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

Section 42.—Low-Income Housing Credit

Low-income housing credit; satis- factory bond; “bond factor” amounts for the period July through September 2004. This ruling announces the monthly bond factor amounts to be used by taxpayers who dispose of qualified low-income buildings or interests therein during the period July through September 2004.

Rev. Rul. 2004–89

In Rev. Rul. 90–60, 1990–2 C.B. 3, the Internal Revenue Service provided

guidance to taxpayers concerning the general methodology used by the Treasury Department in computing the bond factor amounts used in calculating the amount of bond considered satisfactory by the Secretary under § 42(j)(6) of the Internal Revenue Code. It further announced that the Secretary would publish in the Internal Revenue Bulletin a table of bond factor amounts for dispositions occurring during each calendar month.

Rev. Proc. 99–11, 1999–1 C.B. 275, established a collateral program as an alternative to providing a surety bond for taxpayers to avoid or defer recapture of the low-income housing tax credits under § 42(j)(6). Under this program, taxpayers

may establish a Treasury Direct Account and pledge certain United States Treasury securities to the Internal Revenue Service as security.

This revenue ruling provides in Table 1 the bond factor amounts for calculating the amount of bond considered satisfactory under § 42(j)(6) or the amount of United States Treasury securities to pledge in a Treasury Direct Account under Rev. Proc. 99–11 for dispositions of qualified low-income buildings or interests therein during the period July through September 2004.

Rul. 2004–16, 2004–8 I.R.B. 503. For dispositions occurring during the period April through June 2004, see Rev. Rul. 2004–40, 2004–15 I.R.B. 716.

For a list of bond factor amounts applicable to dispositions occurring during other calendar years, see: Rev. Rul. 98–3, 1998–1 C.B. 248; Rev. Rul. 2001–2, 2001–1 C.B. 255; Rev. Rul.

2001–53, 2001–2 C.B. 488; Rev. Rul. 2002–72, 2002–2 C.B. 759; and Rev. Rul. 2003–117, 2003–46 I.R.B. 1051. For dispositions occurring during the period January through March 2004, see Rev.

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posed regulations are adopted as amended by this Treasury decision.

This document also contains an amendment to the regulations under section 408(a) regarding the approval of nonbank trustees of individual retirement accounts. Section 1.408–2(e)(5)(v)(A) of the regulations currently provides that a person seeking approval to serve as a nonbank trustee must demonstrate that, except for investments pooled in a common investment fund, the investments of each account will not be commingled with any other property. Because section 408(q)(1) expressly provides that deemed IRAs need not satisfy the requirements of section 408(a)(5) regarding the commingling of IRA and plan assets, §1.408–2(e)(5)(v)(A) is modified to reflect the statutory rule.

In addition, this document contains a temporary amendment to the regulations under section 408(a) regarding the approval of nonbank trustees. This temporary amendment modifies the requirements for approval as a nonbank trustee for certain governmental units that intend to serve as the trustees of individual retirement accounts subject to section 408(q).

Explanation of Provisions and Summary of Comments

A. Overview

Section 408(q) provides that, if a qualified employer plan allows employees to make voluntary employee contributions to a separate account or annuity established under the plan and under the terms of the qualified employer plan the account or annuity meets the applicable requirements of section 408 or section 408A for an individual retirement account or annuity, then the account or annuity is treated for purposes of the Code in the same manner as an individual retirement plan rather than as a qualified employer plan. It further provides that contributions to such a “deemed IRA” are treated as contributions to the deemed IRA rather than to the qualified employer plan. Section 408(q) also expressly provides that the requirements of section 408(a)(5) regarding the commingling of IRA assets with other property shall not apply to deemed IRAs.

In general, the proposed regulations provided that a qualified employer plan and a deemed IRA would be treated as

DRAFTING INFORMATION

The principal author of this revenue ruling is David McDonnell of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Mr. McDonnell at (202) 622–3040 (not a toll-free call).

Section 408.—Individual Retirement Accounts

26 CFR 1.408–2: Individual retirement accounts.

T.D. 9142

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

Deemed IRAs in Qualified Retirement Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains final regulations providing guidance under section 408(q) regarding accounts or annuities that are part of qualified employer plans but are to be treated as individual retirement plans. These regulations reflect changes made to the law by the Economic Growth and Tax Relief Reconciliation Act of 2001 and by the Job Creation and Worker Assistance Act of 2002. This document also contains temporary regulations under section 408(a) providing a special rule for governmental units seeking approval to serve as nonbank trustees of individual retirement accounts for purposes of section 408(q). These regulations affect administrators of, participants in, and beneficiaries of qualified employer plans.

DATES: Effective Date: These regulations are effective July 22, 2004.

Applicability Dates: For dates of applicability, see §§1.408(q)–1(i) and 1.408–2T(e)(8)(iv).

FOR FURTHER INFORMATION CONTACT: Linda Conway at (202) 622–6090 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507) under control number 1545–1841. Responses to this collection of information are required for taxpayers who want to include individual retirement plans as part of a qualified employer plan.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

The estimated annual burden per respondent/recordkeeper is 50 hours.

Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224, and to the Office of Manage- ment and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

This document contains amendments to the Income Tax Regulations (26 CFR Part 1) under section 408(q) of the Internal Revenue Code (Code). On May 20, 2003, a notice of proposed rulemaking (REG–157302–02, 2003–1 C.B. 1021) was published in the Federal Register (68 FR 27493) under section 408(q). No public hearing was requested or held. Written comments responding to the notice of proposed rulemaking were received. After consideration of all the comments, the pro

August 23, 2004 302 2004–34 I.R.B.

The proposed regulations included a rule for individual retirement annuities similar to that for individual retirement accounts. Under the proposed regulations, separate annuity contracts were to be maintained for individual retirement annuities when the qualified employer plan also maintains annuity contracts. However, unlike the rules applicable to deemed individual retirement accounts which provide for separate accounts and not separate trusts, section 408(q)(1)(A) expressly provides that a separate annuity is to be established for a deemed individual retirement annuity. Accordingly, these final regulations retain the rule in the proposed regulations that a separate annuity is to be established under the plan with respect to deemed individual retirement annuities.

C. Disqualification

Section 1.408(q)–1(g) of the proposed regulations provided that the failure of any of the deemed IRAs maintained by the plan to satisfy the applicable requirements of section 408 or 408A caused the plan as a whole to fail to satisfy the plan’s qualification requirements. The proposed regulations further provided that, if the qualified employer plan failed to satisfy its qualification requirements, the deemed IRA portion would no longer be a deemed IRA because section 408(q) does not apply if the plan is not a qualified employer plan. The proposed regulations provided, however, that although the account or annuity that was intended to be a deemed IRA was no longer a deemed IRA, it could still be treated as a traditional or a Roth IRA if it satisfied the applicable requirements of section 408 or 408A (including the requirements regarding the commingling of assets under section 408(a)(5)).

Several commentators objected to this rule as inconsistent with the general rule that the qualified employer plan and the deemed IRA portion of the plan are separate entities and with the requirement that the deemed IRA assets and the other assets of the qualified employer plan must be maintained in separate trusts. Some commentators objected in particular to the rule that the failure of the qualification of a deemed IRA could result in the failure of the qualification of the plan as a whole. They stated that various aspects of the op

separate entities under the Code and that each entity would be subject to the rules generally applicable to that entity for purposes of the Code. Thus, a qualified employer plan (excluding the deemed IRA portion of the plan), whether it is a plan under section 401(a), 403(a), or 403(b), or a governmental plan under section 457(b), would be subject to the rules applicable to that type of plan rather than to the rules applicable to IRAs under section 408 or 408A. Similarly, the deemed IRA portion of the qualified employer plan would generally be subject to the rules applicable to traditional and Roth IRAs under sections 408 and 408A, respectively, and not to the rules applicable to plans under section 401(a), 403(a), 403(b), or 457.

B. Separate Trusts

Section 1.408(q)–1(f)(2) of the proposed regulations provided that any trust holding deemed individual retirement account assets must be separate from the trust holding the other assets of the qualified employer plan. The separate trust rule was intended to ensure better compliance with the IRA requirements and limit confusion of IRA and plan assets. The proposed regulations also provided a comparable rule for deemed IRAs that are individual retirement annuities.

Several commentators argued that a separate trust for deemed individual retirement accounts should not be required where the assets of the qualified employer plan are already held in a trust. They argued the plan’s trust could satisfy the requirement of section 408 that the individual retirement account be held in a trust and that separate accounting would ensure compliance with the IRA requirements and avoid any confusion of IRA and plan assets. They also argued the requirement of a separate trust would unduly complicate the administration of the plan and lead to potentially higher costs for the plan sponsor. In response to these comments, the final regulations provide that a separate trust is not required in those cases in which the qualified employer plan maintains a trust but only if separate accounting is maintained for each deemed IRA. Revenue Procedure 2003–13, 2003–1 C.B. 317, which includes sample amendments providing for separate trusts for deemed

IRAs, does not apply to the extent it provides to the contrary.

The regulations specify that if deemed IRAs are held in a single trust that includes the qualified employer plan, the trustee must maintain a separate account for each deemed IRA and the qualified employer plan.

Permitting deemed IRAs that are individual retirement accounts to be held in a single trust that includes the qualified employer plan raises the issue of whether, if the qualified employer plan portion of the trust invests in life insurance contracts, the deemed IRA would be considered to have violated section 408(a)(3), which provides that “no part of the trust funds will be invested in life insurance contracts.” The regulations clarify that, in that case, section 408(a)(3) is treated as satisfied if no part of the separate account of any of the deemed IRAs is invested in life insurance contracts.

Section 408A(b) and the regulations thereunder set forth rules under which a Roth IRA must be clearly designated as a Roth IRA. Pursuant to the regulations under §1.408A–2, Roth IRAs that are individual retirement accounts must be trusts separate from traditional IRAs. These final regulations permit a departure from these rules for deemed Roth IRAs, allowing them to be held in a single trust with deemed traditional IRAs, provided that the trustee maintains separate accounts for the deemed Roth IRAs and deemed traditional IRAs of each participant, and each of those accounts is clearly designated as such. Thus, the rules under §§1.408A–2 and 1.408A–4 of the regulations, regarding designation and redesignation of IRAs as Roth IRAs, apply to deemed IRAs as if the separate accounts maintained for the deemed Roth IRAs and deemed traditional IRAs were separate trusts.

The requirements for separate accounts within a trust as described above are not meant to imply that a trust that includes deemed IRAs and a qualified employer plan (or Roth and traditional IRAs) can be segmented for other purposes. For example, where a qualified employer plan and deemed IRAs are included in the same trust, there cannot be separate trustees for each account, and the trustee for the trust must be either a bank or a nonbank trustee that satisfies the requirements of section 408(a)(2) and the regulations thereunder.

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E. Other Comments

Other comments included one noting that the proposed regulations require that the plan document of the qualified employer plan must contain the deemed IRA provisions and that Revenue Procedure 2003–13 provides that the deemed IRA provisions must address every applicable point in the IRA Listing of Required Modifications. The commentator suggested that plan sponsors be permitted to incorporate by reference the terms of separate IRA agreements or annuities. Although incorporation by reference may be possible in some circumstances, it is not possible where the IRA document is inconsistent with the provisions of the plan. For example, assuming the deemed IRA is to provide for commingling as allowed under section 408(q), it is not possible to incorporate an IRA document that prohibits such commingling.

Various comments were received relating to administrative issues such as reporting and withholding rules and whether the separate rules applicable to qualified employer plans and IRAs were to be applied. As indicated in §1.408(q)–1(c) of the proposed regulations, except as otherwise provided in the regulations, the qualified employer plan and the deemed IRA are treated as separate entities under the Code and they are subject to the separate rules applicable to qualified employer plans and IRAs, respectively. Accordingly, the reporting and withholding rules on plan and IRA distributions apply separately depending on whether the distributions are made from the deemed IRA or the qualified employer plan. Thus, for example, the reporting rules for required minimum distributions apply separately for the two portions of the plan. Similarly, a total distribution of amounts held in the qualified employer plan portion and the deemed IRA portion is reported on two Forms 1099-R, “ Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. ”, one for the distribution from the deemed IRA portion and one for the rest of the distribution. Also, the 20% withholding

eration of deemed IRAs are not within the control of the employer.

The final regulations provide that the failure of either the qualified employer plan portion or the deemed IRA portion of the plan to satisfy the applicable qualification rules of each will not cause the other portion to be automatically disqualified. This rule applies, however, only if the deemed IRA portion and the qualified employer plan portion are maintained as separate trusts (or separate annuity contracts, as required in the case of individual retirement annuities). If both the deemed IRA portion and the qualified plan portion are included in separate trusts and the qualified employer plan is disqualified, the IRA portion cannot be a deemed IRA under section 408(q) but it will not fail to satisfy the applicable requirements of section 408 or 408A if it satisfies the applicable requirements of those sections, including, with respect to individual retirement accounts, the requirements of section 408(a)(5). However, if the IRA assets and the non-IRA assets have been commingled (except in a common trust fund or common investment fund as permitted by section 408(a)(5)), the IRA portion will fail to satisfy the requirements of section 408(a). ¹ Likewise, if the IRA assets and the non-IRA assets are commingled (except as permitted by section 408(a)(5)), and the IRA is disqualified, the plan will also be disqualified.

D. Governmental Units as Nonbank Trustees

As noted above, the proposed regulations provided that a qualified employer plan and a related deemed IRA are generally treated as separate entities under the Code and each is subject to the rules applicable to that entity. Thus, under the proposed regulations, an individual retirement account that is a deemed IRA would be required to satisfy the requirements of section 408(a) except for the commingling limitations of section 408(a)(5). Consistent with this general rule, §1.408(q)–1(f)(1) of the proposed regulations provided that the trustee or

custodian of an individual retirement account must be a bank or other person that receives approval from the Commissioner to serve as a nonbank trustee pursuant to §1.408–2(e) of the regulations.

Several commentators noted that because the nonbank trustee criteria were designed to test private entities, it is difficult, if not impossible, for most state and local governments to satisfy them. They also argued that, although it may be possible for a state or local government to appoint a bank or an approved nonbank trustee for the deemed IRA portion of the plan, this would impose unnecessary costs and administrative hardships on these governments that would outweigh any corresponding benefit and that such an appointment may contravene state law.

Several commentators argued that governments should be exempt from the nonbank trustee requirements, but the IRS and Treasury continue to believe that governments, like private entities, must demonstrate to the satisfaction of the Commissioner that the manner in which the government will administer the deemed IRA will be consistent with the requirements of section 408(a). Accordingly, the final regulations adopt the rule of the proposed regulations that the trustee of the deemed IRA must be a bank or a nonbank trustee approved by the Commissioner. The IRS and Treasury acknowledge, however, that §1.408–2(e) of the regulations sets forth several criteria that governments may have difficulty satisfying. Accordingly, this document temporarily amends §1.408–2(e) to provide that a governmental unit may serve as the trustee of any deemed IRA established by that governmental unit as part of its qualified employer plan if that governmental unit establishes to the satisfaction of the Commissioner that the manner in which it will administer the deemed IRA will be consistent with the requirements of section 408. The temporary amendment also provides special rules regarding the application of §1.408–2(e) to governmental units.

1 The Department of Labor has advised the IRS and Treasury that consistent with section 4(c) of the Employee Retirement Income Security Act (ERISA), accounts and annuities (and contributions thereto) established in accordance with section 408(q) of the Code are not to be treated as part of the pension plan under which such accounts and annuities are allowed (or as a separate pension plan) “for purposes of any provision of [title I of ERISA] other than § 403(c), 404, or 405 (relating to exclusive benefit, and fiduciary and co-fiduciary responsibilities) and part 5 (relating to administration and enforcement).” Accordingly, fiduciaries need to take appropriate steps to ensure that they satisfy any fiduciary duties associated with implementation and operation of a deemed IRA feature that is related to a plan covered under title I of ERISA. These duties may include, but are not limited to, a duty to monitor the activities of holders of deemed IRAs in order to prevent disqualification of the deemed IRA feature and/or the qualified employer plan where the plan is intended to be maintained as a tax-qualified plan.

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Title IV. For example, neither the assets in, nor the benefits attributable to, the deemed IRA are taken into account in determining the amount of the PBGC’s variable-rate premium, and an individual who is a participant in the deemed IRA but who is not a participant in the qualified employer plan is not included in the PBGC’s flat-rate participant count. In addition, for purposes of Title IV, the deemed IRA will be treated as separate from the qualified employer plan in the event of termination of the qualified employer plan, and the fiduciary of the deemed IRA would continue to be responsible for the continued operation, transfer, or termination of the deemed IRA. The PBGC would allocate the assets of the qualified employer plan to the priority categories under section 4044 of ERISA without regard to any assets in, or benefits attributable to, the deemed IRA, and the PBGC would not serve as trustee of the deemed IRA. Termination of a deemed IRA would not be subject to the rules governing plan termination under Title IV of ERISA.

Effective Date

The regulations apply to accounts or annuities established under section 408(q) on or after August 1, 2003.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required.

It is hereby certified that the collection of information in these final regulations will not have a significant economic impact on a substantial number of small entities. The collection of information in the regulations is in §1.408(q)–1(f)(2) and consists of the optional requirement that deemed IRAs may be held in trusts or annuity contracts separate from the trust or annuity contract of the qualified employer plan. This certification is based on the fact that the burden of reporting these separate trusts and annuity contracts is small, particularly for small entities. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking will be submitted to the

rules of section 3405(c) do not apply to a distribution from the deemed IRA portion but would apply to a distribution from the qualified employer plan portion, and section 72(t) applies separately to the two portions.

Questions were also raised regarding who may participate in a deemed IRA. For example, one commentator, noting that the term employee is not defined by section 408(q) or by the proposed regulations, asked whether that term includes self-employed individuals. Although em- ployee is not defined by section 408(q), section 408(q)(3)(B) defines a voluntary employee contribution, in part, as a contribution by an individual “as an employee under a qualified employer plan which allows employees” to elect to make contributions to a separate account under the plan. Thus, these regulations provide that to the extent a self-employed individual is an employee for purposes of the qualified employer plan, that individual will be treated as an employee for purposes of section 408(q). In the case of a qualified plan under section 401(a) and a qualified annuity plan under section 403(a), em- ployee includes self-employed individuals as defined in section 401(c). The only circumstance under which a self-employed individual may participate in a section 403(b) plan is when a self-employed minister described in section 414(e)(5) participates in a retirement income account as described in section 403(b)(9). In contrast, section 457(e)(2) permits independent contractors as well as employees to participate in a section 457 plan. However, since section 408(q) permits only employees to make contributions to a deemed IRA, only employees (including self-employed individuals) may be permitted to participate in a deemed IRA maintained by a governmental section 457 plan.

Another commentator asked whether an employee can participate in a deemed IRA if he or she does not participate in the qualified employer plan, or even if the employee is not eligible to participate in the qualified employer plan. Again, as noted above, the deemed IRA and the qualified employer plan are generally treated as separate entities under the Code. Section 408(q) does not impose a requirement that an employee must participate in both portions of the plan or that an employee must

be eligible to participate in both portions of the plan. Accordingly, the two portions of the plan may have different eligibility requirements.

One commentator asked whether the automatic enrollment principles applicable to section 401(k), 403(b), and 457 plans under Revenue Rulings 2000–8, 2000–1 C.B. 617; 2000–35, 2000–2 C.B. 138; and 2000–33, 2000–2 C.B. 142, apply to deemed IRAs. These revenue rulings specify the criteria to be met in order for an employee’s compensation to be automatically reduced by a certain amount where that amount is contributed as an elective deferral to these three types of plans. The IRS and Treasury agree that the automatic enrollment principles applicable to section 401(k), 403(b), and 457 plans in the cited revenue rulings may also be applied to deemed IRAs.

With respect to the requirements for approval as a nonbank trustee, one commentator noted that §1.408–2(e)(5)(v) requires that an applicant must demonstrate that, except for investments pooled in a common investment fund, the investments of each account will not be commingled with any other property. The commentator noted that this requirement is inconsistent with the provisions of section 408(q)(1), which provide that the requirements of section 408(a)(5) regarding commingling do not apply to deemed IRAs. Accordingly, this document amends §1.408–2(e)(5)(v) to provide that an applicant that intends to serve as a nonbank trustee need not satisfy this requirement with respect to any assets held in a deemed IRA.

Finally, these regulations provide that neither the assets held in the deemed IRA portion of the qualified employer plan, nor any benefits attributable thereto, shall be taken into account for purposes of determining the benefits of employees and their beneficiaries under the plan (within the meaning of section 401(a)(2)) or determining the plan’s assets or liabilities for purposes of section 404 or 412. The Pension Benefit Guaranty Corporation (PBGC) has advised the IRS and Treasury that a deemed IRA feature that is related to a qualified employer plan is not covered by Title IV of ERISA. The PBGC has further advised that the deemed IRA feature is treated as a separate entity from the qualified employer plan for purposes of

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other requirements of §1.408–2(e)(2) to (e)(6), the Commissioner may apply the requirements in a manner that is consistent with the applicant’s status as a governmental unit.

(ii) Governmental unit . For purposes of this special rule, the term governmental unit means a State, political subdivision of a State, and any agency or instrumentality of a State or political subdivision of a State.

(iii) Additional rules . The Commissioner may in revenue rulings, notices, or other guidance of general applicability provide additional rules for governmental units seeking approval as nonbank trustees.

(iv) Effective date . This special rule is applicable for written applications made on or after August 1, 2003, or such earlier application as the Commissioner deems appropriate.

Par. 4. Section 1.408(q)–1 is added to read as follows:

§1.408(q)–1 Deemed IRAs in qualified employer plans.

(a) In general . Under section 408(q), a qualified employer plan may permit employees to make voluntary employee contributions to a separate account or annuity established under the plan. If the requirements of section 408(q) and this section are met, such account or annuity is treated in the same manner as an individual retirement plan under section 408 or 408A (and contributions to such an account or annuity are treated as contributions to an individual retirement plan and not to the qualified employer plan). The account or annuity is referred to as a deemed IRA.

(b) Types of IRAs . If the account or annuity meets the requirements applicable to traditional IRAs under section 408, the account or annuity is deemed to be a traditional IRA, and if the account or annuity meets the requirements applicable to Roth IRAs under section 408A, the account or annuity is deemed to be a Roth IRA. Simplified employee pensions (SEPs) under section 408(k) and SIMPLE IRAs under section 408(p) may not be used as deemed IRAs.

(c) Separate entities . Except as provided in paragraphs (d) and (g) of this section, the qualified employer plan and the deemed IRA are treated as separate entities under the Internal Revenue Code

Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

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. For the applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6) to the temporary regulations, refer to the Special Analyses section of the preamble to the cross-referencing notice of proposed rulemaking (REG–101447–04) published in this issue of the Bulletin. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding the final regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for coment on their impact on small business. The temporary regulations will also be submitted to the Chief Counsel for Advocacy for such comment.

Drafting Information

The principal authors of these regulations are Robert Walsh of the Tax Exempt and Government Entities Division and Linda Conway, Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and Treasury participated in the development of these regulations.

- - - -

Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are 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 * * * §1.408–2 also issued under 26 U.S.C. 408(a) and 26 U.S.C. 408(q). - * * §1.408(q)–1 also issued under 26 U.S.C. 408(q). - * *

Par. 2. In §1.408–2, paragraph (e)(5) (v)(A) is revised and (e)(8) is added to read as follows:

§1.408–2 Individual retirement accounts

• • • • (e) - -

(5) - - (v) Custody of investments . (A) Except for investments pooled in a common investment fund in accordance with the provisions of paragraph (e)(5)(vi) of this section and for investments of accounts established under section 408(q) on or after August 1, 2003, the investments of each account will not be commingled with any other property.

• • • • (8) [Reserved]. For further guidance, see §1.408–2T(e)(8).

Par. 3. Section 1.408–2T is added to read as follows:

§1.408–2T Individual retirement accounts (temporary).

(a) through (e)(7) [Reserved]. For further guidance, see §1.408–2(a) through (e)(7).

(8) Special rules for governmental units . (i) A governmental unit that seeks to qualify as a nonbank trustee of a deemed IRA that is part of its qualified employer plan must demonstrate to the satisfaction of the Commissioner that it is able to administer the trust in a manner that is consistent with the requirements of section 408. The demonstration must be made by written application to the Commissioner. Notwithstanding the requirement of §1.408–2(e)(1) that a person must demonstrate by written application that the requirements of paragraphs (e)(2) to (e)(6) of that section will be met in order to qualify as a nonbank trustee, a governmental unit that maintains a plan qualified under section 401(a), 403(a), 403(b) or 457 need not demonstrate that all of these requirements will be met with respect to any individual retirement accounts maintained by that governmental unit pursuant to section 408(q). For example, a governmental unit need not demonstrate that it satisfies the net worth requirements of §1.408–2(e)(3)(ii) if it demonstrates instead that it possesses taxing authority under applicable law. The Commissioner, in his discretion, may exempt a governmental unit from certain other requirements upon a showing that the governmental unit is able to administer the deemed IRAs in the best interest of the participants. Moreover, in determining whether a governmental unit satisfies the

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tracts of the qualified employer plan. In addition, the contract must satisfy the requirements of section 408(b) and there must be separate accounting for the interest of each participant in those cases where the individual retirement annuities are held under a single annuity contract.

(4) Deductibility . The deductibility of voluntary employee contributions to a traditional deemed IRA is determined in the same manner as if they were made to any other traditional IRA. Thus, for example, taxpayers with compensation that exceeds the limits imposed by section 219(g) may not be able to make contributions to deemed IRAs, or the deductibility of such contributions may be limited in accordance with sections 408 and 219(g). However, section 219(f)(5), regarding the taxable year in which amounts paid by an employer to an individual retirement plan are includible in the employee’s income, is not applicable to deemed IRAs.

(5) Rollovers and transfers . The same rules apply to rollovers and transfers to and from deemed IRAs as apply to rollovers and transfers to and from other IRAs. Thus, for example, the plan may provide that an employee may request and receive a distribution of his or her deemed IRA account balance and may roll it over to an eligible retirement plan in accordance with section 408(d)(3), regardless of whether that employee may receive a distribution of any other plan benefits.

(6) Nondiscrimination . The availability of a deemed IRA is not a benefit, right or feature of the qualified employer plan under §1.401(a)(4)–4.

(7) IRA assets and benefits not taken into account in determining benefits un- der or funding of qualified employer plan . Neither the assets held in the deemed IRA portion of the qualified employer plan, nor any benefits attributable thereto, shall be taken into account for purposes of:

(i) determining the benefits of employees and their beneficiaries under the plan (within the meaning of section 401(a)(2)); or

(ii) determining the plan’s assets or liabilities for purposes of section 404 or 412.

(g) Disqualifying defects - (1) Single trust . If the qualified employer plan fails to satisfy the qualification requirements applicable to it, either in form or operation, any deemed IRA that is an individual retirement account and that is included as

and are subject to the separate rules applicable to qualified employer plans and IRAs, respectively. Issues regarding eligibility, participation, disclosure, nondiscrimination, contributions, distributions, investments, and plan administration are generally to be resolved under the separate rules (if any) applicable to each entity under the Internal Revenue Code.

(d) Exceptions . The following exceptions to treatment of a deemed IRA and the qualified employer plan as separate entities apply:

(1) The plan document of the qualified employer plan must contain the deemed IRA provisions and a deemed IRA must be in effect at the time the deemed IRA contributions are accepted. Notwithstanding the preceding sentence, employers that provided deemed IRAs for plan years beginning before January 1, 2004, (but after December 31, 2002) are not required to have such provisions in their plan documents before the end of such plan years.

(2) The requirements of section 408(a)(5) regarding commingling of assets do not apply to deemed IRAs. Accordingly, the assets of a deemed IRA may be commingled for investment purposes with those of the qualified employer plan. However, the restrictions on the commingling of plan and IRA assets with other assets apply to the assets of the qualified employer plan and the deemed IRA.

(e) Application of distribution rules . (1) Rules applicable to distributions from qualified employer plans under the Internal Revenue Code and regulations do not apply to distributions from deemed IRAs. Instead, the rules applicable to distributions from IRAs apply to distributions from deemed IRAs. Also, any restrictions that a trustee, custodian, or insurance company is permitted to impose on distributions from traditional and Roth IRAs may be imposed on distributions from deemed IRAs (for example, early withdrawal penalties on annuities).

(2) The required minimum distribution rules of section 401(a)(9) must be met separately with respect to the qualified employer plan and the deemed IRA. The determination of whether a qualified employer plan satisfies the required minimum distribution rules of section 401(a)(9) is made without regard to whether a participant satisfies the required minimum distribution requirements with respect to

the deemed IRA that is established under such plan.

(f) Additional rules - (1) Trustee . The trustee or custodian of an individual retirement account must be a bank, as required by section 408(a)(2), or, if the trustee is not a bank, as defined in section 408(n), the trustee must have received approval from the Commissioner to serve as a nonbank trustee or nonbank custodian pursuant to §1.408–2(e). For further guidance regarding governmental units serving as nonbank trustees of deemed IRAs established under section 408(q), see §1.408–2T(e)(8).

(2) Trusts . (i) General rule. Deemed IRAs that are individual retirement accounts may be held in separate individual trusts, a single trust separate from a trust maintained by the qualified employer plan, or in a single trust that includes the qualified employer plan. A deemed IRA trust must be created or organized in the United States for the exclusive benefit of the participants. If deemed IRAs are held in a single trust that includes the qualified employer plan, the trustee must maintain a separate account for each deemed IRA. In addition, the written governing instrument creating the trust must satisfy the requirements of section 408(a) (1), (2), (3), (4), and (6).

(ii) Application of section 408(a)(3) . If deemed IRAs are held in a single trust that includes the qualified employer plan, section 408(a)(3) is treated as satisfied if no part of the separate accounts of any of the deemed IRAs is invested in life insurance contracts, regardless of whether the separate account for the qualified employer plan invests in life insurance contracts.

(iii) Separate accounts for traditional and Roth deemed IRAs . The rules of section 408A(b) and the regulations thereunder, requiring each Roth IRA to be clearly designated as a Roth IRA, will not fail to be satisfied solely because Roth deemed IRAs and traditional deemed IRAs are held in a single trust, provided that the trustee maintains separate accounts for the Roth deemed IRAs and traditional deemed IRAs of each participant, and each of those accounts is clearly designated as such.

(3) Annuity contracts . Deemed IRAs that are individual retirement annuities may be held under a single annuity contract or under separate annuity contracts. However, the contract must be separate from any annuity contract or annuity con

2004–34 I.R.B. 307 August 23, 2004

elect to make contributions to deemed IRAs and with respect to which the individual has designated the contribution as a contribution to which section 408(q) applies.

(3) Employee . An employee includes any individual who is an employee under the rules applicable to the qualified employer plan under which the deemed IRA is established.

(i) Effective date . This section applies to accounts or annuities established under section 408(q) on or after August 1, 2003.

PART 602 - OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 5. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. - * * Par. 6. In § 602.101, paragraph (b) is amended by adding the following entry in numerical order to the table to read as follows:

Current OMB control No.

part of the trust of that qualified employer plan does not satisfy section 408(q). Accordingly, any account maintained under such a plan as a deemed IRA ceases to be a deemed IRA at the time of the disqualifying event. In addition, the deemed IRA also ceases to satisfy the requirements of sections 408(a) and 408A. Also, if any one of the deemed IRAs fails to satisfy the applicable requirements of sections 408 or 408A, and the assets of that deemed IRA are included as part of the trust of the qualified employer plan, section 408(q) does not apply and the plan will fail to satisfy the plan’s qualification requirements.

(2) Separate trusts and annuities . If the qualified employer plan fails to satisfy its qualification requirements, either in form or operation, but the assets of a deemed IRA are held in a separate trust (or where a deemed IRA is an individual retirement annuity), then the deemed IRA does not automatically fail to satisfy the applicable requirements of section 408 or 408A. Instead, its status as an IRA will be determined by considering whether the account or the annuity satisfies the applica

CFR part or section where identified and described

• ---

ble requirements of sections 408 and 408A (including, in the case of individual retirement accounts, the prohibition against the commingling of assets under section 408(a)(5)). Also, if a deemed IRA fails to satisfy the requirements of a qualified IRA and the assets of the deemed IRA are held in a separate trust (or where the deemed IRA is an individual retirement annuity), the qualified employer plan will not fail the qualification requirements applicable to it under the Code solely because of the failure of the deemed IRA.

(h) Definitions . The following definitions apply for purposes of this section:

(1) Qualified employer plan . A quali- fied employer plan is a plan described in section 401(a), an annuity plan described in section 403(a), a section 403(b) plan, or a governmental plan under section 457(b).

(2) Voluntary employee contribution . A voluntary employee contribution is any contribution (other than a mandatory contribution within the meaning of section 411(c)(2)(C)) which is made by an individual as an employee under a qualified employer plan that allows employees to

1.408(q)–1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1545–1841

• ---

SUMMARY: This document contains final regulations relating to partnership transactions involving contracts accounted for under a long-term contract method of accounting. The regulations are necessary to resolve issues that were reserved in final regulations under section 460 that were published in the Federal Register on May 15, 2002, addressing other mid-contract changes in taxpayer engaged in completing such contracts. The effect of the regulations is to explain the tax consequences of these partnership transactions.

DATES: Effective Date: These regulations are effective July 16, 2004.

Applicability Date: These regulations apply to transactions on or after May 15, 2002.

FOR FURTHER INFORMATION CONTACT: Richard Probst at (202) 622–3060 (not a toll-free number).

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

Approved July 14, 2004.

Gregory F. Jenner, Acting Assistant Secretary of the Treasury .

(Filed by the Office of the Federal Register on July 21, 2004, 8:45 a.m., and published in the issue of the Federal Register for July 22, 2004, 69 F.R. 43735)

Section 460.—Special Rules for Long-Term Contracts

26 CFR 1.460–4: Methods of accounting for long- term contracts.

T.D. 9137

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Partnership Transactions Involving Long-Term Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

August 23, 2004 308 2004–34 I.R.B.

tract, with both the contract price and allocable contract costs based on amounts taken into account by both parties.

The final section 460 regulations provide that a contribution to a partnership in a transaction described in section 721(a), a transfer of a partnership interest, and a distribution by a partnership to which section 731 applies (other than a distribution of a contract accounted for under a long-term contract method of accounting) are step-in-the-shoes transactions. In a notice issued concurrently with the final regulations, Notice 2002–37, 2002–23 I.R.B. 1095, the Treasury Department and IRS announced their intention to publish regulations setting forth the special rules that apply to these partnership transactions and described many of these rules. The notice further provided that these regulations would apply to contributions, transfers, and distributions occurring on or after May 15, 2002. On August 6, 2003, a notice of proposed rulemaking (REG–128203–02, 2003–41 I.R.B. 828) relating to partnership transactions involving contracts accounted for under a long-term contract method of accounting was published in the Federal Register (68 FR 46516). Comments were received from the public in response to the notice of proposed rulemaking. No public hearing was requested or held. After consideration of all comments, the proposed regulations are adopted as amended by this Treasury decision.

Explanation and Summary of Contents

The regulations proposed on August 6, 2003, provide that the constructive completion rules do not apply to a transfer by a partnership (transferor partnership) of all of its assets and liabilities to a second partnership (transferee partnership) in an exchange described in section 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership, under §1.708–1(b)(4) (relating to terminations under section 708(b)(1)(B)) or §1.708–1(c)(3)(i) (relating to certain partnership mergers). One commentator suggested clarifying that the constructive completion rules apply to other distributions of an interest in a partnership (lower-tier partnership) holding one or more contracts accounted for under a

SUPPLEMENTARY INFORMATION:

Background

Section 460 of the Internal Revenue Code generally requires that taxpayers determine taxable income from a long-term contract using the percentage-of-completion method (PCM). Under regulations finalized in 2001 (T.D. 8929, 2001–1 C.B. 756), a taxpayer using the PCM generally includes a portion of the total contract price in income for each taxable year that the taxpayer incurs contract costs allocable to the long-term contract. More specifically, to determine the income from a long-term contract, the taxpayer first computes the completion factor for the contract, which is the percentage of the estimated total allocable contract costs that the taxpayer has incurred (based on the all events test of section 461, including economic performance, regardless of the taxpayer’s method of accounting) through the end of the taxable year. Second, the taxpayer computes the amount of cumulative gross receipts from the contract by multiplying the completion factor by the total contract price, which is the amount that the taxpayer reasonably expects to receive under the contract. Third, the taxpayer computes the amount of current-year gross receipts, which is the difference between the cumulative gross receipts for the current taxable year and the cumulative gross receipts for the immediately preceding taxable year. This difference may be a loss (a negative number) based on revisions to estimates of total allocable contract costs or total contract price. Fourth, the taxpayer takes into account both the current-year gross receipts and the amount of allocable contract costs actually incurred during the taxable year. To the extent any portion of the total contract price has not been included in taxable income by the completion year, section 460(b)(1) and the regulations require the taxpayer to include that portion in income for the taxable year following the completion year.

A long-term contract or a portion of a long-term contract that is exempt from the PCM may be accounted for under any permissible method, including the completed contract method (CCM). Under the CCM, a taxpayer does not take into account the gross contract price and allocable contract

costs until the contract is complete, even though progress payments are received in years prior to completion.

A taxpayer generally must allocate costs to a contract subject to section 460(a) in the same manner as direct and indirect costs are capitalized to property produced by a taxpayer under section 263A. The regulations provide exceptions, however, that reflect the differences in the cost allocation rules of sections 263A and 460.

Section 460(h) directs the Secretary to prescribe regulations to the extent necessary or appropriate to carry out the purpose of section 460, including regulations to prevent a taxpayer from avoiding section 460 by using related parties, pass-through entities, intermediaries, options, and other similar arrangements.

On May 15, 2002, final regulations under section 460 were issued to address a mid-contract change in taxpayer engaged in completing a contract accounted for under a long-term contract method of accounting (T.D. 8995, 2002–1 C.B. 1070). The regulations divide the rules regarding a mid-contract change in taxpayer into two categories-constructive completion transactions and step-in-the-shoes transactions.

In a constructive completion transaction, the taxpayer that originally accounted for the long-term contract (old taxpayer) must recognize income from the contract as of the time of the transaction. The contract price used to determine the amount of income recognized by the taxpayer is the amount realized from the transaction, reduced by any amounts paid by the old taxpayer to the taxpayer subsequently accounting for the long-term contract (new taxpayer) that are allocable to the contract. Similarly, the new taxpayer in a constructive completion transaction is treated as though it entered into a new contract as of the date of the transaction. The new taxpayer’s contract price is the amount that the new taxpayer reasonably expects to receive under the contract, reduced by the price paid by the new taxpayer for the contract, and increased by any amounts paid by the old taxpayer to the new taxpayer that are allocable to the contract. In contrast, in a step-in-the-shoes transaction, the old taxpayer’s obligation to account for the contract terminates on the date of the transaction and is assumed by the new taxpayer. The new taxpayer must assume the old taxpayer’s methods of accounting for the con

2004–34 I.R.B. 309 August 23, 2004

rise to a liability under section 752, and, if so, how the regulations would need to be revised to account for such liabilities. No written comments were received. However, if a contract accounted for under a long-term contract method of accounting is contributed to a partnership, then, to the extent that progress payments give rise to a liability, section 752(b) would require the transferring partner to reduce its basis in its partnership by the amount of that liability, either when the contract is contributed (to the extent that the liability is allocated to other partners) or when the liability is extinguished. Thus, because the proposed regulations require the partner to reduce the partner’s basis in its partnership interest by the amount of progress payments received, the proposed regulations could require two reductions in basis for the same payments.

Ordinarily, progress payments do not give rise to liabilities within the meaning of section 752 and the regulations thereunder. However, to the extent that there is a case in which a progress payment gives rise to such a liability, the Treasury Department and IRS agree that taxpayers should not be required to reduce their basis twice for the same progress payment, and believe that a similar rule should be provided for transfers to corporations. Accordingly, upon a contribution of a contract accounted for under a long-term contract method of accounting to a partnership or corporation, the final regulations provide that the required reduction in basis for progress payments received does not apply to the extent that such progress payments give rise to a liability (other than a liability described in section 357(c)(3)).

Finally, one commentator suggested that the regulations clarify that the fair market value of a contract contributed to a partnership does not necessarily equal the full amount of expected remaining profit on the contributed contract. The Treasury Department and IRS believe that it is sufficiently clear under the proposed regulations that the fair market value of the contributed contract is determined under general tax principles. Thus, this comment has not been adopted.

Special Analysis

It has been determined that this Treasury decision is not a significant regula

long-term contract method of accounting by another partnership (upper-tier partnership). This comment has been adopted.

One commentator suggested that the final regulations clarify the application of the constructive completion rules if a partnership that holds a contract accounted for under a long-term contract method of accounting terminates under section 708(b)(1)(A) because the number of its owners is reduced to one. In response to this comment, the final regulations provide that the entire contract will be treated as being distributed from the partnership for purposes of the constructive completion rules, because the partnership ceases to exist for tax purposes. In addition, the final regulations provide that the partnership must apply the constructive completion rules immediately prior to the transaction or transactions resulting in the termination of the partnership.

Consistent with §1.706–1(c)(2)(ii), the proposed regulations generally provide that upon the transfer or liquidation of an interest in a partnership holding a contract accounted for under a long-term contract method of accounting, the step-in-the-shoes rules apply to a contract accounted for under a long-term contract method of accounting only if the partnership’s books are properly closed with respect to that contract under section 706. The proposed regulations provide that if the partnership’s books are not closed with respect to the contract, the partnership shall compute its income or loss from each contract accounted for under a long-term contract method of accounting for the period that includes the date of the transfer or liquidation as though no change in taxpayer had occurred with respect to that contract, and may pro rate income from the contract under a reasonable method complying with section 706. The proposed regulations also provide similar rules for distributions of property (other than a contract accounted for under a long-term contract method of accounting) from a partnership holding a long-term contract, and for contributions of property (other than a contract accounted for under a long-term contract method of accounting) to a partnership holding a contract accounted for under a long-term contract method of accounting.

The proposed regulations requested comments regarding whether similar rules

should be provided with respect to transfers of stock in an S corporation holding a contract accounted for under a long-term contract method of accounting. Under section 1377(a)(1) and §1.1377–1(a), each shareholder’s pro rata share of any S corporation item for any taxable year is generally the sum of the amounts determined with respect to the shareholder by assigning an equal portion of the item to each day of the S corporation’s taxable year, and then dividing that portion pro rata among the shares outstanding on that day. Under section 1377(a)(2) and §1.1377–1(b), an S corporation may elect to close its books if a shareholder’s entire interest in an S corporation is terminated during the S corporation’s taxable year, and the corporation and all affected shareholders agree. No comments were received.

The Treasury Department and IRS have concluded that similar rules should be provided for transfers of S corporation stock and conversions to and from S corporation status. Thus, the final regulations generally provide that upon the transfer of stock in an S corporation holding a contract accounted for under a long-term contract method of accounting, or the conversion to or from S corporation status by a corporation holding such a contract, the step-in-the-shoes rules apply to the contract only if the S corporation’s books are closed under section 1362(e)(3), section 1362(e)(6)(C), section 1362(e)(6)(D), section 1377(a)(2), or §1.1502–76. If the S corporation’s books are not closed, the S corporation computes its income or loss from the contract for the period that includes the date of the transfer as though no change in taxpayer had occurred with respect to the contract, and must pro rate income from the contract in accordance with the rules generally applicable to such transfers or conversions.

In Rev. Rul. 73–301, 1973–2 C.B. 215, the IRS ruled that the progress payments described in the ruling did not constitute a liability within the meaning of section 752. See also Rev. Rul. 81–241, 1981–2 C.B. 146 (citing and following Rev. Rul. 73–301). The proposed regulations requested comments regarding whether there are circumstances under which the receipt of progress payments under a contract accounted for under a long-term contract method of accounting could give

August 23, 2004 310 2004–34 I.R.B.

• • • • Par. 3. Section 1.460–4 is amended as follows:

1. Revising the sixth sentence in paragraph (k)(1).

2. Revising paragraph (k)(2)(iv).

3. Removing the first word “The” in paragraph (k)(3)(i), adding in its place “Except as otherwise provided in paragraph (k)(3)(v)(D) of this section, the”.

4. Revising paragraph (k)(3)(i)(I).

5. Redesignating paragraphs (k)(3)(i) (J), (K) and (L) as paragraphs (k)(3)(i)(K), (L) and (M), respectively.

6. Adding a new paragraph (k)(3)(i)(J).

7. Revising newly designated paragraph (k)(3)(i)(K).

8. Revising paragraph (k)(3)(iv).

9. Revising paragraph (k)(3)(v).

10. Adding paragraph (k)(5) Example 9 through Example 13 .

11. Revising the first sentence in paragraph (k)(6).

The additions and revisions read as follows:

§1.460–4 Methods of accounting for long-term contracts.

• • • • (k) - * (1) - - - Special rules relating to the treatment of certain partnership transactions are provided in paragraphs (k)(2)(iv) and (k)(3)(v) of this section. - * *

(2) - * (iv) Special rules relating to distribu- tions of certain contracts by a partnership

• (A) In general . The constructive completion rules of paragraph (k)(2) of this section apply both to the distribution of a contract accounted for under a long-term contract method of accounting by a partnership to a partner and to the distribution of an interest in a partnership (lower-tier partnership) holding (either directly or through other partnerships) one or more contracts accounted for under a long-term contract method of accounting by another partnership (upper-tier partnership). Notwithstanding the previous sentence, the constructive completion rules of paragraph (k)(2) of this section do not apply to a transfer by a partnership (transferor partnership) of all of its assets and liabilities to a second partnership (transferee partnership) in an exchange described in

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

Drafting Information

The principal authors of these regulations are Matthew Lay and Richard Probst of the Office of the Associate Chief Counsel (Passthroughs and Special Industries). However, personnel from other offices of the Treasury Department and IRS participated in their development.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.460–0 is amended as follows:

1. Revising the entry for paragraph 1.460–4(k)(2)(iv).

2. Adding entries for §1.460–4(k)(2) (iv)(A) through (E).

3. Revising the entry for §1.460–4(k) (3)(iv).

4. Revising the entry for §1.460–4(k) (3)(iv)(A)( 2 ) and adding entries for §1.460–4(k)(3)(iv)(C) and (D).

5. Revising the entry for §1.460–4(k) (3)(v).

6. Adding entries for §1.460–4(k)(3) (v)(A) through (D).

7. Adding entries for §1.460–6(g)(3) (ii)(D)( 1 ) and ( 2 ).

The additions and revisions read as follows:

§1.460–0 Outline of regulations under section 460.

---

§1.460–4 Methods of accounting for long-term contracts.

• • • • (k) - * (2) - * (iv) Special rules relating to distributions of certain contracts by a partnership.

(A) In general. (B) Old taxpayer. (C) New taxpayer. (D) Basis rules. (E) Section 751. ( 1 ) In general. ( 2 ) Ordering rules. (3) - - (iv) Special rules related to certain corporate and partnership transactions.

(A) - - ( 2 ) Basis adjustment in excess of stock or partnership interest basis.

• • • • (C) Definition of old taxpayer and new taxpayer for certain partnership transactions.

(D) Exceptions to step-in-the-shoes rules for S corporations.

(v) Special rules relating to certain partnership transactions.

(A) Section 704(c). ( 1 ) Contributions of contracts. ( 2 ) Revaluations of partnership property.

( 3 ) Allocation methods. (B) Basis adjustments under sections 743(b) and 734(b). (C) Cross reference. (D) Exceptions to step-in-the-shoes rules.

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§1.460–6 Look-back method.

• • • • (g) - - (3) - - (ii) - - * (D) - - ( 1 ) In general. ( 2 ) Special rules for certain passthrough entity transactions.

2004–34 I.R.B. 311 August 23, 2004

(K) Transfers of partnership interests (other than transfers which cause the partnership to terminate under section 708(b)(1)(A));

• • • • (iv) Special rules related to certain corporate and partnership transactions

• (A) Old taxpayer — basis adjustment

• ( 1 ) In general . Except as provided in paragraph (k)(3)(iv)(A)( 2 ) of this section, in the case of a transaction described in paragraph (k)(3)(i)(D), (E), or (I) of this section, the old taxpayer must adjust its basis in the stock or partnership interest of the new taxpayer by —

( i ) Increasing such basis by the amount of gross receipts the old taxpayer has recognized under the contract; and

( ii ) Reducing such basis by the amount of gross receipts the old taxpayer has received or reasonably expects to receive under the contract (except to the extent such gross receipts give rise to a liability other than a liability described in section 357(c)(3)). ( 2 ) Basis adjustment in excess of stock or partnership interest basis . If the old and new taxpayer do not join in the filing of a consolidated Federal income tax return, the old taxpayer may not adjust its basis in the stock or partnership interest of the new taxpayer under paragraph (k)(3)(iv)(A)( 1 ) of this section below zero and the old taxpayer must recognize ordinary income to the extent the basis in the stock or partnership interest of the new taxpayer otherwise would be adjusted below zero. If the old and new taxpayer join in the filing of a consolidated Federal income tax return, the old taxpayer must create an (or increase an existing) excess loss account to the extent the basis in the stock of the new taxpayer otherwise would be adjusted below zero under paragraph (k)(3)(iv)(A)( 1 ) of this section. See §§1.1502–19 and 1.1502–32(a)(3)(ii).

( 3 ) Subsequent dispositions of certain contracts . If the old taxpayer disposes of a contract in a transaction described in paragraph (k)(3)(i)(D), (E), or (I) of this section that the old taxpayer acquired in a transaction described in paragraph (k)(3)(i)(D), (E), or (I) of this section, the basis adjustment rule of this paragraph (k)(3)(iv)(A) is applied by treating the old taxpayer as having recognized the amount of gross receipts recognized by the previous old tax

section 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership, under §1.708–1(b)(4) (relating to terminations under section 708(b)(1)(B)) or §1.708–1(c)(3)(i) (relating to certain partnership mergers). If a partnership that holds a contract accounted for under a long-term contract method of accounting terminates under section 708(b)(1)(A) because the number of its owners is reduced to one, the entire contract will be treated as being distributed from the partnership for purposes of the constructive completion rules, and the partnership must apply paragraph (k)(2) of this section immediately prior to the transaction or transactions resulting in the termination of the partnership.

(B) Old taxpayer . The partnership that distributes the contract is treated as the old taxpayer for purposes of paragraph (k)(2)(ii) of this section. For purposes of determining the total contract price (or gross contract price) under paragraph (k)(2)(ii) of this section, the fair market value of the contract is treated as the amount realized from the transaction. For purposes of determining each partner’s distributive share of partnership items, any income or loss resulting from the constructive completion must be allocated among the partners of the old taxpayer as though the partnership closed its books on the date of the distribution.

(C) New taxpayer . The partner receiving the distributed contract is treated as the new taxpayer for purposes of paragraph (k)(2)(iii) of this section. For purposes of determining the total contract price (or gross contract price) under paragraph (k)(2)(iii) of this section, the new taxpayer’s basis in the contract (including the uncompleted property, if applicable) after the distribution (as determined under section 732) is treated as consideration paid by the new taxpayer that is allocable to the contract. Thus, the total contract price (or gross contract price) of the new contract is reduced by the partner’s basis in the contract (including the uncompleted property, if applicable) immediately after the distribution.

(D) Basis rules . For purposes of determining the new taxpayer’s basis in the contract (including the uncompleted property, if applicable) under section 732, and the amount of any basis adjustment under sec

tion 734(b), the partnership’s basis in the contract (including the uncompleted property, if applicable) immediately prior to the distribution is equal to—

( 1 ) The partnership’s allocable contract costs (including transaction costs);

( 2 ) Increased (or decreased) by the amount of cumulative taxable income (or loss) recognized by the partnership on the contract through the date of the distribution (including amounts recognized as a result of the constructive completion); and

( 3 ) Decreased by the amounts that the partnership has received or reasonably expects to receive under the contract.

(E) Section 751 - ( 1 ) In general . Contracts accounted for under a long-term contract method of accounting are unrealized receivables within the meaning of section 751(c). For purposes of section 751, the amount of ordinary income or loss attributable to a contract accounted for under a long-term contract method of accounting is the amount of income or loss that the partnership would take into account under the constructive completion rules of paragraph (k)(2) of this section if the contract were disposed of for its fair market value in a constructive completion transaction, adjusted to account for any income or loss from the contract that is allocated under section 706 to that portion of the taxable year of the partnership ending on the date of the distribution, sale, or exchange.

( 2 ) Ordering rules . Because the distribution of a contract accounted for under a long-term contract method of accounting is the distribution of an unrealized receivable, section 751(b) may apply to the distribution. A partnership that distributes a contract accounted for under a long-term contract method of accounting must apply paragraph (k)(2)(ii) of this section before applying the rules of section 751(b) to the distribution.

(3) - - (i) - - (I) Contributions of contracts accounted for under a long-term contract method of accounting to which section 721(a) applies;

(J) Contributions of property (other than contracts accounted for under a long-term contract method of accounting) to a partnership that holds a contract accounted for under a long-term contract method of accounting;

August 23, 2004 312 2004–34 I.R.B.

income or loss that the contributing partner would take into account if the contract were disposed of for its fair market value in a constructive completion transaction. This calculation is treated as occurring immediately after the partner has applied paragraph (k)(3)(ii)(A) of this section, but before the contribution to the partnership. Finally, this amount is reduced by the amount of income, if any, that the contributing partner is required to recognize as a result of the contribution.

( 2 ) Revaluations of partnership prop- erty . The principles of section 704(c) and §1.704–3 apply to allocations of income or loss with respect to a long-term contract that is revalued by a partnership under §1.704–1(b)(2)(iv)( f ). The amount of built-in income or built-in loss attributable to such a contract is equal to the amount of income or loss that would be taken into account if, at the time of the revaluation, the contract were disposed of for its fair market value in a constructive completion transaction.

( 3 ) Allocation methods . In the case of a contract accounted for under the CCM, any built-in income or loss under section 704(c) is taken into account in the year the contract is completed. In the case of a contract accounted for under a long-term contract method of accounting other than the CCM, any built-in income or loss under section 704(c) must be taken into account in a manner that reasonably accounts for the section 704(c) income or loss over the remaining term of the contract.

(B) Basis adjustments under sec- tions 743(b) and 734(b) . For purposes of §§1.743–1(d), 1.755–1(b), and 1.755–1(c), the amount of ordinary income or loss attributable to a contract accounted for under a long-term contract method of accounting is the amount of income or loss that the partnership would take into account under the constructive completion rules of paragraph (k)(2) of this section if, at the time of the sale of a partnership interest or the distribution to a partner, the partnership disposed of the contract for its fair market value in a constructive completion transaction. If all or part of the transferee’s basis adjustment under section 743(b) or the partnership’s basis adjustment under section 734(b) is allocated to a contract accounted for under a long-term contract method of accounting, the basis adjustment shall reduce or

payer under the contract and any amount recognized by the previous old taxpayer with respect to the contract in connection with the transaction in which the old taxpayer acquired the contract. In addition, the old taxpayer is treated as having received or as reasonably expecting to receive under the contract any amount the previous old taxpayer received or reasonably expects to receive under the contract. Similar principles will apply in the case of multiple successive transfers described in paragraph (k)(3)(i)(D), (E), or (I) of this section involving the contract.

(B) New Taxpayer - ( 1 ) Contract price adjustment . Generally, payments between the old taxpayer and the new taxpayer with respect to the contract in connection with the transaction do not affect the contract price. Notwithstanding the preceding sentence and paragraph (k)(3)(iii)(B) of this section, however, in the case of transactions described in paragraph (k)(3)(i)(B), (D), (E), or (I) of this section, the total contract price (or gross contract price) must be reduced to the extent of any amount recognized by the old taxpayer with respect to the contract in connection with the transaction ( e.g., any amount recognized under section 351(b) or section 357 that is attributable to the contract and any income recognized by the old taxpayer pursuant to the basis adjustment rule of paragraph (k)(3)(iv)(A) of this section).

( 2 ) Basis in contract . The new taxpayer’s basis in a contract (including the uncompleted property, if applicable) acquired in a transaction described in paragraphs (k)(3)(i)(A) through (E) or paragraph (k)(3)(i)(I) of this section will be computed under section 362, section 334, or section 723, as applicable. Upon a new taxpayer’s completion (actual or constructive) of a CCM or a PCM contract acquired in a transaction described in paragraphs (k)(3)(i)(A) through (E) or paragraph (k)(3)(i)(I) of this section, the new taxpayer’s basis in the contract (including the uncompleted property, if applicable) is reduced to zero. The new taxpayer is not entitled to a deduction or loss in connection with any basis reduction pursuant to this paragraph (k)(3)(iv)(B)( 2 ).

(C) Definition of old taxpayer and new taxpayer for certain partnership transactions . For purposes of paragraphs (k)(3)(ii), (iii) and (iv) of this section, in the case of a transaction described in

paragraph (k)(3)(i)(I) of this section, the partner contributing the contract to the partnership is treated as the old taxpayer, and the partnership receiving the contract from the partner is treated as the new taxpayer.

(D) Exceptions to step-in-the-shoes rules for S corporations . Upon a transfer described in paragraph (k)(3)(i)(F) of this section or a conversion described in paragraph (k)(3)(i)(G) of this section, paragraphs (k)(3)(ii) and (iii) of this section apply to a contract accounted for under a long-term contract method of accounting only if the S corporation’s books are closed under section 1362(e)(3), section 1362(e)(6)(C), section 1362(e)(6)(D), section 1377(a)(2), or §1.1502–76 on the date of the transfer or conversion. In these cases, the corporation is treated as both the old taxpayer and the new taxpayer for purposes of paragraphs (k)(3)(ii) and (iii) of this section. In all other cases involving these transfers, the corporation shall compute its income or loss from each contract accounted for under a long-term contract method of accounting for the period that includes the date of the transaction as though no change in taxpayer had occurred with respect to the contract, and must allocate the income or loss from the contract for that period in accordance with the rules generally applicable to transfers of S corporation stock and conversions to or from S corporation status. This paragraph (k)(3)(iv)(D) is applicable for transactions on or after July 16, 2004. In addition, this paragraph (k)(3)(iv)(D) may be relied upon for transactions on or after May 15, 2002.

(v) Special rules relating to certain partnership transactions - (A) Section 704(c) - ( 1 ) Contributions of contracts . The principles of section 704(c)(1)(A), section 737, and the regulations thereunder apply to income or loss with respect to a contract accounted for under a long-term contract method of accounting that is contributed to a partnership. The amount of built-in income or built-in loss attributable to a contributed contract that is subject to section 704(c)(1)(A) is determined as follows. First, the contributing partner must take into account any income or loss required under paragraph (k)(3)(ii)(A) of this section for the period ending on the date of the contribution. Second, the partnership must determine the amount of

2004–34 I.R.B. 313 August 23, 2004

increase, as the case may be, the affected party’s income or loss from the contract. In the case of a contract accounted for under the CCM, the basis adjustment is taken into account in the year in which the contract is completed. In the case of a contract accounted for under a long-term contract method of accounting other than the CCM, the portion of that basis adjustment that is recovered in each taxable year of the partnership must be determined by the partnership in a manner that reasonably accounts for the adjustment over the remaining term of the contract.

(C) Cross reference . See paragraph (k)(2)(iv)(E) of this section for rules relating to the application of section 751 to the transfer of an interest in a partnership holding a contract accounted for under a long-term contract method of accounting.

(D) Exceptions to step-in-the-shoes rules . Upon a contribution described in paragraph (k)(3)(i)(J) of this section, a transfer described in paragraph (k)(3)(i)(K) of this section, or a distribution described in paragraph (k)(3)(i)(L) of this section, paragraphs (k)(3)(ii) and (iii) of this section apply to a contract accounted for under a long-term contract method of accounting only if the partnership’s books are properly closed with respect to that contract under section 706. In these cases, the partnership is treated as both the old taxpayer and the new taxpayer for purposes of paragraphs (k)(3)(ii) and (iii) of this section. In all other cases involving these transactions, the partnership shall compute its income or loss from each contract accounted for under a long-term contract method of accounting for the period that includes the date of the transaction as though no change in taxpayer had occurred with respect to the contract, and must allocate the income or loss from the contract for that period under a reasonable method complying with section 706.

• • • • (5) - - Example 9 . Constructive completion - PCM distribution of contract by partnership - (i) Facts . In Year 1, W, X, Y, and Z each contribute $100,000 to form equal partnership PRS. In Year 1, PRS enters into a contract. The total contract price is $1,000,000 and the estimated total allocable contract costs are $800,000. In Year 1, PRS incurs costs of $600,000 and receives $650,000 in progress payments under the contract. Under the contract, PRS performed all of the services required in order to be entitled to receive the progress payments, and there was no

obligation to return the payments or perform any additional services in order to retain the payments. PRS properly accounts for the contract under the PCM. In Year 2, PRS distributes the contract to X in liquidation of X’s interest. PRS incurs no costs and receives no progress payments in Year 2 prior to the distribution. At the time of the distribution, PRS’s only asset other than the long-term contract and the partially constructed property is $450,000 cash ($400,000 initially contributed and $50,000 in excess progress payments). The fair market value of the contract is $150,000. Pursuant to the distribution, X assumes PRS’s contract obligations and rights. In Year 2, X incurs additional allocable contract costs of $50,000. X correctly estimates at the end of Year 2 that X will have to incur an additional $75,000 of allocable contract costs in Year 3 to complete the contract (rather than $150,000 as originally estimated by PRS). Assume that X properly accounts for the contract under the PCM, that PRS has no income or loss other than income or loss from the contract, and that PRS has an election under section 754 in effect in Year 2.

(ii) Tax consequences to PRS . For Year 1, PRS reports receipts of $750,000 (the completion factor multiplied by total contract price ($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a profit of $150,000, which is allocated equally among W, X, Y, and Z ($37,500 each). Immediately prior to the distribution of the contract to X in Year 2, the contract is deemed completed. Under paragraph (k)(2)(iv)(B) of this section, the fair market value of the contract ($150,000) is treated as the amount realized from the transaction. For purposes of applying the PCM in Year 2, the total contract price is $800,000 (the sum of the amounts received under the contract and the amount treated as realized from the transaction ($650,000 + $150,000)) and the total allocable contract costs are $600,000. Thus, in Year 2 PRS reports receipts of $50,000 (total contract price minus receipts already reported ($800,000 - $750,000)), and costs incurred in Year 2 of $0, for a profit of $50,000. Under paragraph (k)(2)(iv)(B) of this section, this profit must be allocated among W, X, Y, and Z as though the partnership closed its books on the date of the distribution. Accordingly, each partner’s distributive share of this income is $12,500.

(iii) Tax consequences to X . X’s basis in its interest in PRS immediately prior to the distribution is $150,000 (X’s $100,000 initial contribution, increased by $37,500, X’s distributive share of Year 1 income, and $12,500, X’s distributive share of Year 2 income). Under paragraph (k)(2)(iv)(D) of this section, PRS’s basis in the contract (including the uncompleted property, if applicable) immediately prior to the distribution is equal to $150,000 (the partnership’s allocable contract costs, $600,000, increased by the amount of income recognized by PRS on the contract through the date of the distribution (including amounts recognized as a result of the constructive completion), $200,000, decreased by the amounts that the partnership has received or reasonably expects to receive under the contract, $650,000). Under section 732, X’s basis in the contract (including the uncompleted property) after the distribution is $150,000. Under paragraph (k)(2)(iv)(C) of this section, X’s basis in the contract (including the uncompleted property) is treated as consideration paid by X that is allocable to the

contract. X’s total contract price is $200,000 (the amount remaining to be paid under the terms of the contract less the consideration allocable to the contract ($350,000 - $150,000)). For Year 2, X reports receipts of $80,000 (the completion factor multiplied by the total contract price [($50,000/$125,000) x $200,000]) and costs of $50,000 (the costs incurred after the distribution of the contract), for a profit of $30,000. For Year 3, X reports receipts of $120,000 (the total contract price minus receipts already reported ($200,000 - $80,000)) and costs of $75,000, for a profit of $45,000.

(iv) Section 734(b) . Because X’s basis in the contract (including the uncompleted property) immediately after the distribution, $150,000, is equal to PRS’s basis in the contract (including the uncompleted property) immediately prior to the distribution, there is no basis adjustment under section 734(b).

Example 10. Constructive completion - CCM

• distribution of contract by partnership - (i) Facts . The facts are the same as in Example 9, except that PRS and X properly account for the contract under the CCM.

(ii) Tax consequences to PRS . PRS reports no income or costs from the contract in Year 1. Immediately prior to the distribution of the contract to X in Year 2, the contract is deemed completed. Under paragraph (k)(2)(iv)(B) of this section, the fair market value of the contract ($150,000) is treated as the amount realized from the transaction. For purposes of applying the CCM in Year 2, the gross contract price is $800,000 (the sum of the amounts received under the contract and the amount treated as realized from the transaction ($650,000 + $150,000)) and the total allocable contract costs are $600,000. Thus, in Year 2 PRS reports profits of $200,000 ($800,000 $600,000). This profit must be allocated among W, X, Y, and Z as though the partnership closed its books on the date of the distribution. Accordingly, each partner’s distributive share of this income is $50,000.

(iii) Tax consequences to X . X’s basis in its interest in PRS immediately prior to the distribution is $150,000 ($100,000 initial contribution, increased by $50,000, X’s distributive share of Year 2 income). Under paragraph (k)(2)(iv)(D) of this section, PRS’s basis in the contract (including the uncompleted property, if applicable) immediately prior to the distribution is equal to $150,000 (the partnership’s allocable contract costs, $600,000, increased by the amount of cumulative taxable income recognized by PRS on the contract through the date of the distribution (including amounts recognized as a result of the constructive completion), $200,000, decreased by the amounts that the partnership has received or reasonably expects to receive under the contract, $650,000). Under section 732, X’s basis in the contract (including the uncompleted property) after the distribution is $150,000. Under paragraph (k)(2)(iv)(C) of this section, X’s basis in the contract is treated as consideration paid by X that is allocable to the contract. Under the CCM, X reports no gross receipts or costs in Year 2. For Year 3, the completion year, X reports its gross contract price of $200,000 (the amount remaining to be paid under the terms of the contract less the consideration allocable to the contract ($350,000 - $150,000)) and its total allocable contract costs of $125,000 (the allocable contract costs that X incurred to complete the contract ($50,000 + $75,000)), for a profit of $75,000.

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(iv) Section 734(b) . The results under section 734(b) are the same as in Example 9 . Example 11. Step-in-the-shoes - PCM - con- tribution of contract to partnership - (i) Facts . In Year 1, X enters into a contract that X properly accounts for under the PCM. The total contract price is $1,000,000 and the estimated total allocable contract costs are $800,000. In Year 1, X incurs costs of $600,000 and receives $650,000 in progress payments under the contract. Under the contract, X performed all of the services required in order to be entitled to receive the progress payments, and there was no obligation to return the payments or perform any additional services in order to retain the payments. In Year 2, X contributes the contract (including the uncompleted property) with a basis of $0 and $125,000 of cash to partnership PRS in exchange for a one-fourth partnership interest. X incurs costs of $10,000, and receives no progress payments in Year 2 prior to the contribution of the contract. X and the other three partners of PRS share equally in its capital, profits, and losses. The parties determine that, at the time of the contribution, the fair market value of the contract is $160,000. Following the contribution in Year 2, PRS incurs additional allocable contract costs of $40,000. PRS correctly estimates at the end of Year 2 that it will have to incur an additional $75,000 of allocable contract costs in Year 3 to complete the contract (rather than $150,000 as originally estimated by PRS).

(ii) Tax consequences to X . For Year 1, X reports receipts of $750,000 (the completion factor multiplied by the total contract price ($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a profit of $150,000. Because the mid-contract change in taxpayer results from a transaction described in paragraph (k)(3)(i)(I) of this section, X is not treated as completing the contract in Year 2. Under paragraph (k)(3)(ii)(A) of this section, for Year 2, X reports receipts of $12,500 (the completion factor multiplied by the total contract price ($610,000/$800,000 x $1,000,000, or $762,500), decreased by receipts already reported, $750,000) and costs of $10,000, for a profit of $2,500. Under section 722, X’s initial basis in its interest in PRS is $125,000. Pursuant to paragraph (k)(3)(iv)(A)( 1 ) of this section, X must increase its basis in its interest in PRS by the amount of gross receipts X recognized under the contract, $762,500, and reduce its basis by the amount of gross receipts X received under the contract, the $650,000 in progress payments. Accordingly, X’s basis in its interest in PRS is $237,500.

(iii) Tax consequences to PRS . Because the midcontract change in taxpayer results from a step-inthe-shoes transaction, PRS must account for the contract using the same methods of accounting used by X prior to the transaction. The total contract price is the sum of any amounts that X and PRS have received or reasonably expect to receive under the contract, and total allocable contract costs are the allocable contract costs of X and PRS. For Year 2, PRS reports receipts of $134,052 (the completion factor multiplied by the total contract price [($650,000/$725,000) x $1,000,000], $896,552, decreased by receipts reported by X, $762,500) and costs of $40,000, for a profit of $94,052. For Year 3, PRS reports receipts of $103,448 (the total contract price minus prior year receipts ($1,000,000 - $896,552)) and costs of $75,000, for a profit of $28,448.

(iv) Section 704(c) . The principles of section 704(c) and §1.704–3 apply to allocations of income or loss with respect to the contract contributed by X. In this case, the amount of built-in income that is subject to section 704(c) is the amount of income or loss that the contributing partner would take into account if the contract were disposed of for its fair market value in a constructive completion transaction. This calculation is treated as occurring immediately after the partner has applied paragraph (k)(3)(ii)(A) of this section, but before the contribution to the partnership. In a constructive completion transaction, the total contract price would be $810,000 (the sum of the amounts received under the contract and the amount realized in the deemed sale ($650,000 + $160,000)). X would report receipts of $47,500 (total contract price minus receipts already reported ($810,000 $762,500)) and costs of $0, for a profit of $47,500. Thus, the amount of built-in income that is subject to section 704(c) is $47,500. The partnership must apply section 704(c) to this income in a manner that reasonably accounts for the income over the remaining term of the contract. For example, in Year 2, PRS could allocate $26,810 to X under section 704(c) (the amount of built-in income, $47,500, multiplied by a fraction, the numerator of which is the completion factor for the year, $650,000/$725,000, less the completion factor for the prior year, $610,000/$800,000, and the denominator of which is 100 percent reduced by the completion factor for the taxable year preceding the event creating the section 704(c) income or loss, $610,000/$800,000). The remaining $67,242 would be allocated equally among all of the partners. In Year 3, the completion year, PRS could allocate $20,690 to X under section 704(c) ($47,500 x [($725,000/$725,000 - $650,000/$725,000) / (100 percent - $610,000/$800,000)]). The remaining $7,758 would be allocated equally among all the partners.

Example 12. Step-in-the-shoes - CCM - con- tribution of contract to partnership - (i) Facts . The facts are the same as in Example 11, except that X and PRS properly account for the contract under the CCM, and X has a basis of $610,000 in the contract (including the uncompleted property).

(ii) Tax consequences to X . X reports no income or costs from the contract in Years 1 or 2. X is not treated as completing the contract in Year 2. Under section 722, X’s initial basis in its interest in PRS is $735,000 (the sum of $125,000 cash and X’s basis of $610,000 in the contract (including the uncompleted property)). Pursuant to paragraph (k)(3)(iv)(A)( 1 )( ii ) of this section, X must reduce its basis in its interest in PRS by the amount of gross receipts X received under the contract, or $650,000. Accordingly, X’s basis in its interest in PRS is $85,000.

(iii) Tax consequences to PRS . PRS must account for the contract using the same methods of accounting used by X prior to the transaction. Under the CCM, PRS reports no gross receipts or costs in Year 2. For Year 3, the completion year, PRS reports its gross contract price of $1,000,000 (the sum of any amounts that X and PRS have received or reasonably expect to receive under the contract), and total allocable contract costs of $725,000 (the allocable contract costs of X and PRS), for a profit of $275,000.

(iv) Section 704(c) . In this case, the amount of built-in income that is subject to section 704(c) is the amount of income or loss that the contributing part

ner would take into account if the contract were disposed of for its fair market value in a constructive completion transaction. This calculation is treated as occurring immediately after the partner has applied paragraph (k)(3)(ii)(A) of this section, but before the contribution to the partnership. In a constructive completion transaction, X would report its gross contract price of $810,000 (the sum of the amounts received under the contract and the amount realized in the deemed sale ($650,000 + $160,000)) and its total allocable contract costs of $610,000, for a profit of $200,000. Thus, the amount of built-in income that is subject to section 704(c) is $200,000. Out of PRS’s income of $275,000, in Year 3, $200,000 must be allocated to X under section 704(c), and the remaining $75,000 is allocated equally among all of the partners.

Example 13. Step-in-the-shoes - PCM - trans- fer of a partnership interest - (i) Facts . In Year 1, W, X, Y, and Z each contribute $100,000 to form equal partnership PRS. In Year 1, PRS enters into a contract. The total contract price is $1,000,000 and the estimated total allocable contract costs are $800,000. In Year 1, PRS incurs costs of $600,000 and receives $650,000 in progress payments under the contract. Under the contract, PRS performed all of the services required in order to be entitled to receive the progress payments, and there was no obligation to return the payments or perform any additional services in order to retain the payments. PRS properly accounts for the contract under the PCM. In Year 2, W transfers W’s interest in PRS to T for $150,000. Assume that $10,000 of PRS’s Year 2 costs are incurred prior to the transfer, $40,000 are incurred after the transfer; and that PRS receives no progress payments in Year 2. Also assume that the fair market value of the contract on the date of the transfer is $160,000, that PRS closes its books with respect to the contract under section 706 on the date of the transfer, and that PRS correctly estimates at the end of Year 2 that it will have to incur an additional $75,000 of allocable contract costs in Year 3 to complete the contract (rather than $150,000 as originally estimated by PRS).

(ii) Income reporting for period ending on date of transfer . For Year 1, PRS reports receipts of $750,000 (the completion factor multiplied by total contract price ($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a profit of $150,000. This profit is allocated equally among W, X, Y, and Z ($37,500 each). Under paragraph (k)(3)(ii)(A) of this section, for the part of Year 2 ending on the date of the transfer of W’s interest, PRS reports receipts of $12,500 (the completion factor multiplied by the total contract price ($610,000/$800,000 x $1,000,000) minus receipts already reported ($750,000)) and costs of $10,000 for a profit of $2,500. This profit is allocated equally among W, X, Y, and Z ($625 each).

(iii) Income reporting for period after transfer . PRS must continue to use the PCM. For the part of Year 2 beginning on the day after the transfer, PRS reports receipts of $134,052 (the completion factor multiplied by the total contract price decreased by receipts reported by PRS for the period ending on the date of the transfer [($650,000/$725,000 x $1,000,000) - $762,500]) and costs of $40,000, for a profit of $94,052. This profit is shared equally among T, X, Y, and Z ($23,513 each). For Year 3, PRS reports receipts of $103,448 (the total contract price minus prior year receipts ($1,000,000 - $896,552)) and costs of $75,000, for a profit of $28,448. The

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of paragraph (g)(3)(ii)(D)( 1 ) of this section, in the case of a transaction described in §1.460–4(k)(3)(i)(I), the contributing partner is treated as the old taxpayer, and the partnership is treated as the new taxpayer. In the case of transactions described in §1.460–4(k)(3)(i)(F), (G), (J), (K), or (L), the old taxpayer is not required to provide the information described in paragraph (g)(3)(ii)(D)( 1 ) of this section, because information necessary for the new taxpayer to apply the look-back method is provided by the pass-through entity. This paragraph (g)(3)(ii)(D) is applicable for transactions on or after August 6, 2003.

• • • • (4) Effective date . Except as provided in paragraph (g)(3)(ii)(D) of this section, this paragraph (g) is applicable for transactions on or after May 15, 2002.
• • • • Par. 5. In §1.704–3, a sentence is added at the end of paragraph (a)(3)(ii) to read as follows:

§1.704–3 Contributed property.

(a) * - (3) - * (ii) * * * See §1.460–4(k)(3)(v)(A) for a rule relating to the amount of built-in income or built-in loss attributable to a contract accounted for under a long-term contract method of accounting.

• • • • Par. 6. Section 1.722–1 is amended by adding a sentence between the sixth and seventh sentences to read as follows:

§1.722–1 Basis of contributing partner’s interest.

• • • See §1.460–4(k)(3)(iv)(A) for rules relating to basis adjustments required where a contract accounted for under a long-term contract method of accounting is transferred in a contribution to which section 721(a) applies.
• • • • Par. 7. A sentence is added at the end of §1.723–1 to read as follows:

§1.723–1 Basis of property contributed to partnership.

• • • See §1.460–4(k)(3)(iv)(B)( 2 ) for rules relating to adjustments to the basis of

profit for Year 3 is shared equally among T, X, Y, and Z ($7,112 each).

(iv) Tax consequences to W . W’s amount realized is $150,000. W’s adjusted basis in its interest in PRS is $138,125 ($100,000 originally contributed, plus $37,500, W’s distributive share of PRS’s Year 1 income, and $625, W’s distributive share of PRS’s Year 2 income prior to the transfer). Accordingly, W’s income from the sale of W’s interest in PRS is $11,875. Under paragraph (k)(2)(iv)(E) of this section, for purposes of section 751(a), the amount of ordinary income attributable to the contract is determined as follows. First, the partnership must determine the amount of income or loss from the contract that is allocated under section 706 to the period ending on the date of the sale ($625). Second, the partnership must determine the amount of income or loss that the partnership would take into account under the constructive completion rules of paragraph (k)(2) of this section if the contract were disposed of for its fair market value in a constructive completion transaction. Because PRS closed its books under section 706 with respect to the contract on the date of the sale, this calculation is treated as occurring immediately after the partnership has applied paragraph (k)(3)(ii)(A) of this section on the date of the sale. In a constructive completion transaction, the total contract price would be $810,000 (the sum of the amounts received under the contract and the amount realized in the deemed sale ($650,000 + $160,000)). PRS would report receipts of $47,500 (total contract price minus receipts already reported ($810,000 - $762,500)) and costs of $0, for a profit of $47,500. Thus, the amount of ordinary income attributable to the contract is $47,500, and W’s share of that income is $11,875. Thus, under §1.751–1(a), all of W’s $11,875 of income from the sale of W’s interest in PRS is ordinary income.

(v) Tax consequences to T . T’s adjusted basis for its interest in PRS is $150,000. Under §1.743–1(d)(2), the amount of income that would be allocated to T if the contract were disposed of for its fair market value (adjusted to account for income from the contract for the portion of PRS’s taxable year that ends on the date of the transfer) is $11,875. Under §1.743–1(b), the amount of T’s basis adjustment under section 743(b) is $11,875. Under paragraph (k)(3)(v)(B) of this section, the portion of T’s basis adjustment that is recovered in Year 2 and Year 3 must be determined by PRS in a manner that reasonably accounts for the adjustment over the remaining term of the contract. For example, PRS could recover $6,703 of the adjustment in Year 2 (the amount of the basis adjustment, $11,875, multiplied by a fraction, the numerator of which is the excess of the completion factor for the year, $650,000/$725,000, less the completion factor for the prior year, $610,000/$800,000, and the denominator of which is 100 percent reduced by the completion factor for the taxable year preceding the transfer, $610,000/$800,000). T’s distributive share of income in Year 2 from the contract would be adjusted from $23,513 to $16,810 as a result of the basis adjustment. In Year 3, the completion year, PRS could recover $5,172 of the adjustment ($11,875 x [($725,000/$725,000 - $650,000/$725,000) / (100 percent - $610,000/$800,000)]). T’s distributive share of income in Year 3, the completion year, from the contract would be adjusted from $7,112 to $1,940 as a result of the basis adjustment.

• • • • (6) Effective date . Except as provided in paragraph (k)(3)(iv)(D) of this section, this paragraph (k) is applicable for transactions on or after May 15, 2002. - * * * *

Par. 4. Section 1.460–6 is amended by revising paragraphs (g)(3)(ii)(D) and (g)(4) to read as follows:

§1.460–6 Look-back method.

• • • • (g) - - (3) - - (ii) - - (D) Information old taxpayer must pro- vide - ( 1 ) In general . Except as provided in paragraph (g)(3)(ii)(D)( 2 ) of this section, in order to help the new taxpayer to apply the look-back method with respect to pre-transaction taxable years, any old taxpayer that accounted for income from a long-term contract under the PCM or PCCM for either regular or alternative minimum tax purposes is required to provide the information described in this paragraph to the new taxpayer by the due date (not including extensions) of the old taxpayer’s income tax return for the first taxable year ending on or after a step-in-the-shoes transaction described in §1.460–4(k)(3)(i). The required information is as follows - ( i ) The portion of the contract reported by the old taxpayer under PCM for regular and alternative minimum tax purposes ( i.e., whether the old taxpayer used PCM, the 40/60 PCCM method, or the 70/30 PCCM method);

( ii ) Any submethods used in the application of PCM ( e.g., the simplified cost-tocost method or the 10-percent method);

( iii ) The amount of total contract price reported by year;

( iv ) The numerator and the denominator of the completion factor by year;

( v ) The due date (not including extensions) of the old taxpayer’s income tax returns for each taxable year in which income was required to be reported;

( vi ) Whether the old taxpayer was a corporate or a noncorporate taxpayer by year; and

( vii ) Any other information required by the Commissioner by administrative pronouncement.

( 2 ) Special rules for certain pass- through entity transactions . For purposes

August 23, 2004 316 2004–34 I.R.B.

§1.1362–3 Treatment of S termination year.

(a) - - *See §1.460–4(k)(3)(iv)(D) for rules relating to the computation of the S corporation’s income or loss from a contract accounted for under a long-term contract method of accounting in the S termination year.

• • • • Par. 14. Section 1.1377–1 is amended by adding a sentence at the end of paragraph (a)(1) to read as follows:

§1.1377–1 Pro Rata Share.

(a) * - (1) * * * See §1.460–4(k)(3)(iv)(D) for rules relating to the computation of the shareholders’ pro rata share of the S corporation’s income or loss from a contract accounted for under a long-term contract method of accounting.

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

Approved July 1, 2004.

Gregory Jenner, Assistant Secretary of the Treasury .

(Filed by the Office of the Federal Register on July 15, 2004, 8:45 a.m., and published in the issue of the Federal Register for July 16, 2004, 69 F.R. 42551)

Section 7805.—Rules and Regulations

26 CFR 301.7805-1: Rules and regulations.

Obsolete revenue rulings. This ruling obsoletes prior rulings that are no longer considered determinative. Rev. Ruls. 58–120, 70–58, 79–64, and 80–366 obsoleted. Rev. Procs. 89–37 and 96–18 obsoleted.

Rev. Rul. 2004–90

The Internal Revenue Service is continuing its program of reviewing rulings (including revenue rulings, revenue procedures and notices) published in the Internal Revenue Bulletin to identify those rulings that, although not specifically revoked

contracts accounted for using a long-term contract method of accounting that are acquired in certain contributions to which section 721(a) applies.

Par. 8. In §1.732–1, a sentence is added at the end of paragraph (c)(1)(i) to read as follows:

§1.732–1 Basis of distributed property other than money.

• • • • (c) - - (1) - - (i) * * * See §1.460–4(k)(2)(iv)(D) for a rule determining the partnership’s basis in a long-term contract accounted for under a long-term contract method of accounting.
• • • • Par. 9. In §1.734–1, the undesignated paragraph immediately following paragraph (b)(1)(ii) is revised to read as follows:

§1.734–1 Optional adjustment to basis of undistributed partnership property.

• • • • (b) - - (1) - - (ii) * - See §1.460–4(k)(2)(iv)(D) for a rule determining the partnership’s basis in a longterm contract accounted for under a longterm contract method of accounting. The provisions of this paragraph (b)(1) are illustrated by the following examples:
• • • • Par. 10. Section 1.743–1 is amended as follows:

1. A sentence is added at the end of paragraph (d)(2).

2. A sentence is added at the end of paragraph (j)(2).

The additions read as follows:

§1.743–1 Optional adjustment to basis of partnership property.

• • • • (d) - - (2) * * * See §1.460–4(k)(3)(v)(B) for a rule relating to the computation of income or loss that would be allocated to the transferee from a contract accounted for under a long-term contract method of accounting as a result of the hypothetical transaction.
• • • • (j) - - (2) - - - See §1.460–4(k)(3)(v)(B) for rules relating to the effect of a basis adjustment under section 743(b) that is allocated to a contract accounted for under a long-term contract method of accounting in determining the transferee’s distributive share of income or loss from the contract.
• • • • Par. 11. In §1.751–1, a sentence is added at the end of paragraph (a)(2) to read as follows:

§1.751–1 Unrealized receivables and inventory items.

(a) - - (2) * * * See §1.460–4(k)(2)(iv)(E) for rules relating to the amount of ordinary income or loss attributable to a contract accounted for under a long-term contract method of accounting.

• • • • Par. 12. Section 1.755–1 is amended as follows:

1. Adding a sentence at the end of paragraph (b)(1)(ii).

2. Paragraph (c)(5) is redesignated as paragraph (c)(6).

3. New paragraph (c)(5) is added. The additions read as follows:

§1.755–1 Rules for allocation of basis.

• • • • (b) - - (1) - - (ii) * * * See §1.460–4(k)(3)(v)(B) for a rule relating to the computation of income or loss that would be allocated to the transferee from a contract accounted for under a long-term contract method of accounting as a result of the hypothetical transaction.
• • • • (c) - - (5) Cross reference . See §1.460–4(k) (3)(v)(B) for a rule relating to the computation of unrealized appreciation or depreciation in a contract accounted for under a long-term contract method of accounting.
• • • • Par. 13. Section 1.1362–3 is amended by adding a sentence at the end of paragraph (a) to read as follows:

2004–34 I.R.B. 317 August 23, 2004

or superseded, are no longer considered determinative because: (1) the applicable statutory provisions or regulations have been changed or repealed; (2) the ruling position is specifically covered by statute, regulations, or subsequent published position; or (3) the facts set forth no longer exist or are not sufficiently described to

permit clear application of the current statute and regulations.

This revenue ruling publishes a list of rulings that have been identified under the Service’s review program as no longer being determinative. The rulings are categorized by the Assistant Chief Counsel offices in the Office of Associate Chief

Assistant Chief Counsel (Administrative Provisions and Judicial Practice)

Ruling No. C.B. Citation