Part I. Rulings — Internal Revenue Bulletin 2004-27

Section 42.—Low-Income Housing Credit

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 263A.—Capital- ization and Inclusion in Inventory Costs of Cer- tain Expenses

26 CFR 1.263A–7: Changing a method of accounting under section 263A.

Final regulations provide that any section 481(a) adjustment resulting from a change in method of accounting under section 263A may be taken into account over the same number of taxable years that applies to taxpayers changing a method of accounting under the general administrative procedures issued by the Service. See T.D. 9131, page 2.

Section 280G.—Golden Parachute Payments

Federal short-term, mid-term, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 382.—Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change

The adjusted applicable federal long-term rate is set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 412.—Minimum Funding Standards

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 420.—Transfers of Excess Pension Assets to Retiree Health Accounts

26 CFR 1.420–1: Significant reduction in retiree health coverage during the cost maintenance period.

Post-retirement health benefits; waiver. This ruling holds that an employer

has reduced retiree health coverage, within the meaning of section 420(c)(2)(E) of the Code, if an individual who has coverage for retiree health benefits (“covered individual”) accepts an offer from the employer to waive the coverage in exchange for enhanced pension benefits.

Rev. Rul. 2004–65

ISSUE

Has an employer reduced retiree health coverage, within the meaning of § 420(c)(3)(E) of the Internal Revenue Code, if an individual who has coverage for retiree health benefits (“covered individual”) accepts an offer from the employer to waive such coverage in exchange for enhanced pension benefits?

FACTS

Employer M maintains Plan X, a single-employer defined benefit plan qualified under § 401(a) of the Code with a plan year ending June 30. Plan X contains a retiree health benefits account that satisfies the requirements of § 401(h). Under Plan X, Employer M is permitted to make qualified transfers of excess pension assets, in accordance with § 420, to such account from time to time to fund applicable health benefits. On June 30, 2002, Employer M makes a qualified transfer of excess pension assets to the § 401(h) account. Effective July 1, 2004, Employer M offers to covered individuals the opportunity to receive enhanced pension benefits in return for waiving their applicable health benefits.

LAW AND ANALYSIS

Section 420(a) provides that if there is a qualified transfer of any excess pension assets of a defined benefit plan (other than a multiemployer plan) to a health benefits account which is part of such a plan, the related trust shall not be treated as failing to meet the requirements of § 401(a) or (h) solely by reason of such transfer. In addition, no amount shall be includible in gross income of the employer solely by reason of such transfer, and such transfer shall not be

treated as an employer reversion for purposes of § 4980 or as a prohibited transaction for purposes of § 4975.

Among the requirements for a transfer to be a qualified transfer as defined in § 420(b) is that the minimum cost requirements of § 420(c)(3) must be satisfied. Section 420(c)(3)(A) provides, in relevant part, that each group health plan or arrangement under which applicable health benefits are provided must provide that the applicable employer cost for each taxable year during the cost maintenance period shall not be less than the higher of the applicable employer costs for each of the two (2) taxable years immediately preceding the taxable year of the qualified transfer. Section 420(c)(3)(B) defines applicable employer cost, and § 420(c)(3)(C) allows the minimum cost requirement to be applied separately with regard to individuals eligible for benefits under title XVIII of the Social Security Act. Under § 420(c)(3)(D), the cost maintenance period is the period of five (5) taxable years beginning with the taxable year in which the qualified transfer occurs. Section 420(c)(3)(E) provides that the Secretary shall prescribe such regulations as may be necessary to prevent an employer who significantly reduces retiree health coverage during the cost maintenance period from being treated as satisfying the minimum cost requirement.

Section 420(e)(1)(C) defines “applicable health benefits” to mean health benefits or coverage which are provided to (i) retired employees who, immediately before the qualified transfer, are entitled to receive such benefits upon retirement and who are entitled to pension benefits under the plan, and (ii) their spouses and dependents.

Section 1.420–1 of the Income Tax Regulations provides guidance pursuant to § 420(c)(3)(E) regarding when an employer is considered to have significantly reduced retiree health coverage during the cost maintenance period. Section 1.420–1(b) provides, in general, that there is a significant reduction if, for any taxable year beginning on or after January 1, 2002, that is included in the cost maintenance period, either the employer-initiated

2004–27 I.R.B. 1 July 6, 2004

reduction percentage for that year exceeds 10%, or the sum of the employer-initiated reduction percentage for that taxable year and all prior taxable years during the cost maintenance period exceeds 20%. The employer-initiated reduction percentage for any taxable year equals the number of individuals (retired employees plus their spouses and dependents) receiving coverage for applicable health benefits as of the day before the first day of the taxable year whose coverage for applicable health benefits ended during the taxable year by reason of employer action, divided by the total number of such individuals receiving coverage for applicable health benefits as of the day before the first day of the taxable year.

Section 1.420–1(b)(4) defines the term “employer action” for purposes of determining the employer-initiated reduction percentage. An individual’s eligibility for applicable health benefits ends during a taxable year by reason of employer action if, on any day within the taxable year, the individual’s eligibility for applicable health benefits ends as a result of a plan amendment or any other action of the employer ( e.g., the sale of all or a part of the employer’s business) that, in conjunction with the plan terms, has the effect of ending the individual’s eligibility.

An employer’s offer to covered individuals to waive their retiree health benefit coverage in exchange for an incentive offered by the employer, such as enhanced pension benefits, is employer action under § 1.420–1(b)(4). Accordingly, if a covered individual accepts the offer to waive such coverage, the cessation of coverage will be treated as an employer-initiated reduction in coverage for purposes of determining whether the employer has significantly reduced retiree health coverage during the cost maintenance period.

HOLDING

An employer has reduced retiree health coverage, within the meaning of § 420(c)(3)(E), if an individual who has coverage for retiree health benefits (“covered individual”) accepts an offer from the employer to waive such coverage in exchange for enhanced pension benefits.

This ruling does not address other tax consequences that could arise from the offer.

DRAFTING INFORMATION

The principal author of this revenue ruling is Diane S. Bloom of the Employee Plans, Tax Exempt and Government Entities Division. For further information regarding this revenue ruling, contact the Employee Plans taxpayer assistance telephone service between the hours of 8:00 a.m. and 6:30 p.m. Eastern time, Monday through Friday, by calling (877) 829–5500 (a toll-free number). Ms. Bloom may be reached at (202) 283–9888 (not a toll-free number).

Section 448.—Limitation on Use of Cash Method of Accounting

26 CFR 1.448–1: Limitation on the use of the cash receipts and disbursements method of accounting.

T.D. 9131

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Administrative Simplification of Section 481(a) Adjustment Periods in Various Regulations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains amendments to regulations under sections 263A and 448 of the Internal Revenue Code. The amendments apply to taxpayers changing a method of accounting under the regulations and are necessary to conform the rules governing those changes to the rules provided in general guidance issued by the IRS for changing a method of accounting. Specifically, the amendments will allow taxpayers changing their method of accounting under the regulations to take any adjustment under section 481(a) resulting from the change into account over the same number of taxable years that is provided in the general guidance.

DATES: Effective Date : These regulations are effective on or after June 16, 2004.

FOR FURTHER INFORMATION CONTACT: Christian Wood, 202–622–4930 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On May 12, 2003, the IRS and Treasury published in the Federal Register (68 FR 25310) proposed amendments to the regulations (REG–142605–02, 2003–23 I.R.B. 1010) under sections 263A and 448 of the Internal Revenue Code (Code). These amendments pertain to the period for taking into account the adjustment required under section 481 to prevent duplications or omissions of amounts resulting from a change in method of accounting under section 263A or 448. Neither public comments in response to the proposed regulations nor any request to speak at a public hearing were received. The proposed regulations under sections 263A and 448 are adopted as revised by this Treasury decision.

The proposed regulations provided that they are applicable to taxable years ending on or after the date those regulations are published as final regulations. However, the proposed regulations allowed taxpayers to rely on them for taxable years ending on or after May 12, 2003, by filing a Form 3115, “ Application for Change in Accounting Method,” in the time and manner provided in the regulations (in the case of a change in method of accounting under section 448) or applicable administrative procedure (in the case of a change in method of accounting under section 263A) for such a taxable year that reflects a section 481 adjustment period that is consistent with the proposed regulations. Taxpayers may continue to rely on the proposed regulations for taxable years ending on or after May 12, 2003, but ending before June 16, 2004.

Special Analyses

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

July 6, 2004 2 2004–27 I.R.B.

year of such cessation or termination, the balance of the adjustment not previously taken into account in computing taxable income. For purposes of this paragraph (g)(3)(i), the determination as to whether a taxpayer has ceased to engage in the trade or business to which the section 481(a) adjustment relates, or has terminated its existence, is to be made under the principles of §1.446–1(e)(3)(ii) and its underlying administrative procedures.

(ii) De minimis rule for a taxpayer other than a cooperative. Notwithstanding paragraph (g)(2)(i) and (ii) of this section, a taxpayer other than a cooperative (within the meaning of section 1381(a)) that is required to change from the cash method by this section may elect to use, in lieu of the adjustment period described in paragraph (g)(2)(i) and (ii) of this section, the adjustment period for de minimis section 481(a) adjustments provided in the applicable administrative procedure issued under §1.446–1(e)(3)(ii) for obtaining the Commissioner’s consent to a change in accounting method. A taxpayer may make an election under this paragraph (g)(3)(ii) only if

- - - (i) - - (5) Effective date of paragraph (g)(2)(i) . Paragraph (g)(2)(i) of this section applies to taxable years ending on or after June 16, 2004.

Mark E. Matthews, Deputy Commissioner for Services and Enforcement .

Approved June 1, 2004.

Gregory F. Jenner, Acting Assistant Secretary of the

Treasury (Tax Policy) .

(Filed by the Office of the Federal Register on June 15, 2004, 8:45 a.m., and published in the issue of the Federal Register for June 16, 2004, 69 F.R. 33571)

Section 467.—Certain Payments for the Use of Property or Services

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

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

Drafting Information

The principal authors of these regulations are Christian Wood and Grant Anderson of the Office of Associate Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. In §1.263A–7, paragraph (b)(2)(ii) is revised to read as follows:

§1.263A–7 Changing a method of accounting under section 263A.

- - - (b) - - (2) - - (ii) Adjustment required by section 481(a). In the case of any taxpayer required or permitted to change its method of accounting for any taxable year under section 263A and the regulations thereunder, the change will be treated as initiated by the taxpayer for purposes of the adjustment required by section 481(a). The taxpayer must take the net section 481(a) adjustment into account over the section 481(a) adjustment period as determined under the applicable administrative procedures issued under § 1.446–1(e)(3)(ii) for obtaining the Commissioner’s consent to a change in accounting method (for example, see Rev. Proc. 2002–9, 2002–1 C.B. 327, and Rev. Proc. 97–27, 1997–1

C.B. 680 (also see § 601.601(d)(2) of this chapter). This paragraph applies to taxable years ending on or after June 16, 2004.

- - - Par. 3. Section 1.448–1 is amended as follows:

Paragraphs (g)(2)(i) and (g)(3)(i) are revised.
Paragraphs (g)(3)(ii) and (g)(3)(iii) are removed.
Paragraph (g)(3)(iv) is redesignated as paragraph (g)(3)(ii) and the introductory language is revised.
Paragraph (g)(6) is removed.
Paragraph (i)(1) is amended by removing the language “and (4)” and adding “(4), and (5)” in its place.
Paragraph (i)(5) is added. The revisions and addition read as follows:

§1.448–1 Limitation on the use of the cash receipts and disbursements method of accounting.

- - - (g) - - (2) - - (i) In general . Except as otherwise provided in paragraphs (g)(2)(ii) and (g)(3) of this section, a taxpayer required by this section to change from the cash method must take the net section 481(a) adjustment into account over the section 481(a) adjustment period as determined under the applicable administrative procedures issued under §1.446–1(e)(3)(ii) for obtaining the Commissioner’s consent to a change in accounting method (for example, see Rev. Proc. 2002–9, 2002–1 C.B. 327, and Rev. Proc. 97–27, 1997–1 C.B. 680 (also see § 601.601(d)(2) of this chapter), provided the taxpayer complies with the provisions of paragraph (h)(2) or (3) of this section for its first section 448 year.
- - - (3) - - (i) Cessation of trade or business . If the taxpayer ceases to engage in the trade or business to which the section 481(a) adjustment relates, or if the taxpayer operating the trade or business terminates existence, and such cessation or termination occurs prior to the expiration of the adjustment period described in paragraph (g)(2)(i) or (ii) of this section, the taxpayer must take into account, in the taxable

2004–27 I.R.B. 3 July 6, 2004

Section 468.—Special Rules for Mining and Solid Waste Reclamation and Closing Costs

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 482.—Allocation of Income and Deductions Among Taxpayers

Federal short-term, mid-term, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 483.—Interest on Certain Deferred Payments

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 642.—Special Rules for Credits and Deductions

Federal short-term, mid-term, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 671.—Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners

What are the gift tax consequences if the grantor of a trust with respect to which the grantor is treated as the owner of the trust under subpart E, part I, subchap

ter J, chapter 1 of the Internal Revenue Code (subpart E), pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, and what are the estate tax consequences if, pursuant to the governing instrument or applicable local law, the grantor may or must be reimbursed by the trust for that income tax? See Rev. Rul. 2004-64, page 7.

Section 807.—Rules for Certain Reserves

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 846.—Discounted Unpaid Losses Defined

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 1274.—Determi- nation of Issue Price in the Case of Certain Debt Instru- ments Issued for Property

(Also sections 42, 280G, 382, 412, 467, 468, 482, 483, 642, 807, 846, 1288, 7520, 7872.)

Federal rates; adjusted federal rates; adjusted federal long-term rate and the long-term exempt rate. For purposes of sections 382, 642, 1274, 1288, and other sections of the Code, tables set forth the rates for July 2004.

Rev. Rul. 2004–66

This revenue ruling provides various prescribed rates for federal income tax purposes for July 2004 (the current

month). Table 1 contains the short-term, mid-term, and long-term applicable federal rates (AFR) for the current month for purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the short-term, mid-term, and long-term adjusted applicable federal rates (adjusted AFR) for the current month for purposes of section 1288(b). Table 3 sets forth the adjusted federal long-term rate and the long-term tax-exempt rate described in section 382(f). Table 4 contains the appropriate percentages for determining the low-income housing credit described in section 42(b)(2) for buildings placed in service during the current month. Table 5 contains the federal rate for determining the present value of annuity, an interest for life or for a term of years, or a remainder or a reversionary interest for purposes of section 7520. Finally, Table 6 contains the blended annual rate for 2004 for purposes of section 7872.

July 6, 2004 4 2004–27 I.R.B.

REV. RUL. 2004–66 TABLE 1

Applicable Federal Rates (AFR) for July 2004

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-term

AFR 2.26% 2.25% 2.24% 2.24% 110% AFR 2.50% 2.48% 2.47% 2.47% 120% AFR 2.72% 2.70% 2.69% 2.68% 130% AFR 2.95% 2.93% 2.92% 2.91%

Mid-term

AFR 4.11% 4.07% 4.05% 4.04% 110% AFR 4.53% 4.48% 4.46% 4.44% 120% AFR 4.94% 4.88% 4.85% 4.83% 130% AFR 5.36% 5.29% 5.26% 5.23% 150% AFR 6.20% 6.11% 6.06% 6.03% 175% AFR 7.25% 7.12% 7.06% 7.02%

Long-term

AFR 5.34% 5.27% 5.24% 5.21% 110% AFR 5.88% 5.80% 5.76% 5.73% 120% AFR 6.42% 6.32% 6.27% 6.24% 130% AFR 6.97% 6.85% 6.79% 6.75%

REV. RUL. 2004–66 TABLE 2

Rates Under Section 382 for July 2004

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-term adjusted 1.78% 1.77% 1.77% 1.76% AFR

Mid-term adjusted AFR 3.34% 3.31% 3.30% 3.29%

Long-term adjusted 4.72% 4.67% 4.64% 4.63% AFR

REV. RUL. 2004–66 TABLE 3

Rates Under Section 382 for July 2004

Adjusted federal long-term rate for the current month 4.72%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted federal long-term rates for the current month and the prior two months.) 4.72%

REV. RUL. 2004–66 TABLE 4

Appropriate Percentages Under Section 42(b)(2) for July 2004

Appropriate percentage for the 70% present value low-income housing credit 8.10% Appropriate percentage for the 30% present value low-income housing credit 3.47%

2004–27 I.R.B. 5 July 6, 2004

REV. RUL. 2004–66 TABLE 5

Rate Under Section 7520 for July 2004

Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest 5.0%

REV. RUL. 2004–66 TABLE 6

Blended Annual Rate for 2004

Section 7872(e)(2) blended annual rate for 2004 1.98%

Section 1288.—Treatment of Original Issue Discount on Tax-Exempt Obligations

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 2032A.—Valuation of Certain Farm, etc., Real Property

26 CFR 20.2032A–4: Method of valuing farm real property.

Special use value; farms; interest rates. The 2004 interest rates to be used in computing the special use value of farm real property for which an election is made under section 2032A of the Code are listed for estates of decedents.

Rev. Rul. 2004–63

This revenue ruling contains a list of the average annual effective interest rates on new loans under the Farm Credit System. This revenue ruling also contains a list of the states within each Farm Credit System Bank Chartered Territory.

Under § 2032A(e)(7)(A)(ii) of the Internal Revenue Code, rates on new Farm Credit System Bank loans are used in computing the special use value of real property used as a farm for which an election is made under § 2032A. The rates in this revenue ruling may be used by estates that value farmland under § 2032A as of a date in 2004.

Average annual effective interest rates, calculated in accordance with § 2032A(e)(7)(A) and § 20.2032A–4(e) of the Estate Tax Regulations, to be used under § 2032A(e)(7)(A)(ii), are set forth in the accompanying Table of Interest Rates (Table 1). The states within each Farm

REV. RUL. 2004–63 TABLE 1

TABLE OF INTEREST RATES

Credit System Bank Chartered Territory are set forth in the accompanying Table of Farm Credit System Bank Chartered Territories (Table 2).

Rev. Rul. 81–170, 1981–1 C.B. 454, contains an illustrative computation of an average annual effective interest rate. The rates applicable for valuation in 2003 are in Rev. Rul. 2003–53, 2003–1 C.B. 969. For rate information for years prior to 2003, see Rev. Rul. 2002–26, 2002–1 C.B. 906, and other revenue rulings that are referenced therein.

DRAFTING INFORMATION

The principal author of this revenue ruling is Lane Damazo of the Office of the Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Lane Damazo at (202) 622–3090 (not a toll-free call).

(Year of Valuation 2004) Farm Credit System Bank Servicing State in Which Property is Located Rate

AgFirst, FCB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.32

AgriBank, FCB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.93

CoBank, ACB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.64

Texas, FCB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.59

U.S. AgBank, FCB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.84

July 6, 2004 6 2004–27 I.R.B.

REV. RUL. 2004–63 TABLE 2

TABLE OF FARM CREDIT SYSTEM BANK CHARTERED TERRITORIES

Farm Credit System Bank Location of Property

AgFirst, FCB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Delaware, District of Columbia, Florida, Georgia, Maryland, North Carolina, Pennsylvania, South Carolina, Virginia, West Virginia.

AgriBank, FCB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Arkansas, Illinois, Indiana, Iowa, Kentucky, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota, Tennessee, Wisconsin, Wyoming.

CoBank, ACB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alaska, Connecticut, Idaho, Maine, Massachusetts, Montana, New Hampshire, New Jersey, New York, Oregon, Rhode Island, Vermont, Washington.

Texas, FCB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alabama, Louisiana, Mississippi, Texas.

U.S. Agbank, FCB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Arizona, California, Colorado, Hawaii, Kansas, New Mexico, Nevada, Oklahoma, Utah

FACTS

In Year 1, A, a United States citizen, establishes and funds Trust, an irrevocable inter vivos trust, for the benefit of A ’s descendants. The governing instrument of Trust requires that the trustee be a person not related or subordinate to A within the meaning of § 672(c) of the Internal Revenue Code. A appoints a trustee that satisfies this requirement. Trust is governed by the laws of State. Under the terms of Trust, A retains no beneficial interest in or power over Trust income or corpus that would cause the transfer to Trust to constitute an incomplete gift for federal gift tax purposes, or that would cause Trust corpus to be included in A ’s gross estate for federal estate tax purposes on A ’s death. However, A retains sufficient powers with respect to Trust so that A is treated as the owner of Trust under subpart E.

During Year 1, Trust receives taxable income of $10 x . Pursuant to § 671, A includes the $10 x in A ’s taxable income. As a result, A ’s personal income tax liability for Year 1 increases by $2.5 x . A dies in Year 3. As of the date of A ’s death, the fair market value of Trust’s assets is $150 x .

Situation 1 : Neither State law nor the governing instrument of Trust contains any provision requiring or permitting the trustee to distribute to A amounts sufficient to satisfy A ’s income tax liability attributable to the inclusion of Trust’s income in A ’s taxable income. Accordingly, A pays

Section 2036.—Transfers With Retained Life Estate

26 CFR 20.2036–1: Transfers with retained life es- tate.

What are the gift tax consequences if the grantor of a trust with respect to which the grantor is treated as the owner of the trust under subpart E, part I, subchapter J, chapter 1 of the Internal Revenue Code (subpart E), pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, and what are the estate tax consequences if, pursuant to the governing instrument or applicable local law, the grantor may or must be reimbursed by the trust for that income tax? See Rev. Rul. 2004-64, page 7.

Section 2501.—Imposition of Tax

Section 2511.—Transfers in General

26 CFR 25.2511–1: Transfers in general. (Also §§ 671, 2036, 2501, 2512; 20.2036–1, 25.2511–2.)

Tax reimbursement clause. This ruling addresses issues presented with respect to a trust whose grantor is treated as its owner. It addresses the gift tax consequences when the grantor pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income. It also addresses the estate tax consequences if, pursuant to the governing instrument or applicable local law, the grantor may or must be reimbursed by the trust for that income tax.

Rev. Rul. 2004–64

ISSUES

With respect to a trust whose grantor is treated as the owner of the trust under subpart E, part I, subchapter J, chapter 1 of the Internal Revenue Code (subpart E), what are the gift tax consequences when the grantor pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, and what are the estate tax consequences if, pursuant to the governing instrument or applicable local law, the grantor may or must be reimbursed by the trust for that income tax?

2004–27 I.R.B. 7 July 6, 2004

the additional $2.5 x liability from A ’s own funds.

Situation 2 : The governing instrument of Trust provides that if A is treated as the owner of any portion of Trust pursuant to the provisions of subpart E for any taxable year, the trustee shall distribute to A for the taxable year, income or principal sufficient to satisfy A ’s personal income tax liability attributable to the inclusion of all or part of Trust’s income in A ’s taxable income. Accordingly, the trustee distributes $2.5 x to A to reimburse A for the $2.5 x income tax liability.

Situation 3 : The governing instrument of Trust provides that if A is treated as the owner of any portion of Trust pursuant to the provisions of subpart E for any taxable year, the trustee may, in the trustee’s discretion, distribute to A for the taxable year, income or principal sufficient to satisfy A ’s personal income tax liability attributable to the inclusion of all or part of Trust’s income in A ’s taxable income. Pursuant to the exercise of the trustee’s discretionary power, the trustee distributes $2.5 x to A to reimburse A for the $2.5 x income tax liability.

LAW AND ANALYSIS

Under § 671, if the grantor of a trust is treated as the owner of any portion of the trust under subpart E, those items of income, deductions, and credits against tax of the trust that are attributable to that portion of the trust must be included in computing the taxable income of the grantor.

Section 2501 imposes a tax on the transfer of property by gift by an individual, resident or nonresident. Section 2511(a) provides that the gift tax applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.

Section 2512(b) provides that the gift tax applies only to the extent that property is transferred for less than an adequate and full consideration in money or money’s worth.

Section 25.2511–2(b) of the Gift Tax Regulations provides that a gift is complete and subject to gift tax to the extent the donor has so parted with dominion and control as to leave in the donor no power to change the disposition of the property,

whether for the benefit of the donor, or any other person.

Section 25.2511–1(c)(1) provides that the gift tax applies with respect to any transaction in which an interest in property is gratuitously passed or conferred on another regardless of the means or device employed. Thus, the gift tax may apply if one party forgives or fails to collect on the indebtedness of another. Section 25.2511–1(a); Estate of Lang v. Commissioner, 64 T.C. 404 (1975), aff’d, 613 F.2d 770 (9 ^th Cir. 1980); Rev. Rul. 81–264, 1981–2 C.B. 185. Similarly, the gift tax applies if one person gratuitously pays the tax liability of another. Doerr v. United States, 819 F.2d 162 (7 ^th Cir. 1987) (donor’s payment of the donee’s state gift tax liability constitutes an additional gift to the donee).

Section 2036(a)(1) provides that the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which the decedent has retained for life or for any period not ascertainable without reference to the decedent’s death or for any period that does not in fact end before death the possession or enjoyment of, or the right to the income from, the property.

Section 20.2036–1(b)(2) of the Estate Tax Regulations provides that the use, possession, right to income, or other enjoyment of transferred property is treated as having been retained by the decedent to the extent that the transferred property is to be applied towards the discharge of a legal obligation of the decedent. Estate of Prudowsky v. Commissioner, 55 T.C. 890 (1971), aff’d, 465 F.2d 62 (7 ^th Cir. 1972) (property held under the state Uniform Gifts to Minors Act was included in the decedent’s gross estate under § 2036(a)(1) because decedent, as custodian, retained the power to use the property to satisfy the decedent’s legal obligation to support the minor for whose benefit the custodianship was established); Richards v. Commissioner, T.C.M. 1965–263, aff’d, 375 F.2d 997 (10 ^th Cir. 1967) (trust corpus includible in decedent’s gross estate under § 2036(a)(1) because mandatory distributions of trust income to the decedent’s spouse satisfied the decedent’s spousal

support obligation). On the other hand, § 2036 generally does not apply when trust property may be used to satisfy the decedent’s legal obligations only in the discretion of the trustee, whether or not the discretion is exercised by the trustee. Commissioner v. Estate of Douglas, 143 F.2d 961 (3d Cir. 1944), acq. 1944 C.B. 7; Estate of Mitchell v. Commissioner, 55 T.C. 576 (1970), acq. 1971–2 C.B. 3.

In the present situations, Trust includes provisions that cause A to be treated as the owner of Trust under subpart E and, as a result, to be liable for any income tax attributable to Trust’s income. Thus, even though A is not a Trust beneficiary, any income tax A pays that is attributable to Trust’s income is paid in discharge of A ’s own liability, imposed on A by § 671.

In Situation 1, A ’s payment of the $2.5 x income tax liability does not constitute a gift by A to Trust’s beneficiaries for federal gift tax purposes because A, not Trust, is liable for the taxes. In contrast, in the situation presented in Doerr v. United States, cited above, the donor’s payment was for the donee’s tax liability and, as a result, the payment constituted an additional gift to the donee. In addition, no portion of Trust is includible in A ’s gross estate for federal estate tax purposes under § 2036, because A has not retained the right to have trust property expended in discharge of A ’s legal obligation.

In Situation 2, the governing instrument of Trust requires the trustee to reimburse A from Trust’s assets for the amount of income tax A pays that is attributable to Trust’s income. A ’s payment of the $2.5 x income tax liability does not constitute a gift by A, because A is liable for the tax. The trustee’s distribution of $2.5 x to A as reimbursement for the income tax payment by A is not a gift by the trust beneficiaries to A, because the distribution from Trust is mandated by the terms of the trust instrument.

However, A has retained the right to have trust property expended in discharge of A ’s legal obligation. A ’s retained right to receive reimbursement attributable to Trust’s income causes the full value of Trust’s assets at A ’s death ($150 x ) to be included in A ’s gross estate under § 2036(a)(1). The result would be the same if, under applicable state law, the trustee must, unless the governing instrument provides otherwise, reimburse A for

July 6, 2004 8 2004–27 I.R.B.

DRAFTING INFORMATION

The principal author of this revenue ruling is Elizabeth Madigan of the Office of the Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Ms. Madigan at (202) 622–3090 (not a toll-free call).

Section 2512.—Valuation of Gifts

Section 7520.—Valuation Tables

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

Section 7872.—Treatment of Loans With Below-Market Interest Rates

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of July 2004. See Rev. Rul. 2004-66, page 4.

A ’s personal income tax liability attributable to the inclusion of all or part of the Trust’s income in A ’s taxable income, and the governing instrument does not provide otherwise.

In Situation 3, the governing instrument of Trust provides the trustee with the discretion to reimburse A from Trust’s assets for the amount of income tax A pays that is attributable to Trust’s income. As is the case in Situation 1 and Situation 2, A ’s payment of the $2.5 x income tax liability does not constitute a gift by A because A is liable for the income tax. Further, the $2.5 x paid to A from Trust as reimbursement for A ’s income tax payment was distributed pursuant to the exercise of the trustee’s discretionary authority granted under the terms of the trust instrument. Accordingly, this payment is not a gift by the trust beneficiaries to A . In addition, assuming there is no understanding, express or implied, between A and the trustee regarding the trustee’s exercise of discretion, the trustee’s discretion to satisfy A ’s obligation would not alone cause the inclusion of the trust in A ’s gross estate for federal estate tax purposes. This is the case regardless of whether or not the trustee actually reimburses A from Trust assets for the amount of income tax A pays that is attributable to Trust’s income. The result would be the same if the trustee’s discretion to reimburse A for this income tax is granted under applicable state law rather than under the governing instrument. However, such discretion combined with other facts (including but not limited to: an understanding or pre-existing arrangement between A and

the trustee regarding the trustee’s exercise of this discretion; a power retained by A to remove the trustee and name A as successor trustee; or applicable local law subjecting the trust assets to the claims of A ’s creditors) may cause inclusion of Trust’s assets in A ’s gross estate for federal estate tax purposes.

HOLDINGS

When the grantor of a trust, who is treated as the owner of the trust under subpart E, pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, the grantor is not treated as making a gift of the amount of the tax to the trust beneficiaries. If, pursuant to the trust’s governing instrument or applicable local law, the grantor must be reimbursed by the trust for the income tax payable by the grantor that is attributable to the trust’s income, the full value of the trust’s assets is includible in the grantor’s gross estate under § 2036(a)(1). If, however, the trust’s governing instrument or applicable local law gives the trustee the discretion to reimburse the grantor for that portion of the grantor’s income tax liability, the existence of that discretion, by itself (whether or not exercised) will not cause the value of the trust’s assets to be includible in the grantor’s gross estate.

PROSPECTIVE APPLICATION

The Internal Revenue Service will not apply the estate tax holding in Situation 2 of this revenue ruling adversely to a grantor’s estate with respect to any trust created before October 4, 2004.

2004–27 I.R.B. 9 July 6, 2004