Bulletin No. 1996–8 February 27, 1996 OF THIS ISSUE Bulletin Index-Digest System, a research and reference service supplementing the Bulletin, ... CORP:T:R (TD 8645), Room 5228,

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Bulletin No. 1996–8February 27, 1996

HIGHLIGHTSOF THIS ISSUE

These synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

PS–7–89, page 24.Proposed regulations under section 1254 of the Coderelating to the treatment of gain from the disposition ofinterest in certain natural resource recapture propertyby S corporations and their shareholders.

T.D. 8645, page 4.Final regulations under section 469 of the Codeproviding rules for rental real estate activities oftaxpayers engaged in certain real property trades orbusinesses.

T.D. 8646, page 10.Final regulations under section 861 of the Codeprovides guidance concerning the allocation and appor-tionment of research and experimental expenditures forpurposes of determining taxable income from sourcesinside and outside the U.S.

EMPLOYEE PLANS

Notice 96–11, page 19.Guidelines are set forth for determining for February1996, the weighted average interest rate and theresulting permissible range of interest rates used tocalculate current liability for purposes of the full fundinglimitation of section 412(c)(7) of the Code as amendedby the Omnibus Budget Reconciliation Act of 1987 andby the Uruguay Round Agreements Act (GATT).

EXEMPT ORGANIZATIONS

Announcement 96–10, page 30.A list is provided of organizations that no longer qualifyas organizations to which contributions are deductibleunder section 170 of the Code.

EXCISE TAXES

Announcement 96–9, page 30.Effective after December 31, 1995, the rates for fueltaxes and the base amount not subject to the luxury taxhave changed. Also, excise taxes on transportation andon the superfund expired December 31, 1995.

ADMINISTRATIVE

Rev. Proc. 96–25, page 19.Automobile owners and lessees. This procedure providesowners and lessees of passenger automobiles withtables detailing the limitations on depreciation deduc-tions for automobiles first placed in service duringcalendar year 1996 and the amounts to be included inincome for automobiles first leased during calendaryear 1996.

Rev. Proc. 96–26, page 22.Backup withholding; substitute Form W–9. The require-ments for payors that want to use a substitute Form W–9, Request for Taxpayer Identification Number andCertification, are clarified.

Finding Lists begin on page 00.Announcement of Disbarments and Suspensions begin on page 00.Announcement of Declaratory Judgment Proceeding Under Section 7428 on page 00.

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Mission of the ServiceThe purpose of the Internal Revenue Service is tocollect the proper amount of tax revenue at the leastcost; serve the public by continually improving the

quality of our products and services; and perform in amanner warranting the highest degree of publicconfidence in our integrity, efficiency and fairness.

Statement of Principlesof Internal RevenueTax AdministrationThe function of the Internal Revenue Service is toadminister the Internal Revenue Code. Tax policyfor raising revenue is determined by Congress.

With this in mind, it is the duty of the Service tocarry out that policy by correctly applying the lawsenacted by Congress; to determine the reasonablemeaning of various Code provisions in light of theCongressional purpose in enacting them; and toperform this work in a fair and impartial manner,with neither a government nor a taxpayer point ofview.

At the heart of administration is interpretation of theCode. It is the responsibility of each person in theService, charged with the duty of interpreting thelaw, to try to find the true meaning of the statutoryprovision and not to adopt a strained construction inthe belief that he or she is ‘‘protecting the revenue.’’The revenue is properly protected only when we as-certain and apply the true meaning of the statute.

The Service also has the responsibility of applyingand administering the law in a reasonable,practical manner. Issues should only be raised byexamining officers when they have merit, neverarbitrarily or for trading purposes. At the sametime, the examining officer should never hesitateto raise a meritorious issue. It is also importantthat care be exercised not to raise an issue or toask a court to adopt a position inconsistent withan established Service position.

Administration should be both reasonable andvigorous. It should be conducted with as littledelay as possible and with great courtesy andconsiderateness. It should never try to overreach,and should be reasonable within the bounds of lawand sound administration. It should, however, bevigorous in requiring compliance with law and itshould be relentless in its attack on unreal taxdevices and fraud.

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IntroductionThe Internal Revenue Bulletin is the authoritativeinstrument of the Commissioner of Internal Revenue forannouncing official rulings and procedures of theInternal Revenue Service and for publishing TreasuryDecisions, Executive Orders, Tax Conventions, legisla-tion, court decisions, and other items of generalinterest. It is published weekly and may be obtainedfrom the Superintendent of Documents on a subscrip-tion basis. Bulletin contents of a permanent nature areconsolidated semiannually into Cumulative Bulletins,which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletinall substantive rulings necessary to promote a uniformapplication of the tax laws, including all rulings thatsupersede, revoke, modify, or amend any of thosepreviously published in the Bulletin. All publishedrulings apply retroactively unless otherwise indicated.Procedures relating solely to matters of internalmanagement are not published; however, statements ofinternal practices and procedures that affect the rightsand duties of taxpayers are published.

Revenue rulings represent the conclusions of theService on the application of the law to the pivotal factsstated in the revenue ruling. In those based onpositions taken in rulings to taxpayers or technicaladvice to Service field offices, identifying details andinformation of a confidential nature are deleted toprevent unwarranted invasions of privacy and to complywith statutory requirements.

Rulings and procedures reported in the Bulletin do nothave the force and effect of Treasury DepartmentRegulations, but they may be used as precedents.Unpublished rulings will not be relied on, used, or citedas precedents by Service personnel in the disposition ofother cases. In applying published rulings and proce-dures, the effect of subsequent legislation, regulations,court decisions, rulings, and procedures must beconsidered, and Service personnel and others con-cerned are cautioned against reaching the sameconclusions in other cases unless the facts andcircumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based onprovisions of the Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows:Subpart A, Tax Conventions, and Subpart B, Legislationand Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellanous.To the extent practicable, pertinent cross references tothese subjects are contained in the other Parts andSubparts. Also included in this part are Bank SecrecyAct Administrative Rulings. Bank Secrecy Act Admin-istrative Rulings are issued by the Department of theTreasury’s Office of the Assistant Secretary(Enforcement).

Part IV.—Items of General Interest.With the exception of the Notice of Proposed Rulemak-ing and the disbarment and suspension list included inthis part, none of these announcements are consoli-dated in the Cumulative Bulletins.

The first Bulletin for each month includes an index forthe matters published during the preceding month.These monthly indexes are cumulated on a quarterlyand semiannual basis, and are published in the firstBulletin of the succeeding quarterly and semi-annualperiod, respectively.

The Bulletin Index-Digest System, a research andreference service supplementing the Bulletin, may beobtained from the Superintendent of Documents on asubscription basis. It consists of four Services: ServiceNo. 1, Income Tax; Service No. 2, Estate and GiftTaxes; Service No. 3, Employment Taxes; Service No.4, Excise Taxes. Each Service consists of a basicvolume and a cumulative supplement that provides (1)finding lists of items published in the Bulletin, (2)digests of revenue rulings, revenue procedures, andother published items, and (3) indexes of Public Laws,Treasury Decisions, and Tax Conventions.

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

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

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

Section 280F.—Limitation onDepreciation for Luxury Automobiles;Limitation where Certain PropertyUsed for Personal Purposes

26 CFR 280F–5T: Leased Property(temporary).

This procedure provides owners and lessees ofpassenger automobiles with tables detailing thelimitations on depreciation deductions for auto-mobiles first placed in service during calendaryear 1996 and the amounts to be included in in-come for automobiles first leased during calendaryear 1996. See Rev. Proc. 96–25, page 19.

26 CFR 280F–7: Property leased after December31, 1986.

This procedure provides owners and lessees ofpassenger automobiles with tables detailing thelimitations on depreciation deductions for auto-mobiles first placed in service during calendaryear 1996 and the amounts to be included in in-come for automobiles first leased during calendaryear 1996. See Rev. Proc. 96–25, page 19.

Section 469.—Passive ActivityLosses and Credits Limited

26 CFR 1.469–4: Definition of activity.

T.D. 8645

DEPARTMENT OF THE TREASURYInternal Revenue Service26 CFR Part 1

Rules for Certain Rental Real EstateActivities

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document containsfinal regulations providing rules forrental real estate activities of taxpayersengaged in certain real property tradesor businesses. The regulations reflectchanges to the law made by the Omni-bus Budget Reconciliation Act of 1993,and affect taxpayers subject to thelimitations on passive activity lossesand passive activity credits.

DATES: These regulations are effectiveon January 1, 1995. See §1.469–11 forapplicability.

ADDRESSES: Send submissions to:CC:DOM:CORP:T:R (TD 8645), Room

5228, Internal Revenue Service, POB7604, Ben Franklin Station, Wash-ington, DC 20044. In the alternative,submissions may be hand deliveredbetween the hours of 8:00 a.m. and5:00 p.m. to: CC:DOM:CORP:T:R (TD8645), Courier’s Desk, Internal Reve-nue Service, 1111 Constitution AvenueNW, Washington, DC.

FOR FURTHER INFORMATIONCONTACT: William M. Kostak at(202) 622-3080 (not a toll-freenumber).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information con-tained in these final regulations hasbeen reviewed and approved by theOffice of Management and Budget inaccordance with the Paperwork Reduc-tion Act (44 U.S.C. 3504(h)) undercontrol number 1545–AS38. The esti-mated annual burden per respondentvaries from 0.10 hours to 0.25 hours,depending on individual circumstances,with an estimated average of 0.15hours.

Comments concerning the accuracyof this burden estimate and suggestionsfor reducing this burden should be sentto the Internal Revenue Service, Attn:IRS Reports Clearance Officer, IT:FP,Washington, DC 20224, and to theOffice of Management and Budget,Attn: Desk Officer for the Departmentof the Treasury, Office of Informationand Regulatory Affairs, Washington,DC 20503.

Background

This document amends 26 CFR part1 to provide rules relating to thetreatment of rental real estate activitiesof certain taxpayers under the passiveactivity loss and credit limitations ofsection 469. Section 469 disallowslosses from passive activities to theextent they exceed income from pas-sive activities and similarly disallowscredits from passive activities to theextent they exceed tax liability alloca-ble to passive activities. In general,passive activities are activities in whichthe taxpayer does not materially partici-pate. In addition, until the enactment of

the Omnibus Budget Reconciliation Actof 1993 (OBRA 1993), all rentalactivities (including those in which ataxpayer materially participated) werepassive.

OBRA 1993 added section 469(c)(7),which provides that rental real estateactivities of qualifying taxpayers arenot subject to the rule that treats allrental activities as passive. Thus, arental real estate activity of a qualify-ing taxpayer is not passive if thetaxpayer materially participates in theactivity. Further, section 469(c)(7)provides that each of a qualifyingtaxpayer’s interests in rental real estateis treated as a separate activity unlessthe taxpayer elects to treat all interestsin rental real estate as a single activity.

On January 10, 1995, the IRS pub-lished in the Federal Register a noticeof proposed rulemaking (60 FR 2557[PS–80–93, 1995–1 C.B. 1015]) toprovide guidance regarding section469(c)(7). A number of public com-ments were received concerning theproposed regulations, and a publichearing was held on May 11, 1995.After consideration of the commentsreceived, the proposed regulations areadopted as revised by this Treasurydecision.

Explanation of provisions

I. General Background

The proposed regulations providerules for determining whether a tax-payer qualifies for treatment undersection 469(c)(7). The proposed regula-tions also provide rules for determiningthe rental real estate activities ofqualifying taxpayers for purposes ofsection 469. Except for modificationsin response to comments received onthe proposed regulations, the finalregulations generally adopt the rulescontained in the proposed regulations.

II. Public Comments

Several comments requested that theService reconsider the rule in theproposed regulations prohibitingqualifying taxpayers from groupingrental real estate activities with otheractivities in determining whether thetaxpayers materially participate in therental real estate activities. After care-


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ful consideration, the final regulationsadopt the rule in the proposed regula-tions because that position is consistentwith the statutory language and thelegislative history.

Several comments suggested that therule in the proposed regulations pro-hibiting the grouping of rental realestate activities with other activities bemodified to allow qualifying taxpayersto group the activities of developmentor construction of rental real estatewith rental real estate activities. Thefinal regulations do not adopt thismodification because in most casesdevelopment and construction activitiesare separate and distinct from rentalactivities. In addition, this modificationwould introduce significant administra-tive difficulties in determining whichdevelopment activities or constructionactivities qualify. However, the IRSand Treasury Department invite com-ments concerning whether the materialparticipation tests in §1.469–5T(a)should be amended to include a look-back material participation test fortaxpayers significantly involved in thedevelopment or construction of theirrental real estate interests.

Several comments requested clar-ification regarding whether a qualifyingtaxpayer’s participation in a manage-ment activity may count towards mate-rial participation in a rental real estateactivity if the management activityincludes the management of rental realestate owned by the taxpayer. The finalregulations clarify that a qualifyingtaxpayer may participate in a rental realestate activity through participation in amanagement activity. In determiningwhether the taxpayer materially partici-pates in the rental real estate activity,however, work the taxpayer performsin the management activity is takeninto account only to the extent it isperformed in managing the taxpayer’sown rental real estate. The final regula-tions also clarify that a qualifyingtaxpayer who owns rental real estatethrough an entity, including a C corpo-ration that is subject to section 469,may count work performed by the tax-payer in managing the rental real estateof the entity in establishing materialparticipation in the taxpayer’s rentalreal estate activities. Thus, if a qualify-ing taxpayer owns some interests inrental real estate through a closely heldC corporation and makes the electionto treat all interests in rental real estateas a single activity, the aggregate rentalreal estate activity will include those

interests held through the closely heldC corporation for purposes of materialparticipation.

One comment requested that theregulations modify the definition oftrade or business to clarify that ataxpayer’s real property trades or busi-nesses are determined without regard tothe taxpayer’s grouping of activitiesunder §1.469–4. The final regulationsclarify that a taxpayer’s grouping ofactivities under §1.469–4 does notcontrol the determination of the tax-payer’s real property trades or busi-nesses for purposes of this section.

Several comments requested that theregulations provide a detailed definitionof real property trades or businessesbeyond the cross-reference to section469(c)(7)(C). However, to avoid com-plex and mechanical rules, the finalregulations do not adopt a detaileddefinition of real property trades orbusinesses. Instead, the regulationsprovide that taxpayers may use anyreasonable method for determiningtheir real property trades or businesses.

Several comments requested that thefinal regulations modify the rule in theproposed regulations providing thatonly employees who are five-percentowners of their employer at all timesduring the taxable year may treatpersonal services performed as anemployee as services performed in areal property trade or business. Thecomments suggested that the regula-tions should take into account personalservices performed by employees thatare five-percent owners for a signifi-cant portion of a taxable year. Inresponse to these comments, the finalregulations are modified to provide thatan employee may count services per-formed in a real property trade orbusiness during the portion of thetaxable year that the employee is afive-percent owner in the employer.

Several comments requested clar-ification concerning whether a qualify-ing taxpayer that makes an election totreat all interests in rental real estate asa single activity will be treated ashaving a single rental real estateactivity for purposes of the formerpassive activity rule under section469(f). In addition, comments requestedthat the regulations be modified toprovide that qualifying taxpayers thatmake the aggregation election will betreated as having separate activities forpurposes of the disposition rules undersection 469(g) and §1.469–4(g). In re-

sponse to these comments, the finalregulations clarify that a qualifyingtaxpayer that makes the election totreat all interests in rental real estate asa single rental real estate activity willbe treated as having a single activityfor all purposes of section 469, includ-ing sections 469(f) and (g). The statu-tory language and the legislative his-tory do not support a rule allowing aqualifying taxpayer to treat all interestsin rental real estate as a single activityfor purposes of material participationand section 469(f), but as separateactivities for purposes of section469(g).

In addition, in response to comments,the final regulations provide an exam-ple illustrating the operation of theformer passive activity rule for qualify-ing taxpayers that make the election totreat all interests in rental real estate asa single activity. This example illus-trates that qualifying taxpayers thatmake the aggregation election may usecurrent net income from the aggregaterental real estate activity to offset theprior-year disallowed passive losses ofthe aggregate rental real estate activity,regardless of which rental real estateinterests within that activity producedthe income or prior-year losses.

Some comments requested that theregulations permit qualifying taxpayersto make or revoke the aggregationelection on an amended income taxreturn. After careful consideration ofthis issue, the final regulations adoptthe rule in the proposed regulations thataggregation elections must be made orrevoked on an original return. The finalregulations provide, however, that theelection may be revoked in any year inwhich the facts are materially changedfrom those in the taxable year forwhich the election was made.

In addition, one comment requestedclarification as to what constitutes amaterial change in the facts and cir-cumstances that would allow a taxpayerto revoke an aggregation election.However, the final regulations do notprovide an example or bright-line rulefor determining when a material changein the facts and circumstances hasoccurred, because this determination isintended to be a broad factual inquiry.Providing an example or bright-linerule may inappropriately restrict thescope of that inquiry.

One comment requested the modi-fication of the rule in the proposed


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regulations that the aggregation electionhas no effect in years the taxpayer isnot a qualifying taxpayer. Instead, thecomment suggested that, for ease ofadministration and compliance, the ag-gregation election should be bindingand irrevocable for all future years,including years in which the taxpayeris not a qualifying taxpayer. However,the final regulations adopt the rule inthe proposed regulations because theposition advocated by the commentwould be unfavorable to many tax-payers and would not significantlyimprove administration.

Several comments requested that theregulations modify the rule in theproposed regulations treating eachrental real estate interest of a pass-through entity as a separate interest ofa person owning a fifty-percent orgreater interest in the capital, gain,loss, income, deduction, or credit of theentity at any time during a taxableyear. A commentator stated that thisrule is burdensome on many pass-through entities and should be elimi-nated or modified. The final regulationsmodify this rule so that it applies onlywhen a qualifying taxpayer owns afifty-percent or greater interest in thecapital, profits, or losses of a pass-through entity for a taxable year.Accordingly, this rule will not apply ifa qualifying taxpayer owns a fifty-percent or greater interest in a singleitem of income or deduction but doesnot own a fifty-percent or greaterinterest in the overall capital, profits, orlosses of the passthrough entity.

In response to one comment, thefinal regulations also clarify the ap-plication of the fifty-percent ownershiprule to tiered passthrough entities. Thefinal regulations provide that if apassthrough entity owns a fifty-percentor greater interest in the capital, profits,or losses of another passthrough entityfor a taxable year, each interest inrental real estate of the lower-tier entitywill be a separate interest in rental realestate of the upper-tier entity.

In response to another comment, thefinal regulations clarify that section469(i) applies after the rules of section469(c)(7) are applied. Accordingly, the$25,000 offset will be applied onlyagainst passive losses from rental realestate activities, and not against lossesthat are allowable as a result of section469(c)(7). In addition, the final regula-tions clarify that adjusted gross incomefor purposes of section 469(i) is notreduced by any losses from rental real

estate that are allowable as a result ofsection 469(c)(7).

Several comments requested a modi-fication to the effective date provision,to provide that aggregation electionsmade for taxable years beginning be-fore January 1, 1995, are not bindingfor future years. Because taxpayers hadsufficient notice of the rules of section469(c)(7) and these regulations, thismodification is unnecessary and wouldadd administrative complexity. Accord-ingly, the final regulations adopt theeffective date provision of the proposedregulations.

Finally, in response to a comment,the activity regrouping rule of §1.469–4(e)(2) is clarified to provide that ataxpayer may not regroup activitiesunless the taxpayer’s original groupingwas clearly inappropriate or there hasbeen a material change in the facts andcircumstances that makes the originalgrouping clearly inappropriate.

III. Effective Dates

In general, section 469(c)(7) appliesfor taxable years beginning after De-cember 31, 1993. These regulations areeffective for taxable years beginning onor after January 1, 1995. These regula-tions are also effective for electionsunder section 469(c)(7)(A) and para-graph (g) of these regulations that aremade with returns filed on or afterJanuary 1, 1995.

Special Analyses

It has been determined that thisTreasury decision is not a significantregulatory action as defined in EO12866. Therefore, a regulatory assess-ment is not required. It also has beendetermined that section 553(b) of theAdministrative Procedure Act (5 U.S.C.chapter 5) and the Regulatory Flex-ibility Act (5 U.S.C. chapter 6) do notapply to these regulations, and, there-fore, a Regulatory Flexibility Analysisis not required. Pursuant to section7805(f) of the Internal Revenue Code,the notice of proposed rulemakingpreceding these regulations was submit-ted to the Small Business Administra-tion for comment on its impact onsmall business.

Drafting Information

The principal author of these regula-tions is William M. Kostak, Office of

Assistant Chief Counsel (Passthroughsand Special Industries), IRS. However,other personnel from the IRS andTreasury Department participated intheir development.

* * * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR part 1 isamended as follows:

PART I—INCOME TAXES

Paragraph 1. The authority citationfor part 1 is amended by adding anentry in numerical order to read asfollows:

Authority: 26 U.S.C. 7805. * * * Section 1.469–9 also issued under 26

U.S.C. 469(c)(6), (h)(2), and (l)(1). Par. 2. Section 1.469–0 is amended

by:1. Revising the entry for §1.469–

4(h).2. Revising the heading for §1.469–9

and adding entries for paragraphs (a)through (j) of §1.469–9.

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

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

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

6. The revisions and additions readas follows:

§1.469–0 Table of contents.

* * * * * *

§1.469–4 Definition of Activity.

* * * * * *

(h) Rules for grouping rental realestate activities for taxpayers qualifyingunder section 469(c)(7).

* * * * * *

§1.469–9 Rules for certain rentalreal estate activities.

(a) Scope and purpose. (b) Definitions.

(1) Trade or business. (2) Real property trade or

business.(3) Rental real estate.(4) Personal services.


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(5) Material participation. (6) Qualifying taxpayer.

(c) Requirements for qualifyingtaxpayers.(1) In general.(2) Closely held C

corporations.(3) Requirement of material

participation in the realproperty trades or busi-nesses.

(4) Treatment of spouses. (5) Employees in real prop-

erty trades or businesses.(d) General rule for determining

real property trades orbusinesses.(1) Facts and circumstances. (2) Consistency requirement.

(e) Treatment of rental real estateactivities of a qualifyingtaxpayer.(1) In general.(2) Treatment as a former

passive activity. (3) Grouping rental real estate

activities with otheractivities.(i) In general.(ii) Special rule for certain

management activities.(4) Example.

(f) Limited partnership interests inrental real estate activities.(1) In general.(2) De minimis exception.

(g) Election to treat all interestsin rental real estate as a singlerental real estate activity.(1) In general.(2) Certain changes not mate-

rial. (3) Filing a statement to

make or revoke theelection.

(h) Interests in rental real estateheld by certain passthroughentities.(1) General rule.(2) Special rule if a qualify-

ing taxpayer holds a fifty-percent or greater interestin a passthrough entity.

(3) Special rule for interestsheld in tiered passthroughentities.

(i) [Reserved].(j) $25,000 offset for rental real

estate activities of qualifyingtaxpayers.(1) In general. (2) Example.

* * * * * *

§1.469–11 Effective date andtransition rules.

* * * * * *

(b) * * * (2) Additional transition rule for

1992 amendments.(3) Fresh starts under consistency

rules.(i) Regrouping when tax liability is

first determined under Project PS–1–89.

(ii) Regrouping when tax liability isfirst determined under §1.469–4.

(iii) Regrouping when taxpayer isfirst subject to section 469(c)(7).

(4) Certain investment creditproperty.

* * * * * *

Par. 3. Section 1.469–4 is amendedby revising paragraphs (e)(1) and (2)and (h). The revisions read as follows:

§1.469–4 Definition of Activity.

* * * * * *

(e) * * *(1) Original groupings. Except as

provided in paragraph (e)(2) of thissection and §1.469–11, once a taxpayerhas grouped activities under this sec-tion, the taxpayer may not regroupthose activities in subsequent taxableyears. Taxpayers must comply withdisclosure requirements that the Com-missioner may prescribe with respect toboth their original groupings and theaddition and disposition of specificactivities within those chosen groupingsin subsequent taxable years.

(2) Regroupings. If it is determinedthat a taxpayer’s original grouping wasclearly inappropriate or a materialchange in the facts and circumstanceshas occurred that makes the originalgrouping clearly inappropriate, the tax-payer must regroup the activities andmust comply with disclosure require-ments that the Commissioner mayprescribe.

* * * * * *

(h) Rules for grouping rental realestate activities for taxpayers qualify-ing under section 469(c)(7). See§1.469–9 for rules for certain rentalreal estate activities.

Par. 4. Section 1.469-9 is revised toread as follows:

§1.469–9 Rules for certain rentalreal estate activities.

(a) Scope and purpose. This sectionprovides guidance to taxpayers engagedin certain real property trades or busi-nesses on applying section 469(c)(7) totheir rental real estate activities.

(b) Definitions. The following defi-nitions apply for purposes of thissection:

(1) Trade or business. A trade orbusiness is any trade or businessdetermined by treating the types ofactivities in §1.469–4(b)(1) as if theyinvolved the conduct of a trade orbusiness, and any interest in rental realestate, including any interest in rentalreal estate that gives rise to deductionsunder section 212.

(2) Real property trade or business.Real property trade or business isdefined in section 469(c)(7)(C).

(3) Rental real estate. Rental realestate is any real property used bycustomers or held for use by customersin a rental activity within the meaningof §1.469–1T(e)(3). However, anyrental real estate that the taxpayergrouped with a trade or businessactivity under §1.469–4(d)(1)(i)(A) or(C) is not an interest in rental realestate for purposes of this section.

(4) Personal services. Personal serv-ices means any work performed by anindividual in connection with a trade orbusiness. However, personal servicesdo not include any work performed byan individual in the individual’s capac-ity as an investor as described in§1.469–5T(f)(2)(ii).

(5) Material participation. Materialparticipation has the same meaning asunder §1.469–5T. Paragraph (f) of thissection contains rules applicable tolimited partnership interests in rentalreal estate that a qualifying taxpayerelects to aggregate with other interestsin rental real estate of that taxpayer.

(6) Qualifying taxpayer. A qualify-ing taxpayer is a taxpayer that owns atleast one interest in rental real estateand meets the requirements of para-graph (c) of this section.

(c) Requirements for qualifying tax-payers—(1) In general. A qualifyingtaxpayer must meet the requirements ofsection 469(c)(7)(B).

(2) Closely held C corporations. Aclosely held C corporation meets therequirements of paragraph (c)(1) of thissection by satisfying the requirements


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of section 469(c)(7)(D)(i). For purposesof section 469(c)(7)(D)(i), gross re-ceipts do not include items of portfolioincome within the meaning of §1.469–2T(c)(3).

(3) Requirement of material par-ticipation in the real property trades orbusinesses. A taxpayer must materiallyparticipate in a real property trade orbusiness in order for the personalservices provided by the taxpayer inthat real property trade or business tocount towards meeting the requirementsof paragraph (c)(1) of this section.

(4) Treatment of spouses. Spousesfiling a joint return are qualifyingtaxpayers only if one spouse separatelysatisfies both requirements of section469(c)(7)(B). In determining the realproperty trades or businesses in whicha married taxpayer materially partici-pates (but not for any other purposeunder this paragraph (c)), work per-formed by the taxpayer’s spouse in atrade or business is treated as workperformed by the taxpayer under§1.469–5T(f)(3), regardless of whetherthe spouses file a joint return for theyear.

(5) Employees in real propertytrades or businesses. For purposes ofparagraph (c)(1) of this section, per-sonal services performed during ataxable year as an employee generallywill be treated as performed in a tradeor business but will not be treated asperformed in a real property trade orbusiness, unless the taxpayer is a five-percent owner (within the meaning ofsection 416(i)(1)(B)) in the employer.If an employee is not a five-percentowner in the employer at all timesduring the taxable year, only thepersonal services performed by theemployee during the period theemployee is a five-percent owner in theemployer will be treated as performedin a real property trade or business.

(d) General rule for determiningreal property trades or businesses—(1)Facts and circumstances. The deter-mination of a taxpayer’s real propertytrades or businesses for purposes ofparagraph (c) of this section is basedon all of the relevant facts andcircumstances. A taxpayer may use anyreasonable method of applying the factsand circumstances in determining thereal property trades or businesses inwhich the taxpayer provides personalservices. Depending on the facts andcircumstances, a real property trade orbusiness consists either of one or more

than one trade or business specificallydescribed in section 469(c)(7)(C). Ataxpayer’s grouping of activities under§1.469–4 does not control the deter-mination of the taxpayer’s real propertytrades or businesses under this para-graph (d).

(2) Consistency requirement. Once ataxpayer determines the real propertytrades or businesses in which personalservices are provided for purposes ofparagraph (c) of this section, thetaxpayer may not redetermine thosereal property trades or businesses insubsequent taxable years unless theoriginal determination was clearly inap-propriate or there has been a materialchange in the facts and circumstancesthat makes the original determinationclearly inappropriate.

(e) Treatment of rental real estateactivities of a qualifying taxpayer—(1)In general. Section 469(c)(2) does notapply to any rental real estate activityof a taxpayer for a taxable year inwhich the taxpayer is a qualifyingtaxpayer under paragraph (c) of thissection. Instead, a rental real estateactivity of a qualifying taxpayer is apassive activity under section 469 forthe taxable year unless the taxpayermaterially participates in the activity.Each interest in rental real estate of aqualifying taxpayer will be treated as aseparate rental real estate activity,unless the taxpayer makes an electionunder paragraph (g) of this section totreat all interests in rental real estate asa single rental real estate activity. Eachseparate rental real estate activity, orthe single combined rental real estateactivity if the taxpayer makes anelection under paragraph (g), will be anactivity of the taxpayer for all purposesof section 469, including the formerpassive activity rules under section469(f) and the disposition rules undersection 469(g). However, section 469will continue to be applied separatelywith respect to each publicly tradedpartnership, as required under section469(k), notwithstanding the rules ofthis section.

(2) Treatment as a former passiveactivity. For any taxable year in whicha qualifying taxpayer materially partici-pates in a rental real estate activity,that rental real estate activity will betreated as a former passive activityunder section 469(f) if disalloweddeductions or credits are allocated tothe activity under §1.469–1(f)(4).

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

general. For purposes of this section, aqualifying taxpayer may not group arental real estate activity with any otheractivity of the taxpayer. For example, ifa qualifying taxpayer develops realproperty, constructs buildings, andowns an interest in rental real estate,the taxpayer’s interest in rental realestate may not be grouped with thetaxpayer’s development activity or con-struction activity. Thus, only the par-ticipation of the taxpayer with respectto the rental real estate may be used todetermine if the taxpayer materiallyparticipates in the rental real estateactivity under §1.469–5T.

(ii) Special rule for certain manage-ment activities. A qualifying taxpayermay participate in a rental real estateactivity through participation, withinthe meaning of §§1.469–5(f) and 5T(f),in an activity involving the manage-ment of rental real estate (even if thismanagement activity is conductedthrough a separate entity). In determin-ing whether the taxpayer materiallyparticipates in the rental real estateactivity, however, work the taxpayerperforms in the management activity istaken into account only to the extent itis performed in managing the tax-payer’s own rental real estate interests.

(4) Example. The following exampleillustrates the application of this para-graph (e).

Example. (i) Taxpayer B owns interests inthree rental buildings, U, V and W. In 1995, Bhas $30,000 of disallowed passive losses alloca-ble to Building U and $10,000 of disallowedpassive losses allocable to Building V under§1.469–1(f)(4). In 1996, B has $5,000 of netincome from building U, $5,000 of net lossesfrom building V, and $10,000 of net income frombuilding W. Also in 1996, B is a qualifyingtaxpayer within the meaning of paragraph (c) ofthis section. Each building is treated as aseparate activity of B under paragraph (e)(1) ofthis section, unless B makes the election underparagraph (g) to treat the three buildings as asingle rental real estate activity. If the buildingsare treated as separate activities, material par-ticipation is determined separately with respectto each building. If B makes the election underparagraph (g) to treat the buildings as a singleactivity, all participation relating to the buildingsis aggregated in determining whether B mate-rially participates in the combined activity.

(ii) Effective beginning in 1996, B makes theelection under paragraph (g) to treat the threebuildings as a single rental real estate activity. Bworks full-time managing the three buildings andthus materially participates in the combinedactivity in 1996 (even if B conducts thismanagement function through a separate entity,including a closely held C corporation). Accord-ingly, the combined activity is not a passiveactivity of B in 1996. Moreover, as a result ofthe election under paragraph (g), disallowed


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passive losses of $40,000 ($30,000 + $10,000)are allocated to the combined activity. B’s netincome from the activity for 1996 is $10,000($5,000 – $5,000 + $10,000). This net income isnonpassive income for purposes of section 469.However, under section 469(f), the net incomefrom a former passive activity may be offsetwith the disallowed passive losses from the sameactivity. Because Buildings U, V and W aretreated as one activity for all purposes of section469 due to the election under paragraph (g), andthis activity is a former passive activity undersection 469(f), B may offset the $10,000 of netincome from the buildings with an equal amountof disallowed passive losses allocable to thebuildings, regardless of which buildings pro-duced the income or losses. As a result, B has$30,000 ($40,000 – $10,000) of disallowed pas-sive losses remaining from the buildings after1996.

(f) Limited partnership interests inrental real estate activities—(1) Ingeneral. If a taxpayer elects underparagraph (g) of this section to treat allinterests in rental real estate as a singlerental real estate activity, and at leastone interest in rental real estate is heldby the taxpayer as a limited partnershipinterest (within the meaning of §1.469–5T(e)(3)), the combined rental realestate activity will be treated as alimited partnership interest of the tax-payer for purposes of determiningmaterial participation. Accordingly, thetaxpayer will not be treated under thissection as materially participating inthe combined rental real estate activityunless the taxpayer materially partici-pates in the activity under the testslisted in §1.469–5T(e)(2) (dealing withthe tests for determining the materialparticipation of a limited partner).

(2) De minimis exception. If aqualifying taxpayer elects under para-graph (g) of this section to treat allinterests in rental real estate as a singlerental real estate activity, and thetaxpayer’s share of gross rental incomefrom all of the taxpayer’s limitedpartnership interests in rental real estateis less than ten percent of the tax-payer’s share of gross rental incomefrom all of the taxpayer’s interests inrental real estate for the taxable year,paragraph (f)(1) of this section does notapply. Thus the taxpayer may deter-mine material participation under anyof the tests listed in §1.469–5T(a) thatapply to rental real estate activities.

(g) Election to treat all interests inrental real estate as a single rentalreal estate activity—(1) In general. Aqualifying taxpayer may make an elec-tion to treat all of the taxpayer’sinterests in rental real estate as a singlerental real estate activity. This election

is binding for the taxable year in whichit is made and for all future years inwhich the taxpayer is a qualifyingtaxpayer under paragraph (c) of thissection, even if there are interveningyears in which the taxpayer is not aqualifying taxpayer. The election maybe made in any year in which the tax-payer is a qualifying taxpayer, and thefailure to make the election in one yeardoes not preclude the taxpayer frommaking the election in a subsequentyear. In years in which the taxpayer isnot a qualifying taxpayer, the electionwill not have effect and the taxpayer’sactivities will be those determinedunder §1.469–4. If there is a materialchange in the taxpayer’s facts andcircumstances, the taxpayer may revokethe election using the procedure de-scribed in paragraph (g)(3) of thissection.

(2) Certain changes not material.The fact that an election is lessadvantageous to the taxpayer in aparticular taxable year is not, of itself,a material change in the taxpayer’sfacts and circumstances. Similarly, abreak in the taxpayer’s status as aqualifying taxpayer is not, of itself, amaterial change in the taxpayer’s factsand circumstances.

(3) Filing a statement to make orrevoke the election. A qualifying tax-payer makes the election to treat allinterests in rental real estate as a singlerental real estate activity by filing astatement with the taxpayer’s originalincome tax return for the taxable year.This statement must contain a declara-tion that the taxpayer is a qualifyingtaxpayer for the taxable year and ismaking the election pursuant to section469(c)(7)(A). The taxpayer may makethis election for any taxable year inwhich section 469(c)(7) is applicable.A taxpayer may revoke the electiononly in the taxable year in which amaterial change in the taxpayer’s factsand circumstances occurs or in asubsequent year in which the facts andcircumstances remain materiallychanged from those in the taxable yearfor which the election was made. Torevoke the election, the taxpayer mustfile a statement with the taxpayer’soriginal income tax return for the yearof revocation. This statement mustcontain a declaration that the taxpayeris revoking the election under section469(c)(7)(A) and an explanation of thenature of the material change.

(h) Interests in rental real estateheld by certain passthrough entities—

(1) General rule. Except as provided inparagraph (h)(2) of this section, aqualifying taxpayer’s interest in rentalreal estate held by a partnership or anS corporation (passthrough entity) istreated as a single interest in rental realestate if the passthrough entity groupedits rental real estate as one rentalactivity under §1.469–4(d)(5). If thepassthrough entity grouped its rentalreal estate into separate rental activitiesunder §1.469–4(d)(5), each rental realestate activity of the passthrough entitywill be treated as a separate interest inrental real estate of the qualifyingtaxpayer. However, the qualifying tax-payer may elect under paragraph (g) ofthis section to treat all interests inrental real estate, including the rentalreal estate interests held through pass-through entities, as a single rental realestate activity.

(2) Special rule if a qualifying tax-payer holds a fifty-percent or greaterinterest in a passthrough entity. If aqualifying taxpayer owns, directly orindirectly, a fifty-percent or greaterinterest in the capital, profits, or lossesof a passthrough entity for a taxableyear, each interest in rental real estateheld by the passthrough entity will betreated as a separate interest in rentalreal estate of the qualifying taxpayer,regardless of the passthrough entity’sgrouping of activities under §1.469–4(d)(5). However, the qualifying tax-payer may elect under paragraph (g) ofthis section to treat all interests inrental real estate, including the rentalreal estate interests held through pass-through entities, as a single rental realestate activity.

(3) Special rule for interests held intiered passthrough entities. If a pass-through entity owns a fifty-percent orgreater interest in the capital, profits, orlosses of another passthrough entity fora taxable year, each interest in rentalreal estate held by the lower-tier entitywill be treated as a separate interest inrental real estate of the upper-tierentity, regardless of the lower-tierentity’s grouping of activities under§1.469–4(d)(5).

(i) [Reserved].(j) $25,000 offset for rental real

estate activities of qualifying tax-payers—(1) In general. A qualifyingtaxpayer’s passive losses and creditsfrom rental real estate activities (in-cluding prior-year disallowed passiveactivity losses and credits from rentalreal estate activities in which the


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taxpayer materially participates) areallowed to the extent permitted undersection 469(i). The amount of losses orcredits allowable under section 469(i)is determined after the rules of thissection are applied. However, lossesallowable by reason of this section arenot taken into account in determiningadjusted gross income for purposes ofsection 469(i)(3).

(2) Example. The following exampleillustrates the application of this para-graph (j).

Example. (i) Taxpayer A owns building X andbuilding Y, both interests in rental real estate. In1995, A is a qualifying taxpayer within themeaning of paragraph (c) of this section. A doesnot elect to treat X and Y as one activity undersection 469(c)(7)(A) and paragraph (g) of thissection. As a result, X and Y are treated asseparate activities pursuant to section 469(c)(7)-(A)(ii). A materially participates in X which has$100,000 of passive losses disallowed from prioryears and produces $20,000 of losses in 1995. Adoes not materially participate in Y whichproduces $40,000 of income in 1995. A also has$50,000 of income from other nonpassivesources in 1995. A otherwise meets the require-ments of section 469(i).

(ii) Because X is not a passive activity in1995, the $20,000 of losses produced by X in1995 are nonpassive losses that may be used byA to offset part of the $50,000 of nonpassiveincome. Accordingly, A is left with $30,000($50,000 – $20,000) of nonpassive income. Inaddition, A may use the prior year disallowedpassive losses of X to offset any income from Xand passive income from other sources. There-fore, A may offset the $40,000 of passive incomefrom Y with $40,000 of passive losses from X.

(iii) Because A has $60,000 ($100,000 –$40,000) of passive losses remaining from X andmeets all of the requirements of section 469(i), Amay offset up to $25,000 of nonpassive incomewith passive losses from X pursuant to section469(i). As a result, A has $5,000 ($30,000 –$25,000) of nonpassive income remaining anddisallowed passive losses from X of $35,000($60,000 – $25,000) in 1995.

Par. 5. Section 1.469–11 is amendedas follows:

1. Paragraph (a)(2) is amended byremoving ‘‘; and’’ and adding ‘‘;’’ inits place.

2. Paragraph (a)(3) is redesignatedas paragraph (a)(4) and a new para-graph (a)(3) is added.

3. Paragraph (b)(1) is revised.4. The heading for paragraph (b)(2)

is revised; the headings for paragraphs(b)(2)(i) and (b)(2)(ii) are removed;paragraph (b)(2)(ii) is removed, andparagraph (b)(2)(i) is redesignated asparagraph (b)(2).

5. Paragraph (b)(3) is redesignatedas paragraph (b)(4).

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

The added and revised provisionsread as follows:

§1.469–11 Effective date andtransition rules.

(a) * * *(3) The rules contained in §1.469–9

apply for taxable years beginning on orafter January 1, 1995, and to electionsmade under §1.469–9(g) with returnsfiled on or after January 1, 1995; and

* * * * * *

(b) * * * (1) Application of 1992amendments for taxable years begin-ning before October 4, 1994. Except asprovided in paragraph (b)(2) of thissection, for taxable years that end afterMay 10, 1992, and begin beforeOctober 4, 1994, a taxpayer maydetermine tax liability in accordancewith Project PS–1–89 published at1992–1 C.B. 1219 (see §601.601(d)(2)-(ii)(b) of this chapter).

(2) Additional transition rule for1992 amendments. * * *

(3) Fresh starts under consistencyrules—(i) Regrouping when tax lia-bility is first determined under ProjectPS–1–89. For the first taxable year inwhich a taxpayer determines its taxliability under Project PS–1–89, thetaxpayer may regroup its activitieswithout regard to the manner in whichthe activities were grouped in thepreceding taxable year and must re-group its activities if the grouping inthe preceding taxable year is inconsist-ent with the rules of Project PS–1–89.

(ii) Regrouping when tax liability isfirst determined under §1.469–4. Forthe first taxable year in which ataxpayer determines its tax liabilityunder §1.469–4, rather than under therules of Project PS–1–89, the taxpayermay regroup its activities without re-gard to the manner in which theactivities were grouped in the preced-ing taxable year and must regroup itsactivities if the grouping in the preced-ing taxable year is inconsistent with therules of §1.469–4.

(iii) Regrouping when taxpayer isfirst subject to section 469(c)(7). Forthe first taxable year beginning afterDecember 31, 1993, a taxpayer may re-group its activities to the extent neces-sary or appropriate to avail itself of theprovisions of section 469(c)(7) andwithout regard to the manner in which

the activities were grouped in thepreceding taxable year.

* * * * * *

Margaret Milner Richardson,Commissioner of

Internal Revenue.

Approved December 12, 1995.

Leslie Samuels,Assistant Secretary of

the Treasury (Tax Policy).

(Filed by the Office of the Federal Register onDecember 21, 1995, 8:45 a.m., and publishedin the issue of the Federal Register forDecember 22, 1995, 60 F.R. 66496)

Section 861.—Income From SourcesWithin the United States

26 CFR 1.861–8: Computation of taxableincome from sources within the United Statesand from other sources and activities.

T.D. 8646

DEPARTMENT OF THE TREASURYInternal Revenue Service26 CFR Part 1

Allocation and Apportionment ofResearch and ExperimentalExpenditures


ACTION: Final regulations.

SUMMARY: This document providesguidance concerning the allocation andapportionment of research and experi-mental expenditures for purposes ofdetermining taxable income fromsources within and without the UnitedStates. This document affects taxpayersthat have income from United Statesand foreign sources and that have madeexpenditures for research and experi-mentation that the taxpayer deductsunder section 174 of the InternalRevenue Code of 1986.

EFFECTIVE DATE: January 1, 1996.

FOR FURTHER INFORMATIONCONTACT: Carl Cooper at (202)622-3840 (not a toll-free number).


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Background and Explanation ofProvisions

On May 24, 1995, the IRS publisheda notice of proposed rulemaking andnotice of public hearing in the FederalRegister (60 FR 27453 [INTL–23–95,1995–1 C.B. 987]) proposing amend-ments to the Income Tax Regulations(26 CFR part 1) under section 861 ofthe Internal Revenue Code of 1986.Section 1.861–8(e)(3) of the IncomeTax Regulations provides rules regard-ing the allocation and apportionment ofresearch and experimental expendituresfor purposes of determining taxableincome from sources inside and outsidethe United States.

The notice of proposed rulemakingproposed three principal changes to theexisting regulations. First, allocation ofresearch and experimental expendituresto three digit SIC code product catego-ries of gross income would be permit-ted. Second, the percentage of researchand experimental expenditures that maybe exclusively apportioned to UnitedStates source income under the salesmethod of apportionment under§1.861–8(e)(3)(ii) would be increasedfrom 30 percent to 50 percent. Third,use of the optional gross incomemethods of apportionment would con-stitute a binding election to use suchmethods in subsequent years. Theelection would not be revocable with-out the prior consent of the Commis-sioner. The three changes were pro-posed in part on the basis of aneconomic study performed by theTreasury Department pursuant to Rev.Proc. 92–56 (1992–2 C.B. 409), ‘‘TheRelationship between U.S. Researchand Development and Foreign In-come,’’ which was published by theTreasury Department simultaneouslywith the proposed regulations.

Written comments responding to thenotice were received, and a publichearing was held on September 8,1995.

Regarding the determination of prod-uct categories under §1.861–8(e)-(3)(i)(B) of the proposed regulations,commenters suggested that the rulerequiring a taxpayer to determine rele-vant product categories by reference tothe three digit classification of theStandard Industrial Classification Man-ual should be modified to allow deter-minations by reference to the five digit

classifications of the Manual. Thissuggestion was not adopted, becausesuch a rule would too narrowly restrictthe necessarily broad scope of thededuction. The IRS continues to be-lieve that research and experimentationis an inherently speculative activity,that findings may contribute unex-pected benefits, and that gross incomederived from successful research andexperimentation must bear the cost ofunsuccessful research and experi-mentation.

Commenters suggested that the reg-ulations permit taxpayers to determineproduct categories by reference to twoor three digit categories at the annualelection of the taxpayer. This sugges-tion was not adopted. The regulationsprovide that a taxpayer may determineproduct categories by reference to twoor three digit categories. A taxpayermay aggregate, disaggregate or changea previously selected SIC code cate-gory if the taxpayer establishes to thesatisfaction of the Commissioner that,due to changes in the relevant facts, achange in product category is appropri-ate. This rule provides a simple andworkable format for balancing the needfor consistency with the desire forflexibility.

Referring to current §1.861–8(g) Ex-ample 6 (which has been redesignated§1.861–17(h) Example 4), commenterssuggested that the regulations allow theuse of the Wholesale Trade SIC codecategory with respect to sales from anyother category. The current §1.861–8(g)Example 6 was not correct on this pointand does not override the rule statedparenthetically in the list of two digitSIC code categories in present §1.861–8(e)(3)(i)(A) that wholesale trade maynot be combined with other productcategories. The final regulations in-clude this rule along with Example 6corrected to conform to the rule.

Regarding the exclusive place ofperformance apportionment rule under§1.861–8(e)(3)(ii)(A) of the proposedregulations, commenters suggestedadding a rule providing that if the ratioof foreign research and experimentalexpenditures in a three digit SIC codecategory of all foreign affiliates of aUnited States consolidated group overforeign affiliate sales in that SIC codecategory exceed fifty percent of theratio of United States consolidatedgroup research and experimental expen-ditures in that SIC code category overUnited States consolidated group salesin that SIC code category, then the

United States consolidated group re-search and experimental expendituresshould be exclusively apportioned toUnited States source gross income.This suggestion has not been adopted.Although a foreign affiliate may incursubstantial research and experimentalexpenditures in a given product cate-gory, the foreign affiliate may stillbenefit from the research and experi-mental expenditures of the UnitedStates consolidated group. See Perkin-Elmer Corporation v. Commissioner,103 T.C. 464 (1994).

Regarding the optional gross incomemethods of apportionment under§1.861–8(e)(3)(iii) of the proposed reg-ulations, commenters suggested that thefinal regulations include a fifty percentexclusive place of performance appor-tionment under the optional gross in-come methods to be parallel with§1.861–8(e)(3)(ii)(A). This suggestionhas been adopted in part. Section(b)(1)(ii) of the final regulations in-cludes a twenty-five percent exclusiveplace of performance apportionmentunder the optional gross incomemethods. This twenty-five percent ex-clusive apportionment ensures that tax-payers electing to use one of theoptional gross income methods alsoobtain results comparable to thoseobtained by taxpayers electing to usethe sales method, i.e., an overallallocation that is twenty-five percentlower on average than the allocation toforeign source income resulting fromthe current regulations. The TreasuryDepartment study does not support agreater exclusive apportionment.

Commenters suggested that the pro-posed regulations should be modifiedto reduce the floor on the amount ofresearch and experimental expendituresthat must be apportioned to foreignsource income under the optional grossincome methods from fifty percent tothirty percent of the amount that wouldhave been apportioned under the salesmethod. This suggestion has not beenadopted. The adoption of this suggestedrule in addition to the twenty-fivepercent exclusive apportionment rule isnot supported by the Treasury Depart-ment study.

Commenters suggested the elimina-tion of the binding election to use theoptional gross income methods under§1.861–8(e)(3)(iii)(C) of the proposedregulations. Commenters also suggestedthat the binding election rule should bemodified to provide for a change ofmethod without the prior consent of the


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Commissioner after five years’ use ofone method. This suggestion, whichrecognizes the need for consistencywhile reducing the administrative bur-den on taxpayers, has been adopted.

Commenters suggested that the effec-tive date election under §1.861–8(e)-(3)(vi) of the proposed regulationspermit election by fiscal year taxpayerswhose taxable years begin after August1, 1994, but before January 1, 1995.This suggestion has been adopted.

Finally, these provisions, which werepreviously published as §1.861–8(e)(3),have been renumbered and will now bepublished as §1.861–17. This changehas been made solely for the purposeof achieving greater clarity in format-ting and is not intended to result in anyadditional substantive changes.

Special Analyses

It has been determined that thesefinal regulations are not a significantregulatory action as defined in EO12866. Therefore, a regulatory assess-ment is not required. It also has beendetermined that section 553(b) of theAdministrative Procedure Act (5 U.S.C.chapter 5) and the Regulatory Flex-ibility Act (5 U.S.C. chapter 6) do notapply to these regulations, and there-fore a Regulatory Flexibility Analysisis not required. Pursuant to section7805(f) of the Internal Revenue Code,the notice of proposed rulemakingpreceding these final regulations hasbeen submitted to the Chief Counselfor Advocacy of the Small BusinessAdministration for comment on itsimpact on small business.


The principal author of these regula-tions is Carl Cooper, Office of theAssociate Chief Counsel (Interna-tional). However, other personnel fromIRS and Treasury participated in theirdevelopment.

* * * * * *

Amendments to the Regulations

Accordingly, 26 CFR part 1 isamended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citationcontinues to read as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.861–8 is amended

by:1. Revising paragraph (e)(3) to

read as set forth below.2. Removing and reserving para-

graph (g), Examples 3 through 16 and23.

§1.861–8 Computation of taxableincome from sources within theUnited States and from other sourcesand activities.

* * * * * *

(e) * * *(3) Research and experimental ex-

penditures. For rules regarding theallocation and apportionment of re-search and experimental expenditures,see §1.861–17.

* * * * * *

Par. 3. Section 1.861–17 is added toread as follows:§1.861–17 Allocation and apportion-ment of research and experimentalexpenditures.

(a) Allocation—(1) In general. Themethods of allocation and apportion-ment of research and experimentalexpenditures set forth in this sectionrecognize that research and experimen-tation is an inherently speculative ac-tivity, that findings may contributeunexpected benefits, and that the grossincome derived from successful re-search and experimentation must bearthe cost of unsuccessful research andexperimentation. Expenditures for re-search and experimentation that a tax-payer deducts under section 174 or-dinarily shall be considered deductionsthat are definitely related to all incomereasonably connected with the relevantbroad product category (or categories)of the taxpayer and therefore allocableto all items of gross income as a class(including income from sales, royalties,and dividends) related to such productcategory (or categories). For purposesof this allocation, the product category(or categories) that a taxpayer may beconsidered to have shall be determinedin accordance with the provisions ofparagraph (a)(2) of this section.

(2) Product categories—(i) Alloca-tion based on product categories. Or-dinarily, a taxpayer’s research andexperimental expenditures may be di-vided between the relevant productcategories. Where research and experi-

mentation is conducted with respect tomore than one product category, thetaxpayer may aggregate the categoriesfor purposes of allocation and appor-tionment; however, the taxpayer maynot subdivide the categories. Whereresearch and experimentation is notclearly identified with any productcategory (or categories), it will beconsidered conducted with respect toall the taxpayer’s product categories.

(ii) Use of three digit standardindustrial classification codes. A tax-payer shall determine the relevantproduct categories by reference to thethree digit classification of the StandardIndustrial Classification Manual (SICcode). A copy may be purchased fromthe Superintendent of Documents,United States Government Printing Of-fice, Washington, DC 20402. Theindividual products included withineach category are enumerated in Ex-ecutive Office of the President, Officeof Management and Budget, StandardIndustrial Classification Manual, 1987(or later edition, as available).

(iii) Consistency. Once a taxpayerselects a product category for the firsttaxable year for which this section iseffective with respect to the taxpayer, itmust continue to use that productcategory in following years, unless thetaxpayer establishes to the satisfactionof the Commissioner that, due tochanges in the relevant facts, a changein the product category is appropriate.For this purpose, a change in thetaxpayer’s selection of a product cate-gory shall include a change from athree digit SIC code category to a twodigit SIC code category, a change froma two digit SIC code category to athree digit SIC code category, or anyother aggregation, disaggregation orchange of a previously selected SICcode category.

(iv) Wholesale trade category. Thetwo digit SIC code category ‘‘Whole-sale trade’’ is not applicable withrespect to sales by the taxpayer ofgoods and services from any other ofthe taxpayer’s product categories and isnot applicable with respect to a domes-tic international sales corporation(DISC) or foreign sales corporation(FSC) for which the taxpayer is arelated supplier of goods and servicesfrom any of the taxpayer’s productcategories.

(v) Retail trade category. The twodigit SIC code category ‘‘Retail trade’’is not applicable with respect to sales


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by the taxpayer of goods and servicesfrom any other of the taxpayer’sproduct categories, except wholesaletrade, and is not applicable with respectto a DISC or FSC for which the tax-payer is a related supplier of goods andservices from any other of the tax-payer’s product categories, exceptwholesale trade.

(3) Affiliated Groups—(i) In gen-eral. Except as provided in paragraph(a)(3)(ii) of this section, the allocationand apportionment required by thissection shall be determined as if allmembers of the affiliated group (asdefined in §1.861–14T(d)) were asingle corporation. See §1.861–14T.

(ii) Possessions corporations. (A)For purposes of the allocation andapportionment required by this section,sales and gross income from productsproduced in whole or in part in apossession by an electing corporation(within the meaning of section 936(h)-(5)(E)), and dividends from an electingcorporation, shall not be taken intoaccount, except that this paragraph(a)(3)(ii) shall not apply to sales of(and gross income and dividends at-tributable to sales of) products withrespect to which an election undersection 936(h)(5)(F) is not in effect.

(B) The research and experimentalexpenditures taken into account forpurposes of this section shall bereduced by the amount of such expen-ditures included in computing the cost-sharing amount (determined under sec-tion 936(h)(5)(C)(i)).

(4) Legally mandated research andexperimentation. Where research andexperimentation is undertaken solely tomeet legal requirements imposed by apolitical entity with respect to improve-ment or marketing of specific productsor processes, and the results cannotreasonably be expected to generateamounts of gross income (beyond deminimis amounts) outside a singlegeographic source, the deduction forsuch research and experimentation shallbe considered definitely related andtherefore allocable only to the grouping(or groupings) of gross income withinthat geographic source as a class (andapportioned, if necessary, between suchgroupings as set forth in paragraphs (c)and (d) of this section). For example,where a taxpayer performs tests on aproduct in response to a requirementimposed by the U.S. Food and DrugAdministration, and the test resultscannot reasonably be expected to gen-

erate amounts of gross income (beyondde minimis amounts) outside the UnitedStates, the costs of testing shall beallocated solely to gross income fromsources within the United States.

(b) Exclusive apportionment—(1) Ingeneral. An exclusive apportionmentshall be made under this paragraph (b),where an apportionment based upongeographic sources of income of adeduction for research and experimen-tation is necessary (after applying theexception in paragraph (a)(4) of thissection).

(i) Exclusive apportionment underthe sales method. If the taxpayerapportions on the sales method underparagraph (c) of this section, an amountequal to fifty percent of such deductionfor research and experimentation shallbe apportioned exclusively to the statu-tory grouping of gross income or theresidual grouping of gross income, asthe case may be, arising from thegeographic source where the researchand experimental activities which ac-count for more than fifty percent of theamount of such deduction wereperformed.

(ii) Exclusive apportionment underthe optional gross income methods. Ifthe taxpayer apportions on the optionalgross income methods under paragraph(d) of this section, an amount equal totwenty-five percent of such deductionfor research and experimentation shallbe apportioned exclusively to the statu-tory grouping or the residual groupingof gross income, as the case may be,arising from the geographic sourcewhere the research and experimentalactivities which account for more thanfifty percent of the amount of suchdeduction were performed.

(iii) Exception. If the applicable fiftypercent geographic source test of thepreceding paragraph (b)(1)(i) or (ii) isnot met, then no part of the deductionshall be apportioned under this para-graph (b)(1).

(2) Facts and circumstances sup-porting an increased exclusive ap-portionment—(i) In general. The exclu-sive apportionment provided for inparagraph (b)(1) of this section reflectsthe view that research and experimenta-tion is often most valuable in thecountry where it is performed, for tworeasons. First, research and experimen-tation often benefits a broad productcategory, consisting of many individualproducts, all of which may be sold inthe nearest market but only some of

which may be sold in foreign markets.Second, research and experimentationoften is utilized in the nearest marketbefore it is used in other markets, andin such cases, has a lower value perunit of sales when used in foreignmarkets. The taxpayer may establish tothe satisfaction of the Commissionerthat, in its case, one or both of theconditions mentioned in the precedingsentences warrant a significantlygreater exclusive allocation percentagethan allowed by paragraph (b)(1) ofthis section because the research andexperimentation is reasonably expectedto have very limited or long delayedapplication outside the geographicsource where it was performed. Pastexperience with research and experi-mentation may be considered in deter-mining reasonable expectations.

(ii) Not all products sold in foreignmarkets. For purposes of establishingthat only some products within theproduct category (or categories) aresold in foreign markets, the taxpayershall compare the commercial produc-tion of individual products in domesticand foreign markets made by itself, byuncontrolled parties (as defined underparagraph (c)(2)(i) of this section) ofproducts involving intangible propertywhich was licensed or sold by thetaxpayer, and by those controlled cor-porations (as defined under paragraph(c)(3)(ii) of this section) that canreasonably be expected to benefit di-rectly or indirectly from any of thetaxpayer’s research expense connectedwith the product category (or catego-ries). The individual products comparedfor this purpose shall be limited, fornonmanufactured categories, solely tothose enumerated in Executive Officeof the President, Office of Managementand Budget Standard Industrial Classi-fication Manual, 1987 (or later edition,as available), and, for manufacturedcategories, solely to those enumeratedat a 7-digit level in the U.S. Bureau ofthe Census, Census of Manufacturers:1992, Numerical List of ManufacturedProducts, 1993, (or later edition, asavailable). Copies of both of thesedocuments may be purchased from theSuperintendent of Documents, UnitedStates Government Printing Office,Washington, DC 20402.

(iii) Delayed application of researchfindings abroad. For purposes ofestablishing the delayed application ofresearch findings abroad, the taxpayershall compare the commercial introduc-tion of its own particular products and


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processes (not limited by those listed inthe Standard Industrial ClassificationManual or the Numerical List of Manu-factured Products) in the United Statesand foreign markets, made by itself, byuncontrolled parties (as defined underparagraph (c)(2)(i) of this section) ofproducts involving intangible propertythat was licensed or sold by thetaxpayer, and by those controlled cor-porations (as defined under paragraph(c)(3)(i) of this section) that canreasonably be expected to benefit,directly or indirectly, from the tax-payer’s research expense. For purposesof evaluating the delay in the applica-tion of research findings in foreignmarkets, the taxpayer shall use a safehaven discount rate of 10 percent peryear of delay unless he is able toestablish to the satisfaction of theCommissioner, by reference to the costof money and the number of yearsduring which economic benefit can bedirectly attributable to the results of thetaxpayer’s research, that another dis-count rate is more appropriate.

(c) Sales method—(1) In general.The amount equal to the remainingportion of such deduction for researchand experimentation, not apportionedunder paragraph (a)(4) or (b)(1)(i) ofthis section, shall be apportioned be-tween the statutory grouping (or amongthe statutory groupings) within theclass of gross income and the residualgrouping within such class in the sameproportions that the amount of salesfrom the product category (or catego-ries) that resulted in such gross incomewithin the statutory grouping (or statu-tory groupings) and in the residualgrouping bear, respectively, to the totalamount of sales from the productcategory (or categories).

(i) Apportionment in excess of grossincome. Amounts apportioned underthis section may exceed the amount ofgross income related to the productcategory within the statutory grouping.In such case, the excess shall beapplied against other gross incomewithin the statutory grouping. See§1.861–8(d)(1) for instances where theapportionment leads to an excess ofdeductions over gross income withinthe statutory grouping.

(ii) Leased property. For purposes ofthis paragraph (c), amounts receivedfrom the lease of equipment during ataxable year shall be regarded as salesreceipts for such taxable year.

(2) Sales of uncontrolled parties. Forpurposes of the apportionment under

paragraph (c)(1) of this section, thesales from the product category (orcategories) by each party uncontrolledby the taxpayer, of particular productsinvolving intangible property that waslicensed or sold by the taxpayer to suchuncontrolled party shall be taken fullyinto account both for determining thetaxpayer’s apportionment and for deter-mining the apportionment of any othermember of a controlled group ofcorporations to which the taxpayerbelongs if the uncontrolled party canreasonably be expected to benefit di-rectly or indirectly (through any mem-ber of the controlled group of corpora-tions to which the taxpayer belongs)from the research expense connectedwith the product category (or catego-ries) of such other member. An uncon-trolled party can reasonably be ex-pected to benefit from the researchexpense of a member of a controlledgroup of corporations to which thetaxpayer belongs if such member canreasonably be expected to license, sell,or transfer intangible property to thatuncontrolled party or transfer secretprocesses to that uncontrolled party,directly or indirectly through a memberof the controlled group of corporationsto which the taxpayer belongs. Pastexperience with research and experi-mentation shall be considered in deter-mining reasonable expectations.

(i) Definition of uncontrolled party.For purposes of this paragraph (c)(2)the term uncontrolled party means aparty that is not a person with arelationship to the taxpayer specified insection 267(b), or is not a member of acontrolled group of corporations towhich the taxpayer belongs (within themeaning of section 993(a)(3) or927(d)(4)).

(ii) Licensed products. In the case oflicensed products, if the amount ofsales of such products is unknown (forexample, where the licensed product isa component of a large machine), areasonable estimate based on the prin-ciples of section 482 should be made.

(iii) Sales of intangible property. Inthe case of sales of intangible property,regardless of whether the considerationreceived in exchange for the intangibleis a fixed amount or is contingent onthe productivity, use, or disposition ofthe intangible, if the amount of sales ofproducts utilizing the intangible prop-erty is unknown, a reasonable estimateof sales shall be made annually. Ifnecessary, appropriate economic analy-ses shall be used to estimate sales.

(3) Sales of controlled parties. Forpurposes of the apportionment underparagraph (c)(1) of this section, thesales from the product category (orcategories) of the taxpayer shall betaken fully into account and the salesfrom the product category (or catego-ries) of a corporation controlled by thetaxpayer shall be taken into account tothe extent provided in this paragraph(c)(3) for determining the taxpayer’sapportionment, if such corporation canreasonably be expected to benefit di-rectly or indirectly (through anothermember of the controlled group ofcorporations to which the taxpayerbelongs) from the taxpayer’s researchexpense connected with the productcategory (or categories). A corporationcontrolled by the taxpayer can reason-ably be expected to benefit from thetaxpayer’s research expense if thetaxpayer can be expected to license,sell, or transfer intangible property tothat corporation or transfer secret proc-esses to that corporation, either directlyor indirectly through a member of thecontrolled group of corporations towhich the taxpayer belongs. Past ex-perience with research and experimen-tation shall be considered in determin-ing reasonable expectations.

(i) Definition of a corporation con-trolled by the taxpayer. For purposes ofthis paragraph (c)(3), the term acorporation controlled by the taxpayermeans any corporation that has arelationship to the taxpayer specified insection 267(b) or is a member of acontrolled group of corporations towhich the taxpayer belongs (within themeaning of section 993(a)(3) or927(d)(4).

(ii) Sales to be taken into account.The sales from the product category (orcategories) of a corporation controlledby the taxpayer taken into account shallbe equal to the amount of sales thatbear the same proportion to the totalsales of the controlled corporation asthe total value of all classes of thestock of such corporation owned di-rectly or indirectly by the taxpayer,within the meaning of section 1563,bears to the total value of all classes ofstock of such corporation.

(iii) Sales not to be taken intoaccount more than once. Sales from theproduct category (or categories) be-tween or among such controlled corpo-rations or the taxpayer shall not betaken into account more than once; insuch a situation, the amount sold by theselling corporation to the buying corpo-


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ration shall be subtracted from the salesof the buying corporation.

(iv) Effect of cost-sharing arrange-ments. If the corporation controlled bythe taxpayer has entered into a bonafide cost-sharing arrangement, in ac-cordance with the provisions of§1.482–7, with the taxpayer for thepurpose of developing intangible prop-erty, then that corporation shall notreasonably be expected to benefit fromthe taxpayer’s share of the researchexpense.

(d) Gross income methods—(1)(i) Ingeneral. In lieu of applying the salesmethod of paragraph (c) of this section,the remaining amount of the deductionfor research and experimentation, notapportioned under paragraph (a)(4) or(b)(1)(ii) of this section, shall beapportioned as prescribed in paragraphs(d)(2) and (3) of this section, betweenthe statutory grouping (or among thestatutory groupings) of gross incomeand the residual grouping of grossincome.

(ii) Optional methods to be appliedto all research and experimental expen-ditures. These optional methods mustbe applied to the taxpayer’s entirededuction for research and experimen-tal expense remaining after applyingthe exception in paragraph (a)(4) ofthis section, and may not be applied ona product category basis. Thus, afterthe allocation of the taxpayer’s entirededuction for research and experimen-tal expense under paragraph (a)(2) ofthis section (by attribution to SIC codecategories), the taxpayer must thenapportion as necessary the entire de-duction as allocated by separateamounts to various product categories,using only the sales method underparagraph (c) of this section or only theoptional gross income methods underthis paragraph (d). The taxpayer maynot use the sales method for a portionof the deduction and optional grossincome methods for the remainder ofthe deduction separately allocated.

(2) Option one. The taxpayer mayapportion its research and experimentalexpenditures ratably on the basis ofgross income between the statutorygrouping (or among the statutorygroupings) of gross income and theresidual grouping of gross income inthe same proportions that the amountof gross income in the statutory group-ing (or groupings) and the amount ofgross income in the residual groupingbear, respectively, to the total amount

of gross income, if the conditionsdescribed in paragraph (d)(2)(i) and (ii)of this section are both met.

(i) The amount of research andexperimental expense ratably appor-tioned to the statutory grouping (orgroupings in the aggregate) is not lessthan fifty percent of the amount thatwould have been so apportioned if thetaxpayer had used the method de-scribed in paragraph (c) of this section;and

(ii) The amount of research andexperimental expense ratably appor-tioned to the residual grouping is notless than fifty percent of the amountthat would have been so apportioned ifthe taxpayer had used the methoddescribed in paragraph (c) of thissection.

(3) Option two. If, when the amountof research and experimental expense isapportioned ratably on the basis ofgross income, either of the conditionsdescribed in paragraph (d)(2)(i) or (ii)of this section is not met, the taxpayermay either—

(i) Where the condition of paragraph(d)(2)(i) of this section is not met,apportion fifty percent of the amount ofresearch and experimental expense thatwould have been apportioned to thestatutory grouping (or groupings in theaggregate) under paragraph (c) of thissection to such statutory grouping (orto such statutory groupings in theaggregate and then among such group-ings on the basis of gross incomewithin each grouping), and apportionthe balance of the amount of researchand experimental expenses to the re-sidual grouping; or

(ii) Where the condition of para-graph (d)(2)(ii) of this section is notmet, apportion fifty percent of theamount of research and experimentalexpense that would have been appor-tioned to the residual grouping underparagraph (c) of this section to suchresidual grouping, and apportion thebalance of the amount of research andexperimental expenses to the statutorygrouping (or to the statutory groupingsin the aggregate and then among suchgroupings ratably on the basis of grossincome within each grouping).

(e) Binding election—(1) In general.A taxpayer may choose to use eitherthe sales method under paragraph (c) ofthis section or the optional grossincome methods under paragraph (d) ofthis section for its original return for itsfirst taxable year to which this section

applies. The taxpayer’s use of eitherthe sales method or the optional grossincome methods for its return filed forits first taxable year to which thissection applies shall constitute a bind-ing election to use the method chosenfor that year and for four taxable yearsthereafter.

(2) Change of method. The tax-payer’s election of a method may notbe revoked during the period referredto in paragraph (e)(1) of this sectionwithout the prior consent of the Com-missioner. After the expiration of thatperiod, the taxpayer may changemethods without the prior consent ofthe Commissioner. However, the tax-payer’s use of the new method shallconstitute a binding election to use thenew method for its return filed for thefirst year for which the taxpayer usesthe new method and for four taxableyears thereafter. The taxpayer’s elec-tion of the new method may not berevoked during that period without theprior consent of the Commissioner.

(i) Short taxable years. For purposesof this paragraph (e), the term taxableyear includes a taxable year of lessthan twelve months.

(ii) Affiliated groups. In the case ofan affiliated group, the period referredto in paragraph (e)(1) of this sectionshall commence as of the latest taxableyear in which any member of the grouphas changed methods.

(f) Special rules for partnerships—(1) Research and experimental expendi-tures. For purposes of applying thissection, if research and experimentalexpenditures are incurred by a part-nership in which the taxpayer is apartner, the taxpayer’s research andexperimental expenditures shall includethe taxpayer’s distributive share of thepartnership’s research and experimentalexpenditures.

(2) Purpose and location of expendi-tures. In applying the exception forexpenditures undertaken to meet legalrequirements under paragraph (a)(4) ofthis section and the exclusive appor-tionment for the sales method and theoptional gross income methods underparagraph (b) of this section, a part-ner’s distributive share of research andexperimental expenditures incurred bya partnership shall be treated as in-curred by the partner for the samepurpose and in the same location asincurred by the partnership.

(3) Apportionment under the salesmethod. In applying the remaining


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apportionment for the sales methodunder paragraph (c) of this section, ataxpayer’s sales from a product cate-gory shall include the taxpayer’s shareof any sales from the product categoryof any partnership in which the tax-payer is a partner. For purposes of thepreceding sentence, a taxpayer’s shareof sales shall be proportionate to thetaxpayer’s distributive share of thepartnership’s gross income in the prod-uct category.

(g) Effective date. This section ap-plies to taxable years beginning afterDecember 31, 1995. However, a tax-payer may at its option, apply thissection in its entirety to all taxableyears beginning after August 1, 1994.

(h) Examples. The following exam-ples illustrate the application of thissection:

Example 1—(i) Facts. X, a domestic corpora-tion, is a manufacturer and distributor of smallgasoline engines for lawn mowers. Gasolineengines are a product within the category,Engines and Turbines (SIC Industry Group 351).Y, a wholly owned foreign subsidiary of X, alsomanufactures and sells these engines abroad.During 1996, X incurred expenditures of $60,000on research and experimentation, which itdeducts as a current expense, to invent andpatent a new and improved gasoline engine. Allof the research and experimentation was per-formed in the United States. In 1996, thedomestic sales by X of the new engine total$500,000 and foreign sales by Y total $300,000.X provides technology for the manufacture ofengines to Y via a license that requires thepayment of an arm’s length royalty. In 1996, X’sgross income is $160,000, of which $140,000 isU.S. source income from domestic sales ofgasoline engines and $10,000 is foreign sourceroyalties from Y, and $10,000 is U.S. sourceinterest income.

(ii) Allocation. The research and experimentalexpenditures were incurred in connection withsmall gasoline engines and they are definitelyrelated to the items of gross income to which theresearch gives rise, namely gross income fromthe sale of small gasoline engines in the UnitedStates and royalties received from subsidiary Y,a foreign manufacturer of gasoline engines.Accordingly, the expenses are allocable to thisclass of gross income. The U.S. source interestincome is not within this class of gross incomeand, therefore, is not taken into account.

(iii) Apportionment. (A) For purposes of ap-plying the foreign tax credit limitation, thestatutory grouping is general limitation grossincome from sources without the United Statesand the residual grouping is gross income fromsources within the United States. Since therelated class of gross income derived from theuse of engine technology consists of both grossincome from sources without the United States(royalties from Y) and gross income fromsources within the United States (gross incomefrom engine sales), X’s deduction of $60,000 forits research and experimental expenditure mustbe apportioned between the statutory and residualgrouping before the foreign tax credit limitation

may be determined. Because more than 50percent of X’s research and experimental activitywas performed in the United States, 50 percentof that deduction can be apportioned exclusivelyto the residual grouping of gross income, grossincome from sources within the United States.The remaining 50 percent of the deduction canthen be apportioned between the residual andstatutory groupings on the basis of sales of smallgasoline engines by X and Y. Alternatively, X’sdeduction for research and experimentation canbe apportioned under the optional gross incomemethod. The apportionment for 1996 is asfollows:

(1) Tentative Apportionment on the Basis ofSales.

(i) Research and experimental ex-pense to be apportioned between re-sidual and statutory groupings of grossincome: $60,000

(ii) Less: Exclusive apportionmentof research and experimental expenseto the residual grouping of grossincome ($60,000 3 50 percent): $30,000

(iii) Research and experimental ex-pense to be apportioned between re-sidual and statutory groupings of grossincome on the basis of sales: $30,000

(iv) Apportionment of research andexperimental expense to the residualgrouping of gross income ($30,000 3$500,000/($500,000 + $300,000)): $18,750

(v) Apportionment of research andexperimental expense to the statutorygrouping of gross income ($30,000 3$300,000/($500,000 + $300,000)): $11,250

(vi) Total apportioned deduction forresearch and experimentation: $60,000

(vii) Amount apportioned to theresidual grouping ($30,000 + $18,750): $48,750

(viii) Amount apportioned to thestatutory grouping: $11,250

(2) Tentative Apportionment on the Basis ofGross Income.

(i) Exclusive apportionment of re-search and experimental expense to theresidual grouping of gross income($60,000 3 25 percent): $15,000

(ii) Research and experimental ex-pense apportioned to sources withinthe United States (residual grouping)($45,000 3 $140,000/($140,000 +$10,000)): $42,000

(iii) Research and experimental ex-pense apportioned to sources withincountry Y (statutory grouping)($45,000 3 $10,000/($140,000 +$10,000)): $3,000

(iv) Amount apportioned to theresidual grouping: $57,000

(v) Amount apportioned to the statu-tory grouping: $3,000

(B) The total research and experimental ex-pense apportioned to the statutory grouping($3,000) under the gross income method isapproximately 26 percent of the amount appor-tioned to the statutory grouping under the salesmethod. Thus, X may use option two of thegross income method (paragraph (d)(3) of thissection) and apportion to the statutory groupingfifty percent (50%) of the $11,250 apportioned to

that grouping under the sales method. Thus, Xapportions $5,625 of research and experimentalexpense to the statutory grouping. X’s use of theoptional gross income methods will constitute abinding election to use the optional gross incomemethods for 1996 and four taxable yearsthereafter.

Example 2—(i) Facts. Assume the same factsas in Example 1 except that X also spends$30,000 in 1996 for research on steam turbines,all of which is performed in the United States,and X has steam turbine sales in the UnitedStates of $400,000. X’s foreign subsidiary Yneither manufactures nor sells steam turbines.The steam turbine research is in addition to the$60,000 in research which X does on gasolineengines for lawnmowers. X thus has a deductionof $90,000 for its research activity. X’s grossincome is $200,000, of which $140,000 is U.S.source income from domestic sales of gasolineengines, $50,000 is U.S. source income fromdomestic sales of steam turbines, and $10,000 isforeign source royalties from Y.

(ii) Allocation. X’s research expenses generateincome from sales of small gasoline engines andsteam turbines. Both of these products are in thesame three digit SIC code category, Engines andTurbines (SIC Industry Group 351). Therefore,the deduction is definitely related to this productcategory and allocable to all items of incomeattributable to it. These items of X’s income aregross income from the sale of small gasolineengines and steam turbines in the United Statesand royalties from foreign subsidiary Y, aforeign manufacturer and seller of small gasolineengines.

(iii) Apportionment. (A) For purposes of ap-plying the foreign tax credit limitation, thestatutory grouping is general limitation grossincome from sources outside the United Statesand the residual grouping is gross income fromsources within the United States. X’s deductionof $90,000 must be apportioned between thestatutory and residual groupings. Because morethan 50 percent of X’s research and experimentalactivity was performed in the United States, 50percent of that deduction can be apportionedexclusively to the residual grouping, grossincome from sources within the United States.The remaining 50 percent of the deduction canthen be apportioned between the residual andstatutory groupings on the basis of total sales ofsmall gasoline engines and steam turbines by Xand Y. Alternatively, X’s deduction for researchand experimentation can be apportioned underthe optional gross income methods. The appor-tionment for 1996 is as follows:

(1) Tentative Apportionment on the Basis ofSales.

(i) Research and experimental ex-pense to be apportioned between re-sidual and statutory groupings of grossincome: $90,000

(ii) Less: Exclusive apportionmentof the research and experimental ex-pense to the residual grouping of grossincome ($90,000 3 50 percent): $45,000

(iii) Research and experimental ex-pense to be apportioned between theresidual and statutory groupings ofgross income on the basis of sales: $45,000

(iv) Apportionment of research andexperimental expense to the residualgrouping of gross income ($45,000 3($500,000 + $400,000)/($500,000 +$400,000 + $300,000)): $33,750


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(v) Apportionment of research andexperimental expense to the statutorygrouping of gross income ($45,000 3$300,000/($500,000 + $400,000 +$300,000)): $11,250



(viii) Amount apportioned to thestatutory grouping: $11,250

(2) Tentative Apportionment on the Basis ofGross Income.


(ii) Research and experimental ex-pense apportioned to sources withinthe United States (residual grouping)($67,500 3 $190,000/($140,000 +$50,000 + $10,000)): $64,125

(iii) Research and experimental ex-pense apportioned to sources withincountry Y (statutory grouping)($67,500 3 $10,000/($140,000 +$50,000 + $10,000)): $3,375


(v) Amount apportioned to the statu-tory grouping: $3,375

(B) The total research and experimental ex-pense apportioned to the statutory grouping($3,375) under the gross income method is 30percent of the amount apportioned to thestatutory grouping under the sales method. Thus,X may use option two of the gross incomemethod (paragraph (d)(3) of this section) andapportion to the statutory grouping fifty percent(50%) of the $11,250 apportioned to thatgrouping under the sales method. Thus, Xapportions $5,625 of research and experimentalexpense to the statutory grouping. X’s use of theoptional gross income methods will constitute abinding election to use the optional gross incomemethods for 1996 and four taxable yearsthereafter.

Example 3—(i) Facts. Assume the same factsas in Example 1 except that in 1997 X continuesits sales of the new engines, with sales of$600,000 in the United States and $400,000abroad by subsidiary Y. X also acquires a 60percent (by value) ownership interest in foreigncorporation Z and a 100 percent ownershipinterest in foreign corporation C. X transfers itsengine technology to Z for a royalty equal to 5percent of sales, and X enters into an arm’slength cost-sharing arrangement with C to sharethe funding of all of X’s research activity. In1997, corporation Z has sales in country Z equalto $1,000,000. X incurs expense of $80,000 onresearch and experimentation in 1997, and inaddition, X performs $15,000 of research ongasoline engines which was funded by the cost-sharing arrangement with C. All of Z’s sales arefrom the product category, Engines and Turbines(SIC Industry Group 351). X performs all of itsresearch in the United States and $20,000 of itsexpenditure of $80,000 is made solely to meetpollution standards mandated by law. Xestablishes, to the satisfaction of the Commis-sioner, that the expenditure in response to

pollution standards is not expected to generategross income (beyond de minimis amounts)outside the United States.

(ii) Allocation. The $20,000 of research ex-pense which X incurred in connection withpollution standards is definitely related and thusallocable to the residual grouping, gross incomefrom sources within the United States. Theremaining $60,000 in research and experimentalexpenditure incurred by X is definitely related toall gasoline engines and is therefore allocable tothe class of gross income to which the enginesgive rise, gross income from sales of gasolineengines in the United States, royalties fromcountry Y, and royalties from country Z. No partof the $60,000 research expense is allocable todividends from country C, because corporation Chas already paid, through its cost-sharing ar-rangement, for research activity performed by Xwhich may benefit C.

(iii) Apportionment. For purposes of applyingthe foreign tax credit limitation, the statutorygrouping is general limitation gross income fromsources without the United States, and theresidual grouping is gross income from sourceswithin the United States. X’s deduction of$60,000 for its research and experimental expen-diture must be apportioned between these group-ings. Because more than 50 percent of theresearch and experimentation was performed inthe United States, 50 percent of the $60,000deduction can be apportioned exclusively to theresidual grouping. The remaining 50 percent ofthe deduction can then be apportioned betweenthe residual and the statutory grouping on thebasis of sales of gasoline engines by X, Y, andZ. (If X utilized the optional gross incomemethods in 1996, then its use of such methodsconstituted a binding election to use the optionalgross income methods in 1996 and for fourtaxable years thereafter. If X utilized the salesmethod in 1996, then its use of such methodconstituted a binding election to use the salesmethod in 1996 and for four taxable yearsthereafter.) The optional gross income methodsare not illustrated in this Example 3 (see insteadExamples 1 and 2). Since X has only a 60percent ownership interest in corporation Z, only60 percent of Z’s sales (60% of $1,000,000, or$600,000) are included for purposes of appor-tionment. The allocation and apportionment for1997 is as follows:

(A) X’s total research expense: $80,000(B) Less: Legally mandated research

directly allocated to the residualgrouping of gross income: $20,000

(C) Tentative apportionment on thebasis of sales.

(1) Research and experimental ex-pense to be apportioned between re-sidual and statutory groupings of grossincome: $60,000

(2) Less: Exclusive apportionmentof research and experimental expenseto the residual grouping of grossincome ($60,000 3 50 percent): $30,000(3) Research and experimental expenseto be apportioned between the residualand the statutory groupings on thebasis of sales: $30,000

(4) Apportionment of research andexperimental expense to gross incomefrom sources within the United States(residual grouping) ($30,000 3$600,000 / ($600,000 + $400,000 +$600,000)): $11,250

(5) Apportionment of research andexperimental expense to general lim-itation gross income from countries Yand Z (statutory grouping) ($30,000 3$400,000 + $600,000/($600,000 +$400,000 +$600,000)): $18,750

(6) Total apportioned deduction forresearch and experimentation ($30,000+ $30,000): $60,000

(7) Amount apportioned to the re-sidual grouping ($30,000 + $11,250): $41,250

(8) Amount apportioned to the statu-tory grouping of gross income fromsources within countries Y and Z: $18,750

Example 4—Research and Experimentation—(i) Facts. X, a domestic corporation, manufac-tures and sells forklift trucks and other types ofmaterials handling equipment in the UnitedStates. The manufacture and sale of forklifttrucks and other materials handling equipmentbelongs to the product category, Construction,Mining, and Materials Handling Machinery andEquipment (SIC Industry Group 353). X alsosells its forklift trucks to a wholesaling subsidi-ary located in foreign country Y (but title passesin the United States), and X manufacturesforklift trucks in foreign country Z. The whole-saling of forklift trucks to country Y alsobelongs to X’s product category Transportationequipment and, therefore, may not belong to theproduct category, Wholesale trade (SIC MajorGroup 50 and 51). In 1997, X sold $7,000,000 offorklift trucks to purchasers in the United States,$3,000,000 of forklift trucks to the wholesalingsubsidiary in Y, and transferred forklift truckcomponents with an FOB export value of$2,000,000 to its branch in Z. The branch’s salesof finished forklift trucks were $5,000,000. Inresponse to legally mandated emission controlrequirements, X’s United States research depart-ment has been engaged in a research project toimprove the performance and quality of engineexhaust systems used on its products in theUnited States. It incurs expenses of $100,000 forthis purpose in 1997. In the past, X hascustomarily adapted the product improvementsdeveloped originally for the domestic market toits forklift trucks manufactured abroad. Duringthe taxable year 1997, development of animproved engine exhaust system is completedand X begins installing the new system duringthe latter part of the taxable year in productsmanufactured and sold in the United States. Xcontinues to manufacture and sell forklift trucksin foreign countries without the improved engineexhaust systems.

(ii) Allocation. X’s deduction for its researchexpense is definitely related to the income towhich it gives rise, namely income from themanufacture and sale of forklift trucks within theUnited States and in country Z. Although theresearch is undertaken in response to a legalmandate, it can reasonably be expected togenerate gross income from the manufacture andsale of trucks by the branch in Z. Therefore, thededuction is not allocable solely to income fromX’s domestic sales of forklift trucks. It isallocable to income from such sales and incomefrom the sales of X’s branch in Z.

(iii) Apportionment. For the method of appor-tionment on the basis of either sales or grossincome, see Example 3. However, in determiningthe amount of research apportioned to incomefrom foreign and domestic sources, the net salesof the branch in Z are $3,000,000 ($5,000,000less $2,000,000) and the sales within the United


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States are $12,000,000 ($7,000,000 plus$3,000,000 plus $2,000,000). See §1.861–17(c)-(3)(iii).

Example 5—(i) Facts. X, a domestic corpora-tion, is a drug company that manufactures a widevariety of pharmaceutical products for sale in theUnited States. Pharmaceutical products belong tothe product category, Drugs (SIC Industry Group283). X exports its pharmaceutical productsthrough a foreign sales corporation (FSC). X’swholly owned foreign subsidiary Y also man-ufactures pharmaceutical products. In 1997, Xhas domestic sales of pharmaceutical products of$10,000,000, the FSC has sales of pharmaceuti-cal products of $3,000,000, and Y has sales ofpharmaceutical products of $5,000,000. In thatsame year, 1997, X incurs expense of $200,000on research to test a product in response torequirements imposed by the United States Foodand Drug Administration (FDA). X is able toshow that, even though country Y imposescertain testing requirements on pharmaceuticalproducts, the research performed in the UnitedStates is not accepted by country Y for purposesof its own licensing requirements, and theresearch has minimal use abroad. X is furtherable to show that FSC sells goods to countriesthat do not accept or do not require researchperformed in the United States for purposes oftheir own licensing standards.

(ii) Allocation. Since X’s research expense of$200,000 is undertaken to meet the requirementsof the United States Food and Drug Administra-tion, and since it is reasonable to expect that theexpenditure will not generate gross income(beyond de minimis amounts) outside the UnitedStates, the deduction is definitely related andthus allocable to the residual grouping.

(iii) Apportionment. No apportionment is nec-essary since the entire expense is allocated to theresidual grouping, gross income from saleswithin the United States.

Example 6—(i) Facts. X, a domestic corpora-tion, is engaged in continuous research andexperimentation to improve the quality of theproducts that it manufactures and sells, which arefloodlights, flashlights, fuse boxes, and solderlessconnectors. X incurs and deducts $100,000 ofexpenditure for research and experimentation in1997 that was performed exclusively in theUnited States. As a result of this researchactivity, X acquires patents that it uses in its ownmanufacturing activity. X licenses its floodlightpatent to Y and Z, uncontrolled foreign corpora-tions, for use in their own territories, countries Yand Z, respectively. Corporation Y pays X anarm’s length royalty of $3,000 plus $0.20 foreach floodlight sold. Sales of floodlights by Yfor the taxable year are $135,000 (at $4.50 perunit) or 30,000 units, and the royalty is $9,000($3,000 + $0.20 3 30,000). Y has sales of otherproducts of $500,000. Z pays X an arm’s lengthroyalty of $3,000 plus $0.30 for each unit sold. Zmanufactures 30,000 floodlights in the taxableyear, and the royalty is $12,000 ($3,000 + $0.303 30,000). The dollar value of Z’s floodlightsales is not known and cannot be reasonablyestimated because, in this case, the floodlightsare not sold separately by Z but are instead usedas a component in Z’s manufacture of lightingequipment for theaters. The sales of all Z’sproducts, including the lighting equipment fortheaters, are $1,000,000. Y and Z each sell thefloodlights exclusively within their respectivecountries. X’s sales of floodlights for the taxable

year are $500,000 and its sales of its other pro-ducts, flashlights, fuse boxes, and solderlessconnectors, are $400,000. X has gross income of$500,000, consisting of gross income from do-mestic sources from sales of floodlights, flash-lights, fuse boxes, and solderless connectors of$479,000, and royalty income of $9,000 and$12,000 from foreign corporations Y and Z re-spectively. X utilized the optional gross incomemethods of apportionment for its return filed forits first taxable year to which this section applies.

(ii) Allocation. X’s research and experimentalexpenses are definitely related to all of theproducts that it produces, which are floodlights,flashlights, fuse boxes, and solderless connectors.All of these products are in the same three digitSIC Code category, Electric Lighting and WiringEquipment (SIC Industry Group 364). Thus, X’sresearch and experimental expenses are allocableto all items of income attributable to this productcategory, domestic sales income and royaltyincome from the foreign countries in whichcorporations Y and Z operate.

(iii) Apportionment. (A) The statutory group-ing of gross income is general limitation incomefrom sources without the United States. Theresidual grouping is gross income from sourceswithin the United States. X’s deduction of$100,000 for its research expenditures must beapportioned between the groupings. For appor-tionment on the basis of sales in accordance withparagraph (c) of this section, X is entitled to anexclusive apportionment of 50 percent of itsresearch and experimental expense to the residualgrouping, gross income from sources within theUnited States, since more than 50 percent of theresearch activity was performed in the UnitedStates. The remaining 50 percent of the deduc-tion can then be apportioned between theresidual and statutory groupings on the basis ofsales. Since Y and Z are unrelated licensees ofX, only their sales of the licensed product,floodlights, are included for purposes of appor-tionment. Floodlight sales of Z are unknown, butare estimated at ten times royalties from Z, or$120,000. All of X’s sales from the entireproduct category are included for purposes ofapportionment on the basis of sales. Alter-natively, X may apportion its deduction on thebasis of gross income, in accordance withparagraph (d) of this section. The apportionmentis as follows:

(1) Tentative Apportionment on the basis ofsales.

(i) Research and experimental ex-pense to be apportioned between statu-tory and residual groupings of grossincome: $100,000

(ii) Less: Exclusive apportionmentof research and experimental expenseto the residual groupings of grossincome ($100,000 3 50 percent): $50,000

(iii) Research and experimental ex-pense to be apportioned between thestatutory and residual groupings ofgross income on the basis of sales: $50,000

(iv) Apportionment of research andexperimental expense to the residualgroupings of gross income ($50,000 3$900,000/($900,000 + $135,000 +$120,000)): $38,961

(v) Apportionment of research andexperimental expense to the statutory

grouping, royalty income from coun-tries Y and Z ($50,000 3 $135,000 +$120,000/($900,000 + $135,000 +$120,000)): $11,039



(viii) Amount apportioned to thestatutory grouping of sources withincountries Y and Z: $11,039

(2) Tentative apportionment on gross incomebasis.


(ii) Apportionment of research andexperimental expense to the residualgrouping of gross income ($75,000 3$479,000/$500,000): $71,850

(iii) Apportionment of research andexperimental expense to the statutorygrouping of gross income ($75,000 3$9,000 + $12,000/$500,000): $3,150


(v) Amount apportioned to the stat-utory grouping of general limitationincome from sources without theUnited States: $3,150

(B) Since X has elected to use the optionalgross income methods of apportionment and itsapportionment on the basis of gross income tothe statutory grouping, $3,150, is less than 50percent of its apportionment on the basis of salesto the statutory grouping, $11,039, it must useOption two of paragraph (d)(3) of this sectionand apportion $5,520 (50 percent of $11,039) tothe statutory grouping.


Internal Revenue.

Approved December 13, 1995.

Leslie Samuels,Assistant Secretary of

the Treasury.


Section 3406.—Backup Withholding

26 CFR 31.3406(h)–3: Certificates.

When does a substitute Form W–9 thatcontains a single signature line both for thecertifications under section 3406 of the InternalRevenue Code and for unrelated account openingprovisions satisfy the requirement that thecertifications be clearly set forth? See Rev. Proc.96–26, page 22.


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Part III. Administrative, Procedural, and Miscellaneous

Weighted Average Interest Rate Update

Notice 96–11

Notice 88–73 provides guidelines fordetermining the weighted average inter-est rate and the resulting permissiblerange of interest rates used to calculatecurrent liability for the purpose of

the full funding limitation of§ 412(c)(7) of the Internal RevenueCode as amended by the OmnibusBudget Reconciliation Act of 1987 andas further amended by the UruguayRound Agreements Act, Pub. L. 103–465 (GATT).

The average yield on the 30-yearTreasury Constant Maturities for Janu-ary 1996 is 6.05 percent.

The following rates were determinedfor the plan years beginning in themonth shown below.

Month YearWeightedAverage

90% to 108%Permissible

Range

90% to 110%Permissible

Range

February 1996 7.01 6.31 to 7.57 6.31 to 7.71


The principal author of this notice isDonna Prestia of the Employee PlansDivision. For further information re-garding this notice, call (202) 622-6076between 2:30 and 4:00 p.m. Easterntime (not a toll-free number). Ms.Prestia’s number is (202) 622-7377(also not a toll-free number).

26 CFR 601.105: Examination of returns andclaims for refund, credit, or abatement;determination of correct tax liability.(Also Part I, § 280F; 1.280F–7, 1.280F–5T.)

Rev. Proc. 96–25

SECTION 1. PURPOSE

This revenue procedure provides lim-itations on depreciation deductions forowners of passenger automobiles firstplaced in service during calendar year1996, and the amounts to be includedin income by lessees of passengerautomobiles first leased during calendaryear 1996. The tables detailing theseamounts reflect the automobile priceinflation adjustments required by§ 280F(d)(7) of the Internal RevenueCode.

SECTION 2. BACKGROUND

For owners of au tomobi les ,§ 280F(a) imposes dollar limitations onthe depreciation deduction for both theyear that the automobile is placed in

service and each succeeding year.Section 280F(d)(7) requires theamounts allowable as depreciation de-ductions to be increased by a priceinflation adjustment amount for pas-senger automobiles placed in serviceafter calendar year 1988.

For leased automobiles, § 280F(c)requires a reduction in the deductionallowed to the lessee of the automobile.The reduction must be substantiallyequivalent to the limitations on thedepreciation deductions imposed onowners of automobiles . Under§ 1.280F–7(a) of the Income Tax Reg-ulations, this reduction requires thelessees to include in gross income aninclusion amount determined by apply-ing a formula to the amount obtainedfrom a table. The table shows inclusionamounts for a range of fair marketvalues for each tax year after theautomobile is first leased.

SECTION 3. SCOPE ANDOBJECTIVE

01. The limitations on depreciationdeductions in section 4.02 of thisrevenue procedure apply to automobiles(other than leased automobiles) that areplaced in service in calendar year 1996and continue to apply for each tax yearthat the automobile remains in service.

02. The table in section 4.03 of thisrevenue procedure applies to leasedautomobiles for which the lease termbegins in calendar year 1996. Lesseesof such automobiles must use this tableto determine the inclusion amount foreach tax year during which the auto-

mobile is leased. See §§ 1.280F–5T(d)and 1.280F–5T(e) of the temporaryIncome Tax Regulations, § 1.280F–7(a), Rev. Proc. 89–64, 1989–2 C.B.783, Rev. Proc. 90–22, 1990–1 C.B.504, Rev. Proc. 91–30, 1991–1 C.B.563, Rev. Proc. 92–43, 1992–1 C.B.873, Rev. Proc 93–35, 1993–2 C.B.472, Rev. Proc 94–53, 1994–2 C.B.712, and Rev. Proc. 95–9, 1995–1 C.B.498, to determine inclusion amounts forautomobiles first leased before January1, 1996.

SECTION 4. APPLICATION

01. A taxpayer placing an auto-mobile in service for the first timeduring calendar year 1996 is limited tothe depreciation deduction shown inTable 1 of section 4.02(2). A taxpayerfirst leasing an automobile in calendaryear 1996 must use Table 2 in section4.03 to determine the inclusion amountthat is added to gross income. Other-wise, the procedures of § 1.280F–7(a)must be followed.

02. Limitations on Depreciation De-ductions for Certain Automobiles.

(1) Amount of the Inflation Adjust-ment. Under § 280F(d)(7)(B)(i), theautomobile price inflation adjustmentfor any calendar year is the percentage(if any) by which the CPI automobilecomponent for October of the preced-ing calendar year exceeds the CPIautomobile component for October1987. The term ‘‘CPI automobile com-ponent’’ is defined in § 280F(d)(7)(B)-(ii) as the ‘‘automobile component’’ ofthe Consumer Price Index for all Urban


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Consumers published by the Depart-ment of Labor (the CPI). The new carcomponent of the CPI was 115.2 forOctober 1987 and 138.6 for October1995. The October 1995 index ex-ceeded the October 1987 index by 23.4.The Internal Revenue Service has,therefore, determined that the auto-

mobile price inflation adjustment for1996 is 20.31 percent (23.4/115.2 3100%). This adjustment is applicable toall automobiles that are first placed inservice in calendar year 1996. Thedollar limitations in § 280F(a) musttherefore be multiplied by a factor of0.2031, and the resulting increases,

after rounding to the nearest $100, areadded to the 1988 limitations to givethe depreciation limitations for 1996.

(2) Amount of the Limitation. Forautomobiles placed in service in calen-dar year 1996, Table 1 contains thedollar amount of the depreciation lim-itations for each tax year.

REV. PROC. 96–25 TABLE 1

DEPRECIATION LIMITATIONS FOR AUTOMOBILESFIRST PLACED IN SERVICE IN CALENDAR YEAR 1996

Tax Year Amount

1st Tax Year $3,0602nd Tax Year $4,9003rd Tax Year $2,950Each Succeeding Year $1,775

03. Inclusions in Income of Lessees of Automobiles.The inclusion amounts for automobiles first leased in calendar year 1996 are calculated under the procedures described in

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


DOLLAR AMOUNTS FOR AUTOMOBILESWITH A LEASE TERM BEGINNING IN CALENDAR YEAR 1996

Fair Market Valueof Automobile

Over Not Over

Tax Year During Lease

1st 2nd 3rd 4th

5th andLater

$15,500 $15,800 3 6 8 10 1015,800 16,100 5 11 16 19 2116,100 16,400 7 16 24 27 3216,400 16,700 10 21 31 37 4216,700 17,000 12 26 39 46 5317,000 17,500 15 33 49 58 6717,500 18,000 19 42 61 73 8418,000 18,500 23 50 74 88 10218,500 19,000 27 59 86 104 11919,000 19,500 31 67 99 119 13619,500 20,000 35 75 112 134 15420,000 20,500 38 84 125 149 17120,500 21,000 42 93 137 164 18921,000 21,500 46 101 150 179 20721,500 22,000 50 110 162 194 22522,000 23,000 56 122 182 217 25023,000 24,000 64 139 207 247 28624,000 25,000 71 157 232 277 32025,000 26,000 79 174 257 308 35526,000 27,000 87 191 282 338 39027,000 28,000 95 207 308 369 42528,000 29,000 103 224 333 399 460


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Over Not Over


1st 2nd 3rd 4th

5th andLater

29,000 30,000 110 242 358 429 49530,000 31,000 118 259 383 459 53131,000 32,000 126 276 408 490 56532,000 33,000 134 293 433 520 60033,000 34,000 141 310 459 550 63534,000 35,000 149 327 484 581 67035,000 36,000 157 344 509 611 70536,000 37,000 165 361 535 641 74037,000 38,000 172 378 560 672 77538,000 39,000 180 395 585 702 81039,000 40,000 188 412 611 732 84440,000 41,000 196 429 636 762 88041,000 42,000 203 446 661 793 91542,000 43,000 211 463 687 822 95043,000 44,000 219 480 712 853 98544,000 45,000 227 497 737 883 1,02045,000 46,000 235 514 762 914 1,05446,000 47,000 242 531 788 944 1,08947,000 48,000 250 548 813 974 1,12548,000 49,000 258 565 838 1,005 1,15949,000 50,000 266 582 863 1,035 1,19550,000 51,000 273 599 889 1,065 1,23051,000 52,000 281 616 914 1,096 1,26452,000 53,000 289 633 939 1,126 1,29953,000 54,000 297 650 964 1,157 1,33454,000 55,000 304 668 989 1,186 1,37055,000 56,000 312 684 1,015 1,217 1,40456,000 57,000 320 701 1,040 1,247 1,44057,000 58,000 328 718 1,066 1,277 1,47458,000 59,000 336 735 1,091 1,307 1,50959,000 60,000 343 753 1,115 1,338 1,54460,000 62,000 355 778 1,154 1,383 1,59762,000 64,000 370 812 1,205 1,443 1,66764,000 66,000 386 846 1,255 1,504 1,73766,000 68,000 402 880 1,305 1,565 1,80768,000 70,000 417 914 1,356 1,626 1,87670,000 72,000 433 948 1,406 1,686 1,94772,000 74,000 448 982 1,457 1,747 2,01674,000 76,000 464 1,016 1,508 1,807 2,08676,000 78,000 479 1,050 1,558 1,868 2,15678,000 80,000 495 1,084 1,609 1,928 2,22680,000 85,000 522 1,144 1,697 2,034 2,34985,000 90,000 561 1,229 1,823 2,186 2,52390,000 95,000 600 1,314 1,950 2,337 2,69895,000 100,000 638 1,400 2,075 2,489 2,873

100,000 110,000 697 1,527 2,265 2,716 3,135110,000 120,000 774 1,697 2,518 3,019 3,485120,000 130,000 852 1,868 2,770 3,322 3,834130,000 140,000 930 2,038 3,023 3,624 4,185140,000 150,000 1,007 2,208 3,276 3,927 4,534150,000 160,000 1,085 2,378 3,529 4,230 4,884


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Over Not Over


1st 2nd 3rd 4th

5th andLater

160,000 170,000 1,163 2,548 3,781 4,533 5,234170,000 180,000 1,240 2,719 4,033 4,837 5,583180,000 190,000 1,318 2,889 4,286 5,139 5,933190,000 200,000 1,396 3,059 4,539 5,442 6,282200,000 210,000 1,473 3,230 4,791 5,745 6,632210,000 220,000 1,551 3,400 5,044 6,047 6,982220,000 230,000 1,629 3,570 5,296 6,351 7,332230,000 240,000 1,706 3,740 5,550 6,653 7,681240,000 250,000 1,784 3,911 5,801 6,956 8,032

SECTION 5. EFFECTIVE DATE

This revenue procedure is effectivefor automobiles (other than leasedautomobiles) that are first placed inservice during calendar year 1996 andto leased automobiles that are firstleased during calendar year 1996.

DRAFTING INFORMATION

The principal author of this revenueprocedure is Bernard P. Harvey of theOffice of Assistant Chief CounselPassthroughs and Special Industries).For further information regarding thisrevenue procedure contact Mr. Harveyon (202) 622-3110 (not a toll-free call).

26 CFR 601.602: Forms and instructions.(Also Part I, Section 3406; 31.3406(h)–3)

Rev. Proc. 96–26

SECTION 1. PURPOSE

This revenue procedure clarifies thecertification requirements for a sub-stitute Form W–9, Request for Tax-payer Identification Number and Cer-tification, and amplifies Rev. Proc. 83–89, 1983–2 C.B. 613, which providesguidelines for payors of interest, divi-dends, and patronage dividends andbrokers that want to design and providetheir own substitute Forms W–9.

SECTION 2. BACKGROUND

.01 Under §§ 6109(a) (2) and3406(a)(1)(A) of the Internal Revenue

Code, a payee of a reportable paymentmust provide its Taxpayer Identifica-tion Number (TIN) to a person who isrequired to file an information returnwith respect to the payment. In addi-tion, under § 3406(a)(1)(A) the payeeof a reportable interest or dividendpayment generally must certify that itsTIN is correct and that it is not subjectto backup withholding under § 3406(a)-(1)(C) for failure to include interest anddividend income on its tax return(required certifications). Section3406(a)(1)(A) and (D) requires theimposition of backup withholding on areportable interest or dividend paymentto a payee if the payee does notprovide its TIN or make the requiredcertifications.

.02 The Internal Revenue Serviceprovides an official Form W–9 for apayee to provide the required certifica-tions to the payor. A payor may use asubstitute Form W–9 to obtain the TINand the required certifications providedthe certification requirements in thesubstitute Form W–9 comply withsection 4 of Rev. Proc. 83–89. A payormay incorporate the required certifica-tions into other business formscustomarily used, such as accountsignature cards, provided the requiredcertifications are clearly set forth. Seesection 5.01 of Rev. Proc. 83–89.

SECTION 3. SCOPE

This revenue procedure applies topayors that choose to obtain the re-quired certifications by using a sub-stitute Form W–9 incorporated intobusiness forms the payor customarily

uses, as set forth in section 2.02 of thisrevenue procedure.

SECTION 4. FORMAT FORMAKING THE REQUIREDCERTIFICATIONS

.01 Required certifications clearlyset forth. For a payor to be treated ashaving provided a taxpayer with a validsubstitute Form W–9, the requiredcertifications must be clearly set forth.The Service will treat the requiredcertifications as being clearly set forthonly if they meet the provisions ofsection 4.02 or 4.03 of this revenueprocedure.

.02 Separate signature for requiredcertifications. A substitute Form W–9is valid if a separate signature line isprovided just for the requiredcertifications.

.03 Single signature for requiredcertifications and other provisions. Asubstitute Form W–9 is valid if:

(1) a single signature line is pro-vided for the required certifications aswell as other provisions unrelated tothe required certifications;

(2) the language of the requiredcertifications is highlighted, boxed,printed in bold-face type, or presentedin some other manner that distinguishesand causes the language to stand outfrom all other information contained onthe substitute Form W–9; and

(3) the following statement is pro-vided in the same manner prescribed insection 4.03(2) and appears imme-diately above the single signature lineon the substitute Form W–9: ‘‘The


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Internal Revenue Service does notrequire your consent to any provisionof this document other than the cer-tifications required to avoid backupwithholding.’’

SECTION 5. IMPERMISSIBLE USEOF THE CERTIFICATIONS

.01 A payor may not (1) require apayee to agree to provisions includedon a substitute Form W–9 other thanthe required certifications in order toavoid backup withholding, or (2)threaten backup withholding in order tosecure a payee’s acceptance of provi-sions included on a substitute Form W–9 that are unrelated to the requiredcertifications.

.02 If a payor contravenes the provi-sions of section 5.01 of this revenueprocedure, the payor may be subject tocivil or criminal penalties under 31U.S.C. § 333. That section generallyprohibits the use of any words, titles,abbreviations, etc. in connection with abusiness solicitation or activity in amanner that could reasonably be inter-preted to convey a false impression thatsuch activity is approved, endorsed,sponsored, or authorized by the Service.

SECTION 6. EFFECT ON OTHERDOCUMENTS

This revenue procedure amplifiesRev. Proc. 83–89.

SECTION 7. EFFECTIVE DATE

Except for section 5, the provisionsof this revenue procedure apply tosubstitute Forms W–9 completed bypayees after December 31, 1996. Theprovisions of section 5.02 of thisrevenue procedure apply to violationsoccurring after March 31, 1995, theeffective date of 31 U.S.C. § 333.

DRAFTING INFORMATION

The principal author of this revenueprocedure is Renay France of theOffice of Assistant Chief Counsel(Income Tax and Accounting). Forfurther information regarding this reve-nue procedure, contact Renay Franceon (202) 622-4910 (not a toll-free call).


778/20048/28MAY96/B09-007

241996–23 I.R.B.

Part IV. Items of General Interest

Notice of Proposed Rulemaking

Treatment of Gain From theDisposition of Interest in CertainNatural Resource Recapture Propertyby S Corporations and TheirShareholders

PS–7–89


ACTION: Notice of proposed rule-making.

SUMMARY: This document containsproposed regulations under section1254 of the Internal Revenue Coderelating to the tax treatment by Scorporations and their shareholders ofgain from the disposition by an Scorporation (and a former S corpora-tion) of certain natural resource recap-ture property (section 1254 propertyafter enactment of the Tax Reform Actof 1986 and oil, gas, or geothermalproperty before enactment of the TaxReform Act of 1986), and also rulesrelating to the disposition of stock inan S corporation that holds certainnatural resource recapture property.Changes to the applicable tax law weremade by the Tax Reform Act of 1986,and the Subchapter S Revision Act of1982. The regulations provide thepublic with guidance in complying withthe changed tax laws.

DATES: Written comments and re-quests for a public hearing must bereceived by February 20, 1996.

ADDRESSES: Send comments and re-quests for a public hearing to:CC:DOM:CORP:R (PS–7–89), Room5228, Internal Revenue Service, P.O.Box 7604, Ben Franklin Station, Wash-ington, DC 20044. In the alternative,submissions may be hand-delivered toCC:DOM:CORP:R (PS–7–89), Room5228, Internal Revenue Service Build-ing, 1111 Constitution Avenue, NW.,Washington, DC 20224.

FOR FURTHER INFORMATIONCONTACT: James A . Qu inn ,202-622-3060 (not a toll-free number).


Paperwork Reduction Act

The collection of information con-tained in this notice of proposedrulemaking has been submitted to theOffice of Management and Budget(OMB) for review in accordance withthe Paperwork Reduction Act of 1995(44 U.S.C 3507).

Comments on the collection of infor-mation should be sent to the Office ofManagement and Budget, Attn: DeskOfficer for the Department of theTreasury, Office of Information andRegulatory Affairs, Washington, DC20503, with copies to the InternalRevenue Service, Attn: IRS ReportsClearance Officer IT:FP, Washington,DC 20224. Comments on the collectionof information should be received byJanuary 22, 1996.

An agency may not conduct orsponsor, and a person is not required torespond to, a collection of informationunless the collection of informationdisplays a valid control number.

The collection of information iscontained in §1.1254–4(c) of the pro-posed regulations. This information isrequired by the Internal Revenue Serv-ice to verify that taxpayers have re-ported the appropriate amount of gainas ordinary income under section 1254when a shareholder sells stock in an Scorporation that holds natural resourcerecapture property. The likely respond-ents are individuals and businesses andother for-profit institutions.

Books or records relating to a col-lection of information must be retainedas long as their contents may becomematerial in the administration of anyinternal revenue law. Generally, taxreturns and tax return information areconfidential, as required by 26 U.S.C.6103.Estimated total annual reporting bur-den: 1,000 hours.The estimated annual burden per re-spondent varies from .5 hours to 1.5hours, depending on individual circum-stances, with an estimated average of 1hour.Estimated number of respondents:1,000.Estimated annual frequency of re-sponses: On occasion.

Background

On June 11, 1980, proposed amend-ments to the Income Tax Regulations,26 CFR part 1, under sections 170,301, 312, 341, 453, 751, 1254, and1502 of the Internal Revenue Code of1954 (Code) were published in theFederal Register (45 FR 39512). Theseamendments were proposed to conformthe regulations to section 205(a), (b),(c)(1) and (2) of the Tax Reform Actof 1976, Public Law 94–455, 90 Stat.1533, and section 402(c) of the EnergyTax Act of 1978, Public Law 95–618,92 Stat. 3202, and to make certainother technical amendments to theregulations to conform them to section1(c) of the Act of September 12, 1966,Public Law 89–570, 80 Stat. 762,section 211(b)(6) of the Tax ReformAct of 1969, Public Law 91–172, 83Stat. 570, and sections 1042(c)(2),1101(d)(2), 1901(a)(93), and 2110(a) ofthe Tax Reform Act of 1976, 90 Stat.1637, 1658, 1780, 1905. Section1.1254–3 of the proposed regulationsprovided rules relating to the sale orexchange of stock in an electing smallbusiness corporation (hereinafter re-ferred to as an S corporation). Becauseof the substantial changes in the taxtreatment of S corporations since theproposed regulations were issued, theproposed regulations contained in§1.1254–3 needed to be completelyrevised.

This document revises and re-proposes §1.1254–3 of the above-referenced notice of proposed rulemak-ing as amendments to the Income TaxRegulations, 26 CFR part 1, undersection 1254 of the Code, relating to Scorporations (redesignated as §1.1254–4). These amendments are proposed toconform the regulations to section5(a)(37) of the Subchapter S RevisionAct of 1982, Public Law 97–354, 96Stat. 1669, and sections 411 and 413 ofthe Tax Reform Act of 1986, PublicLaw 99–514, 100 Stat. 2225, 2227. Theamendments are to be issued under theauthority contained in sections 1254(b)and 7805 of the Code.

Explanation of Provisions

These proposed regulations containrules for applying the provisions ofsection 1254 to the disposition of


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natural resource recapture property byan S corporation (and a former Scorporation) and the disposition of Scorporation stock.

The proposed regulations providethat the recognition of ordinary incomeunder section 1254 upon the dispositionof natural resource recapture propertyby an S corporation is generally com-puted at the shareholder level. Deter-mining the amount of ordinary incometo be recognized under section 1254 atthe shareholder level is appropriatebecause the determination of section1254 costs can be affected by share-holder elections and characteristics.See, for example, sections 59(e) and1363(c)(2)(A). Similarly, in the case ofoil and gas properties, gain on thedisposition of the property and deple-tion with respect to the property arecomputed at the shareholder level. Seesection 613A(c)(11).

The proposed regulations also con-tain rules relating to the recognition ofordinary income under section 1254upon a sale or exchange of S corpora-tion stock. Under section 1254(b)(2),rules similar to the rules of section 751are to be applied to that portion of theexcess of the amount realized over theadjusted basis of the stock that isattributable to section 1254 costs. Pur-suant to section 1254(b)(2), the pro-posed regulations provide that, as ageneral rule, a shareholder must treatany gain recognized on a sale orexchange of S corporation stock asordinary income to the extent of theshareholder’s section 1254 costs withrespect to the shares sold or exchanged.

The proposed regulations providetwo exceptions to the general rule fordetermining the amount treated asordinary income under section 1254upon a sale or exchange of stock. Thefirst exception is that the general ruledoes not apply to the extent that theshareholder establishes that the gain isnot attributable to the section 1254costs. The portion of the gain recog-nized that is not attributable to section1254 costs is that portion of the gainrecognized that exceeds the amount ofordinary income that the shareholderwould have recognized under section1254 (with respect to the shares sold orexchanged) if, immediately prior to thesale or exchange of the stock, thecorporation had sold at fair marketvalue all of the corporation’s propertythe disposition of which would result inthe recognition by the shareholder of

ordinary income under section 1254.To establish that a portion of the gainrecognized is not attributable to ashareholder’s section 1254 costs, theshareholder must attach to the share-holder’s tax return a statement detailingthe shareholder’s share of the fairmarket value and basis, and the share-holder’s section 1254 costs, for each ofthe S corporation’s natural resourcerecapture properties held immediatelybefore the sale or exchange of stock.

The second exception to the generalrule for sales or exchanges of stock isthat, in the case of a contribution ofproperty to the S corporation prior to astock sale or exchange pursuant to aplan a principal purpose of which is toavoid the recognition of ordinary in-come under section 1254, the selling orexchanging shareholder must recognizeas ordinary income under section 1254the amount of ordinary income theshareholder would have recognized un-der section 1254 (with respect to theshares sold or exchanged) had the Scorporation sold all of its naturalresource recapture property the disposi-tion of which would result in ordinaryincome under section 1254. Section1.1254–4(c)(3) Example 3 of the pro-posed regulations illustrates thisexception.

The proposed regulations alsoprovide rules for determining an Scorporation shareholder’s section 1254costs. Generally, an S corporationshareholder’s section 1254 costs withrespect to any natural resource recap-ture property held by the corporationinclude all of the shareholder’s section1254 costs with respect to the propertywhile in the hands of the S corporation.In the case of a person (acquiringshareholder) who acquires stock fromanother shareholder, the proposed reg-ulations provide that the acquiringshareholder’s section 1254 costs arezero if the acquiring shareholder’s basisfor the stock transferred is determinedby reference to its cost (within themeaning of section 1012) or by refer-ence to the fair market value of thestock on the date of the decedent’sdeath or on the applicable date pro-vided in section 2032 (relating toalternate valuation date). However, anacquiring shareholder’s section 1254costs include any section 1254 costspaid or incurred before the decedent’sdeath, to the extent that the basis of thestock is reduced under section1014(b)(9) (relating to adjustments to

basis if the property is acquired from adecedent prior to death). For stock thatis acquired in a transfer that is a gift,in a transfer that is part sale orexchange and part gift, or a transferdescribed in section 1041, the acquiringshareholder generally acquires the sec-tion 1254 costs of the transferor butreduces the section 1254 costs by theamount of any gain treated as ordinaryincome under section 1254 by thetransferor on the transfer.

The proposed regulations providerules for applying section 1254 to theshareholders of an S corporation thatincurred section 1254 costs while itwas a C corporation (former C corpora-tion). In the case of a C corporationthat holds natural resource recaptureproperty and that elects to be an Scorporation, each shareholder’s section1254 costs as of the beginning of thecorporation’s first taxable year as an Scorporation include a pro rata share ofthe section 1254 costs of the corpora-tion as of the close of the last taxableyear that the corporation was a Ccorporation.

The proposed regulations also pro-vide rules for applying section 1254 toa corporation that holds natural re-source recapture property after thetermination of its S corporation election(former S corporation). In the case ofan S corporation that becomes a Ccorporation, the C corporation’s section1254 costs with respect to any naturalresource recapture property held by thecorporation as of the beginning of thecorporation’s first taxable year as a Ccorporation include the sum of itsshareholders’ section 1254 costs withrespect to the property as of the closeof the last taxable year for which thecorporation was an S corporation. Inthe case of an S termination year asdefined in section 1362(e)(4), theshareholders’ section 1254 costs aredetermined as of the close of the Sshort year as defined in section1362(e)(1)(A).

Because certain transactions willchange the allocation to the share-holders of gain or amount realizedfrom the natural resource recaptureproperty if the S corporation disposesof it subsequent to these transactions,the proposed regulations require thatsection 1254 costs be reallocated toreflect the effects of these transactions.Transactions requiring reallocation ofthe section 1254 costs are transactionsinvolving the issuance of stock by an S


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corporation in a reorganization or oth-erwise, and transfers of natural re-source recapture property to the Scorporation in exchange for stock ofthe S corporation (for example, in asection 351 transaction or in areorganization).

The rules for former S corporationsand the rules for allocating section1254 costs upon certain transfers re-quire the S corporation to determinethe aggregate of its shareholders’ sec-tion 1254 costs. The proposed regula-tions provide rules for the S corpo-ration to apply in determining ashareholder’s section 1254 costs withrespect to natural resource recaptureproperty held by the S corporation. Ingeneral, the S corporation may deter-mine a shareholder’s section 1254 costsby using written data provided by theshareholder or by applying certainassumptions.

These regulations are proposed toapply to dispositions of natural re-source recapture property by an Scorporation (and a former S corpora-tion) and dispositions of S corporationstock occurring after publication ofthese regulations as final regulations inthe Federal Register.

Comments and Requests for a PublicHearing

Before the adoption of these pro-posed regulations, consideration will begiven to any written comments that aretimely submitted (preferably an originaland eight copies) to the IRS. All com-ments will be available for publicinspection and copying. A public hear-ing will be held upon written request tothe Internal Revenue Service by anyperson who also submits written com-ments. If a public hearing is held,notice of the time and place will bepublished in the Federal Register.

Special Analyses

It has been determined that this pro-posed regulation is not a significantregulatory action as defined in Execu-tive Order 12866. Therefore, a regula-tory assessment is not required. It alsohas been determined that section 553(b)of the Administrative Procedure Act (5U.S.C. chapter 5) and the RegulatoryFlexibility Act (5 U.S.C. chapter 6) donot apply to these regulations, and,therefore, a Regulatory FlexibilityAnalysis is not required. Pursuant to

section 7805(f) of the Internal RevenueCode, this notice of proposed rulemak-ing will be submitted to the ChiefCounsel for Advocacy of the SmallBusiness Administration for commenton its impact on small business.


The principal author of these regula-tions is James A. Quinn of the Officeof Assistant Chief Counsel (Pass-throughs and Special Industries), IRS.However, other personnel from the IRSand Treasury Department participatedin their development.

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 1 is pro-posed to be amended as follows:

PART 1—INCOME TAXES

Paragraph. 1. The authority citationfor part 1 continues to read in part asfollows:

Authority: 26 U.S.C. 7805. * * * Section 1.1254–4 also issued under 26U.S.C. 1254(b). * * *

Par. 2. Section 1.1254–0 is amendedby revising the entry for §1.1254–4 toread as follows:

§1.1254–0 Table of contents forsection 1254 recapturerules. * * *

* * * * * *

§1.1254–4 Special rules for Scorporations and their shareholders.

(a) In general.(b) Determination of gain treated

as ordinary income under sec-tion 1254 upon a dispositionof natural resource recaptureproperty by an S corporation.(1) General rule.(2) Examples.

(c) Character of gain recognizedby a shareholder upon a saleor exchange of S corporationstock.(1) General rule.(2) Exceptions.(3) Examples.

(d) Section 1254 costs of a share-holder.

(e) Section 1254 costs of an ac-quiring shareholder after cer-tain acquisitions.(1) Basis determined under sec-

tion 1012.(2) Basis determined by reason

of the application of section1014(a).

(3) Basis determined by reasonof the application of section1014(b)(9).

(4) Gifts and section 1041transfers.

(f) Special rules for former S cor-porations and former C corpo-rations.(1) Section 1254 costs of an S

corporation that was for-merly a C corporation.

(2) Examples.(3) Section 1254 costs of a C

corporation that was for-merly an S corporation.

(g) Determination of a share-holder’s section 1254 costsupon certain stock transactions(1) Issuance of stock. (2) Natural resource recapture

property acquired in ex-change for stock.

(3) Treatment of nonvestedstock.

(4) Exception. (5) Aggregate of S corporation

shareholders’ section 1254costs with respect to naturalresource recapture propertyheld by the S corporation

(6) Examples. (h) Effective date.

* * * * * *

Par. 3. Section 1.1254–4 is amendedby adding text to read as follows:

§1.1254–4 Special rules for Scorporations and their shareholders.

(a) In general. This section providesrules for applying the provisions ofsection 1254 to S corporations andtheir shareholders upon the dispositionby an S corporation (or a former Scorporation) of natural resource recap-ture property and upon the dispositionby a shareholder of stock of an Scorporation that holds natural resourcerecapture property.

(b) Determination of gain treated asordinary income under section 1254upon a disposition of natural resourcerecapture property by an S corpora-tion—(1) General rule. Upon a disposi-


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tion of natural resource recapture prop-erty by an S corporation, the amount ofgain treated as ordinary income undersection 1254 is determined at the share-holder level. Each shareholder mustrecognize as ordinary income undersection 1254 the lesser of—

(i) The shareholder’s section 1254costs with respect to the propertydisposed of; or

(ii) The shareholder’s share of theamount, if any, by which the amountrealized on the sale, exchange, orinvoluntary conversion, or the fairmarket value of the property upon anyother disposition (including a distribu-tion), exceeds the adjusted basis of theproperty.

(2) Examples. The following exam-ples illustrate the provisions of para-graph (b)(1) of this section:

Example 1. Disposition of natural resourcerecapture property other than oil and gasproperty. A and B are equal shareholders in X,an S corporation. On January 1, 1995, X acquiresfor $90,000 an undeveloped mineral property, itssole property. During 1995, X expends anddeducts $100,000 in developing the property. OnJanuary 15, 1996, X sells the property for$250,000 when X’s basis in the property is$90,000. Thus, X recognizes gain of $160,000 onthe sale. A and B’s share of the $160,000 gainrecognized is $80,000 each. Each shareholder has$50,000 of section 1254 costs with respect to theproperty. Under these circumstances, A and Beach are required to recognize $50,000 of the$80,000 of gain on the sale of the property asordinary income under section 1254.

Example 2. Disposition of oil and gas propertythe adjusted basis of which is allocated to theshareholders under section 613A(c)(11). C and Dare equal shareholders in Y, an S corporation.On January 1, 1995, Y acquires for $150,000 anundeveloped oil and gas property, its soleproperty. During 1995, Y expends in developingthe property $40,000 in intangible drilling costswhich it elects to expense under section 263(c).On January 15, 1996, Y sells the property for$200,000. C and D’s share of the $200,000amount realized on the sale is $100,000 each. Cand D each have a basis of $75,000 in theproperty and $20,000 of section 1254 costs withrespect to the property. Under these circum-stances, C and D each are required to recognize$20,000 of the $25,000 gain on the sale of theproperty as ordinary income under section 1254.

(c) Character of gain recognized bya shareholder upon a sale or exchangeof S corporation stock—(1) Generalrule. Except as provided in paragraph(c)(2) of this section, if an S corpora-tion shareholder recognizes gain upon asale or exchange of stock in the Scorporation (determined without regardto section 1254), the gain is treated asordinary income under section 1254 tothe extent of the shareholder’s section

1254 costs (with respect to the sharessold or exchanged).

(2) Exceptions—(i) Gain not attribu-table to section 1254 costs—(A) Gen-eral rule. Paragraph (c)(1) of thissection does not apply to any portionof the gain recognized on the sale orexchange of the stock that the taxpayerestablishes is not attributable to section1254 costs. The portion of the gainrecognized that is not attributable tosection 1254 costs is that portion of thegain recognized that exceeds theamount of ordinary income that theshareholder would have recognized un-der section 1254 (with respect to theshares sold or exchanged) if, imme-diately prior to the sale or exchange ofthe stock, the corporation had sold atfair market value all of the corpora-tion’s property the disposition of whichwould result in the recognition by theshareholder of ordinary income undersection 1254.

(B) Substantiation. To establish thata portion of the gain recognized is notattributable to a shareholder’s section1254 costs so as to qualify for theexception contained in paragraph (c)-(2)(i)(A) of this section, the share-holder must attach to the shareholder’stax return a statement detailing theshareholder’s share of the fair marketvalue and basis, and the shareholder’ssection 1254 costs, for each of the Scorporation’s natural resource recaptureproperties held immediately before thesale or exchange of stock.

(ii) Transactions entered into as partof a plan to avoid recognition ofordinary income under section 1254. Inthe case of a contribution of propertyprior to a sale or exchange of stockpursuant to a plan a principal purposeof which is to avoid recognition ofordinary income under section 1254,paragraph (c)(1) of this section doesnot apply. Instead, the amount recog-nized as ordinary income under section1254 is the amount of ordinary incomethe selling or exchanging shareholderwould have recognized under section1254 (with respect to the shares sold orexchanged) had the S corporation soldits natural resource recapture propertythe disposition of which would haveresulted in the recognition of ordinaryincome under section 1254. Theamount recognized as ordinary incomeunder the preceding sentence reducesthe amount realized on the sale orexchange of the stock. This reducedamount realized is used in determining

any gain or loss on the sale orexchange.

(3) Examples. The following exam-ples illustrate the provisions of thisparagraph (c):

Example 1. Application of general rule upon asale of S corporation stock. C and D are equalshareholders in Y, an S corporation. As ofJanuary 1, 1995, Y holds two mining properties:Blackacre, with an adjusted basis of $5,000 anda fair market value of $35,000, and Whiteacre,with an adjusted basis of $20,000 and a fairmarket value of $15,000. Y also holds securitieswith a basis of $5,000 and a fair market value of$10,000. On January 1, 1995, D sells 50 percentof D’s Y stock to E for $15,000. As of the dateof the sale, D’s adjusted basis in the Y stocksold is $7,500, and D has $18,000 of section1254 costs with respect to Blackacre and $12,000of section 1254 costs with respect to Whiteacre.Under this paragraph (c), the gain recognized byD upon the sale of Y stock is treated as ordinaryincome to the extent of D’s section 1254 costswith respect to the stock sold, unless Destablishes that a portion of such excess is notattributable to D’s section 1254 costs. However,because D would recognize $7,500 in ordinaryincome under section 1254 with respect to thestock sold if Y sold Blackacre (the only asset thedisposition of which would result in ordinaryincome to D under section 1254), the $7,500 ofgain recognized by D upon the sale of D’s Ystock is attributable to D’s section 1254 costs.Therefore, upon the sale of stock to E, Drecognizes $7,500 of ordinary income under thisparagraph (c).

Example 2. Sale of S corporation stock wheregain is not entirely attributable to section 1254costs. Assume the same facts as in Example 1,except that Blackacre has a fair market value of$25,000, and the securities have a fair marketvalue of $20,000. Immediately prior to the saleof stock to E, if Y had sold Blackacre (its onlyasset the disposition of which would result in therecognition of ordinary income to D undersection 1254), D would recognize $5,000 inordinary income with respect to the stock soldunder section 1254. D attaches a statement toD’s tax return for 1995 detailing D’s share of thefair market values and bases, and D’s section1254 costs with respect to Blackacre andWhiteacre. Therefore, upon the sale of stock toE, of the $7,500 gain recognized by D, $5,000 isordinary income under this paragraph (c).

Example 3. Contribution of property prior tosale of S corporation stock as part of a plan toavoid recognition of ordinary income undersection 1254. H owns all of the stock of Z, an Scorporation. As of January 1, 1995, H has $3,000of section 1254 costs with respect to property P,which is natural resource recapture property andZ’s only asset. Property P has an adjusted basisof $5,000 and a fair market value of $8,000. Hhas a basis of $5,000 in Z stock, which has a fairmarket value of $8,000. On January 1, 1995, Hcontributes securities to Z which have a basis of$7,000 and a fair market value of $4,000. OnApril 15, 1995, H sells all of the Z stock to J for$12,000. On that date, H’s adjusted basis in theZ stock is also $12,000. Based on all the factsand circumstances, the sale of stock is part of aplan (along with the contribution by H of thesecurities to Z) that has a principal purpose toavoid recognition of ordinary income undersection 1254. Consequently, under paragraph


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(c)(2)(ii) of this section, H must recognize$3,000 as ordinary income under section 1254,the amount of ordinary income that H wouldrecognize as ordinary income under section 1254if property P were sold at fair market value. Inaddition, H reduces the amount realized on thesale of the stock ($12,000) by $3,000. As aresult, H also recognizes a $3,000 capital loss onthe sale of the stock ($9,000 amount realized less$12,000 adjusted basis).

(d) Section 1254 costs of a share-holder. An S corporation shareholder’ssection 1254 costs with respect to anynatural resource recapture property heldby the corporation include all of theshareholder’s section 1254 costs withrespect to the property in the hands ofthe S corporation. See §1.1254–1(b)(1)for the definition of section 1254 costs.

(e) Section 1254 costs of an acquir-ing shareholder a f ter cer ta inacquisitions—(1) Basis determined un-der section 1012. If stock in an Scorporation that holds natural resourcerecapture property is acquired and theacquiring shareholder’s basis for thestock is determined solely by referenceto its cost (within the meaning ofsection 1012), the amount of section1254 costs with respect to the propertyheld by the corporation in the acquiringshareholder’s hands is zero on theacquisition date.

(2) Basis determined by reason ofthe application of section 1014(a). Ifstock in an S corporation that holdsnatural resource recapture property isacquired from a decedent and theacquiring shareholder’s basis is deter-mined, by reason of the application ofsection 1014(a), solely by reference tothe fair market value of the stock onthe date of the decedent’s death or onthe applicable date provided in section2032 (relating to alternate valuationdate), the amount of section 1254 costswith respect to the property held by thecorporation in the acquiring share-holder’s hands is zero on the acquisi-tion date.

(3) Basis determined by reason ofthe application of section 1014(b)(9). Ifstock in an S corporation that holdsnatural resource recapture property isacquired before the death of the dece-dent, the amount of section 1254 costswith respect to the property held by thecorporation in the acquiring share-holder’s hands includes the amount, ifany, of the section 1254 costs deductedby the acquiring shareholder before thedecedent’s death, to the extent that thebasis of the stock (determined undersection 1014(a)) is required to be

reduced under section 1014(b)(9) (relat-ing to adjustments to basis when theproperty is acquired before the death ofthe decedent).

(4) Gifts and section 1041 transfers.If stock is acquired in a transfer that isa gift, in a transfer that is a part sale orexchange and part gift, or in a transferthat is described in section 1041(a), theamount of section 1254 costs with re-spect to the property held by thecorporation in the acquiring share-holder’s hands immediately after thetransfer is an amount equal to—

(i) The amount of section 1254 costswith respect to the property held by thecorporation in the hands of the trans-feror immediately before the transfer;minus

(ii) The amount of any gain recog-nized as ordinary income under section1254 by the transferor upon thetransfer.

(f) Special rules for former S corpo-rations and former C corporations—(1)Section 1254 costs of an S corporationthat was formerly a C corporation. Inthe case of a C corporation that holdsnatural resource recapture property andthat elects to be an S corporation, eachshareholder’s section 1254 costs as ofthe beginning of the corporation’s firsttaxable year as an S corporation in-clude a pro rata share of the section1254 costs of the corporation as of theclose of the last taxable year that thecorporation was a C corporation.

(2) Examples. The following exam-ples illustrate the application of theprovisions of paragraph (f)(1) of thissection:

Example 1. Sale of natural resource recaptureproperty held by an S corporation that wasformerly a C corporation—(i) Y is a Ccorporation that elects to be an S corporationeffective January 1, 1996. On that date, Y ownsOil Well, which is natural resource recaptureproperty and a capital asset. Y has section 1254costs of $20,000 as of the close of the lasttaxable year that it was a C corporation. OnJanuary 1, 1996, Oil Well has a value of$200,000 and a basis of $100,000. Thus, undersection 1374, Y’s net unrealized built-in gain is$100,000. Also on that date, Y’s basis in OilWell is allocated to A, Y’s sole shareholder,under section 613A(c)(11) and the section 1254costs are allocated to A under §1.1254–4(f)(1).In addition, A has a basis in A’s Y stock of$100,000.

(ii) On November 1, 1996, Y sells Oil Wellfor $250,000. During 1996, Y has taxableincome greater than $100,000, and no othertransactions or items treated as recognized built-in gain or loss. Under section 1374, Y has netrecognized built-in gain of $100,000. Assuming atax rate of 35 percent on capital gain, Y has a

tax of $35,000 under section 1374. The tax of$35,000 is treated as a capital loss under section1366(f)(2). A has a realized gain on the sale of$150,000 ($250,000 minus $100,000) of which$20,000 is recognized as ordinary income undersection 1254, and $130,000 is recognized ascapital gain. Consequently, A recognizes ordi-nary income of $20,000 and net capital gain of$95,000 ($130,000 minus $35,000) on the sale.

Example 2. Sale of stock followed by sale ofnatural resource recapture property held by an Scorporation that was formerly a C corporation—(i) Assume the same facts as in Example 1(i). OnNovember 1, 1996, A sells all of A’s Y stock toP for $250,000. A has a realized gain on the saleof $150,000 ($250,000 minus $100,000) ofwhich $20,000 is recognized as ordinary incomeunder section 1254, and $130,000 is recognizedas capital gain.

(ii) On November 2, 1996, Y sells Oil Wellfor $250,000. During 1996, Y has taxableincome greater than $100,000, and no othertransactions or items treated as recognized built-in gain or loss. Under section 1374, Y has netrecognized built-in gain of $100,000. Assuming atax rate of 35 percent on capital gain, Y has atax of $35,000 under section 1374. The tax of$35,000 is treated as a capital loss under section1366(f)(2). P has a realized gain on the sale of$150,000 ($250,000 minus $100,000), which isrecognized as capital gain. Consequently, Precognizes net capital gain of $115,000($150,000 minus $35,000) on the sale.

(3) Section 1254 costs of a Ccorporation that was formerly an Scorporation. In the case of an Scorporation that becomes a C corpora-tion, the C corporation’s section 1254costs with respect to any naturalresource recapture property held by thecorporation as of the beginning of thecorporation’s first taxable year as a Ccorporation include the sum of itsshareholders’ section 1254 costs withrespect to the property as of the closeof the last taxable year that thecorporation was an S corporation. Inthe case of an S termination year asdefined in section 1362(e)(4), theshareholders’ section 1254 costs aredetermined as of the close of the Sshort year as defined in section1362(e)(1)(A). See paragraph (g)(5) ofthis section for rules on determiningthe aggregate amount of the share-holders’ section 1254 costs.

(g) Determination of a shareholder’ssection 1254 costs upon certain stocktransactions—(1) Issuance of stock.Upon an issuance of stock (whethersuch stock is newly-issued or had beenheld as treasury stock) by an Scorporation in a reorganization orotherwise—

(i) Each recipient of shares must beallocated a pro rata share (determinedsolely with respect to the shares issuedin the transaction) of the aggregate of


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the S corporation shareholders’ section1254 costs with respect to naturalresource recapture property held by theS corporation immediately before theissuance (as determined pursuant toparagraph (g)(5) of this section); and

(ii) Each pre-existing shareholdermust reduce his or her section 1254costs with respect to natural resourcerecapture property held by the Scorporation immediately before the is-suance by an amount equal to the pre-existing shareholder’s section 1254costs immediately before the issuancemultiplied by the percentage of stockof the corporation issued in thetransaction.

(2) Natural resource recapture prop-erty acquired in exchange for stock. Ifnatural resource recapture property istransferred to an S corporation inexchange for stock of the S corporation(for example, in a section 351 transac-tion, or in a reorganization described insection 368), the S corporation mustallocate to its shareholders a pro ratashare of the S corporation’s section1254 costs with respect to the propertyimmediately after the transaction (asdetermined under §1.1254–3(b)(1)).

(3) Treatment of nonvested stock.Stock issued in connection with theperformance of services that is substan-tially nonvested (within the meaning of§1.83–3(b)) is treated as issued for pur-poses of this section at the first time it istreated as outstanding stock of the Scorporation for purposes of section 1361.

(4) Exception. Paragraph (g)(1) ofthis section does not apply to stockissued in exchange for stock of thesame S corporation (as for example, ina recapitalization described in section368(a)(1)(E)).

(5) Aggregate of S corporationshareholders’ section 1254 costs withrespect to natural resource recaptureproperty held by the S corporation—(i)In general. The aggregate of S corpora-tion shareholders’ section 1254 costs isequal to the sum of each shareholder’ssection 1254 costs. The S corporationmust determine each shareholder’s sec-tion 1254 costs under either paragraph(g)(5)(i)(A) (written data) or paragraph(g)(5)(i)(B) (assumptions) of this sec-tion. The S corporation may determinethe section 1254 costs of some share-holders under paragraph (g)(5)(i)(A) ofthis section and of others under para-graph (g)(5)(i)(B) of this section.

(A) Written data. An S corporationmay determine a shareholder’s section

1254 costs by using written dataprovided by a shareholder showing theshareholder’s section 1254 costs withrespect to natural resource recaptureproperty held by the S corporationunless the S corporation knows or hasreason to know that the written data isinaccurate. If an S corporation does notreceive written data upon which it mayrely, the S corporation must use theassumptions provided in paragraph(g)(5)(i)(B) of this section in determin-ing a shareholder’s section 1254 costs.

(B) Assumptions. An S corporationthat does not use written data pursuantto paragraph (g)(5)(i)(A) of this sectionto determine a shareholder’s section1254 costs must use the followingassumptions to determine the share-holder’s section 1254 costs.

(1) The shareholder deducted his orher share of the amount of deductionsunder sections 263(c), 616, and 617 inthe first year in which the shareholdercould claim a deduction for suchamounts, unless in the case of expendi-tures under sections 263(c) or 616 the Scorporation elected to capitalize suchamounts;

(2) The shareholder was not subjectto the following limitations with re-spect to the shareholder’s depletionallowance under section 611, except tothe extent a limitation applied at thecorporate level: the taxable incomelimitation of section 613(a); the deple-table quantity limitations of section613A(c); or the limitations of sections613A(d)(2), (3), and (4) (exclusion ofretailers and refiners).

(6) Examples. The following exam-ples illustrate the provisions of thisparagraph (g):

Example 1. Transfer of natural resourcerecapture property to an S corporation in asection 351 transaction. As of January 1, 1996,A owns all the stock (20 shares) in X, an Scorporation. X holds property that is not naturalresource recapture property that has a fair marketvalue of $2,000 and an adjusted basis of $2,000.On January 1, 1996, B transfers natural resourcerecapture property, Property P, to X in exchangefor 80 shares of X stock in a transaction thatqualifies under section 351. Property P has a fairmarket value of $8,000 and an adjusted basis of$5,000. Pursuant to section 351, B does notrecognize gain on the transaction. Immediatelyprior to the transaction, B’s section 1254 costswith respect to Property P equaled $6,000. Under§1.1254–2(c)(1), B does not recognize any gainunder section 1254 on the section 351 transactionand, under §1.1254–3(b)(1), X’s section 1254costs with respect to Property P immediatelyafter the contribution equal $6,000. Underparagraph (g)(2) of this section, each shareholderis allocated a pro rata share of X’s section 1254

costs. The pro rata share of X’s section 1254costs that is allocated to A equals $1,200 (20percent interest in X multiplied by X’s $6,000 ofsection 1254 costs). The pro rata share of X’ssection 1254 costs that is allocated to B equals$4,800 (80 percent interest in X multiplied byX’s $6,000 of section 1254 costs).

Example 2. Contribution of money in exchangefor stock of an S corporation holding naturalresource recapture property. As of January 1,1996, A and B each own 50 percent of the stock(50 shares each) in X, an S corporation. X holdsnatural resource recapture property, Property P,which has a fair market value of $20,000 and anadjusted basis of $14,000. A’s and B’s section1254 costs with respect to Property P are $4,000and $1,500, respectively. On January 1, 1996, Ccontributes $20,000 to X in exchange for 100shares of X’s stock. Under paragraph (g)(1)(i) ofthis section, X must allocate to C a pro ratashare of its shareholders’ section 1254 costs.Using the assumptions set forth in paragraph(g)(5)(i)(B) of this section, X determines that A’ssection 1254 costs with respect to naturalresource recapture property held by X equal$4,500. Using written data provided by B, Xdetermines that B’s section 1254 costs withrespect to Property P equal $1,500. Thus, theaggregate of X’s shareholders’ section 1254 costsequals $6,000. C’s pro rata share of the $6,000of section 1254 costs equals $3,000 (C’s 50percent interest in X multiplied by $6,000).Under paragraph (g)(1)(ii) of this section, A’ssection 1254 costs are reduced by $2,000 (A’sactual section 1254 costs ($4,000) multiplied by50 percent). B’s section 1254 costs are reducedby $750 (B’s actual section 1254 costs ($1,500)multiplied by 50 percent).

Example 3. Merger involving an S corporationthat holds natural resource recapture property.X, an S corporation with one shareholder, A,holds as its sole asset natural resource recaptureproperty that has a fair market value of $120,000and an adjusted basis of $40,000. A has section1254 costs with respect to the property of$60,000. For valid business reasons, X mergesinto Y, an S corporation with one shareholder, B,in a reorganization described in section368(a)(1)(A). Y holds property that is not naturalresource recapture property that has a fair marketvalue of $120,000 and basis of $120,000. Underparagraph (c) of this section, A does notrecognize ordinary income under section 1254upon the exchange of stock in the mergerbecause A did not otherwise recognize gain onthe merger. Under paragraph (g)(2) of thissection, Y must allocate to A and B a pro ratashare of its $60,000 of section 1254 costs. Thus,A and B are each allocated $30,000 of section1254 costs (50 percent interest in X, each,multiplied by $60,000).

(h) Effective date. This section ap-plies to dispositions of natural resourcerecapture property by an S corporation(and a former S corporation) anddispositions of S corporation stockoccurring after [publication of theseregulations as final regulations in theFederal Register].


Internal Revenue.


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Changes to Excise Tax Rates

Announcement 96–9

The changes listed below are effec-

tive after December 31, 1995, and willbe reflected on Form 720 for the firstquarter of 1996, as well as on the nextrevisions of Forms 4136 and 8849. Ifthese rates are modified by legislation,the IRS will issue another announce-ment and will revise all formsaccordingly.

I. FUEL TAXES

These changes to the fuel taxesreflect the expiration of the LeakingUnderground Storage Tank Trust FundTax (LUST) and a reduction in certainaviation-related fuel taxes.

The rates listed below are effectiveJanuary 1, 1996.

Tax rateIRS per gallonNo. Type of fuel (in cents)

60 Diesel fuel 24.371 Dyed diesel fuel for use in trains 5.5578 Dyed diesel fuel for use in buses 7.361 Special motor fuel (including LPG) 18.362 Gasoline 18.358 Gasoline sold for gasohol production, 10% alcohol 14.33373 Gasoline sold for gasohol production, 7.7% alcohol 15.32174 Gasoline sold for gasohol production, 5.7% alcohol 16.14259 Gasohol, 10% alcohol 12.975 Gasohol, 7.7% alcohol 14.14276 Gasohol, 5.7% alcohol 15.22269 Aviation fuel (other than gasoline) 4.314 Gasoline used in noncommercial aviation (expired) 0.077 Aviation fuel (other than gasoline) for use in commercial aviation 4.364 Inland waterways fuel use tax 24.3

101 Compressed natural gas taxed at 48.54 cents per thousand cubic feet remainsunchanged

The rates of tax for the ‘‘otheralcohol fuels’’ have decreased and willbe listed in the Instructions for Form720.

II. LUXURY TAX

The base amount not subject to theluxury tax for passenger vehicles hasincreased from $32,000 to $34,000effective for sales or uses occurringafter December 31, 1995. Get Form8807, Certain Manufacturers and Re-tailers Excise Taxes, from the IRS tocompute the luxury tax.

III. TRANSPORTATION TAXES

The excise tax on transportation ofpersons and property by air and use ofinternational air travel facilities (IRSNos. 26, 28, and 27) expired December31, 1995. Travelers that paid for ticketsin 1995 for travel in 1996 may beentitled to refunds of the tax. Someairlines are refunding the tax to thetraveler. Therefore, contact the airlineto discuss its refund policy or get Form8849, Claim for Refund of Excise

Taxes, from the IRS to obtain a refund.All refund claims submitted to IRS re-quire an original passenger receipt.

IV. SUPERFUND TAX

The excise tax on domestic andimported petroleum, chemicals, andimported chemical substances (IRSNos. 53, 16, 54, and 17) expiredDecember 31, 1995.

V. HOW TO GET FORMS

Forms can be obtained by calling1-800-829-3676 or downloaded off theIRS home page on Internet at http://www.irs.ustreas.gov.

Deletions from Cumulative List ofOrganizations Contributions to WhichAre Deductible Under Section 170 ofthe Code

Announcement 96–10

The name of an organization that no

longer qualifies as an organizationdescribed in section 170(c)(2) of theInternal Revenue Code of 1986 is listedbelow.

Generally, the Service will not dis-allow deductions for contributionsmade to a listed organization on orbefore the date of announcement in theInternal Revenue Bulletin that an orga-nization no longer qualifies. However,the Service is not precluded fromdisallowing a deduction for any contri-butions made after an organizationceases to qualify under section170(c)(2) if the organization has nottimely filed a suit for declaratoryjudgment under section 7428 and if thecontributor (1) had knowledge of therevocation of the ruling or determina-tion letter, (2) was aware that suchrevocation was imminent, or (3) was inpart responsible for or was aware ofthe activities or omissions of theorganization that brought about thisrevocation.

If on the other hand a suit fordeclaratory judgment has been timelyfiled, contributions from individualsand organizations described in section


778/20048/28MAY96/B09-008

31 1996 –23 I.R.B.

170(c)(2) that are otherwise allowablewill continue to be deductible. Protec-tion under section 7428(c) would beginon (DATE) 1996, and would end onthe date the court first determines thatthe organization is not described insection 170(c)(2) as more particularlyset forth in section 7428(c)(1). Forindividual contributors, the maximumdeduction protected is $1,000, with ahusband and wife treated as onecontributor. This benefit is not ex-tended to any individual who wasresponsible, in whole or in part, for theacts or omissions of the organizationthat were the basis for revocation.

Christian Job Center of Colorado, Inc.Denver, CO

Foundation for Airborne ReliefLong Beach, CA

Southern Legal Defense FoundationRaleigh, NC

Section 7428(c) Validation of CertainContributions Made During Pendencyof Declaratory Judgment Proceedings

This announcement serves notice topotential donors that the organizationlisted below has recently filed a timelydeclaratory judgment suit under section7428 of the Code, challenging revoca-tion of its status as an eligible doneeunder section 170(c)(2).

Protection under section 7428(c) ofthe Code begins on the date that thenotice of revocation is published in theInternal Revenue Bulletin and ends onthe date on which a court first deter-mines that an organization is notdescribed in section 170(c)(2), as moreparticularly set forth in section

7428(c)(1). In the case of individualcontributors, the maximum amount ofcontributions protected during thisperiod is limited to $1,000.00, with ahusband and wife being treated as onecontributor. This protection is notextended to any individual who wasresponsible, in whole or in part, for theacts or omissions of the organizationthat were the basis for the revocation.This protection also applies (but with-out limitation as to amount) to organi-zations described in section 170(c)(2)which are exempt from tax undersection 501(a). If the organizationultimately prevails in its declaratoryjudgment suit, deductibility of contribu-tions would be subject to the normallimitations set forth under section 170.

Southern Legal Defense FoundationRaleigh, NC

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Announcement of the Disbarment, Suspension, or Consent to VoluntarySuspension of Attorneys, Certified Public Accountants, Enrolled Agents andEnrolled Actuaries From Practice Before the Internal Revenue Service

Under 31 Code of Federal Regula-tions, Part 10, an attorney, certifiedpublic accountant, enrolled agent or en-rolled actuary, in order to avoid the in-stitution or conclusion of a proceedingfor his disbarment or suspension frompractice before the Internal RevenueService, may offer his consent tosuspension from such practice. TheDirector of Practice, in his discretion,may suspend an attorney, certifiedpublic accountant, enrolled agent orenrolled actuary in accordance with theconsent offered.

Attorneys, certified public account-ants, enrolled agents and enrolled actu-aries are prohibited in any Internal

Revenue Service matter from directlyor indirectly employing, acceptingassistance from, being employed by,or sharing fees with, any practi-tioner disbarred or suspended frompractice before the Internal RevenueService.

To enable attorneys, certified publicaccountants, enrolled agents and en-rolled actuaries to identify practitionersunder consent suspension from practicebefore the Internal Revenue Service,the Director of Practice will announcein the Internal Revenue Bulletin thenames and addresses of practitionerswho have been suspended from suchpractice, their designation as attor-

ney, certified public accountant, en-rolled agent or enrolled actuary anddate or period of suspension. This an-nouncement will appear in the weeklyBulletin at the earliest practicable dateafter such action and will continue toappear in the weekly Bulletins for fivesuccessive weeks or for as many weeksas is practicable for each attorney,certified public accountant, enrolledagent or enrolled actuary so suspendedand will be consolidated and publishedin the Cumulative Bulletin.

The following individuals have beenplaced under consent suspension frompractice before the Internal RevenueService:

Name Address Designation Date of Suspension

Isdaner, Thomas M. Crofton, MD CPA October 31, 1995 to October 30, 1996Cacciola, Marlene Pittsburg, CA Enrolled

AgentNovember 9, 1995 to May 8, 1996

Goldman, William D. Hot Springs, AR Attorney November 9, 1995 to November 8, 1996Armstrong, David L. Norman, OK CPA Indefinite from November 10, 1995Heckathorn, Ben Red Oak, TX CPA/

AttorneyIndefinite from November 28, 1995

Tisdel, Linda Seattle, WA EnrolledAgent

November 28, 1995 to May 27, 1997

Webb, Herbert M. Gainsville, FL Attorney December 21, 1995 to June 20, 1997Hipp, Robert J. Evanston, IL CPA December 28, 1995 to April 27, 1996Ruff, James M. Willmar, MN CPA January 1, 1996 to March 31, 1996Mulkerin, John J. Wheaton, IL CPA January 5, 1996 to April 4, 1996Redwitz, Robert Irvine, CA CPA February 15, 1996 to May 14, 1996Lind, Stanley L. Milwaukee, WI Attorney March 1, 1996 to February 28, 1997Dais, Robert E. Plano, TX CPA March 1, 1996 to February 28, 1997

Under Section 330, Title 31 of theUnited States Code, the Secretary ofthe Treasury, after due notice andopportunity for hearing, is authorizedto suspend or disbar from practicebefore the Internal Revenue Serviceany person who has violated the rulesand regulations governing the recogni-tion of attorneys, certified public ac-countants, enrolled agents or enrolledactuaries to practice before the InternalRevenue Service.

Attorneys, certified public account-ants, enrolled agents, and enrolledactuaries are prohibited in any InternalRevenue Service matter from directly

or indirectly employing, accepting as-sistance from, being employed by orsharing fees with, any practitionerdisbarred or under suspension frompractice before the Internal RevenueService.

To enable attorneys, certified publicaccountants, enrolled agents andenrolled actuaries to identify suchdisbarred or suspended practitioners,the Director of Practice will announcein the Internal Revenue Bulletin thenames and addresses of practitionerswho have been suspended from suchpractice, their designation as attorney,certified public accountant, enrolled

agent or enrolled actuary, and the dateof disbarment or period of suspension.This announcement will appear in theweekly Bulletin for five successiveweeks or as long as it is practicable foreach attorney, certified public account-ant, enrolled agent or enrolled actuaryso suspended or disbarred and will beconsolidated and published in theCumulative Bulletin.

After due notice and opportunityfor hearing before an administrativelaw judge, the following individualshave been disbarred from further prac-tice before the Internal RevenueService:

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Name Address Designation Effective Date

Muraskin, David New York, NY Attorney November 6, 1995Kelsey, Patrick Poolesville, MD CPA November 13, 1995

Announcement of the Expedited Suspension of Attorneys, Certified PublicAccountants, Enrolled Agents, and Enrolled Actuaries From Practice Before theInternal Revenue Service

Under title 31 of the Code of FederalRegulations, section 10.76, the Directorof Practice is authorized to immediatelysuspend from practice before the Inter-nal Revenue Service any practitionerwho, within five years, from the datethe expedited proceeding is instituted,(1) has had a license to practice as anattorney, certified public accountant, oractuary suspended or revoked forcause; or (2) has been convicted of anycrime under title 26 of the UnitedStates Code or, of a felony under title18 of the United States Code involvingdishonesty or breach of trust.

Attorneys, certified public account-ants, enrolled agents, and enrolled ac-tuaries are prohibited in any Internal

Revenue Service matter from directlyor indirectly employing, accepting as-sistance from, being employed by, orsharing fees with, any practitionerdisbarred or suspended from practicebefore the Internal Revenue Service.

To enable attorneys, certified publicaccountants, enrolled agents, and en-rolled actuaries to identify practitionersunder expedited suspension from prac-tice before the Internal Revenue Serv-ice, the Director of Practice will an-nounce in the Internal Revenue Bulletinthe names and addresses of practition-ers who have been suspended from suchpractice, their designation as attorney,certified public accountant, enrolled

agent, or enrolled actuary, and date orperiod of suspension. This announce-ment will appear in the weekly Bulletinat the earliest practicable date aftersuch action and will continue to appearin the weekly Bulletins for five succes-sive weeks or for as many weeks as ispracticable for each attorney, certifiedpublic accountant, enrolled agent, orenrolled actuary so suspended and willbe consolidated and published in theCumulative Bulletin.

The following individuals have beenplaced under suspension from practicebefore the Internal Revenue Service byvirtue of the expedited proceedingprovisions of the applicable regulations:

Name Address Designation Date of Suspension

Trebatch, Henry T. Great Neck, NY CPA Indefinite from November 6, 1995Roomberg, Alan Minersville, PA CPA Indefinite from November 10, 1995Elfenbein, Emanuel B. Miami, FL Enrolled

AgentIndefinite from November 27, 1995

Cerullo, Louis, J. Boca Raton, FL CPA Indefinite from November 27, 1995Fogel, Harold St. Paul, MN CPA Indefinite from December 13, 1995Glover, Paul L. Downers Grove, IL Attorney Indefinite from December 13, 1995Miller, John R. Akron, OH Attorney Indefinite from December 13, 1995Pofahl, Charles Dallas, TX Attorney Indefinite from December 18, 1995Walburg, Douglas Mahtomedi, MN CPA Indefinite from December 18, 1995Hibler, Thomas M. Plymouth, MI CPA/

AttorneyIndefinite from December 18, 1995

Oringer, Ronald Flanders, NJ CPA Indefinite from December 29, 1995Butcher, Frederick Stillwater, NJ CPA Indefinite from December 29, 1995Tokars, Frederic Atlanta, GA Attorney Indefinite from December 29, 1995Atkins, Sanford I. Moreland Hills, OH Attorney Indefinite from December 29, 1995

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Definition of TermsRevenue rulings and revenue proce-dures (hereinafter referred to as ‘‘rul-ings’’) that have an effect on previousrulings use the following defined termsto describe the effect:

Amplified describes a situation whereno change is being made in a priorpublished position, but the prior posi-tion is being extended to apply to avariation of the fact situation set forththerein. Thus, if an earlier ruling heldthat a principle applied to A, and thenew ruling holds that the same princi-ple also applies to B, the earlier rulingis amplified. (Compare with modified,below).

Clarified is used in those instanceswhere the language in a prior ruling isbeing made clear because the languagehas caused, or may cause, some confu-sion. It is not used where a position ina prior ruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previouslypublished ruling and points out anessential difference between them.

Modified is used where the substanceof a previously published position isbeing changed. Thus, if a prior rulingheld that a principle applied to A butnot to B, and the new ruling holds thatit applies to both A and B, the prior

ruling is modified because it corrects apublished position. (Compare with am-plified and clarified, above).

Obsoleted describes a previouslypublished ruling that is not considereddeterminative with respect to futuretransactions. This term is most com-monly used in a ruling that listspreviously published rulings that areobsoleted because of changes in law orregulations. A ruling may also beobsoleted because the substance hasbeen included in regulations subse-quently adopted.

Revoked describes situations wherethe position in the previously publishedruling is not correct and the correctposition is being stated in the newruling.

Superseded describes a situationwhere the new ruling does nothingmore than restate the substance andsituation of a previously publishedruling (or rulings). Thus, the term isused to republish under the 1986 Codeand regulations the same position pub-lished under the 1939 Code and regula-tions. The term is also used when it isdesired to republish in a single ruling aseries of situations, names, etc., thatwere previously published over aperiod of time in separate rulings. If

If the new ruling does more thanrestate the substance of a prior ruling, acombination of terms is used. Forexample, modified and superseded de-scribes a situation where the substanceof a previously published ruling isbeing changed in part and is continuedwithout change in part and it is desiredto restate the valid portion of thepreviously published ruling in a newruling that is self contained. In thiscase the previously published ruling isfirst modified and then, as modified, issuperseded.

Supplemented is used in situations inwhich a list, such as a list of the namesof countries, is published in a rulingand that list is expanded by addingfurther names in subsequent rulings.After the original ruling has beensupplemented several times, a newruling may be published that includesthe list in the original ruling and theadditions, and supersedes all priorrulings in the series.

Suspended is used in rare situationsto show that the previous publishedrulings will not be applied pendingsome future action such as the issuanceof new or amended regulations, theoutcome of cases in litigation, or theoutcome of a Service study.

AbbreviationsThe following abbreviations in current use andformerly used will appear in material publishedin the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C.—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.

E.O.—Executive Order.ER—Employer.ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contribution Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign Corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—GrantorIC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.

PHC—Personal Holding Company.PO—Possession of the U.S.PR—Partner.PRS—Partnership.PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statements of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D.—Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z—Corporation.

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Numerical Finding List1

Bulletins 1996–1 through 1996–7

Announcements:

96–1, 1996–2 I.R.B. 5796–2, 1996–2 I.R.B. 5796–3, 1996–2 I.R.B. 5796–4, 1996–3 I.R.B. 5096–5, 1996–4 I.R.B. 9996–6, 1996–5 I.R.B. 4396–7, 1996–5 I.R.B. 4496–8, 1996–7 I.R.B. 56

Delegations Orders:

232 (Rev. 2), 1996–7 I.R.B. 49239 (Rev. 1), 1996–7 I.R.B. 49

Notices:

96–2, 1996–2 I.R.B. 1596–1, 1996–3 I.R.B. 3096–4, 1996–4 I.R.B. 6996–5, 1996–6 I.R.B. 2296–6, 1996–5 I.R.B. 2796–7, 1996–6 I.R.B. 2296–8, 1996–6 I.R.B. 2396–9, 1996–6 I.R.B. 2696–10, 1996–7 I.R.B. 47

Proposed Regulations:

DL–1–95, 1996–6 I.R.B. 28EE–20–95, 1996–5 I.R.B. 15EE–34–95, 1996–3 I.R.B. 49EE–35–95, 1996–5 I.R.B. 19EE–53–95, 1996–5 I.R.B. 23IA–33–95, 1996–4 I.R.B. 99INTL–3–95, 1996–6 I.R.B. 29INTL–9–95, 1996–5 I.R.B. 25PS–2–95, 1996–7 I.R.B. 50

Revenue Procedures:

96–1, 1996–1 I.R.B. 896–2, 1996–1 I.R.B. 6096–3, 1996–1 I.R.B. 8296–4, 1996–1 I.R.B. 9496–5, 1996–1 I.R.B. 12996–6, 1996–1 I.R.B. 15196–7, 1996–1 I.R.B. 18596–8, 1996–1 I.R.B. 18796–9, 1996–2 I.R.B. 1596–10, 1996–2 I.R.B. 1796–11, 1996–2 I.R.B. 1896–12, 1996–3 I.R.B. 3096–13, 1996–3 I.R.B. 3196–14, 1996–3 I.R.B. 4196–15, 1996–3 I.R.B. 4196–16, 1996–3 I.R.B. 45

1A cumulative list of all Revenue Rulings,Revenue Procedures, Treasury Decisions, etc.,published in Internal Revenue Bulletins 1995–27through 1995–52 will be found in InternalRevenue Bulletin 1996–1, dated January 2, 1996.

Revenue Procedures—Continued

96–17, 1996–4 I.R.B. 6996–18, 1996–4 I.R.B. 7396–19, 1996–4 I.R.B. 8096–20, 1996–4 I.R.B. 8896–21, 1996–4 I.R.B. 9696–22, 1996–5 I.R.B. 2796–23, 1996–5 I.R.B. 2796–24, 1996–5 I.R.B. 28

Revenue Rulings:

96–1, 1996–1 I.R.B. 796–2, 1996–2 I.R.B. 596–3, 1996–2 I.R.B. 1496–6, 1996–2 I.R.B. 896–4, 1996–3 I.R.B. 1696–5, 1996–3 I.R.B. 2996–7, 1996–3 I.R.B. 1296–8, 1996–4 I.R.B. 6296–9, 1996–4 I.R.B. 596–10, 1996–4 I.R.B. 2796–11, 1996–4 I.R.B. 2896–14, 1996–6 I.R.B. 20

Treasury Decisions:

8630, 1996–3 I.R.B. 198631, 1996–3 I.R.B. 78632, 1996–4 I.R.B. 68633, 1996–4 I.R.B. 208634, 1996–3 I.R.B. 178635, 1996–3 I.R.B. 58636, 1996–4 I.R.B. 648637, 1996–4 I.R.B. 298638, 1996–5 I.R.B. 58639, 1996–5 I.R.B. 128640, 1996–2 I.R.B. 108641, 1996–6 I.R.B. 48642, 1996–7 I.R.B. 48644, 1996–7 I.R.B. 16


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Finding List of Current Action onPreviously Published Items1

Bulletins 1996–1 through 1996–7

*Denotes entry since last publication

Delegation Orders:

232 (Rev. 1)Superseded by232 (Rev. 2), 1996–7 I.R.B. 49

239Amended by239 (Rev. 1), 1996–7 I.R.B. 49

Revenue Procedures:

65–17Modified by96–14, 1996–3 I.R.B. 41

66–49Modified by96–15, 1996–3 I.R.B. 41

88–32Obsoleted by96–15, 1996–3 I.R.B. 41

88–33Obsoleted by96–15, 1996–3 I.R.B. 41

89–19Superseded by96–17, 1996–4 I.R.B. 69

89–48Superseded in part by96–17, 1996–4 I.R.B. 69

91–22Modified by96–1, 1996–1 I.R.B. 8

91–22Amplified by96–13, 1996–3 I.R.B. 31




92–20Modified by96–1, 1996–1 I.R.B. 8

1A cumulative finding list for previouslypublished items mentioned in Internal RevenueBulletins 1995–27 through 1995–52 will befound in Internal Revenue Bulletin 1996–1, datedJanuary 2, 1996.


92–85Modified by96–1, 1996–1 I.R.B. 8



Superseded by96–18, 1996–4 I.R.B. 73

















96–3Amplified by96–12, 1996–3 I.R.B. 30

Revenue Rulings:

66–307Obsoleted by96–3, 1996–2 I.R.B. 14

72–437Modified by96–13, 1996–3 I.R.B. 31

80–80Obsoleted by96–3, 1996–2 I.R.B. 14

82–80Modified by96–14, 1996–3 I.R.B. 41

92–19Supplemented in part96–2, 1996–2 I.R.B. 5

92–75Clarified by96–13, 1996–3 I.R.B. 31

95–10Supplemented and superseded by96–4, 1996–3 I.R.B. 16

95–11Supplemented and superseded by96–5, 1996–3 I.R.B. 29


778/20047/28MAY96/B09-052

37

NOTES


778/20047/28MAY96/B09-052

38

NOTES


778/20047/28MAY96/B09-052

39

NOTES