Part I. Rulings — Internal Revenue Bulletin 2005-35

Section 62.—Adjusted Gross Income Defined

26 CFR 1.62–2: Reimbursement and other expense allowance arrangements.

Tool allowance payments. This ruling holds that tool allowances paid to employees are not paid under an accountable plan because the substantiation and return of excess requirements are not met. All tool allowance payments under the arrangement must be included in the employees’ gross income, reported on the employees’ Forms W-2, and are subject to withholding and payment of federal employment taxes.

Rev. Rul. 2005–52

ISSUE

In the following situation, is the tool allowance paid by the employer to the employees paid under an accountable plan such that the payments are excluded from the employees’ gross income and exempt from the withholding and payment of employment taxes?

FACTS

Employer operates an automobile repair and maintenance business. Employer hires service technicians to work in the business as employees. Employer requires these employees, as a condition of employment, to provide and maintain various tools needed for use in performing repair and maintenance services. Employer pays each employee an hourly wage. In addition, Employer pays each employee a set amount for each hour worked as a “tool allowance” to cover costs the employee incurs for acquiring and maintaining his tools.

Employer sets each employee’s tool allowance annually by using a combination of data from a national survey of average tool expenses for automobile service technicians and specific information concerning tool-related expenses provided by the employee in response to an annual questionnaire completed by all service technicians who work for Employer. Employer

does not reimburse expenses paid or incurred for listed property, as defined by § 280F(d) of the Internal Revenue Code (the Code), or depreciation expenses; thus, these expenses are not taken into account in calculating the amount of the annual tool allowance. Employer uses the data to project the employee’s total annual tool expenses. Employer then uses a projection of the total number of hours the employee is expected to work during the year that will require the use of tools to convert the employee’s estimated annual tool expenses into an hourly rate for the tool allowance. Thus, the hourly tool allowance is an estimate of the tool expense projected to be incurred per hour by the employee over the course of the coming year.

At the end of each pay period, each employee reports to Employer his hours worked requiring the use of tools. Employer multiplies the number of hours reported as worked requiring the use of tools by the employee’s hourly rate for the tool allowance and pays the resulting amount to the employee in addition to compensation for services performed during the pay period. On a quarterly statement furnished to each employee, Employer reports: (1) the amount paid to the employee as a tool allowance during the quarter, and (2) the tool expenses estimated to be incurred in the quarter ( i.e., the hours reported worked requiring the use of tools times the tool allowance). Employees are not required to provide any substantiation of expenses actually incurred for tools either before or after the quarterly reports are issued. Employer does not require employees to return any portion of the tool allowances that exceeds the expenses they actually incur either before or after the quarterly reports are issued.

LAW

Section 61 of the Code provides that gross income means all income from whatever source derived, including compensation for services, fees, commissions, fringe benefits, and similar items.

Section 62(a)(2)(A) of the Code and § 1.62–2(b) of the Income Tax Regulations provide that, for purposes of determining

adjusted gross income, an employee may deduct certain business expenses paid by the employee in connection with the performance of services as an employee under a reimbursement or other expense allowance arrangement with his employer.

Section 62(c) provides that, for purposes of § 62(a)(2)(A), an arrangement will not be treated as a reimbursement or other expense allowance arrangement if (1) the arrangement does not require the employee to substantiate the expenses covered by the arrangement to the payor, or (2) the arrangement provides the employee the right to retain any amount in excess of the substantiated expenses covered under the arrangement.

Section 1.62–2(c)(1) of the regulations provides that a reimbursement or other expense allowance arrangement satisfies the requirements of § 62(c) if it meets the requirements of business connection, substantiation, and returning amounts in excess of substantiated expenses. If an arrangement meets these requirements, all amounts paid under the arrangement are treated as paid under an accountable plan. § 1.62–2(c)(2)(i). Amounts treated as paid under an accountable plan are excluded from the employee’s gross income, are not required to be reported on the employee’s Form W–2, and are exempt from the withholding and payment of income and employment taxes. § 1.62–2(c)(4).

If an arrangement does not satisfy one or more of these requirements, all amounts paid under the arrangement are treated as paid under a “nonaccountable plan.” § 1.62–2(c)(3). Amounts treated as paid under a nonaccountable plan are included in the employee’s gross income, must be reported as wages or other compensation of the employee’s on Form W–2, and are subject to withholding and payment of income and employment taxes. § 1.62–2(c)(5).

Section 1.62–2(d)(1) provides that an arrangement meets the business connection requirements if it provides advances, allowances, or reimbursements only for business expenses that are allowable as deductions and are paid or incurred by the employee in connection with the performance of services as an employee of the

2005–35 I.R.B. 423 August 29, 2005

ation and the return of excess requirements and thus does not qualify as an accountable plan.

Although reasonable expectations for expenses can be used to establish that a plan meets the business connection requirement, satisfaction of the substantiation and return of excess requirements must be based on expenses actually incurred. The arrangement in the facts of this ruling does not require employees to substantiate the actual expenses they are incurring; rather the employees report their time worked requiring the use of tools, and Employer converts the hours into an amount treated as expenses incurred based on statistical data. Reporting hours worked requiring the use of tools is not the equivalent of substantiating actual expenses incurred. Employers may not substitute a reasonable estimate of expenses to be incurred based on statistical data and hours worked for the substantiation of actual expenses that is required by § 1.62–2(e)(3) absent explicit guidance permitting the use of such deemed substantiation. See, e.g., Rev. Proc. 2002–41.

Employer does not cure the absence of substantiation or return of excess by providing employees with the quarterly statement described in this revenue ruling. Employer does not require employees to provide substantiation of expenses actually incurred nor does Employer require employees to return any excess received within a reasonable period of time after receiving the quarterly statement. Thus, Employer is not providing a periodic statement within the meaning of § 1.62–2(g)(2)(ii).

Each of the accountable plan requirements must be independently satisfied. Thus, even if Employer required the employees to substantiate the actual amount of the expenses, and Employer treated any portion of the tool allowances they receive that exceeded substantiated expenses as additional wages, the arrangement would still not be an accountable plan. With the exception of circumstances where employee expenses are covered through a mileage or per diem allowance pursuant to § 1.62–2(f)(2), an arrangement is not an accountable plan if it includes amounts paid in excess of substantiated expenses in wages rather than requiring that they be returned. See § 1.62–2(f)(1); Rev. Proc. 2004–64, 2004–49 I.R.B. 898, (mileage allowances), or Rev. Proc. 2005–10,

employer. If, however, a payor arranges to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) bona fide employee business expenses, the arrangement does not satisfy the business connection requirements and all amounts paid under the arrangement are treated as paid under a nonaccountable plan. § 1.62–2(d)(3)(i).

Section 1.62–2(e)(1) provides that an arrangement meets the substantiation requirements if the arrangement requires each business expense to be substantiated to the payor in accordance with paragraph (e)(3), within a reasonable period of time. An arrangement for those expenses meets the substantiation requirements of § 1.62–2(e)(3) if information submitted to the payor is sufficient to enable the payor to identify the specific nature of each expense and to conclude that the expense is attributable to the payor’s business activity. Generally the employee must submit an expense account or other written statement to the employer showing the business nature and amount of the employee’s expenses. See § 1.162–17(b)(4).

Revenue Procedure 2002–41, 2002–1 C.B. 1098, provides an optional expense substantiation rule applicable only to certain employers in the pipeline construction industry. If an eligible employer’s arrangement to pay employee business expenses otherwise satisfies the business connection and return of excess requirements, and amounts paid under the arrangement do not exceed $13.00 per hour, adjusted for inflation, an employee is deemed to have substantiated the expenses, and amounts paid under the arrangement are treated as paid under an accountable plan.

Section 1.62–2(f)(1) provides that an arrangement meets the return of excess requirements if the arrangement requires the employee to return to the payor within a reasonable period of time any amount paid under the arrangement in excess of substantiated expenses. Section 1.62–2(f)(2) provides authority for the Commissioner to issue rules, for per diem or mileage allowances only, under which an arrangement will be treated as satisfying the return of excess requirement even though the arrangement does not require the employee to return the portion of the allowance related to days or miles of travel substantiated but that exceeds the amount of the

employee’s expenses deemed substantiated pursuant to rules prescribed under § 274(d).

Section 1.62–2(g)(2)(ii) provides that if a payor provides employees with a periodic statement, no less frequently than quarterly, stating the amount, if any, paid under the arrangement that exceeds the expenses the employee has substantiated as required by the arrangement, and requesting the employee to substantiate any additional business expenses that have not yet been substantiated (whether or not such expenses relate to the expenses to which the original advance was paid) and/or to return any amounts remaining unsubstantiated within 120 days of the statement, an expense substantiated or an amount returned within that period will be treated as being substantiated or returned within a reasonable period of time.

Additionally, § 1.62–2(k) provides that if a payor’s reimbursement or other expense allowance arrangement evidences a pattern of abuse of the rules of § 62(c) and the regulations thereunder, all payments made under the arrangement will be treated as made under a nonaccountable plan.

ANALYSIS

An amount paid by an employer to an employee to cover expenses incurred by the employee in the course of employment can be excluded from the employee’s income and wages only if a particular Code section provides an exclusion for such amount or if the amount is paid under an accountable plan. No specific section of the Code excludes from wages amounts paid to employees for acquiring and maintaining tools used in the performance of services as employees. Thus, to be excluded from wages, amounts paid to employees to cover expenses incurred to acquire or maintain such tools must be paid under a reimbursement or other expense allowance arrangement that meets the requirements of § 62(c).

An arrangement qualifies as an accountable plan only if it satisfies all three requirements set forth in the statute and regulations. An arrangement that fails to meet one or more of the three requirements will be treated as a nonaccountable plan.

The arrangement described in this revenue ruling fails to meet both the substanti

August 29, 2005 424 2005–35 I.R.B.

2005–3 I.R.B. 341, ( per diem allowances), or any successors.

HOLDING

The arrangement described in this revenue ruling is not an accountable plan. Therefore, the arrangement is a nonaccountable plan and all tool allowances paid under the arrangement must be included in the employees’ gross income, reported as wages on the employees’ Forms W–2, and are subject to withholding and payment of federal employment taxes.

DRAFTING INFORMATION

The principal author of this revenue ruling is Joe Spires of the Office of Associate Chief Counsel (Tax Exempt & Government Entities). For further information regarding this revenue ruling, contact Jeanne Royal Singley at (202) 622–0047 (not a toll-free call).

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

26 CFR 1.263A–2: Rules relating to property pro- duced by the taxpayer.

When are self-constructed assets produced on a routine and repetitive basis in the ordinary course of a taxpayer’s trade or business for purposes of the simplified production method provided by section 1.263A–2(b)(2)(i)(D)? See Rev. Rul. 2005-53, page 425.

26 CFR 1.263A–1: Uniform capitalization of costs. (Also: § 1.263A–2.)

Assets produced on a routine and repetitive basis. For purposes of the simplified service cost method and simplified production method provided in the regulations under section 263A of the Code, a taxpayer’s self-constructed assets are produced on a routine and repetitive basis in the ordinary course of its trade or business if the assets are either mass-produced (numerous identical goods are manufactured using standardized designs and assembly line techniques) or have a high degree of turnover.

Rev. Rul. 2005–53

BACKGROUND

In Notice 2003–36, 2003–1 C.B. 992, modified by Notice 2003–59, 2003–2 C.B. 429, the Treasury Department and the Internal Revenue Service indicate that they are aware that uncertainty exists as to what types of property constitute “eligible property” under §§ 1.263A–1(h)(2)(i)(D) and 1.263A–2(b)(2)(i)(D) of the Income Tax Regulations for which qualifying taxpayers may use the simplified service cost and simplified production methods. In particular, there is uncertainty about the proper interpretation and application of the term “routine and repetitive.” The notice indicates that the Treasury Department and the Service plan to publish guidance that will clarify the types of property that qualify as eligible property under those sections and address the interpretation and application of the term “routine and repetitive.” This revenue ruling clarifies the types of property that qualify as eligible property for purposes of §§ 1.263A–1(h)(2)(i)(D) and 1.263A–2(b)(2)(i)(D) and how the term “routine and repetitive” is interpreted for this purpose.

ISSUE

Under what circumstances are a taxpayer’s self-constructed assets produced on a routine and repetitive basis in the ordinary course of its trade or business for purposes of the simplified service cost method and the simplified production method (the “simplified methods”) under §§ 1.263A–1(h)(2)(i)(D) and 1.263A–2(b)(2)(i)(D) of the Income Tax Regulations?

FACTS

Situation 1 . U, a manufacturer of office equipment, produces numerous identical copiers during the year using assembly line techniques. U leases the copiers and does not hold them for sale.

Situation 2 . V, a manufacturer of automobiles, regularly produces molds that are specifically designed for the production of particular automobile parts. The molds cannot be adapted for a further or different use after changes or improvements are made to the particular part that is produced by the mold. The molds generally are used

for one to three years. Accordingly, the molds have a high degree of turnover.

Situation 3 . W, a telephone company, manufactures numerous identical poles using standardized designs and assembly line techniques for use in its business.

Situation 4 . X, an electric utility, regularly purchases identical meters and installs them on its customers’ properties. The meters measure the amount of electric current used by X ’s customers. X does not manufacture meters. Meters are included in asset class 49.14 under Rev. Proc. 87–56, 1987–2 C.B. 674, as clarified and modified by Rev. Proc. 88–22, 1988–1 C.B. 785, and have a class life of 30 years. Situation 5 . Y, an electric utility, constructs from various components substations that it uses in transmitting and distributing electricity. Substations and their components are facilities built on land that house an assembly of equipment designed for switching, changing, or regulating the voltage of electricity. Each substation is intended to operate for an extended length of time, is specifically custom designed for a specific geographic site, and serves a particular function within Y ’s electrical grid.

Situation 6 . Z, a company that owns and operates a national chain of restaurants, continually constructs new restaurants each year. Z generally uses a standardized design when constructing new restaurants. However, local zoning laws and the physical characteristics of the specific construction site require Z to modify the design for each new restaurant.

LAW AND ANALYSIS

Section 263A of the Internal Revenue Code provides that producers of real or tangible personal property must capitalize the direct costs and a proper share of the indirect costs of such property.

Section 1.263A–1(e)(3) provides that indirect costs include service costs. For this purpose, § 1.263A–1(e)(4) states that service costs are a type of indirect costs that can be identified specifically with an administrative or support department or function. Service costs include capitalizable service costs, deductible service costs, and mixed service costs. Under § 1.263A–1(e)(4)(ii)(C), mixed service costs include service costs that are partially allocable to production activities

2005–35 I.R.B. 425 August 29, 2005

1.263A–2(b)(2)(i) all share common characteristics that make application of the simplified methods appropriate. Prior to the issuance of the final § 263A regulations, the temporary § 263A regulations, issued under T.D. 8131, 1987–1 C.B. 98, and published in the Federal Register on March 30, 1987, limited the availability of the simplified methods to two categories of property: inventory and non-inventory property held by a taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. The preamble to the temporary § 263A regulations indicates that this limitation was prescribed because the simplified methods are not appropriate to account for the casual or occasional production of property. Instead, the simplified methods were “designed to alleviate the administrative burdens of complying with the new capitalization rules in situations where mass production of assets occurs on a repetitive and routine basis, with a typically high ‘turnover’ rate for the produced assets.” See T.D. 8131, 1987–1 C.B. 98, 102. The final regulations retain these two categories of eligible property in §§ 1.263A–1(h)(2)(i)(A) and (B) and 1.263A–2(b)(2)(i)(A) and (B). See T.D. 8482, 1993–2 C.B. 77, published in the Federal Register on August 9, 1993.

Commentators to the temporary regulations suggested that the categories of property eligible for the simplified methods be expanded to other types of property that share the characteristics that are appropriate for application of the methods. In response, Notice 88–86, 1988–2 C.B. 401, published on August 5, 1988, expanded the availability of the simplified methods to:

property constructed by a taxpayer for use in its trade or business if the taxpayer is also producing, in the ordinary course of its business, inventory property (or any other property with respect to which the use of the simplified production method is permitted under the present regulations), and the property constructed by the taxpayer for use in its trade or business is substantially identical in nature to, and is produced in the same manner as, the inventory property (or such other property) produced by the taxpayer, and

and partially allocable to non-production activities.

Section 1.263A–1(g)(3) provides that indirect costs are generally allocated to intermediate cost objectives such as departments or activities prior to the allocation of such costs to property produced. This section further provides that taxpayers are required to allocate indirect costs using either a specific identification method, a standard cost method, a burden rate method, or any other reasonable allocation method (as defined under the principles of § 1.263A–1(f)(4)).

Section 1.263A–2(b) allows producers to use the simplified production method to determine the additional § 263A costs properly allocable to ending inventories of property produced and other “eligible” property on hand at the end of the taxable year. Section 1.263A–2(b)(3)(i)(A) generally provides that the amount of additional § 263A costs that is allocable to eligible property remaining on hand at the close of the taxable year under the simplified production method is computed by multiplying the § 471 costs on hand at the end of the year by an absorption ratio. Section 1.263A–2(b)(3)(ii)(A) provides that the absorption ratio generally is equal to the additional § 263A costs incurred during the year divided by the § 471 costs incurred during the year.

Additional § 263A costs are the costs, other than interest, that were not capitalized under the taxpayer’s method of accounting immediately prior to the effective date of § 263A, but that are required to be capitalized under § 263A. See § 1.263A–1(d)(3). Section 471 costs generally are the costs, other than interest, that the taxpayer capitalized under its method of accounting immediately prior to the effective date of § 263A. See § 1.263A–1(d)(2).

Section 1.263A–2(b)(2)(i) provides that a taxpayer electing to use the simplified production method generally must use the method for all production activities associated with the following categories of eligible property:

Inventory property . Stock in trade or other property properly includible in the inventory of the taxpayer. See § 1.263A–2(b)(2)(i)(A).
Non-inventory property held for sale . Non-inventory property held by a taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. See § 1.263A–2(b)(2)(i)(B).
Certain self-constructed assets . Self-constructed assets substantially identical in nature to, and produced in the same manner as, inventory property produced by the taxpayer or other property produced by the taxpayer and held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. See § 1.263A–2(b)(2)(i)(C).
Self-constructed assets produced on a repetitive basis . Self-constructed assets produced by the taxpayer on a routine and repetitive basis in the ordinary course of the taxpayer’s trade or business. See § 1.263A–2(b)(2)(i)(D).

Section 1.263A–1(g)(4) generally requires taxpayers to allocate mixed service costs to property produced using reasonable factors or relationships under a direct reallocation method (as defined in § 1.263A–1(g)(4)(iii)(A)), a step-allocation method (as defined in § 1.263A–1(g)(4)(iii)(B)), or any other reasonable allocation method (as defined under the principles of § 1.263A–1(f)(4)).

Section 1.263A–1(h) permits taxpayers to use the simplified service cost method to determine the aggregate portion of mixed service costs incurred during the taxable year that are properly allocable to “eligible property.” The categories of eligible property provided by the simplified service cost method are identical to the four categories of eligible property provided by the simplified production method. Compare § 1.263A–1(h)(2)(i) with § 1.263A–2(b)(2)(i).

Section 1.263A–1(h)(3)(i) provides that under the simplified service cost method, a taxpayer computes its capitalizable mixed service costs by multiplying its total mixed service costs by an allocation ratio. The allocation ratio can be either the labor-based or production-based ratio. See §§ 1.263A–1(h)(4) and (5).

The four categories of eligible property in §§ 1.263A–1(h)(2)(i) and

August 29, 2005 426 2005–35 I.R.B.

line techniques) or have a high degree of turnover.

DRAFTING INFORMATION

The principal author of this revenue ruling is Scott H. Rabinowitz of the Office of Associate Chief Counsel (Income Tax & Accounting). For further information regarding this revenue ruling, contact Mr. Rabinowitz at (202) 622–4970 (not a toll-free call).

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

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

LIFO; price indexes; department stores. The June 2005 Bureau of Labor Statistics price indexes are accepted for use by department stores employing the retail inventory and last-in, first-out inventory methods for valuing inventories for tax years ended on, or with reference to, June 30, 2005.

Rev. Rul. 2005–56

The following Department Store Inventory Price Indexes for June 2005 were issued by the Bureau of Labor Statistics. The indexes are accepted by the Internal Revenue Service, under § 1.472–1(k) of the Income Tax Regulations and Rev. Proc. 86–46, 1986–2 C.B. 739, for appropriate application to inventories of department stores employing the retail inventory and last-in, first-out inventory methods for tax years ended on, or with reference to, June 30, 2005.

The Department Store Inventory Price Indexes are prepared on a national basis and include (a) 23 major groups of departments, (b) three special combinations of the major groups - soft goods, durable goods, and miscellaneous goods, and (c) a store total, which covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco, and contract departments.

property constructed by a taxpayer for use in its trade or business if, in the ordinary course of its production activities, the taxpayer produces such property on a routine and repetitive basis ( i.e., the taxpayer produces numerous items of such property within a taxable year.)

The final regulations follow Notice 88–86 and expand the categories of produced property eligible for the simplified methods by adding §§ 1.263A–1(h)(2)(i)(C) and (D) and 1.263A–2(b)(2)(i)(C) and (D). The simplified methods are predicated on the assumption that it is appropriate to allocate production costs on a ratable basis when assets are either mass-produced ( i.e., numerous identical goods are manufactured using standardized designs and assembly line techniques) or have a high degree of turnover. In contrast, it is not appropriate to allocate production costs on a ratable basis when assets are neither mass-produced nor have a high degree of turnover.

The first three categories of eligible property provided in §§ 1.263A–1(h)(2)(i)(A)–(C) and 1.263A– 2(b)(2)(i)(A)–(C) are either mass-produced and/or have a high degree of turnover or are identical to assets that are mass-produced and/or have a high degree of turnover. The fourth category of eligible property, self-constructed assets produced on a routine and repetitive basis, is similar to these first three categories. It was intended that the fourth category of eligible property provided by the simplified methods, §§ 1.263A–1(h)(2)(i)(D) and 1.263A–2(b)(2)(i)(D), possess the same characteristics shared by all of the preceding categories of eligible property. Therefore, to be eligible under the fourth category, the property also must be either mass-produced (numerous identical goods are manufactured using standardized designs and assembly line techniques) or have a high degree of turnover (in this case have a relatively short useful life). Mass production does not include all the terms provided by § 263A(g) and § 1.263A–2(a)(1) (for example, install, develop, and improve). Instead property is mass-produced only if it is manufactured numerous times during the

year using standardized designs and assembly line techniques.

For example, the fourth category of eligible property provided by the simplified methods, §§ 1.263A–1(h)(2)(i)(D) and 1.263A–2(b)(2)(i)(D), includes property mass-produced by a vertically integrated business for use in its own business that would have been properly included in inventory of a third party if mass-produced for sale by the third party. Thus, if a telephone company mass-produces its own poles for use in its business, the poles would be eligible property for purposes of §§ 1.263A–1(h)(2)(i)(D) and 1.263A–2(b)(2)(i)(D). In Situation 1, U is producing copiers on a routine and repetitive basis for purposes of the simplified methods because the copiers are mass-produced.

In Situation 2, V is producing molds on a routine and repetitive basis for purposes of the simplified methods because the molds have a high degree of turnover.

In Situation 3, W is producing poles on a routine and repetitive basis for purposes of the simplified methods because the poles are mass-produced.

In Situation 4, X is not producing meters on a routine and repetitive basis for purposes of the simplified methods because the meters are neither mass-produced by X nor have a high degree of turnover. Mass production does not include installation of meters and meters do not have a short useful life.

In Situation 5, Y is not producing substations on a routine and repetitive basis for purposes of the simplified methods because the substations are neither mass-produced nor have a high degree of turnover.

In Situation 6, Z is not producing restaurants on a routine and repetitive basis for purposes of the simplified methods because the restaurants are neither mass-produced nor have a high degree of turnover.

HOLDING

For purposes of the simplified methods under §§ 1.263A–1(h)(2)(i)(D) and 1.263A–2(b)(2)(i)(D), a taxpayer’s self-constructed assets are produced on a routine and repetitive basis in the ordinary course of its trade or business if the assets are either mass-produced (numerous identical goods are manufactured using standardized designs and assembly

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

(January 1941 = 100, unless otherwise noted)

Groups June 2004 June 2005

Percent Change from June 2004

to June 2005 ¹

Piece Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490.9 504.8 2.8
Domestics and Draperies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538.7 519.1 -3.6
Women’s and Children’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631.8 650.4 2.9
Men’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 854.5 878.2 2.8
Infants’ Wear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567.3 559.9 -1.3
Women’s Underwear. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508.4 541.4 6.5
Women’s Hosiery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329.9 340.0 3.1
Women’s and Girls’ Accessories . . . . . . . . . . . . . . . . . . . . . . . . . . . 581.5 588.9 1.3
Women’s Outerwear and Girls’ Wear . . . . . . . . . . . . . . . . . . . . . . . 361.9 347.5 -4.0
Men’s Clothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 540.3 536.9 -0.6
Men’s Furnishings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578.3 562.8 -2.7
Boys’ Clothing and Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431.3 413.6 -4.1
Jewelry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 897.4 872.3 -2.8
Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 791.9 810.4 2.3
Toilet Articles and Drugs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 998.9 997.0 -0.2
Furniture and Bedding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624.2 598.7 -4.1
Floor Coverings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 592.9 604.6 2.0
Housewares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712.6 711.9 -0.1
Major Appliances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200.4 204.3 1.9
Radio and Television. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.9 39.0 -6.9
Recreation and Education ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80.7 78.5 -2.7
Home Improvements ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129.3 137.8 6.6
Automotive Accessories ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112.4 114.6 2.0

Groups 1–15: Soft Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559.3 552.0 -1.3 Groups 16–20: Durable Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384.1 379.8 -1.1 Groups 21–23: Misc. Goods ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93.4 93.4 0.0

Store Total ³ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496.5 490.8 -1.1

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

DRAFTING INFORMATION

The principal author of this revenue ruling is Michael Burkom of the Office

of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact

Mr. Burkom at (202) 622–7924 (not a toll-free call).

August 29, 2005 428 2005–35 I.R.B.

Section 861.—Income From Sources Within the United States

26 CFR 1.861–4: Compensation for labor or per- sonal services.

T.D. 9212

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

Source of Compensation for Labor or Personal Services

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that describe the proper basis for determining the source of compensation for labor or personal services performed partly within and partly without the United States. These final regulations will affect individuals who earn compensation for labor or personal services performed partly within and partly without the United States and are needed to provide appropriate guidance regarding the determination of the proper source of that compensation.

DATES: Effective Date : These regulations are effective on July 14, 2005.

Applicability Date : For dates of applicability, see §1.861–4(d).

FOR FURTHER INFORMATION CONTACT: David Bergkuist, (202) 622–3850 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations have 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(d)) under control number 1545–1900. The collections of information in these final regulations are in

§1.861–4(b)(2)(ii)(C)( 1 )( i ), (b)(2)(ii)(D), and (b)(2)(ii)(D)( 6 ). The information required in §1.861–4(b)(2)(ii)(C)( 1 )( i ) will enable an individual, where appropriate, to use an alternative basis other than that described in §1.861–4(b)(2)(ii)(A) or (B) to determine the source of his or her compensation as an employee for labor or personal services performed partly within and partly without the United States. The information required in §1.861–4(b)(2)(ii)(D) and (D)( 6 ) will enable an employee to source certain fringe benefits on a geographical basis. The collections of information will, likewise, allow the IRS to verify these determinations.

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.

Books or records relating to a collection of information must be retained as long as their contents might 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 26 CFR part 1. On August 6, 2004, proposed revisions to the regulations (REG–208254–90; REG–136481–04, 2004–37 I.R.B. 480) under section 861 of the Internal Revenue Code (Code) relating to the source of compensation for labor or personal services were published in the Federal Register (69 FR 47816). In the same document, a prior notice of proposed rulemaking (REG–208254–90, 2000–1 C.B. 577), published in the Federal Reg- ister on January 21, 2000 (65 FR 3401), was withdrawn. A public hearing was held on January 13, 2005. Two written comments were received. After consideration of these comments, the August 6, 2004, proposed regulations are adopted as amended by this Treasury decision.

Summary of Comments and Explanation of Revisions

These final regulations, as proposed in the notice of proposed rulemaking, retain the facts and circumstances basis as the general rule for determining the source of

compensation for labor or personal services performed partly within and partly without the United States received by persons other than individuals and by individuals who are not employees. As proposed, the final regulations provide two general bases for determining the proper source of compensation that an individual receives as an employee for such labor or personal services. Under the first general basis of §1.861–4(b)(2)(ii)(A), an individual will source compensation, other than compensation in the form of certain fringe benefits, on a time basis, as defined in §1.861–4(b)(2)(ii)(E).

Under the second general basis of §1.861–4(b)(2)(ii)(B) and (D), an individual will source compensation in the form of fringe benefits, as described in §1.861–4(b)(2)(ii)(D)( 1 ) through ( 6 ), on a geographical basis ( e.g., at the employee’s principal place of work, as defined in section 217 and §1.217–2(c)(3)). The fringe benefits to which this general basis applies are housing, education, local transportation, tax reimbursement, hazardous or hardship duty pay, and moving expense reimbursement fringe benefits. This general basis will apply only if the amount of the fringe benefit is reasonable and is substantiated by adequate contemporaneous records or sufficient evidence under rules similar to those set forth in §1.274–5T(c) or (h) or §1.132–5.

Comments were received that proposed several changes with regard to the fringe benefits described in §1.861–4(b)(2)(ii)(D)( 1 ) through ( 6 ). Under one suggestion, the specific definitions of the identified fringe benefits would be replaced with broad categories. The comment further suggested that the housing fringe benefit, education fringe benefit, and local transportation fringe benefit include employer-provided allowances that are based on estimated, rather than actual, expenses. The comment also requested that the definition of education fringe benefit be expanded to include payments for the education of the employee’s spouse for studies that relate to the foreign location of the employment, such as language courses and job training at the foreign location, and to include pre-school and post-secondary education, home schooling costs, and language courses of the employee’s dependents. With respect to the transportation fringe benefit, the comment requested

2005–35 I.R.B. 429 August 29, 2005

native basis, the individual must provide the information related to the alternative basis required by applicable Federal tax forms and accompanying instructions. It is expected that the applicable Federal tax forms and accompanying instructions will require individuals with $250,000 or more in compensation for the tax year that use an alternative basis to respond to questions on the tax form and to attach to their income tax returns a written statement that sets forth: (1) the specific compensation income, or the specific fringe benefit, for which an alternative method is used; (2) for each such item, the alternative method of allocation of source used; (3) for each such item, a computation showing how the alternative allocation was computed; and (4) a comparison of the dollar amount of the compensation sourced within and without the United States under both the individual’s alternative basis and the basis for determining source of compensation described in §1.861–4(b)(2)(ii)(A) or (B).

The proposed regulations at §1.861–4(b)(2)(ii)(C)( 3 ) were reserved with respect to artists and athletes who are employees. Although requested, no comments were received on the definition of artists and athletes. The reservation is retained in these final regulations. As noted in the preamble to the proposed regulation, it is intended that the specific rules for artists and athletes who are employees, when issued, will require such individuals to determine the proper source of compensation for labor or personal services on the basis that most correctly reflects the proper source of that income under the facts and circumstances of the particular case, consistent with current law.

Proposed §1.861–4(b)(2)(ii)(F) provided that the source of multi-year compensation of an employee is generally determined on a time basis over the applicable period to which the compensation is attributable. Determination of the applicable period to which the compensation is attributable (including whether the compensation relates to more than one taxable year) is based upon the facts and circumstances of the particular case. Comments requested additional guidance in the area of equity based compensation, particularly with respect to stock options, that relate to services performed over a period of more than one year. These comments

that automobile purchase assistance in the host country be included. The comment also requested that the amount of compensation qualifying for the hazardous or hardship duty pay fringe benefit not be limited to government-provided amounts. The comment suggested that the definition of moving expense reimbursement fringe benefit be expanded to include a list of specific expenses, such as moving allowances, home sale/purchase assistance, temporary living, car loss reimbursement, utility setup, appliance installation, auto registration, driver’s license fees, power converters, and other related expenses. The comment also suggested three additional fringe benefits: home leave allowances, cost-of-living allowances, and exchange rate differential allowances.

The Treasury Department and the IRS considered the various comments regarding the approach, scope, and detail of the identified fringe benefits under the proposed regulations. In response to the comments, the final regulations modify the definition of education fringe benefit to include education expenses of the type described in section 530(b)(4)(A)(i) regardless of whether the education expenses are incurred in connection with enrollment or attendance at a school. The final regulations do not incorporate the suggestion for allowances based on estimated expenses because the Treasury Department and the IRS continue to believe that substantiation of relevant items is the more appropriate approach. Regarding the other proposed changes to the identified fringe benefits, the Treasury Department and the IRS believe that the regulations provide an appropriate scope of benefits, a reasonable manner of determining the appropriate amount of fringe benefit to be sourced geographically, and a reasonable limit to the amount of an individual’s compensation that may be sourced under the exception to the general time basis rule of §1.861–4(b)(2)(ii)(E). As noted in the preamble to the proposed regulations, the Treasury Department and the IRS intend to keep the list and descriptions of identified fringe benefits current and continue to invite comments on whether the identified fringe benefits are appropriately defined and whether other fringe benefits should be identified and sourced on a specific geographic basis.

Furthermore, the final regulations retain the proposed provision that permits an employee to use an alternative basis, based upon the facts and circumstances, to source such compensation if he or she establishes to the satisfaction of the Commissioner that such an alternative basis more properly determines the source of the compensation. An individual seeking to use an alternative basis need not obtain the satisfaction of the Commissioner prior to filing his or her return. To obtain the satisfaction of the Commissioner, an individual who uses an alternative basis must retain in his or her records documentation setting forth why the alternative basis more properly determines the source of the compensation than the basis for determining source of compensation described in §1.861–4(b)(2)(ii)(A) or (B). One comment requested that substantiation by the individual’s employer be accepted as substantiation by the employee, particularly where the alternative method is used by a group of employees. Whether an alternative basis more properly determines the source of an individual’s compensation is based on the facts and circumstances of the individual’s specific case. As a result, it is the individual employee, rather than the employer, who must demonstrate that the alternative basis more properly determines the source of the compensation than the basis for determining source of compensation described in §1.861–4(b)(2)(ii)(A) or (B). It is expected, however, that the individual employee would use, among other documentation, documentation provided by the employer for such substantiation.

Another comment requested relief from any penalties that might arise from inaccurate reporting or withholding if an alternative method is determined not to be acceptable or if the Commissioner determines that a method other than the two general methods determines the source of compensation in a more reasonable manner. The Treasury Department and the IRS believe that the existing standards of penalty administration, including applicable justifications, adequately address this matter.

Section 1.861–4(b)(2)(ii)(C)( 1 )( i ) of the proposed regulations provided that to assert an alternative basis the individual must comply with the requirements set forth in any administrative pronouncement issued by the Commissioner. The final regulations require that to assert an alter

August 29, 2005 430 2005–35 I.R.B.

reflects the proper source of the income under the facts and circumstances of the particular case. In many cases, the facts and circumstances will be such that an apportionment on the time basis, as defined in paragraph (b)(2)(ii)(E) of this section, will be acceptable.

(ii) Example . The application of paragraph (b)(1)(i) is illustrated by the following example.

Example . Corp X, a domestic corporation, receives compensation of $150,000 under a contract for services to be performed concurrently in the United States and in several foreign countries by numerous Corp X employees. Each Corp X employee performing services under this contract performs his or her services exclusively in one jurisdiction. Although the number of employees (and hours spent by employees) performing services under the contract within the United States equals the number of employees (and hours spent by employees) performing services under the contract without the United States, the compensation paid to employees performing services under the contract within the United States is higher because of the more sophisticated nature of the services performed by the employees within the United States. Accordingly, the payroll cost for employees performing services under the contract within the United States is $20,000 out of a total contract payroll cost of $30,000. Under these facts and circumstances, a determination based upon relative payroll costs would be the basis that most correctly reflects the proper source of the income received under the contract. Thus, of the $150,000 of compensation included in Corp X’s gross income, $100,000 ($150,000 x $20,000/$30,000) is attributable to the labor or personal services performed within the United States and $50,000 ($150,000 x $10,000/$30,000) is attributable to the labor or personal services performed without the United States.

(2) Compensation for labor or personal services performed by an individual —(i) In general . Except as provided in paragraph (b)(2)(ii) of this section, in the case of compensation for labor or personal services performed partly within and partly without the United States by an individual, the part of such compensation that is attributable to the labor or personal services performed within the United States, and that is therefore included in gross income as income from sources within the United States, is determined on the basis that most correctly reflects the proper source of that income under the facts and circumstances of the particular case. In many cases, the facts and circumstances will be such that an apportionment on a time basis, as defined in paragraph (b)(2)(ii)(E) of this section, will be acceptable.

(ii) Employee compensation —(A) In general . Except as provided in paragraph (b)(2)(ii)(B) or (C) of this section, in the

requested guidance related to pre-grant sourcing, sourcing based upon exercise date, and non-conventional equity compensation awards. Because under the regulations the applicable period is determined based on the facts and circumstances of the particular case, and a taxpayer may assert an alternative method to source such compensation income pursuant to §1.861–4(b)(2)(ii)(C)( 1 )( i ), the Treasury Department and the IRS concluded that §1.861–4(b)(2)(ii)(F), as proposed, was reasonable in its scope and the rules were not modified in the final regulations.

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 collections of information contained in these regulations will not have a significant economic impact on a substantial number of small entities. Accordingly, a regulatory flexibility analysis is not required. This certification is based upon that fact that the Treasury Department and the IRS believe that a time basis generally is the most appropriate method for determining the source of an individual employee’s compensation for labor or personal services performed partly within and partly without the United States. The information necessary to apply the time basis should be readily available to employers and employees. For example, Form 2555, “Foreign Earned Income”, requires an individual who claims the foreign earned income exclusion to provide the IRS with information relating to the number of business days spent within the United States and any fringe benefits received. In addition, if an employee wishes to use an alternative method to source compensation, it is the employee that must document such alternative method. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these final regulations is David Bergkuist of the Office of

Associate Chief Counsel (International). However, other personnel from the IRS and the Treasury Department participated in their development.

- - - -

Adoption of 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 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.861–4 is amended as follows:

The heading for paragraph (a) is revised.
A sentence is added at the beginning of paragraph (a)(1) introductory text.
Paragraph (b) is revised.
A sentence is added at the end of paragraph (d).

The revisions and addition read as follows:

§1.861–4 Compensation for labor or personal services.

(a) Compensation for labor or personal services performed wholly within the United States . (1) Generally, compensation for labor or personal services, including fees, commissions, fringe benefits, and similar items, performed wholly within the United States is gross income from sources within the United States. - * *

- - - (b) Compensation for labor or per- sonal services performed partly within and partly without the United States —(1) Compensation for labor or personal ser- vices performed by persons other than individuals —(i) In general . In the case of compensation for labor or personal services performed partly within and partly without the United States by a person other than an individual, the part of that compensation that is attributable to the labor or personal services performed within the United States, and that is therefore included in gross income as income from sources within the United States, is determined on the basis that most correctly

2005–35 I.R.B. 431 August 29, 2005

( 1 ) Housing fringe benefit . The source of compensation in the form of a housing fringe benefit is determined based on the location of the individual’s principal place of work. For purposes of this paragraph (b)(2)(ii)(D)( 1 ), a housing fringe benefit includes payments to or on behalf of an individual (and the individual’s family if the family resides with the individual) only for rent, utilities (other than telephone charges), real and personal property insurance, occupancy taxes not deductible under section 164 or 216(a), nonrefundable fees paid for securing a leasehold, rental of furniture and accessories, household repairs, residential parking, and the fair rental value of housing provided in kind by the individual’s employer. A housing fringe benefit does not include payments for expenses or items set forth in §1.911–4(b)(2).

( 2 ) Education fringe benefit . The source of compensation in the form of an education fringe benefit for the education expenses of the individual’s dependents is determined based on the location of the individual’s principal place of work. For purposes of this paragraph (b)(2)(ii)(D)( 2 ), an education fringe benefit includes payments only for qualified tuition and expenses of the type described in section 530(b)(4)(A)(i) (regardless of whether incurred in connection with enrollment or attendance at a school) and expenditures for room and board and uniforms as described in section 530(b)(4)(A)(ii) with respect to education at an elementary or secondary educational institution.

( 3 ) Local transportation fringe benefit . The source of compensation in the form of a local transportation fringe benefit is determined based on the location of the individual’s principal place of work. For purposes of this paragraph (b)(2)(ii)(D)( 3 ), an individual’s local transportation fringe benefit is the amount that the individual receives as compensation for local transportation of the individual or the individual’s spouse or dependents at the location of the individual’s principal place of work. The amount treated as a local transportation fringe benefit is limited to the actual expenses incurred for local transportation and the fair rental value of any vehicle provided by the employer and used predominantly by the individual or the individual’s spouse or dependents for local transportation. For this purpose, actual expenses in

case of compensation for labor or personal services performed partly within and partly without the United States by an individual as an employee, the part of such compensation that is attributable to the labor or personal services performed within the United States, and that is therefore included in gross income as income from sources within the United States, is determined on a time basis, as defined in paragraph (b)(2)(ii)(E) of this section.

(B) Certain fringe benefits sourced on a geographical basis . Except as provided in paragraph (b)(2)(ii)(C) of this section, items of compensation of an individual as an employee for labor or personal services performed partly within and partly without the United States that are described in paragraphs (b)(2)(ii)(D)( 1 ) through ( 6 ) of this section are sourced on a geographical basis in accordance with those paragraphs.

(C) Exceptions and special rules —( 1 ) Alternative basis —( i ) Individual as an em- ployee generally . An individual may determine the source of his or her compensation as an employee for labor or personal services performed partly within and partly without the United States under an alternative basis if the individual establishes to the satisfaction of the Commissioner that, under the facts and circumstances of the particular case, the alternative basis more properly determines the source of the compensation than a basis described in paragraph (b)(2)(ii)(A) or (B), whichever is applicable, of this section. An individual that uses an alternative basis must retain in his or her records documentation setting forth why the alternative basis more properly determines the source of the compensation. In addition, the individual must provide the information related to the alternative basis required by applicable Federal tax forms and accompanying instructions.

( ii ) Determination by Commissioner . The Commissioner may, under the facts and circumstances of the particular case, determine the source of compensation that is received by an individual as an employee for labor or personal services performed partly within and partly without the United States under an alternative basis other than a basis described in paragraph (b)(2)(ii)(A) or (B) of this section if such compensation either is not for a specific time period or constitutes in substance a fringe benefit described in paragraph

(b)(2)(ii)(D) of this section notwithstanding a failure to meet any requirement of paragraph (b)(2)(ii)(D) of this section. The Commissioner may make this determination only if such alternative basis determines the source of compensation in a more reasonable manner than the basis used by the individual pursuant to paragraph (b)(2)(ii)(A) or (B) of this section.

( 2 ) Ruling or other administrative pro- nouncement with respect to groups of tax- payers . The Commissioner may, by ruling or other administrative pronouncement applying to similarly situated taxpayers generally, permit individuals to determine the source of their compensation as an employee for labor or personal services performed partly within and partly without the United States under an alternative basis. Any such individual shall be treated as having met the requirement to establish such alternative basis to the satisfaction of the Commissioner under the facts and circumstances of the particular case, provided that the individual meets the other requirements of paragraph (b)(2)(ii)(C)( 1 )( i ) of this section. The Commissioner also may, by ruling or other administrative pronouncement, indicate the circumstances in which he will require individuals to determine the source of certain compensation as an employee for labor or personal services performed partly within and partly without the United States under an alternative basis pursuant to the authority under paragraph (b)(2)(ii)(C)( 1 )( ii ) of this section.

( 3 ) Artists and athletes . [Reserved.] (D) Fringe benefits sourced on a geo- graphical basis . Except as provided in paragraph (b)(2)(ii)(C) of this section, compensation of an individual as an employee for labor or personal services performed partly within and partly without the United States in the form of the following fringe benefits is sourced on a geographical basis as indicated in this paragraph (b)(2)(ii)(D). The amount of the compensation in the form of the fringe benefit must be reasonable, and the individual must substantiate such amounts by adequate records or by sufficient evidence under rules similar to those set forth in §1.274–5T(c) or (h) or §1.132–5. For purposes of this paragraph (b)(2)(ii)(D), the term principal place of work has the same meaning that it has for purposes of section 217 and §1.217–2(c)(3).

August 29, 2005 432 2005–35 I.R.B.

periods would be the portion of the year following the start of the foreign posting. However, in the case of a foreign posting that requires short-term returns to the United States to perform services for the employer, such short-term returns would not be sufficient to establish distinct, separate, and continuous time periods within the foreign posting time period but would be relevant to the allocation of compensation relating to the overall time period. In each case, the source of the compensation on a time basis is based upon the number of days (or unit of time less than a day, if appropriate) in that separate time period.

(F) Multi-year compensation arrange- ments . The source of multi-year compensation is determined generally on a time basis, as defined in paragraph (b)(2)(ii)(E) of this section, over the period to which such compensation is attributable. For purposes of this paragraph (b)(2)(ii)(F), multi-year compensation means compensation that is included in the income of an individual in one taxable year but that is attributable to a period that includes two or more taxable years. The determination of the period to which such compensation is attributable, for purposes of determining its source, is based upon the facts and circumstances of the particular case. For example, an amount of compensation that specifically relates to a period of time that includes several calendar years is attributable to the entirety of that multi-year period. The amount of such compensation that is treated as from sources within the United States is the amount that bears the same relationship to the total multi-year compensation as the number of days (or unit of time less than a day, if appropriate) that labor or personal services were performed within the United States in connection with the project bears to the total number of days (or unit of time less than a day, if appropriate) that labor or personal services were performed in connection with the project. In the case of stock options, the facts and circumstances generally will be such that the applicable period to which the compensation is attributable is the period between the grant of an option and the date on which all employment-related conditions for its exercise have been satisfied (the vesting of the option).

(G) Examples . The following examples illustrate the application of this paragraph (b)(2)(ii):

curred for local transportation do not include the cost (including interest) of the purchase by the individual, or on behalf of the individual, of an automobile or other vehicle.

( 4 ) Tax reimbursement fringe benefit . The source of compensation in the form of a foreign tax reimbursement fringe benefit is determined based on the location of the jurisdiction that imposed the tax for which the individual is reimbursed.

( 5 ) Hazardous or hardship duty pay fringe benefit . The source of compensation in the form of a hazardous or hardship duty pay fringe benefit is determined based on the location of the hazardous or hardship duty zone for which the hazardous or hardship duty pay fringe benefit is paid. For purposes of this paragraph (b)(2)(ii)(D)( 5 ), a hazardous or hardship duty zone is any place in a foreign country which is either designated by the Secretary of State as a place where living conditions are extraordinarily difficult, notably unhealthy, or where excessive physical hardships exist, and for which a post differential of 15 percent or more would be provided under section 5925(b) of Title 5 of the U.S. Code to any officer or employee of the U.S. Government present at that place, or where a civil insurrection, civil war, terrorism, or wartime conditions threatens physical harm or imminent danger to the health and well-being of the individual. Compensation provided an employee during the period that the employee performs labor or personal services in a hazardous or hardship duty zone may be treated as a hazardous or hardship duty pay fringe benefit only if the employer provides the hazardous or hardship duty pay fringe benefit only to employees performing labor or personal services in a hazardous or hardship duty zone. The amount of compensation treated as a hazardous or hardship duty pay fringe benefit may not exceed the maximum amount that the U.S. government would allow its officers or employees present at that location.

( 6 ) Moving expense reimbursement fringe benefit . Except as otherwise provided in this paragraph (b)(2)(ii)(D)( 6 ), the source of compensation in the form of a moving expense reimbursement is determined based on the location of the employee’s new principal place of work. The source of such compensation is determined based on the location of the em

ployee’s former principal place of work, however, if the individual provides sufficient evidence that such determination of source is more appropriate under the facts and circumstances of the particular case. For purposes of this paragraph (b)(2)(ii)(D)( 6 ), sufficient evidence generally requires an agreement, between the employer and the employee, or a written statement of company policy, which is reduced to writing before the move and which is entered into or established to induce the employee or employees to move to another country. Such written statement or agreement must state that the employer will reimburse the employee for moving expenses that the employee incurs to return to the employee’s former principal place of work regardless of whether he or she continues to work for the employer after returning to that location. The writing may contain certain conditions upon which the right to reimbursement is determined as long as those conditions set forth standards that are definitely ascertainable and can only be fulfilled prior to, or through completion of, the employee’s return move to the employee’s former principal place of work.

(E) Time basis . The amount of compensation for labor or personal services performed within the United States determined on a time basis is the amount that bears the same relation to the individual’s total compensation as the number of days of performance of the labor or personal services by the individual within the United States bears to his or her total number of days of performance of labor or personal services. A unit of time less than a day may be appropriate for purposes of this calculation. The time period for which the compensation for labor or personal services is made is presumed to be the calendar year in which the labor or personal services are performed, unless the taxpayer establishes to the satisfaction of the Commissioner, or the Commissioner determines, that another distinct, separate, and continuous period of time is more appropriate. For example, a transfer during a year from a position in the United States to a foreign posting that lasted through the end of that year would generally establish two separate time periods within that taxable year. The first of these time periods would be the portion of the year preceding the start of the foreign posting, and the second of these time

2005–35 I.R.B. 433 August 29, 2005

Example 1 . B, a nonresident alien individual, was employed by Corp M, a domestic corporation, from March 1 to December 25 of the taxable year, a total of 300 days, for which B received compensation in the amount of $80,000. Under B’s employment contract with Corp M, B was subject to call at all times by Corp M and was in a payment status on a 7-day week basis. Pursuant to that contract, B performed services (or was available to perform services) within the United States for 180 days and performed services (or was available to perform services) without the United States for 120 days. None of B’s $80,000 compensation was for fringe benefits as identified in paragraph (b)(2)(ii)(D) of this section. B determined the amount of compensation that is attributable to his labor or personal services performed within the United States on a time basis under paragraph (b)(2)(ii)(A) and (E) of this section. B did not assert, pursuant to paragraph (b)(2)(ii)(C)( 1 )( i ) of this section, that, under the particular facts and circumstances, an alternative basis more properly determines the source of that compensation than the time basis. Therefore, B must include in income from sources within the United States $48,000 ($80,000 x 180/300) of his compensation from Corporation M.

Example 2 . (i) Same facts as in Example 1 except that Corp M had a company-wide arrangement with its employees, including B, that they would receive an education fringe benefit, as described in paragraph (b)(2)(ii)(D)( 2 ) of this section, while working in the United States. During the taxable year, B incurred education expenses for his dependent daughter that qualified for the education fringe benefit in the amount of $10,000, for which B received a reimbursement from Corp M. B did not maintain adequate records or sufficient evidence of this fringe benefit as required by paragraph (b)(2)(ii)(D) of this section. When B filed his Federal income tax return for the taxable year, B did not apply paragraphs (b)(2)(ii)(B) and (D)( 2 ) of this section to treat the compensation in the form of the education fringe benefit as income from sources within the United States, the location of his principal place of work during the 300-day period. Rather, B combined the $10,000 reimbursement with his base compensation of $80,000 and applied the time basis of paragraph (b)(2)(ii)(A) of this section to determine the source of his gross income.

(ii) On audit, B argues that because he failed to substantiate the education fringe benefit in accordance with paragraph (b)(2)(ii)(D) of this section, his entire employment compensation from Corp M is sourced on a time basis pursuant to paragraph (b)(2)(ii)(A) of this section. The Commissioner, after reviewing Corp M’s fringe benefit arrangement, determines, pursuant to paragraph (b)(2)(ii)(C)( 1 )( ii ) of this section, that the $10,000 educational expense reimbursement constitutes in substance a fringe benefit described in paragraph (b)(2)(ii)(D)( 2 ) of this section, notwithstanding a failure to meet all of the requirements of paragraph (b)(2)(ii)(D) of this section, and that an alternative geographic source basis, under the facts and circumstances of this particular case, is a more reasonable manner to determine the source of the compensation than the time basis used by B.

Example 3 . (i) A, a United States citizen, is employed by Corp N, a domestic corporation. A’s principal place of work is in the United States. A earns an annual salary of $100,000. During the first quarter of

the calendar year (which is also A’s taxable year), A performed services entirely within the United States. At the beginning of the second quarter of the calendar year, A was transferred to Country X for the remainder of the year and received, in addition to her annual salary, $30,000 in fringe benefits that are attributable to her new principal place of work in Country X. Corp N paid these fringe benefits separately from A’s annual salary. Corp N supplied A with a statement detailing that $25,000 of the fringe benefit was paid for housing, as defined in paragraph (b)(2)(ii)(D)( 1 ) of this section, and $5,000 of the fringe benefit was paid for local transportation, as defined in paragraph (b)(2)(ii)(D)( 3 ) of this section. None of the local transportation fringe benefit is excluded from the employee’s gross income as a qualified transportation fringe benefit under section 132(a)(5). Under A’s employment contract, A was required to work on a 5-day week basis, Monday through Friday. During the last three quarters of the year, A performed services 30 days in the United States and 150 days in Country X and other foreign countries.

(ii) A determined the source of all of her compensation from Corp N pursuant to paragraphs (b)(2)(ii)(A), (B), and (D)( 1 ) and ( 3 ) of this section. A did not assert, pursuant to paragraph (b)(2)(ii)(C)( 1 )( i ) of this section, that, under the particular facts and circumstances, an alternative basis more properly determines the source of that compensation than the bases set forth in paragraphs (b)(2)(ii)(A), (B), and (D)( 1 ) and ( 3 ) of this section. However, in applying the time basis set forth in paragraph (b)(2)(ii)(E) of this section, A establishes to the satisfaction of the Commissioner that the first quarter of the calendar year and the last three quarters of the calendar year are two separate, distinct, and continuous periods of time. Accordingly, $25,000 of A’s annual salary is attributable to the first quarter of the year (25 percent of $100,000). This amount is entirely compensation that was attributable to the labor or personal services performed within the United States and is, therefore, included in gross income as income from sources within the United States. The balance of A’s compensation as an employee of Corp N, $105,000 (which includes the $30,000 in fringe benefits that are attributable to the location of A’s principal place of work in Country X), is compensation attributable to the final three quarters of her taxable year. During those three quarters, A’s periodic performance of services in the United States does not result in distinct, separate, and continuous periods of time. Of the $75,000 paid for annual salary, $12,500 (30/180 x $75,000) is compensation that was attributable to the labor or personal services performed within the United States and $62,500 (150/180 x $75,000) is compensation that was attributable to the labor or personal services performed outside the United States. Pursuant to paragraphs (b)(2)(ii)(B) and (D)( 1 ) and ( 3 ) of this section, A sourced the $25,000 received for the housing fringe benefit and the $5,000 received for the local transportation fringe benefit based on the location of her principal place of work, Country X. Accordingly, A included the $30,000 in fringe benefits in her gross income as income from sources without the United States.

Example 4 . Same facts as in Example 3 . Of the 150 days during which A performed services in Country X and in other foreign countries (during

the final three quarters of A’s taxable year), she performed 30 days of those services in Country Y. Country Y is a country designated by the Secretary of State as a place where living conditions are extremely difficult, notably unhealthy, or where excessive physical hardships exist and for which a post differential of 15 percent or more would be provided under section 5925(b) of Title 5 of the U.S. Code to any officer or employee of the U.S. government present at that place. Corp N has a policy of paying its employees a $65 premium per day for each day worked in countries so designated. The $65 premium per day does not exceed the maximum amount that the U.S. government would pay its officers or employees stationed in Country Y. Because A performed services in Country Y for 30 days, she earned additional compensation of $1,950. The $1,950 is considered a hazardous duty or hardship pay fringe benefit and is sourced under paragraphs (b)(2)(ii)(B) and (D)( 5 ) of this section based on the location of the hazardous or hardship duty zone, Country Y. Accordingly, A included the amount of the hazardous duty or hardship pay fringe benefit ($1,950) in her gross income as income from sources without the United States.

Example 5 . (i) During 2006 and 2007, Corp P, a domestic corporation, employed four United States citizens, E, F, G, and H to work in its manufacturing plant in Country V. As part of his or her compensation package, each employee arranged for local transportation unrelated to Corp P’s business needs. None of the local transportation fringe benefit is excluded from the employee’s gross income as a qualified transportation fringe benefit under section 132(a)(5) and (f). (ii) Under the terms of the compensation package that E negotiated with Corp P, Corp P permitted E to use an automobile owned by Corp P. In addition, Corp P agreed to reimburse E for all expenses incurred by E in maintaining and operating the automobile, including gas and parking. Provided that the local transportation fringe benefit meets the requirements of paragraph (b)(2)(ii)(D)( 3 ) of this section, E’s compensation with respect to the fair rental value of the automobile and reimbursement for the expenses E incurred is sourced under paragraphs (b)(2)(ii)(B) and (D)( 3 ) of this section based on E’s principal place of work in Country V. Thus, the local transportation fringe benefit will be included in E’s gross income as income from sources without the United States.

(iii) Under the terms of the compensation package that F negotiated with Corp P, Corp P let F use an automobile owned by Corp P. However, Corp P did not agree to reimburse F for any expenses incurred by F in maintaining and operating the automobile. Provided that the local transportation fringe benefit meets the requirements of paragraph (b)(2)(ii)(D)( 3 ) of this section, F’s compensation with respect to the fair rental value of the automobile is sourced under paragraphs (b)(2)(ii)(B) and (D)( 3 ) of this section based on F’s principal place of work in Country V. Thus, the local transportation fringe benefit will be included in F’s gross income as income from sources without the United States.

(iv) Under the terms of the compensation package that G negotiated with Corp P, Corp P agreed to reimburse G for the purchase price of an automobile that G purchased in Country V. Corp P did not agree to reimburse G for any expenses incurred by

August 29, 2005 434 2005–35 I.R.B.

G in maintaining and operating the automobile. Because the cost to purchase an automobile is not a local transportation fringe benefit as defined in paragraph (b)(2)(ii)(D)( 3 ) of this section, the source of the compensation to G will be determined pursuant to paragraph (b)(2)(ii)(A) or (C) of this section.

(v) Under the terms of the compensation package that H negotiated with Corp P, Corp P agreed to reimburse H for the expenses that H incurred in maintaining and operating an automobile, including gas and parking, which H purchased in Country V. Provided that the local transportation fringe benefit meets the requirements of paragraph (b)(2)(ii)(D)( 3 ) of this section, H’s compensation with respect to the reimbursement for the expenses H incurred is sourced under paragraphs (b)(2)(ii)(B) and (D)( 3 ) of this section based on H’s principal place of work in Country V. Thus, the local transportation fringe benefit will be included in H’s gross income as income from sources without the United States.

Example 6 . (i) On January 1, 2006, Company Q compensates employee J with a grant of options to which section 421 does not apply that do not have a readily ascertainable fair market value when granted. The stock options permit J to purchase 100 shares of Company Q stock for $5 per share. The stock options do not become exercisable unless and until J performs services for Company Q (or a related company) for 5

CFR part or section where identified and described

years. J works for Company Q for the 5 years required by the stock option grant. In years 2006–08, J performs all of his services for Company Q within the United States. In 2009, J performs ¹ /2 of his services for Company Q within the United States and 1/2 of his services for Company Q without the United States. In year 2010, J performs his services entirely without the United States. On December 31, 2012, J exercises the options when the stock is worth $10 per share. J recognizes $500 in taxable compensation (($10-$5) x 100) in 2012.

(ii) Under the facts and circumstances, the applicable period is the 5-year period between the date of grant (January 1, 2006) and the date the stock options become exercisable (December 31, 2010). On the date the stock options become exercisable, J performs all services necessary to obtain the compensation from Company Q. Accordingly, the services performed after the date the stock options become exercisable are not taken into account in sourcing the compensation from the stock options. Therefore, pursuant to paragraph (b)(2)(ii)(A), since J performs 3 ¹ /2 years of services for Company Q within the United States and 1 ¹ /2 years of services for Company Q without the United States during the 5-year period, 7/10 of the $500 of compensation (or $350) recognized in 2012 is income from sources within the United States

and the remaining 3/10 of the compensation (or $150) is income from sources without the United States.

- - - (d) Effective date . - - - Paragraph (b) and the first sentence of paragraph (a)(1) of this section apply to taxable years beginning on or after July 14, 2005.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 4. In §602.101, paragraph (b) is amended by adding an entry for §1.861–4 in numerical order to the table to read as follows:

§602.101 OMB Control numbers.

- - - (b) - *

Current OMB control No.

1.861–4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1545–1900

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

Approved July 5, 2005.

Eric Solomon, Acting Deputy Assistant Secretary

for Tax Policy .

(Filed by the Office of the Federal Register on July 13, 2005, 8:45 a.m., and published in the issue of the Federal Register for July 14, 2005, 70 F.R. 40663)

Section 2651.—Generation Assignment

26 CFR 26.2651–1: Generation assignment.

T.D. 9214

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 26

Predeceased Parent Rule

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the predeceased parent rule, which provides an exception to the general rules of section 2651 of the Internal Revenue Code (Code) for determining the generation assignment of a transferee of property for generation-skipping

transfer (GST) tax purposes. These regulations also provide rules regarding a transferee assigned to more than one generation. The regulations reflect changes to the law made by the Taxpayer Relief Act of 1997 and generally apply to individuals, trusts, and estates.

DATES: Effective Date : These regulations are effective July 18, 2005.

FOR FURTHER INFORMATION CONTACT: Lian A. Mito at (202) 622–7830 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On September 3, 2004, a notice of proposed rulemaking (REG–145988–03, 2004–42 I.R.B. 693) relating to the predeceased parent rule was published in the Federal Register (69 FR 53862). The public hearing scheduled for December 14, 2004, was cancelled because no re

2005–35 I.R.B. 435 August 29, 2005

Two commentators expressed concern that this objective test (specifically, the age at the time of the adoption) provides a strong inducement to engage in a tax-motivated adoption, particularly in the case of older minors, because of the amount of GST tax that thereby may be avoided. One commentator suggested lowering the limit on the age of the individual at the time of the adoption for purposes of the test. The other commentator recommended adding a third element to the definition of adopted individual, namely, that the individual was not adopted primarily for tax-avoidance purposes.

The Treasury Department and the IRS continue to believe that certain adopted minors should be treated as a member of the generation that is one generation below the adoptive parent, but only if the adoption is not primarily for the purpose of avoiding GST tax. Therefore, under the final regulations, the adopted individual will be treated as a member of the generation that is one generation below the adoptive parent for purposes of determining whether transfers from certain individuals to the adopted individual are subject to GST tax if the following requirements are satisfied: (1) the individual is legally adopted by the adoptive parent; (2) the individual is a descendant of a parent of the adoptive parent (or the adoptive parent’s spouse or former spouse); (3) the individual is under the age of 18 at the time of the adoption; and (4) the individual is not adopted primarily for GST tax-avoidance purposes. The determination of whether an adoption is primarily for GST tax-avoidance purposes is to be made based upon all of the facts and circumstances. The Treasury Department and IRS believe that the most significant factor to be considered is whether there is a bona fide parent/child relationship between the adoptive parent and the adopted individual. Other factors that may be considered include (but are not limited to): the age of the adopted individual at the time of the adoption, and the relationship between the adopted individual and the individual’s parents immediately before the adoption. Thus, the adoption of an infant will be less likely to be considered primarily for tax-avoidance purposes than the adoption of an individual who is age 17. Objective evidence that the parent was unwilling or unable to act as the individual’s parent

quests to speak were received. Written comments responding to the notice of proposed rulemaking were received. After consideration of all the comments, the proposed regulations are adopted as amended by this Treasury decision. The revisions are discussed below.

Summary of Comments

The proposed regulations provided that, for purposes of determining whether the predeceased parent rule applies, an individual transferee’s interest in property is established or derived at the time the transferor who transferred the property is subject to either the gift or estate tax on the property. If the transferor will be subject to a transfer tax imposed on the property transferred on more than one occasion, then the relevant time for determining whether the predeceased parent rule applies is the earliest time at which the transferor is subject to the gift or estate tax. In the case of a trust for which an election under section 2056(b)(7) (QTIP election) has been made, the proposed regulations provided that the interest of the remainder beneficiary is considered as established or derived when the QTIP trust was established. However, the proposed regulations also included an exception to this general rule by providing that, to the extent of the QTIP (but not a reverse QTIP) election, the remainder beneficiary’s interest is deemed to have been established or derived on the death of the transferor’s spouse (the income beneficiary), rather than on the transferor’s earlier death.

One commentator indicated that this exception is unnecessary. The commentator believes that the proposed regulations misinterpreted the statute because a remainder beneficiary’s interest in a trust that is subject to a QTIP (but not a reverse QTIP) election should always be deemed to have been established, not at the time of the trust’s creation, but rather at the time when the income-beneficiary spouse is first subject to gift or estate tax on the trust property. This position applies the definition of “transferor” in section 2652 in the context of the reference to “established and derived” in section 2651(e), and is based on the conclusion that the tax in this situation is not imposed on the same transferor on more than one occasion. Thus, because the donee or surviving spouse becomes the

transferor of a trust that is subject to a QTIP (but not reverse QTIP) election, the remainder beneficiary’s interest in such a trust is established upon that spouse’s gift of an interest in the trust or that spouse’s death, in each case the time at which gift or estate tax on the trust is first imposed on that spouse. Viewed from this perspective, this provision of the proposed regulations is not an exception. The Treasury Department and the IRS agree, and the final regulations adopt the suggested change.

Under the proposed regulations, the predeceased parent rule does not apply to transfers to collateral heirs if, at the time of the transfer, “the transferor (or the transferor’s spouse or former spouse) has any living lineal descendant.” Thus, under the proposed regulations, if, at the time of the transfer, the transferor has no living lineal descendants but the transferor’s spouse or former spouse does, the predeceased parent rule will not apply to any transfer by the transferor to a collateral heir. A number of commentators pointed out that the parenthetical language is inconsistent with the purpose and language of the statute, and will inappropriately narrow the application of the predeceased parent rule with respect to collateral heirs. The Treasury Department and the IRS agree, and the parenthetical language is removed in the final regulations. Accordingly, the final regulations require that, for the predeceased parent rule to apply to transfers to collateral heirs, only the transferor must have no living lineal descendants at the time of the transfer.

The proposed regulations provided an exception to the general rule that assigns an individual to the youngest of the generations to which that individual may be assigned. Under the exception, an adopted individual will be treated as a member of the generation that is one generation below the adoptive parent for purposes of determining whether a transfer to the adopted individual from the adoptive parent (or the spouse or former spouse of the adoptive parent, or a lineal descendant of a grandparent of the adoptive parent) is subject to the GST tax. The proposed regulations defined an “adopted individual” as an individual who is: (1) a descendant of a parent of the adoptive parent (or the spouse or former spouse of the adoptive parent); and (2) under the age of 18 at the time of the adoption.

August 29, 2005 436 2005–35 I.R.B.

§26.2651–1 Generation assignment.

(a) Special rule for persons with a deceased parent. (1) In general. (2) Special rules. (3) Established or derived. (4) Special rule in the case of additional contributions to a trust. (b) Limited application to collateral heirs. (c) Examples.

§26.2651–2 Individual assigned to more than one generation.

(a) In general. (b) Exception. (c) Special rules. (1) Corresponding generation adjustment. (2) Continued application of generation assignment. (d) Example.

§26.2651–3 Effective dates.

(a) In general. (b) Transition rule.

Par. 3. Section 26.2612–1 is amended by:

Removing the paragraph designation and heading for (a)(1).
Removing paragraph (a)(2).
Removing the second sentence of paragraph (f) introductory text.
Removing Examples 6 and 7 in paragraph (f).
Redesignating Examples 8 through 15 as Examples 6 through 13 in paragraph (f).
Revising the first sentence of newly designated Example 7 in paragraph (f).
Revising the first sentence of newly designated Example 11 in paragraph (f).

The revisions read as follows:

§26.2612–1 Definitions.

- - - (f) - - Example 7 . Taxable termination resulting from distribution . The facts are the same as in Example 6, except twenty years after C’s death the trustee exercises its discretionary power and distributes the entire principal to GGC. * * *
- - - Example 11 . Exercise of withdrawal right as tax- able distribution . The facts are the same as in Exam- ple 10, except GC holds a continuing right to withdraw trust principal and after one year GC withdraws $10,000. - -

( e.g., the parent abandons the individual, or is adjudicated incompetent or incapacitated) may indicate that an adoption is not primarily for tax-avoidance purposes.

One commentator suggested clarifying the interaction between section 2651(b)(3), regarding the treatment of legal adoptions, and section 2651(f)(1), regarding individuals assigned to more than one generation. In order to provide that clarification, the Treasury Department and the IRS confirm that, for purposes of chapter 13, a legal adoption may create an additional generation assignment, but the adoption does not constitute a substitute for the blood relationship. Specifically, an individual who has been adopted will be treated as a blood relative of the adoptive parent under section 2651(b)(3) and generally is treated as a child of the adoptive parent under state law. In spite of the adoption, however, the adopted individual also continues to be a blood relative of the individual’s birth parents. Thus, the generation assignment of the adopted individual with regard to a transfer from an ancestor of the birth parent, for example, will continue to be measured under section 2651(b), but, subject to the exception in §26.2651–2(b), the relationship between them may be subject to the special rule in section 2651(f)(1), which provides that an individual who would be assigned to more than one generation is assigned to the youngest of those generations.

The proposed regulations provided that any individual who dies no later than 90 days after a transfer is treated as having predeceased the transferor. One commentator recommended that the final regulations apply this 90-day rule to inter vivos, as well as testamentary, transfers. The 90-day rule is intended to replace a similar 90-day rule in §26.2612–1(a)(2), which is limited to testamentary transfers. Moreover, many state statutes contain similar rules that apply only to testamentary transfers. Accordingly, the final regulations do not adopt this recommendation, and revise the language of this provision to confirm that it addresses only transfers occurring by reason of the death of the transferor.

Two commentators requested confirmation that the reference to adoption in §26.2651–2(b) applies solely for purposes of the rule in section 2651(f)(1) and has no application to the rule in section 2651(b).

Accordingly, the introductory language of §26.2651–2(b) has been revised.

Special Analyses

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

Drafting Information

The principal author of these regulations is Lian A. Mito of the Office of Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Amendments to the Regulations

Accordingly, 26 CFR part 26 is amended as follows:

PART 26—GENERATION-SKIPPING TRANSFER TAX REGULATIONS UNDER THE TAX REFORM ACT OF 1986

Paragraph 1. The authority citation for part 26 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. In §26.2600–1, the table is amended by:

Removing the entries for §26.2612–1, paragraphs (a)(1) and (a)(2).
Adding entries for §§26.2651–1, 26.2651–2, and 26.2651–3. The additions read as follows:

§26.2600–1 Table of contents.

2005–35 I.R.B. 437 August 29, 2005

§26.2654–1(a)(2), regarding treatment as separate trusts, apply as if different transferors had contributed to the separate portions of the single trust. Additional subsequent contributions from that transferor will be added to the new share that is treated as a separate trust.

(b) Limited application to collateral heirs . Paragraph (a) of this section does not apply in the case of a transfer to any individual who is not a lineal descendant of the transferor (or the transferor’s spouse or former spouse) if the transferor has any living lineal descendant at the time of the transfer.

Example 1 . T establishes an irrevocable trust, Trust, providing that trust income is to be paid to T’s grandchild, GC, for 5 years. At the end of the 5-year period or on GC’s prior death, Trust is to terminate and the principal is to be distributed to GC if GC is living or to GC’s children if GC has died. The transfer that occurred on the creation of the trust is subject to the tax imposed by chapter 12 of the Internal Revenue Code and, at the time of the transfer, T’s child, C, who is a parent of GC, is deceased. GC is treated as a member of the generation that is one generation below T’s generation. As a result, GC is not a skip person and Trust is not a skip person. Therefore, the transfer to Trust is not a direct skip. Similarly, distributions to GC during the term of Trust and at the termination of Trust will not be GSTs.

Example 2 . On January 1, 2004, T transfers $100,000 to an irrevocable inter vivos trust that provides T with an annuity payable for four years or until T’s prior death. The annuity satisfies the definition of a qualified interest under section 2702(b). When the trust terminates, the corpus is to be paid to T’s grandchild, GC. The transfer is subject to the tax imposed by chapter 12 of the Internal Revenue Code and, at the time of the transfer, T’s child, C, who is a parent of GC, is living. C dies in 2006. In this case, C was alive at the time the transfer by T was subject to the tax imposed by chapter 12 of the Internal Revenue Code. Therefore, section 2651(e) and paragraph (a)(1) of this section do not apply. When the trust subsequently terminates, the distribution to GC is a taxable termination that is subject to the GST tax to the extent the trust has an inclusion ratio greater than zero. See section 2642(a).

Example 3 . T dies testate in 2002, survived by T’s spouse, S, their children, C1 and C2, and C1’s child, GC. Under the terms of T’s will, a trust is established for the benefit of S and of T and S’s descendants. Under the terms of the trust, all income is payable to S during S’s lifetime and the trustee may distribute trust corpus for S’s health, support and maintenance. At S’s death, the corpus is to be distributed, outright, to C1 and C2. If either C1 or C2 has predeceased S, the deceased child’s share of the corpus is to be distributed to that child’s then-living descendants, per stirpes. The executor of T’s estate makes the election under section 2056(b)(7) to treat the trust property as qualified terminable interest property (QTIP) but does not make the election under section 2652(a)(3)

- - - Par. 4. Sections 26.2651–1, 26.2651–2 and 26.2651–3 are added to read as follows:

§26.2651–1 Generation assignment.

(a) Special rule for persons with a de- ceased parent —(1) In general . This paragraph (a) applies for purposes of determining whether a transfer to or for the benefit of an individual who is a descendant of a parent of the transferor (or the transferor’s spouse or former spouse) is a generation-skipping transfer. If that individual’s parent, who is a lineal descendant of the parent of the transferor (or the transferor’s spouse or former spouse), is deceased at the time the transfer (from which an interest of such individual is established or derived) is subject to the tax imposed on the transferor by chapter 11 or 12 of the Internal Revenue Code, the individual is treated as if that individual were a member of the generation that is one generation below the lower of—

(i) The transferor’s generation; or (ii) The generation assignment of the individual’s youngest living lineal ancestor who is also a descendant of the parent of the transferor (or the transferor’s spouse or former spouse).

(2) Special rules —(i) Corresponding generation adjustment . If an individual’s generation assignment is adjusted with respect to a transfer in accordance with paragraph (a)(1) of this section, a corresponding adjustment with respect to that transfer is made to the generation assignment of each—

(A) Spouse or former spouse of that individual;

(B) Descendant of that individual; and (C) Spouse or former spouse of each descendant of that individual.

(ii) Continued application of genera- tion assignment . If a transfer to a trust would be a generation-skipping transfer but for paragraph (a)(1) of this section, any generation assignment determined under this paragraph (a) continues to apply in determining whether any subsequent distribution from (or termination of an interest in) the portion of the trust attributable to that transfer is a generation-skipping transfer.

(iii) Ninety-day rule . For purposes of paragraph (a)(1) of this section, any indi

vidual who dies no later than 90 days after a transfer occurring by reason of the death of the transferor is treated as having predeceased the transferor.

(iv) Local law . A living person is not treated as having predeceased the transferor solely by reason of a provision of applicable local law; e.g., an individual who disclaims is not treated as a predeceased parent solely because state law treats a disclaimant as having predeceased the transferor for purposes of determining the disposition of the disclaimed property.

(3) Established or derived . For purposes of section 2651(e) and paragraph (a)(1) of this section, an individual’s interest is established or derived at the time the transferor is subject to transfer tax on the property. See §26.2652–1(a) for the definition of a transferor. If the same transferor, on more than one occasion, is subject to transfer tax imposed by either chapter 11 or 12 of the Internal Revenue Code on the property so transferred (whether the same property, reinvestments thereof, income thereon, or any or all of these), then the relevant time for determining whether paragraph (a)(1) of this section applies is the earliest time at which the transferor is subject to the tax imposed by either chapter 11 or 12 of the Internal Revenue Code. For purposes of section 2651(e) and paragraph (a)(1) of this section, the interest of a remainder beneficiary of a trust for which an election under section 2523(f) or section 2056(b)(7) (QTIP election) has been made will be deemed to have been established or derived, to the extent of the QTIP election, on the date as of which the value of the trust corpus is first subject to tax under section 2519 or section 2044. The preceding sentence does not apply to a trust, however, to the extent that an election under section 2652(a)(3) (reverse QTIP election) has been made for the trust because, to the extent of a reverse QTIP election, the spouse who established the trust will remain the transferor of the trust for generation-skipping transfer tax purposes.

(4) Special rule in the case of additional contributions to a trust . If a transferor referred to in paragraph (a)(1) of this section contributes additional property to a trust that existed before the application of paragraph (a)(1), then the additional property is treated as being held in a separate trust for purposes of chapter 13 of the Internal Revenue Code. The provisions of

August 29, 2005 438 2005–35 I.R.B.

(reverse QTIP election). In 2003, C1 dies survived by S and GC. In 2004, S dies, and the trust terminates. The full fair market value of the trust is includible in S’s gross estate under section 2044 and S becomes the transferor of the trust under section 2652(a)(1)(A). GC’s interest is considered established or derived at S’s death, and because C1 is deceased at that time, GC is treated as a member of the generation that is one generation below the generation of the transferor, S. As a result, GC is not a skip person and the transfer to GC is not a direct skip.

Example 4 . The facts are the same as in Exam- ple 3 . However, the executor of T’s estate makes the election under section 2652(a)(3) (reverse QTIP election) for the entire trust. Therefore, T remains the transferor because, for purposes of chapter 13 of the Internal Revenue Code, the election to be treated as qualified terminable interest property is treated as if it had not been made. In this case, GC’s interest is established or derived on T’s death in 2002. Because C1 was living at the time of T’s death, the predeceased parent rule under section 2651(e) does not apply, even though C1 was deceased at the time the transfer from S to GC was subject to the tax under chapter 11 of the Internal Revenue Code. When the trust terminates, the distribution to GC is a taxable termination that is subject to the GST tax to the extent the trust has an inclusion ratio greater than zero. See section 2642(a).

Example 5 . T establishes an irrevocable trust providing that trust income is to be paid to T’s grandniece, GN, for 5 years or until GN’s prior death. At the end of the 5-year period or on GN’s prior death, the trust is to terminate and the principal is to be distributed to GN if living, or if GN has died, to GN’s then-living descendants, per stirpes. S is a sibling of T and the parent of N. N is the parent of GN. At the time of the transfer, T has no living lineal descendant, S is living, N is deceased, and the transfer is subject to the gift tax imposed by chapter 12 of the Internal Revenue Code. GN is treated as a member of the generation that is one generation below T’s generation because S, GN’s youngest living lineal ancestor who is also a descendant of T’s parent, is in T’s generation. As a result, GN is not a skip person and the transfer to the trust is not a direct skip. In addition, distributions to GN during the term of the trust and at the termination of the trust will not be GSTs.

Example 6 . On January 1, 2004, T transfers $50,000 to a great-grandniece, GGN, who is the great-grandchild of B, a brother of T. At the time of the transfer, T has no living lineal descendants and B’s grandchild, GN, who is a parent of GGN and a child of B’s living child, N, is deceased. GGN will be treated as a member of the generation that is one generation below the lower of T’s generation or the generation assignment of GGN’s youngest living lineal ancestor who is also a descendant of the parent of the transferor. In this case, N is GGN’s youngest living lineal ancestor who is also a descendant of the parent of T. Because N’s generation assignment is lower than T’s generation, GGN will be treated as a member of the generation that is one generation below N’s generation assignment ( i.e., GGN will be treated as a member of her parent’s generation). As a result, GGN remains a skip person and the transfer to GGN is a direct skip.

Example 7 . T has a child, C. C and C’s spouse, S, have a 20-year-old child, GC. C dies and S subsequently marries S2. S2 legally adopts GC. T transfers $100,000 to GC. Under section 2651(b)(1), GC is assigned to the generation that is two generations below T. However, since GC’s parent, C, is deceased at the time of the transfer, GC will be treated as a member of the generation that is one generation below T. As a result, GC is not a skip person and the transfer to GC is not a direct skip.

§26.2651–2 Individual assigned to more than 1 generation.

(a) In general . Except as provided in paragraph (b) or (c) of this section, an individual who would be assigned to more than 1 generation is assigned to the youngest of the generations to which that individual would be assigned.

(b) Exception . Notwithstanding paragraph (a) of this section, an adopted individual (as defined in this paragraph) will be treated as a member of the generation that is one generation below the adoptive parent for purposes of determining whether a transfer to the adopted individual from the adoptive parent (or the spouse or former spouse of the adoptive parent, or a lineal descendant of a grandparent of the adoptive parent) is subject to chapter 13 of the Internal Revenue Code. For purposes of this paragraph (b), an adopted individual is an individual who is—

(1) Legally adopted by the adoptive parent;

(2) A descendant of a parent of the adoptive parent (or the spouse or former spouse of the adoptive parent);

(3) Under the age of 18 at the time of the adoption; and

(4) Not adopted primarily for the purpose of avoiding GST tax. The determination of whether an adoption is primarily for GST tax-avoidance purposes is made based upon all of the facts and circumstances. The most significant factor is whether there is a bona fide parent/child relationship between the adoptive parent and the adopted individual, in which the adoptive parent has fully assumed all significant responsibilities for the care and raising of the adopted child. Other factors may include (but are not limited to), at the time of the adoption—

(i) The age of the adopted individual (for example, the younger the age of the adopted individual, or the age of the youngest of siblings who are all adopted

together, the more likely the adoption will not be considered primarily for GST tax-avoidance purposes); and

(ii) The relationship between the adopted individual and the individual’s parents (for example, objective evidence of the absence or incapacity of the parents may indicate that the adoption is not primarily for GST tax-avoidance purposes).

(c) Special rules —(1) Corresponding generation adjustment . If an individual’s generation assignment is adjusted with respect to a transfer in accordance with paragraph (b) of this section, a corresponding adjustment with respect to that transfer is made to the generation assignment of each—

(i) Spouse or former spouse of that individual;

(ii) Descendant of that individual; and (iii) Spouse or former spouse of each descendant of that individual.

(2) Continued application of generation assignment . If a transfer to a trust would be a generation-skipping transfer but for paragraph (b) of this section, any generation assignment determined under paragraph (b) or (c) of this section continues to apply in determining whether any subsequent distribution from (or termination of an interest in) the portion of the trust attributable to that transfer is a generation-skipping transfer.

(d) Example . The following example illustrates the provisions of this section:

Example . T has a child, C. C has a 20-year-old child, GC. T legally adopts GC and transfers $100,000 to GC. GC’s generation assignment is determined by section 2651(b)(1) and GC is assigned to the generation that is two generations below T. In addition, because T has legally adopted GC, GC is generally treated as a child of T under state law. Under these circumstances, GC is an individual who is assigned to more than one generation and the exception in §26.2651–2(b) does not apply. Thus, the special rule under section 2651(f)(1) applies and GC is assigned to the generation that is two generations below T. GC remains a skip person with respect to T and the transfer to GC is a direct skip.

§26.2651–3 Effective dates.

(a) In general . The rules of §§ 26.2651–1 and 26.2651–2 are applicable for terminations, distributions, and transfers occurring on or after July 18, 2005. (b) Transition rule . In the case of transfers occurring after December 31, 1997, and before July 18, 2005, taxpayers may

2005–35 I.R.B. 439 August 29, 2005

provisions of the notice of proposed rulemaking without change.

Comments on the Proposed Regulation

None

Modifications of Proposed Regulation

None

Special Analyses

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

Drafting Information

The principal author of these regulations is Kevin B. Connelly, Office of Associate Chief Counsel (Procedure and Administration), Collection Bankruptcy & Summons Division, CC:PA:CBS, IRS.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 301 is amended as follows:

PART 301—PROCEDURE AND ADMINISTRATION

Paragraph 1. The authority citation for part 301 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 301.6343–3 is added to read as follows:

§301.6343–3 Return of property in certain cases.

(a) In general . If money has been levied upon and applied toward the taxpayer’s liability, or property has been levied upon

rely on any reasonable interpretation of section 2651(e).

For this purpose, these final regulations, as well as the proposed regulations issued on September 3, 2004, (69 FR 53862) are treated as a reasonable interpretation of the statute.

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

Approved June 30, 2005.

Eric Solomon, Acting Deputy Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on July 15, 2005, 8:45 a.m., and published in the issue of the Federal Register for July 18, 2005, 70 F.R. 41140)

Section 6343.—Authority to Release Levy and Return Property

26 CFR 301.6343–3: Return of property in certain cases.

T.D. 9213

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 301

Return of Property in Certain Cases

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that amend regulations under section 6343 of the Internal Revenue Code (Code) relating to the return of property in certain cases. The regulations reflect changes made to section 6343 of the Code by the Taxpayer Bill of Rights 2. The regulations also reflect changes affecting levies enacted by the Internal Revenue Service Restructuring and Reform Act of 1998. The regulations affect taxpayers seeking the return of levied property from the Internal Revenue Service (IRS).

DATES: Effective Date : These regulations are effective on July 14, 2005.

Applicability Date : For dates of applicability, see §301.6343–3(k).

FOR FURTHER INFORMATION CONTACT: Kevin B. Connelly, (202) 622–3630 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Procedure and Administration Regulations (26 CFR part 301) relating to the return of property under section 6343 of the Code. Section 501(b) of the Taxpayer Bill of Rights 2 (TBOR2), Public Law 104–168 (110 Stat. 1452), amended section 6343 to authorize the IRS to return levied property in certain cases. The purpose of this provision is, to the extent possible, to return the taxpayer to the position the taxpayer would have been in had the levy not been issued. No interest shall be paid with respect to property returned to the taxpayer under this provision. These final regulations reflect the amendments made by section 501(b) of TBOR2.

These regulations also reflect amendments made by the Internal Revenue Service Restructuring and Reform Act (RRA 1998), Public Law 105–206 (112 Stat. 685), which added new sections 6331(i) and (j) to the Code to provide that no levy may be made during the pendency of proceedings for refund of divisible taxes or prior to completion of an investigation of the status of property that is to be sold under section 6335. RRA 1998 also added section 6331(k) to the Code, which provides that no levy may be made during the period an offer-in-compromise or an installment agreement is pending or in effect. In addition, RRA 1998 added section 6330, which provides in certain circumstances for notice and an opportunity for a hearing before a levy can be made.

Explanation of Provisions

On February 14, 2001, a notice of proposed rulemaking (REG–101520–97, 2001–1 C.B. 1057) reflecting these changes was published in the Federal Register (66 FR 10249). No written comments were received in response to the notice of proposed rulemaking and no public hearing was requested, scheduled or held. These final regulations adopt the

August 29, 2005 440 2005–35 I.R.B.

turn an amount of money equal to the amount seized from the bank account, in the best interest of the taxpayer and the United States.

(d) Best Interests of the United States and the taxpayer to release levy and re- turn of property where levy made in vio- lation of law —(1) In general . If the IRS makes a levy in violation of the law, it is in the best interests of the United States and the taxpayer to release the levy and the IRS will return to the taxpayer any property obtained pursuant to the levy. For example, the IRS will release the levy and return the taxpayer’s property if the levy was made—

(i) Without giving the requisite thirtyday notice of the right to a hearing under section 6330;

(ii) During the pendency of a proceeding for refund of divisible tax in violation of section 6331(i);

(iii) Before investigation of the status of levied upon property in violation of section 6331(j); (iv) During the pendency of an offer-in-compromise in violation of section 6331(k)(1); or (v) During the period an offer to enter into an installment agreement is pending (or for 30 days following the rejection of an offer, or, if the rejection is timely appealed, during the period that the appeal is pending) or during the period an installment agreement is in effect (or during the 30 days following a termination or, if a timely appeal of termination is filed, during the period the appeal is pending) in violation of section 6331(k)(2).

(2) Property may not be credited to out- standing liability without the taxpayer’s permission . When the release of a levy and the return of property are required under this paragraph (d), the property or the proceeds from the sale of the property received by the IRS pursuant to the levy must be returned to the taxpayer unless the taxpayer requests otherwise. The property or proceeds of sale may not be credited to any outstanding tax liability of the taxpayer, including the one with respect to which the IRS made the levy, without the written permission of the taxpayer.

(e) Time of return . Levied upon property in possession of the IRS (other than money) may be returned under paragraphs (c) and (d) of this section at any time. An amount of money equal to the amount of money levied upon or received from a sale of property may be returned at any time be

and sold, and the receipts have been applied toward the taxpayer’s liability, or property has been levied upon and purchased by the United States and the United States still possesses the property, and the Commissioner determines that any of the conditions in paragraph (c) of this section exist, the Commissioner may return—

(1) An amount of money equal to the amount of money levied upon;

(2) An amount of money equal to the amount of money received by the United States from a sale of the property; or

(3) The specific property levied upon and purchased by the United States.

(b) Return of levied upon property in possession of the Internal Revenue Service (IRS) pending sale under section 6335 . Other than as provided in §301.6343–1(b) or in paragraph (d) of this section, the Commissioner, in his or her discretion, may return levied upon property that is in the possession of the United States pending sale under section 6335.

(c) Conditions authorizing the return of property . The Commissioner may return property upon determining that one of the following conditions exist:

(1) Premature or not in accordance with administrative procedures . The levy was premature or otherwise not in accordance with the administrative procedures of the Secretary.

(2) Installment agreement . Subsequent to the levy, the taxpayer enters into an agreement under section 6159 to satisfy the liability for which the levy was made by means of installment payments. If, however, the agreement specifically provides that already levied upon property will not be returned under section 6343(d), the Commissioner may not grant a request for return of property under this paragraph (c)(2).

(3) Facilitate collection . The return of property will facilitate the collection of the tax liability for which the levy was made.

(4) Best interests of the United States and the taxpayer —(i) In general . The taxpayer or the National Taxpayer Advocate (or his or her delegate) has consented to the return of property, and the return of property would be in the best interest of the taxpayer, as determined by the National Taxpayer Advocate (or his or her delegate), and in the best interest of the United States, as determined by the Commissioner.

(ii) Best interest of the taxpayer . The National Taxpayer Advocate (or his or her delegate) generally will determine whether the return of property is in the best interest of the taxpayer. If, however, a taxpayer requests the Commissioner to return property and has not specifically requested the National Taxpayer Advocate (or his or her delegate) to determine the taxpayer’s best interest, a finding by the Commissioner that the return of property is in the best interest of the taxpayer will be sufficient to support the return of property. Only the National Taxpayer Advocate (or his or her delegate) may determine that a return of property is not in the best interest of the taxpayer.

(5) Examples . The following examples illustrate the provisions of this paragraph (c):

Example 1 . A owes $1,000 in Federal income taxes. The IRS levies on a broker with respect to a money market account belonging to the taxpayer and receives payment from the broker which it applies to the taxpayer’s outstanding liability. However, the IRS failed to follow procedure provided by the Internal Revenue Manual (but not required by statute) with regard to managerial approval prior to the making of the levy. The Commissioner may return an amount of money equal to the amount of money the IRS levied upon and applied toward the taxpayer’s tax liability.

Example 2 . B owes $1,000 in Federal income taxes. The IRS levies on a bank with respect to a savings account belonging to the taxpayer and receives funds from the bank, which it applies to the taxpayer’s liability. Subsequent to the levy, B enters into an installment agreement, under which B will pay timely installments to satisfy the entire liability. The installment agreement does not by its terms preclude the return of levied upon property. The revenue officer verifies that B is financially capable of paying the entire liability, including accruals, in the agreed-upon installment payments. The Commissioner may return an amount of money equal to the amount of money levied upon and applied toward the taxpayer’s liability.

Example 3 . C owns a house that is deteriorating and in unsalable condition. C is in the process of renovating the house for sale when the IRS levies upon C’s bank account for the payment of a $20,000 outstanding Federal tax liability and receives funds in the amount of $3,000, which it applies toward C’s liability. A notice of federal tax lien is the only lien encumbrancing the house. C requests that an amount of money equal to the amount seized from the bank account be returned so that C can complete the renovations on the house. Without the funds, C will be unable to complete the renovations and sell the house. Upon examination, the Commissioner determines that the IRS will be able to collect the entire tax liability if C’s house is restored to salable condition. If the National Taxpayer Advocate, or the Commissioner in lieu of the National Taxpayer Advocate, determines that the return of the seized money is in the taxpayer’s best interest, the Commissioner may re

2005–35 I.R.B. 441 August 29, 2005

quested (or property purchased by the United States).

(i) No interest . No interest will be paid on any money returned under this section.

(j) Administrative collection upon de- fault . If the Commissioner returns property under this section, and the taxpayer fails to pay the previously assessed liability for which the levy was made on the returned property, the Commissioner may administratively collect the liability. Collection may include levying again on the returned property as long as statutory and administrative requirements are followed.

(k) Effective date . This section is applicable on July 14, 2005.

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

Approved June 30, 2005.

Eric Solomon, Acting Deputy Assistant Secretary

of the Treasury (Tax Policy) .

(Filed by the Office of the Federal Register on July 13, 2005, 8:45 a.m., and published in the issue of the Federal Register for July 14, 2005, 70 F.R. 40669)

fore the expiration of 9 months from the date of the levy. When a request for the return of money filed in accordance with paragraph (h) of this section is filed before the expiration of the 9-month period, or a determination to return an amount of money is made before the expiration of the 9-month period, the money may be returned within a reasonable period of time after the expiration of the 9-month period if additional time is necessary for investigation or processing.

(f) Purchase by the United States . For purposes of paragraph (a)(2) of this section, if property is declared purchased by the United States at a sale pursuant to section 6335(e)(1)(C), the United States will be treated as having received an amount of money equal to the minimum price determined by the Commissioner before the sale.

(g) Determinations by the Commis- sioner . The Commissioner must determine whether any of the conditions authorizing the return of property exists if a taxpayer submits a request for the return of property in accordance with paragraph (h) of this section. The Commissioner also may make this determination independently. If the Commissioner determines that conditions authorizing the return of property are not present, the Commis

sioner may not authorize the return of property. If the Commissioner determines that conditions authorizing the return of property are present, the Commissioner may (but is not required to, unless the reason for the return of property is that the levy was made in violation of law and is governed by paragraph (d) of this section) authorize the return of property. If the Commissioner decides independently to return property under paragraph (c)(4) of this section based on the best interests of the taxpayer and the United States, the taxpayer or the National Taxpayer Advocate (or his or her delegate) must consent to the return of property.

(h) Procedures for request for the re- turn of property —(1) Manner . A request for the return of property must be made in writing to the address on the levy form.

(2) Form . The written request must include the following information—

(i) The name, current address, and taxpayer identification number of the person requesting the return of money (or property purchased by the United States);

(ii) A description of the property levied upon;

(iii) The date of the levy; and (iv) A statement of the grounds upon which the return of money is being re

August 29, 2005 442 2005–35 I.R.B.