Part I. Rulings — Internal Revenue Bulletin 2001-6

spouse, if there is less than a 15% probability that individuals who are not lineal descendants will receive any trust corpus. This probability must be computed at the date of transfer to the trust taking into consideration the interests of all individuals living at that time. This change will afford drafters the flexibility to provide for alternative remainder beneficiaries in the event the primary remainder beneficiary and his or her descendants predecease the individual who is the measuring life for the term of the charitable interest.

The application of the probability test may be illustrated by assuming a grantor establishes a charitable lead annuity trust (CLAT) that provides for the annuity to be paid to a charity for the life of A who is age 75 on the date the CLAT is created. On A’s death, the corpus is to pass to A’s only child, B, age 50 on the date the CLAT is created. If B predeceases A, the corpus is to pass to B’s issue then living and if B has no living issue at that time, then to A’s heirs at law (which class could include A’s siblings, uncles, aunts, nieces and nephews). B has no living children on the date the CLAT is created. Based on the current applicable Life Table contained in §20.2031–7 of the Estate Tax Regulations (Life Table 90CM), the probability that B will predecease A, and the trust will pass to individuals who are not lineal descendants of A is 10.462%, taking into account the interests of remainder beneficiaries living at the time the trust was created. Since the probability that any trust corpus will pass to beneficiaries who are not lineal descendants of A is less than 15%, the CLAT will satisfy the requirement that all noncharitable remainder beneficiaries are lineal descendants of A or A’s spouse.

Several commentators identified hypothetical situations where an individual who is either unrelated to the remainder beneficiaries, or a remote family member, could be used as a measuring life to achieve an estate planning objective. The commentators suggested three alternative standards that would expand the class of permissible measuring lives. None of these suggestions has been adopted.

First, one commentator suggested that the regulations allow a charitable lead trust to use as a measuring life an ancestor

Section 162(k).—Stock Reacquisition Expenses

26 CFR None: None.

Does section 162(k) of the Internal Revenue Code disallow any deduction claimed by a corporation under section 404(k) for payments in redemption of its stock held by an ESOP that are used to make distributions to terminating ESOP participants? See Rev. Rul. 2001–6, page 491.

Section 170.—Charitable, Etc., Contributions and Gifts

26 CFR 1.170A–6: Charitable contributions in trust.

T.D. 8923

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1, 20, and 25

Lifetime Charitable Lead Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the definitions of a guaranteed annuity interest and a unitrust interest for purposes of the income, gift, and estate tax charitable deductions. The regulations affect taxpayers who make transfers to charitable lead trusts. The regulations restrict the permissible terms for charitable lead trusts and are necessary to ensure that the amount the taxpayer claims as a charitable deduction reasonably correlates to the amount ultimately passing to the charitable organization.

DATES: Effective Dates : These regulations are effective January 5, 2001.

Applicability Dates : For dates of applicability of these regulations, see §§1.170A–6(e), 20.2055–2(e)(3)(iii), and 25.2522(c)–3(e).

FOR FURTHER INFORMATION CONTACT: Scott S. Landes at 202-622-3090.

SUPPLEMENTARY INFORMATION:

Background

On April 5, 2000, the IRS published in the Federal Register (65 F.R. 17835) a

notice of proposed rulemaking (REG–100291–00, 2000–16 I.R.B. 917) relating to the permissible terms for charitable guaranteed annuity interests and unitrust interests. This document adopts final regulations with respect to the notice of proposed rulemaking. Written comments were received with respect to the proposed regulations, but no public hearing was requested or held. A summary of the principal comments received is provided below.

In general, in order to qualify as a guaranteed annuity interest or unitrust interest for purposes of the income, estate, and gift tax charitable deductions under sections 170(c), 2055(e)(2), and 2522(c)(2), respectively, the permissible term for the charitable lead interest must be either a specified term of years, or the life or lives of individuals living at the date of the transfer. The proposed regulations limit the individuals who may be used as measuring lives to the donor, the donor’s spouse, and a lineal ancestor of all the remainder beneficiaries. This proposed limitation is intended to eliminate abusive schemes utilizing seriously ill individuals, who are unrelated to the grantor or the remainder beneficiaries, as measuring lives for charitable lead trusts.

Commentators argued that by limiting the class of individuals who can be used as measuring lives in a charitable lead trust, the regulations preclude the use of these trusts in certain nonabusive situations. In response to these comments, several changes were made to the final regulations to provide a greater degree of flexibility for selecting a measuring life.

The final regulations expand the class of permissible measuring lives to include an individual who, with respect to all noncharitable remainder beneficiaries, is either a lineal ancestor or the spouse of a lineal ancestor of those beneficiaries. Thus, remainder beneficiaries can include step-children and step-grandchildren of the individual who is the measuring life, and charitable organizations (described in section 170, 2055, or 2522).

The final regulations also provide that a trust will satisfy the requirement that all noncharitable remainder beneficiaries are lineal descendants of the individual who is the measuring life, or that individual’s

2001–6 I.R.B. 485 February 5, 2001

als” is removed, and “certain individuals” is added in its place.

c. The third sentence is removed, and six new sentences are added in its place.

d. In the penultimate sentence, the language “of years” is added after the word “term”, the language “an individual” is removed, and “the donor” is added in its place.

Paragraph (c)(2)(ii)(A) is amended as follows:

a. In the fifth sentence, the language “of years” is added after the word “term”, “an individual or individuals” is removed, and ”certain individuals” is added in its place.

b. The last sentence is removed, and six new sentences are added in its place.

Paragraph (e) is amended by adding four sentences to the end of the paragraph.
The authority citation at the end of the section is removed. The additions read as follows:

§1.170A–6 Charitable contributions in trust.

(c) * * * (2) * * * (i) * * * (A) * * * Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and an individual who, with respect to all remainder beneficiaries (other than charitable organizations described in section 170, 2055, or 2522), is either a lineal ancestor or the spouse of a lineal ancestor of those beneficiaries. A trust will satisfy the requirement that all noncharitable remainder beneficiaries are lineal descendants of the individual who is the measuring life, or that individual’s spouse, if there is less than a 15% probability that individuals who are not lineal descendants will receive any trust corpus. This probability must be computed, based on the current applicable Life Table contained in §20.2031–7, at the time property is transferred to the trust taking into account the interests of all primary and contingent remainder beneficiaries who are living at that time. An interest payable for a specified term of years can qualify as a guaranteed annuity interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of

of any remainder beneficiary rather than an ancestor of all remainder beneficiaries. Under the suggested standard, the charitable lead trust could provide a nominal remainder interest for descendants of the measuring life, with the balance passing to the grantor’s family members. Thus, the standard would do little to prevent the abuse the regulations are intended to address.

Second, one commentator suggested that the regulations provide that an individual is a permissible measuring life if all remainder beneficiaries are natural objects of the individual’s bounty. However, the determination of whether a person is the natural object of one’s bounty requires an inquiry into facts that may be difficult to ascertain or verify. Such a subjective standard would create uncertainty and would be difficult to administer.

Third, one commentator suggested that if the charitable interest is payable for the life of an individual, then the trust must require that, in the event the individual fails to survive to a normal life expectancy, a guaranteed lump sum will be paid to charity (determined actuarially), that will make up for the shortfall in the charitable annuity. A provision requiring such a payment in the event of the premature death of the measuring life would be complex and inconsistent with the valuation rules of section 7520. In addition, this requirement would in substance convert a life interest to a term of years interest and in some cases allow that term interest to be commuted. Thus, such a requirement may conflict with other rules prohibiting commutation or prepayment of the charitable lead interest.

In summary, the Treasury Department and the IRS acknowledge that there may be situations in which the grantor, for a valid estate planning objective, may desire to use an individual as a measuring life who does not satisfy the criteria in the regulations (for example, where a remainder beneficiary is dependent on a nonfamily member for support and the trust corpus is intended to provide that support after the death of the nonfamily member). However, the Treasury Department and the IRS believe that in these situations the grantor’s objectives can be satisfied through the use of other permissible estate planning techniques. In situations where

a charitable lead trust is utilized, the Treasury Department and the IRS believe that the final regulations allow adequate flexibility for achieving legitimate estate planning objectives while providing reasonable safeguards to preclude abusive arrangements.

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 has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

Drafting Information

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

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1, 20, and 25 are amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Section 1.170A–6 also issued under 26 U.S.C. 170(f)(4); 26 U.S.C. 642(c)(5). *

Par. 2. Section 1.170A–6 is amended as follows:

Paragraph (c)(2)(i)(A) is amended as follows:

a. In the first sentence, the comma is removed.

b. In the second sentence, the language “of years” is added after the word “term”, the language “an individual or individu

February 5, 2001 486 2001–6 I.R.B.

21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. The rule in this paragraph that a charitable interest may be payable for the life or lives of only certain specified individuals does not apply in the case of a charitable guaranteed annuity interest payable under a charitable remainder trust described in section 664. * * *

(ii) * * * (A) * * * Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and an individual who, with respect to all remainder beneficiaries (other than charitable organizations described in section 170, 2055, or 2522), is either a lineal ancestor or the spouse of a lineal ancestor of those beneficiaries. A trust will satisfy the requirement that all noncharitable remainder beneficiaries are lineal descendants of the individual who is the measuring life, or that individual’s spouse, if there is less than a 15% probability that individuals who are not lineal descendants will receive any trust corpus. This probability must be computed, based on the current applicable Life Table contained in §20.2031–7, at the time property is transferred to the trust taking into account the interests of all primary and contingent remainder beneficiaries who are living at that time. An interest payable for a specified term of years can qualify as a unitrust interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. The rule in this paragraph that a charitable interest may be payable for the life or lives of only certain specified individuals does not apply in the case of a charitable unitrust interest payable under a charitable remainder trust described in section 664.

(e) Effective date . * * * In addition, the rule in paragraphs (c)(2)(i)(A) and (ii)(A) of this section that guaranteed annuity interests and unitrust interests, respectively, may be payable for a specified term of years or for the life or lives of only certain individuals applies to transfers made on or after April 4, 2000. If a

transfer is made to a trust on or after April 4, 2000, that uses an individual other than one permitted in paragraphs (c)(2)(i)(A) and (ii)(A) of this section, the trust may be reformed to satisfy this rule. As an alternative to reformation, rescission may be available for a transfer made on or before March 6, 2001. See §25.2522(c)–3(e) of this chapter for the requirements concerning reformation or possible rescission of these interests.

PART 20—ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16, 1954

Par. 3. The authority citation for part 20 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 4. Section 20.2055–2 is amended as follows:

Paragraph (e)(2)(vi) ( a ) is amended as follows:

a. In the third sentence, the language “of years” is added after the word “term”, the language “an individual or individuals” is removed, and ”certain individuals” is added in its place.

b. The fourth sentence is removed, and six new sentences are added in its place.

c. In the penultimate sentence, the language “of years” is added after the word “term”, the language “an individual” is removed, and “the decedent’s spouse” is added in its place.

Paragraph (e)(2)(vii)( a ) is amended as follows:

a. In the sixth sentence, the language “of years” is added after the word “term”, the language “of an individual or individuals” is removed, and “of certain individuals” is added in its place.

b. The last sentence is removed, and six new sentences are added in its place.

(2) * * * (vi) * * * ( a ) * * * Only one or more of the following individuals may be used as measuring lives: the decedent’s spouse, and an individual who, with respect to all remainder beneficiaries (other than charitable organizations described in section 170, 2055, or 2522), is either a lineal ancestor or the spouse of a lineal ancestor of those beneficiaries. A trust will satisfy the requirement that all noncharitable remainder beneficiaries are lineal descendants of the individual who is the measuring life, or that individual’s spouse, if there is less than a 15% probability that individuals who are not lineal descendants will receive any trust corpus. This probability must be computed, based on the current applicable Life Table contained in §20.2031–7, as of the date of the decedent’s death taking into account the interests of all primary and contingent remainder beneficiaries who are living at that time. An interest payable for a specified term of years can qualify as a guaranteed annuity interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. The rule in this paragraph that a charitable interest may be payable for the life or lives of only certain specified individuals does not apply in the case of a charitable guaranteed annuity interest payable under a charitable remainder trust described in section 664.

(vii) * * * ( a ) * * * Only one or more of the following individuals may be used as measuring lives: the decedent’s spouse, and an individual who, with respect to all remainder beneficiaries (other than charitable organizations described in section 170, 2055, or 2522), is either a lineal ancestor or the spouse of a lineal ancestor of those beneficiaries. A trust will satisfy the requirement that all noncharitable remainder beneficiaries are lineal descendants of the individual who is the measuring life, or that individual’s spouse, if there is less than a 15% probability that individuals who are not lineal descendants will receive any trust corpus. This probability must be computed, based

Paragraph (e)(3) is amended as follows:

a. The period at the end of paragraph (e)(3)(ii)( c ) is removed, a comma is added and the word “and” is added after the comma.

b. A new paragraph (e)(3)(iii) is added. The additions read as follows:

§20.2055–2 Transfers not exclusively for charitable purposes.

(e) * * *

2001–6 I.R.B. 487 February 5, 2001

on the current applicable Life Table contained in §20.2031–7, as of the date of the decedent’s death taking into account the interests of all primary and contingent remainder beneficiaries who are living at that time. An interest payable for a specified term of years can qualify as a unitrust interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. The rule in this paragraph that a charitable interest may be payable for the life or lives of only certain specified individuals does not apply in the case of a charitable unitrust interest payable under a charitable remainder trust described in section 664.

(3) * * * (iii) The rule in paragraphs (e)(2)(vi)( a ) and (vii)( a ) of this section that guaranteed annuity interests or unitrust interests, respectively, may be payable for a specified term of years or for the life or lives of only certain individuals is generally effective in the case of transfers pursuant to wills and revocable trusts where the decedent dies on or after April 4, 2000. Two exceptions from the application of this rule in paragraphs (e)(2)(vi)( a ) and (vii)( a ) of this section are provided in the case of transfers pursuant to a will or revocable trust executed on or before April 4, 2000. One exception is for a decedent who dies on or before July 3, 2001, without having republished the will (or amended the trust) by codicil or otherwise. The other exception is for a decedent who was on April 4, 2000, under a mental disability to change the disposition of the decedent’s property, and either does not regain competence to dispose of such property before the date of death, or dies prior to the later of: 90 days after the date on which the decedent first regains competence, or July 3, 2001, without having republished the will (or amended the trust) by codicil or otherwise. If a guaranteed annuity interest or unitrust interest created pursuant to a will or revocable trust where the decedent dies on or after April 4, 2000, uses an individual other than one permitted in paragraphs (e)(2)(vi)( a ) and (vii)( a ) of this section,

and the interest does not qualify for this transitional relief, the interest may be reformed into a lead interest payable for a specified term of years. The term of years is determined by taking the factor for valuing the annuity or unitrust interest for the named individual measuring life and identifying the term of years (rounded up to the next whole year) that corresponds to the equivalent term of years factor for an annuity or unitrust interest. For example, in the case of an annuity interest payable for the life of an individual age 40 at the time of the transfer, assuming an interest rate of 7.4% under section 7520, the annuity factor from column 1 of Table S(7.4), contained in IRS Publication 1457, Book Aleph, for the life of an individual age 40 is 12.0587 (Publication 1457 is available from the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402). Based on Table B(7.4), contained in Publication 1457, Book Aleph, the factor 12.0587 corresponds to a term of years between 31 and 32 years. Accordingly, the annuity interest must be reformed into an interest payable for a term of 32 years. A judicial reformation must be commenced prior to the later of July 3, 2001, or the date prescribed by section 2055(e)(3)(C)(iii). Any judicial reformation must be completed within a reasonable time after it is commenced. A non-judicial reformation is permitted if effective under state law, provided it is completed by the date on which a judicial reformation must be commenced. In the alternative, if a court, in a proceeding that is commenced on or before July 3, 2001, declares any transfer made pursuant to a will or revocable trust where the decedent dies on or after April 4, 2000, and on or before March 6, 2001, null and void ab initio, the Internal Revenue Service will treat such transfers in a manner similar to that described in section 2055(e)(3)(J).

PART 25—GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

Par. 5. The authority citation for part 25 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 6. Section 25.2522(c)–3 is amended as follows:

Paragraph (c)(2)(vi)( a ) is amended as follows:

a. In the third sentence, the language “of years” is added after the word “term”, the language “a named individual or individuals” is removed, and “certain individuals” is added in its place.

b. The fourth sentence is removed, and six new sentences are added in its place.

c. In the sentence beginning “For example, the amount”, the language “of years” is added after the word “term”, the language “an individual” is removed, and “the donor” is added in its place.

Paragraph (c)(2)(vii)( a ) is amended as follows:

a. In the sixth sentence, the language ”of years” is added after the word “term”, the language “an individual or individuals” is removed, and “certain individuals” is added in its place.

b. The last sentence is removed, and six new sentences are added in its place.

Paragraph (e) is amended by adding nine new sentences to the end of the paragraph.

The additions read as follows:

§25.2522(c)–3 Transfers not exclusively for charitable, etc., purposes in the case of gifts made after July 31, 1969.

(c) * * * (2) * * * (vi) * * * ( a ) * * * Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and an individual who, with respect to all remainder beneficiaries (other than charitable organizations described in section 170, 2055, or 2522), is either a lineal ancestor or the spouse of a lineal ancestor of those beneficiaries. A trust will satisfy the requirement that all noncharitable remainder beneficiaries are lineal descendants of the individual who is the measuring life, or that individual’s spouse, if there is less than a 15% probability that individuals who are not lineal descendants will receive any trust corpus. This probability must be computed, based on the current applicable Life Table contained in §20.2031–7, at the time property is transferred to the trust taking into account the interests of all primary and contingent remainder beneficiaries who are living at that time. An interest payable for a specified term of years can qualify as a guaranteed annuity interest even if the governing instrument contains a savings

February 5, 2001 488 2001–6 I.R.B.

clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. The rule in this paragraph that a charitable interest may be payable for the life or lives of only certain specified individuals does not apply in the case of a charitable guaranteed annuity interest payable under a charitable remainder trust described in section 664. * * *

(vii) * * * ( a ) * * * Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and an individual who, with respect to all remainder beneficiaries (other than charitable organizations described in section 170, 2055, or 2522), is either a lineal ancestor or the spouse of a lineal ancestor of those beneficiaries. A trust will satisfy the requirement that all noncharitable remainder beneficiaries are lineal descendants of the individual who is the measuring life, or that individual’s spouse, if there is less than a 15% probability that individuals who are not lineal descendants will receive any trust corpus. This probability must be computed, based on the current applicable Life Table contained in §20.2031–7, at the time property is transferred to the trust taking into account the interests of all primary and contingent remainder beneficiaries who are living at that time. An interest payable for a specified term of years can qualify as a unitrust interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. The rule in this paragraph that a charitable interest may be payable for the life or lives of only certain specified individuals does not apply in the case of a charitable unitrust interest payable under a charitable remainder trust described in section 664.

(e) Effective date . * * * In addition, the rule in paragraphs (c)(2)(vi)( a ) and

(vii)( a ) of this section that guaranteed annuity interests or unitrust interests, respectively, may be payable for a specified term of years or for the life or lives of only certain individuals applies to transfers made on or after April 4, 2000. If a transfer is made on or after April 4, 2000, that uses an individual other than one permitted in paragraphs (c)(2)(vi)( a ) and (vii)( a ) of this section, the interest may be reformed into a lead interest payable for a specified term of years. The term of years is determined by taking the factor for valuing the annuity or unitrust interest for the named individual measuring life and identifying the term of years (rounded up to the next whole year) that corresponds to the equivalent term of years factor for an annuity or unitrust interest. For example, in the case of an annuity interest payable for the life of an individual age 40 at the time of the transfer, assuming an interest rate of 7.4% under section 7520, the annuity factor from column 1 of Table S(7.4), contained in IRS Publication 1457, Book Aleph, for the life of an individual age 40 is 12.0587 (Publication 1457 is available from the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402). Based on Table B(7.4), contained in Publication 1457, Book Aleph, the factor 12.0587 corresponds to a term of years between 31 and 32 years. Accordingly, the annuity interest must be reformed into an interest payable for a term of 32 years. A judicial reformation must be commenced prior to October 15th of the year following the year in which the transfer is made and must be completed within a reasonable time after it is commenced. A non-judicial reformation is permitted if effective under state law, provided it is completed by the date on which a judicial reformation must be commenced. In the alternative, if a court, in a proceeding that is commenced on or before July 3, 2001, declares any transfer, made on or after April 4, 2000, and on or before March 6, 2001, null and void ab initio, the Internal Revenue Service will treat such transfers in a manner similar to that described in section 2055(e)(3)(J).

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

Approved December 20, 2000.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 4, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 5, 2001, 66 F.R. 1040)

Section 301.—Distributions of Property

26 CFR 1.301–1: Rules applicable with respect to distributions of money and other property.

T.D. 8924

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Liabilities Assumed in Certain Corporate Transactions

AGENCY: Internal Revenue Service (IRS), Treasury

ACTION: Temporary and final regulations.

SUMMARY: These temporary and final regulations relate to the assumption of liabilities in certain corporate transactions under section 301 of the Internal Revenue Code. The temporary and final regulations affect corporations and their shareholders. Changes to the applicable law were made by the Miscellaneous Trade and Technical Corrections Act of 1999, Public Law 106–36 (113 Stat. 127). The text of these temporary regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking (REG–106791–00) on page 521 of this Bulletin.

DATES: Effective Date : These regulations are effective January 4, 2001.

Applicability Date : For dates of applicability, see the Effective Dates portion of the preamble under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Mary Dean, (202) 622-7550 (not a toll-free number).

SUPPLEMENTARY INFORMATION

2001–6 I.R.B. 489 February 5, 2001

existing law that fail to reflect the true economics of certain transactions. For reasons similar to those that motivated the enactment of section 357(d), these interpretations are inappropriate for purposes of section 301. Notice 99–59, 1999–2 C.B. 761, illustrates one such case. In the transaction addressed in Notice 99–59, a corporation distributes property subject to a recourse liability, with the expectation that the distributee will take the position that it receives little or no net distribution, even though it is anticipated that the distributor will later satisfy its continuing primary liability on the debt.

Explanation of Provisions

Liabilities Assumed in Connection with Distributions to Shareholders

This document contains amendments to the Income Tax Regulations (26 CFR part

under section 301 relating to liabilities assumed in connection with distributions made by a corporation to shareholders with respect to their stock. The regulations provide that the amount of a distribution under section 301 will be reduced by the amount of any liability that is treated as assumed by the distributee within the meaning of section 357(d)(1) and (2).

The Treasury and the IRS intend to propose regulations under sections 357(d) and 301 clarifying the treatment of the subsequent payment of assumed liabilities. Prior to the issuance of such regulations, the Treasury and the IRS believe that such payments generally should be treated in a manner consistent with the treatment of the liabilities assumed. Thus, in a situation where a liability is treated as assumed by the transferee under the rules of section 357(d), a later payment by the party whose liability was treated as assumed should be treated in accordance with the relationship of the parties ( e.g., a distribution or capital contribution). See, e.g., Enoch v. Commissioner, 57 T.C. 781 (1972), acq. in part, 1974–2 C.B. 2, 4, nonacq., 1984–2 C.B. 5.

Effective Date

The regulations apply generally to distributions occurring after January 4, 2001. The regulations also apply to distributions occurring on or prior to January 4, 2001, if the distribution is made as part of a

Background

A. State of the Law Before the Miscellaneous Trade and Technical Corrections Act of 1999

Section 301(b)(2) of the Internal Revenue Code (Code) provides that in a distribution of property made by a corporation to a shareholder with respect to its stock, the amount of the distribution shall be reduced (but not below zero) by (A) the amount of any liability of the corporation assumed by the shareholder in connection with the distribution and (B) the amount of any liability to which the property was subject immediately before, and after, the distribution. See also §1.301–1(g) of the regulations.

Section 357 of the Code generally provides rules for the treatment of the assumption of liabilities in connection with transfers of property to which section 351 or 361 of the Code applies. Prior to the Miscellaneous Trade and Technical Corrections Act of 1999 (the Act), section 357(a) provided that, except as otherwise provided, in such transfers the assumption of the transferor’s liability or acquisition of property subject to a liability is not treated as money or other property, i.e ., is not treated as boot received by the transferor.

Prior to the Act, section 357(c) provided that in an exchange to which section 351 applies or section 361 applies by reason of a section 368(a)(1)(D) reorganization, if the sum of the amount of the liabilities assumed plus the amount of the liabilities to which the property transferred is subject exceeds the total of the adjusted basis of the property transferred pursuant to such exchange, then such excess is considered as a gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be.

B. Enactment of Amendments to Section 357

The Act amended the language in section 357(a) and (c) and added new section 357(d). Under the amendment to section 357(a) and (c), the reference to the acquisition of an asset subject to a liability was eliminated. Section 357(c) gain will be realized only on the excess of the amount of liabilities assumed over the adjusted

basis of the property transferred in the transaction. New section 357(d) sets forth the rules for determining the amount of both recourse and nonrecourse liabilities assumed. Section 357(d) states that except as provided in regulations, a recourse liability (or portion thereof) is treated as having been assumed if, based on all the facts and circumstances, the transferee has agreed to, and is expected to, satisfy such liability, whether or not the transferor has been relieved of such liability. A nonrecourse liability is treated as having been assumed by the transferee of any asset subject to such liability, except that the amount of nonrecourse liability treated as having been assumed is reduced by the lesser of (A) the amount of such liability which an owner of other assets not transferred to the transferee and also subject to such liability has agreed with the transferee to, and is expected to, satisfy, or (B) the fair market value of such other assets. Congress provided these clarifications because certain interpretations of the existing law failed to adequately reflect the true economics of many transactions, resulting in inappropriate positions claimed by taxpayers. See S. Rep. No. 106–2, at 75 (1999).

Section 357(d)(3) directs the Secretary to prescribe regulations necessary to carry out the purposes of subsection (d). It also authorizes the Secretary to prescribe regulations which provide that the manner in which a liability is treated as assumed under subsection (d) is applied, where appropriate, elsewhere in the Code.

C. Application of Regulatory Authority to Section 301

The Treasury and the IRS have determined that it is appropriate to apply the rules of section 357(d), relating to the manner in which a liability is treated as assumed, to distributions of property under section 301 of the Code. Section 301(b)(2)(A) provides that the amount of the distribution will be reduced if the transferee assumes a liability of the corporation. Section 301(b)(2)(B) provides that the amount of the distribution will be reduced if the transferee receives property subject to a liability. These two sections do not provide specific rules for determining the amount of liabilities assumed, as contained in section 357(d). The lack of specific rules has led to interpretations of

February 5, 2001 490 2001–6 I.R.B.

transaction described in, or substantially similar to, the transaction in Notice 99–59, including transactions designed to reduce gain. Under section 7805(b)(3), the Secretary may provide that any regulation may take effect or apply retroactively to prevent abuse. These regulations are being applied retroactively to prevent the abuse described in Notice 99–59. No inference should be drawn regarding the tax treatment of distributions not covered by these 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. Because no preceding notice of proposed rulemaking is required for this temporary regulation, the provisions of the Regulatory Flexibility Analysis do not apply.

This Treasury decision is issued pursuant to the grants of authority in sections 357(d)(3) and 7805 of the Internal Revenue Code. This Treasury decision provides specific rules for determining the amount by which a distribution under section 301(b) will be reduced, by applying the rules of section 357(d). Section 357(d) was intended to clarify the law because certain interpretations of existing law did not reflect the economics of certain transactions. Issuing the regulation in proposed form would continue the difficulty in ascertaining the appropriate reduction in distributions under section 301(b). Based on these considerations, it is determined that this temporary regulation will provide taxpayers with the necessary guidance and authority to ensure equitable administration of the tax laws. Therefore, it would be contrary to the public interest to issue this Treasury decision with prior notice under section 553(b) or subject to the effective date limitation of section 553(d) of title 5 of the United States Code.

Pursuant to section 7805(f) of the Internal Revenue Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805. * * * Section 1.301–1 also issued under 26 U.S.C. 357(d)(3). Section 1.301–1T also issued under 26 U.S.C. 357(d)(3). * * *

Par. 2. Section 1.301–1 is amended by adding two new sentences at the end of paragraph (g) to read as follows:

§1.301–1 Rules applicable with respect to distributions of money and other property.

(g) * * * This paragraph (g) applies to distributions occurring on or before January 4, 2001. See §1.301–1T for rules for distributions occurring after January 4, 2001, and for distributions made on or before January 4, 2001, if the distribution is made as part of a transaction described in, or substantially similar to, the transaction in Notice 1999–59, 1999–2 C.B. 761, including transactions designed to reduce gain (see §601.601(d)(2) of this chapter).

Par. 3. Section 1.301–1T is added to read as follows:

§1.301–1T Rules applicable with respect to distributions of money and other property (temporary).

(a) through (f). [Reserved] For further guidance, see §1.301–1(a) through (f).

(g) Reduction for liabilities - - (1) General rule . For the purpose of section 301, no reduction shall be made for the amount of any liability, unless the liability is assumed by the shareholder within the meaning of section 357(d)(1) and (2).

(2) No reduction below zero . Any reduction pursuant to paragraph (g)(1) of this section shall not cause the amount of the distribution to be reduced below zero.

(3) Effective dates - - (i) In general . This paragraph (g) applies to distributions occurring after January 4, 2001 .

(ii) Retroactive application . This paragraph also applies to distributions made on or before January 4, 2001, if the distribution is made as part of a transaction described in, or substantially similar to, the transaction in Notice 1999–59 (1999–2 C.B. 761), including transactions designed to reduce gain (see §601.601(d)(2) of this chapter).

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

Approved December 20, 2000.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 3, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 4, 2001, 66 F.R. 723)

Section 404.—Deduction for Contributions of an Employer to an Employees’ Trust or Annuity Plan and Compensation Under a Deferred-Payment Plan

Deductibility of payments in redemp- tion of stock held by an employee stock ownership plan. This ruling holds that payments in redemption of stock held by an ESOP that are used to make distributions to terminating ESOP participants are not deductible and that such payments do not constitute “applicable dividends” under section 404(k)(1) of the Code.

Rev. Rul. 2001–6

ISSUE

Whether payments in redemption of stock held by an ESOP that are used to make distributions to terminating ESOP participants constitute “applicable dividends” under section 404(k)(1) of the Internal Revenue Code that are deductible.

FACTS

Corporation A (a C corporation) has a single class of voting common stock outstanding. Corporation A maintains an employee stock ownership plan (ESOP),

2001–6 I.R.B. 491 February 5, 2001

as defined in section 4975(e)(7) of the Internal Revenue Code (Code), which holds stock of Corporation A. The terms of the ESOP provide that when Corporation A pays dividends on its stock, the ESOP trustee may 1) allocate the dividends on the employer securities in a participant’s account to the participant; 2) allocate the dividends on the employer securities in a participant’s account to the plan and distribute it in cash to the participant not later than 90 days after the close of the plan year in which paid; or 3) use the dividends on employer securities allocated to a participant’s account to repay a loan to the ESOP the proceeds of which were used to acquire the employer securities, provided that employer securities with a fair market value at least equal to the value of those dividends are allocated to the participant’s account.

Under the plan, participants may elect to take a distribution in cash or stock at retirement or termination of employment. In the current year, 100 participants with account balances from $2,000 to $200,000, totaling $5 million, separate from service, become eligible for distributions from the ESOP, and elect cash distributions. As allowed under the plan, Corporation A redeems the shares in the terminating participants’ accounts for $5 million immediately prior to the distributions. Corporation A claims that the redemptions are treated as dividends under the applicable rules of sections 301, 302, and 316. The ESOP pays the $5 million redemption proceeds to the terminating participants within 90 days after the close of the plan year in which the plan received the proceeds.

LAW AND ANALYSIS

Section 162(k)(1) provides, with exceptions not relevant here, that no deduction otherwise allowable under Chapter 1 is allowed for any amount paid or incurred by a corporation in connection with the reacquisition of its stock or of the stock of any related person (as defined in section 465(b)(3)(C)).

Section 404(k)(1) of the Code provides that, in the case of a C corporation, there is allowed as a deduction for a taxable year the amount of any applicable dividend paid in cash by such corporation during the taxable year with respect to

applicable employer securities. This deduction is in addition to the deductions allowed in section 404(a).

Section 404(k)(2)(A) provides, in relevant part, that the term “applicable dividend” means any dividend which, in accordance with plan provisions, is paid to the plan and is distributed in cash to participants in the plan or their beneficiaries not later than 90 days after the close of the plan year in which paid.

Under section 404(k)(4), the deduction is allowable in the taxable year of the corporation in which the dividend is paid or distributed to a participant or beneficiary.

Section 404(k)(5)(A) provides that the Secretary may disallow the deduction under paragraph (1) for any dividend if the Secretary determines that such dividend constitutes, in substance, an evasion of taxation.

Under these facts, redemption payments are paid in connection with the “reacquisition” of the issuer’s stock. Thus, section 162(k)(1) bars the deduction of such payments without regard to whether they would otherwise be deductible under section 404(k).

Moreover, the treatment of redemption proceeds as “applicable dividends” under section 404(k) would produce such anomalous results that section 404(k) cannot reasonably be construed as encompassing such payments. See, e.g., Helvering v. Hammel, 311 U.S. 504, 510–511 (1941) (the words of a statute must be given “a restricted rather than a literal or usual meaning . . . where acceptance of that meaning would lead to absurd results . . . or would thwart the obvious purpose of the statute.”) The application of section 404(k) to redemption amounts not only would allow employers to claim deductions for payments that do not represent true economic costs, but also would vitiate important rights and protections for recipients of ESOP distributions, including the right to reduce taxes by utilizing the return of basis provisions under section 72, the right to make rollovers of ESOP distributions received upon separation from service, and the protection against involuntary cash-outs. See sections 72(e)(5)(D) and 411(a)(11)(C); section 1.402(c)–2, A–4(e) of the Income Tax Regulations. Therefore, the term “applicable dividends” under section 404(k) does not include amounts paid for the redemp

tion of stock held by an ESOP, whether or not such redemption proceeds constitute dividends under sections 301, 302, and 316. Further, section 404(k)(5)(A) authorizes the Secretary to disallow a deduction under section 404(k)(1) for any dividend that constitutes, in substance, an evasion of taxation. Pursuant to section 404(k)(5)(A), a deduction under section 404(k)(1) would be disallowed for payments in redemption of employer securities used to make distributions to terminating ESOP participants because such treatment would constitute, in substance, an evasion of taxation.

HOLDING

Payments in redemption of stock held by an ESOP that are used to make distributions to terminating ESOP participants are not deductible. In addition, such payments do not constitute “applicable dividends” under section 404(k)(1) of the Internal Revenue Code. This revenue ruling applies without regard to whether there is appreciation in the employer securities in the ESOP.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Steven J. Linder of the Employee Plans, Tax Exempt and Government Entities Division (T:EP) and John T. Ricotta of the Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). For further information regarding this revenue ruling, please contact the Employee Plans’ taxpayer assistance telephone service between the hours of 1:30 and 3:30 p.m. Eastern time, Monday through Thursday, by calling (202) 283-9516. Mr. Linder’s number is (202) 283-9888. Mr. Ricotta’s number is (202) 622-6060. (These telephone numbers are not toll-free.)

Section 664.—Charitable Remainder Trusts

26 CFR 1.664–1: Charitable remainder trusts.

T.D. 8926

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

February 5, 2001 492 2001–6 I.R.B.

the Treasury Department’s authority to address this or other abuses of the rules governing the taxation of charitable remainder trusts or their beneficiaries.

S. Rep. No. 33 at 201. Thus, Congress has neither prohibited nor discouraged further regulatory activity in the charitable remainder trust area. To the contrary, based on the legislative history to the 1997 Act, Congress intended the Treasury Department to continue to take all necessary action to prevent abuses in this area.

Several commentators questioned the authority to issue the regulations under section 643(a)(7). Two commentators maintained that the proposed regulations overstep the bounds of administrative rulemaking in that section 643(a)(7) was enacted along with the foreign trust provisions of the Small Business Job Protection Act of 1996 (SBJP Act), Public Law 104–88, 110 Stat. 1755 (1996), and therefore applies only to foreign trusts. One commentator, citing the introductory clause of section 664(a), “[n]otwithstanding any other provision of this subchapter,” argued that the Treasury Department and the IRS are prohibited from applying section 643(a)(7) to charitable remainder trusts. Some commentators maintained that section 643(a)(7) does not authorize the promulgation of regulations imposing a deemed sale where no actual sale has occurred. These commentators implied that regulatory authority under section 643(a)(7) should be limited to the concept of distributable net income (DNI). The Treasury Department and the IRS disagree with these views.

Although the SBJP Act included dramatic changes in the foreign trust area, the trust anti-abuse rule was not limited to foreign trusts and in fact contains no reference to foreign trusts. Furthermore, the Treasury Department and the IRS believe that Congress put the anti-abuse rule in section 643 because that section contains the rules applicable to all of Part 1 of Subchapter J of the Internal Revenue Code. Section 643(a)(7) gives the Secretary of the Treasury the authority to “prescribe such regulations as may be necessary or appropriate to carry out the purposes of this part, including regulations to prevent avoidance of such purposes” (emphasis added). “Part” in this

Prevention of Abuse of Charitable Remainder Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document finalizes regulations that modify the application of the rules governing the character of certain distributions from a charitable remainder trust. These regulations are necessary to prevent taxpayers from using charitable remainder trusts to achieve inappropriate tax avoidance. The regulations affect charitable remainder trusts described in section 664 and certain beneficiaries of those trusts.

EFFECTIVE DATES : These regulations are effective January 5, 2001. For dates of applicability of these regulations, see §§1.643(a)–8(d), 1.664–2(a)(1)(i)( e ), and 1.664–3(a)(1)(i)( l ).

FOR FURTHER INFORMATION CONTACT: Catherine Moore (202) 622-3070.

SUPPLEMENTARY INFORMATION:

Background

On October 18, 1999, proposed regulations (REG–116125–99, 1999–2 C.B. 552) to amend §§1.643(a)–8 and 1.664–1 of the Income Tax Regulations (26 CFR Part 1) were published in the Federal Register (64 F.R. 56718). Several written comments were received in response to the notice of proposed rulemaking, and a public hearing was held on February 9, 2000. After considering all the comments, the proposed regulations under sections 643 and 664 are adopted as revised by this Treasury decision. The comments received and the revisions made are discussed below.

Explanation of Provisions and Summary of Comments

I. General Background

The proposed regulations were issued in response to certain abusive transactions that attempt to use a section 664 charitable remainder trust to convert appreciated assets into cash while avoiding tax on the gain from the disposition of the assets. In these abusive transactions, a taxpayer typically contributes highly appreciated

assets to a charitable remainder trust having a relatively short term and a relatively high payout rate. Rather than sell the assets to obtain cash to pay the annuity or unitrust amount to the beneficiary, the trustee borrows money, enters into a forward sale of the assets, or engages in some similar transaction. The borrowing, forward sale, or other similar transaction does not result in current income to the trust; thus, the parties attempt to characterize the distribution of cash to the beneficiary as a tax-free return of corpus under section 664(b)(4). The proposed regulations provide that, in this situation, the trust shall be treated as having sold a pro rata portion of the trust assets.

II. Public Comments

One commentator argued that the transactions targeted by the regulations are not abusive because they comply with the statutory changes made to section 664 by the Taxpayer Relief Act of 1997 (1997 Act), Public Law 105–34, 111 Stat. 788 (1997). Those statutory changes require that the annual payout rate to noncharitable beneficiaries not exceed 50 percent of the value of the property contributed to the charitable remainder trust and that the actuarial value of the charity’s remainder interest be not less than 10 percent of the value of such property. Although the charitable remainder trusts involved in transactions targeted by the proposed regulations are drafted to comply with these statutory changes, the transactions result in the same kind of abuse that Congress was concerned about in the 1997 Act. It does not follow that because Congress did not anticipate in 1997 this latest abuse that Congress intended to allow it.

In the legislative history to the 1997 Act, Congress labeled the accelerated charitable remainder trusts it was targeting as “abusive and . . . inconsistent with the purpose of the charitable remainder trust rules.” S. Rep. No. 33, 105th Cong., 1st Sess. 201 (1997). Congress noted the efforts of the Treasury Department and the IRS to combat abuse in the area through issuing proposed regulations in 1997, stating: The Committee intends that the provision of the Committee bill does not limit or alter the validity of regulations proposed by the Treasury Department on April 18, 1997, or

2001–6 I.R.B. 493 February 5, 2001

context refers to Part 1 of Subchapter J and encompasses sections 641 through 685, including section 664 governing charitable remainder trusts. The legislative history to the SBJP Act clarifies that the anti-abuse rule is not limited to foreign trusts or the DNI rules. The House Conference Report states:

[The rule] authorizes the Secretary of the Treasury to issue regulations, on or after the date of enactment, that may be necessary or appropriate to carry out the purposes of the rules applicable to estates, trusts, and beneficiaries, including regulations to prevent the avoidance of those purposes. H.R. Conf. Rep. No. 737, 104th Cong., 2d Sess. 335 (1996).

In addition, the plain language of section 664(a) does not prohibit the promulgation of regulations that apply section 643(a)(7) to abusive charitable remainder trust transactions. Section 664(a) states in full:

Notwithstanding any other provision of this subchapter, the provisions of this section shall, in accordance with regulations prescribed by the Secretary, apply in the case of a charitable remainder annuity trust and a charitable remainder unitrust. This language provides that the provisions of section 664 apply in the case of a charitable remainder annuity trust and charitable remainder unitrust. The Treasury Department and the IRS, however, do not view this language as providing that no other provisions of subchapter J can apply in the case of abusive charitable remainder trust transactions. Applying these regulations to abusive charitable remainder trust transactions does not conflict with or override the provisions of section 664. Accordingly, the Treasury Department and the IRS believe that the plain language of section 664(a) does not prohibit promulgation of these regulations.

After considering the comments questioning the authority to promulgate and finalize the proposed regulations, the Treasury Department and the IRS have concluded that the regulations are an appropriate exercise of their regulatory authority and are authorized by the regulatory authority granted to them under section 643(a)(7) and 664(a).

Another commentator, while supporting the proposed regulations in general, suggested that the regulations contain a more precise definition of the targeted abuse. In response to this comment, the stated purpose in §1.643(a)–8(a) has been modified to include a specific reference to the rules regarding the characterization of distributions from charitable remainder trusts in the hands of the recipients.

That same commentator requested clarification of whether a deemed sale by a charitable remainder trust under §1.643(a)–8(b) would generate unrelated business taxable income (UBTI) within the meaning of section 512. Section 664(c) provides that whether a charitable remainder trust has UBTI for any taxable year, and thus is subject to tax for that year, is determined under the normal rules of sections 512, 513, and 514. The proposed regulations do not affect this general rule. However, an example in the final regulations clarifies that, to the extent that a borrowing by a charitable remainder trust is recharacterized as a deemed sale by the trust under §1.643(a)–8(b), the borrowing is not “acquisition indebtedness” within the meaning of section 514(c).

Another commentator suggested eliminating the provisions in §§1.664–2(a)(1)(i)(a) and 1.664–3(a)(1)(i)(g) of the regulations requiring that the annuity amount or the fixed percentage unitrust amount generally be paid by the end of the year for which it is due. That commentator contended that the payment rule is no longer necessary in light of the proposed regulations.

The Treasury Department and the IRS believe that the proposed regulations serve a function different from the payment rule. The proposed regulations seek to eliminate tax-free distributions from charitable remainder trusts due to manipulation of the character of distributions from those trusts. The payment rule, on the other hand, eliminates tax-free distributions from charitable remainder trusts due to manipulation of the timing of the distributions. A particular distribution could run afoul of either of these rules, or both rules.

In response to this comment, and to further clarify the different functions of the two rules, some minor changes have been made to the proposed regulation to eliminate references to timing and to clarify the application of the deemed sale rule. In

addition, in order to make it less likely that a non-abusive trust would violate the payment rule, two new exceptions have been added to §§1.664–2(a)(1)(i)(a) and 1.664–3(a)(1)(i)(g). These new exceptions provide that a distribution of cash made within a reasonable period of time after the close of the year may be characterized as corpus under section 664(b)(4) to the extent it was attributable to (i) a contribution of cash to the trust with respect to which a deduction was allowable under section 170, 2055, 2106, or 2522, or (ii) a return of basis in any asset contributed to the trust with respect to which a deduction was allowable under section 170, 2055, 2106, or 2522, and sold by the trust during the year for which the annuity or unitrust amount was due.

One commentator asserted that the proposed regulations should not apply to charitable remainder trusts established prior to the date the proposed regulations were published in the Federal Register . This commentator compared the effective date of the proposed regulations to the effective date of the 1997 Act’s trust provisions. Each of the changes made by the 1997 Act applies to transfers made to trusts after the date specified in the 1997 Act, while the regulations apply to distributions made by trusts after October 18, 1999. The Treasury Department and the IRS do not believe this assertion has merit. These effective dates are not comparable because the 1997 Act and these regulations apply to different aspects of charitable remainder trusts. The 1997 Act changed the requirements a trust must meet to qualify as a charitable remainder trust. Whether a trust qualifies as a charitable remainder trust is determined at the time property is transferred to the trust. As a result, it was appropriate to set the effective dates for the 1997 Act with respect to the time that transfers were made to a trust. The regulations, on the other hand, change the character of a distribution from a charitable remainder trust. The character of a distribution from a charitable remainder trust is not determined until after the distribution is made. Accordingly, the regulations can be applied, without being retroactive, to distributions made after the date the proposed regulations were filed with the Federal Register . Section 7805(b)(1).

February 5, 2001 494 2001–6 I.R.B.

Furthermore, the Treasury Department and the IRS would have had the authority under section 7805(b)(3) to write regulations that take effect retroactively to prevent abuse. The abuse targeted by these regulations is well documented in Notice 94–78 (1994–2 C.B. 555), the legislative history to the 1997 Act, the changes to the charitable remainder trust regulations that were finalized in 1998 (T.D. 8791, 1999–1 C.B. 364), and Notice 2000–15 (2000–12 I.R.B. 826).

Finally, the preamble to the proposed regulations requested comments on two specific issues: (1) whether there are situations where the application of the proposed regulation would be inappropriate, and (2) whether an approach that more directly related the distributed funds to the asset that is the subject of the borrowing or forward sale would be more appropriate. No comments were received on either of these issues.

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 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 understanding of the Treasury Department and the IRS that the number of charitable remainder trusts engaging in transactions affected by these regulations is not substantial, and none are small entities within the meaning of the Regulatory Flexibility Act (5 U.S.C. chapter 6). 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 Code, the preceding notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are Mary Beth Collins and Catherine Moore, Office of Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Section 1.643(a)–8 also issued under 26 U.S.C. 643(a)(7). * * *

Par. 2. Section 1.643(a)–8 is added to read as follows:

§1.643(a)–8 Certain distributions by charitable remainder trusts.

(a) Purpose and scope . This section is intended to prevent the avoidance of the purposes of the charitable remainder trust rules regarding the characterizations of distributions from those trusts in the hands of the recipients and should be interpreted in a manner consistent with this purpose. This section applies to all charitable remainder trusts described in section 664 and the beneficiaries of such trusts.

(b) Deemed sale by trust . (1) For purposes of section 664(b), a charitable remainder trust shall be treated as having sold, in the year in which a distribution of an annuity or unitrust amount is made from the trust, a pro rata portion of the trust assets to the extent that the distribution of the annuity or unitrust amount would (but for the application of this subparagraph (b)) be characterized in the hands of the recipient as being from the category described in section 664(b)(4) and exceeds the amount of the previously undistributed

(i) cash contributed to the trust (with respect to which a deduction was allowable under section 170, 2055, 2106, or 2522), plus (ii) basis in any contributed property (with respect to which a deduction was allowable under section 170, 2055, 2106, or 2522) that was sold by the trust.

(2) Any transaction that has the purpose or effect of circumventing the rules in this paragraph (b) shall be disregarded.

(3) For purposes of paragraph (b)(1) of this section, “trust assets” do not include cash or assets purchased with the proceeds of a trust borrowing, forward sale, or similar transaction.

(4) Proper adjustment shall be made to any gain or loss subsequently realized for gain or loss taken into account under paragraph (b)(1) of this section.

Example 1 . Deemed sale by trust . Donor contributes stock having a fair market value of $2 million to a charitable remainder unitrust with a unitrust amount of 50 percent of the net fair market value of the trust assets and a two-year term. The stock has a total adjusted basis of $400,000. In Year 1, the trust receives dividend income of $20,000. As of the valuation date, the trust’s assets have a net fair market value of $2,020,000 ($2 million in stock, plus $20,000 in cash). To obtain additional cash to pay the unitrust amount to the noncharitable beneficiary, the trustee borrows $990,000 against the value of the stock. The trust then distributes $1,010,000 to the beneficiary before the end of Year 1. Under section 664(b)(1), $20,000 of the distribution is characterized in the hands of the beneficiary as dividend income. The rest of the distribution, $990,000, is attributable to an amount received by the trust that did not represent either cash contributed to the trust or a return of basis in any contributed asset sold by the trust during Year 1. Under paragraph (b)(3) of this section, the stock is a trust asset because it was not purchased with the proceeds of the borrowing. Therefore , in Year 1, under paragraph (b)(1) of this section, the trust is treated as having sold $990,000 of stock and as having realized $792,000 of capital gain (the trust’s basis in the shares deemed sold is $198,000). Thus, in the hands of the beneficiary, $792,000 of the distribution is characterized as capital gain under section 664(b)(2) and $198,000 is characterized as a tax-free return of corpus under section 664(b)(4). No part of the $990,000 loan is treated as acquisition indebtedness under section 514(c) because the entire loan has been recharacterized as a deemed sale.

Example 2 . Adjustment to trust’s basis in assets deemed sold . The facts are the same as in Example 1 . During Year 2, the trust sells the stock for $2,100,000. The trustee uses a portion of the proceeds of the sale to repay the outstanding loan, plus accrued interest. Under paragraph (b)(4) of this section, the trust’s adjusted basis in the stock is $1,192,000 ($400,000 plus the $792,000 of gain recognized in Year 1). Therefore, the trust recognizes capital gain (as described in section 664(b)(2)) in Year 2 of $908,000.

Example 3 . Distribution of cash contributions . Upon the death of D, the proceeds of a life insurance policy on D’s life are payable to T, a charitable remainder annuity trust. The terms of the trust provide that, for a period of three years commencing upon D’s death, the trust shall pay an annuity amount equal to $x annually to A, the child of D. After the expiration of such three-year period, the remainder interest in the trust is to be transferred to charity Z. In Year 1, the trust receives payment of the life insurance proceeds and pays the appropriate pro rata portion of the $x annuity to A from the insurance proceeds. During Year 1, the trust has no income. Because the entire distribution is attributable to a cash contribution (the insurance proceeds) to the trust for which a charitable deduction was allowable

2001–6 I.R.B. 495 February 5, 2001

under section 2055 with respect to the present value of the remainder interest passing to charity, the trust will not be treated as selling a pro rata portion of the trust assets under paragraph (b)(1) of this section. Thus, the distribution is characterized in A’s hands as a tax-free return of corpus under section 664(b)(4).

(d) Effective date . This section is applicable to distributions made by a charitable remainder trust after October 18, 1999. Par. 3. Section 1.664–1 is amended as follows:

Paragraph (d)(1)(iii) is redesignated as paragraph (d)(1)(iv).
New paragraph (d)(1)(iii) is added. The addition reads as follows:

§1.664–1 Charitable remainder trusts.

(d) * * * (1) * * * (iii) 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.

Par. 4. §1.664–2 is amended as follows:

Paragraphs (a)(1)(i)( a )( 1 ) and (a)(1)(i)( a )( 2 ) are revised.
Paragraph (a)(1)(i)( a )( 3 ) is added.
Paragraph (a)(1)(i)( e ) is amended by adding a sentence at the end.

The revision and additions read as follows.

§1.664–2 Charitable remainder annuity trust.

(a) * * * (1) * * * (i) * * * ( a ) * * * ( 1 ) The trust pays the annuity amount by distributing property (other than cash) that it owned at the close of the taxable year to pay the annuity amount, and the trustee elects to treat any income generated by the distribution as occurring on the last day of the taxable year in which the annuity amount is due;

( 2 ) The trust pays the annuity amount by distributing cash that was contributed to the trust (with respect to which a deduction was allowable under section 170, 2055, 2106, or 2522); or ( 3 ) The trust pays the annuity amount by distributing cash received as a return of basis in any asset that was contributed to the trust (with respect to which a deduc

tion was allowable under section 170, 2055, 2106, or 2522), and that is sold by the trust during the year for which the annuity amount is due.

( e ) * * * Paragraphs (a)(1)(i)( a )( 2 ) and ( 3 ) of this section apply only to distributions made on or after January 5, 2001.

Par. 5. §1.664–3 is amended as follows:

Paragraphs (a)(1)(i)( g )( 1 ) and (a)(1)(i)( g )( 2 ) are revised.
Paragraph (a)(1)(i)( g )( 3 ) is added.
Paragraph (a)(1)(i)( l ) is amended by adding a sentence at the end.

The revision and additions read as follows.

( g ) * * * ( 1 ) The trust pays the unitrust amount by distributing property (other than cash) that it owned at the close of the taxable year, and the trustee elects to treat any income generated by the distribution as occurring on the last day of the taxable year in which the unitrust amount is due;

( 2 ) The trust pays the unitrust amount by distributing cash that was contributed to the trust (with respect to which a deduction was allowable under section 170, 2055, 2106, or 2522); or ( 3 ) The trust pays the unitrust amount by distributing cash received as a return of basis in any asset that was contributed to the trust (with respect to which a deduction was allowable under section 170, 2055, 2106, or 2522), and that is sold by the trust during the year for which the unitrust amount is due.

( l ) * * * Paragraphs (a)(1)(i)( g )( 2 ) and ( 3 ) of this section apply only to distributions made on or after January 5, 2001.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

Section 708.—Continuation of Partnership

26 CFR 1.708–1: Continuation of Partnership.

T.D. 8925

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Partnership Mergers and Divisions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations on the tax consequences of partnership mergers and divisions. The final regulations affect partnerships and their partners.

DATES: Effective Date : These regulations are effective January 4, 2001.

Applicability Date : For dates of applicability of these regulations, see §§1.708–1(c)(7), 1.708–1(d)(7), and 1.752–5(a).

FOR FURTHER INFORMATION CONTACT: Mary Beth Collins or Dan Carmody, (202) 622-3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document amends sections 708 and 752 of the Income Tax Regulations (26 CFR part 1) regarding partnership mergers and divisions.

On January 11, 2000, a notice of proposed rulemaking and a notice of public hearing (REG–111119–99, 2000–5 I.R.B. 455) were published in the Federal Register (65 F.R. 1572) regarding sections 708, 743, and 752 of the Internal Revenue Code. No one requested to speak at the public hearing. Accordingly, the public hearing scheduled for May 4, 2000, was canceled in the Federal Register (65 F.R. 24897) on April 28, 2000. Comments responding to the proposed regulations were received. After consideration of the comments, the proposed regulations are adopted as revised by this Treasury decision.

Approved December 13, 2000.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 4, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 5, 2001, 66 F.R. 1034)

February 5, 2001 496 2001–6 I.R.B.

I. Partnership Mergers

Section 708(b)(2)(A) provides that in the case of a merger or consolidation of two or more partnerships, the resulting partnership is, for purposes of section 708, considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership. Section 1.708–1(b)(2)(i) of the Income Tax Regulations provides that if the resulting partnership can be considered a continuation of more than one of the merging partnerships, the resulting partnership is the continuation of the partnership that is credited with the contribution of the greatest dollar value of assets to the resulting partnership. If the members of none of the merging partnerships own more than a 50 percent interest in the capital and profits of the resulting partnership, all of the merged partnerships are considered terminated, and a new partnership results. The taxable years of the merging partnerships that are considered terminated are closed under section 706(c).

II . Partnership Divisions

Section 708(b)(2)(B) provides that, in the case of a division of a partnership into two or more partnerships, the resulting partnerships (other than any resulting partnership the members of which had an interest of 50 percent or less in the capital and profits of the prior partnership) are considered a continuation of the prior partnership. Section 1.708–1(b)(2)(ii) provides that any other resulting partnership is not considered a continuation of the prior partnership but is considered a new partnership. If the members of none of the resulting partnerships owned an interest of more than 50 percent in the capital and profits of the prior partnership, the prior partnership is terminated. Where members of a partnership that has been divided do not become members of a resulting partnership that is considered a continuation of the prior partnership, such members’ interests are considered liquidated as of the date of the division.

Explanation of Revisions and Summary of Comments

I. Assets-Up Form for Partnership Mergers and Divisions

The proposed regulations provide that the form of a partnership merger or divi

sion accomplished under laws of the applicable jurisdiction will be respected if the partnership undertakes the steps of one of two prescribed forms. Generally, for partnership mergers, a terminating partnership contributes its assets and liabilities to the resulting partnership in exchange for interests in the resulting partnership, and immediately thereafter, the terminated partnership distributes interests in the resulting partnership to its partners in liquidation of the terminating partnership (Assets-Over Form). Alternatively, for partnership mergers, the terminating partnership liquidates by distributing its assets and liabilities to its partners who then contribute the assets and liabilities to the resulting partnership (AssetsUp Form). The default rule for partnership mergers is the Assets-Over Form, so that if a transaction is not characterized under the Assets-Up Form, it will be characterized under the Assets-Over Form regardless of whether that form is followed.

In general, for partnership divisions, a prior partnership transfers certain assets and liabilities to a resulting partnership in exchange for interests in the resulting partnership, and immediately thereafter, the prior partnership distributes the resulting partnership interests to partners who are designated to receive interests in the resulting partnership (Assets-Over Form). Alternatively, for partnership divisions, the prior partnership distributes certain assets and liabilities to some or all of its partners who then contribute the assets and liabilities to a resulting partnership in exchange for interests in the resulting partnership (Assets-Up Form). As with partnership mergers, the default rule for partnership divisions is the Assets-Over Form, so that if a transaction is not characterized under the Assets-Up Form, it will be characterized under the AssetsOver Form regardless of whether that form is followed.

One commentator expressed concern that where the assets of an operating business are distributed to the partners as joint owners, and the partners continue to operate the business, the owners of the assets may be considered to remain partners for federal income tax purposes. Under the proposed regulations, it was intended that the Assets-Up Form would be respected where the assets are conveyed to the partners under the laws of the applicable juris

diction and then reconveyed to the resulting partnership. An example has been added to the final regulations to confirm this result. The example also confirms that a partnership can use the Assets-Up Form for partnership mergers and divisions regardless of whether the partners could otherwise generally hold certain assets, such as undivided interests in goodwill, outside of a partnership.

The same commentator suggested that the Assets-Up Form should be respected if, rather than actually conveying ownership of the assets under applicable jurisdictional law, the partners assign their rights to receive title to the assets in liquidation of the partnership, or direct the partnership to transfer title to the assets to the resulting partnership. In providing that the Assets-Up Form would be respected in accomplishing partnership mergers and divisions, the IRS and Treasury did not intend to establish a regime whereby partners essentially could elect between the Assets-Up Form and the Assets-Over Form by creating different documents that have the same legal effect. The IRS and Treasury believe that if the Assets-Up Form is to be respected, a partnership must actually undertake the steps that are necessary, under the laws of the applicable jurisdiction, to convey ownership of the assets that are distributed to the partners. For most types of assets, this will not require the actual transfer and recording of a deed or certificate of title.

While the IRS and Treasury believe that it should be necessary for a partnership to actually convey ownership of the partnership’s assets to its partners in order to follow the Assets-Up Form, it should not be necessary for the partners to actually assume the liabilities of the partnership in order to follow such form. Pursuant to section 752 and the regulations thereunder, a partner essentially is deemed to have directly incurred a share of the partnership’s liabilities. Requiring the partners to actually assume debt that they already are deemed to have incurred is unnecessary. Such a requirement also could create a trap for the unwary. If a partner momentarily assumes an amount of the partnership’s debt that is less than the partner’s share of such debt under section 752 (and other partners momentarily assume an amount of debt in excess of their shares), the partner could inappropri

2001–6 I.R.B. 497 February 5, 2001

partnership in a merger to fund the purchase of one or more partners’ interests in a terminating partnership without triggering the disguised sale rules, which otherwise would cause all of the partners in the terminating partnership to recognize gain or loss as a result of the purchase. Specifically, the proposed regulations provide that if the merger agreement (or similar document) specifies that the resulting partnership is purchasing the exiting partner’s interest in the terminating partnership and the amount paid for the interest, the transaction will be treated as a sale of the exiting partner’s interest to the resulting partnership.

Because the transaction described in the proposed regulations is treated as a sale of a partnership interest, the resulting partnership inherits the exiting partner’s capital account in the terminating partnership and any section 704(c) liability of the exiting partner. Additionally, if the terminating partnership has an election in effect under section 754 (or makes an election under section 754), the resulting partnership will have a special basis adjustment regarding the terminating partnership’s property under section 743. The proposed regulations provide that the resulting partnership’s basis adjustments under section 743 must be allocated solely to the partners who were partners in the resulting partnership immediately before the merger.

Commentators questioned whether the exiting partner must be a party to the merger agreement in order to obtain the benefit of the special buy-out rule contained in the proposed regulations. Another commentator asked whether the exiting partner must consent to the sale treatment. The commentator explained that it may be difficult to receive consent from small investors in a large partnership whose interests are being sold to the resulting partnership.

The IRS and Treasury believe that the exiting partner does not have to be a party to the merger agreement in order to obtain the benefit of the special buy-out rule. However, to ensure that all partners to the transaction treat the transaction consistently when filing their returns, the final regulations require that, prior to or contemporaneous with the transfer, the exiting partner must consent to the sale treatment provided in the special rule.

ately recognize gain as a result of the deemed distribution.

II. Bifurcation of Assets-Over Form and Assets-Up Form

The proposed regulations provide that the form of a partnership merger or division accomplished under laws of the applicable jurisdiction will be respected if the partnership undertakes the steps of either the Assets-Over Form or the Assets-Up Form. One commentator recommended that a single partnership merger or division be respected if the partnership undertakes the steps of the Assets-Over Form with respect to some assets and the Assets-Up Form with respect to others. For example, in a partnership merger, the terminating partnership could distribute some assets to certain partners who then contribute the assets to the resulting partnership in exchange for interests in the resulting partnership (Assets-Up Form), and simultaneously, the terminating partnership could transfer the remaining assets to the resulting partnership in exchange for interests in the resulting partnership and then distribute the interests to the remaining partners in liquidation of their interests in the terminating partnership (Assets-Over Form).

In the preamble to the proposed regulations, the IRS and Treasury recognized that there are numerous transactions that may be undertaken pursuant to local jurisdictional law to accomplish the result of a partnership merger or division. The rules set forth in the proposed regulations were not intended to provide unlimited flexibility among the various structural alternatives for accomplishing these transactions. Instead, the proposed regulations were intended to provide a set of administrable rules that taxpayers and the IRS could apply in characterizing these transactions.

In view of this purpose, the IRS and Treasury do not believe it is appropriate for a partnership merger to be accomplished using both the Assets-Over Form and the Assets-Up Form when all the assets and liabilities of the terminated partnership are transferred to a single resulting partnership. While a partnership merger may be accomplished by using any number of transactional structures, the result is a single transaction that combines two partnerships. In the two alternatives set forth in the proposed regulations, and adopted in these

final regulations, each partner must participate (or will be deemed to participate) in the partnership merger in the same manner (with the exception of those partners who are subject to the buy-out rule). Therefore, if the partners wish for a partnership merger to be characterized under the Assets-Up Form, the terminated partnership must undertake the steps of the Assets-Up Form for all of its assets when it distributes the assets to its partners. Otherwise, the transaction will be characterized under the Assets-Over Form. However, where more than two partnerships are combined, each combination will be viewed as a separate merger so that the characterization of a merger of one partnership into the resulting partnership under the Assets-Over Form will not prevent a simultaneous merger of another partnership into the same resulting partnership from being characterized under the Assets-Up Form.

For the same reasons, with respect to partnership divisions, the IRS and Treasury believe that it is appropriate to require consistency in applying either the Assets-Over Form or the Assets-Up Form to characterize a transfer of assets to a resulting partnership. However, where a single partnership is divided in a transaction that involves a transfer of assets (either actual or deemed) to multiple partnerships, the transfer to each resulting partnership should be viewed separately. As with mergers involving more than two partnerships, it is consistent with the purposes of these regulations, in the context of divisions, to allow the transfer to one resulting partnership to be characterized under the Assets-Over Form while characterizing the transfer to another resulting partnership under the Assets-Up Form. The proposed regulations provided an example that illustrates when such a division accomplished under both the AssetsOver Form and the Assets-Up Form will be respected. The final regulations do not change the example. See §1.708–1(d)(5) Example 7 of the final regulations. The final regulations also add an example to illustrate when a division accomplished under both the Assets-Over Form and the Assets-Up Form will not be respected.

III. Clarification of Partnership Merger Buy-out Rule

The proposed regulations contain a special buy-out rule that allows a resulting

February 5, 2001 498 2001–6 I.R.B.

Commentators noted that the resulting partnership’s basis adjustments under section 743 should not be allocated solely to the partners who were partners in the resulting partnership immediately before the merger. As indicated in §1.708–1(c)(4) Example 4 of the proposed regulations, where the resulting partnership has acquired an interest in the terminating partnership in accordance with the special buy-out rule, the terminating partnership, as part of the merger, distributes assets to the resulting partnership in liquidation of the resulting partnership’s interest in the terminating partnership. Accordingly, the resulting partnership should take an exchanged basis in the distributed assets under section 732(b), rather than a transferred basis that includes the basis adjustment under section 743(b). In response to these comments, the IRS and Treasury have removed the proposed regulations under section 743 and have clarified the example to indicate that the basis rules under section 732(b) apply.

Commentators also asked whether a partnership termination under section 708(b)(1)(B) occurs immediately before a merger if exiting partners sell 50 percent or more of the total interests in the terminating partnership under the buy-out provision. Although not discussed in the final regulations, it follows from treating the buyout as occurring immediately prior to the merger that, if exiting partners sell 50 percent or more of the total interest in the terminating partnership’s capital and profits as part of a merger, then a partnership termination under section 708(b)(1)(B) will occur immediately before the merger.

IV. Partnership Division Tax Consequences

The proposed regulations provide that the resulting partnership that is regarded as continuing shall file a return for the taxable year of the partnership that has been divided. Commentators requested that the final regulations clarify the tax consequences of a partnership that is regarded as continuing. For instance, commentators asked how a partnership files a return and which partnership retains the prior partnership’s employer identification number (EIN) when more than one resulting partnership is consid

ered a continuation of the prior partnership. Additionally, commentators asked whether subsequent elections by one resulting partnership that is regarded as continuing binds all resulting partnerships that are regarded as continuing.

In response to these comments, the final regulations clarify certain tax consequences that follow from a partnership division when more than one resulting partnership is regarded as continuing. Specifically, the final regulations provide that when more than one resulting partnership is regarded as continuing, the resulting partnership that is treated as the divided partnership will file a return for the taxable year of the partnership that has been divided and retain the EIN of the prior partnership. All other resulting partnerships that are regarded as continuing and all new partnerships (i.e., resulting partnerships that are not considered continuing) will file separate returns for the taxable year beginning on the day after the date of the division with new EINs for each partnership.

The final regulations also provide that all resulting partnerships that are continuing partnerships are subject to preexisting elections that were made by the prior partnership. However, a post-division election that is made by a resulting partnership will not bind any of the other resulting partnerships.

V. Definition of Partnership Mergers and Divisions

The proposed regulations do not define what constitutes a partnership merger or division. Some commentators have requested that these terms be defined in the final regulations. Other practitioners have stated that the selectivity that would be created by attempting to draw lines in such definitions could lead to planning opportunities that would be adverse to the government’s interest. The IRS and Treasury have decided not to provide comprehensive definitions of what is a partnership merger or division in these final regulations.

In addition to requesting guidance as to the general definitions of a partnership merger and division, some commentators have asked more narrowly whether a partnership division can occur when only one partner from the prior partnership is a partner in a resulting partnership.

Consider the following example: ABC partnership owns X business and Y business. A and B each own a 20-percent interest, and C owns a 60-percent interest in the ABC partnership. C does not want to continue in the partnership with A and B and would like to operate X business with D. Accordingly, ABC partnership distributes X business to C in liquidation of C’s interest in partnership ABC. Subsequently, C forms a partnership with D and contributes X business to the CD partnership. After the distribution and contribution of X business, AB partnership owns Y business and CD partnership owns X business.

The IRS and Treasury believe that the above transaction does not constitute a division. To have a division, at least two members of the prior partnership must be members of each resulting partnership that exists after the transaction. In the above example, C is the only member of the ABC partnership in the CD partnership. Accordingly, this transaction would not be treated as a division for Federal income tax purposes. The final regulations modify the proposed regulations to clarify this result.

VI. Application of Sections 704(c) and 737 in Partnership Divisions

In the preamble to the proposed regulations, the IRS and Treasury requested comments as to whether expanded exceptions under sections 704(c)(1)(B) and 737 would be appropriate in the context of partnership divisions. Most commentators agreed that it would not be wise to expand the current exceptions. In a related point, some commentators stated that the contribution of assets in a division should not create new section 704(c) property or section 737 net precontribution gain.

To the extent that a partnership division merely affects a restructuring of the form in which the partners hold property (that is, each partner’s overall interest in each partnership property does not change), the IRS and Treasury agree that a partnership division should not create new section 704(c) property or section 737 net precontribution gain. However, it is not clear that this result is necessarily appropriate where a division is non- pro rata as to the partners, where some property is extracted from or added to the partnerships in

2001–6 I.R.B. 499 February 5, 2001

connection with the division, or where new partners are added to the ownership group in connection with the division. The IRS and Treasury intend to study this issue and request comments in this regard.

VII. Effective Date

The proposed regulations apply to mergers and divisions occurring on or after the date final regulations are published in the Federal Register . Commentators requested that the final regulations allow partnerships to apply the regulations to mergers and divisions occurring on or after January 11, 2000, (the date the proposed regulations were published in the Federal Register ). The commentators explained that the regulations provide needed clarity in an area that has lacked guidance.

The IRS and Treasury believe it is appropriate to allow partnerships to apply the final regulations retroactively to the publication date of the proposed regulations. Therefore, the final regulations apply to mergers and divisions occurring on or after January 4, 2001. However, a

partnership may apply the rules in the final regulations for mergers and divisions occurring on or after January 11, 2000.

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 these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking that preceded these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Mary Beth Collins, Office of Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.708–1 is amended as follows:

Paragraph (b) is amended by removing paragraph (b)(2) and by redesignating each paragraph listed in the first column of the following table as the paragraph listed in the second column as indicated in the following table:

Old Paragraph Redesignated Paragraph

(b)(1)(i) (b)(1) (b)(1)(i)( a ) (b)(1)(i) (b)(1)(i)( b ) (b)(1)(ii) (b)(1)(ii) (b)(2) (b)(1)(iii) (b)(3) (b)(1)(iii)( a ) (b)(3)(i) (b)(1)(iii)( b ) (b)(3)(ii) (b)(1)(iv) (b)(4) (b)(1)(v) (b)(5)

Paragraphs (c) and (d) are added to read as follows:

§1.708–1 Continuation of partnership.

(c) Merger or consolidation —(1) General rule . If two or more partnerships merge or consolidate into one partnership, the resulting partnership shall be considered a continuation of the merging or consolidating partnership the members of which own an interest of more than 50 percent in the capital and profits of the resulting partnership. If the resulting partnership can, under the preceding sentence, be considered a continuation of more than one of the merging or consolidating partnerships,

it shall, unless the Commissioner permits otherwise, be considered the continuation solely of that partnership which is credited with the contribution of assets having the greatest fair market value (net of liabilities) to the resulting partnership. Any other merging or consolidating partnerships shall be considered as terminated. If the members of none of the merging or consolidating partnerships have an interest of more than 50 percent in the capital and profits of the resulting partnership, all of the merged or consolidated partnerships are terminated, and a new partnership results.

(2) Tax returns . The taxable years of any merging or consolidating partnerships which are considered terminated shall be

closed in accordance with the provisions of section 706(c) and the regulations thereunder, and such partnerships shall file their returns for a taxable year ending upon the date of termination, i.e., the date of merger or consolidation. The resulting partnership shall file a return for the taxable year of the merging or consolidating partnership that is considered as continuing. The return shall state that the resulting partnership is a continuation of such merging or consolidating partnership, shall retain the employer identification number (EIN) of the partnership that is continuing, and shall include the names, addresses, and EINs of the other merged or consolidated partnerships. The respec

February 5, 2001 500 2001–6 I.R.B.

tive distributive shares of the partners for the periods prior to and including the date of the merger or consolidation and subsequent to the date of merger or consolidation shall be shown as a part of the return.

(3) Form of a merger or consol- idation —(i) Assets-over form . When two or more partnerships merge or consolidate into one partnership under the applicable jurisdictional law without undertaking a form for the merger or consolidation, or undertake a form for the merger or consolidation that is not described in paragraph (c)(3)(ii) of this section, any merged or consolidated partnership that is considered terminated under paragraph (c)(1) of this section is treated as undertaking the assets-over form for Federal income tax purposes. Under the assetsover form, the merged or consolidated partnership that is considered terminated under paragraph (c)(1) of this section contributes all of its assets and liabilities to the resulting partnership in exchange for an interest in the resulting partnership, and immediately thereafter, the terminated partnership distributes interests in the resulting partnership to its partners in liquidation of the terminated partnership.

(ii) Assets-up form . Despite the partners’ transitory ownership of the terminated partnership’s assets, the form of a partnership merger or consolidation will be respected for Federal income tax purposes if the merged or consolidated partnership that is considered terminated under paragraph (c)(1) of this section distributes all of its assets to its partners (in a manner that causes the partners to be treated, under the laws of the applicable jurisdiction, as the owners of such assets) in liquidation of the partners’ interests in the terminated partnership, and immediately thereafter, the partners in the terminated partnership contribute the distributed assets to the resulting partnership in exchange for interests in the resulting partnership.

(4) Sale of an interest in the merging or consolidating partnership . In a transaction characterized under the assets-over form, a sale of all or part of a partner’s interest in the terminated partnership to the resulting partnership that occurs as part of a merger or consolidation under section 708(b)(2)(A), as described in paragraph (c)(3)(i) of this section, will be respected as a sale of a partnership inter

est if the merger agreement (or another document) specifies that the resulting partnership is purchasing interests from a particular partner in the merging or consolidating partnership and the consideration that is transferred for each interest sold, and if the selling partner in the terminated partnership, either prior to or contemporaneous with the transaction, consents to treat the transaction as a sale of the partnership interest. See section 741 and §1.741–1 for determining the selling partner’s gain or loss on the sale or exchange of the partnership interest.

(5) Examples . The following examples illustrate the rules in paragraphs (c)(1) through (4) of this section:

Example 1 . Partnership AB, in whose capital and profits A and B each own a 50-percent interest, and partnership CD, in whose capital and profits C and D each own a 50-percent interest, merge on September 30, 1999, and form partnership ABCD. Partners A, B, C, and D are on a calendar year, and partnership AB and partnership CD also are on a calendar year. After the merger, the partners have capital and profits interests as follows: A, 30 percent; B, 30 percent; C, 20 percent; and D, 20 percent. Since A and B together own an interest of more than 50 percent in the capital and profits of partnership ABCD, such partnership shall be considered a continuation of partnership AB and shall continue to file returns on a calendar year basis. Since C and D own an interest of less than 50 percent in the capital and profits of partnership ABCD, the taxable year of partnership CD closes as of September 30, 1999, the date of the merger, and partnership CD is terminated as of that date. Partnership ABCD is required to file a return for the taxable year January 1 to December 31, 1999, indicating thereon that, until September 30, 1999, it was partnership AB. Partnership CD is required to file a return for its final taxable year, January 1 through September 30, 1999.

Example 2 . (i) Partnership X, in whose capital and profits A owns a 40-percent interest and B owns a 60-percent interest, and partnership Y, in whose capital and profits B owns a 60-percent interest and C owns a 40-percent interest, merge on September 30, 1999. The fair market value of the partnership X assets (net of liabilities) is $100X, and the fair market value of the partnership Y assets (net of liabilities) is $200X. The merger is accomplished under state law by partnership Y contributing its assets and liabilities to partnership X in exchange for interests in partnership X, with partnership Y then liquidating, distributing interests in partnership X to B and C.

(ii) B, a partner in both partnerships prior to the merger, owns a greater than 50-percent interest in the resulting partnership following the merger. Accordingly, because the fair market value of partnership Y’s assets (net of liabilities) was greater than that of partnership X’s, under paragraph (c)(1) of this section, partnership X will be considered to terminate in the merger. As a result, even though, for state law purposes, the transaction was undertaken with partnership Y contributing its assets and liabilities to partnership X and distributing interests in partner

ship X to its partners, pursuant to paragraph (c)(3)(i) of this section, for Federal income tax purposes, the transaction will be treated as if partnership X contributed its assets to partnership Y in exchange for interests in partnership Y and then liquidated, distributing interests in partnership Y to A and B.

Example 3 . (i) The facts are the same as in Example 2, except that partnership X is engaged in a trade or business and has, as one of its assets, goodwill. In addition, the merger is accomplished under state law by having partnership X convey an undivided 40-percent interest in each of its assets to A and an undivided 60-percent interest in each of its assets to B, with A and B then contributing their interests in such assets to partnership Y. Partnership Y also assumes all of the liabilities of partnership X.

(ii) Under paragraph (c)(3)(ii) of this section, the form of the partnership merger will be respected so that partnership X will be treated as following the assets-up form for Federal income tax purposes.

Example 4 . (i) Partnership X and partnership Y merge when the partners of partnership X transfer their partnership X interests to partnership Y in exchange for partnership Y interests. Immediately thereafter, partnership X liquidates into partnership Y. The resulting partnership is considered a continuation of partnership Y, and partnership X is considered terminated.

(ii) The partnerships are treated as undertaking the assets-over form described in paragraph (c)(3)(i) of this section because the partnerships undertook a form that is not the assets-up form described in paragraph (c)(3)(ii) of this section. Accordingly, for Federal income tax purposes, partnership X is deemed to contribute its assets and liabilities to partnership Y in exchange for interests in partnership Y, and, immediately thereafter, partnership X is deemed to have distributed the interests in partnership Y to its partners in liquidation of their interests in partnership X.

Example 5 . (i) A, B, and C are partners in partnership X. D, E, and F are partners in Partnership Y. Partnership X and partnership Y merge, and the resulting partnership is considered a continuation of partnership Y. Partnership X is considered terminated. Under state law, partnerships X and Y undertake the assets-over form of paragraph (c)(3)(i) of this section to accomplish the partnership merger. C does not want to become a partner in partnership Y, and partnership X does not have the resources to buy C’s interest before the merger. C, partnership X, and partnership Y enter into an agreement specifying that partnership Y will purchase C’s interest in partnership X for $150 before the merger, and as part of the agreement, C consents to treat the transaction in a manner that is consistent with the agreement. As part of the merger, partnership X receives from partnership Y $150 that will be distributed to C immediately before the merger, and interests in partnership Y in exchange for partnership X’s assets and liabilities.

(ii) Because the merger agreement satisfies the requirements of paragraph (c)(4) of this section and C provides the necessary consent, C will be treated as selling its interest in partnership X to partnership Y for $150 before the merger. See section 741 and §1.741–1 to determine the amount and character of C’s gain or loss on the sale or exchange of its interest in partnership X.

2001–6 I.R.B. 501 February 5, 2001

(iii) Because the merger agreement satisfies the requirements of paragraph (c)(4) of this section, partnership Y is considered to have purchased C’s interest in partnership X for $150 immediately before the merger. See §1.704–1(b)(2)(iv)( l ) for determining partnership Y’s capital account in partnership X. Partnership Y’s adjusted basis of its interest in partnership X is determined under section 742 and §1.742–1. To the extent any built-in gain or loss on section 704(c) property in partnership X would have been allocated to C (including any allocations with respect to property revaluations under section 704(b) (reverse section 704(c) allocations)), see section 704 and §1.704–3(a)(7) for determining the built-in gain or loss or reverse section 704(c) allocations apportionable to partnership Y. Similarly, after the merger is completed, the built-in gain or loss and reverse section 704(c) allocations attributable to C’s interest are apportioned to D, E, and F under section 704(c) and §1.704–3(a)(7).

(iv) Under paragraph (c)(3)(i) of this section, partnership X contributes its assets and liabilities attributable to the interests of A and B to partnership Y in exchange for interests in partnership Y; and, immediately thereafter, partnership X distributes the interests in partnership Y to A and B in liquidation of their interests in partnership X. At the same time, partnership X distributes assets to partnership Y in liquidation of partnership Y’s interest in partnership X. Partnership Y’s bases in the distributed assets are determined under section 732(b).

(6) Prescribed form not followed in cer- tain circumstances . (i) If any transactions described in paragraph (c)(3) or (4) of this section are part of a larger series of transactions, and the substance of the larger series of transactions is inconsistent with following the form prescribed in such paragraph, the Commissioner may disregard such form, and may recast the larger series of transactions in accordance with their substance.

(ii) Example . The following example illustrates the rules in paragraph (c)(6) of this section:

Example . A, B, and C are equal partners in partnership ABC. ABC holds no section 704(c) property. D and E are equal partners in partnership DE. B and C want to exchange their interests in ABC for all of the interests in DE. However, rather than exchanging partnership interests, DE merges with ABC by undertaking the assets-up form described in paragraph (c)(3)(ii) of this section, with D and E receiving title to the DE assets and then contributing the assets to ABC in exchange for interests in ABC. As part of a prearranged transaction, the assets acquired from DE are contributed to a new partnership, and the interests in the new partnership are distributed to B and C in complete liquidation of their interests in ABC. The merger and division in this example represent a series of transactions that in substance are an exchange of interests in ABC for interests in DE. Even though paragraph (c)(3)(ii) of this section provides that the form of a merger will be respected for Federal income tax purposes if the steps prescribed under the assets-up form are fol

lowed, and paragraph (d)(3)(i) of this section provides a form that will be followed for Federal income tax purposes in the case of partnership divisions, these forms will not be respected for Federal income tax purposes under these facts, and the transactions will be recast in accordance with their substance as a taxable exchange of interests in ABC for interests in DE.

(7) Effective date . This paragraph (c) is applicable to partnership mergers occurring on or after January 4, 2001. However, a partnership may apply paragraph (c) of this section to partnership mergers occurring on or after January 11, 2000. (d) Division of a partnership —(1) General rule . Upon the division of a partnership into two or more partnerships, any resulting partnership (as defined in paragraph (d)(4)(iv) of this section) or resulting partnerships shall be considered a continuation of the prior partnership (as defined in paragraph (d)(4)(ii) of this section) if the members of the resulting partnership or partnerships had an interest of more than 50 percent in the capital and profits of the prior partnership. Any other resulting partnership will not be considered a continuation of the prior partnership but will be considered a new partnership. If the members of none of the resulting partnerships owned an interest of more than 50 percent in the capital and profits of the prior partnership, none of the resulting partnerships will be considered a continuation of the prior partnership, and the prior partnership will be considered to have terminated. Where members of a partnership which has been divided into two or more partnerships do not become members of a resulting partnership which is considered a continuation of the prior partnership, such members’ interests shall be considered liquidated as of the date of the division.

(2) Tax consequences —(i) Tax returns . The resulting partnership that is treated as the divided partnership (as defined in paragraph (d)(4)(i) of this section) shall file a return for the taxable year of the partnership that has been divided and retain the employer identification number (EIN) of the prior partnership. The return shall include the names, addresses, and EINs of all resulting partnerships that are regarded as continuing. The return shall also state that the partnership is a continuation of the prior partnership and shall set forth separately the respective distributive

shares of the partners for the periods prior to and including the date of the division and subsequent to the date of division. All other resulting partnerships that are regarded as continuing and new partnerships shall file separate returns for the taxable year beginning on the day after the date of the division with new EINs for each partnership. The return for a resulting partnership that is regarded as continuing and that is not the divided partnership shall include the name, address, and EIN of the prior partnership.

(ii) Elections . All resulting partnerships that are regarded as continuing are subject to preexisting elections that were made by the prior partnership. A subsequent election that is made by a resulting partnership does not affect the other resulting partnerships.

(3) Form of a division —(i) Assets-over form . When a partnership divides into two or more partnerships under applicable jurisdictional law without undertaking a form for the division, or undertakes a form that is not described in paragraph (d)(3)(ii) of this section, the transaction will be characterized under the assetsover form for Federal income tax purposes.

(A) Assets-over form where at least one resulting partnership is a continuation of the prior partnership . In a division under the assets-over form where at least one resulting partnership is a continuation of the prior partnership, the divided partnership (as defined in paragraph (d)(4)(i) of this section) contributes certain assets and liabilities to a recipient partnership (as defined in paragraph (d)(4)(iii) of this section) or recipient partnerships in exchange for interests in such recipient partnership or partnerships; and, immediately thereafter, the divided partnership distributes the interests in such recipient partnership or partnerships to some or all of its partners in partial or complete liquidation of the partners’ interests in the divided partnership.

(B) Assets-over form where none of the resulting partnerships is a continuation of the prior partnership . In a division under the assets-over form where none of the resulting partnerships is a continuation of the prior partnership, the prior partnership will be treated as contributing all of its assets and liabilities to new resulting partnerships in exchange for interests in the

February 5, 2001 502 2001–6 I.R.B.

resulting partnerships; and, immediately thereafter, the prior partnership will be treated as liquidating by distributing the interests in the new resulting partnerships to the prior partnership’s partners.

(ii) Assets-up form —(A) Assets-up form where the partnership distributing assets is a continuation of the prior part- nership . Despite the partners’ transitory ownership of some of the prior partnership’s assets, the form of a partnership division will be respected for Federal income tax purposes if the divided partnership (which, pursuant to §1.708–1(d) (4)(i), must be a continuing partnership) distributes certain assets (in a manner that causes the partners to be treated, under the laws of the applicable jurisdiction, as the owners of such assets) to some or all of its partners in partial or complete liquidation of the partners’ interests in the divided partnership, and immediately thereafter, such partners contribute the distributed assets to a recipient partnership or partnerships in exchange for interests in such recipient partnership or partnerships. In order for such form to be respected for transfers to a particular recipient partnership, all assets held by the prior partnership that are transferred to the recipient partnership must be distributed to, and then contributed by, the partners of the recipient partnership.

(B) Assets-up form where none of the resulting partnerships are a continuation of the prior partnership . If none of the resulting partnerships are a continuation of the prior partnership, then despite the partners’ transitory ownership of some or all of the prior partnership’s assets, the form of a partnership division will be respected for Federal income tax purposes if the prior partnership distributes certain assets (in a manner that causes the partners to be treated, under the laws of the applicable jurisdiction, as the owners of such assets) to some or all of its partners in partial or complete liquidation of the partners’ interests in the prior partnership, and immediately thereafter, such partners contribute the distributed assets to a resulting partnership or partnerships in exchange for interests in such resulting partnership or partnerships. In order for such form to be respected for transfers to a particular resulting partnership, all assets held by the prior partnership that are transferred to the resulting partnership must be distributed to, and then con

tributed by, the partners of the resulting partnership. If the prior partnership does not liquidate under the applicable jurisdictional law, then with respect to the assets and liabilities that, in form, are not transferred to a new resulting partnership, the prior partnership will be treated as transferring these assets and liabilities to a new resulting partnership under the assets-over form described in paragraph (d)(3)(i)(B) of this section.

(4) Definitions —(i) Divided partner- ship . For purposes of paragraph (d) of this section, the divided partnership is the continuing partnership which is treated, for Federal income tax purposes, as transferring the assets and liabilities to the recipient partnership or partnerships, either directly (under the assets-over form) or indirectly (under the assets-up form). If the resulting partnership that, in form, transferred the assets and liabilities in connection with the division is a continuation of the prior partnership, then such resulting partnership will be treated as the divided partnership. If a partnership divides into two or more partnerships and only one of the resulting partnerships is a continuation of the prior partnership, then the resulting partnership that is a continuation of the prior partnership will be treated as the divided partnership. If a partnership divides into two or more partnerships without undertaking a form for the division that is recognized under paragraph (d)(3) of this section, or if the resulting partnership that had, in form, transferred assets and liabilities is not considered a continuation of the prior partnership, and more than one resulting partnership is considered a continuation of the prior partnership, the continuing resulting partnership with the assets having the greatest fair market value (net of liabilities) will be treated as the divided partnership.

(ii) Prior partnership . For purposes of paragraph (d) of this section, the prior partnership is the partnership subject to division that exists under applicable jurisdictional law before the division.

(iii) Recipient partnership . For purposes of paragraph (d) of this section, a recipient partnership is a partnership that is treated as receiving, for Federal income tax purposes, assets and liabilities from a divided partnership, either directly (under the assets-over form) or indirectly (under the assets-up form).

(iv) Resulting partnership . For purposes of paragraph (d) of this section, a resulting partnership is a partnership resulting from the division that exists under applicable jurisdictional law after the division and that has at least two partners who were partners in the prior partnership. For example, where a prior partnership divides into two partnerships, both partnerships existing after the division are resulting partnerships.

(5) Examples . The following examples illustrate the rules in paragraphs (d)(1), (2), (3), and (4) of this section:

Example 1 . Partnership ABCD is in the real estate and insurance businesses. A owns a 40-percent interest, and B, C, and D each owns a 20-percent interest, in the capital and profits of the partnership. The partnership and the partners report their income on a calendar year. On November 1, 1999, they separate the real estate and insurance businesses and form two partnerships. Partnership AB takes over the real estate business, and partnership CD takes over the insurance business. Because members of resulting partnership AB owned more than a 50-percent interest in the capital and profits of partnership ABCD (A, 40 percent, and B, 20 percent), partnership AB shall be considered a continuation of partnership ABCD. Partnership AB is required to file a return for the taxable year January 1 to December 31, 1999, indicating thereon that until November 1, 1999, it was partnership ABCD. Partnership CD is considered a new partnership formed at the beginning of the day on November 2, 1999, and is required to file a return for the taxable year it adopts pursuant to section 706(b) and the applicable regulations.

Example 2 . (i) Partnership ABCD owns properties W, X, Y, and Z, and divides into partnership AB and partnership CD. Under paragraph (d)(1) of this section, partnership AB is considered a continuation of partnership ABCD and partnership CD is considered a new partnership. Partnership ABCD distributes property Y to C and titles property Y in C’s name. Partnership ABCD distributes property Z to D and titles property Z in D’s name. C and D then contribute properties Y and Z, respectively, to partnership CD in exchange for interests in partnership CD. Properties W and X remain in partnership AB.

(ii) Under paragraph (d)(3)(ii) of this section, partnership ABCD will be treated as following the assets-up form for Federal income tax purposes.

Example 3 . (i) The facts are the same as in Example 2, except partnership ABCD distributes property Y to C and titles property Y in C’s name. C then contributes property Y to partnership CD. Simultaneously, partnership ABCD contributes property Z to partnership CD in exchange for an interest in partnership CD. Immediately thereafter, partnership ABCD distributes the interest in partnership CD to D in liquidation of D’s interest in partnership ABCD.

(ii) Under paragraph (d)(3)(i) of this section, because partnership ABCD did not undertake the assets-up form with respect to all of the assets transferred to partnership CD, partnership ABCD will be treated as undertaking the assets-over form in transferring the assets to partnership CD. Accordingly, for Federal income tax purposes, partnership ABCD

2001–6 I.R.B. 503 February 5, 2001

is deemed to contribute property Y and property Z to partnership CD in exchange for interests in partnership CD, and immediately thereafter, partnership ABCD is deemed to distribute the interests in partnership CD to partner C and partner D in liquidation of their interests in partnership ABCD.

Example 4 . (i) Partnership ABCD owns three parcels of property: property X, with a value of $500; property Y, with a value of $300; and property Z, with a value of $200. A and B each own a 40percent interest in the capital and profits of partnership ABCD, and C and D each own a 10 percent interest in the capital and profits of partnership ABCD. On November 1, 1999, partnership ABCD divides into three partnerships (AB1, AB2, and CD) by contributing property X to a newly formed partnership (AB1) and distributing all interests in such partnership to A and B as equal partners, and by contributing property Z to a newly formed partnership (CD) and distributing all interests in such partnership to C and D as equal partners in exchange for all of their interests in partnership ABCD. While partnership ABCD does not transfer property Y, C and D cease to be partners in the partnership. Accordingly, after the division, the partnership holding property Y is referred to as partnership AB2.

(ii) Partnerships AB1 and AB2 both are considered a continuation of partnership ABCD, while partnership CD is considered a new partnership formed at the beginning of the day on November 2, 1999. Under paragraph (d)(3)(i)(A) of this section, partnership ABCD will be treated as following the assets-over form, with partnership ABCD contributing property X to partnership AB1 and property Z to partnership CD, and distributing the interests in such partnerships to the designated partners.

Example 5 . (i) The facts are the same as in Example 4, except that partnership ABCD divides into three partnerships by operation of state law, without undertaking a form.

(ii) Under the last sentence of paragraph (d)(4)(i) of this section, partnership AB1 will be treated as the resulting partnership that is the divided partnership. Under paragraph (d)(3)(i)(A) of this section, partnership ABCD will be treated as following the assetsover form, with partnership ABCD contributing property Y to partnership AB2 and property Z to partnership CD, and distributing the interests in such partnerships to the designated partners.

Example 6 . (i) The facts are the same as in Example 4, except that partnership ABCD divides into three partnerships by contributing property X to newly-formed partnership AB1 and property Y to newly-formed partnership AB2 and distributing all interests in each partnership to A and B in exchange for all of their interests in partnership ABCD.

(ii) Because resulting partnership CD is not a continuation of the prior partnership (partnership ABCD), partnership CD cannot be treated, for Federal income tax purposes, as the partnership that transferred assets (i.e., the divided partnership), but instead must be treated as a recipient partnership. Under the last sentence of paragraph (d)(4)(i) of this section, partnership AB1 will be treated as the resulting partnership that is the divided partnership. Under paragraph (d)(3)(i)(A) of this section, partnership ABCD will be treated as following the assetsover form, with partnership ABCD contributing property Y to partnership AB2 and property Z to partnership CD, and distributing the interests in such

partnerships to the designated partners.

Example 7 . (i) Partnership ABCDE owns Blackacre, Whiteacre, and Redacre, and divides into partnership AB, partnership CD, and partnership DE. Under paragraph (d)(1) of this section, partnership ABCDE is considered terminated (and, hence, none of the resulting partnerships are a continuation of the prior partnership) because none of the members of the new partnerships (partnership AB, partnership CD, and partnership DE) owned an interest of more than 50 percent in the capital and profits of partnership ABCDE.

(ii) Partnership ABCDE distributes Blackacre to A and B and titles Blackacre in the names of A and B. A and B then contribute Blackacre to partnership AB in exchange for interests in partnership AB. Partnership ABCDE will be treated as following the assets-up form described in paragraph (d)(3)(ii)(B) of this section for Federal income tax purposes.

(iii) Partnership ABCDE distributes Whiteacre to C and D and titles Whiteacre in the names of C and D. C and D then contribute Whiteacre to partnership CD in exchange for interests in partnership CD. Partnership ABCDE will be treated as following the assets-up form described in paragraph (d)(3)(ii)(B) of this section for Federal income tax purposes.

(iv) Partnership ABCDE does not liquidate under state law so that, in form, the assets in new partnership DE are not considered to have been transferred under state law. Partnership ABCDE will be treated as undertaking the assets-over form described in paragraph (d)(3)(i)(B) of this section for Federal income tax purposes with respect to the assets of partnership DE. Thus, partnership ABCDE will be treated as contributing Redacre to partnership DE in exchange for interests in partnership DE; and, immediately thereafter, partnership ABCDE will be treated as distributing interests in partnership DE to D and E in liquidation of their interests in partnership ABCDE. Partnership ABCDE then terminates.

(6) Prescribed form not followed in cer- tain circumstances . If any transactions described in paragraph (d)(3) of this section are part of a larger series of transactions, and the substance of the larger series of transactions is inconsistent with following the form prescribed in such paragraph, the Commissioner may disregard such form, and may recast the larger series of transactions in accordance with their substance.

(7) Effective date . This paragraph (d) is applicable to partnership divisions occurring on or after January 4, 2001. However, a partnership may apply paragraph (d) of this section to partnership divisions occurring on or after January 11, 2000. Par. 3. Section 1.752-1 is amended as follows:

A sentence is added to the end of paragraph (f).
The current Example in paragraph (g) is redesignated as Example 1 .
Example 2 is added in paragraph (g). The additions read as follows:

§1.752–1 Treatment of partnership liabilities.

(f) * * * When two or more partnerships merge or consolidate under section 708(b)(2)(A), as described in §1.708–1(c)(3)(i), increases and decreases in partnership liabilities associated with the merger or consolidation are netted by the partners in the terminating partnership and the resulting partnership to determine the effect of the merger under section 752.

(g) * * * Example 1 . *** * *** Example 2 . Merger or consolidation of partner- ships holding property encumbered by liabilities . (i) B owns a 70 percent interest in partnership T. Partnership T’s sole asset is property X, which is encumbered by a $900 liability. Partnership T’s adjusted basis in property X is $600, and the value of property X is $1,000. B’s adjusted basis in its partnership T interest is $420. B also owns a 20 percent interest in partnership S. Partnership S’s sole asset is property Y, which is encumbered by a $100 liability. Partnership S’s adjusted basis in property Y is $200, the value of property Y is $1,000, and B’s adjusted basis in its partnership S interest is $40.

(ii) Partnership T and partnership S merge under section 708(b)(2)(A). Under section 708(b)(2)(A) and §1.708–1(c)(1), partnership T is considered terminated and the resulting partnership is considered a continuation of partnership S. Partnerships T and S undertake the form described in §1.708–1(c)(3)(i) for the partnership merger. Under §1.708–1(c)(3)(i), partnership T contributes property X and its $900 liability to partnership S in exchange for an interest in partnership S. Immediately thereafter, partnership T distributes the interests in partnership S to its partners in liquidation of their interests in partnership T. B owns a 25 percent interest in partnership S after partnership T distributes the interests in partnership S to B.

(iii) Under paragraph (f) of this section, B nets the increases and decreases in its share of partnership liabilities associated with the merger of partnership T and partnership S. Before the merger, B’s share of partnership liabilities was $650 (B had a $630 share of partnership liabilities in partnership T and a $20 share of partnership liabilities in partnership S immediately before the merger). B’s share of S’s partnership liabilities after the merger is $250 (25 percent of S’s total partnership liabilities of $1,000). Accordingly, B has a $400 net decrease in its share of S’s partnership liabilities. Thus, B is treated as receiving a $400 distribution from partnership S under section 752(b). Because B’s adjusted basis in its partnership S interest before the deemed distribution under section 752(b) is $460 ($420 + $40), B will not recognize gain under section 731. After the merger, B’s adjusted basis in its partnership S interest is $60.

February 5, 2001 504 2001–6 I.R.B.

Par. 4. In §1.752–5, paragraph (a) is amended by adding two sentences after the third sentence.

§1.752–5 Effective dates and transition rules.

(a) In general . * * * In addition, §1.752–1(f) last sentence and (g) Example 2, do not apply to any liability incurred or assumed by a partnership prior to January 4, 2001. Nevertheless, §1.752–1(f) last sentence and (g) Example 2, may be relied on for any liability incurred or assumed by a partnership prior to January 4, 2001, and, unless the partnership makes an election under paragraph (b)(1) of this section, on or after December 28, 1991, other than a liability incurred or assumed by the partnership pursuant to a written binding contract in effect prior to December 28, 1991, and at all times thereafter. * * *

David A. Mader, Acting Deputy Commissioner

of Internal Revenue.

Approved December 20, 2000.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 3, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 4, 2001, 66 F.R. 715)

Section 1502.—Regulations

26 CFR 1.1502–78T: Rules for filing applications for tentative carryback adjustments.

T.D. 8919

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

and exceptions as the Secretary may by regulations prescribe. Section 1.6411–4 refers taxpayers to the consolidated return regulations, specifically §1.1502–78, for further rules applicable to consolidated groups filing for a tentative carryback adjustment.

Section 1.1502–78(a) addresses the proper party to file an application for a tentative carryback adjustment. However, there is no provision addressing the time for filing such application. Section 1.1502–78 does not currently alter the statutory rule as to “when” the end of a taxable year occurs for purposes of determining whether the twelve-month rule of section 6411 has been satisfied. Under §1.1502–76, the due date for the separate return of a new member is generally extended until the due date of the return of the consolidated group. In certain instances, however, such separate return cannot be filed before the expiration of the twelve-month period under section 6411(a). Thus, a new member may be prevented from filing an application for a tentative carryback adjustment.

Section 1.1502–76(b)(1)(i) provides that the consolidated return must include the common parent’s items of income, gain, deduction, loss, and credit for the entire consolidated year, and each subsidiary’s items for the portion of the year for which it is a member. Items of a corporation for the portion of the year not included in the consolidated return must be included in a separate return (including the consolidated return of another group). Thus, the items of a new member of a consolidated group are included in two returns: first, the consolidated return for the period of time it is a member of the group; and second, a separate return (including the consolidated return of another group) for the pre-affiliation period prior to becoming a member of the consolidated group. This pre-affiliation period is a separate return year as defined in §1.1502–1(e).

Guidance on Filing an Application for a Tentative Carryback Adjustment in a Consolidated Return Context

Application for a Tentative period of twelve (12) months after the end The tax returns for the periods that end Carryback Adjustment in a of such taxable year. Section 6411(c) pro- and begin upon a corporation becoming Consolidated Return Context vides that if the corporation seeking a ten- (or ceasing to be) a member of a consoli tative carryback adjustment made or was dated group are separate taxable years for

AGENCY: Internal Revenue Service required to make a consolidated return for all Federal income tax purposes. Section (IRS), Treasury. the year in which the loss or credit arose 1.1502–76(b)(2)(i). Although these peri or for the preceding taxable year affected ods are separate taxable years, items of

ACTION: Temporary regulations .

by such loss or credit, the provisions of income, gain, deduction, loss, and credit

SUMMARY: This document contains Section 6411(a) apply only to such extent (other than extraordinary items) may be temporary regulations relating to the fil- and subject to such conditions, limitations ratably allocated between such years if:

2001–6 I.R.B. 505 February 5, 2001

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations .

SUMMARY: This document contains temporary regulations relating to the fil

ing of an application for a tentative carryback adjustment. These temporary regulations provide guidance to determine the time for filing such application by a consolidated group. This document also contains temporary regulations relating to the filing of an application for a tentative carryback adjustment by certain corporations for the separate return year created by their becoming a member of a consolidated group. These temporary regulations may affect all consolidated groups. The text of these temporary regulations also serves as the text of proposed regulations set forth in the notice of proposed rulemaking (REG–119352–00) on page 525 of this Bulletin.

DATES: Effective Date: January 4, 2001.

Applicability Date: For dates of applicability for these regulations, see paragraph (g)(2)(v) of this section.

FOR FURTHER INFORMATION CONTACT: Christopher M. Bass or Frances L. Kelly, (202) 622-7770.

SUPPLEMENTARY INFORMATION:

Background

This document contains temporary amendments to the Income Tax Regulations (26 CFR Part 1) under section 1502 of the Internal Revenue Code of 1986 (Code). The amendments provide guidance as to the time for filing an application for a tentative carryback adjustment by a consolidated group. The amendments also extend the time for filing an application for a tentative carryback adjustment by certain corporations for the separate return year created by their becoming new members of a consolidated group.

Section 6411(a) requires that an application for a tentative carryback adjustment be filed on or after the date of filing for the return for the taxable year of the loss (or unused business credit) from which the carryback results and within a period of twelve (12) months after the end of such taxable year. Section 6411(c) provides that if the corporation seeking a tentative carryback adjustment made or was required to make a consolidated return for the year in which the loss or credit arose or for the preceding taxable year affected by such loss or credit, the provisions of Section 6411(a) apply only to such extent and subject to such conditions, limitations

(1) the corporation is not required to change its annual accounting period or its method of accounting as a result of its change in status as a member; and (2) a timely ratable allocation election is made. Section 1.1502–76(b)(2)(ii)(A). If a ratable allocation cannot be made (or is not made), the corporation must close its books at the close of the day on which its status as a member changes and its items of income, gain, deduction, loss, and credit for the pre-affiliation period are included in its separate return. Section 1.1502–76(b)(2)(ii). Section 1.1502–76(c) determines the time for filing the new member’s separate return. The provisions of this section apply only to a corporation which, immediately prior to becoming a new member of a group, was the common parent of another consolidated group, or was not required to join in the filing of a consolidated return. Under §1.1502–76(c), the due date of the new member’s separate return is dependent upon the filing of the consolidated group’s tax return. If the consolidated return for the group has been filed by the due date for the new member’s separate return, then the separate return must be filed no later than the due date of the consolidated group’s return, including extensions. If the consolidated return for the group has not been filed by the due date for the new member’s separate return, then the separate return must be filed on or before such due date. In each case, the due date for the new member’s separate return is determined with regard to extensions of time for filing but without regard to the member’s new affiliated status. The close of the new member’s separate return year is treated as the close of its normal taxable year. Therefore, §1.1502–76(c) effectively extends the period of time in which a new member is required to file its separate return because otherwise, the taxable year would end on the date it becomes a member. Section 1.1502–76(b)(2).

While §1.1502–76(c) extends the due date for filing the new member’s separate return, there is no similar provision that extends the due date for filing an application for a tentative carryback adjustment for the separate return year. Neither section 6411(a) nor §1.1502–78 interprets the close of the new member’s separate return

year as the close of its normal taxable year. Therefore, an application for a tentative carryback adjustment must be filed: (1) on or after the extended date for filing the return for the taxable year; and (2) within a period of twelve months after the close of such taxable year. Since the separate return year is treated as a separate taxable year for all Federal income tax purposes under §1.1502–76(b)(2)(i), a new member that chooses to file an application for a tentative carryback adjustment under section 6411 must do so within twelve (12) months after the close of its separate return year (not its normal taxable year).

The practical effect of extending the due date for filing the new member’s separate return under §1.1502–76(c) without extending the time period for filing an application for a tentative carryback adjustment is that a corporation that becomes a member of a consolidated group early in its taxable year may effectively be precluded from filing the application. This results because the twelvemonth period for filing the refund application may expire prior to the due date (extended or unextended) for the filing of the new member’s separate return.

The problem is illustrated by the following example:

On April 30, 2000, 100% of the stock of Corporation X, a stand-alone corporation, is acquired by Group Y. Both Corporation X and Group Y file their returns on a calendar year basis. Under §1.1502–76(c), Corporation X’s separate return for the period, January 1-April 30, 2000 (the April 2000 Year), is due on or before September 15, 2001 (with extensions). However, its application for a tentative carryback adjustment for the April 2000 Year is due no later than April 30, 2001, twelve months after the end of the April 2000 Year.

As a practical matter, the separate return of some new members cannot be filed before the group’s consolidated return is filed. As previously noted, §1.1502–76(b)(2) provides, under certain circumstances, that the new member’s items of income, gain, deduction, loss, and credit may be ratably allocated between the pre-affiliation and the postaffiliation periods. The new member may not know whether the common parent will

elect to ratably allocate its items. Such allocation would alter the income or loss of the new member for its separate return year. The new member also may not know the proper amount of income and loss to report and thus cannot file its separate return or its application for a tentative carryback adjustment until the group’s consolidated return has been filed. Furthermore, Rev. Rul. 75–327 (1975–2 C.B. 481) holds that, because the IRS must rely on the information provided by the taxpayer in its application for a tentative carryback adjustment and much of that information (such as NOLs) is based on the return for the loss year, section 6411(a) requires that the return for the loss year be filed before the application for a tentative refund can be filed.

This problem is not generally faced by corporations that become members of a consolidated group in the latter part of their taxable year. For example, if Corporation X had been acquired on October 15, 2000, rather than April 15, 2000, its application for a tentative carryback adjustment would be due on or before October 15, 2001, a month after its separate return is due (with extensions).

Explanation of Provisions

The consolidated return regulations do not address the time for filing an application for a tentative carryback adjustment. Rather, the consolidated return regulations rely upon the general provisions of section 6411 for guidance. The amendments to §1.1502–78 provide a general rule for all consolidated taxpayers stating that the provisions of section 6411(a) shall apply to determine the time for filing an application for a tentative carryback adjustment by a consolidated group.

In addition, the amendments provide a special rule designed to remedy the problem faced by some corporations that become new members of a consolidated group. For such members, the amendments extend the period of time for filing an application for a tentative carryback adjustment resulting from losses or credits arising in the new member’s last separate return year. For these purposes, the amendments treat the separate return year as ending on the same date as the end of the current taxable year of the consolidated group.

February 5, 2001 506 2001–6 I.R.B.

The special rule of these temporary regulations will apply only to a corporation that, immediately prior to becoming a new member of a group, was the common parent of another consolidated group, or was not required to join in the filing of a consolidated return. The situation not covered involves the acquisition of a member of another consolidated group. In this case, the corporation’s items of income, gain, deduction, loss and credit for the period prior to becoming a member of the new consolidated group will be included in the consolidated return of its former group. The due date for the former group’s consolidated return is not affected by the acquisition and the due date for its application for a tentative carryback adjustment relates back to the end of the former group’s taxable year.

The approach taken attempts to provide consistency between §1.1502–76(c) and §1.1502–78. In addition, this approach provides certainty to taxpayers and allows for simplicity of administration by the IRS.

Special Analyses

It has been determined that this notice of temporary rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. Because no preceding notice of proposed rulemaking is required for this temporary regulation, the provisions of the Regulatory Flexibility Act do not apply.

This Treasury decision ensures that all new members of consolidated groups have the opportunity to file an application for a tentative carryback adjustment, a benefit currently unavailable to some new members. Issuing this regulation in proposed form would continue the difficulty of filing an application for a tentative carryback adjustment for affected new members. Based on these considerations, it is determined that this temporary regulation will provide taxpayers with the necessary guidance and authority to ensure equitable administration of the tax laws. Therefore, it would be contrary to the public interest to issue this Treasury decision with prior notice under section 553(b) or subject to the effective date limitation of section 553(d) of title 5 of the United States Code. Pursuant to section 7805(f) of the Code, these regulations will be submitted to the Chief Counsel for Advocacy of the Small

Business Administration for comment on their impact on small business.

Drafting Information

The principal authors of these temporary regulations are Christopher M. Bass and Frances L. Kelly, Office of the Associate Chief Counsel (Corporate). However, other personnel from the IRS and Treasury Department participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 — INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Section 1.1502–78T also issued under 26 U.S.C. 1502 and 6411(c). * * *

Par. 2. Section 1.1502–78T is added to read as follows:

§1.1502–78T Rules for filing applications for tentative carryback adjustments.

(a) through (f) [Reserved]. For further guidance, see §1.1502–78(a) through (f).

(g) Time for filing application—(1) General rule. The provisions of section 6411(a) apply to the filing of an application for a tentative carryback adjustment by a consolidated group.

(2) Special rule for new members— (i) New member. A new member is a corporation that, in the preceding taxable year, did not qualify as a member, as defined in §1.1502–1(b), of the consolidated group that it now joins.

(ii) End of taxable year. Solely for the purpose of complying with the twelve-month requirement for making an application for a tentative carryback adjustment under section 6411(a), the separate return year of a qualified new member shall be treated as ending on the same date as the end of the current taxable year of the consolidated group that the qualified new member joins.

(iii) Qualified new member . A new member of a consolidated group qualifies for purposes of the provisions of this paragraph (g)(2), if immediately prior to becoming a new member, either—

(A) It was the common parent of a consolidated group; or

(B) It was not required to join in the filing of a consolidated return.

(iv) Examples . The provisions of this paragraph (g)(2) may be illustrated by the following examples:

Example 1. Individual A owns 100 percent of the stock of X, a corporation filing returns on a calendar year basis. On January 31 of year 1, X becomes a member of the Y consolidated group, which also files returns on a calendar year basis. X is a qualified new member as defined in paragraph (g)(2)(iii)(B) of this section because, immediately prior to becoming a new member of the Y consolidated group, X was not required to join in the filing of a consolidated return. As a result of its becoming a new member of Group Y, X’s separate return for the short taxable year (January 1 of year 1 through January 31 of year 1) is due September 15 of year 2 (with extensions). Section 1.1502–76(c). Group Y’s consolidated return is also due September 15 of year 2 (with extensions). Section 1.1502–76(c). Solely for the purpose of complying with the twelve-month requirement for making an application for a tentative carryback adjustment under Section 6411(a), X’s taxable year for the separate return year is treated as ending on December 31 of year 1. X’s application for a tentative carryback adjustment is therefore due on or before December 31 of year 2.

Example 2 . Assume the same facts as in Example 1 except that immediately prior to becoming a new member of Group Y, X was a member of the Z consolidated group. Because X was required to join in the filing of the consolidated return for Group Z, X is not a qualified new member as defined in paragraph (g)(2)(iii) of this section. X’s items for the one-month period will be included in the consolidated return for Group Z. Group Z’s application for a tentative carryback adjustment, if any, continues to be due within 12 months of the end of its taxable year, which is not affected by X’s change in status as a new member of Group Y.

(v) Effective date . The provisions of this paragraph (g)(2) apply for applications by new members of consolidated groups for tentative carryback adjustments resulting from net operating losses, net capital losses, or unused business credits arising in separate return years of new members that begin on or after January 1, 2001.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

Approved December 13, 2000.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 3, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 4, 2001, 66 F.R. 713)

2001–6 I.R.B. 507 February 5, 2001

issues presented. Similarly, whether the positions of the United States in the administrative and litigation proceedings were substantially justified is not relevant for an award under the qualified offer rule. An award based upon the taxpayer having made a qualified offer is limited to those reasonable administrative and litigation costs incurred on or after the date of the last qualified offer, with respect to the adjustments that were included in the last qualified offer, and litigated to a judicial determination. If the taxpayer qualifies as a prevailing party without regard to the qualified offer rule, the reasonable administrative and litigation costs to which the taxpayer is thus entitled may not be awarded again by reason of the taxpayer having made a qualified offer.

A qualified offer is a written offer that:

is made by the taxpayer to the United States during the qualified offer period; 2) establishes the taxpayer’s liability (determined without regard to interest) by setting forth the amount of the taxpayer’s offer on all adjustments at issue in the proceeding at the time the qualified offer is made; 3) is designated as a qualified offer at the time it is made; and 4) remains open at least until the earliest of the date the offer is rejected, the date the trial begins, or the 90 ^th day after the date the offer is made.

Section 7430.—Awarding of Costs and Certain Fees

26 CFR 301.7430–7T: Qualified offers (temporary).

T.D. 8922

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 301

Awards of Attorney’s Fees and Other Costs Based Upon Qualified Offers

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains temporary regulations relating to the circumstances under which a party, by reason of having made a qualified offer, will be entitled to an award of reasonable administrative and litigation costs in a civil tax proceeding brought in a court of the United States (including the Tax Court). The regulations implement certain changes made by section 3101(e) of the Internal Revenue Service Restructuring and Reform Act of 1998. They affect taxpayers who make qualified offers. The text of these regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking (REG–121928–98) on page 520 of this Bulletin.

The qualified offer period ends on the

regulations set forth in the notice of pro- be compared with the liability under the last date which is thirty days before the date the posed rulemaking (REG–121928–98) on qualified offer. These regulations apply in case is first set for trial. In cases that are page 520 of this Bulletin. multiple taxpayer situations, such as joint pending in the United States Tax Court,

DATES: Effective Dates . These regula- returns, but do not set forth any special cases are placed upon a calendar for trial. tions are effective January 3, 2001. rules regarding the aggregation or segrega- Each case appearing on a trial calendar is

Applicability Date : These regulations tion of the qualified offer or liability in sit- to be called at the time and place schedapply to qualified offers made in adminis- uations that may present special circum- uled. In determining when the qualified

stances, such as claims for innocent spouse offer period ends for cases in the Tax Court

trative or court proceedings described in

relief. After study, further guidance may be and other courts of the United States using

section 7430 after January 3, 2001.

issued elaborating on the treatment of such calendars for trial, a case is considered to

FOR FURTHER INFORMATION CON- situations under these regulations. be set for trial on the date scheduled for the TACT: Thomas D. Moffitt (202) 622- To qualify as a prevailing party under calendar call. Cases may be removed from 7900 (not a toll-free number). this rule, in addition to the above, taxpay- a trial calendar at any time. Thus, a case

ers must also satisfy the net worth require- may be removed from a calendar before the

SUPPLEMENTARY INFORMATION:

ments of section 7430(c)(4)(A)(ii). date that precedes by thirty days the date

Background Furthermore, to qualify for an award, tax- scheduled for that calendar. To promote

payers must satisfy the remaining require- the settlement of such cases, the qualified

This document contains amendments to ments of section 7430, such as not unrea- offer period does not end until the case the Procedure and Administration sonably protracting the proceedings and, remains on a calendar for trial on the date Regulations (26 CFR part 301) that reflect for purposes of an award of litigation costs, that precedes by 30 days the scheduled date changes to section 7430 made by section exhausting their administrative remedies. of the calendar call for that trial session. 3101(e) of the Internal Revenue Service On the other hand, a taxpayer qualifying as The qualified offer period may not be Restructuring and Reform Act of 1998 a prevailing party by reason of having extended, although the period during relating to the circumstances under which made a qualified offer need not substantial- which a qualified offer remains open may taxpayers may recover reasonable adminis- ly prevail on either the amount in contro- extend beyond the end of the qualified trative and litigation costs in a court pro- versy or the most significant issue or set of offer period.

February 5, 2001 508 2001–6 I.R.B.

DATES: Effective Dates . These regulations are effective January 3, 2001.

Applicability Date : These regulations apply to qualified offers made in administrative or court proceedings described in section 7430 after January 3, 2001.

FOR FURTHER INFORMATION CONTACT: Thomas D. Moffitt (202) 6227900 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Procedure and Administration Regulations (26 CFR part 301) that reflect changes to section 7430 made by section 3101(e) of the Internal Revenue Service Restructuring and Reform Act of 1998 relating to the circumstances under which taxpayers may recover reasonable administrative and litigation costs in a court pro

ceeding with respect to the determination or refund of any tax, interest or penalty when taxpayers have made a qualified offer.

Explanation of Provisions

In general, a prevailing party may recover the reasonable administrative and litigation costs incurred in administrative and court proceedings if the proceedings relate to the determination or refund of any tax, interest or penalty under the Internal Revenue Code. The regulations provide information concerning the circumstances under which the making of a qualified offer will result in the taxpayer being a prevailing party for purposes of a recovery of costs. In general, a taxpayer is a prevailing party by reason of making a qualified offer if the taxpayer’s liability under the last qualified offer would equal or exceed the amount of the taxpayer’s liability (determined without regard to interest) attributable to the adjustments included in the last qualified offer that were actually determined by the court through litigation, plus the amount of any additional adjustments included in the last qualified offer that were determined by settlements entered into after the making of the last qualified offer. Adjustments raised by any party subsequent to the making of the last qualified offer are disregarded in determining the liability of the taxpayer to be compared with the liability under the last qualified offer. These regulations apply in multiple taxpayer situations, such as joint returns, but do not set forth any special rules regarding the aggregation or segregation of the qualified offer or liability in situations that may present special circumstances, such as claims for innocent spouse relief. After study, further guidance may be issued elaborating on the treatment of such situations under these regulations.

To qualify as a prevailing party under this rule, in addition to the above, taxpayers must also satisfy the net worth requirements of section 7430(c)(4)(A)(ii). Furthermore, to qualify for an award, taxpayers must satisfy the remaining requirements of section 7430, such as not unreasonably protracting the proceedings and, for purposes of an award of litigation costs, exhausting their administrative remedies. On the other hand, a taxpayer qualifying as a prevailing party by reason of having made a qualified offer need not substantially prevail on either the amount in controversy or the most significant issue or set of

A taxpayer cannot qualify as a prevailing party by reason of having made a qualified offer if the determination of the court in the proceeding with respect to the adjustments included in the last qualified offer is entered exclusively pursuant to a settlement. Neither can a taxpayer qualify as a prevailing party by reason of having made a qualified offer in any proceeding in which the amount of tax liability is not in issue, including any declaratory judgment proceeding, any proceeding to enforce or quash any summons issued pursuant to the Internal Revenue Code of 1986, and any action to restrain disclosure under section 6110(f).

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 these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, 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.

Drafting Information

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

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 301 is amended as follows:

PART 301—PROCEDURE AND ADMINISTRATION

Paragraph 1. The authority citation for part 301 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 301.7430–7T is added to read as follows:

§301.7430–7T Qualified offers (temporary).

(a) In general . Section 7430(c)(4)(E) (the qualified offer rule) provides that a party to a court proceeding satisfying the timely filing and net worth requirements of section 7430(c)(4)(A)(ii) shall be treated as the prevailing party if the liability of the taxpayer pursuant to the judgment in the proceeding (determined without regard to interest) is equal to or less than the liability of the taxpayer which would have been so determined if the United States had accepted the last qualified offer of the party as defined in section 7430(g). For purposes of this section, the term judgment means the cumulative determinations of the court concerning the adjustments at issue and litigated to a determination in the court proceeding. In making the comparison between the liability under the qualified offer and the liability under the judgment, the taxpayer’s liability under the judgment is further modified by the provisions of paragraph (b)(3) of this section. The provisions of the qualified offer rule do not apply if the taxpayer’s liability under the judgment, as modified by the provisions of paragraph (b)(3) of this section, is determined exclusively pursuant to a settlement, or to any proceeding in which the amount of tax liability is not in issue, including any declaratory judgment proceeding, any proceeding to enforce or quash any summons issued pursuant to the Internal Revenue Code, and any action to restrain disclosure under section 6110(f). If the qualified offer rule applies to the court proceeding, the determination of whether the liability under the qualified offer would have equaled or exceeded the liability pursuant to the judgment is made by reference to the last qualified offer made with respect to the tax liability at issue in the administrative or court proceeding. An award of reasonable administrative and litigation costs under the qualified offer rule only includes those costs incurred on or after the date of the last qualified offer and is limited to those costs attributable to the adjustments at issue at the time the last qualified offer was made that were included in the court’s judgment

other than by reason of settlement. The qualified offer rule is inapplicable to reasonable administrative or litigation costs otherwise awarded to a taxpayer who is a prevailing party under any other provision of section 7430(c)(4). This section sets forth the requirements to be satisfied for a taxpayer to be treated as a prevailing party by reason of the taxpayer making a qualified offer as well as the circumstances leading to the application of the exceptions, special rules, and coordination provisions of the qualified offer rule. Furthermore, this section sets forth the elements necessary for an offer to be treated as a qualified offer under section 7430(g). (b) Requirements for treatment as a prevailing party based upon having made a qualified offer .—(1) In general . In order to be treated as a prevailing party by reason of having made a qualified offer, the liability of the taxpayer for the type or types of tax and the taxable year or years at issue in the proceeding, as calculated pursuant to paragraph (b)(2) of this section, based on the last qualified offer, as defined in paragraph (c) of this section, made by the taxpayer in the court or administrative proceeding, must equal or exceed the liability of the taxpayer pursuant to the judgment by the court for the same type or types of tax and the same taxable year or years, as calculated pursuant to paragraph (b)(3) of this section. Furthermore, the taxpayer must meet the timely filing and net worth requirements of section 7430(c)(4)(A)(ii). If all of the adjustments subject to the last qualified offer are settled prior to the entry of the judgment by the court, the taxpayer is not a prevailing party by reason of having made a qualified offer. The taxpayer may, however, still qualify as a prevailing party if the requirements of section 7430(c)(4)(A) are met. (2) Liability under the last qualified offer . For purposes of making the comparison of liability described in paragraph (b)(1) of this section, the taxpayer’s liability under the last qualified offer is the change in the taxpayer’s liability for the type or types of tax and the taxable year or years at issue in the proceeding from the tax shown on the return or returns (or as previously adjusted) which would have resulted from the acceptance by the United States of the taxpayer’s last quali

2001–6 I.R.B. 509 February 5, 2001

fied offer on all of the adjustments at issue in the administrative or court proceeding at the time that offer was made. The portion of a taxpayer’s liability that is attributable to adjustments raised by either party after the making of the last qualified offer is not included in the calculation of the liability under that offer. The taxpayer’s liability under the last qualified offer is calculated without regard to adjustments to be fully resolved, by stipulation of the parties, through any other pending court or administrative proceeding. Furthermore, the taxpayer’s liability under the last qualified offer is calculated without regard to interest unless the taxpayer’s liability for, or entitlement to, interest is a contested issue in the administrative or court proceeding and is one of the adjustments included in the last qualified offer.

(3) Liability pursuant to the judgment . For purposes of making the comparison of liability described in paragraph (b)(1) of this section, the taxpayer’s liability pursuant to the judgment is the change in the taxpayer’s liability for the type or types of tax and the taxable year or years at issue in the proceeding from the tax shown on the return or returns (or as previously adjusted), resulting from amounts contained, or to be contained, in the judgment as a result of the court’s determinations, and amounts contained in settlements not included in the judgment, that are attributable to all adjustments that were included in the last qualified offer. This liability includes amounts attributable to adjustments included in the last qualified offer and settled by the parties prior to the entry of judgment regardless of whether those amounts are actually included in the judgment entered by the court. The taxpayer’s liability pursuant to the judgment does not include amounts attributable to adjustments that are not included in the last qualified offer, even if those amounts are actually included in the judgment entered by the court. The taxpayer’s liability pursuant to the judgment is calculated without regard to adjustments to be fully resolved, by stipulation of the parties, through any other pending court or administrative proceeding. Furthermore, the taxpayer’s liability pursuant to the judgment is calculated without regard to interest unless the taxpayer’s liability for, or entitlement to, interest is a contested

issue in the administrative or court proceeding and is one of the adjustments included in the last qualified offer. Where adjustments raised by either party subsequent to the making of the last qualified offer are included in the judgment entered by the court, or are settled prior to the court proceeding, the taxpayer’s liability pursuant to the judgment is calculated by treating the subsequently raised adjustments as if they had never been raised.

(c) Qualified offer —(1) In general . A qualified offer is defined in section 7430(g) to mean a written offer which— (i) Is made by the taxpayer to the United States during the qualified offer period;

(ii) Specifies the offered amount of the taxpayer’s liability (determined without regard to interest, unless interest is a contested issue in the proceeding);

(iii) Is designated at the time it is made as a qualified offer for purposes of section 7430(g); and (iv) By its terms, remains open during the period beginning on the date it is made and ending on the earliest of the date the offer is rejected, the date the trial begins, or the 90 ^th day after the date the offer is made.

(2) To the United States . (i) A qualified offer is made to the United States if it is delivered to the Internal Revenue Service; Office of Appeals; Office of Chief Counsel (including field personnel), Internal Revenue Service; or Department of Justice office or personnel having jurisdiction over the tax matter at issue in the administrative or court proceeding. If those offices or persons are unknown to the taxpayer making the qualified offer, the taxpayer may deliver the offer to the appropriate office, as follows:

(A) If the taxpayer’s initial pleading in a court proceeding has been answered, the taxpayer may deliver the offer to the office that filed the answer.

(B) If the taxpayer’s petition in the Tax Court has not yet been answered, the taxpayer may deliver the offer to the Office of Chief Counsel, 1111 Constitution Avenue, NW., Washington, DC 20224.

(C) If the taxpayer’s initial pleading in a court of the United States other than the Tax Court has not yet been answered, the taxpayer may deliver the offer to the Attorney General of the United States, 950 Pennsylvania Ave., NW., Washington,

DC 20530-0001 and for a suit brought in a United States district court, a copy of the offer should also be delivered to the United States Attorney for the district in which the suit was brought.

(D) In any other situation, the taxpayer may deliver the offer to the office that sent the taxpayer the first letter of proposed deficiency which allows the taxpayer an opportunity for administrative review in the Internal Revenue Service Office of Appeals.

(ii) Until an offer is received by the appropriate personnel or office under this paragraph (c)(2) of this section, it is not considered to have been made, with the following exception. If the offer is deposited in the United States mail, in an envelope or other appropriate wrapper, postage prepaid, properly addressed to the appropriate personnel or office under this paragraph (c)(2), the date of the United States postmark stamped on the cover in which the offer is mailed shall be deemed to be the date of receipt of that offer by the addressee. If any offer is deposited with a designated delivery service, as defined in section 7502(f)(2), in lieu of the United States mail, the provisions of section 7502(f)(1) shall apply in determining whether that offer qualifies for this exception.

(3) Specifies the offered amount . A qualified offer specifies the offered amount if it specifies the dollar amount for the liability of the taxpayer, calculated as set forth in paragraph (b)(2) of this section. This amount must be with respect to all of the adjustments at issue in the administrative or court proceeding at the time the offer is made and only those adjustments. The specified amount must be that amount, the acceptance of which by the United States will fully resolve the taxpayer’s liability, and only that liability, (determined without regard to adjustments stipulated by the parties to be fully resolved through another pending court or administrative proceeding, or interest, unless interest is a contested issue in the proceeding) for the type or types of tax and the taxable year or years at issue in the proceeding.

(4) Designated at the time it is made as a qualified offer . An offer is not a qualified offer unless it is designated in writing at the time it is made that it is a qualified offer for purposes of section 7430(g). An

February 5, 2001 510 2001–6 I.R.B.

offer made at a time when one or more adjustments not included in the first letter of proposed deficiency which allows the taxpayer an opportunity for administrative review in the Internal Revenue Service Office of Appeals have been raised by the taxpayer and remain unresolved, is not considered to be designated as a qualified offer at the time it is made unless contemporaneously or prior to the making of the qualified offer, the taxpayer has provided the United States with the substantiation and legal and factual arguments necessary to allow for informed consideration of the merits of those adjustments. For example, a taxpayer will be considered to have provided the United States with the necessary substantiation and legal and factual arguments if the taxpayer (or a qualified representative of the taxpayer described in §601.502 of this chapter) participates in an Appeals office conference, participates in a District Counsel conference, or confers with the Department of Justice and at that time discloses all relevant information regarding the taxpayer’s tax matter to the extent such information and its relevance were known or should have been known to the taxpayer at the time of such conference. All relevant information includes, but is not limited to, the legal and factual arguments supporting the taxpayer’s position on any adjustments raised by the taxpayer after the issuance of the first letter of proposed deficiency which allows the taxpayer an opportunity for administrative review in the Internal Revenue Service Office of Appeals.

(5) Remains open . A qualified offer remains open for acceptance by the Government from the date it is made, as defined in paragraph (c)(2) of this section, at least until the earliest of the date it is rejected in writing by a person with authority to reject the settlement, the date the trial begins, or the 90 ^th day after being received by the United States. The offer, by its written terms, may remain open after the occurrence of one or more of the above-referenced events. Once made, the period during which a qualified offer remains open may be extended by the taxpayer prior to its expiration, but such an extension cannot be used to make an offer meet the minimum period for remaining open required by this paragraph.

(6) Last qualified offer . A taxpayer may make multiple qualified offers during the qualified offer period. For purposes of the

comparison under paragraph (b) of this section, the making of a qualified offer supersedes any previously made qualified offers. In making the comparison described in paragraph (b) of this section, only the qualified offer made most closely in time to the end of the qualified offer period is compared to the taxpayer’s liability under the judgment.

(7) Qualified offer period . To constitute a qualified offer, an offer must be made during the qualified offer period. The qualified offer period begins on the date on which the first letter of proposed deficiency which allows the taxpayer an opportunity for administrative review in the Internal Revenue Service Office of Appeals is sent to the taxpayer. For this purpose, the date of the notice of claim disallowance will begin the qualified offer period in a refund case. If there has been no notice of claim disallowance in a refund case, the qualified offer period begins on the date on which the answer or other responsive pleading is filed with the court. The qualified offer period ends on the date which is thirty days before the date the case is first set for trial. In determining when the qualified offer period ends for cases in the Tax Court and other courts of the United States using calendars for trial, a case will be considered to be set for trial on the date scheduled for the calendar call. A case may be removed from a trial calendar at any time. Thus, a case may be removed from a calendar before the date that precedes by thirty days the date scheduled for that calendar. The qualified offer period does not end until the case remains on a calendar for trial on the date that precedes by 30 days the scheduled date of the calendar call for that trial session. The qualified offer period may not be extended beyond the periods set forth in this paragraph, although the period during which a qualified offer remains open may extend beyond the end of the qualified offer period.

(d) [Reserved] (e) Examples . The following examples illustrate the provisions of this section:

Example 1 . Definition of a judgment. The Internal Revenue Service audits Taxpayer A for year X and issues a notice of proposed deficiency (30-day letter) proposing to disallow deductions 1, 2, 3, and 4. A files a protest and participates in a conference with the Internal Revenue Service Office of Appeals (Appeals). Appeals allows deduction 1, and issues a statutory notice of deficiency for deductions 2, 3, and 4. A’s petition to the United States Tax Court for year X never mentions deduction 2. Prior to trial, A

concedes deduction 3. After the trial, the Tax Court issues an opinion allowing A to deduct a portion of deduction 4. As used in paragraph (a) of this section, the term judgment means the cumulative determinations of the court concerning the adjustments at issue in the court proceeding. Thus, the term judgment does not include deduction 1 because it was never at issue in the court proceeding. Similarly, the term judgment does not include deduction 2 because it was not placed at issue by A in the court proceeding. Although deduction 3 was at issue in the court proceeding, it is not included in the term judgment because it was not determined by the court, but rather by concession or settlement. For purposes of section 7430(c)(4)(e), the term judgment only includes the portion of deduction 4 disallowed by the Tax Court.

Example 2 . Liability under the offer and liability under the judgment . Assume the same facts as in Example 1 except that A makes a qualified offer after the Appeals conference which is not accepted by the Internal Revenue Service. A’s offer is with respect to all adjustments at issue at that time. Those adjustments are deductions 2, 3, and 4. At the conclusion of the litigation, A’s entitlement to an award based upon the qualified offer will depend, among other things, on a comparison of the change in A’s liability for income tax for year X resulting from the judgment of the Tax Court with the change that would have resulted had the Internal Revenue Service accepted A’s qualified offer. In making this comparison, the term judgment (as discussed in Example 1 ) is modified by including the amounts of settled or conceded adjustments that were at issue at the time the qualified offer was made. Any settled or conceded adjustments that were not at issue at the time the qualified offer was made, either because the settlement or concession occurred before the offer or because the adjustment was not raised until after the offer, are not included in the comparison. Thus, A’s offer on deductions 2, 3, and 4 is compared with the change in A’s liability resulting from the Tax Court’s determination of deduction 4, and the concessions of issues 2 and 3 by A.

Example 3 . Offer Must resolve full liability . Assume the same facts as in Example 2 except that A’s offer after the Appeals conference explicitly states that it is only with respect to adjustments 2 and 3 and not with respect to adjustment 4. Even if A’s liability pursuant to the judgment, calculated under paragraph (b)(3) of this section as illustrated in Example 2, is equal to or less than it would have been had the Internal Revenue Service accepted A’s offer after the Appeals conference, A is not a prevailing party under section 7430(c)(4)(E). This is because a qualified offer must include all adjustments at issue at the time the offer is made. Since A’s offer excluded adjustment 4, which was an adjustment at issue at the time the offer was made, it does not constitute a qualified offer pursuant to paragraph (b)(2) of this section.

Example 4 . Qualified offer rule inapplicable when all issues settled . Taxpayer B receives a notice of proposed deficiency (30-day letter) proposing to disallow both a personal interest deduction in the amount of $10,000 (Adjustment 1), and a charitable contribution deduction in the amount of $2,000 (Adjustment 2), and to include in income $4,000 of unreported interest income (Adjustment 3). B timely files a protest with Appeals. At the Appeals confer

2001–6 I.R.B. 511 February 5, 2001

ence B presents substantiation for the charitable contribution and presents arguments that the interest paid was deductible mortgage interest and that the interest received was held in trust for Taxpayer C. At the conference, B also provides the Appeals officer assigned to B’s case a written offer to settle the case for a deficiency of $2,000, exclusive of interest. The offer states that it is a qualified offer for purposes of section 7430(g) and that it will remain open for acceptance by the Internal Revenue Service for a period in excess of 90 days. After considering B’s substantiation and arguments, the Appeals Officer accepts the $2,000 offer to settle the case in full. Although B’s offer is a qualified offer, because all three adjustments contained in the qualified offer were settled, the qualified offer rule is inapplicable.

Example 5 . Qualified offer rule inapplicable when all issues contained in the qualified offer are settled; subsequently raised adjustments ignored . Assume the same facts as in Example 4 except that B’s qualified offer was for a deficiency of $1,800 and the Internal Revenue Service rejected that offer. Subsequently, the Internal Revenue Service issued a statutory notice of deficiency disallowing the three adjustments contained in Example 4, and, in addition, disallowing a home office expense in the amount of $5,000 (Adjustment 4). After petitioning the Tax Court, B presents the field attorney assigned to the case with a written offer, which is not designated as a qualified offer for purposes of section 7430(g), to settle the three adjustments that had been the subject of the qualified offer, plus adjustment 4, for a total deficiency of $2,500. After negotiating with B, a settlement is reached on the three adjustments that were the subject of the rejected qualified offer, for a deficiency of $1,800. Adjustment 4 is litigated in the Tax Court and the court determines that B is entitled to the full $5,000 deduction for that adjustment. Consequently, a decision is entered by the Tax Court reflecting the $1,800 settlement amount, which matches exactly the amount of B’s only qualified offer in the case. Although the determined liability for adjustments 1, 2, and 3, equals that of the rejected qualified offer, because all three adjustments contained in the qualified offer were settled, the qualified offer rule is inapplicable.

Example 6 . Exclusion of adjustments made after the qualified offer is made . Assume the same facts as in Example 5 except the settlement is reached only on adjustments 1 and 2, for a liability of $1,500. Adjustments 3 and 4 are tried in the Tax Court and in accordance with the court’s opinion, the taxpayer has a $300 deficiency attributable to Adjustment 3, and a $1,550 deficiency attributable to adjustment 4. Consequently, a decision is entered reflecting the $1,500 settled amount, the $300 liability on adjustment 3, and the $1,550 liability on adjustment 4. The $3,350 deficiency reflected in the Tax Court’s decision exceeds the last (and only) qualified offer made by B. For purposes of determining whether B is a prevailing party as a result of having made a qualified offer in the proceeding, the liability attributable to adjustment 4, which was raised after the last qualified offer was made, is not included in the comparison of B’s liability under the judgment with B’s offered liability under the last qualified offer. Thus, B’s $1,800 liability under the judgment, as modified for purposes of the qualified offer rule comparison, is equal to B’s offered liability under the last qualified offer. Because B’s liability under

the last qualified offer equals or exceeds B’s liability under the judgment, as calculated under paragraph (b)(3) of this section, B is a prevailing party for purposes of section 7430. Assuming B satisfies the remaining requirements of section 7430, B may recover those reasonable administrative and litigation costs attributable to adjustment 3. To qualify for any further award of reasonable administrative and litigation costs, B must satisfy the full requirements of section 7430(c)(4)(A).

Example 7 . Qualified offer in a refund case . Taxpayer C timely files an amended return claiming a refund of $1,000. This refund claim results from several omitted deductions which, if allowed, would reduce D’s tax liability from $10,000 to $9,000. C receives a notice of claim disallowance and files a complaint with the appropriate United States District Court. Subsequently, C makes a qualified offer for a refund of $500. The offer is rejected and after trial the court finds C is entitled to a refund of $700. The change in C’s liability from the tax shown on the return that would have resulted from the acceptance of C’s qualified offer is a reduction in that liability of $500. The change in C’s liability from the tax shown on the return resulting from the judgment of the court is a reduction in that liability of $700. Because C’s liability under the qualified offer exceeds C’s liability under the judgment, C is a prevailing party for purposes of section 7430. Assuming C satisfies the remaining requirements of section 7430, C may recover those reasonable litigation costs incurred on or after the date of the qualified offer. To qualify for any further award of reasonable administrative and litigation costs C must satisfy the full requirements of section 7430(c)(4)(A).

Example 8 . End of qualified offer period when case is removed from tax court trial calendar more than 30 days before scheduled trial calendar . Taxpayer E has petitioned the Tax Court in response to the issuance of a notice of deficiency. E receives notice that the case will be heard on the July trial session in E’s city of residence. The scheduled date for the calendar call for that trial session is July 1 ^st . On May 15 ^th, E’s motion to remove the case from the July trial session and place it on the October trial session for that city is granted. The scheduled date for the calendar call for the October trial session is October 1st. On May 31 ^st, E delivers a qualified offer to the field attorney assigned to the case. On August 31 ^st, E delivers a revised qualified offer to the field attorney assigned to the case. Neither offer is accepted. The case is tried during the October trial session, and at some time thereafter, a decision is entered by the court. Assume the judgment in the case, as calculated under paragraph (b)(3) of this section, is greater than the amount offered, as calculated under paragraph (b)(2) of this section, in the qualified offer delivered on May 31 ^st, but less than the amount offered, as similarly calculated, in the qualified offer delivered on August 31 ^st . Because the qualified offer period did not end until September 1 ^st, and the offer of August 31 ^st otherwise satisfied the requirements of paragraph (c) of this section, the last qualified offer which is compared to the judgment was the offer delivered on August 31 ^st . Consequently, E is a prevailing party under section 7430(c)(4)(e).

Example 9 . End of qualified offer period when case is removed from tax court trial calendar less than 30 days before scheduled trial calendar . Assume the same facts as in Example 8 except that

E’s motion was granted on June 15 ^th . Because the qualified offer period had ended on June 1st when the case remained on the July trial session on the date that preceded by 30 days the scheduled date of the calendar call for that trial session, the offer delivered on May 31 ^st was E’s last qualified offer. The August 31 ^st offer is not a qualified offer for purposes of this rule. Consequently, E is not a prevailing party under the qualified offer rule. Therefore, E must satisfy the full requirements of section 7430(c)(4)(A) to qualify for any award of reasonable administrative and litigation costs .

Example 10 . When a qualified offer can be made and to whom it must be made . During the examination of Taxpayer F’s return, the Internal Revenue Service issues a notice of deficiency without having first issued a 30-day letter. After receiving the notice of deficiency F timely petitions the Tax Court. The next day F mails an offer to the office that issued the notice of deficiency, which offer satisfies the requirements of paragraphs (c)(3),(4),(5) and (6) of this section. This is the only written offer made by F during the administrative or court proceeding, and by its terms it is to remain open for a period in excess of 90 days after the date of mailing to the office issuing the notice of deficiency. The office that issued the notice of deficiency transmitted the offer to the field attorney with jurisdiction over the Tax Court case. After answering the case, the field attorney refers the case to Appeals pursuant to Rev. Proc. 87–24 (1987–1 C.B. 720). After careful consideration, Appeals rejects the offer and holds a conference with F where some adjustments are settled. The remainder of the adjustments are tried in the Tax Court and F’s liability resulting from the Tax Court’s determinations, when added to F’s liability resulting from the settled adjustments, is less than F’s liability would have been under the offer rejected by Appeals. Because the Tax Court case had not yet been answered when the offer was sent, F properly mailed the offer to the office that issued the notice of deficiency. Thus, F’s offer satisfied the requirements of paragraph (c)(2) of this section. Furthermore, even though F did not receive a 30-day letter, F’s offer was made after the beginning of the qualified offer period, satisfying the requirements of paragraph (c)(7) of this section, because the issuance of the statutory notice provided F with notice of the Internal Revenue Service’s determination of a deficiency, and the docketing of the case provided F with an opportunity for administrative review in the Internal Revenue Service Office of Appeals under Rev. Proc. 87–24 (1987–1 C.B. 720). Because F’s offer satisfied all of the requirements of paragraph (c) of this section, the offer was a qualified offer and F is a prevailing party.

Example 11 . Last qualified offer . Assume the same facts as in Example 10 except that at the Appeals conference F makes a new qualified offer concerning the remaining issues. Because this subsequent qualified offer is closer in time to the end of the qualified offer period than the offer made one day after the petition was filed, the subsequent offer would be the last qualified offer made by F and it is F’s liability under this offer which would be compared to F’s liability under the judgment to determine whether F was a prevailing party under the qualified offer rule.

Example 12 . Substitution of parties permitted under last qualified offer . Taxpayer G receives a 30

February 5, 2001 512 2001–6 I.R.B.

day letter and participates in a conference with the Office of Appeals but no agreement is reached. Subsequently, G receives a notice of deficiency and petitions the Tax Court. Upon receiving the Internal Revenue Service’s answer to the petition, G sends a qualified offer to the field attorney who signed the answer, by United States mail. The qualified offer stated that it would remain open for more than 90 days. Thirty days after making the offer, G dies and, on motion under Rule 63(a) of the Tax Court’s Rules of Practice and Procedure by G’s personal representative, H is substituted for G as a party in the Tax Court proceeding. H makes no qualified offers to settle the case and the case proceeds to trial, with the Tax Court issuing an opinion partially in favor of H. Even though H was not a party when the qualified offer was made, that offer constitutes a qualified

offer because by its terms, when made, it was to remain open until at least the earlier of the date it is rejected, the date of trial, or 90 days. If the liability of H under that last qualified offer, as determined under paragraph (b)(2) of this section, equals or exceeds the liability under the judgment of the Tax Court, as determined under paragraph (b)(3) of this section, H will be a prevailing party for purposes of an award of reasonable litigation costs under section 7430. (f) Effective date . This section is applicable with respect to qualified offers made in administrative or court proceedings described in section 7430 after January 3, 2001 and before January 3, 2004.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

Approved December 6, 2000.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 3, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 4, 2001, 66 F.R. 725)

2001–6 I.R.B. 513 February 5, 2001