These synopses are intended only as aids to the reader in

Bulletin No. 1998–7

February 17, 1998

Internal Revenue

bulletin

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

GIFT TAX

T.D. 8745, page 15.

Rev. Rul. 98–8, page 24.

Final regulations under section 171 of the Code relate to the

federal income tax treatment of bond premium and bond issuance premium.

Disposition of qualifying income interest. If a surviving

spouse acquires the remainder interest in a trust subject to

a QTIP election under section 2056(b)(7) of the Code in connection with the transfer by the surviving spouse of property

or cash to the holder of the remainder interest, the surviving

spouse makes a gift under sections 2511, 2512, and 2519

of the Code.

T.D. 8747, page 18.

T.D. 8743, page 26.

Final regulations under section 280B of the Code relate to

deductions available upon demolition of a building.

T.D. 8746, page 4.

Final regulations under section 1396 of the Code relate to

the period employers may use in computing the empowerment zone employment credit.

T.D. 8749, page 16.

Final regulations under section 1202 of the Code relate to

the 50-percent exclusion for gain from certain small business stock.

EXEMPT ORGANIZATIONS

Rev. Proc. 98–19, page 30.

Final regulations under section 2702 of the Code permit the

reformation of a personal residence trust or a qualified personal residence trust in order to comply with the applicable

requirements for such trusts.

T.D. 8744, page 20.

Final regulations under section 2518 of the Code relate to

the treatment of disclaimers for estate and gift tax purposes.

EMPLOYMENT TAX

Organizations excepted from reporting lobbying expenditures. This procedure provides guidance to organizations exempt from taxation under Code section 501(a) on

the application of amendments made to Code sections

162(e) and 6033(e) by section 13222 of the Omnibus Budget Reconciliation Act of 1993. Rev. Procs. 95–35 and

95–35A superseded.

Announcement 98–9, page 35.

Announcement 98–10, page 35.

A list is given of organizations now classified as private foundations.

This procedure sets forth the acceptable form of written assurances that will except the sale or exchange of a principal

residence from information reporting.

This announcement provides corrections to the 1998 Circular E, Employer’s Tax Guide (Publication 15).

ADMINISTRATIVE

Rev. Proc. 98–20, page 32.

Finding Lists begin on page 40.

Announcement of Disbarments and Suspensions begins on page 37.

Department of the Treasury

Internal Revenue Service

Mission of the Service

ucts and services; and perform in a manner warranting

the highest degree of public confidence in our integrity, efficiency, and fairness.

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 prod-

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 officers when

they have merit, never arbitrarily or for trading purposes.

At the same time, the examining officer should never hesitate to raise a meritorious issue. It is also important that

care be exercised not to raise an issue or to ask a court to

adopt a position inconsistent with an established Service

position.

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 courtesy and considerateness. It should never

try to overreach, and should be reasonable within the

bounds of law and sound administration. It should, however, be vigorous in requiring compliance with law and it

should be relentless in its attack on unreal tax devices and

fraud.

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.

dures 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, court decisions, rulings, and proce-

The first Bulletin for each month includes a cumulative index

for the matters published during the preceding months.

These monthly indexes are cumulated on a semiannual basis

and are published in the first Bulletin of the succeeding semiannual 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, DC 20402.

3

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

Section 121.—Exclusion of Gain

From Sale of Principal Residence

Guidance is provided on the acceptable form of

written assurances (certification) that a real estate

reporting person must obtain from the seller of a

principal residence to except such sale or exchange

from the information reporting requirements for real

estate transactions under section 6045(e)(5). See

Rev. Proc. 98–20, page 32.

Section 162.—Trade or Business

Expenses

26 CFR 1.162–20: Expenditures attributable to

lobbying, political campaigns, attempts to influence

legislation, etc., and certain advertising.

This revenue procedure provides guidance to organizations exempt from taxation under § 501(a) of

the Internal Revenue Code of 1986 on the application of amendments made to §§ 162(e) and 6033(e)

by § 13222 of the Omnibus Budget Reconciliation

Act of 1993. The revenue procedure identifies certain tax-exempt organizations that will be treated as

satisfying the requirements of § 6033(e)(3). Those

organizations will not be subject to the reporting and

notice requirements of § 6033(e)(1) or the tax imposed by § 6033(e)(2). Procedures for other exempt

organizations to establish that they satisfy the requirements of § 6033(e)(3) are also provided. Rev.

Proc. 95–35, 1995–2 C.B. 391, and Rev. Proc.

95–35A, 1995–2 C.B. 392, are superseded. See Rev.

Proc. 98–19, page 30.

Section 171.—Amortizable Bond

Premium

26 CFR 1.171: Bond premium.

T.D. 8746

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

Amortizable Bond Premium

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations relating to the federal income tax treatment of bond premium and

bond issuance premium. The regulations

reflect changes to the law made by the

Tax Reform Act of 1986 and the Techni-

February 17, 1998

cal and Miscellaneous Revenue Act of

1988. The regulations will provide

needed guidance to holders and issuers of

debt instruments.

DATES: Effective Date: March 2, 1998.

Applicability date: For dates of applicability of the final regulations, see Effective Dates under SUPPLEMENTARY

INFORMATION.

FOR FURTHER INFORMATION CONTACT: William E. Blanchard, (202) 6223950 (not a toll-free number).

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 requirements of the Paperwork

Reduction Act of 1995 (44 U.S.C.

3507(d)) under control number 15451491. Responses to these collections of

information are required by the IRS to determine whether a holder of a bond has

elected to amortize bond premium and

whether an issuer or a holder has changed

its method of accounting for premium.

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 estimated annual burden per respondent varies from 0.25 hours to 0.75

hours, depending on individual circumstances, with an estimated average of 0.5

hours.

Comments concerning the accuracy of

this burden estimate and suggestions for

reducing this burden should be sent to the

Internal Revenue Service, Attn: IRS

Reports Clearance Officer, T:FP, Washington, DC 20224, and to the Office of

Management and Budget, Attn: Desk

Officer for the Department of Treasury,

Office of Information and Regulatory Affairs, Washington, DC 20503.

Books or records relating to the 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

4

tax return information are confidential, as

required by 26 U.S.C. 6103.

Background

Sections 1.171-1 through 1.171-4 of

the Income Tax Regulations were promulgated in 1957 and last amended in 1968.

In the Tax Reform Act of 1986, section

171(b) was amended to require that bond

premium be amortized by reference to a

constant yield. In the Technical and Miscellaneous Revenue Act of 1988, section

171(e) was amended to require that amortizable bond premium be treated as an offset to interest income.

On June 27, 1996, the IRS published a

notice of proposed rulemaking in the Federal Register (61 F.R. 33396 [FI–48–95,

1996–2 C.B. 449]) relating to the federal

income tax treatment of bond premium

and bond issuance premium. A public

hearing was not held because no one requested to speak at the hearing that had

been scheduled for October 23, 1996.

The IRS did receive a few comments on

the proposed regulations. The proposed

regulations, with certain changes to respond to the comments, are adopted as

final regulations.

Explanation of Provisions

In general, bond premium arises when a

holder acquires a bond for more than the

principal amount of the bond. Similarly,

bond issuance premium arises when an issuer issues a bond for more than the principal amount of the bond. A holder will purchase, and an issuer will issue, a bond for

more than its principal amount when the

stated interest rate on the bond is higher

than the current market yield for the bond.

The holder’s treatment of bond premium

is addressed in §§1.171–1 through

1.171–5. The issuer’s treatment of bond

issuance premium is addressed in §1.163–

13. In each case, the amortization of premium is based on constant yield principles.

For this reason, the final regulations use

concepts and definitions from the original

issue discount (OID) regulations (in general, see §§1.1271–1 through 1.1275–7T).

Determination of Bond Premium

Under the proposed regulations, bond

premium is defined as the excess of a

1998–7 I.R.B.

holder’s basis in a bond over the sum of

the remaining amounts payable on the

bond other than payments of qualified

stated interest. The holder generally determines the amount of bond premium as

of the date the holder acquires the bond.

The proposed regulations provide special rules that limit a holder’s basis solely

for purposes of determining bond premium. For example, if a bond is convertible into stock of the issuer at the holder’s

option, for purposes of determining bond

premium, the holder must reduce its basis

in the bond by the value of the conversion

option. This reduction prevents the

holder from inappropriately amortizing

the cost of the embedded conversion

option.

The final regulations adopt the rules of

the proposed regulations for determining

the amount of bond premium, if any, on a

bond. However, in response to comments, the final regulations clarify the determination of basis in the case of a convertible bond acquired in a transferred

basis transaction.

Amortization of Bond Premium

(a) In general

Under section 171, the holder of a taxable bond acquired at a premium may

elect to amortize bond premium. The

holder of a tax-exempt bond acquired at a

premium must amortize the premium. As

premium is amortized, the holder’s basis

in the bond is reduced by a corresponding

amount under section 1016(a)(5).

Under the proposed regulations, a

holder amortizes bond premium by offsetting qualified stated interest income with

bond premium. An offset is calculated for

each accrual period using constant yield

principles. However, the offset for an accrual period is only taken into account

when the holder takes qualified stated interest into account under the holder’s regular method of accounting. Thus, a holder

using the cash receipts and disbursements

method of accounting does not take bond

premium into account until a qualified

stated interest payment is received.

The final regulations adopt the rules in

the proposed regulations for amortizing

bond premium.

(b) Excess premium

For certain bonds (for example, bonds

that pay a variable rate of interest or that

1998–7 I.R.B

provide for an interest holiday), the

amount of bond premium allocable to an

accrual period could exceed the amount

of qualified stated interest allocable to

that period. The proposed regulations address this situation by providing that the

excess bond premium is not allowed as a

deduction but is carried forward to future

accrual periods.

Several commentators stated that this

excess premium should be allowable as a

current deduction for the accrual period in

which the excess occurs. In response to

these comments, the final regulations

adopt rules for excess premium that are

similar to the rules for negative adjustments on contingent payment debt instruments and deflation adjustments on inflation-indexed debt instruments. Under the

final regulations, any excess bond premium allocable to an accrual period is deductible by the holder under section

171(a)(1) for the accrual period. The

amount deductible, however, is limited by

the amount of the holder’s prior income

inclusions on the bond. If any of the excess bond premium is not deductible

under section 171(a)(1), this amount is

carried forward to the next accrual period

and is treated as bond premium allocable

to that period.

Bonds Subject to Certain Contingencies

If a bond provides for one or more alternative payment schedules, the yield of

the bond cannot be determined without

making assumptions about the actual payment schedule. The OID regulations provide rules for making these assumptions.

For example, the rules assume that an issuer will exercise a call option if doing so

would minimize the yield of the debt instrument and that a holder will exercise a

put option if doing so would maximize

the yield of the debt instrument.

The proposed regulations under section

171 generally use similar assumptions to

determine the holder’s yield on a bond

that provides for alternative payment

schedules. However, in the case of an issuer’s option on a taxable bond, the proposed regulations reverse the assumption

in the OID regulations by assuming that

the issuer will exercise the option only if

doing so would increase the yield on the

bond. See section 171(b)(1)(B)(ii). Thus,

under the proposed regulations, a holder

generally must amortize bond premium

5

on a taxable bond by reference to the

stated maturity date, even if it appears

likely the bond will be called. In this

case, if the bond is actually called, the

proposed regulations provide that the

holder may deduct the unamortized premium. If the bond is partially called and

the partial call is not a pro-rata prepayment, the proposed regulations do not

allow the holder to deduct a portion of the

unamortized premium. Instead, the

holder must recompute the yield of the

bond on the date of the partial call and

amortize the remaining premium by reference to the recomputed yield.

In general, the final regulations adopt

the rules of the proposed regulations. In

response to a comment, the final regulations limit the issuer rule for taxable

bonds to call options.

Bond Issuance Premium

Under existing §1.61–12(c), a corporate issuer treats premium received upon

issuance of a bond as a separate item of

income. Over the term of the bond, the

premium is taken into income, and the

full amount of the stated interest is deducted. The proposed regulations revise

the treatment of bond issuance premium.

Under the proposed regulations, bond issuance premium is amortized as an offset

to the issuer’s otherwise allowable interest deduction, not as a separate item of income. The amount of bond issuance premium amortized in any period is based on

a constant yield. In addition, the proposed regulations apply to all issuers, not

just corporate issuers.

In general, the final regulations adopt

the rules in the proposed regulations for

bond issuance premium. However, the

final regulations contain several important changes from the proposed regulations. First, in response to comments, the

final regulations clarify the treatment of a

debt instrument subject to an alternative

payment schedule by explicitly cross-referencing §1.1272–1(c). Second, the final

regulations provide that, in the case of a

debt instrument subject to a mandatory

sinking fund provision, the issuer must

determine the payment schedule by assuming that a pro rata portion of the debt

instrument will be called under the sinking fund provision. This rule produces

more economic interest accruals than the

February 17, 1998

accruals determined by ignoring the sinking fund provision as under the proposed

regulations. Third, the final regulations

adopt rules for excess bond issuance premium allocable to an accrual period.

These rules are similar to the rules for excess bond premium described above.

Aggregation Rules

Although the proposed regulations do

not provide for an aggregate method of

accounting for premium, comments were

requested on the need for an aggregate

method. Because no comments were received, the final regulations do not provide rules for an aggregate method of accounting for premium.

Bonds Not Subject to the Final

Regulations

The final regulations generally apply to

bonds acquired or issued at a premium.

Certain bonds, however, are excluded

from the application of the final regulations. For example, the final regulations

exclude debt instruments described in

section 1272(a)(6)(C) (regular interests in

a REMIC, qualified mortgages held by a

REMIC, and certain other debt instruments, or pools of debt instruments, with

payments subject to acceleration). No inference is intended regarding the treatment of debt instruments described in section 1272(a)(6)(C).

Effective Dates

The final regulations relating to bond

premium are effective for bonds acquired

on or after March 2, 1998. However, if a

holder makes the election to amortize

bond premium for the taxable year containing March 2, 1998, or any subsequent

taxable year, the regulations apply to

bonds held on or after the first day of the

taxable year in which the election is

made.

The final regulations relating to bond

issuance premium apply to debt instruments issued on or after March 2, 1998.

The final regulations also provide automatic consent for a taxpayer to change its

method of accounting for premium in certain circumstances. Because the change

is made on a cut-off basis, no items of income or deduction are omitted or duplicated. Therefore, no adjustment under

section 481 is allowed.

February 17, 1998

Special Analyses

It is hereby certified that these regulations do not have significant economic

impact on a substantial number of small

entities. This certification is based upon

the fact that the regulations merely require a taxpayer to attach to the taxpayer’s return a statement that indicates

whether the taxpayer is making an election under section 171 or is changing its

accounting method for bond premium or

bond issuance premium. Therefore, a

Regulatory Flexibility Analysis under the

Regulatory Flexibility Act (5 U.S.C.

chapter 6) is not required.

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 has also been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not

apply to these regulations. Pursuant to

section 7805(f) of the Internal Revenue

Code, the notice of proposed rulemaking

was submitted to the Chief Counsel for

Advocacy of the Small Business Administration for comment on its impact on

small business.

Drafting Information

Several persons from the Office of Assistant Chief Counsel (Financial Institutions and Products) and the Treasury Department participated in the development

of these regulations.

*

*

*

*

*

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR parts 1 and 602

are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 is amended by adding entries in numerical order to read as follows:

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

Section 1.171–2 also issued under 26

U.S.C. 171(e).

Section 1.171–3 also issued under 26

U.S.C. 171(e).

Section 1.171–4 also issued under 26

U.S.C. 171(c). * * *

Par. 2. Section 1.61–12 is amended by

revising paragraph (c) to read as follows:

6

§1.61–12 Income from discharge of

indebtedness.

* * * * *

(c) Issuance and repurchase of debt instruments—(1) Issuance. An issuer does

not realize gain or loss upon the issuance

of a debt instrument. For rules relating to

an issuer’s interest deduction for a debt

instrument issued with bond issuance premium, see §1.163–13.

(2) Repurchase—(i) In general. An issuer does not realize gain or loss upon the

repurchase of a debt instrument. However, if a debt instrument provides for

payments denominated in, or determined

by reference to, a nonfunctional currency,

an issuer may realize a currency gain or

loss upon the repurchase of the instrument. See section 988 and the regulations

thereunder. For purposes of this paragraph (c)(2), the term repurchase includes

the retirement of a debt instrument, the

conversion of a debt instrument into stock

of the issuer, and the exchange (including

an exchange under section 1001) of a

newly issued debt instrument for an existing debt instrument.

(ii) Repurchase at a discount. An issuer realizes income from the discharge

of indebtedness upon the repurchase of a

debt instrument for an amount less than

its adjusted issue price (within the meaning of §1.1275–1(b)). The amount of discharge of indebtedness income is equal to

the excess of the adjusted issue price over

the repurchase price. See section 108 and

the regulations thereunder for additional

rules relating to income from discharge of

indebtedness. For example, to determine

the repurchase price of a debt instrument

that is repurchased through the issuance

of a new debt instrument, see section

108(e)(10).

(iii) Repurchase at a premium. An issuer may be entitled to a repurchase premium deduction upon the repurchase of a

debt instrument for an amount greater than

its adjusted issue price (within the meaning

of §1.1275–1(b)). See §1.163– 7(c) for the

treatment of repurchase premium.

(iv) Effective date. This paragraph

(c)(2) applies to debt instruments repurchased on or after March 2, 1998.

* * * * *

Par. 3. Section 1.163-13 is added to

read as follows:

1998–7 I.R.B.

§1.163–13 Treatment of bond issuance

premium.

(a) General rule. If a debt instrument

is issued with bond issuance premium,

this section limits the amount of the issuer’s interest deduction otherwise allowable under section 163(a). In general, the

issuer determines its interest deduction by

offsetting the interest allocable to an accrual period with the bond issuance premium allocable to that period. Bond issuance premium is allocable to an accrual

period based on a constant yield. The use

of a constant yield to amortize bond issuance premium is intended to generally

conform the treatment of debt instruments

having bond issuance premium with those

having original issue discount. Unless

otherwise provided, the terms used in this

section have the same meaning as those

terms in section 163(e), sections 1271

through 1275, and the corresponding regulations. Moreover, unless otherwise provided, the provisions of this section apply

in a manner consistent with those of section 163(e), sections 1271 through 1275,

and the corresponding regulations. In addition, the anti-abuse rule in §1.1275–2(g)

applies for purposes of this section. For

rules dealing with the treatment of bond

premium by a holder, see §§1.171–1

through 1.171–5.

(b) Exceptions. This section does not

apply to—

(1) A debt instrument described in section 1272(a)(6)(C) (regular interests in a

REMIC, qualified mortgages held by a

REMIC, and certain other debt instruments, or pools of debt instruments, with

payments subject to acceleration); or

(2) A debt instrument to which

§1.1275–4 applies (relating to certain

debt instruments that provide for contingent payments).

(c) Bond issuance premium. Bond issuance premium is the excess, if any, of

the issue price of a debt instrument over

its stated redemption price at maturity.

For purposes of this section, the issue

price of a convertible bond (as defined in

§1.171–1(e)(1)(iii)(C)) does not include

an amount equal to the value of the conversion option (as determined under

§1.171–1(e)(1)(iii)(A)).

(d) Offsetting qualified stated interest

with bond issuance premium—(1) In general. An issuer amortizes bond issuance

premium by offsetting the qualified stated

1998–7 I.R.B

interest allocable to an accrual period

with the bond issuance premium allocable

to the accrual period. This offset occurs

when the issuer takes the qualified stated

interest into account under its regular

method of accounting.

(2) Qualified stated interest allocable

to an accrual period. See §1.446–2(b) to

determine the accrual period to which

qualified stated interest is allocable and to

determine the accrual of qualified stated

interest within an accrual period.

(3) Bond issuance premium allocable

to an accrual period. The bond issuance

premium allocable to an accrual period is

determined under this paragraph (d)(3).

Within an accrual period, the bond issuance premium allocable to the period

accrues ratably.

(i) Step one: Determine the debt instrument’s yield to maturity. The yield to

maturity of a debt instrument is determined under the rules of §1.1272–1(b)(1)(i).

(ii) Step two: Determine the accrual

periods. The accrual periods are determined under the rules of §1.1272–1(b)(1)(ii).

(iii) Step three: Determine the bond issuance premium allocable to the accrual

period. The bond issuance premium allocable to an accrual period is the excess of

the qualified stated interest allocable to

the accrual period over the product of the

adjusted issue price at the beginning of

the accrual period and the yield. In performing this calculation, the yield must be

stated appropriately taking into account

the length of the particular accrual period.

Principles similar to those in §1.1272–

1(b)(4) apply in determining the bond issuance premium allocable to an accrual

period.

(4) Bond issuance premium in excess of

qualified stated interest—(i) Ordinary income. If the bond issuance premium allocable to an accrual period exceeds the

qualified stated interest allocable to the

accrual period, the excess is treated as ordinary income by the issuer for the accrual period. However, the amount

treated as ordinary income is limited to

the amount by which the issuer’s total interest deductions on the debt instrument

in prior accrual periods exceed the total

amount treated by the issuer as ordinary

income on the debt instrument in prior accrual periods.

7

(ii) Carryforward. If the bond issuance

premium allocable to an accrual period

exceeds the sum of the qualified stated interest allocable to the accrual period and

the amount treated as ordinary income for

the accrual period under paragraph

(d)(4)(i) of this section, the excess is carried forward to the next accrual period

and is treated as bond issuance premium

allocable to that period. If a carryforward

exists on the date the debt instrument is

retired, the carryforward is treated as ordinary income on that date.

(e) Special rules—(1) Variable rate

debt instruments. An issuer determines

bond issuance premium on a variable rate

debt instrument by reference to the stated

redemption price at maturity of the equivalent fixed rate debt instrument constructed for the variable rate debt instrument. The issuer also allocates any bond

issuance premium among the accrual periods by reference to the equivalent fixed

rate debt instrument. The issuer constructs the equivalent fixed rate debt instrument, as of the issue date, by using the

principles of §1.1275–5(e).

(2) Inflation-indexed debt instruments.

An issuer determines bond issuance premium on an inflation-indexed debt instrument by assuming that there will be no inflation or deflation over the term of the

instrument. The issuer also allocates any

bond issuance premium among the accrual

periods by assuming that there will be no

inflation or deflation over the term of the

instrument. The bond issuance premium

allocable to an accrual period offsets qualified stated interest allocable to the period.

Notwithstanding paragraph (d)(4) of this

section, if the bond issuance premium allocable to an accrual period exceeds the

qualified stated interest allocable to the

period, the excess is treated as a deflation

adjustment under §1.1275–7T(f)(1)(ii).

See §1.1275–7T for other rules relating to

inflation-indexed debt instruments.

(3) Certain debt instruments subject to

contingencies—(i) In general. Except as

provided in paragraph (e)(3)(ii) of this

section, the rules of §1.1272–1(c) apply to

determine a debt instrument’s payment

schedule for purposes of this section. For

example, an issuer uses the payment

schedule determined under §1.1272–1(c)

to determine the amount, if any, of bond

issuance premium on the debt instrument,

the yield and maturity of the debt instru-

February 17, 1998

ment, and the allocation of bond issuance

premium to an accrual period.

(ii) Mandatory sinking fund provision.

Notwithstanding paragraph (e)(3)(i) of

this section, if a debt instrument is subject

to a mandatory sinking fund provision described in §1.1272–1(c)(3), the issuer

must determine the payment schedule by

assuming that a pro rata portion of the

debt instrument will be called under the

sinking fund provision.

(4) Remote and incidental contingencies. For purposes of determining the

amount of bond issuance premium and allocating bond issuance premium among

accrual periods, if a bond provides for a

contingency that is remote or incidental

(within the meaning of §1.1275–2(h)), the

issuer takes the contingency into account

under the rules for remote and incidental

contingencies in §1.1275–2(h).

(f) Example. The following example illustrates the rules of this section:

Example—(i) Facts. On February 1, 1999, X issues for $110,000 a debt instrument maturing on

February 1, 2006, with a stated principal amount of

$100,000, payable at maturity. The debt instrument

provides for unconditional payments of interest of

$10,000, payable on February 1 of each year. X uses

the calendar year as its taxable year, X uses the cash

receipts and disbursements method of accounting,

and X decides to use annual accrual periods ending

on February 1 of each year. X’s calculations assume

a 30-day month and 360-day year.

(ii) Amount of bond issuance premium. The issue

price of the debt instrument is $110,000. Because

the interest payments on the debt instrument are

qualified stated interest, the stated redemption price

at maturity of the debt instrument is $100,000.

Therefore, the amount of bond issuance premium is

$10,000 ($110,000–$100,000).

(iii) Bond issuance premium allocable to the first

accrual period. Based on the payment schedule and

the issue price of the debt instrument, the yield of the

debt instrument is 8.07 percent, compounded annually. (Although, for purposes of simplicity, the yield

as stated is rounded to two decimal places, the computations do not reflect this rounding convention.)

The bond issuance premium allocable to the accrual

period ending on February 1, 2000, is the excess of

the qualified stated interest allocable to the period

($10,000) over the product of the adjusted issue price

at the beginning of the period ($110,000) and the

yield (8.07 percent, compounded annually). Therefore, the bond issuance premium allocable to the accrual period is $1,118.17 ($10,000– $8,881.83).

(iv) Premium used to offset interest. Although X

makes an interest payment of $10,000 on February

1, 2000, X only deducts interest of $8,881.83, the

qualified stated interest allocable to the period

($10,000) offset with the bond issuance premium allocable to the period ($1,118.17).

(g) Effective date. This section applies

to debt instruments issued on or after

March 2, 1998.

February 17, 1998

(h) Accounting method changes—(1)

Consent to change. An issuer required to

change its method of accounting for bond

issuance premium to comply with this

section must secure the consent of the

Commissioner in accordance with the requirements of §1.446–1(e). Paragraph

(h)(2) of this section provides the Commissioner’s automatic consent for certain

changes.

(2) Automatic consent. The Commissioner grants consent for an issuer to

change its method of accounting for bond

issuance premium on debt instruments issued on or after March 2, 1998. Because

this change is made on a cut-off basis, no

items of income or deduction are omitted

or duplicated and, therefore, no adjustment under section 481 is allowed. The

consent granted by this paragraph (h)(2)

applies provided—

(i) The change is made to comply with

this section;

(ii) The change is made for the first taxable year for which the issuer must account for a debt instrument under this section; and

(iii) The issuer attaches to its federal income tax return for the taxable year containing the change a statement that it has

changed its method of accounting under

this section.

Par. 4. Sections 1.171-1 through 1.1714 are revised to read as follows:

§1.171–1 Bond premium.

(a) Overview—(1) In general. This

section and §§1.171–2 through 1.171–5

provide rules for the determination and

amortization of bond premium by a

holder. In general, a holder amortizes

bond premium by offsetting the interest

allocable to an accrual period with the

premium allocable to that period. Bond

premium is allocable to an accrual period

based on a constant yield. The use of a

constant yield to amortize bond premium

is intended to generally conform the treatment of bond premium to the treatment of

original issue discount under sections

1271 through 1275. Unless otherwise

provided, the terms used in this section

and §§1.171–2 through 1.171–5 have the

same meaning as those terms in sections

1271 through 1275 and the corresponding

regulations. Moreover, unless otherwise

provided, the provisions of this section

and §§1.171–2 through 1.171–5 apply in

8

a manner consistent with those of sections

1271 through 1275 and the corresponding

regulations. In addition, the anti-abuse

rule in §1.1275–2(g) applies for purposes

of this section and §§1.171–2 through

1.171–5.

(2) Cross-references. For rules dealing

with the adjustments to a holder’s basis to

reflect the amortization of bond premium,

see §1.1016–5(b). For rules dealing with

the treatment of bond issuance premium

by an issuer, see §1.163–13.

(b) Scope—(1) In general. Except as

provided in paragraph (b)(2) of this section and §1.171–5, this section and

§§1.171–2 through 1.171–4 apply to any

bond that, upon its acquisition by the

holder, is held with bond premium. For

purposes of this section and §§1.171–2

through 1.171–5, the term bond has the

same meaning as the term debt instrument

in §1.1275–1(d).

(2) Exceptions. This section and

§§1.171–2 through 1.171–5 do not apply

to—

(i) A bond described in section 1272(a)(6)(C) (regular interests in a REMIC,

qualified mortgages held by a REMIC,

and certain other debt instruments, or

pools of debt instruments, with payments

subject to acceleration);

(ii) A bond to which §1.1275–4 applies

(relating to certain debt instruments that

provide for contingent payments);

(iii) A bond held by a holder that has

made a §1.1272–3 election with respect to

the bond;

(iv) A bond that is stock in trade of the

holder, a bond of a kind that would properly be included in the inventory of the

holder if on hand at the close of the taxable year, or a bond held primarily for

sale to customers in the ordinary course of

the holder’s trade or business; or

(v) A bond issued before September 28,

1985, unless the bond bears interest and

was issued by a corporation or by a government or political subdivision thereof.

(c) General rule—(1) Tax-exempt

obligations. A holder must amortize bond

premium on a bond that is a tax-exempt

obligation. See §1.171–2(c) Example 4.

(2) Taxable bonds. A holder may elect

to amortize bond premium on a taxable

bond. Except as provided in paragraph

(c)(3) of this section, a taxable bond is

any bond other than a tax-exempt obligation. See §1.171–4 for rules relating to

1998–7 I.R.B.

the election to amortize bond premium on

a taxable bond.

(3) Bonds the interest on which is partially excludable. For purposes of this

section and §§1.171–2 through 1.171–5, a

bond the interest on which is partially excludable from gross income is treated as

two instruments, a tax-exempt obligation

and a taxable bond. The holder’s basis in

the bond and each payment on the bond

are allocated between the two instruments

based on a reasonable method.

(d) Determination of bond premium—

(1) In general. A holder acquires a bond

at a premium if the holder’s basis in the

bond immediately after its acquisition by

the holder exceeds the sum of all amounts

payable on the bond after the acquisition

date (other than payments of qualified

stated interest). This excess is bond premium, which is amortizable under

§1.171–2.

(2) Additional rules for amounts

payable on certain bonds. Additional

rules apply to determine the amounts

payable on a variable rate debt instrument, an inflation-indexed debt instrument, a bond that provides for certain alternative payment schedules, and a bond

that provides for remote or incidental contingencies. See §1.171–3.

(e) Basis. A holder determines its basis

in a bond under this paragraph (e). This

determination of basis applies only for

purposes of this section and §§1.171–2

through 1.171–5. Because of the application of this paragraph (e), the holder’s

basis in the bond for purposes of these

sections may differ from the holder’s

basis for determining gain or loss on the

sale or exchange of the bond.

(1) Determination of basis—(i) In general. In general, the holder’s basis in the

bond is the holder’s basis for determining

loss on the sale or exchange of the bond.

(ii) Bonds acquired in certain exchanges. If the holder acquired the bond

in exchange for other property (other than

in a reorganization defined in section 368)

and the holder’s basis in the bond is determined in whole or in part by reference to

the holder’s basis in the other property,

the holder’s basis in the bond may not exceed its fair market value immediately

after the exchange. See paragraph (f) Example 1 of this section. If the bond is acquired in a reorganization, see section

171(b)(4)(B).

1998–7 I.R.B

(iii) Convertible bonds—(A) General

rule. If the bond is a convertible bond,

the holder’s basis in the bond is reduced

by an amount equal to the value of the

conversion option. The value of the conversion option may be determined under

any reasonable method. For example, the

holder may determine the value of the

conversion option by comparing the market price of the convertible bond to the

market prices of similar bonds that do not

have conversion options. See paragraph

(f) Example 2 of this section.

(B) Convertible bonds acquired in certain exchanges. If the bond is a convertible bond acquired in a transaction described in paragraph (e)(1)(ii) of this

section, the holder’s basis in the bond

may not exceed its fair market value immediately after the exchange reduced by

the value of the conversion option.

(C) Definition of convertible bond. A

convertible bond is a bond that provides

the holder with an option to convert the

bond into stock of the issuer, stock or debt

of a related party (within the meaning of

section 267(b) or 707(b)(1)), or into cash

or other property in an amount equal to the

approximate value of such stock or debt.

(2) Basis in bonds held by certain

transferees. Notwithstanding paragraph

(e)(1) of this section, if the bond is transferred basis property (as defined in section 7701(a)(43)) and the transferor had

acquired the bond at a premium, the

holder’s basis in the bond is—

(i) The holder’s basis for determining

loss on the sale or exchange of the bond;

reduced by

(ii) Any amounts that the transferor

could not have amortized under this paragraph (e) or under §1.171–4(c), except to

the extent that the holder’s basis already

reflects a reduction attributable to such

nonamortizable amounts.

(f) Examples. The following examples

illustrate the rules of this section:

Example 1. Bond received in liquidation of a

partnership interest—(i) Facts. PR is a partner in

partnership PRS. PRS does not have any unrealized

receivables or inventory items as defined in section

751. On January 1, 1998, PRS distributes to PR a

taxable bond, issued by an unrelated corporation, in

liquidation of PR’s partnership interest. At that

time, the fair market value of PR’s partnership interest is $40,000 and the basis is $100,000. The fair

market value of the bond is $40,000.

(ii) Determination of basis. Under section

732(b), PR’s basis in the bond is equal to PR’s basis

in the partnership interest. Therefore, PR’s basis for

9

determining loss on the sale or exchange of the bond

is $100,000. However, because the distribution is

treated as an exchange for purposes of section

171(b)(4), PR’s basis in the bond is $40,000 for purposes of this section and §§1.171–2 through 1.171–

5. See paragraph (e)(1)(ii) of this section.

Example 2. Convertible bond—(i) Facts. On

January 1, 1998, A purchases for $1,100 B corporation’s bond maturing on January 1, 2001, with a

stated principal amount of $1,000, payable at maturity. The bond provides for unconditional payments

of interest of $30 on January 1 and July 1 of each

year. In addition, the bond is convertible into 15

shares of B corporation stock at the option of the

holder. On January 1, 1998, B corporation’s nonconvertible, publicly-traded, three-year debt with a

similar credit rating trades at a price that reflects a

yield of 6.75 percent, compounded semiannually.

(ii) Determination of basis. A’s basis for determining loss on the sale or exchange of the bond is

$1,100. As of January 1, 1998, discounting the remaining payments on the bond at the yield at which

B’s similar nonconvertible bonds trade (6.75 percent, compounded semiannually) results in a present

value of $980. Thus, the value of the conversion option is $120. Under paragraph (e)(1)(iii)(A) of this

section, A’s basis is $980 ($1,100–$120) for purposes of this section and §§1.171–2 through 1.171–

5. The sum of all amounts payable on the bond

other than qualified stated interest is $1,000. Because A’s basis (as determined under paragraph

(e)(1)(iii)(A) of this section) does not exceed

$1,000, A does not acquire the bond at a premium.

§1.171–2 Amortization of bond premium.

(a) Offsetting qualified stated interest

with premium—(1) In general. A holder

amortizes bond premium by offsetting the

qualified stated interest allocable to an accrual period with the bond premium allocable to the accrual period. This offset

occurs when the holder takes the qualified

stated interest into account under the

holder’s regular method of accounting.

(2) Qualified stated interest allocable

to an accrual period. See §1.446–2(b) to

determine the accrual period to which

qualified stated interest is allocable and to

determine the accrual of qualified stated

interest within an accrual period.

(3) Bond premium allocable to an accrual period. The bond premium allocable to an accrual period is determined

under this paragraph (a)(3). Within an accrual period, the bond premium allocable

to the period accrues ratably.

(i) Step one: Determine the holder’s

yield. The holder’s yield is the discount

rate that, when used in computing the present value of all remaining payments to be

made on the bond (including payments of

qualified stated interest), produces an

amount equal to the holder’s basis in the

February 17, 1998

bond as determined under §1.171–1(e).

For this purpose, the remaining payments

include only payments to be made after

the date the holder acquires the bond.

The yield is calculated as of the date the

holder acquires the bond, must be constant over the term of the bond, and must

be calculated to at least two decimal

places when expressed as a percentage.

(ii) Step two: Determine the accrual

periods. A holder determines the accrual

periods for the bond under the rules of

§1.1272–1(b)(1)(ii).

(iii) Step three: Determine the bond

premium allocable to the accrual period.

The bond premium allocable to an accrual

period is the excess of the qualified stated

interest allocable to the accrual period

over the product of the holder’s adjusted

acquisition price (as defined in paragraph

(b) of this section) at the beginning of the

accrual period and the holder’s yield. In

performing this calculation, the yield must

be stated appropriately taking into account

the length of the particular accrual period.

Principles similar to those in §1.1272–

1(b)(4) apply in determining the bond premium allocable to an accrual period.

(4) Bond premium in excess of qualified stated interest—(i) Taxable bonds—

(A) Bond premium deduction. In the case

of a taxable bond, if the bond premium allocable to an accrual period exceeds the

qualified stated interest allocable to the

accrual period, the excess is treated by the

holder as a bond premium deduction

under section 171(a)(1) for the accrual period. However, the amount treated as a

bond premium deduction is limited to the

amount by which the holder’s total interest inclusions on the bond in prior accrual

periods exceed the total amount treated by

the holder as a bond premium deduction

on the bond in prior accrual periods. A

deduction determined under this paragraph (a)(4)(i)(A) is not subject to section

67 (the 2-percent floor on miscellaneous

itemized deductions). See Example 1 of

§1.171–3(e).

(B) Carryforward. If the bond premium

allocable to an accrual period exceeds the

sum of the qualified stated interest allocable to the accrual period and the amount

treated as a deduction for the accrual period under paragraph (a)(4)(i)(A) of this

section, the excess is carried forward to the

next accrual period and is treated as bond

premium allocable to that period.

February 17, 1998

(ii) Tax-exempt obligations. In the case

of a tax-exempt obligation, if the bond

premium allocable to an accrual period

exceeds the qualified stated interest allocable to the accrual period, the excess is a

nondeductible loss. If a regulated investment company (RIC) within the meaning

of section 851 has excess bond premium

for an accrual period that would be a

nondeductible loss under the prior sentence, the RIC must use this excess bond

premium to reduce its tax-exempt interest

income on other tax-exempt obligations

held during the accrual period.

(5) Additional rules for certain bonds.

Additional rules apply to determine the

amortization of bond premium on a variable rate debt instrument, an inflation-indexed debt instrument, a bond that provides for certain alternative payment

schedules, and a bond that provides for

remote or incidental contingencies. See

§1.171–3.

(b) Adjusted acquisition price. The adjusted acquisition price of a bond at the

beginning of the first accrual period is the

holder ’s basis as determined under

§1.171–1(e). Thereafter, the adjusted acquisition price is the holder’s basis in the

bond decreased by—

(1) The amount of bond premium previously allocable under paragraph (a)(3)

of this section; and

(2) The amount of any payment previously made on the bond other than a payment of qualified stated interest.

(c) Examples. The following examples

illustrate the rules of this section. Each

example assumes the holder uses the calendar year as its taxable year and has

elected to amortize bond premium, effective for all relevant taxable years. In addition, each example assumes a 30-day

month and 360-day year. Although, for

purposes of simplicity, the yield as stated

is rounded to two decimal places, the

computations do not reflect this rounding

convention. The examples are as follows:

Example 1. Taxable bond—(i) Facts. On February 1, 1999, A purchases for $110,000 a taxable

bond maturing on February 1, 2006, with a stated

principal amount of $100,000, payable at maturity.

The bond provides for unconditional payments of

interest of $10,000, payable on February 1 of each

year. A uses the cash receipts and disbursements

method of accounting, and A decides to use annual

accrual periods ending on February 1 of each year.

(ii) Amount of bond premium. The interest payments on the bond are qualified stated interest.

10

Therefore, the sum of all amounts payable on the

bond (other than the interest payments) is $100,000.

Under §1.171–1, the amount of bond premium is

$10,000 ($110,000–$100,000).

(iii) Bond premium allocable to the first accrual

period. Based on the remaining payment schedule

of the bond and A’s basis in the bond, A’s yield is

8.07 percent, compounded annually. The bond premium allocable to the accrual period ending on February 1, 2000, is the excess of the qualified stated interest allocable to the period ($10,000) over the

product of the adjusted acquisition price at the beginning of the period ($110,000) and A’s yield (8.07

percent, compounded annually). Therefore, the

bond premium allocable to the accrual period is

$1,118.17 ($10,000–$8,881.83).

(iv) Premium used to offset interest. Although A

receives an interest payment of $10,000 on February

1, 2000, A only includes in income $8,881.83, the

qualified stated interest allocable to the period

($10,000) offset with bond premium allocable to the

period ($1,118.17). Under §1.1016–5(b), A’s basis

in the bond is reduced by $1,118.17 on February 1,

2000.

Example 2. Alternative accrual periods—(i)

Facts. The facts are the same as in Example 1 of this

paragraph (c) except that A decides to use semiannual accrual periods ending on February 1 and August 1 of each year.

(ii) Bond premium allocable to the first accrual

period. Based on the remaining payment schedule

of the bond and A’s basis in the bond, A’s yield is

7.92 percent, compounded semiannually. The bond

premium allocable to the accrual period ending on

August 1, 1999, is the excess of the qualified stated

interest allocable to the period ($5,000) over the

product of the adjusted acquisition price at the beginning of the period ($110,000) and A’s yield,

stated appropriately taking into account the length of

the accrual period (7.92 percent/2). Therefore, the

bond premium allocable to the accrual period is

$645.29 ($5,000–$4,354.71). Although the accrual

period ends on August 1, 1999, the qualified stated

interest of $5,000 is not taken into income until February 1, 2000, the date it is received. Likewise, the

bond premium of $645.29 is not taken into account

until February 1, 2000. The adjusted acquisition

price of the bond on August 1, 1999, is $109,354.71

(the adjusted acquisition price at the beginning of

the period ($110,000) less the bond premium allocable to the period ($645.29)).

(iii) Bond premium allocable to the second accrual period. Because the interval between payments of qualified stated interest contains more than

one accrual period, the adjusted acquisition price at

the beginning of the second accrual period must be

adjusted for the accrued but unpaid qualified stated

interest. See paragraph (a)(3)(iii) of this section and

§1.1272–1(b)(4)(i)(B). Therefore, the adjusted acquisition price on August 1, 1999, is $114,354.71

($109,354.71 + $5,000). The bond premium allocable to the accrual period ending on February 1,

2000, is the excess of the qualified stated interest allocable to the period ($5,000) over the product of the

adjusted acquisition price at the beginning of the period ($114,354.71) and A’s yield, stated appropriately taking into account the length of the accrual

period (7.92 percent/2). Therefore, the bond premium allocable to the accrual period is $472.88

($5,000–$4,527.12).

1998–7 I.R.B.

(iv) Premium used to offset interest. Although A

receives an interest payment of $10,000 on February

1, 2000, A only includes in income $8,881.83, the

qualified stated interest of $10,000 ($5,000 allocable

to the accrual period ending on August 1, 1999, and

$5,000 allocable to the accrual period ending on

February 1, 2000) offset with bond premium of

$1,118.17 ($645.29 allocable to the accrual period

ending on August 1, 1999, and $472.88 allocable to

the accrual period ending on February 1, 2000). As

indicated in Example 1 of this paragraph (c), this

same amount would be taken into income at the

same time had A used annual accrual periods.

Example 3. Holder uses accrual method of accounting—(i) Facts. The facts are the same as in Example 1 of this paragraph (c) except that A uses an

accrual method of accounting. Thus, for the accrual

period ending on February 1, 2000, the qualified

stated interest allocable to the period is $10,000, and

the bond premium allocable to the period is

$1,118.17. Because the accrual period extends beyond the end of A’s taxable year, A must allocate

these amounts between the two taxable years.

(ii) Amounts allocable to the first taxable year.

The qualified stated interest allocable to the first taxable year is $9,166.67 ($10,000 3 11/12). The bond

premium allocable to the first taxable year is

$1,024.99 ($1,118.17 3 11/12).

(iii) Premium used to offset interest. For 1999, A

includes in income $8,141.68, the qualified stated

interest allocable to the period ($9,166.67) offset

with bond premium allocable to the period

($1,024.99). Under §1.1016–5(b), A’s basis in the

bond is reduced by $1,024.99 in 1999.

(iv) Amounts allocable to the next taxable year.

The remaining amounts of qualified stated interest

and bond premium allocable to the accrual period

ending on February 1, 2000, are taken into account

for the taxable year ending on December 31, 2000.

Example 4. Tax-exempt obligation—(i) Facts.

On January 15, 1999, C purchases for $120,000 a

tax-exempt obligation maturing on January 15,

2006, with a stated principal amount of $100,000,

payable at maturity. The obligation provides for unconditional payments of interest of $9,000, payable

on January 15 of each year. C uses the cash receipts

and disbursements method of accounting, and C decides to use annual accrual periods ending on January 15 of each year.

(ii) Amount of bond premium. The interest payments on the obligation are qualified stated interest.

Therefore, the sum of all amounts payable on the

obligation (other than the interest payments) is

$100,000. Under §1.171–1, the amount of bond premium is $20,000 ($120,000–$100,000).

(iii) Bond premium allocable to the first accrual

period. Based on the remaining payment schedule

of the obligation and C’s basis in the obligation, C’s

yield is 5.48 percent, compounded annually. The

bond premium allocable to the accrual period ending

on January 15, 2000, is the excess of the qualified

stated interest allocable to the period ($9,000) over

the product of the adjusted acquisition price at the

beginning of the period ($120,000) and C’s yield

(5.48 percent, compounded annually). Therefore,

the bond premium allocable to the accrual period is

$2,420.55 ($9,000–$6,579.45).

(iv) Premium used to offset interest. Although C

receives an interest payment of $9,000 on January

15, 2000, C only receives tax-exempt interest in-

1998–7 I.R.B

come of $6,579.45, the qualified stated interest allocable to the period ($9,000) offset with bond premium allocable to the period ($2,420.55). Under

§1.1016–5(b), C’s basis in the obligation is reduced

by $2,420.55 on January 15, 2000.

§1.171–3 Special rules for certain

bonds.

(a) Variable rate debt instruments. A

holder determines bond premium on a

variable rate debt instrument by reference

to the stated redemption price at maturity

of the equivalent fixed rate debt instrument constructed for the variable rate debt

instrument. The holder also allocates any

bond premium among the accrual periods

by reference to the equivalent fixed rate

debt instrument. The holder constructs

the equivalent fixed rate debt instrument,

as of the date the holder acquires the variable rate debt instrument, by using the

principles of §1.1275–5(e). See paragraph (e) Example 1 of this section.

(b) Inflation-indexed debt instruments.

A holder determines bond premium on an

inflation-indexed debt instrument by assuming that there will be no inflation or

deflation over the remaining term of the

instrument. The holder also allocates any

bond premium among the accrual periods

by assuming that there will be no inflation

or deflation over the remaining term of

the instrument. The bond premium allocable to an accrual period offsets qualified stated interest allocable to the period.

Notwithstanding §1.171–2(a)(4), if the

bond premium allocable to an accrual period exceeds the qualified stated interest

allocable to the period, the excess is

treated as a deflation adjustment under

§1.1275–7T(f)(1)(i). See §1.1275–7T for

other rules relating to inflation-indexed

debt instruments.

(c) Yield and remaining payment schedule of certain bonds subject to contingencies—(1) Applicability. This paragraph

(c) provides rules that apply in determining the yield and remaining payment

schedule of certain bonds that provide for

an alternative payment schedule (or

schedules) applicable upon the occurrence of a contingency (or contingencies).

This paragraph (c) applies, however, only

if the timing and amounts of the payments

that comprise each payment schedule are

known as of the date the holder acquires

the bond (the acquisition date) and the

bond is subject to paragraph (c)(2), (3), or

(4) of this section. A bond does not pro-

11

vide for an alternative payment schedule

merely because there is a possibility of

impairment of a payment (or payments)

by insolvency, default, or similar circumstances. See §1.1275–4 for the treatment

of a bond that provides for a contingency

that is not described in this paragraph (c).

(2) Remaining payment schedule that is

significantly more likely than not to occur.

If, based on all the facts and circumstances as of the acquisition date, a single

remaining payment schedule for a bond is

significantly more likely than not to

occur, this remaining payment schedule is

used to determine and amortize bond premium under §§1.171–1 and 1.171–2.

(3) Mandatory sinking fund provision.

Notwithstanding paragraph (c)(2) of this

section, if a bond is subject to a mandatory sinking fund provision described in

§1.1272–1(c)(3), the provision is ignored

for purposes of determining and amortizing bond premium under §§1.171–1 and

1.171–2.

(4) Treatment of certain options—(i)

Applicability. Notwithstanding paragraphs (c)(2) and (3) of this section, the

rules of this paragraph (c)(4) determine

the remaining payment schedule of a

bond that provides the holder or issuer

with an unconditional option or options,

exercisable on one or more dates during

the remaining term of the bond, to alter

the bond’s remaining payment schedule.

(ii) Operating rules. A holder determines the remaining payment schedule of

a bond by assuming that each option will

(or will not) be exercised under the following rules:

(A) Issuer options. In general, the issuer is deemed to exercise or not exercise

an option or combination of options in the

manner that minimizes the holder’s yield

on the obligation. However, the issuer of

a taxable bond is deemed to exercise or

not exercise a call option or combination

of call options in the manner that maximizes the holder’s yield on the bond.

(B) Holder options. A holder is

deemed to exercise or not exercise an option or combination of options in the manner that maximizes the holder’s yield on

the bond.

(C) Multiple options. If both the issuer

and the holder have options, the rules of

paragraphs (c)(4)(ii)(A) and (B) of this

section are applied to the options in the

order that they may be exercised. Thus,

February 17, 1998

the deemed exercise of one option may

eliminate other options that are later in

time.

(5) Subsequent adjustments—(i) In

general. Except as provided in paragraph

(c)(5)(ii) of this section, if a contingency

described in this paragraph (c) (including

the exercise of an option described in

paragraph (c)(4) of this section) actually

occurs or does not occur, contrary to the

assumption made pursuant to paragraph

(c) of this section (a change in circumstances), then solely for purposes of section 171, the bond is treated as retired and

reacquired by the holder on the date of the

change in circumstances for an amount

equal to the adjusted acquisition price of

the bond as of that date. If, however, the

change in circumstances results in a substantially contemporaneous pro-rata prepayment as defined in §1.1275–2(f)(2),

the pro-rata prepayment is treated as a

payment in retirement of a portion of the

bond. See paragraph (e) Example 2 of

this section.

(ii) Bond premium deduction on the issuer’s call of a taxable bond. If a change

in circumstances results from an issuer’s

call of a taxable bond or a partial call that

is a pro-rata prepayment, the holder may

deduct as bond premium an amount equal

to the excess, if any, of the holder’s adjusted acquisition price of the bond over

the greater of—

Example 1. Variable rate debt instrument—(i)

Facts. On March 1, 1999, E purchases for $110,000

a taxable bond maturing on March 1, 2007, with a

stated principal amount of $100,000, payable at maturity. The bond provides for unconditional payments of interest on March 1 of each year based on

the percentage appreciation of a nationally-known

commodity index. On March 1, 1999, it is reason-

Accrual period

ending

Adjusted

acquisition

price at beginning

of accrual period

3/1/00

3/1/01

3/1/02

3/1/03

3/1/04

3/1/05

3/1/06

3/1/07

$110,000.00

109,129.29

108,170.48

107,114.66

105,952.02

104,671.75

103,261.95

101,709.51

(iv) Qualified stated interest for each accrual period. Assume the bond actually pays the following

amounts of qualified stated interest:

Accrual period ending

Qualified stated interest

3/1/00

3/1/01

3/1/02

3/1/03

3/1/04

3/1/05

3/1/06

3/1/07

$2,000.00

0.00

0.00

10,000.00

8,000.00

12,000.00

15,000.00

8,500.00

February 17, 1998

(A) The amount received on redemption; and

(B) The amounts that would have been

payable under the bond (other than payments of qualified stated interest) if no

change in circumstances had occurred.

(d) Remote and incidental contingencies. For purposes of determining and

amortizing bond premium, if a bond provides for a contingency that is remote or

incidental (within the meaning of

§1.1275–2(h)), the holder takes the contingency into account under the rules for

remote and incidental contingencies in

§1.1275–2(h).

(e) Examples. The following examples

illustrate the rules of this section. Each

example assumes the holder uses the calendar year as its taxable year and has

elected to amortize bond premium, effective for all relevant taxable years. In addition, each example assumes a 30-day

month and 360-day year. Although, for

purposes of simplicity, the yield as stated

is rounded to two decimal places, the

computations do not reflect this rounding

convention. The examples are as follows:

(v) Premium used to offset interest. E’s interest

income for each accrual period is determined by offsetting the qualified stated interest allocable to the

period with the bond premium allocable to the period. For the accrual period ending on March 1,

2000, E includes in income $1,129.29, the qualified

stated interest allocable to the period ($2,000) offset

with the bond premium allocable to the period

($870.71). For the accrual period ending on March

1, 2001, the bond premium allocable to the accrual

period ($958.81) exceeds the qualified stated interest allocable to the period ($0) and, therefore, E does

12

ably expected that the bond will yield 12 percent,

compounded annually. E uses the cash receipts and

disbursements method of accounting, and E decides

to use annual accrual periods ending on March 1 of

each year. Assume that the bond is a variable rate

debt instrument under §1.1275–5.

(ii) Amount of bond premium. Because the bond

is a variable rate debt instrument, E determines and

amortizes its bond premium by reference to the

equivalent fixed rate debt instrument constructed for

the bond as of March 1, 1999. Because the bond

provides for interest at a single objective rate that is

reasonably expected to yield 12 percent, compounded annually, the equivalent fixed rate debt instrument for the bond is an eight-year bond with a

principal amount of $100,000, payable at maturity.

It provides for annual payments of interest of

$12,000. E’s basis in the equivalent fixed rate debt

instrument is $110,000. The sum of all amounts

payable on the equivalent fixed rate debt instrument

(other than payments of qualified stated interest) is

$100,000. Under §1.171–1, the amount of bond premium is $10,000 ($110,000–$100,000).

(iii) Bond premium allocable to each accrual period. E allocates bond premium to the remaining accrual periods by reference to the payment schedule

on the equivalent fixed rate debt instrument. Based

on the payment schedule of the equivalent fixed rate

debt instrument and E’s basis in the bond, E’s yield

is 10.12 percent, compounded annually. The bond

premium allocable to the accrual period ending on

March 1, 2000, is the excess of the qualified stated

interest allocable to the period for the equivalent

fixed rate debt instrument ($12,000) over the product of the adjusted acquisition price at the beginning

of the period ($110,000) and E’s yield (10.12 percent, compounded annually). Therefore, the bond

premium allocable to the accrual period is $870.71

($12,000–$11,129.29). The bond premium allocable to all the accrual periods is listed in the following schedule:

Premium allocable

to accrual period

$870.71

958.81

1,055.82

1,162.64

1,280.27

1,409.80

1,552.44

1,709.51

$10,000.00

not have interest income for this accrual period.

However, under §1.171–2(a)(4)(i)(A), E may deduct

as bond premium $958.81, the excess of the bond

premium allocable to the accrual period ($958.81)

over the qualified stated interest allocable to the accrual period ($0). For the accrual period ending on

March 1, 2002, the bond premium allocable to the

accrual period ($1,055.82) exceeds the qualified

stated interest allocable to the accrual period ($0)

and, therefore, E does not have interest income for

the accrual period. Under §1.171–2(a)(4)(i)(A), E’s

deduction for bond premium for the accrual period

1998–7 I.R.B.

is limited to $170.48, the excess of E’s total interest

inclusions on the bond in prior accrual periods

($1,129.29) over the total amount treated by E as a

bond premium deduction in prior accrual periods

Accrual

period

ending

Qualified

stated

interest

3/1/00

3/1/01

3/1/02

3/1/03

3/1/04

3/1/05

3/1/06

3/1/07

$2,000.00

0.00

0.00

10,000.00

8,000.00

12,000.00

15,000.00

8,500.00

Example 2. Partial call that results in a pro-rata

prepayment—(i) Facts. On April 1, 1999, M purchases for $110,000 N’s taxable bond maturing on

April 1, 2006, with a stated principal amount of

$100,000, payable at maturity. The bond provides

for unconditional payments of interest of $10,000,

payable on April 1 of each year. N has the option to

call all or part of the bond on April 1, 2001, at a 5

percent premium over the principal amount. M uses

the cash receipts and disbursements method of accounting.

(ii) Determination of yield and the remaining

payment schedule. M’s yield determined without regard to the call option is 8.07 percent, compounded

annually. M’s yield determined by assuming N exercises its call option is 6.89 percent, compounded

annually. Under paragraph (c)(4)(ii)(A) of this section, it is assumed N will not exercise the call option

because exercising the option would minimize M’s

yield. Thus, for purposes of determining and amortizing bond premium, the bond is assumed to be a

seven-year bond with a single principal payment at

maturity of $100,000.

(iii) Amount of bond premium. The interest payments on the bond are qualified stated interest.

Therefore, the sum of all amounts payable on the

bond (other than the interest payments) is $100,000.

Under §1.171–1, the amount of bond premium is

$10,000 ($110,000–$100,000).

(iv) Bond premium allocable to the first two accrual periods. For the accrual period ending on

April 1, 2000, M includes in income $8,881.83, the

qualified stated interest allocable to the period

($10,000) offset with bond premium allocable to the

period ($1,118.17). The adjusted acquisition price

on April 1, 2000, is $108,881.83 ($110,000–

$1,118.17). For the accrual period ending on April

1, 2001, M includes in income $8,791.54, the qualified stated interest allocable to the period ($10,000)

offset with bond premium allocable to the period

($1,208.46). The adjusted acquisition price on April

1, 2001, is $107,673.37 ($108,881.83–$1,208.46).

(v) Partial call. Assume N calls one-half of M’s

bond for $52,500 on April 1, 2001. Because it was

assumed the call would not be exercised, the call is a

change in circumstances. However, the partial call

is also a pro-rata prepayment within the meaning of

§1.1275–2(f)(2). As a result, the call is treated as a

retirement of one-half of the bond. Under paragraph

1998–7 I.R.B

($958.81). Under §1.171–2(a)(4)(i)(B), E must

carry forward the remaining $885.34 of bond premium allocable to the period ending March 1, 2002,

and treat it as bond premium allocable to the period

Premium

allocable

to accrual

period

Interest

income

$870.71

958.81

1,055.82

1,162.64

1,280.27

1,409.80

1,552.44

1,709.51

$10,000.00

$1,129.29

0.00

0.00

7,951.93

6,719.73

10,590.20

13,447.56

6,790.49

(c)(5)(ii) of this section, M may deduct $1,336.68,

the excess of its adjusted acquisition price in the retired portion of the bond ($107,673.37/2, or

$53,836.68) over the amount received on redemption ($52,500). M’s adjusted basis in the portion of

the bond that remains outstanding is $53,836.68

($107,673.37– $53,836.68).

§1.171–4 Election to amortize bond

premium on taxable bonds.

(a) Time and manner of making the

election—(1) In general. A holder makes

the election to amortize bond premium by

offsetting interest income with bond premium in the holder’s timely filed federal

income tax return for the first taxable year

to which the holder desires the election to

apply. The holder should attach to the return a statement that the holder is making

the election under this section.

(2) Coordination with OID election. If

a holder makes an election under

§1.1272–3 for a bond with bond premium, the holder is deemed to have made

the election under this section.

(b) Scope of election. The election

under this section applies to all taxable

bonds held during or after the taxable year

for which the election is made.

(c) Election to amortize made in a subsequent taxable year—(1) In general. If a

holder elects to amortize bond premium

and holds a taxable bond acquired before

the taxable year for which the election is

made, the holder may not amortize

amounts that would have been amortized

in prior taxable years had an election been

in effect for those prior years.

(2) Example. The following example

illustrates the rule of this paragraph (c):

Example—(i) Facts. On May 1, 1999, C purchases for $130,000 a taxable bond maturing on

13

ending March 1, 2003. The amount E includes in income for each accrual period is shown in the following schedule:

Premium

deduction

Premium

carryforward

$958.81

170.48

$885.34

May 1, 2006, with a stated principal amount of

$100,000, payable at maturity. The bond provides

for unconditional payments of interest of $15,000,

payable on May 1 of each year. C uses the cash receipts and disbursements method of accounting and

the calendar year as its taxable year. C has not previously elected to amortize bond premium, but does

so for 2002.

(ii) Amount to amortize. C’s basis for determining

loss on the sale or exchange of the bond is $130,000.

Thus, under §1.171–1, the amount of bond premium

is $30,000. Under §1.171–2, if a bond premium election were in effect for the prior taxable years, C would

have amortized $3,257.44 of bond premium on May

1, 2000, and $3,551.68 of bond premium on May 1,

2001, based on annual accrual periods ending on May

1. Thus, for 2002 and future years to which the election applies, C may amortize only $23,190.88

($30,000–$3,257.44–$3,551.68).

(d) Revocation of election. The election under this section may not be revoked unless approved by the Commissioner. Because a revocation of the

election is a change in accounting

method, a taxpayer must follow the rules

under §1.446–1(e)(3)(i) to request the

Commissioner’s consent to revoke the

election. A revocation of the election applies to all taxable bonds held during or

after the taxable year for which the revocation is effective. The holder may not

amortize any remaining bond premium on

bonds held at the beginning of the taxable

year for which the revocation is effective.

Therefore, no adjustment under section

481 is allowed upon the revocation of the

election because no items of income or

deduction are omitted or duplicated.

Par. 5. Section 1.171–5 is added to

read as follows:

§1.171–5 Effective date and transition

rules.

(a) Effective date—(1) In general. Sec-

February 17, 1998

tions 1.171-1 through 1.171–4 apply to

bonds acquired on or after March 2, 1998.

However, if a holder makes the election

under §1.171–4 for the taxable year containing March 2, 1998, or any subsequent

taxable year, §§1.171–1 through 1.171–4

apply to bonds held on or after the first

day of the taxable year in which the election is made.

(2) Transition rule for use of constant

yield. Notwithstanding paragraph (a)(1)

of this section, §1.171–2(a)(3) (providing

that the bond premium allocable to an accrual period is determined with reference

to a constant yield) does not apply to a

bond issued before September 28, 1985.

(b) Coordination with existing election.

A holder is deemed to have made the election under §1.171-4 for the taxable year

containing March 2, 1998, if the holder

elected to amortize bond premium under

section 171 and that election is effective

on March 2, 1998. If the holder is

deemed to have made the election under

§1.171–4 for the taxable year containing

March 2, 1998, §§1.171–1 through

1.171–4 apply to bonds acquired on or

after the first day of that taxable year. See

§1.171–4(d) for rules relating to a revocation of an election under section 171.

(c) Accounting method changes—(1)

Consent to change. A holder required to

change its method of accounting for bond

premium to comply with §§1.171–1

through 1.171–3 must secure the consent

of the Commissioner in accordance with

the requirements of §1.446–1(e). Paragraph (c)(2) of this section provides the

Commissioner’s automatic consent for certain changes. A holder making the election

under §1.171–4 does not need the Commissioner’s consent to make the election.

(2) Automatic consent. The Commissioner grants consent for a holder to

change its method of accounting for bond

premium with respect to taxable bonds to

which §§1.171–1 through 1.171–3 apply.

Because this change is made on a cut-off

basis, no items of income or deduction are

omitted or duplicated and, therefore, no

adjustment under section 481 is allowed.

The consent granted by this paragraph

(c)(2) applies provided—

(i) The holder elected to amortize bond

premium under section 171 for a taxable

year prior to the taxable year containing

March 2, 1998, and that election has not

been revoked;

February 17, 1998

(ii) The change is made for the first taxable year for which the holder must account for a bond under §§1.171–1

through 1.171–3; and

(iii) The holder attaches to its return for

the taxable year containing the change a

statement that it has changed its method

of accounting under this section.

Par. 6. Section 1.249–1 is amended by

revising paragraph (c) and the first sentence of paragraph (d)(2) to read as follows:

§1.249–1 Limitation on deduction of

bond premium on repurchase.

*

*

*

*

*

(c) Repurchase premium. For purposes

of this section, the term repurchase premium means the excess of the repurchase

price paid or incurred to repurchase the

obligation over its adjusted issue price

(within the meaning of §1.1275–1(b)) as

of the repurchase date. For the general

rules applicable to the deductibility of repurchase premium, see §1.163–7(c). This

paragraph (c) applies to convertible obligations repurchased on or after March 2,

1998.

(d) * * *

(2) * * * For a convertible obligation

repurchased on or after March 2, 1998, a

call premium specified in dollars under

the terms of the obligation is considered

to be a normal call premium on a nonconvertible obligation if the call premium applicable when the obligation is repurchased does not exceed an amount equal

to the interest (including original issue

discount) that otherwise would be deductible for the taxable year of repurchase

(determined as if the obligation were not

repurchased). * * *

*

*

*

*

*

Par. 7. Section 1.1016–5 is amended by

revising paragraph (b) to read as follows:

§1.1016–5 Miscellaneous adjustments to

basis.

*

*

*

*

*

(b) Amortizable bond premium—(1) In

general. A holder’s basis in a bond is reduced by the amount of bond premium

used to offset qualified stated interest income under §1.171–2. This reduction occurs when the holder takes the qualified

14

stated interest into account under the

holder’s regular method of accounting.

(2) Special rules for taxable bonds. A

holder’s basis in a taxable bond is reduced

by the amount of bond premium allowed

as a deduction under §1.171–3(c)(5)(ii)

(relating to the issuer’s call of a taxable

bond) or under §1.171–2(a)(4)(i)(A) (relating to excess bond premium).

(3) Special rule for tax-exempt obligations. A holder’s basis in a tax-exempt

obligation is reduced by the amount of excess bond premium that is treated as a

nondeductible loss under §1.171– 2(a)(4)(ii).

*

*

*

*

*

§1.1016–9 [Removed]

Par. 8. Section 1.1016–9 is removed.

Par. 9. Section 1.1275–1 is amended

by:

1. Redesignating paragraph (b)(2) as

paragraph (b)(3). 2. Adding a new paragraph (b)(2).

The addition reads as follows:

§1.1275–1 Definitions.

*

*

*

*

*

(b) * * *

(2) Bond issuance premium. If a debt

instrument is issued with bond issuance

premium (as defined in §1.163–13(c)), for

purposes of determining the issuer’s adjusted issue price, the adjusted issue price

determined under paragraph (b)(1) of this

section is also decreased by the amount of

bond issuance premium previously allocable under §1.163–13(d)(3).

*

*

*

*

*

PART 602—OMB CONTROL

NUMBERS UNDER THE

PAPERWORK REDUCTION ACT

Par. 10. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 11. Section 602.101, paragraph (c)

is amended by:

1. Removing the following entry from

the table:

§602.101 OMB Control numbers.

*

*

*

*

*

(c) * * *

1998–7 I.R.B.

CFR part or section

where identified

and described

Current OMB

control No.

* * * * *

1.171–3 . . . . . . . . . . . . . . . . .1545–0172

*

*

*

*

*

2. Adding entries in numerical order to

the table to read as follows:

ACTION: Final regulations.

SUMMARY: This document contains

final regulations relating to deductions

available upon demolition of a building.

These final regulations reflect changes to

the law made by the Tax Reform Act of

1984 and affect owners and lessees of real

property who demolish buildings.

DATES: The regulations are effective

December 30, 1997.

§602.101 OMB Control numbers.

*

*

*

*

*

(c) * * *

CFR part or section

where identified

and described

Current OMB

control No.

* * * * *

1.163–13 . . . . . . . . . . . . . . . .1545–1491

* * * * *

1.171–4 . . . . . . . . . . . . . . . . .1545–1491

1.171–5 . . . . . . . . . . . . . . . . .1545–1491

*

*

*

*

*

Michael P. Dolan,

Deputy Commissioner of

Internal Revenue.

Approved December 15, 1997.

Donald C. Lubick,

Acting Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on

December 30, 1997, 8:45 a.m., and published in the

issue of the Federal Register for December 31, 1997,

62 F.R. 68173)

Section 280B.—Demolition of

Structures

26 CFR 1.280B–1: Demolition of structures.

T.D. 8745

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Definition of Structure

AGENCY: Internal Revenue Service

(IRS), Treasury.

1998–7 I.R.B

FOR FURTHER INFORMATION CONTACT: Bernard P. Harvey, (202) 6223110 (not a toll-free number). For dates

of applicability of these regulations, see §

1.280B–1(c).

SUPPLEMENTARY INFORMATION:

Background

This document contains final regulations under section 280B of the Internal

Revenue Code. Section 280B was added

by the Tax Reform Act of 1976, Public

Law 94–455, 2124(b), 90 Stat. 1520,

1918 (Oct. 4, 1976), and significant

amendments were made to the provision

by the Economic Recovery Tax Act of

1981, Public Law 97–34, 212(d)(2)(C)

and (e)(2), 95 Stat. 172, 239 (Aug. 13,

1981) (1981 Act) and the Tax Reform Act

of 1984, Public Law 98–369, 1063, 98

Stat. 494, 1047 (July 18, 1984) (1984

Act). Transition rules were provided in

the Tax Reform Act of 1986, Public Law

99–514, 1878(h), 100 Stat. 2085, 2904

(Oct. 22, 1986) (1986 Act). As originally

enacted, section 280B required any costs

or losses incurred on account of the demolition of any certified historic structure (a

building or structure meeting certain requirements) to be capitalized into the land

upon which the demolished structure was

located. The 1981 Act modified the definition of certified historic structure for purposes of section 280B from a building or

structure meeting certain requirements to a

building (or its structural components)

meeting certain requirements. The 1984

Act substituted “any structure” for “certified historic structure.”

A notice of proposed rulemaking was

published in the Federal Register (61 F.R.

31473 [PS–39–93, 1996–2 C.B. 489]) on

June 20, 1996. The one written comment

received supports the position announced

in the notice of proposed rulemaking.

15

These final regulations define what

“structure” means for purposes of section

280B.

Explanation of Provisions

These final regulations define the term

“structure” for purposes of section 280B

as a building and its structural components as those terms are defined in §1.48–

1(e) of the Income Tax Regulations.

Thus, under section 280B, a structure will

include only a building and its structural

components and not other inherently permanent structures such as oil and gas storage tanks, blast furnaces, and coke ovens.

The final regulations rely on the legislative history underlying the 1984 and

1986 Acts, which refer repeatedly to

buildings rather than to structures generally. In addition, the legislative history of

the 1984 Act discusses the difficulty of

applying the intent test of §1.165–3 of the

regulations, which applies to the demolition of buildings, and indicates that the

newly added language is meant to eliminate this difficulty.

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 and, because

these regulations do not impose on small

entities a collection of information requirement, the Regulatory Flexibility Act

(5 U.S.C. chapter 6) does not apply.

Therefore, a Regulatory Flexibility

Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue

Code, the notice of proposed rulemaking

preceding these regulations was submitted to the Chief Counsel for Advocacy of

the Small Business Administration for

comment on its impact on small business.

Drafting Information

The principal author of these regulations is Bernard P. Harvey, Office of Assistant Chief Counsel (Passthroughs and

Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

*

*

*

*

*

February 17, 1998

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is 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 1.280B–1 is added to

read as follows:

§1.280B–1 Demolition of structures.

(a) In general. Section 280B provides

that, in the case of the demolition of any

structure, no deduction otherwise allowable under chapter 1 of subtitle A shall be

allowed to the owner or lessee of such

structure for any amount expended for the

demolition or any loss sustained on account of the demolition, and that the expenditure or loss shall be treated as properly chargeable to the capital account with

respect to the land on which the demolished structure was located.

(b) Definition of structure. For purposes of section 280B, the term structure

means a building, as defined in §1.48–

1(e)(1), including the structural components of that building, as defined in

§1.48–1(e)(2).

(c) Effective date. This section is effective for demolitions commencing on or

after December 30, 1997.

tain tax-exempt organizations that will be treated as

satisfying the requirements of § 6033(e)(3). Those

organizations will not be subject to the reporting and

notice requirements of § 6033(e)(1) or the tax imposed by § 6033(e)(2). Procedures for other exempt

organizations to establish that they satisfy the requirements of § 6033(e)(3) are also provided. Rev.

Proc. 95–35, 1995–2 C.B. 391, and Rev. Proc.

95–35A, 1995–2 C.B. 392, are superseded. See Rev.

Proc. 98–19, page 30.

Section 1202.—50 Percent

Exclusion for Gain From Certain

Small Business Stock

26 CFR 1.1202–2: Qualified small business stock;

effect of redemptions.

T.D. 8749

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Qualified Small Business Stock

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

Michael P. Dolan,

Deputy Commissioner of

Internal Revenue.

SUMMARY: This document contains

final regulations relating to the 50-percent

exclusion for gain from certain small

business stock. The final regulations

reflect changes to the law made by the

Omnibus Budget Reconciliation Act of

1993 and provide guidance to the issuers

and owners of the stock of certain small

businesses.

Donald C. Lubick,

Acting Assistant Secretary of

the Treasury.

DATES: This regulation is effective December 31, 1997. For dates of applicability of these regulations, see §1.1202–2(e).

(Filed by the Office of the Federal Register on

December 29, 1997, 8:45 a.m., and published in the

issue of the Federal Register for December 30, 1997,

62 F.R. 67725)

FOR FURTHER INFORMATION CONTACT: Catherine A. Prohofsky of the Office of the Assistant Chief Counsel

(Income Tax and Accounting) at 202-6224930 (not a toll-free call).

Section 501.—Exemption From

Tax on Corporations, Certain

Trusts, Etc.

This revenue procedure provides guidance to organizations exempt from taxation under § 501(a) of

the Internal Revenue Code of 1986 on the application of amendments made to §§ 162(e) and 6033(e)

by § 13222 of the Omnibus Budget Reconciliation

Act of 1993. The revenue procedure identifies cer-

February 17, 1998

SUPPLEMENTARY INFORMATION:

Background

Section 1202 of the Internal Revenue

Code allows a taxpayer (other than a corporation) to exclude 50 percent of certain

gain from the sale or exchange of qualified small business stock held for more

16

than 5 years. This document contains

amendments to the Income Tax Regulations (26 CFR part 1) that provide guidance relating to the effect of redemptions

on the availability of this exclusion.

On June 6, 1996, the Federal Register

published a notice of proposed rulemaking (IA–26–94), 61 F.R. 28821, relating

to the effect of certain redemptions on the

50-percent exclusion of gain from the sale

or exchange of qualified small business

stock under section 1202. The proposed

regulations provide that these redemptions are disregarded in determining

whether the anti-churning rules of section

1202(c) are violated.

Four comments responding to this notice were received. A public hearing was

held on October 3, 1996. After consideration of the comments, the proposed regulations under section 1202 are adopted as

modified by this Treasury decision.

Summary of Comments and

Modifications

The notice of proposed rulemaking requested comments on how to determine

when an independent contractor has terminated services. One commentator suggested that the determination of whether

services of an independent contractor

were terminated should be based on all

the facts and circumstances, with termination conclusively presumed if no further

services were provided for six months.

The IRS and Treasury Department have

not adopted this suggestion, but are continuing to study this issue and request additional comments.

Commentators suggested an additional

exception for all redemptions occurring in

the ordinary course of business or for legitimate business reasons. The final regulations do not incorporate this suggestion.

The exceptions in the final regulations relate to redemptions that are incident to

certain events affecting a shareholder.

Because of the extraordinary nature of

these events and the fact that they are generally not within the control of the issuing

corporation, the exceptions are unlikely to

lead to avoidance of the requirement that

qualified small business stock be purchased at original issue. The IRS and

Treasury are concerned, however, that a

much broader exception for redemptions

that arise out of the ordinary business

needs and purposes of the issuing corpo-

1998–7 I.R.B.

ration, and are not incident to extraordinary events affecting its shareholders,

would be much more likely to undermine

the original issue requirement.

Two commentators requested that the

final regulations be effective for stock

purchases by an issuing corporation at

any time after August 10, 1993. The effective date has been modified in response to this suggestion. The final regulations will apply to stock issued after

August 10, 1993. Thus, regardless of the

date on which a redemption occurs (or on

which the redeemed stock was issued) the

redemption is treated as provided in the

final regulations for purposes of determining whether stock issued after August

10, 1993, is qualified small business

stock.

The Chief Counsel for Advocacy of the

Small Business Administration recommended the inclusion of an exception for

redemptions occurring in connection with

the divorce of a shareholder. This suggestion has been adopted. The final regulations provide that redemptions of stock

occurring incident to the divorce of a

shareholder are disregarded in determining whether redemptions exceed de minimis amounts.

The Chief Counsel for Advocacy also

requested that the IRS and Treasury Department analyze the current use of section 1202. No exclusion under section

1202 can be claimed until 1998 because

stock must be issued after August 10,

1993, to be qualified small business stock,

and must be held for more than 5 years to

qualify for the exclusion. Thus, the available tax return data do not provide the information necessary to analyze the current use of section 1202.

Minor clarifying changes in the regulatory language have also been made.

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, and because

these regulations do not impose a collection of information on small entities, the

Regulatory Flexibility Act (5 U.S.C.

chapter 6) does not apply. Pursuant to

1998–7 I.R.B

section 7805(f) of the Internal Revenue

Code, the notice of proposed rulemaking

preceding these final regulations was submitted to the Chief Counsel for Advocacy

of the Small Business Administration for

comment on its impact on small business.

Drafting Information

The principal author of these regulations is Catherine A. Prohofsky, Office of

the Assistant Chief Counsel (Income Tax

and Accounting). However, other personnel from the IRS and Treasury Department participated in their development.

*

*

*

*

*

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is amended

as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 is amended by adding an entry in

numerical order to read as follows:

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

Section 1.1202–2 is also issued under

26 U.S.C. 1202(k). * * *

Par. 2. Sections 1.1202–0 and 1.1202–

2 are added to read as follows:

§1.1202–0 Table of contents.

This section lists the major captions

that appear in the regulations under

§1.1202–2.

§1.1202–2 Qualified small business

stock; effect of redemptions.

(a) Redemptions from taxpayer or related person.

(1) In general.

(2) De minimis amount.

(b) Significant redemptions.

(1) In general.

(2) De minimis amount.

(c) Transfers by shareholders in connection with the performance of

services not treated as purchases.

(d) Exceptions for termination of services, death, disability or mental

incompetency, or divorce.

(1) Termination of services.

(2) Death.

(3) Disability or mental incompetency.

(4) Divorce.

(e) Effective date.

17

§1.1202–2 Qualified small business

stock; effect of redemptions.

(a) Redemptions from taxpayer or related person—(1) In general. Stock acquired by a taxpayer is not qualified small

business stock if, in one or more purchases during the 4-year period beginning

on the date 2 years before the issuance of

the stock, the issuing corporation purchases (directly or indirectly) more than a

de minimis amount of its stock from the

taxpayer or from a person related (within

the meaning of section 267(b) or 707(b))

to the taxpayer.

(2) De minimis amount. For purposes

of this paragraph (a), stock acquired from

the taxpayer or a related person exceeds a

de minimis amount only if the aggregate

amount paid for the stock exceeds $10,000

and more than 2 percent of the stock held

by the taxpayer and related persons is acquired. The following rules apply for purposes of determining whether the 2-percent limit is exceeded. The percentage of

stock acquired in any single purchase is

determined by dividing the stock’s value

(as of the time of purchase) by the value

(as of the time of purchase) of all stock

held (directly or indirectly) by the taxpayer and related persons immediately before the purchase. The percentage of

stock acquired in multiple purchases is the

sum of the percentages determined for

each separate purchase.

(b) Significant redemptions—(1) In

general. Stock is not qualified small

business stock if, in one or more purchases during the 2-year period beginning

on the date 1 year before the issuance of

the stock, the issuing corporation purchases more than a de minimis amount of

its stock and the purchased stock has an

aggregate value (as of the time of the respective purchases) exceeding 5 percent

of the aggregate value of all of the issuing

corporation’s stock as of the beginning of

such 2-year period.

(2) De minimis amount. For purposes

of this paragraph (b), stock exceeds a de

minimis amount only if the aggregate

amount paid for the stock exceeds

$10,000 and more than 2 percent of all

outstanding stock is purchased. The following rules apply for purposes of determining whether the 2-percent limit is exceeded. The percentage of the stock

acquired in any single purchase is determined by dividing the stock’s value (as of

February 17, 1998

the time of purchase) by the value (as of

the time of purchase) of all stock outstanding immediately before the purchase. The

percentage of stock acquired in multiple

purchases is the sum of the percentages

determined for each separate purchase.

(c) Transfers by shareholders in connection with the performance of services

not treated as purchases. A transfer of

stock by a shareholder to an employee or

independent contractor (or to a beneficiary of an employee or independent contractor) is not treated as a purchase of the

stock by the issuing corporation for purposes of this section even if the stock is

treated as having first been transferred to

the corporation under §1.83–6(d)(1) (relating to transfers by shareholders to employees or independent contractors).

(d) Exceptions for termination of services, death, disability or mental incompetency, or divorce. A stock purchase is

disregarded if the stock is acquired in the

following circumstances:

(1) Termination of services—(i) Employees and directors. The stock was acquired by the seller in connection with the

performance of services as an employee

or director and the stock is purchased

from the seller incident to the seller’s retirement or other bona fide termination of

such services;

(ii) Independent contractors. [Reserved];

(2) Death. Prior to a decedent’s death,

the stock (or an option to acquire the

stock) was held by the decedent or the

decedent’s spouse (or by both), by the

decedent and joint tenant, or by a trust revocable by the decedent or the decedent’s

spouse (or by both), and—

(i) The stock is purchased from the

decedent’s estate, beneficiary (whether by

bequest or lifetime gift), heir, surviving

joint tenant, or surviving spouse, or from

a trust established by the decedent or

decedent’s spouse; and

(ii) The stock is purchased within 3

years and 9 months from the date of the

decedent’s death;

(3) Disability or mental incompetency.

The stock is purchased incident to the disability or mental incompetency of the

selling shareholder; or

(4) Divorce. The stock is purchased incident to the divorce (within the meaning

of section 1041(c)) of the selling shareholder.

February 17, 1998

(e) Effective date. This section applies

to stock issued after August 10, 1993.

Michael P. Dolan,

Deputy Commissioner of

Internal Revenue.

Approved December 22, 1997.

Donald C. Lubick,

Acting Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on

December 30, 1997, 8:45 a.m., and published in the

issue of the Federal Register for December 31, 1997,

62 F.R. 68165)

Section 1396.—Empowerment

Zone Employment Credit

26 CFR 1.1396–1: Qualified zone employees.

T.D. 8747

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Empowerment Zone

Employment Credit

AGENCY: Internal Revenue Service

(IRS), Treasury

ACTION: Final regulations.

SUMMARY: This document contains

final regulations relating to the period employers may use in computing the empowerment zone employment credit

under section 1396 of the Internal Revenue Code. The regulations reflect and

implement certain changes made by the

Omnibus Budget Reconciliation Act of

1993 (OBRA ’93). They affect employers

of employees who live and work in an

empowerment zone designated under the

statute. The regulations provide employers with the guidance necessary to claim

the credit.

DATES: These regulations are effective

December 30, 1997. For dates of applicability, see § 1.1396–1(c) of these regulations.

FOR FURTHER INFORMATION CONTACT: Robert G. Wheeler, (202) 6226060 (not a toll-free number).

18

SUPPLEMENTARY INFORMATION:

Background

On December 16, 1996, a notice of proposed rulemaking [REG–209834–96]

containing proposed regulations relating

to the period employers may use in computing the empowerment zone employment credit under section 1396 of the Internal Revenue Code was published in the

Federal Register (61 F.R. 66000).

No written comments responding to

this notice were received. No one requested an opportunity to speak at a public hearing. Therefore, no public hearing

was held. The regulations proposed by

REG–209834–96 are adopted with minor

clarifications by this Treasury decision.

Explanation of Provisions

This document contains amendments to

the Income Tax Regulations (26 CFR part

1) relating to the empowerment zone employment credit under section 1396. Section 1396 was added to the Internal Revenue Code by the Omnibus Budget

Reconciliation Act of 1993 (OBRA’93).

Section 1397D of the Code authorizes the

Secretary of the Treasury to prescribe regulations that may be necessary or appropriate to carry out the purposes of section

1396.

Section 1396 provides employers with

a credit for certain wages (qualified zone

wages) paid or incurred by an employer

for services performed by a qualifed zone

employee. The amount of the empowerment zone employment credit under section 1396 is equal to a specified percentage of the qualified zone wages paid or

incurred by the employer during the calendar year that ends with or within the

taxable year of the employer. Questions

have arisen about the definition of a

“qualified zone employee” in section

1396(d). In particular, questions have

been raised about the appropriate period

under section 1396(d)(1)(A) during which

substantially all of the services performed

by an employee for his or her employer

must be performed within an empowerment zone in a trade or business of the

employer.

Under the regulations, an employer

may use either each pay period of the calendar year or the entire calendar year as

the relevant period in determining

1998–7 I.R.B.

whether a particular employee performed

substantially all of his or her services

within an empowerment zone (the “location-of-services” requirement). For each

taxable year the employer must use the

same method for all its employees, but the

employer may change methods from one

taxable year to the next. The description of

the pay period method has been revised

slightly to clarify that the relevant pay periods are those for the calendar year with respect to which the credit is being claimed

(i.e., the calendar year ending with or

within the employer’s taxable year).

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, and because

the regulation does not impose a collection of information on small entities, the

Regulatory Flexibility Act (5 U.S.C.

chapter 6) does not apply. Pursuant to

section 7805(f) of the Internal Revenue

Code, the notice of proposed rulemaking

preceding these regulations was submitted to the Chief Counsel for Advocacy of

the Small Business Administration for

comment on its impact on small business.

Drafting Information

The principal author of these regulations is Robert G. Wheeler, Office of Associate Chief Counsel, Employee Benefits and Exempt Organizations. However,

other personnel from the IRS and Treasury Department participated in their development.

*

*

*

*

*

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is amended

as follows:

PART 1 — INCOME TAXES

Paragraph 1. The authority citation for

part 1 is amended by adding an entry in

numerical order to read as follows:

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

Section 1.1396–1 also issued under 26

U.S.C. 1397D.

1998–7 I.R.B

Par. 2. A new undesignated center

heading and §1.1396-1 are added to read

as follows:

Empowerment Zone Employment Credit

§1.1396–1 Qualified zone employees.

(a) In general. A qualified zone employee of an employer is an employee

who satisfies the location-of-services requirement and the abode requirement

with respect to the same empowerment

zone and is not otherwise excluded by

section 1396(d).

(1) Location-of-services requirement.

The location-of- services requirement is

satisfied if substantially all of the services

performed by the employee for the employer are performed in the empowerment

zone in a trade or business of the employer.

(2) Abode requirement. The abode requirement is satisfied if the employee’s

principal place of abode while performing

those services is in the empowerment

zone.

(b) Period for applying location-of-services requirement. In applying the location-of-services requirement, an employer

may use either the pay period method described in paragraph (b)(1) of this section

or the calendar year method described in

paragraph (b)(2) of this section. For each

taxable year of an employer, the employer

must either use the pay period method

with respect to all of its employees or use

the calendar year method with respect to

all of its employees. The employer may

change the method applied to all of its employees from one taxable year to the next.

(1) Pay period method—(i) Relevant

period. Under the pay period method, the

relevant period for applying the locationof-services requirement is each pay period in which an employee provides services to the employer during the calendar

year with respect to which the credit is

being claimed (i.e., the calendar year that

ends with or within the relevant taxable

year). If an employer has one pay period

for certain employees and a different pay

period for other employees (e.g., a weekly

pay period for hourly wage employees

and a bi-weekly pay period for salaried

employees), the pay period actually applicable to a particular employee is the

relevant pay period for that employee

under this method.

19

(ii) Application of method. Under this

method, an employee does not satisfy the

location-of-services requirement during a

pay period unless substantially all of the

services performed by the employee for

the employer during that pay period are

performed within the empowerment zone

in a trade or business of the employer.

(2) Calendar year method—(i) Relevant

period. Under the calendar year method,

the relevant period for an employee is the

entire calendar year with respect to which

the credit is being claimed. However, for

any employee who is employed by the employer for less than the entire calendar

year, the relevant period is the portion of

that calendar year during which the employee is employed by the employer.

(ii) Application of method. Under this

method, an employee does not satisfy the

location-of-services requirement during

any part of a calendar year unless substantially all of the services performed by the

employee for the employer during that

calendar year (or, if the employee is employed by the employer for less than the

entire calendar year, the portion of that

calendar year during which the employee

is employed by the employer) are performed within the empowerment zone in

a trade or business of the employer.

(3) Examples. This paragraph (b) may

be illustrated by the following examples.

In each example, the following assumptions apply. The employees satisfy the

abode requirement at all relevant times

and all services performed by the employees for their employer are performed in a

trade or business of the employer. The

employees are not precluded from being

qualified zone employees by section

1396(d)(2) (certain employees ineligible).

No portion of the employees’ wages is

precluded from being qualified zone

wages by section 1396(c)(2) (only first

$15,000 of wages taken into account) or

section 1396(c)(3) (coordination with targeted jobs credit and work opportunity

credit). The examples are as follows:

Example 1. (i) Employer X has a weekly pay period for all its employees. Employee A works for X

throughout 1997. During each of the first 20 weekly

pay periods in 1997, substantially all of A’s work for

X is performed within the empowerment zone in

which A resides. A also works in the zone at various

times during the rest of the year, but there is no other

pay period in which substantially all of A’s work for

X is performed within the empowerment zone. Employer X uses the pay period method.

February 17, 1998

(ii) For each of the first 20 pay periods of 1997, A

is a qualified zone employee, all of A’s wages from

X are qualified zone wages, and X may claim the

empowerment zone employment credit with respect

to those wages. X cannot claim the credit with respect to any of A’s wages for the rest of 1997.

Example 2. (i) Employer Y has a weekly pay period for its factory workers and a bi-weekly pay period for its office workers. Employee B works for Y

in various factories and Employee C works for Y in

various offices. Employer Y uses the pay period

method.

(ii) Y must use B’s weekly pay periods to determine the periods (if any) in which B is a qualified

zone employee. Y may claim the empowerment

zone employment credit with respect to B’s wages

only for the weekly pay periods for which B is a

qualified zone employee, because those are B’s only

wages that are qualified zone wages. Y must use C’s

bi-weekly pay periods to determine the periods (if

any) in which C is a qualified zone employee. Y

may claim the credit with respect to C’s wages only

for the bi-weekly pay periods for which C is a qualified zone employee, because those are C’s only

wages that are qualified zone wages.

Example 3. (i) Employees D and E work for Employer Z throughout 1997. Although some of D’s

work for Z in 1997 is performed outside the empowerment zone in which D resides, substantially all of

it is performed within that empowerment zone. E’s

work for Z is performed within the empowerment

zone in which E resides for several weeks of 1997

but outside the zone for the rest of the year so that,

viewed on an annual basis, E’s work is not substantially all performed within the empowerment zone.

Employer Z uses the calendar year method.

(ii) D is a qualified zone employee for the entire

year, all of D’s 1997 wages from Z are qualified

zone wages, and Z may claim the empowerment

zone employment credit with respect to all of those

wages, including the portion attributable to work

outside the zone. Under the calendar year method, E

is not a qualified zone employee for any part of

1997, none of E’s 1997 wages are qualified zone

wages, and Z cannot claim any empowerment zone

employment credit with respect to E’s wages for

1997. Z cannot use the calendar year method for D

and the pay period method for E because Z must use

the same method for all employees. For 1998, however, Z can switch to the pay period method for E if

Z also switches to the pay period method for D and

all of Z’s other employees.

(c) Effective date. This section applies

with respect to wages paid or incurred on

or after December 21, 1994.

Michael P. Dolan,

Deputy Commissioner of

Internal Revenue.

Donald C. Lubick,

Acting Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on

December 29, 1997, 8:45 a.m., and published in the

issue of the Federal Register for December 30, 1997,

62 F.R. 67726)

February 17, 1998

Section 2044.—Certain

Property for Which Marital

Deduction was Previously

Allowed

26 CFR 20.2044–1: Certain property for which

marital deduction was previously allowed.

What are the gift tax consequences to the surviving spouse of the acquisition by the surviving spouse

of the remainder interest in a trust subject to a qualified terminable interest property (QTIP) election

under § 2056(b)(7) of the Internal Revenue Code?

See Rev. Rul. 98–8, page 24.

Section 2056.—Bequests, Etc.,

to Surviving Spouse

26 CFR 20.2056(b)(7): Election with respect to life

estate for surviving spouse.

What are the gift tax consequences to the surviving spouse of the acquisition by the surviving spouse

of the remainder interest in a trust subject to a qualified terminable interest property (QTIP) election

under § 2056(b)(7) of the Internal Revenue Code?

See Rev. Rul. 98–8, page 24.

Section 2511.—Transfers in

General

26 CFR 25.251–1: Transfers in general.

If a surviving spouse acquires the remainder interest in a trust subject to a QTIP election under

§ 2056(b)(7) in connection with the transfer by the

surviving spouse of property or cash to the holder of

the remainder interest, does the surviving spouse

make a gift under § 2511 of the Internal Revenue

Code? See Rev. Rul. 98–8, page 24.

Section 2512.—Valuation of

Gifts

Section 25.2512–8: Transfers for insufficient

consideration.

If a surviving spouse acquires the remainder interest in a trust subject to a QTIP election under

§ 2056(b)(7) in connection with the transfer by the

surviving spouse of property or cash to the holder of

the remainder interest, what is the value of the gift

under § 2512 of the Internal Revenue Code? See

Rev. Rul. 98–8, page 24.

Section 2518.—Disclaimers

26 CFR 25.2518–2: Requirements for a qualified

disclaimer.

T.D. 8744

20

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 20 and 25

Disclaimer of Interests and

Powers

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final Regulations.

SUMMARY: This document contains

final regulations relating to the treatment

of disclaimers for estate and gift tax purposes. The regulations clarify certain provisions governing the disclaimer of property interests and powers and, in addition,

conform the regulations to court decisions

holding the current regulation invalid

with respect to the disclaimer of joint

property interests. The final regulations

will affect persons who disclaim property

interests, powers, or interests in jointly

owned property.

DATES: Effective date: The final regulations are effective December 31, 1997.

Applicability dates: The amendments

to §§25.2518–l(a) and 25.2518–2(c)(3)

(substituting the statutory language in

section 2518(b)(2)(A) “transfer creating

the interest,” for “taxable transfer”) and

conforming changes to §§20.2041–3(d)(6)(i), 20.2046–1, 20.2056(d)–2 (a) and

(b), 25.2511–l(c)(1), 25.2514–3(c)(5), are

applicable for transfers creating the interest or power to be disclaimed made on or

after December 31, 1997. The amendments to §25.2518–2(c)(4) (relating to the

disclaimer of joint property and bank accounts) are applicable for disclaimers

made on or after December 31, 1997.

FOR FURTHER INFORMATION CONTACT: James F. Hogan (202) 622-3090

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On August 21, 1996, the IRS published

in the Federal Register (61 F.R. 43197) a

notice of proposed rulemaking (REG–

208216–91) amending the regulations

under section 2518. The IRS received

comments on the proposed regulations;

however, no request for a public hearing

was received so no public hearing was

1998–7 I.R.B.

held. This document adopts final regulations with respect to this notice of proposed rulemaking.

The proposed regulations substituted the

statutory language of section 2518(b)(2)(A), “transfer creating the interest,” for

“taxable transfer” as the reference point for

determining when the 9-month time period

for making the disclaimer commences.

This change clarifies that the starting point

for the 9-month period is not dependent on

the actual imposition of a transfer tax at the

time that the interest to be disclaimed is

created. Comments with respect to the

clarification in the proposed regulation

supported the change.

Under the proposed regulations, the

one-half survivorship interest in jointlyheld property that was unilaterally severable could be disclaimed within 9 months

of the date of death of the first joint tenant

to die. The proposed regulations did not

extend the same treatment to joint interests

that are not unilaterally severable (e.g.,

tenancies by the entirety), but the preamble invited comments on this subject.

The comments received unanimously

suggested that a surviving joint tenant

should be allowed to disclaim, within 9

months of the date of death of the first

joint tenant to die, his or her survivorship

interest in a tenancy, whether or not that

tenancy is unilaterally severable. The

comments noted that parties purchasing a

residence often do not make an informed

decision regarding whether the residence

should be held as joint tenants or tenants

by the entirety, and generally are not

aware that the decision to take title to the

property as either joint tenants with right

of survivorship or tenants by the entirety

will affect the ability to disclaim their interest in the property after the death of the

first joint tenant to die.

Accordingly, the final regulations

allow the disclaimer of jointly-held property that is not unilaterally severable on

the same basis as joint property that is

unilaterally severable. Thus, a surviving

joint tenant may disclaim the one-half

survivorship interest in property that the

joint tenant held either in joint tenancy

with right of survivorship or in tenancy by

the entirety, within 9 months of the death

of the first joint tenant to die. The rule

also significantly simplifies the disclaimer of jointly-held property, eliminating certain special rules that were depen-

1998–7 I.R.B

dent on the application of section 2515 to

the creation of the tenancy.

The proposed regulations provided rules

regarding the disclaimer of interests in

Joint bank accounts and brokerage accounts, generally recognizing that the creation of such accounts are not completed

gifts under certain circumstances. Comments noted that other kinds of investment

accounts, such as accounts held at mutual

funds, accord the parties rights that are

similar to the rights of parties with respect

to joint bank accounts and brokerage accounts. Accordingly, the final regulations

have expanded the special rule with respect to the disclaimer of jointly-held bank

and brokerage accounts to include jointlyheld investment accounts such as accounts

held at mutual funds.

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, and because these regulations do not impose a collection of information on small entities, the Regulatory

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

not apply. Pursuant to section 7805(f) of

the Internal Revenue Code, the Notice of

Proposed Rulemaking preceding these regulations was submitted to the Small Business Administration for comment on their

impact on small business.

Drafting Information

The principal author of these regulations is Dale Carlton, Office of the Chief

Counsel, IRS. Other personnel from the

IRS and Treasury Department participated in their development.

*

*

*

*

*

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR parts 20 and 25

are amended as follows:

PART 20—ESTATE TAX; ESTATES OF

DECEDENTS DYING AFTER

AUGUST 16, 1954

Paragraph 1. The authority citation for

part 20 continues to read in part as follows:

21

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

Par. 2. Section 20.2041–3 is amended

as follows:

1. Paragraph (d)(6)(i) is amended by

revising the first sentence and by adding a

new sentence after the first sentence.

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

The additions and revisions read as follows:

§20.2041–3 Powers of appointment

created after October 21. 1942.

*

*

*

*

*

(d) * * *

(6)(i) A disclaimer or renunciation of a

general power of appointment created in a

transfer made after December 31, 1976, is

not considered to be the release of the

power if the disclaimer or renunciation i”

a qualified disclaimer as described in section 2518 and the corresponding regulations. For rules relating to when the transfer creating the power occurs, see

25.2518–2(c) (3) of this chapter. * * *

*

*

*

*

*

(iii) The first and second sentences of

paragraph (d)(6)(i) of this section are applicable for transfers creating the power

to be disclaimed made on or after December 31, 1997.

*

*

*

*

*

Par. 3. Section 20.2046–1 is revised to

read as follows:

520.2046–1 Disclaimed property.

(a) This section shall apply to the disclaimer or renunciation of an interest in

the person disclaiming by a transfer made

after December 31, 1976. For rules relating to when the transfer creating the interest occurs, see §25.2518–2(C) (3) and (c)

(4) of this chapter. If a qualified disclaimer is made with respect to such a

transfer, the Federal estate tax provisions

are to apply with respect to the property

interest disclaimed as if the interest had

never been transferred to the person making the disclaimer. See section 2518 and

the corresponding regulations for rules relating to a qualified disclaimer.

(b) The first and second sentences of

this section are applicable for transfers

creating the interest to be disclaimed

made on or after December 31, 1997.

Par. 4. Section 20.2056 (d)–2 is

amended as follows:

February 17, 1998

1. Paragraph (a) is amended by revising

the first sentence and adding a new sentence after the first sentence.

2. Paragraph (b) is revised.

3. A new paragraph (c) is added.

The additions and revisions read as follow:

120.2056(d)–2 Marital deduction: effect

of disclaimers of postDecember 31. 1976

transfers.

(a) * * * If a surviving spouse disclaims

an interest in property passing to such

spouse from the decedent, which interest

was created in a transfer made after December 31, 1976, the effectiveness of the

disclaimer will be determined by section

2518 and the corresponding regulations.

For rules relating to when the transfer

creating the interest occurs, see

§25.25182(c)(3) and (c)(4) of this chapter.

***

(b) Disclaimer by a person other than a

surviving spouse. If an interest in property

passes from a decedent to a person other

than the surviving spouse, and the interest

is created in a transfer made after December 31, 1976, and—

(1) The person other than the surviving

spouse makes a qualified disclaimer with

respect to such interest; and

(2) The surviving spouse is entitled to

such interest in property as a result of

such disclaimer, the disclaimed interest is

treated as passing directly from the decedent to the surviving spouse. For rules relating to when the transfer creating the interest occurs, see §25.2518–2(c)(3) and

(c)(4) of this chapter.

(c) Effective date. The first and second

sentences of paragraphs (a) and (b) of this

section are applicable for transfers creating the interest to be disclaimed made on

or after December 31, 1997.

PART 25—GIFT TAX; GIFTS MADE

AFTER DECEMBER 31, 1954

Par. 5. The authority citation for part 25

is amended by adding an entry in numerical order to read as follows:

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

Section 25.2518–2 is also issued under

26 U. S. C. 2518 (b). * * *

Par. 6. Section 25.2511–1 is amended

as follows:

1. In paragraph (c)(l), the fourth sentence is revised.

2. A new paragraph (c)(3) is added.

February 17, 1998

The additions and revisions read as follows: 25. 2511–1 Transfers in asneral.

*

*

*

*

*

(c)(l) * * * However, in the case of a

transfer creating an interest in property

(within the meaning of 25.2518–2(c) (3)

and (c) (4) ) made after December 31,

1976, this paragraph (c)(l) shall not apply

to the donee if, as a result of a qualified

disclaimer by the donee, the interest

passes to a different donee. * * *

*

*

*

*

*

(3) The fourth sentence of paragraph

(c)(l) of this section is applicable for

transfers creating an interest to be disclaimed made on or after December 31,

1997.

*

*

*

*

*

Par. 7. Section 25.2514–3 is amended

as follows:

1. Paragraph (c) (5) is amended by revising the first sentence and adding a new

sentence after the first sentence.

2. A new paragraph (c)(7) is added.

The additions and revisions read as follows:

§425.2514–3 Powers of appointment

created after October 21. 1942.

*

*

*

*

*

(c) * * *

(5) * * * A disclaimer or renunciation of

a general power of appointment created in

a transfer made after December 31, 1976,

is not considered a release of the power for

gift tax purposes if the disclaimer or renunciation is a qualified disclaimer as described in section 2518 and the corresponding regulations. For rules relating to

when a transfer creating the power occurs,

see §25.2518–2(c) (3) . * * *

*

*

*

*

*

(7) The first and second sentences of

paragraph (c)(5) of this section are applicable for transfers creating the power to be

disclaimed made on or after December

31, 1997.

*

*

*

*

*

Par. 8. Section 25.2518–1 is amended

as follows:

1. Paragraph (a)(l) is revi ;ed.

2. In paragraph (a)(2), the last three

sentences of the example are removed and

22

four new sentences are added in their

place.

3. A new paragraph (a)(3) is added.

The additions and revisions read as follows:

§425.2518–1 Oualified disclaimers of

property: In general.

(a) * * * (1) In aeneral. The rules described in this section, §25. 2518–2, and

§25. 2518– 3 apply to the qualified disclaimer of an interest in property which is

created in the person disclaiming by a

transfer made after December 31, 1976.

In general, a qualified disclaimer is an

irrevocable and unqualified refusal to accept the ownership of an interest in property. For rules relating to the determination of when a transfer creating an interest

occurs, see §25.2518–2(c)(3) and (4)

(2) * * *

Example. * * * The transfer creating the remainder interest in the trust occurred in 1968. See

§25.2511–l(c)(2). Therefore, section 2518 does not

apply to the disclaimer of the remainder interest because the transfer creating the interest was made

prior to January 1, 1977. If, however, W had caused

the gift to be incomplete by also retaining the power

to designate the person or persons to receive the

trust principal at death, and, as a result, no transfer

(within the meaning of 2§5.2511–l(c)(2)) of the remainder interest was made at the time of the creation

of the trust, section 2518 would apply to any disclaimer made after W’s death with respect to an interest in the trust property.

(3) Paragraph (a)(l) of this section is

applicable for transfers creating the interest to be disclaimed made on or after December 31, 1997.

*

*

*

*

*

Par. 9. Section 25.2518–2 is amended

as follows:

1. The text of paragraph (c)(3) following the heading is redesignated as paragraph (c)(3)(i) and amended as follows:

a. In the first, eighth, and eleventh sentences, the word “taxable” is removed in

each place it appears.

b. In the second and ninth sentences,

the language “taxable transfer” is removed and “transfer creating an interest”

is added in each place it appears.

c. In the third sentence the language

“taxable transfers” is removed and “transfers creating an interest” is added.

d. The fourth, fifth, sixth, and seventh

sentences are removed and five new sentences are added in their place.

1998–7 I.R.B.

2–3. A new paragraph (c) (3 (ii) is

added.

4. Paragraph (c)(4) is revised.

5. In paragraph (c)(5), Example (7) is

revised.

6. In paragraph (c)(5), Example (8) is

removed.

7. In paragraph (c)(5), Example (9) is

redesignated as Example (12) and is revised.

8. In paragraph (c)(5), Example (10) is

redesignated as Example (11) and the first

sentence is revised.

9. In paragraph (c)(5), new Examples

(8), (9), (10), (13), and (14), are added.

The additions and revisions read as follows:

625.2518–2 Requirements for a qualified

disclaimer.

*

*

*

*

*

(c) * * * (3) Transfer. (i) * * * With respect to transfers made by a decedent at

death or transfers that become irrevocable

at death, the transfer creating the interest

occurs on the date of the decedent’s death,

even if an estate tax is not imposed on the

transfer. For example, a bequest of foreign-situs property by a nonresident alien

decedent is regarded as transfer creating

an interest in property even if the transfer

would not be subject to estate tax. If there

is a transfer creating an interest in property

during the transferor’s lifetime and such

interest is later included in the transferor’s

gross estate for estate tax purposes (or

would have been included if such interest

were subject to estate tax), the 9-month

period for making the qualified disclaimer

is determined with reference to the earlier

transfer creating the interest. In the case of

a general power of appointment, the

holder of the power has a 9-month period

after the transfer creating the power in

which to disclaim. If a person to whom

any interest in property passes by reason

of the exercise, release, or lapse of a general power desires to make a qualified disclaimer, the disclaimer must be made

within a 9-month period after the exercise,

release, or lapse regardless of whether the

exercise, release, or lapse is subject to estate or gift tax. * * *

(ii) Sentences 1 through 10 and 12 of

paragraph (c)(3)(i) of this section are applicable for transfers creating the interest

to be disclaimed made on or after December 31, 1997.

1998–7 I.R.B

(4) Joint property—(i) Interests in joint

tenancy with right of survivorship or tenancies by the entirety. Except as provided

in paragraph (c)(4)(iii) of this section

(with respect to joint bank, brokerage, and

other investment accounts), in the case of

an interest in a joint tenancy with right of

survivorship or a tenancy by the entirety,

a qualified disclaimer of the interest to

which the disclaimant succeeds upon creation of the tenancy must be made no later

than 9 months after the creation of the

tenancy regardless of whether such interest can be unilaterally severed under local

law. A qualified disclaimer of the survivorship interest to which the survivor

succeeds by operation of law upon the

death of the first joint tenant to die must

be made no later than 9 months after the

death of the first joint tenant to die regardless of whether such interest can be unilaterally severed under local law and, except as provided in paragraph (c)(4)(ii) of

this section (with respect to certain tenancies created on or after July 14, 1988),

such interest is deemed to be a one-half

interest in the property. (See, however,

section 2518(b)(2)(B) for a special rule in

the case of disclaimers by persons under

age 21.) This is the case regardless of the

portion of the property attributable to consideration furnished by the disclaimant

and regardless of the portion of the property that is included in the decedent’s

gross estate under section 2040 and regardless of whether the interest can be

unilaterally severed under local law. See

paragraph (c)(5), Examples (7) and (8), of

this section.

(ii) Certain tenancies in real property

between spouses created on or after July

14. 1988. In the case of a joint tenancy between spouses or a tenancy by the entirety

in real property created on or after July

14, 1988, to which section 2523(i)(3) applies (relating to the creation of a tenancy

where the spouse of the donor is not a

United States citizen), the surviving

spouse may disclaim any portion of the

joint interest that is includible in the decedent’s gross estate under section 2040.

See paragraph (c)(5), Example (9), of this

section.

(iii) Special rule for joint bank, brokerege, and other investment accounts

(e.g., accounts held at mutual funds) established between spouses or between

persons other than husband and wife. In

23

the case of a transfer to a joint bank, brokerage, or other investment account (e.g.,

an account held at a mutual fund), if a

transferor may unilaterally regain the

transferor’s own contributions to the account without the consent of the other cotenant, such that the transfer is not a completed gift under §25.2511–l(h)(4), the

transfer creating the survivor’s interest in

the decedent’s share of the account occurs

on the death of the deceased cotenant. Accordingly, if a surviving joint tenant desires to make a qualified disclaimer with

respect to funds contributed by a deceased

cotenant, the disclaimer must be made

within 9 months of the cotenant’s death.

The surviving joint tenant may not disclaim any portion of the joint account attributable to consideration furnished by

that surviving joint tenant. See paragraph

(c)(5), Examples (12), (13), and (14), of

this section, regarding the treatment of

disclaimed interests under sections 2518,

2033 and 2040.

(iv) Effective date. This paragraph

(c)(4) is applicable for disclaimers made

on or after December 31, 1997.

(5) Examples. * * *

*

*

*

*

*

Example (7). On February 1, 1990, A purchased

real property with A’s funds. Title to the property

was conveyed to “A and B, as joint tenants with

right b’ survivorship.” Under applicable state law,

the joint interest is unilaterally severable by either

tenant. B dies on May 1, 1998, and is survived by A.

On January 1, 1999, A disclaims the one-half survivorship interest in the property to which A succeeds as a result of B’s death. Assuming that the

other requirements of section 2518(b) are satisfied,

A has made a qualified disclaimer of the one-half

survivorship interest (but not the interest retained by

A upon the creation of the tenancy, which may not

be disclaimed by A). The result is the same whether

or not A and B are married and regardless of the proportion of consideration furnished by A and B in

purchasing the property.

Example (8). Assume the iame facts as in Example (7) except that A and B are married and title to

the property was conveyed to “A and B, as tenants

by the entirety.” Under applicable state law, the tenancy cannot be unilaterally severed by either tenant.

Assuming that the other requirements of section

2518(b) are satisfied, A has made a qualified disclaimer of the one-half survivorship interest (but not

the interest retained by A upon the creation of the

tenancy, which may not be disclaimed by A). The result is the same regardless of the proportion of consideration furnished by A and B in purchasing the

property.

Example (9). On March 1, 1989, H and W purchase a tract of vacant land which is conveyed to

them as tenants by the entirety. The entire consideration is paid by H. W is not a United States citizen. H

February 17, 1998

d es on June 1, 1998. W can disclaim the entire joint

interest because this is the interest includible in H’s

gross estate under section 2040(a). Assuming that

W’s disclaimer is received by the executor of H’s estate no later than 9 months after June 1, 1998, and

the other requirements of section 2518(b) are satisfied, W’s disclaimer of the property would be a qualified disclaimer. The result would be the same if the

property was held in joint tenancy with right of survivorship that was unilaterally severable under local

law.

Example (10). In 1986, pouses A and B purchased a personal residence taking title as tenants

by the entirety. B dies on July 10, 1998. A wishes to

disclaim the one-half undivided interest to which A

would succeed by right of survivorship. If A makes

the disclaimer, the propery interest would pass under

B’s will to their child C. C, an adult, and A resided in

the residence at B’s death and will continue to reside

there in the future. A continues to own a one-half undivided interest in the property. Assuming that the

other requirements of section 2518(b) are satisfied,

A may make a qualified disclaimer with respect to

the one-half undivided survivorship interest in the

residence if A delivers the written disclaimer to the

personal representative of B’s estate by April 10,

1999, since A is not deemed to have accepted the interest or any of its benefits prior to that time and A’s

occupancy of the residence after B’s death is consistent with A’s retained undivided ownership interest.

The result would be the same if property was held in

joint tenancy with right of survivorship that was unilaterally severable under local law.

Example (11). H and W, husband and wife, reside

in state X, a community property state. * * *

Example (12). On July 1, 1990, A opens a bank

account that is held jointly with B, A’s spouse, and

transfers $50,000 of A’s money to the account. A and

B are United States citizens. A can regain the entire

account without B’s consent, such that the transfer is

not a completed gift under §25.2511–l(h)(4). A dies

on August 15, 1998, and B disclaims the entire

amount in the bank account on October 15, 1998.

Assuming that the remaining requirements of section 2518(b) are satisfied, B made a qualified disclaimer under section 2518 (a) because the disclaimer was made within 9 months after A’s death at

which time B had succeeded to full dominion and

control over the account. Under state law, B is

treated as predeceasing A with respect to the disclaimed interest. The disclaimed account balance

passes through A’s probate estate and is no longer

joint property includible in A’s gross estate under

section 2040.The entire account is, instead, includible in A’s gross estate und~er section 2033. The result would be the same if A and B were not married.

Example (13). The facts ire the same as Example

(12), except that B, rather than A, dies on August 15,

1998. A may not make a qualified disclaimer with

respect to any of the funds in the bank account, because A furnished the funds for the entire account

and A did not relinq ish dominion and control over

the funds. .

Example (14). The fact s are the same as Example

(12), except that B disclaims 40 F ercent of the funds

in the account. Since, under state law, B is treated as

predeceasing A with respect to the disclaimed in interest, the 40 percent portion of the account balance

that was disclaln~d passes as part of A’s probate estate, and is no longer characterized as joint property.

February 17, 1998

This 40 percent portion of the account balance is,

therefore, includible in A’s gross estate under section

2033. The remaining 60 percent of the account balance that was not disclaimed retains its character as

joint property and, therefore, is includible in A’s

gross estate as provide in section 2040(b). Therefore, 30 percent (1/2 3 60 percent) of the account

balance is includible in A’s gross estate under section 2040(b), and a total of 70 percent of the aggregate account balance is includible in A’s gross estate.

If A and B were not married, then the 40 percent portion of the account subject to the disclaimer would

be includible in A’s gross estate as provided in section 2033 and the 60 percent portion of the account

not subject to the disclaimer would be includible in

A’s gross estate as provided in section 2040(a), because A furnished all of the funds with respect to the

account.

*

*

*

*

*

Michael P. Dolan,

Deputy Commissioner of

Internal Revenue.

Approved December 10, 1997.

Donald C. Lubick,

Acting Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on

December 30, 1997, 8:45 a.m., and published in the

issue of the Federal Register for December 31, 1997,

62 F.R. 68183)

Section 2519.—Dispositions of

Certain Life Estates

26 CFR 25.2519–1: Dispositions of certain life

estates.

(Also sections 2044; 2056; 2511; 2512; 20.2044–1;

20.2056(b)–7; 25.2511–1; 25.2512–8)

Disposition of qualifying income interest. If a surviving spouse acquires the

remainder interest in a trust subject to a

QTIP election under section 2056(b)(7) of

the Code in connection with the transfer

by the surviving spouse of property or

cash to the holder of the remainder interest, the surviving spouse makes a gift

under sections 2511, 2512, and 2519 of

the Code.

Rev. Rul. 98–8

ISSUE

What are the gift tax consequences to

the surviving spouse of the acquisition by

the surviving spouse of the remainder interest in a trust subject to a qualified terminable interest property (QTIP) election

24

under § 2056(b)(7) of the Internal Revenue Code?

FACTS

The decedent, D, died in 1993 survived

by S, D’s spouse. Under the terms of D’s

will, a trust (the QTIP Trust) was established under which S was to receive all of

the trust income, payable at least annually, for S’s life. On S’s death, the remainder was to be distributed outright to C,

D’s adult child. S was not given a general

power of appointment over the trust

property.

On the federal estate tax return filed for

D’s estate, the executor made an election

under § 2056(b)(7) to treat the trust property as QTIP, and a marital deduction was

allowed to D’s estate for the value of the

property passing from D to the QTIP Trust.

Subsequently, S, C, and the trustee of

the QTIP Trust entered into the following

transaction: (1) S acquired C’s remainder

interest in the QTIP Trust; (2) S gave C a

promissory note in the face amount of x

dollars (the value of the remainder interest) for the remainder interest; (3) the

trustee distributed all of the QTIP Trust

assets (having a value of x + y dollars) to

S; and (4) S thereupon paid x dollars from

those assets to C in satisfaction of the

promissory note.

At the conclusion of the transaction,

the QTIP Trust was terminated; S held

QTIP Trust assets having a value of y dollars (which was equal to the value of S’s

life interest in the trust); and C held assets

having a value of x dollars (which was

equal to the value of the remainder interest in the trust). S contended that the

transaction was not subject to gift tax because S received full and adequate consideration (the x dollar remainder interest in

the QTIP Trust) in exchange for the x dollar promissory note given by S TO C.

LAW AND ANALYSIS

Section 2044(a) provides that the value

of the gross estate includes the value of

any property described in § 2044(b) in

which the decedent had a qualifying income interest for life. Section 2044(b)

provides that § 2044 applies to any property if a deduction was allowed with respect to the transfer of the property to the

decedent under § 2056(b)(7).

Section 2056(a) provides that the value

of the taxable estate is, except as limited

1998–7 I.R.B.

by § 2056(b), determined by deducting

from the value of the gross estate an

amount equal to the value of any interest

in property that passes or has passed from

the decedent to the surviving spouse.

Under § 2056(b)(1), if an interest passing to the surviving spouse will terminate,

no deduction is allowed with respect to

such interest if, after termination of the

spouse’s interest, an interest in the property passes or has passed (for less than an

adequate and full consideration in money

or money’s worth) from the decedent to

any person other than the surviving

spouse (or the estate of such spouse).

Section 2056(b)(7)(A) provides that

qualified terminable interest property, for

purposes of § 2056(a), is treated as passing to the surviving spouse, and no part of

such property is treated as passing to any

person other than the surviving spouse.

In general, qualified terminable interest

property is property in which the spouse

receives a qualifying income interest for

life,and with respect to which the executor makes an election to treat the property

as QTIP.

Section 2511(a) provides that the gift

tax applies whether the transfer is in trust

or otherwise, whether the gift is direct or

indirect, and whether the property is real

or personal, tangible or intangible.

Section 2512(b) provides that where

property is transferred for less than an adequate and full consideration in money or

money’s worth, the amount by which the

value of the property exceeds the value of

the consideration is deemed a gift.

Section 2519(a) provides that any disposition of all or part of a qualifying income interest for life in any property to

which the section applies is treated as a

transfer of all interests in the property

other than the qualifying income interest.

Section 2519(b) provides that the section

applies to any property if a deduction was

allowed with respect to the transfer of

such property to the donor under

§ 2056(b)(7).

The estate tax marital deduction provisions are intended to provide a special tax

benefit that allows property to pass to the

surviving spouse without the decedent’s

estate paying tax on its value. Tax is deferred on the transfer until the surviving

spouse either dies or makes a lifetime disposition of the property. Under either circumstance, a transfer (estate or gift) tax is

1998–7 I.R.B

paid. United States v. Stapf, 375 U.S.

118, 128 (1963), 1964-1 (Part 1) C.B.

535, 537; Estate of Clayton v. Commissioner, 976 F.2d 1486, 1491 (5th Cir.

1992); Estate of Letts v.Commissioner,

109 T.C. 290 (1997), (“It is a basic policy

of the marital deduction that property that

passes untaxed from a predeceasing

spouse to a surviving spouse is included

in the estate of the surviving spouse.”)

The statutory scheme of the QTIP provisions is consistent with this congressional intent. Thus, a marital deduction is

allowed under § 2056(b)(7) for property

passing from a decedent to a QTIP trust in

which the surviving spouse possesses a

lifetime income interest. Sections 2519

and 2044 act to defer the taxable event on

the marital deduction property only so

long as the surviving spouse continues to

hold the lifetime income interest.

Under § 2519, if a surviving spouse

disposes of any part of the qualifying income interest, the spouse is treated as

making a gift of the remainder interest in

the underlying property (i.e., all interests

in the property other than the income interest). Correspondingly, under § 2511,

the disposition of the income interest by

the spouse is treated as a gift, to the extent

the income interest is transferred to another for less than adequate consideration.

The term “disposition,” as used in §

2519, applies broadly to circumstances in

which the surviving spouse’s right to receive the income is relinquished or otherwise terminated, by whatever means. See

H. Rep. No. 201, 97th Cong., 1st Sess.

161 (1981) that states:

The bill provides that property subject to a [QTIP election] will be subject

to transfer taxes at the earlier of (1) the

date on which the spouse disposes (either by gift, sale, or otherwise) of all or

part of the qualifying income interest,

or (2) upon the spouse’s death.

A commutation, which is a proportionate division of trust property between the

life beneficiary and remainderman based

on the respective values of their interests

is, in the context of a QTIP trust, a taxable

disposition by the spouse of the qualifying income interest, resulting in a gift

under § 2519 of the value of the remainder interest. The commutation of the

spouse’s income interest in the QTIP trust

is essentially a sale of the income interest

by the spouse to the trustee (or the re-

25

mainderman) in exchange for an amount

equal to the value of the income interest.

Sales and commutations are expressly

characterized as dispositions in the applicable legislative history and regulations. Section 25.2519–1(g), Example 2

(illustrating that the sale by the spouse of

the spouse’s income interest to the trust

remaindermen is a disposition of the income interest); § 25.2519–1(f) providing

that “[T]he sale of qualified terminable

interest property, followed by the payment to the donee-spouse of a portion of

the proceeds equal to the value of the

donee-spouse’s income interest, is considered a disposition of the qualifying income interest”. See also, Estate of

Novotny v. Commissioner, 93 T.C. 12

(1989), in which the surviving spouse and

remainderman divided the sale proceeds

of QTIP property proportionately on the

basis of the respective values of their interests; the court indicated that the commutation constituted a disposition by the

spouse of the income interest for purposes

of § 2519 and was thus subject to gift tax.

There is little distinction between the

sale and commutation transactions treated

as dispositions in the regulations and the

transaction presented here, where S acquired the remainder interest. In both

cases, after the transaction the spouse’s

income interest in the trust is terminated

and the spouse receives outright ownership of property having a net value equal

to the value of the spouse’s income interest. Similarly, the remainderman receives

ownership of property equal in value to

the remainder interest. Thus, the transaction in the instant case essentially effectuates a commutation of S’s income interest

in the trust, a transaction that is a disposition of S’s income interest under § 2519.

Therefore, under § 2519, S is regarded as

making a gift of x dollars, the value of the

remainder interest in the QTIP Trust.

Section 25.2519–1(f).

This conclusion that S has made a gift

is also supported by an additional analysis. S acquired an asset (the remainder interest in the QTIP Trust) that is already

subject to inclusion in S’s transfer tax

base under § 2044. In analogous situations, the courts have recognized that the

receipt of an asset that does not effectively increase the value of the recipient’s

gross estate does not constitute adequate

consideration for purposes of the gift and

February 17, 1998

estate tax. See Commissioner v. Wemyss,

324 U.S. 303, 307 (1945), 1945 C.B. 416,

(“The section taxing as gifts transfers that

are not made for `adequate and full

[money] consideration’ aims to reach

those transfers which are withdrawn from

the donor’s estate.”)

A companion case to Commissioner v.

Wemyss, Merrill v. Fahs, 324 U.S. 308

(1945), 1945 C.B. 418, and the cases that

preceded it, involved situations where A,

an individual, transferred property to B,

A’s spouse (or future spouse), in exchange

for B’s relinquishment of marital rights in

A’s property. The Court held that B’s relinquishment of the marital rights did not

constitute adequate and full consideration

for A’s transfer because the assets subject

to the marital rights were already includible in A’s taxable estate. The property

subject to dower and marital rights is

clearly included in the gross estate of the

property owner. Thus, to conclude that

the relinquishment of dower and marital

rights by the spouse of the property

owner constituted adequate and full consideration for a transfer by the property

owner for gift tax purposes would effectively subvert the legislative intent and

statutory scheme of the gift tax provisions. Merrill v. Fahs, at 311–312. See

also, Commissioner v. Bristol, 121 F.2d

129, 136 (1st Cir. 1941).

Likewise, in the present situation, property subject to the QTIP election was intended to be subject to either gift or estate

tax. S’s receipt of the remainder interest

does not increase the value of S’s taxable

estate because that property is already

subject to inclusion in S’s taxable estate

under § 2044. Rather, S’s issuance of the

note results in a depletion of S’s taxable

estate that is not offset by S’s receipt of

the remainder interest. Thus, for estate

and gift tax purposes, S’s receipt of the remainder interest cannot constitute adequate and full consideration under

§ 2512 for the promissory note transferred

by S to C. As was the case in Merrill v.

Fahs, any other result would subvert the

legislative intent and statutory scheme underlying § 2056(b)(7). Therefore, under

§ 2511, S has made a gift to C equal to the

value of the promissory note S gave to C.

In addition, a gift tax would be imposed under the above alternative rationales even if S acquired only a portion of

February 17, 1998

C’s remainder interest; e.g., S acquired 60

percent of C’s remainder interest. If,

under applicable state law, such a transaction results in a partial termination of the

trust, S would be treated as disposing of

part of S’s income interest in the trust, and

the commutation analysis would apply.

See, e.g., Restatement (Second) of Trusts

§ 340(2) (1959). See also, § 25.2519–

1(g), Example 4, (illustrating the estate

and gift tax consequences of the disposition of a portion of the spouse’s income

interest). If the trust does not terminate, S

would nonetheless be treated as making a

transfer under §§ 2511 and 2512 for less

than adequate and full consideration to

the extent of the value of the property or

cash S transfers in exchange for the partial

remainder interest.

Further, the conclusion of this revenue

ruling would be the same if S transferred

to C property or cash rather than the

promissory note. The economic effect of

the transaction is identical, regardless

whether S uses S’s own funds to finance

the transaction or gives a promissory note

and discharges the note using some of the

QTIP Trust assets received in the transaction. Thus, the result is the same for

transfer tax purposes.

HOLDING

If a surviving spouse acquires the remainder interest in a trust subject to a

QTIP election under § 2056(b)(7) in connection with the transfer by the surviving

spouse of property or cash to the holder of

the remainder interest, the surviving

spouse makes a gift both under § 2519

and under §§ 2511 and 2512. The amount

of the gift is equal to the greater of (i) the

value of the remainder interest (pursuant

to § 2519), or (ii) the value of the property

or cash transferred to the holder of the remainder interest (pursuant to §§ 2511 and

2512).

DRAFTING INFORMATION

The principal author of this revenue

ruling is Deborah Ryan of the office of

Assistant Chief Counsel (Passthroughs

and Special Industries. For further information regarding this revenue ruling contact Ms. Ryan on (202) 622-3090 (not a

toll-free call).

26

Section 2702.—Special

Valuation Rules in Case of

Transfers of Interest in Trusts

26 CFR 25.2702–5: Personal residence trusts.

T.D. 8743

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 25 and 602

Sale of Residence From

Qualified Personal Residence

Trust

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations

SUMMARY: This document contains

final regulations permitting the reformation of a personal residence trust or a

qualified personal residence trust in order

to comply with the applicable requirements for such trusts. The final regulations also provide that the governing instruments of such trusts must prohibit the

sale of a residence held in the trust to the

grantor of the trust, the grantor’s spouse,

or an entity controlled by the grantor or

the grantor’s spouse.

DATES: The regulations are effective

December 23, 1997.

FOR FURTHER INFORMATION CONTACT: Lane Damazo (202) 622-3090

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been

reviewed and approved by the Office of

Management and Budget in accordance

with the Paperwork Reduction Act (44

U.S.C. 3507) under control number 15451485. Responses to this collection of information are required in order to ensure

the proper collection of the gift tax.

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.

1998–7 I.R.B.

The estimated annual burden per respondent/recordkeeper varies from 3

hours to 3.25 hours, depending on individual circumstances, with an estimated

average of 3.1 hours.

Comments concerning the accuracy of

this burden estimate and suggestions for

reducing this burden should be sent to the

Internal Revenue Service, Attn: IRS Reports Clearance Officer T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attention: Desk

Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Books or records relating to this collection of information must be retained as

long as their contents may become material in the administration of any internal

revenue law. Generally, tax returns and

tax return information are confidential, as

required by 26 U.S.C. 6103.

Background

On April 16, 1996, the IRS published in

the Federal Register a notice of proposed

rulemaking (formerly PS–004–96) at 61

FR 16623. The IRS received written and

oral comments on the proposed regulations and held a public hearing on July 24,

1996. This document adopts final regulations with respect to this notice of proposed rulemaking.

Comments with respect to §25.2702–

5(a)(2) indicated that the procedure permitting reformation of trust instruments

will be helpful to taxpayers and pr

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