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

INCOME TAX

T.D. 8994, page 1078.Final regulations under sections 444, 641, 1361, 1362, and1377 of the Code relate to the qualification and taxation ofelecting small business trusts (ESBTs), and to the definition ofdeferral entities for purposes of electing a taxable year otherthan the required taxable year. Notices 97–12 and 97–49 andRev. Proc. 98–23 superseded.

T.D. 8995, page 1070.Final regulations under section 460 of the Code provide rulesapplicable when there is a mid-contract change in the taxpayeraccounting for a long-term contract that has been under a long-term contract method of accounting.

Notice 2002–37, page 1095.This notice announces that regulations will be issued address-ing partnership transactions involving contracts accounted forunder a long-term contract method of accounting.

EMPLOYEE PLANS

Rev. Rul. 2002–32, page 1069.Cafeteria plans. In an asset sale, transferred employees whohave elected to participate in health flexible spending arrange-ments (FSAs) under the seller’s cafeteria plan may continue toexclude salary reduction amounts and medical reimburse-ments from gross income without interruption at the same levelof coverage after becoming employees of the buyer.

REG–105885–99, page 1103.Proposed regulations under section 457 of the Code wouldprovide guidance on compensation deferred under eligible sec-tion 457 deferred compensation plans of state and local gov-ernmental employers and tax-exempt entities. The regulationsreflect changes made to section 457 by the Tax Reform Act of1986, the Small Business Job Protection Act of 1996, the Eco-nomic Growth and Tax Relief Reconciliation Act of 2001, andother legislation. These regulations would also make varioustechnical changes and clarifications to the existing final regula-tions. A public hearing is scheduled for August 28, 2002.

EMPLOYMENT TAX

Rev. Rul. 2002–35, page 1067.Wages subject to federal employment tax. This ruling clari-fies that payments to employees for equipment they arerequired to provide as a condition of employment are wages forfederal employment tax purposes, unless paid under anaccountable plan. Rev. Rul. 68–624 revoked.

Rev. Proc. 2002–41, page 1098.This procedure provides that employers in the pipeline con-struction industry may use an optional expense substantiationrule to provide reimbursements under an accountable plan toemployees who also furnish welding rigs or mechanics rigs asa condition of employment and use those rigs in their perfor-mance of services as employees.

(Continued on the next page)Finding Lists begin on page ii.

Bulletin No. 2002–23June 10, 2002

ADMINISTRATIVE

Rev. Proc. 2002–40, page 1096.Net operating losses; 5-year carryback. This documentprovides procedures that certain taxpayers with net operatinglosses incurred in 2001 or 2002 must follow on or beforeOctober 31, 2002, for applying or electing out of the new5-year carryback period enacted by the Job Creation andWorker Assistance Act of 2002.

Announcement 2002–55, page 1125.This document contains corrections to final regulations (T.D.8985, 2002–14 I.R.B. 707) relating to the character of gain orloss from hedging transactions.

Announcement 2002–56, page 1126.The Service announces that an updated edition of Publication597, Information on the U.S. – Canada Income TaxTreaty (revised May 2002), is now available.

Announcement 2002–57, page 1126.The Service announces that an updated edition of Publication1544, Reporting Cash Payments of Over $10,000 (revisedMarch 2002), is now available. The Spanish version of this pub-lication, Publication 1544SP, Informe de Pagos en Efectivoen Exceso de $10,000 (revised April 2002), is also available.

June 10, 2002 2002–23 I.R.B.

The IRS MissionProvide America’s taxpayers top quality service by helpingthem understand and meet their tax responsibilities and by

applying the tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly and may be obtained from theSuperintendent of Documents on a subscription basis. Bulletincontents are consolidated semiannually into Cumulative Bulle-tins, which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform application ofthe tax laws, including all rulings that supersede, revoke,modify, or amend any of those previously published in the Bul-letin. All published rulings apply retroactively unless otherwiseindicated. Procedures relating solely to matters of internalmanagement are not published; however, statements of inter-nal practices and procedures that affect the rights and dutiesof taxpayers are published.

Revenue rulings represent the conclusions of the Service onthe application of the law to the pivotal facts stated in the rev-enue ruling. In those based on positions taken in rulings to tax-payers or technical advice to Service field offices, identifyingdetails and information of a confidential nature are deleted toprevent unwarranted invasions of privacy and to comply withstatutory requirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,court decisions, rulings, and procedures must be considered,

and Service personnel and others concerned are cautionedagainst reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A, TaxConventions and Other Related Items, and Subpart B, Legisla-tion and Related Committee Reports.

Part III.—Administrative, Procedural, andMiscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the Treasury’s Office of the Assistant Secre-tary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The first Bulletin for each month includes a cumulative index forthe matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the first Bulletin of the succeeding semiannualperiod, respectively.

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

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

2002–23 I.R.B. June 10, 2002

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

Section 62.—Adjusted GrossIncome Defined

(Also §§ 3121(a), 3306(b), 3401(a), 7805(b).)26 CFR 1.62–2: Reimbursements and other expenseallowance arrangements.(Also §§ 31.3121(a), 31.3306(b), 31.3401(a),301.7805–1.)

Wages subject to federal employ-ment tax. This ruling clarifies that pay-ments to employees for equipment theyare required to provide as a condition ofemployment are wages for federalemployment tax purposes, unless paidunder an accountable plan.

Rev. Rul. 2002–35

ISSUE

Whether amounts paid to employeesfor employee-provided equipment,including vehicles, that are used by theemployee to provide services as anemployee are wages subject to federalemployment taxes?

FACTS

Situation 1 — Business A is engagedin pipeline construction and repair. Ahires welder B and heavy equipmentmechanic C to perform services asemployees in connection with the con-struction of a pipeline. Business Arequires B to provide and maintain awelding rig for B’s use in providing weld-ing services and requires C to provide andmaintain a mechanics rig for C’s use inperforming repair and maintenance ser-vices at the work site on the employer’sheavy equipment. B and C are required toprovide rigs sufficient to perform therequired employee services. (Neitheremployee B nor C is an independent con-tractor.)

A welding rig consists of a truckequipped with a welding machine andother specialized welding equipmentrequired to perform welding services. B ispaid an hourly wage of $X for the perfor-mance of services as an employee. Inaddition, A pays B an hourly amount of$Y per hour for providing the weldingrig. This rig reimbursement is only paid

for those hours that B performs servicesas A’s employee.

A mechanics rig consists of a heavytruck equipped with a crane, weldingmachine, and various other equipmentused in the repair of heavy constructionequipment. C is paid an hourly wage of$X for the performance of services as anemployee. In addition A pays C an addi-tional $Y amount per day for providingthe mechanics rig. This rig reimburse-ment is only paid for the days that C per-forms services as A’s employee.

Business A requires B and C to eachexecute a document specifying that theemployee owns the rig provided and willinsure and maintain the rig. Employees Band C bear all expenses associated withthe operation and maintenance of theirrespective rigs. The flat dollar amountpaid as rig reimbursement is not related tothe actual employee business expenses Bor C incurs while performing services asan employee of A. Business A does notrequire B or C to substantiate expensesincurred related to the rig provided. Nordoes A require B or C to return anyamount paid as a rig reimbursement thatexceeds the actual employee businessexpenses B or C incurs in connection withproviding a rig while performing servicesas an employee of A.

Situation 2 — Business A also hireslaborer D to perform services as anemployee. Employee D uses D’s pickuptruck for transportation along the pipe-line. Employee D is paid an hourly wageof $X for the performance of services asan employee and is also paid an addi-tional amount of $Y per day for providingthe pickup truck. Business A does notrequire D to substantiate mileage oractual employee business expensesincurred while performing services as anemployee of A. Employee D is notrequired to return any of the dailyamounts paid for the pickup truck if theamount paid exceeds the employee busi-ness expenses D incurred in connectionwith the pickup truck while performingservices as an employee of A. (Laborer Dis not an independent contractor.)

LAW AND ANALYSIS

Section 3402(a) of the Internal Rev-enue Code (Code) requires employerspaying wages to deduct and withholdincome tax on wages. For income taxwithholding purposes, § 3401(a) providesthat the term “wages,” with certain excep-tions, means all remuneration for servicesperformed by an employee for anemployer. Under §§ 3111 and 3301, Fed-eral Insurance Contributions Act (FICA)tax and Federal Unemployment Tax Act(FUTA) tax, respectively, excise taxes areimposed on the employer in an amountequal to a percentage of the wages paidby that employer. Under § 3101, FICAtax also is imposed on the employee.Under §§ 3121(a) and 3306(b), the term“wages” for FICA tax purposes andFUTA tax purposes, respectively, means,with certain exceptions, all remunerationfor employment. Under §§ 3121(b) and3306(c), “employment” is defined as anyservice, of whatever nature, performed byan employee for the person employinghim.

Consistent with this definition, § 31.3121(a)–1(c) of the Employment TaxRegulations provides that the name bywhich the remuneration for employmentis designated is immaterial. Section31.3121(a)–1(d) further provides thatgenerally, the basis upon which remu-neration is paid to an employee is imma-terial in determining whether the remu-neration constitutes wages under FICA.

No specific section of the Code orregulations excepts from wages amountspaid to employees for providing equip-ment used in the performance of servicesas an employee. However, amounts paidto employees for certain employee busi-ness expenses incurred in connection withsuch equipment are excluded from wagesif paid under a reimbursement or otherexpense allowance arrangement thatmeets the requirements of § 62(c).

Under § 1.62–2(c)(1) of the IncomeTax Regulations, a reimbursement orother expense allowance arrangement sat-isfies the requirements of § 62(c) if itmeets the requirements set forth in para-graphs (d), (e), and (f) of § 1.62–2 (busi-ness connection, substantiation, andreturn of excess). If an arrangement meets

2002–23 I.R.B. 1067 June 10, 2002

these requirements, all amounts paidunder the arrangement are treated as paidunder an accountable plan. § 1.62–2(c)(2)(i). Amounts paid under anaccountable plan are excluded from theemployee’s gross income, are notrequired to be reported on the employee’sForm W-2, and are exempt from the with-holding and payment of employmenttaxes. §§ 31.3121(a)–3, 31.3306(b)–2,31.3401(a)–4, and 1.6041–3(h)(1).

If an arrangement does not satisfy oneor more of these requirements, allamounts paid under the arrangement arepaid under a “nonaccountable plan.”Amounts paid under a nonaccountableplan are included in the employee’s grossincome for the taxable year, must bereported to the employee on Form W-2,and are subject to withholding and pay-ment of employment taxes. §§ 1.62–2(c)(5), 31.3121(a)–3(b)(2), 31.3306(b)–2(b)(2), 31.3401(a)–4(b)(2), and § 1.6041–3(h)(1). Additionally, § 1.62–2(k) pro-vides that if a payor’s reimbursement orother expense allowance arrangement evi-dences a pattern of abuse of the rules of§ 62(c) and the regulations thereunder, allpayments made under the arrangementwill be treated as made under a nonac-countable plan.

Rev. Rul. 68–624, 1968–2 C.B. 424,considered what portion of the totalamount paid by a corporation for the useof a truck and the services of a driver wasallocable as wages of the driver for fed-eral employment tax purposes. The driverhauled stone from the corporation’squarry to its river loading dock at a fixedamount per load. The corporation allo-cated one-third of the amount paid to theemployee as wages and two-thirds as pay-ment for the use of the truck. The rulingheld that an allocation of the amountspaid to an individual when the payment isfor both personal services and the use ofequipment must be governed by the factsin each case. If the contract of employ-ment did not specify a reasonable divisionof the total amount paid between wagesand equipment, a proper allocation couldhave been arrived at by reference to theprevailing wage scale in a particularlocality for similar services in operatingthe same class of equipment or the fairrental value of similar equipment.

Rev. Rul. 68–624 pre-dates the TaxReform Act of 1986 (TRA ’86), Pub. L.

99–514, and the Family Support Act of1988, Pub. L. 100–485, which limit thededuct ions of employee businessexpenses. Pursuant to section 132 of TRA’86, which added § 67 to the Code,employee business expenses are allowedonly as miscellaneous itemized deduc-tions, to the extent that the aggregate ofthose deductions exceeds 2 percent ofadjusted gross income. Section 62(c),which was enacted in the Family SupportAct of 1988, in part limits employee busi-ness expense reimbursements that can beexcluded from adjusted gross income tothose paid under an accountable plan.Further, Rev. Rul. 68–624 does notaddress whether the truck driver wasengaged in the trade or business of truckrental in addition to the trade or businessof being an employee.

An arrangement that merely allocatescompensation paid to an employeebetween wages and a reimbursement forbusiness expenses will not meet therequirements of § 62(c). For example, inShotgun Delivery, Inc. v. United States,269 F.3d 969 (9th Cir. 2001), the courtheld that a courier company’s arrange-ment that paid employee drivers 40 per-cent of the delivery charge rate less anhourly minimum wage payment did notmeet the business connection requirementbecause the drivers were reimbursedregardless of actual mileage driven orexpenses incurred. Accordingly, thearrangement was not a valid accountableplan under § 62(c).

CONCLUSION

Under the facts specified in Situations1 and 2, the amounts paid to employeesB, C, and D for providing equipment,including vehicles, used in performingservices for the employer as an employeeare not paid under an accountable plan.Each arrangement fails the business con-nection requirement because in each situ-ation the employer pays an amount to theemployee regardless of whether theemployee incurs (or is reasonablyexpected to incur) business expenses thatwould be deductible under §§ 161through 198. Each arrangement fails torequire the employee to substantiateemployee business expenses, as requiredby § 1.62–2(e). Finally, the arrangementsdo not require the return of excess asrequired under § 1.62–2(f).

HOLDING

In Situations 1 and 2, because theamounts paid to the employee for provid-ing equipment, including vehicles, for usein performing services as an employee arenot paid under an accountable plan, theyare wages subject to the withholding andpayment of income and employmenttaxes.

This ruling is not intended to provideguidance regarding the treatment of pay-ment for equipment, including vehicles,provided by independent contractors.

See Rev. Proc. 2002–41, publishedelsewhere in this Internal Revenue Bulle-tin, regarding a deemed substantiationrule for use in implementing an account-able plan in connection with reimburse-ments to certain employees for costs asso-ciated with providing welding rigs ormechanics rigs.

EFFECT ON OTHER REVENUERULINGS

This ruling revokes Rev. Rul. 68–624.

EFFECTIVE DATE

This revenue ruling is effective forpayments to employees after October 13,1988 (the date of enactment for § 62(c),as part of the Family Support Act of1988).

Under the authority of § 7805(b), ataxpayer that actually paid amounts sepa-rate from wages for the use of employee-provided equipment (such as described inSituation 1 and the truck described inRev. Rul. 68–624) and reported thesepayments on timely issued Forms 1099for calendar years beginning before Janu-ary 1, 2002, may continue to report thesepayments on Form 1099 for periods end-ing on or before December 31, 2002.

DRAFTING INFORMATION

The principal author of this revenueruling is Joe Spires of the Office of theDivision Counsel/Associate Chief Coun-sel (Tax Exempt and Government Enti-ties), IRS. However, other personnel fromthe IRS and Treasury Department partici-pated in its development. For furtherinformation regarding this revenue ruling,call Mr. Spires at (202) 622–6040 (not atoll-free number).

June 10, 2002 1068 2002–23 I.R.B.

Section 125.—Cafeteria Plans

(Also sections 106, 4980B.)

Cafeteria Plans. In an asset sale,transferred employees who have electedto participate in health flexible spendingarrangements (FSAs) under the seller’scafeteria plan may continue to excludesalary reduction amounts and medicalreimbursements from gross income with-out interruption at the same level of cov-erage after becoming employees of thebuyer.

Rev. Rul. 2002–32

ISSUE

In an asset sale, may transferredemployees who have elected to partici-pate in health flexible spending arrange-ments (FSAs) under seller’s I.R.C. § 125cafeteria plan continue that benefit with-out interruption at the same level of cov-erage after becoming employees ofbuyer?

FACTS

Situation (1). Employer S maintains acafeteria plan under section 125. One ofthe benefits available under the plan is ahealth FSA that provides for the reim-bursement of participating employees’medical care expenses that are not cov-ered by other insurance. To participate inthe health FSA, employees elect pre-taxsalary reduction for the right to receivemedical care expense reimbursementsduring the plan year up to a maximumamount equal to the amount of the reduc-tion elected for the year. Employer B isan unrelated business entity.

During a plan year, S and B enter intoan agreement under which B acquires aportion of the assets of S and, as part ofthe acquisition, employees of S who workin connection with the acquired assets ter-minate employment with S and are trans-ferred to and become employees of B.Employer B has, or agrees to create, acafeteria plan that offers a health FSAthrough pre-tax salary reduction. It is theobjective of both S and B that the admin-istration of the transferred employees’health FSAs following the asset sale haveas little impact on the transferred employ-

ees as possible. Following the sale, S willcontinue its business operations, includ-ing its health FSA. S and B agree that thetransferred employees who have electedto participate in S’s FSA will continue inS’s FSA for the agreed upon period. S andB also agree on the extent, if any, towhich the existing salary reduction elec-tions made by the transferred employeesfor the FSAs under S’s plan will continueas if made under B’s plan.

Situation (2). Same facts as in Situa-tion (1) except that, as part of the sale, Bagrees to cover the transferred employeeswho have elected to participate in S’shealth FSA under B’s health FSA. UnderB’s health FSA, the transferred employ-ees will have the same level of coverageprovided under S’s health FSA and willbe treated as if their participation hadbeen continuous from the beginning ofS’s plan year. The transferred employees’existing salary reduction elections will betaken into account for the remainder ofB’s plan year as if made under B’s healthFSA. To implement this arrangement, Bamends its plan documents to provide thattransferred employees who elected to par-ticipate in S’s health FSA become partici-pants in B’s health FSA as of the begin-ning of S’s plan year and at the level ofcoverage provided under S’s health FSA,except that transferred employees whocontinue participation in S’s health FSAafter the sale (e.g., by election of COBRAcontinuation coverage) are not covered byB’s health FSA for that year. In addition,B’s health FSA is amended to provide forreimbursement of medical care expensesincurred by the transferred employees atany time during S’s plan year (includingclaims incurred before the sale), up to theamount of the employees’ election andreduced by amounts previously reim-bursed by S. Thus, medical care expensesincurred prior to the closing date of thesale but not previously reimbursed as wellas medical care expenses incurred afterthe closing date of the sale are reimburs-able under B’s health FSA. S amends itsplan documents to provide that the trans-ferred employees cease to be eligible formedical care expense reimbursementsfrom S as of the closing date, except tothe extent of any COBRA continuationcoverage election. S and B have deter-mined that the agreements between themare consistent with applicable law.

LAW AND ANALYSIS

In general, section 106(a) provides thatgross income of an employee does notinclude employer-provided coverageunder an accident or health plan. Undersection 105(b), an employee may excludeamounts received through employer-provided accident or health insurance ifthose amounts are paid to reimburseexpenses incurred by the employee dur-ing the period of coverage for medicalcare (of the employee, the employee’sspouse, or the employee’s dependents) forpersonal injuries or sickness.

Section 125(a) states that no amountwill be included in the gross income of aparticipant in a cafeteria plan solelybecause, under the plan, the participantmay choose among the benefits in theplan.

Section 125(d) defines a cafeteria planas a written benefit plan under which allparticipants are employees, and the par-ticipants may choose among two or morebenefits consisting of cash and certainqualified benefits.

Section 125(f) defines qualified ben-efits as any benefit not includible in thegross income of the employee by reasonof an express provision of Chapter 1 ofthe Code other than certain specified ben-efits that are not qualified benefits. Aqualified benefit includes employer-provided accident or health coverageunder section 106(a) and reimbursementsfor medical care expenses under section105(b).

Section 1.125–4 of the Income TaxRegulations provides the circumstancesunder which an employer can permit acafeteria plan participant to change anexisting election during a period of cover-age and make a new election for theremaining portion of the period of cover-age. Generally, cafeteria plan participantsare permitted to make election changes ifthere has been a change in status eventand the election change satisfies the con-sistency rule. An election change satisfiesthe consistency rule with respect to acci-dent or health coverage only if the elec-tion change is on account of and corre-sponds with a change in status that affectseligibility for coverage under an employ-er’s plan.

2002–23 I.R.B. 1069 June 10, 2002

Under the asset sale described in bothSituation (1), where transferred employ-ees maintain their existing health FSAsunder S’s cafeteria plan, and in Situation(2), where B agrees to cover the trans-ferred employees who have elected toparticipate in S’s health FSA, there is noloss of eligibility for coverage under§ 1.125–4. Therefore, transferred employ-ees continue to be subject to their existingFSA elections and may not change thoseelections during the remainder of the planyear of the asset sale (unless an eventoccurs thereafter which permits an elec-tion change under § 1.125–4).

For COBRA purposes, transferredemployees in Situation (1) do not suffer aloss of coverage under S’s FSA during theplan year. Consequently, if S’s FSA satis-fies the requirements of Q&A-8(c) in§ 54.4980B–2, there is no obligation tomake COBRA continuation coverageavailable to the transferred employeeswith respect to their coverage under S’sFSA. However, if S’s FSA does not sat-isfy the requirements of Q&A-8(c) in§ 54.4980B–2 and is otherwise subject toCOBRA, then it will be obligated tomake COBRA continuation coverageavailable beginning on the first day of theplan year after the current plan year. Foradditional information, see § 54.4980B–2,Q&A-8 and § 54.4980B–9. In Situation(2), the obligation of S to extend toCOBRA qualified beneficiaries the rightto elect COBRA continuation coverage isnot affected by the coverage provided byB.

HOLDING

In an asset sale, transferred employeeswho have elected to participate in healthFSAs under seller’s cafeteria plan maycontinue to exclude the salary reductionamounts and medical expense reimburse-ments from gross income without inter-ruption and at the same level of coverageafter becoming employees of buyer eitherwhen seller agrees to continue its existinghealth FSAs for the transferred employ-ees as described in Situation (1) or whenbuyer agrees to adopt a continuation ofseller’s health FSAs for the transferredemployees as described in Situation (2).

EFFECT ON OTHER REVENUERULING(S)

None

DRAFTING INFORMATION

The principal author of this revenueruling is Shoshanna Chaiton of the Officeof Division Counsel/Associate ChiefCounsel (Tax Exempt and GovernmentEntities). For further information regard-ing this revenue ruling, contact her at(202) 622–6080 (not a toll-free call).

Section 172.—Net OperatingLoss Deduction

Procedures are provided that certaintaxpayers with net operating lossesincurred in 2001 or 2002 must follow onor before October 31, 2002, if they wishto apply, or elect out of, the new 5-yearcarryback period enacted by section 102of the Job Creation and Worker Assis-tance Act of 2002. See Rev. Proc. 2002–40, page 1096.

Section 460.—Special Rulesfor Long-Term Contracts

26 CFR 1.460–4: Methods of accounting for long-term contracts.

T.D. 8995

DEPARTMENT OF THETREASURYInternal Revenue Service26 CFR Parts 1 and 602

Mid-Contract Change inTaxpayer

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document containsfinal regulations concerning a mid-contract change in taxpayer of a contractaccounted for under a long-term contractmethod of accounting. A taxpayer that isa party to such a contract will be affectedby these regulations.

DATES: Effective Date: These regula-tions are effective May 15, 2002.

Applicability Date: These regulationsapply to transactions on or after May 15,2002.

FOR FURTHER INFORMATION CON-TACT: John Aramburu at (202) 622–4960(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information con-tained in these final regulations has beenreviewed and approved by the Office ofManagement and Budget in accordancewith the Paperwork Reduction Act of1995 (44 U.S.C. 3507(d)) under controlnumber 1545–1732.

The collection of information in thesefinal regulations is in § 1.460–6(g)(3)(ii)(D). This information isrequired to enable taxpayers to makelook-back computations when the incomefrom a long-term contract has been previ-ously reported by another taxpayer.

An agency may not conduct or spon-sor, and a person is not required torespond to, a collection of informationunless it displays a valid control number.

The estimated average annual disclo-sure burden per respondent is 2 hours.

Comments concerning the accuracy ofthis burden estimate and suggestions forreducing this burden should be sent to theInternal Revenue Service, Attn: IRSReports Clearance Officer, W:CAR:MP:FP, Washington, DC 20224, and tothe Office of Management and Budget,Attn: Desk Officer for the Department ofthe Treasury, Office of Information andRegulatory Affairs, Washington, DC20503.

Books or records relating to a collec-tion of information must be retained aslong as their contents might becomematerial in the administration of anyinternal revenue law. Generally, taxreturns and tax return information areconfidential, as required by 26 U.S.C.6103.

Background

Section 460 generally requires thatlong-term contracts be accounted for

June 10, 2002 1070 2002–23 I.R.B.

under the percentage-of-completionmethod (PCM), under which a taxpayermust recognize income according to theestimated percentage of the contract thatis completed during each taxable year andmake a look-back computation of interestto compensate the government (or thetaxpayer) for any underestimation (oroverestimation) of income from the con-tract. However, home construction con-tracts and certain contracts of smallerconstruction contractors are exempt fromthese requirements. Moreover, residentialbuilders are entitled to use the 70/30percentage-of-completion/capitalized costmethod (PCCM), and certain shipbuildersare entitled to use the 40/60 PCCM. Along-term contract or a portion of a long-term contract that is exempt from thePCM may be accounted for under anypermissible method, including the com-pleted contract method (CCM), underwhich a taxpayer does not report incomeuntil a contract is complete, even thoughprogress payments are received in yearsprior to completion.

This document contains amendmentsto 26 CFR part 1. On February 16, 2001,a notice of proposed rulemaking (REG–105946–00, 2001–1 C.B. 1069) relatingto a mid-contract change in taxpayer of acontract accounted for under a long-termcontract method of accounting was pub-lished in the Federal Register (66 FR10643). Written comments were receivedfrom the public in response to the noticeof proposed rulemaking. No public hear-ing was requested or held. After consider-ation of all comments, the proposed regu-lations are adopted as amended by thisTreasury decision.

Explanation and Summary ofComments

The proposed regulations divide therules regarding a mid-contract change intaxpayer of a contract accounted forunder a long-term contract method ofaccounting into two categories—constructive completion transactions andstep-in-the-shoes transactions. Generally,a constructive completion transactionresults in the taxpayer originally account-ing for the long-term contract (old tax-payer) recognizing income from the con-tract based on a contract price that takesinto account any amounts realized fromthe transaction or paid by the old taxpayer

to the taxpayer subsequently accountingfor the long-term contract (new taxpayer)that are allocable to the contract. Simi-larly, the new taxpayer in a constructivecompletion transaction is treated asthough it entered into a new contract as ofthe date of the transaction, with the con-tract price taking into account the pur-chase price and any amount paid by theold taxpayer that is allocable to the con-tract. In the case of a step-in-the-shoestransaction, the old taxpayer’s obligationto account for the contract terminates onthe date of the transaction and is assumedby the new taxpayer. The new taxpayermust assume the old taxpayer’s methodsof accounting for the contract, with boththe contract price and allocable contractcosts based on amounts taken intoaccount by both parties.

Commentators raised concerns regard-ing the general application of step-in-the-shoes treatment to contracts of S corpora-tions accounted for using the CCM. Forexample, these commentators were con-cerned with the potential for income shift-ing that can occur when the stock of an Scorporation that is accounting for a long-term contract using the CCM is sold to aparty with a lower marginal tax rate or toa tax indifferent shareholder. Similarly,income from a CCM contract could beshifted to a party with a lower tax rate ora tax indifferent party by making an Selection or transferring the contract in asection 351 transaction, followed by an Selection and a sale of stock. To preventsuch a shifting of income, these commen-tators generally recommend that thetransferor be required to apply the PCMto CCM contracts in progress as of thetransaction date.

While these commentators’ concernsand recommendations relate solely toCCM contracts, the potential for suchincome shifting also exists with PCMcontracts due to the fact that recognitionof income under both the PCM and theCCM does not correspond to the receiptof progress payments. In addition, manyof the commentators’ concerns are notunique to the section 460 regulations assimilar opportunities are presented when-ever an S corporation or an electing Scorporation has assets with built-in gainor loss. Moreover, adoption of the com-mentators’ recommendation would triggertax as of the transaction date and thus

would be inconsistent with the policy ofproviding for tax-free reorganizations ofgoing concerns. Thus, the commentators’proposals for addressing this potentialabuse were not adopted. However, as inthe proposed regulations, the final regula-tions contain an anti-abuse rule that isdesigned to prevent such income shifting.

Commentators suggested that for pur-poses of the section 1374 built-in gainrules applicable to S corporation elec-tions, long-term contracts should be val-ued at the amount of income reportableunder the PCM on the date of the elec-tion. The section 1374 regulations cur-rently measure recognized built-in gainattributable to a long-term contractaccounted for using the CCM based onthe amount of income reportable underthe PCM on the date of the election. See§ 1.1374–4(g). These final regulations,however, do not provide a specific rule todetermine the value of a long-term con-tract because the fair market value of along-term contract reflects a variety offactors, including the amount earned bythe old taxpayer as compared to theprogress payments received and retainedby the old taxpayer, and the new taxpay-er’s estimates of future revenues andcosts.

One commentator pointed out thatwhile the preamble indicates the treat-ment of partnership transactions (i.e.,transactions described in sections 721 and731, and transfers of partnership interests)have been reserved, the proposed regula-tions, by default, place these transactionsin the taxable, constructive completioncategory. This commentator suggestedthat the regulations reserve the treatmentof partnership transactions and provideonly that taxpayers use reasonable meth-ods.

The final regulations provide that acontribution to a partnership in a transac-tion described in section 721(a), a transferof a partnership interest, and a distribu-tion by a partnership to which section 731applies (other than a distribution of a con-tract accounted for using a long-term con-tract method of accounting) are step-in-the-shoes transact ions. The finalregulations, however, reserve on the spe-cial rules that will apply to such transfers.As described in Notice 2002–37, 2002–23I.R.B. 1030, the IRS and TreasuryDepartment intend to publish regulations

2002–23 I.R.B. 1071 June 10, 2002

that will set forth the special rules thatwill apply to such partnership transac-tions in a separate project. These regula-tions will be effective for contributions oflong-term contracts to partnerships andtransfers of interests in partnerships thatare engaged in long-term contracts on orafter May 15, 2002.

One commentator objected to therequired use of the simplified marginalimpact method of computing look backinterest in the case of a step-in-the-shoestransaction. In response to this comment,the final regulations give taxpayers theoption of using this method withoutrequiring it, except in those cases inwhich the existing regulations require itsuse. See § 1.460–6(d)(4).

Questions have arisen as to whetherthe implementation of these rules requiresa taxpayer to request a change in methodof accounting by filing a Form 3115,“Application for Change in AccountingMethod.” In response to these questions,the final regulations clarify that the appli-cation of these rules to a transactionoccurring after the effective date is not achange in method of accounting and,therefore, does not require the filing ofForm 3115.

In addition to changes made inresponse to the comments and questionsdescribed above, the final regulationsclarify the application of the step-in-the-shoes rules to certain transfers of con-tracts that result in the old taxpayer rec-ognizing income with respect to thecontract. Specifically, the final regula-tions explain how the old taxpayer calcu-lates the gain realized with respect to thecontract in these transactions, clarify theoperation of the basis adjustment rule incertain cases of successive transfers of acontract, and provide that the contractprice of a new taxpayer should bereduced to the extent that the old taxpayerrecognizes income with respect to thecontract in connection with these transac-tions. The final regulations also clarifythat a taxpayer is not entitled to a loss inthe amount of its basis in the contract(including the uncompleted property, ifapplicable) where that basis is determinedunder section 362 or 334. In addition, tothe extent the basis of the contract(including the uncompleted property, ifapplicable) reflects the old taxpayer’s rec-ognition of income attributable to the

contract in the step-in-the-shoes transac-tion, such income recognition reduces thetotal contract price. Accordingly, the newtaxpayer recovers this additional basisover the time that it performs the con-tract. To the extent the basis of the con-tract (including the uncompleted property,if applicable) reflects costs incurred bythe old taxpayer that have not yet beendeducted (i.e., in the case of a CCM con-tract), such costs will give rise to a deduc-tion upon completion of the contract.Therefore, disallowing the new taxpayer aloss for its basis in the contract (includingthe uncompleted property, if applicable)is necessary to prevent the new taxpayerfrom benefitting twice from the sameitem. Finally, the final regulations includenew examples to illustrate these rules.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. 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) does not apply to these regula-tions. It is hereby certified that the collec-tion of information in this Treasury deci-sion will not have a significant economicimpact on a substantial number of smallentities. This certification is based on thefact that the relevant information isalready maintained by taxpayers. There-fore, a Regulatory Flexibility Analysisunder the Regulatory Flexibility Act (5U.S.C. chapter 6) is not required. Pursu-ant to section 7805(f) of the Code, theproposed regulations preceding theseregulations were submitted to the ChiefCounsel for Advocacy of the Small Busi-ness Administration for comment on theirimpact on small business.

Drafting Information

The principal author of these regula-tions is John Aramburu, Office of Associ-ate Chief Counsel (Income Tax andAccounting). However, other personnelfrom the IRS and Treasury Departmentparticipated in their development.

* * * * *Adoption of Amendments to theRegulations

Accordingly, 26 CFR part 1 isamended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. In § 1.358–1, a sentence is

added at the end of paragraph (a) to readas follows:

§ 1.358–1 Basis to distributees.

(a) * * * See § 1.460–4(k)(3)(iv)(A)for rules relating to stock basis adjust-ments required where a contractaccounted for using a long-term contractmethod of accounting is transferred in atransaction described in section 351 or areorganization described in section368(a)(1)(D) with respect to which therequirements of section 355 (or so muchof section 356 as relates to section 355)are met.

* * * * *

Par. 3. In § 1.334–1, a sentence isadded at the end of paragraph (b) to readas follows:

§ 1.334–1 Basis of property received inliquidations.

* * * * *(b) * * * See § 1.460–4(k)(3)(iv)(B)(2)

for rules relating to adjustments to thebasis of certain contracts accounted forusing a long-term contract method ofaccounting that are acquired in certainliquidations described in section 332.

* * * * *Par. 4. In § 1.362–1, a sentence is

added at the end of paragraph (a) to readas follows:

§ 1.362–1 Basis to corporations.

(a) * * * See § 1.460–4(k)(3)(iv)(B)(2)for rules relating to adjustments to thebasis of certain contracts accounted forusing a long-term contract method ofaccounting that are acquired in certaintransfers described in section 351 and cer-tain reorganizations described in section368(a).

* * * * *

June 10, 2002 1072 2002–23 I.R.B.

Par. 5. In § 1.381(c)(4)–1, a sentenceis added at the end of paragraph (a)(2) toread as follows:

§ 1.381(c)(4)–1 Method of accounting.

(a) * * *(2) * * *See § 1.460–4(k) for rules

relat ing to transfers of contractsaccounted for using a long-term contractmethod of accounting in a transaction towhich section 381 applies.

* * * * *Par. 6. Section 1.460–0 is amended by:1. Revising the entry for paragraph (k)

of § 1.460–4.2. Adding entries for paragraphs (k)(1)

through (k)(6) of § 1.460–4.3. Adding entries for paragraphs (g)

through (g)(4) of § 1.460–6.

§ 1.460–0 Outline of regulations undersection 460.

* * * * *

§ 1.460–4 Methods of accounting forlong-term contracts.

* * * * *(k) Mid-contract change in taxpayer.(1) In general.(2) Constructive completion transactions.(i) Scope.(ii) Old taxpayer.(iii) New taxpayer.(iv) Special rules relating to distributionsof certain contracts by a partnership.[Reserved.](3) Step-in-the-shoes transactions.(i) Scope.(ii) Old taxpayer.(A) In general.(B) Gain realized on the transaction.(iii) New taxpayer.(A) Method of accounting.(B) Contract price.(C) Contract costs.(iv) Special rules related to certain corpo-rate transactions.(A) Old taxpayer — basis adjustment.(1) In general.(2) Basis adjustment in excess of stockbasis.(3) Subsequent dispositions of certaincontracts.(B) New taxpayer.

(1) Contract price adjustment.(2) Basis in contract.(v) Special rules related to certain part-nership transactions. [Reserved.](4) Anti-abuse rule.(5) Examples.(6) Effective date.

* * * * *

§ 1.460–6 Look-back method.

* * * * *(g) Mid-contract change in taxpayer.(1) In general.(2) Constructive completion transactions.(3) Step-in-the-shoes transactions.(i) General rules.(ii) Application of look-back method topre-transaction period.(A) Contract Price(B) Method.(C) Interest accrual period.(D) Information old taxpayer must pro-vide.(iii) Application of look-back method topost-transaction years.(iv) S corporation elections.(4) Effective date.

* * * * *

Par. 7. Section 1.460–4 is amended by:1. Adding a sentence at the end of

paragraph (a).2. Adding paragraph (k).The additions read as follows:

§ 1.460–4 Methods of accounting forlong-term contracts.

(a) * * * Finally, paragraph (k) of thissection provides rules relating to a mid-contract change in taxpayer of a contractaccounted for using a long-term contractmethod of accounting.

* * * * *(k) Mid-contract change in taxpayer

— (1) In general. The rules in this para-graph (k) apply if prior to the completionof a long-term contract accounted forusing a long-term contract method by ataxpayer (old taxpayer), there is a transac-tion that makes another taxpayer (newtaxpayer) responsible for accounting forincome from the same contract. For pur-poses of this paragraph (k) and § 1.460–6(g), an old taxpayer also includes any

old taxpayer(s) (e.g., predecessors) of theold taxpayer. In addition, a change in sta-tus from taxable to tax exempt or fromdomestic to foreign, or vice versa, will beconsidered a change in taxpayer. Finally,a contract will be treated as the same con-tract if the terms of the contract are notsubstantially changed in connection withthe transaction, whether or not the cus-tomer agrees to release the old taxpayerfrom any or all of its obligations underthe contract. The rules governing con-structive completion transactions are pro-vided in paragraph (k)(2) of this section,while the rules governing step-in-the-shoes transactions are provided in para-graph (k)(3) of this section. Special rulesrelated to the treatment of certain partner-ship transactions are reserved under para-graphs (k)(2)(iv) and (k)(3)(v) of this sec-tion. For application of the look-backmethod to mid-contract changes in tax-payers for contracts accounted for usingthe PCM, see § 1.460–6(g).

(2) Constructive completion transac-tions — (i) Scope. The constructivecompletion rules in this paragraph (k)(2)apply to transactions (constructivecompletion transactions) that result in achange in the taxpayer responsible forreporting income from a contract and thatare not described in paragraph (k)(3)(i) ofthis section. Constructive completiontransactions generally include, forexample, taxable sales under section 1001and deemed asset sales under section 338.

(ii) Old taxpayer. The old taxpayer istreated as completing the contract on thedate of the transaction. The total contractprice (or, gross contract price in the caseof a long-term contract accounted forunder the CCM) for the old taxpayer isthe sum of any amounts realized from thetransaction that are allocable to the con-tract and any amounts the old taxpayerhas received or reasonably expects toreceive under the contract. Total contractprice (or gross contract price) is reducedby any amount paid by the old taxpayerto the new taxpayer, and by any transac-tion costs, that are allocable to the con-tract. Thus, the old taxpayer’s allocablecontract costs determined under para-graph (b)(5) of this section do not includeany consideration paid, or costs incurred,as a result of the transaction that are allo-cable to the contract. In the case of a

2002–23 I.R.B. 1073 June 10, 2002

transaction subject to section 338 or1060, the amount realized from the trans-action allocable to the contract is deter-mined by using the residual method under§§ 1.338–6 and 1.338–7.

(iii) New taxpayer. The new taxpayeris treated as entering into a new contracton the date of the transaction. The newtaxpayer must evaluate whether the newcontract should be classified as a long-term contract within the meaning of§ 1.460–1(b) and account for the contractunder a permissible method of account-ing. For a new taxpayer who accounts fora contract using the PCM, the total con-tract price is any amount the new tax-payer reasonably expects to receive underthe contract consistent with paragraph(b)(4) of this section. Total contract priceis reduced by the amount of any consid-eration paid by the new taxpayer as aresult of the transaction, and by any trans-action costs, that are allocable to the con-tract and is increased by the amount ofany consideration received by the newtaxpayer as a result of the transaction thatis allocable to the contract. Similarly, thegross contract price for a contractaccounted for using the CCM is allamounts the new taxpayer is entitled bylaw or contract to receive consistent withparagraph (d)(3) of this section, adjustedfor any consideration paid (or received)by the new taxpayer as a result of thetransaction, and for any transaction costs,that are allocable to the contract. Thus,the new taxpayer’s allocable contractcosts determined under paragraph (b)(5)of this section do not include any consid-eration paid, or costs incurred, as a resultof the transaction that are allocable to thecontract. In the case of a transaction sub-ject to sections 338 or 1060, the amountof consideration paid that is allocable tothe contract is determined by using theresidual method under §§ 1.338–6 and1.338–7.

(iv) Special rules relating to distribu-tions of certain contracts by a partner-ship. [Reserved]

(3) Step-in-the-shoes transactions —(i) Scope. The step-in-the-shoes rules inthis paragraph (k)(3) apply to the follow-ing transactions that result in a change inthe taxpayer responsible for reportingincome from a contract accounted for

using a long-term contract method ofaccounting (step-in-the-shoes transac-tions) —

(A) Transfers to which section 361applies if the transfer is in connectionwith a reorganization described in section368(a)(1)(A), (C) or (F);

(B) Transfers to which section 361applies if the transfer is in connectionwith a reorganization described in section368(a)(1)(D) or (G), provided the require-ments of section 354(b)(1)(A) and (B) aremet;

(C) Distributions to which section 332applies, provided the contract is trans-ferred to an 80-percent distributee;

(D) Transfers described in section 351;(E) Transfers to which section 361

applies if the transfer is in connectionwith a reorganization described in section368(a)(1)(D) with respect to which therequirements of section 355 (or so muchof section 356 as relates to section 355)are met;

(F) Transfers (e.g., sales) of S corpora-tion stock;

(G) Conversion to or from an S corpo-ration;

(H) Members joining or leaving a con-solidated group;

(I) Contributions to which section721(a) applies;

(J) Transfers of partnership interests;(K) Distributions to which section 731

applies (other than the distribution of thecontract); and

(L) Any other transaction designated inthe Internal Revenue Bulletin by theInternal Revenue Service. See § 601.601(d)(2)(ii) of this chapter.

(ii) Old taxpayer — (A) In general.The new taxpayer will “step into theshoes” of the old taxpayer with respect tothe contract. Thus, the old taxpayer’sobligation to account for the contract ter-minates on the date of the transaction andis assumed by the new taxpayer, as setforth in paragraph (k)(3)(iii) of this sec-tion. As a result, an old taxpayer using thePCM is required to recognize incomefrom the contract based on the cumulativeallocable contract costs incurred as of thedate of the transaction. Similarly, an oldtaxpayer using the CCM is not required torecognize any revenue and may not

deduct allocable contract costs incurredwith respect to the contract.

(B) Gain realized on the transaction.The amount of gain the old taxpayer real-izes on the transfer of a contract in a step-in-the-shoes transaction must be deter-mined after application of paragraph(k)(3)(ii)(A) of this section using the rulesof paragraph (k)(2) of this section thatapply to constructive completion transac-tions. (The amount of gain realized on atransfer of a contract is relevant, forexample, in determining the amount ofgain recognized with respect to the con-tract in a section 351 transaction in whichthe old taxpayer receives from the newtaxpayer money or property other thanstock of the transferee.)

(iii) New taxpayer — (A) Method ofaccounting. Beginning on the date of thetransaction, the new taxpayer mustaccount for the long-term contract byusing the same method of accountingused by the old taxpayer prior to thetransaction. The same method of account-ing must be used for such contract regard-less of whether the old taxpayer’s methodis the new taxpayer’s principal method ofaccounting under § 1.381(c)(4)–1(b)(3) orwhether the new taxpayer is otherwiseeligible to use the old taxpayer’s method.Thus, if the old taxpayer uses the PCM toaccount for the contract, the new taxpayersteps into the shoes of the old taxpayerwith respect to its completion factor andpercentage of completion methods (suchas the 10-percent method), even if thenew taxpayer has not elected such meth-ods for similarly classified contracts.Similarly, if the old taxpayer uses theCCM, the new taxpayer steps into theshoes of the old taxpayer with respect tothe CCM, even if the new taxpayer is nototherwise eligible to use the CCM. How-ever, the new taxpayer is not necessarilybound by the old taxpayer’s method forsimilarly classified contracts entered intoby the new taxpayer subsequent to thetransaction and must apply general taxprinciples, including section 381, to deter-mine the appropriate method to accountfor these subsequent contracts. To theextent that general tax principles allowthe taxpayer to account for similarly clas-sified contracts using a method other thanthe old taxpayer’s method, the taxpayer is

June 10, 2002 1074 2002–23 I.R.B.

not required to obtain the consent of theCommissioner to begin using such othermethod.

(B) Contract price. In the case of along-term contract that has beenaccounted for under PCM, the total con-tract price for the new taxpayer is the sumof any amounts the old taxpayer or thenew taxpayer has received or reasonablyexpects to receive under the contract con-sistent with paragraph (b)(4) of this sec-tion. Similarly, the gross contract price inthe case of a long-term contractaccounted for under the CCM includes allamounts the old taxpayer or the new tax-payer is entitled by law or by contract toreceive consistent with paragraph (d)(3)of this section.

(C) Contract costs. Total allocablecontract costs for the new taxpayer arethe allocable contract costs as definedunder paragraph (b)(5) of this sectionincurred by either the old taxpayer priorto, or the new taxpayer after, the transac-tion. Thus, any payments between the oldtaxpayer and the new taxpayer withrespect to the contract in connection withthe transaction are not treated as allocablecontract costs.

(iv) Special rules related to certaincorporate transactions—(A) Old tax-payer—basis adjustment—(1) In general.Except as provided in paragraph(k)(3)(iv)(A)(2) of this section, in thecase of a transaction described in para-graph (k)(3)(i)(D) or (E) of this section,the old taxpayer must adjust its basis inthe stock of the new taxpayer by—

(i) Increasing such basis by the amountof gross receipts the old taxpayer has rec-ognized under the contract; and

(ii) Reducing such basis by the amountof gross receipts the old taxpayer hasreceived or reasonably expects to receiveunder the contract.

(2) Basis adjustment in excess of stockbasis. If the old and new taxpayer do notjoin in the filing of a consolidated Federalincome tax return, the old taxpayer maynot adjust its basis in the stock of the newtaxpayer under paragraph (k)(3)(iv)(A)(1)of this section below zero and the old tax-payer must recognize ordinary income tothe extent the basis in the stock of thenew taxpayer otherwise would beadjusted below zero. If the old and newtaxpayer join in the filing of a consoli-dated Federal income tax return, the old

taxpayer must create an (or increase anexisting) excess loss account to the extentthe basis in the stock of the new taxpayerotherwise would be adjusted below zerounder paragraph (k)(3)(iv)(A)(1) of thissection. See §§ 1.1502–19 and 1.1502–32(a)(3)(ii).

(3) Subsequent dispositions of certaincontracts. If the old taxpayer disposes ofa contract in a transaction described inparagraph (k)(3)(i)(D) or (E) of this sec-tion that the old taxpayer acquired in atransaction described in paragraph(k)(3)(i)(D) or (E) of this section, thebasis adjustment rule of this paragraph(k)(3)(iv)(A) is applied by treating the oldtaxpayer as having recognized the amountof gross receipts recognized by the previ-ous old taxpayer under the contract andany amount recognized by the previousold taxpayer with respect to the contractin connection with the transaction inwhich the old taxpayer acquired the con-tract. In addition, the old taxpayer istreated as having received or as reason-ably expecting to receive under the con-tract any amount the previous old tax-payer received or reasonably expects toreceive under the contract. Similar prin-ciples will apply in the case of multiplesuccessive transfers described in para-graph (k)(3)(i)(D) or (E) of this sectioninvolving the contract.

(B) New Taxpayer—(1) Contract priceadjustment. Generally, payments betweenthe old taxpayer and the new taxpayerwith respect to the contract in connectionwith the transaction do not affect the con-tract price. Notwithstanding the precedingsentence and paragraph (k)(3)(iii)(B) ofthis section, however, in the case of trans-act ions described in paragraph(k)(3)(i)(B), (D) or (E) of this section, thetotal contract price (or gross contractprice) must be reduced to the extent ofany amount recognized by the old tax-payer with respect to the contract in con-nection with the transaction (e.g., anyamount recognized under section 351(b)or 357 that is attributable to the contractand any income recognized by the oldtaxpayer pursuant to the basis adjustmentrule of paragraph (k)(3)(iv)(A)).

(2) Basis in Contract. The new taxpay-er’s basis in a contract (including theuncompleted property, if applicable)acquired in a transaction described inparagraphs (k)(3)(i)(A) through (E) of

this section will be computed under sec-tion 362 or section 334, as applicable.Upon a new taxpayer’s completion(actual or constructive) of a CCM or aPCM contract acquired in a transactiondescribed in paragraphs (k)(3)(i)(A)through (E) of this section, the new tax-payer’s basis in the contract (includingthe uncompleted property, if applicable)is reduced to zero. The new taxpayer isnot entitled to a deduction or loss in con-nection with any basis reduction pursuantto this paragraph (k)(3)(iv)(B)(2).

(v) Special rules related to certainpartnership transactions. [Reserved]

(4) Anti-abuse rule. Notwithstandingthis paragraph (k), in the case of a trans-action entered into with a principal pur-pose of shifting the tax consequencesassociated with a long-term contract in amanner that substantially reduces theaggregate U.S. Federal income tax liabil-ity of the parties with respect to that con-tract, the Commissioner may allocate tothe old (or new) taxpayer the incomefrom that contract properly allocable tothe old (or new) taxpayer. For example,the Commissioner may reallocate incomefrom a long-term contract in a transactionin which a contract accounted for usingthe CCM, or using the PCM where theold taxpayer has received advance pay-ments in excess of its contribution to thecontract, is transferred to a tax indifferentparty (e.g., a foreign person not subject toU.S. Federal income tax).

(5) Examples. The following examplesillustrate the rules of this paragraph (k).For purposes of these examples, it isassumed that the contract is a long-termconstruction contract accounted for usingthe PCM prior to the transaction unlessstated otherwise and the contract is nottransferred with a principal purpose ofshifting the tax consequences associatedwith a long-term contract in a manner thatsubstantially reduces the aggregate U.S.Federal income tax liability of the partieswith respect to that contract. Theexamples are as follows:

Example 1. Constructive completion—PCM—(i) Facts. In Year 1, X enters into a contract. Thetotal contract price is $1,000,000 and the estimatedtotal allocable contract costs are $800,000. In Year1, X incurs costs of $200,000. In Year 2, X incursadditional costs of $400,000 before selling the con-tract as part of a taxable sale of its business in Year2 to Y, an unrelated party. At the time of sale, X hasreceived $650,000 in progress payments under thecontract. The consideration allocable to the contract

2002–23 I.R.B. 1075 June 10, 2002

under section 1060 is $150,000. Pursuant to the sale,the new taxpayer Y immediately assumes X’s con-tract obligations and rights. Y is required to accountfor the contract using the PCM. In Year 2, Y incursadditional allocable contract costs of $50,000. Y cor-rectly estimates at the end of Year 2 that it will haveto incur an additional $75,000 of allocable contractcosts in Year 3 to complete the contract.

(ii) Old taxpayer. For Year 1, X reports receiptsof $250,000 (the completion factor multiplied bytotal contract price ($200,000/$800,000 x$1,000,000)) and costs of $200,000, for a profit of$50,000. X is treated as completing the contract inYear 2 because it sold the contract. For purposes ofapplying the PCM in Year 2, the total contract priceis $800,000 (the sum of the amounts received underthe contract and the amount realized in the sale($650,000 + $150,000)) and the total allocable con-tract costs are $600,000 (the sum of the costsincurred in Year 1 and Year 2 ($200,000 +$400,000)). Thus, in Year 2, X reports receipts of$550,000 (total contract price minus receipts alreadyreported ($800,000 - $250,000)) and costs incurredin year 2 of $400,000, for a profit of $150,000.

(iii) New taxpayer. Y is treated as entering intoa new contract in Year 2. The total contract price is$200,000 (the amount remaining to be paid underthe terms of the contract less the consideration paidallocable to the contract ($1,000,000 - $650,000 -$150,000)). The estimated total allocable contractcosts at the end of Year 2 are $125,000 (the allo-cable contract costs that Y reasonably expects toincur to complete the contract ($50,000 + $75,000)).In Year 2, Y reports receipts of $80,000 (the comple-tion factor multiplied by the total contract price[($50,000/$125,000) x $200,000] and costs of$50,000 (the costs incurred after the purchase), for aprofit of $30,000. For Year 3, Y reports receipts of$120,000 (total contract price minus receipts alreadyreported ($200,000 - $80,000)) and costs of$75,000, for a profit of $45,000.

Example 2. Constructive completion—CCM—(i) Facts. The facts are the same as in Example 1,except that X and Y properly account for the con-tract under the CCM.

(ii) Old taxpayer. X does not report any incomeor costs from the contract in Year 1. In Year 2, thecontract is deemed complete for X, and X reports itsgross contract price of $800,000 (the sum of theamounts received under the contract and the amountrealized in the sale ($650,000 + $150,000)) and itstotal allocable contract costs of $600,000 (the sumof the costs incurred in Year 1 and Year 2 ($200,000+ $400,000)) in that year, for a profit of $200,000.

(iii) New taxpayer. Y is treated as entering intoa new contract in Year 2. Under the CCM, Y reportsno gross receipts or costs in Year 2. Y reports itsgross contract price of $200,000 (the amountremaining to be paid under the terms of the contractless the consideration paid allocable to the contract($1,000,000 - $650,000 - $150,000)) and its totalallocable contract costs of $125,000 (the allocablecontract costs that Y incurred to complete the con-tract ($50,000 + $75,000)) in Year 3, the completionyear, for a profit of $75,000.

Example 3. Step-in-the-shoes — PCM — (i)Facts. The facts are the same as in Example 1,except that X transfers the contract (including theuncompleted property) to Y in exchange for stock ofY in a transaction that qualifies as a statutory merger

described in section 368(a)(1)(A) and does notresult in gain or loss to X under section 361(a).

(ii) Old taxpayer. For Year 1, X reports receiptsof $250,000 (the completion factor multiplied bytotal contract price ($200,000/$800,000 x$1,000,000)) and costs of $200,000, for a profit of$50,000. Because the mid-contract change in tax-payer results from a transaction described in para-graph (k)(3)(i) of this section, X is not treated ascompleting the contract in Year 2. In Year 2, Xreports receipts of $500,000 (the completion factormultiplied by the total contract price and minus theYear 1 gross receipts [($600,000/$800,000 x$1,000,000) - $250,000]) and costs of $400,000, fora profit of $100,000.

(iii) New taxpayer. Because the mid-contractchange in taxpayer results from a step-in-the-shoestransaction, Y must account for the contract usingthe same methods of accounting used by X prior tothe transaction. Total contract price is the sum ofany amounts that X and Y have received or reason-ably expect to receive under the contract, and totalallocable contract costs are the allocable contractcosts of X and Y. Thus, the estimated total allocablecontract costs at the end of Year 2 are $725,000 (thecumulative allocable contract costs of X and theestimated total allocable contract costs of Y($200,000 + $400,000 + $50,000 + $75,000)). InYear 2, Y reports receipts of $146,552 (the comple-tion factor multiplied by the total contract priceminus receipts reported by the old taxpayer([($650,000/$725,000) x $1,000,000] - $750,000)and costs of $50,000, for a profit of $96,552. ForYear 3, Y reports receipts of $103,448 (the totalcontract price minus prior year receipts ($1,000,000- $896,552)) and costs of $75,000, for a profit of$28,448.

Example 4. Step-in-the-shoes — CCM — (i)Facts. The facts are the same as in Example 3,except that X properly accounts for the contractunder the CCM.

(ii) Old taxpayer. X reports no income or costsfrom the contract in Years 1, 2 or 3.

(iii) New taxpayer. Because the mid-contractchange in taxpayer results from a step-in-the-shoestransaction, Y must account for the contract usingthe same method of accounting used by X prior tothe transaction. Thus, in Year 3, the completion year,Y reports receipts of $1,000,000 and total contractcosts of $725,000, for a profit of $275,000.

Example 5. Step in the shoes — PCM — basisadjustment. The facts are the same as in Example 3,except that X transfers the contract (including theuncompleted property) with a basis of $0 and$125,000 of cash to a new corporation, Z, inexchange for all of the stock of Z in a section 351transaction. Thus, under section 358(a), X’s basis inthe Z stock is $125,000. Pursuant to paragraph(k)(3)(iv)(A)(1) of this section, X must increase itsbasis in the Z stock by the amount of gross receiptsX recognized under the contract, $750,000($250,000 receipts in Year 1 + $500,000 receipts inYear 2), and reduce its basis by the amount of grossreceipts X received under the contract, the $650,000in progress payments. Accordingly, X’s basis in theZ stock is $225,000. All other results are the same.

Example 6. Step in the shoes—CCM—basisadjustment—(i) Facts. The facts are the same as inExample 4, except that X receives progress pay-ments of $800,000 (rather than $650,000) and trans-

fers the contract (including the uncompleted prop-erty) with a basis of $600,000 and $125,000 of cashto a new corporation, Z, in exchange for all of thestock of Z in a section 351 transaction. X and Z donot join in filing a consolidated Federal income taxreturn.

(ii) Old taxpayer. X reports no income or costsunder the contract in Years 1, 2, or 3. Under section358(a), X’s basis in Z is $725,000. Pursuant to para-graph (k)(3)(iv)(A)(1), X must reduce its basis inthe stock of Z by $800,000, the progress paymentsreceived by X. However, X may not reduce its basisin the Z stock below zero pursuant paragraph(k)(3)(iv)(A)(2) of this section. Accordingly, X’sbasis in the Z stock is reduced by $725,000 to zeroand X must recognize ordinary income of $75,000.

(iii) New taxpayer. Upon completion of the con-tract in Year 3, Z reports gross receipts of $925,000($1,000,000 original contract price - $75,000income recognized by the old taxpayer pursuant tothe basis adjustment rule of paragraph (k)(3)(iv)(A))and total contract costs of $725,000, for a profit of$200,000.

Example 7. Step in the shoes—PCM—gain rec-ognized in transaction—(i) Facts. The facts are thesame as in Example 3, except that X transfers thecontract (including the uncompleted property) witha basis of $0 and an unrelated capital asset with avalue of $100,000 and a basis of $0 to a new corpo-ration, Z, in exchange for stock of Z with a value of$200,000 and $50,000 of cash in a section 351transaction.

(ii) Old taxpayer. For year 1, X reports receiptsof $250,000 ($200,000/$800,000 x $1,000,000) andcosts of $200,000, for a profit of $50,000. X is nottreated as completing the contract in Year 2. In Year2, X reports receipts of $500,000 (($600,000/$800,000 x $1,000,000 = $750,000 cumulative grossreceipts) - $250,000 prior year cumulative grossreceipts) and costs of $400,000, for a profit of$100,000. Under paragraph (k)(3)(ii)(B) of this sec-tion, X determines that the gain realized on thetransfer of the contract to Z under the constructivecompletion rules of paragraph (k)(2)(ii) of this sec-tion is $50,000 (total contract price of $800,000($150,000 value allocable to the contract +$650,000 progress payments) - $750,000 previouslyrecognized cumulative gross receipts — $0 costsincurred but not recognized). The gain realized onthe transfer of the unrelated capital asset to Z is$100,000. The amount of gain X must recognize dueto the receipt of $50,000 cash in the exchange is$50,000, of which $30,000 is allocated to the con-tract ($150,000 value of contract/$250,000 totalvalue of property transferred to Z x $50,000) and istreated as ordinary income, and $20,000 is allocatedto the unrelated capital asset ($100,000 value ofcapital asset/$250,000 total value of property trans-ferred to Z x $50,000). Under section 358(a), X’sbasis in the Z stock is $0. However, pursuant toparagraph (k)(3)(iv)(A)(1) of this section, X mustincrease its basis in the Z stock by $750,000, theamount of gross receipts recognized under the con-tract, and must reduce its basis in the Z stock by$650,000, the amount of gross receipts X receivedunder the contract. Therefore, X’s basis in the Zstock is $100,000.

(iii) New taxpayer. Z must account for the con-tract using the same PCM method used by X priorto the transaction. Pursuant to paragraph

June 10, 2002 1076 2002–23 I.R.B.

(k)(3)(iv)(B)(1) of this section, the total contractprice is $970,000 ($1,000,000 amount X and Z havereceived or reasonably expect to receive under thecontract - $30,000 income recognized by X withrespect to the contract as a result of the receipt of$50,000 cash in the transaction). In Year 2, Z reportsgross receipts of $119,655 ($650,000/$725,000 x$970,000 = $869,655 current year cumulative grossreceipts - $750,000 cumulative gross receiptsreported by the old taxpayer) and costs of $50,000,for a profit of $69,655. In Year 3, Z reports grossreceipts of $100,345 ($970,000-$869,655) and costsof $75,000, for a profit of $25,345.

Example 8. Step in the shoes—CCM—gain rec-ognized in transaction—(i) Facts. The facts are thesame as in Example 4, except that X transfers thecontract (including the uncompleted property) witha basis of $600,000 and an unrelated capital assetwith a value of $125,000 and a basis of $0 to a newcorporation, Z, in exchange for all the stock of Zwith a value of $175,000 and $100,000 of cash in asection 351 transaction. X and Z do not join in fil-ing a consolidated Federal income tax return.

(ii) Old taxpayer. X reports no income or costsunder the contract in Years 1, 2, or 3. Under para-graph (k)(3)(ii)(B), X determines that the gain real-ized on the transfer of the contract to Z under theconstructive completion rules of paragraph (k)(2)(ii)of this section is $200,000 ($800,000 total contractprice ($150,000 value allocable to the contract +$650,000 progress payments) - $600,000 costsincurred but not recognized). The gain realized onthe transfer of the unrelated capital asset to Z is$125,000. The amount of gain X must recognize dueto the receipt of $100,000 of cash in the exchange is$100,000, of which $54,545 is allocated to the con-tract ($150,000 value of the contract/$275,000 totalvalue of property transferred to Z x $100,000) andis treated as ordinary income, and $45,455 is allo-cated to the unrelated capital asset ($125,000 valueof capital asset/$275,000 total value of propertytransferred to Z x $100,000). Under section 358(a),X’s basis in the Z stock is $600,000 ($600,000 basisin the contract and unrelated capital asset transferred- $100,000 cash received + $100,000 gain recog-nized). Pursuant to paragraph (k)(3)(iv)(A)(1) of thissection, X must reduce its basis in the stock of Z by$650,000, the progress payments received under thecontract. However, X may not reduce its basis in theZ stock below zero pursuant to paragraph(k)(3)(iv)(A)(2) of this section. Accordingly, X’sbasis in the Z stock is reduced by $600,000 to zeroand X must recognize income of $50,000.

(iii) New taxpayer. Z must account for the con-tract using the same CCM used by X prior to thetransaction. Pursuant to paragraph (k)(3)(iv)(B)(1)of this section, the total contract price is $895,455($1,000,000 original contract price - $54,545income recognized by old taxpayer with respect tothe contract as a result of the receipt of cash in thetransaction - $50,000 income recognized by the oldtaxpayer pursuant to the basis adjustment rule ofparagraph (k)(3)(iv)(A)). Accordingly, upon comple-tion of the contract in Year 3, Z reports grossreceipts of $895,455 and total contract costs of$725,000, for a profit of $170,455.

(6) Effective date. This paragraph (k)is applicable for transactions on or afterMay 15, 2002. Application of the rules of

this paragraph (k) to a transaction thatoccurs on or after May 15, 2002, is not achange in method of accounting.

Par. 8. In § 1.460–6, paragraph (g) isrevised to read as follows:

§ 1.460–6 Look-back method.

* * * * *(g) Mid-contract change in taxpayer

— (1) In general. The rules in this para-graph (g) apply if, as described in§ 1.460–4(k), prior to the completion of along-term contract accounted for usingthe PCM or the PCCM by a taxpayer (oldtaxpayer), there is a transaction thatmakes another taxpayer (new taxpayer)responsible for accounting for incomefrom the same contract. The rules govern-ing constructive completion transactionsare provided in paragraph (g)(2) of thissection, while the rules governing step-in-the-shoes transactions are provided inparagraph (g)(3) of this section. For pur-poses of this paragraph, pre-transactionyears are all taxable years of the old tax-payer in which the old taxpayeraccounted for (or should have accountedfor) gross receipts from the contract, andpost-transaction years are all taxableyears of the new taxpayer in which thenew taxpayer accounted for (or shouldhave accounted for) gross receipts fromthe contract.

(2) Constructive completion transac-tions. In the case of a transactiondescribed in § 1.460–4(k)(2)(i) (construc-tive completion transaction), the look-back method is applied by the old tax-payer with respect to pre-transactionyears upon the date of the transactionand, if the new taxpayer uses the PCM orthe PCCM to account for the contract, bythe new taxpayer with respect to post-transaction years upon completion of thecontract. The contract price and allocablecontract costs to be taken into account bythe old taxpayer or the new taxpayer inapplying the look-back method aredescribed in § 1.460–4(k)(2).

(3) Step-in-the-shoes transactions —(i) General rules. In the case of a transac-tion described in § 1.460–4(k)(3)(i) (step-in-the-shoes transaction), the look-backmethod is not applied at the time of thetransaction, but is instead applied for thefirst time when the contract is completedby the new taxpayer. Upon completion ofthe contract, the look-back method is

applied by the new taxpayer with respectto both pre-transaction years and post-transaction years, taking into account allamounts reasonably expected to bereceived by either the old or new taxpayerand all allocable contract costs incurredduring both periods as described in§ 1.460–4(k)(3). The new taxpayer isliable for filing the Form 8697 and forinterest computed on hypothetical under-payments of tax, and is entitled to receiveinterest with respect to hypothetical over-payments of tax, for both pre- and post-transaction years. The old taxpayer willbe secondarily liable for any interestrequired to be paid with respect to pre-transaction years reduced by any intereston pre-transaction overpayments.

(ii) Application of look-back method topre-transaction period — (A) Contractprice. The actual contract price for pre-transaction taxable years must be deter-mined by the new taxpayer withoutregard to any contract price adjustmentdescribed in paragraph (k)(3)(iv)(B)(1) ofthis section.

(B) Method. The new taxpayer mayapply the look-back method to each pre-transaction taxable year that is a redeter-mination year using the simplified mar-ginal impact method described inparagraph (d) of this section (regardlessof whether or not the old taxpayer wouldhave actually used that method and with-out regard to the tax liability ceiling). Butsee paragraph (d)(4) of this section,which requires use of the simplified mar-ginal impact method by certain pass-through entities.

(C) Interest accrual period. Withrespect to any hypothetical underpaymentor overpayment of tax for a pre-transaction taxable year, interest accruesfrom the due date of the old taxpayer’stax return (not including extensions) forthe taxable year of the underpayment oroverpayment until the due date of the newtaxpayer’s return (not including exten-sions) for the completion year or the yearof a post-completion adjustment, which-ever is applicable.

(D) Information old taxpayer mustprovide. In order to help the new taxpayerto apply the look-back method withrespect to pre-transaction taxable years,any old taxpayer that accounted forincome from a long-term contract underthe PCM or PCCM for either regular or

2002–23 I.R.B. 1077 June 10, 2002

alternative minimum tax purposes isrequired to provide the informationdescribed in this paragraph to the newtaxpayer by the due date (not includingextensions) of the old taxpayer’s incometax return for the first taxable year endingon or after a step-in-the-shoes transactiondescribed in § 1.460–4(k)(3)(i). Therequired information is as follows —

(1) The portion of the contractreported by the old taxpayer under PCMfor regular and alternative minimum taxpurposes (i.e., whether the old taxpayerused PCM, the 40/60 PCCM method, orthe 70/30 PCCM method);

(2) Any submethods used in the appli-cation of PCM (e.g., the simplified cost-to-cost method or the 10-percentmethod);

(3) The amount of total contract pricereported by year;

(4) The numerator and the denomina-tor of the completion factor by year;

(5) The due date (not including exten-sions) of the old taxpayer’s income taxreturns for each taxable year in whichincome was required to be reported;

(6) Whether the old taxpayer was acorporate or a noncorporate taxpayer byyear; and

(7) Any other information required bythe Commissioner by administrative pro-nouncement.

(iii) Application of look-back methodto post-transaction years. With respect topost-transaction taxable years, the newtaxpayer must use the same look-backmethod it uses for other contracts (i.e.,the simplified marginal impact method orthe actual method) to determine theamount of any hypothetical overpaymentor underpayment of tax and the timeperiod for computing interest on theseamounts.

(iv) S corporation elections. Followingthe conversion of a C corporation into anS corporation, the look-back method isapplied at the entity level with respect tocontracts entered into prior to the conver-sion, notwithstanding section 460(b)(4)(B)(i).

(4) Effective date. This paragraph (g)is applicable for transactions on or afterMay 15, 2002.

§ 1.1362–2 [Amended]

Par. 9. In § 1.1362–2, paragraph (c)(6)Example 2, first sentence is amended byremoving the language “§ 1.451–3(b)”and adding “§ 1.460–1(b)(1)” in its place,

and removing the language “§ 1.451–3(c)(1)” and adding “§ 1.460–4(b)” in itsplace.

§ 1.1374–4 [Amended]

Par. 10. In § 1.1374–4, paragraph (g),first sentence is amended by removing thelanguage “§ 1.451–3(d)” and adding“§ 1.460–4(d)” in its place, and removingthe language “§ 1.451–3(c)” and adding“§ 1.460–4(b)” in its place.

PART 602 — OMB CONTROL NUM-BERS UNDER THE PAPERWORKREDUCTION ACT

Par. 11. The authority section for part602 continues to read as follows:

Authority: 26 U.S.C. 7805Par. 12. In § 602.101, paragraph (b) is

amended by revising the following entryin numerical order to the table to read asfollows:

§ 602.101 OMB Control numbers.

* * * * *(b) * * *

CFR part or section whereidentified and described

Current OMBcontrol No.

* * * * *

1.460–6..................................................................................................................................................................... 1545–10311545–15721545–1732

* * * * *

Robert E. Wenzel,Deputy Commissioner of

Internal Revenue.

Approved May 2, 2002.

Pamela F. Olson,Acting Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on May14, 2002, 8:45 a.m., and published in the issue ofthe Federal Register for May 15, 2002, 67 F.R.34603)

Section 1361.—S CorporationDefined

26 CFR 1.1361–1: S corporation defined.

T.D. 8994

DEPARTMENT OF THETREASURYInternal Revenue Service26 CFR Parts 1 and 602

Electing Small Business Trust

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations and removalof temporary regulations.

SUMMARY: This document containsfinal regulations relating to the qualifica-tion and treatment of electing small busi-ness trusts (ESBTs). The final regulationsinterpret the rules added to the InternalRevenue Code (Code) by section 1302 ofthe Small Business Job Protection Act of1996, section 1601 of the Taxpayer Relief

June 10, 2002 1078 2002–23 I.R.B.

Act of 1997, and section 316 of the Com-munity Renewal Tax Relief Act of 2000.In addition, the final regulations providethat an ESBT, or a trust described in sec-tion 401(a) of the Code or section501(c)(3) of the Code and exempt fromtaxation under section 501(a) of the Code,is not treated as a deferral entity for pur-poses of § 1.444–2T. The final regula-tions affect S corporations and certaintrusts that own S corporation stock.

DATES: Effective Date: These regula-tions are effective May 14, 2002.

Dates of Applicability: The regulationsregarding ESBTs under § 1.641(c)–1(d)through (k), (l) Examples 2 – 5, § 1.1361–1(h)(1)(vi), (h)(3)(i)(F), (h)(3)(ii),(j)(12), and (m), § 1.1362–6(b)(2)(iv),§ 1.1377–1(a)(2)(iii) and (c) Example 3apply for taxable years beginning on andafter May 14, 2002. The regulationsregarding taxation of ESBTs under§ 1.641(c)–1(a), (b), (c), and (l) Example1 are applicable for taxable years ofESBTs that end on and after December29, 2000. The regulations under§ 1.444–4 are applicable to taxable yearsbeginning on or after December 29, 2000.

FOR FURTHER INFORMATION CON-TACT: Concerning the final regulations,Bradford Poston or James A. Quinn,(202) 622–3060; specifically concerning§ 1.444–4, Michael F. Schmit, (202) 622–4960 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information in thesefinal regulations have been reviewed and,pending receipt and evaluation of publiccomments, approved by the Office ofManagement and Budget in accordancewith the Paperwork Reduction Act (44U.S.C. 3507) and assigned control num-ber 1545–1591.

The collections of information in thesefinal regulations are in § 1.1361–1(j)(12),§ 1.1361–1(m), and § 1.444–4(c). Theinformation required by § 1.1361–1(j)(12)and § 1.1361–1(m) is needed to allowtrusts to elect to be ESBTs and to allowfor the conversion of a qualified subchap-ter S trust (QSST) to an ESBT and theconversion of an ESBT to a QSST. Thelikely respondents are trusts.

The information required by § 1.444–4(c) is needed to allow certain S corpora-tions to reinstate their previous taxableyear that was terminated under § 1.444–2T. The likely respondents are businessesand other for-profit institutions.

Comments on the collections of infor-mation should be sent to the Office ofManagement and Budget, Attn.: DeskOfficer for the Department of the Trea-sury, Office of Information and Regula-tory Affairs, Washington, DC 20503 withcopies to the Internal Revenue Service,Attn.: IRS Reports Clearance Officer,W:CAR:MP:FP:S, Washington, DC20224. Comments on the collection ofinformation should be received by July15, 2002. Comments are specificallyrequested concerning:

Whether the collections of informationare necessary for the proper performanceof the functions of the Internal RevenueService, including whether the informa-tion will have practical utility;

The accuracy of the estimated burdenassociated with the collections of infor-mation;

How the quality, utility, and clarity ofthe information to be collected may beenhanced;

How the burden of complying with thecollections of information may be mini-mized, including through the applicationof automated collection techniques orother forms of information technology;and

Estimates of capital or start-up costs ofoperation, maintenance, and purchase ofservice to provide information.

The burden contained in § 1.444–4 isreflected in the burden of Form 8716.

Estimated total annual reporting bur-den: 7,500 hours.

Estimated annual burden per respon-dent: 1 hour.

Estimated number of respondents:7,500.

Est imated annual frequency ofresponses: On occasion.

An agency may not conduct or spon-sor, and a person is not required torespond to, a collection of informationunless it displays a valid control numberassigned by the Office of Managementand Budget.

Books or records relating to a collec-tion of information must be retained aslong as their contents may become mate-

rial in the administration of any internalrevenue law. Generally, tax returns andtax return information are confidential, asrequired by 26 U.S.C. 6103.

Background

On December 29, 2000, proposedregulations (REG–251701–96, 2001–1C.B. 396) were published in the FederalRegister (65 FR 82963) containing pro-posed amendments to the Income TaxRegulations (26 CFR Part 1) relating to Scorporations and electing small businesstrusts (ESBTs). Section 1302 of the SmallBusiness Job Protection Act of 1996,Public Law 104–188 (110 Stat. 1755)(August 20, 1996) (the 1996 Act),amended sections 641 and 1361 of theCode to permit an ESBT to be an S cor-poration shareholder. Further amend-ments were made to section 1361(e) bythe Taxpayer Relief Act of 1997, PublicLaw 105–34 (111 Stat. 1601(c)(1))(August 5, 1997), and the CommunityRenewal Tax Relief Act of 2000, PublicLaw 106–554 (114 Stat. 2763) (Decem-ber 21, 2000). Prior section 641(d) wasredesignated as section 641(c) by theInternal Revenue Service Restructuringand Reform Act of 1998, Public Law105–206 (112 Stat. 6007(f)(2)) (July 22,1998).

On December 29, 2000, proposed andtemporary regulations were also pub-lished in the Federal Register (REG–251701–96, 2001–1 C.B. 396 [65 FR82963]) and (T.D. 8915, 2001–1 C.B. 359[65 FR 82926]) containing amendmentsto the Income Tax Regulations (26 CFRPart 1) relating to the election of a taxableyear other than the required taxable year.

A public hearing was held on the pro-posed and temporary regulations on April25, 2001. Written comments werereceived on the proposed and temporaryregulations. The proposed regulations,with certain changes in response to thecomments, are adopted as final regula-tions, and the temporary regulations areremoved.

Summary of Comments andExplanation of Revisions

Beneficiaries and Potential CurrentBeneficiaries

For a trust to qualify as an electingsmall business trust (ESBT) and as a

2002–23 I.R.B. 1079 June 10, 2002

shareholder in a subchapter S corporation,only certain types of persons are permit-ted to be beneficiaries of the trust. Once atrust makes the ESBT election, eachpotential current beneficiary (PCB) of thetrust is treated as a shareholder of the Scorporation. Thus, the identity of the ben-eficiaries affects whether a trust can be anESBT, while the identity and number ofPCBs affect whether the corporation canbe a S corporation. It is possible undercertain circumstances for a person to be aPCB, as that term is defined in section1361(e)(2) and the proposed regulations,without being a beneficiary, as that termis defined in the proposed regulations.For example, a person who may receive adistribution from an ESBT under a cur-rently exercisable power of appointmentis a PCB but is not treated as a benefi-ciary until the power is actually exer-cised.

Some commentators expressed con-cerns about the possible adverse effects ofthe definition of PCBs, especially in situ-ations involving potential recipients of acurrently exercisable power of appoint-ment. Some commentators suggested thata person should have to meet the defini-tion of a beneficiary before the personcould be considered a PCB. Commenta-tors also suggested that a person who mayreceive a distribution under a currentlyexercisable power of appointment shouldnot be treated as a PCB until exercise ofthe power. Several commentators sug-gested that a temporary waiver or releaseof a broad power of appointment shouldbe sufficient to limit the number of PCBsduring a period of time.

The final regulations do not change thebasic definition of PCBs. While there isno statutory definition of beneficiary insection 1361(e), there is a statutory defi-nition of PCB. Under section 1361(e)(2),a PCB is, “with respect to any period, anyperson who at any time during suchperiod is entitled to, or, at the discretionof any person, may receive, a distributionfrom the principal or income of the trust.”The IRS and the Treasury Departmentbelieve that it would be inconsistent withthis statutory definition not to treat a per-son as a PCB until an actual distributionis made to that person pursuant to theexercise of a power of appointment. Thefinal regulations provide that an attemptto temporarily waive, release, or limit a

power of appointment would not be effec-tive to limit the PCBs because of uncer-tainty as to the effectiveness of a tempo-rary waiver, release, or limitation on thepower of appointment under state law andthe potential to manipulate a temporarywaiver, release, or limitation on a powerof appointment to avoid the S corporationshareholder limitation rules. However, apermanent release of a power of appoint-ment that is effective under local law mayreduce the number of PCBs of an ESBT.

Another commentator suggested thatthe separate share provisions of section663(c) should apply so that beneficiariesor PCBs of the share holding the assetsother than the S corporation stock wouldnot be counted as beneficiaries or PCBsof the S portion. There is no authority toignore beneficiaries and PCBs of a por-tion of a trust holding assets other than Scorporation stock. The statutory defini-tions of an ESBT and of a PCB look to allthe persons who are beneficiaries orPCBs of the trust, not just the S portion.In addition, the separate share provisionsof section 663(c) are not applicablebecause they generally apply only forpurposes of allocating distributable netincome under sections 661 and 662.

Two commentators requested guidanceon what period of time is considered indetermining who are PCBs in light of thestatutory definition. They suggested thatperiod means any moment in time. Thus,if an event occurs during a taxable yearthat changes who the PCBs are, the PCBsbefore and after the event would not becounted cumulatively for purposes of the75-shareholder limit. The shareholderlimitation in section 1361(b)(1)(A) meansthat an S corporation may not have morethan 75 shareholders at any particulartime during the taxable year. See Rev.Rul. 78–390, 1978–2 C.B. 220. The finalregulations clarify that a person is treatedas a shareholder of the S corporation atany moment in time when that person isentitled to, or in the discretion of any per-son may, receive a distribution of princi-pal or income of the trust. The final regu-lations also provide that a person who,after the exercise of a power of appoint-ment, receives only a future interest in thetrust is not a PCB.

One commentator was concernedabout the statement in the proposed regu-lations that if a person holds a general

lifetime power of appointment, the corpo-ration will exceed the 75-shareholderlimit and thus the corporation’s S electionwill terminate. The commentator pointedout that a beneficiary’s power to with-draw assets from a trust is considered ageneral power of appointment but thebeneficiary is the only one who canreceive those assets. The final regulationsclarify that the potential recipients of cur-rent distributions pursuant to an exerciseof the power are considered, not whetherthe power is a general or special power ofappointment.

The proposed regulations provide thata person with a future beneficial interestis not a beneficiary of an ESBT if thatinterest is so remote as to be negligible.This provision permitted trusts to qualifyas ESBTs even though there was a remotepossibility that all the named beneficia-ries would die and the trust assets wouldescheat to the state, an impermissiblebeneficiary of an ESBT. The CommunityRenewal Tax Relief Act of 2000 elimi-nated this potential problem by changingthe statutory definition of permissiblebeneficiaries to include an organizationdescribed in section 170(c)(1) that holds acontingent interest in the trust and is nota PCB. The final regulations, therefore,remove the provision regarding remotebeneficiaries and the accompanyingexample.

Interests in Trust Acquired by Purchase

Two commentators requested clarifica-tion on whether a trust is eligible to be anESBT if it acquires property in a part-gift,part-sale transaction, such as a gift ofencumbered property or a net gift, inwhich the donor transfers property to atrust provided the trust pays the resultinggift tax. Section 1361(e)(1)(A)(ii) pro-vides that a trust is eligible to be anESBT only if “no interest in the trust wasacquired by purchase.” Sect ion1361(e)(1)(C) defines purchase as “anyacquisition if the basis of the propertyacquired is determined under section1012.” The proposed regulations providethat if any portion of a beneficiary’s basisin the beneficiary’s interest is determinedunder section 1012, the beneficiary’sinterest was acquired by purchase. Thefinal regulations clarify that the prohibi-tion on purchases applies to purchases ofa beneficiary’s interest in the trust, not to

June 10, 2002 1080 2002–23 I.R.B.

purchases of property by the trust. A netgift of a beneficial interest in a trust,where the donee pays the gift tax, wouldbe treated as a purchase of a beneficialinterest under these rules, while a net giftto the trust itself, where the trustee of thetrust pays the gift tax, would not.

Grantor Trusts

Most commentators praised the posi-tion in the proposed regulations that atrust, all or a portion of which is treatedas owned by an individual (deemedowner) under subpart E, part I, subchap-ter J, chapter 1 of the Code (grantortrust), may elect to be an ESBT. Onecommentator, however, suggested thatgrantor trusts should not be permitted tomake ESBT elections. The final regula-tions continue to provide that a grantortrust may elect to be an ESBT.

The proposed regulations provide thatif a grantor trust makes an ESBT election,the trust consists of a grantor portion, anS portion, and a non-S portion. The itemsof income, deduction, and credit attribut-able to the grantor portion are taxed to thedeemed owner of that portion. The S por-tion is taxed under the special rules ofsection 641(c), while the non-S portion issubject to the normal trust taxation rulesof subparts A through D of subchapter J.

Commentators made several sugges-tions regarding the taxation of a grantortrust that elects to be an ESBT. Some sug-gested that the taxation rules of section641(c) should override the grantor trustrules of section 671, and thus all tax itemsattributable to the trust’s shares in the Scorporation should be taxed to the trust,not the deemed owner. Some suggestedthe grantor trust rules should not apply toany tax items of a trust that makes anESBT election. According to these com-mentators, this approach would eliminateadministrative complexity in determiningwhat portion of the trust is treated asowned by the deemed owner. Others sug-gested that the trustee should be permittedto elect to have all items attributable tothe S corporation taxed to the trust, not tothe deemed owner. Others suggested thatnone of the S items should be taxed to thedeemed owner but that ESBTs should besubject to additional reporting require-ments to ensure the collection of theproper tax. Another suggested that thedeemed owner should be taxed on the

items from an ESBT only if the deemedowner is treated as owning the entiretrust, not just a portion of the trust. Othercommentators agreed with the taxationregime set forth in the proposed regula-tions.

The IRS and the Treasury Departmentbelieve that the qualification and taxationof ESBTs are two separate issues and thatthe proposed regulations take the correctposition regarding the taxation of grantortrusts that make ESBT elections. Section1361(e)(1) expands the permissible share-holders of an S corporation to includetrusts that meet the definition of an ESBT.Grantor trusts are not excluded from thedefinition of an ESBT and, therefore, arepermitted to make ESBT elections. Mak-ing an ESBT election, however, does notalter the long established treatment of taxitems attributable to the portion of a trusttreated as owned by the grantor oranother. Section 671 requires that itemsof income, deduction, and credit attribut-able to the portion of the trust treated asowned by a grantor or another must betaken into account by that deemed owner.Only remaining items of the trust are sub-ject to the provisions of subparts Athrough D of subchapter J. The specialtaxation rules for ESBTs are contained insubpart A and, therefore, only apply toany portion of the trust that is not treatedas owned by the grantor or another undersubpart E.

As pointed out by one of the commen-tators, the issue of determining what por-tion, if any, of a trust is treated as ownedby the grantor or another has existed foryears in a much broader context than inthe application of the ESBT rules. Thespecial taxation rules of section 641(c)would apply only to S items, while nor-mal trust taxation rules clearly apply tonon-S items. As a result, taxing all the Sitems to the trust would not eliminate theneed to determine what portion of thetrust is a grantor trust and the resultingadministrative difficulties with respect tothe non-S tax items of the trust.

Some commentators requested clarifi-cation of the effect of an ESBT electionby a grantor trust. One commentator sug-gested that if a wholly-owned grantortrust makes an ESBT election, only thedeemed owner should be treated as theshareholder of the S corporation. Anothercommentator made a similar suggestion

where the grantor has retained the powerto amend or revoke the trust or to makegifts from the trust. The IRS and the Trea-sury Department believe that the defini-tional and qualification requirements ofsection 1361(e) apply to any trust thatmakes an ESBT election irrespective ofwhether it is a grantor trust. Therefore,the final regulations continue to providethat the deemed owner is treated as aPCB along with others who meet the defi-nition of a PCB.

Charitable Contributions

The proposed regulations provide thatif an otherwise allowable deduction of theS portion is attributable to a charitablecontribution paid by the S corporation,the contribution will be deemed to bepaid by the S portion pursuant to theterms of the trust’s governing instrumentand will be deductible if the otherrequirements of section 642(c)(1) are met.Several commentators requested clarifica-tion concerning the other requirements ofsection 642(c)(1), the application of thelimitations under section 681, and theelection to treat charitable paymentsmade after the close of a taxable year asmade during the taxable year. One com-mentator suggested that the S portionshould be entitled to a deduction for itsshare of any charitable contribution madeby the S corporation because it is a sepa-rately stated item under section 1366 thatthe S portion takes into account undersection 641(c)(2)(C)(i).

Section 641(c)(2)(C) specifies theitems of income, loss, deduction, or creditthat the S portion is required to take intoaccount in determining its tax. Theseitems include items required to be takeninto account under section 1366, that is,the trust’s pro rata share of the S corpo-ration’s items passed through to it as ashareholder. Both section 641(c)(2)(C)and section 1366(a) reference items thatmust be taken into account but do notthemselves provide the authority toinclude in income, deduct from income,or claim a credit with respect to thoseitems. That authority comes from otherCode sections. A charitable contributionmade by an S corporation is required tobe a separately stated item under section1366 because whether the item is deduct-ible depends on the identity of the share-holder and the provisions of the Code

2002–23 I.R.B. 1081 June 10, 2002

applicable to charitable contributionsmade by that type of shareholder. Thus,for an individual shareholder, the contri-bution is deductible only in accordancewith the provisions of section 170, whilefor a trust or estate, the contribution isdeductible only in accordance with theprovisions of section 642(c).

The final regulations continue to pro-vide that the S portion’s share of a chari-table contribution made by the S corpora-tion is deductible only if it meets therequirements of section 642(c)(1). Thefinal regulations clarify how thoserequirements apply to such a contribution.If a contribution is paid from the S corpo-ration’s gross income, the contributionwill be deemed to be paid by the S por-tion pursuant to the terms of the trust’sgoverning instrument. The limitations ofsection 681, regarding unrelated businessincome, apply to determine whether thecontribution is deductible by the S por-tion. The final regulations also clarify thatthe charitable contribution is deductibleby the S portion, if at all, only in the yearthat it is an item required to be taken intoaccount by the trust under section 1366.The trustee may not make the election totreat a contribution made by the S corpo-ration after the close of the taxable yearas made during the taxable year. Thiselection is available only for charitablepayments actually made by the trust, notfor the trust’s share of contributions madeby another entity.

One commentator suggested that if thetrust contributes S corporation stock to acharitable organization, the S portionshould be entitled to a charitable deduc-tion with respect to the contribution.Deductions available to the S portion arelimited by section 641(c)(2)(C) to S cor-poration items required to be taken intoaccount under section 1366 and the S por-tion’s share of state and local incometaxes and administrative expenses. Chari-table contributions by the trust are notitems included in the list of items thatmay be taken into account by the S por-tion under section 641(c)(2)(C). There-fore, the final regulations do not changethe rule that no deduction is available toeither the S portion or the non-S portionwith respect to a contribution of S corpo-ration stock to charity.

Interest Paid on Loans to Acquire SCorporation Stock

The proposed regulations provide thatinterest expense incurred by the trust topurchase S corporation stock is allocatedto the S portion but is not an administra-tive expense. Therefore, the interest is notan allowable deduction of the S portionunder section 641(c)(2)(C)(iii). Severalcommentators suggested that the interestshould be deductible. Some thought theinterest should be allocated to the non-Sportion and deducted under the invest-ment interest limitations of section163(d). Others thought the interest shouldbe allocated to the S portion but shouldbe considered a deductible administrativeexpense. One commentator suggested thatif the shareholders are required to buy thestock of a departing shareholder pursuantto the terms of a stock purchase agree-ment, any interest expense incurred as aresult of financing the stock purchasewith a loan should be deductible whenpaid by an ESBT. Another commentatorsuggested that if interest paid on a loan toacquire S corporation stock is not deduct-ible, it should be added to the basis of theacquired stock.

Because the purchase of S corporationstock increases the S portion, rather thanthe non-S portion, of the trust, interestexpenses incurred in the purchase shouldbe allocated to the S portion. These inter-est expenses would be deductible by the Sportion only if they are “administrativeexpenses” under section 641(c)(2)(C)(iii).The IRS and the Treasury Departmentbelieve that, for purposes of section641(c)(2)(C)( i i i ) , “adminis t ra t iveexpenses” include the tradit ionalexpenses necessary for the managementand preservation of trust assets, but donot include expenses incurred to acquireadditional assets. The final regulations,therefore, continue to provide that, in allcases, interest incurred to purchase S cor-poration stock is a nondeductible expenseallocable to the S portion. Because thereis no authority to permit nondeductibleinterest expenses to increase the basis ofassets, the final regulations do not adoptthis suggestion.

Tax Credit Carryovers

Section 641(c)(4) and the proposedregulations provide that if a trust is no

longer an ESBT, any loss carryover orexcess deductions of the S portion thatare referred to in section 642(h) are takeninto account by the entire trust or by thebeneficiaries if the entire trust terminates.One commentator suggested that any taxcredit carryovers of the S portion shouldreceive similar treatment. Section641(c)(4) permits the entire trust to takeinto account only those items specified insection 642(h), which does not includetax credit carryovers. The S portion’s taxcredit carryovers and any other items notlisted in section 642(h) are forfeited oncethe trust is no longer an ESBT, just asthey are upon the termination of a trust orestate. The final regulations, therefore, donot adopt the commentator’s suggestion.

Distributions From the ESBT

One commentator suggested that thetax treatment of distributions to beneficia-ries in the proposed regulations is incon-sistent with section 641(c)(1)(A), whichprovides that the portion of an ESBT con-sisting of the S corporation stock istreated as a separate trust. The proposedregulations provide that distributions tobeneficiaries from the S portion or thenon-S portion, including distributions ofthe S corporation stock, are, to the extentof the distributable net income of thenon-S portion, deductible under section651 or 661 in determining the taxableincome of the non-S portion, and areincludible in the gross income of the ben-eficiaries under section 652 or 662. Thecommentator recommended that, becausethe S portion and the non-S portion aretreated as separate trusts, the source ofthe distribution should determine its taxtreatment.

The final regulations do not adopt thecommentator’s suggestion because sec-tion 641(c)(3) provides that section641(c) does not affect the taxation of anydistribution from the trust except for theexclusion of the S portion items from thedistributable net income of the entiretrust. Thus, the rules otherwise applicableto trust distributions apply to ESBTs.

ESBT Election

The proposed regulations provide thatthe ESBT election is filed with the ser-vice center where the trust files itsincome tax returns. The election to be a

June 10, 2002 1082 2002–23 I.R.B.

qualified subchapter S trust (QSST) isfiled with the service center where the Scorporation files its income tax returns.The preamble to the proposed regulationsrequested comments on whether the rulesfor filing the QSST election should bechanged so the election is filed with theservice center where the trust files itsreturns. One commentator suggested thereshould be consistent filing locations forQSST elections, ESBT elections, andconversions from QSST to ESBT orESBT to QSST. The commentator, there-fore, suggested that all these documentsbe filed with the service center(s) wherethe trust and the S corporation file theirreturns.

The final regulations provide that theESBT election and the election to convertfrom an ESBT to a QSST or from aQSST to an ESBT are all filed with theservice center where the S corporationfiles its income tax returns. Thus, the rulein the final regulations will establish aconsistent filing location for QSST andESBT elections and conversions.

One commentator suggested thatgrantor trusts should be permitted tomake protective ESBT elections in lightof the uncertain status of some trusts thatmay be grantor trusts under section 674.The IRS and the Treasury Departmentcontinue to believe that a conditionalESBT election that only becomes effec-tive in the event the trust is not a wholly-owned grantor trust should not be avail-able. A conditional ESBT election shouldnot be allowed because the ESBT electionmust have a fixed effective date. If, in theabsence of a conditional ESBT election,the trust is an ineligible shareholder, reliefunder section 1362(f) may be availablefor an S corporation. In addition, a trustthat qualifies as an ESBT may make anESBT election notwithstanding that thetrust is a wholly-owned grantor trust.

Expedited Section 1362(f) Relief

In several contexts, commentatorsrequested some form of expedited relief ifan S corporation’s election is inadvert-ently ineffective or is inadvertently termi-nated. In all these situations, the S corpo-ration may seek relief under section1362(f). The facts and circumstances of aparticular situation are considered indetermining whether relief is available,

and the procedures for obtaining thisrelief are well established.

Effect under Section 1377 of Change inStatus of a Trust

A commentator suggested that a trust’sconversion to an ESBT should result in acomplete termination of the trust’s inter-est in the S corporation for purposes ofsection 1377(a)(2) because the incidenceof taxation with respect to S corporationitems will change as a result of the ESBTelection. The proposed regulations pro-vide that the election would result in atermination only if, prior to the election,the trust was described in section1361(c)(2)(A)(ii) or (iii). The commenta-tor also recommended that the regulationsaddress the conversion from an ESBT toanother type of trust and the availabilityof an election under § 1.1368–1(g) totreat the S corporation’s taxable year astwo separate years in the case of a quali-fying disposition.

The final regulations do not adopt thesuggestion that all conversions of a trustto an ESBT should be treated as a com-plete termination of the trust’s interest inthe S corporation for purposes of section1377(a)(2). The final regulations expandon the rule in the proposed regulations tocover all types of conversions. Under thisrule, conversion of a trust to an ESBT ora QSST does not result in the prior trustterminating its entire interest in the S cor-poration, unless the prior trust wasdescribed in section 1361(c)(2)(A)(ii) or(iii). When a trust described in section1361(c)(2)(A)(ii) or (iii) converts to anESBT or a QSST, the shareholders of theS corporation under section 1361(c)(2)(B)change from the estate of the deemedowner or testator to the PCBs of theESBT, or the current income beneficiaryof the QSST. When a trust changes froma wholly-owned grantor trust or QSST toan ESBT or from an ESBT to a QSST, theindividuals who are shareholders of the Scorporation under section 1361(c)(2)(B)remain the same. The election to termi-nate the taxable year provided in section1377(a)(2) applies to the termination of ashareholder’s interest in the S corpora-tion. Accordingly, it is appropriate to treatthe conversion of a trust described in sec-tion 1361(c)(2)(A)(ii) or (iii) to an ESBTor QSST as a termination of the priortrust’s interest in the S corporation, but

not to treat other conversions to an ESBTor QSST as terminations. The electionunder § 1.1368–1(g) is also not availablebecause the conversion of the trust is nota qualifying disposition.

Section 444 Elections

One commentator suggested that thefinal regulations permit an S corporationto retroactively reinstate a section 444election that it had treated as terminatedby operation of § 1.444–2T(a) (prior tothe issuance of the temporary regulations)as a result of an ESBT or certain tax-exempt trusts becoming a shareholder ofthe corporation under the auspices of the1996 Act. The commentator believes thatfailure to provide such relief would resultin inequitable treatment of such S corpo-rations because, under the rules of section444, once their elections are terminated,they are precluded from again making asection 444 election.

The IRS and the Treasury Departmentbelieve that it is appropriate to allow Scorporations under these circumstances torequest that the IRS disregard the termi-nation and permit the S corporation tocontinue to use the same fiscal year that itused previously under section 444. How-ever, for reasons of administrative conve-nience, and in order to reduce the burdenon taxpayers of having to file amendedreturns and make retroactive paymentsunder section 7519, the prior terminationwill be disregarded only at the S corpora-tion’s request, and on a prospective basis.

The final regulations provide a proce-dure for such requests. To illustrate theprocedure, assume that, prior to 1997, anS corporation had made a section 444election to use a taxable year ending onSeptember 30th. On January 1, 1997, anESBT acquired a shareholder interest inthe S corporation. The S corporationtreated its 444 election as terminatedunder § 1.444–2T(a) as a result of theESBT’s shareholder interest. The S cor-poration changed to its required taxableyear for the short period beginning Octo-ber 1, 1996, and ending December 31,1996, and filed Form 1120S, “U.S.Income Tax Return for an S Corpora-tion,” on the basis of a calendar year forall subsequent taxable years.

Under the final regulations, the S cor-poration may request that the IRS disre-gard the prior termination by filing Form

2002–23 I.R.B. 1083 June 10, 2002

8716, Election to Have a Tax Year OtherThan a Required Tax Year, with theappropriate Service Center by October15, 2002, and by designating on the form“CONTINUATION OF SECTION 444ELECTION UNDER § 1.444–4.” TheForm 8716 must indicate that under the Scorporation’s prior section 444 election, itused a taxable year ending September30th. The request will be effective for thetaxable year beginning January 1, 2002.No amended returns, no retroactive pay-ments under section 7519, and no returnsunder § 1.7519–2T(a) for previous yearsin which the S corporation used itsrequired year are required as a result ofthe request. Moreover, the S corporationneed not make a required payment undersection 7519 for its taxable year endingSeptember 30, 2002; its first requiredpayment for the taxable year beginningOctober 1, 2002, is due on May 15, 2003.The S corporation will be required to filea return under § 1.7519–2T for each tax-able year beginning on or after January 1,2002.

Effective Dates

The portion of the regulations involv-ing the taxation of the grantor, S, andnon-S portions of an ESBT was proposedto be applicable for taxable years ofESBTs that end on or after December 29,2000, the date that the proposed regula-tions were published in the Federal Reg-ister. The remainder of the regulationsinvolving ESBTs was proposed to beapplicable on or after the date that finalregulations are published in the FederalRegister . Several commentatorsexpressed concerns about the proposedapplicability with regard to the taxation ofthe grantor portion of an ESBT. One com-mentator suggested that the proposedeffective date discriminated against trustswith a situs in Guam. Others suggestedthat the rules regarding taxation of thegrantor portion should not be applicablebefore the date the final regulations arepublished. One commentator suggestedthat these rules should only apply eitherto trusts created after the final regulationsare published or after a substantial transi-tion period.

The IRS and the Treasury Departmentbelieve that the applicable date for therules concerning the taxation of an ESBTwith a grantor portion is reasonable and

appropriate. These rules do not discrimi-nate against trusts with a particular situsbecause they apply to all trusts whereversituated. In the case of a grantor trust thatmade an ESBT election, the tax treatmentof the grantor portion set forth in the pro-posed regulations may be different fromthe tax treatment that the trust and thegrantor had thought was available. Theproposed regulations, however, were pub-lished before the end of the 2000 taxableyear and before income from that taxableyear was required to be included on anyperson’s income tax return. Thus, prior tothe filing of income tax returns for 2000,it was known that the income from thegrantor portion of the trust was to betaken into account by the deemed owner,not by the trust. In some situations, thetrust, rather than the deemed owner, mayhave made estimated tax payments. Rec-ognizing that the payment of estimatedtax by the trust might subject the deemedowner to a penalty for underpayment ofestimated taxes, the IRS and the TreasuryDepartment provided relief by issuingNotice 2001–25, 2001–1 C.B. 941. ThatNotice provides procedures for a trust toelect to have its estimated tax paymentscredited to the account of the deemedowner and provides that, for purposes ofcalculating any underpayment of esti-mated tax, income attributable to the Scorporation was to be taken into accounton the last day of the deemed owner’s2000 taxable year.

Some commentators were concernedthat existing ESBTs with currently exer-cisable, broad powers of appointmentshave resulted in S corporations exceedingthe shareholder limit and have caused thetermination of the S corporations’ elec-tions. The regulations regarding the defi-nition of PCBs are applicable only fortaxable years of ESBTs that begin on orafter May 14, 2002. Therefore, personswho may receive a distribution from anESBT pursuant to a currently exercisablepower of appointment will not be consid-ered PCBs of the ESBT until the first dayof the ESBT’s first taxable year thatbegins on or after May 14, 2002, and theS corporation’s election will not terminatebefore that date. In addition, under sec-tion 1361(e)(2) if the trust disposes of allits stock in the S corporation within 60days after that date, the persons, whowould first meet the definition of PCBs

on that date, will not be PCBs and thecorporation’s S status will not be affected.

One commentator was concerned bythe applicability date of the regulationsinvolving the deductibility of state andlocal income taxes and administrativeexpenses. Section 641(c)(2)(C)(iii) pro-vides that the S portion may take intoaccount its allocable share of state andlocal income taxes and administrativeexpenses, but only to the extent providedin the regulations. The commentatornoted that before final regulations areissued there is no authority for an ESBTto deduct any of these items. Therefore,the commentator requested that trusts beallowed to rely on the regulatory provi-sions regarding these items for taxableyears beginning after December 31, 1996.The effective date provisions have beenmodified based on this suggestion.

Additional Provisions

The final regulations clarify that thebasis of S corporation stock in the S por-tion must be adjusted in accordance withsection 1367 and the regulations thereun-der. If the ESBT owns stock in more thanone S corporation, the adjustments to thebasis in the S corporation stock of each Scorporation must be determined sepa-rately.

Effect on other documents

The following documents are super-seded for taxable years of ESBTs begin-ning on and after May 14, 2002.

Notice 97–12 (1997–1 C.B. 385).Notice 97–49 (1997–2 C.B. 304).Rev. Proc. 98–23 (1998–1 C.B. 662).

Special Analysis

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assess-ment is not required. It has also beendetermined that section 553(b) of theAdministrative Procedure Act (5 U.S.C.chapter 5) does not apply to these regula-tions. It is hereby certified that the collec-tions of information in the regulationswill not have a significant economicimpact on a substantial number of smallentities. This certification is based uponthe fact that (1) the estimated average

June 10, 2002 1084 2002–23 I.R.B.

burden per trust in complying with thecollections of information in § 1.1361–1(m) is 1 hour, and (2) the requirementfor S corporations to comply with§ 1.444–4(c) will affect very few taxpay-ers and the associated burden is minimal.Therefore, a Regulatory FlexibilityAnalysis under the Regulatory FlexibilityAct (5 U.S.C. chapter 6) is not required.Pursuant to section 7805(f) of the Code,the notice of proposed rulemaking pre-ceding these regulations was submitted tothe Chief Counsel for Advocacy of theSmall Business Administration for com-ment on the regulations’ impact on smallbusiness.

Drafting Information

The principal authors of these regula-tions are Bradford Poston and James A.Quinn of the Office of Associate ChiefCounsel (Passthroughs and Special Indus-tries), IRS. However, other personnelfrom the IRS and the Treasury Depart-ment participated in their development.

Adoption of Amendments to theRegulations

Accordingly, 26 CFR parts 1 and 602are amended as follows:

PART I—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by adding an entry innumerical order to read in part as follows:

Authority: 26 U.S.C. 7805. * * *Section 1.444–4 is also issued under

26 U.S.C. 444(g). * * *Par. 2. Section 1.444–4 is added to

read as follows:

§ 1.444–4 Tiered structure.

(a) Electing small business trusts. Forpurposes of § 1.444–2T, solely withrespect to an S corporation shareholder,the term deferral entity does not include atrust that is treated as an electing smallbusiness trust under section 1361(e). An Scorporation with an electing small busi-ness trust as a shareholder may make anelection under section 444. This para-graph is applicable to taxable years begin-ning on and after December 29, 2000;however, taxpayers may voluntarily apply

it to taxable years of S corporationsbeginning after December 31, 1996.

(b) Certain tax-exempt trusts. For pur-poses of § 1.444–2T, solely with respectto an S corporation shareholder, the termdeferral entity does not include a trustthat is described in section 401(a) or501(c)(3), and is exempt from taxationunder section 501(a). An S corporationwith a trust as a shareholder that isdescribed in section 401(a) or section501(c)(3), and is exempt from taxationunder section 501(a) may make an elec-tion under section 444. This paragraph isapplicable to taxable years beginning onand after December 29, 2000; howevertaxpayers may voluntarily apply it to tax-able years of S corporations beginningafter December 31, 1997.

(c) Certain terminations disregarded—(1) In general. An S corporation that isdescribed in this paragraph (c)(1) mayrequest that a termination of its electionunder section 444 be disregarded, andthat the S corporation be permitted toresume use of the year it previouslyelected under section 444, by followingthe procedures of paragraph (c)(2) of thissection. An S corporation is described inthis paragraph if the S corporation is oth-erwise qualified to make a section 444election, and its previous election was ter-minated under § 1.444–2T(a) solelybecause —

(i) In the case of a taxable year begin-ning after December 31, 1996, a trust thatis treated as an electing small businesstrust became a shareholder of such S cor-poration; or

(ii) In the case of a taxable year begin-ning after December 31, 1997, a trust thatis described in section 401(a) or501(c)(3), and is exempt from taxationunder section 501(a) became a share-holder of such S corporation.

(2) Procedure—(i) In general. An Scorporation described in paragraph (c)(1)of this section that wishes to make therequest described in paragraph (c)(1) ofthis section must do so by filing Form8716, Election To Have a Tax Year OtherThan a Required Tax Year, and typing orprinting legibly at the top of such form —“CONTINUATION OF SECTION 444ELECTION UNDER § 1.444–4.” Inorder to assist the Internal Revenue Ser-vice in updating the S corporation’saccount, on Line 5 the Box “Changing

to” should be checked. Additionally, theelection month indicated must be the lastmonth of the S corporation’s previouslyelected section 444 election year, and theeffective year indicated must end in 2002.

(ii) Time and place for filing Form8716. Such form must be filed on orbefore October 15, 2002, with the servicecenter where the S corporation’s returnsof tax (Forms 1120S) are filed. In addi-tion, a copy of the Form 8716 should beattached to the S corporation’s shortperiod Federal income tax return for thefirst election year beginning on or afterJanuary 1, 2002.

(3) Effect of request—(i) Taxable yearsbeginning on or after January 1, 2002.An S corporation described in paragraph(c)(1) of this section that requests, inaccordance with this paragraph, that a ter-mination of its election under section 444be disregarded will be permitted toresume use of the year it previouslyelected under section 444, commencingwith its first taxable year beginning on orafter January 1, 2002. Such S corporationwill be required to file a return under§ 1.7519–2T for each taxable year begin-ning on or after January 1, 2002. No pay-ment under section 7519 will be due withrespect to the first taxable year beginningon or after January 1, 2002. However, arequired payment will be due on or beforeMay 15, 2003, with respect to such S cor-poration’s second continued section 444election year that begins in calendar year2002.

(ii) Taxable years beginning prior toJanuary 1, 2002. An S corporationdescribed in paragraph (c)(1) of this sec-tion that requests, in accordance with thisparagraph, that a termination of its elec-tion under section 444 be disregarded willnot be required to amend any prior Fed-eral income tax returns, make anyrequired payments under section 7519, orfile any returns under § 1.7519–2T, withrespect to taxable years beginning on orafter the date the termination of its sec-tion 444 election was effective and priorto January 1, 2002.

(iii) Section 7519: required paymentsand returns. The Internal Revenue Ser-vice waives any requirement for an S cor-poration described in paragraph (c)(1) ofthis section to file the federal tax returnsand make any required payments undersection 7519 for years prior to the taxable

2002–23 I.R.B. 1085 June 10, 2002

year of continuation as described in para-graph (c)(3)(i) of this section, if for suchyears the S corporation filed its Federalincome tax returns on the basis of itsrequired taxable year.

§ 1.444–4T [Removed]

Par. 3. Section 1.444–4T is removed.Par. 4. Sections 1.641(c)–0 and

1.641(c)–1 are added to read as follows:

§ 1.641(c)–0 Table of contents.

This section lists the major captionscontained in § 1.641(c)–1.

§ 1.641(c)–1 Electing small businesstrust.

(a) In general.(b) Definitions.(1) Grantor portion.(2) S portion.(3) Non-S portion.(c) Taxation of grantor portion.(d) Taxation of S portion.(1) In general.(2) Section 1366 amounts.(3) Gains and losses on disposition of Sstock.(4) State and local income taxes andadministrative expenses.(e) Tax rates and exemption of S portion.(1) Income tax rate.(2) Alternative minimum tax exemption.(f) Adjustments to basis of stock in the Sportion under section 1367.(g) Taxation of non-S portion.(1) In general.(2) Dividend income under section1368(c)(2).(3) Interest on installment obligations.(4) Charitable deduction.(h) Allocation of state and local incometaxes and administration expenses.(i) Treatment of distributions from thetrust.(j) Termination or revocation of ESBTelection.(k) Effective date.(l) Examples.

§ 1.641(c)–1 Electing small businesstrust.

(a) In general. An electing small busi-ness trust (ESBT) within the meaning ofsection 1361(e) is treated as two separate

trusts for purposes of chapter 1 of theInternal Revenue Code. The portion of anESBT that consists of stock in one ormore S corporations is treated as onetrust. The portion of an ESBT that con-sists of all the other assets in the trust istreated as a separate trust. The grantor oranother person may be treated as theowner of all or a portion of either or bothsuch trusts under subpart E, part I, sub-chapter J, chapter 1 of the Internal Rev-enue Code. The ESBT is treated as asingle trust for administrative purposes,such as having one taxpayer identificationnumber and filing one tax return. See§ 1.1361–1(m).

(b) Definitions—(1) Grantor portion.The grantor portion of an ESBT is theportion of the trust that is treated asowned by the grantor or another personunder subpart E.

(2) S portion. The S portion of anESBT is the portion of the trust that con-sists of S corporation stock and that is nottreated as owned by the grantor oranother person under subpart E.

(3) Non-S portion. The non-S portionof an ESBT is the portion of the trust thatconsists of all assets other than S corpo-ration stock and that is not treated asowned by the grantor or another personunder subpart E.

(c) Taxation of grantor portion. Thegrantor or another person who is treatedas the owner of a portion of the ESBTincludes in computing taxable incomeitems of income, deductions, and creditsagainst tax attributable to that portion ofthe ESBT under section 671.

(d) Taxation of S portion—(1) In gen-eral. The taxable income of the S portionis determined by taking into account onlythe items of income, loss, deduction, orcredit specified in paragraphs (d)(2), (3),and (4) of this section, to the extent notattributable to the grantor portion.

(2) Section 1366 amounts—(i) In gen-eral. The S portion takes into account theitems of income, loss, deduction, or creditthat are taken into account by an S corpo-ration shareholder pursuant to section1366 and the regulations thereunder.Rules otherwise applicable to trusts applyin determining the extent to which anyloss, deduction, or credit may be takeninto account in determining the taxableincome of the S portion. See § 1.1361–1(m)(3)(iv) for allocation of those items

in the taxable year of the S corporation inwhich the trust is an ESBT for part of theyear and an eligible shareholder undersection 1361(a)(2)(A)(i) through (iv) forthe rest of the year.

(ii) Special rule for charitable contri-butions. If a deduction described in para-graph (d)(2)(i) of this section is attribut-able to an amount of the S corporation’sgross income that is paid by the S corpo-ration for a charitable purpose specifiedin section 170(c) (without regard to sec-tion 170(c)(2)(A)), the contribution willbe deemed to be paid by the S portionpursuant to the terms of the trust’ govern-ing instrument within the meaning of sec-tion 642(c)(1) . The limitations of section681, regarding unrelated business income,apply in determining whether the contri-bution is deductible in computing the tax-able income of the S portion.

(iii) Multiple S corporations. If anESBT owns stock in more than one S cor-poration, items of income, loss, deduc-tion, or credit from all the S corporationsare aggregated for purposes of determin-ing the S portion’s taxable income.

(3) Gains and losses on disposition ofS stock—(i) In general. The S portiontakes into account any gain or loss fromthe disposition of S corporation stock. Nodeduction is allowed under section1211(b)(1) and (2) for capital losses thatexceed capital gains.

(ii) Installment method. If incomefrom the sale or disposition of stock in anS corporation is reported by the trust onthe installment method, the income recog-nized under this method is taken intoaccount by the S portion. See paragraph(g)(3) of this section for the treatment ofinterest on the installment obligation. See§ 1.1361–1(m)(5)(ii) regarding treatmentof a trust as an ESBT upon the sale of allS corporation stock using the installmentmethod.

(iii) Distributions in excess of basis.Gain recognized under section 1368(b)(2)from distributions in excess of theESBT’s basis in its S corporation stock istaken into account by the S portion.

(4) State and local income taxes andadministrative expenses—(i) In general.State and local income taxes and admin-istrative expenses directly related to the Sportion and those allocated to that portionin accordance with paragraph (h) aretaken into account by the S portion.

June 10, 2002 1086 2002–23 I.R.B.

(ii) Special rule for certain interest.Interest paid by the trust on money bor-rowed by the trust to purchase stock in anS corporation is allocated to the S portionbut is not a deductible administrativeexpense for purposes of determining thetaxable income of the S portion.

(e) Tax rates and exemption of Sportion—(1) Income tax rate. Except forcapital gains, the highest marginal trustrate provided in section 1(e) is applied tothe taxable income of the S portion. Seesection 1(h) for the rates that apply to theS portion’s net capital gain.

(2) Alternative minimum tax exemp-tion. The exemption amount of the S por-tion under section 55(d) is zero.

(f) Adjustments to basis of stock in theS portion under section 1367. The basisof S corporation stock in the S portionmust be adjusted in accordance with sec-tion 1367 and the regulations thereunder.If the ESBT owns stock in more than oneS corporation, the adjustments to thebasis in the S corporation stock of each Scorporation must be determined sepa-rately with respect to each S corporation.Accordingly, items of income, loss,deduction, or credit of an S corporationthat are taken into account by the ESBTunder section 1366 can only result in anadjustment to the basis of the stock ofthat S corporation and cannot affect thebasis in the stock of the other S corpora-tions held by the ESBT.

(g) Taxation of non-S portion—(1) Ingeneral. The taxable income of the non-Sportion is determined by taking intoaccount all items of income, deduction,and credit to the extent not taken intoaccount by either the grantor portion orthe S portion. The items attributable tothe non-S portion are taxed under sub-parts A through D of part I, subchapter J,chapter 1 of the Internal Revenue Code.The non-S portion may consist of morethan one share pursuant to section 663(c).

(2) Dividend income under section1368(c)(2). Any dividend income within

the meaning of section 1368(c)(2) isincludible in the gross income of thenon-S portion.

(3) Interest on installment obligations.If income from the sale or disposition ofstock in an S corporation is reported bythe trust on the installment method, theinterest on the installment obligation isincludible in the gross income of thenon-S portion. See paragraph (d)(3)(ii) ofthis section for the treatment of incomefrom such a sale or disposition.

(4) Charitable deduction. For purposesof applying section 642(c)(1) to paymentsmade by the trust for a charitable pur-pose, the amount of gross income of thetrust is limited to the gross income of thenon-S portion. See paragraph (d)(2)(ii) ofthis section for special rules concerningcharitable contributions paid by the S cor-poration that are deemed to be paid by theS portion.

(h) Allocation of state and localincome taxes and administration ex-penses. Whenever state and local incometaxes or administration expenses relate tomore than one portion of an ESBT, theymust be allocated between or among theportions to which they relate. These itemsmay be allocated in any manner that isreasonable in light of all the circum-stances, including the terms of the gov-erning instrument, applicable local law,and the practice of the trustee withrespect to the trust if it is reasonable andconsistent. The taxes and expenses appor-tioned to each portion of the ESBT aretaken into account by that portion.

(i) Treatment of distributions from thetrust. Distributions to beneficiaries fromthe S portion or the non-S portion, includ-ing distributions of the S corporationstock, are deductible under section 651 or661 in determining the taxable income ofthe non-S portion, and are includible inthe gross income of the beneficiariesunder section 652 or 662. However, theamount of the deduction or inclusion can-not exceed the amount of the distributable

net income of the non-S portion. Items ofincome, loss, deduction, or credit takeninto account by the grantor portion or theS portion are excluded for purposes ofdetermining the distributable net incomeof the non-S portion of the trust.

(j) Termination or revocation of ESBTelection. If the ESBT election of the trustterminates pursuant to § 1.1361–1(m)(5)or the ESBT election is revoked pursuantto § 1.1361–1(m)(6), the rules containedin this section are thereafter not appli-cable to the trust. If, upon termination orrevocation, the S portion has a net operat-ing loss under section 172; a capital losscarryover under section 1212; or deduc-tions in excess of gross income; then anysuch loss, carryover, or excess deductionsshall be allowed as a deduction, in accor-dance with the regulations under section642(h), to the trust, or to the beneficiariessucceeding to the property of the trust ifthe entire trust terminates.

(k) Effective date. This section gener-ally is applicable for taxable years ofESBTs beginning on and after May 14,2002. However, paragraphs (a), (b), (c),and (l) Example 1 of this section areapplicable for taxable years of ESBTs thatend on and after December 29, 2000.ESBTs may apply paragraphs (d)(4) and(h) of this section for taxable years ofESBTs beginning after December 31,1996.

(l) Examples. The following examplesillustrate the rules of this section:

Example 1. Comprehensive example. (i) Trusthas a valid ESBT election in effect. Under section678, B is treated as the owner of a portion of Trustconsisting of a 10% undivided fractional interest inTrust. No other person is treated as the owner of anyother portion of Trust under subpart E. Trust ownsstock in X, an S corporation, and in Y, a C corpora-tion. During 2000, Trust receives a distribution fromX of $5,100, of which $5,000 is applied againstTrust’s adjusted basis in the X stock in accordancewith section 1368(c)(1) and $100 is a dividendunder section 1368(c)(2). Trust makes no distribu-tions to its beneficiaries during the year.

(ii) For 2000, Trust has the following items of income and deduction:Ordinary income attributable to X under section 1366Y ..............................................................................................................................................................$5,000Dividend income from Y ...................................................................................................................................................................................................................$900Dividend from X representing C corporation earnings and profits..................................................................................................................................................$100

Total trust income .......................................................................................................................................................................................................................$6,000

Charitable contributions attributable to X under section 1366.........................................................................................................................................................$300Trustee fees ........................................................................................................................................................................................................................................$200State and local income taxes .............................................................................................................................................................................................................$100

2002–23 I.R.B. 1087 June 10, 2002

(iii) Trust’s items of income and deduction are divided into a grantor portion, an S portion, and a non-S portion for purposes of determining the taxation of thoseitems. Income is allocated to each portion as follows:

B must take into account the items of income attributable to the grantor portion, that is, 10% of each item, as follows:Ordinary income from X....................................................................................................................................................................................................................$500Dividend income from Y .....................................................................................................................................................................................................................$90Dividend income from X .....................................................................................................................................................................................................................$10Total grantor portion income.............................................................................................................................................................................................................$600

The total income of the S portion is $4,500, determined as follows:Ordinary income from X.................................................................................................................................................................................................................$5,000Less: Grantor portion ......................................................................................................................................................................................................................($500)Total S portion income ...................................................................................................................................................................................................................$4,500

The total income of the non-S portion is $900 determined as follows:Dividend income from Y (less grantor portion)................................................................................................................................................................................$810Dividend income from X (less grantor portion) .................................................................................................................................................................................$90Total non-S portion income...............................................................................................................................................................................................................$900

(iv) The administrative expenses and the state and local income taxes relate to all three portions and under state law would be allocated ratably to the $6,000of trust income. Thus, these items would be allocated 10% (600/6000) to the grantor portion, 75% (4500/6000) to the S portion and 15% (900/6000) to the non-Sportion.

(v) B must take into account the following deductions attributable to the grantor portion of the trust:Charitable contributions from X ..........................................................................................................................................................................................................$30Trustee fees ..........................................................................................................................................................................................................................................$20State and local income taxes ...............................................................................................................................................................................................................$10

(vi) The taxable income of the S portion is $4,005, determined as follows:Ordinary income from X.................................................................................................................................................................................................................$4,500Less: Charitable contributions from X (less grantor portion) .......................................................................................................................................................($270)

75% of trustee fees......................................................................................................................................................................................................................($150)75% of state and local income taxes............................................................................................................................................................................................($75)

Taxable income of S portion ..........................................................................................................................................................................................................$4,005

(vii) The taxable income of the non-S portion is $755, determined as follows:Dividend income from Y ...................................................................................................................................................................................................................$810Dividend income from X .....................................................................................................................................................................................................................$90

Total non-S portion income...........................................................................................................................................................................................................$900Less: 15% of trustee fees..................................................................................................................................................................................................................($30)

15% state and local income taxes..................................................................................................................................................................................................$15)Personal exemption .....................................................................................................................................................................................................................($100)

Taxable income of non-S portion......................................................................................................................................................................................................$755

Example 2. Sale of S stock. Trust has a validESBT election in effect and owns stock in X, an Scorporation. No person is treated as the owner ofany portion of Trust under subpart E. In 2003, Trustsells all of its stock in X to a person who is unrelatedto Trust and its beneficiaries and realizes a capitalgain of $5,000. This gain is taken into account bythe S portion and is taxed using the appropriatecapital gain rate found in section 1(h).

Example 3. (i) Sale of S stock for an installmentnote. Assume the same facts as in Example 2, exceptthat Trust sells its stock in X for a $400,000 install-ment note payable with stated interest over tenyears. After the sale, Trust does not own any S cor-poration stock.

(ii) Loss on installment sale. Assume Trust’sbasis in its X stock was $500,000. Therefore, Trustsustains a capital loss of $100,000 on the sale. Uponthe sale, the S portion terminates and the excessloss, after being netted against the other items takeninto account by the S portion, is made available tothe entire trust as provided in section 641(c)(4).

(iii) Gain on installment sale. Assume Trust’sbasis in its X stock was $300,000 and that the$100,000 gain will be recognized under the install-ment method of section 453. Interest income will berecognized annually as part of the installment pay-ments. The portion of the $100,000 gain recognized

annually is taken into account by the S portion.However, the annual interest income is includible inthe gross income of the non-S portion.

Example 4. Charitable lead annuity trust. Trustis a charitable lead annuity trust which is not treatedas owned by the grantor or another person undersubpart E. Trust acquires stock in X, an S corpora-tion, and elects to be an ESBT. During the taxableyear, pursuant to its terms, Trust pays $10,000 to acharitable organization described in section170(c)(2). The non-S portion of Trust receives anincome tax deduction for the charitable contributionunder section 642(c) only to the extent the amountis paid out of the gross income of the non-S portion.To the extent the amount is paid from the S portionby distributing S corporation stock, no charitablededuction is available to the S portion.

Example 5. ESBT distributions. (i) As of January1, 2002, Trust owns stock in X, a C corporation. Noportion of Trust is treated as owned by the grantoror another person under subpart E. X elects to be anS corporation effective January 1, 2003, and Trustelects to be an ESBT effective January 1, 2003. OnFebruary 1, 2003, X makes an $8,000 distribution toTrust, of which $3,000 is treated as a dividend fromaccumulated earnings and profits under section1368(c)(2) and the remainder is applied againstTrust’s basis in the X stock under section 1368(b).

The trustee of Trust makes a distribution of $4,000to Beneficiary during 2003. For 2003, Trust’s shareof X’s section 1366 items is $5,000 of ordinaryincome. For the year, Trust has no other income andno expenses or state or local taxes.

(ii) For 2003, Trust has $5,000 of taxableincome in the S portion. This income is taxed toTrust at the maximum rate provided in section 1(e).Trust also has $3,000 of distributable net income(DNI) in the non-S portion. The non-S portion ofTrust receives a distribution deduction under section661(a) of $3,000, which represents the amount dis-tributed to Beneficiary during the year ($4,000), notto exceed the amount of DNI ($3,000). Beneficiarymust include this amount in gross income under sec-tion 662(a). As a result, the non-S portion has notaxable income.

Par. 5. Section 1.1361–0 is amendedby adding entries for § 1.1361–1(j)(12)and (m) to read as follows:

§ 1.1361–0 Table of contents.

* * * * *

§ 1.1361–1 S corporation defined.

June 10, 2002 1088 2002–23 I.R.B.

* * * * *(j) * * *(12) Converting a QSST to an ESBT.

* * * * *(m) Electing small business trust (ESBT).(1) Definition.(2) ESBT election.(3) Effect of ESBT election.(4) Potential current beneficiaries.(5) ESBT terminations.(6) Revocation of ESBT election.(7) Converting an ESBT to a QSST.(8) Examples.(9) Effective date.

* * * * *Par. 6. Section 1.1361–1 is amended

by:1. Adding paragraphs (h)(1)(vi) and

(h)(3)(i)(F).2. Adding a sentence to the beginning

of paragraph (h)(3)(ii) introductorytext.

3. Adding paragraph (j)(12).4. Adding a sentence to the end of

paragraph (k)(2)(i).5. Adding paragraph (m).

The additions read as follows:

§ 1.1361–1 S corporation defined.

* * * * *(h) * * * (1) * * *(vi) Electing small business trusts. An

electing small business trust (ESBT)under section 1361(e). See paragraph (m)of this section for rules concerningESBTs including the manner of makingthe election to be an ESBT under section1361(e)(3).

* * * * *(3) * * * (i) * * *(F) If S corporation stock is held by an

ESBT, each potential current beneficiaryis treated as a shareholder. However, iffor any period there is no potential cur-rent beneficiary of the ESBT, the ESBT istreated as the shareholder during suchperiod. See paragraph (m)(4) of this sec-tion for the definition of potential currentbeneficiary.

(ii) * * * See § 1.641(c)–1 for the rulesfor the taxation of an ESBT. * * *

* * * * *(j) * * *(12) Converting a QSST to an ESBT.

For a trust that seeks to convert from a

QSST to an ESBT, the consent of theCommissioner is hereby granted torevoke the QSST election as of the effec-tive date of the ESBT election, if all thefollowing requirements are met:

(i) The trust meets all of the require-ments to be an ESBT under paragraph(m)(1) of this section except for therequirement under paragraph (m)(1)(iv)(A) of this section that the trust nothave a QSST election in effect.

(ii) The trustee and the current incomebeneficiary of the trust sign the ESBTelection. The ESBT election must be filedwith the service center where the S corpo-ration files its income tax return. ThisESBT election must state at the top of thedocument “ATTENTION ENTITYCONTROL—CONVERSION OF AQSST TO AN ESBT PURSUANT TOSECTION 1.1361–1(j)” and include allinformation otherwise required for anESBT election under paragraph (m)(2) ofthis section. A separate election must bemade with respect to the stock of each Scorporation held by the trust.

(iii) The trust has not converted froman ESBT to a QSST within the 36-monthperiod preceding the effective date of thenew ESBT election.

(iv) The date on which the ESBT elec-tion is to be effective cannot be more than15 days and two months prior to the dateon which the election is filed and cannotbe more than 12 months after the date onwhich the election is filed. If an electionspecifies an effective date more than 15days and two months prior to the date onwhich the election is filed, it will beeffective on the day that is 15 days andtwo months prior to the date on which itis filed. If an election specifies an effec-tive date more than 12 months after thedate on which the election is filed, it willbe effective on the day that is 12 monthsafter the date it is filed.

(k) * * *(2) * * * (i) * * * Paragraphs

(h)(1)(vi), (h)(3)(i)(F), (h)(3)(ii), and(j)(12) of this section are applicable fortaxable years beginning on and after May14, 2002.

* * * * *(m) Electing small business trust

(ESBT)—(1) Definition—(i) Generalrule. An electing small business trust(ESBT) means any trust if it meets the

following requirements: the trust does nothave as a beneficiary any person otherthan an individual, an estate, an organiza-tion described in section 170(c)(2)through (5), or an organization describedin section 170(c)(1) that holds a contin-gent interest in such trust and is not apotential current beneficiary; no interestin the trust has been acquired by pur-chase; and the trustee of the trust makes atimely ESBT election for the trust.

(ii) Qualified beneficiaries—(A) Ingeneral. For purposes of this section, abeneficiary includes a person who has apresent, remainder, or reversionary inter-est in the trust.

(B) Distributee trusts. A distributeetrust is the beneficiary of the ESBT onlyif the distributee trust is an organizationdescribed in section 170(c)(2) or (3). Inall other situations, any person who has abeneficial interest in a distributee trust isa beneficiary of the ESBT. A distributeetrust is a trust that receives or mayreceive a distribution from an ESBT,whether the rights to receive the distribu-tion are fixed or contingent, or immediateor deferred.

(C) Powers of appointment. A personin whose favor a power of appointmentcould be exercised is not a beneficiary ofan ESBT until the holder of the power ofappointment actually exercises the powerin favor of such person.

(D) Nonresident aliens. A nonresidentalien as defined in section 7701(b)(1)(B)is an eligible beneficiary of an ESBT.However, see paragraph (m)(4)(i) and(m)(5)(iii) of this section if the nonresi-dent alien is a potential current benefi-ciary of the ESBT (which would result inan ineligible shareholder and terminationof the S corporation election).

(iii) Interests acquired by purchase. Atrust does not qualify as an ESBT if anyinterest in the trust has been acquired bypurchase. Generally, if a person acquiresan interest in the trust and therebybecomes a beneficiary of the trust asdefined in paragraph (m)(1)(ii)(A), andany portion of the basis in the acquiredinterest in the trust is determined undersection 1012, such interest has beenacquired by purchase. This includes a netgift of a beneficial interest in the trust, inwhich the person acquiring the beneficialinterest pays the gift tax. The trust itselfmay acquire S corporation stock or other

2002–23 I.R.B. 1089 June 10, 2002

property by purchase or in a part-gift,part-sale transaction.

(iv) Ineligible trusts. An ESBT doesnot include—

(A) Any qualified subchapter S trust(as defined in section 1361(d)(3)) if anelection under section 1361(d)(2) applieswith respect to any corporation the stockof which is held by the trust;

(B) Any trust exempt from tax or notsubject to tax under subtitle A; or

(C) Any charitable remainder annuitytrust or charitable remainder unitrust (asdefined in section 664(d)).

(2) ESBT election—(i) In general. Thetrustee of the trust must make the ESBTelection by signing and filing, with theservice center where the S corporationfiles its income tax return, a statementthat meets the requirements of paragraph(m)(2)(ii) of this section. If there is morethan one trustee, the trustee or trusteeswith authority to legally bind the trustmust sign the election statement. If anyone of several trustees can legally bindthe trust, only one trustee needs to signthe election statement. Generally, onlyone ESBT election is made for the trust,regardless of the number of S corpora-tions whose stock is held by the ESBT.However, if the ESBT holds stock in mul-tiple S corporations that file in differentservice centers, the ESBT election mustbe filed with all the relevant service cen-ters where the corporations file theirincome tax returns. This requirementapplies only at the time of the initialESBT election; if the ESBT later acquiresstock in an S corporation which files itsincome tax return at a different servicecenter, a new ESBT election is notrequired.

(ii) Election statement. The electionstatement must include—

(A) The name, address, and taxpayeridentification number of the trust, thepotential current beneficiaries, and the Scorporations in which the trust currentlyowns stock;

(B) An identification of the election asan ESBT election made under section1361(e)(3);

(C) The first date on which the trustowned stock in each S corporation;

(D) The date on which the election isto become effective (not earlier than 15days and two months before the date onwhich the election is filed); and

(E) Representations signed by thetrustee stating that—

(1) The trust meets the definitionalrequirements of section 1361(e)(1); and

(2) All potential current beneficiariesof the trust meet the shareholder require-ments of section 1361(b)(1).

(iii) Due date for ESBT election. TheESBT election must be filed within thetime requirements prescribed in para-graph (j)(6)(iii) of this section for filing aqualified subchapter S trust (QSST) elec-tion.

(iv) Election by a trust described insection 1361(c)(2)(A)(ii) or (iii). A trustthat is a qualified S corporation share-holder under section 1361(c)(2)(A)(ii) or(iii) may elect ESBT treatment at anytime during the 2-year period described inthose sections or the 16-day-and-2-monthperiod beginning on the date after the endof the 2-year period. If the trust makes anineffective ESBT election, the trust willcontinue nevertheless to qualify as an eli-gible S corporation shareholder for theremainder of the period described in sec-tion 1361(c)(2)(A)(ii) or (iii).

(v) No protective election. A trust can-not make a conditional ESBT electionthat would be effective only in the eventthe trust fails to meet the requirements foran eligible trust described in section1361(c)(2)(A)(i) through (iv). If a trustattempts to make such a conditionalESBT election and it fails to qualify as aneligible S corporation shareholder undersection 1361(c)(2)(A)(i) through (iv), theS corporation election will be ineffectiveor will terminate because the corporationwill have an ineligible shareholder. Reliefmay be available under section 1362(f)for an inadvertent ineffective S corpora-tion election or an inadvertent S corpora-tion election termination. In addition, atrust that qualifies as an ESBT may makean ESBT election notwithstanding thatthe trust is a wholly-owned grantor trust.

(3) Effect of ESBT election—(i) Gen-eral rule. If a trust makes a valid ESBTelection, the trust will be treated as anESBT for purposes of chapter 1 of theInternal Revenue Code as of the effectivedate of the ESBT election.

(ii) Employer Identification Number.An ESBT has only one employer identifi-cation number (EIN). If an existing trustmakes an ESBT election, the trust contin-ues to use the EIN it currently uses.

(iii) Taxable year. If an ESBT electionis effective on a day other than the firstday of the trust’s taxable year, the ESBTelection does not cause the trust’s taxableyear to close. The termination of theESBT election (including a terminationcaused by a conversion of the ESBT to aQSST) other than on the last day of thetrust’s taxable year also does not causethe trust’s taxable year to close. In eithercase, the trust files one tax return for thetaxable year.

(iv) Allocation of S corporation items.If, during the taxable year of an S corpo-ration, a trust is an ESBT for part of theyear and an eligible shareholder undersection 1361(c)(2)(A)(i) through (iv) forthe rest of the year, the S corporationitems are allocated between the two typesof trusts under section 1377(a). See§ 1.1377–1(a)(2)(iii).

(v) Estimated taxes. If an ESBT elec-tion is effective on a day other than thefirst day of the trust’s taxable year, thetrust is considered one trust for purposesof estimated taxes under section 6654.

(4) Potential current beneficiaries—(i)In general. For purposes of determiningwhether a corporation is a small businesscorporation within the meaning of section1361(b)(1), each potential current benefi-ciary of an ESBT generally is treated as ashareholder of the corporation. Subject tothe provisions of this paragraph (m)(4), apotential current beneficiary generally is,with respect to any period, any personwho at any time during such period isentitled to, or in the discretion of any per-son may receive, a distribution from theprincipal or income of the trust. A personis treated as a shareholder of the S corpo-ration at any moment in time when thatperson is entitled to, or in the discretionof any person may, receive a distributionof principal or income of the trust. Noperson is treated as a potential currentbeneficiary solely because that personholds any future interest in the trust.

(ii) Grantor trusts. If all or a portion ofan ESBT is treated as owned by a personunder subpart E, part I, subchapter J,chapter 1 of the Internal Revenue Code,such owner is a potential current benefi-ciary in addition to persons described inparagraph (m)(4)(i) of this section.

(iii) Special rule for dispositions ofstock. Notwithstanding the provisions ofparagraph (m)(4)(i) of this section, if a

June 10, 2002 1090 2002–23 I.R.B.

trust disposes of all of its S corporationstock, any person who first met the defi-nition of a potential current beneficiaryduring the 60-day period ending on thedate of such disposition is not a potentialcurrent beneficiary and thus is not ashareholder of that corporation.

(iv) Distributee trusts—(A) In general.This paragraph (m)(4)(iv) contains therules for determining who are the poten-tial current beneficiaries of an ESBT if adistributee trust becomes entitled to, or atthe discretion of any person, may receivea distribution from principal or income ofan ESBT. A distributee trust does notinclude a trust that is not currently inexistence. For this purpose, a trust is notcurrently in existence if the trust has noassets and no items of income, loss,deduction, or credit. Thus, if a trustinstrument provides for a trust to befunded at some future time, the futuretrust is not currently a distributee trust.

(B) If the distributee trust is not a trustdescribed in section 1361(c)(2)(A), thenthe distributee trust is the potential cur-rent beneficiary of the ESBT and the cor-poration’s S corporation election termi-nates.

(C) If the distributee trust is a trustdescribed in section 1361(c)(2)(A), thepersons who would be its potential cur-rent beneficiaries (as defined in para-graphs (m)(4)(i) and (ii) of this section) ifthe distributee trust were an ESBT aretreated as the potential current beneficia-ries of the ESBT. Notwithstanding thepreceding sentence, however, if the dis-tributee trust is a trust described in sec-tion 1361(c)(2)(A)(ii) or (iii), the estatedescribed in section 1361(c)(2)(B)(ii) or(iii) is treated as the potential current ben-eficiary of the ESBT for the 2-year periodduring which such trust would be permit-ted as a shareholder.

(D) For the purposes of paragraph(m)(4)(iv)(C) of this section, a trust willbe deemed to be described in section1361(c)(2)(A) if such trust would qualifyfor a QSST election under section1361(d) or an ESBT election under sec-tion 1361(e) if it owned S corporationstock.

(v) Contingent distributions. A personwho is entitled to receive a distributiononly after a specified time or upon theoccurrence of a specified event (such asthe death of the holder of a power of

appointment) is not a potential currentbeneficiary until such time or the occur-rence of such event.

(vi) Currently exercisable powers ofappointment—(A) In general. A person towhom a distribution is or may be madeduring a period pursuant to a power ofappointment is a potential current benefi-ciary. Thus, if any person has a lifetimepower of appointment that would permitdistributions from the trust to be made tomore than 75 persons, the corporation’s Scorporation election will terminatebecause the number of potential currentbeneficiar ies wil l exceed the75-shareholder l imit of sect ion1361(b)(1)(A). Also, the S corporationelection will terminate if the currentlyexercisable power of appointment allowsdistributions to be made to an ineligibleshareholder as defined in section1361(b)(1)(B) and (C).

(B) Waiver or release. If the holder ofa power of appointment permanentlyreleases the power in a manner that isvalid under applicable local law, the per-sons that would be potential current ben-eficiaries solely because of the power willnot be potential current beneficiaries afterthe effective date of the release. Anattempt to temporarily waive, release, orlimit a currently exercisable power ofappointment will be ignored in determin-ing who are potential current beneficia-ries of the trust.

(vii) Number of shareholders. Eachpotential current beneficiary of the ESBT,as defined in paragraphs (m)(4)(i)through (vi) of this section, is counted asa shareholder of any S corporation whosestock is owned by the ESBT. During anyperiod in which the ESBT has no poten-tial current beneficiaries, the ESBT iscounted as the shareholder. A person iscounted as only one shareholder of an Scorporation even though that person maybe treated as a shareholder of the S cor-poration by direct ownership and throughone or more eligible trusts described insection 1361(c)(2)(A). Thus, for example,if a person owns stock in an S corporationand is a potential current beneficiary ofan ESBT that owns stock in the same Scorporation, that person is counted as oneshareholder of the S corporation. Simi-larly, if a husband owns stock in an Scorporation and his wife is a potentialcurrent beneficiary of an ESBT that owns

stock in the same S corporation, the hus-band and wife will be counted as oneshareholder of the S corporation.

(viii) Miscellaneous. Payments madeby an ESBT to a third party on behalf ofa beneficiary are considered to be pay-ments made directly to the beneficiary.The right of a beneficiary to assign thebeneficiary’s interest to a third party doesnot result in the third party being a poten-tial current beneficiary until that interestis actually assigned.

(5) ESBT terminations—(i) Ceasing tomeet ESBT requirements. A trust ceases tobe an ESBT on the first day the trust failsto meet the definition of an ESBT undersection 1361(e). The last day the trust istreated as an ESBT is the day before thedate on which the trust fails to meet thedefinition of an ESBT.

(ii) Disposition of S stock. In general,a trust ceases to be an ESBT on the firstday following the day the trust disposesof all S corporation stock. However, if thetrust is using the installment method toreport income from the sale or dispositionof its stock in an S corporation, the trustceases to be an ESBT on the day follow-ing the earlier of the day the last install-ment payment is received by the trust orthe day the trust disposes of the install-ment obligation.

(iii) Potential current beneficiariesthat are ineligible shareholders. If apotential current beneficiary of an ESBTis not an eligible shareholder of a smallbusiness corporation within the meaningof section 1361(b)(1), the S corporationelection terminates. For example, the Scorporation election will terminate if anonresident alien becomes a potential cur-rent beneficiary of an ESBT. Such apotential current beneficiary is treated asan ineligible shareholder beginning on theday such person becomes a potential cur-rent beneficiary, and the S corporationelection terminates on that date. However,see the special rule of paragraph(m)(4)(iii) of this section. If the S corpo-ration election terminates, relief may beavailable under section 1362(f).

(6) Revocation of ESBT election. AnESBT election may be revoked only withthe consent of the Commissioner. Theapplication for consent to revoke the elec-tion must be submitted to the InternalRevenue Service in the form of a letter

2002–23 I.R.B. 1091 June 10, 2002

ruling request under the appropriate rev-enue procedure.

(7) Converting an ESBT to a QSST.For a trust that seeks to convert from anESBT to a QSST, the consent of theCommissioner is hereby granted torevoke the ESBT election as of the effec-tive date of the QSST election, if all thefollowing requirements are met:

(i) The trust meets all of the require-ments to be a QSST under section1361(d).

(ii) The trustee and the current incomebeneficiary of the trust sign the QSSTelection. The QSST election must be filedwith the service center where the S corpo-ration files its income tax return. ThisQSST election must state at the top of thedocument “ATTENTION ENTITYCONTROL—CONVERSION OF ANESBT TO A QSST PURSUANT TOSECTION 1.1361–1(m)” and include allinformation otherwise required for aQSST election under § 1.1361–1(j)(6). Aseparate QSST election must be madewith respect to the stock of each S corpo-ration held by the trust.

(iii) The trust has not converted from aQSST to an ESBT within the 36-monthperiod preceding the effective date of thenew QSST election.

(iv) The date on which the QSST elec-tion is to be effective cannot be more than15 days and two months prior to the dateon which the election is filed and cannotbe more than 12 months after the date onwhich the election is filed. If an electionspecifies an effective date more than 15days and two months prior to the date onwhich the election is filed, it will beeffective on the day that is 15 days andtwo months prior to the date on which itis filed. If an election specifies an effec-tive date more than 12 months after thedate on which the election is filed, it willbe effective on the day that is 12 monthsafter the date it is filed.

(8) Examples. The provisions of thisparagraph (m) are illustrated by the fol-lowing examples in which it is assumed,unless otherwise specified, that all non-corporate persons are citizens or residentsof the United States:

Example 1. (i) ESBT election with section 663(c)separate shares. On January 1, 2003, M contributesS corporation stock to Trust for the benefit of M’sthree children A, B, and C. Pursuant to section663(c), each of Trust’s separate shares for A, B, andC will be treated as separate trusts for purposes of

determining the amount of distributable net income(DNI) in the application of sections 661 and 662.On January 15, 2003, the trustee of Trust files avalid ESBT election for Trust effective January 1,2003. Trust will be treated as a single ESBT andwill have a single S portion taxable under section641(c).

(ii) ESBT acquires stock of an additional S cor-poration. On February 15, 2003, Trust acquiresstock of an additional S corporation. Because Trustis already an ESBT, Trust does not need to make anadditional ESBT election.

(iii) Section 663(c) shares of ESBT convert toseparate QSSTs. Effective January 1, 2004, A, B, C,and Trust’s trustee elect to convert each separateshare of Trust into a separate QSST pursuant toparagraph (m)(7) of this section. For each separateshare, they file a separate election for each S corpo-ration whose stock is held by Trust. Each separateshare will be treated as a separate QSST.

Example 2. (i) Invalid potential current benefi-ciary. Effective January 1, 2003, Trust makes avalid ESBT election. On January 1, 2004, A, a non-resident alien, becomes a potential current benefi-ciary of Trust. Trust does not dispose of all of its Scorporation stock within 60 days after January 1,2004. As of January 1, 2004, A is a potential currentbeneficiary of Trust and therefore is treated as ashareholder of the S corporation. Because A is notan eligible shareholder of an S corporation undersection 1361(b)(1), the S corporation election of anycorporation in which Trust holds stock terminateseffective January 1, 2004. Relief may be availableunder section 1362(f).

(ii) Invalid potential current beneficiary and dis-position of S stock. Assume the same facts as inExample 2 (i) except that within 60 days after Janu-ary 1, 2004, trustee of Trust disposes of all Trust’sS corporation stock. A is not considered a potentialcurrent beneficiary of Trust and therefore is nottreated as a shareholder of any S corporation inwhich Trust previously held stock.

Example 3. Subpart E trust. M transfers stock inX, an S corporation, and other assets to Trust for thebenefit of B and B’s siblings. M retains no powers orinterest in Trust. Under section 678(a), B is treatedas the owner of a portion of Trust that includes aportion of the X stock. No beneficiary has acquiredany portion of his or her interest in Trust by pur-chase, and Trust is not an ineligible trust under para-graph (m)(1)(iv) of this section. Trust is eligible tomake an ESBT election.

Example 4. Subpart E trust continuing aftergrantor’s death. On January 1, 2003, M transfersstock in X, an S corporation, and other assets toTrust. Under the terms of Trust, the trustee of Trusthas complete discretion to distribute the income orprincipal to M during M’s lifetime and to M’s chil-dren upon M’s death. During M’s life, M is treatedas the owner of Trust under section 677. The trusteeof Trust makes a valid election to treat Trust as anESBT effective January 1, 2003. On March 28,2004, M dies. Under applicable local law, Trust doesnot terminate on M’s death. Trust continues to be anESBT after M’s death, and no additional ESBT elec-tion needs to be filed for Trust after M’s death.

Example 5. Potential current beneficiaries anddistributee trust holding S corporation stock.Trust-1 has a valid ESBT election in effect. Thetrustee of Trust-1 has the power to make distribu-

tions to A directly or to any trust created for thebenefit of A. On January 1, 2003, M creates Trust-2for the benefit of A. Also on January 1, 2003, thetrustee of Trust-1 distributes some S corporationstock to Trust-2. A, as the current income benefi-ciary of Trust-2, makes a timely and effective elec-tion to treat Trust-2 as a QSST. Because Trust-2 is avalid S corporation shareholder, the distribution toTrust-2 does not terminate the ESBT election ofTrust-1. Trust-2 itself will not be counted toward the75-shareholder limit of section 1361(b)(1)(A). Addi-tionally, because A is already counted as an S cor-poration shareholder because of A’s status as apotential current income beneficiary of Trust-1, A isnot counted again by reason of A’s status as thedeemed owner of Trust-2.

Example 6. Potential current beneficiaries anddistributee trust not holding S corporation stock. (i)Distributee trust that would itself qualify as anESBT. Trust-1 holds stock in X, an S corporation,and has a valid ESBT election in effect. Under theterms of Trust-1, the trustee has discretion to makedistributions to A, B, and Trust-2, a trust for thebenefit of C, D, and E. Trust-2 would qualify to bean ESBT, but it owns no S corporation stock and hasmade no ESBT election. Under paragraph (m)(4)(iv)of this section, Trust-2’s potential current beneficia-ries are treated as the potential current beneficiariesof Trust-1 and are counted as shareholders for pur-poses of section 1361(b)(1). Thus, A, B, C, D, and Eare potential current beneficiaries of Trust-1 and arecounted as shareholders for purposes of section1361(b)(1). Trust-2 itself will not be counted as ashareholder of Trust-1 for purposes of section1361(b)(1).

(ii) Distributee trust that would not qualify as anESBT or a QSST. Assume the same facts as in para-graph (i) of this Example 6 except that D is a non-resident alien. Trust-2 would not be eligible to makean ESBT or QSST election if it owned S corporationstock and therefore Trust-2 is a potential currentbeneficiary of Trust-1. Since Trust-2 is not an eli-gible shareholder, X’s S corporation election termi-nates.

(iii) Distributee trust that is a section1361(c)(2)(A)(ii) trust. Assume the same facts as inparagraph (i) of this Example 6 except that Trust-2is a trust treated as owned by A under section 676because A has the power to revoke Trust-2 at anytime prior to A’s death. On January 1, 2003, A dies.Because Trust-2 is a trust described in section1361(c)(2)(A)(ii) during the 2-year period beginningon the day of A’s death, under paragraph(m)(4)(iv)(C) of this section, Trust-2’s only potentialcurrent beneficiary is the person listed in section1361(c)(2)(B)(ii), A’s estate. Thus, B and A’s estateare potential current beneficiaries of Trust-1 and arecounted as shareholders for purposes of section1361(b)(1).

Example 7. Potential current beneficiaries andpowers of appointment. M creates Trust for the ben-efit of A. A also has a currently exercisable power toappoint income or principal to anyone except A, A’screditors, A’s estate, and the creditors of A’s estate.The potential current beneficiaries of Trust will be Aand all other persons except for A’s creditors, A’sestate, and the creditors of A’s estate. This numberwill exceed the 75-shareholder limit of section1361(b)(1)(A). If Trust holds S corporation stock,the corporation’s S election will terminate.

June 10, 2002 1092 2002–23 I.R.B.

(9) Effective date. This paragraph (m)is applicable for taxable years of ESBTsbeginning on and after May 14, 2002.

Par. 7. Section 1.1362–6 is amendedby revising paragraph (b)(2)(iv) to read asfollows:

§ 1.1362–6 Election and consents.* * * * *

(b) * * *(2) * * *(iv) Trusts. In the case of a trust

described in section 1361(c)(2)(A)(including a trust treated under section1361(d)(1)(A) as a trust described in sec-tion 1361(c)(2)(A)(i) and excepting anelecting small business trust described insection 1361(c)(2)(A)(v) (ESBT)), onlythe person treated as the shareholder forpurposes of section 1361(b)(1) must con-sent to the election. When stock of thecorporation is held by a trust, both hus-band and wife must consent to any elec-tion if the husband and wife have a com-munity interest in the trust property. Seeparagraph (b)(2)(i) of this section forrules concerning community interests in Scorporation stock. In the case of anESBT, the trustee and the owner of anyportion of the trust that consists of thestock in one or more S corporations undersubpart E, part I, subchapter J, chapter 1of the Internal Revenue Code must con-sent to the S corporation election. If thereis more than one trustee, the trustee ortrustees with authority to legally bind thetrust must consent to the S corporationelection.

* * * * *

Par. 8. Section 1.1362–7 is amendedby:

1. Revising the section heading.2. Adding a sentence to the end of

paragraph (a).The revision and addition read as fol-

lows:

§ 1.1362–7 Effective dates.

(a) * * * Section 1.1362–6(b)(2)(iv) isapplicable for taxable years beginning onand after May 14, 2002.* * * * *

Par. 9. Section 1.1377–0 is amendedby adding an entry for § 1.1377–1(a)(2)(iii) to read as follows:

§ 1.1377–0 Table of contents.

* * * * *

§ 1.1377–1 Pro rata share.

(a) * * * (2) * * *(iii) Shareholder trust conversions.

* * * * *

Par. 10. Section 1.1377–1 is amendedby:

1. Adding paragraph (a)(2)(iii).2. Adding Example 3 to paragraph (c).The additions read as follows:

§ 1.1377–1 Pro rata share.

(a) * * *(2) * * *(iii) Shareholder trust conversions. If,

during the taxable year of an S corpora-tion, a trust that is an eligible shareholderof the S corporation converts from a trustdescribed in section 1361(c)(2)(A)(i), (ii),(iii), or (v) for the first part of the year toa trust described in a different subpart ofsection 1361(c)(2)(A)(i), (ii), or (v) forthe remainder of the year, the trust’s shareof the S corporation items is allocatedbetween the two types of trusts. The firstday that a qualified subchapter S trust(QSST) or an electing small business trust(ESBT) is treated as an S corporationshareholder is the effective date of theQSST or ESBT election. Upon the con-version, the trust is not treated as termi-nating its entire interest in the S corpora-tion for purposes of paragraph (b) of thissection, unless the trust was a trustdescribed in section 1361(c)(2)(A)(ii) or(iii) before the conversion.

* * * * *(c) * * *Example 3. Effect of conversion of a qualified

subchapter S trust (QSST) to an electing small busi-ness trust (ESBT). (i) On January 1, 2003, Trustreceives stock of S corporation. Trust’s currentincome beneficiary makes a timely QSST electionunder section 1361(d)(2), effective January 1, 2003.Subsequently, the trustee and current income benefi-ciary of Trust elect, pursuant to § 1.1361–1(j)(12),to terminate the QSST election and convert to anESBT, effective July 1, 2004. The taxable year of Scorporation is the calendar year. In 2004, Trust’s prorata share of S corporation’s nonseparately com-puted income is $100,000.

(ii) For purposes of computing the income allo-cable to the QSST and to the ESBT, Trust is treatedas a QSST through June 30, 2004, and Trust istreated as an ESBT beginning July 1, 2004. Pursu-ant to section 1377(a)(1), the pro rata share of Scorporation income allocated to the QSST is$49,727 ($100,000 x 182 days/366 days), and thepro rata share of S corporation income allocated tothe ESBT is $50,273 ($100,000 x 184 days/366days).

Par. 11. Section 1.1377–3 is revised toread as follows:

§ 1.1377–3 Effective dates.

Section 1.1377–1 and 1.1377–2 applyto taxable years of an S corporationbeginning after December 31, 1996,except that § 1.1377–1(a)(2)(iii), and (c)Example 3 are applicable for taxableyears beginning on and after May 14,2002.

PART 602—OMB CONTROLNUMBERS UNDER THEPAPERWORK REDUCTION ACT

Par. 12. The authority citation for part602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 13. In § 602.101, paragraph (b) isamended by adding an entry for 1.444–4and revising the entry for 1.1361–1 innumerical order to the table to read asfollows:

§ 602.101 OMB Control numbers

* * * * *(b) * * *

CFR part or section whereidentified and described

Current OMBcontrol No.

* * * * *1.444–4..................................................................................................................................................................... 1545–1591* * * * *1.1361–1................................................................................................................................................................... 1545–0731

1545–1591* * * * *

2002–23 I.R.B. 1093 June 10, 2002

Robert E. Wenzel,Deputy Commissioner of

Internal Revenue.

Approved May 3, 2002.

Pamela F. Olson,Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on May13, 2002, 8:45 a.m., and published in the issue ofthe Federal Register for May 14, 2002, 67 F.R.34388)

June 10, 2002 1094 2002–23 I.R.B.

Part III. Administrative, Procedural, and Miscellaneous

Partnership TransactionsInvolving Long-term Contracts

Notice 2002–37

The Internal Revenue Service (IRS)and the Treasury Department (Treasury)intend to publish regulations addressingpartnership transactions involving con-tracts accounted for under a long-termcontract method of accounting.

BACKGROUND

Concurrently with this Notice, the IRSand Treasury are issuing final regulationsunder § 460 of the Internal Revenue Codeto address a mid-contract change in tax-payer engaged in completing a contractaccounted for under a long-term contractmethod of accounting. In general, theregulations divide the rules regarding amid-contract change in taxpayer engagedin completing this type of contract intotwo categories—constructive completiontransactions and step-in-the-shoes trans-actions. The regulations provide that atransfer described in § 721(a) of a long-term contract to a partnership and a trans-fer of a partnership interest are step-in-the-shoes transactions. The IRS andTreasury intend to publish regulationsaddressing these and other partnershiptransact ions involving contractsaccounted for under a long-term contractmethod of accounting. This Noticedescribes the special rules that will applyto such transactions.

DESCRIPTION OF REGULATIONSRELATING TO PARTNERSHIPS

The IRS and Treasury believe thatstep-in-the-shoes treatment generally isappropriate for contributions of contractsto partnerships in transactions subject to§ 721(a). Accordingly, the contribution ofa contract accounted for under a long-term contract method of accounting to apartnership in a transaction subject to§ 721(a) is a step-in-the-shoes transac-tion.

The regulations will require a partnerthat contributes a contract accounted forunder a long-term contract method ofaccounting to a partnership to increase the

basis of the partnership interest by theamount of gross receipts that the partnerhas recognized with respect to the con-tract, and reduce the basis of the partner-ship interest by the amount of grossreceipts the partner has received or rea-sonably expects to receive under the con-tract. However, the partner may notreduce the basis of the partnership interestbelow zero, but must recognize income tothe extent that the basis of the partnershipinterest would be reduced below zero.The regulations will provide that, inapplying a long-term contract method ofaccounting to the contributed contract, thepartnership must reduce its total contractprice (or gross contract price) by theamount of income recognized by the con-tributing partner. These rules follow pro-visions in the final mid-contract change intaxpayer regulations regarding transfersof long-term contracts in certain corpo-rate transactions qualifying for step-in-the-shoes treatment.

Section 704(c) generally provides thatincome, gain, loss, or deduction attribut-able to property that is contributed to apartnership must be allocated to the con-tributing partner. The purpose of § 704(c)is to prevent the shifting of tax conse-quences among partners with respect toprecontribution gain or loss. The regula-tions will apply § 704(c) principles toincome or loss attributable to a contrib-uted contract accounted for under a long-term contract method of accounting. Theamount of income or loss subject to§ 704(c) will be (i) the amount that wouldbe taken into account (under the construc-tive completion rules) if, immediatelybefore the contribution of the contract tothe partnership, the partner disposed ofthe contract for its fair market value in afully taxable transaction, reduced by (ii)the amount of income, if any, that thepartner is required to recognize as a resultof the contribution. The regulations willprovide additional guidance on the man-ner of applying § 704(c) to income or lossfrom a contributed contract. The regula-tions will provide that for periods prior tothe date that the regulations are pub-lished, taxpayers must apply § 704(c) tosuch income or loss in any manner that

reasonably accounts for the § 704(c)income or loss over the life of the con-tract.

Section 741 provides that gain or lossrecognized on the sale or exchange of aninterest in a partnership shall be consid-ered as gain or loss from a capital asset,except as provided in § 751. Section751(a) provides that the amount of anymoney, or the fair market value of anyproperty, received by a transferor partnerin exchange for all or any part of the part-ner’s interest in the partnership attribut-able to unrealized receivables (as definedin § 751(c)) or inventory items (asdefined in § 751(d)) of the partnershipshall be considered as an amount realizedfrom the sale or exchange of propertyother than a capital asset. In Rev. Rul.79–51, 1979–1 C.B. 225, the IRS ruledthat where a partner sold the partner’sentire interest in a partnership, amountsreceived in exchange for the partner’sinterest attributable to the value at thetime of sale of the partnership’s partiallycompleted contracts, the income fromwhich was being accounted for on thecompleted contract method, were taxedunder § 751(a).

The transfer of an interest in a partner-ship engaged in a contract accounted forunder a long-term contract method ofaccounting is a step-in-the-shoes transac-tion. The regulations will provide thatcontracts accounted for under a long-termcontract method of accounting are unreal-ized receivables within the meaning of§ 751(c). The amount of ordinary incomeor loss attributable to a contract under theregulations will be the amount of incomeor loss that the partnership would takeinto account (under the constructivecompletion rules) if, at the time of atransfer of a partnership interest or a dis-tribution to a partner (as the case may be),the partnership disposed of the contractfor its fair market value in a fully taxabletransaction.

The IRS and the Treasury do notbelieve that step-in-the-shoes treatment isappropriate for distributions of long-termcontracts by a partnership to a partner ina transaction subject to § 731(a). In thesetransactions, a step-in-the-shoes rule maynot produce appropriate results if the part-ner’s basis in the contract (including the

2002–23 I.R.B. 1095 June 10, 2002

uncompleted property, if applicable) thatis distributed by a partnership is not equalto the partnership’s basis in the contract(including the uncompleted property, ifapplicable). The regulations will providethat a distribution of a contract accountedfor under a long-term contract method ofaccounting by a partnership to a partner isa constructive completion transaction. Indetermining the partnership’s income onthe constructive completion transactionunder § 1.460–4(k)(2), the fair marketvalue of the contract will be treated as theamount paid for the contract.

Section 751(b)(1) provides that to theextent a partner receives in a distribution— (A) partnership property which is (i)unrealized receivables or (ii) inventoryitems which have appreciated substan-tially in value, in exchange for all or apart of the partner’s interest in other part-nership property (including money), or(B) partnership property (includingmoney) other than property described in§ 751(b)(1)(A)(i) or (ii) in exchange forall or part of the partner’s interest in part-nership property described in § 751(b)(1)(A)(i) or (ii), the transaction shallbe considered a sale or exchange of theproperty between the distributee partnerand the partnership. Because the distribu-tion of a contract accounted for under along-term contract method of accountingis treated as a constructive completiontransaction, a distribution of the contractcauses the partnership to recognize all ofthe ordinary income or loss attributable tothe contract. Although no income or lossremains in the contract after the construc-tive completion, the partnership may holdother assets that may cause § 751(b) toapply. Therefore, the regulations willrequire a partnership that distributes acontract accounted for under a long-termcontract method of accounting to applythe constructive completion rules beforeapplying the rules of § 751(b) to the dis-tribution.

Where a partnership that holds a con-tract accounted for under a long-termcontract method of accounting makes adistribution to a partner that has the effectof reducing that partner’s share of ordi-nary income or loss from the contract, theregulations generally will not require aconstructive completion of the entire con-tract. However, consistent with the gen-

eral principles of subchapter K,§ 751(b) may apply to such a transaction.

Section 732 determines the basis ofproperty (other than money) distributedby a partnership to a partner. Section734(b) provides for an adjustment to thebasis of partnership property as a result ofcertain distributions from partnershipsthat have a § 754 election in effect. Theregulations will provide that if a contractaccounted for under a long-term contractmethod of accounting is distributed to apartner, then for purposes of determiningthe partner’s basis in the contract (includ-ing the uncompleted property, if appli-cable) under § 732, and the amount ofany basis adjustment under § 734(b), thepartnership’s basis in the contract (includ-ing the uncompleted property, if appli-cable) immediately prior to the distribu-tion will be the partnership’s allocablecontract costs (including transactioncosts), increased (or decreased) by theamount of income (or loss) recognized bythe partnership on the contract throughthe date of the distribution (includingamounts recognized as a result of the con-structive completion), and decreased bythe amounts that the partnership hasreceived or reasonably expects to receiveunder the contract.

In addition, the regulations will pro-vide that if a contract accounted for undera long-term contract method of account-ing is distributed to a partner, then, incomputing the total contract price for thenew contract under § 1.460–4(k)(2)(iii),the partner’s basis in the contract (includ-ing the uncompleted property, if appli-cable) after the distribution (as deter-mined under § 732) will be deemed to bethe consideration paid by the partner forthe contract. Thus, the total contract priceof the new contract will be reduced by thepartner’s basis in the contract (includingthe uncompleted property, if applicable)immediately after the distribution.

EFFECTIVE DATES

The regulations will be effective forcontributions of long-term contracts topartnerships, distributions by partnershipsengaged in long-term contracts, and trans-fers of interests in partnerships that areengaged in long-term contracts occurringon or after May 15, 2002.

REQUEST FOR PUBLIC COMMENT

Comments are requested on the scopeand substance of the regulations. Directall written comments to Internal RevenueService, Attn: CC:ITA:RU (NT 2002–37),Room 5226, P.O. Box 7604, Ben FranklinStation, Washington, DC 20044. In thealternative, comments may be hand deliv-ered Monday through Friday between thehours of 8:00 a.m. and 5:00 p.m. to:CC:ITA:RU (NT 2002–37), Courier’sdesk, Internal Revenue Service, 1111Constitution Avenue, NW, Washington,DC, or submitted electronically to:Notice.Comments@m1.irs.counsel.treas.gov. Please submit all comments byAugust 12, 2002. All submissions will beopen to public inspection.

DRAFTING INFORMATION

The principal author of this Notice isRichard T. Probst of the Office of theAssociate Chief Counsel (Passthroughsand Special Industries). However, otherpersonnel from Treasury and the IRS par-ticipated in its development. For furtherinformation regarding this Notice, contactMr. Probst at (202) 622–3060 (not a toll-free call).

26 CFR 601.105: Examination of returns and claimsfor refund, credit or abatement; determination ofcorrect tax liability.(Also Part I, § 172.)

Rev. Proc. 2002–40

SECTION 1. PURPOSE

.01 The Job Creation and WorkerAssistance Act of 2002 (the Act) added§ 172(b)(1)(H) to the Internal RevenueCode to provide a 5-year carrybackperiod for net operating losses (NOLs) forany taxable year ending during 2001 and2002. Pub. L. No. 107–147, § 102(a), 116Stat. 21 (March 9, 2002). Consistent withthe intent of Congress as reflected in cor-respondence to the Treasury Departmentsubsequent to the Act’s enactment, thisrevenue procedure provides qualifyingtaxpayers who filed returns for a taxableyear ending during 2001 and 2002 with-out taking advantage of the new 5-yearcarryback with a limited opportunity to

June 10, 2002 1096 2002–23 I.R.B.

do so and to apply for a tentative carry-back adjustment if they act on or beforeOctober 31, 2002.

.02 Specifically, this revenue proce-dure allows taxpayers that incurred anNOL in a taxable year ending during2001 or 2002 and elected under§ 172(b)(3) to forgo the NOL carrybackperiod to revoke their elections in order toapply the 5-year carryback period. Thisrevenue procedure also allows such tax-payers, as well as taxpayers who used a2-year carryback period for an NOL in ataxable year ending during 2001 or 2002,to file an application for a tentative carry-back adjustment under § 6411(a) basedon a 5-year NOL carryback period even ifthe 12-month period for filing such anapplication has expired. A revocationand/or application for tentative carrybackadjustment under this revenue proceduremust be made on or before October 31,2002. Finally, this revenue procedureallows taxpayers that filed returns for ataxable year ending in 2001 or 2002, andwho neither elected to forgo the carry-back period, nor used the 2-year carry-back period, to elect to relinquish the5-year carryback period (and therebyretain the ability to use the 2-year carry-back period) if they act on or beforeOctober 31, 2002.

.03 In connection with these rulesallowing taxpayers to reevaluate optionsregarding the carryback period, the Inter-nal Revenue Service and TreasuryDepartment intend to provide relief forconsolidated groups that failed to waivethe portion of the carryback period forconsolidated net operating losses attribut-able to certain acquired members forwhich such members were members ofanother group. The scope of such reliefwill be announced shortly in separateguidance.

SECTION 2. BACKGROUND

.01 Section 172(b)(1)(A)(i) generallyprovides that an NOL for any taxable yearmust be carried back to each of the 2years preceding the taxable year of suchNOL. Section 172(b)(3) provides that anytaxpayer entitled to a carryback periodunder § 172(b)(1) may elect to relinquishthe carryback period with respect to anNOL for any taxable year.

.02 Section 102 of the Act amended§ 172 of the Code in two respects. First,

§ 172(b)(1)(H) was added to allow a5-year carryback period for NOLs for anytaxable year ending during 2001 and2002. Second, § 172(j) was added toallow any taxpayer entitled to the 5-yearcarryback under § 172(b)(1)(H) from anyloss year to elect to relinquish that carry-back period with respect to an NOL forany taxable year. A taxpayer making thiselection generally must apply the 2-yearcarryback period set forth in§ 172(b)(1)(A)(i).

.03 An election to relinquish either theNOL carryback period in general under§ 172(b)(3), or just the 5-year carrybackperiod under § 172(j), must be made bythe due date (including extensions) for fil-ing the taxpayer’s return for the taxableyear of the NOL and in the manner pre-scribed by the Secretary.

.04 Section 6411(a) provides that ataxpayer may file an application for a ten-tative carryback adjustment of the tax forthe prior taxable year affected by an NOLcarryback from any taxable year. Section6411(a) also provides that the applicationmust be filed on or after the date of filingfor the return for the taxable year of theNOL from which the carryback resultsand within a period of 12 months aftersuch taxable year or, with respect to anyportion of a business credit carrybackattributable to an NOL from a subsequenttaxable year, within a period of 12months from the end of such subsequenttaxable year. Section 6411(b) provides a90-day period during which the Servicewill make a limited examination of theapplication to discover omissions anderrors of computation and determine theamount of the decrease in tax attributableto the carryback. The Service may disal-low, without further action, any applica-tion that contains errors of computationthat cannot be corrected within the 90-dayperiod or that contains material omis-sions. The decrease in tax attributable tothe carryback will be applied againstunpaid amounts of tax. Any remainder ofthe decrease will, within the 90-dayperiod, be credited or refunded.

.05 It has been brought to the attentionof the Service and Treasury Departmentthat some taxpayers that incurred an NOLin a taxable year ending during 2001 filedreturns before the Act became law andeither elected under § 172(b)(3) to relin-quish the NOL carryback period in gen-

eral or applied the 2-year carrybackperiod. In some cases, these taxpayersmight have wished to take advantage ofthe 5-year carryback period, had theybeen aware of its availability, and applyfor a tentative carryback adjustment. TheChairmen and Ranking Members of boththe House Ways and Means Committeeand the Senate Finance Committee haveadvised the Treasury Department of theirintent that qualifying taxpayers beallowed to take advantage of the 5-yearNOL carryback period to the maximumextent possible, and that they intend topursue technical corrections legislationthat will clarify this intent. Specifically,the technical corrections legislation willallow the Service to issue guidance toallow taxpayers to reconsider a previouselection under § 172(b)(3) to relinquishthe NOL carryback period in general, andto file an application for a tentative carry-back adjustment under § 6411(a), to takeadvantage of the 5-year carryback period,on or before October 31, 2002. Whenenacted, this legislation will be effectiveas if originally included in the Act. Thisrevenue procedure describes how the Ser-vice is taking into account Congressionalintent in administering the provision.

SECTION 3. SCOPE

This revenue procedure applies to tax-payers that incurred an NOL for any tax-able year ending in 2001 or 2002.

SECTION 4. TAXPAYERS THATELECTED TO FORGO THECARRYBACK PERIOD

.01 In order to give effect to the intentof Congress to allow taxpayers a 5-yearNOL carryback period, any taxpayer thatpreviously elected under § 172(b)(3) toforgo the carryback period for an NOLfor any taxable year ending in 2001 or2002 may revoke such election in order toapply the 5-year carryback period by fol-lowing the procedures of section 7 of thisrevenue procedure on or before October31, 2002. Any revocation of the electionto forgo the NOL carryback period willalso apply to a carryback of any alterna-tive tax NOL for the same taxable year.

.02 If a taxpayer that previouslyelected under § 172(b)(3) to forgo the car-ryback period for an NOL incurred in ataxable year ending in 2001 or 2002 does

2002–23 I.R.B. 1097 June 10, 2002

not want to revoke that election in orderto use the 5-year carryback period pro-vided by § 172(b)(1)(H), the taxpayerneed not file any additional form or state-ment. Unless the taxpayer follows theprocedures set forth in section 7 of thisrevenue procedure, the taxpayer’s previ-ous election applies as well to forgo the5-year carryback period.

SECTION 5. TAXPAYERS THATAPPLIED THE 2-YEAR CARRYBACKPERIOD

.01 If a taxpayer that previously filedan application for a tentative carrybackadjustment (whether or not the Servicehas acted upon such application) or anamended return using a 2-year carrybackperiod for an NOL incurred in a taxableyear ending in 2001 or 2002, and that didnot elect to forgo the 5-year carrybackperiod under § 172(j), wants to use the5-year carryback provided under § 172(b)(1)(H), the taxpayer may do so by fol-lowing the procedures of section 7 of thisrevenue procedure on or before October31, 2002. Any amendment of a priorrefund claim will also apply to a carry-back of any alternative tax NOL for thesame taxable year. In the case of anamended application for a tentative carry-back adjustment, the 90-day perioddescribed in § 6411(b) will begin on thedate the amended declaration is filed.

.02 If a taxpayer that previously filedan application for a tentative carrybackadjustment or an amended return using a2-year carryback period for an NOLincurred in a taxable year ending in 2001or 2002 prefers to apply the 2-year carry-back period, rather than the 5-year carry-back period provided under § 172(b)(1)(H), the taxpayer need not file anyform or statement in order to satisfy therequirements for an election under § 172(j) to forgo the 5-year carryback period.Unless the taxpayer follows the proce-dures of section 7 of this revenue proce-dure, the taxpayer will be considered tohave made an election under§ 172(j) to forgo the 5-year carrybackperiod in favor of the 2-year carrybackperiod.

SECTION 6. TAXPAYERS THATNEITHER ELECTED TO FORGO THECARRYBACK PERIOD NOR APPLIEDTHE 2-YEAR CARRYBACK PERIOD

.01 Any taxpayer that:(1) filed a federal income tax

return for a taxable year ending in 2001or 2002;

(2) did not elect under § 172(b)(3)to forgo the carryback period in generalfor an NOL incurred in such taxable year;and

(3) did not previously file anapplication for a tentative carrybackadjustment or an amended return using a2-year carryback period for such NOL,may apply the 2-year carryback period, inlieu of the 5-year carryback period, byfollowing the procedures of section 7 ofthis revenue procedure on or before Octo-ber 31, 2002.

.02 For any taxpayer described in sec-tion 6.01 of this revenue procedure thatdoes not follow the procedures of section7 of this revenue procedure to apply the2-year carryback period, the 5-year carry-back period will apply by operation oflaw. In that event, the period of limita-tions provided in § 6511 will apply in thecase of any claim for refund on anamended return, and the period providedin § 6411(a) will apply in the case of anytentative carryback adjustment, that isbased on the 5-year carryback period.

SECTION 7. PROCEDURES

.01 What to File. A taxpayer describedin section 4 or 5 of this revenue proce-dure that wants to use the 5-year carry-back period must file the appropriateform(s) using a 5-year carryback period.A taxpayer described in section 6 of thisrevenue procedure that wants to relin-quish the 5-year carryback period (andthus retain its ability to use the 2-yearcarryback period) must file the appropri-ate form(s) using a 2-year carrybackperiod, even if no refund or change in taxliability is shown on the form(s). Theappropriate form(s) are:

(1) for corporations, a Form 1139,Corporation Application for TentativeRefund, or Form 1120X, Amended U.S.Corporation Income Tax Return;

(2) for individuals, a Form 1045,Application for Tentative Refund, or Form

1040X, Amended U.S. Individual IncomeTax Return; and

(3) for estates or trusts, a Form1045, or amended Form 1041, U.S.Income Tax Return for Estates and Trusts.

.02 Labels. Taxpayers described insection 4.01 of this revenue procedureshould type or print across the top of theappropriate form “Revocation of NOLcarryback waiver pursuant to Rev. Proc.2002–40.” Taxpayers described in section5.01 of this revenue procedure shouldtype or print across the top of the appro-priate form “Amended refund claim pur-suant to Rev. Proc. 2002–40.”

.03 When to File. Any form filed pur-suant to this revenue procedure must befiled on or before October 31, 2002.

SECTION 8. EFFECTIVE DATE

This revenue procedure is effective forNOLs arising in taxable years endingafter December 31, 2000.

DRAFTING INFORMATION

The principal author of this revenueprocedure is Martin Scully, Jr. of theOffice of Associate Chief Counsel(Income Tax and Accounting). For furtherinformation regarding this revenue proce-dure, contact Mr. Scully at (202) 622–4960 (not a toll-free call).

26 CFR 1.62–2: Reimbursements and other expenseallowance arrangements.(Also Part I, § 62.)

Rev. Proc. 2002–41

The purpose of this revenue procedureis to provide an optional expense substan-tiation rule so that businesses in the pipe-line construction industry can providereimbursements under an accountableplan to employees who also furnish weld-ing rigs or mechanics rigs as part of theirperformance of services as employees.This revenue procedure is not intended tosuggest that all workers providing suchservices and equipment are employees.Rather, the method in this revenue proce-dure may be applied when businesseschoose to use an accountable plan toreimburse individuals who are employeesfor rig-related expenses incurred asemployees.

June 10, 2002 1098 2002–23 I.R.B.

As part of the Industry Issue Resolu-tion Pilot Program, announced in Notice2000–65, representatives of the pipelineconstruction industry requested clarifica-tion of the proper treatment of amountspaid to employee welders and heavyequipment mechanics who provide heavyequipment in connection with the perfor-mance of services. At issue was whetherthe amounts should be treated as pay-ments of rent, payments of wages, or asthe reimbursement of expenses subject tothe accountable plan requirements.

Employers in the pipeline constructionindustry encounter several challenges toreimbursing under an accountable planthe costs relating to employee-providedwelding rigs and mechanics rigs, particu-larly in determining the proper amount ofthe expense incurred. Rig welders andheavy equipment mechanics work formultiple companies for relatively shortperiods. Therefore, the proper allocationof fixed costs related to the equipmentamong employers is unclear. Moreover,although the rigs are mobile, the existingmileage-based expense substantiationprovision does not accurately reflect rig-related costs because rigs are used prima-rily while stationary. Further, theseemployees incur substantial expenses asemployees in providing these rigs as acondition of employment. Due to theseunique features, reimbursing employeesfor rig-related expenses under the existingaccountable plan requirements is unwork-able for this industry. In order to enablethis industry to reimburse rig-relatedexpenses to employees under an account-able plan, this revenue procedure pro-vides an optional expense substantiationrule under which rig-related expensesmay be treated as substantiated whenreimbursing these expenses under anaccountable plan.

Under this revenue procedure anemployer may pay certain welders andheavy equipment mechanics an amount ofup to $13 per hour for rig-relatedexpenses that is deemed substantiatedunder an accountable plan when paid inaccord with this revenue procedure (up to$8 per hour if the employer provides fuelor otherwise reimburses fuel expenses).This revenue procedure provides for anannual inflation adjustment to theseamounts after 2003, if necessary and iseffective for payments made on or after

January 1, 2003. The rules are providedin Questions and Answers below.

The Service recognizes that employersin other industries may similarly providepayments to employees for the costs ofproviding equipment as employees usedin the performance of services as employ-ees. To the extent that the unique featuresof other industries creates similar chal-lenges to implementing accountableplans, the Service welcomes commentsregarding the appropriateness and designof similar relief. We specifically requestcomments concerning other categories ofqualified nonpersonal use vehicles ownedby employees and used by the employeesin the course of providing services asemployees, especially where the nature ofan industry results in employees workingfor multiple employers during each year,for which a deemed substantiation rulewould be appropriate.

TABLE OF CONTENTS

SECTION 1. PURPOSE AND SCOPE

Q-1. Must an employer use this rev-enue procedure to reimburse employeesfor rig-related expenses?

Q-2. What is the tax treatment ofamounts deemed substantiated under thisrevenue procedure?

Q-3. Which employers may use thedeemed substantiation rule provided inthis revenue procedure?

Q-4. For which vehicles and equip-ment may eligible employers use thedeemed substantiation rule provided inthis revenue procedure?

SECTION 2. BACKGROUND

Q-5. What provisions of the tax lawapply when an employer reimburses anemployee for employee business ex-penses?

Q-6. What are the tax consequences toan employee when an employer reim-burses expenses under a nonaccountableplan?

Q-7. What are the tax consequences toan employee when an employer reim-burses expenses under an accountableplan?

SECTION 3. DEEMEDSUBSTANTIATION FOR RIG-RELATED EXPENSES

Q-8. What is the amount of rig-relatedexpenses that can be deemed substanti-ated under this revenue procedure?

Q-9. For what types of vehicles mayrig-related expenses be deemed substanti-ated?

Q-10. May expenses be deemed sub-stantiated for pickup trucks under thisrevenue procedure?

Q-11. Are welding rigs and mechanicsrigs qualified nonpersonal use vehicles?

Q-12. For which employees may aneligible employer deem rig-relatedexpenses substantiated under this revenueprocedure?

Q-13. Under what circumstances mayan eligible employer anticipate that anemployee would incur rig-relatedexpenses while performing services as anemployee for an eligible employer underthe deemed substantiation rule?

Q-14. Will the amount deemed sub-stantiated under this revenue procedurebe adjusted for inflation?

Q-15. May an independent contractordetermine deductible expenses under thisrevenue procedure?

SECTION 4. EMPLOYEETREATMENT OF RIG-RELATEDEXPENSES

Q-16. May an employee exclude fromincome amounts reimbursed and deemedsubstantiated under this revenue proce-dure?

Q-17. May an employee claim deduc-tions for rig-related expenses that exceedamounts reimbursed under an account-able plan or deemed substantiated underthis revenue procedure?

Q-18. May an employee treat pay-ments made under a nonaccountable planas if they were made under an account-able plan by voluntarily substantiatingexpenses and returning any excess to theemployer?

Q-19. May an employee deduct anyrig-related expenses that exceed thosereimbursed by an employer and deemedsubstantiated under this revenue proce-dure on Schedule C, Profit or Loss FromBusiness?

Q-20. May an employee deduct anyrig-related expenses that exceed those

2002–23 I.R.B. 1099 June 10, 2002

reimbursed by an employer and deemedsubstantiated under this revenue proce-dure on Schedule E, SupplementalIncome and Loss?

Q-21. May an employee deductexpenses that an eligible employer hasalready reimbursed under an accountableplan?

SECTION 5. SPECIAL RULES FOREMPLOYERS

Q-22. May an eligible employer estab-lish an accountable plan to reimburse rigwelders or heavy equipment mechanicsfor non-rig-related business expenses?

Q-23. May an eligible employer sub-stitute a rig-related reimbursement for aportion of wages otherwise payable to anemployee?

Q-24. What are the tax consequencesif an employer that uses the deemed sub-stantiation rule in this revenue procedureprovides an additional reimbursement ofrig-related expenses?

SECTION 6. EFFECTIVE DATE

SECTION 7. REQUEST FORCOMMENTS

SECTION 8. DRAFTINGINFORMATION

SECTION 1. PURPOSE AND SCOPE

Q-1. Must an employer use this rev-enue procedure to reimburse employeesfor rig-related expenses?

A-1. No. Use of the rule described inthis revenue procedure is not mandatory,and an employer may, outside the scopeof this revenue procedure, reimburseactual expenses under an arrangementthat meets the accountable plan require-ments of § 62(c) of the Internal RevenueCode (Code) and regulations thereunder.Alternatively, an employer may reimburseemployee business expenses under a non-accountable plan (defined in Answer 6),or may choose not to reimburse employeebusiness expenses.

Q-2. What is the tax treatment ofamounts deemed substantiated underthis revenue procedure?

A-2. If the other requirementsdescribed in Answer 5 are satisfied, theamounts substantiated in accordance withthis revenue procedure are treated as paid

under an accountable plan. Thus, theamounts are not reported as wages onForm W–2 and are exempt from the with-holding and payment of income andemployment taxes. Also, no return ofinformation (e.g., Form 1099) is requiredfor payments made under an accountableplan. § 1.6041–3(h)(1).

Q-3. Which employers may use thedeemed substantiation rule provided inthis revenue procedure?

A-3. This substantiation rule may beused by any “eligible employer.” An eli-gible employer is any employer that hiresemployee rig welders or heavy equipmentmechanics and requires, as a condition ofemployment, that the rig welders andheavy equipment mechanics provide awelding rig or mechanics rig and use therig in performing services as an employeeemployed in the construction, repair, ormaintenance of transportation mainlinepipeline. The business of transportationmainline pipeline construction or repairincludes the construction, maintenance, orrepair of transportation mainline pipelineup to the first metering station or connec-tion. This includes mainline pipelinewhether it transports coal, gas, water, orother transportable materials, vapors, orliquids. The first metering station or con-nection means the point where a valve,consumer connection, or town border sta-tion divides mainline transmission linesor higher pressure lateral and branch linesfrom lower pressure distribution systems.

Q-4. For which vehicles and equip-ment may eligible employers use thedeemed substantiation rule provided inthis revenue procedure?

A-4. Eligible employers may use thedeemed substantiation rule in this revenueprocedure only to reimburse employeesfor expenses related to the use of weldingrigs and mechanics rigs described inAnswer 9.

SECTION 2. BACKGROUND

Q-5. What provisions of the tax lawapply when an employer reimburses anemployee for employee businessexpenses?

A-5. The tax rules that apply when anemployer reimburses an employee foremployee business expenses depend uponwhether the reimbursement is made underan accountable plan or nonaccountableplan. An accountable plan is a reimburse-

ment or other expense allowance arrange-ment that meets three requirements under§ 1.62–2: business connection, substantia-tion, and return of amounts in excess ofsubstantiated expenses. The business con-nection requirement is satisfied if thearrangement provides advances, allow-ances or reimbursements only for busi-ness expenses allowable as deductionsunder §§ 161–198 that are paid orincurred by an employee (or that theemployer reasonably expects theemployee to incur) in connection with theperformance of services as an employee.The substantiation requirement is satis-fied if the arrangement requires eachbusiness expense to be substantiated tothe employer within a reasonable periodof time. The return of excess requirementis satisfied if the arrangement requires theemployee to return to the payor within areasonable period of time any amountpaid under the arrangement in excess ofthe expenses substantiated. A nonaccount-able plan is a reimbursement or otherexpenses allowance arrangement thatdoes not satisfy one or more of the threerequirements.

Q-6. What are the tax consequencesto an employee when an employer reim-burses expenses under a nonaccountableplan?

A-6. Generally, § 162(a) allows adeduction for all the ordinary and neces-sary expenses paid or incurred during thetaxable year in carrying on any trade orbusiness, including the trade or businessof being an employee. Under § 1.62–2(c)(5), amounts treated as paid under anonaccountable plan are included in theemployee’s gross income, must bereported as wages on the employee’sForm W–2, and are subject to withhold-ing and payment of income and employ-ment taxes (Federal Insurance Contribu-tions Act (FICA), Federal UnemploymentTax Act (FUTA), and income tax with-holding). See also Employment TaxRegulations §§ 31.3121(a)–3 (FICA);31.3306(b)–2 (FUTA); 31.3401(a)–4(income tax withholding); and IncomeTax Regulation § 1.6041–3(h)(1) (returnof information exemption) (for exemptionfrom reporting requirements for paymentsmade under an accountable plan beforeJanuary 1, 2001, see § 1.6041–3(i)(1)).The employee may still deduct theexpenses. However, those deductions may

June 10, 2002 1100 2002–23 I.R.B.

only be claimed as miscellaneous item-ized deductions, which are limited by§ 67 to the amount exceeding 2 percent ofadjusted gross income.

Q-7. What are the tax consequencesto an employee when an employer reim-burses expenses under an accountableplan?

A-7. Section 1.62–2(c)(4) providesthat amounts treated as paid under anaccountable plan are excluded from theemployee’s gross income, are notreported as wages or other compensationon the employee’s Form W–2, and areexempt from the withholding and pay-ment of income and employment taxes.

SECTION 3. DEEMEDSUBSTANTIATION FOR RIG-RELATED EXPENSES

Q-8. What is the amount of rig-related expenses that can be deemedsubstantiated under this revenue proce-dure?

A-8. If an eligible employer either pro-vides fuel or separately reimburses fuelexpenses, expenses of up to $8 per hourfor welding rigs or mechanics rigs may bedeemed substantiated if the other require-ments in this revenue procedure are met.If an eligible employer does not providefuel or separately reimburse fuelexpenses, rig-related expenses of up to$13 per hour for welding or mechanicsrigs may be deemed substantiated if theother requirements in this revenue proce-dure are met.

Q-9. For what types of vehicles mayrig-related expenses be deemed substan-tiated?

A-9. Under this revenue procedure,rig-related expenses may be deemed sub-stantiated only with respect to weldingrigs and mechanics rigs. For purposes ofthis revenue procedure, welding rigs are¾ ton or heavier trucks equipped with awelding machine and other necessaryequipment, such as tanks and generators.For purposes of this revenue procedure,mechanics rigs are heavy trucks equippedwith a permanently installed mechanicsbed and other necessary equipment that isused to repair and maintain heavymachinery on a job site. As explained inAnswer 11, mechanics rigs and weldingrigs are qualified nonpersonal use

vehicles. The rule in this revenue proce-dure is not available for any othervehicles.

Q-10. May expenses be deemed sub-stantiated for pickup trucks under thisrevenue procedure?

A-10. No. Expenses for pickup trucksmay not be deemed substantiated as rig-related expenses under this revenue pro-cedure unless the pickup truck is part of awelding rig as described in Answer 9.(See Rev. Proc. 2001–54 for rules underwhich the amount of ordinary and neces-sary expenses of local travel or transpor-tation incurred by an employee will bedeemed substantiated under § 1.274–5when an employer provides a mileageallowance under an accountable plan.)

Q-11. Are welding rigs and mechanicsrigs qualified nonpersonal use vehicles?

A-11. Under the authority of § 1.274–5T(k)(2)(ii)(S), the Commissioner, solelyfor purposes of applying the deemed sub-stantiation rule in this revenue procedure,designates the welding rigs and mechan-ics rigs as described in Answer 9 as quali-fied nonpersonal use vehicles.

Q-12. For which employees may aneligible employer deem rig-relatedexpenses substantiated under this rev-enue procedure?

A-12. An eligible employer may deemrig-related expenses substantiated onlyfor employee rig welders and heavyequipment mechanics who are required,as a condition of employment, to providea welding or mechanics rig for use in pro-viding personal services as an employee.

Q-13. Under what circumstances mayan eligible employer anticipate that anemployee would incur rig-relatedexpenses while performing services asan employee for an eligible employerunder the deemed substantiation rule?

A-13. An eligible employer’s reim-bursement will meet the business connec-tion requirement of § 1.62–2(d) if the eli-gible employer reasonably anticipates thatthe employee will incur rig-relatedexpenses in connection with the perfor-mance of services for the employer. Itwould not be reasonable for an eligibleemployer to anticipate that an employeewould incur rig-related expenses forhours that it actually knew the employ-ee’s rig was not used (such as during awork stoppage for inclement weather).

Q-14. Will the amount deemed sub-stantiated under this revenue procedurebe adjusted for inflation?

A-14. Yes. For calendar years after2003, the hourly rate will be adjustedannually for inflation under § 1(f)(3),except that the base year for such adjust-ment will be calendar year 2002 and noadjustment will be made unless theincrease is at least one dollar. Any adjust-ment will be rounded to the nearest dol-lar. Any adjustment to the rates providedin this revenue procedure will be pub-lished annually.

Q-15. May an independent contractordetermine deductible expenses underthis revenue procedure?

A-15. No. Independent contractorsengaged in the trade or business of pro-viding welding services or services asheavy equipment mechanics may not usethe deemed substantiation method in thisrevenue procedure to determine deduct-ible expenses in their trade or business.

SECTION 4. EMPLOYEETREATMENT OF RIG-RELATEDEXPENSES

Q-16. May an employee exclude fromincome amounts reimbursed and deemedsubstantiated under this revenue proce-dure?

A-16. Yes. This is true even if theamounts reimbursed and deemed substan-tiated exceed the actual rig-relatedexpenses. For example, assume anemployee incurs $20,000 in rig-relatedexpenses, and the employer reimburses$20,800 at the $13 per hour rate for weld-ing rigs provided under this revenue pro-cedure. Because the reimbursement waspaid under an accountable plan, the entirereimbursement is excluded from theemployee’s income.

Q-17. May an employee claim deduc-tions for rig-related expenses that exceedamounts reimbursed under an account-able plan or deemed substantiated underthis revenue procedure?

A-17. Yes. To the extent employeebusiness expenses exceed those reim-bursed under an accountable plan, theymay be claimed as miscellaneous item-ized deductions on Schedule A. To dothis, the employee must report all reim-bursed amounts, including those deemedsubstantiated, and must offset expenseson Form 2106.

2002–23 I.R.B. 1101 June 10, 2002

Q-18. May an employee treat pay-ments made under a nonaccountableplan as if they were made under anaccountable plan by voluntarily substan-tiating expenses and returning anyexcess to the employer?

A-18. No. An employee cannot createan accountable plan. Under § 1.62–2(c)(3), if an employer provides a nonac-countable plan, an employee whoreceives payments under the plan cannotcompel the employer to treat the pay-ments as paid under an accountable planby voluntarily substantiating the expensesor returning any excess to the employer.

Q-19. May an employee deduct anyrig-related expenses that exceed thosereimbursed by an employer and deemedsubstantiated under this revenue proce-dure on Schedule C, Profit or LossFrom Business?

A-19. No. Expenses incurred in con-nection with the trade or business ofbeing an employee may not be deductedon Schedule C.

Q-20. May an employee deduct anyrig-related expenses that exceed thosereimbursed by an employer and deemedsubstantiated under this revenue proce-dure on Schedule E, SupplementalIncome and Loss?

A-20. No. Expenses incurred in con-nection with the trade or business ofbeing an employee may not be deductedon Schedule E.

Q-21. May an employee deductexpenses that an eligible employer hasalready reimbursed under an account-able plan?

A-21. No.

SECTION 5. SPECIAL RULES FOREMPLOYERS

Q-22. May an eligible employer estab-lish an accountable plan to reimburserig welders or heavy equipment mechan-ics for non-rig-related business ex-penses?

A-22. Yes. An employer may establisha separate accountable plan to reimbursenon-rig-related employee businessexpenses incurred by rig welders or heavyequipment mechanics in addition to thearrangement provided under this revenueprocedure. For example, Rev. Proc.2001–47 provides rules under which anemployer may establish an accountableplan for which the amount of ordinary

and necessary business expenses of anemployee for lodging, meal, and inciden-tal expenses or for meal and incidentalexpenses incurred while traveling awayfrom home will be deemed substantiatedunder § 1.274–54.

Q-23. May an eligible employer sub-stitute a rig-related reimbursement for aportion of wages otherwise payable to anemployee?

A-23. This revenue procedure is notintended to permit the recharacterizationof wages otherwise payable to anemployee. For example, if an employernormally pays an employee $35 per hourin wages and does not provide a rig reim-bursement in the event of inclementweather, the employer may not recharac-terize a portion of the $35 hourly wageinto rig reimbursement during inclementweather. If an employer’s reimbursementor other expenses allowance arrangementevidences a pattern of abuse of theaccountable plan rules, then all paymentsmade under the arrangement will betreated as paid under a nonaccountableplan.

Q-24. What are the tax consequencesif an employer that uses the deemed sub-stantiation rule in this revenue proce-dure provides an additional reimburse-ment of rig-related expenses?

A-24. If an employer that uses thedeemed substantiation rule separatelyreimburses an employee for any rig-related expenses, the additional paymentis treated as paid under a nonaccountableplan. Thus, the additional payment isreported as wages or other compensationof the employee’s Form W–2, and is sub-ject to withholding and payment ofincome and employment taxes.

For example, employee A is reim-bursed for rig-related expenses deemedsubstantiated under this revenue proce-dure, and A incurs expenses for cleaningthe rig and an oil change. The employerpays employee A an additional $25 perweek to cover cleaning and the oilchange. Because the employer also pays arig reimbursement under this revenueprocedure, the $25 paid by the employeris treated as paid under a nonaccountableplan. Thus, the additional payment isreported as wages or other compensationof the employee’s Form W–2, and is sub-ject to withholding and payment ofincome and employment taxes.

SECTION 6. EFFECTIVE DATE

This revenue procedure is effective forpayments made on or after January 1,2003.

SECTION 7. REQUEST FORCOMMENTS

We welcome comments regarding thisrevenue procedure. We specificallyrequest comments concerning other cat-egories of qualified nonpersonal usevehicles owned by employees and usedby the employees in the course of provid-ing services as employees, especiallywhere the nature of an industry results inemployees working for multiple employ-ers during each year, for which a deemedsubstantiation rule would be appropriate.

Comments regarding this revenue pro-cedure should be sent by September 9,2002 in writing, and should referenceRev. Proc. 2002–41. Comments can beaddressed to:

CC:ITA:RU (Rev. Proc. 2002–41),room 5226Internal Revenue ServicePOB 7604, Ben Franklin StationWashington, DC 20044

Comments also may be hand deliveredbetween the hours of 8 a.m. and 5 p.m.to:

CC:ITA:RU (Rev. Proc. 2002–41)Courier’s DeskInternal Revenue Service1111 Constitution Avenue, NWWashington, DC.

Alternatively, taxpayers may transmitcomments electronically via the followinge-mail address:

Notice.Comments@irscounsel.treas.gov

SECTION 8. DRAFTINGINFORMATION

The principal author of this revenueprocedure is Joe Spires of the Office ofthe Division Counsel/Associate ChiefCounsel (Tax Exempt and GovernmentEntities), IRS. However, other personnelfrom the IRS and Treasury Departmentparticipated in its development. For fur-ther information regarding this revenueprocedure, call Mr. Spires at (202) 622–6040 (not a toll-free number).

June 10, 2002 1102 2002–23 I.R.B.

Part IV. Items of General Interest

Notice of ProposedRulemaking and Notice ofPublic Hearing

Compensation DeferredUnder Eligible DeferredCompensation Plans

REG–105885–99

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemakingand notice of public hearing.

SUMMARY: This document containsproposed regulations that would provideguidance on compensation deferred undereligible section 457(b) deferred compen-sation plans of state and local governmen-tal and tax-exempt entities. The regula-tions reflect the changes made to section457 by the Tax Reform Act of 1986, theSmall Business Job Protection Act of1996, the Taxpayer Relief Act of 1997,the Economic Growth and Tax ReliefReconciliation Act of 2001, the Job Cre-ation and Worker Assistance Act of 2002,and other legislation. The regulationswould also make various technicalchanges and clarifications to the existingfinal regulations on many discrete issues.These regulations provide the public withguidance necessary to comply with thelaw and will affect plan sponsors, admin-istrators, participants, and beneficiaries.The document also provides a notice ofpublic hearing on these proposed regula-tions.

DATES: Written and electronic commentsmust be received by August 7, 2002.Requests to speak and outlines of topicsto be discussed at the public hearingscheduled for August 28, 2002, must bereceived no later than August 7, 2002.

ADDRESSES: Send submissions toCC:ITA:RU (REG–105885–99), room5226, Internal Revenue Service, POB7604, Ben Franklin Station, Washington,DC 20044. Submissions may be handdelivered between the hours of 8 a.m. and5 p.m. to CC:ITA:RU (REG–105885–99),Courier’s Desk, Internal Revenue Ser-

vice, 1111 Constitution Avenue, NW,Washington, DC. Alternatively, taxpayersmay submit comments electronicallydirectly to the IRS Internet site atwww.irs.gov/regs. The public hearing willbe held in the IRS Auditorium, InternalRevenue Building, 1111 ConstitutionAvenue, NW, Washington, DC.

FOR FURTHER INFORMATION CON-TACT: Concerning the regulations, pleasecontact Cheryl Press, (202) 622–6060(not a toll-free number). To be placed onthe attendance list for the hearing, pleasecontact LaNita Van Dyke at (202) 622–7180 (not a toll-free number.)

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information in thisnotice of proposed rulemaking has beenreviewed and approved by the Office ofManagement and Budget in accordancewith the Paperwork Reduction Act (44U.S.C. 3507) under control number1545–1580.

An agency may not conduct or spon-sor, and a person is not required torespond to, a collection of informationunless it displays a valid control numberassigned by the Office of Managementand Budget.

Books or records relating to the collec-tion of information must be retained aslong as their contents may become mate-rial in the administration of any internalrevenue law. Generally, tax returns andtax return information are confidential, asrequired by 26 U.S.C. 6103.

Background

On September 23, 1982, final regula-tions (T.D. 7836, 1982–2 C.B. 91) undersection 457 of the Internal Revenue Codeof 1954 (Code) were published in theFederal Register (47 FR 42335 ) (Sep-tember 27, 1982) (final regulations). Thefinal regulations provide guidance forcomplying with the changes to the appli-cable tax law made by the Revenue Actof 1978 (92 Stat. 2779) relating todeferred compensation plans maintainedby state and local governments and rural

electric cooperatives. These proposedregulations would amend the final regula-tions to conform them to the manyamendments made to section 457 by sub-sequent legislation, including section1107 of the Tax Reform Act of 1986(TRA ’86) (100 Stat. 2494), section 1404of the Small Business Job Protection Actof 1996 (SBJPA) (110 Stat. 1755) (1996),section 1071 of the Taxpayer Relief Actof 1997 (TRA ’97) (111 Stat. 788) (1997),sections 615, 631, 632, 634, 635, 641,647, 649, and other sections of the Eco-nomic Growth and Tax Relief Reconcilia-tion Act of 2001 (EGTRRA) (115 Stat.38) (2001), and paragraphs (o)(8) and(p)(5) of section 411 of the Job Creationand Worker Assistance Act of 2002 (116Stat. 21) (2002). These proposed regula-tions would also amend the final regula-tions to provide additional guidance onsection 457 issues raised since the finalregulations were published in 1982. Thisdocument also incorporates the guidanceprovided in Notice 98–8, 1998–1 C.B.355, with respect to amendments made tosection 457 by the SBJPA and TRA ’97,including the section 457(g) trust require-ment for eligible plans of state and localgovernments (eligible governmentalplans).

Explanation of Provisions

Overview

The proposed regulations would pro-vide broad guidance regarding the rulesapplicable to eligible deferred compensa-tion plans described in section 457(b)(eligible plans) and, in particular, provideclear standards for the administration andoperation of eligible plans. The proposedregulations would amend the existingfinal regulations to update them forchanges in the law, including the manychanges made by EGTRRA, and respondto the comments and inquiries receivedfrom state and local governments and tax-exempt employers that sponsor eligibleplans, from participants and beneficiaries,and from service providers and otheradvisors.

The proposed regulations at §§ 1.457–1 through 1.457–3 include a generaloverview of section 457, as applicable to

2002–23 I.R.B. 1103 June 10, 2002

both eligible plans and ineligible plansthat are subject to section 457(f), andgeneral definitional provisions. Specificrules applicable to eligible plans are con-tained in proposed §§ 1.457–4 through1.457–10, while rules applicable to thosedeferred compensation plans that fail tosatisfy the requirements applicable to eli-gible plans (ineligible plans) are con-tained in proposed § 1.457–11.

1. General provisions and establishmentof eligible plans

Section 457, as amended by TRA ’86,applies to tax-exempt employers as wellas to state and local governments. Eli-gible employers may maintain eligibleplans, which must satisfy the require-ments of section 457(b) in both form andoperation, or may maintain ineligibleplans. Benefits under eligible plans areexcludable from income of plan partici-pants until paid, in the case of an eligiblegovernmental plan, or, in the case of aneligible plan of a tax-exempt employer,until paid or made available. Benefitsunder ineligible plans are, under section457(f), includible in income whendeferred or, if later, when rights to thebenefits are not subject to a substantialrisk of forfeiture. Certain types of plansof state and local government and tax-exempt entities are not subject to section457. These types are listed in the defini-tion of plan in proposed § 1.457–2.

The proposed regulations make clearthat the requirements of section 457(b)for eligible plans apply to both electivecontributions and to other types of contri-butions, such as mandatory contributions,nonelective employer contributions, andemployer matching contributions. Thus,for example, proposed § 1.457–2(b)defines annual deferrals to include bothelective salary reduction contributionsand nonelective employer contributions.Annual deferrals also include compensa-tion deferred under eligible plans that aredefined benefit plans.

An eligible plan must satisfy therequirements of section 457(b) andrelated provisions both in form and inoperation. Under the proposed regula-tions, an eligible plan must be establishedin writing, must include all of the mate-

rial terms for benefits under the plan, andmust be operated in compliance with therequirements reflected in the regulations.Of course, plan sponsors retain flexibilityin determining whether to provide certaindesign options permitted under section457. For example, although these pro-posed regulat ions permit cer tainin-service distributions of smaller accountbalances in accordance with section457(e)(9), an eligible plan is not requiredto offer participants this distributionoption. However, any optional featuresincorporated into an eligible plan mustmeet the requirements of section 457 andthe regulations in both form and opera-tion.

All amounts deferred under an eligiblegovernmental plan are required to be setaside in a trust, custodial account, orannuity contract for the exclusive benefitof participants and their beneficiaries.However, under section 457(b)(6), allamounts deferred under an eligible planof a tax-exempt employer are required tobe unfunded. This requirement for an eli-gible plan of a tax-exempt employer doesnot alter any provision of Title I of theEmployee Retirement Income SecurityAct of 1974 (ERISA). Accordingly, aneligible plan of a tax-exempt employermay be subject to certain of the require-ments of Title I.. In the case of an eligibleplan of a tax-exempt employer that issubject to Title I of ERISA, compliancewith the exclusive purpose, trust, funding,and certain other rules will cause the planto fail to satisfy section 457(b)(6). SeeQ&A-25 of Notice 87–13, 1987–1 C.B.432.

The proposed regulations include cer-tain basic rules regarding the taxation ofcontributions and benefits under ineli-gible plans, especially the relationshipbetween deferred compensation under anineligible plan and property transfers towhich section 83 applies, but are notintended to provide complete or compre-hensive guidance under section 457(f).Similarly, the proposed regulations referto, but do not provide specific guidanceon, certain arrangements that are nottreated as plans providing deferred com-pensation, such as bona fide severancepay plans described in section 457(e)(11).

2. Annual deferrals, deferral limitations,and deferral agreements under eligibleplans

a. Annual Deferrals

Proposed § 1.457–4 sets forth rulesregarding deferrals under eligible plansunder section 457(b). The proposed regu-lations would expand the rules containedin the final regulations. Examples havebeen included in order to illustrate theapplication of the rules to specific cir-cumstances and to address common ques-tions and situations encountered in theadministration of eligible plans.

The proposed regulations use the termannual deferrals to describe all amountscontributed or deferred under an eligibleplan, whether by voluntary salary reduc-tion contribution or by other employercontribution, and all earnings thereon. If,as is typical, amounts contributed to theeligible plan are fully vested, the total ofamounts contributed to the eligible planduring a taxable year is the same as thetotal of the annual deferrals for the tax-able year.

The proposed regulations would alsoclarify that the rules concerning agree-ments for deferrals operate on a cashbasis. Thus, under proposed § 1.457–4(b),an agreement to defer compensation isvalid if it is made before the first day ofthe month in which compensation is paidor made available. In general, there is norequirement that the agreement be enteredinto prior to the time the services givingrise to the compensation are performed.However, compensation payable in thefirst month of employment may bedeferred only if an agreement is enteredinto prior to the time a participant per-forms services for the employer. The pro-posed regulations provide explicitly thatnonelective employer contributions aretreated as being made under a validagreement. In addition, Rev. Rul. 2000–33, 2000–2 C.B. 142, provides guidanceconcerning automatic enrollment undereligible plans. Contributions made underan automatic enrollment arrangementdescribed in that Revenue Ruling may betreated as made under a valid agreement.

June 10, 2002 1104 2002–23 I.R.B.

b. Deferral Limitations

The proposed regulations under§ 1.457–4 explain the annual limits thatapply to annual deferrals under eligibleplans. These contribution limits are some-times referred to as “plan ceilings.” Gen-erally, the basic annual limit or plan ceil-ing for a year cannot exceed a specifieddollar amount for the year or, if less, 100percent of a participant’s “includiblecompensation.” Under EGTRRA, the dol-lar amount is $11,000 for 2002; $12,000for 2003; $13,000 for 2004; $14,000 for2005; and $15,000 for 2006 and thereaf-ter. After 2006, the $15,000 amount isadjusted for cost-of-living. As a result ofthe enactment of the Job Creation andWorker Assistance Act of 2002, PublicLaw 107–147 (116 Stat. 21) on March 9,2002, the calculation of includible com-pensation is no longer reduced by theexclusions from gross income under sec-tions 402(g), 125, 132(f), and 457. Thus,for years beginning after December 31,2001, includible compensation is nolonger reduced by elective deferrals to aneligible plan. If a participant’s includiblecompensation is less than the applicabledollar limit, the dollar amount equal to100 percent of includible compensation isthe basic annual limit for the participant.

An eligible plan may also permit cer-tain “catch-up” contributions. First, inaccordance with section 414(v) as addedto the Code by EGTRRA, a plan mayallow a participant who attains age 50 bythe end of the year to elect to have anadditional deferral for the year. The addi-tional amount permitted under this age 50catch-up is $1,000 for 2002, $2,000 for2003, $3,000 for 2004, $4,000 for 2005,and $5,000 for 2006. Proposed regula-tions (REG–142499–01, 2001–45 I.R.B.476) under section 414(v) were publishedin the Federal Register on October 23,2001 (66 FR 53555) as § 1.414(v)–1.

Second, an eligible plan may permit alarger catch-up amount in the last threeyears ending before the participant attainsnormal retirement age. The amount ofthis special section 457 catch-up is twotimes the basic annual limit (e.g., an addi-tional $15,000 for 2006), but only to theextent the participant has not previouslydeferred the maximum amount under aneligible plan or similar tax-deferredretirement plan (called the underutilized

amount or underutilized limitation in theproposed regulations). Alternatively, theage 50 catch-up is available in the lastthree years ending before the participantattains normal retirement age if the age50 catch-up amount is larger than the spe-cial section 457 catch-up amount. Underthe proposed regulations, a participantmay not elect to have the special section457 catch-up apply more than once,unless the participant is covered by a planof another employer. If a participant alsoor later participates in an eligible plan ofa different employer and otherwise meetsthe requirements for limited catch-up, theparticipant may elect under the new planto have the special section 457 catch-upapply.

For purposes of the special section 457catch-up, the proposed regulations pro-vide that the plan must designate a nor-mal retirement age between the age atwhich participants have the right toreceive immediate retirement benefitsunder the basic pension plan of the stateor tax-exempt entity without actuarial orsimilar reduction and age 70 ½. Alterna-tively, a plan may provide that a partici-pant is allowed to designate a normalretirement age within these ages. The pro-posed regulations provide a special rulefor defining normal retirement age in eli-gible plans of qualified police or firefight-ers as defined under section415(b)(2)(H)(ii)(I), taking into accountthat these participants are often eligiblefor retirement at a younger age than otherworkers.

The proposed regulations require aneligible plan to set forth the plan’s normalretirement age. However, as discussed inthis preamble under Proposed EffectiveDate, plan amendments to reflect thisrequirement are not required to beadopted until guidance is issued address-ing when plan amendments must beadopted.

3. Individual limitation for combinedannual deferrals under eligible plans

Before enactment of EGTRRA, a coor-dination limitation applied under whichthe basic annual limitation and the specialsection 457 catch-up limitation werereduced by amounts excluded from a par-ticipant’s income for any taxable year byreason of a salary reduction or electivecontribution under a section 401(k) plan

or a section 403(b) contract. EGTRRAeliminated coordination with section401(k) plans and section 403(b) contractsfor 2002 and thereafter. However, coordi-nation with these types of arrangements isstill taken into account for purposes ofdetermining the underutilized amount foryears before 2002, so that these rules con-tinue to be reflected in the proposed regu-lations for that sole purpose.

EGTRRA did not eliminate section457(c) under which the maximum amountexcludable under all eligible plans,including eligible governmental plans andeligible plans of a tax-exempt entity, can-not exceed applicable section 457 planlimitations. Thus, these limitations,including the basic limitation, the age 50catch-up limitation, and the special sec-tion 457 catch-up limitation, apply notonly on a plan basis, but also on an indi-vidual basis for cases in which an indi-vidual participates in more than one eli-gible plan during a taxable year. Theproposed regulations include rules forhow the applicable section 457 limita-tions apply on an individual basis. Therules for applying catch-up limits on anindividual basis provide that the specialsection 457 catch-up available in the lastthree years prior to normal retirement ageis taken into account only to the extentthat an annual deferral is made for a par-ticipant under an eligible plan as a resultof plan provisions permitted under thespecial section 457 catch-up and, if theapplicable catch-up amount is not thesame for each such eligible plan, the indi-vidual limit is applied using the catch-upamount under whichever plan that has thelargest catch-up amount applicable to theparticipant. However, as discussed above,a participant may not elect to have thespecial section 457 catch-up apply morethan once, unless the participant is cov-ered by a plan of another employer.

The proposed regulations allow an eli-gible governmental plan to pay out anannual deferral to the extent the deferralexceeds the individual limit or to correcta deferral in excess of the plan’s limit.

4. Sick and vacation pay deferrals

The proposed regulations would per-mit an eligible plan to provide that a par-ticipant may elect to defer accumulatedsick pay, accumulated vacation pay, and

2002–23 I.R.B. 1105 June 10, 2002

back pay if certain conditions are satis-f ied. In accordance with sect ion457(b)(4), the plan must provide thatthese amounts may be deferred for anycalendar month only if an agreement pro-viding for the deferral is entered intobefore the beginning of the month inwhich the amounts would otherwise bepaid or made available to the participant.Thus, a participant is not permitted toelect to receive the value of accumulatedsick and vacation pay on or after the dateon which the employer makes that payavailable to the participant in cash. Anydeferrals under an eligible plan of sickand vacation pay or back pay are subjectto the maximum deferral limitations ofsection 457 in the year of deferral. Thus,the total amount deferred for any yearcannot exceed the plan ceiling for theyear, taking into account the 100 percentof includible compensation limit.

5. Excess deferrals

The proposed regulations address thetreatment of excess deferrals and theeffect of excess deferrals on plan eligibil-ity under section 457(b). The proposedregulations also provide that an eligiblegovernmental plan may self correctexcess deferrals and will not fail to satisfythe applicable requirements of the pro-posed regulations (including the distribu-tion rules and the funding rules) solely byreason of a distribution of excess defer-rals.

Under the proposed regulations, if anexcess deferral arises under the maximumdeferral limits of section 457(b) for a planof a governmental employer, an eligiblegovernmental plan is required to correctthe failure by distributing the excessdeferral to the participant, with allocablenet income, as soon as administrativelypracticable after the plan determines thatthe amount would be an excess deferral.If excess deferrals of this type are not dis-tributed, the plan will be an ineligibleplan with respect to which benefits aretaxed according to the rules of section457(f). If an excess deferral arises underthe maximum deferral limits of section457(b) for a plan of a tax-exemptemployer, the plan is not an eligible plan.

For purposes of these rules, all plansunder which an individual participates byvirtue of his or her relationship with asingle employer are treated as a singleplan.

As stated previously, while EGTRRArepealed the coordination limitation undersection 457(c), EGTRRA did not elimi-nate the requirement that the maximumamount excludable under all eligibleplans under section 457(c) as revised byEGTRRA, including eligible governmen-tal plans and eligible plans of a tax-exempt entity, cannot exceed the appli-cable section 457(b) limitations. Thus, anexcess deferral that results from the appli-cation of the new individual limitation formultiple eligible plans under section457(c) may also be, but is not required tobe, distributed to the participant. How-ever, consistent with the legislative his-tory to section 457(c), the proposed regu-lations make clear that a plan will notlose its status as an eligible plan by fail-ing to distribute those excess deferralsthat result from the application of thisrequirement (although those amounts arecurrently includible in the participant’sincome).

Comments are specifically requestedconcerning record-keeping requirementswith respect to excess deferrals that arenot distributed and, in particular, concern-ing the maintenance of records adequateto keep track of any previously taxedexcess deferrals that remain in an eligibleplan. In addition, comments are alsorequested as to the proper income andpayroll tax reporting of distributions ofexcess deferrals.

6. Minimum distribution requirements

EGTRRA eliminated the special mini-mum distribution rules that applied to eli-gible plans. Thus, the proposed regula-tions generally incorporate by referencethe requirements of section 401(a)(9) andthe regulations thereunder concerningminimum distributions to participants andbeneficiaries. Final and temporary regula-tions (T.D. 8987, 2002–19 I.R.B. 852)under section 401(a)(9) were published inthe Federal Register on April 17, 2002(67 FR 18988). These regulations provide

rules for defined benefit plans anddefined contribution plans. Generally, therules for defined contribution plans applyto eligible deferred compensation plans.Beginning in 2003, a simple uniformtable generally applies to all employees todetermine the minimum distributionrequired during their lifetime, includingemployees covered by an eligibledeferred compensation plan.1 The oneexception to this rule for lifetime distribu-tions is for an employee with a spousedesignated as the employee’s sole benefi-ciary and the spouse is more than 10years younger than the employee. In thatcase the employee can use the employeeand spouse’s joint and last survivorexpectancy to determine the minimumdistribution required during the employ-ee’s lifetime.

7. Loans

Proposed § 1.457–6(f) sets forth rulesgoverning loans from eligible plans. Thisproposal responds to the numerous inquir-ies received concerning the availability ofloans from eligible plans maintained bystate and local governments, the assets ofwhich are held in trust pursuant to section457(g).

While section 457(g) does not directlyaddress the issue of whether, or underwhat circumstances, loans may be madeavailable from trusteed eligible plans, thelegislative history to the SBJPA indicatesthat the new statutory provisions shouldbe interpreted as permitting participantloans from the eligible plan trust underthe rules applicable to loans from quali-fied plans. H.R. Rep. 104–737, at 251.Commentators, some citing this legisla-tive history and some citing pre-ERISAcase law and rulings interpreting theexclusive benefit requirement of section401(a), have urged the IRS to issue for-mal guidance concerning loans from eli-gible plans. These comments take theposition that the availability of loans willmake savings through eligible plans moreattractive to participants and will decreasethe disparity between eligible plans andthe other tax-favored voluntary retirementsavings plans.

1Employees may use these new final regulations for distributions for 2002 or may use regulations proposed in 1987 or 2001.

June 10, 2002 1106 2002–23 I.R.B.

The pre-ERISA requirements appli-cable to loans from qualified plansrequire a facts and circumstances analysisof the availability of the loan feature toall participants, the rate of return, theoverall prudence of the investment of thetrust corpus in the note of an individualparticipant, and the pattern of repay-ments. See, e.g., Central Motor Co. v.United States, 583 F.2d 470, 488–491(10th Cir. 1978); Winger’s DepartmentStore v. Commissioner, 82 T.C. 869(1982); Ma-Tran Corp. v. Commissioner,70 T.C. 158 (1978); and Feroleto SteelCo. v. Commissioner, 69 T.C. 97 (1977).See also Rev. Rul. 67–258 (1967–2 CB68).

Under the proposed regulations, a loanfrom an unfunded eligible plan of a tax-exempt organization would be treated asan impermissible distribution, in violationof the requirements of section 457. How-ever, for loans from an eligible govern-mental plan, the proposed regulationsinclude a facts and circumstances generalstandard. This general standard isintended to apply to determine whetherthe loan is bona fide and for the exclusivepurpose of benefitting participants andbeneficiaries under section 457(g), as wasrequired under pre-ERISA law for quali-fied plans. Among the facts and circum-stances are whether the loan has a fixedrepayment schedule and a reasonableinterest rate, and whether there are repay-ment safeguards to which a prudentlender would adhere.2 The proposed regu-lations require a loan to bear a reasonablerate of interest in order to satisfy therequirement that assets and income of aneligible governmental plan be held for theexclusive benefit of participants and theirbeneficiaries. The proposed regulationswould also clarify that section 72(p)applies with respect to loans made underan eligible governmental plan. Regula-tions interpreting section 72(p)(2) are at§ 1.72(p)–1.

If the proposed regulations are final-ized in their current form, it is anticipatedthat the IRS will modify its currentno-rule position regarding the issuance ofprivate letter rulings to eligible plans thatprovide for loans.

8. Distributions from eligible plans

a. Eligible Governmental Plans

EGTRRA substantially altered thetaxation of distributions from an eligiblegovernmental plan by providing thatamounts held under such an eligible planare not included in a participant’s or ben-eficiary’s gross income until distributed.The proposed regulations would interpretthis EGTRRA change as applying to allparticipants in an eligible governmentalplan. Thus, an eligible governmental planmay permit participants who are currentlyentitled to be paid after 2001 to changetheir previously irrevocable paymentelections.

Under EGTRRA, after 2001, the directrollover rules applicable to qualifiedplans and section 403(b) contracts willapply to distributions from an eligiblegovernmental plan. The direct rolloverrules for qualified plans and section403(b) contracts are generally explainedat §§ 35.3405–1, 31.3405(c)–1,1.401(a)(31)–1, 1.402(c)–2, and1.402(f)–1. These direct rollover regula-tions have not been updated sinceEGTRRA to reflect that rollovers are per-mitted for distributions from eligible gov-ernmental plans (nor do those regulationsreflect that amounts may be rolled over toeligible governmental plans after 2001).

b. Eligible Plans of Tax-Exempt Entities

Amounts deferred under an eligibleplan of a tax-exempt entity continue to betaxable when paid or made available. Theproposed regulations explain these rules,including the exceptions for amountsavailable in the event of unforeseeableemergency and distributions of smalleraccounts (not in excess of $5,000).

9. Plan terminations and plan-to-plantransfers

The proposed regulations address thetopic of plan terminations and plan-to-plan transfers. These topics have becomeincreasingly important in light of therecent statutory changes that impose a

trust requirement on eligible governmen-tal plans. In particular, questions havebeen raised with respect to hospitals andother entities that change from govern-ment to private entities, whether or nottax-exempt. The direct rollovers that willbe permitted by EGTRRA beginning in2002 for eligible governmental plans pro-vide participants affected by these typesof events the ability to retain their retire-ment savings in a funded, tax-deferredsavings vehicle by rollover to IRAs,qualified plan, or section 403(b) con-tracts. The proposed regulations provide ablueprint for the different plan termina-tion and plan-to-plan transfer alternativesavailable to sponsors of eligible plans inthese situations.

a. Plan Terminations

The proposed regulations would allowa plan to have provisions permitting plantermination whereupon amounts could bedistributed without violating the distribu-tion requirements of section 457. Underthe proposed regulations, an eligible planis terminated only if all amounts deferredunder the plan are paid to participants assoon as administratively practicable. Ifthe amounts deferred under the plan arenot distributed, the plan is treated as afrozen plan and must continue to complywith all of the applicable statutoryrequirements necessary for plan eligibil-ity. The proposed regulations generallyfollow the approach of Rev. Rul. 89–87,1982–2 C.B. 81, which provides guidanceon the termination of qualified plans. Inthat revenue ruling, a qualified plan underwhich benefit accruals have ceased is notterminated if assets of the plan remain inthe plan’s related trust rather than beingdistributed as soon as administrativelyfeasible.

The proposed regulations also high-light the consequences to the plan in thecase of an employer that ceases to be aneligible employer but fails to terminatethe plan or to transfer its assets under therules of the proposed regulationsdescribed below.

2 See, for example, the standards in Rev. Rul. 69–494, 1969–2 C.B. 88, for determining when plan investments are primarily for the purpose of benefitting employees or their beneficiaries.

2002–23 I.R.B. 1107 June 10, 2002

b. Plan-to-plan Transfers

The proposed regulations wouldclarify that transfers between certaintypes of eligible plans do not violate therequirements of section 457(b), includingthe distribution requirements of section457(d), if certain conditions are satisfied.Thus, an eligible governmental plan maytransfer its assets to another eligible gov-ernmental plan; likewise, an unfunded,tax-exempt plan may transfer amountsdeferred to another unfunded, tax-exemptplan. However, in the same manner thatrollovers are not permitted betweenunfunded plans of tax-exempt employersand funded governmental plans (andbecause of potential violations of theexclusive benefit rule applicable to eli-gible governmental plans), amounts can-not be transferred from an eligible plan ofa tax-exempt employer to an eligible gov-ernmental plan or from an eligible gov-ernmental plan to an eligible plan of atax-exempt employer.

Plan-to-plan transfers within similartypes of eligible plans are permitted intwo kinds of circumstances. First, it iscontemplated that transfers may occurwhen a participant in the transferor planterminates employment with the transf-eror employer and is employed by thetransferee employer. Transfers withrespect to individual participants are per-mitted if both plans agree to the transfer,the participant has terminated employ-ment with the transferor, and the partici-pant whose amounts deferred are beingtransferred will have an amount deferredimmediately after the transfer at leastequal to the amount deferred immediatelybefore the transfer.

Second, the proposed regulations alsocontemplate certain asset transfers of allamounts deferred under the plan in theevent an activity of a state or local gov-ernment is privatized or otherwise ceasesto be performed by a governmental entity.Thus, as an alternative to plan terminationor a plan-to-plan transfer, the proposedregulations provide that a governmentemployer that loses its eligible status maytransfer the eligible plan to another eli-gible government employer within thesame state. For example, a county hospi-tal that maintains an eligible plan and thatceases to be a governmental entity could

transfer the plan to the county for contin-ued administration.

The proposed regulations also addresstransfers between eligible governmentalplans and qualified defined benefit planswith respect to past service credit.Because the proposed regulations specifi-cally state that a transfer for past servicecredit is not treated as a distribution forpurposes of section 457, such a transfercould be made while the participant isstill working.

10. Qualified domestic relations orders

The proposed regulations address theissue of qualified domestic relationsorders (QDROs). The administration ofQDROs has created difficulties for eli-gible employers and section 457 planadministrators and participants, andnumerous inquiries and private letter rul-ing requests involving the application ofjudicial domestic relations orders to par-ticipants’ accounts in eligible section457(b) deferred compensation plans havebeen received. The proposed regulationsprovide that an eligible plan may honorthe terms of a QDRO without jeopardiz-ing its eligible status.

Under the proposed regulations, asprovided under section 457 as amendedby EGTRRA, an eligible plan does notbecome an ineligible plan described insection 457(f) solely because its adminis-trator or sponsor complies with a QDROdescribed in section 414(p) (taking intoaccount the special rule sect ion414(p)(11) for governmental and churchplans), including a QDRO requiring thedistribution of the benefits of a participantto an alternate payee in advance of thegeneral rules for eligible plan distribu-tions under § 1.457–6. In the case of aneligible governmental plan, amounts paidto the alternate payee who is the spouseor former spouse of a participant underthe QDRO are taxable to the alternatepayee when they are paid.

In the case of an eligible plan of a tax-exempt entity, amounts payable to thealternate payee who is the spouse orformer spouse of a participant under theQDRO are taxable to the alternate payeewhen they are paid or made available tothe alternate payee. In addition, amountsdeferred under an eligible plan of a tax-exempt entity that are attributable to thealternate payee are treated as made avail-

able on the date the alternate payee is firstable to receive a distribution.

11. Rollovers to eligible plans

EGTRRA now allows rollovers contri-butions to be accepted by an eligible gov-ernmental plan, but only if the receivingeligible governmental plan maintains therollover amount in a separate account.The proposed regulations include suchrollovers as part of the amount deferredunder the receiving plan, but a rollovercontribution is not taken into account asan annual deferral under the plan for pur-poses of the plan ceiling limit on annualdeferrals. While EGTRRA does notrequire a separate account for each typeof rollover contributions (e.g., an accountfor rollovers from qualified plans whichis separate from rollovers from section403(b) contracts) , comments arerequested on whether there are any spe-cial characteristics applicable to qualifiedplans, section 403(b) contracts, or indi-vidual retirement arrangements (IRAs)under section 72(t) (imposing an addi-tional income tax on early distributionsfrom such plans, contracts, or arrange-ments) which could be lost if multipletypes of separate accounts are not main-tained.

12. Correction program for section457(b) eligible deferred compensationplans

Employee Plans, within the Office ofthe Commissioner, Tax Exempt and Gov-ernment Entities (TE/GE), has compre-hensive correction programs for sponsorsof retirement plans (qualified retirementplans, 403(b) plans, and SimplifiedEmployee Pensions). These programs,including the Employee Plans Compli-ance Resolution System (EPCRS), Rev.Proc. 2001–17, 2001–1 C.B. 589, permitplan sponsors to correct plan defects andthereby continue to provide their employ-ees retirement benefits on a tax-favoredbasis. Employee Plans intends to expandthe provisions of EPCRS to includeappropriate correction procedures for cer-tain failures arising under eligibledeferred compensation plans. The publicis invited to submit comments to assist inthe development of these procedures.Comments should be sent to:

June 10, 2002 1108 2002–23 I.R.B.

Internal Revenue ServiceAttention: T:EP:RA:VC1111 Constitution Avenue, NWWashington, D.C. 20224

Pending the update of EPCRS, sub-missions related to section 457 (b) eli-gible deferred compensation plan failureswill be accepted by Employee Plans on aprovisional basis outside of EPCRS.

13. Ineligible plans

The proposed regulations includeguidance regarding ineligible plans undersection 457(f). Section 457(f) was in sec-tion 457 when it was added to the Codein 1978 for governmental employees, andextended to employees of tax-exemptorganizations (other than churches or cer-tain church-controlled organizations) in1986, because unfunded amounts held bya tax-exempt entity compound tax freelike an eligible plan, a qualified plan, or asection 403(b) contract. Section 457(f)was viewed as essential in order to pro-vide an incentive for employers that arenot subject to income taxes to adopt aneligible plan, a qualified plan, or a section403(b) contract.3 Section 457(f) generallyprovides that, in the case of an agreementor arrangement for the deferral of com-pensation, the deferred compensation isincluded in gross income when deferredor, if later, when the rights to payment ofthe deferred compensation cease to besubject to a substantial risk of forfeiture.Section 457(f) does not apply to an eli-gible plan, a qualified plan, a section403(b) contract, a section 403(c) contract,a transfer of property described in section83, a trust to which section 402(b)applies, or a qualified governmentalexcess benefit arrangement described insection 415(m).

The proposed regulations reflect thestatutory changes in section 457(f) thathave been made since 1982—which iswhen the current outstanding regulationswere issued—and clarify the interactionbetween sections 457(f) and 83 (relatingto the transfer of property in connectionwith the performance of services). Underthe proposed regulations, section 457(f)does not apply to a transfer of property if

section 83 applies to the transfer. Further,section 457(f) does not apply if the dateon which there is no substantial risk offorfeiture with respect to the compensa-tion is on or after the date on which thereis a transfer of property to which section83 applies. However, section 457(f)applies if the date on which there is nosubstantial risk of forfeiture with respectto the compensation deferred precedes thedate on which there is a transfer of prop-erty to which section 83 applies. The pro-posed regulations include severalexamples, including an example illustrat-ing that section 457(f) does not fail toapply merely because benefits are subse-quently paid by a transfer of property.Comments are requested on the coordina-tion of section 457(f) and section 83under these proposed regulations.

In 2000, the IRS issued Announcement2000–1, 2000–1 C.B. 294, in which itprovided interim guidance on certainbroad-based, nonelective plans of a stateor local government that were in exist-ence before 1999. Comments arerequested on whether similar guidanceshould be included in the final regula-tions, and, if so, how the guidance shouldapply to arrangements, such as thosemaintained by certain state or local gov-ernmental educational institutions, underwhich supplemental compensation is pay-able as an incentive to terminate employ-ment, or as an incentive to retainretirement-eligible employees, to ensurean appropriate workforce during periodsin which a temporary surplus or deficit inworkforce is anticipated.

Proposed Effective Date

It is proposed that these regulationsapply generally for taxable years begin-ning after December 31, 2001. This is thegeneral applicability date of the changesmade in section 457 by EGTRRA. Spe-cial effective date provisions apply toprovisions relating to coordination of sec-tions 457(f) and 83 and for qualifieddomestic relations orders. Plan amend-ments to reflect EGTRRA, and any otherrequirement under these regulations, arenot required to be adopted until the laterof when guidance is issued addressing

when plan amendments must be adoptedor the date final regulations are issued.However, employers may rely on theseproposed regulations in taxable yearsbeginning after August 20, 1996 (which isthe earliest applicability date for require-ments applicable to eligible plans underthe SBJPA). Comments are requested onwhether an applicability date later thantaxable years beginning after December31, 2001, should apply when the regula-tions are issued in final form.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a signifi-cant regulatory action as defined inExecutive Order 12866. Therefore, aregulatory assessment is not required. Italso has been determined that section553(b) of the Administrative ProcedureAct (5 U.S.C. chapter 5) does not apply tothese regulations, and because the regula-tions do not impose a collection of infor-mation on small entities, the RegulatoryFlexibility Act (5 U.S.C. chapter 6) doesnot apply. Pursuant to section 7805(f) ofthe Internal Revenue Code, these pro-posed regulations will be submitted to theChief Counsel for Advocacy of the SmallBusiness Administration for comment onits impact on small business

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any written or electroniccomments (a signed original and eight (8)copies) that are submitted timely to theIRS. The IRS and Treasury specificallyrequest comments on the clarity of theproposed regulations and how they maybe made easier to understand. All com-ments will be available for public inspec-tion and copying.

A public hearing has been scheduledfor August 28, 2002, beginning at 10 a.m.in the IRS Auditorium of the InternalRevenue Building, 1111 ConstitutionAvenue, NW, Washington, DC. All visi-tors must present photo identification toenter the building. Because of accessrestrictions, visitors will not be admitted

3See generally the Report to the Congress on the Tax Treatment of Deferred Compensation under Section 457, Department of the Treasury, January 1992 (available from the Office of TaxPolicy, Room 5315, Treasury Department, 1500 Pennsylvania Avenue, NW, Washington DC 20220).

2002–23 I.R.B. 1109 June 10, 2002

beyond the immediate entrance more than30 minutes before the hearing starts. Forinformation about having your nameplaced on the building access list toattend the hearing, see the “FOR FUR-THER INFORMATION CONTACT”section of this preamble.

The rules of 26 CFR 601.601(a)(3)apply to the hearing. Persons who wish topresent oral comments at the hearingmust submit written comments and anoutline of the topics to be discussed andthe time to be devoted to each topic(signed original and eight (8) copies) byAugust 7, 2002. A period of 10 minuteswill be allotted to each person for makingcomments. An agenda showing the sched-ule of speakers will be prepared after thedeadline for receiving outlines haspassed. Copies of the agenda will beavailable free of charge at the hearing.

Drafting Information

The principal author of these regula-tions is Cheryl Press, Office of DivisionCounsel/Associate Chief Counsel (TaxExempt and Government Entities), IRS.However, other personnel from the IRSand Treasury Department participated intheir 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 citation forpart 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Sections 1.457–1, 1.457–2,

1.457–3, and 1.457–4 are revised to readas follows:

§ 1.457–1 General overview of section457.

Section 457 provides rules for non-qualified deferred compensation plansestablished by eligible employers asdefined under § 1.457–2(d). Eligibleemployers can establish either deferredcompensation plans that are eligible plansand that meet the requirements of section457(b) and §§ 1.457–3 through 1.457–10,

or deferred compensation plans orarrangements that do not meet therequirements of section 457(b) and§§ 1.457–3 through 1.457–10 and that aresubject to tax treatment under section457(f) and § 1.457–11.

§ 1.457–2 Definitions.

This section sets forth the definitionsthat are used under §§ 1.457–1 through1.457–11.

(a) Amount(s) deferred. Amount(s)deferred means the total annual deferralsunder an eligible plan in the current andprior years, adjusted for gain or loss.Except as otherwise specifically indi-cated, amount(s) deferred includes anyrollover amount held by an eligible planas provided under § 1.457–10(e).

(b) Annual deferral(s)—(1) Annualdeferral(s) means, with respect to a tax-able year, the amount of compensationdeferred under an eligible plan, whetherby salary reduction or by nonelectiveemployer contribution. The amount ofcompensation deferred under an eligibleplan is taken into account as an annualdeferral in the taxable year of the partici-pant in which deferred, or, if later, theyear in which the amount of compensa-tion deferred is no longer subject to asubstantial risk of forfeiture.

(2) If the amount of compensationdeferred under the plan during a taxableyear is not subject to a substantial risk offorfeiture, the amount taken into accountas an annual deferral is not adjusted toreflect gain or loss allocable to the com-pensation deferred. If, however, theamount of compensation deferred underthe plan during the taxable year is subjectto a substantial risk of forfeiture, theamount of compensation deferred that istaken into account as an annual deferralin the taxable year in which the substan-tial risk of forfeiture lapses must beadjusted to reflect gain or loss allocableto the compensation deferred until thesubstantial risk of forfeiture lapses.

(3) If the eligible plan is a defined ben-efit plan within the meaning of section414(j), the annual deferral for a taxableyear is the present value of the increaseduring the taxable year of the partici-pant’s accrued benefit that is not subjectto a substantial risk of forfeiture (disre-garding any such increase attributable toprior annual deferrals). For this purpose,

present value must be determined usingactuarial assumptions and methods thatare reasonable (both individually and inthe aggregate), as determined by theCommissioner.

(c) Beneficiary. Beneficiary means abeneficiary of a participant, a partici-pant’s estate, or any other person whoseinterest in the plan is derived from theparticipant, including an alternate payeeas described in § 1.457–10(c).

(d) Catch-up. Catch-up amount orcatch-up limitation for a participant for ataxable year means the annual deferralpermitted under section 414(v) (asdescribed in § 1.457–4(c)(2)) or section457(b)(3) (as described in § 1.457–4(c)(3)) to the extent the amount of theannual deferral for the participant for thetaxable year is permitted to exceed theplan ceiling applicable under section457(b)(2) (as described in § 1.457–4(c)(1)).

(e) Eligible employer. Eligible em-ployer means an entity that is a state asdefined in paragraph (l) of this sectionthat establishes a plan or a tax-exemptentity as defined in paragraph (m) of thissection that establishes a plan. The perfor-mance of services as an independent con-tractor for a state or local government ora tax-exempt entity is treated as the per-formance of services for an eligibleemployer. The term eligible employerdoes not include a church as defined insection 3121(w)(3)(A), a qualifiedchurch-controlled organization as definedin section 3121(w)(3)(B), or the Federalgovernment or any agency or instrumen-tality thereof.

(f) Eligible plan. An eligible plan is aplan that meets the requirements of§§ 1.457–3 through 1.457–10 that isestablished and maintained by an eligibleemployer. An eligible governmental planis an eligible plan that is established andmaintained by an eligible employer asdefined in paragraph (l) of this section.An arrangement does not fail to constitutea single eligible governmental planmerely because the arrangement is fundedthrough more than one trustee, custodian,or insurance carrier. An eligible plan of atax-exempt entity is an eligible plan that isestablished and maintained by an eligibleemployer as defined in paragraph (m) ofthis section.

June 10, 2002 1110 2002–23 I.R.B.

(g) Includible compensation. Includ-ible compensation of a participant means,with respect to a taxable year, the partici-pant’s compensation, as defined in section415(c)(3), for services performed for theeligible employer. The amount of includ-ible compensation is determined withoutregard to any community property laws.

(h) Ineligible plan. Ineligible planmeans a plan established and maintainedby an eligible employer that is not main-tained in accordance with §§ 1.457–3through 1.457–10. A plan that is notestablished by an eligible employer asdefined in paragraph (e) of this section isneither an eligible nor an ineligible plan.

(i) Nonelective employer contribution.A nonelective employer contribution is acontribution made by an eligibleemployer for the participant with respectto which the participant does not have thechoice to receive the contribution in cashor property. Solely for purposes of section457 and §§ 1.457–2 through 1.457–11,the term nonelective employer contribu-tion includes employer contributions thatwould be described in section 401(m) ifthey were contributions to a qualifiedplan.

(j) Participant. Participant in an eli-gible plan means an individual who iscurrently deferring compensation, or whohas previously deferred compensationunder the plan by salary reduction or bynonelective employer contribution andwho has not received a distribution of hisor her entire benefit under the eligibleplan. Only individuals who perform ser-vices for the eligible employer, either asan employee or as an independent con-tractor, may defer compensation under theeligible plan.

(k) Plan. Plan includes any agreementor arrangement between an eligibleemployer and a participant or participantsunder which the payment of compensa-tion is deferred (whether by salary reduc-tion or by nonelective employer contribu-tion). The following types of plan are nottreated as agreements or arrangementunder which compensation is deferred: abona fide vacation leave, sick leave, com-pensatory time, severance pay, disabilitypay, or death benefit plan described insection 457(e)(11)(A)(i) and any planpaying length of service awards to bonafide volunteers (and their beneficiaries)

on account of qualified services per-formed by such volunteers as described insection 457(e)(11)(A)(ii). Further, theterm plan does not include any of the fol-lowing (and section 457 and §§ 1.457–2through 1.457–11 do not apply to any ofthe following)—

(1) Any nonelective deferred compen-sation under which all individuals (otherthan those who have not satisfied anyapplicable initial service requirement)with the same relationship with the eli-gible employer are covered under thesame plan with no individual variations oroptions under the plan as described insection 457(e)(12), but only to the extentthe compensation is attributable to ser-vices performed as an independent con-tractor;

(2) An agreement or arrangementdescribed in § 1.457–11(b);

(3) Any plan satisfying the conditionsin section 1107(c)(4) of the Tax ReformAct of 1986 (TRA ’86) (relating to certainplans for state judges); and

(4) Any of the following plans orarrangements (to which specific transi-tional statutory exclusions apply)—

(i) A plan or arrangement of a tax-exempt entity in existence prior to Janu-ary 1, 1987, if the conditions of section1107(c)(3)(B) of the TRA ’86, asamended by section 1011(e)(6) of Techni-cal and Miscellaneous Revenue Act of1988 (TAMRA), are satisfied;

(ii) A collectively bargained nonelec-tive deferred compensation plan in effecton December 31, 1987, if the conditionsof section 6064(d)(2) of TAMRA are sat-isfied;

(iii) Amounts described in section6064(d)(3) of TAMRA (relating to certainnonelective deferred compensationarrangements in effect before 1989); and

(iv) Any plan satisfying the conditionsin section 1107(c)(4) or (5) of TRA ’86(relating to certain plans for certain indi-viduals with respect to which the Serviceissued guidance before 1977).

(l) State. State includes the 50 Statesof the United States, the District ofColumbia, a political subdivision of astate or the District of Columbia, or anyagency or instrumentality of a state or theDistrict of Columbia.

(m) Tax-exempt entity. Tax-exemptentity includes any organization (other

than a governmental unit) exempt fromtax under subtitle A of the Internal Rev-enue Code.

(n) Trust. Trust means a trust describedunder section 457(g) and § 1.457–8. Cus-todial accounts and contracts described insection 401(f) are treated as trusts underthe rules described in § 1.457–8(a)(2).

§ 1.457–3 General introduction toeligible plans.

(a) Compliance in form and operation.An eligible plan is a written plan estab-lished and maintained by an eligibleemployer that is maintained, in both formand operation, in accordance with therequirements of §§ 1.457–4 through1.457–10. An eligible plan must containall the material terms and conditions forbenefits under the plan. An eligible planmay contain certain optional features notrequired for plan eligibility under section457(b), such as distributions for unfore-seeable emergencies, loans, plan-to-plantransfers, additional deferral elections,acceptance of rollovers to the plan, anddistributions of smaller accounts to eli-gible participants. However, except asotherwise specifically provided in§§ 1.457–4 through 1.457–10, if an eli-gible plan contains any optional provi-sions, the optional provisions must meet,in both form and operation, the relevantrequirements under section 457 and§§ 1.457–2 through 1.457–10.

(b) Treatment as single plan. In anycase in which multiple plans are used toavoid or evade the requirements of§§ 1.457–4 through 1.457–10, the Com-missioner may apply the rules under§§ 1.457–4 through 1.457–10 as if theplans were a single plan.

§ 1.457–4 Annual deferrals, deferrallimitations, and deferral agreementsunder eligible plans.

(a) Taxation of annual deferrals.Annual deferrals that satisfy the require-ments of paragraphs (b) and (c) of thissection are excluded from the grossincome of a participant in the yeardeferred or contributed and are notincludible in gross income until paid tothe participant in the case of an eligible

2002–23 I.R.B. 1111 June 10, 2002

governmental plan, or until paid or other-wise made available to the participant inthe case of an eligible plan of a tax-exempt entity. See § 1.457–7.

(b) Agreement for deferral. In order tobe an eligible plan, the plan must providethat compensation may be deferred forany calendar month by salary reductiononly if an agreement providing for thedeferral has been entered into before thefirst day of the month in which the com-pensation is paid or made available. Anew employee may defer compensationpayable in the calendar month duringwhich the participant first becomes anemployee if an agreement providing forthe deferral is entered into on or beforethe first day on which the participant per-forms services for the eligible employer.An eligible plan may provide that if aparticipant enters into an agreement pro-viding for deferral by salary reductionunder the plan, the agreement will remainin effect until the participant revokes oralters the terms of the agreement. Non-elective employer contributions aretreated as being made under an agreemententered into before the first day of thecalendar month.

(c) Maximum deferral limitations—(1)Basic annual limitation. (i) Except asdescribed in paragraphs (c)(2) and (3) ofthis section, in order to be an eligibleplan, the plan must provide that theannual deferral amount for a taxable year(the plan ceiling) may not exceed thelesser of—

(A) The applicable annual dollaramount specified in section 457(e)(15):$11,000 for 2002; $12,000 for 2003;$13,000 for 2004; $14,000 for 2005; and$15,000 for 2006 and thereafter. After2006, the $15,000 amount is adjusted forcost-of-living in the manner described inparagraph (c)(4) of this section; or

(B) 100 percent of the participant’sincludible compensation for the taxableyear.

(ii) The amount of annual deferralspermitted by the 100 percent of includiblecompensation limitation under paragraph(c)(1)(i)(B) of this section is determinedunder section 457(e)(5) and § 1.457–2(g).

(iii) For purposes of determining theplan ceiling under this paragraph (c), theannual deferral amount does not includeany rollover amounts received by the eli-gible plan under § 1.457–10(e).

(iv) The provisions of this paragraph(c)(1) are illustrated by the followingexamples:

Example 1. (i) Facts. Participant A, who earns$14,000 a year, enters into a salary reduction agree-ment in 2006 with A’s eligible employer and electsto defer $13,000 of A’s compensation for that year.Participant A is not eligible for the catch-updescribed in paragraph (c)(2) or (3) of this section,participates in no other retirement plan, and has noother income exclusions taken into account in com-puting includible compensation.

(ii) Conclusion. The annual deferral limit for Ain 2006 is the lesser of $15,000 or 100 percent ofincludible compensation, $14,000. A’s annual defer-ral of $13,000 is permitted under the plan because itis not in excess of $14,000 and thus does not exceed100 percent of A’s includible compensation.

Example 2. (i) Facts. Assume the same facts asin Example 1, except that A’s eligible employer pro-vides an immediately vested, matching employercontribution under the plan for participants whomake salary reduction deferrals under A’s eligibleplan. The matching contribution is equal to 100 per-cent of elective contributions, but not in excess of10 percent of compensation (in A’s case, $1,400).

(ii) Conclusion. Participant A’s annual deferralexceeds the limitations of this paragraph (c)(1). A’smaximum deferral limitation in 2006 is $14,000. A’ssalary reduction deferral of $13,000 combined withA’s eligible employer’s nonelective employer contri-bution of $1,400 exceeds the basic annual limitationof this paragraph (c)(1) because A’s annual deferralstotal $14,400. A has an excess deferral for the tax-able year of $400, the amount exceeding A’s permit-ted annual deferral limitation. The $400 excessdeferral is treated as described in paragraph (e) ofthis section.

Example 3. (i) Facts. Beginning in year 2002,Eligible Employer X contributes $3,000 per year forfive years to Participant B’s eligible plan account.B’s interest in the account vests in 2006. B hasannual compensation of $50,000 in each of the fiveyears 2002 through 2006. Participant B is 41 yearsold. B is not eligible for the catch-up described inparagraph (c)(2) or (3) of this section, participates inno other retirement plan, and has no other incomeexclusions taken into account in computing includ-ible compensation. Adjusted for gain or loss, thevalue of B’s benefit when B’s interest in the accountvests in 2006 is $17,000.

(ii) Conclusion. Under this vesting schedule,$17,000 is taken into account as an annual deferralin 2006. B’s annual deferrals under the plan are lim-ited to a maximum of $15,000 in 2006. Thus, theaggregate of the amounts deferred, $17,000, is inexcess of the B’s maximum deferral limitation by$2,000. The $2,000 is treated as an excess deferraldescribed in paragraph (e) of this section.

(2) Age 50 catch-up—(i) In general. Inaccordance with section 414(v) and theregulations thereunder, an eligible gov-ernmental plan may provide for catch-upcontributions for a participant who is age50 by the end of the year, provided thatsuch age 50 catch-up contributions do notexceed the catch-up limit under section414(v)(2) for the taxable year. The maxi-

mum amount of age 50 catch-up contribu-tions for a taxable year under section414(v) is as follows: $1,000 for 2002;$2,000 for 2003; $3,000 for 2004; $4,000for 2005; and $5,000 for 2006 and there-after. After 2006, the $5,000 amount isadjusted for cost-of-living. For additionalguidance, see regulations under section414(v).

(ii) Coordination with special section457 catch-up. In accordance with sections414(v)(6)(C) and 457(e)(18), the age 50catch-up described in this paragraph(c)(2) does not apply for any taxable yearfor which a higher limitation appliesunder the special section 457 catch-upunder paragraph (c)(3) of this section.Thus, for purposes of this paragraph(c)(2)(ii) and paragraph (c)(3) of this sec-tion, the special section 457 catch-upunder paragraph (c)(3) of this sectionapplies for any taxable year if and only ifthe plan ceiling taking into account para-graph (c)(1) and (3) of this section (anddisregarding the age 50 catch-updescribed in this paragraph (c)(2)) islarger than the plan ceiling taking intoaccount paragraph (c)(1) of this sectionand the age 50 catch-up described in thisparagraph (c)(2) (and disregarding para-graph (c)(3) of this section). Thus, a par-ticipant who is eligible for the age 50catch-up for a year and for whom the yearis also one of the participant’s last threetaxable years ending before the partici-pant attains normal retirement age isentitled to the larger of—

(A) The plan ceiling under paragraph(c)(1) of this section and the age 50catch-up described in this paragraph(c)(2) (and disregarding paragraph (c)(3)of this section) or

(B) The plan ceiling under paragraphs(c)(1) and (3) of this section (and disre-garding the age 50 catch-up described inthis paragraph (c)(2)).

(iii) Examples. The provisions of thisparagraph (c)(2) are illustrated by the fol-lowing examples:

Example 1. (i) Facts. Participant C, who is 55, iseligible to participate in an eligible governmentalplan in 2006. The plan provides a normal retirementage of 65. The plan provides limitations on annualdeferrals up to the maximum permitted under para-graphs (c)(1) and (3) of this section and the age 50catch-up described in this paragraph (c)(2). For2006, C will receive compensation of $40,000 fromthe eligible employer. C desires to defer the maxi-mum amount possible in 2006. The applicable basicdollar limit of paragraph (c)(1)(i)(A) of this section

June 10, 2002 1112 2002–23 I.R.B.

is $15,000 for 2006 and the additional dollar amountpermitted under the age 50 catch-up is $5,000 for2006.

(ii) Conclusion. C is eligible for the age 50catch-up in 2006 because C is 55 in 2006. However,C is not eligible for the special section 457 catch-upunder paragraph (c)(3) of this section in 2006because 2006 is not one of the last three taxableyears ending before C attains normal retirement age.Accordingly, the maximum that C may defer for2006 is $20,000.

Example 2. (i) Facts. The facts are the same asin Example 1, except that, in 2006, C will attain age62. The maximum amount that C can elect under thespecial section 457 catch-up under paragraph (c)(3)of this section is $2,000 for 2006.

(ii) Conclusion. The maximum that C may deferfor 2006 is $20,000. This is the sum of the basicplan ceiling under paragraph (c)(1) of this sectionequal to $15,000 and the age 50 catch-up equal to$5,000. The special section 457 catch-up underparagraph (c)(3) of this section is not applicablesince it provides a smaller plan ceiling.

Example 3. (i) Facts. The facts are the same asin Example 2, except that the maximum additionalamount that C can elect under the special section457 catch-up under paragraph (c)(3) of this sectionis $7,000 for 2006.

(ii) Conclusion. The maximum that C may deferfor 2006 is $22,000. This is the sum of the basicplan ceiling under paragraph (c)(1) of this sectionequal to $15,000, plus the additional special section457 catch-up under paragraph (c)(3) of this sectionequal to $7,000. The additional dollar amount per-mitted under the age 50 catch-up is not applicable toC for 2006 because it provides a smaller plan ceil-ing.

(3) Special section 457 catch-up—(i)In general. Except as provided in para-graph (c)(2)(ii) of this section, an eligibleplan may provide that, for one or more ofthe participant’s last three taxable yearsending before the participant attains “nor-mal retirement age,” the plan ceiling is anamount not in excess of the lesser of—

(A) Twice the dollar amount in effectunder paragraph (c)(1)(i)(A) of this sec-tion; or

(B) The underutilized limitation deter-mined under paragraph (c)(3)(ii) of thissection.

(ii) Underutilized limitation. Theunderutilized amount determined underthis paragraph (c)(3)(ii) is the sum of—

(A) The plan ceiling established underparagraph (c)(1) of this section for thetaxable year; plus

(B) The plan ceiling established underparagraph (c)(1) of this section (or undersection 457(b)(2) for any year before theapplicability date of this section) for anyprior taxable year or years, less theamount of annual deferrals under the planfor such prior taxable year or years (dis-

regarding any annual deferrals under theplan permitted under the age 50 catch-upunder paragraph (c)(2) of this section).

(iii) Determining underutilized limita-tion under paragraph (c)(3)(ii)(B) of thissection. In determining the includiblecompensation of a participant under§ 1.457–2(g) for purposes of calculatingthe amount described in paragraph(c)(3)(ii)(A) of this section, includiblecompensation is not reduced by contribu-tions of amounts described in paragraph(c)(3)(ii)(B) of this section. In addition, aprior taxable year is taken into accountunder paragraph (c)(3)(ii)(B) of this sec-tion only if it is a year beginning afterDecember 31, 1978, in which the partici-pant was eligible to participate in theplan, and in which compensation deferred(if any) under the plan during the yearwas subject to a plan ceiling establishedunder paragraph (c)(1) of this section.

(iv) Special rules concerning applica-tion of the coordination limit for yearsprior to 2002 for purposes of determiningthe underutilized limitation—(A) Generalrule. For purposes of determining theunderutilized limitation for years prior to2002, participants remain subject to therules in effect prior to the repeal of thecoordination limitation under section457(c)(2). Thus, the applicable basicannual limitation under paragraph (c)(1)of this section and the special section 457catch-up under this paragraph (c)(3) foryears in effect prior to 2002 are reduced,for purposes of determining a partici-pant’s underutilized amount under a plan,by amounts excluded from the partici-pant’s income for any prior taxable yearby reason of a salary reduction or electivecontribution under any other eligible sec-tion 457(b) plan, section 401(k) qualifiedcash or deferred arrangement, section402(h)(1)(B) simplified employee pen-sion (SARSEP), section 403(b) annuitycontract, and section 408(p) simple retire-ment account, or under any plan forwhich a deduction is allowed because ofa contribution to an organizationdescribed in section 501(c)(18) (pre–2002coordination plans). Similarly, in apply-ing the section 457(b)(2)(B) limitation forincludible compensation for years prior to2002, the limitation is 33 1/3 percent ofthe participant’s compensation includiblein gross income.

(B) Coordination limitation applied toparticipant. For purposes of determiningthe underutilized limitation for years priorto 2002, the coordination limitationapplies to pre-2002 coordination plans ofall employers for whom a participant hasperformed services, not only to those ofthe eligible employer. Thus, for purposesof determining the amount excluded froma participant’s gross income in any priortaxable year under paragraph (c)(3)(ii)(B)of this section, the participant’s annualdeferral under an eligible plan, and salaryreduction or elective deferrals under allother pre-2002 coordination plans, mustbe determined on an aggregate basis. Tothe extent that the combined deferral foryears prior to 2002 exceeded the maxi-mum deferral limitations, the amount istreated as an excess deferral under para-graph (e) of this section for those prioryears.

(C) Special rule where no annualdeferrals under the eligible plan. A par-ticipant who, although eligible, did notdefer any compensation under the eligibleplan in any given year before 2002 is notsubject to the coordinated deferral limit,even though the participant may havedeferred compensation under one of theother pre-2002 coordination plans. Anindividual is treated as not havingdeferred compensation under an eligibleplan for a prior taxable year if all annualdeferrals under the plan are distributed inaccordance with paragraph (e) of this sec-tion. Thus, to the extent that a participantparticipated solely in one or more of theother pre-2002 coordination plans duringa prior taxable year (and not the eligibleplan), the participant is not subject to thecoordinated limitation for that prior tax-able year. However, the participant istreated as having deferred amounts in aprior taxable year for purposes of deter-mining the underutilized limitation forthat prior taxable year under this para-graph (c)(3)(iv)(C), but only to the extentthat the participant’s salary reduction con-tributions or elective deferrals under allpre-2002 coordination plans have notexceeded the maximum deferral limita-tions in effect under section 457(b) forthat prior taxable year. To the extent anemployer did not offer an eligible plan toan individual in a prior given year, nounderutilized limitation is available to theindividual for that prior year, even if the

2002–23 I.R.B. 1113 June 10, 2002

employee subsequently becomes eligibleto participate in an eligible plan of theemployer.

(D) Examples. The provisions of thisparagraph (c)(3)(iv) are illustrated by thefollowing examples:

Example 1. (i) Facts. In 2001 and in years priorto 2001, Participant D earned $50,000 a year andwas eligible to participate in both an eligible planand a section 401(k) plan. However, D had alwaysparticipated only in the section 401(k) plan and hadalways deferred the maximum amount possible. Foreach year before 2002, the maximum amount per-mitted under section 401(k) exceeded the limitationof paragraph (c)(3)(i) of this section. In 2002, D isin the 3-year period prior to D’s attainment of theeligible plan’s normal retirement age of 65, and Dnow wants to participate in the eligible plan andmake annual deferrals of up to $30,000 under theplan’s special section 457 catch-up provisions.

(ii) Conclusion. Participant D is treated as hav-ing no underutilized amount under paragraph(c)(3)(ii)(B) of this section for 2002 for purposes ofthe catch-up limitation under section 457(b)(3) andparagraph (c)(3) of this section because, in each ofthe years before 2002, D has deferred an amount inexcess of the limitation of paragraph (c)(3)(i) of thissection.

Example 2. (i) Facts. Assume the same facts asin Example 1, except that D only deferred $2,500per year under the section 401(k) plan for one yearbefore 2002.

(ii) Conclusion. D is treated as having anunderutilized amount under paragraph (c)(3)(ii)(B)of this section for 2002 for purposes of the specialsection 457 catch-up limitation. This is because Dhas deferred an amount for prior years that is lessthan the limitation of paragraph (c)(1)(i) of this sec-tion.

Example 3. (i) Facts. Participant E, who earned$15,000 for 2000, entered into a salary reductionagreement in 2000 with E’s eligible employer andelected to defer $3,000 for that year. For 2000, E’seligible employer provided an immediately vested,matching employer contribution under the plan forparticipants who make salary reduction deferralsunder E’s eligible plan. The matching contributionwas equal to 100 percent of elective contributions,but not in excess of 10 percent of compensationbefore salary reduction deferrals (in E’s case,$1,500). For 2000, E was not eligible for anycatch-up contribution, participated in no other retire-ment plan, and had no other income exclusionstaken into account in computing taxable compensa-tion.

(ii) Conclusion. Participant E’s annual deferralexceeded the limitations of section 457(b) for 2000.E’s maximum deferral limitation in 2000 was$4,000 because E’s includible compensation was$12,000 ($15,000 minus the deferral of $3,000) andthe applicable limitation for 2000 was one-third ofthe individual’s includible compensation (one-thirdof $12,000 equals $4,000). E’s salary reductiondeferral of $3,000 combined with E’s eligibleemployer’s matching contribution of $1,500exceeded the limitation of section 457(b) for 2000because E’s annual deferrals totaled $4,500. E hadan excess deferral for 2000 of $500, the amount

exceeding E’s permitted annual deferral limitation,and E’s underutilized amount for 2000 is zero.

(v) Normal retirement age—(A) Gen-eral rule. For purposes of the special sec-tion 457 catch-up in this paragraph (c)(3),a plan must specify the normal retirementage under the plan. A plan may definenormal retirement age as any age that ison or after the earlier of age 65 or the ageat which participants have the right toretire and receive, under the basic definedbenefit pension plan of the state or tax-exempt entity, immediate retirement ben-efits without actuarial or similar reductionbecause of retirement before some laterspecified age, and that is not later thanage 70 ½. Alternatively, a plan may pro-vide that a participant is allowed to desig-nate a normal retirement age within theseages. For purposes of the special section457 catch-up in this paragraph (c)(3), anentity sponsoring more than one eligibleplan may not permit a participant to havemore than one normal retirement ageunder the eligible plans it sponsors.

(B) Special rule for eligible plans ofqualified police or firefighters. An eli-gible plan with participants that includequalified police or firefighters as definedunder section 415(b)(2)(H)(ii)(I) maydesignate a normal retirement age forsuch qualified police or firefighters that isearlier than the earliest normal retirementage designated under the general rule ofparagraph (c)(3)(i)(A) of this section, butin no event may the normal retirementage be earlier than age 40. Alternatively,a plan may allow a qualified police orfirefighter participant to designate a nor-mal retirement age that is between age 40and age 70 ½.

(vi) Examples. The provisions of thisparagraph (c)(3) are illustrated by the fol-lowing examples:

Example 1. (i) Facts. Participant F, who willturn 61 on April 1, 2006, becomes eligible to partici-pate in an eligible plan on January 1, 2006. The planprovides a normal retirement age of 65. The planprovides limitations on annual deferrals up to themaximum permitted under paragraphs (c)(1)through (3) of this section. For 2006, F will receivecompensation of $40,000 from the eligibleemployer. F desires to defer the maximum amountpossible in 2006. The applicable basic dollar limit ofparagraph (c)(1)(i)(A) of this section is $15,000 for2006 and the additional dollar amount permittedunder the age 50 catch-up in paragraph (c)(2) of thissection for an individual who is at least age 50 is$5,000 for 2006.

(ii) Conclusion. F is not eligible for the specialsection 457 catch-up under paragraph (c)(3) of thissection in 2006 because 2006 is not one of the last

three taxable years ending before F attains normalretirement age. Accordingly, the maximum that Fmay defer for 2006 is $20,000. See also paragraph(c)(2)(iii) Example 1 of this section.

Example 2. (i) Facts. The facts are the same asin Example 1 except that, in 2006, F elects to deferonly $2,000 under the plan (rather than the maxi-mum permitted amount of $20,000). In addition,assume that the applicable basic dollar limit of para-graph (c)(1)(i)(A) of this section continues to be$15,000 for 2007 and the additional dollar amountpermitted under the age 50 catch-up in paragraph(c)(2) of this section for an individual who is at leastage 50 continues to be $5,000 for 2007. In F’s tax-able year 2007, which is one of the last three taxableyears ending before F attains the plan’s normalretirement age of 65, F again receives a salary of$40,000 and elects to defer the maximum amountpermissible under the plan’s catch-up provisionsprescribed under paragraph (c) of this section.

(ii) Conclusion. For 2007, which is one of thelast three taxable years ending before F attains theplan’s normal retirement age of 65, the applicablelimit on deferrals for F is the larger of the amountunder the special section 457 catch-up or $20,000,which is the basic annual limitation ($15,000) andthe age 50 catch-up limit of section 414(v) ($5,000).For 2007, F’s special section 457 catch-up amount isthe lesser of two times the basic annual limitation($30,000) or the sum of the basic annual limitation($15,000) plus the $13,000 underutilized limitationunder paragraph (c)(3)(ii) of this section (the$15,000 plan ceiling in 2006, minus the $2,000 con-tributed for F in 2006), or $28,000. Thus, the maxi-mum amount that F may defer in 2007 is $28,000.

Example 3. (i) Facts. The facts are the same asin Examples 1 and 2, except that F does not makeany contributions to the plan before 2010. In addi-tion, assume that the applicable basic dollar limita-tion of paragraph (c)(1)(i)(A) of this section contin-ues to be $15,000 for 2010 and the additional dollaramount permitted under the age 50 catch-up in para-graph (c)(2) of this section for an individual who isat least age 50 continues to be $5,000 for 2010. InF’s taxable year 2010, the year in which F attainsage 65 (which is the normal retirement age underthe plan), F desires to defer the maximum amountpossible under the plan. F’s compensation for 2010is again $40,000.

(ii) Conclusion. For 2010, the maximum amountthat F may defer is $20,000. The special section 457catch-up provisions under paragraph (c)(3) of thissection are not applicable because 2010 is not a tax-able year ending before the year in which F attainsnormal retirement age.

(4) Cost-of-living adjustment. Foryears beginning after December 31, 2006,the $15,000 dollar limitation in paragraph(c)(1)(i)(A) of this section will beadjusted to take into account increases inthe cost-of-living. The adjustment in thedollar limitation is made at the same timeand in the same manner as under section415(d) (relating to qualified plans undersection 401(a)), except that the baseperiod is the calendar quarter beginningJuly 1, 2005, and any increase which is

June 10, 2002 1114 2002–23 I.R.B.

not a multiple of $500 will be rounded tothe next lowest multiple of $500.

(d) Deferral of sick, vacation, andback pay under an eligible plan—(1) Ingeneral. An eligible plan may providethat a participant may elect to defer accu-mulated sick pay, accumulated vacationpay, and back pay under an eligible planif certain conditions are satisfied. Theplan must provide, in accordance withparagraph (b) of this section, that theseamounts may be deferred for any calendarmonth only if an agreement providing forthe deferral is entered into before thebeginning of the month in which theamounts would otherwise be paid ormade available and the participant is anemployee in that month. Any deferralsmade under this paragraph (d)(1) underan eligible plan are subject to the maxi-mum deferral limitations of paragraph (c)of this section.

(2) Examples. The provisions of thisparagraph (d) are illustrated by the fol-lowing examples:

Example 1. (i) Facts. Participant G, age 62, is aparticipant in an eligible plan providing a normalretirement age of 65. Under the terms of G’semployer’s eligible plan and G’s sick leave plan, Gmay, during November of 2003 (which is one of thethree years prior to normal retirement age), make aone-time election to contribute amounts representingaccumulated sick pay to the eligible plan in Decem-ber of 2003 (within the maximum deferral limita-tions). Alternatively, such amounts may remain inthe “bank” under the sick leave plan. No cash out ofthe sick pay is available at any time prior to termi-nation of employment. The total value of G’s accu-mulated sick pay (determined, in accordance withthe terms of the sick leave plan, by reference to G’scurrent salary) is $4,000 in December of 2003.

(ii) Conclusion. Under the terms of the eligibleplan and sick leave plan, G may elect beforeDecember of 2003 to defer the $4,000 value ofaccumulated sick pay under the eligible plan, pro-vided that G’s other annual deferrals to the eligibleplan for 2003, when added to the $4,000, do notexceed G’s maximum deferral limitation for theyear.

Example 2. (i) Facts. Employer X maintains aneligible plan and a vacation leave plan. Under theterms of the vacation leave plan, employees gener-ally accrue three weeks of vacation per year. Up toone week’s unused vacation may be carried overfrom one year to the next, so that in any single yearan employee may have a maximum of four weeksvacation time. At the beginning of each calendaryear, under the terms of the eligible plan (whichconstitutes an agreement providing for the deferral),the value of any unused vacation time from the prioryear in excess of one week is automatically contrib-uted to the eligible plan, to the extent of the employ-ee’s maximum deferral limitations. Amounts inexcess of the maximum deferral limitations are for-feited.

(ii) Conclusion. The value of the unused vaca-tion pay contributed to X’s eligible plan pursuant tothe terms of the plan and the terms of the vacationleave plan is treated as an annual deferral to the eli-gible plan in the calendar year the contribution ismade. No amounts contributed to the eligible planwill be considered made available to a participant inX’s eligible plan.

(e) Excess deferrals under an eligibleplan—(1) In general. Any amountdeferred under an eligible plan for thetaxable year of a participant that exceedsthe maximum deferral limitations setforth in paragraphs (c)(1) through (3) ofthis section, and any amount that exceedsthe individual limitation under § 1.457–5,constitutes an excess deferral taxable inaccordance with § 1.457–11 for that tax-able year. Thus, an excess deferral isincludible in gross income in the taxableyear deferred or, if later, the first taxableyear in which there is no substantial riskof forfeiture.

(2) Excess deferrals under an eligiblegovernmental plan other than as a resultof the individual limitation. In order to bean eligible governmental plan, the planmust provide that any excess deferralsresulting from a failure of a plan to applythe limitations of paragraphs (c)(1)through (3) of this section to amountsdeferred under the eligible plan (com-puted without regard to the individuallimitation under § 1.457–5) will be dis-tributed to the participant, with allocablenet income, as soon as administrativelypracticable after the plan determines thatthe amount is an excess deferral. For pur-poses of determining whether there is anexcess deferral resulting from a failure ofa plan to apply the limitations of para-graphs (c)(1) through (3) of this section,all plans under which an individual par-ticipates by virtue of his or her relation-ship with a single employer are treated asa single plan. An eligible governmentalplan does not fail to satisfy the require-ments of paragraphs (a) through (d) ofthis section or §§ 1.457–6 through1.457–10 (including the distribution rulesunder § 1.457–6 and the funding rulesunder § 1.457–8) solely by reason of adistribution made under this paragraph(e)(2). If such excess deferrals are notcorrected by distribution under this para-graph (e)(2), the plan will be an ineligibleplan under which benefits are taxable inaccordance with § 1.457–11.

(3) Excess deferrals under an eligibleplan of a tax-exempt employer other than

as a result of the individual limitation. Ifa plan of a tax-exempt employer fails tocomply with the limitations of paragraphs(c)(1) through (3) of this section, the planwill be an ineligible plan under whichbenefits are taxable in accordance with§ 1.457–11. For purposes of determiningwhether there is an excess deferral result-ing from a failure of a plan to apply thelimitations of paragraphs (c)(1) through(3) of this section, all plans under whichan individual participates by virtue of hisor her relationship with a single employerare treated as a single plan.

(4) Excess deferrals arising fromapplication of the individual limitation.An eligible plan may provide that anexcess deferral as a result of a failure tocomply with the individual limitationunder § 1.457–5 for a taxable year maybe distributed to the participant, with allo-cable net income, as soon as administra-tively practicable after the plan deter-mines that the amount is an excessdeferral. An eligible plan does not fail tosatisfy the requirements of paragraphs (a)through (d) of this section or §§ 1.457–6through 1.457–10 (including the distribu-tion rules under § 1.457–6 and the fund-ing rules under § 1.457–8) solely by rea-son of a distribution made under thisparagraph (e)(4). Although a plan willstill maintain eligible status if excessdeferrals are not distributed under thisparagraph (e)(4), a participant mustinclude the excess amounts in income asprovided in paragraph (e)(1) of this sec-tion.

(5) Examples. The provisions of thisparagraph (e) are illustrated by the fol-lowing examples:

Example 1. (i) Facts. In 2006, the eligible planof State Employer X in which Participant H partici-pates permits a maximum deferral of the lesser of$15,000 or 100 percent of includible compensation.In 2006, H, who has compensation of $28,000, nev-ertheless defers $16,000 under the eligible plan. Par-ticipant H is age 45 and normal retirement age underthe plan is age 65. For 2006, the applicable dollarlimit under paragraph (c)(1)(i)(A) of this section is$15,000.

(ii) Conclusion. Participant H has deferred$1,000 in excess of the $15,000 limitation providedfor under the plan for 2006. The $1,000 excess mustbe included by H into H’s income for 2006. In orderto correct the failure and still be an eligible plan, theplan must distribute the excess deferral, with allo-cable net income, as soon as administratively prac-ticable after determining that the amount exceedsthe plan deferral limitations. If the excess deferral isnot distributed, the plan will be an ineligible plan

2002–23 I.R.B. 1115 June 10, 2002

with respect to which benefits are taxable in accor-dance with § 1.457–11.

Example 2. (i) Facts. The facts are the same asin Example 1, except that H’s deferral under the eli-gible plan is limited to $11,000 and H also makes asalary reduction contribution of $5,000 to an annu-ity contract under section 403(b) with the sameEmployer X.

(ii) Conclusion. H’s deferrals are within the plandeferral limitations of Employer X. Because of therepeal of the application of the coordination limita-tion under former paragraph (2) of section 457(c),H’s salary reduction deferrals under the annuity con-tract are no longer considered in determining H’sapplicable deferral limits under paragraphs (c)(1)through (3) of this section.

Example 3. (i) Facts. The facts are the same asin Example 1, except that H’s deferral under the eli-gible governmental plan is limited to $14,000 and Halso makes a deferral of $4,000 to an eligible gov-ernmental plan of a different employer. ParticipantH is age 45 and normal retirement age under botheligible plans is age 65.

(ii) Conclusion. Because of the application ofthe individual limitation under § 1.457–5, H has anexcess deferral of $3,000 (the sum of $14,000 plus$4,000 equals $18,000, which is $3,000 in excess ofthe dollar limitation of $15,000). The $3,000 excessdeferral, with allocable net income, may be distrib-uted from either plan as soon as administrativelypracticable after determining that the combinedamount exceeds the deferral limitations. If the$3,000 excess deferral is not distributed to H, eachplan will continue to be an eligible plan, but the$3,000 must be included by H into H’s income for2006.

Example 4. (i) Facts. Assume the same facts asin Example 3, except that H’s deferral under the eli-gible governmental plan is limited to $14,000 and Halso makes a deferral of $4,000 to an eligible planof Employer Y, a tax-exempt entity.

(ii) Conclusion. The results are the same as inExample 3, i.e., because of the application of theindividual limitation under § 1.457–5, H has anexcess deferral of $3,000. If the $3,000 excessdeferral is not distributed to H, each plan will con-tinue to be an eligible plan, but the $3,000 must beincluded by H into H’s income for 2006.

Par. 3. Sections 1.457–5 through1.457–12 are added to read as follows:

§ 1.457–5 Individual limitation forcombined annual deferrals undermultiple eligible plans

(a) General rule. The individual limi-tation under section 457(c) and this sec-tion equals the basic annual deferral limi-tation under § 1.457–4(c)(1)(i)(A), theage 50 catch-up amount under § 1.457–4(c)(2), and the special section 457catch-up amount under § 1.457–4(c)(3),applied by taking into account the com-bined annual deferral for the participantfor any taxable year under all eligibleplans. While an eligible plan may includeprovisions under which it will meet the

individual limitation under section 457(c)and this section, annual deferrals by aparticipant that exceed the individuallimit under section 457(c) and this sectionwill not cause a plan to lose its eligiblestatus. However, to the extent the com-bined annual deferrals for a participantfor any taxable year exceed the individuallimitation under section 457(c) and thissection for that year, the amounts aretreated as excess deferrals as described in§ 1.457–4(e).

(b) Limitation applied to participant.The individual limitation in this sectionapplies to eligible plans of all employersfor whom a participant has performed ser-vices, including both eligible governmen-tal plans and eligible plans of a tax-exempt entity and both eligible plans ofthe employer and eligible plans of otheremployers. Thus, for purposes of deter-mining the amount excluded from a par-ticipant’s gross income in any taxableyear (including the underutilized limita-tion under § 1.457–4(c)(3)(ii)(B)), theparticipant’s annual deferral under an eli-gible plan, and the participant’s annualdeferrals under all other eligible plans,must be determined on an aggregatebasis. To the extent that the combinedannual deferral amount exceeds the maxi-mum deferral limitation applicable under§ 1.457–4(c)(1)(i)(A), (c)(2), or (c)(3),the amount is treated as an excess defer-ral under § 1.457–4(e).

(c) Special rules for catch-up amountsunder multiple eligible plans. For pur-poses of applying section 457(c) and thissection, the special section 457 catch-upunder § 1.457–4(c)(3) is taken intoaccount only to the extent that an annualdeferral is made for a participant under aneligible plan as a result of plan provisionspermitted under § 1.457–4(c)(3). In addi-tion, if a participant has annual deferralsunder more than one eligible plan and theapplicable catch-up amount under§ 1.457–4(c)(2) or (3) is not the same foreach such eligible plan for the taxableyear, section 457(c) and this section areapplied using the catch-up amount underwhichever plan has the largest catch-upamount applicable to the participant.

(d) Examples. The provisions of thissection are illustrated by the followingexamples:

Example 1. (i) Facts. Participant F is age 62 in2006 and participates in two eligible plans during2006, Plans J and K, which are each eligible plans

of two different governmental entities. Each planincludes provisions allowing the maximum annualdeferral permitted under § 1.457–4(c)(1) through(3). For 2006, the underutilized amount under§ 1.457–4(c)(3)(ii)(B) is $20,000 under Plan J and is$40,000 under Plan K. Normal retirement age is age65 under both plans. Participant F defers $15,000under each plan. Participant F’s includible compen-sation is in each case in excess of the deferral. Nei-ther plan designates the $15,000 contribution as acatch-up permitted under each plan’s special section457 catch-up provisions.

(ii) Conclusion. For purposes of applying thissection to Participant F for 2006, the maximumexclusion is $20,000. This is equal to the sum of$15,000 plus $5,000, which is the age 50 catch-upamount. Thus, F has an excess amount of $10,000which is treated as an excess deferral for ParticipantF for 2006 under § 1.457–4(e).

Example 2. (i) Facts. Participant E, who willturn 63 on April 1, 2006, participates in four eligibleplans during 2006: Plan W which is an eligible gov-ernmental plan; and Plans X, Y, and Z which areeach eligible plans of three different tax-exemptentities. For 2006, the limitation under these plansthat apply to Participant E under all four plans under§ 1.457–4(c)(1)(i)(A) is $15,000. For 2006, theadditional age 50 catch-up limitation that applies toParticipant E under Plan W under § 1.457–4(c)(2) is$5,000. Further, for 2006, different limitations under§§ 1.457–4(c)(3) and (c)(3)(ii)(B) apply to Partici-pant E under each of these plans, as follows: underPlan W, the underutilized limitation under § 1.457–4(c)(3)(ii)(B) is $7,000; under Plan X, the underuti-lized limitation under § 1.457–4(c)(3)(ii)(B) is$2,000; under Plan Y, the underutilized limitationunder § 1.457–4(c)(3)(ii)(B) is $8,000; and underPlan Z, § 1.457–4(c)(3) is not applicable since nor-mal retirement age is age 62 under Plan Z. Partici-pant E’s includible compensation is in each case inexcess of any applicable deferral.

(ii) Conclusion. For purposes of applying thissection to Participant E for 2006, Participant Ecould elect to defer $23,000 under Plan Y, which isthe maximum deferral limitation under §§ 1.457–4(c)(1) through (3), and to defer no amount underPlans W, X, and Z. The $23,000 maximum amountis equal to the sum of $15,000 plus $8,000, which isthe catch-up amount applicable to Participant Eunder Plan Y and which is the largest catch-upamount applicable to Participant E under any of thefour plans for 2006. Alternatively, Participant Ecould instead elect to defer the following combina-tion of amounts: $5,000 to Plan W and an aggregatetotal of $15,000 to Plans X, Y, and Z; $22,000 toPlan W and none to any of the other three plans;$17,000 to Plan X and none to any of the other threeplans; or $15,000 to Plan Z and none to any of theother three plans.

(iii) If the underutilized amount under Plans W,X, and Y for 2006 were in each case zero (becauseE had always contributed the maximum amount orE was a new participant) or an amount not in excessof $5,000, the maximum exclusion under this sec-tion would be $20,000 for Participant E for 2006($15,000 plus the $5,000 age 50 catch-up amount),which Participant E could contribute to Plan W.

June 10, 2002 1116 2002–23 I.R.B.

§ 1.457–6 Timing of distributions undereligible plans.

(a) In general. Except as provided inparagraph (c) of this section (relating todistributions on account of an unforesee-able emergency), paragraph (e) of thissection (relating to distributions of smallaccounts), § 1.457–10(a) (relating to planterminations), or § 1.457–10(c) (relatingto domestic relations orders), amountsdeferred under an eligible governmentalplan may not be paid to a participant orbeneficiary before the participant has aseverance from employment with the eli-gible employer. For rules relating toloans, see paragraph (f) of this section.

(b) Severance from employment—(1)Employees. An employee has a severancefrom employment with the eligibleemployer if the employee dies, retires, orotherwise has a severance from employ-ment with the eligible employer.

(2) Independent contractors—(i) Ingeneral. An independent contractor isconsidered to have a severance fromemployment with the eligible employerupon the expiration of the contract (or inthe case of more than one contract, allcontracts) under which services are per-formed for the eligible employer, if theexpiration constitutes a good-faith andcomplete termination of the contractualrelationship. An expiration does not con-stitute a good faith and complete termina-tion of the contractual relationship if theeligible employer anticipates a renewal ofa contractual relationship or the indepen-dent contractor becoming an employee.For this purpose, an eligible employer isconsidered to anticipate the renewal ofthe contractual relationship with an inde-pendent contractor if it intends to againcontract for the services provided underthe expired contract, and neither the eli-gible employer nor the independent con-tractor has eliminated the independentcontractor as a possible provider of ser-vices under any such new contract. Fur-ther, an eligible employer is considered tointend to again contract for the servicesprovided under an expired contract if theeligible employer’s doing so is condi-tioned only upon incurring a need for theservices, the availability of funds, or both.

(ii) Special rule. Notwithstandingparagraph (b)(2)(i) of this section, theplan is considered to satisfy the require-

ment described in paragraph (a) of thissection that no amounts deferred underthe plan be paid or made available to theparticipant before the participant has aseverance from employment with the eli-gible employer, if, with respect toamounts payable to a participant who isan independent contractor, an eligibleplan provides that—

(A) No amount will be paid to the par-ticipant before a date at least 12 monthsafter the day on which the contractexpires under which services are per-formed for the eligible employer (or, inthe case of more than one contract, allsuch contracts expire); and

(B) No amount payable to the partici-pant on that date will be paid to the par-ticipant if, after the expiration of the con-tract (or contracts) and before that date,the participant performs services for theeligible employer as an independent con-tractor or an employee.

(c) Rules applicable to distributionsfor unforeseeable emergencies—(1) Ingeneral. An eligible plan may permit adistribution to a participant or beneficiaryfaced with an unforeseeable emergency.The distribution must satisfy the require-ment of paragraph (c)(2) of this section.

(2) Requirements—(i) Unforeseeableemergency defined. An unforeseeableemergency must be defined in the plan asa severe financial hardship of the partici-pant or beneficiary resulting from an ill-ness or accident of the participant or ben-eficiary, the participant’s or beneficiary’sspouse or the participant’s or beneficia-ry’s dependent (as defined in section152(a)); loss of the participant’s or ben-eficiary’s property due to casualty; orother similar extraordinary and unforesee-able circumstances arising as a result ofevents beyond the control of the partici-pant or the beneficiary. For example, theimminent foreclosure of or eviction fromthe participant’s or beneficiary’s primaryresidence may constitute an unforeseeableemergency. In addition, the need to payfor medical expenses, including non-refundable deductibles, as well as for thecost of prescription drug medication, mayconstitute an unforeseeable emergency.Finally, the need to pay for the funeralexpenses of a family member may alsoconstitute an unforeseeable emergency.Except in extraordinary circumstances,the purchase of a home and the payment

of college tuition are not unforeseeableemergencies under this paragraph (c)(2).

(ii) Unforeseeable emergency distribu-tion standard. Whether a participant orbeneficiary is faced with an unforeseeableemergency permitting a distribution underthis paragraph (c) is to be determinedbased on the relevant facts and circum-stances of each case, but, in any case, adistribution on account of unforeseeableemergency may not be made to the extentthat such emergency is or may be relievedthrough reimbursement or compensationfrom insurance or otherwise; by liquida-tion of the participant’s assets, to theextent the liquidation of such assetswould not itself cause severe financialhardship; or by cessation of deferralsunder the plan.

(iii) Distribution necessary to satisfyemergency need. Distributions because ofan unforeseeable emergency must be lim-ited to the amount reasonably necessaryto satisfy the emergency need (which mayinclude any amounts necessary to pay anyfederal, state, or local income taxes orpenalties reasonably anticipated to resultfrom the distribution).

(d) Minimum required distributions foreligible plans. In order to be an eligibleplan, a plan must meet the distributionrequirements of section 457(d)(1) and (2).Under section 457(d)(2), a plan mustmeet the minimum distribution require-ments of section 401(a)(9). See section401(a)(9) and the regulations thereunderfor these requirements. Section 401(a)(9)requires that a plan begin lifetime distri-butions to a participant no later than April1 of the calendar year following the laterof the calendar year in which the partici-pant attains age 70 ½ or the calendar yearin which the participant retires.

(e) Distributions of smaller acc-ounts—(1) In general. An eligible planmay provide for a distribution of all or aportion of a dollar amount which is notattributable to rollover contributions (asdefined in section 411(a)(11)(D)). Inorder to permit such a distribution, an eli-gible plan must provide that the amountof the distribution must not exceed thedollar limit under section 411(a)(11)(A)(which is $5,000 for 2002) and that thedistribution is made only if no amounthas been deferred under the plan by or forthe participant during the two-year periodending on the date of the distribution and

2002–23 I.R.B. 1117 June 10, 2002

there has been no prior distribution underthe plan to the participant under this para-graph (e). An eligible plan is not requiredto permit distributions under this para-graph (e).

(2) Alternative provisions possible.Consistent with the provisions of para-graph (e)(1) of this section, a plan mayprovide that the total amount deferred fora participant or beneficiary, if not inexcess of the applicable dollar limit ofsection 411(a)(11)(A), will be distributedautomatically to the participant or benefi-ciary if the requirements of paragraph(e)(1) of this section are met. Alterna-tively, the plan may provide for the totalamount deferred for a participant or ben-eficiary, if not in excess of the applicabledollar limit of section 411(a)(11)(A), tobe distributed to the participant or benefi-ciary only if the participant or beneficiaryso elects. The plan is permitted to substi-tute a specified dollar amount that is lessthan the applicable dollar limit of section411(a)(11)(A) under either of these alter-natives. In addition, these two alternativescan be combined; for example, a plancould provide for automatic distributionsfor account balances totaling an amountnot in excess of the applicable dollar limitof section 411(a)(11)(A) but allow partici-pants or beneficiary to elect a distributionif the total account balance is above $500but not above the applicable dollar limitof section 411(a)(11)(A).

(f) Loans from eligible plans—(1) Eli-gible plans of tax-exempt entities. If aparticipant or beneficiary receives(directly or indirectly) any amountdeferred as a loan from an eligible plan ofa tax-exempt entity, that amount will betreated as having been paid or madeavailable to the individual as a distribu-tion under the plan, in violation of thedistribution requirements of section457(d).

(2) Eligible governmental plans. Thedetermination of whether the availabilityof a loan, the making of a loan, or a fail-ure to repay a loan made from a trustee(or a person treated as a trustee under sec-tion 457(g)) of an eligible governmentalplan to a participant or beneficiary istreated as a distribution (directly or indi-rectly) for purposes of this section, andthe determination of whether the avail-ability of the loan, the making of the loan,or a failure to repay the loan is in any

other respect a violation of the require-ments of section 457(b) and the regula-tions, depends on the facts and circum-stances. Thus, for example, a loan mustbear a reasonable rate of interest in orderto satisfy the exclusive benefit require-ment of section 457(g)(1) and § 1.457–8(a)(1). See also § 1.457–7(b)(3) relatingto the application of section 72(p) withrespect to the taxation of a loan madeunder an eligible governmental plan, and§ 1.72(p)–1 relating to section 72(p)(2).

(3) Example. The provisions of para-graph (f)(2) of this section are illustratedby the following example:

Example. (i) Facts. Eligible Plan X of State Y isfunded through Trust Z. Plan X provides for anemployee’s account balance under Plan X to be paidin 5 annual installments (of 1/5th the account bal-ance the first year, 1/4th the account balance thesecond year, etc.) beginning at severance fromemployment with State Y. Plan X includes a loanprogram under which any active employee with avested account balance may receive a loan fromTrust Z. Loans are made pursuant to plan provisionsregarding loans that are set forth in the plan underwhich loans bear a reasonable rate of interest andare secured by the employee’s account balance. Inorder to avoid taxation under § 1.457–7(b)(3) andsection 72(p)(1), the plan provisions limit theamount of loans and require loans to be repaid inlevel installments as required under section72(p)(2). Participant J’s vested account balanceunder Plan X is $50,000. J receives a loan fromTrust Z in the amount of $5,000 on December 1,2003 to be repaid in level installments made quar-terly over the 5-year period ending on November30, 2008. Participant J makes the required repay-ments until J has a severance from employmentfrom State Y in 2005 and subsequently fails to repaythe outstanding loan balance of $2,250. The $2,250loan balance is offset against J’s $80,000 accountbalance benefit under Plan X, and J is paid one fifthof the remaining $77,750 in 2005.

(ii) Conclusion. The making of the loan to J willnot be treated as a violation of the requirements ofsection 457(b) or the regulations. The cancellationof the loan at severance from employment does notcause Plan X to fail to satisfy the requirements forplan eligibility under section 457. In addition,because the loan satisfies the maximum amount andrepayment requirements of section 72(p)(2), J is notrequired to include any amount in income as a resultof the loan until 2005, when J has income of $2,250as a result of the offset (which is a permissible dis-tribution under this section) and income of $15,550(one fifth of $77,750) as a result of the first annualinstallment payment.

§ 1.457–7 Taxation of distributions undereligible plans.

(a) General rules for when amountsare included in gross income. The rulesfor determining when an amount deferredunder an eligible plan is includible in thegross income of a participant or benefi-ciary depend on whether the plan is aneligible governmental plan or an eligibleplan of a tax-exempt entity. Paragraph (b)of this section sets forth the rules for aneligible governmental plan. Paragraph (c)of this section sets forth the rules for aneligible plan of a tax-exempt entity.

(b) Amounts included in gross incomeunder an eligible governmental plan—(1)Amounts included in gross income in yearpaid under an eligible governmental plan.Except as provided in paragraphs (b)(2)and (3) of this section (or in § 1.457–10(c) relating to payments to a spouse orformer spouse pursuant to a qualifieddomestic relations order), amountsdeferred under an eligible governmentalplan are includible in the gross income ofa participant or beneficiary for the taxableyear in which paid to the participant orbeneficiary under the plan.

(2) Rollovers to individual retirementarrangements and other eligible retire-ment plans. A trustee-to-trustee transfer inaccordance with section 401(a)(31) (gen-erally referred to as a direct rollover) isnot includible in gross income of a par-ticipant or beneficiary in the year trans-ferred. In addition, any payment made inthe form of an eligible rollover distribu-tion (as defined in section 402(c)(4)) isnot includible in gross income in the yearpaid to the extent the payment is trans-ferred to an eligible retirement plan (asdefined in section 402(c)(8)(B)) within 60days, including the transfer to the eligibleretirement plan of any property distrib-uted from the eligible governmental plan.For this purpose, the rules of section402(c)(2) through (7) and (9) apply. Anytrustee-to-trustee transfer under this para-graph (b)(2) is a distribution that is sub-ject to the distribution requirements of§ 1.457–6.

(3) Amounts taxable under section72(p)(1). In accordance with section72(p), the amount of any loan from aneligible governmental plan to a partici-pant or beneficiary (including any pledge

June 10, 2002 1118 2002–23 I.R.B.

or assignment treated as a loan under sec-tion 72(p)(1)(B)) is treated as having beenreceived as a distribution from the planunder section 72(p)(1), except to theextent set forth in section 72(p)(2) (relat-ing to loans that do not exceed a maxi-mum amount and that are repayable inaccordance with certain terms) and§ 1.72(p)–1. Thus, except to the extent aloan satisfies section 72(p)(2), anyamount loaned from an eligible govern-mental plan to a participant or beneficiary(including any pledge or assignmenttreated as a loan under section72(p)(1)(B)) is includible in the grossincome of the participant or beneficiaryfor the taxable year in which the loan ismade. See generally § 1.72(p)–1.

(4) Examples. The provisions of thisparagraph (b) are illustrated by the fol-lowing examples:

Example 1. (i) Facts. Eligible Plan G of a gov-ernmental entity permits distribution of benefits in asingle sum or in installments of up to 20 years, withsuch benefits to commence at any date that is afterseverance from employment (but not later than theplan’s normal retirement age of 65). Effective forparticipants who have a severance from employmentafter December 31, 2001, Plan X allows anelection—as to both the date on which payments areto begin and the form in which payments are to bemade—to be made by the participant at any timethat is before the commencement date selected.However, Plan X chooses to require elections to befiled at least 30 days before the commencement dateselected in order for Plan X to have enough time tobe able to effectuate the election.

(ii) Conclusion. No amounts are included ingross income before actual payments begin. Ifinstallment payments begin (and the installmentpayments are payable over at least 10 years so asnot to be eligible rollover distributions), the amountincluded in gross income for any year is equal to theamount of the installment payment paid during theyear.

Example 2. (i) Facts. Same facts as in Example1, except that the same rules are extended to partici-pants who had a severance from employment beforeJanuary 1, 2002.

(ii) Conclusion. For all participants (i.e., boththose who have a severance from employment afterDecember 31, 2001, and those who have a sever-ance from employment before January 1, 2002(including those whose benefit payments have com-menced before January 1, 2002)), no amounts areincluded in gross income before actual paymentsbegin. If installment payments begin (and theinstallment payments are payable over at least 10years so as not to be eligible rollover distributions),the amount included in gross income for any year isequal to the amount of the installment payment paidduring the year.

(c) Amounts included in gross incomeunder an eligible plan of a tax-exemptentity—(1) Amounts included in gross

income in year paid or made availableunder an eligible plan of a tax-exemptentity. Amounts deferred under an eligibleplan of a tax-exempt entity are includiblein the gross income of a participant orbeneficiary for the taxable year in whichpaid or otherwise made available to theparticipant or beneficiary under the plan.Thus, amounts deferred under an eligibleplan of a tax-exempt entity are includiblein the gross income of the participant orbeneficiary in the year the amounts arefirst made available under the terms ofthe plan, even if the plan has not distrib-uted the amounts deferred. Amountsdeferred under an eligible plan of a tax-exempt entity are not considered madeavailable to the participant or beneficiarysolely because the participant or benefi-ciary is permitted to choose among vari-ous investments under the plan.

(2) When amounts deferred are consid-ered to be made available under an eli-gible plan of a tax-exempt entity—(i)General rule. Except as provided in para-graphs (c)(2)(ii) through (iv) of this sec-tion, amounts deferred under an eligibleplan of a tax-exempt entity are consideredmade available (and, thus, are includiblein the gross income of the participant orbeneficiary under this paragraph (c)) atthe earliest date, on or after severancefrom employment, on which the planallows distributions to commence, but inno event later than the date on which dis-tributions must commence pursuant tosection 401(a)(9). For example, in thecase of a plan that permits distribution tocommence on the date that is 60 daysafter the close of the plan year in whichthe participant has a severance fromemployment with the eligible employer,amounts deferred are considered to bemade available on that date. However,distributions deferred in accordance withparagraphs (c)(2)(ii) through (iv) of thissection are not considered made availableprior to the applicable date under para-graphs (c)(2)(ii) through (iv) of this sec-tion. In addition, no portion of a partici-pant or beneficiary’s account is treated asmade available (and thus currentlyincludible in income) under an eligibleplan of a tax-exempt entity merelybecause the participant or beneficiaryunder the plan may elect to receive a dis-tribution in any of the following circum-stances:

(A) If the requirements of § 1.457–4(d) are met, a distribution of amountsrepresenting accumulated sick and vaca-tion pay solely because a participant wasentitled to take paid sick or vacation leavein lieu of regular compensation orbecause the participant could havedeferred these amounts under an eligibleplan at an earlier date. However, to theextent that the participant is able toreceive the value of accumulated sick andvacation pay in cash (in addition to regu-lar compensation) at the time of the elec-tion to defer, these amounts are consid-ered made available.

(B) If the requirements of § 1.457–6(c)(2) are met, a distribution in the eventof an unforeseeable emergency.

(C) If the requirements of § 1.457–6(e)(1) are met, a distribution not inexcess of the dollar limit under section411(a)(11)(A) (which is $5,000 for 2002)either before or after the participant has aseverance from employment with theemployer.

(ii) Initial election to defer commence-ment of distributions—(A) In general. Aneligible plan of a tax-exempt entity mayprovide a period for making an initialelection during which the participant orbeneficiary may elect, in accordance withthe terms of the plan, to defer the pay-ment of some or all of the amountsdeferred to a fixed or determinable futuretime. The period for making this initialelection must expire prior to the first timethat any such amounts would be consid-ered made available under the plan underparagraph (c)(2)(i) of this section.

(B) Failure to make initial election todefer commencement of distributions.Generally, if no initial election is made bya participant or beneficiary under thisparagraph (c)(2)(ii), then the amountsdeferred under an eligible plan of a tax-exempt entity are considered made avail-able and taxable to the participant or ben-eficiary in accordance with paragraph(c)(2)(i) of this section at the earliesttime, on or after severance from employ-ment ( but in no event later than the dateon which distributions must commencepursuant to section 401(a)(9)), that distri-bution is permitted to commence underthe terms of the plan. However, the planmay provide for a default payment sched-ule that applies if no election is made. Ifthe plan provides for a default payment

2002–23 I.R.B. 1119 June 10, 2002

schedule, the amounts deferred areincludible in the gross income of the par-ticipant or beneficiary in the year theamounts deferred are first made availableunder the terms of the default paymentschedule.

(iii) Additional election to defer com-mencement of distribution. An eligibleplan of a tax-exempt entity is permitted toprovide that a participant or beneficiarywho has made an initial election underparagraph (c)(2)(ii)(A) of this sectionmay make one additional election to defer(but not accelerate) commencement ofdistributions under the plan before distri-butions have commenced in accordancewith the initial deferral election underparagraph (c)(2)(ii)(A) of this section.Amounts payable to a participant or ben-eficiary under an eligible plan of a tax-exempt entity are not treated as madeavailable merely because the plan allowsthe participant to make an additional elec-tion under this paragraph (c)(2)(iii). Aparticipant or beneficiary is not precludedfrom making an additional election todefer commencement of distributionsmerely because the participant or benefi-ciary has previously received a distribu-tion under § 1.457–6(c) because of anunforeseeable emergency, has received adistribution of smaller amounts under§ 1.457–6(e), has made (and revoked)other deferral or method of payment elec-tions within the initial election period, oris subject to a default payment scheduleunder which the commencement of ben-efits is deferred (for example, until a par-ticipant is age 65).

(iv) Election as to method of payment.An eligible plan of a tax-exempt entitymay provide that the election as to themethod of payment under the plan maybe made at any time prior to the time theamounts are distributed in accordancewith the participant or beneficiary’s initialor additional election to defer commence-ment of distributions under paragraph(c)(2)(ii) or (iii) of this section. Where nomethod of payment is elected, the entireamount deferred will be includible in thegross income of the participant or benefi-ciary when the amounts first becomemade available in accordance with a par-ticipant’s initial or additional elections todefer under paragraphs (c)(2)(ii) and (iii)of this section, unless the eligible planprovides for a default method of payment

(in which case amounts are consideredmade available and taxable when paidunder the terms of the default paymentschedule).

(3) Examples. The provisions of thisparagraph (c) are illustrated by the fol-lowing examples:

Example 1. (i) Facts. Eligible Plan X of a tax-exempt entity provides that a participant’s totalaccount balance, representing all amounts deferredunder the plan, is payable to a participant in a singlesum 60 days after severance from employmentthroughout these examples, unless, during a 30-dayperiod immediately following the severance, theparticipant elects to receive the single sum paymentat a later date (that is not later than the plan’s nor-mal retirement age of 65) or elects to receive distri-bution in 10 annual installments to begin 60 daysafter severance from employment (or at a later date,if so elected, that is not later than the plan’s normalretirement age of 65). On November 13, 2002, par-ticipant K, a calendar year taxpayer, has a severancefrom employment with the eligible employer. Kdoes not, within the 30-day window period, elect topostpone distributions to a later date or to receivepayment in 10 fixed annual installments.

(ii) Conclusion. The single sum payment is pay-able to K 60 days after the date K has a severancefrom employment (January 12, 2003), and is includ-ible in the gross income of K in 2003 under section457(a).

Example 2. (i) Facts. The terms of eligible PlanX are the same as described in Example 1. Partici-pant L participates in eligible Plan X. On November11, 2002, participant L has a severance from theemployment of the eligible employer. On November24, 2002, L makes an initial deferral election not toreceive the single sum payment payable 60 daysafter the severance, and instead elects to receive theamounts in 10 annual installments to begin 60 daysafter severance from employment.

(ii) Conclusion. No portion of L’s account isconsidered made available in 2002 or 2003 before apayment is made and no amount is includible in thegross income of L until distributions commence.The annual installment payable in 2003 will beincludible in L’s gross income in 2003.

Example 3. (i) Facts. The facts are the same asin Example 1, except that eligible Plan X also pro-vides that those participants who are receiving dis-tributions in 10 annual installments may, at any timeand without restriction, elect to receive a cash out ofall remaining installments. Participant M elects toreceive a distribution in 10 annual installments com-mencing in 2003.

(ii) Conclusion. M’s total account balance, rep-resenting the total of the amounts deferred under theplan, is considered made available in, and is includ-ible in M’s gross income, in 2003.

Example 4. (i) Facts. The facts are the same asin Example 3, except that, instead of providing foran unrestricted cash out of remaining payments, theplan provides that participants or beneficiaries whoare receiving distributions in 10 annual installmentsmay accelerate the payment of the amount remain-ing payable to the participant upon the occurrence ofan unforeseeable emergency as described in§ 1.457–6(c)(1) in an amount not exceeding thatdescribed in § 1.457–6(c)(2).

(ii) Conclusion. No amount is considered madeavailable to participant M on account of M’s right toaccelerate payments upon the occurrence of anunforeseeable emergency.

Example 5. (i) Facts. Eligible Plan Y of a tax-exempt entity provides that distributions will com-mence 60 days after a participant’s severance fromemployment unless the participant elects, within a30-day window period following severance fromemployment, to defer distributions to a later date(but no later than the year following the calendaryear the participant attains age 70 ½). The plan pro-vides that a participant who has elected to defer dis-tributions to a later date may make an election as toform of distribution at any time prior to the 30th daybefore distributions are to commence.

(ii) Conclusion. No amount is considered madeavailable prior to the date distributions are to com-mence by reason of a participant’s right to defer ormake an election as to the form of distribution.

Example 6. (i) Facts. The facts are the same asin Example 1, except that the plan also permits par-ticipants who have earlier made an election to deferdistribution to make one additional deferral electionat any time prior to the date distributions are sched-uled to commence. Participant N has a severancefrom employment at age 50. The next day, duringthe 30-day period provided in the plan, N elects toreceive distribution in the form of 10 annual install-ment payments beginning at age 55. Two weekslater, within the 30-day window period, N makes anew election permitted under the plan to receive 10annual installment payments beginning at age 60(instead of age 55). When N is age 59, N electsunder the additional deferral election provisions, todefer distributions until age 65.

(ii) Conclusion. In this example, N’s election todefer distributions until age 65 is a valid election.The two elections N makes during the 30-day win-dow period are not additional deferral electionsdescribed in paragraph (c)(2)(iii) of this sectionbecause they are made before the first permissiblepayout date under the plan. Therefore, the plan isnot precluded from allowing N to make the addi-tional deferral election. However, N can make nofurther election to defer distributions beyond age 65because this additional deferral election can only bemade once.

§ 1.457–8 Funding rules for eligibleplans.

(a) Eligible governmental plans—(1)In general. In order to be an eligible gov-ernmental plan, all amounts deferredunder the plan, all property and rightspurchased with such amounts, and allincome attributable to such amounts,property, or rights, must be held in trustfor the exclusive benefit of participantsand their beneficiaries. A trust describedin this paragraph (a) that also meets therequirements of §§ 1.457–3 through1.457–10 is treated as an organizationexempt from tax under section 501(a),and a participant’s or beneficiary’s inter-est in amounts in the trust is includible in

June 10, 2002 1120 2002–23 I.R.B.

the gross income of the participants andbeneficiaries only to the extent, and at thetime, provided for in section 457(a) and§§ 1.457–4 through 1.457–10.

(2) Trust requirement. (i) A trustdescribed in this paragraph (a) must beestablished pursuant to a written agree-ment that constitutes a valid trust understate law. The terms of the trust mustmake it impossible, prior to the satisfac-tion of all liabilities with respect to par-ticipants and their beneficiaries, for anypart of the assets and income of the trustto be used for, or diverted to, purposesother than for the exclusive benefit ofparticipants and their beneficiaries.

(ii) Amounts deferred under an eligiblegovernmental plan must be transferred toa trust within a period that is not longerthan is reasonable for the proper adminis-tration of the participant accounts (ifany). For purposes of this requirement,the plan may provide for amountsdeferred for a participant under the planto be transferred to the trust within aspecified period after the date theamounts would otherwise have been paidto the participant. For example, the plancould provide for amounts deferred underthe plan to be contributed to the trustwithin 15 business days following themonth in which these amounts would oth-erwise have been paid to the participant.

(3) Custodial accounts and annuitycontracts treated as trusts—(i) In gen-eral. For purposes of the trust require-ment of this paragraph (a), custodialaccounts and annuity contracts describedin section 401(f) that satisfy the require-ments of this paragraph (a)(3) are treatedas trusts under rules similar to the rules ofsection 401(f). Therefore, the provisionsof § 1.401(f)–1(b) will generally apply todetermine whether a custodial account oran annuity contract is treated as a trust.The use of a custodial account or annuitycontract as part of an eligible governmen-tal plan does not preclude the use of atrust or another custodial account orannuity contract as part of the same plan,provided that all such vehicles satisfy therequirements of section 457(g)(1) and (3)and paragraphs (a)(1) and (2) of this sec-tion and that all assets and income of theplan are held in such vehicles.

(ii) Custodial accounts—(A) In gen-eral. A custodial account is treated as atrust, for purposes of section 457(g)(1)

and paragraph (a)(1) and (2) of this sec-tion, if the custodian is a bank, asdescribed in section 408(n), or a personwho meets the nonbank trustee require-ments of paragraph (a)(3)(ii)(B) of thissection, and the account meets therequirements of paragraphs (a)(1) and (2)of this section, other than the requirementthat it be a trust.

(B) Nonbank trustee status. The custo-dian of a custodial account may be a per-son other than a bank only if the persondemonstrates to the satisfaction of theCommissioner that the manner in whichthe person will administer the custodialaccount will be consistent with therequirements of section 457(g)(1) and (3).To do so, the person must demonstratethat the requirements of § 1.408–2(e)(2)through (6) (relating to nonbank trustees)are met. The written application must besent to the address prescribed by theCommissioner in the same manner as pre-scribed under § 1.408–2(e). To the extentthat a person has already demonstrated tothe satisfaction of the Commissioner thatthe person satisfies the requirements of§ 1.408–2(e) in connection with a quali-fied trust (or custodial account or annuitycontract) under section 401(a), that per-son is deemed to satisfy the requirementsof this paragraph (a)(3)(ii)(B).

(iii) Annuity contracts. An annuitycontract is treated as a trust for purposesof section 457(g)(1) and paragraph (a)(1)of this section if the contract is an annu-ity contract, as defined in section 401(g),that has been issued by an insurance com-pany qualified to do business in the State,and the contract meets the requirementsof paragraphs (a)(1) and (2) of this sec-tion, other than the requirement that it bea trust. An annuity contract does notinclude a life, health or accident, prop-erty, casualty, or liability insurance con-tract.

(4) Combining assets. [Reserved](b) Eligible plans maintained by tax-

exempt entity—(1) General rule. In orderto be an eligible plan of a tax-exemptentity, the plan must be unfunded andplan assets must not be set aside for par-ticipants or their beneficiaries. Under sec-tion 457(b)(6) and this paragraph (b), aneligible plan of a tax-exempt entity mustprovide that all amounts deferred underthe plan, all property and rights to prop-erty (including rights as a beneficiary of a

contract providing life insurance protec-tion) purchased with such amounts, andall income attributable to such amounts,property, or rights, must remain (untilpaid or made available to the participantor beneficiary) solely the property andrights of the eligible employer (withoutbeing restricted to the provision of ben-efits under the plan), subject only to theclaims of the eligible employer’s generalcreditors.

(2) Additional requirements. For pur-poses of paragraph (b)(1) of this section,the plan must be unfunded regardless ofwhether or not the amounts were deferredpursuant to a salary reduction agreementbetween the eligible employer and theparticipant. Any funding arrangementunder an eligible plan of a tax-exemptentity that sets aside assets for the exclu-sive benefit of participants violates thisrequirement, and amounts deferred aregenerally immediately includible in thegross income of plan participants andbeneficiaries. Nothing in this paragraph(b) prohibits an eligible plan from permit-ting participants and their beneficiaries tomake an election among different invest-ment options available under the plan,such as an election affecting the invest-ment of the amounts described in para-graph (b)(1) of this section.

§ 1.457–9 Effect on eligible govern-mental plan when not administered inaccordance with eligibility requirements.

A plan of a state ceases to be an eli-gible governmental plan on the first dayof the first plan year beginning more than180 days after the date on which theCommissioner notifies the state in writingthat the plan is being administered in amanner that is inconsistent with one ormore of the requirements of §§ 1.457–3through 1.457–8, or 1.457–10. However,the plan may correct the plan inconsisten-cies specified in the written notificationbefore the first day of that plan year andcontinue to maintain plan eligibility. If aplan ceases to be an eligible governmen-tal plan, amounts subsequently deferredby participants will be includible inincome when deferred, or, if later, whenthe amounts deferred cease to be subjectto a substantial risk of forfeiture, as pro-vided at § 1.457–11. Amounts deferredbefore the date on which the plan ceasesto be an eligible governmental plan, and

2002–23 I.R.B. 1121 June 10, 2002

any earnings thereon, will be treated as ifthe plan continues to be an eligible gov-ernmental plan and will not be includiblein participant’s or beneficiary’s grossincome until paid to the participant orbeneficiary.

§ 1.457–10 Miscellaneous provisions.

(a) Plan terminations and frozenplans—(1) In general. An eligibleemployer may amend its plan to eliminatefuture deferrals for existing participantsor to limit participation to existing partici-pants and employees. An eligible planmay also contain provisions that permitplan termination and permit amountsdeferred to be distributed on termination.In order for a plan to be considered termi-nated, amounts deferred under an eligibleplan must be distributed to all plan par-ticipants and beneficiaries as soon asadministratively practicable after termina-tion of the eligible plan. The mere provi-sion for, and making of, distributions toparticipants or beneficiaries upon a plantermination will not cause an eligible planto cease to satisfy the requirements ofsection 457(b) or the regulations.

(2) Employers that cease to be eligibleemployers—(i) Plan not terminated. Aneligible employer that ceases to be an eli-gible employer may no longer maintainan eligible plan. If the employer was atax-exempt entity and the plan is not ter-minated as permitted under paragraph(a)(2)(ii) of this section, the tax conse-quences to participants and beneficiariesin the previously eligible (unfunded) planof an ineligible employer will be deter-mined in accordance with either section451 if the employer becomes an entityother than a state or §1.457–11 if theemployer becomes a state. If theemployer was a state and the plan is nei-ther terminated as permitted under para-graph (a)(2)(ii) of this section nor trans-ferred to another eligible plan of that stateas permitted under paragraph (b) of thissection, the tax consequences to partici-pants in the previously eligible govern-mental plan of an ineligible employer, theassets of which are held in trust pursuantto § 1.457–8(a), will be determined inaccordance with section 402(b) (section403(c) in the case of an annuity contract)and the trust will no longer be treated asa trust that is exempt from tax under sec-tion 501(a).

(ii) Plan termination. As an alternativeto determining the tax consequences tothe plan and participants under paragraph(a)(2)(i) of this section, the employer mayterminate the plan and distribute theamounts deferred (and all plan assets) toall plan participants as soon as adminis-tratively practicable in accordance withparagraph (a)(1) of this section. Such dis-tribution may include eligible rolloverdistributions in the case of a plan that wasan eligible governmental plan. In addi-tion, if the employer is a state, anotheralternative to determining the tax conse-quences under paragraph (a)(2)(i) of thissection is to transfer the assets of the eli-gible governmental plan to an eligiblegovernmental plan of another eligibleemployer within the same state under theplan-to-plan transfer rules of paragraph(b) of this section.

(3) Examples. The provisions of thisparagraph (a) are illustrated by the fol-lowing examples:

Example 1. (i) Facts. Employer Y, a corporationthat owns a state hospital, sponsors an eligible gov-ernmental plan funded through a trust. Employer Yis acquired by a for-profit hospital and Employer Yceases to be an eligible employer under section457(e)(1) or § 1.457–2(e). Employer Y terminatesthe plan and, during the next 6 months, distributes toparticipants and beneficiaries all amounts deferredthat were under the plan.

(ii) Conclusion. The termination and distributiondoes not cause the plan to fail to be an eligible gov-ernmental plan. Amounts that are distributed as eli-gible rollover distributions may be rolled over to aneligible retirement plan described in section402(c)(8)(B).

Example 2. (i) Facts. The facts are the same asin Example 1, except that Employer Y decides tocontinue to maintain the plan.

(ii) Conclusion. If Employer Y continues tomaintains the plan, the tax consequences to partici-pants and beneficiaries with respect to compensationdeferred thereafter will be determined in accordancewith either section 402(b) if the compensationdeferred is funded through a trust, section 403(c) ifthe compensation deferred is funded through annu-ity contracts, or § 1.457–11 if the compensationdeferred is not funded through a trust or annuitycontract. In addition, if Employer Y continues tomaintain the plan, the trust (including amountsdeferred before the date on which the plan ceases tobe an eligible governmental plan and any earningsthereon) will no longer be treated as exempt fromtax under section 501(a).

Example 3. (i) Facts. Employer Z, a corporationthat owns a tax-exempt hospital, sponsors anunfunded eligible plan. Employer Z is acquired by afor-profit hospital and is no longer an eligibleemployer under section 457(e)(1) or § 1.457–2(e).Employer Z terminates the plan and distributes allamounts deferred under the eligible plan to partici-pants and beneficiaries within a one-year period.

(ii) Conclusion. Distributions under the plan aretreated as made under an eligible plan of a tax-exempt entity and the distributions of the amountsdeferred are includible in the gross income of theparticipant or beneficiary in the year distributed.

Example 4. (i) Facts. The facts are the same asin Example 3, except that Employer Z decides tomaintain instead of terminate the plan.

(ii) Conclusion. If Employer Z maintains theplan, the tax consequences to participants and ben-eficiaries in the plan will thereafter be determined inaccordance with section 451.

(b) Plan-to-plan transfers—(1) Gen-eral rule. An eligible governmental planmay provide for the transfer of amountsdeferred by a participant or beneficiary toanother eligible governmental plan, andan eligible plan of a tax-exempt entitymay provide for transfers of amountsdeferred by a participant to another eli-gible plan of a tax-exempt entity, if theconditions in paragraph (b)(2) of this sec-tion are met. An eligible governmentalplan may accept transfers from anothereligible governmental plan as describedin the preceding sentence, and an eligibleplan of a tax-exempt entity may accepttransfers from another eligible plan of atax-exempt entity as described in the pre-ceding sentence. However, a state maynot transfer the assets of its eligible gov-ernmental plan to a tax-exempt entity’seligible plan and the plan of a tax-exemptentity may not accept such a transfer.Similarly, a tax-exempt entity may nottransfer the assets of its eligible plan to aneligible governmental plan and an eligiblegovernmental plan may not accept such atransfer. In addition, if the conditions inparagraph (b)(4) of this section (relatingto permissive past service credit andrepayments under section 415) are met,an eligible governmental plan of a statemay provide for the transfer of amountsdeferred by a participant or beneficiary toa qualified plan (under section 401(a))maintained by a state. However, a quali-fied plan may not transfer assets to aneligible governmental plan or to an eli-gible plan of a tax-exempt entity, and aneligible governmental plan or the plan ofa tax-exempt entity may not accept such atransfer.

(2) Requirements for plan-to-plantransfers among eligible plans. A transferunder paragraph (b)(1) of this sectionfrom an eligible governmental plan toanother eligible governmental plan is per-mitted only if the following conditionsare met —

June 10, 2002 1122 2002–23 I.R.B.

(i) The transferor plan provides fortransfers;

(ii) The receiving plan provides for thereceipt of transfers;

(iii) The participant or beneficiarywhose amounts deferred are being trans-ferred will have an amount deferredimmediately after the transfer at leastequal to the amount deferred with respectto that participant or beneficiary immedi-ately before the transfer; and

(iv) The participant or beneficiarywhose amounts deferred are being trans-ferred has had a severance from employ-ment with the transferring employer andis performing services for the entity main-taining the receiving plan. However, thisparagraph (b)(2)(iv) is not required to besatisfied if—

(A) All of the assets held by the eli-gible governmental plan are transferred;

(B) The transfer is to another eligiblegovernmental plan maintained by an eli-gible employer that is a state entity withinthe same state; and

(C) The participants whose deferredamounts are being transferred are not eli-gible for additional annual deferrals in thereceiving plan unless they are performingservices for the entity maintaining thereceiving plan.

(3) Examples. The provisions of para-graphs (b)(1) and (2) of this section areillustrated by the following examples:

Example 1. (i) Facts. Participant A, the presidentof City X’s hospital, has accepted a position withanother hospital which is a tax-exempt entity. A par-ticipates in the eligible governmental plan of City X.A would like to transfer the amounts deferred underCity X’s eligible governmental plan to the eligibleplan of the tax-exempt hospital.

(ii) Conclusion. City X’s plan may not transferA’s amounts deferred to the tax-exempt employer’seligible plan. In addition, because the amountsdeferred would no longer be held in trust for theexclusive benefit of participants and their beneficia-ries, the transfer would violate the exclusive benefitrule of section 457(g) and § 1.457–8(a).

Example 2. (i) Facts. County M, located in StateS, operates several health clinics and maintains aneligible governmental plan for employees of thoseclinics. One of the clinics operated by County M isbeing acquired by a hospital operated by State S,and employees of that clinic will become employeesof State S. County M permits those employees totransfer their balances under County M’s eligiblegovernmental plan to the eligible governmental planof State S.

(ii) Conclusion. If the eligible governmentalplans of County M and State S provide for the trans-fer and acceptance of the transfer (and the otherrequirements of paragraph (b)(1) of this section are

satisfied), the transfer will not cause either plan toviolate the requirements of section 457 or theseregulations.

Example 3. (i) Facts. City Employer Z, a hospi-tal, sponsors an eligible governmental plan. CityEmployer Z is located in State B. All of the assetsof City Employer Z are being acquired by a tax-exempt hospital. City Employer Z, in accordancewith the plan-to-plan transfer rules of paragraph (b)of this section, would like to transfer the totalamount of assets deferred under City Employer Z’seligible governmental plan to the acquiring tax-exempt entity’s eligible plan.

(ii) Conclusion. City Employer Z may not per-mit participants to transfer the amounts to the eli-gible plan of the tax-exempt entity. In addition,because the amounts deferred would no longer beheld in trust for the exclusive benefit of participantsand their beneficiaries, the transfer would violate theexclusive benefit rule of section 457(g) and§ 1.457–8(a).

Example 4. (i) Facts. The facts are the same asin Example 3, except that City Employer Z, prior tothe transfer of all of its assets to the eligible plan ofthe tax-exempt entity, decides to transfer all of theamounts deferred under City Z’s eligible govern-mental plan to the eligible governmental plan of therelated state government entity, State B.

(ii) Conclusion. If City Employer Z’s (transf-eror) eligible governmental plan provides for suchtransfer and the eligible governmental plan of theState B permits the acceptance of such a transfer(and the other requirements of paragraph (b)(1) ofthis section are satisfied), City Employer Z maytransfer the total amounts deferred under its eligiblegovernmental plan, prior to termination of that plan,to the eligible governmental plan maintained byState B. However, the participants of City EmployerZ whose deferred amounts are being transferred arenot eligible to participate in the eligible governmen-tal plan of State B, the receiving plan, unless theyare performing services for State B.

(4) Purchase of permissive past ser-vice credit by plan-to-plan transfers froman eligible governmental plan to a quali-fied plan—(i) General rule. An eligiblegovernmental plan of a state may providefor the transfer of amounts deferred by aparticipant or beneficiary to a definedbenefit governmental plan (as defined insection 414(d)) of that state, and noamount shall be includible in grossincome by reason of the transfer, if theconditions in paragraph (b)(4)(ii) of thissection are met. A transfer under thisparagraph (b)(4) is not treated as a distri-bution for purposes of § 1.457–6. There-fore, such a transfer may be made beforeseverance from employment.

(ii) Conditions for plan-to-plan trans-fers from an eligible governmental planto a qualified plan. A transfer may bemade under this paragraph (b)(4) only ifthe transfer is either—

(A) For the purchase of permissivepast service credit (as defined in section415(n)(3)(A)) under the receiving definedbenefit governmental plan; or

(B) A repayment to which section 415does not apply by reason of section415(k)(3).

(iii) Example. The provisions of thisparagraph (b)(4) are illustrated by the fol-lowing example:

Example. (i) Facts. Plan X is an eligible govern-mental plan maintained by County Y for its employ-ees. Plan X provides for distributions only in theevent of death, an unforeseeable emergency, or sev-erance from employment with Y (including retire-ment from Y). Plan S is a qualified defined benefitplan maintained by State T for its employees.County Y is within State T. Employee A is anemployee of Y and is a participant in Plan X.Employee A previously was an employee of T andis still entitled to benefits under Plan S. Plan Sincludes provisions allowing participants in certainplans, including Plan X, to transfer assets to Plan Sfor the purchase past service credit under Plan S notin excess of the credit permitted under section415(n) and does not permit the amount transferredto exceed the amount necessary to fund the benefitresulting from the past service credit. Although notrequired to do so, Plan X allows A to transfer assetsto Plan T to provide a past service benefit underPlan T.

(ii) Conclusion. Assuming that the special rulesat section 415(n)(3) are satisfied with respect to thetransfer, the transfer is permitted under this para-graph (b)(4).

(c) Qualified domestic relations ordersunder eligible plans—(1) General rule.An eligible plan does not become anineligible plan described in section 457(f)solely because its administrator or spon-sor complies with a qualified domesticrelations order as defined in section414(p), including an order requiring thedistribution of the benefits of a participantto an alternate payee in advance of thegeneral rules for eligible plan distribu-tions under § 1.457–6. If a distribution orpayment is made from an eligible plan toan alternate payee pursuant to a qualifieddomestic relations order, rules similar tothe rules of section 402(e)(1)(A) shallapply to the distribution or payment.

(2) Examples. The provisions of thisparagraph (c) are illustrated by the fol-lowing examples:

Example 1. (i) Facts. Participant C and C’sspouse D are divorcing. C is employed by State Sand is a participant in an eligible plan maintained byS. C has an account valued at $100,000 under theplan. Pursuant to the divorce, a court issues a quali-fied domestic relations order on September 1, 2003,that allocates 50 percent of C’s $100,000 plan

2002–23 I.R.B. 1123 June 10, 2002

account to D and specifically provides for an imme-diate distribution to D of D’s share within 6 monthsof the order. Payment is made to D in January of2004.

(ii) Conclusion. S’s eligible plan does notbecome an ineligible plan described in section457(f) and § 1.457–11 solely because its administra-tor or sponsor complies with the qualified domesticrelations order requiring the immediate distributionto D in advance of the general rules for eligible plandistributions under § 1.457–6. In accordance withsection 402(e)(1)(A), D (not C) must include thedistribution in gross income. The distribution isincludible in D’s gross income in 2004. If the quali-fied domestic relations order were to provide fordistribution to D at a future date, amounts deferredattributable to D’s share will be includible in D’sgross income when paid to D.

Example 2. (i) Facts. The facts are the same asin Example 1, except that S is a tax-exempt entity,instead of a state.

(ii) Conclusion. S’s eligible plan does notbecome an ineligible plan described in section457(f) and § 1.457–11 solely because its administra-tor or sponsor complies with the qualified domesticrelations order requiring the immediate distributionto D in advance of the general rules for eligible plandistributions under § 1.457–6. In accordance withsection 402(e)(1)(A), D (not C) must include thedistribution in gross income. The distribution isincludible in D’s gross income in 2004, assumingthat the plan did not make the distribution availableto D in 2003. If the qualified domestic relationsorder were to provide for distribution to D at afuture date, amounts deferred attributable to D’sshare would be includible in D’s gross income whenpaid or made available to D.

(d) Death benefits and life insuranceproceeds. A death benefit plan under sec-tion 457(e)(11) is not an eligible plan. Inaddition, no amount paid or made avail-able under an eligible plan as death ben-efits or life insurance proceeds is exclud-able from gross income under section101.

(e) Rollovers to eligible governmentalplans—(1) General rule. An eligible gov-ernmental plan may accept contributionsthat are eligible rollover distributions (asdefined in section 402(c)(4)) made fromanother eligible retirement plan (asdefined in section 402(c)(8)(B)) if theconditions in paragraph (e)(2) of this sec-tion are met. Amounts contributed to aneligible governmental plan as eligiblerollover distributions are not taken intoaccount for purposes of the annual limiton annual deferrals by a participant in§ 1.457–4(c) or §1.457–5, but are other-wise treated in the same manner asamounts deferred under section 457 forpurposes of §§ 1.457–3 through 1.457–9and this section.

(2) Conditions for rollovers to an eli-gible governmental plan. An eligible gov-

ernmental plan that permits eligible roll-over distributions made from anothereligible retirement plan to be paid into theeligible governmental plan is requiredunder this paragraph (e)(2) to provide thatit will separately account for any eligiblerollover distributions it receives.

(3) Example. The provisions of thisparagraph (e) are illustrated by the fol-lowing example:

Example. (i) Facts. Plan T is an eligible govern-mental plan that provides that employees who areeligible to participate in Plan T may make rollovercontributions to Plan T from amounts distributed toan employee from an eligible retirement plan. Aneligible retirement plan is defined in Plan T asanother eligible governmental plan, a qualified sec-tion 401(a) or 403(a) plan, or a section 403(b) con-tract, or an individual retirement arrangement (IRA)that holds such amounts. Plan T requires rollovercontributions to be paid by the eligible retirementplan directly to Plan T (a direct rollover) or to bepaid by the participant within 60 days after the dateon which the participant received the amount fromthe other eligible retirement plan. Plan T does nottake rollover contributions into account for purposesof the plan’s limits on amounts deferred that con-form to § 1.457–4(c). Rollover contributions paid toPlan T are invested in the trust in the same manneras amounts deferred under Plan T and rollover con-tributions (and earnings thereon) are available fordistribution to the participant at the same time andin the same manner as amounts deferred under PlanT. In addition, Plan T provides that, for each partici-pant who makes a rollover contribution to Plan T,the Plan T recordkeeper is to establish a separateaccount for the participant’s rollover contributions.The recordkeeper calculates earnings and losses forinvestments held in the rollover account separatelyfrom earnings and losses on other amounts heldunder the plan and calculates disbursements fromand payments made to the rollover account sepa-rately from disbursements from and payments madeto other amounts held under the plan.

(ii) Conclusion. Plan T does not lose its status asan eligible governmental plan as a result of thereceipt of rollover contributions.

(f) Deemed IRAs under eligible gov-ernmental plans. [Reserved]

§ 1.457–11 Tax treatment of participantsif plan is not an eligible plan.

(a) In general. Under section 457(f), ifan eligible employer provides for a defer-ral of compensation under any agreementor arrangement that is an ineligibleplan—

(1) Compensation deferred under theagreement or arrangement is includible inthe gross income of the participant orbeneficiary for the first taxable year inwhich there is no substantial risk of for-

feiture (within the meaning of section457(f)(3)(B)) of the rights to such com-pensation;

(2) If the compensation deferred issubject to a substantial risk of forfeiture,the amount includible in gross income forthe first taxable year in which there is nosubstantial risk of forfeiture includesearnings thereon to the date on whichthere is no substantial risk of forfeiture;

(3) Earnings credited on the compen-sation deferred under the agreement orarrangement that are not includible ingross income under paragraph (a)(2) ofthis section are includible in the grossincome of the participant or beneficiaryonly when paid or made available to theparticipant or beneficiary, provided thatthe interest of the participant or benefi-ciary in any assets (including amountsdeferred under the plan) of the entitysponsoring the agreement or arrangementis not senior to the entity’s general credi-tors; and

(4) Amounts paid or made available toa participant or beneficiary under theagreement or arrangement are includiblein the gross income of the participant orbeneficiary under section 72, relating toannuities.

(b) Exceptions. Paragraph (a) of thissection does not apply with respect to—

(1) A plan described in section 401(a)which includes a trust exempt from taxunder section 501(a);

(2) An annuity plan or contractdescribed in section 403;

(3) That portion of any plan whichconsists of a transfer of propertydescribed in section 83;

(4) That portion of any plan whichconsists of a trust to which section 402(b)applies; or

(5) A qualified governmental excessbenefit arrangement described in section415(m).

(c) Coordination of section 457(f) withsection 83—(1) Transfer of propertydescribed in section 83. Under paragraph(b)(3) of this section, section 457(f) andparagraph (a) of this section do not applyto that portion of any plan which consistsof a transfer of property described in sec-tion 83. For this purpose, a transfer ofproperty described in section 83 means atransfer of property to which section 83applies. Section 457(f) and paragraph (a)of this section do not apply if the date on

June 10, 2002 1124 2002–23 I.R.B.

which there is no substantial risk of for-feiture with respect to compensationdeferred under an agreement or arrange-ment that is not an eligible plan is on orafter the date on which there is a transferof property to which section 83 applies.However, section 457(f) and paragraph(a) of this section apply if the date onwhich there is no substantial risk of for-feiture with respect to compensationdeferred under an agreement or arrange-ment that is not an eligible plan precedesthe date on which there is a transfer ofproperty to which section 83 applies. Ifdeferred compensation payable in prop-erty is includible in gross income undersection 457(f), then, as provided in sec-tion 72, the amount includible in grossincome when that property is later trans-ferred or made available to the serviceprovider is the excess of the value of theproperty at that time over the amount pre-viously included in gross income undersection 457(f).

(2) Examples. The provisions of thisparagraph (c) are illustrated in the follow-ing examples:

Example 1. (i) Facts. As part of an arrangementfor the deferral of compensation, an eligibleemployer agrees on December 1, 2002, to pay anindividual rendering services for the eligibleemployer a specified dollar amount on January 15,2005. The arrangement provides for the payment tobe made in the form of property having a fair mar-ket value equal to the specified dollar amount. Theindividual’s rights to the payment are not subject toa substantial risk of forfeiture (within the meaningof section 457(f)(3)(B)).

(ii) Conclusion. In this example, because there isno substantial risk of forfeiture with respect to theagreement to transfer property in 2005, the presentvalue (as of December 1, 2002) of the payment isincludible in the individual’s gross income for 2002.Under paragraph (a)(4) of this section, when thepayment is made on January 15, 2005, the amountincludible in the individual’s gross income is equalto the excess of the fair market value of the propertywhen paid, over the amount that was includible ingross income for 2002 (which is the basis allocableto that payment).

Example 2. (i) Facts. As part of an arrangementfor the deferral of compensation, individuals A andB rendering services for a tax-exempt entity eachreceive in 2010 property that is subject to a substan-tial risk of forfeiture (within the meaning of section457(f)(3)(B) and within the meaning of section83(c)(1)). Individual A makes an election to includethe fair market value of the property in gross incomeunder section 83(b) and individual B does not makethis election. The substantial risk of forfeiture forthe property transferred to individual A lapses in2012 and the substantial risk of forfeiture for theproperty transferred to individual B also lapses in2012. Thus, the property transferred to individual Ais included in A’s gross income for 2010 when A

makes a section 83(b) election and the propertytransferred to individual B is included in B’s grossincome for 2012 when the substantial risk of forfei-ture for the property lapses.

(ii) Conclusion. In this example 2, in each case,the compensation deferred is not subject to section457(f) or this section because section 83 applies tothe transfer of property on or before the date onwhich there is no substantial risk of forfeiture withrespect to compensation deferred under the arrange-ment.

Example 3. (i) Facts. In 2010, X, a tax-exemptentity, agrees to pay deferred compensation toemployee C. The amount payable is $100,000 to bepaid 10 years later in 2020. The commitment tomake the $100,000 payment is not subject to a sub-stantial risk of forfeiture. In 2010, the present valueof the $100,000 is $50,000. In 2018, X transfers toC property having a fair market value (for purposesof section 83) equal to $70,000. The transfer is inpartial settlement of the commitment made in 2010and, at the time of the transfer in 2018, the presentvalue of the commitment is $80,000. In 2020, Xpays C the $12,500 that remains due.

(ii) Conclusion. In this example 3, C has incomeof $50,000 in 2010. In 2018, C has income of$30,000, which is the amount transferred in 2018,minus the allocable portion of the basis that resultsfrom the $50,000 of income in 2010. (Under section72(e)(2)(B), income is allocated first. The income isequal to $30,000 ($80,000 minus the $50,000 basis),with the result that the allocable portion of the basisis equal to $40,000 ($70,000 minus the $30,000 ofincome).) In 2020, C has income of $2,500 ($12,500minus $10,000, which is the excess of the original$50,000 basis over the $40,000 basis allocated tothe transfer made in 2018).

§ 1.457–12 Effective dates.

Sections 1.457–1 through 1.457–11apply for taxable years beginning afterDecember 31, 2001, except that § 1.457–11(c) does not apply with respect to anoption without a readily ascertainable fairmarket value (within the meaning of sec-tion 83(e)(3)) that was granted on orbefore May 8, 2002, and, § 1.457–10(c)(relating to qualified domestic relationsorders) applies for transfers, distributions,and payments made after December 31,2001.

Robert E. Wenzel,Deputy Commissioner of

Internal Revenue.

(Filed by the Office of the Federal Register on May7, 2002, 8:45 a.m., and published in the issue of theFederal Register for May 8, 2002, 67 F.R. 30826)

Hedging Transactions;Corrections

Announcement 2002–55

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Correcting amendment.

SUMMARY: This document containscorrections to final regulations (T.D.8985, 2002–14 I.R.B. 707) that were pub-lished in the Federal Register onWednesday, March 20, 2002 (67 FR12863), relating to the character of gainor loss from hedging transactions.

DATES: This correction is effectiveMarch 20, 2002.

FOR FURTHER INFORMATION CON-TACT: Elizabeth Handler (202) 622–3930 or Viva Hammer (202) 622–0869(not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

The final regulations that are the sub-ject of these corrections are under section1221 of the Internal Revenue Code.

Need for Correction

As published, the final regulationscontain errors that may prove to be mis-leading and are in need of clarification.

Correction of Publication

Accordingly, 26 CFR Part 1 is cor-rected by making the following correctingamendments:

PART 1 — INCOME TAXES

1. The authority citation for part 1 con-tinues to read in part as follows:

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

§ 1.446–4 [Corrected]

2. Section 1.446–4, paragraph (d)(3) isamended by removing the language“§ 1.1221–2(a)(4)(i)” from the last sen-tence and adding the language “§ 1.1221–2(a)(4)” in its place.

2002–23 I.R.B. 1125 June 10, 2002

§ 1.1256(e)–1 [Corrected]

3. Section 1.1256(e)–1, paragraph (c)is amended by removing the language“(f)(1)(ii)” from the second sentence andadding the language “(g)(1)(ii)” in itsplace.

New Revision of Publication597, Information on the U.S.– Canada Income Tax Treaty

Announcement 2002–56

Publication 597, revised May 2002, isnow available from the Internal RevenueService. It replaces the May 1998 revi-sion.

This publication discusses a number ofthe treaty provisions that often apply toU.S. citizens or residents who may beliable for Canadian tax.

You can get a copy of this publicationby calling 1–800–TAX-FORM (1–800–829–3676). You can also write to the IRSForms Distribution Center nearest you.Check your income tax package for theaddress. The publication is also availableon the IRS web site at www.irs.gov.

New Revision of Publication1544, Reporting CashPayments of Over $10,000(and Publication 1544SP,Informe de Pagos enEfectivo en Exceso de$10,000)

Announcement 2002–57

Publication 1544, revised March 2002,is now available from the Internal Rev-enue Service. It replaces the August 1997revision. The publication is also availablein Spanish as Publication 1544SP.

The publication explains why, when,and how to report large cash payments. Italso discusses the substantial penalties fornot reporting them.

You can get either version of this pub-lication by calling 1–800–TAX-FORM(1–800–829–3676). You can also write tothe IRS Forms Distribution Center near-est you. Check your income tax packagefor the address. Both versions are alsoavailable on the IRS web site atwww.irs.gov.

June 10, 2002 1126 2002–23 I.R.B.

Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as“rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe theeffect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position isbeing extended to apply to a variation ofthe fact situation set forth therein. Thus, ifan earlier ruling held that a principleapplied to A, and the new ruling holdsthat the same principle also applies to B,the earlier ruling is amplified. (Comparewith 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 in aprior ruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previouslypublished ruling and points out an essen-tial 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 but notto B, and the new ruling holds that it

applies to both A and B, the prior rulingis modified because it corrects a pub-lished position. (Compare with amplifiedand clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly usedin a ruling that lists previously publishedrulings that are obsoleted because ofchanges in law or regulations. A rulingmay also be obsoleted because the sub-stance has been included in regulationssubsequently adopted.

Revoked describes situations where theposition in the previously published rul-ing is not correct and the correct positionis being stated in the new ruling.

Superseded describes a situation wherethe new ruling does nothing more thanrestate the substance and situation of apreviously published ruling (or rulings).Thus, the term is used to republish underthe 1986 Code and regulations the sameposition published under the 1939 Codeand regulations. The term is also usedwhen it is desired to republish in a singleruling a series of situations, names, etc.,that were previously published over aperiod of time in separate rulings. If the

new ruling does more than restate thesubstance of a prior ruling, a combinationof terms is used. For example, modifiedand superseded describes a situationwhere the substance of a previously pub-lished ruling is being changed in part andis continued without change in part and itis desired to restate the valid portion ofthe previously published ruling in a newruling that is self contained. In this case,the previously published ruling is firstmodified and then, as modified, is super-seded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further namesin subsequent rulings. After the originalruling has been supplemented severaltimes, a new ruling may be published thatincludes the list in the original ruling andthe additions, and supersedes all prior rul-ings in the series.

Suspended is used in rare situations toshow that the previous published rulingswill not be applied pending some futureaction such as the issuance of new oramended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in currentuse and formerly used will appear inmaterial published in 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 Contributions 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—Grantor.IC—Insurance Company.I.R.B.—Intemal 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.

2002–23 I.R.B. i June 10, 2002

Numerical Finding List1

Bulletins 2002–1 through 2002–22

Announcements:

2002–1, 2002–2 I.R.B. 3042002–2, 2002–2 I.R.B. 3042002–3, 2002–2 I.R.B. 3052002–4, 2002–2 I.R.B. 3062002–5, 2002–4 I.R.B. 4202002–6, 2002–5 I.R.B. 4582002–7, 2002–5 I.R.B. 4592002–8, 2002–6 I.R.B. 4942002–9, 2002–7 I.R.B. 5362002–10, 2002–7 I.R.B. 5392002–11, 2002–6 I.R.B. 4942002–12, 2002–8 I.R.B. 5532002–13, 2002–7 I.R.B. 5402002–14, 2002–7 I.R.B. 5402002–15, 2002–7 I.R.B. 5402002–16, 2002–7 I.R.B. 5412002–17, 2002–8 I.R.B. 5612002–18, 2002–10 I.R.B. 6212002–19, 2002–8 I.R.B. 5612002–20, 2002–8 I.R.B. 5612002–21, 2002–8 I.R.B. 5622002–22, 2002–8 I.R.B. 5622002–23, 2002–8 I.R.B. 5632002–24, 2002–9 I.R.B. 6062002–25, 2002–10 I.R.B. 6212002–26, 2002–11 I.R.B. 6292002–27, 2002–11 I.R.B. 6292002–28, 2002–11 I.R.B. 6302002–29, 2002–11 I.R.B. 6312002–30, 2002–11 I.R.B. 6322002–31, 2002–15 I.R.B. 7472002–32, 2002–12 I.R.B. 6642002–33, 2002–12 I.R.B. 6662002–34, 2002–13 I.R.B. 7022002–35, 2002–12 I.R.B. 6672002–36, 2002–13 I.R.B. 7032002–37, 2002–13 I.R.B. 7032002–38, 2002–14 I.R.B. 7382002–39, 2002–14 I.R.B. 7382002–40, 2002–15 I.R.B. 7472002–41, 2002–14 I.R.B. 7392002–42, 2002–14 I.R.B. 7392002–43, 2002–16 I.R.B. 7922002–44, 2002–17 I.R.B. 8092002–45, 2002–18 I.R.B. 8332002–46, 2002–18 I.R.B. 8342002–47, 2002–18 I.R.B. 8442002–48, 2002–17 I.R.B. 8092002–49, 2002–19 I.R.B. 9192002–50, 2002–18 I.R.B. 8452002–51, 2002–22 I.R.B. 10632002–52, 2002–19 I.R.B. 9192002–53, 2002–22 I.R.B. 1063

Court Decisions:

2073, 2002–14 I.R.B. 7182074, 2002–20 I.R.B. 954

Notices:

2002–1, 2002–2 I.R.B. 2832002–2, 2002–2 I.R.B. 2852002–3, 2002–2 I.R.B. 2892002–4, 2002–2 I.R.B. 2982002–5, 2002–3 I.R.B. 3202002–6, 2002–3 I.R.B. 3262002–7, 2002–6 I.R.B. 4892002–8, 2002–4 I.R.B. 3982002–9, 2002–5 I.R.B. 4502002–10, 2002–6 I.R.B. 4902002–11, 2002–7 I.R.B. 5262002–12, 2002–7 I.R.B. 5262002–13, 2002–8 I.R.B. 5472002–14, 2002–8 I.R.B. 5482002–15, 2002–8 I.R.B. 5482002–16, 2002–9 I.R.B. 5672002–17, 2002–9 I.R.B. 5672002–18, 2002–12 I.R.B. 6442002–19, 2002–10 I.R.B. 6192002–20, 2002–17 I.R.B. 7962002–21, 2002–14 I.R.B. 7302002–22, 2002–14 I.R.B. 7312002–23, 2002–15 I.R.B. 7422002–24, 2002–16 I.R.B. 7852002–25, 2002–15 I.R.B. 7432002–26, 2002–15 I.R.B. 7432002–27, 2002–18 I.R.B. 8142002–28, 2002–16 I.R.B. 7852002–29, 2002–17 I.R.B. 7972002–30, 2002–17 I.R.B. 7972002–31, 2002–19 I.R.B. 9082002–32, 2002–21 I.R.B. 9892002–33, 2002–21 I.R.B. 9892002–34, 2002–21 I.R.B. 9902002–35, 2002–21 I.R.B. 9922002–36, 2002–22 I.R.B. 1029

Proposed Regulations:

REG–209135–88, 2002–4 I.R.B. 418REG–209114–90, 2002–9 I.R.B. 576REG–104762–00, 2002–18 I.R.B. 825REG–105369–00, 2002–18 I.R.B. 828REG–107100–00, 2002–7 I.R.B. 529REG–107184–00, 2002–20 I.R.B. 967REG–107366–00, 2002–12 I.R.B. 645REG–118861–00, 2002–12 I.R.B. 651REG–105344–01, 2002–2 I.R.B. 302REG–112991–01, 2002–4 I.R.B. 404REG–115054–01, 2002–7 I.R.B. 530REG–119436–01, 2002–3 I.R.B. 377REG–120135–01, 2002–8 I.R.B. 552REG–125450–01, 2002–5 I.R.B. 457REG–125626–01, 2002–9 I.R.B. 604REG–136193–01, 2002–21 I.R.B. 995REG–142299–01, 2002–4 I.R.B. 418REG–154920–01, 2002–22 I.R.B. 1060

Proposed Regulations:—Continued:

REG–159079–01, 2002–6 I.R.B. 493REG–161424–01, 2002–21 I.R.B. 1010REG–163892–01, 2002–20 I.R.B. 968REG–165706–01, 2002–16 I.R.B. 787REG–167648–01, 2002–16 I.R.B. 790REG–102740–02, 2002–13 I.R.B. 701REG–108697–02, 2002–19 I.R.B. 918

Revenue Procedures:

2002–1, 2002–1 I.R.B. 12002–2, 2002–1 I.R.B. 822002–3, 2002–1 I.R.B. 1172002–4, 2002–1 I.R.B. 1272002–5, 2002–1 I.R.B. 1732002–6, 2002–1 I.R.B. 2032002–7, 2002–1 I.R.B. 2492002–8, 2002–1 I.R.B. 2522002–9, 2002–3 I.R.B. 3272002–10, 2002–4 I.R.B. 4012002–11, 2002–7 I.R.B. 5262002–12, 2002–3 I.R.B. 3742002–13, 2002–8 I.R.B. 5492002–14, 2002–5 I.R.B. 4502002–15, 2002–6 I.R.B. 4902002–16, 2002–9 I.R.B. 5722002–17, 2002–13 I.R.B. 6762002–18, 2002–13 I.R.B. 6782002–19, 2002–13 I.R.B. 6962002–20, 2002–14 I.R.B. 7322002–21, 2002–19 I.R.B. 9112002–22, 2002–14 I.R.B. 7332002–23, 2002–15 I.R.B. 7442002–24, 2002–17 I.R.B. 7982002–25, 2002–17 I.R.B. 8002002–26, 2002–15 I.R.B. 7462002–27, 2002–17 I.R.B. 8022002–28, 2002–18 I.R.B. 8152002–31, 2002–19 I.R.B. 9162002–32, 2002–20 I.R.B. 9592002–33, 2002–20 I.R.B. 9632002–36, 2002–21 I.R.B. 9932002–37, 2002–22 I.R.B. 10302002–38, 2002–22 I.R.B. 10372002–39, 2002–22 I.lR.B.; 1046

Revenue Rulings:

2002–1, 2002–2 I.R.B. 2682002–2, 2002–2 I.R.B. 2712002–3, 2002–3 I.R.B. 3162002–4, 2002–4 I.R.B. 3892002–5, 2002–6 I.R.B. 4612002–6, 2002–6 I.R.B. 4602002–7, 2002–8 I.R.B. 5432002–8, 2002–9 I.R.B. 5642002–9, 2002–10 I.R.B. 6142002–10, 2002–10 I.R.B. 6162002–11, 2002–10 I.R.B. 6082002–12, 2002–11 I.R.B. 6242002–13, 2002–12 I.R.B. 6372002–14, 2002–12 I.R.B. 636

1 A cumulative list of all revenue rulings, revenue

procedures, Treasury decisions, etc., published in

Internal Revenue Bulletins 2001–27 through 2001–53 is

in Internal Revenue Bulletin 2002–1, dated January 7, 2002.

June 10, 2002 ii 2002–23 I.R.B.

Revenue Rulings:—Continued:

2002–15, 2002–13 I.R.B. 6682002–16, 2002–15 I.R.B. 7402002–17, 2002–14 I.R.B. 7162002–18, 2002–16 I.R.B. 7792002–19, 2002–16 I.R.B. 7782002–20, 2002–17 I.R.B. 7942002–21, 2002–17 I.R.B. 7932002–22, 2002–19 I.R.B. 8492002–23, 2002–18 I.R.B. 8112002–24, 2002–19 I.R.B. 8482002–25, 2002–19 I.R.B. 9042002–26, 2002–19 I.R.B. 9062002–27, 2002–20 I.R.B. 9252002–28, 2002–20 I.R.B. 9412002–29, 2002–20 I.R.B. 9402002–30, 2002–21 I.R.B. 9712002–31, 2002–22 I.R.B. 1023

Tax Conventions:

2002–14 I.R.B. 725

Treasury Decisions:

8968, 2002–2 I.R.B. 2748969, 2002–2 I.R.B. 2768970, 2002–2 I.R.B. 2818971, 2002–3 I.R.B. 3088972, 2002–5 I.R.B. 4438973, 2002–4 I.R.B. 3918974, 2002–3 I.R.B. 3188975, 2002–4 I.R.B. 3798976, 2002–5 I.R.B. 4218977, 2002–6 I.R.B. 4638978, 2002–7 I.R.B. 5008979, 2002–6 I.R.B. 4668980, 2002–6 I.R.B. 4778981, 2002–7 I.R.B. 4968982, 2002–8 I.R.B. 5448983, 2002–9 I.R.B. 5658984, 2002–13 I.R.B. 6688985, 2002–14 I.R.B. 7078986, 2002–16 I.R.B. 7808987, 2002–19 I.R.B. 8528988, 2002–20 I.R.B. 9298989, 2002–20 I.R.B. 9208990, 2002–20 I.R.B. 9478991, 2002–21 I.R.B. 9728992, 2002–21 I.R.B. 9818993, 2002–22 I.R.B. 1026

2002–23 I.R.B. iii June 10, 2002

Finding List of Current Actionson Previously Published Items2

Bulletins 2002–1 through 2002–22

Announcements:

2001–83Modified byAnn. 2002–36, 2002–13 I.R.B. 703

2002–9Corrected byAnn. 2002–30, 2002–11 I.R.B. 632Ann. 2002–35, 2002–12 I.R.B. 667

Notices:

90–24Modified and superseded byNotice 2002–24, 2002–16 I.R.B. 785

98–31Supplemented byAnn. 2002–37, 2002–13 I.R.B. 703

98–43Modified and superseded byNotice 2002–5, 2002–3 I.R.B. 320

2000–11Obsoleted byNotice 2002–3, 2002–2 I.R.B. 289

2001–10Revoked byNotice 2002–8, 2002–4 I.R.B. 398

2001–61Supplemented byNotice 2002–15, 2002–8 I.R.B. 548

2001–68Supplemented byNotice 2002–15, 2002–8 I.R.B. 548

2002–14Modified and superseded byRev. Proc. 2002–28, 2002–18 I.R.B. 815

Proposed Regulations:

REG–209135–88Corrected byAnn. 2002–15, 2002–7 I.R.B. 540Ann. 2002–30, 2002–11 I.R.B. 632

REG–251502–96Withdrawn byAnn. 2002–33, 2002–12 I.R.B. 666

REG–105316–98Withdrawn byREG–161424–01, 2002–21 I.R.B. 1010

REG–113526–98Withdrawn byREG–105369–00, 2002–18 I.R.B. 828

Proposed Regulations:—Continued

REG–107100–00Corrected byAnn. 2002–30, 2002–11 I.R.B. 632

REG–107566–00Withdrawn byREG–163892–01, 2002–20 I.R.B. 968

REG–105344–01Corrected byAnn. 2002–7, 2002–5 I.R.B. 459

REG–112991–01Corrected byAnn. 2002–30, 2002–11 I.R.B. 632Ann. 2002–38, 2002–14 I.R.B. 738

REG–115054–01Corrected byAnn. 2002–30, 2002–11 I.R.B. 632

REG–119436–01Corrected byAnn. 2002–30, 2002–11 I.R.B. 632

REG–120135–01Corrected byAnn. 2002–30, 2002–11 I.R.B. 632

REG–125450–01Corrected byAnn. 2002–30, 2002–11 I.R.B. 632

REG–125626–01Corrected byAnn. 2002–30, 2002–11 I.R.B. 632

REG–126485–01Corrected byAnn. 2002–30, 2002–11 I.R.B. 632

REG–137519–01Corrected byAnn. 2002–30, 2002–11 I.R.B. 632

REG–142299–01Corrected byAnn. 2002–15, 2002–7 I.R.B. 540Ann. 2002–30, 2002–11 I.R.B. 632

REG–142686–01Corrected byAnn. 2002–30, 2002–11 I.R.B. 632

REG–159079–01Corrected byAnn. 2002–30, 2002–11 I.R.B. 632

Revenue Procedures:

74–33Superseded byRev. Proc. 2002–39, 2002–22 I.R.B. 1046

Revenue Procedures:—Continued

84–37Modified byRev. Proc. 2002–1, 2002–1 I.R.B. 1

84–57Obsoleted byT.D. 8976, 2002–5 I.R.B. 421

85–16Superseded byRev. Proc. 2002–39, 2002–22 I.R.B. 1046

87–32Clarified, modified, amplified, and superseded byRev. Proc. 2002–38, 2002–22 I.R.B. 1037

87–50Modified byRev. Proc. 2002–10, 2002–4 I.R.B. 401

89–45Superseded byRev. Proc. 2002–23, 2002–15 I.R.B. 744

91–71Clarified and superseded byRev. Proc. 2002–32, 2002–20 I.R.B. 959

96–13Modified byRev. Proc. 2002–1, 2002–1 I.R.B. 1

97–27Modified and amplified byRev. Proc. 2002–19, 2002–13 I.R.B. 696

98–49Obsoleted byT.D. 8976, 2002–5 I.R.B. 421

99–49Modified and superseded byRev. Proc. 2002–9, 2002–3 I.R.B. 327

2000–11Modified, amplified, and superseded byRev. Proc. 2002–37, 2002–22 I.R.B. 1030

2000–20Modified byRev. Proc. 2002–6, 2002–1 I.R.B. 203

2000–46Superseded byRev. Proc. 2002–22, 2002–14 I.R.B. 733

2001–1Superseded byRev. Proc. 2002–1, 2002–1 I.R.B. 1

2001–2Superseded byRev. Proc. 2002–2, 2002–1 I.R.B. 82

2 A cumulative list of current actions on previously published

items in Internal Revenue Bulletins 2001–27 through 2001–53 is

in Internal Revenue Bulletin 2002–1, dated January 7, 2002.

June 10, 2002 iv 2002–23 I.R.B.

Revenue Procedures:—Continued

2001–3Superseded byRev. Proc. 2002–3, 2002–1 I.R.B. 117

2001–4Superseded byRev. Proc. 2002–4, 2002–1 I.R.B. 127

2001–5Superseded byRev. Proc. 2002–5, 2002–1 I.R.B. 173

2001–6Superseded byRev. Proc. 2002–6, 2002–1 I.R.B. 203

2001–7Superseded byRev. Proc. 2002–7, 2002–1 I.R.B. 249

2001–8Superseded byRev. Proc. 2002–8, 2002–1 I.R.B. 252

2001–13Corrected byAnn. 2002–5, 2002–4 I.R.B. 420

2001–16Modified byAnn. 2002–26, 2002–11 I.R.B. 629

2001–27Supplemented byRev. Proc. 2002–20, 2002–14 I.R.B. 732

2001–35Obsoleted, except as provided in section 5.02 byRev. Proc. 2002–24, 2002–17 I.R.B. 798

2001–36Superseded byRev. Proc. 2002–3, 2002–1 I.R.B. 117

2001–41Superseded byRev. Proc. 2002–2, 2002–1 I.R.B. 82

2001–51Superseded byRev. Proc. 2002–3, 2002–1 I.R.B. 117

2002–3Modified byRev. Proc. 2002–22, 2002–14 I.R.B. 733

2002–6Modified byNotice 2002–1, 2002–2 I.R.B. 283Rev. Proc. 2002–21, 2002–19 I.R.B. 911

2002–8Modified byNotice 2002–1, 2002–2 I.R.B. 283

Revenue Procedures:—Continued

2002–9Modified and clarified byAnn. 2002–17, 2002–8 I.R.B. 561Modified and amplified byRev. Rul. 2002–9, 2002–10 I.R.B. 614Rev. Proc. 2002–17, 2002–13 I.R.B. 676Rev. Proc. 2002–19, 2002–13 I.R.B. 696Rev. Proc. 2002–27, 2002–17 I.R.B. 802Rev. Proc. 2002–28, 2002–18 I.R.B. 815Rev. Proc. 2002–33, 2002–20 I.R.B. 963Rev. Proc. 2002–36, 2002–21 I.R.B. 993

2002–10Modified byAnn. 2002–49, 2002–19 I.R.B. 919

Revenue Rulings:

55–261Distinguished byRev. Rul. 2002–19, 2002–16 I.R.B. 778

55–747Revoked byNotice 2002–8, 2002–4 I.R.B. 398

61–146Distinguished byRev. Rul. 2002–3, 2002–3 I.R.B. 316

64–328Modified byNotice 2002–8, 2002–4 I.R.B. 398

66–110Modified byNotice 2002–8, 2002–4 I.R.B. 398

73–304Superseded byRev. Proc. 2002–26, 2002–15 I.R.B. 746

73–305Superseded byRev. Proc. 2002–26, 2002–15 I.R.B. 746

76–270Amplified and superseded byRev. Rul. 2002–20, 2002–17 I.R.B. 794

79–151Distinguished byRev. Rul. 2002–19, 2002–16 I.R.B. 778

79–284Superseded byRev. Proc. 2002–26, 2002–15 I.R.B. 746

80–218Superseded byRev. Rul. 2002–23, 2002–18 I.R.B. 811

87–112Clarified byRev. Rul. 2002–22, 2002–19 I.R.B. 849

Revenue Rulings:—Continued

89–29Obsoleted byT.D. 8976, 2002–5 I.R.B. 421

92–19Supplemented in part byRev. Rul. 2002–12, 2002–11 I.R.B. 624

2002–7Corrected byAnn. 2002–13, 2002–7 I.R.B. 540

Treasury Decisions:

8971Corrected byAnn. 2002–20, 2002–8 I.R.B. 561

8972Corrected byAnn. 2002–23, 2002–8 I.R.B. 563

8973Corrected byAnn. 2002–14, 2002–7 I.R.B. 540

8975Corrected byAnn. 2002–21, 2002–8 I.R.B. 562

8976Corrected byAnn. 2002–21, 2002–8 I.R.B. 562

8978Corrected byAnn. 2002–39, 2002–14 I.R.B. 738

2002–23 I.R.B. v June 10, 2002