assignment of income doctrine examples

What is “Assignment of Income” Under the Tax Law?

Gross income is taxed to the individual who earns it or to owner of property that generates the income. Under the so-called “assignment of income doctrine,” a taxpayer may not avoid tax by assigning the right to income to another.

Specifically, the assignment of income doctrine holds that a taxpayer who earns income from services that the taxpayer performs or property that the taxpayer owns generally cannot avoid liability for tax on that income by assigning it to another person or entity. The doctrine is frequently applied to assignments to creditors, controlled entities, family trusts and charities.

However, a taxpayer can shift liability for capital gains on property not yet sold by making a bona fide gift of the underlying property. In that case, the donee of a gift of securities takes the “carryover” basis of the donor.

For example, shares now valued at $50 gifted to a donee in which the donor has a tax basis of $10, would yield a taxable gain to the donee of its eventual sale price less the $10 carryover basis. The donor escapes income tax on any of the appreciation.

For guidance on this issue, please contact our professionals at 315.242.1120 or [email protected] .

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Recognizing when the IRS can reallocate income

C Corporation Income Taxation
IRS Practice & Procedure

Transactions between related parties come under close scrutiny by the IRS because they are not always conducted at arm's length. If the amounts involved in the transaction do not represent fair market values, the IRS can change the characteristics of the transaction to reflect its actual nature.

The IRS may attempt to reallocate income between a closely held corporation and its shareholders based on several sets of rules, including the following:

Assignment-of-income rules that have been developed through the courts;
The allocation-of-income theory of Sec. 482; and
The rules for allocation of income between a personal service corporation and its employee-owners of Sec. 269A.

Income reallocation under the assignment - of - income doctrine is dependent on determining who earns or controls the income. Justice Oliver Wendell Holmes made the classic statement of the assignment - of - income doctrine when he stated that the Supreme Court would not recognize for income tax purposes an "arrangement by which the fruits are attributed to a different tree from that on which they grew" ( Lucas v. Earl , 281 U.S. 111, 115 (1930)).

Reallocation under Sec. 482 is used to prevent tax evasion or to more clearly reflect income when two or more entities are controlled by the same interests. Note the use of the word "or" in the preceding sentence. The Code empowers the IRS to allocate income even if tax evasion is not present if the allocation will more clearly reflect the income of the controlled interests. The intent of these provisions is to place the controlled entity in the same position as if it were not controlled so that the income of the controlled entity is clearly reflected (Regs. Sec. 1. 482 - 1 (a)) .

Example 1. Performing services for another group member: Corporations P and S are members of the same controlled group. S asks P to have its financial staff perform an analysis to determine S' s borrowing needs. P does not charge S for this service. Under Sec. 482, the IRS could adjust each corporation's taxable income to reflect an arm's - length charge by P for the services it provided to S .

Under Sec. 269A(a), the IRS has the authority to allocate income, deductions, credits, exclusions, and other items between a personal service corporation (PSC) and its employee - owners if:

The PSC performs substantially all of its services for or on behalf of another corporation, partnership, or other entity; and
The PSC was formed or used for the principal purpose of avoiding or evading federal income tax by reducing the income or securing the benefit of any expense, deduction, credit, exclusion, or other item for any employee-owner that would not otherwise be available.

A PSC will not be considered to have been formed or availed of for the principal purpose of avoiding or evading federal income taxes if a safe harbor is met. The safe harbor applies if the employee - owner's federal income tax liability is not reduced by more than the lesser of (1) $2,500 or (2) 10% of the federal income tax liability of the employee - owner that would have resulted if the employee - owner personally performed the services (Prop. Regs. Sec. 1. 269A - 1 (c)).

For purposes of this rule, a PSC is a corporation, the principal activity of which is the performance of personal services when those services are substantially performed by employee - owners (Sec. 269A(b)(1)). An employee - owner is any employee who owns on any day during the tax year more than 10% of the PSC's outstanding stock. As with many related - party provisions, the Sec. 318 stock attribution rules (with modifications) apply in determining stock ownership (Sec. 269A(b)(2)).

Example 2. Reallocation of income: H forms M Corp., which is a PSC. A few months later, he transfers shares of stock of an unrelated corporation to M . The following year, M receives dividends from the unrelated corporation and claims the Sec. 243(a) 50% dividend exclusion. The IRS may reallocate the dividend income from M to H if the principal purpose of the transfer of the unrelated stock to M was to use the 50% dividend exclusion under Sec. 243. However, the amounts to reallocate to H must exceed the safe - harbor amounts.

These rules usually apply when an individual performs personal services for an employer that does not offer tax - advantaged employee benefits (such as a qualified retirement plan and other employee fringe benefits). In those situations, the individual may set up a 100%- owned C corporation that contracts with the employer. The employer then pays the corporation. The individual functions as the employee of the corporation, and the corporation sets up tax - advantaged fringe benefit programs. The individual generally is able to "zero out" the income of the corporation with payments for salary and fringe benefits.

Despite the significant authority that Sec. 269A grants to the IRS, there is little evidence of the IRS or the courts using this statute. In a 1987 private letter ruling, the IRS held that a one - owner , one - employee medical corporation did not violate the statute, even though it retained only nominal amounts of taxable income, and the corporate structure allowed the individual to achieve a significant pension plan deduction. These facts were not sufficient to establish a principal purpose of tax avoidance (IRS Letter Ruling 8737001). In Sargent , 929 F.2d 1252 (8th Cir. 1991), the Eighth Circuit indicated a lack of interest in applying Sec. 269A because, in that case, the court felt the PSC had been set up for other legitimate reasons.

This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations , 31st Edition (March 2018), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com ).

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The research credit: documenting qualified services, income tax treatment of loyalty point programs, tax court rules cancellation of debt is part of gain realization, listing of reportable transactions under the apa.

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ASSIGNMENT OF INCOME DOCTRINE – SECTION 61 INTERNAL REVENUE CODE – J. RONALD JACKSON

I don’t want to pay tax on this income, assignment of income doctrine.

By: J Ronald “Ron” Jackson, MBA, CPA

Under federal income tax law gross income is taxed to the person who earns it or to the owner of property that generates the income. It is not uncommon for a high tax bracket taxpayer to want to shift income to a lower tax bracket family member in order to save on taxes and the income stay within the family unit. Alternatively, one who has appreciated stock or other type of property that he knows will be sold in the near future may wish to save on income taxes by gifting a portion of the property to a lower tax bracket family member who will report the sale at his or her lower income tax bracket. Alternatively, the individual may want a double benefit by gifting the appreciated property to a qualified charity thereby gaining a charitable income tax deduction for the value of the contributed property and being relieved of paying income taxes on the gain from the sale of the gifted property. This shifting of income, if permitted for income tax purposes, may provide considerable income tax savings.

The assignment of income doctrine was developed from court decisions which decided the issues, including the various methods employed in attempting to determine who earned the income. There was a time during the World War II years and thereafter, until around 1963, that the top income tax brackets could be as high as 91% – 93%. In addition to family members, the issues often arose when a high bracket taxpayer would make a gift of property (often the issues were gifts of appreciated stock that were to be sold shortly) to a qualified charity. The taxpayer would then take a charitable income tax deduction and not report the gain as he no longer owned the stock when sold. This shifting of income to a lower bracket taxpayer could have large savings in taxes for the high bracket taxpayer.

A simple example of income earned and taxed to the one who earns the income is when one works for weekly wages. The work week ends on Friday but the actual paycheck is not delivered until the following Wednesday. The wages are earned, for income tax purposes, at the end of the week (Friday). If the individual tells his employer to pay the earned wages to the individual’s mother, and the employer did that, the wages would still be taxed for federal income tax purposes to the individual since he earned the wages. The fact he may have made a gift of his earned wages does not change the income tax treatment as his employer has to include the earned wages on the individual’s W-2 form.

The above is a simple illustration of the doctrine that one who earns the income has to pay income tax on the wages. Let’s look at another situation. Suppose Perry, an individual taxpayer, owns all of the stock ownership in a very successful corporation (Company A) that he has run for many years. Perry is approached by the owners of another corporation (Company B) with an interest in purchasing Perry’s stock ownership in Company A. Negotiations have progressed and a total value has been tentatively negotiated of $5,000,000.00. The actual contract is still to be finalized and there are some remaining details to settle. Perry believes it will be finalized and signed within a reasonably short time. Perry, who is in a very high federal income tax bracket and who is a very civic-minded individual, has been told of the benefit of donating appreciated property to charity. Perry contacts the local Community Foundation and arranges to create the Perry Charitable Fund through the Community Foundation. The charitable fund will provide donations to his church and to other qualified charities that Perry usually supports. Perry then donates fifteen percent of his stock ownership, valued at $750,000.00 to the Community Foundation. Later after negotiations are completed, all of Company A’s stock is sold to Company B for the negotiated price of $5,000,000.00. Perry is happy. He has made a substantial profit from his years of work, made a donation to his favorite charity for which he plans to take a charitable income tax deduction, and will only have to report and pay income tax at capital gain rates on 85% of his stock as he has given 15% away.

Perry files his income tax return for the year and reports his taxable gain on the sale of his 85% ownership interest in Company A. About one year later Perry is audited by the IRS. The IRS agent questions why he did not report gain on the 15% of stock given to the Foundation. Perry replies that he did not own the stock as it was gifted to the charity before the date of the sale. The IRS auditor states that Perry should pay income tax on the gain on the stock given to the Community Foundation since it appears to have been a “done deal” before Perry gave the stock away and for that reason Perry owes income tax on all of the stock. Perry argues that no contracts were signed until weeks after the gift and that the deal could have fallen through at any time before signed by all parties. Perry disagreed with the audit. His tax dispute is now pending before the United States Tax Court. How will the court decide?

Section 61 of the Internal Revenue Code provides that gross income means all income earned from whatever source derived, and then lists several examples such as wages, services rendered, gains from the sales of property, and several other examples. In 1930, the U. S. Supreme Court summarized when addressing who earned income that “The fruits cannot be attributed to a different tree from that on which they grew.” Lucas v. Earl, 281 U.S. 111 (1930). This in effect clarified that gross income is to be taxed to the one that earns it and led to the fact that one cannot avoid paying income tax on earned income by gifting the property that created the income when it has been earned on or before the gift. An example would be when a corporation declares a dividend payable say on November 1st to stockholders of record on October 10th. A stockholder who owned the stock on October 10th is the one who has earned the income even if he or she sells or assigns their stock between October 10th and November 1st. The dividend is taxed to the owner on October 10, the date the dividend was declared.

In Perry’s case he argues that the negotiations were not complete when he made his gift, and that Company B could have backed out of the deal. When the court decides it will consider the stage of the negotiations, whether Company B had the financial backing to complete the deal, whether any contracts or preliminary statements of intent were prepared for review, and how long was the interval between the tentative agreement and the actual sale will all be considered. Situations like these happen from time to time. When the issue arises, it should be discussed in advance of the transaction, if possible, with your legal tax advisors who should be well versed in this area of tax law. One should be aware of the assignment of income doctrine in situations where it could apply in connection with his/her estate planning. What if this had been a publicly traded company?

If you have questions regarding Assignment of Income Doctrine and would like to discuss these issues, please contact Cody Walls, MBA, CPA at Denton Law Firm at 270-450-8253.

THIS ARTICLE IS DESIGNED TO PROVIDE GENERAL INFORMATION PREPARED BY THE PROFESSIONALS AT DENTON LAW FIRM, PLLC IN REGARD TO THE SUBJECT MATTER COVERED. IT IS PROVIDED WITH THE UNDERSTANDING THAT THE AUTHOR IS NOT ENGAGED IN RENDERING LEGAL, ACCOUNTING, OR OTHER PROFESSIONAL SERVICE. ALTHOUGH PREPARED BY PROFESSIONALS, THESE MATERIALS SHOULD NOT BE UTILIZED AS A SUBSTITUTE FOR PROFESSIONAL SERVICE IN SPECIFIC SITUATIONS. IF LEGAL ADVICE OR OTHER EXPERT ASSISTANCE IS REQUIRED, THE SERVICE OF A PROFESSIONAL SHOULD BE SOUGHT.

Battling Uphill Against the Assignment of Income Doctrine: Ryder

Benjamin Alarie

Kathrin Gardhouse

Benjamin Alarie is the Osler Chair in Business Law at the University of Toronto and the CEO of Blue J Legal Inc. Kathrin Gardhouse is a legal research associate at Blue J Legal .

In this article, Alarie and Gardhouse examine the Tax Court ’s recent decision in Ryder and use machine-learning models to evaluate the strength of the legal factors that determine the outcome of assignment of income cases.

I. Introduction

Researching federal income tax issues demands distilling the law from the code, regulations, revenue rulings, administrative guidance, and sometimes hundreds of tax cases that may all be relevant to a particular situation. When a judicial doctrine has been developed over many decades and applied in many different types of cases, the case-based part of this research can be particularly time consuming. Despite an attorney’s best efforts, uncertainty often remains regarding how courts will decide a new set of facts, as previously decided cases are often distinguished and the exercise of judicial discretion can at times lead to surprises. To minimize surprises as well as the time and effort involved in generating tax advice, Blue J ’s machine-learning modules allow tax practitioners to assess the likely outcome of a case if it were to go to court based on the analysis of data from previous decisions using machine learning. Blue J also identifies cases with similar facts, permitting more efficient research.

In previous installments of Blue J Predicts, we examined the strengths and weaknesses of ongoing or recently decided appellate cases, yielding machine-learning-generated insights about the law and predicting the outcomes of cases. In this month’s column, we look at a Tax Court case that our predictor suggests was correctly decided (with more than 95 percent confidence). The Ryder case 1 has received significant attention from the tax community. It involved tax avoidance schemes marketed by the law firm Ernest S. Ryder & Associates Inc. (R&A) that produced more than $31 million in revenue between 2003 and 2011 and for which the firm reported zero taxable income. The IRS unmasked more than 1,000 corporate entities that R&A’s owner, Ernest S. Ryder , had created and into which he funneled the money. By exposing the functions that these entities performed, the IRS played the most difficult role in the case. Yet, there are deeper lessons that can be drawn from the litigation by subjecting it to analysis using machine learning.

In this installment of Blue J Predicts, we shine an algorithmic spotlight on the legal factors that determine the outcomes of assignment of income cases such as Ryder . For Ryder , the time for filing an appeal has elapsed and the matter is settled. Thus, we use it to examine the various factors that courts look to in this area and to show the effect those factors have in assignment of income cases. Equipped with our machine-learning module, we are able to highlight the fine line between legitimate tax planning and illegitimate tax avoidance in the context of the assignment of income doctrine.

II. Background

In its most basic iteration, the assignment of income doctrine stands for the proposition that income is taxed to the individual who earns it, even if the right to that income is assigned to someone else. 2 Courts have held that the income earner is responsible for the income tax in the overwhelming majority of cases, including Ryder . It is only in a small number of cases that courts have been willing to accept the legitimacy of an assignment and have held that the assignee is liable for the earned income. Indeed, Blue J ’s “Assigned Income From Services” predictor, which draws on a total of 242 cases and IRS rulings, includes only 10 decisions in which the assignee has been found to be liable to pay tax on the income at issue.

The wide applicability of the assignment of income doctrine was demonstrated in Ryder , in which the court applied the doctrine to several different transactions that occurred between 1996 and 2011. Ryder founded his professional law corporation R&A in 1996 and used his accounting background, law degree, and graduate degree in taxation for the benefit of his clients. R&A designed, marketed, sold, and administered six aggressive tax-saving products that promised clients the ability to “defer a much greater portion of their income than they ever dreamed possible, and, as a result, substantially reduce their tax liability.” 3 In 2003 the IRS caught on to Ryder ’s activities when his application to have 800 employee stock option plans qualified at the same time was flagged for review. A decade of investigations and audits of Ryder and his law firm spanning from 2002 to 2011 followed.

What is interesting in this case is that Ryder , through his law firm R&A, directly contracted with his clients for only three of the six tax-saving products that his firm designed, marketed, and sold (the stand-alone products). The fees collected by R&A from two of the stand-alone products were then assigned to two other entities through two quite distinct mechanisms. For the other three tax-saving products, the clients contracted — at least on paper — with other entities that Ryder created (the group-tax products). Yet, the court treated the income from all six tax-saving products identically. The differences between the six types of transactions did not affect the outcome of the case — namely, that it is R&A’s income in all six instances. Blue J ’s predictor can explain why: The factors that our predictor highlights as relevant for answering the question whether the assignment of income doctrine applies have less to do with the particular strategy that the income earner conjures up for making it look like the income belongs to someone else, and more to do with different ways of pinpointing who actually controls the products, services, and funds. In Ryder , the choices ultimately come down to whether that is R&A or the other entity.

We will begin the analysis of the case by taking a closer look at two of the six tax-saving products, paying particular attention to the flow of income from R&A’s clients to R&A and Ryder ’s assignment of income to the other entities. We have selected one of the tax-saving products in which Ryder drew up an explicit assignment agreement, and another one in which he tried to make it look like the income was directly earned by another entity he had set up. Regardless of the structures and means employed, the court, based on the IRS ’s evidence, traced this income to R&A and applied the assignment of income doctrine to treat it as R&A’s income.

This article will not cover in detail the parts of the decision in which the court reconstructs the many transactions Ryder and his wife engaged in to purchase various ranches using the income that had found its way to R& A. As the court puts it, the complexity of the revenues and flow of funds is “baroque” when R&A is concerned, and when it comes to the ranches, it becomes “ rococo .” 4 We will also not cover the fraud and penalty determinations that the court made in this case.

III. The Tax Avoidance Schemes

We will analyze two of the six schemes discussed in the case. The first is the staffing product, and the second is the American Specialty Insurance Group Ltd. (ASIG) product. Each serves as an example of different mechanisms Ryder employed to divert income tax liability away from R&A. In the case of the staffing product, Ryder assigned income explicitly to another entity. The ASIG product involved setting up another entity that Ryder argued earned the income directly itself.

A. The Staffing Product

R&A offered a product to its clients in the course of which the client could lease its services to a staffing corporation, which would in turn lease the client’s services back to the client’s operating business. The intended tax benefit lay “with the difference between the lease payment and the wages received becoming a form of compensation that was supposedly immune from current taxation.” 5 At first, the fees from the staffing product were invoiced by and paid to R&A. When the IRS started its investigation, Ryder drew up an “Agreement of Assignment and Assumption” with the intent to assign all the clients and the income from the staffing product to ESOP Legal Consultants Inc. ( ELC ). Despite the contractual terms limiting the agreement to the 2004-2006 tax years, Ryder used ELC ’s bank account until 2011 to receive fees paid by the various S corporations he had set up for his clients to make the staffing product work. R&A would then move the money from this bank account into Ryder ’s pocket in one way or another. ELC had no office space, and the only evidence of employees was six names on the letterhead of ELC indicating their positions. When testifying in front of the court, two of these employees failed to mention that they were employed by ELC , and one of them was unable to describe the work ELC was allegedly performing. Hence, the court concluded that ELC did not have any true employees of its own and did not conduct any business. Instead, it was R&A’s employees that provided any required services to the clients. 6

B. The ASIG Product

R&A sold “disability and professional liability income insurance” policies to its clients using ASIG, a Turks and Caicos corporation that was a captive insurer owned by Capital Mexicana . Ryder had created these two companies during his previous job with the help of the Turks and Caicos accounting firm Morris Cottingham Ltd. The policies Ryder sold to his clients required them to pay premiums to ASIG as consideration for the insurance. The premiums were physically mailed to R& A. Also , the clients were required to pay a 2 percent annual fee, which was deposited into ASIG’s bank account. In return, the clients received 98 percent of the policy’s cash value in the event that they became disabled, separated from employment, turned 60, or terminated the policy. 7

R&A’s involvement in these deals, aside from setting up ASIG, was to find the clients who bought the policies, assign them a policy number, draft a policy, and open a bank account for the client, as well as provide legal services for the deal as needed. It was R&A that billed the client and that ensured, with Morris Cottingham ’s help, that the fees were paid. R&A employees would record the ASIG policy fee paid by the clients, noting at times that “pymt bypassed [R&A’s] books.” 8 Quite an effort went into disguising R&A’s involvement.

First, there was no mention of R&A on the policy itself. Second, ASIG’s office was located at Morris Cottingham’s Turks and Caicos corporate services. Ryder also set up a post office box for ASIG in Las Vegas. Any mail sent to it was forwarded to Ryder . Third, to collect the fees, R&A would send a letter to Morris Cottingham for signature, receive the signed letter back, and then fax it to the financial institution where ASIG had two accounts. One of these was nominally in ASIG’s name but really for the client’s benefit, and the other account was in Ryder ’s name. The financial institution would then move the amount owed in fees from the former to the latter account. Whenever a client filed for a benefit under the policy, the client would prepare a claim package and pay a termination fee that also went into the ASIG account held in Ryder ’s name. The exchanges between the clients and ASIG indicate that these fees were to reimburse ASIG for its costs and services, as well as to allow it to derive a profit therefrom. But the court found that ASIG itself did nothing. Even the invoices sent to clients detailing these fee payments that were on ASIG letterhead were in fact prepared by R&A. In addition to the annual fees and the termination fee, clients paid legal fees on a biannual basis for services Ryder provided. These legal fees, too, were paid into the ASIG account in Ryder ’s name. 9

IV. Assignment of Income Doctrine

The assignment of income doctrine attributes income tax to the individual who earns the income, even if the right to that income is assigned to another entity. The policy rationale underlying the doctrine is to prevent high-income taxpayers from shifting their taxable income to others. 10 The doctrine is judicial and was first developed in 1930 by the Supreme Court in Lucas , a decision that involved contractual assignment of personal services income between a husband and wife. 11 The doctrine expanded significantly over the next 20 years and beyond, and it has been applied in many different types of cases involving gratuitous transfers of income or property. 12 The staffing product, as of January 2004, involved an anticipatory assignment of income to which the assignment of services income doctrine had been held to apply in Banks . 13 The doctrine is not limited to situations in which the income earner explicitly assigns the income to another entity; it also captures situations in which the actual income earner sets up another entity and makes it seem as if that entity had earned the income itself, as was the case with the ASIG product. 14

In cases in which the true income earner is in question, the courts have held that “the taxable party is the person or entity who directed and controlled the earning of the income, rather than the person or entity who received the income.” 15 Factors that the courts consider to determine who is in control of the income depend on the particular situation at issue in the case. For example, when a personal services business is involved, the court looks at the relationship between the hirer and the worker and who has the right to direct the worker’s activities. In partnership cases, the courts apply the similarity test, asking whether the services the partnership provided are similar to those the partner provided. In other cases, the courts have inquired whether an agency relationship can be established. In yet other cases the courts have taken a broad and flexible approach and consulted all the available evidence to determine who has the ultimate direction and control over the earnings. 16

V. Factors Considered in Ryder

Judge Mark V. Holmes took a flexible approach in Ryder . He found that none of the entities that Ryder papered into existence had their own office or their own employees. They were thus unable to provide the services Ryder claims they were paid for. In fact, the entities did not provide any services at all — the services were R&A’s doing. To top it off, R&A did nothing but set up the entities, market their tax benefits, and move money around once the clients signed up for the products. There was no actual business activity conducted. The court further found that the written agreements the clients entered into with the entities that purported to provide services to them were a sham and that oral contracts with R&A were in fact what established the relevant relationship, so that R&A must be considered the contracting party. In the case of the ASIG product, for example, a client testified that the fees he paid to Ryder were part of his retirement plan. Ryder had represented to him that the ASIG product was established to create an alternative way to accumulate retirement savings. 17

Regarding the staffing product in which there existed an explicit assignment of income agreement between R&A and ELC , the court found that ELC only existed on paper and in the form of bank accounts, with the effect that R&A was ultimately controlling the income even after the assignment. A further factor that the court emphasized repeatedly was that R&A, and Ryder personally as R&A’s owner, kept benefitting from the income after the assignment (for example, in the staffing product case) or, as in the case of the ASIG product, despite the income allegedly having been earned by a third party (that is, ASIG). 18

VI. Analysis

The aforementioned factors are reflected in Blue J ’s Assigned Income From Services predictor. 19 We performed predictions for the following scenarios:

the staffing product and R&A’s assignment of the income it generated to ELC with the facts as found by the court;

the staffing product and R&A’s assignment of the income it generated to ELC if Ryder ’s version of the facts were accepted;

the ASIG product and service as the court interpreted and characterized the facts; and

the ASIG product and service according to Ryder ’s narrative.

What is interesting and indicative of the benefits that machine-learning tools such as Blue J ’s predictor can provide to tax practitioners is that even if the court had found in Ryder ’s favor on all the factual issues reasonably in dispute, Ryder would still not have been able to shift the tax liability to ELC or ASIG respectively, according to our model and analysis.

The court found that R&A contracted directly with, invoiced, and received payments from its clients regarding the staffing product up until 2004, when Ryder assigned the income generated from this product explicitly to ELC . From then onward, ELC received the payments from the clients instead of R&A. Further, the court found that ELC did not have its own employees or office space and did not conduct any business activity. Our data show that the change in the recipient of the money would have made no difference regarding the likelihood of R&A’s liability for the income tax in this scenario.

According to Ryder ’s version of the facts, ELC did have its own employees, 20 even though there is no mention of a separate office space from which ELC allegedly operated. Yet, Ryder maintains that ELC was the one providing the staffing services to its clients after the assignment of the clients to the company in January 2004. Even if Ryder had been able to convince the court of his version of the facts, it would hardly have made a dent in the likelihood of the outcome that R&A would be held liable for the tax payable on the income from the staffing product.

With Ryder ’s narrative as the underlying facts, our predictor is still 94 percent confident that R&A would have been held liable for the tax. The taxation of the income in the hands of the one who earned it is not easily avoided with a simple assignment agreement, particularly if the income earner keeps benefiting from the income after the assignment and continues to provide services himself without giving up control over the services for the benefit of the assignee. The insight gained from the decision regarding the staffing product is that the court will take a careful look behind the assignment agreement and, if it is not able to spot a legitimate assignee, the assignment agreement will be disregarded.

The court made the same factual findings regarding the ASIG product as it did for the staffing product post-assignment. Ryder , however, had more to say here in support of his case. For one, he pointed to ASIG’s main office that was located at the Morris Cottingham offices. Morris Cottingham was also the one that, on paper, contracted with clients for the insurance services and the collection of fees was conducted, again on paper, in the name of Morris Cottingham . The court also refers to actual claims that the clients made under their policies. There is also a paper trail that indicates that the clients were explicitly acknowledging and in fact paying ASIG for its costs and services. From all this we can conclude that Ryder was able to argue that ASIG had its own independent office, had one or more employees providing services, and that ASIG engaged in actual business activity. However, even if these facts had been admitted as accurately reflecting the ASIG product, our data show that with a 92 percent certainty R&A would still be liable for the income tax payable on the income the ASIG product generated. It is clear that winning a case involving the assignment of income doctrine on facts such as the ones in Ryder is an uphill battle. If the person behind the scenes remains involved with the services provided without giving up control over them, and benefits from the income generated, it is a lost cause to argue that the assignment of income doctrine should be applied with the effect that the entity that provides the services on paper is liable for the income tax.

C. Ryder as ASIG’s Agent

Our data reveal that to have a more substantial shot at succeeding with his case under the assignment of income doctrine, Ryder would have had to pursue a different line of argument altogether. Had he set R&A up as ASIG’s agent rather than tried to disguise its involvement with the purported insurance business, Ryder would have been more likely to succeed in shifting the income tax liability to ASIG. For our analysis of the effect of the different factors discussed by the court in Ryder , we assume at the outset that Ryder would do everything right — that is, ASIG would have its own workers and office, and it would do something other than just moving money around (best-case scenario). We then modify each factor one by one to reveal their respective effect.

From this scenario testing, we can conclude that if R&A had had an agency agreement with ASIG, received some form of compensation for its services from ASIG, held itself out to act on ASIG’s behalf, and the client was interested in R&A’s service because of its affiliation with ASIG, Ryder would have reduced the likelihood to 73 percent of R&A being liable for the income tax. Add to these agency factors an element of monitoring by ASIG and the most likely result flips — there would be a 64 percent likelihood that ASIG would be liable for the income tax. If ASIG were to go beyond monitoring R&A’s services by controlling them too, the likelihood that ASIG would be liable for the income tax would increase to 82 percent. Let’s say Ryder had given Morris Cottingham oversight and control over R&A’s services for ASIG, then the question whether ASIG employs any workers other than R&A arguably becomes moot because there would necessarily be an ASIG employee who oversees R&A. Accordingly, there is hardly any change in the confidence level of the prediction that ASIG is liable for the income tax when the worker factor is absent.

Interestingly, this is quite different from the effect of the office factor. Keeping everything else as-is, the absence of having its own ASIG-controlled office decreases the likelihood of ASIG being liable to pay the income tax from 82 to 54 percent. Note here that our Assigned Income From Services predictor is trained on data from relatively old cases; only 14 are from the last decade. This may explain why the existence of a physical office space is predicted to play such an important role when the courts determine whether the entity that allegedly earns the income is a legitimate business. In a post-pandemic world, it may be possible that a trend will emerge that puts less emphasis on the physical office space when determining the legitimacy of a business.

The factor that stands out as the most important one in our hypothetical scenario in which R&A is the agent of ASIG is the characterization of ASIG’s own business activity. In the absence of ASIG conducting its own business, nothing can save Ryder ’s case. This makes intuitive sense because if ASIG conducts no business, it must be R&A’s services alone that generate the income; hence R&A is liable for the tax on the income. Also very important is the contracting party factor: If the client were to contract with R&A rather than ASIG in our hypothetical scenario, the likelihood that R&A would be held liable for the income tax is back up to 72 percent, all else being equal. If the client were to contract with both R&A and ASIG, it is a close case, leaning towards ASIG’s liability with 58 percent confidence. Much less significant is who receives the payment between the two. If it is R&A, ASIG remains liable for the income tax with a likelihood of 71 percent, indicating a drop in confidence by 11 percent compared with a scenario in which ASIG received the payment.

To summarize, if Ryder had pursued a line of argument in which he set up R&A as ASIG’s agent, giving ASIG’s employee(s) monitoring power and ideally control over R&A’s services for ASIG, he would have had a better chance of succeeding under the assignment of income doctrine. As we have seen, the main prerequisite for his success would have been to convince the court that it would be appropriate to characterize ASIG as conducting business. Ideally, Ryder also would have made sure that the client contracted for the services with ASIG and not with R&A. However, it is significantly less important that ASIG receives the money from the client. The historical case law also suggests that Ryder would have been well advised to set up a physical office for ASIG; however, given the new reality of working from home, this factor may no longer be as relevant as these older previously decided cases indicate.

VII. Conclusion

We have seen that R&A’s chances to shift the liability for the tax payable on the staffing and the ASIG product income was virtually nonexistent. The difficulty of this case from the perspective of the IRS certainly lay in gathering the evidence, tracing the money through the winding paths of Ryder ’s paper labyrinth, and making it comprehensible for the court. Once this had been accomplished, the IRS had a more-or-less slam-dunk case regarding the applicability of the assignment of income doctrine. As mentioned at the outset, an assignment of income case will always be an uphill battle for the taxpayer because income is generally taxable to whoever earns it.

Yet, in cases in which the disputed question is who earned the income and not whether the assignment agreement has shifted the income tax liability, the parties must lean into the factors discussed here to convince the court of the legitimacy (or the illegitimacy, in the case of the government) of the ostensibly income-earning entity and its business. Our analysis can help decide which of the factors must be present to have a plausible argument, which ones are nice to have, and which should be given little attention in determining an efficient litigation strategy.

1 Ernest S. Ryder & Associates Inc. v. Commissioner , T.C. Memo. 2021-88 .

2 Lucas v. Earl , 281 U.S. 111, 114-115 (1930).

3 Ryder , T.C. Memo. 2021-88, at 7.

4 Id. at 32.

5 Id. at 17, 19, and 111-112.

6 Id. at 51-52, 111-112, and 123-126.

7 Id. at 9-12.

8 Id. at 96.

10 CCH, Federal Taxation Comprehensive Topics, at 4201.

11 Lucas , 281 U.S. at 115.

12 See , e.g. , “familial partnership” cases — Burnet v. Leininger , 285 U.S. 136 (1932); Commissioner v. Tower , 327 U.S. 280 (1946); and Commissioner v. Culbertson , 337 U.S. 733 (1949). For an application in the commercial context, see Commissioner v. Banks , 543 U.S. 426 (2005).

13 Banks , 543 U.S. at 426.

14 See , e.g. , Johnston v. Commissioner , T.C. Memo. 2000-315 , at 487.

16 Ray v. Commissioner , T.C. Memo. 2018-160 .

17 Ryder , T.C. Memo. 2021-88, at 90-91.

18 Id. at 48, 51, and 52.

19 The predictor considered several further factors that play a greater role in other fact patterns.

20 The court mentions that ELC’s letterhead set out six employees and their respective positions with the company.

END FOOTNOTES

A Tax Planning Cautionary Tale: Timing and Formalities Are Critical

A business owner learned the hard way (and at great cost) not to dawdle or cut corners when it comes to tax plans involving the sale of a business.

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A red alarm clock sits atop stacks of coins of varying heights.

This cautionary tale is based upon the recent tax case of Estate of Hoensheid v Commissioner , TC Memo 2023-34. When owners of a company plan to sell their business, there is very often a desire to minimize the resultant income tax. This tax is effectively taxing the increase in the value of the business often earned over many years and decades into a single year. The resultant tax will often be at the highest marginal rate, substantially reducing the net proceeds to the seller.

Many of the tools used to minimize income tax in this situation have a charitable giving component. When properly planned and implemented, three separate goals are achieved.

First, a portion of the otherwise taxable gain on the sale becomes nontaxable because a portion of the asset being sold is transferred to an IRS-recognized charitable structure.

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Second, there is an income tax deduction equal to the fair market value of the appreciated asset contributed to the charitable structure. This compounds the economic value of the tax savings structure. A portion of the gain is sold tax-free by the charitable organization, and the seller receives a charitable deduction equal to the fair market value of the asset contributed. For example, if we are selling a company for a $20 million taxable gain, we could expect a tax of $6 million based upon a 30% combined federal and state tax rate. This leaves net proceeds of $14 million.

Note also that the seller has no say in how the $6 million in tax is spent by the government. If we gift a portion of the company to an IRS-recognized charitable structure, then you could direct the funds to be used for the Wounded Warrior Project , the Make-A-Wish Foundation or any legitimate charitable cause that you wish. Note that those funds would need to be distributed to a 501(c)(3) charity focusing on that desired purpose.

If we transfer $5 million to a charitable structure before the sale, the taxable gain itself is now only $15 million. This is because the net gain is reduced by the $5 million contributed to charity. The stock owned by the charity is sold tax free. Then the taxable gain is further reduced by a charitable contribution deduction equal to the fair market value of the stock contributed to charity. This results in a net tax of approximately $3 million. However, this is only a small part of the story.

The third goal is where the magic happens. Contributing the appreciated asset to a well-planned charitable structure provides an economic benefit to the charity and builds substantial wealth for the family, typically due to the time value of money. These structures provide independent economic value or wealth to the family and to the charity. Careful consideration must be given to each client’s financial and nonfinancial goals.

These charitable structures are typically referred to by acronyms, leading to a veritable alphabet soup of alternatives: CRTs (charitable remainder trusts), CLTs (charitable lead trusts), PIFs (pooled income funds), CHLLCs (charitable limited liability companies), to name just a few overall categories. For my clients, we always recommend a structure that provides the client investment control of the funds while invested within the charitable structure. These structures can also provide significant asset protection for the client and their family.

An example of a $7 million investment into an intergenerational split interest trust PIF (a form of a pooled income fund) would provide the following results for a family where Dad is 49 years old and has kids ages 28, 24 and 11:

$7 million contribution
Income tax deduction: $2,171,200
Projected annual income of 6%: $420,000 per year to Dad for his entire life and, at his death, to his children for their entire lives
Client can maintain investment control
Trust can own investment income real estate, if desired

Alternatively, a $3 million investment into a deferred inheritance trust (a form of CLAT) could provide an overall benefit to the family of over $16 million. The charity would also receive over $8 million. A dollar-for-dollar income tax deduction is provided of $3 million. This provides an estimated tax savings of $1,289,100. With the tax savings, the net cost of the $3 million investment is only $1,710,900.

Here’s how that would work: The client invests $3 million into the deferred inheritance trust. Of that amount, $150,000 is invested in municipal bonds to pay the required annual charitable distributions. $2,850,000 is used to acquire a life insurance policy within the deferred inheritance trust. This will provide over $8 million to the charity and almost $17 million to the client’s children, income- and estate-tax-free.

These are only a few of the economic possibilities available with this type of planning. The key is to first identify your financial and nonfinancial goals, such as establish minimum cash flow and not worth needs. Goals may include providing predictable safe, risk-free income for yourself and your kids or other loved ones, or asset protection for yourself or your loved ones. Then identify the alternatives that best satisfy those goals.

What was lost in the case of Estate of Hoensheid v Commissioner

Any possible benefit from the above type of planning was lost to the owners of Commercial Steel Treaty Corporation (CSTC). CSTC was owned by the taxpayer in the case and his two brothers (collectively, the business owners). The loss in planning benefits is directly attributable to the taxpayer’s own conduct and behavior in waiting too long to implement and trying to save money on appraisal costs.

The business owners received a letter of intent on April 2015 from a buyer who would pay $92 million for their company. The business owners wished to make a contribution to utilize the type of tax planning referred to above, but only if the sale of the company actually closed or was completed. In correspondence with the tax attorney, the brothers indicated that they wanted to “wait as long as possible to pull the trigger” on the contributor. In part, because if the sale did not go through, then the contributor would own less stock than his two brothers and have less control over the company.

The stock was contributed to Fidelity Charitable two days before the sale actually closed. The taxpayer (probably hoping to save a few dollars) did not hire an IRS-recognized and qualified appraiser.

The court relied upon the “assignment of income doctrine” to determine that the sale had progressed too far for Fidelity Charitable to be an owner for income tax purposes. This means that the entire gain, including the portion transferred to Fidelity Charitable, is deemed owned by and taxed entirely to the taxpayer at closing for income tax purposes. In other words, the sale or deal was virtually certain to close or be completed even though the sale did not formally close for two more days.

The assignment of income doctrine is a long-standing “first principle of income taxation” that recognizes that income is taxed to those “who earn or otherwise create the right to receive it” and that tax cannot be avoided by “anticipatory arrangements and contracts however skillfully devised.” The court believed that the charitable transfer of stock was subject to a pending, pre-negotiated transaction with a fixed right to proceeds in the transaction. The court did not believe that Fidelity Charitable or the taxpayer had any meaningful risk that the sale would not close.

A qualified appraisal is important, emphasis on ‘qualified’

The case itself is replete with damaging correspondence and testimony evidence that the taxpayer did not wish to contribute any amount if the sale did not close. The result is that our first goal above was lost because the entire sale was taxable to the owner. The court then went further and denied the charitable contribution deduction itself. The taxpayer did not comply with the regulatory requirements to substantiate the deductions found in Internal Revenue Code Section 170 . In particular, the court determined that the taxpayer did not obtain a “qualified appraisal.” The taxpayer obtained a price quote from a qualified appraiser, but used an unqualified, presumably cheaper, alternative.

The bottom-line result was particularly harsh for the taxpayer. Fidelity Charitable was contractually entitled to a portion of the sale proceeds even though the entire gain was taxable to the business owner. The business owner was also not even entitled to the charitable contribution deduction due to the failure to have a qualified appraiser/appraisal. Definitely not the desired economic result for the taxpayer and his family.

Three lessons to learn from this case

1. All planning should be implemented far sooner. All planning particularly charitable and noncharitable alternatives involving a transfer of ownership prior to the sale must be completed well before the formal closing of the sale or deal. If the sale or deal has progressed too far, you run the risk of any presale transfers being disregarded for tax purposes under the assignment of income doctrine. “Too far” means there is a meaningful possibility that the sale will not actually close.

The issuance of a letter of intent (LOI), which is not typically binding, begins a countdown for completion. Try to implement the plan before the LOI is issued, even though the LOI is subject to negotiation. Note that the best planning is done long before the sale is in progress. Some of the best results are obtained by planning at least two years prior to the sale.

2. Seek a qualified tax attorney’s advice. A qualified tax attorney can guide you through the maze of decisions involved with business sales. Note that many mergers and acquisitions attorneys specifically say that they do not give tax advice. Retain and listen to the advice of your tax attorney. Be candid about concerns that you may have, such as the possibility that the sale may not close. Creative solutions may be available.

3. Carefully follow the IRS rules for the tax planning or structure. In tax planning and in life, we should strive to minimize risk and maximize benefits. Here, the taxpayer did not bother to use an IRS-qualified appraiser.

The appraisal itself did not include a statement that the appraisal was prepared for federal tax purposes, included an incorrect date of contribution (possibly as a result of the application of the assignment of income doctrine), included a premature date of appraisal, did not adequately describe the method of valuation, was not even signed by the appraiser, did not include the appraiser’s qualifications, did not describe the property contributed in sufficient detail, and did not include an explanation of the specific basis for the valuation.

The simplest advice here is to dot the i’s and cross the t’s on a timely basis. The cheapest advice may actually be the more expensive, as happened here.

Assignment of Income Lawyers

(This may not be the same place you live)

What Happens if you Assign your Income?

There are some instances when a person may choose to assign a portion of their income to another individual. You may be able to do this by asking your employer to send your paycheck directly to a third party.

It should be noted, however, that if you choose to assign your income to a third party, then this does not mean that you will be able to avoid paying taxes on that income. In other words, you will still be responsible for paying taxes on that income regardless of whether you decide to assign your income to a third party or not. This guideline is known as the “assignment of income doctrine.”

The primary purpose of the “assignment of income doctrine” is to ensure that a person does not simply assign their income to a third party to avoid having to pay taxes. If they do, then they can be charged and convicted of committing tax evasion .

One other important thing to bear in mind about income assignments is that they are often confused with the concept of wage garnishments. However, income or wage assignments are different from wage garnishments. In a situation that involves wage garnishment, a person’s paycheck is involuntarily withheld from them to pay off a debt like outstanding child support payments and is typically ordered by a court.

In contrast, an income or wage assignment is when a person voluntarily agrees to assign their income to someone else through a contract or a similar type of agreement.

How is Assigned Income Taxed?

Are there any exceptions, should i consult with an attorney.

As previously discussed, a taxpayer will still be required to pay taxes on any income that is assigned to a third party. The person who earns the income is the one who will be responsible for paying taxes on the income, not the person to whom it is assigned. The same rule applies to income that a person receives from property or assets.

For example, if a person earns money through a source of what is considered to be a passive stream of income, such as from stock dividends, the person who owns these assets will be the one responsible for paying taxes on the income they receive from it. The reason for this is because income is generally taxed to the person who owns any income-generating property under the law.

If a person chooses to give away their income-generating property and/or assets as a gift to a family member, then they will no longer be taxed on any income that is earned from those property or assets. This rule will be triggered the moment that the owner has given up their complete control and rights over the property in question.

In order to demonstrate how this might work, consider the following example:

Instead, the person to whom the apartment building was transferred will now be liable for paying taxes on any income they receive from tenants paying rent to live in the building since they are the new owner.

There is one exception to the rule provided by the assignment of income doctrine and that is when income is assigned in a scenario that involves a principal-agent relationship . For example, if an agent receives income from a third-party that is intended to be paid to the principal, then this income is usually not taxable to the agent. Instead, it will be taxable to the principal in this relationship.

Briefly, an agent is a person who acts on behalf of another (i.e., the principal) in certain situations or in regard to specific transactions. On the other hand, a principal is someone who authorizes another person (i.e., the agent) to act on their behalf and represent their interests under particular circumstances.

For example, imagine a sales representative that is employed by a large corporation. When the sales representative sells the corporation’s product or service to a customer, they will receive money from the customer in exchange for that service or product. Although the sales representative is the one being paid in the transaction, the money actually belongs to the corporation. Thus, it is the corporation who would be liable for paying taxes on the income.

In other words, despite the fact that this income may appear to have been earned by the corporation’s agent (i.e., the sales representation in this scenario), the corporation (i.e., the principal) will still be taxed on the income since the sales representative is acting on behalf of the corporation to generate income for them.

One other exception that may apply here is known as a “kiddie tax.” A kiddie tax is unearned or investment-related income that belongs to a child, but must be paid by the earning child’s parent and at the tax rate assigned to adults (as opposed to children). This is also to help prevent parents from abusing the tax system by using their child’s lower tax rate to shift over assets or earned income and take advantage of their child’s lower tax bracket rate.

So, even though a parent has assigned money or assets to a child that could be considered their earned income, the money will still have to be paid by the parent and taxed at a rate that is reserved for adults. The child will not need to pay any taxes on this earned income until it reaches a certain amount.

In general, the tax rules that exist under the assignment of income doctrine can be confusing. There are several exceptions to these rules and many of them require knowing how to properly apply them to the specific facts of each individual case.

Therefore, if you have any questions about taxable income streams or are involved in a dispute over taxable income with the IRS, then it may be in your best interest to contact an accountant or a local tax attorney to provide further guidance on the matter. An experienced tax attorney can help you to avoid incurring extra tax penalties and can assist you in resolving your income tax issue in an efficient manner.

Your attorney will also be able to explain the situation and can recommend various options to settle the assignment of income issue or any related concerns. In addition, your attorney will be able to communicate with the IRS on your behalf and can provide legal representation if you need to appear in court.

Lastly, if you think you are not liable for paying taxes on income that has been assigned to you by someone else, then your lawyer can review the facts of your claim and can find out whether you may be able to avoid having to pay taxes on that income.

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Tax Law on “Assignment of Income”

Gross income is taxed to the individual who earns it or to an owner of property that generates the income. Under the so-called “assignment of income doctrine,” a taxpayer may not avoid tax by assigning the right to income to another. Specifically, the assignment of income doctrine holds that a taxpayer who earns income from services that the taxpayer performs or property that the taxpayer owns generally cannot avoid liability for tax on that income by assigning it to another person or entity. The doctrine is frequently applied to assignments to creditors, controlled entities, family trusts and charities.

A taxpayer cannot, for tax purposes, assign income that has already accrued from property the taxpayer owns. This aspect of the assignment of income doctrine is often applied to interest, dividends, rents, royalties, and trust income. And, under the same rationale, an assignment of an interest in a lottery ticket is effective only if it occurs before the ticket is ascertained to be a winning ticket. However, a taxpayer can shift liability for capital gains on property not yet sold by making a bona fide gift of the underlying property. In that case, the donee of a gift of securities takes the “carryover” basis of the donor. For example, shares now valued at $50 gifted to a donee in which the donor has a tax basis of $10, would yield a taxable gain to the donee of its eventual sale price less the $10 carryover basis. The donor escapes income tax on any of the appreciation.

For more information about this article, please contact our tax professionals at [email protected] or toll free at 844.4WINDES (844.494.6337).

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FAQ: What Is the Assignment of Income?

Assignment of income allows you to assign part of your income directly to another person. While there are several valid reasons to assign your income to someone else, many taxpayers mistakenly believe that it can help lower their taxable income. While assignment of income allows you to divert income, you cannot divert taxes.

In this article, we’ll provide some examples of failed attempts at avoiding income taxes through the assignment of income and the valid reasons someone might want to assign income to someone else.

RELATED: Tax Evasion Vs. Tax Avoidance: The Difference and Why It Matters

You Can’t Use Assignment of Income to Avoid Paying Taxes

The assignment of income doctrine states that the taxpayer who earns the income must pay the tax on that income, even if he gave the right to collect the income to another person.

The doctrine is quite clear: taxpayers must pay their own taxes. However, that doesn’t stop many people from thinking they can avoid paying taxes or minimize their taxable income through the assignment of income.

Here are a few scenarios we commonly see.

High-Earning Individuals: In an attempt to avoid having to pay the higher tax rates on their substantial income, high-earning individuals sometimes try to divert income to a lower-income family member in a significantly lower tax bracket. The assignment of income doctrine prevents this scheme from working.
Charitable Donating : Even if a taxpayer assigns part of their income to a charitable organization, they will still have to pay the taxes. However, they might be eligible to claim a deduction for donations to charity while building some good karma by helping others in need.
Owning Multiple Businesses: A taxpayer who controls multiple businesses might try to divert income from one business to another, especially if one has the potential to receive a tax benefit but requires a higher income to do so. Not only is this illegal, but it also will not lower the taxable income of the business.

You Can Use Assignment of Income to… Assign Your Income

The assignment of income doctrine does not stop you from diverting part of your income to someone else. In fact, that’s the whole point! Maybe you’re helping to support an elderly family member, or you consistently donate to the same charity every month or year. Whatever the case, you can assign the desired amount of your income to go to another person or organization.

While there are no tax benefits involved in assigning income versus making traditional payments or donations, it can be a more convenient option if you’re making regular payments throughout the year.

S.H. Block Tax Services Provides Clear Answers For Complicated Questions

If you have any questions about how to go about assigning part of your income to a family member in need or a separate business entity, please contact S.H. Block Tax Services today. We can answer all of your questions and address all of your concerns regarding the assignment of income and provide suggestions on valid and legal ways to save on your taxes.

Please call us today at (410) 872-8376 or complete this brief contact form to get started on the path toward tax compliance and financial freedom.

The content provided here is for informational purposes only and should not be construed as legal advice on any subject.

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Gross Income: Tax Benefit, Claim of Right and Assignment of Income (Portfolio 502)

The Portfolio, Gross Income: Tax Benefit, Claim of Right and Assignment of Income, addresses three areas of gross income that are substantially judicial in origin and nature.

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The Bloomberg Tax Portfolio, Gross Income: Tax Benefit, Claim of Right and Assignment of Income, No. 502, addresses three areas of gross income that are substantially judicial in origin and nature. It analyzes in depth the nature, concept, scope, and application of the tax benefit doctrine, the claim of right doctrine, and the assignment of income doctrine.

The tax benefit doctrine excludes from a taxpayer’s gross income any recovery or refund of an amount deducted in a prior taxable year to the extent the deduction did not reduce tax liability. Under the claim of right doctrine, a taxpayer must include in gross income for the year of receipt any income received under a claim of right free of restrictions.

Under the assignment of income doctrine, gross income from personal services must be included in the gross income of the person who rendered the services. In addition, under that doctrine, gross income from property must be included in the gross income of the person who beneficially owns the property.

The Worksheets include relevant legislative history for provisions discussed in detail and for which regulations have not yet been issued.

I. Introduction II. Tax Benefit Doctrine III. Claim of Right Doctrine IV. Assignment of Income

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Section 1202 Planning: When Might the Assignment of Income Doctrine Apply to a Gift of QSBS?

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Blogs Qualified Small Business Stock (QSBS) Tax Law Defined™ Blog

Scott W. Dolson

Section 1202 allows taxpayers to exclude gain on the sale of QSBS if all eligibility requirements are met. Section 1202 also places a cap on the amount of gain that a stockholder is entitled to exclude with respect to a single issuer’s stock. [i] A taxpayer has at least a $10 million per-issuer gain exclusion, but some taxpayer’s expected gain exceeds that cap. In our article Maximizing the Section 1202 Gain Exclusion Amount , we discussed planning techniques for increasing, and in some cases multiplying, the $10 million gain exclusion cap through gifting QSBS to other taxpayers. [ii] Increased awareness of this planning technique has contributed to a flurry of stockholders seeking last-minute tax planning help. This article looks at whether you can “multiply” Section 1202’s gain exclusion by gifting qualified small business stock (QSBS) when a sale transaction is imminent.

This is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045. During the past several years, there has been an increase in the use of C corporations as the start-up entity of choice.  Much of this interest can be attributed to the reduction in the corporate rate from 35% to 21%, but savvy founders and investors have also focused on qualifying for Section 1202’s generous gain exclusion.  Recently proposed tax legislation sought to curb Section 1202’s benefits, but that legislation, along with the balance of President Biden’s Build Back Better bill, is currently stalled in Congress.

The Benefits of Gifting QSBS

Section 1202(h)(1) provides that if a stockholder gifts QSBS, the recipient of the gift is treated as “(A) having acquired such stock in the same manner as the transferor, and (B) having held such stock during any continuous period immediately preceding the transfer during which it was held (or treated as held under this subsection by the transferor.” This statute literally allows a holder of $100 million of QSBS to gift $10 million worth to each of nine friends, with the result that the holder and his nine friends each having the right to claim a separate $10 million gain exclusion. Under Section 1202, a taxpayer with $20 million in expected gain upon the sale of founder QSBS can increase the overall tax savings from approximately $2.4 million (based on no Federal income tax on $10 million of QSBS gain) to $4.8 million (based on no Federal income tax on $20 million of QSBS gain) by gifting $10 million worth of QSBS to friends and family. [iii]

A reasonable question to ask is whether it is ever too late to make a gift of QSBS for wealth transfer or Section 1202 gain exclusion cap planning? What about when a sale process is looming but hasn’t yet commenced? Is it too late to make a gift when a nonbinding letter of intent to sell the company has been signed? What about the situation where a binding agreement has been signed but there are various closing conditions remaining to be satisfied, perhaps including shareholder approval? Finally, is it too late to make a gift when a definitive agreement has been signed and all material conditions to closing have been satisfied?

Although neither Section 1202 nor any other tax authorities interpreting Section 1202 address whether there are any exceptions to Section 1202’s favorable treatment of gifts based on the timing of the gift, the IRS is not without potential weapons in its arsenal.

Application of the Assignment of Income Doctrine

If QSBS is gifted in close proximity to a sale, the IRS might claim that the donor stockholder was making an anticipatory assignment of income. [iv]

As first enunciated by the Supreme Court in 1930, the anticipatory assignment of income doctrine holds that income is taxable to the person who earns it, and that such taxes cannot be avoided through “arrangement[s] by which the fruits are attributed to a different tree from that on which they grew.” [v] Many assignment of income cases involve stock gifted to charities immediately before a prearranged stock sale, coupled with the donor claiming a charitable deduction for full fair market value of the gifted stock.

In Revenue Ruling 78-197, the IRS concluded in the context of a charitable contribution coupled with a prearranged redemption that the assignment of income doctrine would apply only if the donee is legally bound, or can be compelled by the corporation, to surrender shares for redemption. [vi] In the aftermath of this ruling, the Tax Court has refused to adopt a bright line test but has generally followed the ruling’s reasoning. For example, in Estate of Applestein v. Commissioner , the taxpayer gifted to custodial accounts for his children stock in a corporation that had entered into a merger agreement with another corporation. Prior to the gift, the merger agreement was approved by the stockholders of both corporations. Although the gift occurred before the closing of the merger transaction, the Tax Court held that the “right to the merger proceeds had virtually ripened prior to the transfer and that the transfer of the stock constituted a transfer of the merger proceeds rather than an interest in a viable corporation.” [vii] In contrast, in Rauenhorst v. Commissioner , the Tax Court concluded that a nonbinding letter of intent would not support the IRS’ assignment of income argument because the stockholder at the time of making the gift was not legally bound nor compelled to sell his equity. [viii]

In Ferguson v. Commissioner , the Tax Court focused on whether the percentage of shares tendered pursuant to a tender offer was the functional equivalent of stockholder approval of a merger transaction, which the court viewed as converting an interest in a viable corporation to the right to receive cash before the gifting of stock to charities. [ix] The Tax Court concluded that there was an anticipatory assignment of income in spite of the fact that there remained certain contingencies before the sale would be finalized. The Tax Court rejected the taxpayer’s argument that the application of the assignment of income doctrine should be conditioned on the occurrence of a formal stockholder vote, noting that the reality and substance of the particular events under consideration should determine tax consequences.

Guidelines for Last-Minute Gifts

Based on the guidelines established by Revenue Ruling 78-197 and the cases discussed above, the IRS should be unsuccessful if it asserts an assignment of income argument in a situation where the gift of QSBS is made prior to the signing of a definitive sale agreement, even if the company has entered into a nonbinding letter of intent. The IRS’ position should further weakened with the passage of time between the making of a gift and the entering into of a definitive sale agreement. In contrast, the IRS should have a stronger argument if the gift is made after the company enters into a binding sale agreement. And the IRS’ position should be stronger still if the gift of QSBS is made after satisfaction of most or all material closing conditions, and in particular after stockholder approval. Stockholders should be mindful of Tax Court’s comment that the reality and substance of events determines tax consequences, and that it will often be a nuanced set of facts that ultimately determines whether the IRS would be successful arguing for application of the assignment of income doctrine.

Transfers of QSBS Incident to Divorce

The general guidelines discussed above may not apply to transfers of QSBS between former spouses “incident to divorce” that are governed by Section 1041. Section 1041(b)(1) confirms that a transfer incident to divorce will be treated as a gift for Section 1202 purposes. Private Letter Ruling 9046004 addressed the situation where stock was transferred incident to a divorce and the corporation immediately redeemed the stock. In that ruling, the IRS commented that “under section 1041, Congress gave taxpayers a mechanism for determining which of the two spouses will pay the tax upon the ultimate disposition of the asset. The spouses are thus free to negotiate between themselves whether the ‘owner’ spouse will first sell the asset, recognize the gain or loss, and then transfer to the transferee spouse the proceeds from the sale, or whether the owner spouse will first transfer the asset to the transferee spouse who will then recognize gain or loss upon its subsequent sale.” Thus, while there are some tax cases where the assignment of income doctrine has been successfully asserted by the IRS in connection with transfers between spouses incident to divorce, Section 1041 and tax authorities interpreting its application do provide divorcing taxpayers an additional argument against application of the doctrine, perhaps even where the end result might be a multiplication of Section 1202’s gain exclusion.

More Resources

In spite of the potential for extraordinary tax savings, many experienced tax advisors are not familiar with QSBS planning. Venture capitalists, founders and investors who want to learn more about QSBS planning opportunities are directed to several articles on the Frost Brown Todd website:

Planning for the Potential Reduction in Section 1202’s Gain Exclusion
Section 1202 Qualification Checklist and Planning Pointers
A Roadmap for Obtaining (and not Losing) the Benefits of Section 1202 Stock
Maximizing the Section 1202 Gain Exclusion Amount
Advanced Section 1045 Planning
Recapitalizations Involving Qualified Small Business Stock
Section 1202 and S Corporations
The 21% Corporate Rate Breathes New Life into IRC § 1202
View all QSBS Resources

Contact  Scott Dolson  or  Melanie McCoy  (QSBS estate and trust planning) if you want to discuss any QSBS issues by telephone or video conference.

[i] References to “Section” are to sections of the Internal Revenue Code.

[ii] The planning technique of gifting QSBS recently came under heavy criticism in an article written by two investigative reporters. See Jesse Drucker and Maureen Farrell, The Peanut Butter Secret: A Lavish Tax Dodge for the Ultrawealthy. New York Times , December 28, 2021.

[iii] But in our opinion, in order to avoid a definite grey area in Section 1202 law, the donee should not be the stockholder’s spouse. The universe of donees includes nongrantor trusts, including Delaware and Nevada asset protection trusts.

[iv] This article assumes that the holder of the stock doesn’t have sufficient tax basis in the QSBS to take advantage of the 10X gain exclusion cap – for example, the stock might be founder shares with a basis of .0001 per share.

[v] Lucas v. Earl , 281 U.S. 111 (1930). The US Supreme Court later summarized the assignment of income doctrine as follows: “A person cannot escape taxation by anticipatory assignments, however skillfully devised, where the right to receive income has vested.” Harrison v. Schaffner , 312 U.S. 579, 582 (1941).

[vi] Revenue Ruling 78-197, 1978-1 CB 83.

[vii] Estate of Applestein v. Commissioner , 80 T.C. 331, 346 (1983).

[viii] Gerald A. Rauenhorst v. Commissioner , 119 T.C. 157 (2002).

[ix] Ferguson v. Commissioner , 108 T.C. 244 (1997).

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TAX MATTERS

Appreciated stock donation not treated as a taxable redemption

The tax court holds that taxpayers made an absolute gift..

Individual Income Taxation

The Tax Court granted summary judgment to a married couple, ruling that the IRS improperly recharacterized their charitable donations of stock as taxable redemptions. The court held the couple made an absolute gift in each tax year at issue, and although the charity soon after redeemed the stock, the court respected the form of the transaction.

Facts: Jon and Helen Dickinson claimed a charitable contribution deduction on their joint federal income tax returns for 2013 through 2015, due to a contribution each year by Jon Dickinson of appreciated stock in his employer, Geosyntec Consultants Inc. (GCI), a privately held company, to Fidelity Investments Charitable Gift Fund, a Sec. 501(c)(3) tax-exempt organization. Dickinson was GCI’s CFO.

GCI’s board of directors authorized shareholders to donate GCI shares to Fidelity in written consent actions in 2013 and 2014, stating that Fidelity’s donor-advised fund program required Fidelity “to immediately liquidate the donated stock” and that the charity “promptly tenders the donated stock to the issuer for cash.” The board also authorized donations in 2015.

GCI confirmed in letters to Fidelity the recording of Fidelity’s new ownership of the shares. Dickinson signed a letter of understanding to Fidelity regarding each stock donation, stating that the stock was “exclusively owned and controlled by Fidelity.” Fidelity sent confirmation letters stating that it had “exclusive legal control over the contributed asset.” Fidelity redeemed the GCI shares for cash shortly after each donation.

The IRS issued a notice of deficiency, asserting that the Dickinsons were liable for tax on the redemption of the donated GCI shares and a penalty under Sec. 6662(a) for each year. The Service contended the donations should be treated in substance as taxable redemptions of the shares for cash by Dickinson, followed by donations of the cash to Fidelity.

The Dickinsons petitioned the Tax Court for a redetermination of the deficiencies and penalties and moved for summary judgment.

Issue: Generally, pursuant to Sec. 170 and Regs. Sec. 1.170A-1(c)(1), a taxpayer may deduct the fair market value of appreciated property donated to a qualified charity without recognizing the gain in the property.

In Humacid Co. , 42 T.C. 894, 913 (1964), the Tax Court stated: “The law with respect to gifts of appreciated property is well established. A gift of appreciated property does not result in income to the donor so long as [1] he gives the property away absolutely and parts with title thereto [2] before the property gives rise to income by way of a sale.”

The issue before the court was whether the form of Dickinson’s donations of GCI stock should be respected as meeting the requirements in Humacid Co. , or recharacterized as taxable redemptions resulting in income to the Dickinsons.

Holding: The Tax Court held that the form of the stock donations should be respected, as both prongs of Humacid Co. were satisfied, and granted the taxpayers summary judgment.

Regarding the first prong, the court held that Dickinson transferred all his rights in the shares to Fidelity, based on GCI’s letters to Fidelity confirming the transfer of ownership in the shares, Fidelity’s letters to the Dickinsons stating it had “exclusive legal control” over the donated stock, and the letters of understanding. Thus, Dickinson made an absolute gift.

The Tax Court analyzed the second prong under the assignment-of-income doctrine. This provides that a taxpayer cannot avoid taxation by assigning a right to income to another. The court stated: “Where a donee redeems shares shortly after a donation, the assignment of income doctrine applies only if the redemption was practically certain to occur at the time of the gift, and would have occurred whether the shareholder made the gift or not.”

The Tax Court noted that in Palmer , 62 T.C. 684 (1974), it held there was no assignment of income where there was not yet a vote for a redemption at the time of a stock donation, even though the vote was anticipated. Similarly, the court reasoned that “the redemption in this case was not a fait accompli at the time of the gift” and held Dickinson did not avoid income due to the redemption by donating the GCI shares. Thus, the court respected the form of the transaction.

The Tax Court did not apply Rev. Rul. 78-197, in which the IRS ruled that it “will treat the proceeds as income to the donor under facts similar to those in the Palmer decision only if the donee is legally bound, or can be compelled by the [issuing] corporation, to surrender the shares for redemption.” The court noted that it has not adopted the revenue ruling, and furthermore, the IRS did not allege that Dickinson had a fixed right to redemption income at the time of the donation.

Dickinson , T.C. Memo. 2020-128

— By Mark Aquilio, CPA, J.D., LL.M. , professor of accounting and taxation, St. John’s University, Queens, N.Y.

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Granting partial summary judgment for the government, the U.S. District Court for the Northern District of Texas has held that the IRS properly denied a charitable deduction stemming from a couple's donation of a 4% limited partnership interest to a private foundation to establish a DAF, so the couple was not entitled to a refund for the resulting tax paid ( Kevin M. Keefer, et ux. v. United States ).

Kevin Keefer was a limited partner in Burbank HHG Hotel, LP (Burbank), which owned and operated a single hotel. On April 23, 2015, Burbank and the Apple Hospitality REIT (Apple) exchanged a nonbinding letter of intent (LOI) for Apple to purchase Burbank. Burbank had not signed the LOI and continued courting potential buyers. On June 18, 2015, Keefer assigned to Pi Foundation a 4% limited partner interest in Burbank to establish a DAF. Although Burbank had tentatively agreed to sell the hotel to Apple for $54m, the sales contract had not been signed, and Apple had not yet reviewed the property or associated records. The parties signed a sales contract on July 2, 2015, and the sale closed on August 11, 2015.

The Keefers commissioned an appraisal of the donated interest as of June 18, 2015, which:

Described the appraiser's qualifications
Did not include the appraiser's tax identification numbers
Included a "Statement of Limiting Conditions," stating that Keefer and Pi had agreed that Pi "would only share in the net proceeds from the Seller's Closing Statement [and] not in Other Assets of the Partnership not covered in the sale"

The appraisal concluded the fair market value of the donated interest was $1.257m. Pi sent Keefer a 12-page packet of documents related to establishing the DAF (DAF Packet), which he signed on June 8, 2015. In early September 2015, Pi sent Keefer a brief letter acknowledging the donation (Acknowledgment Letter).

In their timely filed joint federal income tax return for 2015, the Keefers claimed a $1.257m charitable contribution deduction for the donation to the DAF. Their Form 1040 provided their appraiser's tax identification number, the appraisal, the DAF Packet, and the Acknowledgement Letter.

The IRS issued a deficiency notice in July or August 2019, denying the charitable deduction and increasing the Keefers' 2015 tax liability by $423,304 plus penalties and accruing interest. The IRS asserted that (1) the Keefers did not have a CWA from the donee showing the DAF "has exclusive legal control over the assets contributed" and (2) their appraisal did not include the appraiser's identifying number.

The Keefers paid the additional tax and filed a refund claim in November 2019, which the IRS denied in March 2020 as untimely. In November 2019, the Keefers filed the instant refund action in district court.

District court refund claim

Both parties moved for summary judgment. The Keefers made four claims:

Claim 1 : The IRS erred in denying their deduction and refund request
Alternative Claim 2 : If the court finds the contribution was actually an anticipatory assignment of income, the Keefers are nonetheless entitled to a refund of tax, interest and penalties
Alternative Claim 3 : If the court disallows the charitable contribution deduction, the IRS should be required to recalculate the Keefers' basis in the contributed asset and refund resulting overpaid taxes, penalties and interest
Claim 4 : The court should grant summary judgment denying the IRS's defense of variance to the Keefers' two alternative claims

The government asserted that (1) the defense of variance barred the Keefers' two alternative claims and (2) the Keefers' were not entitled to any refund.

Ultimately, the court concluded that:

The Keefers' refund claim was timely
The Doctrine of Variance did not bar the taxpayers' claims
The donation was an anticipatory assignment of income
The IRS properly denied the Keefers' charitable deduction because their CWA did not meet the requirements of IRC Section 170(f)(8) and (18)
The taxpayers were not entitled to a refund of their 2015 taxes

A discussion of the last three points follows.

Assignment of income

Noting that a taxpayer may not escape tax on earned income by assigning that income to another party, the court stated, "[T]he critical question is whether the [donated] asset itself, or merely the income from it, has been transferred." The Keefers argued that their donation of the 4% interest met both prongs of the test established in Humacid Co. v. Commissioner , 42 T.C. 894 (1964), which provided that courts will respect the form of a donation of appreciated stock if the donor donates the property and title to it completely before the property produces income from a sale. Specifically, the Keefers contended that the hotel's sale to Apple remained uncertain when they assigned to Pi the 4% partnership interest, including all rights and interest pertaining to the interest. The government contended that the hotel's sale was "practically certain" at the time of the donation and "the Keefers carved out and retained a portion of the partnership asset by oral agreement."

When the Keefers signed the agreement to assign the partnership interest to Pi on June 18, 2015, the court concluded, the hotel was not yet under contract. The contract to sell the hotel was signed on July 2, 2015, and Apple had 30 days to review the property and potentially back out of the contract. Absent a binding obligation to close the sale, "the deal was not 'practically certain' to go through," the court found. The pending sale of the hotel, "even if very likely to occur considering the presence of backup offers and as reflected in the appraiser's estimate that the risk of no sale was only 5% — does not render this donation an anticipatory assignment of income," the court stated.

Turning back to the first Humacid prong, however, the court concluded that the Keefers had carved out a partial interest in the 4% partnership interest when they donated it, and thus did not give the entire interest to Pi. The Keefers asserted that their assignment of the 4% interest subject to an oral agreement that Pi would receive the net proceeds from the sale of the hotel, as opposed to other partnership assets not covered in the sale, "is not a 'carving out' from the 4% partnership interest to Pi any more than the partnership paying a liability for a pre-existing light bill is a 'carving out' from some partnership interest."

The government argued that the oral agreement showed the taxpayers "did not donate a true partnership interest [but gave] away 4% of the net cash from the sale of one of the Partnership's assets [that] the Keefers would otherwise have received from the sale of the hotel. This is a classic assignment of income."

The court rejected the Keefers' light-bill analogy, noting that the funds held back in the Keefers' transfer to Pi were funds that the general partner (1) chose to maintain to comply with loan agreements and (2) had the discretion to withhold from partner distributions. The taxpayers had not made a complete donation of the 4% interest, the court concluded, finding no genuine issue of material fact that they had carved out part of the 4% partnership interest before donating it to Pi. Thus, the anticipatory assignment of income doctrine applied.

Insufficient CWA

The court found that the CWA the Keefers received from Pi did not meet the requirements of IRC Section 170(f)(8) and (18).

The Keefers argued that the Acknowledgement Letter and DAF Packet together constitute a statutorily compliant CWA. The government contended that multiple documents cannot be combined to constitute a CWA unless the documents include a merger clause, and neither document in this case stated that Pi had "exclusive legal control" over the donated assets.

The court concluded that the CWA was not statutorily compliant; therefore, the IRS properly denied the charitable deduction. The court based this conclusion on its finding that (1) the DAF Packet did not constitute a CWA; and (2) the Acknowledgement Letter cannot supplement the DAF Packet. Specifically, the court found that the June 8, 2015 "DAF Packet did not complete the donation or legally obligate Kevin to donate the interest to Pi." The September 9, 2015 Acknowledgement Letter constituted the CWA in this case but did not meet the necessary statutory requirements because it did not "reference the Keefer DAF or otherwise affirm Pi's exclusive legal control, as required by [IRC Section] 170(f)(8)," which requires "strict compliance."

Implications

Taxpayers contemplating making a transfer to a DAF should consider the court's discussion on CWAs. As a general matter, the donee is not required to record or report the information provided on a CWA to the IRS, so the burden falls on the donor to ensure that proper documentation is received for the charitable organization. The court noted that the CWA requirements, under IRC Section 170(f)(8), required strict compliance; thus, IRC Section 170(f)(18) must also require strict compliance because it supplements and cross references IRC Section 170(f)(8): "The taxpayer obtains a [CWA] (determined under rules similar to the rules of [IRC Section 170(f)(8)(C)] from the sponsoring organization (as so defined) of such [DAF] that such organization has exclusive legal control over the assets contributed" (citing Averyt v. Commissioner , T.C. Memo. 2012-198 (internal citations omitted)).

The court noted that the specific language included in IRC Section 170(f)(18) ("exclusive legal control") was not required. Given the lack of guidance in this area, however, failure to make clear that the donee organization had exclusive legal control may result in denial of the donor's charitable deduction. Absent subsequent guidance, a more conservative approach may be for donors to DAFs to request CWAs that contain such language (e.g., "exclusive legal control of contributed assets was held by the [DAF]").

Another small, but important nuance, is that the court in Keefer rejected the government's position that the court should apply the Ninth Circuit's expanded view of the assignment of income doctrine, whereby a deal that is "practically certain to proceed" would cause the assignment of income doctrine to apply ( Ferguson v. Commissioner , 174 F.3d 997, 1003 (9th Cir. 1999)). Given the differences in approach, taxpayers should consult their tax advisor to ensure the proper precedent is being considered pursuant to any charitable contribution.

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Administrative, the irs mission, introduction, ct. d. 2080, rev. rul. 2005-23, rev. proc. 2005-22, reg-147195-04, announcement 2005-24, announcement 2005-25, definition of terms, abbreviations, numerical finding list, finding list of current actions on previously published items, internal revenue bulletin, cumulative bulletins, access the internal revenue bulletin on the internet, internal revenue bulletins on cd-rom, how to order, we welcome comments about the internal revenue bulletin, internal revenue bulletin: 2005-15.

April 11, 2005

Highlights of This Issue

These synopses are intended only as aids to the reader in identifying the subject matter covered. They may not be relied upon as authoritative interpretations.

Ct. D. 2080 Ct. D. 2080

Gross income; litigant’s recovery includes attorney’s contingent fee. The Supreme Court holds that when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee. Commissioner of Internal Revenue v . Banks.

Rev. Rul. 2005-23 Rev. Rul. 2005-23

Federal rates; adjusted federal rates; adjusted federal long-term rate and the long-term exempt rate. For purposes of sections 382, 642, 1274, 1288, and other sections of the Code, tables set forth the rates for April 2005.

T.D. 9190 T.D. 9190

Final regulations under section 664 of the Code concern the ordering rule of regulations section 1.664-1(d). The regulations provide rules for characterizing the income distributions from charitable remainder trusts (CRTs) when the income is subject to different federal income tax rates. The regulations reflect changes made to income tax rates, including capital gains and certain dividends, by the Taxpayer Relief Act of 1997, the Internal Revenue Service Restructuring and Reform Act of 1998, and the Jobs and Growth Tax Relief Reconciliation Act of 2003.

T.D. 9191 T.D. 9191

Final regulations amend regulations under section 163(d) of the Code to provide the rules relating to how and when taxpayers may elect to take qualified dividend income into account as investment income for purposes of calculating the deduction for investment income expense.

T.D. 9192 T.D. 9192

Final regulations under section 1502 of the Code provide guidance concerning the determination of the tax attributes that are available for reduction and the method for reducing those attributes when a member of a consolidated group excludes discharge of indebtedness income from gross income under section 108.

T.D. 9193 T.D. 9193

Final regulations under section 704 of the Code clarify that if section 704(c) property is sold for an installment obligation, the installment obligation is treated as the contributed property for purposes of applying sections 704(c) and 737. Likewise, if the contributed property is a contract, such as an option to acquire property, the property acquired pursuant to the contract is treated as the contributed property for these purposes.

Announcement 2005-25 Announcement 2005-25

This document contains a correction to final regulations (T.D. 9187, 2005-13 I.R.B. 778) that disallow certain losses recognized on sales of subsidiary stock by members of a consolidated group.

Announcement 2005-24 Announcement 2005-24

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

T.D. 9188 T.D. 9188

Temporary and proposed regulations under section 6103 of the Code set forth changes to the list of items of return information that the IRS discloses to the Department of Commerce for the purpose of structuring censuses and national economic accounts and conducting related statistical activities authorized by law.

REG–147195–04 REG–147195–04

Rev. proc. 2005-22 rev. proc. 2005-22.

Qualified mortgage bonds; mortgage credit certificates; national median gross income. Guidance is provided concerning the use of the national and area median gross income figures by issuers of qualified mortgage bonds and mortgage credit certificates in determining the housing cost/income ratio described in section 143(f) of the Code. Rev. Proc. 2004-24 obsoleted.

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

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

Part III.—Administrative, Procedural, and Miscellaneous. To the extent practicable, pertinent cross references to these subjects are contained in the other Parts and Subparts. Also included in this part are Bank Secrecy Act Administrative Rulings. Bank Secrecy Act Administrative Rulings are issued by the Department of the Treasury’s Office of the Assistant Secretary (Enforcement).

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

The last Bulletin for each month includes a cumulative index for the matters published during the preceding months. These monthly indexes are cumulated on a semiannual basis, and are published in the last Bulletin of each semiannual period.

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

Commissioner of internal revenue v . banks, certiorari to the united states court of appeals for the sixth circuit.

January 24, 2005 [1]

Respondent Banks settled his federal employment discrimination suit against a California state agency and respondent Banaitis settled his Oregon state case against his former employer, but neither included fees paid to their attorneys under contingent-fee agreements as gross income on their federal income tax returns. In each case petitioner Commissioner of Internal Revenue issued a notice of deficiency, which the Tax Court upheld. In Banks’ case, the Sixth Circuit reversed in part, finding that the amount Banks paid to his attorney was not includable as gross income. In Banaitis’ case, the Ninth Circuit found that because Oregon law grants attorneys a superior lien in the contingent-fee portion of any recovery, that part of Banaitis’ settlement was not includable as gross income.

Held : When a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee. Pp. 5-12.

(a) Two preliminary observations help clarify why this issue is of consequence. First, taking the legal expenses as miscellaneous itemized deductions would have been of no help to respondents because the Alternative Minimum Tax establishes a tax liability floor and does not allow such deductions. Second, the American Jobs Creation Act of 2004—which amended the Internal Revenue Code to allow a taxpayer, in computing adjusted gross income, to deduct attorney’s fees such as those at issue—does not apply here because it was passed after these cases arose and is not retroactive. Pp. 5-6.

(b) The Code defines “gross income” broadly to include all economic gains not otherwise exempted. Under the anticipatory assignment of income doctrine, a taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party, e.g., Lucas v. Earl , 281 U.S. 111, because gains should be taxed “to those who earn them,” id ., at 114. The doctrine is meant to prevent taxpayers from avoiding taxation through arrangements and contracts devised to prevent income from vesting in the one who earned it. Id ., at 115. Because the rule is preventative and motivated by administrative and substantive concerns, this Court does not inquire whether any particular assignment has a discernible tax avoidance purpose. Pp. 6-7.

(c) The Court agrees with the Commissioner that a contingent-fee agreement should be viewed as an anticipatory assignment to the attorney of a portion of the client’s income from any litigation recovery. In an ordinary case, attribution of income is resolved by asking whether a taxpayer exercises complete dominion over the income in question. However, in the context of anticipatory assignments, where the assignor may not have dominion over the income at the moment of receipt, the question is whether the assignor retains dominion over the income-generating asset. Looking to such control preserves the principle that income should be taxed to the party who earns the income and enjoys the consequent benefits. In the case of a litigation recovery, the income-generating asset is the cause of action derived from the plaintiff’s legal injury. The plaintiff retains dominion over this asset throughout the litigation. Respondents’ counterarguments are rejected. The legal claim’s value may be speculative at the moment of the assignment, but the anticipatory assignment doctrine is not limited to instances when the precise dollar value of the assigned income is known in advance. In these cases, the taxpayer retained control over the asset, diverted some of the income produced to another party, and realized a benefit by doing so. Also rejected is respondents’ suggestion that the attorney-client relationship be treated as a sort of business partnership or joint venture for tax purposes. In fact, that relationship is a quintessential principal-agent relationship, for the client retains ultimate dominion and control over the underlying claim. The attorney can make tactical decisions without consulting the client, but the client still must determine whether to settle or proceed to judgment and make, as well, other critical decisions. The attorney is an agent who is duty bound to act in the principal’s interests, and so it is appropriate to treat the full recovery amount as income to the principal. This rule applies regardless of whether the attorney-client contract or state law confers any special rights or protections on the attorney, so long as such protections do not alter the relationship’s fundamental principal-agent character. The Court declines to comment on other theories proposed by respondents and their amici , which were not advanced in earlier stages of the litigation or examined by the Courts of Appeals. Pp. 7-10.

(d) This Court need not address Banks’ contention that application of the anticipatory assignment principle would be inconsistent with the purpose of statutory fee-shifting provisions, such as those applicable in his case brought under 42 U.S.C. Secs. 1981, 1983, and 2000(e) et seq . He settled his case, and the fee paid to his attorney was calculated based solely on the contingent-fee contract. There was no court-ordered fee award or any indication in his contract with his attorney or the settlement that the contingent fee paid was in lieu of statutory fees that might otherwise have been recovered. Also, the American Jobs Creation Act redresses the concern for many, perhaps most, claims governed by fee-shifting statutes. P. 11.

No. 03-892, 345 F.3d 373; No. 03-907, 340 F.3d 1074, reversed and remanded.

KENNEDY, J., delivered the opinion of the Court, in which all other Members joined, except REHNQUIST, C.J., who took no part in the decision of the cases.

COMMISSIONER OF INTERNAL REVENUE, PETITIONER v . JOHN W. BANKS, II

On writ of certiorari to the united states court of appeals for the sixth circuit, commissioner of internal revenue, petitioner v . sigitas j. banaitis, on writ of certiorari to the united states court of appeals for the ninth circuit.

January 24, 2005

JUSTICE KENNEDY delivered the opinion of the Court.

The question in these consolidated cases is whether the portion of a money judgment or settlement paid to a plaintiff’s attorney under a contingent-fee agreement is income to the plaintiff under the Internal Revenue Code, 26 U.S.C. Sec. 1 et seq . (2000 ed. and Supp. I). The issue divides the courts of appeals. In one of the instant cases, Banks v. Commissioner , 345 F.3d 373 (2003), the Court of Appeals for the Sixth Circuit held the contingent-fee portion of a litigation recovery is not included in the plaintiff’s gross income. The Courts of Appeals for the Fifth and Eleventh Circuits also adhere to this view, relying on the holding, over Judge Wisdom’s dissent, in Cotnam v. Commissioner , 263 F.2d 119, 125-126 (CA5 1959). Srivastava v. Commissioner , 220 F.3d 353, 363-365 (CA5 2000); Foster v. United States , 249 F.3d 1275, 1279-1280 (CA11 2001). In the other case under review, Banaitis v. Commissioner , 340 F.3d 1074 (2003), the Court of Appeals for the Ninth Circuit held that the portion of the recovery paid to the attorney as a contingent fee is excluded from the plaintiff’s gross income if state law gives the plaintiff’s attorney a special property interest in the fee, but not otherwise. Six Courts of Appeals have held the entire litigation recovery, including the portion paid to an attorney as a contingent fee, is income to the plaintiff. Some of these Courts of Appeals discuss state law, but little of their analysis appears to turn on this factor. Raymond v. United States , 355 F.3d 107, 113-116 (CA2 2004); Kenseth v. Commissioner , 259 F.3d 881, 883-884 (CA7 2001); Baylin v. United States , 43 F.3d 1451, 1454-1455 (CA Fed. 1995). Other Courts of Appeals have been explicit that the fee portion of the recovery is always income to the plaintiff regardless of the nuances of state law. O’Brien v. Commissioner , 38 T.C. 707, 712 (1962), aff’d, 319 F.2d 532 (CA3 1963) ( per curiam ); Young v. Commissioner , 240 F.3d 369, 377-379 (CA4 2001); Hukkanen-Campbell v. Commissioner , 274 F.3d 1312, 1313-1314 (CA10 2001). We granted certiorari to resolve the conflict. 541 U.S. 958 (2004).

We hold that, as a general rule, when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee. We reverse the decisions of the Courts of Appeals for the Sixth and Ninth Circuits.

A. Commissioner v. Banks

In 1986, respondent John W. Banks, II, was fired from his job as an educational consultant with the California Department of Education. He retained an attorney on a contingent-fee basis and filed a civil suit against the employer in a United States District Court. The complaint alleged employment discrimination in violation of 42 U.S.C. Secs. 1981 and 1983, Title VII of the Civil Rights Act of 1964, as amended, 42 U.S.C. Sec. 2000e et seq ., and Cal. Govt. Code Ann. Sec. 12965 (West 1986). The original complaint asserted various additional claims under state law, but Banks later abandoned these. After trial commenced in 1990, the parties settled for $464,000. Banks paid $150,000 of this amount to his attorney pursuant to the fee agreement.

Banks did not include any of the $464,000 in settlement proceeds as gross income in his 1990 federal income tax return. In 1997 the Commissioner of Internal Revenue issued Banks a notice of deficiency for the 1990 tax year. The Tax Court upheld the Commissioner’s determination, finding that all the settlement proceeds, including the $150,000 Banks had paid to his attorney, must be included in Banks’ gross income.

The Court of Appeals for the Sixth Circuit reversed in part. 345 F.3d 373 (2003). It agreed the net amount received by Banks was included in gross income but not the amount paid to the attorney. Relying on its prior decision in Estate of Clarks v. Commissioner, 202 F.3d 854 (2000), the court held the contingent-fee agreement was not an anticipatory assignment of Banks’ income because the litigation recovery was not already earned, vested, or even relatively certain to be paid when the contingent-fee contract was made. A contingent-fee arrangement, the court reasoned, is more like a partial assignment of income-producing property than an assignment of income. The attorney is not the mere beneficiary of the client’s largess, but rather earns his fee through skill and diligence. 345 F.3d, at 384-385 (quoting Estate of Clarks , supra , at 857-858). This reasoning, the court held, applies whether or not state law grants the attorney any special property interest ( e.g. , a superior lien) in part of the judgment or settlement proceeds.

B. Commissioner v. Banaitis

After leaving his job as a vice president and loan officer at the Bank of California in 1987, Sigitas J. Banaitis retained an attorney on a contingent-fee basis and brought suit in Oregon state court against the Bank of California and its successor in ownership, the Mitsubishi Bank. The complaint alleged that Mitsubishi Bank willfully interfered with Banaitis’ employment contract, and that the Bank of California attempted to induce Banaitis to breach his fiduciary duties to customers and discharged him when he refused. The jury awarded Banaitis compensatory and punitive damages. After resolution of all appeals and post-trial motions, the parties settled. The defendants paid $4,864,547 to Banaitis; and, following the formula set forth in the contingent-fee contract, the defendants paid an additional $3,864,012 directly to Banaitis’ attorney.

Banaitis did not include the amount paid to his attorney in gross income on his federal income tax return, and the Commissioner issued a notice of deficiency. The Tax Court upheld the Commissioner’s determination, but the Court of Appeals for the Ninth Circuit reversed. 340 F.3d 1074 (2003). In contrast to the Court of Appeals for the Sixth Circuit, the Banaitis court viewed state law as pivotal. Where state law confers on the attorney no special property rights in his fee, the court said, the whole amount of the judgment or settlement ordinarily is included in the plaintiff’s gross income. Id ., at 1081. Oregon state law, however, like the law of some other States, grants attorneys a superior lien in the contingent-fee portion of any recovery. As a result, the court held, contingent-fee agreements under Oregon law operate not as an anticipatory assignment of the client’s income but as a partial transfer to the attorney of some of the client’s property in the lawsuit.

To clarify why the issue here is of any consequence for tax purposes, two preliminary observations are useful. The first concerns the general issue of deductibility. For the tax years in question the legal expenses in these cases could have been taken as miscellaneous itemized deductions subject to the ordinary requirements, 26 U.S.C. Secs. 67-68 (2000 ed. and Supp. I), but doing so would have been of no help to respondents because of the operation of the Alternative Minimum Tax (AMT). For noncorporate individual taxpayers, the AMT establishes a tax liability floor equal to 26 percent of the taxpayer’s “alternative minimum taxable income” (minus specified exemptions) up to $175,000, plus 28 percent of alternative minimum taxable income over $175,000. Secs. 55(a), (b) (2000 ed.). Alternative minimum taxable income, unlike ordinary gross income, does not allow any miscellaneous itemized deductions. Secs. 56(b)(1)(A)(i).

Second, after these cases arose Congress enacted the American Jobs Creation Act of 2004, 118 Stat. 1418. Section 703 of the Act amended the Code by adding Sec. 62(a)(19). Id ., at 1546. The amendment allows a taxpayer, in computing adjusted gross income, to deduct “attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination.” Ibid . The Act defines “unlawful discrimination” to include a number of specific federal statutes, Secs. 62(e)(1) to (16), any federal whistle-blower statute, Sec. 62(e)(17), and any federal, state, or local law “providing for the enforcement of civil rights” or “regulating any aspect of the employment relationship . . . or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law,” Sec. 62(e)(18). Id ., at 1547-1548. These deductions are permissible even when the AMT applies. Had the Act been in force for the transactions now under review, these cases likely would not have arisen. The Act is not retroactive, however, so while it may cover future taxpayers in respondents’ position, it does not pertain here.

The Internal Revenue Code defines “gross income” for federal tax purposes as “all income from whatever source derived.” 26 U.S.C. Sec. 61(a). The definition extends broadly to all economic gains not otherwise exempted. Commissioner v. Glenshaw Glass Co. , 348 U.S. 426, 429-430 (1955); Commissioner v. Jacobson, 336 U.S. 28, 49 (1949). A taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party. Lucas v. Earl , 281 U.S. 111 (1930); Commissioner v. Sunnen, 333 U.S. 591, 604 (1948); Helvering v. Horst , 311 U.S. 112, 116-117 (1940). The rationale for the so-called anticipatory assignment of income doctrine is the principle that gains should be taxed “to those who earn them,” Lucas, supra , at 114, a maxim we have called “the first principle of income taxation,” Commissioner v. Culbertson , 337 U.S. 733, 739-740 (1949). The anticipatory assignment doctrine is meant to prevent taxpayers from avoiding taxation through “arrangements and contracts however skillfully devised to prevent [income] when paid from vesting even for a second in the man who earned it.” Lucas , 281 U.S., at 115. The rule is preventative and motivated by administrative as well as substantive concerns, so we do not inquire whether any particular assignment has a discernible tax avoidance purpose. As Lucas explained, “no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.” Ibid .

Respondents argue that the anticipatory assignment doctrine is a judge-made antifraud rule with no relevance to contingent-fee contracts of the sort at issue here. The Commissioner maintains that a contingent-fee agreement should be viewed as an anticipatory assignment to the attorney of a portion of the client’s income from any litigation recovery. We agree with the Commissioner.

In an ordinary case, attribution of income is resolved by asking whether a taxpayer exercises complete dominion over the income in question. Glenshaw Glass Co., supra , at 431; see also Commissioner v. Indianapolis Power & Light Co ., 493 U.S. 203, 209 (1990); Commissioner v. First Security Bank of Utah , N.A. , 405 U.S. 394, 403 (1972). In the context of anticipatory assignments, however, the assignor often does not have dominion over the income at the moment of receipt. In that instance, the question becomes whether the assignor retains dominion over the income-generating asset, because the taxpayer “who owns or controls the source of the income, also controls the disposition of that which he could have received himself and diverts the payment from himself to others as the means of procuring the satisfaction of his wants.” Horst, supra , at 116-117. See also Lucas, supra , at 114-115; Helvering v. Eubank , 311 U.S. 122, 124-125 (1940); Sunnen, supra , at 604. Looking to control over the income-generating asset, then, preserves the principle that income should be taxed to the party who earns the income and enjoys the consequent benefits.

In the case of a litigation recovery, the income-generating asset is the cause of action that derives from the plaintiff’s legal injury. The plaintiff retains dominion over this asset throughout the litigation. We do not understand respondents to argue otherwise. Rather, respondents advance two counterarguments. First, they say that, in contrast to the bond coupons assigned in Horst , the value of a legal claim is speculative at the moment of assignment, and may be worth nothing at all. Second, respondents insist that the claimant’s legal injury is not the only source of the ultimate recovery. The attorney, according to respondents, also contributes income-generating assets—effort and expertise—without which the claimant likely could not prevail. On these premises respondents urge us to treat a contingent-fee agreement as establishing, for tax purposes, something like a joint venture or partnership in which the client and attorney combine their respective assets—the client’s claim and the attorney’s skill—and apportion any resulting profits.

We reject respondents’ arguments. Though the value of the plaintiff’s claim may be speculative at the moment the fee agreement is signed, the anticipatory assignment doctrine is not limited to instances when the precise dollar value of the assigned income is known in advance. Lucas, supra; United States v. Bayse , 410 U.S. 441, 445, 450-452 (1973). Though Horst involved an anticipatory assignment of a predetermined sum to be paid on a specific date, the holding in that case did not depend on ascertaining a liquidated amount at the time of assignment. In the cases before us, as in Horst , the taxpayer retained control over the income-generating asset, diverted some of the income produced to another party, and realized a benefit by doing so. As Judge Wesley correctly concluded in a recent case, the rationale of Horst applies fully to a contingent-fee contract. Raymond v. United States , 355 F.3d, at 115-116. That the amount of income the asset would produce was uncertain at the moment of assignment is of no consequence.

We further reject the suggestion to treat the attorney-client relationship as a sort of business partnership or joint venture for tax purposes. The relationship between client and attorney, regardless of the variations in particular compensation agreements or the amount of skill and effort the attorney contributes, is a quintessential principal-agent relationship. Restatement (Second) of Agency Sec. 1, Comment e (1957) (hereinafter Restatement); ABA Model Rules of Professional Conduct Rule 1.3, Comments 1, 1.7 1 (2002). The client may rely on the attorney’s expertise and special skills to achieve a result the client could not achieve alone. That, however, is true of most principal-agent relationships, and it does not alter the fact that the client retains ultimate dominion and control over the underlying claim. The control is evident when it is noted that, although the attorney can make tactical decisions without consulting the client, the plaintiff still must determine whether to settle or proceed to judgment and make, as well, other critical decisions. Even where the attorney exercises independent judgment without supervision by, or consultation with, the client, the attorney, as an agent, is obligated to act solely on behalf of, and for the exclusive benefit of, the client-principal, rather than for the benefit of the attorney or any other party. Restatement Secs. 13, 39, 387.

The attorney is an agent who is duty bound to act only in the interests of the principal, and so it is appropriate to treat the full amount of the recovery as income to the principal. In this respect Judge Posner’s observation is apt: “[T]he contingent-fee lawyer [is not] a joint owner of his client’s claim in the legal sense any more than the commission salesman is a joint owner of his employer’s accounts receivable. Kenseth , 259 F.3d, at 883. In both cases a principal relies on an agent to realize an economic gain, and the gain realized by the agent’s efforts is income to the principal. The portion paid to the agent may be deductible, but absent some other provision of law it is not excludable from the principal’s gross income.

This rule applies whether or not the attorney-client contract or state law confers any special rights or protections on the attorney, so long as these protections do not alter the fundamental principal-agent character of the relationship. Cf. Restatement Sec. 13, Comment b , and Sec. 14G, Comment a (an agency relationship is created where a principal assigns a chose in action to an assignee for collection and grants the assignee a security interest in the claim against the assignor’s debtor in order to compensate the assignee for his collection efforts). State laws vary with respect to the strength of an attorney’s security interest in a contingent fee and the remedies available to an attorney should the client discharge or attempt to defraud the attorney. No state laws of which we are aware, however, even those that purport to give attorneys an “ownership” interest in their fees, e.g. , 340 F.3d, at 1082-1083 (discussing Oregon law); Cotnam , 263 F.2d, at 125 (discussing Alabama law), convert the attorney from an agent to a partner.

Respondents and their amici propose other theories to exclude fees from income or permit deductibility. These suggestions include: (1) The contingent-fee agreement establishes a Subchapter K partnership under 26 U.S.C. Secs. 702 704, and 761, Brief for Respondent Banaitis in No. 03-907, p. 5-21; (2) litigation recoveries are proceeds from disposition of property, so the attorney’s fee should be subtracted as a capital expense pursuant to Secs. 1001, 1012, and 1016, Brief for Association of Trial Lawyers of America as Amicus Curiae 23-28, Brief for Charles Davenport as Amicus Curiae 3-13; and (3) the fees are deductible reimbursed employee business expenses under Sec. 62(a)(2)(A) (2000 ed. and Supp. I), Brief for Stephen Cohen as Amicus Curiae . These arguments, it appears, are being presented for the first time to this Court. We are especially reluctant to entertain novel propositions of law with broad implications for the tax system that were not advanced in earlier stages of the litigation and not examined by the Courts of Appeals. We decline comment on these supplementary theories. In addition, we do not reach the instance where a relator pursues a claim on behalf of the United States. Brief for Taxpayers Against Fraud Education Fund as Amicus Curia e 10-20.

The foregoing suffices to dispose of Banaitis’ case. Banks’ case, however, involves a further consideration. Banks brought his claims under federal statutes that authorize fee awards to prevailing plaintiffs’ attorneys. He contends that application of the anticipatory assignment principle would be inconsistent with the purpose of statutory fee shifting provisions. See Venegas v. Mitchell , 495 U.S. 82, 86 (1990) (observing that statutory fees enable “plaintiffs to employ reasonably competent lawyers without cost to themselves if they prevail”). In the federal system statutory fees are typically awarded by the court under the lodestar approach, Hensley v. Eckerhart , 461 U.S. 424, 433 (1983), and the plaintiff usually has little control over the amount awarded. Sometimes, as when the plaintiff seeks only injunctive relief, or when the statute caps plaintiffs’ recoveries, or when for other reasons damages are substantially less than attorney’s fees, court-awarded attorney’s fees can exceed a plaintiff’s monetary recovery. See, e.g. , Riverside v. Rivera , 477 U.S. 561, 564-565 (1986) (compensatory and punitive damages of $33,350; attorney’s fee award of $245,456.25). Treating the fee award as income to the plaintiff in such cases, it is argued, can lead to the perverse result that the plaintiff loses money by winning the suit. Furthermore, it is urged that treating statutory fee awards as income to plaintiffs would undermine the effectiveness of fee-shifting statutes in deputizing plaintiffs and their lawyers to act as private attorneys general.

We need not address these claims. After Banks settled his case, the fee paid to his attorney was calculated solely on the basis of the private contingent-fee contract. There was no court-ordered fee award, nor was there any indication in Banks’ contract with his attorney, or in the settlement agreement with the defendant, that the contingent fee paid to Banks’ attorney was in lieu of statutory fees Banks might otherwise have been entitled to recover. Also, the amendment added by the American Jobs Creation Act redresses the concern for many, perhaps most, claims governed by fee-shifting statutes.

For the reasons stated, the judgments of the Courts of Appeals for the Sixth and Ninth Circuits are reversed, and the cases are remanded for further proceedings consistent with this opinion.

THE CHIEF JUSTICE took no part in the decision of these cases.

[1] Together with No. 03–907, Commissioner of Internal Revenue v. Banaitis, on certiorari to the United States Court of Appeals for the Ninth Circuit.

Time and Manner of Making §163(d)(4)(B) Election to Treat Qualified Dividend Income as Investment Income

Department of the treasury internal revenue service 26 cfr part 1.

Internal Revenue Service (IRS), Treasury.

Final regulations and removal of temporary regulations.

This document contains final regulations relating to an election that may be made by noncorporate taxpayers to treat qualified dividend income as investment income for purposes of calculating the deduction for investment interest. The regulations reflect changes to the law made by the Jobs and Growth Tax Relief Reconciliation Act of 2003. The regulations affect taxpayers making the election under section 163(d)(4)(B) to treat qualified dividend income as investment income.

Effective Date : These regulations are effective March 18, 2005.

Applicability Dates : For dates of applicability, see §1.163(d)-1(d).

FOR FURTHER INFORMATION CONTACT:

Amy Pfalzgraf, (202) 622-4950 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

This document contains amendments to 26 CFR part 1 under section 163(d) of the Internal Revenue Code (Code). On August 5, 2004, temporary regulations (T.D. 9147, 2004-37 I.R.B. 461) were published in the Federal Register (69 FR 47364) relating to an election that may be made by noncorporate taxpayers to treat qualified dividend income as investment income for purposes of calculating the deduction for investment interest. A notice of proposed rulemaking (REG-171386-03, 2004-37 I.R.B. 477) cross-referencing the temporary regulations also was published in the Federal Register (69 FR 47395) on August 5, 2004. No comments in response to the notice of proposed rulemaking or requests to speak at a public hearing were received, and no hearing was held. This Treasury decision adopts the proposed regulations and removes the temporary regulations.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the proposed regulations preceding these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

Part 1—INCOME TAXES

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

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

Par. 2. Section 1.163(d)-1 is revised to read as follows:

§1.163(d)-1 Time and manner for making elections under the Omnibus Budget Reconciliation Act of 1993 and the Jobs and Growth Tax Relief Reconciliation Act of 2003.

(a) Description . Section 163(d)(4) (B)(iii), as added by section 13206(d) of the Omnibus Budget Reconciliation Act of 1993 (Public Law 103-66, 107 Stat. 467), allows an electing taxpayer to take all or a portion of certain net capital gain attributable to dispositions of property held for investment into account as investment income. Section 163(d)(4)(B), as amended by section 302(b) of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (Public Law 108-27, 117 Stat. 762), allows an electing taxpayer to take all or a portion of qualified dividend income, as defined in section 1(h)(11)(B), into account as investment income. As a consequence, the net capital gain and qualified dividend income taken into account as investment income under these elections are not eligible to be taxed at the capital gains rates. An election may be made for net capital gain recognized by noncorporate taxpayers during any taxable year beginning after December 31, 1992. An election may be made for qualified dividend income received by noncorporate taxpayers during any taxable year beginning after December 31, 2002, but before January 1, 2009.

(b) Time and manner for making the elections . The elections for net capital gain and qualified dividend income must be made on or before the due date (including extensions) of the income tax return for the taxable year in which the net capital gain is recognized or the qualified dividend income is received. The elections are to be made on Form 4952, “ Investment Interest Expense Deduction ,” in accordance with the form and its instructions.

(c) Revocability of elections . The elections described in this section are revocable with the consent of the Commissioner.

(d) Effective date . The rules set forth in this section regarding the net capital gain election apply beginning December 12, 1996. The rules set forth in this section regarding the qualified dividend income election apply to any taxable year beginning after December 31, 2002, but before January 1, 2009.

Par. 3. Section 1.163-1T is removed.

Approved March 10, 2005.

(Filed by the Office of the Federal Register on March 17, 2005, 8:45 a.m., and published in the issue of the Federal Register for March 18, 2005, 70 F.R. 13100)

Drafting Information

The principal author of these regulations is Amy Pfalzgraf of the Office of Associate Chief Counsel (Income Tax & Accounting). However, other personnel from the IRS and Treasury Department participated in their development.

Charitable Remainder Trusts; Application of Ordering Rule

Final regulations.

This document contains final regulations on the ordering rules of section 664(b) of the Internal Revenue Code for characterizing distributions from charitable remainder trusts (CRTs). The final regulations reflect changes made to income tax rates, including the rates applicable to capital gains and certain dividends, by the Taxpayer Relief Act of 1997, the Internal Revenue Service Restructuring and Reform Act of 1998, and the Jobs and Growth Tax Relief Reconciliation Act of 2003. The final regulations provide guidance needed to comply with these changes and affect CRTs and their beneficiaries.

Effective Date : These regulations are effective on March 16, 2005.

Applicability Dates : For dates of applicability, see §1.664-1(d)(1)(ix).

Theresa M. Melchiorre, (202) 622-7830 (not a toll-free number).

This document contains amendments to the Income Tax Regulations (26 CFR part 1) under section 664(b) of the Internal Revenue Code. On November 20, 2003, the Treasury Department and the IRS published a notice of proposed rulemaking (REG-110896-98, 2003-2 C.B. 1226) in the Federal Register (68 FR 65419). The public hearing scheduled for March 9, 2004, was cancelled because no requests to speak were received. Several written comments responding to the notice of proposed rulemaking were received. After consideration of the written comments, the proposed regulations are adopted as revised by this Treasury decision. The revisions and a summary of the comments are discussed below.

The proposed regulations reflected changes made to income tax rates, including the rates applicable to capital gains and certain dividends, by the Taxpayer Relief Act of 1997 (TRA), Public Law 105-34 (111 Stat. 788), and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), Public Law 108-27 (117 Stat. 752). These changes affect the ordering rules of section 664(b) for characterizing distributions from CRTs.

Prior to the TRA, long-term capital gains were generally subject to the same Federal income tax rate. The TRA provided, however, that gain from certain types of long-term capital assets would be subject to different Federal income tax rates. Accordingly, after May 6, 1997, a CRT could have at least three classes of long-term capital gains and losses: a class for 28-percent gain (gains and losses from collectibles and section 1202 gains); a class for unrecaptured section 1250 gain (long-term gains not treated as ordinary income that would be treated as ordinary income if section 1250(b)(1) included all depreciation); and a class for all other long-term capital gain. In addition, the TRA provided that qualified 5-year gain (as defined in section 1(h)(9) prior to amendment by the JGTRRA) would be subject to reduced capital gains tax rates under certain circumstances for certain taxpayers. For taxpayers subject to a 10-percent capital gains tax rate, qualified 5-year gain would be taxed at an 8-percent capital gains tax rate effective for taxable years beginning after December 31, 2000. For taxpayers subject to a 20-percent capital gains tax rate, qualified 5-year gain would be taxed at an 18-percent capital gains tax rate provided the holding period for the property from which the gain was derived began after December 31, 2000. As a result, a CRT could also have a class for qualified 5-year gain.

Prior to the JGTRRA, a CRT’s ordinary income was generally subject to the same Federal income tax rate. The JGTRRA provided, however, that qualified dividend income as defined in section 1(h)(11) would be subject to the Federal income tax rate applicable to the class for all other long-term capital gain. As a result, after December 31, 2002, a CRT could have a qualified dividend income class that would be subject to a different Federal income tax rate than that applicable to the CRT’s other types of ordinary income. In addition, the JGTRRA provided that qualified 5-year gain would cease to exist after May 5, 2003, but that it would return after December 31, 2008.

In response to the changes made by the TRA and the technical corrections to the TRA made by the Internal Revenue Service Restructuring and Reform Act of 1998, Public Law 105-206 (112 Stat. 685), the IRS issued guidance on the treatment of capital gains under section 664(b)(2) in Notice 98-20, 1998-1 C.B. 776, as modified by Notice 99-17, 1999-1 C.B. 871. The proposed regulations incorporated the guidance provided in Notice 98-20 and Notice 99-17. In addition, the proposed regulations provided additional guidance on the treatment of qualified dividend income under section 664(b)(1) and the treatment of a class of income that temporarily ceases to exist, like the qualified 5-year gain class.

Explanation of Provisions

The proposed regulations provided that trusts must maintain separate classes within a category of income when two classes are only temporarily subject to the same tax rate (for example, if the current tax rate applicable to one class sunsets in a future year). In the preamble to the proposed regulations, comments were requested on the degree of administrative burden and potential tax benefit or detriment of this requirement. Only one comment was received in response to this request. The commentator pointed out that maintaining a class during a temporary period of suspension could be favorable to taxpayers in one situation and unfavorable in another. For example, maintaining the qualified 5-year gain class during a temporary period of suspension would be advantageous because when the class is again in existence, gain distributed from the class probably would be taxed at a rate lower than the rates applicable to other classes of long-term capital gain. On the other hand, if the 28-percent long-term capital gain class is taxed at 15 percent during a temporary period, gain distributed from that class after the expiration of that temporary period is likely to be taxed at a rate higher than the rates applicable to other classes of long-term capital gain.

The IRS and Treasury Department continue to believe that it is appropriate for CRTs to maintain separate classes for income only temporarily taxed at the same rate, and no comment received indicated that this requirement would be unduly burdensome. Therefore, this requirement remains unchanged in the final regulations.

The proposed regulations provided that, to be eligible for inclusion in the class of qualified dividend income, dividends must meet the definition of section 1(h)(11) and must be received by the trust after December 31, 2002. Several commentators suggested that the final regulations should provide that undistributed dividends received by a CRT prior to January 1, 2003, that would otherwise meet the definition of qualified dividends under section 1(h)(11), be treated as qualified dividends.

Subsequent to the issuance of the proposed regulations, a technical correction was made to the JGTRRA by the Working Families Tax Relief Act of 2004, Public Law 108-311 (118 Stat. 1166), to provide that dividends received by a trust on or before December 31, 2002, shall not be treated as qualified dividend income as defined in section 1(h)(11). Accordingly, this suggestion has not been adopted in the final regulations.

The proposed regulations provided that, in netting capital gains and losses, a net short-term capital loss is first netted against the net long-term capital gain in each class before the long-term capital gains and losses in each class are netted against each other. One commentator suggested that this netting rule be revised to provide that the gains and losses of the long-term capital gain classes be netted prior to netting short-term capital loss against any class of long-term capital gain.

The IRS and Treasury Department believe that the netting rules for CRTs should be consistent with the netting rules applicable generally to other noncorporate taxpayers. Accordingly, the final regulations adopt this suggested change.

The proposed regulations provided that items of income within the ordinary income and capital gains categories are assigned to different classes based on the Federal income tax rate applicable to each type of income in that category in the year the items are required to be taken into account by the CRT. One commentator suggested that the assignment of items of income to different classes in the year the items are required to be taken into account by the CRT should be based on the Federal income tax rate that is likely to apply to that item in the hands of the recipient (for example, depending on the recipient’s marginal income tax rate bracket) in the year in which the item is distributed.

The final regulations do not adopt this change. It is not feasible in many instances for trustees to determine the tax bracket of beneficiaries. The IRS and Treasury Department believe that the assignment of an item to a particular class should be based upon the tax rate applicable to each class when the item is received by the CRT, and not the various tax rates applicable to the classes at the time of a distribution to the beneficiary.

The proposed regulations provided that the determination of the tax character of amounts distributed by a CRT shall be made as of the end of the taxable year of the CRT. One commentator recommended that the language in the proposed regulations be reworded to make it clear that this rule applies to all distributions made by the CRT to recipients throughout the calendar year. In response to the comment, the second sentence in §1.664-1(d)(1)(ii)( a ) is revised in the final regulations to read, “[t]he determination of the character of amounts distributed or deemed distributed at any time during the taxable year of the trust shall be made as of the end of that taxable year.”

The proposed regulations provided that the annuity or unitrust recipient is taxed on the distribution from the CRT based on the tax rates applicable in the year of the distribution to the classes of income that are deemed distributed from the trust. One commentator suggested that the language in the proposed regulations be reworded to make it clear that the tax rates applicable to a distribution or deemed distribution from a CRT to a recipient are the tax rates applicable to the classes of income from which the distribution is derived in the year of distribution, and not the tax rates applicable to the income in the year it is received by the CRT. This suggestion has been adopted. In the final regulations, the third sentence in §1.664-1(d)(1)(ii)( a ) is revised to read as follows:

The tax rate or rates to be used in computing the recipient’s tax on the distribution shall be the tax rates that are applicable, in the year in which the distribution is required to be made, to the classes of income deemed to make up that distribution, and not the tax rates that are applicable to those classes of income in the year the income is received by the trust.

One commentator suggested that a cross-reference to §1.664-1(d)(4) should be made following the above sentence. This suggestion has not been adopted because the IRS and Treasury Department do not believe that a cross reference is needed. Section 1.664-1(d)(1)(ii)( a ) confirms that a class of income will be taxed to the beneficiary at the tax rate applicable to that class in the year the distribution is made. Section 1.664-1(d)(4) identifies the year of the distribution.

One commentator proposed that the final regulations specifically address the treatment of municipal bond income and the effect of the alternative minimum tax (AMT) provisions and section 469 on CRT income. The final regulations do not address these issues, because the IRS and Treasury Department believe they are beyond the scope of these regulations. These regulations are intended to address only the income tax rates applicable to classes of income and the order in which those classes of income are to be applied to determine the character of a distribution in the hands of a recipient. The issues raised by the commentator are more appropriately addressed in separate guidance.

One commentator requested clarification of whether the ordering rules in the proposed regulations apply to a CRT that has lost its tax-exempt status under section 664(c) in the year income is distributed. Section 1.664-1(d)(1)(ii) of the proposed regulations provides that the categories and classes of income determined under §1.664-1(d)(1)(i) are used to determine the character of an annuity or unitrust distribution from the trust in the hands of the recipient, irrespective of whether the trust is exempt from taxation under section 664(c) for the year of the distribution. The final regulations retain this provision.

One commentator recommended that the IRS provide a detailed worksheet that would include all of the possible classes of income a CRT could have so that the trustees can track a CRT’s income from year to year. Because the types of income that each CRT may have can vary widely, the IRS and Treasury Department have determined that such a worksheet is not administratively feasible at this time.

One commentator recommended that a provision similar to §1.664-1(d)(4)(ii) be added to the final regulations to permit the trustee to make corrections when the trustee has made incorrect distributions as a result of mistakes in fiduciary accounting practices, suggesting that such a provision would allow the CRT to receive the benefit of any correction in the year during which the correction is made. The IRS and Treasury Department believe that the proper method to remedy such errors is the filing of amended returns, rather than a current year adjustment and, therefore, such a provision is not included in the final regulations.

One commentator requested that examples addressing the following situations be provided in the final regulations:

Situation 1 . The end result of a short-term capital loss and a combination of long-term capital gains and losses that net to a long-term capital loss;

Situation 2 . The end result when a class of income has a net-loss amount that is carried forward without affecting the tax character of distributions;

Situation 3 . The applicability of the passive loss rules under section 469 to the ordering rules of section 664(b);

Situation 4 . The applicability of the alternative minimum tax (AMT) provisions under section 55 to the ordering rules under section 664(b); and

Situation 5 . The treatment of the distribution of qualified 5-year gain between January 1, 2004, and December 31, 2008.

In response to this request, Examples 4 and 5 have been added to the final regulations. Example 4 addresses situations 1 and 2. Example 5 addresses situation 5. Examples will not be added to address situations 3 and 4 because they involve issues beyond the scope of these final regulations.

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding this regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

PART 1—INCOME TAXES

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

Par. 2. Section 1.664-1 is amended as follows:

1. Paragraph (d)(1) is revised.

2. Paragraph (d)(2) is amended by:

a. Removing the language “or to corpus (determined under subparagraph (1)(i) of this paragraph)” in the first sentence and adding “(determined under paragraph (d)(1)(i)( a ) of this section) or to corpus” in its place.

b. Removing the language “subparagraph (1)(i)(c) of this paragraph” from the fifth sentence and adding “paragraph (d)(1)(i)( a )( 3 ) of this section” in its place.

c. Removing the language “or to corpus in the categories described in subparagraph (1) of this paragraph” from the last sentence and adding “described in paragraph (d)(1)(i)( a ) of this section or to corpus” in its place.

3. Paragraph (e)(1) is amended by removing the language “paragraph (d)(1)” from the first sentence and adding “paragraph (d)(1)(i)( a )” in its place.

The revision reads as follows:

§1.664-1 Charitable remainder trusts.

(d) Treatment of annual distributions to recipients —(1) Character of distributions —(i) Assignment of income to categories and classes at the trust level . ( a ) A trust’s income, including income includible in gross income and other income, is assigned to one of three categories in the year in which it is required to be taken into account by the trust. These categories are—

( 1 ) Gross income, other than gains and amounts treated as gains from the sale or other disposition of capital assets (referred to as the ordinary income category);

( 2 ) Gains and amounts treated as gains from the sale or other disposition of capital assets (referred to as the capital gains category); and

( 3 ) Other income (including income excluded under part III, subchapter B, chapter 1, subtitle A of the Internal Revenue Code).

( b ) Items within the ordinary income and capital gains categories are assigned to different classes based on the Federal income tax rate applicable to each type of income in that category in the year the items are required to be taken into account by the trust. For example, for a trust with a taxable year ending December 31, 2004, the ordinary income category may include a class of qualified dividend income as defined in section 1(h)(11) and a class of all other ordinary income, and the capital gains category may include separate classes for short-term and long-term capital gains and losses, such as a short-term capital gain class, a 28-percent long-term capital gain class (gains and losses from collectibles and section 1202 gains), an unrecaptured section 1250 long-term capital gain class (long-term gains not treated as ordinary income that would be treated as ordinary income if section 1250(b)(1) included all depreciation), a qualified 5-year long-term capital gain class as defined in section 1(h)(9) prior to amendment by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), Public Law 108-27 (117 Stat. 752), and an all other long-term capital gain class. After items are assigned to a class, the tax rates may change so that items in two or more classes would be taxed at the same rate if distributed to the recipient during a particular year. If the changes to the tax rates are permanent, the undistributed items in those classes are combined into one class. If, however, the changes to the tax rates are only temporary (for example, the new rate for one class will sunset in a future year), the classes are kept separate.

(ii) Order of distributions . ( a ) The categories and classes of income (determined under paragraph (d)(1)(i) of this section) are used to determine the character of an annuity or unitrust distribution from the trust in the hands of the recipient irrespective of whether the trust is exempt from taxation under section 664(c) for the year of the distribution. The determination of the character of amounts distributed or deemed distributed at any time during the taxable year of the trust shall be made as of the end of that taxable year. The tax rate or rates to be used in computing the recipient’s tax on the distribution shall be the tax rates that are applicable, in the year in which the distribution is required to be made, to the classes of income deemed to make up that distribution, and not the tax rates that are applicable to those classes of income in the year the income is received by the trust. The character of the distribution in the hands of the annuity or unitrust recipient is determined by treating the distribution as being made from each category in the following order:

( 1 ) First, from ordinary income to the extent of the sum of the trust’s ordinary income for the taxable year and its undistributed ordinary income for prior years.

( 2 ) Second, from capital gain to the extent of the trust’s capital gains determined under paragraph (d)(1)(iv) of this section.

( 3 ) Third, from other income to the extent of the sum of the trust’s other income for the taxable year and its undistributed other income for prior years.

( 4 ) Finally, from trust corpus (with corpus defined for this purpose as the net fair market value of the trust assets less the total undistributed income (but not loss) in paragraphs (d)(1)(i)( a )( 1 ) through ( 3 ) of this section).

( b ) If the trust has different classes of income in the ordinary income category, the distribution from that category is treated as being made from each class, in turn, until exhaustion of the class, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest Federal income tax rate. If the trust has different classes of net gain in the capital gains category, the distribution from that category is treated as being made first from the short-term capital gain class and then from each class of long-term capital gain, in turn, until exhaustion of the class, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate. If two or more classes within the same category are subject to the same current tax rate, but at least one of those classes will be subject to a different tax rate in a future year (for example, if the current rate sunsets), the order of that class in relation to other classes in the category with the same current tax rate is determined based on the future rate or rates applicable to those classes. Within each category, if there is more than one type of income in a class, amounts treated as distributed from that class are to be treated as consisting of the same proportion of each type of income as the total of the current and undistributed income of that type bears to the total of the current and undistributed income of all types of income included in that class. For example, if rental income and interest income are subject to the same current and future Federal income tax rate and, therefore, are in the same class, a distribution from that class will be treated as consisting of a proportional amount of rental income and interest income.

(iii) Treatment of losses at the trust level —( a ) Ordinary income category . A net ordinary loss for the current year is first used to reduce undistributed ordinary income for prior years that is assigned to the same class as the loss. Any excess loss is then used to reduce the current and undistributed ordinary income from other classes, in turn, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest Federal income tax rate. If any of the loss exists after all the current and undistributed ordinary income from all classes has been offset, the excess is carried forward indefinitely to reduce ordinary income for future years and retains its class assignment. For purposes of this section, the amount of current income and prior years’ undistributed income shall be computed without regard to the deduction for net operating losses provided by section 172 or 642(d).

( b ) Other income category . A net loss in the other income category for the current year is used to reduce undistributed income in this category for prior years and any excess is carried forward indefinitely to reduce other income for future years.

(iv) Netting of capital gains and losses at the trust level . Capital gains of the trust are determined on a cumulative net basis under the rules of this paragraph (d)(1) without regard to the provisions of section 1212. For each taxable year, current and undistributed gains and losses within each class are netted to determine the net gain or loss for that class, and the classes of capital gains and losses are then netted against each other in the following order. First, a net loss from a class of long-term capital gain and loss (beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate) is used to offset net gain from each other class of long-term capital gain and loss, in turn, until exhaustion of the class, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate. Second, either —

( a ) A net loss from all the classes of long-term capital gain and loss (beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate) is used to offset any net gain from the class of short-term capital gain and loss; or

(b) A net loss from the class of short-term capital gain and loss is used to offset any net gain from each class of long-term capital gain and loss, in turn, until exhaustion of the class, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest Federal income tax rate.

(v) Carry forward of net capital gain or loss by the trust . If, at the end of a taxable year, a trust has, after the application of paragraph (d)(1)(iv) of this section, any net loss or any net gain that is not treated as distributed under paragraph (d)(1)(ii)( a )( 2 ) of this section, the net gain or loss is carried over to succeeding taxable years and retains its character in succeeding taxable years as gain or loss from its particular class.

(vi) Special transitional rules . To be eligible to be included in the class of qualified dividend income, dividends must meet the definition of section 1(h)(11) and must be received by the trust after December 31, 2002. Long-term capital gain or loss properly taken into account by the trust before January 1, 1997, is included in the class of all other long-term capital gains and losses. Long-term capital gain or loss properly taken into account by the trust on or after January 1, 1997, and before May 7, 1997, if not treated as distributed in 1997, is included in the class of all other long-term capital gains and losses. Long-term capital gain or loss (other than 28-percent gain (gains and losses from collectibles and section 1202 gains), unrecaptured section 1250 gain (long-term gains not treated as ordinary income that would be treated as ordinary income if section 1250(b)(1) included all depreciation), and qualified 5-year gain as defined in section 1(h)(9) prior to amendment by JGTRRA), properly taken into account by the trust before January 1, 2003, and distributed during 2003 is treated as if it were properly taken into account by the trust after May 5, 2003. Long-term capital gain or loss (other than 28-percent gain, unrecaptured section 1250 gain, and qualified 5-year gain), properly taken into account by the trust on or after January 1, 2003, and before May 6, 2003, if not treated as distributed during 2003, is included in the class of all other long-term capital gain. Qualified 5-year gain properly taken into account by the trust after December 31, 2000, and before May 6, 2003, if not treated as distributed by the trust in 2003 or a prior year, must be maintained in a separate class within the capital gains category until distributed. Qualified 5-year gain properly taken into account by the trust before January 1, 2003, and deemed distributed during 2003 is subject to the same current tax rate as deemed distributions from the class of all other long-term capital gain realized by the trust after May 5, 2003. Qualified 5-year gain properly taken into account by the trust on or after January 1, 2003, and before May 6, 2003, if treated as distributed by the trust in 2003, is subject to the tax rate in effect prior to the amendment of section 1(h)(9) by JGTRRA.

(vii) Application of section 643(a)(7) . For application of the anti-abuse rule of section 643(a)(7) to distributions from charitable remainder trusts, see §1.643(a)-8.

(viii) Examples . The following examples illustrate the rules in this paragraph (d)(1):

Example 1 . (i) X, a charitable remainder annuity trust described in section 664(d)(1), is created on January 1, 2003. The annual annuity amount is $100. X’s income for the 2003 tax year is as follows:

(ii) In 2003, the year this income is received by the trust, qualified dividend income is subject to a different rate of Federal income tax than interest income and is, therefore, a separate class of income in the ordinary income category. The annuity amount is deemed to be distributed from the classes within the ordinary income category, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate. Because during 2003 qualified dividend income is taxed at a lower rate than interest income, the interest income is deemed distributed prior to the qualified dividend income. Therefore, in the hands of the recipient, the 2003 annuity amount has the following characteristics:

(iii) The remaining $30 of qualified dividend income that is not treated as distributed to the recipient in 2003 is carried forward to 2004 as undistributed qualified dividend income.

Example 2 . (i) The facts are the same as in Example 1 , and at the end of 2004, X has the following classes of income:

(ii) In 2004, gain in the unrecaptured section 1250 gain class is subject to a 25-percent Federal income tax rate, and gain in the all other long-term capital gain class is subject to a lower rate. The net long-term capital loss in the 28-percent gain class is used to offset the net capital gains in the other classes of long-term capital gain and loss, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate. The $325 net loss in the 28-percent gain class reduces the $175 net gain in the unrecaptured section 1250 gain class to $0. The remaining $150 loss from the 28-percent gain class reduces the $350 gain in the all other long-term capital gain class to $200. As in Example 1 , qualified dividend income is taxed at a lower rate than interest income during 2004. The annuity amount is deemed to be distributed from all the classes in the ordinary income category and then from the classes in the capital gains category, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate. In the hands of the recipient, the 2004 annuity amount has the following characteristics:

(iii) The remaining $160 gain in the all other long-term capital gain class that is not treated as distributed to the recipient in 2004 is carried forward to 2005 as gain in that same class.

Example 3 . (i) The facts are the same as in Examples 1 and 2 , and at the end of 2005, X has the following classes of income:

(ii) There are no long-term capital losses to net against the long-term capital gains. Thus, the net short-term capital loss is used to offset the net capital gains in the classes of long-term capital gain and loss, in turn, until exhaustion of the class, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate. The $50 net short-term loss reduces the $10 net gain in the 28-percent gain class to $0. The remaining $40 net loss reduces the $135 net gain in the unrecaptured section 1250 gain class to $95. As in Examples 1 and 2 , during 2005, qualified dividend income is taxed at a lower rate than interest income; gain in the unrecaptured section 1250 gain class is taxed at 25 percent; and gain in the all other long-term capital gain class is taxed at a rate lower than 25 percent. The annuity amount is deemed to be distributed from all the classes in the ordinary income category and then from the classes in the capital gains category, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate. Therefore, in the hands of the recipient, the 2005 annuity amount has the following characteristics:

(iii) The remaining $20 gain in the unrecaptured section 1250 gain class and the $160 gain in the all other long-term capital gain class that are not treated as distributed to the recipient in 2005 are carried forward to 2006 as gains in their respective classes.

Example 4 . (i) The facts are the same as in Examples 1 , 2 and 3 , and at the end of 2006, X has the following classes of income:

(ii) A net long-term capital loss in one class is used to offset the net capital gains in the other classes of long-term capital gain and loss, in turn, until exhaustion of the class, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate. The $350 net loss in the 28-percent gain class reduces the $20 net gain in the unrecaptured section 1250 gain class to $0. The remaining $330 net loss reduces the $160 net gain in the all other long-term capital gain class to $0. As in Examples 1 , 2 and 3 , during 2006, qualified dividend income is taxed at a lower rate than interest income. The annuity amount is deemed to be distributed from all the classes in the ordinary income category and then from the classes in the capital gains category, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate. In the hands of the recipient, the 2006 annuity amount has the following characteristics:

(iii) The remaining $5 of qualified dividend income that is not treated as distributed to the recipient in 2006 is carried forward to 2007 as qualified dividend income. The $20 net loss in the short-term capital gain class and the $170 net loss in the 28-percent gain class are carried forward to 2007 as net losses in their respective classes.

Example 5 . (i) X, a charitable remainder annuity trust described in section 664(d)(1), is created on January 1, 2002. The annual annuity amount is $100. Except for qualified 5-year gain of $200 realized before May 6, 2003, but not distributed, X has no other gains or losses carried over from former years. X’s income for the 2007 tax year is as follows:

(ii) The annuity amount is deemed to be distributed from all the classes in the ordinary income category and then from the classes in the capital gains category, beginning with the class subject to the highest Federal income tax rate and ending with the class subject to the lowest rate. In 2007, gains distributed to a recipient from both the qualified 5-year gain class and the all other long-term capital gains class are taxed at a 15/5 percent tax rate. Since after December 31, 2008, gains distributed from the qualified 5-year gain class will be taxed at a lower rate than gains distributed from the other classes of long-term capital gain and loss, distributions from the qualified 5-year gain class are made after distributions from the other classes of long-term capital gain and loss. In the hands of the recipient, the 2007 annuity amount has the following characteristics:

(iii) The remaining $140 of qualified 5-year gain that is not treated as distributed to the recipient in 2007 is carried forward to 2008 as qualified 5-year gain.

(ix) Effective dates . The rules in this paragraph (d)(1) that require long-term capital gains to be distributed in the following order: first, 28-percent gain (gains and losses from collectibles and section 1202 gains); second, unrecaptured section 1250 gain (long-term gains not treated as ordinary income that would be treated as ordinary income if section 1250(b)(1) included all depreciation); and then, all other long-term capital gains are applicable for taxable years ending on or after December 31, 1998. The rules in this paragraph (d)(1) that provide for the netting of capital gains and losses are applicable for taxable years ending on or after December 31, 1998. The rule in the second sentence of paragraph (d)(1)(vi) of this section is applicable for taxable years ending on or after December 31, 1998. The rule in the third sentence of paragraph (d)(1)(vi) of this section is applicable for distributions made in taxable years ending on or after December 31, 1998. All other provisions of this paragraph (d)(1) are applicable for taxable years ending after November 20, 2003.

(Filed by the Office of the Federal Register on March 15, 2005, 8:45 a.m., and published in the issue of the Federal Register for March 16, 2005, 70 F.R. 12793)

The principal author of these regulations is Theresa M. Melchiorre, Office of Chief Counsel, IRS. Other personnel from the IRS and Treasury Department participated in their development.

Section 704(c), Installment Obligations and Contributed Contracts

This document contains final regulations under sections 704(c) and 737 relating to the tax treatment of installment obligations and property acquired pursuant to a contract. The regulations affect partners and partnerships and provide guidance necessary to comply with the law.

Effective Date: These regulations are effective November 23, 2003.

Applicability Date: For dates of applicability, see §§1.704-3(f), 1.704-4(g) and 1.737-5.

Christopher L. Trump, (202) 622-3070 (not a toll-free number).

This document contains amendments to 26 CFR part 1 under sections 704 and 737. On November 24, 2003, a notice of proposed rulemaking (REG-160330-02, 2003-2 C.B. 1230) relating to the tax treatment of installment obligations and property acquired pursuant to a contract under sections 704(c) and 737 was published in the Federal Register (68 FR 65864). A notice of correction was published in the Federal Register (69 FR 5797) on February 6, 2004. No comments were received from the public in response to the notice of proposed rulemaking. No public hearing was requested, and accordingly, no hearing was held. This Treasury decision adopts the language of the proposed regulations without change.

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the proposed regulations preceding these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Adoption of Amendments to Regulations

Par. 2. Section 1.704-3 is amended as follows:

1. The paragraph heading for (a)(8) is revised.

2. The text of paragraph (a)(8) is redesignated as paragraph (a)(8)(i).

3. A paragraph heading for newly designated paragraph (a)(8)(i) is added.

4. The first sentence of newly designated paragraph (a)(8)(i) is amended by removing the language “in which no gain or loss is recognized”.

5. Paragraphs (a)(8)(ii) and (a)(8)(iii) are added.

6. Paragraph (f) is amended by:

a. Revising the paragraph heading.

b. Amending the first sentence of paragraph (f) by removing the language “of paragraph (a)(11)” and adding “of paragraphs (a)(8)(ii), (a)(8)(iii) and (a)(11)” in its place.

c. Adding two sentences at the end of paragraph (f).

The revisions and additions read as follows:

§1.704-3 Contributed property.

(8) Special rules —(i) Disposition in a nonrecognition transaction . * * *

(ii) Disposition in an installment sale . If a partnership disposes of section 704(c) property in an installment sale as defined in section 453(b), the installment obligation received by the partnership is treated as the section 704(c) property with the same amount of built-in gain as the section 704(c) property disposed of by the partnership (with appropriate adjustments for any gain recognized on the installment sale). The allocation method for the installment obligation must be consistent with the allocation method chosen for the original property.

(iii) Contributed contracts . If a partner contributes to a partnership a contract that is section 704(c) property, and the partnership subsequently acquires property pursuant to that contract in a transaction in which less than all of the gain or loss is recognized, then the acquired property is treated as the section 704(c) property with the same amount of built-in gain or loss as the contract (with appropriate adjustments for any gain or loss recognized on the acquisition). For this purpose, the term contract includes, but is not limited to, options, forward contracts, and futures contracts. The allocation method for the acquired property must be consistent with the allocation method chosen for the contributed contract.

(f) Effective dates . * * * Paragraph (a)(8)(ii) applies to installment obligations received by a partnership in exchange for section 704(c) property on or after November 24, 2003. Paragraph (a)(8)(iii) applies to property acquired on or after November 24, 2003, by a partnership pursuant to a contract that is section 704(c) property.

Par. 3. Section 1.704-4 is amended as follows:

1. The paragraph heading for (d)(1) is revised.

2. The text of paragraph (d)(1) is redesignated as paragraph (d)(1)(i).

3. A paragraph heading for newly designated paragraph (d)(1)(i) is added.

4. Paragraphs (d)(1)(ii) and (d)(1)(iii) are added.

5. Revising paragraph (g).

§1.704-4 Distribution of contributed property.

(d) Special rules —(1) Nonrecognition transactions, installment obligations and contributed contracts — (i) Nonrecognition transactions . * * *

(ii) Installment obligations . An installment obligation received by the partnership in an installment sale (as defined in section 453(b)) of section 704(c) property is treated as the section 704(c) property for purposes of section 704(c)(1)(B) and this section to the extent that the installment obligation received is treated as section 704(c) property under §1.704-3(a)(8). See §1.737-2(d)(3) for a similar rule in the context of section 737.

(iii) Contributed contracts . Property acquired by the partnership pursuant to a contract that is section 704(c) property is treated as the section 704(c) property for purposes of section 704(c)(1)(B) and this section, to the extent that the acquired property is treated as section 704(c) property under §1.704-3(a)(8). See §1.737-2(d)(3) for a similar rule in the context of section 737.

(g) Effective dates . This section applies to distributions by a partnership to a partner on or after January 9, 1995, except that paragraphs (d)(1)(ii) and (iii) apply to distributions by a partnership to a partner on or after November 24, 2003.

Par. 4. Section 1.737-2 is amended as follows:

1. The paragraph heading for (d)(3) is revised.

2. The text of paragraph (d)(3) is redesignated (d)(3)(i).

3. A paragraph heading for newly designated (d)(3)(i) is added.

4. Paragraphs (d)(3)(ii) and (d)(3)(iii) are added.

§1.737-2 Exceptions and special rules.

(3) Nonrecognition transactions, installment sales and contributed contracts —(i) Nonrecognition transactions . * * *

(ii) Installment sales . An installment obligation received by the partnership in an installment sale (as defined in section 453(b)) of section 704(c) property is treated as the contributed property with regard to the contributing partner for purposes of section 737 to the extent that the installment obligation received is treated as section 704(c) property under §1.704-3(a)(8). See §1.704-4(d)(1) for a similar rule in the context of section 704(c)(1)(B).

(iii) Contributed contracts . Property acquired by a partnership pursuant to a contract that is section 704(c) property is treated as the contributed property with regard to the contributing partner for purposes of section 737 to the extent that the acquired property is treated as section 704(c) property under §1.704-3(a)(8). See §1.704-4(d)(1) for a similar rule in the context of section 704(c)(1)(B).

Par. 5. Section 1.737-5 is revised to read as follows:

§1.737-5 Effective dates.

Sections 1.737-1, 1.737-2, 1.737-3, and 1.737-4 apply to distributions by a partnership to a partner on or after January 9, 1995, except that §1.737-2(d)(3)(ii) and (iii) apply to distributions by a partnership to a partner on or after November 24, 2003.

Approved March 15, 2005.

(Filed by the Office of the Federal Register on March 21, 2005, 8:45 a.m., and published in the issue of the Federal Register for March 22, 2005, 70 F.R. 14394)

The principal author of these regulations is Christopher L. Trump of the Office of the Associate Chief Counsel (Passthroughs & Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

This revenue ruling provides various prescribed rates for federal income tax purposes for April 2005 (the current month). Table 1 contains the short-term, mid-term, and long-term applicable federal rates (AFR) for the current month for purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the short-term, mid-term, and long-term adjusted applicable federal rates (adjusted AFR) for the current month for purposes of section 1288(b). Table 3 sets forth the adjusted federal long-term rate and the long-term tax-exempt rate described in section 382(f). Table 4 contains the appropriate percentages for determining the low-income housing credit described in section 42(b)(2) for buildings placed in service during the current month. Finally, Table 5 contains the federal rate for determining the present value of an annuity, an interest for life or for a term of years, or a remainder or a reversionary interest for purposes of section 7520.

Guidance Under Section 1502; Application of Section 108 to Members of a Consolidated Group

Final regulations, temporary regulations, and removal of temporary regulations.

This document contains final regulations under section 1502 of the Internal Revenue Code that govern the application of section 108 when a member of a consolidated group realizes discharge of indebtedness income. These final regulations affect corporations filing consolidated returns.

Effective Date : These regulations are effective March 21, 2005.

Applicability Dates : For dates of applicability, see §1.1502-11(c)(7), §1.1502-13(g)(3)(i)(A) and (ii)(C), §1.1502-19(h)(2)(ii), §1.1502-21(h)(6), §1.1502-28(d), and §1.1502-32(h)(7).

Concerning §1.1502-11 of the final regulations, Candace B. Ewell at (202) 622-7530 (not a toll-free number), concerning all other sections of the final regulations, Amber R. Cook at (202) 622-7530 (not a toll-free number).

Background and Explanation of Provisions

This document contains amendments to 26 CFR part 1 under section 1502 of the Internal Revenue Code (Code). On September 4, 2003, temporary regulations (T.D. 9089, 2003-2 C.B. 906) (the first temporary regulations) relating to the application of section 108 to members of a consolidated group were published in the Federal Register (68 FR 52487). A notice of proposed rulemaking (REG-132760-03, 2003-2 C.B. 933) cross-referencing the first temporary regulations was published in the Federal Register for the same day (68 FR 52542). The first temporary regulations added §1.1502-28T, which provides guidance regarding the determination of the attributes that are available for reduction when a member of a consolidated group realizes discharge of indebtedness income that is excluded from gross income (excluded COD income) and the method for reducing those attributes. Section 1.1502-28T reflects a consolidated approach that is intended to reduce all attributes that are available to the debtor member.

Because the first temporary regulations may not have provided for the reduction of all the attributes that are available to the debtor member, on December 11, 2003, the IRS and Treasury Department published in the Federal Register (68 FR 69024) temporary regulations (T.D. 9098, 2003-2 C.B. 1248) (the second temporary regulations) under section 1502 amending §1.1502-28T. A notice of proposed rulemaking (REG-153319-03, 2003-2 C.B. 1256) cross-referencing the second temporary regulations was published in the Federal Register for the same day (68 FR 69062). The second temporary regulations clarify that certain attributes that arise (or are treated as arising) in a separate return year are subject to reduction when no SRLY limitation applies to the use of such attributes.

On March 15, 2004, the IRS and Treasury Department published in the Federal Register (69 FR 12069) temporary regulations (T.D. 9117, 2004-15 I.R.B. 721) (the third temporary regulations) under section 1502 amending §§1.1502-13 and 1.1502-28T. A notice of proposed rulemaking (REG-167265-03, 2004-15 I.R.B. 730) (the 2004 proposed regulations) cross-referencing the third temporary regulations was published in the Federal Register for the same day (69 FR 12091). The third temporary regulations address certain technical issues relating to the application of excluded COD income to reduce attributes under sections 108 and 1017 and §1.1502-28T.

The 2004 proposed regulations, in addition to cross-referencing the third temporary regulations, proposed amendments to §§1.1502-28T and 1.1502-11 to provide a methodology for computing consolidated taxable income and for effecting attribute reduction when there is a disposition of the stock of a member in a year during which any member realizes excluded COD income.

No public hearing was requested or held for any of the regulations described above. Written and electronic comments responding to the notices of proposed rulemaking were received. After consideration of all the comments, the proposed regulations are adopted as revised by this Treasury decision, and the affected provisions in the corresponding temporary regulations are removed. The more significant revisions are discussed below.

A. Apportionment of Net Operating Losses

In addition to adding §1.1502-28T, the first temporary regulations added several provisions to §1.1502-21T. Sections 1.1502-21 and 1.1502-21T include rules relating to the amount of consolidated net operating losses apportioned to a subsidiary when a subsidiary departs from the group. The provisions added to §1.1502-21T require a recomputation of the percentage of a consolidated net operating loss attributable to a member when a portion of the loss is carried back to a separate return year or is reduced in respect of excluded COD income, or when a member departs. Questions have arisen regarding the timing of the recomputation of the percentage of a consolidated net operating loss attributable to a member in cases in which a portion of a consolidated net operating loss is carried back to a separate return year or a portion is reduced in respect of excluded COD income. Therefore, these final regulations clarify the timing of the recomputation in these cases.

B. Timing of Asset Basis Reduction

Section 108(b)(4)(A) requires the reduction of the tax attributes listed in section 108(b)(2), including basis in property, in respect of excluded COD income after the determination of the tax imposed for the taxable year of the discharge. Section 1017(a) provides that when any portion of excluded COD income is to be applied to reduce basis, then such portion is applied to reduce the basis of any property held by the taxpayer at the beginning of the taxable year following the taxable year in which the discharge occurs. As a result of the reference in section 1017(a) to the property held by the taxpayer at the beginning of the taxable year following the taxable year in which the discharge occurs, questions have arisen regarding the appropriate time to reduce the basis of property of the taxpayer.

The IRS and Treasury Department believe that the reference in section 1017 to the property held by the taxpayer at the beginning of the taxable year following the taxable year in which the discharge occurs merely identifies those properties the basis of which are subject to reduction. It does not prescribe that basis of property should not be reduced until the beginning of the taxable year following the taxable year in which the discharge occurs. Accordingly, these regulations clarify that basis of property is subject to reduction pursuant to the rules of sections 108 and 1017 and §1.1502-28 after the determination of tax for the year during which the member realizes excluded COD income (and any prior years) and coincident with the reduction of other attributes pursuant to section 108 and §1.1502-28. However, only the basis of property held as of the beginning of the taxable year following the taxable year during which the excluded COD income is realized is available for reduction.

C. Application of Look-Through Rule

The first temporary regulations include a look-through rule that applies if the attribute of the debtor member reduced is the basis of stock of another member of the group. In these cases, corresponding reductions must be made to the attributes attributable to the lower-tier member. To effect those corresponding reductions, the lower-tier member is treated as realizing excluded COD income in the amount of the stock basis reduction. Questions have arisen regarding whether the look-through rule applies when there is a reduction in the basis of stock of a corporation that is a member of the group on the last day of the debtor’s taxable year during which the excluded COD income is realized, but is not a member of the group on the first day of the debtor’s following taxable year. For example, suppose P1 owns all of the stock of S1 and S1 owns all of the stock of S2. P1, S1, and S2 file a consolidated return. In Year 1, P1 realizes excluded COD income. On the last day of Year 1, P1 sells 50 percent of the stock of S1 to P2. P1 reduces its basis in the 50 percent of the S1 stock that it owns on the first day of Year 2 in respect of its excluded COD income. Commentators have questioned whether the look-through rule applies to reduce S1’s attributes.

The IRS and Treasury Department believe that because S1 and S2 were members of the same group on the last day of the debtor’s taxable year during which the excluded COD income was realized, it is appropriate to apply the single entity principles reflected in the look-through rule. The IRS and Treasury Department have also considered whether the look-through rule applies when there is a reduction in the basis of stock of a corporation that is not a member of the group on the last day of the debtor’s taxable year during which the excluded COD income is realized (by reason of the application of the next day rule of §1.1502-76), but is a member of the group on the first day of the debtor’s following taxable year. In these cases too, the IRS and Treasury Department believe that it is appropriate to apply the single entity principles reflected in the look-through rule. Therefore, these regulations provide that, if the basis of stock of a corporation (the lower-tier member) that is owned by another corporation (the higher-tier member) is reduced and both of such corporations are members of the same consolidated group on the last day of the higher-tier member’s taxable year that includes the date on which the excluded COD income is realized or the first day of the higher-tier member’s taxable year that follows the taxable year that includes the date on which the excluded COD income is realized, the look-through rule will apply to reduce the attributes of the lower-tier member.

D. Attributes Available for Reduction on Departure of Debtor Member

Questions have arisen regarding the identification of the attributes available for reduction in cases in which the member that realizes the excluded COD income leaves the group (for example, by reason of a stock acquisition) or the assets of the member are acquired by a corporation that is not a member of the group in a transaction to which section 381(a) applies on or prior to the last day of the consolidated return year during which the excluded COD income is realized. At least one commentator has questioned whether the attributes of other members of the group from which the debtor member departs are available for reduction in these cases. These final regulations confirm that, in such cases, the tax attributes that remain after the determination of the tax imposed on the group that belong to members of the group are available for reduction.

E. Intragroup Reorganizations and Group Structure Changes

Questions have also arisen regarding the application of the attribute reduction rules when a taxpayer that is a member of a consolidated group realizes excluded COD income during the same consolidated return year during which it transfers assets in a transaction to which section 381(a) applies to a corporation that is a member of the group immediately after the transaction. Section 1.108-7 provides that if a taxpayer realizes excluded COD income either during or after a taxable year in which the taxpayer is the distributor or transferor of assets in a transaction described in section 381(a), any tax attributes to which the acquiring corporation succeeds, including the basis of property acquired by the acquiring corporation in the transaction, must reflect the reductions required by section 108(b). If a member of the group transfers assets in a transaction to which section 381(a) applies to a corporation that is a member of the group immediately after the transaction and, as a result, the taxable year of the transferor member ends prior to the end of the consolidated return year, the basis of the transferred property following the transfer may generate depreciation deductions that are allowed in computing the group’s consolidated taxable income for the entire consolidated return year that includes the date of the discharge. Requiring the basis of the transferred property to reflect a reduction in respect of the excluded COD income immediately after the transfer could arguably violate the directive of section 108(b)(4)(A) that attributes (including basis) be reduced only after the determination of tax for the taxable year of the discharge. However, if attributes were reduced after the determination of the group’s tax for the taxable year of the discharge, it may be difficult to determine which attributes of the combined entity are attributable to the debtor member and available for reduction. For example, if after the transaction to which section 381(a) applies the acquiring corporation purchases property, it may be difficult to determine whether that property is property of the debtor the basis of which is available for reduction or property of the acquiring corporation the basis of which may not be available for reduction. Similar issues may arise with respect to other attributes of the transferor.

To address this issue, these final regulations provide that, if the taxable year of a member during which such member realizes excluded COD income ends prior to the last day of the consolidated return year and, on the first day of the taxable year of such member that follows the taxable year during which such member realizes excluded COD income, such member has a successor member, the successor member is treated as if it had realized the excluded COD income. Accordingly, all attributes of the successor member listed in section 108(b)(2) (including attributes that were attributable to the successor member prior to the date such member became a successor member) are subject to reduction prior to the attributes attributable to other members of the group. For this purpose, a successor member means a person to which the member that realizes excluded COD income transfers its assets in a transaction to which section 381(a) applies if such transferee is a member of the group immediately after the transaction. This rule avoids the difficulty of tracing attributes and property of the debtor member once the debtor member has been acquired by another member and recognizes that the direction of a transaction to which section 381(a) applies in a group may not be meaningful. These regulations provide a similar rule for cases in which a member of the group acquires the assets of another member in a transaction to which section 381(a) applies that is also a group structure change.

F. Application of Next Day Rule

Under §1.1502-76, a consolidated return must include the common parent’s items of income, gain, deduction, loss, and credit for the entire consolidated return year, and each subsidiary’s items for the portion of the year for which it is a member. A corporation that leaves a consolidated group during the tax year must generally file a short period separate return (or join in the consolidated return of another group) for the portion of the year not included in the consolidated return. If a corporation ceases to be a member during a consolidated return year, it ceases to be a member at the end of the day on which its status as a member changes, and its tax year ends at the end of that day. Under the next day rule, however, any transaction that occurs on the day the member ceases to be affiliated with the group that is properly allocable to the portion of the subsidiary’s day after the event terminating affiliation must be treated as occurring at the beginning of the following day. Commentators have questioned whether the next day rule can be applied when the debt of a subsidiary is discharged in exchange for stock of the subsidiary and, as a result of the issuance of the subsidiary’s stock to the creditor, the subsidiary ceases to be a member of the group. As a result of the application of that rule, the excluded COD income would be treated as realized at the beginning of the day following the day the subsidiary ceases to be a member of the group, rather than on the day it ceases to be a member of the group.

The IRS and Treasury Department believe that because the excluded COD income accrued in the group, it is not appropriate to apply the next day rule in these cases. Therefore, these regulations provide that the next day rule cannot be applied to treat excluded COD income as realized at the beginning of the day following the day on which it is realized.

G. Timing of Investment Adjustments

Under §1.1502-32, excluded COD income of a subsidiary results in a positive basis adjustment to the extent it is applied to reduce attributes and the reduction of the subsidiary’s attributes (other than credits) in respect of excluded COD income will generally result in a negative basis adjustment. Commentators have requested clarification regarding when these basis adjustments are effective in cases in which a subsidiary ceases to be a member of the group on or prior to the end of the consolidated return year during which a member realizes excluded COD income. Therefore, these regulations clarify that, in those cases, basis adjustments resulting from the realization of excluded COD income and from the reduction of attributes in respect thereof are made immediately after the determination of tax for the group for the consolidated return year during which the excluded COD income is realized (and any prior years) and are effective immediately before the beginning of the day following the day the member departs from the group. Therefore, if the departing member becomes a member of another group (the new group), the adjustments to the basis of the departing member’s stock in respect of the excluded COD income will not cause stock basis adjustments in the new group.

H. Elimination of Circular Stock Basis on Disposition of Member Stock

The 2004 proposed regulations provide a methodology for computing consolidated taxable income and for effecting attribute reduction when there is a disposition of member stock during the same taxable year in which any member realizes excluded COD income. The methodology is intended to prevent the reduction of tax attributes from affecting the basis of the member stock that is sold, which would affect the tax liability of the group for the taxable year of the discharge. Accordingly, the methodology limits the actual reduction of tax attributes to the amount of tax attributes available for reduction following the tentative computation of taxable income (or loss).

Commentators have noted, however, that pursuant to section 108(b)(4)(A), attributes are reduced only after the determination of tax for the taxable year of the discharge. Computing the limitation on attribute reduction based on the tax attributes remaining after a tentative computation of taxable income (or loss) does not account for the use of credits in the computation of the group’s tax liability for the taxable year of the discharge. Therefore, in response to these comments, the final regulations provide for the computation of the limitation on attribute reduction after the computation of the tax imposed by chapter 1 of the Code, rather than after the computation of taxable income (or loss).

I. Transactions Designed to Avoid the Application of the Attribute Reduction Rules

The preamble to the first temporary regulations stated that the IRS and Treasury Department are considering adopting rules under section 1502 (and possibly other Code sections) to address the effect of transitory transactions and other transactions designed to avoid the application of the rules concerning attribute reduction. The IRS and Treasury Department continue to believe that general principles (including step transaction doctrine) could be applied to disregard certain transactions that have the effect of changing the result of the application of the attribute reduction rules. Therefore, the IRS and Treasury Department have decided not to adopt any additional rules at this time.

J. Elective Retroactive Application of Final Regulation

The portion of these regulations finalizing the rules contained in §1.1502-28T apply to discharges of indebtedness that occur after March 21, 2005. Groups, however, may apply those rules in whole, but not in part, to discharges of indebtedness that occur on or before March 21, 2005, and after August 29, 2003.

These regulations also permit further retroactive application of a rule included in the third temporary regulations that prevents the potential duplication of ordinary income recapture under section 1245 that could be caused by reason of the application of both section 1245 and either section 1017(b)(3)(D) (which permits subsidiary stock to be treated as depreciable property to the extent that the subsidiary consents to a corresponding reduction in the basis of its depreciable property) or the look-through rule. This section 1245 rule provides that a reduction of the basis of subsidiary stock is treated as a deduction allowed for depreciation only to the extent that the amount by which the basis of the subsidiary stock is reduced exceeds the total amount of the attributes attributable to such subsidiary that are reduced pursuant to the subsidiary’s consent under section 1017(b)(3)(D) or as a result of the application of the look-through rule. The third temporary regulations made this special rule effective for discharges of indebtedness that occur after August 29, 2003, the effective date of the look-through rule. The IRS and Treasury Department are aware that the problem addressed by this special rule could have occurred in cases of discharges of indebtedness that occurred before August 29, 2003, if section 1017(b)(3)(D) was applied. Accordingly, these final regulations provide that groups may apply this special rule to discharges of indebtedness that occur on or before August 29, 2003, in cases in which section 1017(b)(3)(D) was applied.

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. Further, it is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that these regulations will primarily affect affiliated groups of corporations that have elected to file a consolidated return, which tend to be larger businesses. Accordingly, a regulatory flexibility analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, the notices of proposed rulemaking preceding these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Paragraph 1. The authority citation for part 1 is amended by removing the entries for §§1.1502-13T, 1.1502-19T, and 1.1502-28T and adding the following entry in numerical order to read, in part, as follows:

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

Section 1.1502-28 also issued under 26 U.S.C. 1502. * * *

Par. 2. Section 1.1502-11 is amended as follows:

1. Paragraph (b)(1) is revised.

2. Paragraph (c) is redesignated as paragraph (d).

3. New paragraph (c) is added.

The revision and addition read as follows:

§1.1502-11 Consolidated taxable income.

(b) Elimination of circular stock basis adjustments when there is no excluded COD income —(1) In general . If one member (P) disposes of the stock of another member (S), this paragraph (b) limits the use of S’s deductions and losses in the year of disposition and the carryback of items to prior years. The purpose of the limitation is to prevent P’s income or gain from the disposition of S’s stock from increasing the absorption of S’s deductions and losses, because the increased absorption would reduce P’s basis (or increase its excess loss account) in S’s stock under §1.1502-32 and, in turn, increase P’s income or gain. See paragraph (b)(3) of this section for the application of these principles to P’s deduction or loss from the disposition of S’s stock, and paragraph (b)(4) of this section for the application of these principles to multiple stock dispositions. This paragraph (b) applies only when no member realizes discharge of indebtedness income that is excluded from gross income under section 108(a) (excluded COD income) during the taxable year of the disposition. See paragraph (c) of this section for rules that apply when a member realizes excluded COD income during the taxable year of the disposition. See §1.1502-19(c) for the definition of disposition.

(c) Elimination of circular stock basis adjustments when there is excluded COD income —(1) In general . If one member (P) disposes of the stock of another member (S) in a year during which any member realizes excluded COD income, this paragraph (c) limits the use of S’s deductions and losses in the year of disposition and the carryback of items to prior years, the amount of the attributes of certain members that can be reduced in respect of excluded COD income of certain other members, and the attributes that can be used to offset an excess loss account taken into account by reason of the application of §1.1502-19(c)(1)(iii)(B). In addition to the purpose set forth in paragraph (b)(1) of this section, the purpose of these limitations is to prevent the reduction of tax attributes in respect of excluded COD income from affecting P’s income, gain, or loss on the disposition of S stock (including a disposition of S stock that results from the application of §1.1502-19(c)(1)(iii)(B)) and, in turn, affecting the attributes available for reduction pursuant to sections 108 and 1017 and §1.1502-28. See §1.1502-19(c) for the definition of disposition.

(2) Computation of tax liability, reduction of attributes, and computation of limits on absorption and reduction of attributes . If a member realizes excluded COD income in the taxable year during which P disposes of S stock, the steps used to compute tax liability, to effect the reduction of attributes, and to compute the limitations on the absorption and reduction of attributes are as follows. These steps also apply to determine whether and to what extent an excess loss account must be taken into account as a result of the application of §1.1502-19(b)(1) and (c)(1)(iii)(B).

(i) Limitation on deductions and losses to offset income or gain . First, the determination of the extent to which S’s deductions and losses for the tax year of the disposition (and its deductions and losses carried over from prior years) may offset income and gain is made pursuant to paragraphs (b)(2) and (3) of this section.

(ii) Tentative adjustment of stock basis . Second, §1.1502-32 is tentatively applied to adjust the basis of the S stock to reflect the amount of S’s income and gain included, and unlimited deductions and losses that are absorbed, in the tentative computation of taxable income or loss for the year of the disposition (and any prior years) that is made pursuant to paragraph (b)(2) of this section, but not to reflect the realization of excluded COD income and the reduction of attributes in respect thereof.

(iii) Tentative computation of stock gain or loss . Third, in the case of a disposition of S stock that does not result from the application of §1.1502-19(c)(1)(iii)(B), P’s income, gain, or loss from the disposition of S stock is computed. For this purpose, the result of the computation pursuant to paragraph (c)(2)(ii) of this section is treated as the basis of such stock.

(iv) Tentative computation of tax imposed . Fourth, the tax imposed by chapter 1 of the Internal Revenue Code for the year of disposition (and any prior years) is tentatively computed. For this purpose, in the case of a disposition of S stock that does not result from the application of §1.1502-19(c)(1)(iii)(B), the tentative computation of tax imposed takes into account P’s income, gain, or loss from the disposition of S stock computed pursuant to paragraph (c)(2)(iii) of this section. The tentative computation of tax imposed is made without regard to whether all or a portion of an excess loss account in a share of S stock is required to be taken into account pursuant to §1.1502-19(b)(1) and (c)(1)(iii)(B).

(v) Tentative reduction of attributes . Fifth, the rules of sections 108 and 1017 and §1.1502-28 are tentatively applied to reduce the attributes remaining after the tentative computation of tax imposed pursuant to paragraph (c)(2)(iv) of this section.

(vi) Actual adjustment of stock basis . Sixth, §1.1502-32 is applied to reflect the amount of S’s income and gain included, and unlimited deductions and losses that are absorbed, in the tentative computation of tax imposed for the year of the disposition (and any prior years) made pursuant to paragraph (c)(2)(iv) of this section, and the excluded COD income applied to reduce attributes and the attributes tentatively reduced in respect of the excluded COD income pursuant to paragraph (c)(2)(v) of this section.

(vii) Actual computation of stock gain or loss . Seventh, the group’s actual gain or loss on the disposition of S stock (including a disposition that results from the application of §1.1502-19(c)(1)(iii)(B)) is computed. The result of the computation pursuant to paragraph (c)(2)(vi) of this section is treated as the basis of such stock.

(viii) Actual computation of tax imposed . Eighth, the tax imposed by chapter 1 of the Internal Revenue Code for the year of the disposition (and any prior years) is computed. The actual tax imposed on the group for the year of the disposition is computed by applying the limitation computed pursuant to paragraph (c)(2)(i) of this section, and by including the gain or loss recognized on the disposition of S stock computed pursuant to paragraph (c)(2)(vii) of this section. However, attributes that were tentatively used in the computation of tax imposed pursuant to paragraph (c)(2)(iv) of this section and attributes that were tentatively reduced pursuant to paragraph (c)(2)(v) of this section cannot offset any excess loss account taken into account as a result of the application of §1.1502-19(b)(1) and (c)(1)(iii)(B).

(ix) Actual reduction of attributes . Ninth, the rules of sections 108 and 1017 and §1.1502-28 are actually applied to reduce the attributes remaining after the actual computation of tax imposed pursuant to paragraph (c)(2)(viii) of this section.

(A) S or a lower-tier corporation realizes excluded COD income . If S or a lower-tier corporation of S realizes excluded COD income, the aggregate amount of excluded COD income that is applied to reduce attributes attributable to members other than S and any lower-tier corporation of S pursuant to this paragraph (c)(2)(ix) shall not exceed the aggregate amount of excluded COD income that was tentatively applied to reduce attributes attributable to members other than S and any lower-tier corporation of S pursuant to paragraph (c)(2)(v) of this section. The amount of the actual reduction of attributes attributable to S and any lower-tier corporation of S that may be reduced in respect of the excluded COD income of S or a lower-tier corporation of S shall not be so limited.

(B) A member other than S or a lower-tier corporation realizes excluded COD income . If a member other than S or a lower-tier corporation of S realizes excluded COD income, the aggregate amount of excluded COD income that is applied to reduce attributes (other than credits) attributable to S and any lower-tier corporation of S pursuant to this paragraph (c)(2)(ix) shall not exceed the aggregate amount of excluded COD income that was tentatively applied to reduce attributes (other than credits) attributable to S and any lower-tier corporation of S pursuant to paragraph (c)(2)(v) of this section. The amount of the actual reduction of attributes attributable to any member other than S and any lower-tier corporation of S that may be reduced in respect of the excluded COD income of S or a lower-tier corporation of S shall not be so limited.

(3) Special rules . (i) If the reduction of attributes attributable to a member is prevented as a result of a limitation described in paragraph (c)(2)(ix)(B) of this section, the excluded COD income that would have otherwise been applied to reduce such attributes is applied to reduce the remaining attributes of the same type that are available for reduction under §1.1502-28(a)(4), on a pro rata basis, prior to reducing attributes of a different type. The reduction of such remaining attributes, however, is subject to any applicable limitation described in paragraph (c)(2)(ix)(B) of this section.

(ii) To the extent S’s deductions and losses in the year of disposition (or those of a lower-tier corporation of S) cannot offset income or gain because of the limitation under paragraph (b) of this section or this paragraph (c) and are not reduced pursuant to sections 108 and 1017 and §1.1502-28, such items are carried to other years under the applicable provisions of the Internal Revenue Code and regulations as if they were the only items incurred by S (or a lower-tier corporation of S) in the year of disposition. For example, to the extent S incurs an operating loss in the year of disposition that is limited and is not reduced pursuant to section 108 and §1.1502-28, the loss is treated as a separate net operating loss attributable to S arising in that year.

(4) Definition of lower-tier corporation . A corporation is a lower-tier corporation of S if all of its items of income, gain, deduction, and loss (including the absorption of deduction or loss and the reduction of attributes other than credits) would be fully reflected in P’s basis in S’s stock under §1.1502-32.

(5) Examples . For purposes of the examples in this paragraph (c), unless otherwise stated, the tax year of all persons is the calendar year, all persons use the accrual method of accounting, the facts set forth the only corporate activity, all transactions are between unrelated persons, tax liabilities are disregarded, and no election under section 108(b)(5) is made. The principles of this paragraph (c) are illustrated by the following examples:

Example 1 . Departing member realizes excluded COD income . (i) Facts . P owns all of S’s stock with a $90 basis. For Year 1, P has ordinary income of $30, and S has an $80 ordinary loss and $100 of excluded COD income from the discharge of non-intercompany indebtedness. P sells the S stock for $20 at the close of Year 1. As of the beginning of Year 2, S has Asset A with a basis of $0 and a fair market value of $20.

(ii) Analysis . The steps used to compute the tax imposed on the group, to effect the reduction of attributes, and to compute the limitations on the use and reduction of attributes are as follows:

(A) Computation of limitation on deductions and losses to offset income or gain . To determine the amount of the limitation under paragraph (c)(2)(i) of this section on S’s loss and the effect of the absorption of S’s loss on P’s basis in S’s stock under §1.1502-32(b), P’s gain or loss from the disposition of S’s stock is not taken into account. The group is tentatively treated as having a consolidated net operating loss of $50 (P’s $30 of income minus S’s $80 loss). Thus, $30 of S’s loss is unlimited and $50 of S’s loss is limited under paragraph (c)(2)(i) of this section. Under the principles of §1.1502-21(b)(2)(iv), all of the consolidated net operating loss is attributable to S.

(B) Tentative adjustment of stock basis . Then, pursuant to paragraph (c)(2)(ii) of this section, §1.1502-32 is tentatively applied to adjust the basis of S stock. For this purpose, however, adjustments attributable to the excluded COD income and the reduction of attributes in respect thereof are not taken into account. Under §1.1502-32(b), the absorption of $30 of S’s loss decreases P’s basis in S’s stock by $30 to $60.

(C) Tentative computation of stock gain or loss . Then, P’s income, gain, or loss from the sale of S stock is computed pursuant to paragraph (c)(2)(iii) of this section using the basis computed in the previous step. Thus, P is treated as recognizing a $40 loss from the sale of S stock.

(E) Tentative reduction of attributes . Next, pursuant to paragraph (c)(2)(v) of this section, the rules of sections 108 and 1017 and §1.1502-28 are tentatively applied to reduce attributes remaining after the tentative computation of the tax imposed. Pursuant to §1.1502-28(a)(2), the tax attributes attributable to S would first be reduced to take into account its $100 of excluded COD income. Accordingly, the consolidated net operating loss for Year 1 would be reduced by $50, the portion of that consolidated net operating loss attributable to S under the principles of §1.1502-21(b)(2)(iv), to $0. Then, pursuant to §1.1502-28(a)(4), S’s remaining $50 of excluded COD income would reduce the consolidated capital loss attributable to P of $40 by $40 to $0. The remaining $10 of excluded COD income would have no effect.

(F) Actual adjustment of stock basis . Pursuant to paragraph (c)(2)(vi) of this section, §1.1502-32 is applied to reflect the amount of S’s income and gain included, and unlimited deductions and losses that are absorbed, in the tentative computation of the tax imposed for the year of the disposition and the excluded COD income tentatively applied to reduce attributes and the attributes reduced in respect of the excluded COD income pursuant to the previous step. Under §1.1502-32(b), the absorption of $30 of S’s loss, the application of $90 of S’s excluded COD income to reduce attributes of P and S, and the reduction of the $50 loss attributable to S in respect of the excluded COD income results in a positive adjustment of $10 to P’s basis in the S stock. P’s basis in the S stock, therefore, is $100.

(G) Actual computation of stock gain or loss . Pursuant to paragraph (c)(2)(vii) of this section, P’s actual gain or loss on the sale of the S stock is computed using the basis computed in the previous step. Accordingly, P recognizes an $80 loss on the disposition of the S stock.

(H) Actual computation of tax imposed . Pursuant to paragraph (c)(2)(viii) of this section, the tax imposed is computed by taking into account P’s $80 loss from the sale of S stock. Before the application of §1.1502-28, therefore, the group has a consolidated net operating loss of $50 that is wholly attributable to S under the principles of §1.1502-21(b)(2)(iv), and a consolidated capital loss of $80 that is wholly attributable to P under the principles of §1.1502-21(b)(2)(iv).

(I) Actual reduction of attributes . Pursuant to paragraph (c)(2)(ix) of this section, sections 108 and 1017 and §1.1502-28 are then actually applied to reduce attributes remaining after the actual computation of the tax imposed. Pursuant to §1.1502-28(a)(2), the tax attributes attributable to S must first be reduced to take into account its $100 of excluded COD income. Accordingly, the consolidated net operating loss for Year 1 is reduced by $50, the portion of that consolidated net operating loss attributable to S under the principles of §1.1502-21(b)(2)(iv), to $0. Then, pursuant to §1.1502-28(a)(4), S’s remaining $50 of excluded COD income reduces consolidated tax attributes. In particular, without regard to the limitation imposed by paragraph (c)(2)(ix)(A) of this section, the $80 consolidated capital loss, which under the principles of §1.1502-21(b)(2)(iv) is attributable to P, would be reduced by $50 from $80 to $30. However, the limitation imposed by paragraph (c)(2)(ix)(A) of this section prevents the reduction of the consolidated capital loss attributable to P by more than $40. Therefore, the consolidated capital loss attributable to P is reduced by only $40 in respect of S’s excluded COD income. The remaining $10 of excluded COD income has no effect.

Example 2 . Member other than departing member realizes excluded COD income . (i) Facts . P owns all of S1’s and S2’s stock. P’s basis in S2’s stock is $600. For Year 1, P has ordinary income of $30, S1 has a $100 ordinary loss and $100 of excluded COD income from the discharge of non-intercompany indebtedness, and S2 has $200 of ordinary loss. P sells the S2 stock for $600 at the close of Year 1. As of the beginning of Year 2, S1 has Asset A with a basis of $0 and a fair market value of $10.

(A) Computation of limitation on deductions and losses to offset income or gain . To determine the amount of the limitation under paragraph (c)(2)(i) of this section on S2’s loss and the effect of the absorption of S2’s loss on P’s basis in S2’s stock under §1.1502-32(b), P’s gain or loss from the sale of S2’s stock is not taken into account. The group is tentatively treated as having a consolidated net operating loss of $270 (P’s $30 of income minus S1’s $100 loss and S2’s $200 loss). Consequently, $20 of S2’s loss from Year 1 is unlimited and $180 of S2’s loss from Year 1 is limited under paragraph (c)(2)(i) of this section. Under the principles of §1.1502-21(b)(2)(iv), $90 of the consolidated net operating loss is attributable to S1 and $180 of the consolidated net operating loss is attributable to S2.

(B) Tentative adjustment of stock basis . Then, pursuant to paragraph (c)(2)(ii) of this section, §1.1502-32 is tentatively applied to adjust the basis of S2’s stock. For this purpose, however, adjustments to the basis of S2’s stock attributable to the reduction of attributes in respect of S1’s excluded COD income are not taken into account. Under §1.1502-32(b), the absorption of $20 of S2’s loss decreases P’s basis in S2’s stock by $20 to $580.

(C) Tentative computation of stock gain or loss . Then, P’s income, gain, or loss from the disposition of S2 stock is computed pursuant to paragraph (c)(2)(iii) of this section using the basis computed in the previous step. Thus, P is treated as recognizing a $20 gain from the sale of the S2 stock.

(D) Tentative computation of tax imposed . Pursuant to paragraph (c)(2)(iv) of this section, the tax imposed for the year of disposition is then tentatively computed, taking into account P’s $20 gain from the sale of S2 stock computed pursuant to paragraph (c)(2)(iii) of this section. Although S2’s limited loss cannot be used to offset P’s $20 gain from the sale of S2’s stock under the rules of this section, S1’s loss will offset that gain. Therefore, the group is tentatively treated as having a consolidated net operating loss of $250, $70 of which is attributable to S1 and $180 of which is attributable to S2 under the principles of §1.1502-21(b)(2)(iv).

(E) Tentative reduction of attributes . Next, pursuant to paragraph (c)(2)(v) of this section, the rules of sections 108 and 1017 and §1.1502-28 are tentatively applied to reduce attributes remaining after the tentative computation of the tax imposed. Pursuant to §1.1502-28(a)(2), the tax attributes attributable to S1 would first be reduced to take into account its $100 of excluded COD income. Accordingly, the consolidated net operating loss for Year 1 would be reduced by $70, the portion of that consolidated net operating loss attributable to S1 under the principles of §1.1502-21(b)(2)(iv), to $0. Then, pursuant to §1.1502-28(a)(4), S1’s remaining $30 of excluded COD income would reduce the consolidated net operating loss for Year 1 attributable to S2 of $180 by $30 to $150.

(F) Actual adjustment of stock basis . Pursuant to paragraph (c)(2)(vi) of this section, §1.1502-32 is applied to reflect the amount of S2’s income and gain included, and unlimited deductions and losses that are absorbed, in the tentative computation of the tax imposed for the year of the disposition and the excluded COD income tentatively applied to reduce attributes and the attributes reduced in respect of the excluded COD income pursuant to the previous step. Under §1.1502-32(b), the absorption of $20 of S2’s loss to offset a portion of P’s income and the application of $30 of S1’s excluded COD income to reduce attributes attributable to S2 results in a negative adjustment of $50 to P’s basis in the S2 stock. P’s basis in the S2 stock, therefore, is $550.

(G) Actual computation of stock gain or loss . Pursuant to paragraph (c)(2)(vii) of this section, P’s actual gain or loss on the sale of the S2 stock is computed using the basis computed in the previous step. Therefore, P recognizes a $50 gain on the disposition of the S2 stock.

(H) Actual computation of tax imposed . Pursuant to paragraph (c)(2)(viii) of this section, the tax imposed is computed by taking into account P’s $50 gain from the disposition of the S2 stock. Before the application of §1.1502-28, therefore, the group has a consolidated net operating loss of $220, $40 of which is attributable to S1 and $180 of which is attributable to S2 under the principles of §1.1502-21(b)(2)(iv).

(I) Actual reduction of attributes . Pursuant to paragraph (c)(2)(ix) of this section, sections 108 and 1017 and §1.1502-28 are then actually applied to reduce attributes remaining after the actual computation of the tax imposed. Pursuant to §1.1502-28(a)(2), the tax attributes attributable to S1 must first be reduced to take into account its $100 of excluded COD income. Accordingly, the consolidated net operating loss for Year 1 is reduced by $40, the portion of that consolidated net operating loss attributable to S1 under the principles of §1.1502-21(b)(2)(iv), to $0. Then, pursuant to §1.1502-28(a)(4), without regard to the limitation imposed by paragraph (c)(2)(ix)(B) of this section, S1’s remaining $60 of excluded COD income would reduce S2’s net operating loss of $180 to $120. However, the limitation imposed by paragraph (c)(2)(ix)(B) of this section prevents the reduction of S2’s loss by more than $30. Therefore, S2’s loss of $180 is reduced by $30 to $150 in respect of S1’s excluded COD income. The remaining $30 of excluded COD income has no effect.

Example 3 . Lower-tier corporation of departing member realizes excluded COD income . (i) Facts . P owns all of S1’s stock, S2’s stock, and S3’s stock. S1 owns all of S4’s stock. P’s basis in S1’s stock is $50 and S1’s basis in S4’s stock is $50. For Year 1, P has $50 of ordinary loss, S1 has $100 of ordinary loss, S2 has $150 of ordinary loss, S3 has $50 of ordinary loss, and S4 has $50 of ordinary loss and $80 of excluded COD income from the discharge of non-intercompany indebtedness. P sells the S1 stock for $100 at the close of Year 1. As of the beginning of Year 2, S4 has Asset A with a fair market value of $10. After the computation of tax imposed for Year 1 and before the application of sections 108 and 1017 and §1.1502-28, Asset A has a basis of $0.

(A) Computation of limitation on deductions and losses to offset income or gain . To determine the amount of the limitation under paragraph (c)(2)(i) of this section on S1’s and S4’s losses and the effect of the absorption of S1’s and S4’s losses on P’s basis in S1’s stock under §1.1502-32(b), P’s gain or loss from the sale of S1’s stock is not taken into account. The group is tentatively treated as having a consolidated net operating loss of $400. Consequently, $100 of S1’s loss and $50 of S4’s loss is limited under paragraph (c)(2)(i) of this section.

(B) Tentative adjustment of stock basis . Then, pursuant to paragraph (c)(2)(ii) of this section, §1.1502-32 is tentatively applied to adjust the basis of S1’s stock. For this purpose, adjustments to the basis of S1’s stock attributable to S4’s realization of excluded COD income and the reduction of attributes in respect of such excluded COD income are not taken into account. There is no adjustment under §1.1502-32 to the basis of the S1 stock. Therefore, P’s basis in the S1 stock for this purpose is $50.

(C) Tentative computation of stock gain or loss . Then, P’s income, gain, or loss from the sale of S1 stock is computed pursuant to paragraph (c)(2)(iii) of this section using the basis computed in the previous step. Thus, P is treated as recognizing a $50 gain from the sale of the S1 stock.

(D) Tentative computation of tax imposed . Pursuant to paragraph (c)(2)(iv) of this section, the tax imposed for the year of disposition is then tentatively computed, taking into account P’s $50 gain from the sale of the S1 stock computed pursuant to paragraph (c)(2)(iii) of this section. Although S1’s and S4’s limited losses cannot be used to offset P’s $50 gain from the sale of S1’s stock under the rules of this section, $10 of P’s loss, $30 of S2’s loss, and $10 of S3’s loss will offset that gain. Therefore, the group is tentatively treated as having a consolidated net operating loss of $350, $40 of which is attributable to P, $100 of which is attributable to S1, $120 of which is attributable to S2, $40 of which is attributable to S3, and $50 of which is attributable to S4 under the principles of §1.1502-21(b)(2)(iv).

(E) Tentative reduction of attributes . Next, pursuant to paragraph (c)(2)(v) of this section, the rules of sections 108 and 1017 and §1.1502-28 are tentatively applied to reduce attributes remaining after the tentative computation of the tax imposed. Pursuant to §1.1502-28(a)(2), the tax attributes attributable to S4 would first be reduced to take into account its $80 of excluded COD. Accordingly, the consolidated net operating loss for Year 1 would be reduced by $50, the portion of the consolidated net operating loss attributable to S4 under the principles of §1.1502-21(b)(2)(iv), to $300. Then, pursuant to §1.1502-28(a)(4), S4’s remaining $30 of excluded COD income would reduce the consolidated net operating loss for Year 1 that is attributable to other members. Therefore, the consolidated net operating loss for Year 1 would be reduced by $30. Of that amount, $4 is attributable to P, $10 is attributable to S1, $12 is attributable to S2, and $4 is attributable to S3.

(F) Actual adjustment of stock basis . Pursuant to paragraph (c)(2)(vi) of this section, §1.1502-32 is applied to reflect the amount of S1’s and S4’s income and gain included, and unlimited deductions and losses that are absorbed, in the tentative computation of tax imposed for the year of the disposition and the excluded COD income tentatively applied to reduce attributes and the attributes reduced in respect of the excluded COD income pursuant to the previous step. Under §1.1502-32(b), the application of $80 of S4’s excluded COD income to reduce attributes, and the reduction of S4’s loss in the amount of $50 and S1’s loss in the amount of $10 in respect of the excluded COD income results in a positive adjustment of $20 to P’s basis in the S1 stock. Accordingly, P’s basis in S1 stock is $70.

(G) Actual computation of stock gain or loss . Pursuant to paragraph (c)(2)(vii) of this section, P’s actual gain or loss on the sale of the S1 stock is computed using the basis computed in the previous step. Accordingly, P recognizes a $30 gain on the disposition of the S1 stock.

(H) Actual computation of tax imposed . Pursuant to paragraph (c)(2)(viii) of this section, the tax imposed is computed by taking into account P’s $30 gain from the sale of S1 stock. Before the application of §1.1502-28, therefore, the group has a consolidated net operating loss of $370, $44 of which is attributable to P, $100 of which is attributable to S1, $132 of which is attributable to S2, $44 of which is attributable to S3, and $50 of which is attributable to S4.

(I) Actual reduction of attributes . Pursuant to paragraph (c)(2)(ix) of this section, sections 108 and 1017 and §1.1502-28 are then actually applied to reduce attributes remaining after the actual computation of the tax imposed. Pursuant to §1.1502-28(a)(2), the tax attributes attributable to S4 must first be reduced to take into account its $80 of excluded COD income. Accordingly, the consolidated net operating loss for Year 1 is reduced by $50, the portion of that consolidated net operating loss attributable to S4 under the principles of §1.1502-21(b)(2)(iv), to $320. Then, pursuant to §1.1502-28(a)(4), without regard to the limitation imposed by paragraph (c)(2)(ix)(A) of this section, S4’s remaining $30 of excluded COD income would reduce the consolidated net operating loss for Year 1 by $30 ($4.12 of the consolidated net operating loss attributable to P, $9.38 of the consolidated net operating loss attributable to S1, $12.38 of the consolidated net operating loss attributable to S2, and $4.12 of the consolidated net operating loss attributable to S3) to $290. However, the limitation imposed by paragraph (c)(2)(ix)(A) of this section prevents the reduction of the consolidated net operating loss attributable to P, S2, and S3 by more than $4, $12, and $4 respectively. The $.62 of excluded COD income that would have otherwise reduced the consolidated net operating loss attributable to P, S2, and S3 is applied to reduce the consolidated net operating loss attributable to S1. Therefore, S1 carries forward $90 of loss.

Example 4 . Excess loss account taken into account . (i) Facts . P is the common parent of a consolidated group. On Day 1 of Year 2, P acquired all of the stock of S1. As of the beginning of Year 2, S1 had a $30 net operating loss carryover from Year 1, a separate return limitation year. A limitation under §1.1502-21(c) applies to the use of that loss by the P group. For Years 1 and 2, the P group had no consolidated taxable income or loss. On Day 1 of Year 3, S1 acquired all of the stock of S2 for $10. In Year 3, P had ordinary income of $10, S1 had ordinary income of $25, and S2 had an ordinary loss of $50. In addition, in Year 3, S2 realized $20 of excluded COD income from the discharge of non-intercompany indebtedness. After the discharge of this indebtedness, S2 had no liabilities. As of the beginning of Year 4, S2 had Asset A with a fair market value of $10. After the computation of tax imposed for Year 3 and before the application of sections 108 and 1017 and §1.1502-28, Asset A has a basis of $0. S2 had no taxable income (or loss) for Year 1 and Year 2.

(A) Computation of limitation on deductions and losses to offset income or gain, tentative basis adjustments, tentative computation of stock gain or loss . Because it is not initially apparent that there has been a disposition of stock, paragraph (c)(2)(i) of this section does not limit the use of deductions to offset income or gain, no adjustments to the basis are required pursuant to paragraph (c)(2)(ii) of this section, and no stock gain or loss is computed pursuant to paragraph (c)(2)(iii) of this section or taken into account in the tentative computation of tax imposed pursuant to paragraph (c)(2)(iv) of this section.

(B) Tentative computation of tax imposed . Pursuant to paragraph (c)(2)(iv) of this section, the tax imposed for Year 3 is tentatively computed. For Year 3, the P group has a consolidated taxable loss of $15, all of which is attributable to S2 under the principles of §1.1502-21(b)(2)(iv).

(C) Tentative reduction of attributes . Next, pursuant to paragraph (c)(2)(v) of this section, the rules of sections 108 and 1017 and §1.1502-28 are tentatively applied to reduce attributes remaining after the tentative computation of tax imposed. Pursuant to §1.1502-28(a)(2), the tax attributes attributable to S2 would first be reduced to take into account its $20 of excluded COD income. Accordingly, the consolidated net operating loss for Year 3 is reduced by $15, the portion of that consolidated net operating loss attributable to S2 under the principles of §1.1502-21(b)(2)(iv), to $0. The remaining $5 of excluded COD income is not applied to reduce attributes as there are no remaining attributes that are subject to reduction.

(D) Actual adjustment of stock basis . Pursuant to paragraph (c)(2)(vi) of this section, §1.1502-32 is applied to reflect the amount of S2’s income and gain included, and unlimited deductions and losses that are absorbed, in the tentative computation of tax imposed for the year of the disposition and the excluded COD income tentatively applied to reduce attributes and the attributes reduced in respect of the excluded COD income pursuant to the previous step. Under §1.1502-32, the absorption of $35 of S2’s loss, the application of $15 in respect of S2’s excluded COD income to reduce attributes, and the reduction of $15 in respect of the loss attributable to S2 reduced in respect of the excluded COD income results in a negative adjustment of $35 to the basis of the S2 stock. Therefore, S1 has an excess loss account of $25 in the S2 stock.

(E) Actual computation of stock gain or loss . Pursuant to paragraph (c)(2)(vii) of this section, S1’s actual gain or loss, if any, on the S2 stock is computed. Because S2 realized $5 of excluded COD income that was not applied to reduce attributes, pursuant to §1.1502-19(b)(1) and (c)(1)(iii)(B), S1 is required to take into account $5 of its excess loss account in the S2 stock.

(F) Actual computation of tax imposed . Pursuant to paragraph (c)(2)(viii) of this section, the tax imposed is computed by taking into account the $5 of the excess loss account in the S2 stock required to be taken into account. See §1.1502-28(b)(6) (requiring an excess loss account that is required to be taken into account as a result of the application of §1.1502-19(c)(1)(iii)(B) to be included in the group’s tax return for the year that includes the date of the debt discharge). However, pursuant to paragraph (c)(2)(viii) of this section, such amount may not be offset by any of the consolidated net operating loss attributable to S2. It may, however, subject to applicable limitations, be offset by the separate net operating loss of S1 from Year 1.

(G) Actual reduction of attributes . Pursuant to paragraph (c)(2)(ix) of this section, sections 108 and 1017 and §1.1502-28 are then actually applied to reduce attributes remaining after the actual computation of the tax imposed. Attributes will be actually reduced in the same way that they were tentatively reduced.

(6) Additional rules for multiple dispositions . [Reserved].

(7) Effective date . This paragraph (c) applies to dispositions of subsidiary stock that occur after March 22, 2005. Taxpayers may apply §1.1502-11(c) of REG-167265-03, 2004-15 I.R.B. 730 (see §601.601(d)(2) of this chapter) in whole, but not in part, to any disposition of subsidiary stock that occurs on or before March 22, 2005, if a member of the group realized excluded COD income after August 29, 2003, in the taxable year that includes the date of the disposition of such subsidiary stock.

Par. 3. Section 1.1502-13 is amended as follows:

1. Three sentences are added at the end of paragraph (g)(3)(i)(A).

2. Paragraph (g)(3)(ii)(B) is revised.

3. Paragraph (g)(3)(ii)(C) is added.

The revision and additions read as follows:

§1.1502-13 Intercompany transactions.

(A) * * * For purposes of the preceding sentence, a reduction of the basis of an intercompany obligation pursuant to sections 108 and 1017 and 1.1502-28 is not a comparable transaction. Notwithstanding paragraph (l) of this section, the preceding sentence applies to transactions or events occurring during a taxable year the original return for which is due (without regard to extensions) after March 21, 2005. For transactions or events occurring during a taxable year the original return for which is due (without regard to extensions) on or before March 21, 2005, and after March 12, 2004, see §1.1502-13T(g)(3)(ii)(B)( 3 ) as contained in 26 CFR part 1 revised as of April 1, 2004.

(B) Timing and attributes . For purposes of applying the matching rule and the acceleration rule —

( 1 ) Paragraph (c)(6)(ii) of this section (limitation on treatment of intercompany income or gain as excluded from gross income) does not apply to prevent any intercompany income or gain from being excluded from gross income;

( 2 ) Paragraph (c)(6)(i) of this section (treatment of intercompany items if corresponding items are excluded or nondeductible) will not apply to exclude any amount of income or gain attributable to a reduction of the basis of an intercompany obligation pursuant to sections 108 and 1017 and §1.1502-28; and

( 3 ) Any gain or loss from an intercompany obligation is not subject to section 108(a), section 354 or section 1091.

(C) Effective date . Notwithstanding paragraph (l) of this section, paragraph (g)(3)(ii)(B) of this section applies to transactions or events occurring during a taxable year the original return for which is due (without regard to extensions) after March 12, 2004. For transactions or events occurring during a taxable year the original return for which is due (without regard to extensions) on or before March 12, 2004, see §1.1502-13(g)(3)(ii)(B) as contained in 26 CFR part 1 revised as of April 1, 2003.

§1.1502-13T [Removed]

Par. 4. Section 1.1502-13T is removed.

Par. 5. Section 1.1502-19 is amended as follows:

2. Paragraph (h)(2)(ii) is revised.

The revisions read as follows:

§1.1502-19 Excess loss accounts.

(1) Operating rules —(i) General rule . Except as provided in paragraph (b)(1)(ii) of this section, if P is treated under this section as disposing of a share of S’s stock, P takes into account its excess loss account in the share as income or gain from the disposition.

(ii) Special limitation on amount taken into account . Notwithstanding paragraph (b)(1)(i) of this section, if P is treated as disposing of a share of S’s stock as a result of the application of paragraph (c)(1)(iii)(B) of this section, the aggregate amount of its excess loss account in the shares of S’s stock that P takes into account as income or gain from the disposition shall not exceed the amount of S’s indebtedness that is discharged that is neither included in gross income nor treated as tax-exempt income under §1.1502-32(b)(3)(ii)(C)( 1 ). If more than one share of S’s stock has an excess loss account, such excess loss accounts shall be taken into account pursuant to the preceding sentence, to the extent possible, in a manner that equalizes the excess loss accounts in S’s shares that have an excess loss account.

(iii) Treatment of disposition . Except as provided in paragraph (b)(4) of this section, the disposition is treated as a sale or exchange for purposes of determining the character of the income or gain.

(ii) Application of special limitation . If P was treated as disposing of stock of S because S was treated as worthless as a result of the application of paragraph (c)(1)(iii)(B) of this section after August 29, 2003, the amount of P’s income, gain, deduction, or loss, and the stock basis reflected in that amount, are determined or redetermined with regard to paragraph (b)(1)(ii) of this section. If P was treated as disposing of stock of S because S was treated as worthless as a result of the application of paragraph (c)(1)(iii)(B) of this section on or before August 29, 2003, the group may determine or redetermine the amount of P’s income, gain, deduction, or loss, and the stock basis reflected in that amount with regard to paragraph (b)(1)(ii) of this section.

§1.1502-19T [Removed]

Par. 6. Section 1.1502-19T is removed.

Par. 7. In §1.1502-21, paragraphs (b)(1), (b)(2)(ii)(A), (b)(2)(iv), (c)(2)(vii), and (h)(6) are revised to read as follows:

§1.1502-21 Net operating losses.

(1) Carryovers and carrybacks generally. The net operating loss carryovers and carrybacks to a taxable year are determined under the principles of section 172 and this section. Thus, losses permitted to be absorbed in a consolidated return year generally are absorbed in the order of the taxable years in which they arose, and losses carried from taxable years ending on the same date, and which are available to offset consolidated taxable income for the year, generally are absorbed on a pro rata basis. In addition, the amount of any CNOL absorbed by the group in any year is apportioned among members based on the percentage of the CNOL attributable to each member as of the beginning of the year. The percentage of the CNOL attributable to a member is determined pursuant to paragraph (b)(2)(iv)(B) of this section. Additional rules provided under the Internal Revenue Code or regulations also apply. See, e.g. , section 382(l)(2)(B) (if losses are carried from the same taxable year, losses subject to limitation under section 382 are absorbed before losses that are not subject to limitation under section 382). See paragraph (c)(1)(iii) of this section, Example 2 , for an illustration of pro rata absorption of losses subject to a SRLY limitation. See §1.1502-21T(b)(3)(v) regarding the treatment of any loss that is treated as expired under §1.1502-35T(f)(1).

(ii) Special rules —(A) Year of departure from group . If a corporation ceases to be a member during a consolidated return year, net operating loss carryovers attributable to the corporation are first carried to the consolidated return year, and then are subject to reduction under section 108 and §1.1502-28 in respect of discharge of indebtedness income that is realized by a member of the group and that is excluded from gross income under section 108(a). Only the amount so attributable that is not absorbed by the group in that year or reduced under section 108 and §1.1502-28 is carried to the corporation’s first separate return year. For rules concerning a member departing a subgroup, see paragraph (c)(2)(vii) of this section.

(iv) Operating rules —(A) Amount of CNOL attributable to a member . The amount of a CNOL that is attributable to a member shall equal the product of the CNOL and the percentage of the CNOL attributable to such member.

(B) Percentage of CNOL attributable to a member —( 1 ) In general . Except as provided in paragraph (b)(2)(iv)(B)( 2 ) of this section, the percentage of the CNOL attributable to a member shall equal the separate net operating loss of the member for the year of the loss divided by the sum of the separate net operating losses for that year of all members having such losses. For this purpose, the separate net operating loss of a member is determined by computing the CNOL by reference to only the member’s items of income, gain, deduction, and loss, including the member’s losses and deductions actually absorbed by the group in the taxable year (whether or not absorbed by the member).

( 2 ) Special rules —( i ) Carryback to a separate return year . If a portion of the CNOL attributable to a member for a taxable year is carried back to a separate return year, the percentage of the CNOL attributable to each member as of immediately after such portion of the CNOL is carried back shall be recomputed pursuant to paragraph (b)(2)(iv)(B)( 2 )( iv ) of this section.

( ii ) Excluded discharge of indebtedness income . If during a taxable year a member realizes discharge of indebtedness income that is excluded from gross income under section 108(a) and such amount reduces any portion of the CNOL attributable to any member pursuant to section 108 and §1.1502-28, the percentage of the CNOL attributable to each member as of immediately after the reduction of attributes pursuant to sections 108 and 1017 and §1.1502-28 shall be recomputed pursuant to paragraph (b)(2)(iv)(B)( 2 )( iv ) of this section.

( iii ) Departing member . If during a taxable year a member that had a separate net operating loss for the year of the CNOL ceases to be a member, the percentage of the CNOL attributable to each member as of the first day of the following consolidated return year shall be recomputed pursuant to paragraph (b)(2)(iv)(B)( 2 )( iv ) of this section.

( iv ) Recomputed percentage . The recomputed percentage of the CNOL attributable to each member shall equal the unabsorbed CNOL attributable to the member at the time of the recomputation divided by the sum of the unabsorbed CNOL attributable to all of the members at the time of the recomputation. For purposes of the preceding sentence, a CNOL that is reduced pursuant to section 108 and §1.1502-28 or that is otherwise permanently disallowed or eliminated shall be treated as absorbed.

(vii) Corporations that leave a SRLY subgroup . If a loss member ceases to be affiliated with a SRLY subgroup, the amount of the member’s remaining SRLY loss from a specific year is determined pursuant to the principles of paragraphs (b)(2)(ii)(A) and (b)(2)(iv) of this section.

(6) Certain prior periods . Paragraphs (b)(1), (b)(2)(ii)(A), (b)(2)(iv), and (c)(2)(vii) of this section shall apply to taxable years the original return for which the due date (without regard to extensions) is after March 21, 2005. Paragraph (b)(2)(ii)(A) of this section and §1.1502-21T(b)(1), (b)(2)(iv), and (c)(2)(vii) as contained in 26 CFR part 1 revised as of April 1, 2004, shall apply to taxable years the original return for which the due date (without regard to extensions) is on or before March 21, 2005, and after August 29, 2003. For taxable years the original return for which the due date (without regard to extensions) is on or before August 29, 2003, see paragraphs (b)(1), (b)(2)(ii)(A), (b)(2)(iv), and (c)(2)(vii) of this section and §1.1502-21T(b)(1) as contained in 26 CFR part 1 revised as of April 1, 2003.

Par. 8. Section 1.1502-21T is amended as follows:

1. Paragraphs (a) through (b)(2)(v) are revised.

2. Paragraphs (c)(1) through (h)(7) are revised.

§1.1502-21T Net operating losses (temporary).

(a) through (b)(2)(v) [Reserved]. For further guidance, see §1.1502-21(a) through (b)(2)(v).

(c)(1) through (h)(7) [Reserved]. For further guidance, see §1.1502-21(c)(1) through (h)(7).

Par. 9. Section 1.1502-28 is added to read as follows:

§1.1502-28 Consolidated section 108.

(a) In general . This section sets forth rules for the application of section 108(a) and the reduction of tax attributes pursuant to section 108(b) when a member of the group realizes discharge of indebtedness income that is excluded from gross income under section 108(a) (excluded COD income).

(1) Application of section 108(a) . Section 108(a)(1)(A) and (B) is applied separately to each member that realizes excluded COD income. Therefore, the limitation of section 108(a)(3) on the amount of discharge of indebtedness income that is treated as excluded COD income is determined based on the assets (including stock and securities of other members) and liabilities (including liabilities to other members) of only the member that realizes excluded COD income.

(2) Reduction of tax attributes attributable to the debtor —(i) In general . With respect to a member that realizes excluded COD income in a taxable year, the tax attributes attributable to that member (and its direct and indirect subsidiaries to the extent required by section 1017(b)(3)(D) and paragraph (a)(3) of this section), including basis of assets and losses and credits arising in separate return limitation years, shall be reduced as provided in sections 108 and 1017 and this section. Basis of subsidiary stock, however, shall not be reduced below zero pursuant to paragraph (a)(2) of this section (including when subsidiary stock is treated as depreciable property under section 1017(b)(3)(D) when there is an election under section 108(b)(5)).

(ii) Consolidated tax attributes attributable to a member . For purposes of this section, the amount of a consolidated tax attribute ( e.g. , a consolidated net operating loss) that is attributable to a member shall be determined pursuant to the principles of §1.1502-21(b)(2)(iv). In addition, if the member is a member of a separate return limitation year subgroup, the amount of a tax attribute that arose in a separate return limitation year that is attributable to that member shall also be determined pursuant to the principles of §1.1502-21(b)(2)(iv).

(3) Look-through rules —(i) Priority of section 1017(b)(3)(D) . If a member treats stock of a subsidiary as depreciable property pursuant to section 1017(b)(3)(D), the basis of the depreciable property of such subsidiary shall be reduced pursuant to section 1017(b)(3)(D) prior to the application of paragraph (a)(3)(ii) of this section.

(ii) Application of additional look-through rule . If the basis of stock of a corporation (the lower-tier member) that is owned by another corporation (the higher-tier member) is reduced pursuant to sections 108 and 1017 and paragraph (a)(2) of this section (but not as a result of treating subsidiary stock as depreciable property pursuant to section 1017(b)(3)(D)), and both of such corporations are members of the same consolidated group on the last day of the higher-tier member’s taxable year that includes the date on which the excluded COD income is realized or the first day of the higher-tier member’s taxable year that follows the taxable year that includes the date on which the excluded COD income is realized, solely for purposes of sections 108 and 1017 and this section other than paragraphs (a)(4) and (b)(1) of this section, the lower-tier member shall be treated as realizing excluded COD income on the last day of the taxable year of the higher-tier member that includes the date on which the higher-tier member realized the excluded COD income. The amount of such excluded COD income shall be the amount of such basis reduction. Accordingly, the tax attributes attributable to such lower-tier member shall be reduced as provided in sections 108 and 1017 and this section. To the extent that the excluded COD income realized by the lower-tier member pursuant to this paragraph (a)(3) does not reduce a tax attribute attributable to the lower-tier member, such excluded COD income shall not be applied to reduce tax attributes attributable to any member under paragraph (a)(4) of this section and shall not cause an excess loss account to be taken into account under §1.1502-19(b)(1) and (c)(1)(iii)(B).

(4) Reduction of certain tax attributes attributable to other members . To the extent that, pursuant to paragraph (a)(2) of this section, the excluded COD income is not applied to reduce the tax attributes attributable to the member that realizes the excluded COD income, after the application of paragraph (a)(3) of this section, such amount shall be applied to reduce the remaining consolidated tax attributes of the group, other than consolidated tax attributes to which a SRLY limitation applies, as provided in section 108 and this section. Such amount also shall be applied to reduce the tax attributes attributable to members that arose (or are treated as arising) in a separate return limitation year to the extent that the member that realizes excluded COD income is a member of the separate return limitation year subgroup with respect to such attribute if a SRLY limitation applies to the use of such attribute. In addition, such amount shall be applied to reduce the tax attributes attributable to members that arose in a separate return year or that arose (or are treated as arising) in a separate return limitation year if no SRLY limitation applies to the use of such attribute. The reduction of each tax attribute pursuant to the three preceding sentences shall be made in the order prescribed in section 108(b)(2) and pursuant to the principles of §1.1502-21(b)(1). Except as otherwise provided in this paragraph (a)(4), a tax attribute that arose in a separate return year or that arose (or is treated as arising) in a separate return limitation year is not subject to reduction pursuant to this paragraph (a)(4). Basis in assets is not subject to reduction pursuant to this paragraph (a)(4). Finally, to the extent that the realization of excluded COD income by a member pursuant to paragraph (a)(3) does not reduce a tax attribute attributable to such lower-tier member, such excess shall not be applied to reduce tax attributes attributable to any member pursuant to this paragraph (a)(4).

(b) Special rules —(1) Multiple debtor members —(i) Reduction of tax attributes attributable to debtor members prior to reduction of consolidated tax attributes . If in a single taxable year multiple members realize excluded COD income, paragraphs (a)(2) and (3) of this section shall apply with respect to the excluded COD income of each such member before the application of paragraph (a)(4) of this section.

(ii) Reduction of higher-tier debtor’s tax attributes . If in a single taxable year multiple members realize excluded COD income and one such member is a higher-tier member of another such member, paragraphs (a)(2) and (3) of this section shall be applied with respect to the excluded COD income of the higher-tier member before such paragraphs are applied to the excluded COD income of the other such member. In applying the rules of paragraph (a)(2) and (3) of this section with respect to the excluded COD income of the higher-tier member, the liabilities that give rise to the excluded COD income of the other such member shall not be treated as discharged for purposes of computing the limitation on basis reduction under section 1017(b)(2). A member (the first member) is a higher-tier member of another member (the second member) if the first member is the common parent or investment adjustments under §1.1502-32 with respect to the stock of the second member would affect investment adjustments with respect to the stock of the first member.

(iii) Reduction of additional tax attributes . If more than one member realizes excluded COD income that has not been applied to reduce a tax attribute attributable to such member (the remaining COD amount) and the remaining tax attributes available for reduction under paragraph (a)(4) of this section are less than the aggregate of the remaining COD amounts, after the application of paragraph (a)(2) of this section, each such member’s remaining COD amount shall be applied on a pro rata basis (based on the relative remaining COD amounts), pursuant to paragraph (a)(4) of this section, to reduce such remaining available tax attributes.

(iv) Ownership of lower-tier member by multiple higher-tier members . If stock of a corporation is held by more than one higher-tier member of the group and more than one such higher-tier member reduces its basis in such stock, then under paragraph (a)(3) of this section the excluded COD income resulting from the stock basis reductions shall be applied on a pro rata basis (based on the amount of excluded COD income caused by each basis reduction) to reduce the attributes of the corporation.

(v) Ownership of lower-tier member by multiple higher-tier members in multiple groups . If a corporation is a member of one group (the first group) on the last day of the first group’s higher-tier member’s taxable year that includes the date on which that higher-tier member realizes excluded COD income and is a member of another group (the second group) on the following day and the first group’s higher-tier member and the second group’s higher-tier member both reduce their basis in the stock of such corporation pursuant to sections 108 and 1017 and this section, paragraph (a)(3) of this section shall first be applied in respect of the excluded COD income that results from the reduction of the basis of the corporation’s stock owned by the first group’s higher-tier member and then shall be applied in respect of the excluded COD income that results from the reduction of the basis of the corporation’s stock owned by the second group’s higher-tier member.

(2) Election under section 108(b)(5) —(i) Availability of election . The group may make the election described in section 108(b)(5) for any member that realizes excluded COD income. The election is made separately for each member. Therefore, an election may be made for one member that realizes excluded COD income (either actually or pursuant to paragraph (a)(3) of this section) while another election, or no election, may be made for another member that realizes excluded COD income (either actually or pursuant to paragraph (a)(3) of this section). See §1.108-4 for rules relating to the procedure for making an election under section 108(b)(5).

(ii) Treatment of shares with an excess loss account . For purposes of applying section 108(b)(5)(B), the basis of stock of a subsidiary that has an excess loss account shall be treated as zero.

(3) Application of section 1017 —(i) Timing of basis reduction . Basis of property shall be subject to reduction pursuant to the rules of sections 108 and 1017 and this section after the determination of the tax imposed by chapter 1 of the Internal Revenue Code for the taxable year during which the member realizes excluded COD income and any prior years and coincident with the reduction of other attributes pursuant to section 108 and this section. However, only the basis of property held as of the beginning of the taxable year following the taxable year during which the excluded COD income is realized is subject to reduction pursuant to sections 108 and 1017 and this section.

(ii) Limitation of section 1017(b)(2) . The limitation of section 1017(b)(2) on the reduction in basis of property shall be applied by reference to the aggregate of the basis of the property held by the member that realizes excluded COD income, not the aggregate of the basis of the property held by all of the members of the group, and the liabilities of such member, not the aggregate liabilities of all of the members of the group.

(iii) Treatment of shares with an excess loss account . For purposes of applying section 1017(b)(2) and §1.1017-1, the basis of stock of a subsidiary that has an excess loss account shall be treated as zero.

(4) Application of section 1245 . Notwithstanding section 1017(d)(1)(B), a reduction of the basis of subsidiary stock is treated as a deduction allowed for depreciation only to the extent that the amount by which the basis of the subsidiary stock is reduced exceeds the total amount of the attributes attributable to such subsidiary that are reduced pursuant to the subsidiary’s consent under section 1017(b)(3)(D) or as a result of the application of paragraph (a)(3)(ii) of this section.

(5) Reduction of basis of intercompany obligations and former intercompany obligations —(i) Intercompany obligations that cease to be intercompany obligations . If excluded COD income is realized in a consolidated return year in which an intercompany obligation becomes an obligation that is not an intercompany obligation because the debtor or the creditor becomes a nonmember or because the assets of the creditor are acquired by a nonmember in a transaction to which section 381(a) applies, the basis of such intercompany obligation is not available for reduction in respect of such excluded COD income pursuant to sections 108 and 1017 and this section. However, in such cases, the basis of the debt treated as new debt issued under §1.1502-13(g)(3) is available for reduction in respect of such excluded COD income pursuant to sections 108 and 1017 and this section.

(ii) Intercompany obligations . The reduction of the basis of an intercompany obligation pursuant to sections 108 and 1017 and this section shall not result in the satisfaction and reissuance of the obligation under §1.1502-13(g). Therefore, any income or gain (or reduction of loss or deduction) attributable to a reduction of the basis of an intercompany obligation will be taken into account when §1.1502-13(g)(3) applies to such obligation. Furthermore, §1.1502-13(c)(6)(i) (regarding the treatment of intercompany items if corresponding items are excluded or nondeductible) will not apply to exclude any amount of income or gain attributable to a reduction of the basis of an intercompany obligation pursuant to sections 108 and 1017 and this section. See §1.1502-13(g)(3)(i)(A) and (ii)(B)( 2 ).

(6) Taking into account of excess loss account —(i) Determination of inclusion . The determination of whether any portion of an excess loss account in a share of stock of a subsidiary that realizes excluded COD income is required to be taken into account as a result of the application of §1.1502-19(c)(1)(iii)(B) is made after the determination of the tax imposed by chapter 1 of the Internal Revenue Code for the year during which the member realizes excluded COD income (without regard to whether any portion of an excess loss account in a share of stock of the subsidiary is required to be taken into account) and any prior years, after the reduction of tax attributes pursuant to sections 108 and 1017 and this section, and after the adjustment of the basis of the share of stock of the subsidiary pursuant to §1.1502-32 to reflect the amount of the subsidiary’s deductions and losses that are absorbed in the computation of taxable income (or loss) for the year of the disposition and any prior years, and the excluded COD income applied to reduce attributes and the attributes reduced in respect thereof. See §1.1502-11(c) for special rules related to the computation of tax that apply when an excess loss account is required to be taken into account.

(ii) Timing of inclusion . To the extent an excess loss account in a share of stock of a subsidiary that realizes excluded COD income is required to be taken into account as a result of the application of §1.1502-19(c)(1)(iii)(B), such amount shall be included on the group’s tax return for the taxable year that includes the date on which the subsidiary realizes such excluded COD income.

(7) Dispositions of stock . See §1.1502-11(c) for limitations on the reduction of tax attributes when a member disposes of stock of another member (including dispositions that result from the application of §1.1502-19(c)(1)(iii)(B)) during a taxable year in which any member realizes excluded COD income.

(8) Departure of member . If the taxable year of a member (the departing member) during which such member realizes excluded COD income ends on or prior to the last day of the consolidated return year and, on the first day of the taxable year of such member that follows the taxable year during which such member realizes excluded COD income, such member is not a member of the group and does not have a successor member (within the meaning of paragraph (b)(10) of this section), all tax attributes listed in section 108(b)(2) that remain after the determination of the tax imposed that belong to members of the group (including the departing member and subsidiaries of the departing member) shall be subject to reduction as provided in section 108 and the regulations promulgated thereunder (including §1.108-7(c), if applicable) and this section.

(9) Intragroup reorganization —(i) In general . If the taxable year of a member during which such member realizes excluded COD income ends prior to the last day of the consolidated return year and, on the first day that follows the taxable year of such member during which such member realizes excluded COD income, such member has a successor member, for purposes of applying the rules of sections 108 and 1017 and this section, notwithstanding §1.108-7, the successor member shall be treated as the member that realized the excluded COD income. Thus, all attributes attributable to the successor member listed in section 108(b)(2) (including attributes that were attributable to the successor member prior to the date such member became a successor member) are available for reduction under paragraph (a)(2) of this section.

(ii) Group structure change . If a member that realizes excluded COD income acquires the assets of the common parent of the consolidated group in a transaction to which section 381(a) applies and succeeds such common parent under the principles of §1.1502-75(d)(2) as the common parent of the consolidated group, the member’s attributes that remain after the determination of tax for the group for the consolidated return year during which the excluded COD income is realized (and any prior years) (including attributes that were attributable to the former common parent prior to the date of the transaction to which section 381(a) applies) shall be available for reduction under paragraph (a)(2) of this section.

(10) Definition of successor member . A successor member means a person to which the member that realizes excluded COD income (or a successor member) transfers its assets in a transaction to which section 381(a) applies if such transferee is a member of the group immediately after the transaction.

(11) Non-application of next day rule . For purposes of applying the rules of sections 108 and 1017 and this section, the next day rule of §1.1502-76(b)(1)(ii)(B) shall not apply to treat a member’s excluded COD income as realized at the beginning of the day following the day on which such member’s status as a member changes.

(c) Examples . The principles of paragraphs (a) and (b) of this section are illustrated by the following examples. Unless otherwise indicated, no election under section 108(b)(5) has been made and the taxable year of all consolidated groups is the calendar year. The examples are as follows:

Example 1 . (i) Facts . P is the common parent of a consolidated group that includes subsidiary S1. P owns 80 percent of the stock of S1. In Year 1, the P group sustained a $250 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $125 was attributable to P and $125 was attributable to S1. On Day 1 of Year 2, P acquired 100 percent of the stock of S2, and S2 joined the P group. As of the beginning of Year 2, S2 had a $50 net operating loss carryover from Year 1, a separate return limitation year. In Year 2, the P group sustained a $200 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $90 was attributable to P, $70 was attributable to S1, and $40 was attributable to S2. In Year 3, S2 realized $200 of excluded COD income from the discharge of non-intercompany indebtedness. In that same year, the P group sustained a $50 consolidated net operating loss, of which $40 was attributable to S1 and $10 was attributable to S2 under the principles of §1.1502-21(b)(2)(iv). As of the beginning of Year 4, S2 had Asset A with a fair market value of $10. After the computation of tax imposed for Year 3 and before the application of sections 108 and 1017 and this section, Asset A had a basis of $40 and S2 had no liabilities.

(ii) Analysis —(A) Reduction of tax attributes attributable to debtor . Pursuant to paragraph (a)(2) of this section, the tax attributes attributable to S2 must first be reduced to take into account its excluded COD income in the amount of $200.

( 1 ) Reduction of net operating losses . Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, the net operating loss and the net operating loss carryovers attributable to S2 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 3 is reduced by $10, the portion of the consolidated net operating loss attributable to S2, to $40. Then, again pursuant to section 108(b)(4)(B), S2’s net operating loss carryover of $50 from its separate return limitation year is reduced to $0. Finally, the consolidated net operating loss carryover from Year 2 is reduced by $40, the portion of that consolidated net operating loss carryover attributable to S2, to $160.

( 2 ) Reduction of basis . Following the reduction of the net operating loss and the net operating loss carryovers attributable to S2, S2 reduces its basis in its assets pursuant to section 1017 and §1.1017-1. Accordingly, S2 reduces its basis in Asset A by $40, from $40 to $0.

(B) Reduction of remaining consolidated tax attributes . The remaining $60 of excluded COD income then reduces consolidated tax attributes pursuant to paragraph (a)(4) of this section. In particular, the remaining $40 consolidated net operating loss for Year 3 is reduced to $0. Then, the consolidated net operating loss carryover from Year 1 is reduced by $20 from $250 to $230. Pursuant to paragraph (a)(4) of this section, a pro rata amount of the consolidated net operating loss carryover from Year 1 that is attributable to each of P and S1 is treated as reduced. Therefore, $10 of the consolidated net operating loss carryover from Year 1 that is attributable to each of P and S1 is treated as reduced.

Example 2 . (i) Facts . P is the common parent of a consolidated group that includes subsidiaries S1 and S2. P owns 100 percent of the stock of S1 and S1 owns 100 percent of the stock of S2. None of P, S1, or S2 has a separate return limitation year. In Year 1, the P group sustained a $50 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $10 was attributable to P, $20 was attributable to S1, and $20 was attributable to S2. In Year 2, the P group sustained a $70 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $30 was attributable to P, $30 was attributable to S1, and $10 was attributable to S2. In Year 3, S1 realized $170 of excluded COD income from the discharge of non-intercompany indebtedness. In that same year, the P group sustained a $50 consolidated net operating loss, of which $10 was attributable to S1 and $40 was attributable to S2 under the principles of §1.1502-21(b)(2)(iv). As of the beginning of Year 4, S1’s sole asset was the stock of S2, and S2 had Asset A with a $10 value. After the computation of tax imposed for Year 3 and before the application of sections 108 and 1017 and this section, S1 had a $80 basis in the S2 stock, Asset A had a basis of $0, and neither S1 nor S2 had any liabilities.

(ii) Analysis —(A) Reduction of tax attributes attributable to debtor . Pursuant to paragraph (a)(2) of this section, the tax attributes attributable to S1 must first be reduced to take into account its excluded COD income in the amount of $170.

( 1 ) Reduction of net operating losses . Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, the net operating loss and the net operating loss carryovers attributable to S1 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 3 is reduced by $10, the portion of the consolidated net operating loss for Year 3 attributable to S1, to $40. Then, the consolidated net operating loss carryover from Year 1 is reduced by $20, the portion of that consolidated net operating loss carryover attributable to S1, to $30, and the consolidated net operating loss carryover from Year 2 is reduced by $30, the portion of that consolidated net operating loss carryover attributable to S1, to $40.

( 2 ) Reduction of basis . Following the reduction of the net operating loss and the net operating loss carryovers attributable to S1, S1 reduces its basis in its assets pursuant to section 1017 and §1.1017-1. Accordingly, S1 reduces its basis in the stock of S2 by $80, from $80 to $0.

( 3 ) Tiering down of stock basis reduction . Pursuant to paragraph (a)(3) of this section, for purposes of sections 108 and 1017 and this section, S2 is treated as realizing $80 of excluded COD income. Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, therefore, the net operating loss and net operating loss carryovers attributable to S2 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 3 is reduced by an additional $40, the portion of the consolidated net operating loss for Year 3 attributable to S2, to $0. Then, the consolidated net operating loss carryover from Year 1 is reduced by $20, the portion of that consolidated net operating loss carryover attributable to S2, to $10. Then, the consolidated net operating loss carryover from Year 2 is reduced by $10, the portion of that consolidated net operating loss carryover attributable to S2, to $30. S2’s remaining $10 of excluded COD income does not reduce consolidated tax attributes attributable to P or S1 under paragraph (a)(4) of this section.

(B) Reduction of remaining consolidated tax attributes . Finally, pursuant to paragraph (a)(4) of this section, S1’s remaining $30 of excluded COD income reduces the remaining consolidated tax attributes. In particular, the remaining $10 consolidated net operating loss carryover from Year 1 is reduced by $10 to $0, and the remaining $30 consolidated net operating loss carryover from Year 2 is reduced by $20 to $10.

Example 3 . (i) Facts . P is the common parent of a consolidated group that includes subsidiaries S1, S2, and S3. P owns 100 percent of the stock of S1, S1 owns 100 percent of the stock of S2, and S2 owns 100 percent of the stock of S3. None of P, S1, S2, or S3 had a separate return limitation year prior to Year 1. In Year 1, the P group sustained a $150 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $50 was attributable to S2, and $100 was attributable to S3. In Year 2, the P group sustained a $50 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $40 was attributable to S1 and $10 was attributable to S2. In Year 3, S1 realized $170 of excluded COD income from the discharge of non-intercompany indebtedness. In that same year, the P group sustained a $50 consolidated net operating loss, of which $10 was attributable to S1, $20 was attributable to S2, and $20 was attributable to S3 under the principles of §1.1502-21(b)(2)(iv). At the beginning of Year 4, S1’s only asset was the stock of S2, and S2’s only asset was the stock of S3 with a value of $10. After the computation of tax imposed for Year 3 and before the application of sections 108 and 1017 and this section, S1’s stock of S2 had a basis of $120 and S2’s stock of S3 had a basis of $180. In addition, none of S1, S2, and S3 had any liabilities.

( 1 ) Reduction of net operating losses . Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, the net operating loss and the net operating loss carryovers attributable to S1 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 3 is reduced by $10, the portion of the consolidated net operating loss attributable to S1, to $40. Then, the consolidated net operating loss carryover from Year 2 is reduced by $40, the portion of that consolidated net operating loss carryover attributable to S1, to $10.

(B) Tiering down of stock basis reduction to S2 . Pursuant to paragraph (a)(3) of this section, for purposes of sections 108 and 1017 and this section, S2 is treated as realizing $120 of excluded COD income. Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, therefore, the net operating loss and net operating loss carryovers attributable to S2 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 3 is further reduced by $20, the portion of the consolidated net operating loss attributable to S2, to $20. Then, the consolidated net operating loss carryover from Year 1 is reduced by $50, the portion of that consolidated net operating loss carryover attributable to S2, to $100. Then, the consolidated net operating loss carryover from Year 2 is further reduced by $10, the portion of that consolidated net operating loss carryover attributable to S2, to $0. Following the reduction of the net operating loss and the net operating loss carryovers attributable to S2, S2 reduces its basis in its assets pursuant to section 1017 and §1.1017-1. Accordingly, S2 reduces its basis in its S3 stock by $40 to $140.

(C) Tiering down of stock basis reduction to S3 . Pursuant to paragraph (a)(3) of this section, for purposes of sections 108 and 1017 and this section, S3 is treated as realizing $40 of excluded COD income. Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, therefore, the net operating loss and the net operating loss carryovers attributable to S3 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 3 is further reduced by $20, the portion of the consolidated net operating loss attributable to S3, to $0. Then, the consolidated net operating loss carryover from Year 1 is reduced by $20, the lesser of the portion of that consolidated net operating loss carryover attributable to S3 and the remaining excluded COD income, to $80.

Example 4 . (i) Facts . P is the common parent of a consolidated group that includes subsidiaries S1, S2, and S3. P owns 100 percent of the stock of each of S1 and S2. Each of S1 and S2 owns stock of S3 that represents 50 percent of the value of the stock of S3. None of P, S1, S2, or S3 had a separate return limitation year prior to Year 1. In Year 1, the P group sustained a $160 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $10 was attributable to P, $50 was attributable to S2, and $100 was attributable to S3. In Year 2, the P group sustained a $110 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $40 was attributable to S1 and $70 was attributable to S2. In Year 3, S1 realized $200 of excluded COD income from the discharge of non-intercompany indebtedness, and S2 realized $270 of excluded COD income from the discharge of non-intercompany indebtedness. In that same year, the P group sustained a $50 consolidated net operating loss, of which $10 was attributable to S1, $20 was attributable to S2, and $20 was attributable to S3 under the principles of §1.1502-21(b)(2)(iv). At the beginning of Year 4, S3 had one asset with a value of $10. After the computation of tax imposed for Year 3 and before the application of sections 108 and 1017 and this section, S1’s basis in its S3 stock was $60, S2’s basis in its S3 stock was $120, and S3’s asset had a basis of $200. In addition, none of S1, S2, and S3 had any liabilities.

(ii) Analysis —(A) Reduction of tax attributes attributable to debtors . Pursuant to paragraph (b)(1)(i) of this section, the tax attributes attributable to each of S1 and S2 are reduced pursuant to paragraph (a)(2) of this section. Then, pursuant to paragraph (a)(3) of this section, the tax attributes attributable to S3 are reduced so as to reflect a reduction of S1’s and S2’s basis in the stock of S3. Then, paragraph (a)(4) is applied to reduce additional tax attributes.

( 1 ) Reduction of net operating losses generally . Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, the net operating losses and the net operating loss carryovers attributable to S1 and S2 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B).

( 2 ) Reduction of net operating losses attributable to S1 . The consolidated net operating loss for Year 3 is reduced by $10, the portion of the consolidated net operating loss attributable to S1, to $40. Then, the consolidated net operating loss carryover from Year 2 is reduced by $40, the portion of that consolidated net operating loss carryover attributable to S1, to $70.

( 3 ) Reduction of net operating losses attributable to S2 . The consolidated net operating loss for Year 3 is also reduced by $20, the portion of the consolidated net operating loss attributable to S2, to $20. Then, the consolidated net operating loss carryover from Year 1 is reduced by $50, the portion of that consolidated net operating loss carryover attributable to S2, to $110. Then, the consolidated net operating loss carryover from Year 2 is reduced by $70, the portion of that consolidated net operating loss carryover attributable to S2, to $0.

( 4 ) Reduction of basis . Following the reduction of the net operating losses and the net operating loss carryovers attributable to S1 and S2, S1 and S2 must reduce their basis in their assets pursuant to section 1017 and §1.1017-1. Accordingly, S1 reduces its basis in the stock of S3 by $60, from $60 to $0, and S2 reduces its basis in the stock of S3 by $120, from $120 to $0.

(B) Tiering down of basis reduction . Pursuant to paragraph (a)(3) of this section, for purposes of sections 108 and 1017 and this section, S3 is treated as realizing $180 of excluded COD income. Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, therefore, the net operating loss and the net operating loss carryovers attributable to S3 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 3 is further reduced by $20, the portion of the consolidated net operating loss attributable to S3, to $0. Then, the consolidated net operating loss carryover from Year 1 is reduced by $100, the portion of that consolidated net operating loss carryover attributable to S3, to $10. Following the reduction of the net operating loss and the net operating loss carryover attributable to S3, S3 reduces its basis in its asset pursuant to section 1017 and §1.1017-1. Accordingly, S3 reduces its basis in its asset by $60, from $200 to $140.

(C) Reduction of remaining consolidated tax attributes . Finally, pursuant to paragraph (a)(4) of this section, the remaining $90 of S1’s excluded COD income and the remaining $10 of S2’s excluded COD income reduce the remaining consolidated tax attributes. In particular, the remaining $10 consolidated net operating loss carryover from Year 1 is reduced by $10 to $0. Because that amount is less than the aggregate amount of remaining excluded COD income, such income is applied on a pro rata basis to reduce the remaining consolidated tax attributes. Accordingly, $9 of S1’s remaining excluded COD income and $1 of S2’s remaining excluded COD income is applied to reduce the remaining consolidated net operating loss carryover from Year 1. Consequently, of S1’s excluded COD income of $200, only $119 is applied to reduce tax attributes, and, of S2’s excluded COD income of $270, only $261 is applied to reduce tax attributes.

Example 5 . (i) Facts . P is the common parent of a consolidated group that includes subsidiaries S1, S2, and S3. P owns 100 percent of the stock of S1 and S2, and S1 owns 100 percent of the stock of S3. None of P, S1, S2, or S3 has a separate return limitation year prior to Year 1. In Year 1, the P group sustained a $90 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $10 was attributable to P, $15 was attributable to S1, $20 was attributable to S2, and $45 was attributable to S3. On January 1 of Year 2, P realized $140 of excluded COD income from the discharge of non-intercompany indebtedness. On December 31 of Year 2, S1 issued stock representing 50 percent of the vote and value of its outstanding stock to a person that was not a member of the group. As a result of the issuance of stock, S1 and S3 ceased to be members of the P group. For the consolidated return year of Year 2, the P group sustained a $60 consolidated net operating loss, of which $5 was attributable to S1, $40 was attributable to S2, and $15 was attributable to S3 under the principles of §1.1502-21(b)(2)(iv). As of the beginning of Year 3, P’s only assets were the stock of S1 and S2, S1’s sole asset was the stock of S3, S2 had Asset A with a value of $10, and S3 had Asset B with a value of $10. After the computation of tax imposed for Year 2 and before the application of sections 108 and 1017 and this section, P had a $80 basis in the S1 stock and a $50 basis in the S2 stock, S1 had a $80 basis in the S3 stock, and Asset A and B each had a basis of $10. In addition, none of P, S1, S2, and S3 had any liabilities.

(ii) Analysis . Pursuant to paragraph (a)(2) of this section, the tax attributes attributable to P must first be reduced to take into account its excluded COD income in the amount of $140.

(A) Reduction of net operating losses . Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, the net operating loss and the net operating loss carryover attributable to P under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss carryover from Year 1 is reduced by $10, the portion of that consolidated net operating loss carryover attributable to P, to $80.

(B) Reduction of basis . Following the reduction of the net operating loss and the net operating loss carryover attributable to P, P reduces its basis in its assets pursuant to section 1017 and §1.1017-1. Accordingly, P reduces its basis in the stock of S1 by $80, from $80 to $0, and its basis in the stock of S2 by $50, from $50 to $0.

(C) Tiering down of stock basis reduction to S1 . Pursuant to paragraph (a)(3) of this section, for purposes of sections 108 and 1017 and this section, S1 is treated as realizing $80 of excluded COD income, despite the fact that it ceases to be a member of the group at the end of the day on December 31 of Year 2. Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, therefore, the net operating loss and net operating loss carryovers attributable to S1 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 2 is reduced by $5, the portion of the consolidated net operating loss for Year 2 attributable to S1, to $55. Then, the consolidated net operating loss carryover from Year 1 is reduced by an additional $15, the portion of that consolidated net operating loss carryover attributable to S1, to $65. Following the reduction of the net operating loss and the net operating loss carryover attributable to S1, S1 reduces its basis in its assets pursuant to section 1017 and §1.1017-1. Accordingly, S1 reduces its basis in the stock of S3 by $60, from $80 to $20.

(D) Tiering down of stock basis reduction to S2 . Pursuant to paragraph (a)(3) of this section, for purposes of sections 108 and 1017 and this section, S2 is treated as realizing $50 of excluded COD income. Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, therefore, the net operating loss and net operating loss carryovers attributable to S2 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 2 is reduced by an additional $40, the portion of the consolidated net operating loss for Year 2 attributable to S2, to $15. Then, the consolidated net operating loss carryover from Year 1 is reduced by an additional $10, a portion of the consolidated net operating loss carryover attributable to S2, to $55.

(E) Tiering down of stock basis reduction to S3 . Pursuant to paragraph (a)(3) of this section, for purposes of sections 108 and 1017 and this section, S3 is treated as realizing $60 of excluded COD income (by reason of S1’s reduction in its basis of its S3 stock). Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, therefore, the net operating loss and net operating loss carryovers attributable to S3 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 2 is reduced by an additional $15, the portion of the consolidated net operating loss for Year 2 attributable to S3, to $0. Then, the consolidated net operating loss carryover from Year 1 is reduced by an additional $45, the portion of that consolidated net operating loss carryover attributable to S3, to $10.

Example 6 . (i) Facts . P1 is the common parent of a consolidated group that includes subsidiaries S1, S2, and S3. P1 owns 100 percent of the stock of S1 and S2. S1 owns 100 percent of the stock of S3. None of P1, S1, S2, or S3 has a separate return limitation year prior to Year 1. In Year 1, the P1 group sustained a $120 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $40 was attributable to P1, $35 was attributable to S1, $30 was attributable to S2, and $15 was attributable to S3. On January 1 of Year 2, S3 realized $65 of excluded COD income from the discharge of non-intercompany indebtedness. On June 30 of Year 2, S3 issued stock representing 80 percent of the vote and value of its outstanding stock to P2, the common parent of another group. As a result of the issuance of stock, S3 ceased to be a member of the P1 group and became a member of the P2 group. For the consolidated return year of Year 2, the P1 group sustained a $50 consolidated net operating loss, of which $5 was attributable to S1, $40 was attributable to S2, and $5 was attributable to S3 under the principles of §1.1502-21(b)(2)(iv). As of the beginning of its taxable year beginning on July 1 of Year 2, S3’s sole asset was Asset A with a $10 value. After the computation of tax imposed for Year 2 on the P1 group and before the application of sections 108 and 1017 and this section and the computation of tax imposed for Year 2 on the P2 group, Asset A had a basis of $0. In addition, S3 had no liabilities. On January 1 of Year 3, P1 sold all of its stock of S1.

(ii) Analysis —(A) Reduction of tax attributes attributable to debtor . Pursuant to paragraph (a)(2) of this section, the tax attributes attributable to S3 must first be reduced to take into account its excluded COD income in the amount of $65. Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, the net operating loss and the net operating loss carryover attributable to S3 under the principles of §1.1502-21(b)(2)(iv) are reduced in the order prescribed by section 108(b)(4)(B). Accordingly, the consolidated net operating loss for Year 2 is reduced by $5, the portion of the consolidated net operating loss for Year 2 attributable to S3, to $45. Then, the consolidated net operating loss carryover from Year 1 is reduced by $15, the portion of that consolidated net operating loss carryover attributable to S3, to $105.

(B) Reduction of remaining consolidated tax attributes . Pursuant to paragraphs (a)(4) and (b)(8) of this section, S3’s remaining $45 of excluded COD income reduces the remaining consolidated tax attributes in the P1 group. In particular, the remaining $45 consolidated net operating loss for Year 2 is reduced by an additional $45 to $0.

(C) Basis Adjustments . For purposes of computing P1’s gain or loss on the sale of the S1 stock in Year 3, P1’s basis in its S1 stock will reflect a net positive adjustment of $40, which is the excess of the amount of S3’s excluded COD income that is applied to reduce attributes ($65) over the reduction of S1’s and S3’s attributes in respect of such excluded COD income ($25).

Example 7 . (i) Fact s. P is the common parent of a consolidated group that includes subsidiaries S1 and S2. P owns 100 percent of the stock of S1, and S1 owns 100 percent of the stock of S2. None of P, S1, or S2 has a separate return limitation year prior to Year 1. In Year 1, the P group sustained a $50 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $10 was attributable to P, $20 was attributable to S1, and $20 was attributable to S2. On January 1 of Year 2, S1 realized $55 of excluded COD income from the discharge of non-intercompany indebtedness. On June 30 of Year 2, P transferred all of its assets to S1 in a transaction to which section 381(a) applied. As a result of that transaction, pursuant to §1.1502-75(d)(2)(ii), S1 succeeded P as the common parent of the group. Pursuant to §1.1502-75(d)(2)(iii), S1’s taxable year closed on the date of the acquisition. However, P’s taxable year did not close. On the consolidated return for Year 2, the group sustained a $50 consolidated net operating loss. Under the principles of §1.1502-21(b)(2)(iv), of that amount, $10 was attributable to S1 for its taxable year that ended on June 30, $15 was attributable to S1 as the successor of P, and $25 was attributable to S2.

(ii) Analysis . Pursuant to paragraph (a)(2) of this section, the tax attributes attributable to S1 must first be reduced to take into account its excluded COD income in the amount of $55. For this purpose, S1’s attributes that remain after the determination of tax for the group for Year 2 are subject to reduction. Pursuant to section 108(b)(2)(A) and paragraph (a) of this section, the net operating loss and the net operating loss carryover attributable to S1 under the principles of §1.1502-21(b)(2)(iv) are reduced. Accordingly, the consolidated net operating loss for Year 2 is reduced by $25, the portion of the consolidated net operating loss for Year 2 attributable to S1, to $25. Then, the consolidated net operating loss carryover from Year 1 is reduced by $30, the portion of that consolidated net operating loss carryover attributable to S1 (which includes the portion attributable to P), to $20.

(d) Effective dates . This section applies to discharges of indebtedness that occur after March 21, 2005. Groups, however, may apply this section in whole, but not in part, to discharges of indebtedness that occur on or before March 21, 2005, and after August 29, 2003. For discharges of indebtedness occurring on or before March 21, 2005, and after August 29, 2003, with respect to which a group chooses not to apply this section, see §1.1502-28T as contained in 26 CFR part 1 revised as of April 1, 2004. Furthermore, groups may apply paragraph (b)(4) of this section to discharges of indebtedness that occur on or before August 29, 2003, in cases in which section 1017(b)(3)(D) was applied.

§1.1502-28T [Removed]

Par. 10. Section 1.1502-28T is removed.

Par. 11. Section 1.1502-32 is amended as follows:

1. Paragraph (b)(1)(ii) is redesignated as paragraph (b)(1)(iii).

2. New paragraph (b)(1)(ii) is added.

3. Paragraphs (b)(3)(ii)(C)( 1 ) and (b)(3)(iii)(A) are revised.

4. Paragraph (b)(5)(ii), Example 4 , paragraphs (a), (b), and (c) are revised.

5. Paragraph (h)(7) is revised.

The addition and revisions read as follows:

§1.1502-32 Investment adjustments.

(ii) Special rule for discharge of indebtedness income . Adjustments under this section resulting from the realization of discharge of indebtedness income of a member that is excluded from gross income under section 108(a) (excluded COD income) and from the reduction of attributes in respect thereof pursuant to sections 108 and 1017 and §1.1502-28 (including reductions in the basis of property) when a member (the departing member) ceases to be a member of the group on or prior to the last day of the consolidated return year that includes the date the excluded COD income is realized are made immediately after the determination of tax for the group for the taxable year during which the excluded COD income is realized (and any prior years) and are effective immediately before the beginning of the taxable year of the departing member following the taxable year during which the excluded COD income is realized. Such adjustments when a corporation (the new member) is not a member of the group on the last day of the consolidated return year that includes the date the excluded COD income is realized but is a member of the group at the beginning of the following consolidated return year are also made immediately after the determination of tax for the group for the taxable year during which the excluded COD income is realized (and any prior years) and are effective immediately before the beginning of the taxable year of the new member following the taxable year during which the excluded COD income is realized. If the new member was a member of another group immediately before it became a member of the group, such adjustments are treated as occurring immediately after it ceases to be a member of the prior group.

( 1 ) In general . Excluded COD income is treated as tax-exempt income only to the extent the discharge is applied to reduce tax attributes attributable to any member of the group under section 108, section 1017 or §1.1502-28. However, if S is treated as realizing excluded COD income pursuant to §1.1502-28(a)(3), S shall not be treated as realizing excluded COD income for purposes of the preceding sentence.

(iii) * * *

(A) In general . S’s noncapital, nondeductible expenses are its deductions and losses that are taken into account but permanently disallowed or eliminated under applicable law in determining its taxable income or loss, and that decrease, directly or indirectly, the basis of its assets (or an equivalent amount). For example, S’s Federal taxes described in section 275 and loss not recognized under section 311(a) are noncapital, nondeductible expenses. Similarly, if a loss carryover ( e.g. , under section 172 or 1212) attributable to S expires or is reduced under section 108(b) and §1.1502-28, it becomes a noncapital, nondeductible expense at the close of the last tax year to which it may be carried. However, when a tax attribute attributable to S is reduced as required pursuant to §1.1502-28(a)(3), the reduction of the tax attribute is not treated as a noncapital, nondeductible expense of S. Finally, if S sells and repurchases a security subject to section 1091, the disallowed loss is not a noncapital, nondeductible expense because the corresponding basis adjustments under section 1091(d) prevent the disallowance from being permanent.

Example 4 . Discharge of indebtedness . (a) Facts . P forms S on January 1 of Year 1 and S borrows $200. During Year 1, S’s assets decline in value and the P group has a $100 consolidated net operating loss. Of that amount, $10 is attributable to P and $90 is attributable to S under the principles of §1.1502-21(b)(2)(iv). None of the loss is absorbed by the group in Year 1, and S is discharged from $100 of indebtedness at the close of Year 1. P has a $0 basis in the S stock. P and S have no attributes other than the consolidated net operating loss. Under section 108(a), S’s $100 of discharge of indebtedness income is excluded from gross income because of insolvency. Under section 108(b) and §1.1502-28, the consolidated net operating loss is reduced to $0.

(b) Analysis . Under paragraph (b)(3)(iii)(A) of this section, the reduction of $90 of the consolidated net operating loss attributable to S is treated as a noncapital, nondeductible expense in Year 1 because that loss is permanently disallowed by section 108(b) and §1.1502-28. Under paragraph (b)(3)(ii)(C)( 1 ) of this section, all $100 of S’s discharge of indebtedness income is treated as tax-exempt income in Year 1 because the discharge results in a $100 reduction to the consolidated net operating loss. Consequently, the loss and the cancellation of the indebtedness result in a net positive $10 adjustment to P’s basis in its S stock.

(c) Insufficient attributes . The facts are the same as in paragraph (a) of this Example 4 , except that S is discharged from $120 of indebtedness at the close of Year 1. Under section 108(a), S’s $120 of discharge of indebtedness income is excluded from gross income because of insolvency. Under section 108(b) and §1.1502-28, the consolidated net operating loss is reduced by $100 to $0 after the determination of tax for Year 1. Under paragraph (b)(3)(iii)(A) of this section, the reduction of $90 of the consolidated net operating loss attributable to S is treated as a noncapital, nondeductible expense. Under paragraph (b)(3)(ii)(C)( 1 ) of this section, only $100 of the discharge is treated as tax-exempt income because only that amount is applied to reduce tax attributes. The remaining $20 of discharge of indebtedness income excluded from gross income under section 108(a) has no effect on P’s basis in S’s stock.

(7) Rules related to discharge of indebtedness income excluded from gross income . Paragraphs (b)(1)(ii), (b)(3)(ii)(C)( 1 ), (b)(3)(iii)(A), and (b)(5)(ii), Example 4 , paragraphs (a), (b), and (c) of this section apply with respect to determinations of the basis of the stock of a subsidiary in consolidated return years the original return for which is due (without regard to extensions) after March 21, 2005. However, groups may apply those provisions with respect to determinations of the basis of the stock of a subsidiary in consolidated return years the original return for which is due (without regard to extensions) on or before March 21, 2005, and after August 29, 2003. For determinations of the basis of the stock of a subsidiary in consolidated return years the original return for which is due (without regard to extensions) on or before March 21, 2005, and after August 29, 2003, with respect to which a group chooses not to apply paragraphs (b)(1)(ii), (b)(3)(ii)(C)( 1 ), (b)(3)(iii)(A), and (b)(5)(ii), Example 4 , paragraphs (a), (b), and (c) of this section, see §1.1502-32T(b)(3)(ii)(C)( 1 ), (b)(3)(iii)(A), and (b)(5)(ii), Example 4 , paragraphs (a), (b), and (c) as contained in 26 CFR part 1 revised as of April 1, 2004.

Par. 12. Section 1.1502-32T is amended as follows:

1. Paragraph (a)(3) is added.

2. Paragraphs (b) through (b)(3)(iii)(B) are revised.

3. Paragraphs (b)(5)(i) through (h)(5)(ii) are revised.

4. Paragraph (h)(7) is revised.

§1.1502-32T Investment adjustments (temporary).

(a)(3) through (b)(3)(iii)(B) [Reserved]. For further guidance, see §1.1502-32(a)(3) through (b)(3)(iii)(B).

(b)(5)(i) through (h)(5)(ii) [Reserved]. For further guidance, see §1.1502-32(b)(5)(i) through (h)(5)(ii).

(h)(7) [Reserved]. For further guidance, see §1.1502-32(h)(7).

Par. 13. In §1.1502-76, paragraph (b)(1)(ii)(B)( 3 ) is revised to read as follows:

§1.1502-76 Taxable year of members of group.

( 3 ) Whether the allocation is inconsistent with other requirements under the Internal Revenue Code and regulations promulgated thereunder ( e.g. , if a section 338(g) election is made in connection with a group’s acquisition of S, the deemed asset sale must take place before S becomes a member and S’s gain or loss with respect to its assets must be taken into account by S as a nonmember (but see §1.338-1(d)), or if S realizes discharge of indebtedness income that is excluded from gross income under section 108(a) on the day it becomes a nonmember, the discharge of indebtedness income must be treated as realized by S as a member (see §1.1502-28(b)(11)); and

Par. 14. In §1.1502-80, the second sentence of paragraph (c) is revised to read as follows:

§1.1502-80 Applicability of other provisions of law.

Par. 15. In §1.1502-80T, the third sentence of paragraph (c) is revised to read as follows:

§1.1502-80T Applicability of other provisions of law (temporary).

(Filed by the Office of the Federal Register on March 21, 2005, 8:45 a.m., and published in the issue of the Federal Register for March 22, 2005, 70 F.R. 14395)

The principal author of these regulations is Amber R. Cook of the Office of Associate Chief Counsel (Corporate). However, other personnel from the IRS and Treasury Department participated in their development.

Disclosure of Return Information to the Bureau of the Census

Department of the treasury internal revenue service 26 cfr part 301.

Temporary regulations.

This document contains temporary regulations relating to additions to the list of items of return information disclosed to the Bureau of the Census (Bureau). The regulation adds two items of return information for use in producing demographic statistics programs, including the Bureau’s Small Area Income and Poverty Estimates (SAIPE). The temporary regulations also remove four items that the Bureau has indicated are no longer necessary. The text of these temporary regulations serves as the text of the proposed regulations (REG-147195-04) set forth in the notice of proposed rulemaking on this subject in this issue of the Bulletin.

Effective Date: These regulations are effective March 10, 2005.

Applicability Date: For dates of applicability, see §301.6103(j)(1)-1T(e).

James O’Leary, (202) 622-4580 (not a toll-free number).

Under section 6103(j)(1), upon written request from the Secretary of Commerce, the Secretary of the Treasury is to furnish to the Bureau return information that is prescribed by Treasury regulations for the purpose of, but only to the extent necessary in, structuring censuses and national economic accounts and conducting related statistical activities authorized by law. Section 301.6103(j)(1)-1 of the regulations further defines such purposes by reference to 13 U.S.C. chapter 5 and provides an itemized description of the return information authorized to be disclosed for such purposes.

This document adopts temporary regulations that authorize the IRS to disclose the additional items of return information that have been requested by the Secretary of Commerce to the extent necessary in developing and preparing demographic statistics, including statutorily mandated Small Area Income and Poverty Estimates (SAIPE). The temporary regulations also remove certain items of return information that are enumerated in the existing regulations but that the Secretary of Commerce has indicated are no longer needed.

Temporary regulations in this issue of the Bulletin amend the Procedure and Administration Regulations (26 CFR Part 301) relating to Internal Revenue Code (Code) section 6103(j)(1). The temporary regulations contain rules relating to the disclosure of return information reflected on returns to officers and employees of the Department of Commerce for structuring censuses and national economic accounts and conducting related statistical activities authorized by law.

By letter dated May 11, 2004, the Department of Commerce requested that additional items of return information be disclosed to the Bureau for purposes related to conducting the SAIPE program and used to estimate the number of school-aged children in poverty for each of the over 14,000 districts in the United States. Specifically, the Department of Commerce requested Earned Income and the number of Earned Income Tax Credit-eligible qualifying children. The request indicates that under the Improving America’s Schools Act of 1994 (Public Law 103-382, 108 Stat. 3518 (October 20, 1994)), these estimates were mandated biennially, and under the No Child Left Behind Act of 2002 (Public Law 107-110, 115 Stat. 1425 (January 8, 2002)), they are required annually.

The regulations also remove four items of return information that the Bureau indicated it no longer requires. These items are: end-of-year code; months actively operated; total number of documents and the total amount reported on the Form 1096 ( Annual Summary and Transmittal of U.S. Information Returns ) transmitting Forms 1099-MISC ( Miscellaneous Income ); and Form 941 ( Employer’s Quarterly Federal Tax Return ) indicator and business address on Schedule C ( Profit or Loss From Business ) of Form 1040. Accordingly, the temporary regulations have removed these items from the enumeration of return information to be disclosed to the Bureau.

It has been determined that these temporary regulations are not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), please refer to the cross-reference notice of proposed rulemaking published elsewhere in this issue of the Federal Register . Pursuant to section 7805(f) of the Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Amendments to the Regulations

Accordingly, 26 CFR Part 301 is amended as follows:

PART 301—PROCEDURE AND ADMINISTRATION

Paragraph 1. The authority citation for part 301 is amended by adding an entry in numerical order to read in part, as follows:

Section 301.6103(j)(1)-1T also issued under 26 U.S.C. 6103(j)(1); * * *

Par. 2. Section 301.6103(j)(1)-1 is amended by revising paragraphs (b)(1) introductory text and (b)(3) introductory text to read as follows:

§301.6103(j)(1)-1 Disclosures of return information to officers and employees of the Department of Commerce for certain statistical purposes and related activities.

(b)(1) [Reserved]. For further guidance, see §301.6103(j)(1)-1T(b)(1)

(b)(3) [Reserved]. For further guidance, see §301.6103(j)(1)-1T(b)(3).

Par. 3. Section 301.6103(j)(1)-1T is added to read as follows:

§301.6103(j)(1)-1T Disclosures of return information to officers and employees of the Department of Commerce for certain statistical purposes and related activities (temporary).

(a) [Reserved]. For further guidance, see §301.6103(j)(1)-1(a).

(b) Disclosure of return information reflected on returns to officers and employees of the Bureau of the Census.

(1) Officers or employees of the Internal Revenue Service will disclose the following return information reflected on returns of individual taxpayers to officers and employees of the Bureau of the Census for purposes of, but only to the extent necessary in, conducting and preparing, as authorized by chapter 5 of title 13, United States Code, intercensal estimates of population and income for all geographic areas included in the population estimates program and demographic statistics programs, censuses, and related program evaluation:

(i) Taxpayer identity information (as defined in section 6103(b)(6) of the Internal Revenue Code), validity code with respect to the taxpayer identifying number (as described in section 6109), and taxpayer identity information of spouse and dependents, if reported.

(ii) Location codes (including area/district office and campus/service center codes).

(iii) Marital status.

(iv) Number and classification of reported exemptions.

(v) Wage and salary income.

(vi) Dividend income.

(vii) Interest income.

(viii) Gross rent and royalty income.

(ix) Total of—

(A) Wages, salaries, tips, etc.;

(B) Interest income;

(D) Alimony received;

(E) Business income;

(F) Pensions and annuities;

(G) Income from rents, royalties, partnerships, estates, trusts, etc.;

(H) Farm income;

(I) Unemployment compensation; and

(J) Total Social Security benefits.

(x) Adjusted gross income.

(xi) Type of tax return filed.

(xii) Entity code.

(xiii) Code indicators for Form 1040, Form 1040 (Schedules A, C, D, E, F, and SE), and Form 8814.

(xiv) Posting cycle date relative to filing.

(xv) Social Security benefits.

(xvi) Earned Income (as defined in section 32(c)(2)).

(xvii) Number of Earned Income Tax Credit-eligible qualifying children.

(b)(2) [Reserved]. For further guidance, see §301.6103(j)(1)-1(b)(2).

(b)(3) Officers or employees of the Internal Revenue Service will disclose the following business related return information reflected on returns of taxpayers to officers and employees of the Bureau of the Census for purposes of, but only to the extent necessary in, conducting and preparing, as authorized by chapter 5 of title 13, United States Code, demographic and economic statistics programs, censuses, and surveys. (The “returns of taxpayers” include, but are not limited to: Form 941; Form 990 series; Form 1040 series and Schedules C and SE; Form 1065 and all attending schedules and Form 8825; Form 1120 series and all attending schedules and Form 8825; Form 851; Form 1096; and other business returns, schedules and forms that the Internal Revenue Service may issue.):

(i) Taxpayer identity information (as defined in section 6103(b)(6)) including parent corporation, shareholder, partner, and employer identity information.

(ii) Gross income, profits, or receipts.

(iii) Returns and allowances.

(iv) Cost of labor, salaries, and wages.

(v) Total expenses or deductions.

(vi) Total assets.

(vii) Beginning- and end-of-year inventory.

(viii) Royalty income.

(ix) Interest income, including portfolio interest.

(x) Rental income, including gross rents.

(xi) Tax-exempt interest income.

(xii) Net gain from sales of business property.

(xiii) Other income.

(xiv) Total income.

(xv) Percentage of stock owned by each shareholder.

(xvi) Percentage of capital ownership of each partner.

(xvii) Principal industrial activity code, including the business description.

(xviii) Consolidated return indicator.

(xix) Wages, tips, and other compensation.

(xx) Social Security wages.

(xxi) Deferred wages.

(xxii) Social Security tip income.

(xxiii) Total Social Security taxable earnings.

(xxiv) Gross distributions from employer-sponsored and individual retirement plans from Form 1099-R.

(b)(4) through (b)(6) [Reserved]. For further guidance, see §301.6103(j)(1)-1(b)(4) through (b)(6).

(e) Effective date . This section is applicable to disclosures to the Bureau of the Census on or after March 10, 2005.

Approved February 26, 2005.

(Filed by the Office of the Federal Register on March 10, 2005, 8:45 a.m., and published in the issue of the Federal Register for March 11, 2005, 70 F.R. 12140)

The principal author of these temporary regulations is James C. O’Leary, Office of the Associate Chief Counsel (Procedure & Administration), Disclosure and Privacy Law Division.

Part III. Administrative, Procedural, and Miscellaneous

Section 1. purpose.

This revenue procedure provides guidance with respect to the United States and area median gross income figures that are to be used by issuers of qualified mortgage bonds, as defined in § 143(a) of the Internal Revenue Code, and issuers of mortgage credit certificates, as defined in § 25(c), in computing the housing cost/income ratio described in § 143(f)(5).

SECTION 2. BACKGROUND

.01 Section 103(a) provides that, except as provided in § 103(b), gross income does not include interest on any state or local bond. Section 103(b)(1) provides that § 103(a) shall not apply to any private activity bond that is not a qualified bond (within the meaning of § 141). Section 141(e) provides that the term “qualified bond” includes any private activity bond that (1) is a qualified mortgage bond, (2) meets the applicable volume cap requirements under § 146, and (3) meets the applicable requirements under § 147.

.02 Section 143(a)(1) provides that the term “qualified mortgage bond” means a bond that is issued as part of a “qualified mortgage issue”. Section 143(a)(2)(A) provides that the term “qualified mortgage issue” means an issue of one or more bonds by a state or political subdivision thereof, but only if (i) all proceeds of the issue (exclusive of issuance costs and a reasonably required reserve) are to be used to finance owner-occupied residences; (ii) the issue meets the requirements of subsections (c), (d), (e), (f), (g), (h), (i), and (m)(7) of § 143; (iii) the issue does not meet the private business tests of paragraphs (1) and (2) of § 141(b); and (iv) with respect to amounts received more than 10 years after the date of issuance, repayments of $250,000 or more of principal on financing provided by the issue are used not later than the close of the first semi-annual period beginning after the date the prepayment (or complete repayment) is received to redeem bonds that are part of the issue.

.03 Section 143(f) imposes eligibility requirements concerning the maximum income of mortgagors for whom financing may be provided by qualified mortgage bonds. Section 25(c)(2)(A)(iii)(IV) provides that recipients of mortgage credit certificates must meet the income requirements of § 143(f). Generally, under §§ 143(f)(1) and 25(c)(2)(A)(iii)(IV), these income requirements are met only if all owner-financing under a qualified mortgage bond and all certified indebtedness amounts under a mortgage credit certificate program are provided to mortgagors whose family income is 115 percent or less of the applicable median family income. Under § 143(f)(6), the income limitation is reduced to 100 percent of the applicable median family income if there are fewer than three individuals in the family of the mortgagor.

.04 Section 143(f)(4) provides that the term “applicable median family income” means the greater of (A) the area median gross income for the area in which the residence is located, or (B) the statewide median gross income for the state in which the residence is located.

.05 Section 143(f)(5) provides for an upward adjustment of the income limitations in certain high housing cost areas. Under § 143(f)(5)(C), a high housing cost area is a statistical area for which the housing cost/income ratio is greater than 1.2. The housing cost/income ratio is determined under § 143(f)(5)(D) by dividing (a) the applicable housing price ratio by (b) the ratio that the area median gross income bears to the median gross income for the United States. The applicable housing price ratio is the new housing price ratio (new housing average purchase price for the area divided by the new housing average purchase price for the United States) or the existing housing price ratio (existing housing average area purchase price divided by the existing housing average purchase price for the United States), whichever results in the housing cost/income ratio being closer to 1. This income adjustment applies only to bonds issued, and nonissued bond amounts elected, after December 31, 1988. See § 4005(h) of the Technical and Miscellaneous Revenue Act of 1988, 1988-3 C.B. 1, 311 (1988).

.06 The Department of Housing and Urban Development (HUD) has computed the median gross income for the United States, the states, and statistical areas within the states. The income information was released to the HUD regional offices on February 11, 2005, and may be obtained by calling the HUD reference service at 1-800-245-2691. The income information is also available at HUD’s World Wide Web site, http:huduser.org/datasets/il.html , which provides a menu from which you may select the year and type of data of interest. The Internal Revenue Service annually publishes the median gross income for the United States.

.07 The most recent nationwide average purchase prices and average area purchase price safe harbor limitations were published on February 28, 2005, in Rev. Proc. 2005-15, 2005-9 I.R.B. 638.

SECTION 3. APPLICATION

.01 When computing the housing cost/income ratio under § 143(f)(5), issuers of qualified mortgage bonds and mortgage credit certificates must use $58,000 as the median gross income for the United States. See § 2.06 of this revenue procedure.

.02 When computing the housing cost/income ratio under § 143(f)(5), issuers of qualified mortgage bonds and mortgage credit certificates must use the area median gross income figures released by HUD on February 11, 2005. See § 2.06 of this revenue procedure.

SECTION 4. EFFECT ON OTHER REVENUE PROCEDURES

.01 Rev. Proc. 2004-24, 2004-16 I.R.B. 790, is obsolete except as provided in § 5.02 of this revenue procedure.

.02 This revenue procedure does not affect the effective date provisions of Rev. Rul. 86-124, 1986-2 C.B. 27. Those effective date provisions will remain operative at least until the Service publishes a new revenue ruling that conforms the approach to effective dates set forth in Rev. Rul. 86-124 to the general approach taken in this revenue procedure.

SECTION 5. EFFECTIVE DATES

.01 Issuers must use the United States and area median gross income figures specified in section 3 of this revenue procedure for commitments to provide financing that are made, or (if the purchase precedes the financing commitment) for residences that are purchased, in the period that begins on February 11, 2005, and ends on the date when these United States and area median gross income figures are rendered obsolete by a new revenue procedure.

.02 Notwithstanding section 5.01 of this revenue procedure, issuers may continue to rely on the United States and area median gross income figures specified in Rev. Proc. 2004-24 with respect to bonds originally sold and nonissued bond amounts elected not later than May 11, 2005, if the commitments or purchases described in § 5.01 are made not later than July 10, 2005.

DRAFTING INFORMATION

The principal author of this revenue procedure is David White of the Office of Assistant Chief Counsel (Exempt Organizations/Employment Tax/Government Entities). For further information regarding this revenue procedure, contact Mr. White at (202) 622-3980 (not a toll-free call).

Part IV. Items of General Interest

Notice of proposed rulemaking by cross-reference to temporary regulations disclosure of return information to the bureau of the census.

Notice of proposed rulemaking by cross-reference to temporary regulations.

In this issue of Bulletin, the IRS is issuing temporary regulations (T.D. 9188) relating to additions to, and deletions from, the list of items of return information disclosed to the Bureau of the Census (Bureau) for use in producing demographic statistics programs, including the Bureau’s Small Area Income and Poverty Estimates (SAIPE). These temporary regulations provide guidance to IRS personnel responsible for disclosing the information. The text of these temporary regulations published in this issue of the Bulletin serves as the text of the proposed regulations.

Written and electronic comments and requests for a public hearing must be received by June 9, 2005.

Send submissions to: CC:PA:LPD:PR (REG-147195-04), room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-147195-04), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC or sent electronically, via the IRS Internet site at: www.irs.gov/regs or via the Federal eRulemaking Portal at www.regulations.gov (IRS and REG-147195-04).

Concerning submission of comments, Treena Garrett, (202) 622-7180 (not a toll-free number); concerning the temporary regulations, James O’Leary, (202) 622-4580 (not a toll-free number).

Under section 6103(j)(1), upon written request from the Secretary of Commerce, the Secretary of the Treasury is to furnish to the Bureau of the Census (Bureau) return information that is prescribed by Treasury regulations for the purpose of, but only to the extent necessary in, structuring censuses and national economic accounts and conducting related statistical activities authorized by law. Section 301.6103(j)(1)-1 of the regulations provides an itemized description of the return information authorized to be disclosed for this purpose. Periodically, the disclosure regulations are amended to reflect the changing needs of the Bureau for data for its statutorily authorized statistical activities.

This document contains proposed regulations authorizing IRS personnel to disclose additional items of return information that have been requested by the Secretary of Commerce, and to remove certain items of return information that are enumerated in the existing regulations but that the Secretary of Commerce has indicated are no longer needed.

Temporary regulations in this issue of the Bulletin amend the Procedure and Administration Regulations (26 CFR Part 301) relating to Internal Revenue Code (Code) section 6103(j). The temporary regulations contain rules relating to the disclosure of return information reflected on returns to officers and employees of the Department of Commerce for structuring censuses and national economic accounts and conducting related statistical activities authorized by law.

The text of the temporary regulations also serves as the text of these proposed regulations. The preamble to the temporary regulations explains the proposed regulations.

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, these proposed regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any electronic and written comments (a signed original and eight (8) copies) that are submitted timely to the IRS. The IRS and Treasury Department specifically request comments on the clarity of the proposed regulations and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing may be scheduled if requested in writing by a person that timely submits comments. If a public hearing is scheduled, notice of the date, time, and place for the hearing will be published in the Federal Register .

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 301 is proposed to be amended as follows:

Paragraph 1. The authority citation for part 301 is amended in part, by adding an entry in numerical order to read as follows:

Section 301.6103(j)(1)-1 also issued under 26 U.S.C. 6103(j)(1); * * *

Par. 2. In §301.6103(j)(1)-1 paragraphs (b)(1), (b)(3), and (e) are revised to read as follows:

§301.6103(j)(1)-1 Disclosure of return information to officers and employees of the Department of Commerce for certain statistical purposes and related activities.

(b) [The text of proposed paragraphs (b)(1), (b)(3) and (e) are the same as the text of §301.6103(j)(1)-1T(b)(1), (b)(3) and (e) published elsewhere in this issue of the Bulletin].

(Filed by the Office of the Federal Register on March 10, 2005, 8:45 a.m., and published in the issue of the Federal Register for March 11, 2005, 70 F.R. 12166)

The principal author of these regulations is James C. O’Leary, Office of the Associate Chief Counsel (Procedure & Administration), Disclosure and Privacy Law Division.

Foundations Status of Certain Organizations

The following organizations have failed to establish or have been unable to maintain their status as public charities or as operating foundations. Accordingly, grantors and contributors may not, after this date, rely on previous rulings or designations in the Cumulative List of Organizations (Publication 78), or on the presumption arising from the filing of notices under section 508(b) of the Code. This listing does not indicate that the organizations have lost their status as organizations described in section 501(c)(3), eligible to receive deductible contributions.

Former Public Charities. The following organizations (which have been treated as organizations that are not private foundations described in section 509(a) of the Code) are now classified as private foundations:

If an organization listed above submits information that warrants the renewal of its classification as a public charity or as a private operating foundation, the Internal Revenue Service will issue a ruling or determination letter with the revised classification as to foundation status. Grantors and contributors may thereafter rely upon such ruling or determination letter as provided in section 1.509(a)-7 of the Income Tax Regulations. It is not the practice of the Service to announce such revised classification of foundation status in the Internal Revenue Bulletin.

Loss Limitation Rules; Correction

Correcting amendment.

This document corrects final regulations (T.D. 9187, 2005-13 I.R.B. 778) that were published in the Federal Register on Thursday, March 3, 2005 (70 FR 10319), that disallows certain losses recognized on sales of subsidiary stock by members of a consolidated group.

This correction is effective on April 4, 2005.

Theresa Abell, (202) 622-7700 or Martin Huck, (202) 622-7750 (not toll-free numbers).

The final and temporary regulations (T.D. 9187) that is the subject of this correction is under sections 337(d) and 1502 of the Internal Revenue Code.

Need for Correction

As published, T.D. 9187 contains an error that may prove to be misleading and is in need of clarification.

Correction of Publication

Accordingly, 26 CFR Part 1 is corrected by making the following correcting amendment:

PART 1 - INCOME TAXES

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

Authority: 26 USC 7805 * * *

§1.1502-20 [Corrected]

Section 1.1502-20(i)(3)(viii), second sentence, the language “Any reapportionment of a section 382 limitation made pursuant to the previous sentence shall have the effects described in paragraphs (i)(3)(iii)(D)( ii ) and ( iii ) of this section.” is removed and the language “Any reapportionment of a section 382 limitation made pursuant to the previous sentence shall have the effects described in paragraph (i)(3)(iii)(D)( 2 ) and ( 3 ) of this section.” is added in its place.

(Filed by the Office of the Federal Register on March 24, 2005, 8:45 a.m., and published in the issue of the Federal Register for March 25, 2005, 70 F.R. 15227)

Definition of Terms and Abbreviations

Amplified describes a situation where no change is being made in a prior published position, but the prior position is being extended to apply to a variation of the fact situation set forth therein. Thus, if an earlier ruling held that a principle applied to A, and the new ruling holds that the same principle also applies to B, the earlier ruling is amplified. (Compare with modified , below).

Clarified is used in those instances where the language in a prior ruling is being made clear because the language has caused, or may cause, some confusion. It is not used where a position in a prior ruling is being changed.

Distinguished describes a situation where a ruling mentions a previously published ruling and points out an essential difference between them.

Modified is used where the substance of a previously published position is being changed. Thus, if a prior ruling held that a principle applied to A but not to B, and the new ruling holds that it applies to both A and B, the prior ruling is modified because it corrects a published position. (Compare with amplified and clarified , above).

Obsoleted describes a previously published ruling that is not considered determinative with respect to future transactions. This term is most commonly used in a ruling that lists previously published rulings that are obsoleted because of changes in laws or regulations. A ruling may also be obsoleted because the substance has been included in regulations subsequently adopted.

Revoked describes situations where the position in the previously published ruling is not correct and the correct position is being stated in a new ruling.

Superseded describes a situation where the new ruling does nothing more than restate the substance and situation of a previously published ruling (or rulings). Thus, the term is used to republish under the 1986 Code and regulations the same position published under the 1939 Code and regulations. The term is also used when it is desired to republish in a single ruling a series of situations, names, etc., that were previously published over a period of time in separate rulings. If the new ruling does more than restate the substance of a prior ruling, a combination of terms is used. For example, modified and superseded describes a situation where the substance of a previously published ruling is being changed in part and is continued without change in part and it is desired to restate the valid portion of the previously published ruling in a new ruling that is self contained. In this case, the previously published ruling is first modified and then, as modified, is superseded.

Supplemented is used in situations in which a list, such as a list of the names of countries, is published in a ruling and that list is expanded by adding further names in subsequent rulings. After the original ruling has been supplemented several times, a new ruling may be published that includes the list in the original ruling and the additions, and supersedes all prior rulings in the series.

Suspended is used in rare situations to show that the previous published rulings will not be applied pending some future action such as the issuance of new or amended regulations, the outcome of cases in litigation, or the outcome of a Service study.

Revenue rulings and revenue procedures (hereinafter referred to as “rulings”) that have an effect on previous rulings use the following defined terms to describe the effect:

The following abbreviations in current use and formerly used will appear in material published in the Bulletin.

A —Individual.

Acq. —Acquiescence.

B —Individual.

BE —Beneficiary.

B.T.A. —Board of Tax Appeals.

C —Individual.

C.B. —Cumulative Bulletin.

CFR —Code of Federal Regulations.

COOP —Cooperative.

Ct.D. —Court Decision.

CY —County.

D —Decedent.

DC —Dummy Corporation.

Del. Order —Delegation Order.

DISC —Domestic International Sales Corporation.

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. —Internal Revenue Bulletin.

LE —Lessee.

LP —Limited Partner.

LR —Lessor.

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. —Statement 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.

TT —Trustee.

U.S.C. —United States Code.

X —Corporation.

Y —Corporation.

Z —Corporation.

A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2004-27 through 2004-52 is in Internal Revenue Bulletin 2004-52, dated December 27, 2004.

Bulletins 2005-1 through 2005-15

Announcements

Court Decisions

Proposed Regulations

Revenue Procedures

Revenue Rulings

Tax Conventions

Treasury Decisions

Effect of Current Actions on Previously Published Items

A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2004-27 through 2004-52 is in Internal Revenue Bulletin 2004-52, dated December 27, 2004.

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You may view the Internal Revenue Bulletin on the Internet at www.irs.gov. Under information for: select Businesses. Under related topics, select More Topics. Then select Internal Revenue Bulletins.

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IMAGES

PPT
The Spendthrift Trust & Assignment Of Income Doctrine
CCH Federal Taxation Basic Principles Chapter 4 Gross Income
Income Statement Example: A Free Guide
Income Statements: A Simple Guide
FREE 11+ Income Statement Samples in PDF

VIDEO

Preparation of Income Statement and Balance Sheet(Example)
Income Statement Format
GOD'S PROVIDENCE
{Part-1} Aggregation of incomes (Deemed Incomes and Clubbing of Incomes), Direct Tax Laws
Traditional And Contribution Format Income Statements || Cost Behaviour Analysis || Lecture 05 ||
Chapter 4: Income Statement and Related Information

COMMENTS

What is "Assignment of Income" Under the Tax Law?
The doctrine is frequently applied to assignments to creditors, controlled entities, family trusts and charities. A taxpayer cannot, for tax purposes, assign income that has already accrued from property the taxpayer owns. This aspect of the assignment of income doctrine is often applied to interest, dividends, rents, royalties, and trust income.
Assignment of income doctrine
Assignment of income doctrine. The assignment of income doctrine is a judicial doctrine developed in United States case law by courts trying to limit tax evasion. The assignment of income doctrine seeks to "preserve the progressive rate structure of the Code by prohibiting the splitting of income among taxable entities." [1]
Recognizing when the IRS can reallocate income
The allocation-of-income theory of Sec. 482; and; The rules for allocation of income between a personal service corporation and its employee-owners of Sec. 269A. Assigning income to the entity that earns or controls the income. Income reallocation under the assignment-of-income doctrine is dependent on determining who earns or controls the income.
ASSIGNMENT OF INCOME DOCTRINE
The assignment of income doctrine was developed from court decisions which decided the issues, including the various methods employed in attempting to determine who earned the income. ... An example would be when a corporation declares a dividend payable say on November 1st to stockholders of record on October 10th. A stockholder who owned the ...
Battling Uphill Against the Assignment of Income Doctrine:
The wide applicability of the assignment of income doctrine was demonstrated in Ryder, in which the court applied the doctrine to several different transactions that occurred between 1996 and 2011. Ryder founded his professional law corporation R&A in 1996 and used his accounting background, law degree, and graduate degree in taxation for the ...
SRIVASTAVA v. COMMISSIONER OF INTERNAL REVENUE (2000)
The anticipatory assignment of income doctrine does not recognize such distinctions, however, for the purpose of the doctrine is simply to capture the taxpayer who diverts a stream of income to achieve gain in non-monetary form and to prevent him from evading taxation through such an arrangement. ... For example, "the miscellaneous itemized ...
FAQ: Can a taxpayer assign income to someone else?
Under the assignment of income doctrine, a taxpayer cannot avoid tax liability by assigning a right to income to someone else. The doctrine is invoked, for example, for assignments to creditors, family members, charities, and controlled entities. Thus, the income is taxable to the person who earned it, even if the person assigns the income to ...
A Tax Planning Cautionary Tale: Timing Is Critical
The assignment of income doctrine is a long-standing "first principle of income taxation" that recognizes that income is taxed to those "who earn or otherwise create the right to receive it ...
Assignment of Income Lawyers
The primary purpose of the "assignment of income doctrine" is to ensure that a person does not simply assign their income to a third party to avoid having to pay taxes. ... For example, if an agent receives income from a third-party that is intended to be paid to the principal, then this income is usually not taxable to the agent. ...
Tax Law on "Assignment of Income"
The doctrine is frequently applied to assignments to creditors, controlled entities, family trusts and charities. A taxpayer cannot, for tax purposes, assign income that has already accrued from property the taxpayer owns. This aspect of the assignment of income doctrine is often applied to interest, dividends, rents, royalties, and trust income.
PDF Assignment of Income Planning for Timely Giving
Assignment of Income Doctrine: • If Tree Owner Gives the Apple (or Assigns the Right to Pick the Apple in Advance), Tree Owner Pays the Tax • If Tree Owner Gives the Tree, Apple Recipients Pay the Tax on Any Apples Assignment of Income Doctrine Why does it matter? From tax planning perspective, ideal charitable gift both: 1.
FAQ: What Is the Assignment of Income?
The assignment of income doctrine states that the taxpayer who earns the income must pay the tax on that income, even if he gave the right to collect the income to another person. The doctrine is quite clear: taxpayers must pay their own taxes. However, that doesn't stop many people from thinking they can avoid paying taxes or minimize their ...
Gross Income: Tax Benefit, Claim of Right and Assignment of Income
Description. The Bloomberg Tax Portfolio, Gross Income: Tax Benefit, Claim of Right and Assignment of Income, No. 502, addresses three areas of gross income that are substantially judicial in origin and nature. It analyzes in depth the nature, concept, scope, and application of the tax benefit doctrine, the claim of right doctrine, and the ...
FAQ: What is assignment of income under the tax law?
The doctrine is frequently applied to assignments to creditors, controlled entities, family trusts and charities. A taxpayer cannot, for tax purposes, assign income that has already accrued from property the taxpayer owns. This aspect of the assignment of income doctrine is often applied to interest, dividends, rents, royalties, and trust income.
PDF Assignment of Income: Gifts Of Stock and Dividend Income
The Assignment of Income Doctrine The assignment of income doctrine took root in Lucas v. Earl and was extended in Blair and Helvering v. Horst.7 Under this doctrine, the as-signment of the right to receive future income, without an accompanying transfer of the under- lying asset, will not shift taxability of the income ...
PDF POINTS TO REMEMBER
tingency fees in gross income. The anticipatory assignment of income doctrine provides that a taxpayer can-not exclude an economic gain from gross income by assigning that gain to another person in advance of receiving the gain. The policy advanced by the doctrine is that income should be taxed to the person who earns it.
CPA Journal Online
The case of Dodge is another example in which the anticipatory assignment of income doctrine did not apply. Partner A offered to leave one-half of his estate to Partner B's daughter if B performed all of the work for AB partnership (A and B were brothers). ... While it is clear the anticipatory assignment of income doctrine applies to ...
Section 1202 Planning: When Might the Assignment of Income Doctrine
For example, in Estate of Applestein v. ... Thus, while there are some tax cases where the assignment of income doctrine has been successfully asserted by the IRS in connection with transfers between spouses incident to divorce, Section 1041 and tax authorities interpreting its application do provide divorcing taxpayers an additional argument ...
Appreciated stock donation not treated as a taxable redemption
The Tax Court analyzed the second prong under the assignment-of-income doctrine. This provides that a taxpayer cannot avoid taxation by assigning a right to income to another. The court stated: "Where a donee redeems shares shortly after a donation, the assignment of income doctrine applies only if the redemption was practically certain to ...
PDF Internal Revenue Service
In general, under the anticipatory assignment of income doctrine, a taxpayer who earns or otherwise creates a right to receive income will be taxed on any gain realized from it, if the taxpayer has the right to receive the income or if, based on the realities . PLR-110344-11 5
IRS properly denied charitable deduction for partnership interest ...
Another small, but important nuance, is that the court in Keefer rejected the government's position that the court should apply the Ninth Circuit's expanded view of the assignment of income doctrine, whereby a deal that is "practically certain to proceed" would cause the assignment of income doctrine to apply (Ferguson v.
Internal Revenue Bulletin: 2005-15
The rationale for the so-called anticipatory assignment of income doctrine is the principle that gains should be taxed "to those who earn them," Lucas, supra, at 114, a maxim we have called "the first principle of income taxation," Commissioner v. Culbertson, 337 U.S. 733, 739-740 (1949). The anticipatory assignment doctrine is meant to ...