required contributions.

Q. B–4: Are tax-exempt employers

and governmental entities permitted to

maintain SIMPLE plans?

A. B–4: Yes. Excludable contributions may be made to the SIMPLE IRA

of employees of tax-exempt employers

and governmental entities on the same

basis as contributions may be made to

employees of other eligible employers.

Q. B–5: Do the employer aggregation

and leased employee rules apply for

purposes of the SIMPLE plan rules

under section 408(p)?

A. B–5: For purposes of applying the

SIMPLE plan rules under section

408(p), certain related employers (trades

or businesses under common control)

are treated as a single employer. These

related employers include controlled

groups of corporations under section

414(b), partnerships or sole proprietorships under common control under section 414(c), and affiliated service groups

under section 414(m). In addition,

leased employees described in section

414(n) are treated as employed by the

employer.

Example: Individual P owns Business

A, a computer rental agency, that has

80 employees who received more

than $5,000 in compensation in 1996.

Individual P also owns Business B,

which repairs computers and has 60

employees who received more than

$5,000 in compensation in 1996. Individual P is the sole proprietor of both

businesses. Section 414(c) provides

that the employees of partnerships

and sole proprietorships that are under

common control are treated as employees of a single employer. Thus,

for purposes of the SIMPLE plan

rules, all 140 employees are treated as

employed by Individual P. Therefore,

neither Business A nor Business B is

eligible to establish a SIMPLE plan

for 1997.

C. EMPLOYEE ELIGIBILITY TO

PARTICIPATE IN A SIMPLE PLAN

Q. C–1: Which employees of an employer must be eligible to participate

under the SIMPLE plan?

A. C–1: If an employer establishes a

SIMPLE plan, all employees of the

employer who received at least $5,000

in compensation from the employer during any 2 preceding calendar years

(whether or not consecutive) and who

are reasonably expected to receive at

least $5,000 in compensation during the

calendar year, must be eligible to participate in the SIMPLE plan for the

calendar year.

An employer, at its option, may exclude from eligibility employees described in section 410(b)(3). These employees are:

(1) Employees who are included in a

unit of employees covered by an

agreement that the Secretary of Labor

finds to be a collective bargaining

agreement between employee representatives and one or more employers,

if there is evidence that retirement

benefits were the subject of good

faith bargaining between such employee representatives and such employer or employers;

(2) In the case of a trust established

or maintained pursuant to an agreement that the Secretary of Labor finds

to be a collective bargaining agreement between air pilots represented in

accordance with Title II of the Railway Labor Act and one or more

employees, all employees not covered

by that agreement; and

(3) Employees who are nonresident

aliens and who received no earned

income (within the meaning of section 911(d)(2)) from the employer that

constitutes income from sources

within the United States (within the

meaning of section 861(a)(3)).

As noted in Q&A B–5, the employer

aggregation and leased employee rules

apply for purposes of section 408(p).

Thus, for example, if two related employers must be aggregated under the

rules of section 414(b), all employees of

either employer who satisfy the eligibility criteria must be allowed to participate in the SIMPLE plan.

Q. C–2: May an employer impose

less restrictive eligibility requirements?

A. C–2: An employer may impose

less restrictive eligibility requirements

by eliminating or reducing the prior year

compensation requirements, the current

year compensation requirements, or

both, under its SIMPLE plan. For example, the employer could allow participation for employees who received

$3,000 in compensation during any preceding calendar year. However, the employer cannot impose any other conditions on participating in a SIMPLE plan.

Q. C–3: May an employee participate

in a SIMPLE plan if he or she also

participates in a plan of a different

employer for the same year?

A. C–3: An employee may participate

in a SIMPLE plan even if he or she also

participates in a plan of a different

employer for the same year. However,

the employee’s salary reduction contributions are subject to the limitations of

section 402(g), which provides an aggregate limit on the exclusion for elective

deferrals for any individual. Similarly,

an employee who participates in a

SIMPLE plan and an eligible deferred

compensation plan described in section

457(b) is subject to the limitations described in section 457(c). An employer

that establishes a SIMPLE plan is not

responsible for monitoring compliance

with either of these limitations.

Q. C–4: What definition of compensation applies for purposes of the

SIMPLE plan rules in the case of an

individual who is not a self-employed

individual?

A. C–4: For purposes of the SIMPLE

plan rules, in the case of an individual

who is not a self-employed individual,

compensation means the amount described in section 6051(a)(3) (wages,

tips, and other compensation from the

employer subject to income tax withholding under section 3401(a)), and

amounts described in section 6051(a)(8),

including elective contributions made

under a SIMPLE plan, and compensation

deferred under a section 457 plan. For

purposes of applying the 100-employee

limitation, and in determining whether

an employee is eligible to participate in

a SIMPLE plan (i.e., whether the employee had $5,000 in compensation for

any 2 preceding years), an employee’s

compensation also includes the employee’s elective deferrals under a section

401(k) plan, a salary reduction SEP and

a section 403(b) annuity contract.

Q. C–5: What definition of compensation applies for purposes of the

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SIMPLE plan rules in the case of a

self-employed individual?

A. C–5: For purposes of the SIMPLE

plan rules, in the case of a selfemployed individual, compensation

means net earnings from selfemployment determined under section

1402(a), prior to subtracting any contributions made under the SIMPLE plan

on behalf of the individual.

D. SIMPLE PLAN CONTRIBUTIONS

Q. D–1: What contributions must an

employer make under a SIMPLE plan?

A. D–1: If an employer establishes a

SIMPLE plan, it must make salary reduction contributions, as described in

Q&A D–2, to the extent elected by

employees. In addition, the employer

must make employer matching contributions, as described in Q&As D–4 and

D–5, or employer nonelective contributions, as described in Q&A D–6. These

are the only contributions that may be

made under a SIMPLE plan.

Q. D–2: What is a salary reduction

contribution?

A. D–2: A salary reduction contribution is a contribution made pursuant to

an employee’s election to have an

amount contributed to his or her

SIMPLE IRA, rather than have the

amount paid directly to the employee in

cash. An employee must be permitted to

elect to have salary reduction contributions made at the level specified by the

employee, expressed as a percentage of

compensation for the year. Additionally,

an employer may permit an employee to

express the level of salary reduction

contributions as a specific dollar

amount. An employer may not place any

restrictions on the amount of an employee’s salary reduction contributions (e.g.,

by limiting the contribution percentage),

except to the extent needed to comply

with the annual limit on the amount of

salary reduction contributions described

in Q&A D–3.

Q. D–3: What is the annual limit on

the amount of salary reduction contributions under a SIMPLE plan?

A. D–3: For 1997, the maximum annual amount of salary reduction contributions that can be made on behalf of

any employee under a SIMPLE plan is

$6,000. This amount will be adjusted by

the Service to reflect any changes in the

cost of living.

Q. D–4: What employer matching

contribution is generally required under

a SIMPLE plan?

A. D–4: Under a SIMPLE plan, an

employer is generally required to make

a contribution on behalf of each eligible

employee in an amount equal to the

employee’s salary reduction contributions, up to a limit of 3 percent of the

employee’s compensation for the entire

calendar year.

Q. D–5: Can the 3-percent limit on

matching contributions be reduced?

A. D–5: The 3-percent limit on

matching contributions is permitted to

be reduced for a calendar year at the

election of the employer, but only if:

(1) The limit is not reduced below 1

percent;

(2) The limit is not reduced for more

than 2 years out of the 5-year period

that ends with (and includes) the year

for which the election is effective;

and

(3) Employees are notified of the

reduced limit within a reasonable period of time before the 60-day election period during which employees

can enter into salary reduction agreements. See Q&A E–1.

For purposes of applying the rule

described in paragraph (2) of this Q&A

D–5, in determining whether the limit

was reduced below 3 percent for a year,

any year before the first year in which

an employer (or a predecessor employer) maintains a SIMPLE plan will

be treated as a year for which the limit

was 3 percent. If an employer chooses

to make nonelective contributions for a

year (see Q&A D–6), that year also will

be treated as a year for which the limit

was 3 percent.

Q. D–6: May an employer make nonelective contributions instead of matching contributions?

A. D–6: As an alternative to making

matching contributions under a SIMPLE

plan (as described in Q&A D–4 and

D–5), an employer may make nonelective contributions equal to 2 percent of

each eligible employee’s compensation

for the entire calendar year. The employer’s nonelective contributions must

be made for each eligible employee

regardless of whether the employee

elects to make salary reduction contributions for the calendar year. The employer may, but is not required to, limit

nonelective contributions to eligible employees who have at least $5,000 (or

some lower amount selected by the

employer) of compensation for the year.

For purposes of the 2-percent nonelective contribution, the compensation

taken into account must be limited to

the amount of compensation that may be

taken into account under section

401(a)(17) for the year. The section

401(a)(17) limit for 1997 is $160,000.

This amount will be adjusted by the

Service for subsequent years to reflect

changes in the cost of living.

An employer may substitute the

2-percent nonelective contribution for

the matching contribution for a year,

only if:

(1) Eligible employees are notified

that a 2-percent nonelective contribution will be made instead of a matching contribution; and

(2) This notice is provided within a

reasonable period of time before the

60-day election period during which

employees can enter into salary reduction agreements. See Q&A E–1.

E. EMPLOYEE ELECTIONS

Q. E–1: When must an employee be

given the right to enter into a salary

reduction agreement?

A. E–1: During the 60-day period

immediately preceding January 1 of a

calendar year (i.e., November 2 to December 31 of the preceding calendar

year), an eligible employee must be

given the right to enter into a salary

reduction agreement for the calendar

year, or to modify a prior agreement

(including reducing the amount subject

to this agreement to $0). However, for

the year in which the employee becomes

eligible to make salary reduction contributions, the period during which the

employee may enter into a salary reduction agreement or modify a prior agreement is a 60-day period that includes

either the date the employee becomes

eligible or the day before that date. For

example, if an employer establishes a

SIMPLE plan effective as of July 1,

1997, each eligible employee becomes

eligible to make salary reduction contributions on that date and the 60-day

period must begin no later than July 1

and cannot end before June 30, 1997.

During these 60-day periods, employees have the right to modify their salary

reduction agreements without restrictions. In addition, for the year in which

an employee becomes eligible to make

salary reduction contributions, the employee must be able to commence these

contributions as soon as the employee

becomes eligible, regardless of whether

the 60-day period has ended.

Q. E–2: Can a SIMPLE plan provide

additional or longer election periods?

A. E–2: Nothing precludes a SIMPLE

plan from providing additional or longer

29

periods for permitting employees to enter into salary reduction agreements or

to modify prior agreements. For example, a SIMPLE plan can provide a

90-day election period instead of the

60-day period described in Q&A E–1.

Similarly, in addition to the 60-day

period described in Q&A E–1, a

SIMPLE plan can provide quarterly

election periods during the 30 days

before each calendar quarter.

Q. E–3: Does an employee have the

right to terminate a salary reduction

agreement outside a SIMPLE plan’s normal election period?

A. E–3: An employee must be given

the right to terminate a salary reduction

agreement for a calendar year at any

time during the year. A SIMPLE plan

may provide that an employee who

terminates a salary reduction agreement

at any time other than the periods

described in Q&A E–1 or E–2 is not

eligible to resume participation until the

beginning of the next calendar year.

Q. E–4: Must an employer allow an

employee to select the financial institution to which the employer will make

all SIMPLE plan contributions on behalf

of the employee?

A. E–4: Generally, under section

408(p), an employer must permit an

employee to select the financial institution for the SIMPLE IRA to which the

employer will make all contributions on

behalf of the employee. If an employer

uses Form 5305-SIMPLE as modified in

Q&A K–3, the employer may modify

page 3 of Form 5305–SIMPLE (October

1996) (Model Salary Reduction Agreement) to include a section for employees

to indicate the financial institution they

have selected and any additional information necessary to facilitate transmittal

of the contribution to that institution.

Alternatively, under the exception described in Q&A J–1, an employer may

require that all contributions be made to

a designated financial institution.

F. VESTING REQUIREMENTS

Q. F–1: Must contributions under a

SIMPLE plan be nonforfeitable?

A. F–1: Yes. All contributions under

a SIMPLE plan must be fully vested

and nonforfeitable when made.

Q. F–2: May amounts held in a

SIMPLE IRA be withdrawn at any

time?

A. F–2: Yes. An employer may not

require an employee to retain any portion of the contributions in his or her

SIMPLE IRA or otherwise impose any

withdrawal restrictions.

G. EMPLOYER ADMINISTRATIVE

AND NOTIFICATION

REQUIREMENTS

Q. G–1: What notification requirements apply to employers?

A. G–1: A

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