Part IV. Items — Internal Revenue Bulletin 1999-23

Relief Act of 1997. This information will be used to verify compliance with section 6045 and to determine that the taxable amount of these payments has been computed correctly. The collection of information is mandatory. The likely respondents are businesses and other for profit institutions.

Respondent taxpayers (payors) provide the information by completing one Form 1099-MISC, Miscellaneous Income, for each attorney who has received one or more payments of gross proceeds from the payor during the calendar year. The burden for this requirement is reflected in the burden estimate for Form 1099MISC. The estimated burden of information collection for the 1999 Form 1099MISC is 14 minutes per return.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

This document contains proposed amendments to the Income Tax Regulations (26 CFR Part 1) under section 6045 of the Internal Revenue Code. A new reporting requirement, section 6045(f), was added to the Code by section 1021 of the Taxpayer Relief Act of 1997 (1997 Act) (Public Law 105–34, 111 Stat. 922). Section 6045(f) provides for information reporting for payments of gross proceeds made in the course of a trade or business to attorneys in connection with legal services (whether or not the services are performed for the payor). No information return is required under section 6045(f) for the portion of any payment that is required to be reported under section 6041(a) (or that would be required except for the $600 limitation) or under section 6051 (employee compensation). The 1997 Act also provides that the general

Notice of Proposed Rulemaking and Notice of Public Hearing

Reporting of Gross Proceeds Payments to Attorneys

REG–105312–98

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations relating to the reporting of payments of gross proceeds to attorneys. The regulations reflect changes to the law made by the Taxpayer Relief Act of 1997. The regulations will affect attorneys who receive payments of gross proceeds on behalf of their clients, and certain payors (defendants in lawsuits and their insurance companies and agents) that in the course of their trades or businesses make payments to these attorneys. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written and electronic comments must be received by August 19, 1999. Outlines of topics to be discussed at the public hearing scheduled for September 22, 1999, at 10 a.m., must be received by September 1, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG–105312–98), Room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG–105312–98), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.ustreas.gov/ tax_regs/regslist.html. The public hearing will be held in the IRS Auditorium, 7th Floor, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, A. Katharine Jacob Kiss at (202) 622-4920; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Michael Slaughter at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Manage- ment and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224. Comments on the collection of information should be received by July 20, 1999. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the Internal Revenue Service, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information (see below);

How the quality, utility, and clarity of the information to be collected may be enhanced;

How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques or other forms of information technology; and

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

The collection of information in this proposed regulation is in §1.6045–5(a). This information is required by the IRS to implement section 1021 of the Taxpayer

June 7, 1999 14 1999–23 I.R.B.

exception for reporting to corporations in §1.6041–3(c) does not apply to corporations providing legal services.

Explanation of Provisions

The proposed regulations take into account comments made by, among others, insurance companies and other payors, the American Bar Association, and the members of the Commissioner’s Information Reporting Program Advisory Committee (IRPAC). The operation of section 6045(f) was the subject of a paper presented at the IRPAC meeting held in Washington, DC., on October 28 and 29, 1997, and comments were also received at that meeting.

The proposed regulations clarify that there is no threshold amount below which reporting under section 6045(f) is not required. Additionally, payments made to corporations engaged in providing legal services are reportable.

Several commentators asked whether reporting under section 6045(f) relieves the payor of all other reporting obligations by shifting the reporting obligations to the attorney. The proposed regulations do not adopt this approach. Section 6045 imposes an additional reporting requirement on payors and does not relieve them of any other pre-existing or concurrently existing reporting requirement. The exception in section 6045(f)(2)(B) is limited to situations in which the amount of the attorney fee is already reportable to the attorney as income or wages. The legislative history clearly supports this determination. See, H.R. Conf. Rep. No. 220, 105th Cong., 1st Sess. 546 (1997) and Joint Committee on Taxation Staff, Gen- eral Explanation of Tax Legislation En- acted in 1997, 105th Cong., 1st Sess. 21415 (1997). Several commentators stated that in certain situations, a gross proceeds payment is delivered to the attorney, but the attorney is not listed as a payee on the check. In some instances this results from the operation of local law; in other instances, attorneys request that their names not appear on the check. The proposed regulations provide that when a payment is delivered to an attorney, even if that attorney is not listed as a payee, the payor is required to file an information return under section 6045(f).

Wherever possible, however, the proposed regulations provide exceptions to the reporting requirement. For example, the proposed regulations provide for a rule of administrative convenience if multiple attorneys are listed as payees. Generally, in those situations, the payor is only required to report on the attorney who receives the payment. The IRS and Treasury Department continue to welcome comments on whether additional exceptions to the reporting requirement are appropriate.

Many commentators suggested that Form 1099-B is not the best form for reporting under section 6045(f). The proposed regulations provide that the information return is made on Form 1099-MISC. Several commentators asked the IRS to define legal services. Some commentators requested a narrow definition that would exclude any services that did not require that the provider be an attorney, e.g., property or financial management services. However, those commentators also stated that the attorney would most likely be collecting a fee for rendering those services. The IRS and Treasury Department have proposed a broad definition of legal services that includes any services performed by or under the supervision of an attorney.

One commentator asked whether the attorney’s TIN must be certified. The proposed regulations provide that, consistent with the general rule under sections 6045 and 6041, the attorney’s TIN need not be certified.

The proposed regulations clarify that payments of gross proceeds are subject to backup withholding if the attorney does not provide a TIN. This is consistent with the legislative history that provides:

Third, attorneys are required to promptly supply their TINS to persons required to file these information reports, pursuant to section 6109. Failure to do so could result in the attorney being subject to penalty under section 6723 and the payments being subject to backup withholding under section 3406.

H.R. Conf. Rep. No. 220, at 546 (1997).

Finally, all of the examples in the proposed regulations follow the generally well-established principle of tax law that the income portion of a plaintiff’s settlement is not reportable net of the attorneys

fees. But, cf., Rev. Rul. 80–364, 1980–2 C.B. 294 (Situation 3 holding that the attorney’s fees portion of the settlement is a reimbursement for expenses incurred by the union to enforce the collective bargaining agreement and not includible in the gross income of the individual employees), and Davis v. Commissioner, T.C.M. 1998–248 (following Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959) for determinations under Alabama law).

Special Analyses

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 has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. Chapter 5) does not apply to these regulations.

It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the facts that: (1) the time required to prepare and file a Form 1099-MISC is minimal (currently estimated at 14 minutes per form); and (2) it is not anticipated that, as a result of these regulations, small entities will have to prepare and file more than a few, at most, forms per year. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any electronic or written comments (a signed original and eight (8) copies) that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

1999–23 I.R.B. 15 June 7, 1999

A public hearing has been scheduled for September 22, 1999, beginning at 10 a.m. in the IRS Auditorium of the Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC. Due to building security procedures, visitors must enter at the 10th Street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must submit written comments and an outline of the topics to be discussed and the time to be devoted to each topic (signed original and 8 copies) by September 1, 1999. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these proposed regulations is A. Katharine Jacob Kiss, Office of Assistant Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be 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 1.6041–3, effective on January 1, 2000, is amended by revising

the first sentence of paragraph (q)(1) to read as follows:

§1.6041–3 Payments for which no return of information is required under section 6041.

(q) * * * (1) A corporation described in §1.6049–4(c)(1)(ii)(A), except a corporation engaged in providing legal services, and except a corporation engaged in providing medical and health care services or engaged in the billing and collecting of payments in respect to the providing of medical and health care services. * * *

Par. 3. Section 1.6041–3, currently in effect as of May 21, 1999, is amended by revising the introductory text of paragraph (c) to read as follows:

§1.6041–3 Payments for which no return of information is required under section 6041.

(c) Payments to a corporation, except payments made after December 31, 1997, to a corporation engaged in providing legal services, and except payments made after December 31, 1970, to a corporation engaged in providing medical and health care services or engaged in the billing and collecting of payments in respect to the providing of medical and health care services, other than payments to—

Par. 4. Section 1.6045–5 is added to read as follows:

§1.6045–5 Information reporting on payments to attorneys.

(a) Requirement of reporting —(1) In general. A person engaged in a trade or business that makes a payment in the course of that trade or business to an attorney in connection with legal services (whether or not the services were performed for the payor) must, except as provided in paragraph (c) of this section, file an information return on Form 1099MISC, “Miscellaneous Income”, with the Internal Revenue Service for the calendar

year in which the payment is made. For the time and place of filing Form 1099MISC, see §1.6041–6. The requirements of this paragraph (a)(1) apply whether or not—

(i) Payments to the attorney aggregate less than $600 for the calendar year;

(ii) A portion of a payment is kept by the attorney as compensation for legal services rendered; or

(iii) Other information returns are required with respect to some or all of a payment under other applicable provisions of the Internal Revenue Code and the regulations thereunder.

(2) Information required. The information return required under paragraph (a)(1) of this section must include the following information:

(i) The name, address, and taxpayer identification number (TIN) (as defined in section 7701(a)) of the person making the payment.

(ii) The name, address, and TIN of the attorney to whom the payment was made.

(iii) The aggregate amount of payments for the calendar year.

(iv) Any other information required by Form 1099-MISC and its instructions.

(3) Requirement to furnish statement. A person required to file an information return under paragraph (a)(1) of this section must furnish to the attorney a written statement of the information required to be shown on the return. This requirement may be met by furnishing a copy of the return to the attorney. The written statement must be furnished to the attorney on or before January 31 of the year following the year in which the payment was made.

(b) Special rules —(1) Check delivered to non-payee attorney. If a check is delivered to an attorney who is not a payee, an information return must be filed under paragraph (a)(1) of this section with respect to the attorney if, under the circumstances, it is reasonable for the payor to believe that the attorney is receiving the check in connection with legal services.

(2) Joint or multiple payees —(i) Check delivered to attorney. If more than one attorney is listed as a payee on a check, an information return must be filed under paragraph (a)(1) of this section with respect to the attorney who received the check.

June 7, 1999 16 1999–23 I.R.B.

(ii) Check delivered to non-attorney. If a check has attorney and non-attorney payees and the check is delivered to a nonattorney, an information return must be filed under paragraph (a)(1) of this section with respect to the first listed attorney.

(3) Attorney required to report pay- ments made to the other attorneys. An attorney with respect to whom an information return is filed under paragraph (b)(1) or (2) of this section must file information returns, as required under this section, for payments the attorney makes to any other attorneys.

(c) Exceptions. A return of information is not required under paragraph (a)(1) of this section with respect to the following payments:

(1) Payments of wages or other compensation paid to an attorney by the attorney’s employer.

(2) Payments of compensation or profits paid or distributed to its individual partner by a partnership engaged in providing legal services.

(3) Payments of dividends or corporate earnings and profits paid to its shareholder by a corporation engaged in providing legal services.

(4) Payments of income to an attorney of a fixed or determinable amount required to be reported (or payments that would be required to be reported were it not for failing to meet the dollar amount limitation contained in section 6041(a)) pursuant to section 6041(a) and §1.6041– 1(a). (5) Payments of the balance of the gross proceeds made to an attorney if a payment described in paragraph (c)(4) of this section is made.

(6) Payments made to a foreign attorney, if the foreign attorney can clearly demonstrate that the attorney is not subject to U.S. tax.

(d) Definitions. The following definitions apply for purposes of this section:

(1) Attorney means a person engaged in the practice of law, whether as a sole proprietor, partnership, corporation, or joint venture.

(2) Legal services means all services performed by, or under the supervision of, an attorney.

(e) Attorney to furnish TIN. A payor that is required to make an information return under this section must solicit a TIN

from the attorney at or before the time the payor pays gross proceeds to the attorney. Any attorney whose TIN is solicited must furnish the TIN to the payor, but is not required to certify that the TIN is correct. Except as otherwise provided under section 3406, if the attorney does not furnish the attorney’s TIN, the payment is subject to backup withholding.

(f) Examples. The provisions of this section are illustrated by the following examples:

Example 1. A, a plaintiff in a suit for lost wages against T, is represented by attorney B. A settles her suit for $300,000. Payment is made by a check payable jointly to A and B. T does not know the amount of the attorney fee. B retains $100,000 and disburses the remaining $200,000 net proceeds to A.

T must file a Form W-2 for $300,000 with respect to A under section 6051. T must also file a Form 1099-MISC with respect to B for $300,000 (see paragraph (a)(1)(iii) of this section).

Example 2. The facts are the same as in Example 1, except that T knows that the attorney fee is onethird of the settlement amount, or $100,000. T must file a Form W-2 for $300,000 with respect to A under section 6051. T must also file a Form 1099MISC with respect to B for $100,000 under section 6041. T is not required to file an information return with respect to B for $200,000 (the balance of the gross proceeds) because of the exception provided in paragraph (c)(5) of this section.

Example 3. C, a plaintiff in a suit for physical personal injury against V, is represented by attorney D. C settles his suit for damages that are excludable from C’s gross income under section 104(a)(2). The settlement check is payable jointly to C and D. V does not know the amount of the attorney fee. V must file a return of information with respect to D under paragraph (a)(1) of this section. V is not required to file a return of information with respect to C under section 6041 because the settlement amount is excludable from C’s income under section 104(a)(2). Example 4. W, a defendant in a suit for wrongful injury, knows that D, the plaintiff, has been represented by attorney E throughout the proceeding. State O, where the suit is brought, mandates that certain benefits and settlement awards be made payable to the claimant only. W makes a check payable solely to D and delivers the payment to E’s office. W has made a payment to an attorney (see paragraph (b)(1) of this section) and must file a return of information under paragraph (a) of this section.

Example 5. X, a defendant in a suit for lost wages, reasonably believes that F, the plaintiff, has been represented by attorney G throughout the proceeding as evidenced by filings and correspondence signed by G. X makes a check for damages payable solely to F and delivers it to G’s office. X has made a payment to an attorney (see paragraph (b)(1) of this section) and must file a return of information under paragraph (a) of this section.

Example 6. Y, a defendant in a suit, makes a payment of the gross proceeds of the amount awarded under the suit to the plaintiff’s attorneys, H, I, and J.

H, I, and J are not related parties. The payment is delivered to J’s office. J deposits the monies into her trust account and pays H and I their respective shares. Y must file a return of information with respect to J (see paragraph (b)(2)(i) of this section). J must file a return of information with respect to H and I (see paragraph (b)(3) of this section).

(g) Cross reference to penalties. See the following sections regarding penalties for failure to comply with the requirements of section 6045(f) and this section:

(1) Section 6721 for failure to file a correct information return.

(2) Section 6722 for failure to furnish a correct payee statement.

(3) Section 6723 for failure to comply with other information reporting requirements (including the requirement to furnish a TIN).

(4) Section 7203 for willful failure to supply information (including a taxpayer identification number).

(h) Effective date. The rules in this section apply to payments made after December 31, 1999.

(Filed by the Office of the Federal Register on May 20, 1999, 8:45 a.m., and published in the issue of the Federal Register for May 21, 1999, 64 F.R. 27730)

Notice of Proposed Rulemaking and Notice of Public Hearing

Special Rules Regarding the Simplified Production and Resale Methods With Historic Absorption Ratio Election

REG–113910–98

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations under section 263A that relate to accounting for costs incurred in producing property and acquiring property for resale. The proposed regulations are necessary to address specific problems in the current section 263A regulations and affect persons who elect to use the simplified production or resale meth

Robert E. Wenzel, Deputy Commissioner of

Internal Revenue.

1999–23 I.R.B. 17 June 7, 1999

ods with historic absorption ratio election. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written and electronic comments must be received by August 23, 1999. Outlines of topics to be discussed at the public hearing scheduled for September 1, 1999, at 10 a.m., must be received by August 11, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG–113910–98), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG–113910–98), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.ustreas.gov/ tax_regs/regslist.html. The public hearing will be held in room 2615, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jennifer Nuding, (202)622-4970; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, LaNita Van Dyke at (202) 622-7180 (not toll-free calls).

SUPPLEMENTARY INFORMATION:

Background

Section 263A provides uniform rules for capitalization of certain expenses. Section 263A requires the capitalization of the direct, and an allocable portion of the indirect, costs of real or tangible personal property produced by a taxpayer or real and personal property described in section 1221(1) that is acquired by the taxpayer for resale. The rules under section 263A, which were added by the Tax Reform Act of 1986, Public Law 99-514, section 803, 100 Stat. 2085, 2350, were designed, in part, to properly match in

come with related expenses and, thus, more accurately reflect income. They also were intended to make the tax system more neutral by eliminating the differences in capitalization rules that created distortions in the allocation of economic resources and the manner in which certain economic activity was organized. See S. Rep. No. 313, 99th Cong., 2d Sess. 140 (1986), 1986–3 C.B. Vol. 3 140. However, the legislative history provides authority to the Secretary to prescribe simplifying methods and assumptions where the costs and other burdens of literal compliance with section 263A may outweigh the benefits of the provision (e.g., matching and neutrality). S. Rep. No. 313, 99th Cong., 2d Sess. 142 (1986).

Section 263A costs are the costs that a taxpayer must capitalize under section 263A and equal the sum of a taxpayer’s section 471 costs, its additional section 263A costs, and interest capitalizable under section 263A(f). Additional section 263A costs are the costs, other than interest, that were not capitalized under the taxpayer’s method of accounting immediately prior to the effective date of section 263A, but that are required to be capitalized under section 263A.

Sections 1.263A–1 through 1.263A–3 of the final regulations (T.D. 8482, 1993–2 C.B. 77) were published in the Federal Register for August 9, 1993 (58 F.R. 42207) and amended by T.D. 8559 (59 F.R. 39958), T.D. 8584 (59 F.R. 67187), T.D. 8597 (60 F.R. 36671), T.D. 8728 (62 F.R. 42051) and T.D. 8729 (62 F.R. 44542). The final regulations provide simplified methods for determining the additional section 263A costs properly allocable to eligible property on hand at the end of the taxable year, including ending inventories of property produced and property acquired for resale. The final regulations include the simplified production method contained in the temporary regulations issued under 263A, §1.263A–1T(b)(5), T.D. 8131 (58 F.R. 151), and the simplified resale method, a redesignation of the modified resale method set forth in Notice 89-67, 1989–1 C.B. 723. A taxpayer using either the simplified production method or the simplified resale method determines the additional section 263A costs properly allocable to eligible property on hand at the end

of the taxable year by multiplying its absorption ratio by the section 471 costs on hand at year-end. Under both the simplified production method and the simplified resale method, an absorption ratio is calculated annually and applied to determine the additional section 263A costs allocated to ending inventory.

In response to requests for additional simplification, the final regulations provide an election to use an historic absorption ratio to determine additional section 263A costs allocable to eligible property on hand at year-end that may be used in connection with either the simplified production method or the simplified resale method.

The final regulations permit a taxpayer that properly elects to use the historic absorption ratio to determine the additional section 263A costs allocable to eligible property on hand at the end of the taxable year by using an historic absorption ratio in lieu of an actual absorption ratio, i.e., by multiplying the historic absorption ratio by section 471 costs on hand at yearend. The historic absorption ratio is based on costs capitalized by a taxpayer during its test period, generally the three taxable-year period immediately prior to the taxable year that the taxpayer elects the historic absorption ratio. The historic absorption ratio equals the taxpayer’s additional section 263A costs incurred during the test period divided by the section 471 costs incurred by the taxpayer during the test period. Under the final regulations, taxpayers are required to test the accuracy of the historic absorption ratio every six years. If the test of the ratio indicates more than one-half of one percentage point difference (plus or minus) from the historic absorption ratio, the taxpayer must redetermine its historic absorption ratio using a new updated test period. The final regulations provide that, if elected, the historic absorption ratio must be used for each taxable year within the qualifying period. Generally, the qualifying period includes each of the first five taxable years beginning with the first taxable year after a test period (or an updated test period).

Explanation of Provisions

This document contains proposed amendments to the Income Tax Regula

June 7, 1999 18 1999–23 I.R.B.

specific dollar amount test. The regulations provide that the historic absorption ratio is materially inaccurate if: (1) the taxpayer’s actual absorption ratio deviates by more than 50% and by more than onehalf of one percentage point from the taxpayer’s historic absorption ratio; and (2) the amount of additional section 263A costs capitalizable to items on hand at year-end using the actual absorption ratio deviates by more than $100,000 from the amount of additional section 263A costs capitalizable to items on hand at year-end using the historic absorption ratio. This high threshold is provided so that annual actual absorption ratio computations will be unnecessary in the overwhelming majority of situations. For example, the placement in service of a significant amount of property may have a significant effect on a taxpayer’s actual absorption ratio. However, it may not be necessary for a taxpayer to compute its actual absorption ratio for a year that the taxpayer placed property in service if, based on the taxpayer’s knowledge of the difference between its tax depreciation and book depreciation, and its inventory turnover, the taxpayer knows that it would be impossible for the amount of additional section 263A costs allocable to items on hand at year-end to increase by $100,000 if the taxpayer used the simplified production method without the historic absorption ratio election. Therefore, the taxpayer would not need to calculate an actual absorption ratio for that year.

Proposed Effective Date

The provisions of these regulations are proposed to be effective for taxable years beginning after May 24, 1999.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the 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

tions (26 CFR part 1) that relate to the capitalization of certain costs under section 263A. More specifically, this document contains proposed amendments with respect to the historic absorption ratio election that are necessary to carry out the purpose of section 263A. The rules under section 263A were designed to properly match income with related expenses by requiring all of the costs relating to an item produced or acquired for resale to be included in the basis or inventoriable cost of that item. The simplified production method and the simplified resale method were included in the regulations to provide taxpayers with a simplified method for determining the additional section 263A costs allocable to items on hand at year end. The historic absorption ratio election was provided in response to commentators’ concerns that computations under the simplified production method and the simplified resale method are costly and time consuming because taxpayers must determine absorption ratios annually, even though there may have been little or no change in the taxpayers’ business operations that would cause the absorption ratios to vary from year to year.

The historic absorption ratio election in the final regulations is intended to permit taxpayers to determine additional section 263A costs allocable to items on hand at year-end without calculating actual absorption ratios while still capitalizing the costs properly allocable to property produced or acquired for resale. The historic absorption ratio was selected in lieu of an industry-based ratio because the IRS and Treasury Department believed that a ratio based on taxpayer specific historical data would more reasonably approximate the taxpayer’s annual absorption ratio than an industry-based ratio.

The IRS and Treasury Department have become aware that the historic absorption ratio may become materially inaccurate generally as the result of a significant change in a taxpayer’s circumstances during the qualifying period, thus resulting in a failure to allocate the proper amount of additional section 263A costs to items on hand at year-end. Although the regulations provide that a taxpayer must test its historic absorption ratio every six years, a significant deviation from the taxpayer’s

actual absorption ratio could result in a substantial mismatching of the taxpayer’s income and related expenses during the qualifying period.

The IRS and Treasury Department considered many alternate approaches to revising the historic absorption ratio regulations in order to prevent a substantial mismatching of income and related expenses. Among the approaches considered and rejected were the following: (1) eliminate the historic absorption ratio election entirely; (2) limit use of the historic absorption ratio election to small taxpayers; (3) require taxpayers to retest their historic absorption ratio more frequently, e.g., every three years; and (4) provide a general anti-abuse rule.

These proposed regulations provide for early termination of the qualifying period if the taxpayer’s historic absorption ratio is materially inaccurate. In such a case, the taxpayer must calculate a new historic absorption ratio beginning with the year in which the taxpayer’s historic absorption ratio became materially inaccurate.

Generally, a taxpayer’s historic absorption ratio may become materially inaccurate when the taxpayer experiences a significant change in the taxpayer’s normal business operations and that change has an effect on the taxpayer’s section 263A absorption ratio. For example, the following changes may cause a taxpayer’s historic absorption ratio to become materially inaccurate: a significant change in the taxpayer’s manufacturing process, e.g. implementation of a new inventory management system; a significant change in the taxpayer’s product offering; a significant addition or retirement of equipment used for manufacturing; a significant change in the taxpayer’s components of cost, e.g., a manufacturing operation that becomes significantly more or less labor intensive; a significant change in the taxpayer’s overhead costs, e.g. a new plant, building or building addition; and a significant change in the taxpayer’s trade or business, e.g., the sale or acquisition of a division.

The proposed regulations establish a high threshold for when the historic absorption ratio will be regarded as materially inaccurate. The regulations provide a definition of materially inaccurate that incorporates both a percentage test and a

1999–23 I.R.B. 19 June 7, 1999

Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) and electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for Wednesday, September 1, 1999, in room 2615, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the 10th Street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must submit written or electronic comments by August 23, 1999 and submit an outline of the topics to be discussed and the time to be devoted to each topic (a signed original and eight (8) copies) by August 11, 1999.

A period of 10 minutes will be allocated to each person for making comments.

An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Jennifer Nuding of the Office of

Assistant Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be 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 1.263A–2 is amended as follows:

Paragraphs (b)(4)(ii)(C)( 1 ) and ( 2 ) are revised;
New paragraphs (b)(4)(ii)(C)( 3 ) and ( 4 ) are added;
Paragraph (b)(4)(vi) is amended by: a. Revising the paragraph heading and introductory text;

b. Redesignating the Example as Ex- ample 1 ;

c. Adding new Example 2 and Ex- ample 3.

The revisions and additions read as follows:

§1.263A–2 Rules relating to property produced by the taxpayer.

(b) * * * (4) * * * (ii) * * * (C) Qualifying period —( 1 ) In general. A qualifying period generally includes each of the first five taxable years beginning with the first taxable year after a test period (or an updated test period). However, a qualifying period may be extended under the provisions of paragraph (b)(4)(ii)(C)( 2 ) of this section or may terminate early under the provisions of paragraph (b)(4)(ii)(C)( 3 ) of this section.

( 2 ) Extension of qualifying period. In the first taxable year following the close of each qualifying period, (e.g., the sixth taxable year following the test period), the taxpayer must compute the actual absorption ratio under the simplified production method. If the actual absorption ratio computed for this taxable year (the recomputation year) is within one-half of one percentage point (plus or minus) of

the historic absorption ratio used in determining capitalizable costs for the qualifying period (e.g., the previous five taxable years), the qualifying period is extended to include the recomputation year and the following five taxable years (or a shorter period if the qualifying period is terminated early under the provisions of paragraph (b)(4)(ii)(C)( 3 ) of this section), and the taxpayer must continue to use the historic absorption ratio throughout the extended qualifying period. If, however, the actual absorption ratio computed for the recomputation year is not within one-half of one percentage point (plus or minus) of the historic absorption ratio, the taxpayer must use actual absorption ratios beginning with the recomputation year under the simplified production method and throughout the updated test period. The taxpayer must resume using the historic absorption ratio (determined with reference to the updated test period) in the third taxable year following the recomputation year.

(3) Earlier termination of the qualify- ing period. For taxable years beginning afterMay 24, 1999, a qualifying period closes immediately prior to a taxable year in which the taxpayer’s historic absorption ratio becomes materially inaccurate (early recomputation year). If the taxpayer’s historic absorption ratio is materially inaccurate, as defined in paragraph (b)(4)(ii)(C)(4) of this section, the taxpayer must use its actual absorption ratios computed using the simplified production method beginning with the early recomputation year and throughout the updated test period. The taxpayer must resume using the historic absorption ratio (determined with reference to the updated test period) in the third taxable year following the early recomputation year.

(4) Materially inaccurate. For purposes of this paragraph (b)(4), an historic absorption ratio becomes materially inaccurate in a taxable year that—

( i ) The taxpayer’s actual absorption ratio computed using the simplified production method deviates by more than 50 percent and by more than one-half of one percentage point from the taxpayer’s historic absorption ratio for that year; and

( ii ) The amount of additional section 263A costs capitalizable to eligible property remaining on hand at the close of that year under the simplified production

June 7, 1999 20 1999–23 I.R.B.

method (using the taxpayer’s actual absorption ratio) deviates by more than $100,000 from the amount of additional section 263A costs capitalizable to that property under the simplified production method with historic absorption ratio election for that year.

(vi) Examples. The provisions of this paragraph (b)(4) are illustrated by the following examples:

Example 1. - * *

Example 2. (i) Taxpayer K uses the FIFO method of accounting for inventories and properly elects to use the historic absorption ratio with the simplified production method for 1998. K identifies the following costs incurred during the test period:

1995: Add’l section 263A costs — $3,500,000 Section 471 costs — $75,000,000 1996: Add’l section 263A costs — $4,000,000 Section 471 costs — $80,000,000 1997: Add’l section 263A costs — $4,500,000 Section 471 costs — $85,000,000

(ii) Therefore, K computes a 5% historic absorption ratio as follows:

$3,500,000 + 4,000,000 + 4,500,000 Historic absorption ratio = = 5% $75,000,000 + 80,000,000 + 85,000,000

(iii) In 1998, K incurs $90,000,000 of section 471 costs of which $15,000,000 remain in inventory at the end of the year. In addition, K places $50,000,000 of plant and equipment into service. K’s book depreciation on the new plant and equipment is $5,000,000, while K’s tax depreciation on

the new plant and equipment is $10,000,000. K’s book depreciation is a section 471 cost as described in §1.263A–1(d)(2) and the excess of K’s tax depreciation over K’s book depreciation, $5,000,000, is an additional section 263A cost. K also has $4,500,000 in other additional section 263A costs.

(iv) K must determine whether K’s historic absorption ratio is materially inaccurate in 1998. Under the simplified production method without the historic absorption ratio election, K determines its actual absorption ratio for 1998 as follows:

Actual absorption Ratio = ^{$4,500,000 + $5,000,000} = 10% $90,000,000 + $5,000,000

New paragraphs (d)(4)(ii)(C)(3) and (4) are added;
Paragraph (d)(4)(vi) is amended by: a. Revising the paragraph heading and introductory text;

b. Redesignating the Example as Ex- ample 1 ;

c. Adding new Example 2. The revisions and additions read as follows:

§1.263A–3 Rules relating to property acquired for resale.

(d) * * * (4) * * * (ii) * * * (C) Qualifying period —(1) In general. A qualifying period generally includes each of the first five taxable years beginning with the first taxable year after a test period (or an updated test period). However, a qualifying period may be extended under the provisions of paragraph (d)(4)(ii)(C)( 2 ) of this section or may terminate early under the provisions of paragraph (d)(4)(ii)(C)( 3 ) of this section.

( 2 ) Extension of qualifying period. In the first taxable year following the close of each qualifying period, (e.g., the sixth taxable year following the test period), the taxpayer must compute the actual combined absorption ratio under the simplified resale method. If the actual combined absorption ratio computed for this taxable year (the recomputation year) is within one-half of one percentage point

(v) The difference between K’s actual absorption ratio (10%) under the simplified production method for 1998 and K’s historic absorption ratio (5%) is 5%, which is greater than 50 percent of K’s historic absorption ratio for that year (5% x 50% = 2.5%). Under the simplified production method without the historic absorption ratio election, K determines the additional section 263A costs allocable to its ending inventory by multiplying its actual absorption ratio (10%) by the section 471 costs remaining in its ending inventory as follows:

Add’l section 263A costs = 10% � $15,000,000 = $1,500,000

(vi) Under the simplified production method using the historic absorption ratio, K determines the additional section 263A costs allocable to its ending inventory by multiplying its historic absorption ratio (5%) by the section 471 costs remaining in its ending inventory as follows:

Add’l section 263A costs = 5% � $15,000,000 = $750,000

(vii) The difference between the amount of additional section 263A costs allocable to eligible property remaining on hand at the close of 1998 under the simplified production method using the taxpayer’s actual absorption ratio and the amount of additional section 263A costs allocable to that property under the simplified production method with historic absorption ratio election ($1,500,000 – $750,000 = $750,000) exceeds $100,000. Accordingly, K’s historic absorption ratio is materially inaccurate for 1998.

(viii) Since K’s historic absorption ratio is materially inaccurate in 1998, K’s qualifying period closes immediately prior to the beginning of K’s 1998 taxable year. Therefore, K must update its test period beginning in 1998. K must use actual absorption ratios under the simplified production method beginning in 1998 and throughout the updated test period (1999 and 2000). K must resume using the historic absorption ratio (determined with reference to the updated test period) in 2001, the third taxable year following 1998.

Example 3. (i) Taxpayer L properly elects to use the historic absorption ratio with the simplified pro

duction method for 1999. L computes a 10% historic absorption ratio. On average, L’s inventory turns over approximately fifteen times a year.

(ii) In 1999, L incurs $8,000,000 of section 471 costs of which $500,000 remain in inventory at the end of the year. In addition, L places $5,000,000 of plant and equipment into service. The difference between L’s tax depreciation on the new plant and equipment and L’s book depreciation on that plant and equipment for 1999 is $500,000, which is an additional section 263A cost. There were no other changes in L’s additional 263A costs.

(iii) L can determine, without calculating an actual absorption ratio, that its historic absorption ratio is not materially inaccurate for 1999. The difference between the amount of additional section 263A costs allocated to its ending inventory using its actual absorption ratio and the amount of additional section 263A costs allocated to its ending inventory using its historic absorption ratio will not exceed $100,000 and, therefore, L does not fall within the specific dollar amount test of paragraph (b)(4)(ii)(C)( 4 )( ii ) of this section. Although L’s additional section 263A costs increased by over $100,000 in 1999 (they increased by $500,000) as a result of placing the plant and equipment into service, only a portion of that amount will be allocated to ending inventory. L’s inventory turns over approximately fifteen times a year. Of the $500,000 of additional section 263A costs incurred as the result of placing the plant and equipment into service in 1999, only about $33,000 ($500,000 � 15) will be allocated to ending inventory. Since $33,000 is well below the $100,000 threshold, L can determine without calculating an actual absorption ratio for 1999 that its historic absorption ratio is not materially inaccurate. Since L’s historic absorption ratio is not materially inaccurate in 1999, L’s qualifying period does not terminate early.

Par. 3. Section 1.263A-3 is amended as follows:

Paragraphs (d)(4)(ii)(C)(1) and (2) are revised;

1999–23 I.R.B. 21 June 7, 1999

$100,000 from the amount of additional section 263A costs capitalizable to that property under the simplified resale method with historic absorption ratio election for that year.

(vi) Examples. The provisions of this paragraph (d)(4) are illustrated by the following examples:

Example 1. - * *

Example 2. (i) Taxpayer W operates a mail-order retail business and uses the FIFO method of accounting for inventories. In 1996, 1997 and 1998, W used the simplified resale method without the historic absorption ratio election with the variation permitted in paragraph (d)(3)(iii)(A) of this section, exclusion of beginning inventories from the denominator in the storage and handling costs absorption ratio formula. Taxpayer W elects to use the historic absorption ratio with the simplified resale method for 1999. W identifies the following costs incurred during the test period:

1996: Add’l section 263A costs — $2,000,000 Section 471 costs — $45,000,000 1997: Add’l section 263A costs — $2,500,000 Section 471 costs — $50,000,000 1998: Add’l section 263A costs — $3,000,000 Section 471 costs — $55,000,000

(ii) Therefore, W computes a 5% historic absorption ratio as follows:

(plus or minus) of the historic absorption ratio used in determining capitalizable costs for the qualifying period (e.g., the previous five taxable years), the qualifying period is extended to include the recomputation year and the following five taxable years (or a shorter period if the qualifying period is terminated early under the provisions of paragraph (d)(4)(ii)(C)( 3 ) of this section), and the taxpayer must continue to use the historic absorption ratio throughout the extended qualifying period. If, however, the actual combined absorption ratio computed for the recomputation year is not within onehalf of one percentage point (plus or minus) of the historic absorption ratio, the taxpayer must use actual combined absorption ratios beginning with the recomputation year under the simplified resale method and throughout the updated test period. The taxpayer must resume using the historic absorption ratio (determined with reference to the updated test period) in the third taxable year following the recomputation year.

( 3 ) Earlier termination of the qualify- ing period. For taxable years beginning after [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER], a qualifying period closes immediately prior to a taxable

year in which the taxpayer’s historic absorption ratio becomes materially inaccurate (early recomputation year). If the taxpayer’s historic absorption ratio is materially inaccurate, as defined in paragraph (d)(4)(ii)(C)( 4 ) of this section, the taxpayer must use its actual combined absorption ratios computed using the simplified resale method beginning with the early recomputation year and throughout the updated test period. The taxpayer must resume using the historic absorption ratio (determined with reference to the updated test period) in the third taxable year following the early recomputation year.

( 4 ) Materially inaccurate. For purposes of this paragraph (d)(4), an historic absorption ratio becomes materially inaccurate in a taxable year that—

( i ) The taxpayer’s actual combined absorption ratio computed using the simplified resale method deviates by more than 50 percent and by more than one-half of one percentage point from the taxpayer’s historic absorption ratio for that year; and

( ii ) The amount of additional section 263A costs capitalizable to eligible property remaining on hand at the close of that year under the simplified resale method (using the taxpayer’s actual combined absorption ratio) deviates by more than

$2,000,000 + 2,500,000 + 3,000,000 Historic absorption ratio = = 5% $45,000,000 + 50,000,000 + 55,000,000

(iii) In 1999, W decides to automate part of its repackaging activities. Accordingly, W places new repackaging equipment into service. The repackaging equipment has a basis of $15,000,000 for tax purposes. W’s tax depreciation on the new equipment for 1999 is $3,000,000. This depreciation allowance is an additional section 263A cost and is a handling cost as defined in paragraph (c)(4) of this section. As a result of the new equipment, W’s direct labor costs with respect to its repackaging activities decrease by $500,000 during 1999. In 1999, W incurs $60,000,000 of section 471 costs, of which $6,000,000 remain on hand at the end of the year. W identifies $6,000,000 of storage and handling costs, including W’s tax depreciation on the new equipment and taking into account the reduction in direct labor costs, and $450,000 of purchasing costs incurred in 1999.

(iv) W must determine whether W’s historic absorption ratio is materially inaccurate in 1999. In order to do so, W calculates W’s actual combined absorption ratio for 1999 as follows:

Storage & handling costs = ^$6,000,000 = 10% absorption ratio $60,000,000 Purchasing costs $450,000 = = 0.75% absorption ratio $60,000,000

Combined absorption ratio = 10% + 0.75% = 10.75%

(v) The difference between W’s actual combined absorption ratio (10.75%) under the simplified resale method for 1999 and W’s historic absorption ratio (5%) is 5.75%, which is greater than 50 percent of W’s historic absorption ratio for that year (5% � 50% = 2.5%). Under the simplified resale method without the historic absorption ratio election, W determines the additional section 263A costs allocable to its ending inventory by multiplying its actual combined absorption ratio (10.75%) by the section 471 costs remaining in its ending inventory as follows:

Add’l section 263A costs = 10.75% � $6,000,000 = $645,000

(vi) Under the simplified resale method using the historic absorption ratio, W determines the additional section 263A costs

allocable to its ending inventory by multiplying its historic absorption ratio (5%) by the section 471 costs remaining in its ending inventory as follows:

Add’l section 263A costs = 5% $6,000,000 = $300,000

(vii) The difference between the amount of additional section 263A costs allocable to eligible property remaining on hand at the close of 1999 under the simplified resale method using the taxpayer’s actual combined absorption ratio and the amount of additional section 263A costs allocable to that property under the simplified resale method with historic absorption ratio election ($645,000 – $300,000 = $345,000) exceeds $100,000. Accordingly, W’s historic absorption ratio is materially inaccurate for 1999.

(viii) Since W’s historic absorption ratio was materially inaccurate in 1999,

June 7, 1999 22 1999–23 I.R.B.

W’s qualifying period closes immediately prior to the beginning of W’s 1999 taxable year. Therefore, W must update its test period beginning in 1999. W must use actual combined absorption ratios under the simplified resale method beginning in 1999 and throughout the updated test period (2000 and 2001). W must re

sume using the historic absorption ratio (determined with reference to the updated test period) in 2002, the third taxable year following 1999.

Robert E. Wenzel, Deputy Commissioner of

Internal Revenue.

(Filed by the Office of the Federal Register on May 21, 1999, 8:45 a.m., and published in the issue of the Federal Register for May 24, 1999, 64 F.R. 27936)

1999–23 I.R.B. 23 June 7, 1999