Part I. Rulings — Internal Revenue Bulletin 2003-21

jor medical plan with a $15 physician’s office visit copayment. When Employee A uses the card to satisfy the copayment requirement, the system matches the amount of the transaction, $15, with the copayment under Employee A’s coverage and the fact that the transaction is at a physician’s office.

Second, Employer N permits automatic reimbursement, without further review, of recurring expenses that match expenses previously approved as to amount, provider, and time period ( e.g., for an employee who refills a prescription drug on a regular basis at the same provider for the same amount).

Third, if the merchant, service provider, or other independent third-party ( e.g., Pharmacy Benefit Manager), at the time and point of sale, provides information to verify to Employer N (including electronically by e-mail, the internet, intranet, or telephone) that the charge is for a medical expense, the charge is fully substantiated without the need for submission of a receipt or further review ( i.e., “real-time substantiation”). For example, Employee A fills a prescription at a pharmacy. The Pharmacy Benefit Manager under Employee A’s major medical coverage provides information that $37.85 of the cost of the prescription is a medical expense that is not covered by the major medical coverage. Because the information about the medical expense, $37.85, matches the amount of the transaction, the transaction is substantiated. The transaction would also be fully substantiated where, for example, treatment at a physician’s office results in charges in addition to the copayment and, after obtaining authorization for the card, the provider is prompted to enter treatment codes and charges. The additional third-party information regarding the type of care, date of service, and amount provides substantiation of the expense without the need for further review.

Employer N’s procedures provide that all charges to the card, other than copayments, recurring expenses, and real-time substantiation as described above, are treated as conditional pending confirmation of the charge. Thus, Employer N requires that additional third-party information, such as

Section 105.—Amounts Received Under Accident and Health Plans

(Also Section 106, 125.)

Health plans. This ruling sets forth the rules regarding the use of debit and credit cards to reimburse participants in selfinsured medical reimbursement plans.

Rev. Rul. 2003–43

ISSUE

Whether, under the facts described, employer-provided expense reimbursements made through debit or credit cards and other electronic media are excludable from gross income under § 105 of the Internal Revenue Code.

FACTS

Situation 1. Employer N sponsors one or more major medical plans for employees that provide coverage under accident and health insurance. Each plan has a fixed copayment amount ( e.g., a $15 copayment for physician office visits). Employer N also sponsors both a health flexible spending arrangement (health FSA) and a health reimbursement arrangement (HRA). The health FSA and the HRA reimburse the uninsured medical care expenses of all participating employees and their spouses and dependents up to a maximum reimbursement amount that is fixed at the beginning of each year. The health FSA is paid pursuant to salary reduction elections under Employer N’s § 125 cafeteria plan. The HRA is paid by Employer N and employees make no salary reduction election to pay for the HRA. The HRA plan document specifies that coverage under the HRA is available only after expenses exceeding the dollar amount elected under the § 125 health FSA have been paid from the health FSA. Both the health FSA and the HRA meet the nondiscrimination requirements of § 105(h).

In conjunction with the health FSA and the HRA, Employer N permits electronic reimbursement of medical expenses through the use of a debit card or stored-value card (“card”). Under the arrangement adopted by Employer N, each participating employee

is issued a card and certifies upon enrollment in the health FSA and HRA and each plan year thereafter that the card will only be used for eligible medical care expenses, as defined in § 213(d), of the employee and the employee’s spouse and dependents. The employee also certifies that any expense paid with the card has not been reimbursed and that the employee will not seek reimbursement under any other plan covering health benefits. An employee-cardholder understands that the certification, which is printed on the back of the card, is reaffirmed each time the card is used. The cardholder also agrees to acquire and retain sufficient documentation for any expense paid with the card, including invoices and receipts where appropriate. The card is automatically cancelled at termination of employment.

The cardholder’s use of the card is limited to the maximum dollar amount of coverage available in the cardholder’s health FSA or HRA. As described below, the card is ineffective except at those merchants and service providers authorized by Employer N, so that the use of the card at other merchants or service providers would be rejected. Employer N limits the card’s use to specified Merchant Codes relating to health care. Thus, the card’s use is limited to physicians, pharmacies, dentists, vision care offices, hospitals, and other medical care providers. When a cardholder uses the card at the point-of-sale, the merchant or service provider is paid the full amount of the charge (assuming there is sufficient coverage available in the health FSA or HRA), and the cardholder’s maximum available coverage remaining is reduced by that amount.

To provide assurance that only eligible medical expenses are reimbursed, Employer N has established, in the health FSA and HRA documents, the following procedures for substantiating claimed medical expenses after the use of the card.

First, if the dollar amount of the transaction at a health care provider equals the dollar amount of the copayment for that service under the major medical plan of the specific employee-cardholder, the charge is fully substantiated without the need for submission of a receipt or further review. For example, Employee A is enrolled in a ma

2003–21 I.R.B. 935 May 27, 2003

merchant or service provider is paid the full amount of the charge by the sponsoring bank.

Employer R utilizes substantiation methods identical to those of Employer N in Situation 1, so that copayments, recurring expenses, and real-time substantiation need no further review. Employer R treats all other charges to the card as conditional pending confirmation of the medical expense. If the claim is approved, the employee’s maximum available coverage in the health FSA or HRA is reduced by that amount and Employer R repays the sponsoring bank. If the employee fails to provide substantiation of the medical expense or the claim is denied, Employer R repays the sponsoring bank and the employee becomes liable to Employer R for the charge. To recoup amounts that have been identified as improper payments, Employer R has adopted the same correction procedures as those utilized by Employer N in Situation 1. Also, as described in Situation 1, an employee may obtain benefits under the health FSA or HRA without the use of the credit card.

LAW AND ANALYSIS

Section 61(a)(1) and § 1.61–21(a)(3) of the Income Tax Regulations provide that, except as otherwise provided in subtitle A, gross income includes compensation for services, including fees, commissions, fringe benefits, and similar items.

Section 106 provides that “gross income of an employee does not include employer-provided coverage under an accident or health plan.” Section 1.106–1 provides that the gross income of an employee does not include contributions which the employee’s employer makes to an accident or health plan for compensation (through insurance or otherwise) for personal injuries or sickness to the employee or the employee’s spouse or dependents (as defined in § 152).

Section 105(a) provides that “amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.”

Section 105(e) states that amounts received under an accident or health plan for

merchant or service provider receipts, describing (1) the service or product, (2) the date of the service or sale and, (3) the amount, be submitted for review and substantiation.

An employee may also obtain benefits under the health FSA or HRA without the use of the card by submitting to Employer N either an Explanation of Benefits (EOB) received from a health insurance provider or a receipt from a merchant or service provider showing that funds are owed for an eligible medical expense ( e.g., on a deductible). In this case, Employer N pays the merchant or service provider directly. Alternatively, an employee may pay the merchant or service provider directly and submit a claim for reimbursement, including thirdparty information supporting the claim.

Under Employer N’s card arrangement, a few of the claims that have been reimbursed are subsequently identified as not qualifying for reimbursement. As a result, Employer N has adopted, in the health FSA and HRA plan documents, all of the following correction procedures with respect to the improper payments. First, upon identifying an improper payment, Employer N requires the employee to pay back to the plan an amount equal to the improper payment. Second, where this proves unsuccessful, Employer N has the amount of the improper payment withheld from the employee’s wages or other compensation to the extent consistent with applicable law. Third, if the improper payment still remains outstanding, Employer N utilizes a claims substitution or offset approach to resolve improper claims. For example, if Employee A has received an improper reimbursement of $200 and subsequently submits a substantiated claim incurred during the same coverage period, no reimbursement is made until the improper payment is fully recouped. In addition to the above, Employer N takes other actions to ensure that further violations of the terms of the card do not occur, including denial of access to the card until the indebtedness is repaid by the employee.

If these correction efforts prove unsuccessful, or are otherwise unavailable, the employee remains indebted to Employer N for the amount of the improper payment. In that event and consistent with its business practices, Employer N treats the payment as it would any other business indebtedness.

Situation 2. The facts are the same as Situation 1, except that Employer P’s procedures utilize sampling techniques based on transaction amounts. For example, Employer P reviews 20% of dental office transactions paid with the card that have not been otherwise substantiated and are above $100 on the assumption that no dental cosmetic procedures are available for less than $100. Also, Employer P reviews a smaller percentage ( e.g., 5%) of physician office transactions paid with the card that have not been otherwise substantiated and are below $150 on the assumption that almost all such charges are for eligible medical care. In addition, Employer P does not review any card transaction below a low dollar threshold ( e.g., $25) or where the amount of the transaction is a multiple of a specified whole-dollar amount ( e.g., $5, $10, $15, etc.) on the assumption that these latter amounts are copayments. Only those payments selected for review are required to be substantiated by submission of merchant or service provider receipts. Thus, Employer P does not substantiate all reimbursements made through the card.

Situation 3. Employer R sponsors major medical plans, a health FSA, and an HRA for employees. The health FSA and the HRA meet the nondiscrimination requirements of § 105(h). In conjunction with the health FSA and the HRA, Employer R has entered into an agreement with a sponsoring bank to issue to each participating employee a credit card with individual limits equaling the coverage available in the health FSA or HRA. As in Situation 1, Employer R requires each employee to certify upon enrollment in the plans (which is reaffirmed upon each use of the credit card) that the card will only be used for eligible medical care expenses and that any medical expense paid with the card has not been reimbursed and the employee will not seek reimbursement under any other plan covering health benefits. In addition, as in Situation 1, the credit card is usable only at a merchant or service provider with a specified Merchant Code relating to health care. Pursuant to the agreement between Employer R and the sponsoring bank, Employer R agrees to be liable to the sponsoring bank for all charges made with the credit card against the line of credit. When the card is used at the point-of-sale, the

May 27, 2003 936 2003–21 I.R.B.

to the employee whether or not the employee incurs medical expenses. See § 1.105–2

Not all health-related expenses qualify for tax-free treatment under § 105(b). Only amounts that are paid specifically to reimburse eligible medical care expenses as defined in § 213(d) receive tax-favored treatment. Therefore, to provide certainty that a particular expense is for medical care within the meaning of § 213(d), all claims for expense reimbursements must be substantiated. However, § 105(b) does not specify the method of substantiation. The procedures adopted by Employer N in Situation 1 with respect to the electronic reimbursement of medical expenses meet the requirements of § 105(b). First, Employer N requires a certification upon enrollment and a reaffirmation upon each use of the card, as printed on the back, that the card will only be used for eligible medical care expenses. Second, reimbursements for medical expenses are processed only if they originate with certain vendors having health care related Merchant Codes. Third, Employer N’s procedures provide that every claim is reviewed and substantiated, either automatically without additional documentation or manually through the submission of merchant or service provider receipts. Fourth, Employer N has adopted meaningful correction procedures for claims that are subsequently identified as impermissible. These procedures meet the requirements of § 105(b) and the same conclusion applies to the procedures adopted by Employer R in Situation 3.

In contrast, the sampling techniques adopted by Employer P in Situation 2 do not provide that every claim is substantiated. Thus, because Employer P’s procedures, by plan design, do not specifically limit reimbursements or payments of claims to eligible medical expenses, the procedures do not meet the requirements of § 105(b).

HOLDING

Employer-provided expense reimbursements made through debit or credit cards and other electronic media, as described in Situation 1 and Situation 3, are excludable from gross income under § 105(b). Employer-provided expense reimbursements, as described in Situation 2, are not excludable from gross income under § 105(b) because the payments are made ir

employees are treated as amounts received through accident or health insurance for purposes of § 105. Section 1.105–5(a) provides that an accident or health plan is an arrangement for the payment of amounts to employees in the event of personal injuries or sickness. Thus, amounts that are paid to an employee regardless of whether the employee incurs expenses for medical care or suffers a personal injury or sickness are not received under an accident or health plan.

Section 105(b) states that, except in the case of amounts attributable to (and not in excess of) deductions allowed under § 213 (relating to medical expenses) for any prior taxable year, gross income does not include amounts referred to in § 105(a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by the taxpayer for the medical care (as defined in § 213(d)) of the taxpayer or the taxpayer’s spouse or dependents (as defined in § 152).

Section 1.105–2 provides that only amounts that are paid specifically to reimburse the taxpayer for expenses incurred by the taxpayer for the prescribed medical care are excludable from gross income. Section 105(b) does not apply to amounts that the taxpayer would be entitled to receive irrespective of whether or not the taxpayer incurs expenses for medical care. Accordingly, if an employee is not paid specifically to reimburse medical care expenses but is entitled to receive the payment irrespective of whether any medical expenses have been incurred, none of those payments are excludable from gross income under § 105(b) whether or not the employee has incurred medical expenses during the year.

Under § 125, an employer may establish a cafeteria plan that permits an employee to choose among two or more benefits, consisting of cash (generally, salary) and qualified benefits, including accident or health coverage. Pursuant to § 125, the amount of an employee’s salary reduction applied to purchase such coverage is not included in gross income, even though it is available to the employee and the employee could have chosen to receive cash instead. If an employee elects salary reduction pursuant to § 125, the accident and health coverage is excludable from gross income under § 106 as employer-provided accident or health coverage.

Q&A–7(a) of § 1.125–2 of the Proposed Income Tax Regulations states that health plans that are FSAs must conform to the generally applicable rules under §§ 105 and 106 in order for the coverage and reimbursements to qualify for tax-favored treatment. Thus, health FSAs must qualify as accident or health plans and reimbursements must be paid specifically to reimburse the participant for medical expenses incurred previously during the period of coverage.

Q&A–7(b)(5) of § 1.125–2 addresses claims substantiation for health FSAs and provides that a health FSA may reimburse a medical expense only if the participant provides a written statement from an independent third-party stating that the medical expense has been incurred and the amount of such expense and the participant also provides a written statement that the medical expense has not been reimbursed or is not reimbursable under any other health plan coverage.

Part 1 of Notice 2002–45, 2002–28 I.R.B. 93, describes an HRA as an arrangement that: (1) is paid for solely by the employer and not pursuant to salary reduction; (2) reimburses the employee for medical care expenses as defined in § 213(d); and (3) provides that any unused portion of the maximum dollar amount available during the coverage period is carried forward to subsequent coverage periods. Part 2 of the notice provides that to qualify for the exclusion under §§ 106 and 105, an HRA may only provide benefits that reimburse § 213(d) medical expenses and that each medical expense submitted for reimbursement must be substantiated.

Rev. Rul. 2002–80, 2002–49 I.R.B. 925, describes plans in which amounts are automatically paid to an employee as “advance reimbursements” or “loans” of uninsured medical expenses. The employer treats the “advance reimbursements” or “loans” as an indebtedness that is forgiven by the end of the year or upon termination of employment. In addition, to the extent an employee does not have uninsured medical expenses equal to the “advance reimbursements” or “loans,” the excess payments to the employee are included in gross income. The ruling holds that the exclusion from gross income under § 105(b) does not apply to these plans because the “advance reimbursements” or “loans” are paid

2003–21 I.R.B. 937 May 27, 2003

second corporation, and immediately thereafter, the transferor and the third party are in control of the second corporation.

FACTS

Corporation W, a domestic corporation, engages in businesses A, B, and C. The fair market values of businesses A, B, and C are $40x, $30x, and $30x, respectively. X, a domestic corporation unrelated to W, also engages in business A through its wholly owned domestic subsidiary, Y. The fair market value of X’s Y stock is $30x. W and X desire to consolidate their business A operations within a new corporation in a holding company structure. Pursuant to a prearranged binding agreement with X, W forms a domestic corporation, Z, by transferring all of its business A assets to Z in exchange for all of the stock of Z (the “first transfer”). Immediately thereafter, W contributes all of its Z stock to Y in exchange for stock of Y (the “second transfer”). Simultaneous with the second transfer, X contributes $30x to Y to meet the capital needs of business A after the restructuring in exchange for additional stock of Y (the “third transfer”). After the second and third transfers, Y transfers the $30x and its business A assets to Z (the “fourth transfer”). After the second and third transfers, W and X own 40 percent and 60 percent, respectively, of the outstanding stock of Y. Viewed separately, each of the first transfer, the combined second and third transfers, and fourth transfer qualifies as a transfer described in § 351.

LAW

Section 351(a) provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in § 368(c)) of the corporation.

Section 368(c) defines control to mean the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.

Section 1.351–1(a)(1) of the Income Tax Regulations provides that the phrase “immediately after the exchange” does not nec

respective of whether any medical expenses have been incurred. Thus, in Situation 2, all payments made during the year, including amounts paid to reimburse medical expenses, are included in the gross income of the employee.

SCOPE

This ruling addresses only issues under the specific Code sections mentioned. No inference is intended as to any other section of the Internal Revenue Code.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 2002–80 is distinguished because in that ruling, unlike Situations 1 and 3, a payment is made in advance and irrespective of the employee incurring a medical expense. In Situations 1 and 3, a payment is made concurrent with the employee incurring a medical expense that is substantiated. Final regulations under § 125 will reflect the modifications to the rules concerning claims substantiation of health FSA expenses as set forth in this revenue ruling.

FORM 1099 CONSIDERATION

Under the facts described, payments made to medical service providers through the use of debit, credit, and stored-value cards are reportable by the employer on Form 1099–MISC under § 6041. Section 6041 provides for information reporting by persons engaged in a trade or business who make payments of fixed or determinable income to another person in the course of such trade or business of $600 or more in a taxable year. The exceptions provided in § 1.6041–3 may apply to this requirement, such as the exception for payments to taxexempt hospitals.

EFFECTIVE DATE

The holding in Situation 2 is effective for plan years beginning after December 31, 2003.

COMMENTS REQUESTED

The Service requests comments on sampling techniques or statistical approaches, other than those described in Situation 2, that may be used by employers in identifying types of transactions that should be deemed to be substantiated. The method

ology proposed should demonstrate that the outcome of measures selected provide a high degree of certainty sufficient to constitute substantiation that the employee has incurred a medical expense. Send comments to: CC:PA:RU (Rev. Rul. 2003– 43), Room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Comments may be handdelivered between the hours of 8 a.m. and 4 p.m. to: CC:PA:RU (Rev. Rul. 2003– 43), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. In the alternative, taxpayers may submit comments electronically at: Notice.Comments@irscounsel. treas.gov . All comments will be available for public inspection.

DRAFTING INFORMATION

The principal author of this revenue ruling is Barbara E. Pie of the Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). For further information regarding this revenue ruling, contact Ms. Pie at (202) 622–6080 (not a toll-free call).

Section 351.—Transfer to Corporation Controlled by Transferor

26 CFR 1.351–1: Transfer to corporation controlled by transferor.

Transfer to corporation. This ruling provides guidance regarding the control requirement under section 351 of the Code involving successive transfers of property and stock. Rev. Ruls. 70–140, 70–522, 79– 70, and 79–194 distinguished.

Rev. Rul. 2003–51

ISSUE

Whether a transfer of assets to a corporation (the “first corporation”) in exchange for an amount of stock in the first corporation constituting control satisfies the control requirement of § 351 of the Internal Revenue Code if, pursuant to a binding agreement entered into by the transferor with a third party prior to the exchange, the transferor transfers the stock of the first corporation to another corporation (the “second corporation”) simultaneously with the transfer of assets by the third party to the

May 27, 2003 938 2003–21 I.R.B.

the other transfers, the first transfer would satisfy the technical requirements of a transfer under § 351 because W transfers property to Z in exchange for stock in Z and, immediately after the exchange, W is in control of Z. However, because the first and second transfers are undertaken pursuant to a prearranged binding agreement, it is necessary to determine whether the second transfer causes the first transfer to fail to satisfy the control requirement of § 351.

“Section 351 has been described as a deliberate attempt by Congress to facilitate the incorporation of ongoing businesses and to eliminate any technical constructions which are economically unsound.” Hempt Bros., Inc. v. United States, 490 F.2d 1172, 1177 (3d Cir.), cert. denied, 419 U.S. 826 (1974). Section 351(a) is intended to apply to “certain transactions where gain or loss may have accrued in a constitutional sense, but where in a popular and economic sense there has been a mere change in the form of ownership and the taxpayer has not really ‘cashed in’ on the theoretical gain, or closed out a losing venture.” Portland Oil Co. v. Commissioner, 109 F.2d 479, 488 (1st Cir.), cert. denied, 310 U.S. 650 (1940). See S. Rep. No. 67–275, at 12 (1921) (explaining that the predecessor to § 351 was enacted in 1921 to “permit business to go forward with the readjustments required by existing conditions”). A transaction described under § 351 “lacks a distinguishing characteristic of a sale, in that, instead of the transaction having the effect of terminating or extinguishing the beneficial interests of the transferors in the transferred property, . . . the transferors continue to be beneficially interested in the transferred property and have dominion over it by virtue of their control of the new corporate owner of it.” American Compress & Ware- house Co. v. Bender, 70 F.2d 655, 657 (5th Cir.), cert. denied, 293 U.S. 607 (1934).

As described above, courts have held that the control requirement of § 351 is not satisfied where, pursuant to a binding agreement entered into by the transferor prior to the transfer of property to the corporation in exchange for stock, the transferor loses control of the corporation by a taxable sale of all or part of that stock to a third party that does not also transfer property to the corporation in exchange for stock. Treating a transfer of property that is followed by such a prearranged sale of the stock received as a transfer described in § 351 is

essarily require simultaneous exchanges by two or more persons, but comprehends a situation where the rights of the parties have been previously defined and the execution of the agreement proceeds with an expedition consistent with orderly procedure.

Courts have held that the control requirement of § 351 is not satisfied where, pursuant to a binding agreement entered into by the transferor prior to the transfer of property to the corporation in exchange for stock, the transferor loses control of the corporation by a taxable sale of all or part of that stock to a third party who does not also transfer property to the corporation in exchange for stock. See, e.g., S. Klein on the Square, Inc. v. Commissioner, 188 F.2d 127 (2d Cir.), cert. denied, 342 U.S. 824 (1951); Hazeltine Corp. v. Commissioner, 89 F.2d 513 (3d Cir. 1937); Intermountain Lum- ber Co. v. Commissioner, 65 T.C. 1025 (1976). The Service has reached the same conclusion when addressing similar facts. See Rev. Rul. 79–194, 1979–1 C.B. 145; Rev. Rul. 79–70, 1979–1 C.B. 144; Rev. Rul. 70–522, 1970–2 C.B. 81.

In Rev. Rul. 70–140, 1970–1 C.B. 73, A, an individual, owns all of the stock of corporation X and operates a business similar to that of X through a sole proprietorship. Pursuant to an agreement between A and Y, an unrelated, widely held corporation, A transfers all of the assets of the sole proprietorship to X in exchange for additional shares of X stock. A then transfers all his X stock to Y solely in exchange for voting common stock of Y. The ruling reasons that because the two steps of the transaction are parts of a prearranged plan, they may not be considered independently of each other for federal income tax purposes. The ruling concludes that A’s receipt of the X stock in exchange for the sole proprietorship assets is transitory and without substance for tax purposes because it is apparent that the assets of the sole proprietorship are transferred to X to enable Y to acquire those assets without the recognition of gain to A. Accordingly, the ruling treats A as transferring its sole proprietorship assets directly to Y in a transfer to which § 351 does not apply, and Y as transferring these assets to X, independently of A’s transfer of the X stock to Y in exchange for Y voting stock. The exchange by A of the stock of X solely for voting

stock of Y constitutes an exchange to which § 354 applies. See also § 1.1361–5(b)(3), Example 9 .

In Rev. Rul. 77–449, 1977–2 C.B. 110, amplified by Rev. Rul. 83–34, 1983–1 C.B. 79, and Rev. Rul. 83–156, 1983–2 C.B. 66, a corporation transfers assets to a wholly owned subsidiary, which in turn transfers, as part of the same plan, the same assets to its own wholly owned subsidiary. The ruling states that the transfers should be viewed separately for purposes of § 351. Because each transfer satisfies the requirements of § 351, no gain or loss is recognized by the transferor.

In Rev. Rul. 83–34, corporation P owns 80 percent of the stock of a subsidiary, S1. An unrelated corporation owns the remaining 20 percent. P transfers assets to S1 solely in exchange for additional shares of S1 stock. As part of the same plan, S1 transfers the same assets to S2, a newly formed corporation of which S1 will be an 80 percent shareholder. An unrelated corporation will own the remaining 20 percent of the S2 stock. Citing Rev. Rul. 77– 449, the ruling concludes that the transfers should be viewed separately for purposes of § 351 and that each transfer satisfies the requirements of § 351.

In Rev. Rul. 84–111, 1984–2 C.B. 88, Situation 1, a partnership transfers all of its assets to a newly formed corporation in exchange for all the outstanding stock of the corporation and the assumption by the corporation of the partnership’s liabilities. The partnership then terminates by distributing all the stock of the corporation to the partners in proportion to their partnership interests. The steps undertaken by the partnership were parts of a plan to transfer the partnership operations to a corporation organized for valid business reasons in exchange for its stock and were not devices to avoid or evade recognition of gain. The ruling concludes that, under § 351, the partnership recognizes no gain or loss on the transfer of its assets to the corporation in exchange for the corporation’s stock and the corporation’s assumption of the partnership’s liabilities, notwithstanding the partnership’s subsequent distribution of the corporation’s stock to the partners and consequent loss of control within the meaning of § 368(c) of the corporation.

ANALYSIS

As described above, if the first transfer were viewed as separate from each of

2003–21 I.R.B. 939 May 27, 2003

ACTION: Final regulations.

SUMMARY: This document contains final regulations that provide a new method to be used for calculating the net income attributable to IRA contributions that are distributed as a returned contribution pursuant to section 408(d)(4) of the Internal Revenue Code (Code) or recharacterized pursuant to section 408A(d)(6). These regulations will affect IRA owners and IRA trustees, custodians, and issuers.

DATES: Effective Date: These final regulations are effective on May 5, 2003.

Applicability Date: These final regulations are applicable for calculating income allocable to IRA contributions made on or after January 1, 2004.

FOR FURTHER INFORMATION CONTACT: Cathy Vohs at (202) 622–6090.

SUPPLEMENTARY INFORMATION:

Background

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

under Code sections 408 and 408A. These regulations provide a new method for calculating the net income attributable to IRA contributions that are distributed as a returned contribution pursuant to section 408(d)(4) or recharacterized pursuant to section 408A(d)(6).

Section 408(d)(4) provides that an IRA contribution will not be included in the IRA owner’s gross income when distributed as a returned contribution if: (1) it is received by the IRA owner on or before the day prescribed by law (including extensions) for filing the owner’s federal income tax return for the year of the contribution; (2) no deduction is allowed with respect to the contribution; and (3) the distribution is accompanied by the amount of net income attributable to the contribution.

Section 408A(d)(6) provides that a contribution made to one type of IRA may be recharacterized as having been made to another type of IRA if: (1) the recharacterization transfer occurs on or before the date prescribed by law (including extensions) for filing the IRA owner’s federal income tax return for the year for which the contribution was made; (2) no deduction is allowed with respect to the contribution to the trans

not consistent with Congress’ intent in enacting § 351 to facilitate the rearrangement of the transferor’s interest in its property. Treating a transfer of property that is followed by a nontaxable disposition of the stock received as a transfer described in § 351 is not necessarily inconsistent with the purposes of § 351. Accordingly, the control requirement may be satisfied in such a case, even if the stock received is transferred pursuant to a binding commitment in place upon the transfer of the property in exchange for stock. For example, in Rev. Rul. 84–111, Situation 1, the partnership’s transfer of property to the transferee corporation qualified as a transfer described in § 351, even though the partnership relinquished control of the transferee corporation within the meaning of § 368(c) pursuant to a prearranged plan to transfer the transferee stock.

In Rev. Rul. 70–140, the transfer of assets to the transferor’s wholly owned subsidiary followed by an exchange of stock of the wholly owned subsidiary for stock of another corporation was recast as a direct transfer of assets to the unrelated, widely held corporation in a taxable transaction. In Rev. Rul. 70–140, there was no alternative form of transaction that would have qualified for nonrecognition treatment. In contrast, in this case, W’s transfer of the business A assets to Z was not necessary for W and X to combine their business A assets in a holding company structure in a manner that would have qualified for nonrecognition of gain or loss under § 351. A transfer of W’s business A assets to Y in exchange for Y stock as part of a plan that included X’s transfer of $30x to Y in exchange for Y stock, and Y’s transfer of the business A assets and $30x to Z in exchange for all of the Z stock, would have qualified as successive transfers described in § 351. See Rev. Rul. 83–34; Rev. Rul. 77–449. Accordingly, in these circumstances, Rev. Rul. 70–140 is distinguishable.

In this case, even though the first transfer is followed by a transfer of the stock received, treating the first transfer as a transfer described in § 351 is not inconsistent with the purposes of § 351. Accordingly, the sec

ond transfer will not cause the first transfer to fail to satisfy the control requirement of § 351.

HOLDING

A transfer of assets to the first corporation in exchange for an amount of stock in the first corporation constituting control satisfies the control requirement of § 351 even if, pursuant to a binding agreement entered into by the transferor with a third party prior to the exchange, the transferor transfers the stock of the first corporation to the second corporation simultaneously with the transfer of assets by the third party to the second corporation, and immediately thereafter, the transferor and the third party are in control of the second corporation.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 79–194, 1979–1 C.B. 145, Rev. Rul. 79–70, 1979–1 C.B. 144, Rev. Rul. 70–522, 1970–2 C.B. 81, and Rev. Rul. 70–140, 1970–1 C.B. 73, are distinguished.

DRAFTING INFORMATION

The principal author of this revenue ruling is Lisa K. Leong of the Office of Associate Chief Counsel (Corporate). For further information regarding this revenue ruling, contact Ms. Leong at (202) 622– 7530 (not a toll-free call).

Section 408.—Individual Retirement Accounts

26 CFR 1.408–4: Treatment of distributions from individual retirement arrangements.

T.D. 9056

DEPARTMENT OF THE TREASURY Internal Revenue Service (IRS) 26 CFR Part 1

Earnings Calculation for Returned or Recharacterized IRA Contributions

AGENCY: Internal Revenue Service (IRS), Treasury.

May 27, 2003 940 2003–21 I.R.B.

Explanation of Provisions

These final regulations retain, without change, the methods provided in the proposed regulations. Thus, under these final regulations, for purposes of returned contributions under section 408(d)(4) and recharacterized contributions under section 408A(d)(6), the net income attributable to a contribution is determined by allocating to the contribution a pro-rata portion of the net income on the assets in the IRA (whether positive or negative) during the period the IRA held the contribution. This new method is represented by the following formula:

feror IRA; and (3) the transfer is accompanied by any net income allocable to the contribution.

Notice 2000–39, 2000–2 C.B. 132, provided a new method for calculating net income that generally based the calculation of the amount of net income attributable to a contribution on the actual earnings and losses of the IRA during the time it held the contribution, and provided that under the new method, net income could be negative. Notice 2000–39 provided that until further guidance is issued, either the old method ( i.e., the method specified in

§1.408–4(c)(2)(ii)) or the new method may be used to calculate net income.

Proposed regulations under sections 408 and 408A were published in the Federal Register on July 23, 2002 (REG–124256– 02, 2002–33 I.R.B. 383 [67 FR 48067]). These proposed regulations incorporated, with certain modifications, the new method provided in Notice 2000–39. The public reaction to Notice 2000–39 was generally favorable and few comments were received on the proposed regulations. Consequently, these final regulations adopt the rules in the proposed regulations without modification.

Net Income = Contribution x (Adjusted Closing Balance - Adjusted Opening Balance)

Adjusted Opening Balance.

Under the final regulations, generally, the adjusted opening balance means the fair market value of the IRA at the beginning of the computation period plus the amount of any contributions or transfers made to the IRA during the computation period. A special rule is provided for an IRA asset that is not normally valued on a daily basis. In this case, the fair market value of the asset at the beginning of the computation period is deemed to be the most recent, regularly determined, fair market value of the asset, determined as of a date that coincides with or precedes the first day of the computation period. One commentator suggested that the application of this special rule be extended to all IRA assets as an alternate fair market value determination so that the value of an IRA at the beginning of the computation period could be the most recent statement value just prior to the contribution, rather than the actual value on the exact date of the contribution.

The final regulations do not extend the special valuation rule to all IRA assets because the IRS and Treasury believe that if an IRA asset is normally valued on a daily basis, these values must be used so that the calculation of the amount of net income attributable to a contribution is based on the actual earnings and losses of the IRA during the time it held the contribution. The alternate rule suggested by the commentator would increase the chances of producing anomalous results because account activity in the part of the year that pre

cedes the date the contribution was made would be taken into account in the calculation of the net income attributable to the contribution.

One commentator suggested that where both regular Roth IRA contributions and conversion contributions have been made to the same Roth IRA, the net income calculation attributable to a recharacterization of a conversion contribution may require that some of the regular Roth IRA contributions be recharacterized to the traditional IRA. The commentator recommended that if a conversion contribution is being recharacterized, and the Roth IRA contains both regular contributions and conversion contributions, the final rules should permit the principal amount of any regular Roth IRA contributions in that same Roth IRA to remain in the Roth IRA.

The final regulations retain the rule, without modification, that net income calculations and allocations must be based on the overall value of an IRA and the dollar amounts contributed, distributed or recharacterized to or from the IRA. Even in a recharacterization of an amount converted to a Roth IRA where the Roth IRA contains both regular contributions and conversion contributions, the final regulations do not permit net income, including any losses, to be allocated other than pro rata . Thus, the principal amount of regular Roth IRA contributions cannot be protected against adjustment for their pro rata share of net income, including any net

losses, during the computation period. Once contributions are commingled in an account, those dollars are no longer associated with particular assets or contributions. In the absence of maintaining separate accounts, tying particular assets to a particular contribution would create administrative problems for taxpayers, IRA providers and the IRS.

Effective Date

These final regulations are applicable for calculating income allocable to IRA contributions made on or after January 1, 2004. For purposes of determining net income applicable to IRA contributions made during 2002 and 2003, taxpayers may continue to apply the rules set forth in Notice 2000–39 or may rely on the proposed regulations.

Special Analyses

It has been determined that these final regulations are not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. Because §1.408–11 and A–2(c) of §1.408A–5 impose no new collection of information on small entities, 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 Inter

2003–21 I.R.B. 941 May 27, 2003

of determining net income attributable to IRA contributions made on or after January 1, 2004, and returned pursuant to section 408(d)(4). * * *

* * * * * Par. 3. Section 1.408–11 is added to read as follows:

§1.408–11 Net income calculation for re- turned or recharacterized IRA contribu- tions.

(a) Net income calculation for returned IRA contributions —(1) General rule . For purposes of returned contributions under section 408(d)(4), the net income attributable to a contribution made to an IRA is determined by allocating to the contribution a pro-rata portion of the earnings on the assets in the IRA during the period the IRA held the contribution. This attributable net income is calculated by using the following formula:

nal Revenue Code, the notice of proposed rulemaking that preceded these final regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Cathy A. Vohs of the Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and Treasury participated in their development.

* * * * *

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * §1.408–4 also issued under 26 U.S.C. 408. §1.408–11 also issued under 26 U.S.C. 408. * * * Par. 2. In §1.408–4, paragraph (c)(1) is amended by adding two sentences before the current first sentence to read as follows:

§1.408–4 Treatment of distributions from in- dividual retirement arrangements.

* * * * * (c) * * * (1) * * * The rules in this paragraph (c) apply for purposes of determining net income attributable to IRA contributions made before January 1, 2004, and returned pursuant to section 408(d)(4). The rules in §1.408–11 apply for purposes

Net Income = Contribution x (Adjusted Closing Balance - Adjusted Opening Balance)

Adjusted Opening Balance.

(2) Special rule . If an IRA is established with a contribution and no other contributions, distributions or transfers are made to or from that IRA, then the subsequent distribution of the entire account balance of the IRA pursuant to section 408(d)(4) will satisfy the requirement of that Internal Revenue Code section that the return of a contribution be accompanied by the amount of net income attributable to the contribution.

(b) Definitions . For purposes of this section the following definitions apply:

(1) Adjusted opening balance . The term adjusted opening balance means the fair market value of the IRA at the beginning of the computation period plus the amount of any contributions or transfers (including the contribution that is distributed as a returned contribution pursuant to section 408(d)(4) and recharacterizations of contributions pursuant to section 408A(d)(6)) made to the IRA during the computation period.

(2) Adjusted closing balance . The term adjusted closing balance means the fair market value of the IRA at the end of the computation period plus the amount of any distributions or transfers (including recharacterizations of contributions pursuant to

section 408A(d)(6)) made from the IRA during the computation period.

(3) Computation period . The term com- putation period means the period beginning immediately prior to the time that the contribution being returned was made to the IRA and ending immediately prior to the removal of the contribution. If more than one contribution was made as a regular contribution and is being returned from the IRA, the computation period begins immediately prior to the time the first contribution being returned was contributed.

(4) Regular contribution . The term regu- lar contribution means an IRA contribution made by the IRA owner that is neither a trustee-to-trustee transfer from another IRA nor a rollover from another IRA or retirement plan.

(c) Additional rules . (1) When an IRA asset is not normally valued on a daily basis, the fair market value of the asset at the beginning of the computation period is deemed to be the most recent, regularly determined, fair market value of the asset, determined as of a date that coincides with or precedes the first day of the computation period. In addition, solely for purposes of this section, notwithstanding A–3 of §1.408A–5, recharacterized contributions are

taken into account for the period they are actually held in a particular IRA.

(2) In the case of an IRA that has received more than one regular contribution for a particular taxable year, the last regular contribution made to the IRA for the year is deemed to be the contribution that is distributed as a returned contribution under section 408(d)(4), up to the amount of the contribution identified by the IRA owner as the amount distributed as a returned contribution.

(3) In the case of an individual who owns multiple IRAs, the net income calculation is performed only on the IRA containing the contribution being returned, and that IRA is the IRA that must distribute the contribution.

(d) Examples . The following examples illustrate the net income calculation under section 408(d)(4) and this section:

Example 1 . (i) On May 1, 2004, when her IRA is worth $4,800, Taxpayer A makes a $1,600 regular contribution to her IRA. Taxpayer A requests that $400 of the May 1, 2004, contribution be returned to her pursuant to section 408(d)(4). Pursuant to this request, on February 1, 2005, when the IRA is worth $7,600, the IRA trustee distributes to Taxpayer A the $400 plus attributable net income. During this time, no other contributions have been made to the IRA and no distributions have been made.

May 27, 2003 942 2003–21 I.R.B.

(ii) The adjusted opening balance is $6,400 [$4,800

$1,600] and the adjusted closing balance is $7,600. Thus, the net income attributable to the $400 May 1, 2004, contribution is $75 [$400 x ($7,600 - $6,400) ÷ $6,400]. Therefore, the total to be distributed on February 1, 2005, pursuant to § 408(d)(4) is $475.

Example 2 . (i) Beginning in January 2004, Taxpayer B contributes $300 on the 15th of each month to an IRA for 2004, resulting in an excess regular contribution of $600 for that year. Taxpayer B requests that the $600 excess regular contribution be returned to her pursuant to section 408(d)(4). Pursuant to this request, on March 1, 2005, when the IRA is worth $16,000, the IRA trustee distributes to Taxpayer B the $600 plus attributable net income. The excess regular contributions to be returned are deemed to be the last two made in 2004: the $300 December 15 contribution and the $300 November 15 contribution. On

November 15, the IRA was worth $11,000 immediately prior to the contribution. No distributions or transfers have been made from the IRA and no contributions or transfers, other than the monthly contributions (including $300 in January and February 2005), have been made. (ii) As of the beginning of the computation period (November 15), the adjusted opening balance is $12,200 [$11,000 + $300 + $300 + $300 + $300] and the adjusted closing balance is $16,000. Thus, the net income attributable to the excess regular contributions is $187 [$600 x ($16,000 - $12,200) ÷ $12,200]. Therefore, the total to be distributed as returned contributions on March 1, 2005, to correct the excess regular contribution is $787 [$600 + $187].

Par. 4. In §1.408A–5, A–2(c) is revised to read as follows:

§1.408A–5 Recharacterized contribu- tions.

* * * * * A–2. * * * (c) (1) If paragraph (b) of this A–2 does not apply, then, for purposes of determining net income attributable to IRA contributions, the net income attributable to the amount of a contribution is determined by allocating to the contribution a pro-rata portion of the earnings on the assets in the IRA during the period the IRA held the contribution. This attributable net income is calculated by using the following formula:

Net Income = Contribution x (Adjusted Closing Balance - Adjusted Opening Balance)

Adjusted Opening Balance.

(2) For purposes of this paragraph (c), the following definitions apply:

(i) The term adjusted opening balance means the fair market value of the IRA at the beginning of the computation period plus the amount of any contributions or transfers (including the contribution that is being recharacterized pursuant to section 408A(d)(6) and any other recharacterizations) made to the IRA during the computation period.

(ii) The term adjusted closing balance means the fair market value of the IRA at the end of the computation period plus the amount of any distributions or transfers (including contributions returned pursuant to section 408(d)(4) and recharacterizations of contributions pursuant to section 408A(d)(6)) made from the IRA during the computation period.

(iii) The term computation period means the period beginning immediately prior to the time the particular contribution being recharacterized is made to the IRA and ending immediately prior to the recharacterizing transfer of the contribution. If a series of regular contributions was made to the IRA, and consecutive contributions in that series are being recharacterized, the computation period begins immediately prior to the time the first of the regular contributions being recharacterized was made.

(3) When an IRA asset is not normally valued on a daily basis, the fair market value of the asset at the beginning of the computation period is deemed to be the most recent, regularly determined, fair mar

ket value of the asset, determined as of a date that coincides with or precedes the first day of the computation period. In addition, solely for purposes of this paragraph (c), notwithstanding A–3 of this section, recharacterized contributions are taken into account for the period they are actually held in a particular IRA.

(4) In the case of an individual with multiple IRAs, the net income calculation is performed only on the IRA containing the particular contribution to be recharacterized, and that IRA is the IRA from which the recharacterizing transfer must be made.

(5) In the case of multiple contributions made to an IRA for a particular year that are eligible for recharacterization, the IRA owner can choose (by date and by dollar amount, not by specific assets acquired with those dollars) which contribution, or portion thereof, is to be recharacterized.

(6) The following examples illustrate the net income calculation under section 408A(d)(6) and this paragraph: Example 1 . (i) On March 1, 2004, when her Roth IRA is worth $80,000, Taxpayer A makes a $160,000 conversion contribution to the Roth IRA. Subsequently, Taxpayer A discovers that she was ineligible to make a Roth conversion contribution in 2004 and so she requests that the $160,000 be recharacterized to a traditional IRA pursuant to section 408A(d)(6). Pursuant to this request, on March 1, 2005, when the IRA is worth $225,000, the Roth IRA trustee transfers to a traditional IRA the $160,000 plus allocable net income. No other contributions have been made to the Roth IRA and no distributions have been made.

(ii) The adjusted opening balance is $240,000

[$80,000 + $160,000] and the adjusted closing bal

ance is $225,000. Thus the net income allocable to the $160,000 is -$10,000 [$160,000 x ($225,000 $240,000) ÷ $240,000]. Therefore, in order to recharacterize the March 1, 2004, $160,000 conversion contribution on March 1, 2005, the Roth IRA trustee must transfer from Taxpayer A’s Roth IRA to her traditional IRA $150,000 [$160,000 - $10,000].

Example 2 . (i) On April 1, 2004, when her traditional IRA is worth $100,000, Taxpayer B converts the entire amount, consisting of 100 shares of stock in ABC Corp. and 100 shares of stock in XYZ Corp., by transferring the shares to a Roth IRA. At the time of the conversion, the 100 shares of stock in ABC Corp. are worth $50,000 and the 100 shares of stock in XYZ Corp. are also worth $50,000. Taxpayer B decides that she would like to recharacterize the ABC Corp. shares back to a traditional IRA. However, B may choose only by dollar amount the contribution or portion thereof that is to be recharacterized. On the date of transfer, November 1, 2004, the 100 shares of stock in ABC Corp. are worth $40,000 and the 100 shares of stock in XYZ Corp. are worth $70,000. No other contributions have been made to the Roth IRA and no distributions have been made.

(ii) If B requests that $50,000 (which was the value of the ABC Corp. shares at the time of conversion) be recharacterized, the net income allocable to the $50,000 is $5,000 [$50,000 x ($110,000 - $100,000) ÷ $100,000]. Therefore, in order to recharacterize $50,000 of the April 1, 2004, conversion contribution on November 1, 2004, the Roth IRA trustee must transfer from Taxpayer B’s Roth IRA to a traditional IRA assets with a value of $55,000 [$50,000

$5,000].

(iii) If, on the other hand, B requests that $40,000 (which was the value of the ABC Corp. shares on November 1) be recharacterized, the net income allocable to the $40,000 is $4,000 [$40,000 x ($110,000

$100,000) ÷ $100,000]. Therefore, in order to recharacterize $40,000 of the April 1, 2004, conversion contribution on November 1, 2004, the Roth IRA trustee must transfer from Taxpayer B’s Roth IRA to a traditional IRA assets with a value of $44,000

[$40,000 + $4,000].

2003–21 I.R.B. 943 May 27, 2003

sued by the Bureau of Labor Statistics. The indexes are accepted by the Internal Revenue Service, under § 1.472–1(k) of the Income Tax Regulations and Rev. Proc. 86– 46, 1986–2 C.B. 739, for appropriate application to inventories of department stores employing the retail inventory and last-in, first-out inventory methods for tax years ended on, or with reference to, March 31, 2003. The Department Store Inventory Price Indexes are prepared on a national basis and include (a) 23 major groups of departments, (b) three special combinations of the major groups — soft goods, durable goods, and miscellaneous goods, and (c) a store total, which covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco, and contract departments.

(iv) Regardless of the amount of the contribution recharacterized, the determination of that amount (or of the net income allocable thereto) is not affected by whether the recharacterization is accomplished by the transfer of shares of ABC Corp. or of shares of XYZ Corp.

(7) This paragraph (c) applies for purposes of determining net income attributable to IRA contributions, made on or after January 1, 2004. For purposes of determining net income attributable to IRA contributions made before January 1, 2004, see paragraph (c) of this A–2 of §1.408A–5 (as it appeared in the April 1, 2003, edition of 26 CFR part 1).

* * * * *

David A. Mader, Assistant Deputy Commissioner of

Internal Revenue.

Approved April 25, 2003.

Pamela F. Olson, Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on May 2, 2003, 8:45 a.m., and published in the issue of the Federal Register for May 5, 2003, 68 F.R. 23586)

Section 472.—Last-in, First-out Inventories

26 CFR 1.472–1: Last-in, first-out inventories.

LIFO; price indexes; department stores. The March 2003 Bureau of Labor Statistics price indexes are accepted for use by department stores employing the retail inventory and last-in, first-out inventory methods for valuing inventories for tax years ended on, or with reference to, March 31, 2003.

Rev. Rul. 2003–50

The following Department Store Inventory Price Indexes for March 2003 were is

Percent Change from Mar. 2002 to Mar. 2003 ¹

Groups

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS

(January 1941 = 100, unless otherwise noted)

Mar. Mar. 2002 2003

Piece Goods .............................................................................. 490.6 458.9 -6.5
Domestics and Draperies.......................................................... 583.6 552.6 -5.3
Women’s and Children’s Shoes ............................................... 647.4 642.6 -0.7
Men’s Shoes.............................................................................. 903.0 842.0 -6.8
Infants’ Wear............................................................................. 624.2 600.3 -3.8
Women’s Underwear................................................................. 563.7 524.9 -6.9
Women’s Hosiery...................................................................... 355.7 341.2 -4.1
Women’s and Girls’ Accessories.............................................. 563.4 556.0 -1.3
Women’s Outerwear and Girls’ Wear...................................... 401.0 380.1 -5.2
Men’s Clothing ......................................................................... 594.6 570.0 -4.1
Men’s Furnishings .................................................................... 607.3 591.1 -2.7
Boys’ Clothing and Furnishings............................................... 482.6 470.9 -2.4
Jewelry ...................................................................................... 905.5 871.7 -3.7
Notions ...................................................................................... 800.4 797.7 -0.4
Toilet Articles and Drugs.......................................................... 972.7 976.3 0.4
Furniture and Bedding.............................................................. 630.0 625.2 -0.8
Floor Coverings ........................................................................ 616.3 589.1 -4.4
Housewares ............................................................................... 756.2 734.0 -2.9
Major Appliances...................................................................... 223.2 217.5 -2.6
Radio and Television ................................................................ 51.1 46.6 -8.8
Recreation and Education ² ....................................................... 87.5 83.8 -4.2
Home Improvements ² ............................................................... 125.6 125.7 0.1
Auto Accessories ² ..................................................................... 110.8 111.7 0.8

May 27, 2003 944 2003–21 I.R.B.

Groups

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS

(January 1941 = 100, unless otherwise noted)

Mar. Mar. 2002 2003

Percent Change from Mar. 2002 to Mar. 2003 ¹

Groups 1–15: Soft Goods ..................................................................... 591.8 570.4 -3.6 Groups 16–20: Durable Goods............................................................. 414.6 400.8 -3.3 Groups 21–23: Misc. Goods ² ............................................................... 97.2 95.0 -2.3

Store Total ³ ................................................................................ 526.5 508.5 -3.4

1Absence of a minus sign before the percentage change in this column signifies a price increase. 2Indexes on a January 1986 = 100 base. 3The store total index covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco and contract departments.

DRAFTING INFORMATION

The principal author of this revenue ruling is Michael Burkom of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Burkom at (202) 622–7718 (not a tollfree call).

Section 861.—Income From Sources Within the United States

26 CFR 1.861–8T: Computations of taxable income from sources within the United States and from other sources and activities (Temporary).

26 CFR 1.861–9T: Allocation and apportionment of interest expense (Temporary).

See Rev. Proc. 2003–37, page 950.

Section 864.—Definitions and Special Rules

This revenue procedure provides guidance to taxpayers that use the fair market value method to apportion interest expense for purposes of calculating the foreign tax credit. See Rev. Proc. 2003–37, page 950.

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

This revenue procedure provides guidance to taxpayers that use the fair market value method apportion interest expense for purposes of calculating the foreign tax credit. See Rev. Proc. 2003–37, page 950.

Section 904.—Limitation on Credit

Section 3406.—Backup Withholding

26 CFR 31.3406(d)–5: Backup withholding when the Service or a broker notifies the payor to withhold because the payee’s taxpayer identification number is incorrect.

T.D. 9055

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 31 and 301

Receipt of Multiple Notices With Respect to Incorrect Taxpayer Identification Numbers

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final Regulations.

SUMMARY: This document contains final regulations relating to backup withholding. These regulations clarify the method of determining whether the payor has received two notices that a payee’s taxpayer identification number (TIN) is incorrect. If a payor receives two or more such notices with respect to the same account during a three-year period, the payor must begin backup withholding unless the payee provides verification of its correct TIN pursuant to the regulations. This document also contains regulations which clarify when an information return filer must solicit a payee’s TIN following the receipt of a penalty notice.

DATES: These regulations are effective January 1, 2004.

FOR FURTHER INFORMATION CONTACT: Nancy L. Rose at (202) 622–4910 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Employment Tax Regulations (26 CFR

2003–21 I.R.B. 945 May 27, 2003

part 31) under section 3406 of the Internal Revenue Code (Code), and to the Procedure and Administration Regulations (26 CFR part 301) under section 6724 of the Code. These regulations finalize proposed amendments to existing §§31.3406(d)– 5(d)(2)(ii) and (g)(4), and 301.6724–1(f)(2), (f)(3), (f)(5), and (k). These regulations also revise existing §301.6724(f)(1) and (g)(1) to remove obsolete cross-references. A notice of proposed rulemaking (REG–116644– 01, 2002–31 I.R.B. 268 [67 FR 44579]) was published in the Federal Register on July 3, 2002. The IRS received written comments responding to the notice of proposed rulemaking, but no commentators requested the opportunity to present oral comments at a public hearing. A notice cancelling the public hearing scheduled for October 22, 2002, was published on October 17, 2002 (67 FR 64067).

Explanation of Provisions and Sum- mary of Comments

Section 3406

Section 3406 imposes a requirement to backup withhold on any reportable payment if the Secretary notifies the payor that the TIN furnished by the payee is incorrect. After receiving a notice of incorrect TIN, the payor must backup withhold on reportable payments until the payee furnishes another TIN. However, if the payor receives two notices with respect to the same account within a three year period, the payor must backup withhold on reportable payments until the payor receives a verification of the payee’s TIN from the Social Security Administration or the IRS.

The regulations under section 3406 set forth detailed procedures for payors to follow after receipt of a notice of incorrect TIN from the IRS. When the first such notice is received by the payor, the payor must send a notice (commonly referred to as a “B” notice) to the payee stating that the payee will be subject to backup withholding if the payee does not furnish a certified TIN. If a second notice of incorrect TIN is received by a payor with respect to the payee’s account within a three-year period, the payor must send a second “B” notice to the payee stating that the payee will be subject to backup withholding unless the payor receives verification of the payee’s TIN from the Social Security Administration or IRS.

If the payor receives two or more notices of incorrect TIN with respect to a pay

ee’s account within the same calendar year, the regulations provide that the multiple notices may be treated as one notice for purposes of sending out a first “B” notice, and must be treated as one notice for purposes of sending out a second “B” notice. However, in some cases, a payor may receive multiple notices of incorrect TIN in different calendar years which relate to the same payee’s account for the same year. This may occur where a payor files different types of information returns with respect to the same payee, such as a Form 1099–B (gross proceeds reported by brokers) and a Form 1099–DIV (payment of dividends). Typically these information returns all contain the same TIN, following information contained in the payor’s records. Variations in the processing of such returns by the IRS may result in the issuance of incorrect TIN notices at different times.

The amendments to the regulations provide that two or more notices of incorrect TIN relating to the same payee and the same year, but which are received in different calendar years, count as one notice. Accordingly, a payor who sends a first “B” notice to the payee after receipt of the first notice of incorrect TIN would not be required to send a second “B” notice after receipt of the second notice of incorrect TIN if the second notice relates to an information return filed for the same year as the first notice.

Section 6724

Section 6724 provides for a waiver of information reporting penalties under sections 6721 through 6723 where the failure giving rise to such penalties was due to reasonable cause and not willful neglect. Under §301.6724–1(a) of the regulations, in order to prove reasonable cause for a failure, the filer must establish either that there are significant mitigating factors with respect to the failure or that the failure arose from events beyond the filer’s control. In addition, the filer must have acted in a responsible manner both before and after the failure.

Section 301.6724–1(c)(1)(v) of the regulations provides that certain actions of the payee or another person providing necessary information with respect to the return may be an event beyond the filer’s control. Thus, a payee’s furnishing of an incorrect TIN to a payor may be an event beyond the payor’s control.

As provided in §301.6724–1(a), the payor must also act in a responsible manner with respect to the failure. That section sets forth special rules for acting in a responsible manner with respect to incorrect TINs. The filer is required to make an initial solicitation for the payee’s correct TIN at the time the account is opened, and up to two annual solicitations following receipt of penalty notices.

If a filer receives a penalty notice with respect to an incorrect payee TIN and a notice of incorrect TIN under section 3406(a)(1)(B) during the same calendar year for the same payee, the filer will satisfy the section 6724 annual solicitation requirements by sending the required “B” notice. The filer does not have to make another solicitation pursuant to section 6724.

The amendments to the regulations address the situation where a filer receives a section 3406(a)(1)(B) notice with respect to a payee in one year, and the following year receives a penalty notice with respect to the same payee and the same year as the section 3406(a)(1)(B) notice. The amendments provide that the filer is not required to make an annual solicitation for the payee’s TIN pursuant to section 6724 in this situation, provided the filer has sent the required “B” notice.

The written comments received expressed the view that the proposed regulations clarified the backup withholding rules and reduced the regulatory burden associated with backup withholding. No revisions to the proposed amendments were suggested by commentators.

Special Analyses

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

Drafting Information

The principal author of these regulations is Nancy L. Rose of the Office of the Associate Chief Counsel (Procedure and

May 27, 2003 946 2003–21 I.R.B.

graph (f) either by mail, in the manner set forth in paragraph (e)(2)(i) of this section; by telephone, in the manner set forth in paragraph (e)(2)(ii) of this section; or by requesting the TIN in person.

(3) Coordination with solicitations un- der section 3406(a)(1)(b) . (i) A filer that has been notified of an incorrect TIN pursuant to section 3406(a)(1)(B) (except filers to which §31.3406(d)–5(b)(4)(i)(A) of this chapter applies) will satisfy the solicitation requirement of this paragraph (f) only if it makes a solicitation in the manner and within the time period required under §31.3406(d)–5(d)(2)(i) or (g)(1)(ii) of this chapter, whichever applies.

(ii) A filer that has been notified of an incorrect TIN by a notice pursuant to section 6721 (except filers to which §31.3406(d)–5(b)(4)(i)(A) of this chapter applies) is not required to make the annual solicitation of this paragraph (f) if—

(A) The filer has received an effective notice pursuant to section 3406(a)(1)(B) with respect to the same payee, either during the same calendar year or for information returns filed for the same year; and

(B) The filer makes a solicitation in the manner and within the time period required under §31.3406(d)–5(d)(2)(i) or (g)(1)(ii) of this chapter, whichever applies, before the filer is required to make the annual solicitation of this paragraph (f).

(iii) A filer that has been notified of an incorrect TIN by a notice pursuant to section 6721 with respect to a fiduciary or nominee account to which §31.3406(d)– 5(b)(4)(i)(A) of this chapter applies is required to make the annual solicitation of this paragraph (f).

* * * * *

David A. Mader, Assistant Deputy Commisioner of

Internal Revenue.

Approved April 13, 2003.

Pamela F. Olson, Assistant Secretary of the

Treasury (Tax Policy).

(Filed by the Office of the Federal Register on April 28, 2003, 8:45 a.m., and published in the issue of the Federal Register for April 29, 2003, 68 F.R. 22594)

Administration), Administrative Provisions and Judicial Practice Division.

* * * * *

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 31 and 301 are amended as follows:

PART 31—EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT SOURCE

Par. 1. The authority citation for part 31 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 31.3406(d)–5 is amended by revising paragraphs (d)(2)(ii) and (g)(4) to read as follows:

§31.3406(d)–5 Backup withholding when the Service or a broker notifies the payor to withhold because the payee’s taxpayer identification number is incorrect.

* * * * * (d) * * * (2) * * * (ii) Two or more notices for an account for the same year or received in the same year . A payor who receives, under the same payor taxpayer identification number, two or more notices under paragraph (c)(1) or (2) of this section with respect to the same payee’s account for the same year, or in the same calendar year, need only send one notice to the payee under this section.

* * * * * (g) * * * (4) Receipt of two notices for the same year or in the same calendar year . A payor who receives, under the same payor taxpayer identification number, two or more notices under paragraph (c)(1) or (2) of this section with respect to the same payee’s account for the same year, or in the same calendar year, must treat such notices as one notice for purposes of this paragraph (g).

* * * * *

PART 301—PROCEDURE AND ADMINISTRATION

Par. 3. The authority citation for part 301 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 4. Section 301.6724–1 is amended as follows:

Amending paragraph (f)(1)(ii), fourth sentence, by removing “(n)” after “section 6721”.
Revising paragraphs (f)(2) and (f)(3).
Amending paragraph (f)(5)(vi), last sentence, by removing the language “paragraph (f)(2)” and adding “paragraph (f)(3)” in its place.
Amending paragraph (g)(1) by removing the language “as provided under section 6724(c)(1)”.
Amending paragraph (k), Example 3 (ii), second sentence, by removing the language “§35a.3406–1(c)(1) of this paragraph” and adding “§31.3406(d)–5(d)(2)(i) of this chapter” in its place; and by removing the language “(f)(2)” and adding “(f)(3)” in its place.
Amending paragraph (k), Example 3 (ii), fifth sentence, by removing the language “§301.6721–1T” and adding “§301.6721–1” in its place.
Amending paragraph (k), Example 3 (iii), fifth sentence, by removing the language “§35a.3406–1(c)(1)” and adding “§31.3406(d)–5(d)(2)(i)” in its place.
Amending paragraph (k), Example 3 (iii), last sentence, by removing the language “§301.6721–1T” and adding “§301.6721–1” in its place.
Amending paragraph (k), Example 5, final sentence, by removing the language “§301.6721–1T” and adding “§301.6721–1” in its place.
Amending paragraph (k), Example 6 (ii), sixth sentence, by removing the language “(f)(3)” and adding the language “(f)(2)” in its place.
Amending paragraph (k), Example 7 (ii), fourth sentence, by removing the language “(f)(2)” and adding “(f)(3)” in its place; and by removing the language “§35a.3406–1(c)(1)” and adding “§31.3406(d)–5(g)(1)(ii)” in its place.
Amending paragraph (k), Example 7 (ii), fifth sentence, by removing the language “§35a.3406–1(c)(1)” and adding “§31.3406(d)–5(g)(1)(ii)” in its place.

The revisions read as follows:

§301.6724–1 Reasonable cause.

* * * * * (f) * * * (2) Manner of making annual solicita- tion if notified pursuant to section 6721 . A filer that has been notified of an incorrect TIN by a penalty notice or other notification pursuant to section 6721 may satisfy the solicitation requirement of this para

2003–21 I.R.B. 947 May 27, 2003