Part IV. Items — Internal Revenue Bulletin 2001-49

merge with other corporations. In addition, many state merger laws permit a limited liability company to merge with another limited liability company or with a corporation.

C. Previous Proposal of Regulations

On May 16, 2000, the IRS and Treasury issued a notice of proposed rulemaking (REG–106186–98, 65 FR 31115) providing guidance under section 368(a)(1)(A), including guidance regarding whether certain mergers involving disregarded entities may qualify as statutory mergers under section 368(a)(1)(A) (hereinafter referred to as the 2000 proposed regulations). The 2000 proposed regulations provided that neither the merger of a disregarded entity into a corporation nor the merger of a target corporation into a disregarded entity was a statutory merger or consolidation qualifying as a reorganization under section 368(a)(1)(A). A public hearing on the 2000 proposed regulations was held on August 8, 2000. In addition, written comments were received. While commentators generally agreed that the merger of a disregarded entity into a corporation should not qualify as a statutory merger under section 368(a)(1)(A), commentators asserted that the merger of a target corporation into a disregarded entity with a corporate owner should be able to qualify as a statutory merger under section 368(a)(1)(A). Commentators argued that not permitting the merger of a target corporation into a disregarded entity to qualify as a statutory merger under section 368(a)(1)(A) is inconsistent with the general treatment of the disregarded entity as a division of its owner for Federal tax purposes.

Explanation of Provisions

A. Definitions

After consideration of the comments received, the IRS and Treasury have decided to withdraw the 2000 proposed regulations and issue new proposed regulations (hereinafter referred to as the 2001 proposed regulations) to provide guidance concerning the definition of the terms

Notice of Proposed Rulemaking and Notice of Public Hearing

Statutory Mergers and Consolidations

REG–126485–01

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of Proposed Rulemaking and Notice of Public Hearing.

SUMMARY: This document contains proposed regulations that define the term statutory merger or consolidation as that term is used in section 368(a)(1)(A). The proposed regulations permit certain transactions involving entities that are disregarded as entities separate from their corporate owners for Federal tax purposes to qualify as a statutory merger or consolidation. These proposed regulations affect corporations engaging in statutory mergers and consolidations, and their shareholders. This document also provides a notice of public hearing on these proposed regulations.

DATES: Written or electronic comments and requests to speak (with outlines of oral comments to be discussed) at the public hearing scheduled for March 13, 2002, must be received by February 20, 2002.

ADDRESSES: Send submissions to CC:ITA:RU (REG–126485–01), room 5226, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:ITA:RU (REG–126485–01), Courier’s desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC 20044. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the Tax Regs option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.gov/ tax_regs.reglist.html .

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Reginald Mombrun (202) 622–7750 or Marlene P. Oppenheim (202) 622–7770; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Lanita Van Dyke, (202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

A. Section 368(a) Generally

The Internal Revenue Code of 1986 (the Code) provides general nonrecognition treatment for reorganizations specifically described in section 368(a). Section 368(a)(1)(A) provides that the term reorganization includes “a statutory merger or consolidation.” Section 1.368–2(b)(1) currently provides that a statutory merger or consolidation must be “effected pursuant to the corporation laws of the United States or a State or Territory or the District of Columbia.” A transaction will only qualify as a reorganization under section 368(a)(1)(A), however, if it satisfies certain nonstatutory requirements, including the business purpose requirement of §1.368–1(b), the continuity of business enterprise requirement of §1.368–1(d), and the continuity of interest requirement of §1.368–1(e).

B. Disregarded Entities Generally

A business entity (as defined in §301.7701–2(a)) that has only one owner may be disregarded as an entity separate from its owner for Federal tax purposes. Examples of disregarded entities include a domestic single member limited liability company that does not elect to be classified as a corporation for Federal tax purposes, a corporation (as defined in §301.7701–2(b)) that is a qualified REIT subsidiary (within the meaning of section 856(i)(2)), and a corporation that is a qualified subchapter S subsidiary (within the meaning of section 1361(b)(3)(B)).

Because qualified REIT subsidiaries and qualified subchapter S subsidiaries are corporations under state law, state merger laws generally permit them to

2001–49 I.R.B 555 December 3, 2001

statutory merger and consolidation as those terms are used in section 368(a)(1)(A), including as those terms relate to transactions involving disregarded entities.

The 2001 proposed regulations introduce a number of terms that are employed in the definition of statutory merger or consolidation. The term disregarded entity is defined as a business entity (as defined in §301.7701–2(a)) that is disregarded as an entity separate from its owner for Federal tax purposes. The term combining entity is defined as a business entity that is a corporation (as defined in §301.7701–2(b)) that is not a disregarded entity. The term combining unit is defined as a combining entity and all disregarded entities, if any, the assets of which are treated as owned by such combining entity for Federal tax purposes.

The 2001 proposed regulations provide that, for purposes of section 368(a)(1)(A), a statutory merger or consolidation must be effected pursuant to the laws of the United States or a State or the District of Columbia. Pursuant to such laws, the following events must occur simultaneously at the effective time of the transaction: (1) all of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of each member of one or more combining units (each a transferor unit) become the assets and liabilities of one or more members of one other combining unit (the transferee unit); and (2) the combining entity of each transferor unit ceases its separate legal existence for all purposes.

The IRS and Treasury believe that these definitions of statutory merger and consolidation are consistent with the principles of current law. See Cortland Spe- cialty Co. v. Commissioner, 60 F.2d 937 (2d Cir. 1932), cert. denied, 288 U.S. 599 (1933); Rev. Rul. 2000–5 (2000–1 C.B. 436). In particular, the IRS and Treasury do not intend for the requirement that all of the assets of one or more transferor units be transferred in the statutory merger or consolidation to be interpreted in the same manner as the “substantially all” requirement of 368(a)(1)(C), 368(a)(1)(D), 368(a)(2)(D), and 368(a)(2)(E). However, the IRS and Treasury do intend this requirement to ensure that divisive transactions do not qualify as

statutory mergers or consolidations under section 368(a)(1)(A). See Rev. Rul. 2000–5. In addition, the 2001 proposed regulations, like the 2000 proposed regulations, remove the word corporation from the requirement that, in order to qualify as a reorganization under section 368(a)(1)(A), a merger or consolidation must be “effected pursuant to the corporation laws.” This change conforms the regulations to the IRS’s long-standing position that a transaction may qualify as a reorganization under section 368(a)(1)(A) even if it is undertaken pursuant to laws other than the corporation law of the relevant jurisdiction. See Rev. Rul. 84–104 (1984–2 C.B. 94) (treating a consolidation pursuant to the National Banking Act, 12 U.S.C. 215, as a merger for Federal tax purposes).

Finally, the 2001 proposed regulations remove the word “Territory” from the types of jurisdictions pursuant to the laws of which a transaction that qualifies as a reorganization under section 368(a)(1)(A) may be effected to be consistent with the definition of domestic under section 7701(a)(4), which was amended by section 1906(c) of Tax Reform Act of 1976, Public Law 94–455, 90 Stat. 1525.

In this guidance project, the IRS and Treasury are not addressing the treatment under section 368(a)(1)(A) of transactions that involve one or more foreign corporations. As discussed below, the IRS and Treasury are considering issuing guidance regarding such transactions as part of a separate regulations project.

B. Mergers Involving Disregarded Entities

The 2001 proposed regulations’ definition of a statutory merger or consolidation, unlike the approach of the 2000 proposed regulations, permits certain statutory mergers and consolidations involving disregarded entities to qualify as statutory mergers and consolidations under section 368(a)(1)(A). However, the 2001 proposed regulations provide that such a transaction in which any of the assets and liabilities of a combining entity of a transferor unit become assets and liabilities of one or more disregarded entities of the transferee unit is not a statutory merger or consolidation within the meaning of section 368(a)(1)(A) unless such

combining entity, the combining entity of the transferee unit, such disregarded entities, and each business entity through which the combining entity of the transferee unit holds its interests in such disregarded entities is organized under the laws of the United States or a State or the District of Columbia.

Permitting certain transactions involving disregarded entities that have a single corporate owner to qualify as statutory mergers and consolidations for purposes of section 368(a)(1)(A) is appropriate because it is consistent with the general treatment of a disregarded entity as a division of its owner. Therefore, under the 2001 proposed regulations, the merger of a target corporation into a disregarded entity may qualify as a statutory merger or consolidation for purposes of section 368(a)(1)(A). Consistent with the 2000 proposed regulations, however, the 2001 proposed regulations do not permit the merger of a disregarded entity into a member of a transferee unit, where the owner of the disregarded entity does not also merge into a member of the transferee unit, to qualify as a statutory merger or consolidation under section 368(a)(1)(A). In such a transaction, all of the transferor unit’s assets may not be transferred to the transferee unit, with the result that the transferor unit’s assets may be divided between the transferor unit and the transferee unit. Moreover, the separate legal existence of the combining entity of the transferor unit does not terminate as a matter of law. Although such a transaction cannot qualify as a statutory merger or consolidation under section 368(a)(1)(A), it may qualify for nonrecognition treatment under other provisions of the Code.

C. Request for Comments

Treasury and the IRS are considering further revisions to the regulations under section 368(a)(1)(A) to address statutory mergers and consolidations that involve one or more foreign corporations, including transactions involving a disregarded entity. Comments are requested regarding the appropriate scope for any such revision. Comments also are specifically requested concerning what related changes would be necessary to the regulations under sections 358 (concerning the determination of stock basis in certain

December 3, 2001 556 2001–49 I.R.B.

triangular reorganizations), 367, and 897, as well as other international provisions of the Code. Because a revision of the regulations may include revisions related to transactions under foreign merger or consolidation laws, comments are requested on what changes, if any, may be appropriate to the definition of a statutory merger or consolidation to facilitate the application of the definition in the context of the laws of a foreign jurisdiction. Finally, comments are requested regarding what additional reporting requirements may be appropriate to facilitate administration of the rules regarding statutory mergers or consolidations involving foreign entities.

Effective Date

These regulations are proposed to apply to transactions occurring on or after the date these regulations are published as final regulations in the Federal Register.

Special Analyses

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

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight copies) that are submitted timely to the IRS. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the Tax Regs option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at http:// www.irs.gov/tax_regs/reglist.html . The

IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for March 13, 2002, beginning at 10 am in the auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the 10th Street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the FOR FURTHER INFORMATION CONTACT portion of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments must submit written comments and an outline of the topics to be discussed and the time to be devoted to each topic (a signed original and eight (8) copies) by February 20, 2002. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for reviewing outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal authors of these proposed regulations are Reginald Mombrun and Marlene P. Oppenheim of the office of the Associate Chief Counsel (Corporate), IRS. However, other personnel from the Treasury and the IRS participated in their development.

- - - - Proposed Amendments to the

Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1 - INCOME TAXES

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

Authority: 26 U.S.C. 7805 - - Par. 2. In §1.368–2, paragraph (b)(1) is revised to read as follows:

§1.368–2 Definition of terms.

(b)(1)(i) Definitions. For purposes of this paragraph (b)(1), the following terms shall have the following meanings:

(A) Disregarded entity. A disregarded entity is a business entity (as defined in §301.7701–2(a) of this chapter) that is disregarded as an entity separate from its owner for Federal tax purposes. Examples of disregarded entities include a domestic single member limited liability company that does not elect to be classified as a corporation for Federal tax purposes, a corporation (as defined in §301.7701– 2(b) of this chapter) that is a qualified REIT subsidiary (within the meaning of section 856(i)(2)), and a corporation that is a qualified subchapter S subsidiary (within the meaning of section 1361(b)(3)(B)). (B) Combining entity. A combining entity is a business entity that is a corporation that is not a disregarded entity.

(C) Combining unit. A combining unit is comprised solely of a combining entity and all disregarded entities, if any, the assets of which are treated as owned by such combining entity for Federal tax purposes.

(ii) Statutory merger or consolidation generally. For purposes of section 368(a)(1)(A), a statutory merger or consolidation is a transaction effected pursuant to the laws of the United States or a State or the District of Columbia, in which, as a result of the operation of such laws, the following events occur simultaneously at the effective time of the transaction (A) All of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of each member of one or more combining units (each a transferor unit) become the assets and liabilities of one or more members of one other combining unit (the transferee unit); and

(B) The combining entity of each transferor unit ceases its separate legal existence for all purposes.

2001–49 I.R.B 557 December 3, 2001

(iii) Statutory merger or consolida- tion involving disregarded entities. A transaction effected pursuant to the laws of the United States or a State or the District of Columbia in which any of the assets and liabilities of a combining entity of a transferor unit become assets and liabilities of one or more disregarded entities of the transferee unit is not a statutory merger or consolidation within the meaning of section 368(a)(1)(A) and paragraph (b)(1)(ii) of this section unless such combining entity, the combining entity of the transferee unit, such disregarded entities, and each business entity through which the combining entity of the transferee unit holds its interests in such disregarded entities is organized under the laws of the United States or a State or the District of Columbia.

(iv) Examples. The following examples illustrate the rules of paragraph (b)(1) of this section. In each of the examples, except as otherwise provided, each of V, Y, and Z is a domestic corporation. X is a domestic limited liability company. Except as otherwise provided, X is wholly owned by Y and is disregarded as an entity separate from Y for Federal tax purposes. The examples are as follows:

Example 1. Divisive transaction pursuant to a merger statute. (i) Under State W law, Z transfers some of its assets and liabilities to Y, retains the remainder of its assets and liabilities, and remains in existence following the transaction. The transaction qualifies as a merger under state W corporate law. Prior to the transaction, Y is not treated as owning any assets of an entity that is disregarded as an entity separate from its owner for Federal tax purposes.

(ii) The transaction does not satisfy the requirements of paragraph (b)(1)(ii)(A) of this section because all of the assets and liabilities of Z, the combining entity of the transferor unit, do not become the assets and liabilities of Y, the combining entity and sole member of the transferee unit. In addition, the transaction does not satisfy the requirements of paragraph (b)(1)(ii)(B) of this section because the separate legal existence of Z does not cease. Accordingly, the transaction does not qualify as a statutory merger or consolidation under section 368(a)(1)(A). Example 2. Merger of a target corporation into a disregarded entity in exchange for stock of the owner. (i) Under State W law, Z merges into X. Pursuant to such law, the following events occur simultaneously at the effective time of the transaction: all of the assets and liabilities of Z become the assets and liabilities of X and Z’s separate legal existence

Example 4. Merger of a target corporation into a disregarded entity owned by a partnership. (i) The facts are the same as in Example 2, except that Y is organized as a partnership under the laws of State W and is classified as a partnership for Federal tax purposes.

(ii) The transaction does not meet the requirements of paragraph (b)(1)(ii)(A) of this section. All of the assets and liabilities of Z, the combining entity and sole member of the transferor unit, do not become the assets and liabilities of one or more members of a transferee unit because neither X nor Y qualifies as a combining entity. Accordingly, the transaction cannot qualify as a statutory merger or consolidation for purposes of section 368(a)(1)(A).

ceases for all purposes. In the merger, the Z shareholders exchange their stock of Z for stock of Y. Prior to the transaction, Z is not treated as owning any assets of an entity that is disregarded as an entity separate from its owner for Federal tax purposes.

(ii) The transaction meets the requirements of paragraph (b)(1)(ii) of this section because the transaction is effected pursuant to State W law and the following events occur simultaneously at the effective time of the transaction: all of the assets and liabilities of Z, the combining entity and sole member of the transferor unit, become the assets and liabilities of one or more members of the transferee unit that is comprised of Y, the combining entity of the transferee unit, and X, a disregarded entity the assets of which Y is treated as owning for Federal tax purposes, and Z ceases its separate legal existence for all purposes. Paragraph (b)(1)(iii) does not apply to prevent the transaction from qualifying as a statutory merger or consolidation for purposes of section 368(a)(1)(A) because each of Z, Y, and X is a domestic entity. Accordingly, the transaction qualifies as a statutory merger or consolidation for purposes of section 368(a)(1)(A).

Example 3. Triangular merger of a target corpo- ration into a disregarded entity. (i) The facts are the same as in Example 2, except that V owns 100 percent of the outstanding stock of Y and, in the merger of Z into X, the Z shareholders exchange their stock of Z for stock of V. In the transaction, Z transfers substantially all of its properties to X.

(ii) The transaction is not prevented from qualifying as a statutory merger or consolidation under section 368(a)(1)(A), provided the requirements of section 368(a)(2)(D) are satisfied. Because the assets of X are treated for Federal tax purposes as the assets of Y, Y will be treated as acquiring substantially all of the properties of Z in the merger for purposes of determining whether the merger satisfies the requirements of section 368(a)(2)(D). As a result, the Z shareholders that receive stock of V will be treated as receiving stock of a corporation that is in control of Y, the combining entity of the transferee unit that is the acquiring corporation for purposes of section 368(a)(2)(D). Accordingly, the merger will satisfy the requirements of section 368(a)(2)(D) such that the Z shareholders’ receipt of stock of V in the merger will not cause the transaction to fail to qualify as a reorganization under section 368(a)(1)(A).

Example 5. Merger of a disregarded entity into a corporation. (i) Under State W law, X merges into Z. Pursuant to such law, the following events occur simultaneously at the effective time of the transaction: all of the assets and liabilities of X (but not the assets and liabilities of Y other than those of X) become the assets and liabilities of Z and X’s separate legal existence ceases for all purposes.

(ii) The transaction does not satisfy the requirements of paragraph (b)(1)(ii)(A) of this section because all of the assets and liabilities of a transferor unit do not become the assets and liabilities of one or more members of the transferee unit. The transaction also does not satisfy the requirements of paragraph (b)(1)(ii)(B) of this section because X does not qualify as a combining entity. Accordingly, the transaction cannot qualify as a statutory merger or consolidation for purposes of section 368(a)(1)(A). Example 6. Merger of a corporation into a dis- regarded entity in exchange for interests in the dis- regarded entity. (i) Under State W law, Z merges into X. Pursuant to such law, the following events occur simultaneously at the effective time of the transaction: all of the assets and liabilities of Z become the assets and liabilities of X and Z’s separate legal existence ceases for all purposes. In the merger of Z into X, the Z shareholders exchange their stock of Z for interests in X so that, immediately after the merger, X is not disregarded as an entity separate from Y for Federal tax purposes. Following the merger, pursuant to §301.7701–2(b)(1)(i) of this chapter, X is classified as a partnership for Federal tax purposes.

(ii) The transaction does not meet the requirements of paragraph (b)(1)(ii)(A) of this section because immediately after the merger X is not disregarded as an entity separate from Y and, consequently, all of the assets and liabilities of Z, the combining entity of the transferor unit, do not become the assets and liabilities of one or more members of a transferee unit. Accordingly, the transaction cannot qualify as a statutory merger or consolidation for purposes of section 368(a)(1)(A).

(v) Effective date. This paragraph (b)(1) applies to transactions occurring on or after the date these regulations are published as final regulations in the Federal Register .

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

(Filed by the Office of the Federal Register on November 14, 2001, 8:45 a.m., and published in the issue of the Federal Register for November 15, 2001, 66 F.R. 57400)

December 3, 2001 558 2001–49 I.R.B.

§1.1502–13T, §1.1502–14, or §1.1502– 14T applies, if it occurs in a consolidated return year beginning on or after January 1, 1995.” The example in that regulation contemplates that, to the extent that the transferor does not recognize gain under section 357(c) by reason of the rule of §1.1502–80(d), the transferor’s basis in the stock of the transferee that it receives in the exchange is reduced, with the result that an excess loss account may arise.

A concern has been raised that, as currently drafted, §1.1502–80(d) may produce an unintended basis result in certain intragroup transfers described in section 351. In particular, it is possible that one might conclude that, because §1.1502– 80(d) provides that section 357(c) does not apply to certain intragroup section 351 exchanges, no liabilities can technically be excluded under section 357(c)(3). If that analysis were correct, in the case of a transfer described in section 351 between members of a consolidated group, the transferor’s basis in the stock of the transferee received in the transfer would be reduced by liabilities assumed by the transferee, including those liabilities described in section 357(c)(3) that would not have reduced basis had section 357(c) applied. Assuming the transferor and the transferee are members of the consolidated group at the time the liability does in fact give rise to a deduction on the part of the transferee and is taken into account on the consolidated return, the transferor’s basis in the stock of the transferee would be reduced a second time under the principles of §1.1502–32. This duplicated basis reduction, i.e., once at the time of the transfer described in section 351 and again at the time the liability is taken into account by the consolidated group, may ultimately cause the transferor to recognize an amount of gain on the sale of the stock of the transferee that does not clearly reflect income.

Explanation of Provisions

These proposed regulations clarify that, in certain transfers described in section 351 between members of a consolidated group, a transferee’s assumption of liabilities described in section 357(c)(3)(A), other than those also described in section 357(c)(3)(B), will not reduce the transferor’s basis in the transferee’s stock received in the exchange.

Notice of Proposed Rulemaking and Notice of Public Hearing

Consolidated Returns; Applicability of Other Provisions of Law; Non- Applicability of Section 357(c)

REG–137519–01

AGENCY: Internal Revenue Service (IRS), Treasury.

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

SUMMARY: This document proposes amendments relating to the consolidated return regulations dealing with the nonapplicability of section 357(c) in a consolidated group. The proposed amendments clarify that, in certain transfers described in section 351 between members of a consolidated group, a transferee’s assumption of certain liabilities described in section 357(c)(3) will not reduce the transferor’s basis in the transferee’s stock received in the transfer. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments and requests to speak (with outlines of oral comments to be discussed) at the public hearing scheduled for March 21, 2002, must be submitted by February 28, 2002.

ADDRESSES: Send submissions to: CC:ITA:RU (REG–137519–01), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:ITA:RU (REG–137519–01), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the internet by selecting the “Tax Regs” option on the IRS Home Page, or by submitting comments directly to the IRS internet site at http:www.irs.ustreas.gov/ tax_regs/reglist.html. The public hearing will be held in room 4718, Internal Rev

enue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, T. Ian Russell of the Office of Associate Chief Counsel (Corporate), (202) 622– 7930; concerning submissions, the hearing, and/or to be placed on the building access list to attend the hearing, Donna M. Poindexter (202–622–7180) (not tollfree numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 357(c)(1) generally provides that, in the case of certain exchanges described in section 351, if the sum of the amount of the liabilities assumed by the transferee corporation exceeds the total of the adjusted basis of the property transferred pursuant to such exchange, then such excess shall be considered as gain from the sale or exchange of a capital asset or of property that is not a capital asset. Section 357(c)(3), however, excludes from the computation of liabilities assumed liabilities the payment of which would give rise to a deduction, provided that the incurrence of such liabilities did not result in the creation of, or an increase in, the basis of any property.

Section 358(a) generally provides that, in the case of an exchange to which section 351 applies, the basis of the property permitted to be received without the recognition of gain or loss is decreased by the amount of any money received by the transferor. For this purpose, under section 358(d)(1), the transferee’s assumption of a liability of the transferor is treated as money received by the transferor on the exchange. Section 358(d)(2), however, provides an exception for liabilities excluded under section 357(c)(3).

On August 15, 1994, final regulations (T.D. 8560) adding paragraph (d) to §1.1502–80 were published in the Fed- eral Register (59 FR 41666). A correcting amendment adding a sentence to the end of paragraph (d) of §1.1502–80 was published in the Federal Register for March 14, 1997 (62 FR 12096). As currently in effect, §1.1502–80(d) provides that “[s]ection 357(c) does not apply to any transaction to which §1.1502–13,

2001–49 I.R.B 559 December 3, 2001

358(d)(1), if such transfer occurs in a consolidated return year beginning on or after the date these regulations are published as final regulations in the Federal Register. This paragraph (d)(1) does not apply to a transaction if the transferor or transferee becomes a nonmember as part of the same plan or arrangement. The transferor (or transferee) is treated as becoming a nonmember once it is no longer a member of a consolidated group that includes the transferee (or transferor). For purposes of this paragraph (d)(1), any reference to a transferor or transferee includes, as the context may require, a reference to a successor or predecessor. For rules regarding the application of section 357(c) to transactions occurring in consolidated return years beginning on or after January 1, 1995, but before the date these regulations are published as final regulations in the Federal Register, see §1.1502–80(d) in effect prior to the date these regulations are published as final regulations in the Federal Register (see 26 CFR part 1 revised April 1, 2001). (2) Examples. The principles of paragraph (d)(1) of this section are illustrated by the following examples:

Example 1. P, S, and T are members of a consolidated group. P owns all of the stock of S and T with bases of $30 and $20, respectively. S has assets with a total fair market value equal to $100 and an aggregate basis of $30 and liabilities of $40. S merges into T in a transaction described in section 368(a)(1)(A) (and in section 368(a)(1)(D)). Section 357(c) does not apply to cause S to recognize gain in the merger. P’s basis in T’s stock increases to $50 ($30 plus $20), and T succeeds to S’s $30 basis in the assets transferred and the $40 of liabilities.

Example 2. P owns all the stock of S1. S1 has assets with a total fair market value equal to $100 and an aggregate basis of $30. S1 has $40 of liabilities, $5 of which are described in section 357(c)(3)(A), but not section 357(c)(3)(B), and $35 of which are not described in section 357(c)(3)(A). S1 transfers its assets to a newly formed subsidiary, S2, in exchange for stock of S2 and S2’s assumption of the liabilities of $40 in a transaction to which section 351 applies. Section 357(c) does not apply to cause S1 to recognize gain in connection with the transfer. For purposes of determining S1’s basis in the S2 stock it received in the exchange, section 358(d)(2) operates to exclude $5 of the liabilities from the computation of the amount of liabilities assumed that are treated as money received under section 358(d)(1). S1’s basis in the S2 stock received in the exchange is a $5 excess loss account (reflecting its $30 basis in the assets transferred reduced by $35, the amount of liabilities assumed that are not described in section 357(c)(3)(A)).

Proposed Effective Date

These regulations are proposed to apply to transactions occurring in consolidated return years beginning on or after the date these regulations are published as final regulations in the Federal Register.

Special Analyses

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

Comments and Public Hearing

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

A public hearing has been scheduled for March 21, 2002, beginning at 10 a.m., in room 4718, Internal Revenue Building, 1111 Constitution Avenue NW, Washington, DC.

Because of access restrictions, visitors will not be admitted beyond the Internal Revenue Building lobby more than 15 minutes before the hearing starts.

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

Persons that wish to present oral comments at the hearing must submit timely written comments and an outline of the

topics to be discussed and the time to be devoted to each topic (preferably a signed original and eight (8) copies) by February 28, 2002. A period of 10 minutes will be allotted to each person for making comments.

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

Drafting Information

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

- - - - Proposed Amendments to the

Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1 - INCOME TAXES

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

Authority: 26 U.S.C. 7805 - - Par. 2. In §1.1502–80, paragraph (d) is revised to read as follows:

§1.1502–80 Applicability of other provi- sions of law.

(d) Non-applicability of section 357(c) –(1) In general. Section 357(c) does not apply to cause the transferor to recognize gain in any transaction to which §1.1502–13 applies, if such transaction occurs in a consolidated return year beginning on or after the date these regulations are published as final regulations in the Federal Register. Notwithstanding the foregoing, for purposes of determining the transferor’s basis in property under section 358(a) received in a transfer described in section 351, section 358(d)(2) shall operate to exclude liabilities described in section 357(c)(3)(A), other than those also described in section 357(c)(3)(B), from the computation of the amount of liabilities assumed that is treated as money received under section

December 3, 2001 560 2001–49 I.R.B.

in section 421(a) for the transfer of stock to an individual pursuant to the exercise of an incentive stock option. These conditions include a requirement that the individual not dispose of the stock within two years from the date of the grant of the option, and a requirement that the individual not dispose of the stock within one year after the transfer of the stock to the individual.

Section 423(b) sets forth the requirements for establishment of an employee stock purchase plan. If certain conditions are met, special tax treatment is provided under section 421(a) for the transfer of stock to an individual pursuant to the exercise of an option granted under an employee stock purchase plan. These conditions include a requirement that the individual not dispose of the stock within two years from the date of the grant of the option, and a requirement that the individual not dispose of the stock within one year after the transfer of the stock to the individual.

Section 421(a) provides that at the time stock is transferred to an individual pursuant to the exercise of an option, if the conditions of section 422(a) or 423(a) are met, then no income to the individual results upon the exercise. Section 421(b) provides that at the time stock is transferred to an individual pursuant to the exercise of an option, if the stock is sold or disposed of by the individual and the holding period requirements of section 422(a)(1) or 423(a)(1) are not met, then any income to the individual which results for the taxable year, in which the option was exercised, attributable to the sale or disposition of the stock is income to the individual in the taxable year, of the individual, in which the sale or disposition occurred.

Section 423(c) provides guidance when the option price of a share of stock acquired by an individual pursuant to the exercise of an option granted under an employee stock purchase plan is less than 100 percent of the fair market value of the share at the time the option was granted. Section 423(c) provides that in the event of either the disposition of the share of stock by the individual which meets the holding period requirements of section 423(a) or in the event of the individual’s death while owning the share of stock, that any resulting compensation is

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:ITA:RU (REG–142686–01), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.gov/ tax_regs/reglist.html . The public hearing will be held in the Auditorium of the Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Stephen Tackney of the Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities), (202) 622–6040; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Treena Garrett, (202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Employment Tax Regulations (26 CFR part 31) under sections 3121(a), 3306(b), and 3401(a) of the Internal Revenue Code of 1986 (Code), and to the Income Tax Regulations (26 CFR part 1) under section 424 of the Code. These regulations would clarify current law regarding FICA tax, FUTA tax, and income tax withholding consequences upon the exercise of statutory stock options, i.e., incentive stock options described in section 422(b) and options granted under an employee stock purchase plan described in section 423(b). FICA tax consequences are determined by sections 3101 through 3128, FUTA tax consequences by sections 3301 through 3311, and income tax withholding consequences by sections 3401 through 3406.

A. Statutory Stock Options

Section 422(b) sets forth the requirements for treatment of options as incentive stock options. If certain conditions are met, special tax treatment is provided

(Filed by the Office of the Federal Register on November 13, 2001, 8:45 a.m., and published in the issue of the Federal Register for November 14, 2001, 66 F.R. 57021)

Notice of Proposed Rulemaking and Notice of Public Hearing

Application of the Federal Insurance Contributions Act, Federal Unemployment Tax Act, and Collection of Income Tax at Source to Statutory Stock Options

REG–142686–01

AGENCY: Internal Revenue Service (IRS), Treasury.

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

SUMMARY: This document contains proposed regulations relating to incentive stock options and options granted under employee stock purchase plans. These proposed regulations would provide guidance concerning the application of the Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and Collection of Income Tax at Source to these options. These proposed regulations would affect employers that grant these options and employees who exercise these options. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments and outlines of topics to be discussed at the public hearing scheduled for March 7, 2002, must be received by February 14, 2002.

ADDRESSES: Send submissions to: CC:ITA:RU (REG–142686–01), Room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand

2001–49 I.R.B 561 December 3, 2001

attributable to the individual in the taxable year in which the disposition or death occurred. The compensation attributable to the individual is the amount equal to the lesser of (1) the excess of the fair market value of the share at the time of the disposition or death over the amount paid for the share under the option or (2) the excess of the fair market value of the share at the time the option was granted over the option price.

B. FICA, FUTA, and Income Tax Withholding

FICA

FICA tax is generally imposed on each employer and employee. Under section 3111, FICA tax is imposed on the employer in an amount equal to a percentage of the wages paid by that employer. Under section 3101, FICA tax is also imposed on the employee in an amount equal to a percentage of the wages received by the employee with respect to employment.

FICA tax is composed of a tax for OldAge, Survivors, and Disability Insurance (OASDI) and a tax for Hospital Insurance (HI). The OASDI portion of FICA tax is imposed separately on the employer and on the employee in an amount equal to 6.2 percent of wages. Under section 3121(a)(1), the wages subject to the OASDI portion of FICA tax are limited to the contribution and benefit base for OASDI for that year ($80,400 for calendar year 2001). The HI portion of FICA tax is separately imposed on the employer and the employee in an amount equal to 1.45 percent of wages. There is no dollar limit on the wages subject to the HI portion of FICA tax.

Under section 3102, the employer is required to collect the employee portion of FICA tax by deducting the amount of the tax from wages, as and when paid, and is liable for payment of the tax required to be collected. Under §31.3102–1(a) of the Employment Tax Regulations, the employer is required to collect the employee portion of FICA tax, notwithstanding that the wages are paid in

something other than money, and to pay over the tax in money.

FUTA

FUTA tax is generally imposed under section 3301 on each employer in an amount equal to a percentage of wages paid by the employer with respect to employment. FUTA tax is imposed on the employer in an amount equal to 6.2 percent of wages. Under section 3306(b), wages of an employee subject to the FUTA tax are limited to $7,000 per calendar year.

Income Tax Withholding

Income tax withholding is imposed under section 3402(a), which requires employers paying wages to deduct and withhold income tax on those wages. The amount deducted and withheld is determined in accordance with tables or computational procedures prescribed by the Secretary of the Treasury.

C. Wages

FICA

For FICA purposes, section 3121(a) provides that the term wages, with certain exceptions, means all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash. Similarly, under §31.3121(a)–1(b), the term wages means all remuneration for employment unless specifically excepted under section 3121(a) or §31.3121(a)–1(j). Neither the Code nor the regulations contain an exclusion from wages for the value of stock transferred pursuant to the exercise of an option.

Under §31.3121(a)–1(e), in general, the medium in which the remuneration is paid is immaterial. It may be paid in cash or in kind. The amount of non-cash remuneration is based on the fair market value of the non-cash remuneration at the time of payment.

Under §31.3121(a)–2(a), in general, wages are received by an employee at the time that they are paid by the employer to

the employee. Wages are generally paid by an employer at the time that they are actually or constructively paid.

Under §31.3121(a)–1(i), remuneration for employment, unless specifically excepted under section 3121(a) or §31.3121(a)–1(j), constitutes wages even though at the time paid the relationship of employer and employee no longer exists between the person in whose employ the services were performed and the individual who performed them.

FUTA

For FUTA purposes, section 3306(b) provides that the term wages, with certain exceptions, means all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash. Similarly, under §31.3306(b)–1(b), the term wages means all remuneration for employment unless specifically excepted under section 3306(b) or §31.3306(b)–1(j). Neither the Code nor the regulations contain an exclusion from wages for the value of stock transferred pursuant to the exercise of an option.

Under §31.3306(b)–1(e), in general, the medium in which the remuneration is paid is immaterial. It may be paid in cash or in kind. The amount of non-cash remuneration is based on the fair market value of the non-cash remuneration at the time of payment.

Under §31.3301–4, wages are considered paid when actually or constructively paid.

Under §31.3306(b)–1(i), remuneration for employment paid by an employer to an individual for employment, unless specifically excepted under section 3306(b), constitutes wages even though at the time paid the individual is no longer an employee.

Income tax withholding

For income tax withholding purposes, section 3401(a) provides that the term wages, with certain exceptions, means all remuneration for services performed by an employee for his employer, including the cash value of all remuneration

December 3, 2001 562 2001–49 I.R.B.

requirements of former section 422A(a) (current section 422(a)).

Notice 2001–14 (2001–6 I.R.B. 416) addresses the FICA, FUTA, and income tax withholding consequences applicable to the exercise of statutory stock options. Notice 2001–14 provides that in the case of any statutory stock option exercised before January 1, 2003, the IRS will not assess FICA or FUTA tax upon the exercise of the option and will not treat the disposition of stock acquired by an employee pursuant to the exercise of the option as subject to income tax withholding. Notice 2001–14 also provides that Revenue Ruling 71–52 is obsolete and that the holding of Revenue Ruling 71–52 does not apply to the exercise of a statutory stock option or to the disposition of stock acquired pursuant to the exercise of a statutory stock option. Consistent with that conclusion, Notice 2001–14 also provides that the provisions of Notice 87–49 described above no longer apply.

It has long been recognized that the transfer of stock to an employee pursuant to the exercise of a nonstatutory stock option granted in connection with employment constitutes a payment of compensation to the extent that the fair market value of the stock received by the employee pursuant to the exercise of the nonstatutory option exceeds the option exercise price. Commissioner v. LoBue, 351 U.S. 243 (1956); Commissioner v. Smith, 324 U.S. 177 (1945). The exclusion from gross income for income tax purposes that is provided by section 421(a)(1) for the transfer of stock upon the exercise of a statutory stock option, does not alter the compensatory character of such stock transfers or serve to distinguish statutory stock options from nonstatutory stock options for purposes of sections 3121(a) and 3306(b).

Comments Received Pursuant to Notice 2001–14

Notice 2001–14 announced the intent to issue further administrative guidance clarifying current law with respect to the application of employment taxes to statutory stock options and solicited public

(including benefits) paid in any medium other than cash. Similarly, under §31.3401(a)–1(a), the term wages in general means all remuneration for employment for services performed by an employee for his employer unless specifically excepted under section 3401(a) or 3402(e). Under §31.3401(a)–1(a)(4), in general, the medium in which the remuneration is paid is immaterial. It may be paid in cash or in kind. The amount of non-cash remuneration is based on the fair market value of the non-cash remuneration at the time of payment.

Under §31.3402(a)–1(b), the employer is required to collect the tax by deducting and withholding the amount from the employee’s wages as and when paid, either actually or constructively.

Under §31.3401(a)–1(a)(5), remuneration for services, unless specifically excepted by statute, constitutes wages even though at the time paid the relationship of employer and employee no longer exists between the person in whose employ the services were performed and the individual who performed them.

The legislative history of sections 3401 through 3404 indicates that a purpose of income tax withholding is to enable individuals to pay income tax in the year in which the income is earned. H.R. Conf. Rep. No. 78–510 at 1 (1943); H.R. Rep. No. 78–401 at 1 (1943); Rep. No. 78–221 at 1 (1943); and Senate Rep. No. 78–221 at 1 (1943). Therefore, income tax withholding is generally imposed only upon remuneration paid by an employer to the extent that an employee recognizes income. Section 421(a) provides that if a share of stock is transferred to an individual in a transfer which meets the requirements of section 422(a) or 423(a), no income is recognized at the time of the transfer.

As part of the Social Security Amendments of 1983, Public Law 98–21, 97 Stat. 65 (1983), Congress amended sections 3121(a) and 3306(b) ¹ to provide specifically that regulations providing an exclusion from wages for income tax withholding purposes are not to be con

strued to require a similar exclusion from wages for FICA and FUTA purposes. The legislative history to the Social Security Amendments of 1983 at S. Rep. No. 98–23, 42, 98th Cong., 1st Sess. explains as to FICA and income tax withholding that “[S]ince, [however], the [social] security system has objectives which are significantly different from the objective underlying the income tax withholding rules, the committee believes that amounts exempt from income tax withholding should not be exempt from FICA unless Congress provides an explicit FICA tax exclusion.” The legislative history further explains that Congress intended to reverse the holding in Rowan Companies v. U.S., 452 U.S. 247 (1981), that the definitions of wages for FICA and income tax withholding purposes were the same. Thus, wages for income tax withholding purposes are not always the same as wages for FICA and FUTA purposes.

D. Application of Law to Statutory Stock Options

Revenue Ruling 71–52 (1971–1 C.B. 278) which was published before the statutory changes to sections 3121(a) and 3306(b) mentioned immediately above, addressed the FICA, FUTA, and income tax withholding consequences applicable to the exercise of qualified stock options under former section 422 ² . The ruling holds that a taxpayer does not make a payment of wages for purposes of FICA, FUTA, and income tax withholding at the time of the exercise of a qualified stock option under former section 422.

Notice 87–49 (1987–2 C.B. 355) addressed potential inconsistencies among and coordination of the proposed regulations under former section 422A (current section 422), section 83, and Rev. Rul. 71–52. Notice 87–49 provided that Rev. Rul. 71–52 was being reconsidered, but, until the results of such reconsideration were announced, the principles of Rev. Rul. 71–52 apply to the disposition of stock, acquired by an individual pursuant to the exercise of an incentive stock option, which does not meet the

1 Sections 3121(a) and 3306(b) were amended by section 327(b)(1) and (c)(4), respectively, of the Social Security Amendments of 1983, Public Law 98–21, 97 Stat. 65 (1983). 2 Section 603 of the Tax Reform Act of 1976, Public Law 94–355, 90 Stat. 1520 (1976), amended former section 422 to provide, generally, that qualified stock options could not be granted after May 20, 1976. Current section 422 (Incentive Stock Options) was added to the Internal Revenue Code of 1954 (Code), as section 422A, by section 251(a) of the Economic Recovery Tax Act of 1981, Public Law 97–34, 95 Stat. 172 (1981). Subsequently, section 11801(c)(9)(A)(i) of the Omnibus Budget Reconciliation Act of 1990, Public Law 101–508, 104 Stat. 1388 (1990), repealed former section 422 (Qualified Stock Options) and re-designated former Code section 422A as section 422 of the Internal Revenue Code of 1986.

2001–49 I.R.B 563 December 3, 2001

comments on the anticipated guidance. In response to the request for comments, the IRS received a number of comments addressing a variety of topics pertaining to the application of FICA, FUTA, and income tax withholding to transactions involving statutory stock options. Because the proposed regulations address only the application of the FICA, FUTA, and income tax withholding at the time of exercise of a statutory stock option, only comments relating to these types of transactions are addressed.

The IRS also received comments regarding an employer’s income tax withholding and reporting obligations upon the sale or disposition of stock acquired by an individual pursuant to the exercise of a statutory stock option. The IRS intends to publish two notices, discussed more fully below, at the time of publication of these proposed regulations. One notice includes proposed rules addressing an employer’s income tax withholding and reporting obligations upon the sale or disposition of stock acquired by an individual pursuant to the exercise of a statutory stock option. That notice discusses the comments received in response to Notice 2001–14 relating to those types of transactions.

Most commentators who addressed the application of FICA and FUTA tax at the time of exercise of a statutory stock option argued that there was no statutory basis for such application. As discussed more fully previously, the applicable Code provisions do not provide an exception from FICA or FUTA tax for wages paid to an employee arising from the exercise of a statutory stock option.

Several comments were received requesting that the IRS’s acquiescence on decision in Sun Microsystems v. Commis- sioner, T.C.M. 1995–69, acq. 1997–2 C.B. 1, not be affected by the proposed regulations. The proposed regulations address only the application of FICA and FUTA to statutory stock options and do not address the section 41 issues raised in the Sun Microsystems decision.

Some commentators also expressed concern about the administrative burden of applying FICA and FUTA tax at the time of exercise, especially as to former employees, because there is often no payment of cash compensation to the employee at that time. As a result, some

employees may need to sell some shares of the acquired stock to fund the employment tax obligations, resulting in a disqualifying disposition of the shares sold. In addition, some commentators expressed concern that the administrative burdens stemming from the application of FICA and FUTA tax upon the exercise of statutory stock options would make the use of these options less attractive to employers and employees. However, commentators did not cite applicable Code provisions that provide a statutory basis for excluding this type of compensation from the relevant employment taxes. As discussed below, the proposed regulations would enable the IRS to issue rules of administrative convenience to lessen the administrative burdens that commentators cited.

Explanation of Provisions

These proposed regulations would clarify current law regarding FICA tax, FUTA tax, and income tax withholding on the transfer of stock pursuant to the exercise of statutory stock options. These proposed regulations would provide that at the time of the exercise of a statutory stock option, the individual who was granted the statutory stock option receives wages for FICA and FUTA purposes. These proposed regulations would also provide that the amount of wages received equals the excess of the fair market value of the stock acquired pursuant to the exercise of the statutory stock option over the amount paid for the stock.

The position taken in these regulations is based upon the broad statutory definition of wages for FICA and FUTA purposes and the absence of any statutory exclusion for this form of remuneration. These regulations follow the Congressional directive that no exception from FICA taxes should be created without a specific exclusion and the section 3121(a) and 3306(b) provisions that no exception from FICA and FUTA taxes should be inferred from the fact that income tax withholding does not apply.

These proposed regulations would also provide that income tax withholding is not required when an individual exercises a statutory stock option because no income is recognized at the time of the exercise by reason of section 421(a)(1).

In response to the concerns about administrative burdens, the proposed regulations authorize the IRS to adopt rules of administrative convenience to assist employers and employees in meeting the employment tax obligations. Specifically, the proposed regulations permit the IRS to adopt rules permitting employers to deem the payment of wages resulting from the exercise of a statutory stock option as occurring at a specific date or dates, including over a period of dates, as well as any other appropriate rules of administrative convenience.

Section 424(h) provides that for purposes of the rules governing incentive stock option plans and employee stock purchase plans, if the terms of any option to purchase stock are modified, extended, or renewed, such modification, extension, or renewal is considered as the grant of a new option. Section 424(h)(3) generally defines the term modification as any change in the terms of the option which gives the employee additional benefits. The proposed regulations clarify that the adoption of any of the rules of administrative convenience that may be prescribed by the IRS pursuant to the proposed regulations, and the application of those rules to outstanding incentive stock options under section 422 or outstanding options under an employee stock purchase plan under section 423, will not constitute a modification for purposes of section 424(h).

These regulations are proposed to apply only upon publication of final regulations in the Federal Register and cannot be relied upon prior to publication. These proposed regulations, upon becoming final, would be effective only for the exercise of a statutory stock option that occurs on or after January 1, 2003. If these regulations are finalized as proposed, neither FICA nor FUTA tax will apply to the exercise of a statutory stock option prior to January 1, 2003. Consistent with this proposed position, the IRS will not assert FICA or FUTA tax which is based upon the exercise of a statutory stock option that occurs prior to January 1, 2003. While neither FICA nor FUTA tax will apply to the exercise of a statutory stock option prior to January 1, 2003, if these regulations are finalized as proposed, an employer will be able to apply the final

December 3, 2001 564 2001–49 I.R.B.

regulations to the exercise of a statutory stock option that occurs prior to January 1, 2003, if the employer elects to do so.

Related administrative guidance

As noted above, the IRS is concurrently publishing two notices. One of the two notices sets forth proposed rules of administrative convenience under the authority provided to the IRS in the proposed regulations. These proposed rules would permit employers to deem the payment of wages resulting from the exercise of a statutory stock option as occurring at a specific date or dates, including over a period of dates. The notice also describes certain arrangements available under the current federal tax law that may assist employers and employees, including employee pre-funding of the employee portion of FICA tax and employer advances of funds to satisfy the employee portion of FICA tax.

The IRS is publishing a second notice that proposes rules regarding an employer’s income tax withholding and reporting obligations upon the sale or disposition of stock acquired by an individual pursuant to the exercise of a statutory stock option. As indicated above, the proposed rule in this notice would state that the employer has no income tax withholding obligation when an employee sells or disposes of stock acquired by the employee pursuant to the exercise of a statutory stock option. ³

Special Analyses

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

making will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. All comments will be available for public inspection and copying.

Treasury and the IRS specifically request comments on the clarity of the proposed regulations, how they can be made easier to understand, and the administerability of the rules in the proposed regulations. In addition, the proposed regulations do not include special rules for transactions in which an individual exercising a statutory stock option receives stock subject to a restriction, such as a substantial risk of forfeiture. Treasury and the IRS also specifically request comments as to whether the proposed regulations should include such special rules, including comments as to the prevalence of incentive stock option plans or employee stock purchase plans that impose such terms on stock received pursuant to the exercise of a statutory stock option.

A public hearing has been scheduled for March 7, 2002, beginning at 10 a.m. in the Auditorium of the Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the 10th Street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by February 14, 2002. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these proposed regulations is Stephen Tackney, Office of the Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 31 are proposed to be amended as follows:

Part 1 - INCOME TAXES

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

Authority: 26 U.S.C. 7805 - - Par. 2. Section 1.425–1, as proposed at 49 FR 4519 (February 7, 1984), is amended by adding a sentence immediately after the third sentence of paragraph (e)(5)(i) to read as follows:

§1.425–1 Definitions and special rules applicable to statutory options.

(e) - - (5)(i) - - - In addition, the application to an outstanding option of any of the methods for the payment or withholding of employment taxes under sections

3 These proposed regulations, along with the two notices, are intended to clarify the application of employment taxes to statutory stock options in a manner that recognizes and addresses the practical burdens that are imposed, including the imposition of withholding when neither the employer nor any other person (other than the employee) has control over a payment of remuneration, while also ensuring that “amounts exempt from income tax withholding should not be exempt from FICA unless Congress provides an explicit FICA tax exclusion.” Social Security Amendments of 1983 at S. Rep. No. 98–23, 42, 98th Cong., 1st Sess.

2001–49 I.R.B 565 December 3, 2001

(2) Rules of administrative conve- nience . The Commissioner may prescribe rules of administrative convenience for employers to satisfy obligations under section 3301 that arise with respect to wages received pursuant to the exercise of a statutory stock option. Such rules may include, but are not limited to, permitting employers to deem the payment of wages due to the exercise of the statutory stock option as occurring at a specific date or dates, including over a period of dates.

(3) Effective date . This paragraph (l) is applicable to the exercise of a statutory option that occurs on or after January 1, 2003. Par. 6. In §31.3401(a)–1, paragraph (b)(15) is added to read as follows:

§31.3401(a)–1 Wages.

(b) - - (15) Statutory stock options - (i) When stock is transferred pursuant to an exercise - (A) Statutory stock option defined . For purposes of this section, a statutory stock option is an option that either satisfies the requirements of section 422(b) or is granted under a plan that satisfies the requirements of section 423(b).

(B) Withholding at exercise . If an individual is granted a statutory stock option, withholding is not required when stock is transferred to the individual pursuant to the exercise of the option to the extent that the individual does not recognize income by reason of section 421(a)(1). The provisions of this paragraph (b)(15) are illustrated by the following example:

Example . (i) Individual X is granted an option under a plan that satisfies the requirements of section 423(b). The option allows X to acquire 50 shares of stock of X’s employer, Y, at an exercise price equal to 85% of the fair market value of the stock at the time the option is granted. The fair market value of the Y stock at the time the option is granted is $100 per share. X exercises the option later when the fair market value of the Y stock is $120 per share. Thus, at the time of exercise, X acquires 50 shares of Y stock having a fair market value of $120 per share for $85 per share. X continues to hold the Y stock after exercise. Under section 421(a), no income is recognized at the time of exercise.

(ii) In this Example, for purposes of section 3401, X has not received wages at the time of exercise.

3101, 3111, or 3301 that may be prescribed under §31.3121(a)–1(k)(2) or §31.3306(b)–1(l)(2) of this chapter is not a modification. - -

Part 31 - EMPLOYMENT TAXES AND COLLECTION OF INCOME TAXES AT THE SOURCE

Par. 3. The authority citation for part 31 continues to read in part as follows: Authority: 26 U.S.C. 7805 - - Par. 4. In §31.3121(a)–1, paragraph (k) is added to read as follows:

§31.3121(a)–1 Wages.

(k) Statutory stock options - (1) When an individual receives wages - (i) Statutory stock option defined. For purposes of this section, a statutory stock option is an option that either satisfies the requirements of section 422(b) or is granted under a plan that satisfies the requirements of section 423(b).

(ii) Wages at exercise . If an individual is granted a statutory stock option, the individual receives wages when stock is transferred to the individual pursuant to the exercise of the option. The amount of the wages received by the individual is equal to the excess of the fair market value of the stock, determined at the time of exercise, over the amount paid for the stock by the individual. The provisions of this paragraph (k) are illustrated by the following example:

(ii) In this Example, at the time of exercise, X has received wages equal to the excess of the fair market value of the stock ($120 per share) over the amount paid for the stock ($85 per share). Thus, for purposes of section 3121, X has received wages equal to $35 per share, for a total of $1,750.

(2) Rules of administrative conve- nience . The Commissioner may prescribe

rules of administrative convenience for employers and employees to satisfy obligations under sections 3101 and 3111 that arise with respect to wages received pursuant to the exercise of a statutory stock option. Such rules may include, but are not limited to, permitting employers to deem the payment of wages due to the exercise of the statutory stock option as occurring at a specific date or dates, including over a period of dates.

(3) Effective date . This paragraph (k) is applicable to the exercise of a statutory option that occurs on or after January 1, 2003. Par. 5. In §31.3306(b)–1, paragraph (l) is added to read as follows:

§31.3306(b)–1 Wages.

(l) Statutory stock options - (1) When an individual receives wages - (i) Statu- tory stock option defined . For purposes of this section, a statutory stock option is an option that either satisfies the requirements of section 422(b) or is granted under a plan that satisfies the requirements of section 423(b).

(ii) In this Example, at the time of exercise, X has received wages equal to the excess of the fair market value of the stock ($120 per share) over the amount paid for the stock ($85 per share). Thus, for purposes of section 3306, X has received wages equal to $35 per share, for a total of $1,750.

December 3, 2001 566 2001–49 I.R.B.

granting limited additional relief to those taxpayers who missed deadlines in reliance on the interpretation of Notice 2001–61 described above. Accordingly, the IRS grants the following relief to partners, shareholders, or beneficiaries of passthrough entities that had income tax returns due (either originally or on extension) on or after September 11, 2001, and on or before November 2, 2001 (the date the IRS released Notice 2001–68), but did not file the return because the taxpayer believed that the IRS had granted a 120 day postponement solely by virtue of the taxpayer’s interest in an affected entity. Those taxpayers will have until December 17, 2001, to file a timely return (and make any election required to be made with a timely filed return). The IRS will waive any failure to file penalty if the taxpayer files the return by December 17, 2001. The IRS will waive any failure to pay penalty that accrues from September 11, 2001, through December 17, 2001, as long as the taxpayer pays any balance due by December 17, 2001. Taxpayers that qualify for relief under this notice should mark “Extended pursuant to Announcement 2001–117” in red ink on the top of their returns or other documents filed with the IRS.

This announcement was drafted by the Office of Associate Chief Counsel, Procedure and Administration (Administrative Provisions and Judicial Practice Division). For further information regarding this notice, you may call (202) 622–4940 (not a toll-free call).

(ii) Effective date . This paragraph (b)(15) is applicable to the exercise of a statutory stock option that occurs on or after January 1, 2003.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

(Filed by the Office of the Federal Register on November 13, 2001, 8:45 a.m., and published in the issue of the Federal Register for November 14, 2001, 66 F.R. 56944)

Disaster Relief for Taxpayers With an Interest in Passthrough Entities

Announcement 2001–117

Notice 2001–61 (2001–40 I.R.B. 305) provided filing and paying extensions and postponements for taxpayers affected by the September 11, 2001, Terrorist Attack. An affected taxpayer for purposes of Notice 2001–61 includes, among others, business entities whose principal place of business is located in a covered disaster area, and business entities whose principal place of business is not located in a covered disaster area but whose records necessary to meet a filing or paying deadline are located in a covered disaster area. Affected taxpayers also include trusts and estates whose tax records necessary to meet a filing or paying deadline are located in a covered disaster area. The

IRS received a number of inquiries about the scope of Notice 2001–61 with respect to the partners, shareholders and beneficiaries of partnerships, S corporations, trusts and estates (passthrough entities). In response to those inquiries, Notice 2001–68 (2001–47 I.R.B. 504) noted that the deadline for filing of income tax returns of the partners, shareholders, or beneficiaries of passthrough entities is not postponed or extended solely because the passthrough entity is an affected taxpayer. Notice 2001–68 also noted the availability of other types of relief for those owners of passthrough entities.

Some taxpayer representatives have informed the IRS that they interpreted Notice 2001–61 as including owners of passthrough entities as affected taxpayers regardless of whether the owners themselves were otherwise affected. Those taxpayer representatives believed that if the records of the passthrough entity necessary to prepare Schedule K–1s were located in a covered disaster area, then the owners who would receive copies of the Schedule K–1s for use in preparing their own returns had records in a covered disaster area within the meaning of Notice 2001–61. Some taxpayers who relied on the advice of these taxpayer representatives missed certain tax deadlines between September 11, 2001, and November 2, 2001, when the IRS issued Notice 2001–68.

Although Notice 2001–61 did not grant the relief that some taxpayer representatives believed it did, the extraordinary circumstances surrounding the September 11, 2001, terrorist attacks justify

2001–49 I.R.B 567 December 3, 2001