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

measured solely by need, not related to services rendered, and designed to place the employees in about the same economic position as they were before the tornado. In 1955, the Supreme Court of the United States held that Congress intended under § 61 to tax all gains or undeniable accessions to wealth, clearly realized, over which taxpayers have complete dominion. Com- missioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), 1955–1 C.B. 207. The Internal Revenue Service has concluded that payments made by governmental units under legislatively provided social benefit programs for the promotion of the general welfare ( i.e., based on need) are not includible in the gross income of the recipients of the payments (“general welfare exclusion”). For example, Rev. Rul. 98– 19, 1998–1 C.B. 840, concludes that a relocation payment, authorized by the Housing and Community Development Act of 1974 and funded under the 1997 Emergency Supplemental Appropriations Act for Recovery From Natural Disasters, made by a local jurisdiction to an individual moving from a flood-damaged residence to another residence, is not includible in the individual’s gross income. Likewise, Rev. Rul. 76–144, 1976–1 C.B. 17, concludes that grants received under the Disaster Relief Act of 1974 by individuals unable to meet necessary expenses or serious needs as a result of a disaster are in the interest of general welfare and are not includible in the recipients’ gross income.

Section 102(a) provides that the value of property acquired by gift is excluded from gross income. Under § 102(a) a gift “must proceed from a ‘detached and disinterested generosity,’ ... ‘out of affection, respect, admiration, charity or like impulses.’” Commissioner v. Duberstein, 363 U.S. 278, 285 (1960), 1960–2 C.B. 428, 431. In general, a payment made by a charity to an individual that responds to the individual’s needs, and does not proceed from any moral or legal duty, is motivated by detached and disinterested generosity. Rev. Rul. 99–44, 1999–2 C.B. 549. Section 102(c) provides that § 102(a) shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee. Governmental grants in response to a disaster generally do not qualify as gifts because the govern

Section 61.—Gross Income Defined

26 CFR 1.61–1(a): Gross income (Also §§ 102; 139; 7805; 1.102–1; 301.7805–1.)

Gross income; general welfare; gifts; disaster relief payments. This ruling holds that amounts paid to an individual by a state agency, a charity, or an employer to reimburse the individual for certain expenses the individual incurs as a result of a Presidentially declared disaster are excluded from the individual’s gross income under the administrative general welfare exclusion, sections 102 and 139 of the Code, respectively.

Rev. Rul. 2003–12

ISSUES

(1) Are grants individuals receive under a state’s program to pay or reimburse certain reasonable and necessary medical, temporary housing, or transportation expenses they incur as a result of a flood includible in gross income?

(2) Are grants individuals receive under a charitable organization’s program to pay or reimburse certain medical, temporary housing, or transportation expenses they incur as a result of a flood includible in gross income?

(3) Are grants employees receive under an employer’s program to pay or reimburse certain reasonable and necessary medical, temporary housing, or transportation expenses they incur as a result of a flood includible in gross income?

FACTS

Situation 1. An area within state ST was affected by a flood that was a Presidentially declared disaster as defined in § 1033(h)(3) of the Internal Revenue Code. ST enacted emergency legislation appropriating funds for grants to pay or reimburse medical, temporary housing, and transportation expenses individuals incur as a result of the flood that are not compensated for by insurance or otherwise. ST will not require individuals to provide proof of actual expenses to receive a grant payment. ST ’s program, however, contains requirements (which are described in the program documents) to ensure that the grant amounts are reasonably expected to be commensurate with the amount of unreimbursed

reasonable and necessary medical, temporary housing, and transportation expenses individuals incur as a result of the flood. The grants are not intended to indemnify all flood-related losses or to reimburse the cost of nonessential, luxury, or decorative items and services.

Situation 2. O, a charitable organization described in § 501(c)(3) that is exempt from tax under § 501(a), whose purpose is to provide assistance to individuals who are affected by disasters, also makes grants to distressed individuals affected by the flood described in Situation 1. The grants will pay or reimburse individuals for medical, temporary housing, and transportation expenses they incur as a result of the flood that are not compensated for by insurance or otherwise.

Situation 3. Employer R makes grants to its employees who are affected by the flood described in Situation 1. The grants will pay or reimburse employees for medical, temporary housing, and transportation expenses they incur as a result of the flood that are not compensated for by insurance or otherwise. R will not require individuals to provide proof of actual expenses to receive a grant payment. R ’s program, however, contains requirements (which are described in the program documents) to ensure that the grant amounts are reasonably expected to be commensurate with the amount of unreimbursed reasonable and necessary medical, temporary housing, and transportation expenses R ’s employees incur as a result of the flood. The grants are not intended to indemnify all flood-related losses or to reimburse the cost of nonessential, luxury, or decorative items and services. The grants are available to all employees regardless of length or type of service with R .

LAW AND ANALYSIS

Section 61(a) provides that, except as otherwise provided by law, gross income means all income from whatever source derived. Rev. Rul. 131, 1953–2 C.B. 112, concludes, in part, that certain payments by an employer to its employees for the purpose of helping the employees defray costs they incurred from personal injury and property loss resulting from a tornado do not come within the concept of gross income to the employees under the predecessor of § 61 because the payments are gratuitous,

2003–3 I.R.B. 283 January 21, 2003

interested generosity, the grants made by ST do not qualify for exclusion from income as gifts under § 102.

In Situation 2, the grants made by O are designed to help distressed individuals with unreimbursed medical, temporary housing, or transportation expenses they incur as a result of the flood. Under these facts, O ’s grants are made out of detached and disinterested generosity rather than to fulfill any moral or legal duty. Thus, the grants are excluded from the gross income of the recipients as gifts under § 102. Because payments by non-governmental entities are not considered payments for the general welfare, the grants made by O are not excluded from the recipients’ gross income under the general welfare exclusion. Rev. Rul. 82–106, 1982–1 C.B. 16. It is not necessary to reach the question of whether § 139 applies to the grants.

In Situation 3, the grants made by R to its employees do not qualify as gifts under § 102. Also, because payments by nongovernmental entities are not considered payments for the general welfare, the grants made by R are not excluded from the recipients’ gross income under the general welfare exclusion. The grants, however, are reasonably expected to be commensurate with the unreimbursed reasonable and necessary personal, living, or family expenses that R ’s employees incur as a result of a flood that is a qualified disaster as defined in § 139(c). Moreover, they are paid to compensate individuals for expenses that are not compensated for by insurance or otherwise. Therefore, R ’s grants are qualified disaster relief payments that are excluded from the gross income of R ’s employees under § 139. Similar to the grants in Situation 3, the payments made by the employer described in Rev. Rul. 131 do not qualify as gifts under § 102 and are not excluded from the employees’ gross income under the general welfare exclusion. Whether the payments described in Rev. Rul. 131 are included in an employee’s gross income depends on whether the payments qualify for exclusion under § 139.

HOLDINGS

Under the facts of this ruling: (1) Payments individuals receive under a state’s program to pay or reimburse unreimbursed reasonable and necessary medical, temporary housing, or transportation expenses they incur as a result of a

ment’s intent in making the payments proceeds from its duty to relieve the hardship caused by the disaster. Kroon v. United States, Civ. No. A–90–71 (D. Alaska 1974).

The Victims of Terrorism Tax Relief Act of 2001, Pub. L. No. 107–134, 115 Stat. 2427 (2001), added § 139 to the Code. Section 139(a) provides that gross income does not include any amount received by an individual as a qualified disaster relief payment.

Section 139(b) provides, in part, that the term “qualified disaster relief payment” means any amount paid to or for the benefit of an individual:

(1) to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster (§ 139(b)(1));

(2) to reimburse or pay reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or repair or replacement of its contents to the extent that the need for such repair, rehabilitation, or replacement, is attributable to a qualified disaster (§ 139(b)(2)); or

(3) by a Federal, State, or local government, or agency or instrumentality thereof, in connection with a qualified disaster in order to promote the general welfare (§ 139(b)(4)).

Thus, § 139(b)(4) codifies (but does not supplant) the administrative general welfare exclusion with respect to certain disaster relief payments to individuals. Section 139(b) also provides that the exclusion from income applies only to the extent any expense compensated by such payment is not otherwise compensated for by insurance or otherwise.

Section 139(c) provides that the term “qualified disaster” means:

(1) a disaster that results from a terroristic or military action (as defined in § 692(c)(2));

(2) a Presidentially declared disaster as defined in § 1033(h)(3) (generally, a disaster in an area that has been subsequently determined by the President to warrant federal assistance under the Disaster Relief and Emergency Assistance Act);

(3) a disaster resulting from any event that the Secretary determines to be of a catastrophic nature; or

(4) with respect to amounts described in § 139(b)(4), a disaster that is determined by an applicable Federal, State, or local au

thority (as determined by the Secretary) to warrant assistance from the Federal, State, or local government or an agency or instrumentality thereof.

Because “of the extraordinary circumstances surrounding a qualified disaster, it is anticipated that individuals will not be required to account for actual expenses in order to qualify for the [§ 139] exclusion, provided that the amount of the payments can be reasonably expected to be commensurate with the expenses incurred.” Joint Committee on Taxation Staff, Technical Ex- planation of the “Victims of Terrorism Tax Relief Act of 2001,” as Passed by the House and Senate on December 20, 2001, 107 ^th

Cong., 1 ^st Sess. 16 (2001). As under § 139, the Service will not require individuals to account for actual disaster-related expenses for governmental payments to qualify under the administrative general welfare exclusion if the amount of the payments is reasonably expected to be commensurate with the expenses incurred.

The grants that individuals receive from ST, O, and R, and the payments that the employees receive from their employer in Rev. Rul. 131, are accessions to wealth clearly realized over which the recipients have complete dominion, and therefore come within the concept of gross income under § 61 as described in Glenshaw Glass . Thus, these amounts are included in gross income unless specifically excluded by another provision of law. Accordingly, Rev. Rul. 131 is modified to the extent that it holds that the payments received by the employees from their employer do not come within the concept of gross income.

In Situation 1, the grants made by ST are reasonably expected to be commensurate with the unreimbursed reasonable and necessary medical, temporary housing, or transportation expenses individuals incur as a result of the flood. These expenses are personal, living, or family expenses within the meaning of § 139. Moreover, they are paid to compensate individuals for expenses that are not compensated for by insurance or otherwise. Thus, the grants are in the nature of general welfare and are, therefore, excluded from the recipients’ gross income under the general welfare exclusion. The payments also qualify for exclusion from gross income under § 139. Because ST ’s intent in making the grants proceeds from its duty to relieve the hardship caused by the disaster, not from a detached and dis

January 21, 2003 284 2003–3 I.R.B.

flood are excluded from gross income under the general welfare exclusion. Such payments also qualify for exclusion under § 139.

(2) Payments that individuals receive under a charitable organization’s program to pay or reimburse unreimbursed medical, temporary housing, or transportation expenses they incur as a result of a flood are excluded from gross income under § 102.

(3) Payments that employees receive under an employer’s program to pay or reimburse unreimbursed reasonable and necessary medical, temporary housing, or transportation expenses they incur as a result of a flood are excluded from gross income under § 139.

Amounts that are excluded from gross income under this revenue ruling are not subject to information reporting under § 6041.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 131 is modified.

PROSPECTIVE APPLICATION

Pursuant to the authority contained in § 7805(b), this revenue ruling will not apply adversely to payments received on or before January 21, 2003.

DRAFTING INFORMATION

The principal author of this revenue ruling is Sheldon A. Iskow of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Iskow at (202) 622–4920 (not a tollfree call).

Section 401.—Qualified Pen- sion, Profit-Sharing and Stock Bonus Plans

26 CFR 1.401–1: Qualified pension, profit-sharing and stock bonus plans.

Whether an S corporation ESOP is eligible for the delayed effective date of section 409(p) of the Internal Revenue Code as added by section 656(d)(2) of

the Economic Growth and Tax Relief Reconcil iation Act of 2001. See Rev. Rul. 2003–6, page 286.

26 CFR 1.401(a)(17)–1: Limitation on annual compensation.

Limitation on annual compensation; section 611(c) of EGTRRA. This ruling pertains to whether the allowable compensation limit enacted by section 611(c) of EGTRRA may be applied to former employees and meet the nondiscrimination and coverage requirements of the Code.

Rev. Rul. 2003–11

ISSUE

Whether a plan amendment that reflects the increase in the allowable compensation limit contained in section 611(c) of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Pub. L. 107–16, and applies that increase to former employees, will satisfy the nondiscrimination rules of § 401(a)(4) and the minimum coverage requirements of § 410(b) of the Internal Revenue Code (Code).

FACTS

Plan A is a nongovernmental defined benefit plan with a calendar year plan year and a benefit formula that provides for all participants an annual benefit at normal retirement age equal to the product of: (years of service) x (1 percent) x (high 3-year average compensation). For this purpose, high 3-year average compensation is the average of the compensation over the 3 consecutive plan years for which the average is the highest, and compensation for each year is limited to $150,000, as adjusted for cost-of-living increases (the limit under § 401(a)(17) of the Code prior to the effective date of the EGTRRA amendments to that section). B is a former participant in Plan A who retired as of December 31, 2001. As of December 31, 2001, B has 10 years of service and compensation of $250,000 for each of the 3 years 1999, 2000, and 2001. B’s high 3-year average compensation of $166,667 is determined as the average of annual compensation (as limited by § 401(a)(17) of the Code) of $160,000 for 1999, $170,000 for 2000, and $170,000 for 2001. B’s annual benefit under the plan formula as of December 31, 2001, is $16,667, calculated as (10) x (.01) x ($166,667). As of December 31, 2001, B is a “highly compensated former employee,” as defined in § 1.410(b)–9, and a “former HCE,” as defined in § 1.401(a)(4)–12, for

purposes of applying the nondiscrimination rules under §§ 410(b) and 401(a)(4) respectively.

In 2002, Plan A is amended (1) to use the $200,000 compensation limit for compensation paid in years beginning after December 31, 2001, (2) to use the $200,000 compensation limit for compensation paid in years beginning prior to January 1, 2002, in determining benefit accruals in years beginning after December 31, 2001, and (3) to use the $200,000 compensation limit in determining retirement benefits to be paid after December 31, 2001, to employees who retired on or before December 31, 2001. A high 3-year average compensation of $200,000 is determined for B as of December 31, 2002, as the average of annual compensation (as limited by § 401(a)(17) of the Code, as amended by EGTRRA) of $200,000 for 1999, $200,000 for 2000, and $200,000 for 2001. As of December 31, 2002, B’s annual benefit under the plan formula is $20,000, calculated as (10) x (.01) x ($200,000).

LAW AND ANALYSIS

Section 401(a)(17) limits the annual compensation that may be taken into account for purposes of determining a participant’s benefit accruals under a defined benefit plan or a participant’s allocations under a defined contribution plan. Section 401(a)(17) also limits the annual compensation that may be taken into account for purposes of certain nondiscrimination requirements, including those in §§ 401(a)(4), 401(a)(5), 401(l), 401(k), 401(m), 403(b)(12), 404(a)(2), and 410(b)(2), and for purposes of determining whether a definition of compensation is nondiscriminatory under § 414(s)(3). Under § 401(a)(17), as in effect prior to the effective date of the EGTRRA amendment, the compensation limit was $150,000, indexed in $10,000 increments for cost-of-living adjustments. For 2001, the compensation limit was $170,000. A higher compensation limit applies to eligible participants in certain governmental plans. See § 1.401(a)(17)–1(d)(4)(ii) of the Income Tax Regulations.

Section 611(c) of EGTRRA amended § 401(a)(17) of the Code by increasing the $150,000 limit (as adjusted) to $200,000, and changing the method used for cost-ofliving adjustments. Section 611(c) of EGTRRA made similar amendments to

2003–3 I.R.B. 285 January 21, 2003

Section 409(p).—Prohibited Allocations of Securities in an S Corporation

(Also, §§ 401, 4975, 4979A, 6011, 6111 and 6112; 1.401–1, 54.4975–11, 1.6011–4T, 301.6111–2T and 301.6112–1T.)

Employee stock ownership plans; de- layed effective date, abuse. This ruling states that where the intent of section 409(p) of the Code to limit the establishment of ESOPs by S corporations to those that provide broad-based employee coverage and that benefit rank-and-file employees (as well as highly compensated employees and historical owners) is not present, the delayed effective date in section 656(d)(2) of the EGTRRA is not available and that such transactions are listed transactions.

Rev. Rul. 2003–6

PURPOSE

The Internal Revenue Service and the Treasury Department understand that certain arrangements involving employee stock ownership plans (ESOPs) that hold employer securities in an S corporation are being used for the purpose of claiming eligibility for the delayed effective date of § 409(p) of the Internal Revenue Code, under section 656(d)(2) of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) (Pub. L. 107–16). This revenue ruling alerts taxpayers and their representatives that the tax benefits purportedly generated by these transactions are not allowable for federal income tax purposes. This revenue ruling also alerts taxpayers, their representatives, and organizers or sellers of these transactions to certain responsibilities that may arise from participating in these transactions.

ISSUE

Is an S corporation ESOP described below eligible for the delayed effective date under § 409(p) of the Code provided under section 656(d)(2) of EGTRRA?

FACTS

On or before March 14, 2001, A, a person in the business of providing advice to other companies or individuals, arranges for the establishment of a number of S corpo

§§ 404(l), 408(k), and 505(b)(7) of the Code.

Section 611(i)(1) of EGTRRA provides that the increase in the compensation limit under § 401(a)(17) of the Code applies to years beginning after December 31, 2001. Thus, for purposes of determining benefit accruals or the amount of allocations for plan years beginning on or after January 1, 2002, compensation taken into account may not exceed the compensation limit under § 401(a)(17), as amended by section 611(c) of EGTRRA.

Notice 2001–56, 2001–2 C.B. 277, provides that in the case of a plan that uses annual compensation for periods prior to the first plan year beginning on or after January 1, 2002, to determine accruals or allocations for a plan year beginning on or after January 1, 2002, the plan is permitted to provide that the $200,000 compensation limit applies to annual compensation for such prior periods in determining such accruals or allocations.

Section 1.401(a)(4)–5 provides general rules for determining whether the timing of a plan amendment has the effect of discriminating significantly in favor of highly compensated employees. Section 1.401(a)(4)–5(a) provides that whether the timing of a plan amendment has the effect of discriminating significantly in favor of HCEs or former HCEs is determined at the time the plan amendment first becomes effective for purposes of § 401(a), and is based on all of the relevant facts and circumstances.

Section 1.401(a)(4)–10 provides rules for determining whether a plan satisfies the nondiscrimination requirements of § 401(a)(4) with respect to benefits provided to former employees, generally in the form of a plan amendment. Section 1.401(a)(4)–10(b)(1) provides that a plan is nondiscriminatory with respect to the amount of benefits provided to former employees if, under all of the relevant facts and circumstances, the amount of benefits provided to former employees does not discriminate significantly in favor of former employees who are highly compensated employees (HCEs). For this purpose, § 1.401(a)(4)–10(b)(1) specifies that benefits provided to former employees include all benefits provided to former employees or, at the employer’s option, only those benefits arising out of the amendment providing the benefits.

Section 1.410(b)–2(c) provides rules for determining whether the group of former employees benefiting under a plan for a year satisfies the coverage requirements of § 410(b) with respect to former employees. Section 1.410(b)–2(c)(2) provides that a plan satisfies § 410(b) with respect to former employees if, under all of the relevant facts and circumstances, a group of former employees benefiting under the plan does not discriminate significantly in favor of highly compensated former employees. Section 1.410(b)–3(b) provides that for this purpose, a former employee is treated as benefiting for a plan year if and only if the plan provides a benefit increase to the former employee for the plan year.

Based on all the relevant facts and circumstances, the amendment to Plan A satisfies the requirements of § 401(a)(4) and § 410(b).

HOLDING

A plan amendment to apply the increased compensation limits under section 611(c) of EGTRRA to all former employees (or all former employees who retain accrued benefits under the plan) that is effective as of the first plan year beginning after December 31, 2001, satisfies the requirements of § 401(a)(4) and § 410(b) of the Code.

DRAFTING INFORMATION

The principal drafters of this revenue ruling are Steven Linder of the Employee Plans, Tax Exempt and Government Entities Division and Linda Phillips of the Office of the Associate Chief Counsel/Division Counsel (TEGE). For further information rearding this revenue ruling, please contact the Employee Plans’ taxpayer assistance telephone service at 1–877–829– 5500 (a toll-free number) between the hours of 8:00 a.m. and 6:30 p.m. Eastern Time, Monday through Friday. Mr. Linder may be reached at (202) 283–9888; Ms. Phillips may be reached at (202) 622–6090. The telephone numbers in the preceding sentence are not toll-free.

January 21, 2003 286 2003–3 I.R.B.

an excise tax equal to 50 percent of the allocations is imposed on the S corporation under § 4979A.

Section 409(p) is effective for plan years beginning after December 31, 2004. However, pursuant to section 656(d)(2) of EGTRRA, § 409(p) of the Code is effective for plan years ending after March 14, 2001, for an ESOP that is established after that date, or if the employer securities held by the plan consist of stock in an S corporation that did not have an S election in effect on that date. Notice 2002–2, Q & A–15, 2002–2 I.R.B. 285, provides that an S corporation does not have an election in effect on March 14, 2001, unless a valid election was actually filed on or before that date and is effective with respect to such corporation on or before that date.

The legislative history to section 656 of EGTRRA, which added § 409(p) to the Code, states that § 409(p) is intended to limit the establishment of ESOPs by S corporations to those that provide broad-based employee coverage and that benefit rankand-file employees as well as highly compensated employees and historical owners. (See H.R. Rep. 107–51, pt. 1, at 100, and H.R. Conf. Rep. 107–84, at 274 (2001).) In addition, Congress has expressed concern regarding techniques to avoid or evade the requirements of § 409(p). (See § 409 (p)(7)(B), which provides that the Secretary may, by regulation or other guidance of general applicability, provide that a nonallocation year occurs in any case in which the principal purpose of the ownership structure of an S corporation constitutes an avoidance or evasion of the nonallocation requirements of § 409(p).)

ANALYSIS

In these transactions, A has not formed the ESOPs to provide substantial benefits, or substantial participation in the ownership of the S corporations, to the initial purported participants in the ESOPs. The initial employees of the entity forming the ESOP do not receive more than insubstantial benefits or more than insubstantial ownership interests through the ESOP. For purposes of the effective date of § 409(p), an ESOP is not established until it is adopted by an employer for the purpose of enabling its employees to participate in a more than insubstantial manner in the ownership of the employer’s business and to

rations that have no substantial assets or business, and forms an ESOP for each of those corporations. A takes the position that some or all of the employees of A are eligible to participate under the terms of the ESOP sponsored by each S corporation, but there is no reasonable expectation that these individuals will accrue more than insubstantial benefits under the plans or more than an insubstantial share in the ownership of the S corporations. After March 14, 2001, A markets these S corporations and the associated ESOPs to other taxpayers, including individuals or companies.

After one of the S corporations (and its ESOP) are transferred to one or more taxpayers, the taxpayers restructure their businesses so that the S corporation receives income from those businesses. After the restructuring, the S corporation is wholly or substantially owned by the ESOP. In addition, there are one or more individual taxpayers who are disqualified persons, within the meaning of § 409(p) of the Code (relating to prohibited allocations under an ESOP that holds stock in an S corporation), who are deemed to own in the aggregate at least 50% of the number of shares of the S corporation.

LAW

Section 4975(e)(7) provides that an ESOP is a defined contribution plan which is (1) either a stock bonus plan which is qualified or a stock bonus plan and money purchase pension plan both of which are qualified under § 401(a), and (2) designed to invest primarily in qualifying employer securities. A plan is not treated as an ESOP unless it meets the following requirements, to the extent applicable: § 409(h) (relating to participants’ right to receive employer securities and put options); § 409(o) (relating to participants’ distribution rights and payment requirements); § 409(n) (relating to securities received in transactions to which § 1042 applies); § 409(p) (relating to prohibited allocations of securities in an S corporation); § 664(g) (relating to qualified gratuitous transfers of qualified employer securities); and § 409(e) (relating to participants’ voting rights), if the employer has a registration-type class of securities (as defined in § 409(e)(4)). As authorized by § 4975(e)(7), additional requirements are imposed under § 54.4975–11 of the Excise Tax Regulations.

The legislative history to the Tax Reform Act of 1976 (TRA ’76) (Pub.L. 94– 455) states that an ESOP “is a technique of corporate finance designed to build beneficial equity ownership of shares in the employer corporation into its employees . . . .” (See S. Rep. 94–938 at 180 and 1976–3 C.B. Vol. 3, 218.) Section 1.401–1(a)(2)(ii) of the Income Tax Regulations provides that a qualified profit-sharing plan is established and maintained by an employer to enable employees or their beneficiaries to participate in the profits of the employer’s trade or business. However, § 401(a)(27) permits contributions to be made without regard to profits if the plan is designated as a profitsharing plan. Under § 1.401–1(a)(2)(iii), a stock bonus plan is a plan that provides employees or their beneficiaries benefits similar to those of a profit-sharing plan, except that benefits are distributable in stock of the employer.

Section 409(p) requires that an ESOP that holds employer securities consisting of stock in an S corporation provide that no portion of the assets of the plan attributable to such employer securities may, during a nonallocation year, accrue (or be allocated directly or indirectly under any plan of the employer meeting the requirements of § 401(a)) for the benefit of any disqualified person. Indirect allocations include allocations of income on S corporation stock held in the account of a disqualified person. H.R. Conf. Rep. 107–84 at 276.

Any prohibited allocations in a nonallocation year are treated as distributions and are currently taxable to the disqualified person. Section 409(p)(3) provides that a “nonallocation year” means a plan year during which, at any time, disqualified persons own at least 50 percent of the number of shares of the S corporation. Section 409(p)(4) provides, in general, that a “disqualified person” means a person for whom (1) the aggregate number of deemed-owned shares of such person and the members of such person’s family is at least 20 percent of the number of deemed-owned shares of stock in the S corporation or (2) the number of such deemed-owned shares is at least 10 percent of the number of deemed-owned shares of stock in the S corporation. If an ESOP fails § 409(p), prohibited allocations are treated as currently taxable to the disqualified person under § 409(p)(2), and

2003–3 I.R.B. 287 January 21, 2003

Rev. Rul. 2003–10

ISSUES

(1) Under the all events test of § 451 of the Internal Revenue Code, when does a taxpayer using an accrual method of accounting accrue gross income if the taxpayer ships goods and the customer disputes its liability to the taxpayer because of a clerical mistake in the sales invoice discovered in the next taxable year?

(2) Under the all events test of § 451, when does a taxpayer using an accrual method of accounting accrue gross income if the taxpayer ships the wrong goods and the customer disputes its liability during the taxable year of sale?

(3) Under the all events test of § 451, when does a taxpayer using an accrual method of accounting accrue gross income if the taxpayer ships more items than the customer ordered, the excess quantity is discovered by the customer in the next taxable year, and, in accordance with an agreement with the customer, the taxpayer reduces the quantity that would otherwise have been included in the next shipment?

FACTS

Taxpayer P manufactures products H and M and sells them to retailers for resale. P uses an accrual method of accounting and a calendar taxable year. For federal income tax purposes, P recognizes gross income from sales of products H and M when it ships the product to the retailer.

Situation 1 . In October 2002, X, a retailer, orders 1,000 cases of product M from P at a price of $15 per case. In November 2002, P ships 1,000 cases of M to X and sends X an invoice for the 1,000 cases of M . As the result of a data entry mistake, the amount of the invoice is improperly stated as $16,000 rather than $15,000. In January 2003, X notifies P of the erroneous invoice and P acknowledges that it is entitled to receive only $15,000 for the 1,000 cases of M . X subsequently pays the $15,000 to P.

Situation 2. Y is a retailer that purchases product M from P. In September 2002, Y orders 600 cases of M from P at a price of $15 per case. In October 2002, P ships 600 cases of H to Y and sends Y an invoice for $9,000. In November 2002, Y discovers that P shipped H rather than M and notifies P that it will not pay for the H . In January

provide its employees with more than insubstantial benefits under the ESOP.

For the foregoing reasons, an ESOP adopted by an S corporation under the facts provided above will not be treated as having been established on or before March 14, 2001, and is not entitled to the delayed 2005 effective date for purposes of the nonallocation rules of § 409(p).

Accordingly, because there is a nonallocation year under § 409(p), the disqualified persons under § 409(p)(4) are treated as receiving deemed distributions to the extent of any allocation to their account, pursuant to § 409(p)(2)(A). In addition, excise taxes under § 4979A apply to any nonallocation year.

HOLDING

An S corporation ESOP described in this ruling is not eligible for the delayed effective date under § 409(p) of the Code provided under section 656(d)(2) of EGTRRA, and thus is subject to the nonallocation rules of § 409(p) of the Code effective for plan years ending after March 14, 2001. Any taxpayer who is a disqualified person with respect to the S corporation ESOP is treated as receiving a deemed distribution of stock allocated to the taxpayer’s account and income with respect to that account. In addition, excise taxes under § 4979A apply to any nonallocation year.

LISTED TRANSACTIONS

Transactions that are the same as, or substantially similar to, the transaction described in this revenue ruling are identified as “listed transactions” for purposes of § 1.6011–4T(b)(2) of the temporary Income Tax Regulations and § 301.6111– 2T(b)(2) of the temporary Procedure and Administration Regulations with respect to each disqualified person for plan years beginning prior to January 1, 2005. See also § 301.6112–1T, A–4. Further, it should be noted that, independent of their classification as “listed transactions” for purposes of §§ 1.6011–4T(b)(2) and 301.6111–2T(b)(2), transactions that are the same as, or substantially similar to, the transaction described in this revenue ruling may already be subject to the disclosure requirements of § 6011, the tax shelter registration requirements of § 6111 or the list maintenance requirements of § 6112 (§§ 1.6011–4T, 301.6111–1T, 301.6111–2T, and 301.6112– 1T, A-3 and A–4).

Persons who are required to satisfy the registration requirement of § 6111 with respect to the transaction described in this revenue ruling and who fail to do so may be subject to the penalty under § 6707(a). Persons who are required to satisfy the listkeeping requirement of § 6112 with respect to the transaction and who fail to do so may be subject to the penalty under § 6708(a). In addition, the Service may impose penalties on participants in this transaction or substantially similar transactions, or, as applicable, on persons who participate in the reporting of this transaction or substantially similar transactions, including the accuracy-related penalty under § 6662, and the return preparer penalty under § 6694.

FURTHER GUIDANCE

The Service is developing further guidance to address other abusive arrangements involving S corporation ESOPs.

DRAFTING INFORMATION

The principal drafters of this revenue ruling are Steven Linder of the Employee Plans, Tax Exempt and Government Entities Division and John Ricotta of the Office of the Associate Chief Counsel/ Division Counsel (TEGE). For further information regarding this revenue ruling, please contact the Employee Plans’ taxpayer assistance telephone service at 1–877– 829–5500 (a toll-free number) between the hours of 8:00 a.m. and 6.30 p.m. Eastern Time, Monday through Friday. Mr. Linder may be reached at (202) 283–9888; Mr. Ricotta may be reached at (202) 622– 6060. The telephone numbers in the preceding sentence are not toll-free.

Section 451.—General Rule for Taxable Year of Inclusion

26 CFR 1.451–1: General rule for taxable year of inclusion.

Accrual of income. This ruling addresses the accrual of gross income when a taxpayer’s customer disputes its liability to the taxpayer because of (1) a clerical mistake in a sales invoice, (2) the shipment of the wrong goods, or (3) the shipment of more items than the customer ordered.

January 21, 2003 288 2003–3 I.R.B.

In Situation 3, P mistakenly ships the wrong amount of H and M to Z in December 2002 and sends an invoice for $13,000 to Z . However, because Z does not dispute the shipment P has a fixed right to income relating to the shipment in 2002. Accordingly, P accrues $13,000 of gross sales and includes $13,000, less the corresponding cost of goods sold, in gross income in 2002 because the all events test of § 451 is satisfied.

HOLDINGS

(1) Under the all events test of § 451, if a taxpayer using an accrual method of accounting overbills a customer due to a clerical mistake in an invoice and the customer discovers the error and, in the following taxable year, disputes its liability for the overbilled amount, then the taxpayer accrues gross income in the taxable year of sale for the correct amount.

(2) Under the all events test of § 451, a taxpayer using an accrual method of accounting does not accrue gross income in the taxable year of sale if, during the taxable year of sale, the customer disputes its liability to the taxpayer because the taxpayer shipped incorrect goods.

(3) Under the all events test of § 451, a taxpayer using an accrual method of accounting accrues gross income in the taxable year of sale if the taxpayer ships excess quantities of goods and the customer agrees to pay for the excess quantities of goods.

REQUEST FOR COMMENTS

The Service requests comment on the application of § 451 to a situation in which P ships defective products to a customer that discovers the defect in the next taxable year and disputes its liability to P . In particular, the Service requests comments concerning: (1) whether P has a fixed right to income within the meaning of § 451 in the taxable year of sale (compare Hall- mark Cards, Inc. v. Commissioner, 90 T.C. 26 (1988), with Celluloid Co. v. Commis- sioner, 9 B.T.A. 989 (1927) acq. VII–1 C.B. 6); (2) whether the taxable year concept of accounting requires P to accrue gross income in the taxable year of sale because the dispute did not arise until the next taxable year; (3) examples of situations that should be treated as shipments of defective products ( e.g., shipments of damaged goods, shipments of incorrect goods); and

2003, P and Y settle the dispute by agreeing that Y will pay P $4,500 for the H .

Situation 3 . Z is a retailer that purchases products H and M from P . Each month P ships Z 300 cases of H at a price of $10 per case and 700 cases of M at a price of $15 per case. On December 28, 2002, P mistakenly ships 400 cases of H and 600 cases of M to Z and sends Z an invoice for $13,000. On January 3, 2003, Z discovers that P shipped the wrong amount of H and M and notifies P . Z asks P to correct the situation by adjusting the amount of H and M it ships to Z in January’s monthly shipment. On January 28, 2003, P ships 200 cases of H and 800 cases of M to Z to adjust for the amount of H and M mistakenly shipped to Z in December 2002. In February 2003, Z pays P $13,000 for the H and M it received in December 2002 and in March 2003, Z pays P $14,000 for the H and M it received in January 2003.

LAW AND ANALYSIS

Section 61(a) provides that, except as otherwise provided, gross income means all income from whatever source derived. Section 1.61–3(a) of the Income Tax Regulations provides that in a manufacturing, merchandising, or mining business, “gross income” means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources.

Section 451 provides rules for determining the taxable year of inclusion for items of gross income. Sections 1.446– 1(c)(1)(ii)(A) and 1.451–1(a) provide that under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive the income and the amount thereof can be determined with reasonable accuracy. All the events that fix the right to receive income occur when (1) the required performance takes place, (2) payment is due, or (3) payment is made, whichever happens first. Schlude v. Commissioner, 372 U.S. 128, 133 (1963); Rev. Rul. 84– 31, 1984–1 C.B. 127; Rev. Rul. 80–308, 1980–2 C.B. 162. Section 1.446–1(e)(2)(ii)(b) provides that a change in method of accounting does not include correction of mathematical or posting errors, or errors in the computation of a tax liability.

Section 1.451–1(a) provides that if an amount of income is properly accrued on

the basis of a reasonable estimate and the exact amount is subsequently determined, the difference, if any, shall be taken into account for the taxable year in which such determination is made. Additionally, if a taxpayer ascertains that an item was improperly included in gross income in a prior taxable year, the taxpayer should, if within the period of limitation, file a claim for credit or refund of any overpayment of tax arising therefrom. Gould-Mersereau Co. v. Commissioner, 21 B.T.A. 1316 (1931) acq. 1931–2 C.B. 27. If the right to an amount of income is substantially in controversy the income may not be accrued until the controversy is resolved. North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932); Jamaica Water Co. v. Commis- sioner, 125 F.2d 512 (2d Cir. 1942); Rev. Rul. 60–237, 1960–2 C.B. 164.

In Situation 1, P ’s invoice to X was for an improper amount as a result of a clerical mistake. P may not accrue $16,000 of gross sales in gross income in 2002 because P does not have a fixed right to that amount. Rather, P accrues $15,000 of gross sales and includes $15,000, the correct amount, less the corresponding cost of goods sold, in gross income in 2002. Generally, if P has already filed its income tax return for 2002 when the mistake is discovered, P should, if within the period of limitation, file a claim for refund of any overpayment of tax arising from reporting an improper amount of income on that return. If, however, P has regularly and consistently for a period of two or more taxable years treated invoice amounts as a reasonable estimate of accrued income and, if the exact amount is subsequently determined to be different, has taken the difference into account for the taxable year in which the determination is made, P should seek consent for a change in method of accounting if it wants to begin taking such differences into account in the year of sale.

In Situation 2, the dispute arises in the taxable year of sale. Accordingly, because under § 451 P does not have a fixed right to the income P may not include any amount from that transaction, including the corresponding cost of goods sold, in gross income in 2002. P accrues $4,500 of gross sales and includes $4,500, less the corresponding cost of goods sold, in gross income in 2003, when P and Y settle their dispute by agreeing that Y will pay P the amount of $4,500 for the H .

2003–3 I.R.B. 289 January 21, 2003

eign tax would not be imposed on the taxpayer but for the availability of such a credit.

Section 903 of the Code allows a credit against United States income tax for an amount of tax paid or accrued “in lieu of” an income, war profits or excess profits tax otherwise generally imposed by any foreign country. Section 1.903–1(a) of the regulations provides that a foreign levy is a tax in lieu of an income tax only if it is a tax, and it meets the “substitution requirement” of section 1.903–1(b). Section 1.903–1(b)(2) provides that a foreign tax meets the substitution requirement only to the extent that the liability for the foreign tax is not dependent (by its terms or otherwise) on the availability of a credit for the foreign tax against the income tax liability to another country.

Therefore, if a foreign country imposes a withholding tax only in the event that a credit for the tax is available from the recipient’s country of domicile, the tax is not creditable under section 901 or 903.

HOLDING

The withholding taxes referred to in Article 61 of the Costa Rican Income Tax Law are not creditable taxes under section 901 or 903 of the Code since they are imposed only in the event that a credit for the tax is available from the country in which the recipient operates or resides. This ruling is an official confirmation by the Internal Revenue Service that the withholding taxes referred to in Article 61 are not creditable in the United States.

DRAFTING INFORMATION

The principal author of this revenue ruling is Margaret A. Hogan of the Office of Associate Chief Counsel (International). For further information regarding this revenue ruling, contact Ms. Hogan at 202–622– 3850 (not a toll-free call).

(4) whether the analysis is affected by the course of dealing between P and its customer.

Comments should be submitted by April 21, 2003, either to:

Internal Revenue Service P.O. Box 7604 Ben Franklin Station Washington, DC 20044 Attn: CC:PA:T:CRU (CC:ITA:7) Room 5529

or electronically at: Notice.Comments@ irscounsel.treas.gov (the Service’s comments e-mail address). All comments are available for public inspection and copying. During its review of the comments, the Service will continue to process private letter ruling requests, including requests for consent to change a method of accounting.

DRAFTING INFORMATION

The principal author of this revenue ruling is John P. Moriarty of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Moriarty at (202) 622–4930 (not a tollfree call).

Section 901.—Taxes of Foreign Countries and of Possessions of United States

26 CFR 1.901–2: Income, war profits or excess profits tax paid or accrued. (Also sections 903; 1.903–1.)

Costa Rican income tax law; with- holding taxes. This ruling holds that certain Costa Rican taxes are noncreditable soak-up taxes under sections 901 and 903 of the Code. The ruling also serves as an official confirmation to the Costa Rican Tax Administration that these taxes are noncreditable in the United States.

Rev. Rul. 2003–8

ISSUE

Are the withholding taxes specified in Article 61 of the Costa Rican Income Tax Law creditable taxes under sections 901 and 903 of the Internal Revenue Code of 1986?

FACTS

Costa Rica’s income tax law imposes a withholding tax on various types of income paid to persons operating or residing outside of Costa Rica at rates specified in Costa Rican Income Tax Law Article 59. The Costa Rican Tax Administration has authority to grant a total or partial exemption from liability for withholding taxes on profits, dividends, social participation, interest, commissions, financial expenses, patents, royalties, reinsurance, consolidation and insurance premiums of all types referred to in Article 59. Costa Rican Income Tax Law art. 61. The exemption can be given if the persons who act as withholding or receiving agents, or the interested parties, prove, to the satisfaction of the Costa Rican Tax Administration, that the recipient of such income is not granted in the country in which it operates or resides any credit against its tax liability for the withholding tax that was paid to Costa Rica. Id. In order to claim an exemption under Article 61, the Costa Rican Tax Administration requires the foreign recipient or its withholding agent to provide certification from the tax authorities of the country in which the recipient operates or resides verifying that the tax is not creditable in that country. Costa Rican Income Tax Regulation art. 65.

LAW AND ANALYSIS

Section 901 of the Code allows a credit against United States income tax for the amount of any income, war profits, and excess profits taxes paid or accrued to any foreign country. Section 1.901–2(a)(1) of the Income Tax Regulations provides that a foreign levy is an income tax only if it is a tax, and if the predominant character of that tax is an income tax in the United States sense. Section 1.901–2(a)(3)(ii) provides that the predominant character of a foreign tax is that of an income tax in the United States sense only to the extent that liability for the tax is not dependent, by its terms or otherwise, on the availability of a credit for the tax against income tax liability to another country. Section 1.901–2(c)(1) provides that liability for foreign tax is dependent on the availability of a credit for the foreign tax against income tax liability to another country only if and to the extent that the for

January 21, 2003 290 2003–3 I.R.B.

the “unhedged” 60-day period requirement with respect to the prior transaction. The requirements are: (i) the prior transaction is closed during the taxable year or during the 30 days thereafter; (ii) the subsequent transaction is substantially similar to the prior transaction and would otherwise cause a constructive sale of the AFP; (iii) the subsequent transaction is closed before the 30th day after the close of the taxable year in which the prior transaction occurs; and (iv) the 60-day unhedged requirements of § 1259(c)(3)(A)(ii) and (iii) are met with respect to the subsequent transaction.

ANALYSIS

Short Sale 1

Short Sale 1 is described in § 1259(c)(1) and is closed before the end of the 30th day after 2002. In addition, A holds the 100 shares of X stock for the 60-day period beginning on the date Short Sale 1 is closed. During part of the 60-day period beginning on the date Short Sale 1 is closed, however, A ’s risk of loss with respect to X stock is reduced because A entered into Short Sale 2. Thus, Short Sale 1 fails the closed transaction exception unless the reestablished position exception causes Short Sale 2 to be disregarded.

Short Sale 2 is substantially similar to Short Sale 1, is entered into during the 60day period beginning on the date Short Sale 1 is closed, is described in § 1259(c)(1) and is closed by the deadline contained in § 1259(c)(3)(B)(ii)(II). In addition, A holds the 100 shares of X stock for the 60-day period beginning on the date Short Sale 2 is closed. During the 60-day period beginning on the date Short Sale 2 is closed, however, A ’s risk of loss with respect to X stock is reduced because A entered into Short Sale 3. Thus, the reestablished position exception does not cause Short Sale 2 to be disregarded unless the reestablished position exception also causes Short Sale 3 to be disregarded.

Short Sale 3 is substantially similar to Short Sale 2, is entered into during the 60day period beginning on the date Short Sale 2 is closed, is described in § 1259(c)(1) and is closed by the deadline contained in § 1259(c)(3)(B)(ii)(II). In addition, A holds the 100 shares of X stock for the 60-day period beginning on the date Short Sale 3 is closed, and during the 60-day period beginning on the date Short Sale 3 is closed,

Section 1259.—Constructive Sales Treatment for Appreciated Financial Positions

Constructive sales; reestablished po- sitions. This ruling provides guidance on the interaction between section 1259(c) (3)(A) of the Code (exception for certain closed transactions) and section 1259(c) (3)(B) (treatment of positions which are reestablished).

Rev. Rul. 2003–1

ISSUE

If a taxpayer enters into successive short sales of its entire appreciated financial position, must the taxpayer recognize gain pursuant to § 1259(a)(1) of the Internal Revenue Code if all of the short sales are closed before the 30th day after the end of the taxpayer’s taxable year and the entire appreciated financial position is held unhedged for a 60-day period beginning on the date on which the last of the short sales is closed?

FACTS

A is a calendar year taxpayer. On January 1, 2002, A owns 100 shares of stock in X Corporation ( X stock). On February 1, 2002, A enters into a short sale of 100 shares of X stock (Short Sale 1). In March of 2002, A purchases an additional 100 shares of X stock and delivers those shares to close Short Sale 1. On April 1, 2002, A enters into a second short sale of 100 shares of X stock (Short Sale 2). In May of 2002, A purchases an additional 100 shares of X stock and delivers those shares to close Short Sale 2. On June 3, 2002, A enters into a third short sale of 100 shares of X stock (Short Sale 3). On January 15, 2003, A purchases an additional 100 shares of X stock. Prior to the deadline contained in § 1259(c)(3)(B)(ii)(II), A delivers those shares to close Short Sale 3. A continues to hold the 100 shares of X stock during the 60-day period beginning on the date Short Sale 3 is closed. At all relevant times during that period, A ’s risk of loss with respect to the 100 shares of X stock is not reduced by reason of a circumstance described in § 1259(c)(3)(A)(iii). That is, the 100 shares of X stock are held “unhedged”

during the 60-day period. At all relevant times, the 100 shares of X stock are appreciated.

LAW

Section 1259(a)(1) provides that if there is a constructive sale of an appreciated financial position (AFP), the taxpayer must recognize gain as if the position were sold, assigned, or otherwise terminated at its fair market value on the date of the constructive sale. “Appreciated financial position” is defined in § 1259(b)(1) to include a position with respect to stock if there would be gain were the position sold, assigned, or otherwise terminated at its fair market value. Section 1259(c)(1)(A) treats a taxpayer as having made a constructive sale of an AFP if the taxpayer enters into a short sale of the same or substantially identical property.

Section 1259(c)(3)(A) provides an exception (closed transaction exception) to § 1259(a)(1) for certain closed transactions. The closed transaction exception disregards any transaction that would otherwise be treated as a constructive sale during the taxable year if: (i) the transaction is closed before the end of the 30th day after the close of the taxable year; (ii) the taxpayer holds the AFP throughout the 60-day period beginning on the date the transaction is closed; and (iii) at no time during the 60day period is the taxpayer’s risk of loss with respect to the position reduced by reason of a circumstance that would be described in § 246(c)(4) if references to stock included references to the position. That is, the taxpayer must hold the AFP “unhedged” for a 60-day period beginning on the date of the closing of the transaction that would otherwise be treated as a constructive sale.

If certain requirements are met, even though a subsequent risk-reducing transaction would otherwise prevent the closed transaction exception from applying to some prior transaction, § 1259(c)(3)(B) may cause the subsequent transaction to be disregarded for this purpose. In general, this rule (the reestablished positions exception) applies when a taxpayer closes out a transaction (the prior transaction) that would otherwise cause a constructive sale of an AFP and, during the 60-day period following the closing of the prior transaction, the taxpayer enters into a substantially similar transaction (the subsequent transaction) that, if not disregarded, would violate

2003–3 I.R.B. 291 January 21, 2003

that of A and enters into a series of transactions identical to those of A, and if the value of the 100 shares of X stock at the time of Short Sale 3 is higher than B ’s basis but lower than A ’s basis, then A would realize gain because of Short Sale 1 but B would not. Nothing in the statute or legislative history indicates that Congress intended this dissimilar treatment.

Second, requiring appreciation when A enters into subsequent transactions would treat A differently from a taxpayer, C, who enters into only Short Sale 1 and holds that short position open until the date Short Sale 3 is closed. Although C would have reduced risk for a longer period of time than A, Short Sale 1 would be a closed transaction that is not subject to § 1259(a) for C but would be subject to § 1259(a) for A . There also is nothing in the statute or legislative history indicating that Congress intended this dissimilar treatment.

Third, requiring appreciation when A enters into subsequent transactions would create circularity problems if the value of the AFP at the time of the later short sale is between the taxpayer’s original basis in the AFP and the value of the AFP at the time of the first short sale. In these cases, whether the later short sale is a disregarded transaction would depend on whether the first short sale produced a basis increase as a result of causing a constructive sale to occur, which would depend, in turn, on whether the later short sale is disregarded. As a consequence, many reestablished positions would fail to meet the requirement that they would otherwise be treated as a constructive sale if the existence of unrealized appreciation in the position were tested on the date of the subsequent transaction and, for this purpose, the prior transaction were treated, at least provisionally, as causing a constructive sale. Failure to treat the prior transaction as causing a constructive sale, at least provisionally, would result in the reestablished position failing to meet the requirement that the prior transaction “would otherwise be treated as a constructive sale.”

Consequently, ignoring changes in value of the AFP after the initial transaction occurs avoids unwarranted, differential application of the closed transaction exception and also avoids a potential circularity problem in the interpretation of the exception. When there is a series of more than two transactions, the foregoing analysis also ap

A ’s risk of loss with respect to X stock is not reduced. Accordingly, Short Sale 3 is disregarded as a reestablished position with respect to Short Sale 2, Short Sale 2 in turn is disregarded as a reestablished position with respect to Short Sale 1, and Short Sale 1, therefore, is treated as a closed transaction under § 1259(c)(3)(A).

Short Sale 2

The next question is whether Short Sale 2 causes a constructive sale or whether it too is disregarded for this purpose on the grounds that it is a closed transaction. The analysis supporting the application of that exception is similar to that for Short Sale

1. Short Sale 2 is described in § 1259(c)(1) and is closed before the end of the 30th day after 2002. In addition, A holds the 100 shares of X stock for the 60-day period beginning on the date Short Sale 2 is closed. During part of the 60-day period beginning on the date Short Sale 2 is closed, however, A ’s risk of loss with respect to X stock is reduced because A entered into Short Sale 3. Thus, Short Sale 2 fails the closed transaction exception unless Short Sale 3 is disregarded as a reestablished position. As noted above, Short Sale 3 is disregarded as a reestablished position with respect to Short Sale 2. Therefore, Short Sale 2 is also a closed transaction under § 1259(c)(3)(A).

Short Sale 3

Short Sale 3 is described in § 1259(c)(1) and is closed before the end of the 30th day after 2002. In addition, A holds the 100 shares of X stock for the 60-day period beginning on the date Short Sale 3 is closed. During the 60-day period beginning on the date Short Sale 3 is closed, A ’s risk of loss with respect to X stock is not reduced. Therefore, Short Sale 3 is a closed transaction under § 1259(c)(3)(A).

Rapid Series of Transactions

A entered into Short Sale 3 on June 3, 2002, more than 60 days after the date on which Short Sale 1 closed. If Short Sale 3 had occurred within that 60-day period, the analysis of Short Sale 1 would remain the same except that, for Short Sale 1 to be a closed transaction, Short Sale 3 would have to be a reestablished position not only with respect to Short Sale 2 but also with respect to Short Sale 1 directly. Thus, if A had

entered into Short Sale 2 on March 15, 2002, closed Short Sale 2 on March 18, 2002, entered into Short Sale 3 on March 20, 2002, and closed Short Sale 3 on March 25, 2002, Short Sale 3 would qualify to be disregarded as a reestablished position with respect to Short Sale 1 as well as with respect to Short Sale 2.

Decline in Value of the AFP

Section 1259(c)(3)(B)(ii)(I) describes a subsequent transaction that may be disregarded as one “which also would otherwise be treated as a constructive sale of [the AFP].” For the reasons explained below, this provision requires only that the subsequent transaction be a transaction described in § 1259(c)(1) that would cause a constructive sale of the AFP if the subsequent transaction occurred on the date of entering into the prior transaction. This provision does not require that the subsequent transaction independently would cause a constructive sale based on appreciation in the position at the time the subsequent transaction occurs. Thus, the conclusion in this ruling that Short Sale 1 is a closed transaction under § 1259(c)(3)(A) would apply even if the 100 shares of X stock had declined in value below A ’s basis at the time A entered into each subsequent transaction.

Requiring appreciation of the 100 shares of X stock owned by A at the time A enters into each subsequent transaction could cause Short Sale 1 to fail the closed transaction exception. For example, assume that on the date that A entered into Short Sale 3, the 100 shares of X stock still owned by A had declined in value below A ’s basis. If § 1259(c)(3)(B)(ii)(I) required that the X stock be appreciated at that time, Short Sale 3 would fail to be a disregarded, reestablished position with respect to Short Sale 2. If Short Sale 3 were not disregarded, then Short Sale 2 would fail the no-risk-reduction requirement in § 1259(c)(3)(A)(iii), which would then cause Short Sale 2 to fail as a disregarded, reestablished position with respect to Short Sale 1.

Requiring appreciation when A enters into subsequent transactions would create several unwarranted results. First, in certain circumstances it would treat more favorably a taxpayer, B, who has a lower tax basis and, therefore, a larger amount of unrealized appreciation. Thus, if B holds appreciated X stock with a basis lower than

January 21, 2003 292 2003–3 I.R.B.

plies to any of the intermediate transactions for purposes of determining whether the reestablished positions exception allows the intermediate transaction to benefit from the closed transaction exception.

HOLDING

Section 1259(c)(3)(A) applies to Short Sale 1, Short Sale 2, and Short Sale 3. Therefore, A does not recognize gain pursuant to § 1259(a)(1).

DRAFTING INFORMATION

The principal author of this revenue ruling is Kate Sleeth of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact Ms. Sleeth at (202) 622–3920 (not a tollfree call).

Section 4975.—Tax on Pro- hibited Transactions

26 CFR 54–4975–11: “ESOP” requirements.

Whether an S corporation ESOP is eligible for the

delayed effective date of section 409(p) of the Inter nal Revenue Code as added by section 656(d)(2) of

the Economic Growth and Tax Relief Reconcilia tion Act of 2001. See Rev. Rul. 2003–6, page 286.

Section 4979A.—Tax on Cer- tain Prohibited Allocations of Qualified Securities

Whether transactions involving an S corporation ESOP and the delayed effective date of section 409(p) of the Internal Revenue Code, as added by section

656(d)(2) of the Economic Growth and Tax Relief

Reconciliation Act of 2001, may give rise to the excise tax on the prohibited allocation of qualified securities. See Rev. Rul. 2003–6, page 286.

Section 6011.—General Re- quirement of Return, State- ment, or List

26 CFR 1.6011–4T: Requirement of statement dis- closing participation in certain transactions by corporate taxpayers.

Whether transactions involving an S corporation ESOP and the delayed effective date of section 409(p) of the Internal Revenue Code, as added by section 656(d)(2) of the Economic Growth and Tax Relief Reconciliation Act of 2001, are listed transactions. See Rev. Rul. 2003–6, page 286.

Section 6111.—Registration of Tax Shelters

26 CFR 301.6111–2T: Confidential corporate tax shelters.

Whether transactions involving an S corporation

ESOP and the delayed effective date of section 409(p)

of the Internal Revenue Code, as added by section

656(d)(2) of the Economic Growth and Tax Relief

Reconciliation Act of 2001, are listed transactions. See

Rev. Rul. 2003–6, page 286.

Section 6112.—Organizers and Sellers of Potentially Abu- sive Tax Shelters Must Keep Lists of Investors

26 CFR 301.6112–1T: Questions and answers re- lating to the requirement to maintain a list of in- vestors in potentially abusive tax shelters.

Whether a list must be maintained identifying each

person who was sold an interest in transactions involving an S corporation ESOP and the delayed ef fective date of section 409(p) of the Internal Revenue

Code, as added by section 656(d)(2) of the Economic Growth and Tax Relief Reconciliation Act of 2001. See Rev. Rul. 2003–6, page 286.

2003–3 I.R.B. 293 January 21, 2003