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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 contrib

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Airs%3A46fb5ac2a7707560. Public record. Not legal advice.