Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Internal Revenue Bulletin 2005-39 · 2026-10-03 edition · updated 2026-10-04 · United States
Section 402.—Taxability of Beneficiary of Employees’ Trust
26 CFR 1.402(a)–1: Taxability of beneficiary under a trust which meets the requirements of section 401(a).
T.D. 9223
DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1
Value of Life Insurance Contracts When Distributed From a Qualified Retirement Plan
AGENCY : Internal Revenue Service (IRS), Treasury.
ACTION : Final regulations.
SUMMARY : This document contains final regulations under section 402(a) of the Internal Revenue Code regarding the amount includible in a distributee’s income when life insurance contracts are distributed by a qualified retirement plan and regarding the treatment of property sold by a qualified retirement plan to a plan participant or beneficiary for less than fair market value. This document also contains final regulations under sections 79 and 83 of the Internal Revenue Code regarding the amounts includible in income when an employee is provided permanent benefits in combination with group-term life insurance or when a life insurance contract is transferred in connection with the performance of services. These regulations will affect administrators of, participants in, and beneficiaries of qualified retirement plans. These regulations will also affect employers who provide permanent benefits in combination with group-term life insurance for their employees and employees who receive those permanent
benefits, as well as service recipients who transfer life insurance contracts to service providers in connection with the performance of services, and service providers to whom those life insurance contracts are transferred.
DATES : These regulations are effective August 29, 2005.
FOR FURTHER INFORMATION CONTACT : Concerning the section 79 regulations, Betty Clary at (202) 622–6080; concerning the section 83 regulations, Robert Misner at (202) 622–6030; concerning the section 402 regulations, Bruce Perlin or Linda Marshall at (202) 622–6090 (not toll-free numbers).
SUPPLEMENTARY INFORMATION :
Background
A. In General
This document contains amendments to the Income Tax Regulations (26 CFR part 1) under section 402(a) of the Internal Revenue Code (Code) relating to the amount includible in a distributee’s income when a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection is distributed by a retirement plan qualified under section 401(a), and relating to the sale of property by a qualified retirement plan to a plan participant or beneficiary for less than the fair market value of the property. This document also contains amendments to the regulations under sections 79 and 83 relating, respectively, to permanent benefits that are provided to employees in combination with group-term life insurance, and to life insurance contracts that are transferred in connection with the performance of services.
Section 402(a) generally provides that any amount actually distributed to any distributee by any employees’ trust described in section 401(a) which is exempt
from tax under section 501(a) is taxable to the distributee in the taxable year of the distributee in which distributed, in accordance with section 72. Distributions from a qualified employees’ trust generally are subject to withholding and reporting requirements pursuant to section 3405 and regulations thereunder. Section 1.402(a)–1(a)(1)(iii) provides, in general, that a distribution of property by a section 401(a) plan is taken into account by the distributee at its fair market value . Prior to its amendment by this Treasury decision, §1.402(a)–1(a)(2) (which was originally published in 1956) provided, in general, that upon the distribution of a life insurance contract, the “entire cash value” of the contract must be included in the distributee’s income. 1 Section 1.402(a)–1(a) did not define fair market value or entire cash value, and questions have arisen regarding the interaction between these two provisions and regarding whether the term entire cash value includes a reduction for surrender charges.
On April 30, 1975, proposed regulations under section 402 regarding the taxation of certain lump sum distributions from qualified plans (the 1975 proposed regulations) were published in the Fed- eral Register (40 FR 18798) to reflect changes to section 402 made by the Employee Retirement Income Security Act of 1974 (ERISA) (Public Law 93–406, 88 Stat. 829). Under §1.402(a)–1(a)(2) of the 1975 proposed regulations, the distribution of an annuity contract must be treated as a lump sum distribution under section 402(e) for purposes of determining the separate tax imposed under section 402(e)(1)(A), 2 even if the distribution of the annuity contract itself is not currently taxable. The 1975 proposed regulations also expanded the situations in which the distribution of a retirement income, endowment, or other life insurance contract is not currently taxable to include the situation where, within 60 days after the distribution of such contract, the contract is treated as a rollover contribution under
1 Section 1.402(a)–1(a)(2) also provides rules regarding the taxation of the distribution of an annuity contract. In certain cases, the distribution of an annuity contract is not includible in the participant’s gross income until distributions are made from the annuity contract.
2 The tax imposed under section 402(e)(1)(A), as in effect at the time of the 1975 proposed regulations, generally was based on 10-year averaging of the tax otherwise payable with respect to a lump-sum distribution.
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from the application of such rules, generally parallel the prohibited transaction provisions under Title I of ERISA.
Prohibited Transaction Exemption (PTE) 77–8 (1977–2 C.B. 425), subsequently amended and redesignated as Prohibited Transaction Exemption 92–6, was jointly issued in 1977 by the Department of Labor and the IRS to provide an exemption from the restrictions of sections 406(a) and 406(b)(1) and (b)(2) of ERISA and from the taxes imposed by sections 4975(a) and (b) of the Code for certain transactions. Under the exemption set forth in PTE 77–8 and PTE 92–6, an employee benefit plan is permitted to sell individual life insurance contracts and annuities for the cash surrender value of the contracts to certain specified parties, provided conditions are satisfied. Under PTE 77–8 and PTE 92–6, such specified parties are: (1) a plan participant insured under such policies, (2) a relative of such insured participant who is the beneficiary under the contract, (3) an employer any of whose employees are covered by the plan, or (4) another employee benefit plan.
The preamble to PTE 77–8 (citing Rev. Rul. 59–195, 1959–1 C.B. 18) noted that, for Federal income tax purposes, the value of an insurance policy is not the same as, and may exceed, its cash surrender value, and that a purchase of an insurance policy at its cash surrender value may therefore be a purchase of property for less than its fair market value. At the time PTE 77–8 was issued, the regulations under section 402 did not address the consequences of a sale of property by a section 401(a) plan to a plan participant or beneficiary for less than the fair market value of that property. In this regard, the preamble to PTE 77–8 stated that the Federal income tax consequences of such a bargain purchase was required to be determined in accordance with generally applicable Federal income tax rules but that any income realized by a participant or relative of such participant upon such a purchase under the conditions of PTE 77–8 would not be deemed a distribution from the plan to such participant for purposes of subchapter D of chapter 1 of subtitle A of the Internal Revenue Code ( i.e., sections 401 to 424 relating to qualified pension, profit-sharing, and stock bonus plans).
section 402(a)(5), as in effect after December 31, 1973.
Section 79 generally requires that the cost of group-term life insurance coverage provided by an employer on the life of an employee that is in excess of $50,000 of coverage be included in the income of the employee. Pursuant to §1.79–1(b), under specified circumstances, group-term life insurance may be combined with other benefits, referred to as permanent benefits. A permanent benefit is defined in §1.79–0 as an economic value extending beyond one policy year (for example, a paid-up or cash surrender value) that is provided under a life insurance policy. Section 1.79–0 further provides that certain features are not permanent benefits, including: (a) a right to convert (or continue) life insurance after group life insurance coverage terminates, (b) any other feature that provides no economic benefit (other than current insurance protection) to the employee, and (c) a feature under which term life insurance is provided at a level premium for a period of five years or less.
Permanent benefits provided to an employee are subject to taxation under rules described in §1.79–1(d). Under those rules, the cost of the permanent benefits, reduced by the amount paid for those benefits by the employee, is included in the employee’s income. Section 1.79–1(d) provides that the cost of the permanent benefits cannot be less than an amount determined under a formula set forth in the regulations. Prior to its amendment by this Treasury decision, §1.79–1(d) provided that one of the factors used in the formula for determining the cost of permanent benefits was “the net level premium reserve at the end of that policy year for all benefits provided to the employee by the policy or, if greater, the cash value of the policy at the end of that policy year.”
Section 83(a) generally provides that when property is transferred to any person in connection with the performance of services, the service provider must include in gross income (as compensation income) the excess of the fair market value of the property over the amount (if any) paid for the property. For this purpose, the fair market value of the property is determined without regard to lapse restrictions and is determined at the first time that the transferee’s rights in the property are either transferable or not subject to a substantial
risk of forfeiture. Prior to its amendment by this Treasury decision, §1.83–3(e) generally provided that in the case of “a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, only the cash surrender value of the contract is considered to be property.”
In T.D. 9092, 2003–2 I.R.B. 1055, published in the Federal Register on September 17, 2003 (68 FR 54336), relating to split-dollar life insurance arrangements, §1.83–3(e) was amended to add the following sentence: “Notwithstanding the previous sentence, in the case of a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, or any undivided interest therein, that is part of a split-dollar life insurance arrangement (as defined in §1.61–22(b)(1) or (2)) that is entered into, or materially modified (within the meaning of §1.61–22(j)(2)), after September 17, 2003, the policy cash value and all other rights under such contract (including any supplemental agreements thereto and whether or not guaranteed), other than current life insurance protection, are treated as property for purposes of this section.”
The prohibited transaction provisions of ERISA generally prohibit various transactions between plans covered by Title I of ERISA and certain parties in interest (including plan participants) with respect to such plans. Specifically, unless an exemption from the prohibited transaction rules applies, sections 406(a)(1)(A) and (D) of ERISA provide that a fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect sale or exchange, or leasing, of any property between the plan and a party in interest; or transfer to, or use by or for the benefit of, a party in interest of any assets of the plan. Accordingly, unless a statutory or administrative exemption is applicable, the prohibited transaction rules are applicable to the sale of a life insurance contract, or annuity contract, by a plan to a party in interest.
Section 4975 of the Code sets forth parallel rules that impose excise taxes on the amount involved with respect to prohibited transactions involving certain plans. The prohibited transaction provisions under section 4975, as well as the exemptions
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not expected to be paid because they are expected to be eliminated or reversed in the future (under the contract or under another contract for which the first contract is exchanged), but this future elimination or reversal is not always reflected in the calculation of the contract’s reserve. If such a contract is distributed prior to the elimination or reversal of those charges, both the cash surrender value and the reserve under the contract could significantly understate the fair market value of the contract. Thus, in some cases, it would not be appropriate to use either the net surrender value ( i.e., the contract’s cash value after reduction for any surrender charges) or, because of the unusual nature of the contract, the contract’s reserves to determine the fair market value of the contract. Accordingly, Q&A–10 of Notice 89–25 should not be interpreted to provide that a contract’s reserves (including life insurance reserves (if any) computed under section 807(d), together with any reserves for advance premiums, dividend accumulations, etc.) are always an accurate representation of the contract’s fair market value.
The IRS and Treasury recognized that taxpayers could have difficulty determining the fair market value of a life insurance contract for which the contract’s reserves (including life insurance reserves (if any) computed under section 807(d), together with any reserves for advance premiums, dividend accumulations, etc.) are not an accurate representation of the contract’s fair market value. Accordingly, the IRS issued Rev. Proc. 2004–16, 2004–1 C.B. 559), which provided interim rules under which the cash value (without reduction for surrender charges) of a life insurance contract distributed from a qualified plan may be treated as the fair market value of that contract, provided that certain requirements are satisfied. This safe harbor for determining fair market value was also available for purposes of sections 79 and 83.
D. Comments and Public Hearing on the 2004 Proposed Regulations and Rev. Proc. 2004–16
The IRS received comments on the 2004 proposed regulations, and a public hearing was held on June 9, 2004. While none of the commentators objected to the proposed amendments to the regulations,
B. The 2004 Proposed Regulations
In February 2004, the IRS issued proposed amendments to the regulations under section 402(a) (REG–126967–03, 2004–1 C.B. 566 [69 FR 7384]) to clarify that the requirement that a distribution of property be included in the distributee’s income at fair market value is controlling in those situations where the regulations provided for the inclusion of the entire cash value of a retirement income, endowment, or other life insurance contract. The 2004 proposed regulations provided that the fair market value of a life insurance contract is determined taking into account the value of all rights under the contract, including any supplemental agreements thereto and whether or not guaranteed. The proposed regulations also provided that, if a qualified retirement plan transfers property to a plan participant or beneficiary for consideration that is less than the fair market value of the property, the transfer would be treated as a distribution by the plan to the participant or beneficiary to the extent the fair market value of the distributed property exceeds the value of the consideration received. Thus, under the proposed regulations, such a transfer would be treated as a distribution for purposes of applying the plan qualification requirements of section 401(a).
The 2004 proposed regulations also contained proposed amendments to existing regulations under section 83 to clarify that fair market value is also controlling with respect to a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection and thus all of the rights under the contract (including any supplemental agreements thereto and whether or not guaranteed) must be considered in determining that fair market value. The proposed regulations contained proposed amendments to §1.83–3(e), which generally apply the definition of property for new split-dollar life insurance arrangements to all situations subject to section 83 involving the transfer of life insurance contracts. The proposed regulations also contained proposed amendments to §1.79–(d) to replace the term “cash value” in the formula for determining the cost of permanent benefits with the term “fair market value.”
C. Determination of Fair Market Value
As noted under the heading In Gen- eral, §1.402(a)–1(a)(1)(iii) does not define the term fair market value . In Rev. Rul. 59–195, the IRS addressed the determination of fair market value of a life insurance contract in situations similar to those in which an employer purchases and pays the premiums on an insurance policy on the life of one of its employees for several years and on which further premiums must be paid, and subsequently sells such policy. The IRS held that the value of such a policy for purposes of computing taxable gain to the employee in the year of purchase should be determined under the method of valuation prescribed in §25.2512–6 of the Gift Tax Regulations. Under this method, the value of such a policy is not its cash surrender value but the interpolated terminal reserve at the date of sale plus the proportionate part of any premium paid by the employer prior to the date of the sale which is applicable to a period subsequent to the date of the sale. Section 25.2512–6 also provides that if “because of the unusual nature of the contract such approximation is not reasonably close to the full value, this method may not be used.” Thus, this method may not be used to determine the fair market value of an insurance policy where the reserve does not reflect the value of all of the relevant features of the policy.
Q&A–10 of Notice 89–25, 1989–1 C.B. 662, described a distribution from a qualified plan of a life insurance policy with a value substantially higher than the cash surrender value stated in the policy. The notice concluded that the practice of using cash surrender value as fair market value is not appropriate where the total policy reserves, including life insurance reserves (if any) computed under section 807(d), together with any reserves for advance premiums, dividend accumulations, etc., represent a much more accurate approximation of the policy’s fair market value.
Since Notice 89–25 was issued, life insurance contracts have been marketed that are structured in a manner which results in a temporary period during which neither a contract’s reserves nor its cash surrender value represent the fair market value of the contract. For example, some life insurance contracts may provide for large surrender charges and other charges that are
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sideration that is less than the fair market value of the property, the transfer is treated as a distribution under the plan to the participant or beneficiary to the extent the fair market value of the distributed property exceeds the value of the consideration. Thus, in contrast to the statement to the contrary in the preamble to PTE 77–8, these regulations provide that any bargain element in the sale is treated as a distribution under section 402(a). In addition, any such bargain element is treated as a distribution under the plan for all other purposes of the Code, including the qualification requirements of section 401(a). Thus, for example, this bargain element is treated as a distribution for purposes of applying the limitations on in-service distributions from certain qualified retirement plans and the limitations of section 415. The rule treating the bargain element in a sale as a distribution from a qualified plan applies to transfers that occur on or after August 29, 2005. For transfers before that date, the bargain element in the sale must be included in the plan participant’s income under section 61. However, such a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection occurring before that date is deemed not to give rise to a distribution for purposes of applying the requirements of subchapter D of chapter 1 of subtitle A of the Code.
These final regulations also retain the rules set forth in the 2004 proposed regulations under sections 79 and 83 that clarify that fair market value is also controlling with respect to life insurance contracts under those sections and, thus, that all of the rights under the contract (including any supplemental agreements thereto and whether or not guaranteed) must be considered in determining that fair market value. These final regulations amend §1.79–1(d) to replace the term cash value in the formula for determining the cost of permanent benefits with the term fair market value . These final regulations also amend §1.83–3(e) generally to apply the definition of property for new split-dollar life insurance arrangements to all situations involving the transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection. Section 83(a) requires that the excess of
a number of commentators raised concerns regarding the safe harbor formula for fair market value set forth in Rev. Proc. 2004–16. Several commentators recommended that final guidance provide more than one safe harbor for determining the fair market value of a policy and asserted that the safe harbor formulas under Rev. Proc. 2004–16 produce a value that is too high and does not reflect market realities. Suggestions were made that the interpolated terminal reserve (ITR) and tax reserve valuation methods under section 807(d) be used as alternatives to the interim safe harbor formula.
Some commentators claimed that the interim safe harbor provided by Rev. Proc 2004–16 was not usable for all types of life insurance policies. In particular, these commentators asserted that the formulas did not function well for traditional whole life policies. In addition, commentators were concerned about the possible double-counting of certain dividends under the formulas, and the fact that the formulas did not make an explicit adjustment for withdrawals or distributions, nor did they provide for any recognition of the possibility that a surrender charge would apply in the future.
E. Rev. Proc. 2005–25 — Safe Harbors for Determining Fair Market Value
After reviewing the comments to the prior guidance, the IRS and Treasury concluded that the safe harbor formulas in Rev. Proc. 2004–16 did not function well for certain types of traditional policies, and also should be revised to reflect a discount for the possibility that a surrender charge would apply in certain situations. Accordingly, Rev. Proc. 2005–25, 2005–17 I.R.B. 962, was issued to modify and supersede Rev. Proc. 2004–16 in order to make adjustments to the safe harbor formulas. These new safe harbor formulas replace the formulas in Rev. Proc. 2004–16 for distributions, sales, and other transfers made on or after February 13, 2004, and for permanent benefits provided on or after February 13, 2004. For all periods, including periods before May 1, 2005, taxpayers may rely on the safe harbors in Rev. Proc. 2005–25. In addition, for periods on or after February 13, 2004, and before May 1, 2005, taxpayers may rely on the safe harbors in Rev. Proc. 2004–16.
Explanation of Provisions
These final regulations retain the rules set forth in the 2004 proposed regulations under section 402(a) providing that the requirement that a distribution of property be included in the distributee’s income at fair market value is controlling in those situations where the former regulations provided for the inclusion of the entire cash value of a retirement income, endowment, or other life insurance contract. Thus, these final regulations clarify that, in those cases where a qualified plan distributes a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, the fair market value of such a contract ( i.e., the value of all rights under the contract, including any supplemental agreements thereto and whether or not guaranteed) is generally included in the distributee’s income, and not merely the entire cash value of the contract. However, these final regulations retain the rules from existing final regulations setting forth the situations under which a distribution of such a contract is not currently includible in income.
These final regulations also set forth a portion of the rules included in the 1975 proposed regulations. Under those rules, the distribution of an annuity contract must be treated as a lump sum distribution for purposes of determining the amount of tax under the 10-year averaging rule of section 402(e) (as in effect prior to the amendment by the Tax Reform Act of 1986, Public Law 99–514, 100 Stat. 2085), even if the distribution of the annuity contract itself is not currently taxable. The distribution of a retirement income, endowment, or other life insurance contract is not taxable in the situation where within 60 days after the distribution of such contract, the contract is treated as a rollover contribution under section 402(a)(5), as in effect after December 31, 1973. Although the final regulations reject the use of the term entire cash value as found in the 1975 proposed regulations, no inference should be made that other rules in the 1975 proposed regulations that have not been included in these final regulations have also been rejected.
These final regulations retain the rules provided in the 2004 proposed regulations that, if a qualified plan transfers property to a plan participant or beneficiary for con
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§1.83–3 Meaning and use of certain terms.
- (e) * * * In the case of a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, or any undivided interest therein, the policy cash value and all other rights under such contract (including any supplemental agreements thereto and whether or not guaranteed), other than current life insurance protection, are treated as property for purposes of this section. However, in the case of the transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, which was part of a split-dollar arrangement (as defined in §1.61–22(b)) entered into (as defined in §1.61–22(j)) on or before September 17, 2003, and which is not materially modified (as defined in §1.61–22(j)(2)) after September 17, 2003, only the cash surrender value of the contract is considered to be property. - * *
- Par. 4. Section 1.402(a)–1 is amended by:
- Revising paragraph (a)(1)(iii).
- Revising paragraph (a)(2). The revisions read as follows:
§1.402(a)–1 Taxability of beneficiary under a trust which meets the requirements of section 401(a).
(a) * - (1) - * (iii) Except as provided in paragraph (b) of this section, a distribution of property by a trust described in section 401(a) and exempt under section 501(a) shall be taken into account by the distributee at its fair market value. In the case of a distribution of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, or any interest therein, the policy cash value and all other rights under such contract (including any supplemental agreements thereto and whether or not guaranteed) are included in determining the fair market value of the contract. In addition, in the case of a transfer of property that occurs on or after August 29, 2005, where a trust described in section 401(a)
the fair market value of the property over the amount paid for the property be included in income. The purpose of the changes to the regulations is to clarify that, unless specifically excepted from the definition of permanent benefits or fair market value, the value of all features of a life insurance policy providing an economic benefit to a service provider (including, for example, the value of a springing cash value feature) must be included in determining the employee’s income.
These final regulations do not affect the relief granted by the provisions of Section IV, paragraph 4 of Notice 2002–8, 2002–1 C.B. 398, to the parties to any insurance contract that is part of a pre-January 28, 2002, split-dollar life insurance arrangement. Also, consistent with the effective date of the final split-dollar life insurance regulations at §1.61–22(j), these final regulations do not apply to the transfer of a life insurance contract which is part of a split-dollar life insurance arrangement entered into on or before September 17, 2003, and not materially modified after that date. However, taxpayers are reminded that, in determining the fair market value of property transferred under section 83, lapse restrictions (such as life insurance contract surrender charges) are ignored.
Effective Date
These regulations are effective August 29, 2005. The amendments to §1.402(a)–1(a) apply to any distribution of a retirement income, endowment, or other life insurance contract occurring on or after February 13, 2004. The amendment to §1.79–1 is applicable to permanent benefits provided on or after February 13, 2004. The amendment to §1.83–3(e) is applicable to any transfer occurring on or after February 13, 2004.
Special Analyses
It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. In addition, because no collection of information is imposed on small entities, the provisions of
the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply, and therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.
Drafting Information
The principal authors of these regulations are Bruce Perlin and Linda Marshall, Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and Treasury participated in the development of these regulations.
- - - -
Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * * Par. 2. In §1.79–1, paragraph (d)(3) is revised to read as follows:
§1.79–1 Group-term life insurance—general rules.
- (d) - - (3) Formula for determining deemed death benefit . The deemed death benefit (DDB) at the end of any policy year for any particular employee is equal to—
R/Y where R is the net level premium reserve at the end of that policy year for all benefits provided to the employee by the policy or, if greater, the fair market value of the policy at the end of that policy year; and
Y is the net single premium for insurance (the premium for one dollar of paidup, whole life insurance) at the employee’s age at the end of that policy year.
- Par. 3. In §1.83–3, paragraph (e), the fourth and fifth sentences are revised to read as follows:
2005–39 I.R.B. 595 September 26, 2005
and exempt under section 501(a) transfers property to a plan participant or beneficiary in exchange for consideration and where the fair market value of the property transferred exceeds the value of the consideration, then the excess of the fair market value of the property transferred by the trust over the value of the consideration received by the trust is treated as a distribution to the distributee under the plan for all purposes under the Internal Revenue Code. Where such a transfer occurs before that date, the excess of the fair market value of the property transferred by the trust over the value of the consideration received by the trust is includible in the gross income of the participant or beneficiary under section 61. However, such a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection occurring before that date is not treated as a distribution for purposes of applying the requirements of subchapter D of chapter 1 of subtitle A of the Internal Revenue Code.
- (2) If a trust described in section 401(a) and exempt under section 501(a) purchases an annuity contract for an employee and distributes it to the employee in a year in which the trust is exempt, and the contract contains a cash surrender value which may be available to an employee by surrendering the contract, such cash surrender value will not be considered income to the employee unless and until the contract is surrendered. For the rule as to nontransferability of annuity contracts issued after 1962, see §1.401–9(b)(1). For additional requirements regarding distributions of annuity contracts, see, e.g., §§1.401(a)–20, Q&A–2, 1.401(a)(31)–1, Q&A–17, and 1.401(a)(9)–6, Q&A–4. However, the distribution of an annuity contract must be treated as a lump sum distribution for purposes of determining the amount of tax under the 10-year averaging rule of section 402(e) (as in effect prior to amendment by the Tax Reform Act of 1986, Public Law 99–514, 100 Stat. 2085). If, however, the contract distributed by such exempt trust is a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, the fair market value of the contract at the time of distribution
must be included in the distributee’s income in accordance with the provisions of section 402(a), except to the extent that, within 60 days after the distribution of the contract, all or any portion of such value is irrevocably converted into a contract under which no part of any proceeds payable on death at any time would be excludable under section 101(a) (relating to life insurance proceeds), or the contract is treated as a rollover contribution under section 402(c). If the contract distributed by such trust is a transferable annuity contract, or a retirement income, endowment, or other life insurance contract and such contract is not treated as a rollover contribution under section 402(c), then, notwithstanding the preceding sentence, the fair market value of the contract is includible in the distributee’s gross income unless, within such 60 days, such contract is made nontransferable.
Mark E. Matthews, Deputy Commissioner for Services and Enforcement.
Approved August 9, 2005.
Eric Solomon, Acting Deputy Assistant Secretary
for Tax Policy.
(Filed by the Office of the Federal Register on August 26, 2005, 8:45 a.m., and published in the issue of the Federal Register for August 29, 2005, 70 F.R. 50967)
Section 408A.—Roth IRAs
26 CFR 1.408A–4T: Converting amounts to Roth IRAs.
T.D. 9220
DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1
Converting an IRA Annuity to a Roth IRA
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Temporary Regulations.
SUMMARY: This document contains temporary regulations under section 408A of the Internal Revenue Code (Code). These temporary regulations provide guidance concerning the tax consequences of converting a non-Roth IRA annuity to a Roth IRA. These temporary regulations affect individuals establishing Roth IRAs, beneficiaries under Roth IRAs, and trustees, custodians and issuers of Roth IRAs. The text of these temporary regulations also serves as the text of proposed regulations (REG–122857–05) set forth in a notice of proposed rulemaking in this issue of the Bulletin.
DATES: Effective Date : These regulations are effective August 19, 2005.
Applicability Date : These regulations are applicable to any Roth IRA conversion where an annuity contract is distributed or treated as distributed from a traditional IRA on or after August 19, 2005.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Cathy A. Vohs, 202–622–6090.
SUPPLEMENTARY INFORMATION:
Background
Roth IRAs and Conversions
This document contains temporary regulations that amend the Income Tax Regulations (26 CFR part 1) under section 408A of the Code relating to Roth IRAs. Section 408A of the Code, which was added by section 302 of the Taxpayer Relief Act of 1997, Public Law 105–34 (111 Stat. 788), establishes the Roth IRA as a type of individual retirement plan, effective for taxable years beginning on or after January 1, 1998. Under Code section 408A, a Roth IRA is treated like a traditional IRA with several significant exceptions. Like amounts held in traditional IRAs, amounts held in Roth IRAs generally are exempt from Federal income tax under Code section 408(e)(1). Likewise, contributions to traditional IRAs and Roth IRAs are subject to specific limitations.
The identifying characteristic of Roth IRAs is that all contributions are aftertax contributions, and qualified distributions are tax free. Thus, unlike certain contributions to traditional IRAs, which
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may be deductible, contributions to Roth IRAs cannot be deducted from gross income. Distributions from a traditional IRA are includable in gross income except to the extent attributable to a return of basis. However, qualified distributions from Roth IRAs are excludable from gross income. Under section 408A(d)(2), a qualified distribution from a Roth IRA is a distribution that is made: (1) at least 5 years after the account owner (or the account owner’s spouse) made a Roth IRA contribution, and (2) after age 59 1 /2, after death, on account of disability, or for a first-time home purchase.
A taxpayer whose modified adjusted gross income for a year does not exceed $100,000 may convert an amount held in a non-Roth IRA ( i.e., a traditional IRA or SIMPLE IRA) to an amount held in a Roth IRA. This conversion requires taking into income the value of the non-Roth IRA being converted (to the extent the conversion is not a conversion of basis in the non-Roth IRA), essentially converting the value into an after-tax rollover contribution to the Roth IRA. A conversion may be accomplished by means of a rollover, trustee-to-trustee transfer, or account redesignation.
Regardless of the means used to convert, any amount converted from a non-Roth IRA to a Roth IRA is treated as distributed from the non-Roth IRA and rolled over to the Roth IRA. The conversion amount is generally includible in gross income for the year of the conversion under section 408(d)(1) and (2). In the case of a conversion involving property, the conversion amount generally is the fair market value of the property on the date of distribution or the date the property is treated as distributed from the traditional IRA.
Final regulations regarding Roth IRAs were published in the Federal Register on February 4, 1999 (T.D. 8816, 1999–1 C.B. 518 [64 FR 5597). Section 1.408A–4 provides rules relating to converting amounts from a traditional IRA to a Roth IRA. Section 1.408A–4, A–7, which sets forth the tax consequences of converting an amount held in a traditional IRA to a Roth IRA, provides that any amount that is converted to a Roth IRA is includible in gross income
as a distribution according to the rules of section 408(d)(1) and (2) for the taxable year in which the amount is distributed or transferred from the traditional IRA.
Under A–1 of §1.408A–7, any amount converted from a non-Roth IRA to a Roth IRA is treated as a distribution for which a Form 1099-R, “ Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. ” must be filed by the trustee maintaining the non-Roth IRA.
Fair Market Value of Annuity Contracts
Before the enactment of section 408A, the need to value an annuity contract as a result of distribution from a qualified plan or IRA rarely arose. The distribution of an annuity contract from a qualified plan or a traditional IRA is generally not a taxable event because, in most cases, the distributed annuity account contract continues to be subject to requirements necessary for tax deferral, e.g., the annuity remains subject to the minimum distribution requirements of section 401(a)(9). In such a case, no amount is includible in income until amounts are actually distributed from the annuity contract. However, in certain situations, the Code provides that the fair market value of an individual retirement annuity is treated as a taxable distribution. For example, under section 408(e), the fair market value of the annuity is included in taxable income if the annuity ceases to be an individual retirement annuity because of violations of requirements set forth under that subsection.
Section 25.2512–6 of the Gift Tax Regulations provides rules regarding the valuation of certain life insurance contracts for gift tax purposes 1 . Under these rules, the value of a life insurance contract or of a contract for the payment of an annuity issued by a company regularly engaged in the selling of contracts of that character is established through the sale of the particular contract by the company, or through the sale by the company of comparable contracts. In addition, §25.2512–6 provides that, as the value of an insurance policy through sale of comparable contracts is not readily ascertainable when the gift is of a contract which has been in force
for some time and on which further premium payments are to be made, the value may be approximated by adding to the interpolated terminal reserve at the date of the gift the proportionate part of the gross premium last paid before the date of the gift which covers the period extending beyond that date. If, however, because of the unusual nature of the contract, such approximation is not reasonably close to the full value, this method may not be used. Thus, this method may not be used to determine the fair market value of an insurance policy where the reserve does not reflect the value of all relevant features of the policy. These gift tax valuation rules also apply for purposes of commercial annuity contracts. See Examples 1 and 2 of §25.2512–6. In addition, under §20.2031–8 of the Estate Tax Regulations, the same rules govern the valuation of such life insurance and commercial annuity contracts for estate tax purposes. See §§20.2031–7(b) and 20.2039–1(c).
Under A–12 of §1.401(a)(9)–6, an employee’s entire interest under an annuity contract is the dollar amount credited to the employee or beneficiary under the contract plus the actuarial value of any additional benefits (such as survivor benefits in excess of the account balance) that will be provided under the contract. This rule requiring that the value of additional benefits under an annuity contract be included in the employee’s entire interest, for purposes of determining the required minimum distribution under section 401(a)(9), is based on the general requirement that the fair market value of all assets must be reflected in valuing an account balance under a defined contribution plan. However, certain additional benefits may be disregarded for purposes of calculating the required minimum distribution, such as when there is a pro-rata reduction in additional benefits for a withdrawal and a guaranteed return of premiums upon death, to reflect the fact that distributions are being made to satisfy section 401(a)(9).
Rev. Proc. 2005–25, 2005–17 I.R.B. 962, provides safe harbor formulas that, if used to determine the value of a life insurance contact, retirement income contract, endowment contract, or other contract providing life insurance protection that is dis
1 In Rev. Rul. 59–195, 1959–1 C.B. 18, the IRS ruled that, in situations similar to those in which an employer purchases and pays the premiums on an insurance policy on the life of one of its employees and subsequently sells such policy, on which further premiums must be paid, the value of such policy for computing taxable gain in the year of purchase should be determined under the method of valuation prescribed in §25.2512–6 of the Gift Tax Regulations.
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version occurs soon after the annuity was purchased.
Under the temporary regulations, if the conversion occurs after the annuity contract has been in force for some time and no further premium payments are to be made, fair market value is determined through the sale by the company of comparable contracts. The temporary regulations further provide that, if the conversion occurs after the annuity contract has been in force for some time and future premium payments are to be made, fair market value is determined through an approximation that is based on the interpolated terminal reserve at the date of the conversion, plus the proportionate part of the gross premium last paid before the date of the conversion which covers the period extending beyond that date. However, if, because of the unusual nature of the contract, this approximation is not reasonably close to the full value, this method may not be used.
These temporary regulations also provide authority for the Commissioner to issue additional guidance regarding the fair market value of an individual retirement annuity, including formulas to be used for determining fair market value. The IRS and Treasury Department expect to issue additional guidance regarding the rules to be used in determining the fair market value of a non-Roth IRA annuity. It is anticipated that such guidance will be similar to the provisions of Rev. Proc. 2005–25, 2005–17 I.R.B. 962 (April 25, 2005), except that the adjustment for potential surrender charges, to the extent permitted, will not exceed 9 percent. It is also anticipated that such guidance will provide that in determining fair market value, the value of all additional benefits (such as guaranteed minimum death benefits) under the contract must be taken into account. The IRS and Treasury Department request comments regarding this anticipated guidance. The IRS and Treasury Department also request comments regarding whether the method used to calculate the fair market value of an annuity contract that is converted to a Roth IRA should also apply for purposes of the determining fair market value of an annuity contract under sections 408(e) and 401(a)(9). These comments may be submitted in conjunction with the comments submitted on the proposed regulations discussed below.
tributed or otherwise transferred from a qualified plan, will meet the definition of fair market value for purposes of applying the rules of section 402(a) (as well as sections 79, 83, and 402(b)).
Explanation of Provisions
These temporary regulations under section 408A clarify that, when a non-Roth individual retirement annuity is converted to a Roth IRA, the amount that is treated as distributed is the fair market value of the annuity contract on the date the annuity contract is converted. Similarly, when a non-Roth individual retirement account holds an annuity contract as an account asset and the account is converted to a Roth IRA, the amount that is treated as distributed with respect to the annuity contract is the fair market value of the annuity contract on the date the annuity contract is distributed or treated as distributed from the non-Roth IRA.
Some taxpayers and their advisers assert that the only amount includible in income as a distribution when a non-Roth individual retirement annuity is converted to a Roth IRA is the cash surrender value of the contract, even when the cash surrender value does not accurately reflect the fair market value of the contract. In particular, some advisers market a transaction in which taxpayers are encouraged to invest their non-Roth IRA funds in a single premium annuity contract with significant artificial penalties that apply in the first year (or years) of the contract if the annuity is surrendered, causing the annuity to have a low cash surrender value in the early years of the contract. Under this transaction, shortly after the annuity contract is purchased by the non-Roth IRA, the taxpayer converts the IRA to a Roth IRA. In such a case, the taxpayer asserts that the only amount includible in gross income as a result of the conversion is the low cash surrender value. This assertion is made even though the surrender penalties are unlikely to be paid because the taxpayers do not expect to surrender the contract during the early years. In this case, the taxpayers expect that the ultimate payments under the contract will be qualified distributions from the Roth IRA ( i.e., tax-exempt), and thus, they also expect the artificially depressed cash surrender value to
be the only amount ever includible in gross income.
In another situation, a taxpayer purchases a non-Roth individual retirement variable annuity with a guaranteed minimum death benefit equal to the highest account value ever attained under the contract, adjusted for withdrawals. If an amount is withdrawn from the contract, the death benefit is reduced dollar for dollar (rather than a pro-rata reduction) by the amount of the withdrawal. Prior to the date of conversion, the annuity has a death benefit far in excess of the account value and the taxpayer withdraws from the IRA annuity all but a minimum account value that will keep the IRA annuity in force. Because the withdrawal reduces the guaranteed minimum death benefit on a dollar-for-dollar basis, the remaining death benefit will be significantly greater than the current account value, and accordingly, the current account value will not reflect the fair market value of the contract. For example, suppose such an individual retirement variable annuity has a guaranteed minimum death benefit of $200,000 with an account value of $100,000. The taxpayer withdraws $99,000 leaving a $1,000 account value and a $101,000 death benefit ($200,000 less $99,000). The taxpayer then converts the IRA annuity into a Roth IRA and takes the position that the $1,000 account value is the conversion amount even though the account value does not reflect the fair market value of the additional $100,000 that will be paid upon the taxpayer’s death. In this case, the taxpayer expects that the entire benefit payment of $101,000 will be a qualified distribution from the Roth IRA ( i.e., tax-exempt), and thus, expects that the $1,000 account value on the date of conversion will be the only amount ever includible in gross income.
The IRS and Treasury Department have concluded that cash surrender value is not always an appropriate measure of fair market value with respect to non-Roth IRA annuities that are converted to Roth IRA annuities. Rather than use the cash surrender value as the basis for determining fair market value, these temporary regulations follow the gift tax regulations in providing that the fair market value of an individual retirement annuity is established by the premiums paid for such annuity if the con
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of contracts of that character generally is established as follows—
(A) If the conversion occurs soon after the contract was sold and there have been no material changes in market conditions, the fair market value of the contract is established through the sale of the particular contract by the company ( i.e., the actual premiums paid for such contract);
(B) If the conversion occurs after the contract has been in force for some time and no further premium payments are to be made, the fair market value of the contract is established through the sale by the company of comparable contracts;
(C) If the conversion occurs after the contract has been in force for some time and future premium payments are to be made, the fair market value of the contract is established through an approximation that is based on the interpolated terminal reserve at the date of the conversion, plus the proportionate part of the gross premium last paid before the date of the conversion which covers the period extending beyond that date. However, if, because of the unusual nature of the contract, this approximation is not reasonably close to the full value, this method may not be used. Thus, this method may not be used to determine the fair market value of an annuity contract where the reserve does not reflect the value of all relevant features of the contract.
(2) Additional guidance . Additional guidance regarding the fair market value of an individual retirement annuity, including formulas to be used for determining fair market value, may be issued by the Commissioner in revenue rulings, notices, or other guidance published in the Internal Revenue Bulletin (See §601.601(d)(2)(ii)(b)).
(c) Effective date . The provisions of this A–14 are applicable to any conversion where an annuity contract is distributed or treated as distributed from a traditional IRA on or after August 19, 2005.
(d) Definitions . The definitions set forth in §1.408A–8 apply for purposes of this A–14.
Mark E. Matthews, Deputy Commissioner for Services and Enforcement.
Approved August 9, 2005.
Proposed regulations regarding the determination of fair market value of an annuity contract are contained in this issue of the Bulletin. The preamble and text of these temporary regulations also serves as the preamble and text of the proposed regulations.
Effective Date
The temporary amendments to §1.408A–4 of the regulations are applicable to any Roth IRA conversion where an annuity contract is distributed or treated as distributed from a traditional IRA on or after August 19, 2005. No implication is intended concerning whether or not a rule to be adopted in these regulations is applicable law for taxable years ending before that date.
Special Analyses
It has been determined that these temporary 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 temporary regulations. For applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), refer to the notice of proposed rulemaking published in this issue of the Bulletin. Pursuant to section 7805(f) of the Code, these temporary regulations will be 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 temporary regulations is Cathy A. Vohs of the Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and Treasury Department participated in the development of these regulations.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for Part 1 continues to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * * §1.408A–4T also issued under 26 U.S.C. 408A * * *
Par. 2. Section 1.408A–4 is amended by adding, in numerical order, Q–14 and A–14, to read as follows:
§1.408A–4 Converting amounts to Roth IRAs.
- Q–14. [Reserved]. For further guidance, see §1.408A–4T, Q–14.
A–14. [Reserved]. For further guidance, see §1.408A–4T, A–14.
Par. 3. Section 1.408A–4T is added to read as follows:
§1. 408A–4T Converting amounts to Roth IRAs.
- Q–14. What is the amount that is includable in income as a distribution when a conversion involves an annuity contract?
A–14. (a) In general . Notwithstanding §1.408–4(e), when part or all of a traditional IRA that is an individual retirement annuity described in section 408(b) is converted to a Roth IRA, for purposes of determining the amount includible in gross income as a distribution under §1.408A–4, A–7, the amount that is treated as distributed is the fair market value of the annuity contract on the date the annuity contract is converted. Similarly, when a traditional IRA that is an individual retirement account described in section 408(a) holds an annuity contract as an account asset and the traditional IRA is converted to a Roth IRA, for purposes of determining the amount includible in gross income as a distribution under §1.408A–4, A–7, the amount that is treated as distributed with respect to the annuity contract is the fair market value of the annuity contract on the date that the annuity contract is distributed or treated as distributed from the traditional IRA.
(b) Determination of fair market value —(1) General rule . For purposes of this A–14, the fair market value of an individual retirement annuity issued by a company regularly engaged in the selling
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Section 1.469–1T(e)(1) of the temporary Income Tax Regulations provides in general that an activity is a passive activity of the taxpayer for a taxable year if and only if the activity: (i) is a trade or business activity (within the meaning of § 1.469–1T(e)(2)) in which the taxpayer does not materially participate for the taxable year; or (ii) a rental activity (within the meaning of § 1.469–1T(e)(3)), without regard to whether or to what extent the taxpayer participates in the activity.
Section 1.469–1T(e)(3)(i) provides in general that an activity is a rental activity for a taxable year if: (A) during the taxable year, tangible property held in connection with the activity is used by customers or held for use by customers; and (B) the gross income attributable to the conduct of the activity during the taxable year represents (or, in the case of an activity in which property is held for use by customers, the expected gross income from the conduct of the activity will represent) amounts paid or to be paid principally for the use of the tangible property (without regard to whether the use of the property by customers is pursuant to a lease or pursuant to a service contract or other arrangement that is not denominated a lease).
Section 1.469–1T(e)(3)(ii)(C) provides that an activity involving the use of tangible property is not a rental activity for a taxable year if for the taxable year extraordinary personal services (within the meaning of § 1.469–1T(e)(3)(v)) are provided by or on behalf of the owner of the property in connection with making the property available for use by customers (without regard to the average period of customer use).
Section 1.469–1T(e)(3)(v) provides that for purposes of § 1.469– 1T(e)(3)(ii)(C), extraordinary personal services are provided in connection with making property available for use by customers only if the services provided in connection with the use of the property are performed by individuals, and the use by customers of the property is incidental to their receipt of the services. For example, the use by patients of a hospital’s boarding facilities generally is incidental to their receipt of the personal services provided by the hospital’s medical and nursing staff. Similarly, the use by students of a boarding school’s dormitories generally is incidental to their receipt of the personal
Eric Solomon, Acting Deputy Assistant Secretary
for Tax Policy.
(Filed by the Office of the Federal Register on August 19, 2005, 8:45 a.m., and published in the issue of the Federal Register for August 22, 2005, 70 F.R. 48868)
Section 469.—Passive Activity Losses and Credits Limited
26 CFR 1.469–1T: General rules (Temporary).
If an individual provides air transportation services through a passthrough entity, may those services qualify as extraordinary personal services. See Rev. Rul. 2005-64, page 600.
26 CFR 1.469–1T: General rules. (Also §§ 4261, 4262, 4291; 1.469–4, 1.469–5, 1.469–5T, 40.6011(a)–1.)
Interaction of sections 469 and 4261. This ruling describes the circumstances in which losses incurred by an individual who provides air transportation through a passthrough entity can qualify as passive losses under section 469 of the Code. In addition, this ruling describes the applicability of section 4261 to the amounts paid for the air transportation services.
Rev. Rul. 2005–64
ISSUES
(1) Whether the losses incurred by an individual who engages in an air transportation activity in the circumstances described below are passive losses within the meaning of § 469 of the Internal Revenue Code?
(2) Whether the amounts paid for the air transportation services described below are subject to the tax imposed by § 4261?
FACTS
Situation 1 . A is the CEO and part owner of the closely held C corporation, Corp1 . A participates in the activities of Corp1 for more than 500 hours during the year. A is also the sole owner of SCorp1, an S corporation. SCorp1 ’s sole asset is an aircraft with a maximum certificated takeoff weight of more than six thousand (6,000) pounds. SCorp1 leases the aircraft to Corp1 to satisfy Corp1 ’s air transportation needs, but supplies neither the
pilot necessary to operate the aircraft nor the crew necessary to maintain the aircraft. Corp1 pays SCorp1 only for the lease of the aircraft. A has incurred significant losses from the operation of SCorp1 .
Situation 2 . B is the CEO and part owner of the closely held C corporation, Corp2 . B participates in the activities of Corp2 for more than 500 hours during the year. B is also the sole owner of SCorp2, an S corporation. SCorp2 ’s sole asset is an aircraft with a maximum certificated takeoff weight of more than six thousand (6,000) pounds. SCorp2 employs a pilot and crew to operate and maintain the aircraft. Corp2 pays SCorp2 a guaranteed monthly fee plus an additional amount for each flying hour. Corp2 uses the aircraft to transport its employees throughout the continental United States. In the conduct of its air transportation activity, SCorp2 usually supplies its own aircraft, but is solely responsible for the provision of alternative aircraft in the event that SCorp2 ’s aircraft is undergoing maintenance or is being provided to other customers. SCorp2 ’s activities include the provision of air transportation services to Corp2, including, but not limited to, the use of the aircraft, with pilot and crew, fuel, and food provided by SCorp2 . SCorp2 is the only air transportation business in which B is involved. Upon initiation of SCorp2 ’s business, B decided to group B ’s activities conducted through SCorp2 with B ’s activities conducted through Corp2 for purposes of § 1.469–4 of the Income Tax Regulations. B has incurred significant losses from the operation of SCorp2 .
LAW AND ANALYSIS
Section 469(a) disallows passive activity losses and credits for the taxable year for individuals, estates, trusts, closely held C corporations, and personal service corporations. Section 469(c)(2) provides that, except as provided in § 469(c)(7) (concerning special rules for taxpayers engaged in real property businesses), the term passive activity includes any rental activity. Section 469(c)(4) provides that § 469(c)(2) shall be applied without regard to whether or not the taxpayer materially participates in the activity.
Section 469(j)(8) defines “rental activity” as any activity where payments are principally for the use of tangible property.
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Section 1.469–5(f)(1) provides in general that any work done by an individual (without regard to the capacity in which the individual does the work) in connection with an activity in which the individual owns an interest at the time the work is done shall be treated as participation of the individual in the activity.
Section 1.469–5T(a) provides in general that an individual shall be treated, for purposes of § 469 and the regulations thereunder, as materially participating in an activity for the taxable year if and only if: (1) the individual participates in the activity for more than 500 hours during the year; (2) the individual’s participation in the activity for the taxable year constitutes substantially all of the participation in the activity of all individuals (including individuals who are not owners of interests in the activity) for the year; (3) the individual participates in the activity for more than 100 hours during the taxable year, and the individual’s participation in the activity is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year; (4) the activity is a significant participation activity (within the meaning of § 1.469–5T(c)) for the taxable year, and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours; (5) the individual materially participated in the activity (determined without regard to § 1.469–5T(a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year; (6) the activity is a personal service activity (within the meaning of § 1.469–5T(d)), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or (7) based on all of the facts and circumstances (taking into account the rules in § 1.469–5T(b)), the individual participates in the activity on a regular, continuous, and substantial basis during the year.
Section 4261(a) imposes a tax on the amount paid for taxable transportation of any person by air and § 4261(b) imposes a tax on the amount paid for each domestic segment of taxable transportation. Section 4262(a)(1) generally defines taxable transportation as including transportation by air which begins and ends in the
services provided by the school’s teaching staff.
Section 1.469–1T(e)(3)(viii) provides several examples to illustrate the operation of § 1.469–1T(e)(3). In Example (1), the taxpayer is engaged in an activity of leasing photocopying equipment. The average period of customer use for the equipment exceeds 30 days. Pursuant to the lease agreements, skilled technicians employed by the taxpayer maintain the equipment and service malfunctioning equipment for no additional charge. Service calls occur frequently (three times per week on average) and require substantial labor. The value of the maintenance and repair services (measured by the cost to the taxpayer of employees performing these services) exceeds 50 percent of the amount charged for the use of the equipment. Under these facts, services performed by individuals are provided in connection with the use of the photocopying equipment, but the customers’ use of the photocopying equipment is not incidental to their receipt of the services. Therefore, extraordinary personal services (within the meaning of § 1.469–1T(e)(3)(v)) are not provided in connection with making the photocopying equipment available for use by customers, and the activity is a rental activity.
In Example (3) of § 1.469–1T (e)(3)(viii), the taxpayer is engaged in an activity of transporting goods for customers. In conducting the activity, the taxpayer provides tractor-trailers to transport goods for customers pursuant to arrangements under which the tractor-trailers are selected by the taxpayer, may be replaced at the sole option of the taxpayer, and are operated and maintained by drivers and mechanics employed by the taxpayer. The average period of customer use for the tractor-trailers exceeds 30 days. Under these facts, the use of tractor-trailers by taxpayer’s customers is incidental to their receipt of personal services provided by the taxpayer. Accordingly, the services performed in the activity are extraordinary personal services (within the meaning of § 1.469–1T(e)(3)(v)) and, under § 1.469–1T(e)(3)(ii)(C), the activity is not a rental activity.
Section 1.469–4 sets forth the rules for grouping a taxpayer’s trade or business activities and rental activities for purposes of applying the passive activity loss and credit limitation rules of § 469. Section
1.469–4(a) further states that a taxpayer’s activities include those conducted through C corporations that are subject to § 469, S corporations, and partnerships.
Section 1.469–4(b)(1) states that “trade or business activities” are activities, other than rental activities or activities that are treated under § 1.469–1T(e)(3)(vi)(B) as incidental to an activity of holding property for investment, that: (i) involve the conduct of a trade or business (within the meaning of § 162); (ii) are conducted in anticipation of the commencement of a trade or business; or (iii) involve research or experimental expenditures that are deductible under § 174 (or would be deductible if the taxpayer adopted the method described in § 174(a)). Section 1.469–4(b)(2) provides that “rental activities” are activities that constitute rental activities within the meaning of § 1.469–1T(e)(3).
Section 1.469–4(c)(1) states that one or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of § 469. Section 1.469–4(c)(2) provides that a facts and circumstances test determines whether activities constitute an appropriate economic unit.
Section 1.469–4(c)(3) provides several examples that illustrate the application of § 1.469–4(c). In Example (2), Taxpayer B, an individual, is a partner in a business that sells non-food items to grocery stores (partnership L ). B also is a partner in a partnership that owns and operates a trucking business (partnership Q ). The two partnerships are under common control. The predominant portion of Q ’s business is transporting goods for L, and Q is the only trucking business in which B is involved. Under § 1.469–4(c), B appropriately treats L ’s wholesale activity and Q ’s trucking activity as a single activity.
Section 1.469–4(d)(1) limits a taxpayer’s ability to group a rental activity with a trade or business activity and § 1.469–4(d)(5)(ii) provides that an activity that a taxpayer conducts through a C corporation subject to § 469 may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially or significantly participates in the other activity.
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rental activity for purposes of § 469. Section 1.469–1T(e)(3)(ii)(C).
Pursuant to § 1.469–1T(e)(1)(i), the air transportation activity is not a passive activity if B materially participates in the activity. In this situation, Corp2 and SCorp2 are under common control, the predominant portion of SCorp2 ’s air transportation service business is transporting executives for Corp2, and SCorp2 is the only air transportation service business in which B is involved. B has consistently chosen to group the activity conducted through SCorp2 with Corp2 ’s trade or business activity and to treat those activities as a single activity for the measurement of material participation in the activity of SCorp2 . Section 1.469–4(c)(1) and (c)(3), Example (2). Because B participates for more than 500 hours in the Corp2 activity that is grouped with the activity conducted through SCorp2 for purposes of measuring material participation in the SCorp2 activity, B materially participates in the SCorp2 activity under § 1.469–5T(a)(1). Accordingly, the provision of air transportation services is not a passive activity, and losses incurred by B through SCorp2 are not subject to the limitations of § 469. If, however, B did not participate in Corp 2 for more than 500 hours and did not otherwise materially participate in the grouped activities, the losses incurred by B through SCorp2 would be subject to the passive loss limitations of § 469.
SCorp2 provides taxable transportation service to Corp2 because SCorp2 retains possession, command and control of the aircraft; thus, the taxes imposed by § 4261 apply to the amounts paid (including monthly and hourly fees) by Corp2 to SCorp2 for the taxable transportation. Corp2 is liable for the tax and SCorp2 is responsible for collecting the § 4261 taxes and filing the return.
HOLDINGS
(1) In Situation 1, A ’s activities conducted through SCorp1 are rental activities, and therefore the losses incurred in the activities are passive losses subject to the limitations of § 469. In Situation 2, B ’s activities conducted through SCorp2 are not rental activities because extraordinary personal services are provided. Because B consistently grouped the activities conducted through Corp2 and SCorp2 for
United States. Section 4262(d) provides that the term “transportation” includes layover or waiting time and movement of the aircraft in deadhead service. All amounts paid for air transportation service, including hourly, per diem, or monthly fees, are subject to the tax imposed by § 4261. Rev. Rul. 76–556, 1976–2 C.B. 354.
Under § 4261(d), the tax generally is paid by the person making payment for the air transportation service and § 4291 generally provides that the person receiving the payment is responsible for collecting the tax. Section 40.6011(a)–1(a)(3) of the Excise Tax Procedural Regulations provides that the person required to collect the tax must file the return.
If the owner of an aircraft leases it to others for the transportation of persons but retains possession, command, and control of the aircraft, the owner is furnishing taxable transportation within the meaning of § 4261. However, if the owner of the aircraft transfers the complete possession, command, and control of the aircraft, the owner is not engaging in a taxable transportation service, but is merely leasing the aircraft. Rev. Rul. 60–311, 1960–2 C.B. 341. If the owner of the aircraft employs the pilot and crew and provides their services with the aircraft, the owner is deemed to have the essential elements of possession, command, and control of the aircraft at all times, irrespective of the fact that the lessee may direct the pilot as to destination and other details concerning actual flights when using the aircraft. Rev. Rul. 76–394, 1976–2 C.B. 355. Situation 1 . In this situation, SCorp1 holds an aircraft in connection with its activities, such aircraft is used by customers or held for use by customers, and the gross income attributable to the conduct of the activities represents an amount paid or to be paid principally for the use of the aircraft. Therefore, the activity conducted in SCorp1 is a rental activity. Section 1.469–1T(e)(3)(i). Section 1.469–1T(e)(3)(ii)(C) does not alter this conclusion because there are no extraordinary personal services provided in connection with making the aircraft available to Corp1 and because the use of the aircraft, rather than the provision of services, is the dominant element of the relationship between SCorp1 and Corp1 . See Frank v. Commissioner, T.C. Memo 1996–177 (1996) (holding that taxpayer’s
losses from its airplane leasing activities were passive because the services rendered to the lessee were not the dominant element of the relationship between the taxpayer and the lessee).
This ruling does not address whether § 1.469–4(d)(1), which limits a taxpayer’s ability to group a rental activity with a trade or business activity, would prevent A from grouping the rental activity conducted through SCorp1 with the trade or business activity conducted through Corp1 . Even if such a grouping were permitted, however, § 1.469–4(d)(5)(ii) provides that a taxpayer can group activities conducted through a closely held C corporation with other activities of the taxpayer only for the purpose of establishing material or significant participation in the other activities. Consequently, grouping the activities A conducts through Corp1 and SCorp1 will not change the character of the activity A conducts through SCorp1 . The activity will remain a rental activity because the grouping is only for purposes of establishing material or significant participation and will remain a passive activity because, under § 469(c)(4), material participation in rental activities does not change their passive nature. Accordingly, the losses incurred by A through SCorp1 are losses from a passive activity and are subject to the limitations of § 469.
SCorp1 does not provide taxable transportation within the meaning of § 4262(a)(1) to Corp1 because SCorp1 does not retain possession, command and control of the aircraft; thus, the taxes imposed by § 4261 do not apply to amounts paid by Corp1 to SCorp1 for the lease of the aircraft.
Situation 2 . In this situation, the services provided by SCorp2 in connection with the use of the aircraft by Corp2 are provided by individuals. In addition, the use of the aircraft by Corp2 is incidental to Corp2 ’s receipt of the services provided, as the use of a seat on the aircraft is incidental to the passenger’s receipt of the personal services provided by the aircraft’s air transportation staff. Accordingly, extraordinary personal services within the meaning of § 1.469–1T(e)(3)(v) are provided on behalf of the owner of the aircraft in connection with making the aircraft available for use by customers. Therefore, the activity B conducts through SCorp2 is not a
September 26, 2005 602 2005–39 I.R.B.
purposes of measuring material participation in the activity of SCorp2, and participates in the Corp2 activity for more than 500 hours a year, B materially participates in the SCorp2 activity. Therefore, the losses incurred by B through SCorp2 are not losses from a passive activity.
(2) In Situation 1, Corp1 does not pay SCorp1 for taxable transportation and § 4261 does not apply. In Situation 2, Corp2 pays SCorp2 for taxable transportation; therefore, § 4261 applies to the amount paid for the services.
DRAFTING INFORMATION
The principal author of the § 469 portion of this revenue ruling is Timothy J. Leska of the Office of Associate Chief Counsel (Passthroughs & Special Industries). The principal author of the § 4261 portion of this revenue ruling is Taylor Cortright of the Office of Associate Chief Counsel (Passthroughs
& Special Industries). For further information regarding this revenue ruling, contact Mr. Leska at (202) 622–3050 or Ms. Cortright at (202) 622–3130 (not toll-free calls).
Section 472.—Last-in, First-out Inventories
26 CFR 1.472–1: Last-in, first-out inventories.
LIFO; price indexes; department stores. The July 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, July 31, 2005.
Rev. Rul. 2005–63
The following Department Store Inventory Price Indexes for July 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, July 31, 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.
BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS
(January 1941 = 100, unless otherwise noted)
Groups July 2004 July 2005
Percent Change
from July 2004
to July 2005 1
- Piece Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507.8 495.0 -2.5
- Domestics and Draperies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525.0 517.7 -1.4
- Women’s and Children’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608.5 629.0 3.4
- Men’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 831.7 867.0 4.2
- Infants’ Wear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560.5 548.0 -2.2
- Women’s Underwear. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508.0 541.2 6.5
- Women’s Hosiery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330.4 339.7 2.8
- Women’s and Girls’ Accessories . . . . . . . . . . . . . . . . . . . . . . . . . . . 565.8 580.5 2.6
- Women’s Outerwear and Girls’ Wear . . . . . . . . . . . . . . . . . . . . . . . 335.9 321.7 -4.2
- Men’s Clothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532.7 520.6 -2.3
- Men’s Furnishings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567.0 552.6 -2.5
- Boys’ Clothing and Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420.9 386.1 -8.3
- Jewelry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 907.8 870.2 -4.1
- Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 798.6 809.2 1.3
- Toilet Articles and Drugs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 993.3 997.1 0.4
- Furniture and Bedding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 616.3 599.1 -2.8
- Floor Coverings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 587.7 609.8 3.8
- Housewares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712.1 712.2 0.0
- Major Appliances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199.6 203.5 2.0
- Radio and Television. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.6 38.9 -6.5
- Recreation and Education 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80.3 77.9 -3.0
- Home Improvements 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129.8 137.6 6.0
- Automotive Accessories 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112.7 115.1 2.1
2005–39 I.R.B. 603 September 26, 2005
BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS
(January 1941 = 100, unless otherwise noted)
Groups July 2004 July 2005
Percent Change
from July 2004
to July 2005 1
Groups 1–15: Soft Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 545.1 537.3 -1.4 Groups 16–20: Durable Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382.3 379.6 -0.7 Groups 21–23: Misc. Goods 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93.3 93.0 -0.3
Store Total 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487.2 481.6 -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).
Section 4261.—Imposition of Tax
26 CFR 49.4261–1: Imposition of tax; in general.
If an individual provides air transportation services through a passthrough entity, may the amounts paid for those services be subject to tax. See Rev. Rul. 2005-64, page 600.
Section 4291.—Cases Where Persons Receiving Payment Must Collect Tax
26 CFR 49.4291–1: Persons receiving payment must collect tax.
T.D. 9221
DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 40 and 49
Collected Excise Taxes; Duties of Collector
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations and removal of temporary regulations.
SUMMARY: This document contains final regulations relating to the reporting obligations of persons that receive payments for air transportation or communications services subject to excise tax when persons liable for tax refuse to pay the tax. The final regulations affect persons that receive payments subject to tax and persons liable for those taxes.
DATES: Effective Date : These regulations are effective August 26, 2005.
Applicability Date : For dates of applicability, see §§40.6302(c)–3(g) and 49.4291–1.
FOR FURTHER INFORMATION CONTACT: Taylor Cortright, (202) 622–3130 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
This document amends the Excise Tax Procedural Regulations (26 CFR part 40) and the Facilities and Services Excise Tax Regulations (26 CFR part 49). On August 10, 2004, a temporary regulation (T.D. 9149, 2004–38 I.R.B. 494 [60 FR 48393]) was published in the Federal Register . A notice of proposed rulemaking (REG–163909–02, 2004–38 I.R.B. 499 [69 FR 48432]) cross-referencing the temporary regulations was published in the Federal Register on the same day. A written comment was received and no public hearing was requested or held. After considering the comment, the proposed regulations are adopted by this Treasury decision with clarifying changes. The corresponding temporary regulations are removed.
Special Analyses
It has been determined that these 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
September 26, 2005 604 2005–39 I.R.B.
A new sentence is added at the end of the paragraph.
Paragraphs (a) and (b) are added. The revisions and addition read as follows:
§49.4291–1 Persons receiving payment must collect tax.
- Applicable October 1, 2004, this report must be made on or before the report due date. - - - For purposes of this section, the report due date is—
(a) In the case of a person using the alternative method of making deposits described in §40.6302(c)–3 of this chapter, the due date of the return on which the item of adjustment relating to the uncollected tax would be reflected if items of adjustment were determined without regard to the limitation in §40.6302(c)–3 of this chapter; and
(b) In any other case, the due date of the return on which the tax would have been reported but for the refusal to pay or inability to collect.
§49.4291–1T [Removed]
Par. 6. Section 49.4291–1T is removed.
Mark E. Matthews, Deputy Commissioner for Services and Enforcement.
Approved July 20, 2005.
Eric Solomon, Acting Deputy Secretary of the Treasury (Tax Policy).
(Filed by the Office of the Federal Register on August 24, 2005, 8:45 a.m., and published in the issue of the Federal Register for August 25, 2005, 70 F.R. 49869)
these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these final regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.
Drafting Information
The principal author of these regulations is Taylor Cortright of the Office of Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.
- - - -
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 40 and 49 are amended as follows:
PART 40—EXCISE TAX PROCEDURAL REGULATIONS
Paragraph 1. The authority citation for part 40 is amended by removing the entry for §40.6302(c)–3T to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * * Par. 2. Section 40.6302(c)–3 is amended as follows:
- Paragraph (b)(2)(ii) is revised.
- Paragraph (g) is amended by removing the language “October 1, 2001” and adding the language “October 1, 2001, except that paragraph (b)(2)(ii)(B) of this section is applicable October 1, 2004” in its place.
The revision reads as follows:
§40.6302(c)–3 Special rules for use of Government depositaries under chapter 33.
- (b) - - (2) - - (ii) Separate account . The account required under paragraph (b)(2)(i)(A) of this section (the separate account)—
(A) Must reflect for each month all items of tax that are included in amounts billed or tickets sold to customers during the month;
(B) May not reflect an item of adjustment for any month during a quarter if the adjustment results from a refusal to pay or inability to collect the tax and the uncollected tax has not been reported under §49.4291–1 of this chapter on or before the due date of the return for that quarter; and
(C) Must reflect for each month items of adjustment (including bad debts and errors) relating to the tax for prior months within the period of limitations on credits or refunds.
§40.6302(c)–3T [Removed]
Par. 3. Section 40.6302(c)–3T is removed.
PART 49—FACILITIES AND SERVICES EXCISE TAXES
Par. 4. The authority citation for part 49 continues to read, in part, as follows: Authority: 26 U.S.C. 7805 * * * Par. 5. Section 49.4291–1 is amended as follows:
- The fourth sentence is revised.
- The fifth sentence is amended by removing the language “this information” and adding the language “this report” in its place.
2005–39 I.R.B. 605 September 26, 2005
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