32.1.4  Outlining and Drafting Substantive Regulatory Text

Manual Transmittal

October 11, 2011

Purpose

(1) This transmits revised CCDM 32.1.4, Chief Counsel Regulation Handbook; Outlining and Drafting Substantive Regulatory Text.

Background

CCDM 32.1.4, Outlining and Drafting Substantive Regulatory Text, is being revised to reflect current office practice.

Material Changes

(1) Exhibit 32.1.4–1 was revised and made compliant with Section 508 of the Rehabilitation Act.

(2) Tables and Exhibits 32.1.4–2 through 32.1.4–8 were made compliant with Section 508 of the Rehabilitation Act.

Effect on Other Documents

CCDM 32.1.4 dated August 11, 2004 is superseded.

Audience

Chief Counsel

Effective Date

(10-11-2011)

Deborah A. Butler
Associate Chief Counsel
(Procedure & Administration)

32.1.4.1  (08-11-2004)
Overview of Drafting Process

  1. After the initial policy decisions are made, the drafting team should begin drafting the regulation. Outlines are not required, but may be useful in certain cases. The drafting team should consult this Handbook and contact the Federal Register Liaison (FRL) assigned to the project to ensure compliance with all required procedures. See Exhibit 32.1.4-1, Regulation Checklist.

32.1.4.1.1  (08-11-2004)
Drafting Standards — Executive Order 12866

  1. Executive Order 12866 mandates that the following drafting standards are to be used (unless one or more standard is determined to be unreasonable):

    1. Draft regulations to minimize litigation,

    2. Draft regulations to provide a clear legal standard for affected conduct rather than a general standard, to promote simplification and burden reduction,

    3. Specify in clear language the preemptive effect, if any, to be given to the regulation,

    4. Specify in clear language the effect, if any, on existing Federal law or regulation, including all provisions repealed, circumscribed, displaced, impaired, or modified,

    5. Specify in clear language the retroactive effect, if any, to be given to the regulation,

    6. Specify whether administrative proceedings are to be required before parties may file suit in court and, if so, describe those proceedings and any requirement of the exhaustion of administrative remedies, and

    7. Define key terms used in regulations, either explicitly or by reference to other regulations or statutes that explicitly define those items.

32.1.4.2  (08-11-2004)
Outlining a Regulation before Drafting

  1. An outline is not required but outlining may help structure the regulation into manageable pieces. Additionally, an outline enables the drafter to visualize different ways to organize a regulation without the burden of editing text. For example, an initial outline may organize a regulation in the same sequence as the corresponding Internal Revenue Code section, and a later outline might show that the regulation is shorter and clearer if organized by the type of taxpayer affected.

  2. The drafting team should consider the following general guidelines:

    1. Place general provisions before specific provisions,

    2. Place more important provisions before less important provisions,

    3. Place more frequently used provisions before less frequently used provisions,

    4. Place permanent provisions before interim, transitional, and "grand-fathered" provisions, and

    5. Place technical "housekeeping" provisions, usually including the applicability date and transition rules, at the end.

    Example 1: An initial outline may reveal that the organization of the regulation results in too many levels of subtopics. Before drafting any text, the drafting team should correct this problem by breaking a large section into two smaller sections. This eliminates the lowest levels.

    THIS NOT THIS
    -1 VOLUNTARY PRODUCTION OF RECORDS

    -2 INVOLUNTARY PRODUCTION OF RECORDS

    (a) Summons
    (1) Courts that can approve issuance
    (2) Ex parte proceedings
    (i) Notice after proceeding
    (ii) Special court approval
    (b) District conference
    (c) Appellate conference
    -1 PROCEDURE FOR PRODUCING RECORDS

    (a) Voluntary basis
    (b) Involuntary basis
    (1) Summons
    (i) Courts that can approve issuance
    (ii) Ex parte proceedings
    (A) Notice after proceeding
    (B) Special court approval
    (2) District conference
    (3) Appellate conference

    Example 2: The initial outline may reveal that the organization of the regulation is lopsided. The drafting team should combine sections that are too small or divide sections that are too large.

    THIS NOT THIS
    New (a)(1) portion of old (a)(1)
     (2) portion of old (a)(1)
     (3) portion of old (a)(1)
     (4) portion of old (a)(1)
      etc.

    New (b)(1) old (a)(2)
     (2) old (a)(3)
     (3) old (a)(4)
     (4) old (a)(5)

    New (c) old (b)
    (a)(1) 5 pages
    (2) 4 lines
    (3) 14 lines
    (4) 6 lines
    (5) 5 lines
    (b) 1 page

32.1.4.3  (08-11-2004)
Draft Identification Block

  1. Until a regulation is put in signature package, the regulation should include the draft identification block on the first three lines of the first page of every draft, flush at the left margin.

  2. The draft identification block includes:

    • The type of draft (precirculation or circulation) and the draft date

    • The project number

    • The drafter's organization, branch number, and name

    Example:


    Circulation draft of 10-31-2002
    REG-123456-02
    PA:APJP:2:JOAttorney

32.1.4.4  (08-11-2004)
Drafting

  1. The drafting team should consider the following when drafting the text of regulations:

    1. Be precise; avoid legalese; to the extent possible, use singular nouns and pronouns; use the active voice; use gender-neutral terms; use short, simple sentences and brief paragraphs

    2. Do not use "i.e.," "e.g.," "shall," "such," "herein," "thereunder," "hereinafter," "above," or "below." Use "for example," "must," "that," and "in this paragraph" and "in this section" ..

32.1.4.4.1  (08-11-2004)
Organizing General Rules and Exceptions (Stop Sign Format)

  1. The drafting team should place the general rule before exceptions and special rules. This is referred to as a "stop sign format." For the stop sign format to work, the general rule must contain a cross-reference to the exceptions or special rules and a statement about the scope of those rules.

  2. Writing a regulation using the stop sign format may reduce the complexity of a long regulation. This format allows the reader to determine if the exceptions or special rules apply without reading the entire regulation.

    Example:

    If an additional set of complex requirements applies to a corporation with assets or gross receipts that exceed particular thresholds:

    THIS NOT THIS
     Additional rules apply to corporations with assets that exceed [threshold 1] or gross receipts that exceed [threshold 2]. See [cross-reference to later rules].  For additional rules applicable to certain large corporations, see [cross-reference to later rules].

32.1.4.4.2  (08-11-2004)
Using a Logical Organization

  1. After developing a particular rule and any exceptions, the drafting team should review the rule to ensure that the organization is logical.

    Example:

    THIS NOT THIS
     A taxpayer receives tax result [X] if:
    1. The taxpayer [condition 1];

    2. The taxpayer [condition 2]; and

    3. [condition 3].

     A taxpayer that [condition 1] receives tax result [X] if the taxpayer [condition 2], provided that [condition 3].

32.1.4.4.3  (08-11-2004)
Incorporating Material from an Existing Regulation

  1. A new regulation may incorporate rules in an existing regulation. For example, a new regulation might provide that, "For purposes of making this determination, the provisions of §1.XXX-X(a)(5) apply."

  2. If a new regulation will not incorporate all the rules of another regulation section, the drafting team should specify the exception with language such as, "However, the rule in §1.XXX-X(a)(5)(iii) (include general description) does not apply." If the new regulation will add to the incorporated rules, the drafting team should note the addition with language such as, "In addition, the following special rule applies to returns described in §1.XXX-5 (include general description)."

  3. The drafting team should not use internal incorporation if changes to the incorporated provisions are needed to conform them to the new regulation. For example, do not incorporate an S corporation rule into a partnership provision by stating, "Substitute 'partnership' for 'S corporation' each place that it appears."

  4. The drafting team should be aware that any future changes to incorporated existing regulations will automatically affect the new regulation. For example, if §1.XXX-1 incorporates material from §1.XXX-5, an amendment to §1.XXX-5 will also amend §1.XXX-1.

32.1.4.4.4  (08-11-2004)
Using Cross References

  1. A cross-reference refers to rules in another part of a regulation or in a separate regulation. The drafting team should explain the cross-reference, usually with an identifying parenthetical. For example, a cross-reference to §1.382-1 might be explained with: (limitation on net operating losses and built-in losses of a corporation following an ownership change). Similarly, a cross-reference to another part of the regulation that provides an exception might read as follows, "Except as otherwise provided in paragraph (b)(3) of this section (relating to the de minimis exception), this section is effective January 1, 2003."

32.1.4.4.5  (08-11-2004)
Definitions

  1. If a regulation repeatedly uses words that need to be defined, the drafting team should define the words in a separate paragraph or section, usually at the beginning of the regulation.

  2. The drafting team should not define ordinary words used in their usual dictionary meaning. If a term is rarely used, it does not need to be separately defined. Instead, the drafting team should consider replacing the term with specific explanatory language in the few places it appears.

  3. The drafting team should not include operative rules within definitions.

    THIS NOT THIS
    1. Tax on sales. A tax is imposed on each sale of an alcoholic beverage.

    2. Definition. For purposes of this section, alcoholic beverage means beer and wine.

    1. Definition. For purposes of this section, alcoholic beverage means beer and wine. A tax is imposed on each sale of an alcoholic beverage.

  4. In the definition section of a regulation, the drafting team should underline the terms defined. Do not put the term in quotation marks. Only underline the term the first time when it is being defined. The drafting team should use "means" or "is" in definitional sentences. For example, "The term qualified individual means any natural person who..."

  5. If a regulation contains a series of definitions, the definitions may be listed in alphabetical order in a separate section or paragraph and need not be individually designated. The drafting team should begin each definition with the term being defined. If a definition has lower level paragraphs, the drafting team should designate those paragraphs based on the designation of the overall definitional section.

    Example:
      (b) Definitions.
    Employee means a person who—
    (1) [TEXT]; and
    (2) [TEXT]
    Employer means...
    Taxable year means...

  6. Use the following instructional paragraph to add a new definition to an alphabetical series:

    Example:
       Par. 2. In §1.XXX-2, paragraph (b) is amended by adding a new definition in alphabetical order to read as follows:
    §1.XXX-2 [HEADING OF REGULATION].
    * * * * *
     (b) Definitions.
    Employee means a person who—
     (1) [TEXT]; and
     (2) [TEXT]

32.1.4.4.6  (08-11-2004)
Using Handles and Acronyms

  1. The drafting team should use handles as a substitute for long, unwieldy phrases that are used repeatedly. For example, the phrase: "the amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or possession of the United States with respect to foreign mineral income from sources within that country or possession," might be substituted with a handle, such as "(foreign mineral income taxes)" after the second use of the word "possession."

  2. Acronyms also keep the regulation text clean. For example, ozone-depleting chemicals becomes ODCs, voluntary employees’ beneficiary association becomes VEBA, and foreign oil related income becomes FORI.

  3. The drafting team should assign a handle or acronym when a phrase or term is first used in the regulation. The drafting team should spell out the handle or acronym in parentheses without quotation marks following the phrase or term for which it will substitute.

32.1.4.4.7  (08-11-2004)
Examples

  1. The drafting team may use examples in the regulation to illustrate specific provisions of the regulation. It is not necessary to set forth all the facts that form the basis for an example’s conclusion. Instead, the drafting team should provide only the facts necessary to illustrate the pertinent rule and include intermediate legal conclusions as assumed facts. The drafting team should then provide the legal analysis the example is meant to illustrate. An example cannot be the source of a rule.

  2. Examples follow a specified format. The drafting team should begin the paragraph containing one or more examples with a brief introductory text. Single-space the text of an example. If an example has more than one paragraph, the drafting team should designate each paragraph. If there is only one example, use the heading "Example." . If there are multiple examples, number the headings " Example 1." , "Example 2. " , etc. Descriptive titles should be used to assist the reader whenever possible.

  3. For computations, the drafting team should use the percent sign "%" , the dollar sign "$" , and the multiplication sign "x" . The drafting team should use letters of the alphabet, rather than proper names, to designate taxpayers. Use different portions of the alphabet for different types of taxpayers. For example, A, B, and C for three individuals, and X and Y for two corporations.

  4. For a series of examples relying on a common set of facts, the drafting team may provide the facts before beginning the examples. The drafting team may also instruct the reader in an example to assume the same facts, with modifications, as in the previous example.

  5. If using a numbering system in an example, the drafting team should begin with (i) and progress as follows:

    • (i), (ii), (iii), etc.

    • (A), (B), (C), etc.

    • (1), (2), ( 3), etc.

    • (i), (ii), ( iii), etc.

  6. The drafting team should identify the first line of each numbering level used in an example and should avoid using multiple numbering levels in examples whenever possible.

    Example 1:

     
       (g) Examples. The following examples illustrate the rules of this section:
      Example 1. No qualified intermediary. (i) A uses the calendar year as the taxable year and the cash receipts and disbursements method of accounting...
       (ii) Under the agreement, B must deposit cash into the qualified escrow account equal to the agreed upon fair market...
      Example 2. Qualified intermediary . (i) The facts are the same as in Example 1, except that the agreement between A and B requires B to pay $100,000 to a qualified intermediary (QI)...
       (ii) QI deposits the $100,000 received from B into a qualified escrow account, the $100,000 is invested in a...

    Example 2:

     
       (4) Examples. The rules of this paragraph (h) are illustrated by the following examples in which X is an S corporation owned 50% by A and 50% by A’s brother B:

32.1.4.4.8  (08-11-2004)
Special Formats

  1. The various types of special formats used in drafting regulatory text are discussed separately in this subsection.

32.1.4.4.8.1  (08-11-2004)
Table of Contents

  1. A table of contents lists the caption headings in the regulation. The drafting team should designate the table of contents as paragraph (a) if there is one regulation section. If there are multiple regulation sections, or multiple sections are anticipated, the drafting team should designate the table of contents as section -0.

  2. The drafting team should start the table of contents with undesignated introductory text identifying the table of contents. The table of contents appears flush left, single-spaced. All paragraph headings end with a period. The drafting team should not underline paragraph headings. It is not necessary to include every paragraph level in the table of contents, but the drafting team must be consistent from section to section.

    Example:
       Par. 2. Section 52.4681-0 is amended as follows:
     1. The introductory text is revised.
     2. Entries are added for §52.4682-5.
     The revision and addition read as follows:
    §52.4681-0 Table of contents.
     This section lists the table of contents for §§52.4681-1 through 52.4681-5.
    * * * * *
      §52.4681-5 Exports.
     
    (a) Overview.
    (b) Exemption or partial exemption from tax.
    (1) In general.
    (2) Tax imposed if exemption amount exceeded.
    (i) Post-1989 ODCs.
    (ii) Post-1990 ODCs.
    (3) Mixtures.
    (c) Exemption amount.
    (d) Effective date.

32.1.4.4.8.2  (08-11-2004)
Lists

  1. The drafting team should begin each list with introductory material identifying the list.

  2. If the introductory material ends in a complete sentence, the drafting team should end the introduction with a colon and end each item in the list with a period.

  3. If the introductory material ends in an incomplete sentence, the drafting team should end the introduction with two dashes (no space between the dashes and no space between the last word of the introduction and the dashes) and end each item in the list (except the last one) with a semicolon. After the last semicolon use "and" or "or" and end the last item in the list with a period. Flush language is not allowed at the end of the list.

    Example 1:
       (iii) Examples of capital service costs. Costs incurred in the following departments or functions are generally allocated among production or resale activities:
       (A) The administration and coordination of production or resale activities (wherever performed in the business organization of the taxpayer).
       (B) Personnel operation, including the cost of recruiting, hiring, relocation, assigning, and maintaining personnel records or employees.
       (C) Purchasing operations, including purchasing materials and equipment, scheduling and coordinating delivery of materials and equipment to or from factories or job sites, and expediting and follow-up.

    Example 2:
       (a) In general. An escrow account, trust, or fund that is not a qualified settlement fund is a disputed ownership fund if—
       (1) It is established to hold money or property subject to conflicting claims of ownership;
       (2) The fund is subject to the continuing jurisdiction of a court; and
       (3) Money or property cannot be paid or distributed from the fund to, or on behalf of, a claimant or transferor without the approval of the court.

32.1.4.4.8.3  (08-11-2004)
Titles of Forms, Publications, and Notices

  1. A regulation may refer to a form, publication, or notice. The drafting team should include the title of the item when first discussed in the preamble and first discussed in each regulation section amended. The drafting team should place the title in quotation marks, offset by commas.

    Example:

    If the taxpayer timely files Form 3115, "Application for Change in Accounting Method," . . . the Form 3115 will be . . .

32.1.4.4.8.4  (08-11-2004)
Citations

  1. The drafting team should set out citations in parentheses.

    Examples:
      Paperwork Reduction Act (44 U.S.C. 3504(h))
      Taxpayer Relief Act of 1997, Public Law 105-34 (11 Stat. 788, 955 (1997))
      Notice 97-65 (1997-2 C.B. 326 (December 22, 1997)), (see §601.601(d)(2)(ii)(b) of this chapter)
      Rev. Proc. 81-46 (1981-2 C.B. 621), (see §601.601(d)(2)(ii)(b) of this chapter)

32.1.4.4.8.5  (08-11-2004)
Graphs, Time Lines, Flowcharts, etc.

  1. Regulations may contain graphs, time lines, flowcharts, diagrams, pictures, drawings, formulas, and tables as either substantive rules or examples. The OFR has special printing requirements with respect to documents with graphs, timelines, flowcharts, etc. Documents containing these features may need to be prepared in camera-ready copy. The FRL assigned to the project will help the drafting team prepare the document to meet the OFR requirements.

32.1.4.4.9  (08-11-2004)
Sample Documents

  1. For sample documents, see the following exhibits:

    • Exhibit 32.1.4-2, Sample ANPRM

    • Exhibit 32.1.4-3, Sample NPRM

    • Exhibit 32.1.4-4, Sample NPRM By Cross-Reference To Temporary Regulation

    • Exhibit 32.1.4-5, Sample Temporary Regulation

    • Exhibit 32.1.4-6, Sample Final Regulation

    • Exhibit 32.1.4-7, Sample NPRM By Cross-Reference To Temporary Regulations That Amend Existing Final Regulations

    • Exhibit 32.1.4-8, Sample Existing Final Regulations Amended By Temporary Regulations

Exhibit 32.1.4-1 
Regulation Checklist

REGULATION CHECKLIST
Task Complete Date
RIN  
7 Point Memo  
  ANPRM:  
  NPRM:  
  TEMP:  
Copy to Federal Register Liaison  
Green Version (via email)  
  Comments Due  
Signature Package  
  Chief Counsel  
  Commissioner  
  Delivered to Treasury  
  Treasury  
Plain Language Summary  
Submit Regulation to FRL  
Filing and Publication Date Assigned  
Deliver to Publications and Regulations Branch (Room 5203)  
     
  Electronic Delivery to Publication and Regulations Branch by email (removed hidden codes)  
  Form 12971 [Deliver on Date Filed with FR]
  Form 12972 [Deliver on Date Filed with FR]
  Congressional/GAO Submission [Deliver on Date Filed with FR]
Email FILING DATE to: floyd.Williams@irs.gov [on Filing Date]
Email Regulation and PL Summary to the Branch Chief, Senior FRL, and the project's FRL in the Publication and Regulations Branch  
Proofread regulation after publication  
Public Hearing  
  Contact Regulations Unit to schedule  
Assemble Legal File (All Acknowledgement of Receipt forms for the CRA report must be included)  
Final Regulation  
Close File  

Exhibit 32.1.4-2 
Sample Advanced Notice of Proposed Rulemaking (ANPRM)

[4830-01-p]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-125638-01]

RIN 1545-BA00

Guidance Regarding Deduction and Capitalization of Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Advance notice of proposed rulemaking.

SUMMARY: This document describes and explains rules and standards that the IRS and Treasury Department expect to propose in 2002 in a notice of proposed rulemaking that will clarify the application of section 263(a) of the Internal Revenue Code to expenditures incurred in acquiring, creating, or enhancing certain intangible assets or benefits. This document also invites comments from the public regarding these standards. All materials submitted will be available for public inspection and copying.

DATES: Written and electronic comments must be submitted by March 25, 2002.

ADDRESSES: Send submissions to: CC:PALPD:PR (REG-XXXXXX-XX), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PALPD:PR (REG-XXXXXX-XX), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC, or sent electronically, via the IRS Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-XXXXXX-XX).

FOR FURTHER INFORMATION CONTACT: Concerning submissions, Guy Traynor (202) 622-7180; concerning the proposals, Andrew J. Keyso (202) 927-9397 (not tollfree numbers).

SUPPLEMENTARY INFORMATION:

   The IRS and Treasury Department are reviewing the application of section 263(a) of the Internal Revenue Code to expenditures that result in taxpayers acquiring, creating, or enhancing intangible assets or benefits. This document describes and explains rules and standards that the IRS and Treasury Department expect to propose in 2002 in a notice of proposed rulemaking.

   A fundamental purpose of section 263(a) is to prevent the distortion of taxable income through current deduction of expenditures relating to the production of income in future taxable years. See Commissioner v. Idaho Power Co., 418 U.S. 1, 16 (1974). Thus, the Supreme Court has held that expenditures that create or enhance separate and distinct assets or produce certain other future benefits of a significant nature must be capitalized under section 263(a). See INDOPCO. Inc. v. Commissioner, 503 U.S. 79 (1992); Commissioner v. Lincoln Savings & Loan Ass'n, 403 U.S. 345 (1971).

   The difficulty of translating general capitalization principles into clear, consistent, and administrable standards has been recognized for decades. See Welch v. Helvering, 290 U.S. 111, 114-15 (1933). Because courts focus on particular facts before them, the results reached by the courts are often difficult to reconcile and, particularly in recent years, have contributed to substantial uncertainty and controversy. The IRS and Treasury Department are concerned that the current level of uncertainty and controversy is neither fair to taxpayers nor consistent with sound and efficient tax administration

   Recently, much of the uncertainty and controversy in the capitalization area has related to expenditures that create or enhance intangible assets or benefits. To clarify the application of section 263(a), the forthcoming notice of proposed rulemaking will describe the specific categories of expenditures incurred in acquiring, creating, or enhancing intangible assets or benefits that taxpayers are required to capitalize. In addition, the forthcoming notice of proposed rulemaking will recognize that many expenditures that create or enhance intangible assets or benefits do not create the type of future benefits for which capitalization under section 263(a) is appropriate, particularly when the administrative and record keeping costs associated with capitalization are weighed against the potential distortion of income.

   To reduce the administrative and compliance costs associated with section 263(a), the forthcoming notice of proposed rulemaking is expected to provide safe harbors and simplifying assumptions including a "one-year rule," under which expenditures relating to intangible assets or benefits whose lives are of a relatively short duration are not required to be capitalized, and "de minimis rules," under which certain types of expenditures less than a specified dollar amount are not required to be capitalized. The IRS and Treasury Department are also considering additional administrative relief, for example, by providing a "regular and recurring rule," under which transaction costs incurred in transactions that occur on a regular and recurring basis in the routine operation of a taxpayer's trade or business are not required to be capitalized.

   The proposed standards and rules described in this document will not alter the manner in which provisions of the law other than section 263(a) (e.g., sections 195, 263(g), 263(h), or 263A) apply to determine the correct tax treatment of an item. Moreover, these standards and rules will not address the treatment of costs other than those to acquire, create, or enhance intangible assets or benefits, such as costs to repair or improve tangible property. The IRS and Treasury Department are considering separate guidance to address these other costs.

   The following discussion describes the specific expenditures to acquire, create, or enhance intangible assets or benefits for which the IRS and Treasury Department expect to require capitalization in the forthcoming notice of proposed rulemaking. The IRS and Treasury Department anticipate that other expenditures to acquire, create, or enhance intangible assets or benefits generally will not be subject to capitalization under section 263(a).

A. Amounts Paid to Acquire Intangible Property

1. Amounts paid to acquire financial interests.

   Under the expected regulations, capitalization will be required for an amount paid to purchase, originate, or otherwise acquire a security, option, any other financial interest described in section 1 97(e)(1), or any evidence of indebtedness. For a discussion of related transaction costs see section C of this document.

   For example, a financial institution that acquires portfolios of loans from another person or originates loans to borrowers would be required to capitalize the amounts paid for the portfolios or the amounts loaned to borrowers.

2. Amounts paid to acquire intangible property from another person.

   Under the expected regulations, capitalization will be required for an amount paid to another person to purchase or otherwise acquire intangible property from that person.

   For example, an amount paid to another person to acquire an amortizable section 197 intangible from that person would be capitalized. Thus, a taxpayer that acquires a customer base from another person would be required to capitalize the amount paid to that person in exchange for the customer base. On the other hand, a taxpayer that incurs costs to create its own customer base through advertising or other expenditures that create customer goodwill would not be required to capitalize such costs under this rule.

B. Amounts Paid to Create or Enhance Certain Intangible Rights or Benefits

1. 12-month rule.

   The IRS and Treasury Department expect to propose a 12-month rule applicable to expenditures paid to create or enhance certain intangible rights or benefits. Under the rule, capitalization under section 263(a) would not be required for an expenditure described in the following paragraphs 2 through 8 unless that expenditure created or enhanced intangible rights or benefits for the taxpayer that extend beyond the earlier of (i) 12 months after the first date on which the taxpayer realizes the rights or benefits attributable to the expenditure, or (ii) the end of the taxable year following the taxable year in which the expenditure is incurred.

   The IRS and Treasury Department request comments on how the 12-month rule might apply to expenditures paid to create or enhance rights of indefinite duration and contracts subject to termination provisions. For example, comments are requested on whether costs to create contract rights that are terminable at will without substantial penalties would not be subject to capitalization as a result of the 12-month rule.

2. Prepaid items.

   Subject to the 12-month rule, the IRS and Treasury Department expect to propose a rule that requires capitalization of an amount prepaid for goods, services, or other benefits (such as insurance) to be received in the future.

   For example, a taxpayer that prepays the premium for a 3-year insurance policy would be required to capitalize such amount under the rule.

   Similarly, a calendar year taxpayer that pays its insurance premium on December 1, 2002, for a 12-month policy beginning the following February would be required to capitalize the amount of the expenditure. The 12-month rule would not apply because the benefit attributable to the expenditure would extend beyond the end of the taxable year following the taxable year in which the expenditure was incurred. On the other hand, if the insurance contract had a term beginning on December 15, 2002, the taxpayer could deduct the premium expenditure under the 12-month rule because the benefit neither extends more than 12 months beyond December 15, 2002 (the first date the benefit is realized by the taxpayer) nor beyond the taxable year following the year the expenditure was incurred.

3. Certain market entry payments.

   Subject to the 12-month rule, the IRS and Treasury Department expect to propose a rule that requires capitalization of an amount paid to an organization to obtain or renew a membership or privilege from that organization.

   For example, subject to the 12-month rule, the rule would require capitalization of costs to obtain a stock trading privilege, admission to practice medicine at a hospital, and access to the multiple listing service. The rule does not contemplate requiring capitalization for costs to obtain ISO 9000 certification or similar costs.

4. Amounts paid to obtain certain rights from a governmental agency.

   Subject to the 12-month rule, the IRS and Treasury Department expect to propose a rule that requires capitalization of an amount paid to a governmental agency for a trade name, trademark, copyright, license, permit, or other right granted by that governmental agency.

   For example, under the rule, a restaurant would be required to capitalize the amount paid to a state to obtain a license to serve alcoholic beverages that is valid indefinitely.

5. Amounts paid to obtain or modify contract rights.

   Subject to the 12-month rule, the IRS and Treasury Department expect to propose a rule that requires capitalization of amounts in excess of a specified dollar amount (e.g., $5,000) paid to another person to induce that person to enter into, renew, or renegotiate an agreement that produces contract rights enforceable by the taxpayer, including payments for leases, covenants not to compete, licenses to use intangible property, customer contracts and supplier contracts. The IRS and Treasury Department request comments on whether there are standards other than the standard described above that would be more appropriate for determining whether expenditures related to the creation or enhancement of contractual rights should be capitalized.

   Subject to the 12-month rule, this rule would require a lessee to capitalize an amount paid to a lessor in exchange for the lessor's agreement to enter into a lease. This rule also would require a lessee to capitalize an amount paid to a lessor in exchange for the lessor's agreement to terminate a lease and enter into a new lease. See, e.g., U.S. Bancorp v. Commissioner, 111 T.C. 231 (1998). However, this rule would not require a lessee to capitalize an amount paid to a lessor to terminate a lease where the parties do not enter into a new or renegotiated agreement. This rule also would not require a taxpayer to capitalize a payment that does not create enforceable contract rights but, for example, merely creates an expectation that a customer or supplier will maintain its business relationship with the taxpayer. See, e.g., Van Iderstine Co. v. Commissioner, 261 F.2d 211 (2nd Cir. 1958).

6. Amounts paid to terminate certain contracts.

   Subject to the 12-month rule, the IRS and Treasury Department expect to propose a rule that requires capitalization of an amount paid by a lessor to a lessee to induce the lessee to terminate a lease of real or tangible personal property or by a taxpayer to terminate a contract that grants another person the exclusive right to conduct business in a defined geographic area.

   For example, under the rule, a lessor that pays a lessee to terminate a lease of real property with a remaining term of 24 months would be required to capitalize such payment. See, e.g., Peerless Weighing and Vending Machine Corp. v. Commissioner, 52 T.C. 850 (1969). On the other hand, if the lease had a remaining term of 6 months, the 12-month rule would apply, and the taxpayer would not be required to capitalize the termination payment under the rule.

   As a further example, where a taxpayer grants another person the exclusive right to develop the taxpayer's motel chain in four states, and the taxpayer later pays that other person to terminate such right at a time when the remaining useful life of the right is 5 years, the taxpayer would be required to capitalize the termination payment under the rule. See Rodeway Inns of America v. Commissioner, 63 T.C. 414 (1974).

7. Amounts paid in connection with tangible property owned by another.

   Subject to the 12-month rule, the IRS and Treasury Department expect to propose a rule that requires capitalization of amounts in excess of a specified dollar amount paid to facilitate the acquisition, production, or installation of tangible property that is owned by a person other than the taxpayer where the acquisition, production, or installation of the tangible property results in the type of intangible future benefit to the taxpayer for which capitalization is appropriate. This rule would apply even though there is no contractual relationship between the taxpayer and the other person. This rule is intended to require capitalization of expenditures that produce intangible future benefits similar to those that were in issue in Kauai Terminal Ltd. v. Commissioner, 36 B.T.A. 893 (1937) (expenditure incurred to construct a publicly owned breakwater for the purpose of increasing taxpayer's freight lighterage operation). The IRS and Treasury Department request comments on standards that can be established to ensure that the expenditures described in this rule result in the type of future benefits that are similar to those in Kauai Terminal and therefore should be capitalized.

   The IRS and Treasury Department also request comments on whether safe harbors or dollar thresholds should be used to determine whether capitalization of such expenditures is appropriate under section 263(a).

8. Defense or perfection of title to intangible property.

   Subject to the 12-month rule, the IRS and Treasury Department expect to propose a rule that requires capitalization of amounts paid to defend or perfect title to intangible property.

   For example, under the rule, if a taxpayer and another person both claim title to a particular trademark, the taxpayer must capitalize any amount paid to the other person for relinquishment of such claim. See, e.g., J.J. Case Company v. United States, 32 F.Supp. 754 (Ct. CI. 1940).

C. Transaction Costs

   The IRS and Treasury Department expect to propose a rule that requires a taxpayer to capitalize certain transaction costs that facilitate the taxpayer's acquisition, creation, or enhancement of intangible assets or benefits described above (regardless of whether a payment described in sections A or B of this document is made). In addition, this rule would require a taxpayer to capitalize transaction costs that facilitate the taxpayer's acquisition, creation, restructuring, or reorganization of a business entity, an applicable asset acquisition within the meaning of section 1060(c), or a transaction involving the acquisition of capital, including a stock issuance, borrowing, or recapitalization. However, this rule would not require capitalization of employee compensation (except for bonuses and commissions that are paid with respect to the transaction), fixed overhead (e.g., rent, utilities and depreciation), or costs that do not exceed a specified dollar amount, such as $5,000. The IRS and Treasury Department request comments on how expenditures should be aggregated for purposes of applying the de minimis exception, whether the de minimis exception should allow a deduction for the threshold amount where the aggregate transaction costs exceed the threshold amount, and whether there are certain expenditures for which the de minimis exception should not apply (e.g., commissions).

   The IRS and Treasury Department are considering alternative approaches to minimize uncertainty and to ease the administrative burden of accounting for transaction costs. For example, the rules could allow a deduction for all employee compensation (including bonuses and commissions that are paid with respect to the transaction), be based on whether the transaction is regular or recurring, or follow the financial or regulatory accounting treatment of the transaction. The IRS and Treasury Department request comments on whether the recurring or nonrecurring nature of a transaction is an appropriate consideration in determining whether an expenditure to facilitate the transaction must be capitalized under section 263(a) and, if so, what criteria should be applied in distinguishing between recurring and nonrecurring transactions. In addition, the IRS and Treasury Department request comments on whether a taxpayer's treatment of transaction costs for financial or regulatory accounting purposes should be taken into account when developing simplifying assumptions.

   For example, under the rule described above, a taxpayer would be required to capitalize legal fees in excess of the threshold dollar amount paid to its outside attorneys for services rendered in drafting a 3-year covenant not to compete because such costs facilitated the creation of the covenant not to compete. Similarly, the rule would require a taxpayer to capitalize legal fees in excess of the threshold dollar amount paid to its outside attorneys for services rendered in defending a trademark owned by the taxpayer.

   Conversely, a taxpayer that originates a loan to a borrower in the course of its lending business would not be required to capitalize amounts paid to secure a credit history and property appraisal to facilitate the loan where the total amount paid with respect to that loan does not exceed the threshold dollar amount. The taxpayer also would not be required to capitalize the amount of salaries paid to employees or overhead costs of the taxpayer's loan origination department.

   In addition, the rule would require a corporate taxpayer to capitalize legal fees in excess of the threshold dollar amount paid to its outside counsel to facilitate an acquisition of all of the taxpayer's outstanding stock by an acquirer. See, e.g., INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992). However, the rule would not require capitalization of the portion of officers' salaries that is allocable to time spent by the officers negotiating the acquisition. Cf. Wells Fargo & Co. v. Commissioner, 224 F.3d 874 (8th Cir.2000).

   The rule also would not require capitalization of post-acquisition integration costs or severance payments made to employees as a result of an acquisition transaction because such costs do not facilitate the acquisition.

D. Other Items on Which Public Comment is Requested

1. Other costs of creating, acquiring or enhancing intangible assets or benefits that require capitalization.

   The IRS and Treasury Department are considering what general principles of capitalization should be used to identify the costs of acquiring, creating, or enhancing intangible assets or benefits that should be capitalized under section 263(a) but are not described above. The IRS and Treasury Department anticipate that these general principles will apply in rare and unusual circumstances to require capitalization of costs that are similar to those described above. Comments are requested on capitalization principles (for example, a separate and distinct asset test or a significant future benefit test) that can be used to identify other costs that should be capitalized under section 263(a) and the administrability of such principles. The IRS and Treasury Department also request comments on other categories of costs associated with intangible assets or benefits that should be capitalized under section 263(a), but are not described above.

2. Book-Tax conformity.

   The IRS and Treasury Department request comments on whether there are types of expenditures other than those discussed above for which the taxpayer's treatment for financial or regulatory accounting purposes should be taken into account in determining the treatment for federal income tax purposes or to simplify tax reporting.

3. Amortization periods.

   Certain intangibles have readily ascertainable useful lives that can be determined with reasonable accuracy, while others do not. The IRS and Treasury Department expect to provide safe harbor recovery periods and methods for certain capitalized expenditures that do not have readily ascertainable useful lives. Comments are requested regarding whether guidance should provide one uniform period or multiple recovery periods and what the recovery periods and methods should be.

4. De minimis rules.

   The IRS and Treasury Department request comments on whether there are types of expenditures other than those discussed above for which it would be appropriate to prescribe de minimis rules that would not require capitalization under section 263(a). If there are such categories or thresholds, comments are requested on how expenditures would be aggregated in applying these de minimis rules.

5. Costs of Software.

   The IRS and Treasury Department request comments on what rules and principles should be used to distinguish acquired software from developed software and the administrability of those rules and principles. See Rev. Proc. 2000-50, 2000-2 C.B. 601.

 
 
Deputy Commissioner for Services and Enforcement.

Exhibit 32.1.4-3 
Sample Notice of Proposed Rulemaking (NPRM)

[4830-01-p]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-121063-97]

RIN 1545-AX01

Averaging of Farm Income

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations for averaging farm income under section 1301 of the Internal Revenue Code. The regulations reflect the enactment of the provision by the Taxpayer Relief Act of 1997, as amended by the Omnibus Consolidated and Emergency Supplemental Appropriations Act, 1999. The regulations provide guidance to individuals engaged in a farming business who may elect to reduce their regular tax liability by treating all or a portion of the current year's farming income as if it had been earned in equal proportions over the prior three years. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by February 15, 2000. Requests to speak and outlines of topics to be discussed at the public hearing scheduled for April 13, 2000, must be received by January 14, 2000.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-XXXXXX-XX), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be handdelivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-XXXXXX-XX), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC, or sent electronically via the IRS Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-XXXXXX-XX). The public hearing will be held in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Avenue, N.W., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, John M. Moran, at (202) 622-4940j concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Guy Traynor, at (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

   This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) for averaging farm income under section 1301 of the Internal Revenue Code (Code). Section 1301 was enacted by section 933 of the Taxpayer Relief Act of 1997, Public Law 105-34 (111 Stat. 788) (the TRA of 1997), effective for taxable years beginning after December 31, 1997, and ending before January 1, 2001. Section 2011 of the Tax and Trade Relief Extension Act of 1998, which is part of the Omnibus Consolidated and Emergency Supplemental Appropriations Act, 1999, Public Law 105-277, 112 Stat. 2681, amended section 933 of the TRA of 1997 by deleting the January 1, 2001 ending date.

   Section 1301(c) authorizes the Secretary to prescribe regulations as may be appropriate to carry out the purposes of this section, including regulations regarding (1) the order and manner in which items of income, gain, deduction, or loss, or limitations on tax, shall be taken into account in computing the tax imposed by chapter 1 (Normal Taxes and Surtaxes) of subtitle A (Income Taxes) of the Code on the income of any taxpayer to whom this section applies for any taxable year, and (2) the treatment of any short taxable year.

Explanation of Provisions

I. In General

   Under section 1301, an individual may elect to compute the section 1 tax for the current taxable year by designating all or a portion of the individual's farm income (subject to certain limitations) as elected farm income, and subtracting it from taxable income. One-third of the elected farm income is allocated to each of the three prior years' taxable income and the increase in the section 1 tax that results from these additions is calculated. The prior years are referred to as base years. The tax for the current year is the sum of (1) the section 1 tax for the current year without the elected farm income and (2) the increase in the section 1 tax for the three base years that is attributable to elected farm income.

II. Engaged in a Farming Business

   The proposed regulations provide that the term farming business has the same meaning as provided in section 263A(e) (4) and the regulations thereunder. The proposed regulations also provide that an individual engaged in a farming business includes a sole proprietor of a farming business, a partner of a partnership engaged in a farming business, and a shareholder of an S corporation engaged in a farming business.

III. Making, Changing, or Revoking an Election

   The proposed regulations provide that a farm income averaging election is made by filing Schedule J, Farm Income Averaging, with an individual's timely filed Federal income tax return (including extensions). In general, the proposed regulations provide that if an individual has an adjustment for an election year or base year, the individual may also make a late farm income averaging election or change or revoke a previous election. An adjustment is any change in taxable income or tax liability that is permitted to be made by filing an amended Federal income tax return, or a change in taxable income or tax liability resulting from an IRS examination. If there is no adjustment for an election year or a base year, a late election, change, or revocation may be made only with the consent of the Commissioner. The IRS and the Treasury Department anticipate that the Commissioner's consent will be obtained by requesting a letter ruling from the national office.

IV. Calculation of Section 1 Tax

   Farm income averaging allocates one-third of elected farm income from an election year to each of the base years only for the purpose of calculating the section 1 tax attributable to the elected farm income allocated to each base year. The proposed regulations provide that the section 1 tax for the election year is determined by allocating elected farm income to the base years only after all other adjustments and determinations have been made. For example, any net operating loss carryover is applied to an election year before allocating elected farm income to the base years.

   The regulations provide that the allocation of elected farm income to the base years does not affect any determination (other than the calculation of the section 1 tax attributable to the elected farm income) with respect to the election year or the base years. Thus, for example, in applying the section 68 overall limitation on itemized deductions to the election year, adjusted gross income for the election year includes any elected farm income allocated to the base years. Similarly, the section 68 limitation for a base year is not recomputed to take into account any allocation of elected farm income to such base year.

   The proposed regulations provide that calculation of the section 1 tax on elected farm income allocated to a base year is made without any additional adjustments or determinations with respect to that year. For example, if a base year had a partially used capital loss, the remaining capital loss may not be applied to reduce the elected farm income allocated to such year. Similarly, if a base year had a partially used credit, the remaining credit may not applied to reduce the section 1 tax attributable to the elected farm income allocated to such year.

V. Elected Farm Income

   The proposed regulations provide that farm income includes all income, deductions, gains, and losses attributable to an individual's farming business. An individual may designate what type, and how much of each type, of farm income is to be treated as elected farm income. The elected farm income may not exceed an individual's taxable income. In addition, elected farm income from net capital gain attributable to a farming business may not exceed total net capital gain. One-third of each type of elected farm income is then allocated to each base year.

Proposed Effective Date

   The regulations, as proposed, apply to any taxable period ending on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. However, the rules in these proposed regulations may be relied on by individuals for taxable periods ending before the publication of the Treasury decision.

Special Analyses

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

Comments and Public Hearing

   Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. In addition, comments are specifically requested regarding whether wages paid to a shareholder of an S corporation may be electible farm income. All comments will be available for public inspection and copying.

   A public hearing has been scheduled for February 15, 2000, beginning at 10 a.m. in room 2615 of the Internal Revenue Building, 1111 Constitution Avenue, N.W., Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the "FOR FURTHER INFORMATION CONTACT" section of this preamble.

   The rules of 26 CFR 601.601(a) (3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit written or electronic comments and an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by January 14, 2000. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

   The principal author of these regulations is John M. Moran, Office of Associate Chief Counsel (Income Tax and Accounting) . However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

   Income taxes, Reporting and recordkeeping requirements.

Proposed Amendment to the Regulations

   Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1-- INCOME TAXES

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

   Authority: 26 U.S.C. 7805 * * *

   Section 1.1301-1 also issued under 26 U.S.C. 1301(c). * * *

   Par. 2. An undesignated centerheading and §1.1301-1 are added immediately following the center heading "Readjustment of Tax Between Years and Special Limitations" to read as follows:

 
INCOME AVERAGING

§1.1301-1 Averaging of farm income.

   (a) Overview. An individual engaged in a farming business may elect to compute his or her current year (election year) income tax liability under section 1 by averaging, over the prior three-year period (base years), all or a portion of the individual's current year electible farm income (as defined in paragraph (e) of this section). To average farm income, the individual-

   (1) Designates all or a portion of his or her electible farm income for the election year as elected farm income;

   (2) Allocates one-third of the elected farm income to each of the three base years; and

   (3) Determines the election year section 1 tax by determining the sum of-

   (i) The election year section 1 tax without regard to the elected farm income; plus

   (ii) For each base year, the increase in section 1 tax attributable to the elected farm income allocated to such year.

   (b) Individual engaged in a farming business. Farming business has the same meaning as provided in section 263A(e) (4) and the regulations thereunder. An individual engaged in a farming business includes a sole proprietor of a farming business, a partner in a partnership engaged in a farming business, and a shareholder of an S corporation engaged in a farming business. An individual is not required to have been engaged in a farming business in any of the base years in order to make a farm income averaging election.

   (c) Making, changing, or revoking an election--(i) Making an election. A farm income averaging election is made by filing Schedule J, Farm Income Averaging, with an individual's timely filed (including extensions) Federal income tax return for the election year.

   (2) Making a late election, or changing or revoking an election--(i) Adjustments in an election or base year. An individual who has an adjustment for an election year or any base year may make a late farm income averaging election, change the amount of elected farm income in a previous election, or revoke a previous election, if the period of limitation on filing a claim for credit or refund has not expired for the election year. For purposes of this paragraph (c) (2), an adjustment is any change in taxable income or tax liability that is permitted to be made by filing an amended Federal income tax return or a change in taxable income or tax liability made as the result of an IRS examination.

   (ii) No adjustment. If an individual does not have an adjustment described in paragraph (c) (1) (i) of this section, the individual may not make a late farm income averaging election, change the amount of elected farm income in a previous election, or revoke a previous election, without the consent of the Commissioner.

   (d) Calculation of section 1 tax--(1) In general. The section 1 tax for the election year is determined by allocating elected farm income to the base years only after all other adjustments and determinations have been made. For example, any net operating loss (NOL) carryover or net capital loss carryover is applied to an election year before allocating elected farm income to the base years. Similarly, the determination of whether there is a net section 1231 gain or loss in the election year and the determination of the character of the section 1231 items are made before allocating elected farm income to the base years. The allocation of elected farm income to the base years does not affect any determination (other than the calculation of the section 1 tax attributable to the elected farm income) with respect to the election year or the base years. Thus, for example, in applying the section 68 overall limitation on itemized deductions to the election year, adjusted gross income for the election year includes any elected farm income allocated to the base years. Similarly, the section 68 limitation for a base year is not recomputed to take into account any allocation of elected farm income to such base year. The calculation of the section 1 tax on elected farm income allocated to a base year is made without any additional adjustments or determinations with respect to such year. For example, if a base year had a partially used capital loss, the remaining capital loss may not be applied to reduce the elected farm income allocated to such year. Similarly, if a base year had a partially used credit, the remaining credit may not applied to reduce the section 1 tax attributable to the elected farm income allocated to such year.

   (2) Base year was previously an election year or another base year. If a base year for a current farm income averaging election was previously an election year for another farm income averaging election, the base year's section 1 tax is determined after reducing the base year's taxable income by the elected farm income for that prior election year. If a base year for a current farm income averaging election was previously a base year for another farm income averaging election, the base year's section 1 tax is determined after increasing the base year's taxable income by the elected farm income allocated to that year by that prior election.

   (3) Example. The rules of paragraph (d) (2) of this section are illustrated by the following example:

   Example. (i) In each of years 1996, 1997, and 1998, Thad of $20,000. In 1999, T had taxable income of $30,000 (prior to any farm income averaging election) and electible farm income of $10,000. T makes a farm income averaging election with respect to $9,000 of his electible farm income for 1999. Thus, $3,000 of elected farm income is allocated to each of years 1996, 1997, and 1998. T's 1999 tax liability is the sum of--

   (A) The section 1 tax on $21,000 (1999 taxable income minus elected farm income); plus

   (B) For each of years 1996, 1997, and 1998, the section 1 tax on $23,000 minus the section 1 tax on $20,000 (the increase in section 1 tax attributable to the elected farm income allocated to such year).

   (ii) In 2000, T has taxable income of $50,000 and electible farm income of $12,000. T makes a farm income averaging election with respect to all $12,000 of his electible farm income for 2000. Thus, $4,000 of elected farm income is allocated to each of years 1997, 1998, and 1999. T's 2000 tax liability is the sum of--

   (A) The section 1 tax on $38,000 (2000 taxable income minus elected farm income); plus

   (B) For each of years 1997 and 1998, the section 1 tax on $27,000 minus the section 1 tax on $23,000 (the increase in section 1 tax attributable to the elected farm income allocated to such years after increasing such years' taxable income by the elected income allocated to such year by the 1999 farm income averaging election); plus

   (C) For year 1999, the section 1 tax on $25,000 minus the section 1 tax on $21,000 (the increase in section 1 tax attributable to the elected farm income allocated to such year after reducing such year's taxable income by the 1999 elected farm income) .

   (e) Electible farm income--(1) Identification of items attributable to a farming business--(i) In general. Farm income includes items of income, deduction, gain, and loss attributable to the individual's farming business. Farm losses include a NOL carryover or carryback, or a net capital loss carryover, to an election year that is attributable to a farming business. Income, gain or loss from the sale of development rights, grazing rights, and other similar rights is not treated as attributable to a farming business. Farm income does not include wages.

   (ii) Gain or loss on sale or other disposition of property--(A) In general. Gain or loss from the sale or other disposition of property (other than land, but including a structure affixed to the land) that was regularly used in the individual's farming business for a substantial period of time is treated as attributable to a farming business. Whether property was regularly used for a substantial period of time depends on all of the facts and circumstances.

   (B) Cessation of a farming business. If gain or loss described in paragraph (e) (1) (ii) (A) of this section is realized after cessation of a farming business, such gain or loss is treated as attributable to a farming business if the property is sold within a reasonable time after cessation of the farming business. A sale or other disposition within one year of cessation of the farming business is presumed to be within a reasonable time. Whether a sale or other disposition that occurs more than one year after cessation of the farming business is within a reasonable time depends on all of the facts and circumstances.

   (2) Determination of amount that may be elected farm income --(i) Electible farm income. The maximum amount of income that an individual may elect to average (electible farm income) is the sum of any farm income and gain minus any farm deductions or losses (including loss carryovers and carrybacks) that are allowed as a deduction in computing the individual's taxable income. However, electible farm income may not exceed taxable income. In addition, electible farm income from net capital gain attributable to a farming business cannot exceed total net capital gain. An individual who has both ordinary and net capital gain farm income may elect (up to electible farm income) any combination of such ordinary and net capital gain farm income.

   (ii) Examples. The rules of paragraph (e) (2) (i) of this section are illustrated by the following examples:

   Example 1—. A has farm gross receipts of $200,000 and farm ordinary deductions of $50,000. A's taxable income is $150,000 ($200,000—$50,000). A's electible farm income is $150,000, all of which is ordinary income.

   Example 2. B has ordinary farm income of $200,000 and nonfarm losses of $50,000. B's taxable income is $150,000 ($200,000—$50,000). B's electible farm income is $150,000, all of which is ordinary income.

   Example 3. C has a farm capital gain of $50,000 and a nonfarm capital loss of $40,000. C also has ordinary farm income of $60,000. C has taxable income of $70,000 ($50,000—$40,000+$60,000). C's electible farm income is $70,000. C can elect up to $10,000 of farm capital gain and up to $60,000 of farm ordinary income.

   Example 4. D has a nonfarm capital gain of $40,000 and a farm capital loss of $30,000. D also has ordinary farm income of $100,000. D has taxable income of $110,000 ($40,000—$30,000+$100,000). D's electible farm income is $100,000 ordinary farm income minus $30,000 farm capital loss, or $70,000, all of which is ordinary income.

   Example 5. E has a nonfarm capital gain of $20,000 and a farm capital loss of $30,000. E also has ordinary farm income of $100,000. E has taxable income of $97,000 ($20,000—$23,000 +$100,000). E has a farm capital loss carryover of $7,000 ($30,000—$23,000 allowed as a deduction). E's electible farm income is $100,000 ordinary farm income minus $23,000 farm capital loss, or $77,000, all of which is ordinary income.

   (f) Miscellaneous rules--(1) Short taxable year--(i) In general. If a base year or an election year is a short taxable year, the rules of section 443 and the regulations thereunder apply for purposes of calculating the section 1 tax.

   (ii) Base year is a short taxable year. If a base year is a short taxable year, the increase in section 1 tax attributable to the elected farm income allocated to such year is determined after the taxable income for such year has been annualized.

   (iii) Election year is a short taxable year. If an election year is a short taxable year, any elected farm income is first annualized before being allocated to the base years. The increase in section 1 tax attributable to the elected farm income allocated to the base years is the same part of the tax computed on an annual basis as the number of months in the short election year is of 12 months.

   (2) Changes in filing status. An individual is not prohibited from making a farm income averaging election solely because the individual's filing status is not the same in an election year and the base years. For example, an individual who files married filing jointly in the election year, but filed as single in all of the base years, may still elect to average farm income.

   (3) Employment tax. A farm income averaging election has no effect in determining the amount of wages for purposes of the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and the Collection of Income Tax at Source on Wages (Federal income tax withholding), or the amount of net earnings from self-employment for purposes of the Self-Employment Contributions Act (SECA).

   (4) Alternative minimum tax. A farm income averaging election does not apply for purposes of determining the section 55 alternative minimum tax in the election year or any base year. However, an election will apply for purposes of determining the regular tax under sections 53(c) and 55(c).

   (5) Unearned income of minor child. In an election year, if a minor child's investment income is taxable under section 1(g) and a parent makes a farm income averaging election, the tax rate used for purposes of applying section 1(g) is the rate determined after application of the election. With respect to a base year, however, the tax on a minor child’s investment income is not affected by a farm income averaging election.

   (g) Effective date. The rules of this section apply to taxable years ending on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

 
 
Deputy Commissioner for Services and Enforcement.

Exhibit 32.1.4-4 
Sample Notice of Proposed Rulemaking by Cross-Reference to Temporary Regulation

[4830-01-p]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-120168-97]

RIN 1545-AW73

Preparer Due Diligence Requirements for Determining Earned Income Credit Eligibility

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking by cross-reference to temporary regulations and notice of public hearing.

SUMMARY: In the Rules and Regulations section of this issue of the Federal Register, the IRS is issuing temporary regulations relating to the due diligence requirements in determining eligibility for the earned income credit for paid pre parers of federal income tax returns or claims for refund. The text of those regulations also serves as the text of these proposed regulations. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by March 22,1999. Outlines of topics to be discussed at the public hearing scheduled for Thursday, May 20, 1999, at 10 a.m. must be received by Thursday, April 29, 1999.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-XXXXXX-XX), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-XXXXXX-XX), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC, or sent electronically, via the IRS Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-XXXXXX-XX).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Marc C. Porter, (202) 622-4940; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, LaNita Van Dyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

   Temporary regulations in the Rules and Regulations section of this issue of the Federal Register amend the Income Tax Regulations (26 CFR part 1) relating to section 6695. The temporary regulations set forth due diligence requirements that paid preparers of federal income tax returns or claims for refund involving the Earned Income Credit (EIC) must meet to avoid imposition of the penalty under section 6695(g) for taxable years beginning after December 31, 1996. The text of those regulations also serves as the text of these proposed regulations. The preamble to the temporary regulations explains the amendments.

Special Analyses

   It has been determined that this notice of proposed rule making is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulation does not imposed 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, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Comments and Requests for a Public Hearing

   Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department specifically request comments on the clarity of the proposed rule and how it may be made easier to understand. All comments will be available for public inspection and copying.

   A public hearing has been scheduled for May 20, 1999, beginning at 10 a.m. in room 2615 of the Internal Revenue Building, 1111 Constitution Avenue, N.W., Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the "FOR FURTHER INFORMATION CONTACT" section of this preamble.

   The rules of 26 CFR 601.601 (a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit written comments and an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by April 29, 1999. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

   The principal author of these regulations is Marc C. Porter, Office of Assistant Chief Counsel (Income Tax & Accounting). However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

   Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

   Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1 -- INCOME TAXES

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

   Authority: 26 U.S.C. 7805 * * *

Section 1.6695-2 also issued under 26 U.S.C. 6695(9). * * *

   Par. 2. Section 1.6695-2 is added to read as follows:

§1.6695-2 Preparer due diligence requirements for determining earned income tax credit eligibility.

   [The text of proposed §1.6695-2 is the same as the text of §1.6695-2T published elsewhere in this issue of the Federal Register].

 
Deputy Commissioner for Services and Enforcement.

Exhibit 32.1.4-5 
Sample Temporary Regulation

[4830-01-p]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8798]

RIN 1545-AW74

Preparer Due Diligence Requirements for Determining Earned Income Credit Eligibility

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains temporary regulations relating to the due diligence requirements for paid preparers of federal income tax returns or claims for refund involving the earned income credit. The temporary regulations reflect changes to the law made by the Taxpayer Relief Act of 1997. The temporary regulations provide guidance to paid preparers who prepare federal income tax returns or claims for refund claiming the earned income credit. The text of the temporary regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking on this subject in the Proposed Rules section in this issue of the Federal Register.

DATES: These regulations are effective December 21, 1998.

FOR FURTHER INFORMATION CONTACT: Marc C. Porter (202) 622-4940 (not a toll free call).

SUPPLEMENTARY INFORMATION:

Background

   This document contains amendments to the Income Tax Regulations (26 CFR part 1) under section 6695(g) relating to the penalty for failure of a preparer to be diligent in determining a taxpayer's eligibility for the earned income credit (EIC). Section 6695(g) was added by section 1085(a)(2) of the Taxpayer Relief Act of 1997, Public Law 105-34 (11 Stat. 788, 955 (1997) (the Act), effective for taxable years beginning after December 31,1996.

   Section 6695(g) imposes a $100 penalty for each failure by an income tax return preparer to meet the due diligence requirements set forth in this regulation. The IRS may impose the section 6695(g) penalty in addition to any other applicable penalty provided by law.

   In Notice 97-65 (1997-51 I.R.B. 14 (December 22, 1997)), the IRS set forth the preparer due diligence requirements for 1997 returns and claims for refund involving the EIC. To avoid the imposition of the section 6695(g) penalty for 1997 returns and claims for refund, Notice 97-65 requires preparers to meet four requirements: (1) complete the Earned Income Credit Eligibility Checklist attached to Notice 97-65 (Eligibility Checklist), or otherwise record the information necessary to complete the Eligibility Checklist; (2) complete the Earned Income Credit Worksheet (Computation Worksheet), as contained in the 1997 Form 1040 instructions, or otherwise record the computation and information necessary to complete the Computation Worksheet; (3) have no knowledge that any information used by the preparer in determining eligibility for, and amount of, the EIC is incorrect; and (4) retain for three years the Eligibility Checklist and Computation Worksheet (or alternative records), and a record of how and when the information used to determine eligibility for, and amount of, the EIC was obtained by the preparer. This information may be retained either as a paper record or in magnetic media format consistent with Rev. Proc. 81-46 (1981-2 C.B. 621).

   Notice 97-65 also requested comments on preparer due diligence requirements for tax years after 1997. Two comments were received. The commentators did not suggest alternative due diligence requirements. One commentator suggested, however, increased education for the public. The IRS and Treasury Department adhere to the principle that education is an integral part of good tax administration. Therefore, as part of its overall EIC strategy, the IRS has established various educational tools and outreach programs for taxpayers and preparers. These efforts are intended to provide the public with the tools necessary to receive the full amount of the EIC allowed by law.

   The second commentator suggested that preparers should be able to meet the due diligence requirements by using software reviewed and approved by the IRS. The IRS does not approve commercial software. The IRS is currently exploring, however, new opportunities for partnership with outside stakeholders to reduce burden, enhance customer service, and increase compliance. As part of this effort, the IRS will continue to review this comment and evaluate options.

Explanation of Provisions

   The temporary regulations impose due diligence standards on persons who are income tax return preparers with respect to determining eligibility for, or the amount of, the EIC. Consistent with existing regulations under section 6695, these temporary regulations apply a modified definition of income tax return preparer. Section 7701 (a)(36) provides that, in general, the term income tax return preparer means any person who prepares for compensation, or who employs one or more persons to prepare for compensation, any return or claim for refund of tax imposed by subtitle A. The preparation of a substantial portion of a return or claim for refund is treated as if it were the preparation of such return or claim for refund. Persons are considered preparers if they give legal advice concerning a return or claim for refund or if they prepare another return which affects the return or claim for refund (§301.7701-15(a)(2) and (b) and §301.7701-15(b)(3), respectively). The regulations retain this definition of an income tax return preparer, except that preparers who merely give advice or prepare another return that affects the EIC return or claim for refund are not preparers for purposes of the section 6695(g) penalty. Rather, the due diligence standards are imposed only on paid preparers who prepare the return claiming the EIC.

   The temporary regulations essentially adopt the four due diligence requirements in Notice 97-65. Thus, to avoid the penalty under section 6695(g), a preparer must: (1) complete the Eligibility Checklist (Form 8867, Paid Preparer's Earned Income Credit Checklist, or such other form as may be prescribed by the IRS), or otherwise record in the preparer's files the information necessary to complete the Eligibility Checklist; (2) complete the Computation Worksheet (Earned Income Credit Worksheet contained in the Form 1040 instructions), or otherwise record in the preparer's files the computation and information necessary to complete the Computation Worksheet; (3) have no knowledge, and have no reason to know, that any information used by the preparer in determining eligibility for, and amount of, the EIC is incorrect; and (4) retain for three years the Eligibility Checklist and the Computation Worksheet (or alternative records), and a record of how and when the information used to determine eligibility for, and the amount of, the EIC was obtained by the preparer.

   The temporary regulations also provide that the income tax return preparer may avoid the section 6695(g) penalty with respect to a particular income tax return or claim for refund if the preparer can demonstrate to the satisfaction of the IRS that, considering all the facts and circumstances, the preparer's normal office procedures are reasonably designed and routinely followed to ensure compliance with the due diligence requirements of the regulations, and that the particular failure was isolated and inadvertent.

   The temporary regulations will be effective for taxable years beginning after December 31, 1996. However, the Eligibility Checklist contained in Notice 97-65 has been expanded in Form 8867. Therefore, for taxable year 1997, the applicable Eligibility Checklist is the Eligibility Checklist contained in Notice 97-65. For taxable year 1998, a preparer may choose as the applicable Eligibility Checklist either the Eligibility Checklist published in Notice 97-65 modified however, by replacing, $9,770, $25,760, $29,290, and $2,250 each time these figures appear on the 1997 Eligibility Checklist with $10,030, $26,473, $30,095, and $2,300, respectively, or Form 8867. For taxable years beginning after December 31, 1998, the applicable Eligibility Checklist will be the Form 8867.

Special Analyses

   It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For the applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6) refer to the Special Analyses section of the preamble to the cross-reference notice of proposed rulemaking published in the Proposed Rules section in this issue of the Federal Register. Pursuant to section 7805(f) of the Internal Revenue Code, these temporary regulations will be 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 Marc C. Porter, Office of Associate Chief Counsel (Income Tax & Accounting). However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

   Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

   Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAXES

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

   Authority: 26 U.S.C. 7805 * * *

Section 1.6695-2T also issued under 26 U.S.C. 6695(g). * * *

   Par. 2. Section 1.6695-2T is added to read as follows:

§1.6695-2T Preparer due diligence requirements for determining earned income credit eligibility (temporary).

   (a) Penalty for failure to meet due diligence requirements. A person who is an income tax return preparer (preparer) of an income tax return or claim for refund under subtitle A of the Internal Revenue Code (Code) with respect to determining the eligibility for, or the amount of, the earned income credit (EIC) under section 32 and who fails to satisfy the due diligence requirements of paragraph (b) of this section will be subject to a penalty of $100 for each such failure. However, no penalty will be imposed under section 6695(g) on a person who is an income tax return preparer solely by reason of --

   (1) Section 301.7701-15(a)(2) and (b) of this chapter, on account of having given advice on specific issues of law; or

   (2) Section 301.7701-15(b)(3) of this chapter, on account of having prepared the return solely because of having prepared another return that affects amounts reported on the return.

   (b) Due diligence requirements. A preparer must satisfy the following due diligence requirements:

   (1) Completion of eligibility checklist. (i) The preparer must either--

   (A) Complete Form 8867, Paid Preparer's Earned Income Credit Checklist, or such other form as may be prescribed by the IRS (Eligibility Checklist); or

   (B) Otherwise record in the preparer's paper or electronic files the information necessary to complete the Eligibility Checklist (Alternative Eligibility Record). The Alternative Eligibility Record may consist of one or more documents containing the required information.

   (ii) The preparer's completion of the Eligibility Checklist or Alternative Eligibility Record must be based on information provided by the taxpayer to the pre parer or otherwise reasonably obtained by the preparer.

   (2) Computation of credit. (i) The preparer must either --

   (A) Complete the Earned Income Credit Worksheet in the Form 1040 instructions or such other form as may be prescribed by the IRS (Computation Worksheet); or

   (B) Otherwise record in the preparer's paper or electronic files the preparer's EIC computation, including the method and information used to make the computation (Alternative Computation Record). The Alternative Computation Record may consist of one or more documents containing the required information.

   (ii) The preparer's completion of the Computation Worksheet or Alternative Computation Record must be based on information provided by the taxpayer to the preparer or otherwise reasonably obtained by the preparer.

   (3) Knowledge. The preparer must not know, or have reason to know, that any information used by the preparer in determining the taxpayer's eligibility for, or the amount of, the EIC is incorrect. The preparer may not ignore the implications of information furnished to, or known by, the preparer, and must make reasonable inquiries if the information furnished to, or known by, the preparer appears to be incorrect, inconsistent, or incomplete.

   (4) Retention of records. (i) The preparer must retain --

   (A) A copy of the completed Eligibility Checklist or Alternative Eligibility Record;

   (B) A copy of the Computation Worksheet or Alternative Computation Record; and

   (C) A record of how and when the information used to complete the Eligibility Checklist or Alternative Eligibility Record and the Computation Worksheet or Alternative Computation Record was obtained by the preparer, including the identity of any person furnishing the information.

   (ii) These items must be retained for three years after the June 30th following the date the return or claim for refund was presented to the taxpayer for Signature, and may be retained on paper or electronically in the manner prescribed in applicable regulations, revenue rulings, revenue procedures, or other appropriate guidance.

   (c) Exception to penalty. The section 6695(g) penalty will not be applied with respect to a particular income tax return or claim for refund if the preparer can demonstrate to the satisfaction of the IRS that, considering all the facts and circumstances, the preparer's normal office procedures are reasonably designed and routinely followed to ensure compliance with the due diligence requirements of paragraph (b) of this section, and the failure to meet the due diligence requirements of paragraph (b) of this section with respect to the particular return or claim for refund was isolated and inadvertent.

   (d) Effective date -- (1) In general. This section applies to income tax returns and claims for refund for taxable years beginning after December 31, 1996. This section expires on December 21,2001. For the applicable Eligibility Checklist see paragraph (d)(2) of this section.

   (2) Eligibility Checklist -- (i) For the 1997 taxable year. For taxable year 1997, the applicable Eligibility Checklist is the Eligibility Checklist published in Notice 97-65 (1997- 51 I.R.B. 14) December 22, 1997. (See §601.601 (d)(2)(ii)(Q) of this chapter.)

   (ii) For the 1998 taxable year. For taxable year 1998 the applicable Checklist is either--

   (A) The Checklist published in Notice 97-65 (1997-51 I.R.B.14) December 22, 1997, modified however, by applying the figures $10,030, $26,473, $30,095, and $2,300 in place of $9,770, $25,760, $29,290, and $2,250, respectively, each time these figures appear on the 1997 Checklist; or

   (B) Form 8867, Paid Preparer's Earned Income Credit Checklist.

   (iii) For taxable years after 1998. For taxable years beginning after December 31, 1998, the applicable Eligibility Checklist is the Eligibility Checklist contained in Form 8867, Paid Preparer's Earned Income Credit Checklist, or such other form as may be prescribed by the IRS.

 
 
  Deputy Commissioner for Services and Enforcement.
 
Approved:
 
  Assistant Secretary of the Treasury

Exhibit 32.1.4-6 
Sample Final Regulation

[4830-01-p]

T.D. 9034

DEPARTMENT OF THE TREASURY Internal Revenue Service

26 CFR Part 1

Education Tax Credit

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the Hope Scholarship Credit and the Lifetime Learning Credit under section 25A of the Internal Revenue Code. The final regulations reflect changes made to the law by the Taxpayer Relief Act of 1997. These regulations provide guidance to individuals who may claim the Hope Scholarship Credit or the Lifetime Learning Credit for the payment of certain postsecondary educational expenses.

DATES: Effective Date: These regulations are effective December 26, 2002.

   Applicability Dates: For dates of applicability, see § 1.25A-3(f) and § 1.25A-4(d).

FOR FURTHER INFORMATION CONTACT: Marilyn E. Brookens, (202) 622-4920 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

   This document contains amendments to the Income Tax Regulations (26 CFR part 1) regarding the Hope Scholarship Credit and the Lifetime Learning Credit (education tax credit) under section 25A of the Internal Revenue Code. The Taxpayer Relief Act of 1997 (Public Law 105-34 (111 Stat. 788) (TRA '97)) added section 25A to provide the education tax credit. In general, the education tax credit allows taxpayers to claim a nonrefundable credit against their federal income tax for the payment of certain postsecondary educational expenses. The Economic Growth and Tax Relief Reconciliation Act of 2001 (Public Law 107-16 (115 Stat. 38» added section 222 of the Internal Revenue Code to provide an above-the-line deduction for certain postsecondary education expenses paid in taxable years beginning after December 31, 2001, and before January 1, 2006. Section 222 is an alternative to section 25A, and taxpayers cannot claim a section 222 deduction and a section 25A education tax credit in the same year with respect to the same student.

   On November 17, 1997, the IRS published Notice 97-60 (1997- 2 C.B. 310) to provide general guidance on the higher education tax incentives enacted by TRA '97, including the education tax credit. A notice of proposed rulemaking (REG-106388-98, 1999-1 C.B. 756 [64 FR 794]) was published in the Federal Register on January 6, 1999. One request for a public hearing was received. However, the request was withdrawn, and no public hearing was held. The IRS received written and electronic comments responding to the notice of proposed rulemaking. After consideration of all the comments, the proposed regulations are adopted as amended by this Treasury decision. The revisions are discussed below.

Explanation of Provisions and Summary of Comments

1.  Reporting Requirements Under Section 6050S for Eligible Educational Institutions

   Many commentators requested clarification of the information reporting requirements under section 6050S for eligible educational institutions (institutions) that receive payments of qualified tuition and related expenses (qualified expenses). These comments are outside the scope of section 25A, which relates solely to the education tax credit allowable to taxpayers for payments of qualified expenses. However, these comments were considered by the IRS and the Treasury Department in drafting the proposed regulations under section 6050S that were published in the Federal Register (REG-161424-01, 2002-21 I.R.B. 1010 [67 FR 20923]) on April 29, 2002.

2.  Calculation of Education Tax Credit and General Eligibility Requirements

   Several commentators recommended changes to the rules for calculating the amount of any allowable education tax credit. One commentator recommended that the calculation of the Hope Scholarship Credit be simplified so that the credit is allowable for the first $1,500 of qualified expenses, rather than 100 percent of the first $1,000 of qualified expenses, and 50 percent of the next $1,000 of qualified expenses as provided in section 25A(b) (1). This commentator also recommended that the calculation of the Lifetime Learning Credit be simplified so that the credit is allowable for the first $1,000 of qualified expenses, rather than 20 percent of the first $5,000 of qualified expenses as provided in section 25A(c) (1). Another commentator recommended that, for purposes of the income limitations in section 25A(d), income realized on the conversion of a traditional Individual Retirement Account (IRA) to a Roth IRA should be excluded from the definition of modified adjusted gross income. The rules in the proposed regulations regarding calculation of the amount of the education tax credit and the definition of modified adjusted gross income derive from the statutory provisions of section 25A. Therefore, the final regulations do not adopt these recommendations.

   Commentators requested clarification of the rules for claiming the education tax credit in the case of a dependent. Consistent with the legislative history to section 25A, § 1.25A 1( g) of the proposed regulations provides that if a student is a claimed dependent of a taxpayer, only that taxpayer may claim the education tax credit for the student's qualified expenses; however, if the taxpayer is eligible to, but does not claim the student as a dependent, only the student may claim the education tax credit for the student's qualified expenses. The final regulations retain this rule.

   Commentators asked how the student's personal exemption deduction amount under section 151 is calculated if a parent does not claim the student as a dependent on the parent's income tax return in order that the student may claim the education tax credit on the student's income tax return. Section 151(d) (2) provides a special rule for calculating the exemption deduction amount in the case of an individual (for example, a student) for whom a dependency exemption deduction is allowable to another taxpayer (for example, a parent). Under this rule, a student's personal exemption deduction amount is zero on the student's income tax return if a parent is eligible to claim the student as a dependent even if the parent does not in fact claim a dependency exemption deduction for the student. The result is the same if the amount of the dependency exemption deduction allowable to the parent is reduced or eliminated under the phase-out rule in section 151(d) (3).

   Consistent with section 25A(g) (7), the proposed regulations provide that a nonresident alien individual is not eligible to claim an education tax credit, unless the individual is treated as a resident alien of the United States by reason of an election under section 6013(g) or (h). One commentator suggested that Examples 7 and 8 in § 1.25A-3(d) (2) of the proposed regulations should be revised to avoid any confusion about the eligibility of a nonresident alien student to claim an education tax credit. The final regulations modify these examples to avoid any implication that a nonresident alien student may claim an education tax credit, in the absence of an election under section 6013(g) or (h).

   Another commentator requested clarification as to whether a nonresident alien individual who elects to be treated as a resident alien may claim an education tax credit. A limited number of income tax treaties allow certain individuals to elect to be treated as residents of the United States. Because such an election is intended to apply for all tax purposes, an individual for whom a valid election under a treaty is in effect is treated as a resident for purposes of section 25A.

3.  Definitions

   Several commentators requested clarification of the definition of academic period. The proposed regulations provide that academic period means a quarter, semester, trimester, or other period of study (such as a summer school session) as reasonably determined by the eligible educational institution. As stated in the preamble of the proposed regulations, this definition is intended to include institutions that use traditional academic terms and institutions that do not use academic terms, but for example use clock hours or credit hours.

   The IRS and the Treasury Department invited comments on the proposed definition. One commentator suggested that the final regulations provide that, in the case of institutions that use clock hours or credit hours, but do not use traditional academic terms, the term academic period may include a payment period as defined by the Department of Education in 34 CFR 668.4. The final regulations adopt this recommendation.

   Several commentators requested clarification of the definition of qualified tuition and related expenses. The proposed regulations define qualified tuition and related expenses to mean tuition and fees required for the enrollment or attendance of a student for courses of instruction at an eligible educational institution. The proposed regulations provide that, in general, the test for determining whether a fee is a qualified expense is whether the fee is required to be paid to the institution as a condition of the student's enrollment or attendance at the institution. However, the proposed regulations also provide that qualified expenses do not include the costs of room and board, insurance, medical expenses, transportation, and similar personal, living, or family expenses, regardless of whether the payment of such fees is required for the student's enrollment or attendance. The final regulations retain these rules.

   One commentator requested clarification as to whether an education tax credit is allowable for amounts paid in one year for an independent study course which the student has up to two years to complete. The proposed regulations provide that qualified expenses paid in one taxable year may qualify for an education tax credit in the year of the payment if the expenses relate to education furnished during an academic period beginning in the year of payment or within the first three months of the next taxable year. The final regulations retain this rule. Therefore, an education tax credit is allowable for qualified expenses paid in one taxable year for independent study during an academic period that begins in the taxable year of payment or within the first three months of the next taxable year.

   One commentator requested clarification as to when amounts paid for books are qualified expenses. The proposed regulations provide that, in general, an education tax credit is not available for expenses incurred to purchase books. The final regulations continue to provide that qualified expenses include fees for books, supplies, and equipment used in a course of study only if the fees must be paid to the institution for the enrollment or attendance of the student at the institution. In this situation, the amount paid for books is a required fee.

   Other commentators requested clarification as to whether a required student health service fee and a required transportation fee are qualified expenses. Consistent with the legislative history to section 25A, the final regulations continue to provide that qualified expenses do not include fees for room and board, insurance, medical expenses, transportation, and similar personal, living, or family expenses, regardless of whether the fee must be paid to the institution as a condition of the student's enrollment or attendance. Therefore, a required student health fee and a required transportation fee are not qualified expenses. The final regulations clarify that, as stated in the preamble to the proposed regulations, medical expenses include student health fees.

   Several commentators requested clarification of how a required general fee (referred to as a bundled fee) should be treated in calculating the amount of qualified expenses. These commentators explained that often institutions will charge a bundled fee that includes charges for both qualified expenses and personal expenses. These commentators note that, unlike a comprehensive fee, a bundled fee normally does not include tuition charges.

   Section 1.25A-2(d) (4) of the proposed regulations describes the treatment of a comprehensive fee, which typically includes charges for tuition, fees, and personal expenses. The proposed regulations provide that the portion of the comprehensive fee that is allocable to personal expenses is not a qualified expense, and require institutions to make a reasonable allocation between qualified expenses and personal expenses. One commentator recommended that the final regulations provide a similar allocation rule for bundled fees. Another commentator recommended that institutions should not be required to allocate a bundled fee that includes an insubstantial amount of personal expenses. Because personal expenses do not qualify for the education tax credit, the final regulations clarify that the allocation rule in § 1.25A-2(d) (4) applies to any required fee that combines charges for both qualified expenses and personal expenses (such as comprehensive fees and bundled fees).

   One commentator noted that, under the definition of a hobby course in § 1.25A-2(d) (5) of the proposed regulations, one student may be enrolled in a course to receive academic credit toward a degree, another student may be enrolled in the same course on a noncredit basis to acquire or improve job skills, while a third student may be enrolled in the same course as a hobby. Under the proposed regulations, the first and second students may be eligible to claim an education tax credit, but the third student is not. Consistent with sections 25A(c) (2) and 25A(f) (1) (B), the final regulations continue to provide that expenses paid for courses that involve sports, games, or hobbies, or any noncredit course, are not qualified expenses, unless the course is part of the individual's degree program, or, in the case of the Lifetime Learning Credit, the student takes the course to acquire or improve job skills.

4.  Hope Scholarship Credit

   Several commentators requested clarification of the definition of an eligible student for purposes of the Hope Scholarship Credit. One commentator recommended that the year of study requirement in the regulations should be eliminated and that the credit should be allowed for any two years of undergraduate study. The year of study requirement derives from the statutory requirements in section 25A. Therefore, the final regulations do not adopt this recommendation.

   Another commentator requested clarification as to whether a student who completes a one-year postsecondary certificate program and in a later year completes another one-year postsecondary certificate program (or enrolls in a postsecondary degree program) may claim a Hope Scholarship Credit for both years. The final regulations include a new example in § 1.25A- 3(d) (2) that illustrates that the Hope Scholarship Credit is allowable for the first two years of postsecondary education, which may include two one-year certificate programs.

   Commentators requested clarification of Example 3 in § 1.25A-3(d) (2). The commentators asked if an otherwise eligible student who has not completed the first two years of undergraduate study as of the beginning of the taxable year may include qualified expenses paid during the entire taxable year in calculating the Hope Scholarship Credit, even if the student completes the first two years of undergraduate study during the year. The example has been revised to clarify that, if a student has not completed the first two years of undergraduate study as of the beginning of the taxable year, the qualified expenses paid during the entire taxable year may be taken into account in calculating the Hope Scholarship Credit. However, in no event may a Hope Scholarship Credit be claimed for more than two taxable years with respect to the same student.

5.  Special Rules Relating to Characterization and Timing of Payments

   Several commentators requested clarification of the rules for payments of qualified expenses by a third party. One commentator asked how the third party payment rule in § 1.25A-5 of the proposed regulations applies in the case of a taxpayer who, although not divorced, is not treated as married within the meaning of section 7703. The proposed regulations provide that if a third party (someone other than the taxpayer, the taxpayer's spouse, or a claimed dependent) pays qualified expenses on behalf of a student directly to an institution, the student is treated as receiving the payment from the third party and, in turn, paying the qualified expenses to the institution. The final regulations clarify that, for purposes of § 1.25A Exhibit 5(b), a third party includes the spouse of a taxpayer who is not treated as married under section 7703. Thus, for example, if the taxpayer is a custodial parent who is not treated as married under section 7703, then (assuming that the taxpayer claims the student as a dependent) the taxpayer may claim an education tax credit for qualified expenses paid by the noncustodial parent on behalf of the student.

   One commentator requested clarification as to whether an education tax credit is allowable for the amount of any tuition reduction provided by an eligible educational institution to its employees, or their spouses or dependent children. The final regulations provide in § 1.25A-5(b) (2) that an education tax credit is allowable for the amount of any reduction in tuition only if the amount of the tuition reduction is included in the employee's gross income.

   Several commentators requested clarification of the rules in § 1.25A-5(c) of the proposed regulations for reducing the amount of qualified expenses paid during the taxable year by the amount of certain tax-free educational assistance (including any qualified scholarship that is excludable from gross income under section 117) received during the taxable year. The proposed regulations provide a rule for allocating scholarships between qualified expenses and expenses that do not qualify for an education tax credit under section 25A (nonqualified expenses) . The proposed regulations provide that a scholarship will be treated as allocated to qualified expenses, and thus as a qualified scholarship that reduces qualified expenses, unless the student includes the scholarship in income or the terms of the scholarship require that it be applied to nonqualified expenses.

   Several commentators asked whether a student may choose to include in income a restricted scholarship that, by its terms, must be used to pay qualified expenses and claim an education tax credit for qualified expenses covered by the scholarship. The test for purposes of section 25A is whether the scholarship is excludable from gross income under section 117, and not whether the student elects to include the scholarship in income. The legislative history to section 25A states that qualified expenses do not include expenses covered by "education assistance that is not required to be included in the gross income of either the student or the taxpayer claiming the credit." See H.R. Conf. Rep. No. 220, 105th Cong., 1st Sess., at 343 (1997). Section 117 provides, in general, that gross income shall not include a scholarship that, consistent with the terms of the scholarship, is used to pay certain qualified expenses. A restricted scholarship that must be used to pay qualified expenses is a qualified scholarship excludable under section 117. Therefore, for purposes of section 25A, a restricted scholarship that must be used to pay qualified expenses reduces the amount of qualified expenses that may be taken into account in calculating the education tax credit.

   An unrestricted scholarship that may be used to pay any of the student's costs of attendance (such as room and board and any other incidental expenses) is excludable from gross income only if used to pay qualified expenses. To the extent that an unrestricted scholarship, or a portion thereof, is used to pay nonqualified expenses and such use is consistent with the terms of the scholarship, the scholarship is not a qualified scholarship excludable under section 117. In this situation, the scholarship is included in gross income and will not reduce the amount of qualified expenses that may be taken into account in calculating the education tax credit. The final regulations clarify that, for purposes of section 25A, a scholarship or fellowship grant is treated as a qualified scholarship excludable under section 117 (thereby reducing the amount of qualified expenses) except to the extent: (1) the scholarship may be applied, by its terms, to expenses other than qualified expenses (such as room and board) and the student reports the scholarship as income; or (2) the scholarship must be applied, by its terms, to expenses other than qualified expenses (such as room and board) and the student reports the scholarship as income.

   One commentator recommended that the final regulations provide that loans are not excludable educational assistance within the meaning of § 1.25A-5(c), and do not reduce the amount of qualified expenses. Section 1.25A-5(e) (3) of the proposed regulations specifically provides that amounts paid with loan proceeds may qualify for the education tax credit. In addition, an example in § 1.25A-5(c) (4) of the proposed regulations provides that a loan is not tax-free educational assistance within the meaning of § 1.25A-5(c). The final regulations retain these specific provisions on loans.

   The proposed regulations provide that expenses paid with loan proceeds disbursed directly to an institution are, in general, treated as paid on the date of the disbursement of the proceeds. Several commentators recommended that, in accordance with the Department of Education regulations in 34 CFR 668.164(a), the date of disbursement should be the date the institution credits the student's account with the loan proceeds and not the date the lender disburses the loan proceeds to the institution. In general, 34 CFR 668.164 regulates the disbursement of federal student loans under Title IV of the Higher Education Act of 1965 (including the Federal Perkins Loan, Federal Family Education Loan, and William D. Ford Direct Loan Program). These rules require an institution to verify that a student is enrolled and is otherwise eligible to receive the loan proceeds before crediting the student's account or releasing the funds to the student. Consistent with these Department of Education rules, the final regulations clarify that the qualified expenses paid with loan proceeds disbursed directly to an institution are treated as paid at the time the loan proceeds are actually credited to the student's account. In the case of Title IV loan programs, Department of Education rules require the institution to notify the borrower of the date and the amount of the disbursement at the time the institution credits the student's account. See 34 CFR 668.165(a) (2). However, the final regulations provide that if the taxpayer does not know the date the institution credits the student's account, the taxpayer must treat the expenses as paid on the last date for payment prescribed by the institution.

   Several commentators requested clarification as to when a taxpayer may claim an education tax credit for qualified expenses paid through a third party installment payment plan. One commentator explained that institutions and taxpayers may contract with a third party installment payment company to provide an installment payment plan for the institution's students. The commentator explained that, in general, the company agrees to collect tuition payments over a period of time (usually 10 months) and remit the payments to the institution on a predetermined schedule. The commentator asked whether a taxpayer is treated as paying the qualified expenses when the taxpayer pays the third party installment payment company, or when the third party disburses the funds to the institution. The final regulations clarify that when the expenses are treated as paid for purposes of section 25A depends on whether, under the terms of the installment payment agreement, the third party is acting as an agent of the taxpayer or as an agent of the institution.

   One commentator requested clarification as to whether an education tax credit is allowable for any amounts paid for qualified expenses that are retained by the institution, under the institution's refund policy, when the student withdraws. Section 1.25A-5(f) (1) of the proposed regulations provides that the amount of qualified expenses is calculated by adding all the qualified expenses paid for the year, and subtracting any refund received from the institution during the same year. The final regulations retain this rule. Therefore, amounts required to be paid for enrollment or attendance are qualified expenses to the extent that such amounts are not refunded when the student withdraws. The final regulations add a new paragraph § 1.25A- 5(f) (4) to clarify that, with respect to qualified expenses paid with the proceeds of a loan, any refund of loan proceeds by the institution back to the lender on behalf of the borrower is treated as a refund of qualified expenses.

   The proposed regulations provide that if a taxpayer receives a refund of qualified expenses paid in a prior taxable year before the taxpayer files a federal income tax return for the prior year, the amount of qualified expenses for the prior taxable year is reduced by the amount of the refund. One commentator suggested that the taxpayer should have the option of claiming the credit for the full amount of qualified expenses paid in the prior taxable year and then recapturing the credit on the return filed for the taxable year in which the refund was received. The rule in the proposed regulations is intended to simplify the calculation of the education tax credit by avoiding the need to recompute the allowable education tax credit in a later year and report any resulting increase in tax. Therefore, the final regulations do not adopt the recommendation.

   The final regulations clarify that, in the case of a payment of qualified expenses in one taxable year and a refund of qualified expenses in a subsequent taxable year, the recapture amount for the refund year is the difference in tax liability for the prior taxable year (taking into account any redetermination of such tax liability by audit or amended return) that results when the tax liability for the prior year is calculated using the taxpayer's redetermined credit.

Special Analyses

   It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the proposed regulations preceding these regulations were 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 the regulations is Donna Welch, Office of Associate Chief Counsel (Procedure & Administration) , Administrative Provisions & Judicial Practice Division. However, other personnel from the IRS and the Treasury Department participated in the development of the 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 is amended by adding entries in numerical order to read as follows:

   Authority: 26 U.S.C. 7805 * * *

Section 1.25A-1 also issued under section 26 U.S.C. 25A (i).
Section 1.25A-2 also issued under section 26 U.S.C. 25A (i).
Section 1.25A-3 also issued under section 26 U.S.C. 25A (i).
Section 1.25A-4 also issued under section 26 U.S.C. 25A (i).
Section 1.25A-S also issued under section 26 U.S.C. 25A (i) * * *

   Par. 2. Sections 1.25A-O through 1.25A-S are added to read as follows:

§ 1.25A-0 Table of contents.

   This section lists captions contained in §§ 1.25A-1, 1.25A- 2, 1.25A-3, 1.25A-4, and 1.25A-5.

§ 1.25A-1 Calculation of education tax credit and general eligibility requirements.

(a) Amount of education tax credit.
(b) Coordination of Hope Scholarship Credit and Lifetime Learning Credit.
(1) In general.
(2) Hope Scholarship Credit.
(3) Lifetime Learning Credit.
(4) Examples.
(c) Limitation based on modified adjusted gross income.
(1) In general.
(2) Modified adjusted gross income defined.
(3) Inflation adjustment.
(d) Election.
(e) Identification requirement.
(f) Claiming the credit in the case of a dependent.
(1) In general.
(2) Examples.
(g) Married taxpayers.
(h) Nonresident alien taxpayers and dependents.

§ 1.25A-2 Definitions.

(a) Claimed dependent.
(b) Eligible educational institution.
(1) In general.
(2) Rules on federal financial aid programs.
(c) Academic period.
(d) Qualified tuition and related expenses.
(1) In general.
(2) Required fees.
(i) In general.
(ii) Books, supplies, and equipment.
(iii) Nonacademic fees.
(3) Personal expenses.
(4) Treatment of a comprehensive or bundled fee.
(5) Hobby courses.
(6) Examples.

§ 1.25A-3 Hope Scholarship Credit.

(a) Amount of the credit.
(1) In general.
(2) Maximum credit.
(b) Per student credit.
(1) In general.
(2) Example.
(c) Credit allowed for only two taxable years.
(d) Eligible student.
(1) Eligible student defined.
(i) Degree requirement.
(ii) Work load requirement.
(iii) Year of study requirement.
(iv) No felony drug conviction.
(2) Examples.
(e) Academic period for prepayments.
(1) In general.
(2) Example.
(f) Effective date.

§ 1.25A-4 Lifetime Learning Credit.

(a) Amount of the credit.
(1) Taxable years beginning before January 1, 2003.
(2) Taxable years beginning after December 31, 2002.
(3) Coordination with the Hope Scholarship Credit.
(4) Examples.
(b) Credit allowed for unlimited number of taxable years.
(c) Both degree and nondegree courses are eligible for the credit.
(1) In general.
(2) Examples.
(d) Effective date.

§ 1.25A-S Special rules relating to characterization and timing of payments.

(a) Educational expenses paid by claimed dependent.
(b) Educational expenses paid by a third party.
(1) In general.
(2) Special rule for tuition reduction included in gross income of employee.
(3) Examples.
(c) Adjustment to qualified tuition and related expenses for certain excludable educational assistance.
(1) In general.
(2) No adjustment for excludable educational assistance attributable to expenses paid in a prior year.
(3) Scholarships and fellowship grants.
(4) Examples.
(d) No double benefit.
(e) Timing rules.
(1) In general.
(2) Prepayment rule.
(i) In general.
(ii) Example.
(3) Expenses paid with loan proceeds.
(4) Expenses paid through third party installment payment plans.
(i) In general.
(ii) Example.
(f) Refund of qualified tuition and related expenses.
(1) Payment and refund of qualified tuition and related expenses in the same taxable year.
(2) Payment of qualified tuition and related expenses in one taxable year and refund in subsequent taxable year before return filed for prior taxable year.
(3) Payment of qualified tuition and related expenses in one taxable year and refund in subsequent taxable year.
(i) In general.
(ii) Recapture amount.
(4) Refund of loan proceeds treated as refund of qualified tuition and related expenses.
(5) Excludable educational assistance received in a subsequent taxable year treated as a refund.
(6) Examples.

§ 1.25A-1 Calculation of education tax credit and general eligibility requirements.

   (a) Amount of education tax credit. An individual taxpayer is allowed a nonrefundable education tax credit against income tax imposed by chapter 1 of the Internal Revenue Code for the taxable year. The amount of the education tax credit is the total of the Hope Scholarship Credit (as described in § 1.25A-3) plus the Lifetime Learning Credit (as described in § 1.25A-4). For limitations on the credits allowed by subpart A of part IV of subchapter A of chapter 1 of the Internal Revenue Code, see section 26.

   (b) Coordination of Hope Scholarship Credit and Lifetime Learning Credit--(1) In general. In the same taxable year, a taxpayer may claim a Hope Scholarship Credit for each eligible student's qualified tuition and related expenses (as defined in § 1.25A-2(d)) and a Lifetime Learning Credit for one or more other students' qualified tuition and related expenses. However, a taxpayer may not claim both a Hope Scholarship Credit and a Lifetime Learning Credit with respect to the same student in the same taxable year.

   (2) Hope Scholarship Credit. Subject to certain limitations, a Hope Scholarship Credit may be claimed for the qualified tuition and related expenses paid during a taxable year with respect to each eligible student (as defined in § 1.25A-3(d)). Qualified tuition and related expenses paid during a taxable year with respect to one student may not be taken into account in computing the amount of the Hope Scholarship Credit with respect to any other student. In addition, qualified tuition and related expenses paid during a taxable year with respect to any student for whom a Hope Scholarship Credit is claimed may not be taken into account in computing the amount of the Lifetime Learning Credit.

   (3) Lifetime Learning Credit. Subject to certain limitations, a Lifetime Learning Credit may be claimed for the aggregate amount of qualified tuition and related expenses paid during a taxable year with respect to students for whom no Hope Scholarship Credit is claimed.

   (4) Examples. The following examples illustrate the rules of this paragraph (b):

   Example 1. In 1999, Taxpayer A pays qualified tuition and related expenses for his dependent, B, to attend College Y during 1999. Assuming all other relevant requirements are met, Taxpayer A may claim either a Hope Scholarship Credit or a Lifetime Learning Credit with respect to dependent B, but not both. See § 1.25A-3(a) and § 1.25A-4(a).

   Example 2. In 1999, Taxpayer C pays $2,000 in qualified tuition and related expenses for her dependent, D, to attend College Z during 1999. In 1999, Taxpayer C also pays $500 in qualified tuition and related expenses to attend a computer course during 1999 to improve Taxpayer C's job skills. Assuming all other relevant requirements are met, Taxpayer C may claim a Hope Scholarship Credit for the $2,000 of qualified tuition and related expenses attributable to dependent D (see § 1.25A-3(a)) and a Lifetime Learning Credit (see § 1.25A-4(a))for the $500 of qualified tuition and related expenses incurred to improve her job skills.

   Example 3. The facts are the same as in Example 2, except that Taxpayer C pays $3,000 in qualified tuition and related expenses for her dependent, D, to attend College Z during 1999. Although a Hope Scholarship Credit is available only with respect to the first $2,000 of qualified tuition and related expenses paid with respect to D (see § 1.25A-3(a)), Taxpayer C may not add the $1,000 of excess expenses to her $500 of qualified tuition and related expenses in computing the amount of the Lifetime Learning Credit.

   (c) Limitation based on modified adjusted gross income--(1) In general. The education tax credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified adjusted gross income between $40,000 and $50,000 ($80,000 and $100,000 for married individuals who file a joint return). Thus, taxpayers with modified adjusted gross income above $50,000 (or $100,000 for joint filers) may not claim an education tax credit.

   (2) Modified adjusted gross income defined. The term modified adjusted gross income means the adjusted gross income (as defined in section 62) of the taxpayer for the taxable year increased by any amount excluded from gross income under section 911, 931, or 933 (relating to income earned abroad or from certain U.S. possessions or Puerto Rico).

   (3) Inflation adjustment. For taxable years beginning after 2001, the amounts in paragraph (c) (1) of this section will be increased for inflation occurring after 2000 in accordance with section 1(f) (3). If any amount adjusted under this paragraph (c) (3) is not a multiple of $1,000, the amount will be rounded to the next lowest multiple of $1,000.

   (d) Election. No education tax credit is allowed unless a taxpayer elects to claim the credit on the taxpayer's federal income tax return for the taxable year in which the credit is claimed. The election is made by attaching Form 8863, "Education Credits (Hope and Lifetime Learning Credits)" , to the Federal income tax return.

   (e) Identification requirement. No education tax credit is allowed unless a taxpayer includes on the federal income tax return claiming the credit the name and the taxpayer identification number of the student for whom the credit is claimed. For rules relating to assessment for an omission of a correct taxpayer identification number, see sections 6213(b) and (g)(2)(J).

   (f) Claiming the credit in the case of a dependent --(1) In general. If a student is a claimed dependent of another taxpayer, only that taxpayer may claim the education tax credit for the student's qualified tuition and related expenses. However, if another taxpayer is eligible to, but does not, claim the student as a dependent, only the student may claim the education tax credit for the student's qualified tuition and related expenses.

   (2) Examples. The following examples illustrate the rules of this paragraph (f):

   Example 1. In 1999, Taxpayer A pays qualified tuition and related expenses for his dependent, B, to attend University Y during 1999. Taxpayer A claims B as a dependent on his federal income tax return. Therefore, assuming all other relevant requirements are met, Taxpayer A is allowed an education tax credit on his federal income tax return, and B is not allowed an education tax credit on B's federal income tax return. The result would be the same if B paid the qualified tuition and related expenses. See § 1.25A-5(a).

   Example 2. In 1999, Taxpayer C has one dependent, D. In 1999, D pays qualified tuition and related expenses to attend University Z during 1999. Although Taxpayer C is eligible to claim D as a dependent on her federal income tax return, she does not do so. Therefore, assuming all other relevant requirements are met, D is allowed an education tax credit on D's federal income tax return, and Taxpayer C is not allowed an education tax credit on her federal income tax return, with respect to D's education expenses. The result would be the same if C paid the qualified tuition and related expenses on behalf of D. See § 1.25A-5(b)

   (g) Married taxpayers. If a taxpayer is married (within the meaning of section 7703), no education tax credit is allowed to the taxpayer unless the taxpayer and the taxpayer's spouse file a joint Federal income tax return for the taxable year.

   (h) Nonresident alien taxpayers and dependents. If a taxpayer or the taxpayer's spouse is a nonresident alien for any portion of the taxable year, no education tax credit is allowed unless the nonresident alien is treated as a resident alien by reason of an election under section 6013(g) or (h). In addition, if a student is a nonresident alien, a taxpayer may not claim an education tax credit with respect to the qualified tuition and related expenses of the student unless the student is a claimed dependent (as defined in § 1.25A-2(a)).

§ 1.25A-2 Definitions.

   (a) Claimed dependent. A claimed dependent means a dependent (as defined in section 152) for whom a deduction under section 151 is allowed on a taxpayer's federal income tax return for the taxable year. Among other requirements under section 152, a nonresident alien student must be a resident of a country contiguous to the United States in order to be treated as a dependent.

   (b) Eligible educational institution--(1) In general. In general, an eligible educational institution means a college, university, vocational school, or other postsecondary educational institution that is--

   (i) Described in section 481 of the Higher Education Act of 1965 (20 U.S.C. 1088) as in effect on August 5, 1997, (generally all accredited public, nonprofit, and proprietary postsecondary institutions); and

   (ii) Participating in a federal financial aid program under title IV of the Higher Education Act of 1965 or is certified by the Department of Education as eligible to participate in such a program but chooses not to participate.

   (2) Rules on federal financial aid programs. For rules governing an educational institution's eligibility to participate in federal financial aid programs, see 20 U.S.C. 1070; 20 U.S.C. 1094; and 34 CFR 600 and 668.

   (c) Academic period. Academic period means a quarter/ semester/ trimester/ or other period of study as reasonably determined by an eligible educational institution. In the case of an eligible educational institution that uses credit hours or clock hours, and does not have academic terms, each payment period (as defined in 34 CFR 668.4, revised as of July 1, 2002) may be treated as an academic period.

   (d) Qualified tuition and related expenses--(1) In general. Qualified tuition and related expenses means tuition and fees required for the enrollment or attendance of a student for courses of instruction at an eligible educational institution.

   (2) Required fees--(i) In general. Except as provided in paragraph (d) (3) of this section, the test for determining whether any fee is a qualified tuition and related expense is whether the fee is required to be paid to the eligible educational institution as a condition of the student's enrollment or attendance at the institution.

   (ii) Books, supplies, and equipment. Qualified tuition and related expenses include fees for books, supplies, and equipment used in a course of study only if the fees must be paid to the eligible educational institution for the enrollment or attendance of the student at the institution.

   (iii) Nonacademic fees. Except as provided in paragraph (d) (3) of this section, qualified tuition and related expenses include fees charged by an eligible educational institution that are not used directly for, or allocated to, an academic course of instruction only if the fee must be paid to the eligible educational institution for the enrollment or attendance of the student at the institution.

   (3) Personal expenses. Qualified tuition and related expenses do not include the costs of room and board, insurance, medical expenses (including student health fees), transportation, and similar personal, living, or family expenses, regardless of whether the fee must be paid to the eligible educational institution for the enrollment or attendance of the student at the institution.

   (4) Treatment of a comprehensive or bundled fee. If a student is required to pay a fee (such as a comprehensive fee or a bundled fee) to an eligible educational institution that combines charges for qualified tuition and related expenses with charges for personal expenses described in paragraph (d) (3) of this section, the portion of the fee that is allocable to personal expenses is not included in qualified tuition and related expenses. The determination of what portion of the fee relates to qualified tuition and related expenses and what portion relates to personal expenses must be made by the institution using a reasonable method of allocation.

   (5) Hobby courses. Qualified tuition and related expenses do not include expenses that relate to any course of instruction or other education that involves sports, games, or hobbies, or any noncredit course, unless the course or other education is part of the student's degree program, or in the case of the Lifetime Learning Credit, the student takes the course to acquire or improve job skills.

   (6) Examples. The following examples illustrate the rules of this paragraph (d). In each example, assume that the institution is an eligible educational institution and that all other relevant requirements to claim an education tax credit are met. The examples are as follows:

   Example 1. University V offers a degree program in dentistry. In addition to tuition, all students enrolled in the program are required to pay a fee to University V for the rental of dental equipment. Because the equipment rental fee must be paid to University V for enrollment and attendance, the tuition and the equipment rental fee are qualified tuition and related expenses.

   Example 2. First-year students at College Ware required to obtain books and other reading materials used in its mandatory first-year curriculum. The books and other reading materials are not required to be purchased from College Wand may be borrowed from other students or purchased from off-campus bookstores, as well as from College W's bookstore. College W bills students for any books and materials purchased from College W's bookstore. The fee that College W charges for the first-year books and materials purchased at its bookstore is not a qualified tuition and related expense because the books and materials are not required to be purchased from College W for enrollment or attendance at the institution.

   Example 3. All students who attend College X are required to pay a separate student activity fee in addition to their tuition. The student activity fee is used solely to fund on campus organizations and activities run by students, such as the student newspaper and the student government (no portion of the fee covers personal expenses). Although labeled as a student activity fee, the fee is required for enrollment or attendance at College X. Therefore, the fee is a qualified tuition and related expense.

   Example 4. The facts are the same as in Example 3, except that College X offers an optional athletic fee that students may pay to receive discounted tickets to sports events. The athletic fee is not required for enrollment or attendance at College X. Therefore, the fee is not a qualified tuition and related expense.

   Example 5. College Y requires all students to live on campus. It charges a single comprehensive fee to cover tuition, required fees, and room and board. Based on College Y's reasonable allocation, sixty percent of the comprehensive fee is allocable to tuition and other required fees not allocable to personal expenses, and the remaining forty percent of the comprehensive fee is allocable to charges for room and board and other personal expenses. Therefore, only sixty percent of College Y's comprehensive fee is a qualified tuition and related expense.

   Example 6. As a degree student at College Z, Student A is required to take a certain number of courses outside of her chosen major in Economics. To fulfill this requirement, Student A enrolls in a square dancing class offered by the Physical Education Department. Because Student A receives credit toward her degree program for the square dancing class, the tuition for the square dancing class is included in qualified tuition and related expenses.

§ 1.25A-3 Hope Scholarship Credit.

   (a) Amount of the credit--(1) In general. Subject to the phaseout of the education tax credit described in § 1.25A-1(c), the Hope Scholarship Credit amount is the total of--

   (i) 100 percent of the first $1,000 of qualified tuition and related expenses paid during the taxable year for education furnished to an eligible student (as defined in paragraph (d) of this section) who is the taxpayer, the taxpayer's spouse, or any claimed dependent during any academic period beginning in the taxable year (or treated as beginning in the taxable year, see § 1. 25A-5 (e) (2) ); plus

   (ii) 50 percent of the next $1,000 of such expenses paid with respect to that student.

   (2) Maximum credit. For taxable years beginning before 2002, the maximum Hope Scholarship Credit allowed for each eligible student is $1,500. For taxable years beginning after 2001, the amounts used in paragraph (a) (1) of this section to determine the maximum credit will be increased for inflation occurring after 2000 in accordance with section 1(f) (3). If any amount adjusted under this paragraph (a) (2) is not a multiple of $100, the amount will be rounded to the next lowest multiple of $100.

   (b) Per student credit--(1) In general. A Hope Scholarship Credit may be claimed for the qualified tuition and related expenses of each eligible student (as defined in paragraph (d) of this section) .

   (2) Example. The following example illustrates the rule of this paragraph (b). In the example, assume that all the requirements to claim an education tax credit are met. The example is as follows:

   Example. In 1999, Taxpayer A has two dependents, Band C, both of whom are eligible students. Taxpayer A pays $1,600 in qualified tuition and related expenses for dependent B to attend a community college. Taxpayer A pays $5,000 in qualified tuition and related expenses for dependent C to attend University X. Taxpayer A may claim a Hope Scholarship Credit of $1,300 ($1,000 + (.50 x $600)) for dependent B, and the maximum $1,500 Hope Scholarship Credit for dependent C, for a total Hope Scholarship Credit of $2,800.

   (c) Credit allowed for only two taxable years. For each eligible student, the Hope Scholarship Credit may be claimed for no more than two taxable years.

   (d) Eligible student--(1) Eligible student defined. For purposes of the Hope Scholarship Credit, the term eligible student means a student who satisfies all of the following requirements--

   (i) Degree requirement. For at least one academic period that begins during the taxable year, the student enrolls at an eligible educational institution in a program leading toward a postsecondary degree, certificate, or other recognized postsecondary educational credential;

   (ii) Work load requirement. For at least one academic period that begins during the taxable year, the student enrolls for at least one-half of the normal full-time work load for the course of study the student is pursuing. The standard for what is half of the normal full-time work load is determined by each eligible educational institution. However, the standard for half-time may not be lower than the applicable standard for half-time established by the Department of Education under the Higher Education Act of 1965 and set forth in 34 CFR 674.2(b) (revised as of July 1, 2002) for a half-time undergraduate student;

   (iii) Year of study requirement. As of the beginning of the taxable year, the student has not completed the first two years of postsecondary education at an eligible educational institution. Whether a student has completed the first two years of postsecondary education at an eligible educational institution as of the beginning of a taxable year is determined based on whether the institution in which the student is enrolled in a degree program (as described in paragraph (d) (1) (i) of this section) awards the student two years of academic credit at that institution for postsecondary course work completed by the student prior to the beginning of the taxable year. Any academic credit awarded by the eligible educational institution solely on the basis of the student's performance on proficiency examinations is disregarded in determining whether the student has completed two years of postsecondary education; and

   (iv) No felony drug conviction. The student has not been convicted of a federal or state felony offense for possession or distribution of a controlled substance as of the end of the taxable year for which the credit is claimed.

   (2) Examples. The following examples illustrate the rules of this paragraph (d). In each example, assume that the student has not been convicted of a felony drug offense, that the institution is an eligible educational institution unless otherwise stated, that the qualified tuition and related expenses are paid during the same taxable year that the academic period begins, and that a Hope Scholarship Credit has not previously been claimed for the student (see paragraph (c) of this section). The examples are as follows:

   Example 1. Student A graduates from high school in June 1998 and is enrolled in an undergraduate degree program at College U for the 1998 Fall semester on a full-time basis. For the 1999 Spring semester, Student A again is enrolled at College U on a full time basis. For the 1999 Fall semester, Student A is enrolled in less than half the normal full-time course work for her degree program. Because Student A is enrolled in an undergraduate degree program on at least a half-time basis for at least one academic period that begins during 1998 and at least one academic period that begins during 1999, Student A is an eligible student for taxable years 1998 and 1999 (including the 1999 Fall semester when Student A enrolls at College U on less than a half-time basis).

   Example 2. Prior to 1998, Student B attended college for several years on a full-time basis. Student B transfers to College V for the 1998 Spring semester. College V awards Student B credit for some (but not all) of the courses he previously completed, and College V classifies Student B as a first-semester sophomore. During both the Spring and Fall semesters of 1998, Student B is enrolled in at least one-half the normal full-time work load for his degree program at College V. Because College V does not classify Student B as having completed the first two years of postsecondary education as of the beginning of 1998, Student B is an eligible student for taxable year 1998.

   Example 3. The facts are the same as in Example 2. After taking classes on a half-time basis for the 1998 Spring and Fall semesters, Student B is enrolled at College V for the 1999 Spring semester on a full-time basis. College V classifies Student B as a second-semester sophomore for the 1999 Spring semester and as a first-semester junior for the 1999 Fall semester. Because College V does not classify Student B as having completed the first two years of postsecondary education as of the beginning of 1999, Student B is an eligible student for taxable year 1999. Therefore, the qualified expenses and required fees paid for the 1999 Spring semester and the 1999 Fall semester are taken into account in calculating any Hope Scholarship Credit.

   Example 4. Prior to 1998, Student was not enrolled at another eligible educational institution. At the time that Student C enrolls in a degree program at College W for the 1998 Fall semester, Student C takes examinations to demonstrate her proficiency in several subjects. On the basis of Student C's performance on these examinations, College W classifies Student C as a second-semester sophomore as of the beginning of the 1998 Fall semester. Student C is enrolled at College W during the 1998 Fall semester and during the 1999 Spring and Fall semesters on a full-time basis and is classified as a first-semester junior as of the beginning of the 1999 Spring semester. Because Student C was not enrolled in a college or other eligible educational institution prior to 1998 (but rather was awarded three semesters of academic credit solely because of proficiency examinations), Student C is not treated as having completed the first two years of postsecondary education at an eligible educational institution as of the beginning of 1998 or as of the beginning of 1999. Therefore, Student C is an eligible student for both taxable years 1998 and 1999.

   Example 5. During the 1998 Fall semester, Student D is a high school student who takes classes on a half-time basis at College X. Student D is not enrolled as part of a degree program at College X because College X does not admit students to a degree program unless the student has a high school diploma or equivalent. Because Student D is not enrolled in a degree program at College X during 1998, Student D is not an eligible student for taxable year 1998.

   Example 6. The facts are the same as in Example 5. In addition, during the 1999 Spring semester, Student D again attends College X but not as part of a degree program. Student D graduates from high school in June 1999. For the 1999 Fall semester, Student D enrolls in College X as part of a degree program, and College X awards Student D credit for her prior course work at College X. During the 1999 Fall semester, Student D is enrolled in more than one-half the normal full-time work load of courses for her degree program at College X. Because Student D is enrolled in a degree program at College X for the 1999 Fall term on at least a half-time basis, Student D is an eligible student for all of taxable year 1999. Therefore, the qualified tuition and required fees paid for classes taken at College X during both the 1999 Spring semester (during which Student D was not enrolled in a degree program) and the 1999 Fall semester are taken into account in computing any Hope Scholarship Credit.

   Example 7. Student E completed two years of undergraduate study at College S. College S is not an eligible educational institution for purposes of the education tax credit. At the end of 1998, Student E enrolls in an undergraduate degree program at College Z, an eligible educational institution, for the 1999 Spring semester on a full-time basis. College Z awards Student E two years of academic credit for his previous course work at College S and classifies Student E as a first-semester junior for the 1999 Spring semester. Student E is treated as having completed the first two years of postsecondary education at an eligible educational institution as of the beginning of 1999. Therefore, Student E is not an eligible student for taxable year 1999.

   Example 8. Student F received a degree in 1998 from College R. College R is not an eligible educational institution for purposes of the education tax credit. During 1999, Student F is enrolled in a graduate-degree program at College Y, an eligible educational institution, for the 1999 Fall semester on a full time basis. By admitting Student F to its graduate degree program, College Y treats Student F as having completed the first two years of postsecondary education as of the beginning of 1999. Therefore, Student F is not an eligible student for taxable year 1999.

   Example 9. Student G graduates from high school in June 2001. In January 2002, Student G is enrolled in a one-year postsecondary certificate program on a full-time basis to obtain a certificate as a travel agent. Student G completes the program in December 2002 and is awarded a certificate. In January 2003, Student G enrolls in a one-year postsecondary certificate program on a full-time basis to obtain a certificate as a computer programer. Student G meets the degree requirement, the work load requirement, and the year of study requirement for the taxable years 2002 and 2003. Therefore, Student G is an eligible student for both taxable years 2002 and 2003.

   (e) Academic period for prepayments--(1) In general. For purposes of determining whether a student meets the requirements in paragraph (d) of this section for a taxable year, if qualified tuition and related expenses are paid during one taxable year for an academic period that begins during January, February or March of the next taxable year (for taxpayers on a fiscal taxable year, use the first three months of the next taxable year), the academic period is treated as beginning during the taxable year in which the payment is made.

   (2) Example. The following example illustrates the rule of this paragraph (e). In the example, assume that all the requirements to claim a Hope Scholarship Credit are met. The example is as follows:

   Example. Student G graduates from high school in June 1998. After graduation, Student G works full-time for several months to earn money for college. Student G is enrolled on a full-time basis in an undergraduate degree program at University w, an eligible educational institution, for the 1999 Spring semester, which begins in January 1999. Student G pays tuition to University W for the 1999 Spring semester in December 1998. Because the tuition paid by Student G in 1998 relates to an academic period that begins during the first three months of 1999, Student G's eligibility to claim a Hope Scholarship Credit in 1998 is determined as if the 1999 Spring semester began in 1998. Thus, assuming Student G has not been convicted of a felony drug offense as of December 31, 1998, Student G is an eligible student for 1998.

   (f) Effective date. The Hope Scholarship Credit is applicable for qualified tuition and related expenses paid after December 31, 1997, for education furnished in academic periods beginning after December 31, 1997.

§ 1.25A-4 Lifetime Learning Credit.

   (a) Amount of the credit--(1) Taxable years beginning before January 1, 2003. Subject to the phaseout of the education tax credit described in § 1.25A-1(c), for taxable years beginning before 2003, the Lifetime Learning Credit amount is 20 percent of up to $5,000 of qualified tuition and related expenses paid during the taxable year for education furnished to the taxpayer, the taxpayer's spouse, and any claimed dependent during any academic period beginning in the taxable year (or treated as beginning in the taxable year, see § 1.25A-5(e) (2)).

   (2) Taxable years beginning after December 31, 2002. Subject to the phaseout of the education tax credit described in § 1.25A-1(c), for taxable years beginning after 2002, the Lifetime Learning Credit amount is 20 percent of up to $10,000 of qualified tuition and related expenses paid during the taxable year for education furnished to the taxpayer, the taxpayer's spouse, and any claimed dependent during any academic period beginning in the taxable year (or treated as beginning in the taxable year, see § 1.25A-5 (e) (2)).

   (3) Coordination with the Hope Scholarship Credit. Expenses paid with respect to a student for whom the Hope Scholarship Credit is claimed are not eligible for the Lifetime Learning Credit.

   (4) Examples. The following examples illustrate the rules of this paragraph (a). In each example, assume that all the requirements to claim a Lifetime Learning Credit or a Hope Scholarship Credit, as applicable, are met. The examples are as follows:

   Example 1. In 1999, Taxpayer A pays qualified tuition and related expenses of $3,000 for dependent B to attend an eligible educational institution, and Taxpayer A pays qualified tuition and related expenses of $4,000 for dependent C to attend an eligible educational institution. Taxpayer A does not claim a Hope Scholarship Credit with respect to either B or C. Although Taxpayer A paid $7,000 of qualified tuition and related expenses during the taxable year, Taxpayer A may claim the Lifetime Learning Credit with respect to only $5,000 of such expenses. Therefore, the maximum Lifetime Learning Credit Taxpayer A may claim for 1999 is $1,000 (.20 x $5,000).

   Example 2. In 1999, Taxpayer D pays $6,000 of qualified tuition and related expenses for dependent E, and $2,000 of qualified tuition and related expenses for dependent F, to attend eligible educational institutions. Dependent F has already completed the first two years of postsecondary education. For 1999, Taxpayer D claims the maximum $1,500 Hope Scholarship Credit with respect to dependent E. In computing the amount of the Lifetime Learning Credit, Taxpayer D may not include any of the $6,000 of qualified tuition and related expenses paid on behalf of dependent E but may include the $2,000 of qualified tuition and related expenses of dependent F.

   (b) Credit allowed for unlimited number of taxable years. There is no limit to the number of taxable years that a taxpayer may claim a Lifetime Learning Credit with respect to any student.

   (c) Both degree and nondegree courses are eligible for the credit--(1) In general. For purposes of the Lifetime Learning Credit, amounts paid for a course at an eligible educational institution are qualified tuition and related expenses if the course is either part of a postsecondary degree program or is not part of a postsecondary degree program but is taken by the student to acquire or improve job skills.

   (2) Examples. The following examples illustrate the rule of this paragraph (c). In each example, assume that all the requirements to claim a Lifetime Learning Credit are met. The examples are as follows:

   Example 1. Taxpayer A, a professional photographer, enrolls in an advanced photography course at a local community college. Although the course is not part of a degree program, Taxpayer A enrolls in the course to improve her job skills. The course fee paid by Taxpayer A is a qualified tuition and related expense for purposes of the Lifetime Learning Credit.

   Example 2. Taxpayer B, a stockbroker, plans to travel abroad on a "photo-safari" for his next vacation. In preparation for the trip, Taxpayer B enrolls in a noncredit photography class at a local community college. Because Taxpayer B is not taking the photography course as part of a degree program or to acquire or improve his job skills, amounts paid by Taxpayer B for the course are not qualified tuition and related expenses for purposes of the Lifetime Learning Credit.

   (d) Effective date. The Lifetime Learning Credit is applicable for qualified tuition and related expenses paid after June 30, 1998, for education furnished in academic periods beginning after June 30, 1998.

§ 1.25A-S Special rules relating to characterization and timing of payments.

   (a) Educational expenses paid by claimed dependent. For any taxable year for which the student is a claimed dependent of another taxpayer, qualified tuition and related expenses paid by the student are treated as paid by the taxpayer to whom the deduction under section 151 is allowed.

   (b) Educational expenses paid by a third party--(1) In general. Solely for purposes of section 25A, if a third party (someone other than the taxpayer, the taxpayer's spouse if the taxpayer is treated as married within the meaning of section 7703, or a claimed dependent) makes a payment directly to an eligible educational institution to pay for a student's qualified tuition and related expenses, the student is treated as receiving the payment from the third party and, in turn, paying the qualified tuition and related expenses to the institution.

   (2) Special rule for tuition reduction included in gross income of employee. Solely for purposes of section 25A, if an eligible educational institution provides a reduction in tuition to an employee of the institution (or to the spouse or dependent child of an employee, as described in section 132(h) (2)) and the amount of the tuition reduction is included in the employee's gross income, the employee is treated as receiving payment of an amount equal to the tuition reduction and, in turn, paying such amount to the institution.

   (3) Examples. The following examples illustrate the rules of this paragraph (b). In each example, assume that all the requirements to claim an education tax credit are met. The examples are as follows:

   Example 1. Grandparent D makes a direct payment to an eligible educational institution for Student E's qualified tuition and related expenses. Student E is not a claimed dependent in 1999. For purposes of claiming an education tax credit, Student E is treated as receiving the money from her grandparent and, in turn, paying her qualified tuition and related expenses.

   Example 2. Under a court-approved divorce decree, Parent A is required to pay Student C's college tuition. Parent A makes a direct payment to an eligible educational institution for Student C's 1999 tuition. Under paragraph (b) (1) of this section, Student C is treated as receiving the money from Parent A and, in turn, paying the qualified tuition and related expenses. Under the divorce decree, Parent B has custody of Student C for 1999. Parent B properly claims Student C as a dependent on Parent B's 1999 federal income tax return. Under paragraph (a) of this section, expenses paid by Student Care treated as paid by Parent B. Thus, Parent B may claim an education tax credit for the qualified tuition and related expenses paid directly to the institution by Parent A.

   Example 3. University A, an eligible educational institution, offers reduced tuition charges to its employees and their dependent children. F is an employee of University A. F's dependent child, G, enrolls in a graduate-level course at University A. Section 117(d) does not apply, because it is limited to tuition reductions provided for education below the graduate level. Therefore, the amount of the tuition reduction received by G is treated as additional compensation from University A to F and is included in F's gross income. For purposes of claiming a Lifetime Learning Credit, F is treated as receiving payment of an amount equal to the tuition reduction from University A and, in turn, paying such amount to University A on behalf of F's child, G.

   (c) Adjustment to qualified tuition and related expenses for certain excludable educational assistance--(1) In general. In determining the amount of an education tax credit, qualified tuition and related expenses for any academic period must be reduced by the amount of any tax-free educational assistance allocable to such period. For this purpose, tax-free educational assistance means--

   (i) A qualified scholarship that is excludable from income under section 117;

   (ii) A veterans' or member of the armed forces' educational assistance allowance under chapter 30, 31, 32, 34 or 35 of title 38, United States Code, or under chapter 1606 of title 10, United States Code;

   (iii) Employer-provided educational assistance that is excludable from income under section 127; or

   (iv) Any other educational assistance that is excludable from gross income (other than as a gift, bequest, devise, or inheritance within the meaning of section 102(a)).

   (2) No adjustment for excludable educational assistance attributable to expenses paid in a prior year. A reduction is not required under paragraph (c) (1) of this section if the amount of excludable educational assistance received during the taxable year is treated as a refund of qualified tuition and related expenses paid in a prior taxable year. See paragraph (f) (5) of this section.

   (3) Scholarships and fellowship grants. For purposes of paragraph (c) (1) (i) of this section, a scholarship or fellowship grant is treated as a qualified scholarship excludable under section 117 except to the extent--

   (i) The scholarship or fellowship grant (or any portion thereof) may be applied, by its terms, to expenses other than qualified tuition and related expenses within the meaning of section 117(b) (2) (such as room and board) and the student reports the grant (or the appropriate portion thereof) as income on the student's federal income tax return if the student is required to file a return; or

   (ii) The scholarship or fellowship grant (or any portion thereof) must be applied, by its terms, to expenses other than qualified tuition and related expenses within the meaning of section 117(b) (2) (such as room and board) and the student reports the grant (or the appropriate portion thereof) as income on the student's federal income tax return if the student is required to file a return.

   (4) Examples. The following examples illustrate the rules of this paragraph (c). In each example, assume that all the requirements to claim an education tax credit are met. The examples are as follows:

   Example 1. University X charges Student A, who lives on X's campus, $3,000 for tuition and $5,000 for room and board. University X awards Student A a $2,000 scholarship. The terms of the scholarship permit it to be used to pay any of a student's costs of attendance at University X, including tuition, room and board, and other incidental expenses. University X applies the $2,000 scholarship against Student A's $8,000 total bill, and Student A pays the $6,000 balance of her bill from University X with a combination of savings and amounts she earns from a summer job. University X does not require A to pay any additional fees beyond the $3,000 in tuition in order to enroll in or attend classes. Student A does not report any portion of the scholarship as income on her federal income tax return. Since Student A does not report the scholarship as income, the scholarship is treated under paragraph (c) (3) of this section as a qualified scholarship that is excludable under section 117. Therefore, for purposes of calculating an education tax credit, Student A is treated as having paid only $1,000 ($3,000 tuition —$2,000 scholarship) in qualified tuition and related expenses to University X.

   Example 2. The facts are the same as in Example 1, except that Student A reports the entire scholarship as income on the student's federal income tax return. Since the full amount of the scholarship may be applied to expenses other than qualified expenses (room and board) and Student A reports the scholarship as income, the exception in paragraph (c) (3) of this section applies and the scholarship is not treated as a qualified scholarship excludable under section 117. Therefore, for purposes of calculating an education tax credit, Student A is treated as having paid $3,000 of qualified tuition and related expenses to University X.

   Example 3. The facts are the same as in Example 1, except that the terms of the scholarship require it to be used to pay tuition. Under paragraph (c) (3) of this section, the scholarship is treated as a qualified scholarship excludable under section 117. Therefore, for purposes of calculating an education tax credit, Student A is treated as having paid only $1,000 ($3,000 tuition —$2,000 scholarship) in qualified tuition and related expenses to University X.

   Example 4. The facts are the same as in Example 1, except that the terms of the scholarship require it to be used to pay tuition or room and board charged by University X, and the scholarship amount is $6,000. Under the terms of the scholarship, Student A may allocate the scholarship between tuition and room and board in any manner. However, because room and board totals $5,000, that is the maximum amount that can be applied under the terms of the scholarship to expenses other than qualified expenses and at least $1,000 of the scholarship must be applied to tuition. Therefore, the maximum amount of the exception under paragraph (c) (3) of this section is $5,000 and at least $1,000 is treated as a qualified scholarship excludable under section 117 ($6,000 scholarship $5,000 room and board). If Student A reports $5,000 of the scholarship as income on the student's federal income tax return, then Student A will be treated as having paid $2,000 ($3,000 tuition —$1,000 qualified scholarship excludable under section 117) in qualified tuition and related expenses to University X.

   Example 5. The facts are the same as in Example 1, except that in addition to the scholarship that University X awards to Student A, University X also provides Student A with an education loan and pays Student A for working in a work/study job in the campus dining hall. The loan is not excludable educational assistance within the meaning of paragraph (c) of this section. In addition, wages paid to a student who is performing services for the payor are neither a qualified scholarship nor otherwise excludable from gross income. Therefore, Student A is not required to reduce her qualified tuition and related expenses by the amounts she receives from the student loan or as wages from her work/study job.

   Example 6. In 1999, Student B pays University Y $1,000 in tuition for the 1999 Spring semester. University Y does not require Student B to pay any additional fees beyond the $1,000 in tuition in order to enroll in classes. Student B is an employee of Company Z. At the end of the academic period and during the same taxable year that Student B paid tuition to University Y, Student B provides Company Z with proof that he has satisfactorily completed his courses at University Y. Pursuant to an educational assistance program described in section 127(b), Company Z reimburses Student B for all of the tuition paid to University Y. Because the reimbursement from Company Z is employer-provided educational assistance that is excludable from Student B's gross income under section 127, the reimbursement reduces Student B's qualified tuition and related expenses. Therefore, for purposes of calculating an education tax credit, Student B is treated as having paid no qualified tuition and related expenses to University Y during 1999.

   Example 7. The facts are the same as in Example 6 except that the reimbursement from Company Z is not pursuant to an educational assistance' program described in section 127(b), is not otherwise excludable from Student B's gross income, and is taxed as additional compensation to Student B. Because the reimbursement is not excludable educational assistance within the meaning of paragraph (c) (1) of this section, Student B is not required to reduce his qualified tuition and related expenses by the $1,000 reimbursement he received from his employer. Therefore, for purposes of calculating an education tax credit, Student B is treated as paying $1,000 in qualified tuition and related expenses to University Y during 1999.

   (d) No double benefit. Qualified tuition and related expenses do not include any expense for which a deduction is allowed under section 162, section 222, or any other provision of chapter 1 of the Internal Revenue Code.

   (e) Timing rules--(1) In general. Except as provided in paragraph (e) (2) of this section, an education tax credit is allowed only for payments of qualified tuition and related expenses for an academic period beginning in the same taxable year as the year the payment is made. Except for certain individuals who do not use the cash receipts and disbursements method of accounting, qualified tuition and related expenses are treated as paid in the year in which the expenses are actually paid. See § 1.461-1 (a) (1) .

   (2) Prepayment rule--(i) In general. If qualified tuition and related expenses are paid during one taxable year for an academic period that begins during the first three months of the taxpayer's next taxable year (i.e., in January, February, or March of the next taxable year for calendar year taxpayers), an education tax credit is allowed with respect to the qualified tuition and related expenses only in the taxable year in which the expenses are paid.

   (ii) Example. The following example illustrates the rule of this paragraph (e) (2) . In the example, assume that all the requirements to claim an education tax credit are met. The example is as follows:

   Example. In December 1998, Taxpayer A, a calendar year taxpayer, pays College Z $1,000 in qualified tuition and related expenses to attend classes during the 1999 Spring semester, which begins in January 1999. Taxpayer A may claim an education tax credit only in 1998 for payments made in 1998 for the 1999 Spring semester.

   (3) Expenses paid with loan proceeds. An education tax credit may be claimed for qualified tuition and related expenses paid with the proceeds of a loan only in the taxable year in which the expenses are paid, and may not be claimed in the taxable year in which the loan is repaid. Loan proceeds disbursed directly to an eligible educational institution will be treated as paid on the date the institution credits the proceeds to the student's account. For example, in the case of any loan issued or guaranteed as part of a federal student loan program under Title IV of the Higher Education Act of 1965, loan proceeds will be treated as paid on the date of disbursement (as defined in 34 CFR 668.164(a), revised as of July 1, 2002) by the eligible educational institution. If a taxpayer does not know the date the institution credits the student's account, the taxpayer must treat the qualified tuition and related expenses as paid on the last date for payment prescribed by the institution.

   (4) Expenses paid through third party installment payment plans--(i) In general. A taxpayer, an eligible educational institution, and a third party installment payment company may enter into an agreement in which the company agrees to collect installment payments of qualified tuition and related expenses from the taxpayer and to remit the installment payments to the institution. If the third party installment payment company is the taxpayer's agent for purposes of paying qualified tuition and related expenses to the eligible educational institution, the taxpayer is treated as paying the qualified expenses on the date the company pays the institution. However, if the third party installment payment company is the eligible educational institution's agent for purposes of collecting payments of qualified tuition and related expenses from the taxpayer, the taxpayer is treated as paying the qualified expenses on the date the taxpayer pays the company.

   (ii) Example. The following example illustrates the rule of this paragraph (e) (4). The example is as follows:

   Example. Student A, Company B, and College C enter into a written agreement in which Student A agrees to pay the tuition required to attend College C in 10 equal monthly installments to Company B. Under the written agreement, Student A is not relieved of her obligation to pay College C until Company B remits the payments to College C. Under the written agreement, Company B agrees to disburse the monthly installment payments to College C within 30 days of receipt. Because Company B acts as Student A's agent for purposes of paying qualified expenses to College C, Student A is treated as paying qualified expenses on the date Company B disburses payments to College C.

   (f) Refund of qualified tuition and related expenses--(1) Payment and refund of qualified tuition and related expenses in the same taxable year. With respect to any student, the amount of qualified tuition and related expenses for a taxable year is calculated by adding all qualified tuition and related expenses paid for the taxable year, and subtracting any refund of such expenses received from the eligible educational institution during the same taxable year (including refunds of loan proceeds described in paragraph (f) (4) of this section).

   (2) Payment of qualified tuition and related expenses in one taxable year and refund in subsequent taxable year before return filed for prior taxable year. If, in a taxable year, a taxpayer or someone other than the taxpayer receives a refund (including refunds of loan proceeds described in paragraph (f) (4) of this section) of qualified tuition and related expenses paid on behalf of a student in a prior taxable year and the refund is received before the taxpayer files a federal income tax return for the prior taxable year, the amount of the qualified tuition and related expenses for the prior taxable year is reduced by the amount of the refund.

   (3) Payment of qualified tuition and related expenses in one taxable year and refund in subsequent taxable year--(i) In general. If, in a taxable year (refund year), a taxpayer or someone other than the taxpayer receives a refund (including refunds of loan proceeds described in paragraph (f) (4) of this section) of qualified tuition and related expenses paid on behalf of a student for which the taxpayer claimed an education tax credit in a prior taxable year, the tax imposed by chapter 1 of the Internal Revenue Code for the refund year is increased by the recapture amount.

   (ii) Recapture amount. The recapture amount is the difference in tax liability for the prior taxable year (taking into account any redetermination of such tax liability by audit or amended return) that results when the tax liability for the prior year is calculated using the taxpayer's redetermined credit. The redetermined credit is computed by reducing the amount of the qualified tuition and related expenses taken into account in determining any credit claimed in the prior taxable year by the amount of the refund of the qualified tuition and related expenses (redetermined qualified expenses), and computing the allowable credit using the redetermined qualified expenses and the relevant facts and circumstances of the prior taxable year, such as modified adjusted gross income (redetermined credit).

   (4) Refund of loan proceeds treated as refund of qualified tuition and related expenses. If loan proceeds used to pay qualified tuition and related expenses (as described in paragraph (e) (3) of this section) during a taxable year are refunded by an eligible educational institution to a lender on behalf of the borrower, the refund is treated as a refund of qualified tuition and related expenses for purposes of paragraphs (f) (1), (2), and (3) of this section.

   (5) Excludable educational assistance received in a subsequent taxable year treated as a refund. If, in a taxable year, a taxpayer or someone other than the taxpayer receives any excludable educational assistance (described in paragraph (c) (1) of this section) for the qualified tuition and related expenses paid on behalf of a student during a prior taxable year (or attributable to enrollment at an eligible educational institution during a prior taxable year), the educational assistance is treated as a refund of qualified tuition and related expenses for purposes of paragraphs (f) (2) and (3) of this section. If the excludable educational assistance is received before the taxpayer files a Federal income tax return for the prior taxable year, the amount of the qualified tuition and related expenses for the prior taxable year is reduced by the amount of the excludable educational assistance as provided in paragraph (f) (2) of this section. If the excludable educational assistance is received after the taxpayer has filed a federal income tax return for the prior taxable year, any education tax credit claimed for the prior taxable year is subject to recapture as provided in paragraph (f) (3) of this section.

   (6) Examples. The following examples illustrate the rules of this paragraph (f). In each example, assume that all the requirements to claim an education tax credit are met. The examples are as follows:

   Example 1. In January 1998, Student A, a full-time freshman at University X, pays $2,000 for qualified tuition and related expenses for a 16-hour work load for the 1998 Spring semester. Prior to beginning classes, Student A withdraws from 6 course hours. On February 15, 1998, Student A receives a $750 refund from University X. In September 1998, Student A pays University X $1,000 to enroll half-time for the 1998 Fall semester. Prior to beginning classes, Student A withdraws from a 2-hour course, and she receives a $250 refund in October 1998. Student A computes the amount of qualified tuition and related expenses she may claim for 1998 by:

   (i) Adding all qualified expenses paid during the taxable year ($2,000 + 1,000 = $3,000);

   (ii) Adding all refunds of qualified tuition and related expenses received during the taxable year ($750 + $250 = $1,000); and, then

   (iii) Subtracting paragraph (ii) of this Example 1 from paragraph (i) of this Example 1 ($3,000 —$1,000 = $2,000).

   Therefore, Student A's qualified tuition and related expenses for 1998 are $2,000.

   Example 2. (i) In December 1998, Student B, a senior at College Y, pays $2,000 for qualified tuition and related expenses for a 16-hour work load for the 1999 Spring semester. Prior to beginning classes, Student B withdraws from a 4-hour course. On January 15, 1999, Student B files her 1998 income tax return and claims a $400 Lifetime Learning Credit for the $2,000 qualified expenses paid in 1998, which reduces her tax liability for 1998 by $400. On February 15, 1999, Student B receives a $500 refund from College Y.

   (ii) Student B calculates the increase in tax for 1999 by--

   (A) Calculating the redetermined qualified expenses for 1998 ($2,000 —$500 = $1,500);

   (B) Calculating the redetermined credit for the redetermined qualified expenses ($1,500 x .20 = $300); and

   (C) Calculating the difference in tax liability for 1998 resulting from the redetermined credit. Because Student B's tax liability for 1998 was reduced by the full amount of the $400 education tax credit claimed on her 1998 income tax return, the difference in tax liability can be determined by subtracting the redetermined credit from the credit claimed in 1998 ($400 —$300 = $100).

   (iii) Therefore, Student B must increase the tax on her 1999 Federal income tax return by $100.

   Example 3. In September 1998, Student C pays College Z $1,200 in qualified tuition and related expenses to attend evening classes during the 1998 Fall semester. Student C is an employee of Company R. On January 15, 1999, Student C files a federal income tax return for 1998 claiming a Lifetime Learning Credit of $240 (.20 x $1,200), which reduces Student C's tax liability for 1998 by $240. Pursuant to an educational assistance program described in section 127(b), Company R reimburses Student C in February 1999 for the $1,200 of qualified tuition and related expenses paid by Student C in 1998. The $240 education tax credit claimed by Student C for 1998 is subject to recapture. Because Student C paid no net qualified tuition and related expenses for 1998, the redetermined credit for 1998 is zero. Student C must increase the amount of Student C's 1999 tax by the recapture amount, which is $240 (the difference in tax liability for 1998 resulting from the redetermined credit for 1998 ($0)). Because the $1,200 reimbursement relates to expenses for which the taxpayer claimed an education tax credit in a prior year, the reimbursement does not reduce the amount of any qualified tuition and related expenses that Student C paid in 1999.

 
Deputy Commissioner for Services and Enforcement.
Approved:
Assistant Secretary of the Treasury.         

Exhibit 32.1.4-7 
Sample Notice of Proposed Rulemaking by Cross-Reference to Temporary Regulation that Amends Existing Final Regulation

[4830-01-P]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 301

[REG-116664-01]

RIN 1545-BC15

Guidance Necessary to Facilitate Business Electronic Filing

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking by cross-reference to temporary regulations.

SUMMARY: In the Rules and Regulations section of this issue of the Federal Register, the IRS is issuing temporary regulations designed to eliminate regulatory impediments to the electronic filing of certain business income tax returns and other forms. Those regulations affect business taxpayers who file income tax returns electronically. The text of those regulations also serves as the text of these proposed regulations.

DATES: Written or electronic comments and requests for a public hearing must be received by March 19, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-XXXXXX-XX) , room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be handdelivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-XXXXXX-XX), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC, or sent electronically, via the IRS Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-XXXXXX-XX).

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Nathan Rosen (202) 622-4910; concerning submissions of comments and/or requests for a hearing, Robin Jones (202) 622 3521 (not toll-free numbers).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

   The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP 1 Washington, DC 20224. Comments on the collection of information should be received by February 17, 2004. Comments are specifically requested concerning:

   Whether the proposed collection of information is necessary for the proper performance of the functions of the Internal Revenue Service, including whether the information will have practical utility;

   The accuracy of the estimated burden associated with the proposed collection of information (see below);

   How the quality, utility, and clarity of the information to be collected may be enhanced;

   How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques or other forms of information technology; and

   Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of service to provide information.

   The collection of information in this proposed regulation is in §1.170A-11T. Section 170 of the Code permits tax deductions, within limits, for charitable contributions by individuals and corporations. Section 170(a) (2) provides that under certain conditions, corporations may treat a charitable contribution as paid during the taxable year even if the contribution occurs in the following taxable year. Existing regulations provide that to invoke this provision, a corporation must submit with its income tax return a supporting statement and a copy of the board of directors' resolution authorizing the contribution. The proposed regulation eliminates the need to submit the resolution with the return, but provides that the supporting statement must identify the date of the resolution. This information regarding the timing of board action is required to be reported to help ensure that taxpayers properly document their entitlement to deductions for charitable contributions. The IRS cannot ascertain this information from the board resolution itself since, as noted above, taxpayers will no longer have to submit that document with their returns. The collection of information is mandatory. The likely respondents are for-profit corporations.

   Estimated total annual reporting burden: 250,000 hours.

   Estimated average annual burden hours per respondent: .25 hours.

   Estimated number of respondents: 1,000,000

   Estimated annual frequency of responses: annually

   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 may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background and Explanation of Provisions

   Temporary regulations in the Rules and Regulations section of this issue of the Federal Register contain amendments to the Income Tax Regulations (26 CFR Part 1) and the Procedure and Administration Regulations (26 CFR Part 301) designed to eliminate regulatory impediments to the electronic filing of certain income tax returns and other forms. The text of those regulations also serves as the text of these proposed regulations. The preamble to the temporary regulations explains the temporary regulations and these proposed regulations. The regulations generally affect taxpayers who must file any of the following forms: Form 926, "Return by a U.S. Transferor of Property to a Foreign Corporation" ; Form 972, "Consent of Shareholder To Include Specific Amount in Gross Income" ; Form 973, "Corporation Claim for Deduction for Consent Dividends" ; Form 982, "Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)" ; Form 1120, "U.S. Corporation Income Tax Return" ; Form 1120S, "U.S. Income Tax Return for an S Corporation" ; Form 1122, "Authorization and Consent of Subsidiary Corporation To Be Included in a Consolidated Income Tax Return" ; Form 5471, "Information Return of U.S. Persons With Respect To Certain Foreign Corporations" ; Form 5712-A, "Election and Verification of the Cost Sharing or Profit Split Method Under Section 936(h) (5)" ; and Form 8832, "Entity Classification Election."

Special Analyses

   It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that the collection of information described above under the heading "Paperwork Reduction Act" does not affect corporations that elect to be taxed under Subtitle A, Chapter 1, Subchapter S of the Code. Moreover, requiring a corporation to report the information described above concerning board of directors' approval of certain charitable contributions imposes virtually no incremental burden in time or expense. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. Chapter 6) is not required. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

   Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and the Treasury Department specifically request comments on the clarity of the proposed regulations and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing may be scheduled if requested by any person who timely submits comments. If a public hearing is scheduled, notice of the date, time and place for the hearing will be published in the Federal Register.

Drafting Information

   The principal author of these regulations is Nathan Rosen, Office of Associate Chief Counsel (Procedure and Administration), Administrative Provisions and Judicial Practice Division.

List of Subjects

26 CFR Part 1

   Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 301

   Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

   Accordingly, 26 CFR parts 1 and 301 are proposed to be amended as follows:

PART 1--INCOME TAXES

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

   Authority: 26 U.S.C. 7805. * * *

   Par. 2. Section 1.170A-11 is amended by revising paragraph (b) (2) to read as follows:

§1.170A-11 Limitation on, and carryover of, contributions by corporations.

* * * * *

   (b) * * *

   (2) [The text of the proposed amendment to §1.170A-11 (b) (2) is the same as the text of §1.170A-11T(b)(2) published elsewhere in this issue of the Federal Register].

* * * * *

   Par. 3. Section 1.556 2 is amended by:

   1. Revising paragraph (e) (2) (vii) .

   2. Adding paragraph (e) (3).

   The revision and addition read as follows:

§1.556-2 Adjustments to taxable income.

* * * * *

   (e) * * *

   (2) * * *

   (vii) [The text of the proposed amendment to §1.556-2 (e) (2) (vii) is the same as the text of §1.556-2T(e) (2) (vii) published elsewhere in this issue of the Federal Register.

* * * * *

   (3) [The text of the proposed amendment to §1.556-2 (e) (3) is the same as the text of §1.556-2T(e) (3) published elsewhere in this issue of the Federal Register].

* * * * *

   Par. 4. Section 1.565-1 is amended by revising paragraph (b) (3) to read as follows:

§1.565-1 General rule.

* * * * *

   (b) * * *

   (3) [The text of the proposed amendment to §1.565-1 (b) (3) is the same as the text of §1.565-1T(b) (3) published elsewhere in this issue of the Federal Register].

* * * * *

   Par. 5. Section 1.936-7 is amended by revising paragraph (b), Q.& A. 1 to read as follows:

§1.936-7 Manner of making elections under section 936(h) (5); special election for export sales; revocation of election under section 936(a).

* * * * *

   (b) * * *

   Q.& A. 1 [The text of the proposed amendment to §1.936- 7(b), Q.& A. 1 is the same as the text of §1.936-7T(b), Q.& A. 1, published elsewhere in this issue of the Federal Register].

* * * * *

   Par. 6. Section 1.1017-1 is amended by revising paragraph (g) (2) (iii) (B) to read as follows:

§1.1017-1 Basis reductions following a discharge of indebtedness.

* * * * *

   (g) * * *

   (2) * * *

   (iii)* * *

   (B) [The text of the proposed amendment to §1.1017-1 (g) (2) (iii) (B) is the same as the text of §1.1017-1T(g) (2) (iii) (B) published elsewhere in this issue of the Federal Register]

* * * * *

   Par. 7. Section 1.1368-1 is amended by revising paragraphs (f) (5) (iii) and (g) (2) (iii) to read as follows:

§1.1368-1 Distributions by S corporations.

* * * * *

   (f) * * *

   (5) * * *

   (iii) [The text of the proposed amendment to §1.1368-1 (f) (5) (iii) is the same as the text of §1.1368-1T (f) (5) (iii) published elsewhere in this issue of the Federal Register].

* * * * *

   (g) * * *

   (2) * * *

   (iii) [The text of the proposed amendment to §1.1368-1 (g) (2) (iii) is the same as the text of §1.1368-1T (g) (2) (iii) published elsewhere in this issue of the Federal Register].

* * * * *

   Par. 8. Section 1.1377-1 is amended by revising paragraph (b) (5) (i) (C) to read as follows:

§1.1377-1 Pro rata share.

* * * * *

   (b) * * *

   (5) * * *

   (i) * * *

   (C) [The text of the proposed amendment to §1.1377-1 (b) (5) (i) (C) is the same as the text of §1.1377-1T (b) (5) (i) (C) published elsewhere in this issue of the Federal Register].

* * * * *

   Par. 9. Section 1.1502-21 is amended by revising paragraphs (b) (3) (i) and (b) (3) (ii) (B) to read as follows:

§1.1502-21 Net operating losses.

* * * * *

   (b) * * *

   (3) * * * (i) [The text of the proposed amendment to §1.1502-21(b) (3) (i) is the same as the text of §1.1502-21T(b) (3) (i) published elsewhere in this issue of the Federal Register].

   (ii) * * *

   (B) [The text of the proposed amendment to §1.1502-21 (b) (3) (ii) (B) is the same as the text of §1.1502-21T (b) (3) (ii) (B) published elsewhere in this issue of the Federal Register.

* * * * *

   Par. 10. Section 1.1502-75 is amended by revising paragraph (h) (2) to read as follows:

§1.1502-75 Filing of consolidated returns.

* * * * *

   (h) * * *

   (2) [The text of the proposed amendment to §1.1502-75 (h) (2) is the same as the text of §1.1502-75T (h) (2) published elsewhere in the issue of the Federal Register].

* * * * *

   Par. 11. Section 1.1503-2 is amended by revising paragraphs (g) (2) (i), (g) (2) (iv) (B) (3) (iii) and (g) (2) (vi) (B) to read as follows:

§1.1503-2 Dual consolidated loss.

* * * * *

   (g) * * *

   (2) * * * (i) [The text of the proposed amendment to §1.1503-2 (g) (2) (i) is the same as the text of §1.1503-2T(g) (2) (i) published elsewhere in this issue of the Federal Register].

* * * * *

   (iv) * * *

   (B) * * *

   (3) * * *

   (iii) [The text of the proposed amendment to §1.1503-2(g) (2) (iv) (B) (3) (iii) is the same as the text of §1.1503-2T(g) (2) (iv) (B) (3) (iii) published elsewhere in this issue of the Federal Register].

* * * * *

   (vi) * * *

   (B) [The text of the proposed amendment to §1.1503-2(g) (2) (vi) (B) is the same as the text of §1.1503-2T(g) (2) (vi) (B) published elsewhere in this issue of the Federal Register].

* * * * *

   Par. 12. Section 1.6038B-1 is amended by revising paragraphs (b) (1) (i) and (b) (1) (ii) to read as follows:

§1.6038B-1 Reporting of certain transfers to foreign corporations.

* * * * *

   (b) * * * (1) * * * (i) [The text of the proposed amendments to §1.6038B-1 (b) (1) (i) is the same as the text of §1.6038B-IT (b) (1) (i) published elsewhere in this issue of the Federal Register].

   (ii) [The text of the proposed amendment to §1.6038B-1 (b) (1) (ii) is the same as the text of §1.6038B-IT (b) (1) (ii) published elsewhere in this issue of the Federal Register].

* * * *

PART 301--PROCEDURE AND ADMINISTRATION

   Par. 13. The authority citation for part 301 continues to read in part as follows:

   Authority: 26 U.S.C. 7805 * * *

   Par. 14. Section 301.7701-3 is amended by revising paragraph (c) (1) (ii) to read as follows:

§301.7701-3 Classification of certain business entities.

* * * * *

   (c) * * * (1) * * *

   (ii) [The text of the proposed amendment to §301.7701-3 (c) (1) (ii) is the same as the text of §301.7701-3T (c) (1) (ii) published elsewhere in this issue of the Federal Register].

* * * * *

 
Deputy Commissioner for Services and Enforcement.

Exhibit 32.1.4-8 
Sample Existing Final Regulations Amended by Temporary Regulations

[4830-01-p]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9085]

RIN 1545-AY12

Arbitrage and Private Activity Restrictions Applicable to Tax-exempt Bonds Issued by State and Local Governments; Investment-type Property (prepayment); Private Loan (prepayment).

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations on the arbitrage and private activity restrictions applicable to tax-exempt bonds issued by State and local governments. These regulations affect issuers of tax-exempt bonds and provide guidance on the definitions of investment-type property and private loan to help issuers comply with the arbitrage and private activity restrictions.

DATES: Effective Date: These regulations are effective October 3, 2003.

Applicability Date: For dates of applicability, see §§ 1.141-15(b) (3) and 1.148-11(j) of these regulations.

FOR FURTHER INFORMATION CONTACT: Johanna Som de Cerff (202) 622-3980 (not a toll free number).

SUPPLEMENTARY Information:

Background

   This document amends the Income Tax Regulations (26 CFR part 1) under sections 141 and 148 of the Internal Revenue Code by providing rules for determining whether a prepayment for property or services results in a private loan or investment-type property (the final regulations). On April 17, 2002, the IRS published in the Federal Register a notice of proposed rulemaking (REG-113526-98; REG-105369-00) (67 FR 18835) (the proposed regulations). The proposed regulations modify §§ 1.141-5 (c) (2) and 1.148-1 (e) of the Income Tax Regulations to establish which prepayments for property or services give rise to a private loan under section 141(c) or investment-type property under section 148(b) (2) (D). On September 25, 2002, the IRS held a public hearing on the proposed regulations. Written comments responding to the proposed regulations were also received. After consideration of all the comments, the proposed regulations are adopted as amended by this Treasury decision. The revisions are discussed below.

Explanation of Provisions

I. Investment-type Property

A. Existing regulations

The existing regulations, at § 1.148-1(e) (2), contain rules for determining when a prepayment for property or services results in investment-type property. Under that provision, a prepayment generally gives rise to investment-type property if a principal purpose for prepaying is to receive an investment return from the time the prepayment is made until the time payment otherwise would be made. However, a prepayment does not give rise to investment-type property under the existing regulations if (1) it is made for a substantial business purpose other than investment return and the issuer has no commercially reasonable alternative to the prepayment (the business purpose exception); or (2) prepayments on substantially the same terms are made by a substantial percentage of persons who are similarly situated to the issuer but who are not beneficiaries of tax-exempt financing (the customary exception).

B. Business purpose exception

The proposed regulations narrow the scope of the business purpose exception. Under the proposed regulations, a prepayment meets the business purpose exception only if the primary purpose for the prepayment is to accomplish one or more substantial business purposes that (1) are unrelated to any investment return based on the time value of money and (2) cannot be accomplished without the prepayment.

   Commentators suggested that the business purpose exception in the proposed regulations would have limited usefulness and that the language in the existing regulations is superior. However, as discussed in the preamble to the proposed regulations, the business purpose exception in the existing regulations was intended to be a narrow exception and has raised difficult interpretive questions. For example, in many instances it may be unclear whether the alternatives available to the issuer are "commercially reasonable." The IRS and Treasury Department have considered all of the comments relating to the business purpose exception and have concluded that a standard that considers whether one or more business purposes and/or commercially reasonable alternatives exist is not an administrable test for determining whether prepayments give rise to investment-type property. Therefore, based on tax administration considerations and the broad scope of the investment-type property concept, the final regulations delete the business purpose exception. However, the final regulations provide that the Commissioner may, by published guidance, set forth additional circumstances in which a prepayment does not give rise to investment-type property.

C. Customary exception

The proposed regulations retain the customary exception in its present form. Commentators expressed concern that the customary exception may be difficult to apply in some cases. They suggested that the regulations identify examples of prepayments that satisfy the exception. The final regulations retain the customary exception and indicate that it generally applies based on all the facts and circumstances. In addition, the final regulations contain a safe harbor under which a prepayment is deemed to satisfy the customary exception if: (1) the prepayment is made for maintenance, repair, or an extended warranty with respect to personal property (for example, automobiles or electronic equipment), or updates or maintenance or support services with respect to computer software; and (2) the same maintenance, repair, extended warranty, updates or maintenance or support services, as applicable, are regularly provided to nongovernmental persons on the same terms.

D. Certain prepayments to acquire a supply of natural gas or electricity

1. Prepayments for Natural Gas

   The proposed regulations add an exception to the definition of investment-type property for certain natural gas prepayments that are made by or for one or more utilities that are owned by a governmental person, as defined in § 1.141-1(b) (for example, if a joint action agency acquires a natural gas supply for one or more municipal gas or electric utilities). The exception applies only if at least 95 percent of the natural gas purchased with the prepayment is to be consumed by retail customers in the service area of a municipal gas utility, or used to produce electricity that will be furnished to retail customers that a municipal electric utility is obligated to serve under state or Federal law (the use requirement). For this purpose, the service area of a municipal gas utility is defined as (1) any area throughout which the municipal utility provided (at all times during the five-year period ending on the issue date) gas transmission or distribution service, and any area that is contiguous to such an area, or (2) any area where the municipal utility is obligated under state or Federal law to provide gas distribution services as provided in such law.

   Some commentators recommended that the 95 percent threshold be reduced to 85 percent. These commentators stated that various factors make it difficult for municipal gas utilities to determine in advance the precise quantity of gas supplies they will need to serve their customers during a given period. These factors include a limited capability to store gas and variations in demand due to circumstances beyond the utilities' control, such as economic conditions and the weather. In recognition of these unique factors, the final regulations reduce the 95 percent threshold to 90 percent.

   Some commentators recommended that the use requirement apply based on the issuer's reasonable expectations as of the issue date. To ensure that the prepaid gas is consumed by retail customers in the service area of the municipal utility, the final regulations retain the requirement that the prepaid gas supply actually be used for a qualifying purpose.

   Some commentators suggested that the use of natural gas to fuel the transportation of the prepaid gas supply on a pipeline should be a qualifying use under the natural gas exception. The final regulations adopt this comment. Under the final regulations, the use of gas to fuel the pipeline transportation of the prepaid gas supply is a qualifying use and is not pro-rated based on the amount of qualified and nonqualified use of the remaining prepaid gas.

   Commentators indicated that most municipal gas and electric utilities do not have an obligation to serve that arises under state or Federal law. These commentators suggested replacing the "obligation to serve" requirement for municipal electric utilities with a service area rule that is similar to the rule for municipal gas utilities. The final regulations adopt this comment. Commentators also recommended that the definition of service area be expanded to include any area recognized as the service area of the municipal utility under state or Federal law. The final regulations adopt this comment.

   Commentators requested clarification that sales to governmental persons are qualifying sales under the use test. Commentators also requested clarification that a retail customer of a municipal utility is a qualifying end-user even if the prepayment was made by or for another municipal utility. The final regulations do not provide that all sales to governmental persons, or to retail customers of a municipal utility, are qualifying sales. Rather, the final regulations clarify that, in the case of a natural gas prepayment by or for one or more municipal utilities (each, the issuing municipal utility), the use of prepaid gas is a qualifying use if the gas is: (1) furnished to retail gas customers of the issuing municipal utility who are located in the natural gas service area of the issuing municipal utility (other than sales of gas to produce electricity for sale); (2) used by the issuing municipal utility to produce electricity that will be furnished to retail electric customers of the issuing municipal utility who are located in the electricity service area of the issuing municipal utility; (3) used by the issuing municipal utility to produce electricity that will be sold to a municipal utility and furnished to retail electric customers of the purchaser who are located in the electricity service area of the purchaser; (4) sold to a municipal utility if the requirements of (1), (2) or (3) of this paragraph are satisfied by the purchaser (treating the purchaser as the issuing municipal utility); or (5) used to fuel the transportation of the prepaid gas supply on a pipeline. Thus, for example, the sale of gas or electricity by the issuing municipal utility directly to customers of another municipal utility is not a qualifying use.

   Some commentators recommended that the final regulations define "retail customer" as a customer that is not purchasing for resale. The final regulations provide that a retail customer is a customer that purchases natural gas or electricity, as applicable, other than for resale. The final regulations also clarify that the consumption of natural gas by a nongovernmental person to produce electricity for sale is not a qualifying use of natural gas under the 90 percent use test.

   Some commentators requested clarification of which "contiguous" areas may be treated as part of a municipal utility's service area. One commentator suggested that contiguous areas should not be considered part of the service area. To provide clarity, and in light of the expansion of the service area definition to include any area recognized as the service area under state or Federal law, the final regulations eliminate contiguous areas from the definition of service area.

   Some commentators suggested that the definition of service area should be expanded to include any area "in which" (rather than "throughout which" ) the municipal utility provided service during the five-year period. To ensure that the gas or electricity is consumed by customers in an area recognized as the service area of a municipal utility under state or Federal law, or throughout which the municipal utility provided service during the five-year period, the final regulations do not adopt this comment.

2. Prepayments for Electricity

   Some commentators suggested that the natural gas exception should be expanded to include prepayments for electricity. These commentators stated that the restructuring of the electric power industry has affected municipal electric utilities in a manner that is similar to the effect that deregulation of the natural gas industry had on municipal gas utilities. These commentators stated that restructuring has threatened the ability of municipal electric utilities to obtain a secure supply of electric power on commercially reasonable terms, and that electric power prepayment transactions are necessary to obtain a guaranteed supply of electric power on favorable terms in light of restructuring.

   The final regulations add an exception to the definition of investment-type property for certain electricity prepayments that are made by or for one or more municipal utilities (for example, if a joint action agency acquires electricity for one or more municipal electric utilities). The exception applies only if at least 90 percent of the prepaid electricity financed by the issue is used for a qualifying use. For this purpose, electricity is used for a qualifying use if it is to be: (1) furnished to retail electric customers of the issuing municipal utility who are locate~ in the electricity service area of the issuing municipal utility or (2) sold to a municipal utility and furnished to retail electric customers of the purchaser who are located in the electricity service area of the purchaser.

3. Remedial Actions

   The preamble to the proposed regulations states that issuers may apply principles similar to the rules of §1.141-12 to cure a violation of the use requirement. Commentators requested clarification regarding which remedies under §1.141-12 are available for this purpose. The final regulations provide that issuers may apply principles similar to the rules of §1.141-12 to cure a violation of the 90 percent use requirement, and that the "redemption or defeasance " remedy in §1.141 12 (d) and the "alternative use of disposition proceeds" remedy in §1.141-12(e) are available for this purpose.

   Some commentators requested clarification of the amount of nonqualified bonds that must be redeemed or defeased under the "redemption or defeasance" remedy. Under the final regulations, the amount of nonqualified bonds is determined in the same manner as for output contracts taken into account under the private business tests, including the principles of §1.141-7(d), treating nonqualified sales of gas or electricity as satisfying the benefits and burdens test under §1.141-7(c) (1). Commentators also suggested that the definition of "nonqualified bonds" under §1.141-12 ,may require excessive amounts of bonds to be retired. The IRS and Treasury Department are considering this comment in connection with possible amendments to §1.141-12.

4. Commodity Swap Contracts

   The proposed regulations provide that a transaction will not fail to qualify for the natural gas exception by reason of any commodity swap contract that may be entered into between the issuer and an unrelated party (other than the gas supplier), or between the gas supplier and an unrelated party (other than the issuer), so long as each swap contract is an independent contract. For this purpose, the proposed regulations provide that a swap contract is an independent contract if the obligation of each party to perform under the swap contract is not dependent on performance by any person (other than the other party to the swap contract) under another contract (for example, a gas supply contract or another swap contract). Notice 2002-52 (2002-30 I.R.B. 187), provides that a natural gas commodity swap contract will not fail to be an independent contract solely because the swap contract may terminate in the event of a failure of a gas supplier to deliver gas for which the swap contract is a hedge.

   Commentators generally agreed with the provision on swap contracts in the proposed regulations, as modified by Notice 2002-52. The final regulations retain the provision on commodity swap contracts for natural gas prepayments, as modified by Notice 2002-52, and expand it to apply to electricity prepayments.

E. De minimis prepayments

The proposed regulations add an exception for prepayments made within 90 days of the date of delivery of all the property or services to which the prepayment relates. Commentators recommended that the exception apply based on reasonable expectations. The final regulations adopt this comment. This change to a reasonable expectations standard is intended to permit a prepayment to qualify for the de minimis exception even if an unexpected event beyond the control of the issuer causes delivery of the property or services to be delayed beyond the 90 day period. The reasonable expectations standard does not, however, apply to any change to the terms of the prepayment other than an unexpected delay in delivery.

II. Private Loans

   The existing regulations, at §1.141-5(c) (2) (ii), provide rules for determining whether a prepayment for property or services is treated as a loan for purposes of the private loan financing test. The existing regulations for private loans are similar to the existing regulations in §1.148-1(e) (2) for determining whether a prepayment gives rise to investment-type property, except that the private loan regulations focus on whether the prepayment provides a benefit of tax-exempt financing to the seller. The final regulations amend the private loan provisions of §1.141-5(c) (2) to conform to the amendments to the definition of investment-type property in the final regulations.

III. Tables of Contents

   The final regulations amend the tables of contents in §§ 1.141-0 and 1.148-0 to reflect the final regulations and certain previously issued regulations under sections 141 and 148.

Effective Dates

   The final regulations apply to bonds sold on or after October 3, 2003. In addition, issuers may apply the final regulations to bonds sold before October 3, 2003, that are subject to §§ 1.141-5 and 1.148-1.

Special Analyses

   It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the rule does not impose a collection of information on small entities, the provisions of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.) do not apply.

Drafting Information

   The principal authors of these regulations are Rebecca L. Harrigal and Johanna Som de Cerff, Office of Chief Counsel (TE/GE), IRS, and Stephen J. Watson, Office of Tax Policy, Treasury Department. However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

   Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

   Authority: 26 U.S.C. 7805 * * *

   Par. 2. Section 1.141-0 is amended by revising the entry for §1.141-15(b) to read as follows:

§1.141-0 Table of contents.

* * * * *

§1.141-15 Effective dates.

* * * * *

(b) Effective dates.

(1) In general.

(2) Certain short-term arrangements.

(3) Certain prepayments.

* * * * *

   Par. 3. In §1.141-5, paragraph (c) (2) (ii) is revised and paragraphs (c) (2) (iii) and (c) (2) (iv) are added to read as follows:

§1.141-5 Private loan financing test.

* * * * *

   (c) * * *

   (2) * * *

   (ii) Certain prepayments treated as loans. Except as otherwise provided, a prepayment for property or services, including a prepayment for property or services that is made after the date that the contract to buy the property or services is entered into, is treated as a loan for purposes of the private loan financing test if a principal purpose for prepaying is to provide a benefit of tax-exempt financing to the seller. A prepayment is not treated as a loan for purposes of the private loan financing test if--

   (A) Prepayments on substantially the same terms are made by a substantial percentage of persons who are similarly situated to the issuer but who are not beneficiaries of tax-exempt financing;

   (B) The prepayment is made within 90 days of the reasonably expected date of delivery to the issuer of all of the property or services for which ~he prepayment is made; or

   (C) The prepayment meets the requirements of §1.148- 1(e) (2) (iii) (A) or (B) (relating to certain prepayments to acquire a supply of natural gas or electricity).

   (iii) Customary prepayments. The determination of whether a prepayment satisfies paragraph (c) (2) (ii) (A) of this section is generally made based on all the facts and circumstances. In addition, a prepayment is deemed to satisfy paragraph (c) (2) (ii) (A) of this section if--

   (A) The prepayment is made for--

   (1) Maintenance, repair, or an extended warranty with respect to personal property (for example, automobiles or electronic equipment); or

   (2) Updates or maintenance or support services with respect to computer software; and

   (B) The same maintenance, repair, extended warranty, updates or maintenance or support services, as applicable, are regularly provided to nongovernmental persons on the same terms.

   (iv) Additional prepayments as permitted by the Commissioner. The Commissioner may, by published guidance, set forth additional circumstances in which a prepayment is not treated as a loan for purposes of the private loan financing test.

* * * * *

   Par. 4. Section 1.141-15 is amended by adding paragraph (b) (3) to read as follows:

§1.141-15 Effective dates.

* * * * *

   (b) * * *

   (3) Certain prepayments. Except as provided in paragraph (c) of this section, paragraphs (c) (2) (ii), (c) (2) (iii) and (c) (2) (iv) of §1.141-5 apply to bonds sold on or after October 3, 2003. Issuers may apply paragraphs (c) (2) (ii), (c) (2) (iii) and (c) (2) (iv) of §1.141-5, in whole but not in part, to bonds sold before October 3, 2003, that are subject to §1.141-5.

   Par. 5. Section 1.148-0 is amended by:

   1. Adding entries in paragraph (c) for §1.148-1, paragraphs (e) (1) through (e) (3) .

   2. Adding entries in paragraph (c) for §1.148-11, paragraphs (b) (4), (h), (i) and (j).

   The additions read as follows:

§1.148-0 Scope and table of contents.

* * * * *

(c) Table of contents.

* * * * *

§1.148-1 Definitions and elections.

* * * * *

(e) * * *

(1) In general.

(2) Prepayments.

(3) Certain hedges.

* * * * *

§1.148-11 Effective dates.

(b) * * *

(4) No elective retroactive application for safe harbor for establishing fair market value for guaranteed investment contracts and investments purchased for a yield restricted defeasance escrow.

* * * * *

(h) Safe harbor for establishing fair market value for guaranteed investment contracts and investments purchased for a yield restricted defeasance escrow.

(i) Special rule for investments purchased for a yield restricted defeasance escrow.

(j) Certain prepayments.

   Par. 6. In §1.148-1, paragraphs (e) (1) and (2) are revised to read as follows:

§1.148-1 Definitions and elections.

* * * * *

   (e) Investment-type property--(1) In general. Investment-type property includes any property, other than property described in section 148(b) (2) (A), (B), (C) or (E), that is held principally as a passive vehicle for the production of income. For this purpose, production of income includes any benefit based on the time value of money.

   (2) Prepayments--(i) In general--(A) Generally. Except as otherwise provided in this paragraph (e) (2), a prepayment for property or services, including a prepayment for property or services that is made after the date that the contract to buy the property or services is entered into, also gives rise to investment-type property if a principal purpose for prepaying is to receive an investment return from the time the prepayment is made until the time payment otherwise would be made. A prepayment does not give rise to investment-type property if--

   (1) Prepayments on substantially the same terms are made by a substantial percentage of persons who are similarly situated to the issuer but who are not beneficiaries of tax-exempt financing;

   (2) The prepayment is made within 90 days of the reasonably expected date of delivery to the issuer of all of the property or services for which the prepayment is made; or

   (3) The prepayment meets the requirements of paragraph (e)(2)(iii)(A) or (B) of this section.

   (B) Example. The following example illustrates an application of this paragraph (e)(2)(i):

   Example. Prepayment after contract is executed. In 1998, City A enters into a ten-year contract with Company Y. Under the contract, Company Y is to provide services to City A over the term of the contract and in return City A will pay Company Y for its services as they are provided. In 2004, City A issues bonds to finance a lump sum payment to Company Y in satisfaction of City A's obligation to pay for Company Y's services to be provided over the remaining term of the contract. The use of bond proceeds to make the lump sum payment constitutes a prepayment for services under paragraph (e)(2)(i) of this section, even though the payment is made after the date that the contract is executed. (ii) Customary prepayments. The determination of whether a prepayment satisfies paragraph (e)(2)(i)(A)(1) of this section is generally made based on all the facts and circumstances. In addition, a prepayment is deemed to satisfy paragraph (e)(2)(i)(A)(1) of this section if--

   (A) The prepayment is made for--

   (1) Maintenance, repair, or an extended warranty with respect to personal property (for example, automobiles or electronic equipment); or

   (2) Updates or maintenance or support services with respect to computer software; and

   (B) The same maintenance, repair, extended warranty, updates or maintenance or support services, as applicable, are regularly provided to nongovernmental persons on the same terms.

   (iii) Certain prepayments to acquire a supply of natural gas or electricity--(A) Natural gas prepayments. A prepayment meets the requirements of this paragraph (e)(2)(iii)(A) if--

   (1) It is made by or for one or more utilities that are owned by a governmental person, as defined in §1.141-1(b) (each of which is referred to in this paragraph (e)(2)(iii)(A) as the issuing municipal utility), to purchase a supply of natural gas; and

   (2) At least 90 percent of the prepaid natural gas financed by the issue is used for a qualifying use. Natural gas is used for a qualifying use if it is to be--

   (i) Furnished to retail gas customers of the issuing municipal utility who are located in the natural gas service area of the issuing municipal utility, provided, however, that gas used to produce electricity for sale shall not be included under this paragraph (e)(2)(iii)(A)(2)(i);

   (ii) Used by the issuing municipal utility to produce electricity that will be furnished to retail electric customers of the issuing municipal utility who are located in the electricity service area of the issuing municipal utility;

   (iii) Used by the issuing municipal utility to produce electricity that will be sold to a utility that is owned by a governmental person and furnished to retail electric customers of the purchaser who are located in the electricity service area of the purchaser;

   (iv) Sold to a utility that is owned by a governmental person if the requirements of paragraph (e)(2)(iii)(A)(2)(i),

   (ii) or (iii) of this section are satisfied by the purchaser (treating the purchaser as the issuing municipal utility); or

   (v) Used to fuel the pipeline transportation of the prepaid gas supply acquired in accordance with this paragraph (e)(2)(iii)(A).

   (B) Electricity prepayments. A prepayment meets the requirements of this paragraph (e)(2)(iii)(B) if--

   (1) It is made by or for one or more utilities that are owned by a governmental person (each of which is referred to in this paragraph (e) (2) (iii) (B) as the issuing municipal utility) to purchase a supply of electricity; and

   (2) At least 90 percent of the prepaid electricity financed by the issue is used for a qualifying use. Electricity is used for a qualifying use if it is to be--

   (i) Furnished to retail electric customers of the issuing municipal utility who are located in the electricity service area of the issuing municipal utility; or

   (ii) Sold to a utility that is owned by a governmental person and furnished to retail electric customers of the purchaser who are located in the electricity service area of the purchaser.

   (C) Service area. For purposes of this paragraph (e) (2) (iii), the service area of a utility owned by a governmental person consists of--

   (1) Any area throughout which the utility provided, at all times during the 5-year period ending on the issue date--

   (i) In the case of a natural gas utility, natural gas transmission or distribution service; and

   (ii) In the case of an electric utility, electricity distribution service; and

   (2) Any area recognized as the service area of the utility under state or Federal law.

   (D) Retail customer. For purposes of this paragraph (e) (2) (iii), a retail customer is a customer that purchases natural gas or electricity, as applicable, other than for resale.

   (E) Commodity swaps. A prepayment does not fail to meet the requirements of this paragraph (e) (2) (iii) by reason of any commodity swap contract that may be entered into between the issuer and an unrelated party (other than the gas or electricity supplier), or between the gas or electricity supplier and an unrelated party (other than the issuer), so long as each swap contract is an independent contract. A swap contract is an independent contract if the obligation of each party to perform under the swap contract is not dependent on performance by any person (other than the other party to the swap contract) under another contract (for example, a gas or electricity supply contract or another swap contract); provided, however, that a commodity swap contract will not fail to be an independent contract solely because the swap contract may terminate in the event of a failure of a gas or electricity supplier to deliver gas or electricity for which the swap contract is a hedge.

   (F) Remedial action. Issuers may apply principles similar to the rules of §1.141-12, including §1.141-12(d) (relating to redemption or defeasance of nonqualified bonds) and §1.141-12(e) (relating to alternative use of disposition proceeds), to cure a violation of paragraph (e) (2) (iii) (A) (2) or (e) (2) (iii) (B) (2) of this section. For this purpose, the amount of nonqualified bonds is determined in the same manner as for output contracts taken into account under the private business tests, including the principles of §1.141-7(d), treating nonqualified sales of gas or electricity under this paragraph (e) (2) (iii) as satisfying the benefits and burdens test under §1.141-7(c) (1).

   (iv) Additional prepayments as permitted by the Commissioner. The Commissioner may, by published guidance, set forth additional circumstances in which a prepayment does not give rise to investment-type property.

* * * * *

   Par. 7. Section 1.148-11 is amended by adding paragraph (j) to read as follows:

§1.148-11 Effective dates.

* * * * *

   (j) Certain prepayments. Section 1.148-1(e) (1) and (2) apply to bonds sold on or after October 3, 2003. Issuers may apply §1.148-1(e) (1) and (2), in whole but not in part, to bonds sold before October 3, 2003, that are subject to §1.148-1.

 
Dale F. Hart,       
Acting Deputy Commissioner for Services and Enforcement.
Approved: July 25, 2003.
 
Pamela F. Olson,    
Assistant Secretary of the Treasury

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