Revenue Ruling 2004-82

Rev. Rul. 2004-82
Rev. Rul. 2004-82, 2004-35 I.R.B. 350
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
                            LOW-INCOME HOUSING CREDIT
                             Released: July 30, 2004
                           Published: August 30, 2004

 Section 42.–Low-Income Housing Credit, 26 CFR 1.42-5: Monitoring compliance with low-income housing credit requirements.

  Questions are answered pertaining to the vacant unit rule, record retention, and tenant income documentation.

Section 142.–Exempt Facility Bond, 26 CFR 1.103-8: Interest on bonds to finance certain exempt facilities.

  If the full-time security officer for a s 42 low-income housing project occupies a unit in the project, is that unit functionally related and subordinate property and therefore property that is reasonably required for the project?

  Low-income housing credit. This ruling answers 12 questions about the low-income housing credit provisions under section 42 of the Code.

  Low-income housing credit. This ruling answers 12 questions about the low-income housing credit provisions under section 42 of the Code.

PURPOSE

  This revenue ruling answers certain questions about the low-income housing credit under s 42 of the Internal Revenue Code.

LAW AND QUESTIONS AND ANSWERS

A. ELIGIBLE BASIS AND QUALIFIED BASIS ISSUES

Law

  Section 42(a) provides for a credit for investment in certain low-income housing buildings. The amount of the low-income housing credit for any taxable year in the credit period is an amount equal to the applicable percentage of the qualified basis of each qualified low-income building (as defined in s 42(c)(2)).

  Section 42(c)(1)(A) provides that the qualified basis of any qualified low-income building for any taxable year is an amount equal to (i) the applicable fraction (determined as of the close of the taxable year) of (ii) the eligible basis of the building (determined under s 42(d)).

  Section 42(c)(1)(B) defines the applicable fraction as the smaller of the unit fraction or the floor space fraction. Section 42(c)(1)(C) defines the unit fraction as the fraction the numerator of which is the number of low-income units (as defined in s 42(i)(3)(A)) in the building and the denominator of which is the number of residential rental units (that is, all units in the building which are available to rent as personal residences), whether or not occupied, in the building. Section 42(c)(1)(D) defines the floor space fraction as the fraction the numerator of which is the total floor space of the low-income units in the building and the denominator of which is the total floor space of the residential rental units, whether or not occupied, in the building.

  Section 42(d)(1) provides that the eligible basis of a new building is its adjusted basis as of the close of the first taxable year of the credit period. Section 42(d)(4)(A) provides that, except as provided in s 42(d)(4)(B) and (C), the adjusted basis of any building is determined without regard to the adjusted basis of any property that is not residential rental property. Section 42(d)(4)(B) provides that the adjusted basis of any building includes the adjusted basis of property of a character subject to the allowance for depreciation (1) used in common areas or (2) provided as comparable amenities to all residential rental units in the building.

  Section 42(d)(4)(C)(i) provides that the adjusted basis of any building located in a qualified census tract is determined by taking into account the adjusted basis of property (of a character subject to the allowance for depreciation and not otherwise taken into account) used throughout the taxable year in providing any community service facility. Section 42(d)(4)(C)(iii) provides that the term “community service facility” means any facility designed to serve primarily individuals whose income is 60 percent or less of area median income (AMGI) (within the meaning of s 42(g)(1)(B)). Section 42(d)(5)(C)(ii)(I) defines the term “qualified census tract” as any census tract (1) which is designated by the Secretary of Housing and Urban Development (HUD), and (2) for the most recent year for which census data are available on household income in the tract, either in which 50 percent or more of the households have an income which is less than 60 percent of the AMGI for the year or which has a poverty rate of at least 25 percent. See http:// www.huduser.org/datasets/qct.html for a listing of census tracts designated by the Secretary of HUD.

  Section 42(d)(4)(C)(ii) provides that the increase in the adjusted basis of any building which is taken into account because of a community service facility may not exceed 10 percent of the eligible basis of the qualified low-income housing project (as defined in s 42(g)(1)) of which the community service facility is a part. For this purpose, s 42(d)(4)(C)(ii) provides that all community service facilities which are part of the same qualified low-income housing project are treated as one facility.

  Rev. Rul. 2003-77, 2003-29 I.R.B. 75, provides that the requirement that a community service facility must be designed to serve primarily individuals whose income is 60 percent or less of AMGI will be satisfied if the following conditions are met. First, the facility must be used to provide services that will improve the quality of life for community residents. Second, the taxpayer must demonstrate that the services provided at the facility will be appropriate and helpful to individuals in the area of the project whose income is 60 percent or less of AMGI. This may, for example, be demonstrated in the market study required to be conducted under s 42(m)(1)(A)(iii), or another similar study. Third, the facility must be located on the same tract of land as one of the buildings that is part of the qualified low-income housing project. Finally, if fees are charged for services provided, they must be affordable to individuals whose income is 60 percent or less of AMGI.

  The legislative history of s 42 states that residential rental property for purposes of the low-income housing credit has the same meaning as residential rental property for purposes of s 103. The legislative history of s 42 further states that residential

rental property includes residential rental units, facilities for use by the tenants, and other facilities reasonably required by the project. H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-89 (1986), 1986-3 (Vol. 4) C.B. 89.

  In the Tax Reform Act of 1986 (the “1986 Act”), Congress reorganized ss 103 and 103A of the Internal Revenue Code of 1954 (the “1954 Code”) regarding tax-exempt bonds into ss 103 and 141 through 150 of the Internal Revenue Code of 1986. Congress intended that to the extent not amended by the 1986 Act, all principles of pre-1986 Act law would continue to apply to the reorganized provisions. H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-686 (1986), 1986-3 (Vol. 4) C.B. 686. Because no regulations have been promulgated relating to residential rental property for purposes of s 103, the regulations relating to residential rental property promulgated pursuant to the 1954 Code continue to apply except as otherwise modified by the 1986 Act and subsequent law.

  Under s 1.103-8(b)(4)(i) of the Income Tax Regulations, facilities that are functionally related and subordinate to residential rental projects are considered residential rental property. Section 1.103-8(b)(4)(iii) provides that functionally related and subordinate facilities include facilities for use by the tenants, such as swimming pools and other recreational facilities, parking areas, and other facilities reasonably required for the project. Examples in s 1.103-8(b)(4)(iii) of facilities reasonably required for a project include units for resident managers or maintenance personnel.

  Q-1. A new qualified low-income building (Building) is located in an area in which owners of apartment buildings typically employ security officers due to the level of crime in the area.

  (a) If a unit in Building is occupied by a full-time security officer for that building and Building’s owner requires the security officer to live in the unit, is the adjusted basis of that unit includable in Building’s eligible basis under s 42(d)(1)?

  (b) If yes, is that unit a residential rental unit includable in the numerator and denominator of Building’s applicable fraction under s 42(c)(1)(B)?

  A-1. (a) Yes. The legislative history of s 42 indicates that residential rental property includes, in addition to the residential rental units, facilities for use by the tenants and other facilities reasonably required by the project.

  Under s 1.103-8(b)(4)(iii), functionally related and subordinate property is property that is reasonably required for the project. Examples of functionally related and subordinate property are units for resident managers or maintenance personnel. See s 1.103-8(b)(4)(iii). Thus, while units for resident managers or maintenance personnel are not residential rental units, they are treated as part of residential rental property because these units are functionally related and subordinate to the project. The unit occupied by a full-time security officer is similar to the units described in the examples contained in s 1.103-8(b)(4)(iii), and is reasonably required by the project because of the level of crime in the area. Thus, the unit is functionally related and subordinate to Building. As a result, the unit is residential rental property for purposes of s 42 and its adjusted basis is includable in Building’s eligible basis under s 42(d)(1).

  (b) No. The term “residential rental unit” has a different meaning than the term “residential rental property” for purposes of s 42. Under s 1.103- 8(b)(4)(iii), units for resident managers or maintenance personnel are residential rental property because they are functionally related and subordinate to residential rental projects, not because they are residential rental units. Similarly, a unit occupied by a full-time security officer is not a residential rental unit. Only residential rental units are includable in Building’s applicable fraction under s 42(c)(1)(B).

  If in a later year of the credit period, the unit occupied by the full-time security officer is converted to a residential rental unit, the unit will be includable in the denominator of Building’s applicable fraction for that year. If the unit also becomes a low-income unit in a later year, the unit will be includable in the numerator of Building’s applicable fraction for that year.

  Q-2. A new qualified low-income building (Building) received a housing credit allocation on June 1, 2003, and was placed in service in 2004. Building is located in a qualified census tract (as defined in s 42(d)(5)(C)). The neighborhood in which Building is located is an area with a high rate of crime. In 2004, the local police department leases a unit in Building to be used as a police substation (Facility). The Facility is part of the police department’s community outreach program. This Facility is intended to serve as a deterrent to crime in the community, assist the community with solving crime-related problems, reduce the response time to area calls for service, and provide the locally assigned police officers with a local office. The services provided by the police are free of charge. The adjusted basis of the property constituting the Facility (of a character subject to the allowance for depreciation and not otherwise taken into account in the adjusted basis of Building) does not exceed 10 percent of the eligible basis of Building.

  As required by s 42(m)(1)(A)(iii), prior to the allocation of low-income housing credit to Building, a comprehensive market study was conducted to assess the housing needs of the low-income individuals in the area to be served by Building. The study found, among other items, that due to the high rate of crime in the community in which Building is located, providing a police substation would be appropriate and helpful to individuals in the area of Building whose income is 60 percent or less of AMGI.

  (a) Is the adjusted basis of the Facility includable in Building’s eligible basis under s 42(d)(1)?

  (b) If yes, is the Facility includable in Building’s applicable fraction under s 42(c)(1)(B)?

  A-2. (a) Yes. The Facility qualifies as a community service facility under  s 42(d)(4)(C)(iii). Under the facts presented, the Facility is designed to serve primarily individuals whose income is 60 percent or less of AMGI for the following reasons: (1) the services provided at the Facility are services that will help improve the quality of life for community residents; (2) the market study required to be conducted under s 42(m)(1)(A)(iii) found that the services provided at the Facility would be appropriate and helpful to individuals in the area of Building whose income is 60 percent or less of AMGI; (3) the Facility is located within Building; and (4) the services provided at the Facility are affordable to individuals whose income is 60 percent or less of AMGI.

  Because the other requirements set forth in s 42(d)(4)(C) are met, the adjusted basis of Building will be determined by taking into account the adjusted basis of the Facility. Thus, the adjusted basis of the Facility is includable in Building’s eligible basis.

  (b) No. The Facility is not a residential rental unit for purposes of s 42. Therefore, the Facility is not includable in either the numerator or denominator of Building’s applicable fraction.

  Q-3. On applying to the housing credit agency for an allocation of s 42 credits for a new building, the housing credit agency requires that the applicant pay a nonrefundable application fee. If the applicant is successful, an allocation fee is payable to the housing credit agency. Are the application fee and allocation fee includable in the eligible basis of the applicant’s

low-income housing building?

  A-3. No. The application fee and allocation fee are not includable in the eligible basis of the applicant’s low-income housing building because the fees are not capitalizable into the adjusted basis of the building. See s 263 and s 263A. However, depending on the facts and circumstances, all or a portion of these fees may be required to be capitalized as amounts paid to create an intangible asset. See s 1.263(a)-4. Any portion of these fees not required to be capitalized under s 1.263(a)-4 may be deductible as an ordinary and necessary expense under s 162 or s 212, provided the taxpayer satisfies the requirements of those sections.

B. FIRST-YEAR LOW-INCOME UNIT ISSUE

Law

  Section 42(i)(3)(A) defines “low-income unit” as any unit in a building if (i) the unit is rent-restricted (as defined in s 42(g)(2)), and (ii) the individuals occupying the unit meet the income limitation applicable under s 42(g)(1) to the project of which the building is a part (individuals that meet the applicable income limitation are referred to as “income-qualified”). Section 42(i)(3)(B) provides that a unit will not be treated as a low-income unit unless the unit is suitable for occupancy and used other than on a transient basis.

  Section 42(f)(1) defines the “credit period” for a low-income housing credit building as the period of 10 taxable years beginning with (A) the taxable year in which the building is placed in service or (B) at the election of the taxpayer, the succeeding taxable year, but in either case only if the building is a qualified low-income building as of the close of the first year of the period.

  Section 42(f)(2)(A) provides a special rule for determining the amount of the low-income housing credit allowable for the first year of the credit period. It provides that the credit allowable under s 42(a) with respect to any building for the first taxable year of the credit period must be determined by substituting for the applicable fraction under s 42(c)(1) the fraction (i) the numerator of which is the sum of the applicable fractions determined under s 42(c)(1) as of the close of each full month of the first taxable year of the credit period during which the building was in service, and (ii) the denominator of which is 12.

  Q-4. On initial occupancy of a unit in the first year of a newly constructed building’s credit period, an income-qualified tenant moved into the unit on the last day of a month. The unit was rent-restricted in accordance with s 42(g)(2). In determining the low-income housing credit for the building for the first year of the credit period, is the unit treated as a low-income unit for that month for purposes of the fraction calculated under s 42(f)(2)(A)?

  A-4. Yes. The unit is treated as a low-income unit eligible for inclusion in the numerator and denominator of the monthly applicable fraction calculated under s 42(f)(2)(A)(i) if the tenant, who meets the income limitation under s 42(g)(1), resides in the rent-restricted unit on the last day of the month. However, in accordance with s 42(f)(2)(A), the building must have been placed in service for a full month for the unit to be includable in the numerator and denominator of the monthly applicable fraction.

C. EXTENDED LOW-INCOME HOUSING COMMITMENT ISSUE

Law

  Section 42(h)(6)(A) provides that no credit will be allowed with respect to any building for the taxable year unless an extended low-income housing commitment (as defined in s 42(h)(6)(B)) is in effect as of the end of the taxable year. Section 42(h)(6)(B)(i) provides that the term “extended low-income housing commitment” means any agreement between the taxpayer and the housing credit agency which requires that the applicable fraction (as defined in s 42(c)(1)) for the building for each taxable year in the extended use period will not be less than the applicable fraction specified in the agreement and which prohibits the actions described in subclauses (I) and (II) of s 42(h)(6)(E)(ii)” (emphasis added).

  Section 42(h)(6)(E)(ii) provides that the termination of an extended low-income housing commitment under s 42(h)(6)(E)(i) will not be construed to permit before the close of the 3-year period following the termination (I) the eviction or termination of tenancy (other than for good cause) of an existing tenant of any low-income unit, or (II) any increase in the gross rent with respect to a low-income unit not otherwise permitted under s 42.

  Section 42(h)(6)(D) defines the term “extended use period” as the period beginning on the first day in the compliance period on which the building is part of a qualified low-income housing project and ending on the later of (1) the date specified by the agency in the extended low-income housing commitment, or (2) the date which is 15 years after the close of the compliance period.

  Section 42(h)(6)(J) provides that if, during a taxable year, there is a determination that a valid extended low-income housing commitment was not in effect as of the beginning of the year, the determination will not apply to any period before that year and s 42(h)(6)(A) will be applied without regard to the determination provided that the failure is corrected within 1 year from the date of the determination.

  In the Omnibus Budget Reconciliation Act of 1990, 1991-2 C.B. 481, 531  (the “1990 Act”), Congress amended s 42(h)(6)(B)(i) by adding the language emphasized above, which prohibits the actions described in subclauses (I) and (II) of s 42(h)(6)(E)(ii). At the time of this amendment, however, s 42(h)(6)(E)(ii) was already part of s 42.

  The legislative history to s 42 states that the extended low-income housing commitment must prohibit the eviction or termination of tenancy (other than for good cause) of an existing tenant of a low-income unit or any increase in the gross rent inconsistent with the rent restrictions on the unit. H. Rep. No. 894, 101st Cong., 2d Sess. 10, 13 (1990).

  Q-5. Must the extended low-income housing commitment prohibit the actions described in subclauses (I) and (II) of s 42(h)(6)(E)(ii) only for the 3- year period described in s 42(h)(6)(E)(ii)?

  A-5. No. Section 42(h)(6)(B)(i) requires that an extended low-income housing commitment include a prohibition during the extended use period against (1) the eviction or the termination of tenancy (other than for good cause) of an existing tenant of any low-income unit (no-cause eviction protection) and (2) any increase in the gross rent with respect to the unit not otherwise permitted under s 42. When Congress amended s 42(h)(6)(B)(i) to add the language emphasized above, s 42(h)(6)(E)(ii) was already part of s 42. As a result, Congress must have intended the amendment to s 42(h)(6)(B)(i) to add an additional requirement beyond what was contained in s 42(h)(6)(E)(ii), which already prohibited the actions described in that section for the 3 years following the termination of the extended use period. Because the requirements of s 42(h)(6)(B)(i) otherwise apply for the extended use period, Congress must have intended the addition of the prohibition against the actions described in subclauses (I) and (II) of s 42(h)(6)(E)(ii) to apply throughout the extended use period.

  If it is determined by the end of a taxable year that a taxpayer’s extended low-income housing commitment for a building does not meet the requirements for an extended low-income housing commitment under s 42(h)(6)(B) (for example, it does not provide no-cause eviction protection for the tenants of low-income units throughout the extended use period), the low-income housing credit is not allowable with respect to the building for the taxable year, or any prior taxable year. However, if the failure to have a valid extended low-income housing commitment in effect is corrected within 1 year from the date of the determination, the determination will not apply to the current year of the credit period or any prior year.

  Pursuant to this revenue ruling, each housing credit agency is required to review its extended low-income housing commitments for compliance with the interpretation of s 42(h)(6)(B)(i) provided in this question and answer. This review must be completed by December 31, 2004. If during the review period the housing credit agency determines that an extended low-income housing commitment is not in compliance with the interpretation of s 42(h)(6)(B)(i) provided in this question and answer, the 1-year period described under s 42(h)(6)(J) will commence on the date of that determination.

D. HOME INVESTMENT PARTNERSHIP ACT LOAN ISSUES

Law

  Section 42(b)(2)(A) provides that for a qualified low-income building placed in service by the taxpayer after 1987, the term “applicable percentage” means (1) the 70-percent present value credit under s 42(b)(2)(B)(i) for new buildings which are not federally subsidized, and (2) the 30-percent present value credit under s 42(b)(2)(B)(ii) for new buildings which are federally subsidized and for existing buildings.

  In general, s 42(d)(5)(C)(i) provides that in the case of any building located in a designated qualified census tract or difficult development area (as defined in s 42(d)(5)(C)(ii) and (iii)), (I) the eligible basis of a new building will be 130 percent of the eligible basis determined without regard to this rule, and (II) in the case of an existing building, the rehabilitation expenditures taken into account under s 42(e) will be 130 percent of the expenditures determined without regard to this rule.

  Section 42(g)(1) defines the term “qualified low-income housing project” as any project for residential rental property if the project meets the requirements of s 42(g)(1)(A) or (B), whichever the taxpayer elects. The election is irrevocable. The project meets the requirements of s 42(g)(1)(A) if 20 percent or more of the residential units in the project are rent-restricted and occupied by individuals whose income is 50 percent or less of AMGI. The project meets the requirements of s 42(g)(1)(B) if 40 percent or more of the residential units in the project are rent-restricted and occupied by individuals whose income is 60 percent or less of AMGI. The requirement a taxpayer elects is referred to as the “minimum set-aside” for the project.

  Section 42(g)(2)(A) provides that for purposes of s 42(g)(1), a residential unit is rent-restricted if the gross rent with respect to the unit does not exceed 30 percent of the imputed income limitation applicable to the unit.

  Section 42(g)(2)(C) provides that the imputed income limitation applicable to a unit is the income limitation which would apply under s 42(g)(1) to individuals occupying the unit if the number of individuals occupying the unit were: (i) in the case of a unit which does not have a separate bedroom, 1 individual; and (ii) in the case of a unit which has one or more separate bedrooms, 1.5 individuals for each separate bedroom.

  Section 42(g)(3)(A) provides that a building will be treated as a qualified low-income building only if the project (of which the building is a part) meets the requirements of s 42(g)(1) not later than the close of the first year of the credit period for the building.

  Section 42(i)(2)(A) provides that for purposes of s 42(b)(1), a new building will be treated as federally subsidized for any taxable year if, at any time during the taxable year or any prior taxable year, there is or was outstanding any obligation the interest on which is exempt from tax under s 103, or any below market Federal loan, the proceeds of which are or were used (directly or indirectly) with respect to the building or operation thereof.

  Section 42(i)(2)(B) provides that a loan or tax-exempt obligation will not be taken into account under s 42(i)(2)(A) if the taxpayer elects to exclude from eligible basis of the building for purposes of s 42(d), in the case of a loan, the principal amount of the loan, and in the case of a tax-exempt obligation, the proceeds of the obligation.

  Section 42(i)(2)(C) provides that s 42(i)(2)(A) will not apply to any tax-exempt obligation or below market Federal loan used to provide construction financing for any building if (i) the obligation or loan (when issued or made) identified the building for which the proceeds of the obligation or loan would be used, and (ii) the obligation is redeemed, and the loan is repaid, before the building is placed in service.

  Section 42(i)(2)(D) provides that the term “below market Federal loan” means any loan funded in whole or in part with Federal funds if the interest rate payable on the loan is less than the applicable Federal rate (AFR) in effect under s 1274(d)(1) (as of the date the loan was made).

  Section 42(i)(2)(E)(i) generally provides that assistance provided under the HOME Investment Partnerships Act (HOME) with respect to any building will not be treated as a below market Federal loan under s 42(i)(2)(D) if 40 percent or more of the residential units in the building are occupied by individuals whose income is 50 percent or less of AMGI (the special set-aside). Section 42(d)(5)(C) (the 130 percent eligible basis increase) does not apply to any building to which the preceding sentence applies.

  Q-6. Taxpayer owns a new qualified low-income housing project consisting of Buildings 1 and 2, each containing 100 residential rental units. Forty percent of the units in each building are low-income units. Taxpayer elected the minimum set-aside for the project under s 42(g)(1)(B). Also, Taxpayer elected on Form 8609, Low-Income Housing Credit Allocation Certification, to treat the buildings as part of a multiple building project. A HOME loan at less than the AFR was provided with respect to the project.

  (a) How does the special set-aside under s 42(i)(2)(E)(i) apply to qualify Buildings 1 and 2 for the 70-percent present value credit under s 42(b)?

  (b) What rent restriction applies to the low-income units used to satisfy the special set-aside under s 42(i)(2)(E)(i)?

  A-6. (a) To qualify the project for the 70-percent present value credit, Taxpayer must rent at least 40 units in each of Buildings 1 and 2 to tenants whose income is 50 percent or less of AMGI throughout the 15-year compliance period because the rule under s 42(i)(2)(E)(i) applies on a building-by-building basis. Because these units are to be low-income units and Taxpayer elected the minimum set-aside under s 42(g)(1)(B), the same units used to satisfy the special set-aside under s 42(i)(2)(E)(i) will also

satisfy the project’s minimum set-aside.

  (b) The rent restriction that applies for all of the low-income units in the project, including the units in Buildings 1 and 2 which are used to satisfy the special set-aside under s 42(i)(2)(E)(i), is based on the applicable income limitation under s 42(g)(1)(B) because s 42(g)(2)(C) contains no exception for buildings that satisfy the special set-aside contained in s 42(i)(2)(E)(i). Therefore, the imputed income limitation (as defined in s 42(g)(2)(C)) applicable to the units in this project is 60 percent of AMGI. Under s 42(g)(2), rent may not exceed 30 percent of this imputed income limitation.

  Q-7. (a) Taxpayer owns a newly constructed qualified low-income housing project consisting of one building located in a qualified census tract (Building). A HOME loan at less than the AFR was provided with respect to Building. Construction of Building was funded in part with an obligation the interest on which is exempt from tax under s 103 that was outstanding after Building was placed in service. Taxpayer did not elect to exclude from eligible basis the principal amount of the HOME loan or the proceeds of the tax-exempt obligation as provided under s 42(i)(2)(B). Forty percent of the residential units in Building are occupied by individuals whose income is 50 percent or less of area median gross income. Is Building eligible for the increase in eligible basis provided under s 42(d)(5)(C)(i)(I)?

  (b) The facts are the same as in (a) above except that the interest rate on the HOME loan when made was not less than the AFR in effect under s 1274(d)(1), and the tax-exempt obligation was redeemed before Building was placed in service. Is Building eligible for the increase in eligible basis under s 42(d)(5)(C)(i)(I)?

  (c) The facts are the same as in (a) above except that the special set-aside under s 42(i)(2)(E)(i) was not met, and the tax-exempt obligation was redeemed before Building was placed in service. Is Building eligible for the increase in eligible basis under s 42(d)(5)(C)(i)(I)?

  A-7. (a) Yes. Because the tax-exempt obligation is outstanding after Building was placed in service and the proceeds of the obligation were not excluded from Building’s eligible basis under s 42(i)(2)(B), Building is treated as federally subsidized under s 42(i)(2)(A). Inasmuch as the building is treated as federally subsidized, the 30-percent present value credit under s 42(b) will apply to Building. The fact that the tax-exempt obligation caused Building to be federally subsidized makes s 42(i)(2)(E)(i) (which provides that certain HOME loans will not cause a project to be federally subsidized if the special set-aside requirement under that section is satisfied, and whose applicability prohibits the increase in eligible basis under s 42(d)(5)(C)) inapplicable. Accordingly, Building is eligible for the increase in eligible basis under s 42(d)(5)(C)(i)(I).

  If the tax-exempt obligation was redeemed before Building was placed in service or the proceeds of the obligation were excluded from Building’s eligible basis, Building would no longer be treated as federally subsidized by the tax-exempt obligation under s 42(i)(2)(A). Therefore, s 42(i)(2)(E)(i) would be applicable, and cause Building not to be treated as federally subsidized by the HOME loan under s 42(i)(2)(A). Accordingly, the prohibition in s 42(i)(2)(E)(i) against using s 42(d)(5)(C) would apply, and Building would not be eligible for the increase in eligible basis under s 42(d)(5)(C)(i)(I). The 70-percent value credit under s 42(b) would apply to Building.

  (b) Yes. When the HOME loan was made, the interest rate on the loan was not less than the AFR. Therefore, the loan is not described in s 42(i)(2)(D), and the building will not be treated as federally subsidized under s 42(i)(2)(A). The 70-percent present value credit will apply to Building. Because s 42(i)(2)(E)(i) is inapplicable to HOME loans not described in s 42(i)(2)(D), this loan is not subject to s 42(i)(2)(E)(i), and the prohibition in s 42(i)(2)(E)(i) against using s 42(d)(5)(C) does not apply. Accordingly, Building is eligible for the increase in eligible basis under s 42(d)(5)(C)(i)(I).

  (c) Yes. Although Building meets the exception under s 42(i)(2)(C) with respect to the tax-exempt obligation, Building is treated as federally subsidized under s 42(i)(2)(A) because it received a HOME loan at less than the AFR and does not meet the special set-aside under s 42(i)(2)(E)(i). The 30-percent present value credit will apply to Building as it is treated as federally subsidized. Because Building does not meet the special set-aside under s 42(i)(2)(E)(i), the prohibition in s 42(i)(2)(E)(i) against using s 42(d)(5)(C) does not apply, and Building is eligible for the increase in eligible basis under s 42(d)(5)(C)(i)(I).

  If Taxpayer elected to exclude the principal amount of the HOME loan from the eligible basis of Building under s 42(i)(2)(B) (whether or not the special set-aside under s 42(i)(2)(E)(i) was met), Building would not be treated as federally subsidized under s 42(i)(2)(A), and the 70-percent present value credit would apply to Building. Because the HOME loan would not be taken into account, s 42(i)(2)(D) and s 42(i)(2)(E)(i) do not apply to Building. Therefore, Building would not be described in s 42(i)(2)(E)(i). Accordingly, the prohibition in s 42(i)(2)(E)(i) against using s 42(d)(5)(C) would not apply, and Building would be eligible for the increase in eligible basis under s 42(d)(5)(C)(i)(I).

E. VACANT UNIT RULE ISSUES

Law

  Section 1.42-5(c)(1)(ix) provides that a housing credit agency must require the owner of a low-income housing project to certify at least annually to the housing credit agency that, for the preceding 12-month period, if a low-income unit in the project became vacant during the year, reasonable attempts were or are being made to rent that unit or the next available unit of comparable or smaller size to tenants having a qualifying income before any units in the project were or will be rented to tenants not having a qualifying income (the “vacant unit rule”).

  The legislative history to s 42 indicates that vacant units, formerly occupied by low-income individuals, may continue to be treated as occupied by qualified low-income individuals for purposes of the minimum set-aside requirement (as well as for determining qualified basis) provided reasonable attempts are made to rent the unit. H. R. Conf. Rep. No. 841, supra, at II-94.

  Section 42(g)(2)(D)(i) provides that notwithstanding an increase in the income of the occupants of a low-income unit above the income limitation applicable under s 42(g)(1), the unit will continue to be treated as a low-income unit if the income of the occupants initially met the income limitation and the unit continues to be rent-restricted.

  Section 42(g)(2)(D)(ii) provides that if the income of the occupants of the unit increases above 140 percent of the income limitation applicable under s 42(g)(1), the unit ceases to be treated as a low-income unit if any available or subsequently available residential rental unit in the building (of a size comparable to, or smaller than, the unit) is occupied by a new resident whose income exceeds the income limitation (the “available unit rule”).

  Under s 1.42-15(a), a low-income unit in which the aggregate income of the occupants of the unit rises above 140 percent of the

applicable income limitation under s 42(g)(1) is referred to as an “over-income unit.”

  Section 1.42-15(c) provides that a unit is not available for purposes of the available unit rule when the unit is no longer available for rent due to contractual arrangements that are binding under local law (for example, a unit is not available if it is subject to a preliminary reservation that is binding on the owner under local law prior to the date a lease is signed or the unit is occupied).

  Q-8. On July 1, 2003, an income-qualified household (Household) initially occupied a rent-restricted residential rental unit in Building 1 of Project. On October 31, 2003, the property manager moved Household (and transferred Household’s lease) to a similar rent-restricted unit in Building 2 of Project that was not previously occupied. Household occupied the Building 2 unit at the end of 2003. The unit Household vacated in Building 1 was unoccupied during November and December. Are both units in Buildings 1 and 2 low-income units at the end of 2003?

  A-8. No. While a vacant low-income unit generally retains its character as a low-income unit, where an owner simply moves a tenant from a unit in one building to a unit in another building in the same project, both units may not be treated as low-income units; rather, only the unit that the tenant actually occupies at the end of a month in the first year of the credit period and at the end of each year in subsequent years qualifies as a low-income unit. Thus, in this situation, while the unit in Building 1 vacated by Household was treated as a low-income unit during the months it was occupied by Household, the unit ceased to be treated as a low-income unit when Household vacated the unit. At that time, the vacated unit would be treated as a unit not previously occupied.

  Q-9. Ten units previously occupied by income-qualified tenants in a 200-unit mixed-use housing project are vacant. None of the low-income units in the project had been over-income units. The project owner displayed a banner and for rent signs at the entrance to the project, placed classified advertisements in two local newspapers, and contacted prospective low-income tenants on a waiting list for the project and on a local public housing authority list of section 8 voucher holders about the low-income unit vacancies. These are customary methods of advertising apartment vacancies in the area of the project for identifying prospective tenants. Subsequent to the low-income unit vacancies, a market-rate unit of comparable size to the low-income units became vacant. Will the owner violate the vacant unit rule if the owner rents the market-rate unit before any of the low-income units?

  A-9. No. In accordance with s 1.42-5 (c)(1)(ix), the owner of a qualified low-income housing project has to use reasonable attempts to rent a vacant low-income unit or the next available unit of comparable or smaller size to tenants having a qualifying income before any units in the project are rented to tenants not having a qualifying income. Thus, if the project owner makes reasonable attempts to rent the vacant low-income units to income-qualified tenants, the owner may rent the newly vacated market-rate unit before renting the low-income units and continue to characterize the vacant low-income units as low-income units for purposes of the minimum set-aside requirements in s 42(g)(1) and calculation of the applicable fraction under s 42(c)(1)(B).

  What constitutes reasonable attempts to rent a vacant unit is based on facts and circumstances, and may differ from project to project depending on factors such as the size and location of the project, tenant turnover rates, and market conditions. Also, the different advertising methods that are accessible to owners and prospective tenants would affect what is considered reasonable. Under the facts in this situation, the owner used reasonable methods of advertising an apartment vacancy in the area of the project before the owner rented the market-rate unit. Thus, the owner made reasonable attempts to rent the vacant low-income units.

  In addition, the available unit rule is not violated by rental of the market-rate unit before the low-income units because there are no over-income units in the building.

  Q-10. A building has 10 units of comparable size, consisting of 7 low-income units (none was an over-income unit) and 3 market-rate units. All units in the building were occupied except for one market-rate unit. A low-income unit became vacant on March 15, 2004. Between March 15, 2004, and March 29, 2004, the owner made reasonable attempts to rent this unit to an income-qualified tenant. The vacant low-income unit became subject to a reservation (a contractual arrangement that is binding on the building owner under local law prior to the date a lease is signed or the unit is occupied) on March 29, 2004, under which the owner agreed to rent the unit to A, whose income meets the income limitation elected for the project under s 42(g)(1). Thereafter, the owner ceased any efforts to attempt to rent the unit. On April 30, 2004, A signed a lease for the unit and occupied the unit on May 1, 2004. The vacant market-rate unit was rented to a market-rate tenant on April 15, 2004. Did the owner violate the vacant unit rule?

  A-10. No. For purposes of the vacant unit rule, an owner needs to make reasonable attempts to rent an available vacant low-income unit. To determine what constitutes an available unit for purposes of the vacant unit rule, the Internal Revenue Service will adopt the rule under s 1.42-15(c) for when a unit is considered not available. Therefore, a unit is not available for purposes of the vacant unit rule when the unit is no longer available for rent due to contractual arrangements that are binding under local law, such as a reservation entered into between a building owner and a prospective tenant. Thus, in this situation, because the vacant low-income unit was subject to a reservation that was binding under local law prior to the renting of the vacant market-rate unit, the low-income unit was not available when the market-rate unit was rented. Accordingly, the owner no longer needed to make reasonable efforts to rent the low-income unit.

  In addition, the available unit rule is not violated by rental of the market-rate unit because there is no over-income unit in the building.

F. RECORDKEEPING AND RECORD RETENTION ISSUE

Law

  Section 42(m)(1)(A)(i) requires each housing credit agency to allocate low-income housing credits according to a qualified allocation plan. Under s 42(m)(1)(B)(iii), an allocation plan is not qualified unless it contains a procedure that the housing credit agency (or an agent or other private contractor of the agency) will follow in (1) monitoring for noncompliance with the provisions of s 42, (2) notifying the Service of any noncompliance which the agency becomes aware of, and (3) monitoring for noncompliance with habitability standards through regular site visits.

  Under s 1.42-5(a)(2)(i)(A), for the procedure to satisfy s 42(m)(1)(B)(iii), the procedure must include the record-keeping and record retention provisions of s 1.42-5(b). However, a monitoring procedure adopted by a housing credit agency may require additional recordkeeping and record retention provisions beyond those specifically provided in s 1.42-5(b).

  Section 1.42-5(b)(1) provides that a housing credit agency must require the owner of a low-income housing project to keep certain specified records for each qualified low-income building in the project for each year in the compliance period. Under s 1.42-5(b)(2), the owner must be required to retain the records described in s 1.42-5(b)(1) for a particular year for at least 6 years after the due date (with extensions) for filing the Federal income tax return for that year. The records for the first year of the credit period, however, must be retained for at least 6 years beyond the due date (with extensions) for filing the Federal income tax return for the last year of the compliance period (as defined in s 42(i)(1)) of the building. Section 1.42-5(b)(3) also specifies that the owner must be required to retain the original local health, safety, or building code violation reports or notices that were issued by the state or local government unit (as described in s 1.42-5(c)(1)(vi)) for inspection by the housing credit agency.

  The general requirements for keeping records for purposes of the Code are in s 6001 and the regulations thereunder.

  Rev. Proc. 97-22, 1997-1 C.B. 652, provides guidance to taxpayers that maintain books and records by using an electronic storage system that either images their hardcopy (paper) books and records or transfers their computerized books and records to an electronic storage media, such as an optical disk. Rev. Proc. 97-22 provides that records maintained in an electronic storage system that complies with the requirements of this revenue procedure will constitute records within the meaning of s 6001.

  Q-11. May a taxpayer comply with the recordkeeping and record retention provisions under s 1.42-5(b) by using an electronic storage system instead of maintaining hardcopy (paper) books and records?

  A-11. Yes, provided that the electronic storage system satisfies the requirements of Rev. Proc. 97-22. However, complying with the recordkeeping and record retention requirements of the Service does not exempt an owner from having to satisfy any additional recordkeeping and record retention requirements of the monitoring procedure adopted by the housing credit agency. For example, the housing credit agency may require the taxpayer to maintain hardcopy books and records.

  For the basic requirements of maintaining records in an automated data processing system, including electronic storage systems, see Rev. Proc. 98- 25, 1998-1 C.B. 689.

G. TENANT INCOME DOCUMENTATION ISSUE

Law

  Section 1.42-5(b)(1)(vi) provides that a housing credit agency must require the owner of a low-income housing project to keep records for each qualified low-income building in the project that show, for each year in the compliance period, the annual income certification of each low-income tenant per unit. Under s 1.42-5(b)(1)(vii), the housing credit agency must require the owner to keep documentation to support each low-income tenant’s income certification (for example, a copy of the tenant’s Federal income tax return, Forms W-2, or verifications of income from third parties such as employers or state agencies paying unemployment compensation).

  Under s 1.42-5(c)(1)(iii), the housing credit agency must require the owner of a low-income housing project to certify at least annually that, for the preceding 12-month period, the owner has received an annual income certification from each low-income tenant, and documentation to support that certification.

  Rev. Proc. 94-65, 1994-2 C.B. 798, indicates that an owner may satisfy the documentation requirement of s 1.42-5(b)(1)(vii) for a low-income tenant’s income from assets by obtaining a signed, sworn statement from the tenant or prospective tenant if (1) the tenant’s or prospective tenant’s Net Family assets do not exceed $5,000, and (2) the tenant or prospective tenant provides a signed, sworn statement to this effect to the building owner. The revenue procedure provides that a housing credit agency’s monitoring procedure may not permit an owner to rely on a low-income tenant’s signed, sworn statement of annual income from assets if a reasonable person in the owner’s position would conclude that the tenant’s income is higher than the tenant’s represented annual income. In this case, the owner must obtain other documentation of the low-income tenant’s income from assets to satisfy the documentation requirement. In addition, the revenue procedure indicates that a housing credit agency’s monitoring procedure may continue to require that an owner obtain documentation, other than the signed, sworn statement, to support a low-income tenant’s annual certification of income from assets.

  Q-12. On reviewing tenant files of a project, the housing credit agency discovered that for purposes of determining the income of certain tenants, the owner had accepted signed, sworn self-certifications in which the tenants stated that they had not received any child support payments. Is a signed, sworn self-certification by a tenant sufficient documentation under s 1.42- 5(b)(1)(vii) to show that the tenant is not receiving child support payments?

  A-12. Yes. Consistent with the documentation requirements in Rev. Proc. 94-65, a signed, sworn self-certification by a tenant is sufficient documentation under s 1.42-5(b)(1)(vii) to show that a tenant is not receiving child support payments. In addition to specifying that a tenant is not receiving any child support payments, an annual signed, sworn self-certification should indicate whether the tenant will be seeking or expects to receive child support payments within the next 12 months. If the tenant possesses a child support agreement but is not presently receiving any child support payments, the tenant should include an explanation of this and all supporting documentation such as a divorce decree and court documents to enforce payment. Also, the self-certification should indicate that the tenant will notify the owner of any changes in the status of child support.

  A housing credit agency’s monitoring procedure, however, may not permit an owner to rely on a low-income tenant’s signed, sworn statement indicating that the tenant is not receiving child support payments if a reasonable person in the owner’s position would conclude that the tenant’s income is higher than the tenant’s represented annual income. In this case, the owner must obtain other documentation of the low-income tenant’s annual child support payments to satisfy the documentation requirement in s 1.42-5(b)(1)(vii).

  A housing credit agency’s monitoring procedure may continue to require that an owner obtain documentation, other than the statement described above, to support a low-income tenant’s annual certification of child support payments.

DRAFTING INFORMATION

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

 Rev. Rul. 2004-82, 2004-35 I.R.B. 350

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Revenue Ruling 2004-80

Rev. Rul. 2004-80
Rev. Rul. 2004-80, 2004-32 I.R.B. 164
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
                    RETAIL EXCISE TAX; HIGHWAY TRACTOR; TRUCK
                             Released: July 28, 2004
                            Published: August 9, 2004

 Section 4051.–Imposition of Tax on Heavy Trucks and Trailers Sold at Retail,  26 CFR 145.4051-1: Imposition of tax on heavy trucks and trailers sold at retail.

  Retail excise tax; highway tractor; truck. This ruling applies the primarily designed tests in section 145.4051-1(e)(1) and (2) of the regulations under the Highway Revenue Act of 1982 (Pub. L. 97-424) for purposes of determining whether a vehicle is a truck or a highway tractor.

  Retail excise tax; highway tractor; truck. This ruling applies the primarily designed tests in section 145.4051-1(e)(1) and (2) of the regulations under the Highway Revenue Act of 1982 (Pub. L. 97-424) for purposes of determining whether a vehicle is a truck or a highway tractor.

ISSUE

  Is the vehicle described below a truck or a tractor for purposes of the retail excise tax imposed by s 4051 of the Internal Revenue Code?

FACTS

  The vehicle tows trailers and semitrailers (trailers); the trailers exceed 35 feet in length and have a gross vehicle weight (GVW) rating of 20,000 pounds. The vehicle has a standard chassis cab (4-door with crew cab), accommodating five passengers, and is outfitted with certain luxury features. The cab has an electric trailer brake control that connects to the brakes of a towed trailer and to a hook up for trailer lights. The vehicle has two storage boxes behind the cab that can accommodate incidental items such as small tools and vehicle repair equipment.

  The chassis cab has a GVW rating of 23,000 pounds and a gross combination weight (GCW) rating of 43,000 pounds. The vehicle is equipped with hydraulic disc brakes with a four wheel automatic braking system, a 300 horsepower engine, and a six-speed automatic transmission. The front axle of the vehicle has an 8,000 pound rating and the rear axle has a 15,000 pound rating.

  The vehicle has three types of hitching devices: a removable ball gooseneck hitch, a fifth wheel hitch, and a heavy duty trailer receiver hitch. The vehicle’s platform, which is approximately 139 inches long, is designed with a rectangular well to accommodate the gooseneck and fifth wheel hitches (bed hitches). This platform slopes at the rear of the rectangular well and has tie-down hooks. Optional removable steel stake rails can be placed around the platform.

LAW AND ANALYSIS

  Section 4051(a)(1) imposes an excise tax on the first retail sale of automobile truck chassis and bodies, truck trailer and semitrailer chassis and bodies, and tractors of the kind chiefly used for highway transportation in combination with a trailer or semitrailer. The tax is not limited to commercial vehicles. Thus, a vehicle may be subject to tax even if sold for use or used as a recreational or private tow vehicle rather than for commercial purposes.

  Section 145.4051-1(e)(1)(i) of the Temporary Excise Tax Regulations Under the Highway Revenue Act of 1982 (Pub. L. 97-424) defines “tractor” as a highway vehicle primarily designed to tow a vehicle, such as a trailer or semitrailer, but does not carry cargo on the same chassis as the engine. A vehicle equipped with air brakes and/or towing package will be presumed to be primarily designed as a tractor.

  Section 145.4051-1(e)(2) defines “truck” as a highway vehicle that is primarily designed to transport its load on the same chassis as the engine even if it is also equipped to tow a vehicle, such as a trailer or semitrailer.

  “Primarily” means “principally” or “of first importance.” See Malat v. Riddle, 383 U.S. 569 (1966), 1966-1 C.B. 184. “Primarily” does not mean “exclusive.” See Rev. Rul. 77-36, 1977-1 C.B. 347. Therefore, in the context of the primarily designed test, the reference in s 145.4051-1(e)(1)(i) to vehicles not carrying cargo on the same chassis as the engine does not require an absolute inability to carry any cargo on the vehicle’s chassis. This limitation may be satisfied even if the vehicle can carry incidental items of cargo when towing a trailer or semitrailer or is capable of carrying limited amounts of cargo when not engaged in its primary function of towing a trailer or semitrailer.

  Under the primarily designed test, a vehicle that can both carry cargo on its chassis and tow a trailer is characterized as either a truck or tractor depending on which function is of greater importance. The function for which a vehicle is primarily designed is evidenced by physical characteristics such as the vehicle’s capacity to tow a vehicle, carry cargo, and operate (including brake) safely when towing or carrying a cargo. Cargo carrying capacity depends on the vehicle’s GVW rating and the configuration of the vehicle’s bed or platform. Towing capacity depends on the vehicle’s GVW and GCW ratings and whether the vehicle is configured to tow a trailer or semitrailer.

  Some characteristics of the vehicle such as its chassis cab with a GVW rating of 23,000 pounds, a 300 horsepower engine, a front axle with an 8,000 pound rating, and a rear axle with a 15,000 pound rating are consistent with either a cargo carrying or a towing function. In this case, however, the vehicle also has a GCW rating of 43,000 pounds and its engine, brakes, transmission, axle ratings, electric trailer brake control, trailer hook up lights, and hitches enable it to tow a 20,000 pound trailer that may exceed 35 feet in length.

  When the vehicle’s bed hitches are used to tow, the cargo carrying capacity of the vehicle is limited to the storage boxes behind the cab and is minimal in comparison to the GVW of the towed trailer or semitrailer. Neither the steel stake bed rails nor the tie down hooks significantly increase cargo carrying capacity when either of the bed hitches is used. Even if neither of the vehicle’s

two bed hitches is used, the design of the vehicle significantly reduces its cargo carrying capacity when compared to the cargo carrying capacity of a pickup truck body or a flatbed truck body installed on a comparable chassis. The significant reduction in cargo carrying capacity resulting from the vehicle’s platform with its rectangular well and sloping platform at the rear of the rectangular well is evidence that the vehicle is not primarily designed to carry cargo. By accommodating the bed hitches, however, this platform configuration increases the vehicle’s towing capacity and, in conjunction with the other features described above, makes it possible to safely tow a 20,000 pound trailer.

  The vehicle’s physical characteristics, which maximize towing capacity at the expense of carrying capacity, establish that the vehicle is primarily designed to tow a vehicle, such as a trailer or semitrailer, rather than to carry cargo on its chassis.

HOLDING

  The vehicle is a tractor for purposes of s 4051.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Celia Gabrysh of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Celia Gabrysh at (202) 622- 3130 (not a toll-free call).

 Rev. Rul. 2004-80, 2004-32 I.R.B. 164

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Revenue Ruling 2004-71

Rev. Rul. 2004-71
Rev. Rul. 2004-71, 2004-30 I.R.B. 74
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
              OFFSETS UNDER SECTION 6402; ARIZONA AND WISCONSIN LAW
                            Published: July 26, 2004

 Section 6402.–Authority to Make Credits or Refunds, 26 CFR 301.6402-1: Authority to make credits or refunds.

  Offsets under section 6402; Arizona and Wisconsin law. This ruling provides guidance regarding the amount of an overpayment from a joint tax return that the IRS may offset against a spouse’s separate tax liability for taxpayers domiciled in Arizona or Wisconsin. Arizona and Wisconsin are community property states and, under the respective state laws, each spouse has an undivided 50- percent interest in all community property. Rev. Ruls. 80-7 and 85-70 amplified and clarified.

  Offsets under section 6402; Arizona and Wisconsin law. This ruling provides guidance regarding the amount of an overpayment from a joint tax return that the IRS may offset against a spouse’s separate tax liability for taxpayers domiciled in Arizona or Wisconsin. Arizona and Wisconsin are community property states and, under the respective state laws, each spouse has an undivided 50- percent interest in all community property. Rev. Ruls. 80-7 and 85-70 amplified and clarified.

ISSUE

  What amount of an overpayment reported on a joint return may the Internal Revenue Service apply against one spouse’s separate tax liability if the spouses are domiciled in Arizona or Wisconsin?

  This ruling addresses how offsets apply for taxpayers filing joint returns and domiciled in Arizona or Wisconsin. Because these states have similar community property laws, Arizona and Wisconsin are addressed in one ruling. This ruling makes assumptions about the operation of state community property laws which are highly dependent on facts and circumstances. Therefore, taxpayers are cautioned to check current state law and apply it to their particular facts. Taxpayers domiciled in California, Idaho, or Louisiana should refer to Rev. Rul. 2004-72; taxpayers domiciled in Nevada, New Mexico or Washington should refer to Rev. Rul. 2004-73; and taxpayers domiciled in Texas should refer to Rev. Rul. 2004-74.

FACTS

  Situation 1, Arizona. In Year 1, Liable Spouse, who is single, incurs a tax liability of $20,000. Liable Spouse does not pay this tax liability. In Year 2, Liable Spouse and Non-Liable Spouse marry. In Year 4, Liable Spouse and Non-Liable Spouse file a joint return for Year 3, reporting an overpayment of $1,000. The overpayment results from income taxes withheld from Liable Spouse’s and Non-Liable Spouse’s wages during Year 3. Liable Spouse and Non-Liable Spouse are domiciled in Arizona at all relevant times. The tax liability incurred by Liable Spouse for Year 1 is a separate debt under Arizona law. Applying Rev. Rul. 80-7, 1980-1 C.B. 296, the Service determines that $750 of the overpayment is attributable to income taxes withheld from Liable Spouse’s wages, and $250 of the overpayment is attributable to income taxes withheld from Non-Liable Spouse’s wages.

  Arizona law provides that community property is all property acquired during marriage, except for property acquired by a spouse by gift, devise, or descent. See Ariz. Rev. Stat. section 25-211 (2003). There is a rebuttable presumption under Arizona law that all property acquired during marriage is community property. See Mitchell v. Mitchell, 732 P.2d 208, 212 (Ariz. 1987) (en banc). Arizona law defines separate property as property owned by a spouse before marriage and property acquired during marriage by a spouse by gift, devise, or descent. See Ariz. Rev. Stat. section 25-213 (2003). In addition, separate property includes any profits or income derived from separate property during marriage. See Ariz. Rev. Stat. section 25-213 (2003).

  Arizona law provides that a creditor may reach all of the liable spouse’s separate property and all of the community property to satisfy a community debt. See Ariz. Rev. Stat. section 25-215(D) (2003). In addition, a creditor may reach all community property that would have been the liable spouse’s separate property but for marriage and all of the liable spouse’s separate property to satisfy a separate debt. See Ariz. Rev. Stat. section 25- 215(B) (2003). Further, the Service may reach the liable spouse’s interest in any community property that would have been the non-liable spouse’s separate property but for marriage to satisfy a separate debt of the liable spouse. In re Ackerman, 424 F.2d 1148 (9th Cir. 1970). However, a creditor may not reach any of the non-liable spouse’s separate property to satisfy the liable spouse’s separate debt. See Ariz. Rev. Stat. section 25-215(A) (2003).

  Under Arizona law, community debts are debts incurred during marriage for the benefit of the community. See Ariz. Rev. Stat. section 25-215(D) (2003); Johnson v. Johnson, 638 P.2d 705, 711-712 (Ariz. 1981). Arizona law presumes that a debt incurred by a spouse during marriage is a community debt. See In re Marriage of Hrudka, 919 P.2d 179, 186-187 (Ariz. Ct. App. 1995). If a debt is not a community debt, then it is a separate debt. See id. at 187.

  Situation 2, Wisconsin. In Year 1, Liable Spouse, who is single, incurs a tax liability of $20,000. Liable Spouse does not pay this tax liability. In Year 2, Liable Spouse and Non-Liable Spouse marry. In Year 4, Liable Spouse and Non-Liable Spouse file a joint return for Year 3, reporting an overpayment of $1,000. The overpayment results from income taxes withheld from Liable Spouse’s and Non-Liable Spouse’s wages during Year 3. Liable Spouse and Non-Liable Spouse are domiciled in Wisconsin at all relevant times. The tax liability incurred by Liable Spouse for Year 1 is a liability incurred before marriage that is attributable to action or inaction before marriage under Wisconsin law. Applying Rev. Rul. 80-7, 1980-1 C.B. 296, the Service determines that $750 of the overpayment is attributable to income taxes withheld from Liable Spouse’s wages, and $250 of the overpayment is attributable to income taxes withheld from Non-Liable Spouse’s wages.

  Wisconsin law classifies property owned by a spouse as either marital property or individual property. See Wis. Stat. section 766.31 (2002). Marital property is a form of community property, and each spouse has a 50 percent interest in the marital property. See Wis. Stat. section 766.31(3) (2002); Rev. Rul. 87-13, 1987-1 C.B. 20. Marital property includes all property that is not individual property and that was acquired after the determination date. See Wis. Stat. section 766.31 (2002). The determination date is the latest of either: (1) the date of marriage; (2) the date both spouses are domiciled in Wisconsin; or (3) January 1,

1986. See Wis. Stat. section 766.01(5) (2002). Wisconsin law presumes that all property owned by a spouse is marital property. See Wis. Stat. section 766.31(2) (2002). This presumption may be rebutted. See Lloyd v. Lloyd, 487 N.W.2d 647, 652 (Wis. Ct. App. 1992).

  Wisconsin law defines individual property as property owned by a spouse before the determination date. See Wis. Stat. section 766.31(9) (2002). In addition, individual property includes property acquired during marriage and after the determination date if the property is: (1) received by gift, bequest, or devise to one spouse; (2) income paid to one spouse from a trust, unless the trust provides otherwise; (3) received in exchange for or obtained with the proceeds of other individual property; (4) designated as individual property by decree, marital property agreement, or reclassification pursuant to Wis. Stat. section 766.31(10); or (5) recovered for personal injury. See Wis. Stat. section 766.31(7) (2002).

  Wisconsin law classifies debts incurred by a spouse into three separate categories: (1) debts incurred before or during marriage that are attributable to action or inaction before marriage; (2) debts incurred during marriage for the benefit of the marriage or family; and (3) debts incurred during marriage that are not for the benefit of marriage or family. See Wis. Stat. section 766.55 (2002). Wisconsin law presumes that a debt incurred during marriage is for the benefit of the marriage or the family. See Wis. Stat. section 766.55(1) (2002). If a spouse before marriage or during marriage incurs a debt that is attributable to action or inaction before marriage, Wisconsin law allows that spouse’s creditor to reach all marital property that would have been that spouse’s individual property but for the marriage and all individual property of that spouse. See Wis. Stat. section 766.55(2)(c)(1) (2002). Further, Wisconsin law allows the Service to reach the liable spouse’s interest in any marital property that would have been the non-liable spouse’s individual property but for marriage. Vorhies v. Z. Management, Civil No. 86-C695-S (W.D. Wis. 1987). If a spouse incurs a debt for the benefit of the marriage or the family, Wisconsin law allows a creditor to reach all marital property and all individual property of that spouse. See Wis. Stat. section 766.55(2)(b) (2002); Sokaogon Gaming Ent. v. Curda-Derickson, 668 N.W.2d 736 (Wis. Ct. App. 2003). If a debt incurred by a spouse was not for the benefit of the marriage or the family, Wisconsin law allows a creditor to reach that spouse’s individual property and interest in marital property. See Wis. Stat. section 766.55(2)(d) (2002).

  Situation 3, Wisconsin. Liable Spouse and Non-Liable Spouse are domiciled in Wisconsin at all relevant times. In Year 1, Liable Spouse and Non-Liable spouse are single and have no outstanding tax liabilities. In Year 2, Liable Spouse and Non-Liable Spouse marry. For Year 2, Liable Spouse incurs a tax liability, that, under Wisconsin law, is a liability incurred during marriage but is not for the benefit of marriage or family. Non-Liable Spouse is not liable for this tax liability under Wisconsin law.

  In Year 4, Liable Spouse and Non-Liable Spouse file a joint return for Year 3, reporting an overpayment of $1,000. The overpayment resulted from income taxes withheld from Liable Spouse’s and Non-Liable Spouse’s wages during Year 3. Applying Rev. Rul. 80-7, the Service determines that $750 of the overpayment is attributable to income taxes withheld from Liable Spouse’s wages, and $250 of the overpayment is attributable to income taxes withheld from Non-Liable Spouse’s wages. Wisconsin community property laws are the same as in Situation 2.

  Situation 4, Wisconsin. Same as Situation 3, except that under Wisconsin law, Liable Spouse’s Year 2 tax liability is a liability for the benefit of marriage or family.

LAW

  Section 6402(a) of the Internal Revenue Code provides that, in the case of any overpayment, the Service may credit the amount of the overpayment, including interest, against any internal revenue tax liability on the part of the person who made the overpayment and shall refund the balance to the person.

  Revenue Ruling 74-611, 1974-2 C.B. 399, holds that if a husband and wife file a joint return, each spouse has a separate interest in the jointly reported income and a separate interest in any overpayment. However, filing a joint return does not create a new property interest for the husband or the wife. Id.

  Revenue Ruling 80-7, 1980-1 C.B. 296, holds that if a husband and wife file a joint return showing an overpayment, the Service may credit one spouse’s interest in the overpayment against that spouse’s separate tax liability. The amount of the spouse’s interest in the overpayment is calculated by subtracting the spouse’s share of the joint tax liability, determined under a separate tax formula, from the spouse’s contribution towards the joint tax liability. Under the separate tax formula, a spouse’s share of the joint tax liability is calculated as follows:

——————————————————————————
       Spouse’s Separate Tax
___________________________________  x  Joint Tax Liability Reported on Return
Total of Both Spouses’ Separate Tax
——————————————————————————

  Revenue Ruling 85-70, 1985-1 C.B. 361, provides a two-step process to determine the amount of a joint overpayment that the Service may offset against one spouse’s separate tax liability if the spouses are domiciled in a community property state. First, if the joint overpayment is from wages that are community property income, then each spouse is considered to be the recipient of one-half of the aggregated wages regardless of whether the spouses may have earned different amounts of wages (the one-half rule). Accordingly, each spouse has a one-half interest in the overpayment, and the Service may offset the liable spouse’s one-half interest in the overpayment against the liable spouse’s separate federal tax liability regardless of whether state law provides that creditors may reach community property to satisfy the separate debts of a spouse. Id. Rev. Rul. 85-70 does not specifically address what portion of each spouse’s actual wages is treated as having been offset as a result of applying the one-half rule. Under the facts of Rev. Rul. 85-70, and specifically the assumed state laws, that analysis was not necessary. However, applying the second step of Rev. Rul. 85-70 in other cases may require a determination of the amount of each spouse’s actual wages that were offset after applying the one-half rule. For that purpose, each spouse under the first step of Rev. Rul. 85-70 is treated as receiving one half of the wages from each community property source (or, collectively, one-half of the aggregated wages) and as such being entitled to receive one-half of the income tax withheld from each community property source.

  Second, Rev. Rul. 85-70 provides that state law may enable the Service to offset an additional portion of the joint overpayment

from community property sources to satisfy a spouse’s separate federal tax liability. This additional right of offset is available if state law provides that creditors may reach community property to satisfy the separate debts of a spouse. (The amount potentially available to be offset under the second step of Rev. Rul. 85-70 is the amount remaining after application of the first step of that revenue ruling.) However, if state law provides that community property may not be reached to satisfy the premarital or other separate debts of either spouse, then the Service may not offset any portion of the non-liable spouse’s share of the overpayment from community property sources against the liable spouse’s separate tax liability. Id.

  Five-step process to determine amount of joint overpayment that the Service may offset against separate federal tax liability of one spouse.

  A five-step process is required to determine the amount of a joint overpayment that the Service may, pursuant to section 6402(a), offset against the separate federal tax liability of one spouse.

  The first step is to identify the underlying source of the overpayment. The Service looks to the tax payments made by the spouses, including income tax withholding and estimated tax payments and other credits, such as the earned income tax credit, that gave rise to the overpayment. If the earned income tax credit is a source of the overpayment, see Rev. Rul. 87-52, 1987-1 C.B. 347, for guidance.

  The second step is to characterize the underlying source of the overpayment as either separate or community property. Because an overpayment will be characterized in the same manner as the source of the overpayment, an overpayment will be characterized as community property, separate property, or as part community property and part separate property, depending on the character of the source of the overpayment. If the overpayment is part community property and part separate property, the portion of the overpayment attributable to a separate property source must be subtracted from the remainder of the overpayment. The portion of the overpayment attributable to a separate property source is calculated as follows:

———————————————————–
Tax Payment From a Separate Property Source
___________________________________________  x  Overpayment
            Total Tax Payments
———————————————————–

  The third step is to offset the liable spouse’s share of the overpayment from a community property source against the liable spouse’s separate tax liability. Under Rev. Rul. 85-70, the Service may offset the liable spouse’s 50-percent interest in the overpayment from a community property source to satisfy the liable spouse’s separate tax liability.

  The fourth step is to determine whether, under state law, the Service may reach the non-liable spouse’s share of the overpayment from a community property source. See Rev. Rul. 85-70.

  The fifth step is to determine whether the Service may, under state law, reach a portion of the overpayment from a separate property source of the liable spouse or the non-liable spouse.

ANALYSIS

  Apply the five-step process to each situation.

  (1) Step 1.

  In Situation 1, Situation 2, Situation 3, and Situation 4, the overpayment is from income taxes withheld in Year 3 from Liable Spouse’s and Non-Liable Spouse’s wages.

  (2) Step 2.

  Arizona and Wisconsin law presume that all property acquired during marriage by either spouse or both spouses, including wages, is community property. In Situation 1, Situation 2, Situation 3, and Situation 4, the overpayment results from income tax withholding from Liable Spouse’s and Non-Liable Spouse’s wages. Because state law presumes that wages are community property, the entire overpayment in Situation 1, Situation 2, Situation 3, and Situation 4 is assumed to be from a community property source.

  (3) Step 3.

  Under Arizona and Wisconsin law, each spouse has a present and equal interest in all community property. In Situation 1, Situation 2, Situation 3, and Situation 4, $750 of the overpayment is from income tax withholding from Liable Spouse’s wages, and $250 of the overpayment is from income tax withholding from Non-Liable Spouse’s Year 3 wages. Applying Rev. Rul. 85-70, the Service may offset $375 of the income tax withholding attributable to Liable Spouse’s wages and $125 of the income tax withholding attributable to Non-Liable Spouse’s wages. Therefore, in Situation 1, Situation 2, Situation 3, and Situation 4, the Service may offset $500 of the overpayment against Liable Spouse’s separate tax liability.

  (4) Step 4.

  Under Arizona and Wisconsin law, the amount of community property that a creditor may reach depends on the character of the debt.

  In Situation 1, Liable Spouse’s Year 1 tax liability is a separate debt under Arizona law. To satisfy a separate debt, Arizona law provides that a creditor may reach all community property that would have been Liable Spouse’s separate property but for marriage. Under Arizona law, Liable Spouse’s wages and income tax withholdings would have been Liable Spouse’s separate property had Liable Spouse and Non-Liable Spouse not married. Therefore, a creditor may reach all of Liable Spouse’s wages and income tax withholdings to satisfy Liable Spouse’s separate debt. Applying Arizona law in Step 4, and in addition to the amount offset in Step 3, the Service may offset the remaining $375 of the overpayment that is attributable to Liable Spouse’s wages and income tax withholdings.

  In Situation 2, Liable Spouse’s Year 1 federal tax liability is a liability incurred before marriage that is attributable to action or inaction before marriage under Wisconsin law. In this situation, Wisconsin law provides that a creditor may reach all marital property that would have been Liable Spouse’s individual property but for marriage. Under Wisconsin law, Liable Spouse’s wages and income tax withholding would have been Liable Spouse’s separate property had Liable Spouse and Non-Liable Spouse not married. Therefore, a creditor may reach all of Liable Spouse’s wages and income tax withholding to satisfy Liable Spouse’s Year 1 tax liability. Applying Wisconsin law in Step 4, and in addition to the amount offset in Step 3, the Service may offset the

remaining $375 of the overpayment that is attributable to Liable Spouse’s wages and income tax withholdings.

  In Situation 3, Liable Spouse’s Year 2 tax liability is a liability that was incurred during marriage but was not for the benefit of the marriage or the family under Wisconsin law. In this situation, Wisconsin law provides that a creditor may reach Liable Spouse’s interest in marital property. However, because the debt was not for the benefit of the marriage or family, applying Wisconsin law in this Step 4, the Service may reach only Liable Spouse’s individual property and interest in marital property, and therefore may not offset any amount of the overpayment in addition to the amount offset in Step 3, from a community property source. Accordingly, the additional amount the Service may offset under Step 4 is zero.

  In Situation 4, Liable Spouse’s Year 2 tax liability is a liability that was incurred during marriage and was for the benefit of the marriage or the family under Wisconsin law. In this situation, Wisconsin law provides that a creditor may reach all marital property. Accordingly, the Service may offset the remaining $500 of the overpayment against Liable Spouse’s Year 2 tax liability.

  (5) Step 5.

  Under both Arizona and Wisconsin law, a creditor may reach 100 percent of Liable Spouse’s separate property to satisfy Liable Spouse’s separate tax liability. A creditor may not, however, reach any of Non-Liable Spouse’s separate property to satisfy Liable Spouse’s separate tax liability. In Situation 1, Situation 2, Situation 3, and Situation 4, no part of the overpayment is from a separate property source. Accordingly, there is no separate property that the Service may offset against the Liable Spouse’s separate tax liability.

HOLDING

  Situation 1. The Service may offset $875 of the overpayment against Liable Spouse’s separate Year 1 tax liability.

  Situation 2. The Service may offset $875 of the overpayment against Liable Spouse’s separate Year 1 tax liability.

  Situation 3. The Service may offset $500 of the overpayment against Liable Spouse’s separate Year 2 tax liability.

  Situation 4. The Service may offset $1,000 of the overpayment against Liable Spouse’s separate Year 2 tax liability.

EFFECT ON OTHER REVENUE RULINGS

  Revenue Ruling 80-7 and Rev. Rul. 85-70 are amplified and clarified.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Michael A. Skeen of the Office of the Associate Chief Counsel (Procedure and Administration), Administrative Provisions and Judicial Practice Division. For further information regarding this revenue ruling, contact Michael A. Skeen at (202) 622-4910 (not a toll-free call).

 Rev. Rul. 2004-71, 2004-30 I.R.B. 74

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Revenue Ruling 2004-72

Rev. Rul. 2004-72
Rev. Rul. 2004-72, 2004-30 I.R.B. 77
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
        OFFSETS UNDER SECTION 6402; CALIFORNIA, IDAHO, AND LOUISIANA LAW
                            Published: July 26, 2004

 26 CFR 301.6402-1: Authority to make credits or refunds.

  Offsets under section 6402; California, Idaho, and Louisiana law. This ruling provides guidance regarding the amount of an overpayment from a joint tax return that the IRS may offset against a spouse’s separate tax liability for taxpayers domiciled in California, Idaho, or Louisiana. California, Idaho, and Louisiana are community property states and, under the respective state laws, each spouse has an undivided 50-percent interest in all community property. Rev. Ruls. 80-7 and 85-70 amplified and clarified.

  Offsets under section 6402; California, Idaho, and Louisiana law. This ruling provides guidance regarding the amount of an overpayment from a joint tax return that the IRS may offset against a spouse’s separate tax liability for taxpayers domiciled in California, Idaho, or Louisiana. California, Idaho, and Louisiana are community property states and, under the respective state laws, each spouse has an undivided 50-percent interest in all community property. Rev. Ruls. 80-7 and 85-70 amplified and clarified.

ISSUE

  What amount of an overpayment reported on a joint return may the Internal Revenue Service apply against one spouse’s separate tax liability if the spouses are domiciled in California, Idaho, or Louisiana?

  This ruling addresses how offsets apply for taxpayers filing joint returns and domiciled in California, Idaho, or Louisiana. Because these states have similar community property laws, California, Idaho, and Louisiana are addressed in one ruling. This ruling makes assumptions about the operation of state community property laws which are highly dependent on facts and circumstances. Therefore, taxpayers are cautioned to check current state law and apply it to their particular facts. Taxpayers domiciled in Arizona or Wisconsin should refer to Rev. Rul. 2004-71; taxpayers domiciled in Nevada, New Mexico or Washington should refer to Rev. Rul. 2004-73; and taxpayers domiciled in Texas should refer to Rev. Rul. 2004-74.

FACTS

  Situation 1, California. In Year 1, Liable Spouse, who is single, incurs a tax liability of $20,000. Liable Spouse does not pay this tax liability. In Year 2, Liable Spouse and Non-Liable Spouse marry. In Year 4, Liable Spouse and Non-Liable Spouse file a joint return for Year 3, reporting an overpayment of $1,000. The overpayment results from income taxes withheld from Liable Spouse’s and Non-Liable Spouse’s wages during Year 3. Liable Spouse and Non-Liable Spouse are domiciled in California at all relevant times.

  Except as otherwise provided by statute, California law provides that all property, either real or personal, that is acquired during marriage is community property, and each spouse has a 50 percent interest in the community property. See Cal. Fam. Code sections 760, 751 (2003). There is a rebuttable presumption under California law that all property acquired by a spouse during marriage is community property. See In re Marriage of Haines, 39 Cal. Rptr. 2d 673, 681 (1995).

  California law defines separate property as all property owned by a spouse prior to marriage, and all property acquired by a spouse by gift, bequest, devise, or descent. See Cal. Fam. Code section 770(a)(1), (a)(2) (2003). In addition, California law provides that all rents, issues, and profits from separate property are separate property. See Cal. Fam. Code section 770(a)(3) (2003).

  California law provides that a creditor may reach all of the community property to satisfy a debt incurred by a spouse before or during marriage. See Cal. Fam. Code section 910(a) (2003). A creditor may also reach all of the liable spouse’s separate property to satisfy a debt incurred by the liable spouse; however, a creditor may not reach any of the non-liable spouse’s separate property. See Cal. Fam. Code section 913 (2003).

  Situation 2, Idaho. In Year 1, Liable Spouse, who is single, incurs a tax liability of $20,000. Liable Spouse does not pay this tax liability. In Year 2, Liable Spouse and Non-Liable Spouse marry. In Year 4, Liable Spouse and Non-Liable Spouse file a joint return for Year 3, reporting an overpayment of $1,000. The overpayment results from income taxes withheld from Liable Spouse’s and Non-Liable Spouse’s wages during Year 3. Liable Spouse and Non-Liable Spouse are domiciled in Idaho at all relevant times.

  Idaho law defines separate property as all property owned by a spouse before marriage, and all property acquired by a spouse during marriage by gift, bequest, devise or descent, or property acquired with the proceeds of his or her separate property. See Idaho Code section 32-903 (2003). Idaho law defines community property as all other property acquired by either spouse during marriage. See Idaho Code section 32-906(1) (2003). Idaho law provides a rebuttable presumption that property acquired during marriage is community property, and the burden of proof is on the party asserting that the property is separate property. See Worzala v. Worzala, 913 P.2d 1178, 1182 (Idaho 1996).

  Idaho law provides that income generated during marriage from any property, regardless of whether the property is separate or community property, is generally community property, unless: (1) the conveyance by which the property is acquired specifically identifies this property as the separate property of one spouse; or (2) both spouses agree in writing that the property, and any income related to this property, is the separate property of one spouse. See Idaho Code section 32-906(1) (2003).

  Idaho law provides that a creditor may reach all of the community property; both real and personal, to satisfy a spouse’s separate debt. Bliss v. Bliss, 898 P.2d 1081, 1084 (Idaho 1995). If the husband incurs a debt, a creditor may not reach the wife’s separate property to satisfy this debt. See Idaho Code section 32-911 (2003). Further, if the wife incurs a debt before marriage, a creditor may not reach the husband’s separate property to satisfy this debt. See Idaho Code section 32-910 (2003).

  Situation 3, Louisiana. In Year 1, Liable Spouse, who is single, incurs a tax liability of $20,000. Liable Spouse does not pay this tax liability. In Year 2, Liable Spouse and Non-Liable Spouse marry. In Year 4, Liable Spouse and Non-Liable Spouse file a

joint return for Year 3, reporting an overpayment of $1,000. The overpayment results from income taxes withheld from Liable Spouse’s and Non-Liable Spouse’s wages during Year 3. Liable Spouse and Non-Liable Spouse are domiciled in Louisiana at all relevant times, and Liable Spouse’s tax liability is a separate obligation as defined by Louisiana law.

  Louisiana law defines separate property as including property acquired by a spouse prior to marriage, property acquired with that spouse’s separate property, property acquired by a spouse through inheritance or donation to that spouse individually, damages awarded to a spouse in connection with the management of that spouse’s separate property, and property acquired by a spouse from a voluntary partition of the community during marriage. See La. Civ. Code Ann. art. 2341 (2003). Louisiana law defines community property as property acquired by a spouse during marriage that is not separate property. See La. Civ. Code Ann. art. 2338 (2003). Louisiana law provides a rebuttable presumption that all property in the possession of either spouse is community property. See La. Civ. Code Ann. art. 2340 (2003). Each spouse has a 50 percent interest in community property. See La. Civ. Code Ann. art. 2336 (2003).

  Louisiana law provides that a creditor may reach all of the community property to satisfy separate and community obligations. See La. Civ. Code Ann. art. 2345 (2003). In addition, a creditor may reach all of the liable spouse’s separate property to satisfy separate and community obligations. See Id.

  Under Louisiana law, obligations incurred by a spouse are either community obligations or separate obligations. See La. Civ. Code

Ann. art. 2359 (2003). A community obligation is defined as an obligation incurred during marriage for either the common interest of both spouses or for the interest of the other spouse. See La. Civ. Code Ann. art. 2360 (2003). A separate obligation is defined as an obligation that was incurred before marriage, after marriage has terminated, or during marriage, though not for the benefit of the community. See La. Civ. Code Ann. art. 2363 (2003). Louisiana law provides a rebuttable presumption that all obligations incurred during marriage are community obligations. See La. Civ. Code Ann. art. 2361 (2003).

LAW

  Section 6402(a) of the Internal Revenue Code provides that, in the case of any overpayment, the Service may credit the amount of the overpayment, including interest, against any internal revenue tax liability on the part of the person who made the overpayment and shall refund the balance to the person.

  Revenue Ruling 74-611, 1974-2 C.B. 399, holds that if a husband and wife file a joint return, each spouse has a separate interest in the jointly reported income and a separate interest in any overpayment. However, filing a joint return does not create a new property interest for the husband or the wife. Id.

  Revenue Ruling 80-7, 1980-1 C.B. 296, holds that if a husband and wife file a joint return showing an overpayment, the Service may credit one spouse’s interest in the overpayment against that spouse’s separate tax liability. The amount of the spouse’s interest in the overpayment is calculated by subtracting the spouse’s share of the joint tax liability, determined under a separate tax formula, from the spouse’s contribution towards the joint tax liability. Under the separate tax formula, a spouse’s share of the joint tax liability is calculated as follows:

——————————————————————————
       Spouse’s Separate Tax
___________________________________  x  Joint Tax Liability Reported on Return
Total of Both Spouses’ Separate Tax
——————————————————————————

  Revenue Ruling 85-70, 1985-1 C.B. 361, provides a two-step process to determine the amount of a joint overpayment that the Service may offset against one spouse’s separate tax liability if the spouses are domiciled in a community property state. First, if the joint overpayment is from wages that are community property income, then each spouse is considered to be the recipient of one-half of the aggregated wages regardless of whether the spouses may have earned different amounts of wages (the one-half rule). Accordingly, each spouse has a one-half interest in the overpayment, and the Service may offset the liable spouse’s one-half interest in the overpayment against the liable spouse’s separate federal tax liability regardless of whether state law provides that creditors may reach community property to satisfy the separate debts of a spouse. Id. Rev. Rul. 85-70 does not specifically address what portion of each spouse’s actual wages is treated as having been offset as a result of applying the one-half rule. Under the facts of Rev. Rul. 85-70, and specifically the assumed state laws, that analysis was not necessary. However, applying the second step of Rev. Rul. 85-70 in other cases may require a determination of the amount of each spouse’s actual wages that were offset after applying the one-half rule. For that purpose, each spouse under the first step of Rev. Rul. 85-70 is treated as receiving one half of the wages from each community property source (or, collectively, one-half of the aggregated wages) and as such being entitled to receive one-half of the income tax withheld from each community property source.

  Second, Rev. Rul. 85-70 provides that state law may enable the Service to offset an additional portion of the joint overpayment from community property sources to satisfy a spouse’s separate federal tax liability. This additional right of offset is available if state law provides that creditors may reach community property to satisfy the separate debts of a spouse. (The amount potentially available to be offset under the second step of Rev. Rul. 85-70 is the amount remaining after application of the first step of that revenue ruling.) However, if state law provides that community property may not be reached to satisfy the premarital or other separate debts of either spouse, then the Service may not offset any portion of the non-liable spouse’s share of the overpayment from community property sources against the liable spouse’s separate tax liability. Id.

  Five-step process to determine amount of joint overpayment that the Service may offset against separate federal tax liability of one spouse.

  A five-step process is required to determine the amount of a joint overpayment that the Service may, pursuant to section 6402(a), offset against the separate federal tax liability of one spouse.

  The first step is to identify the underlying source of the overpayment. The Service looks to the tax payments made by the spouses, including income tax withholding and estimated tax payments and other credits, such as the earned income tax credit, that gave rise to the overpayment. If the earned income tax credit is a source of the overpayment, see Rev. Rul. 87-52, 1987-1 C.B. 347,

for guidance.

  The second step is to characterize the underlying source of the overpayment as either separate or community property. Because an overpayment will be characterized in the same manner as the source of the overpayment, an overpayment will be characterized as community property, separate property, or as part community property and part separate property, depending on the character of the source of the overpayment. If the overpayment is part community property and part separate property, the portion of the overpayment attributable to a separate property source must be subtracted from the remainder of the overpayment. The portion of the overpayment attributable to a separate property source is calculated as follows:

———————————————————–
Tax Payment From a Separate Property Source
___________________________________________  x  Overpayment
            Total Tax Payments
———————————————————–

  The third step is to offset the liable spouse’s share of the joint overpayment from a community property source against the liable spouse’s separate tax liability. Under Rev. Rul. 85-70, the Service may offset the liable spouse’s 50-percent interest in the overpayment from a community property source to satisfy the liable spouse’s separate tax liability.

  The fourth step is to determine whether, under state law, the Service may reach the non-liable spouse’s share of the overpayment from a community property source. See Rev. Rul. 85-70.

  The fifth step is to determine whether the Service may, under state law, reach a portion of the overpayment from a separate property source of the liable spouse or the non-liable spouse.

ANALYSIS

  Apply the five-step process to each situation.

  (1) Step 1.

  In Situation 1, Situation 2, and Situation 3, the overpayment is from income taxes withheld in Year 3 from Liable Spouse’s and Non-Liable Spouse’s wages.

  (2) Step 2.

  California, Idaho, and Louisiana law presume that all property acquired during marriage by either spouse or both spouses, including wages, is community property. In Situation 1, Situation 2, and Situation 3, the overpayment results from income tax withholding from Liable Spouse’s and Non-Liable Spouse’s wages. Because state law presumes that wages are community property, the entire overpayment in Situation 1, Situation 2, and Situation 3 is assumed to be from a community property source.

  (3) Step 3.

  Under California, Idaho, and Louisiana law, each spouse has a present and equal interest in all community property. In Situation 1, Situation 2, and Situation 3, the Service may offset Liable Spouse’s $500 share of the overpayment, which is from a community property source against Liable Spouse’s separate tax liability.

  (4) Step 4.

  In Situation 1 and Situation 2, under California and Idaho law respectively, a creditor may reach all of the community property to satisfy a debt incurred by Liable Spouse, regardless of whether the debt was incurred before or after marriage. In Situation 3, under Louisiana law, a creditor may reach all of the community property to satisfy a debt, regardless of whether the debt is a separate or community debt. Accordingly, in Situation 1, Situation 2, and Situation 3, the Service may offset the remaining $500 of the overpayment.

  (5) Step 5.

  Under California, Idaho, and Louisiana law, a creditor may reach all of Liable Spouse’s separate property to satisfy Liable Spouse’s separate tax liability. A creditor may not, however, reach any of Non-Liable Spouse’s separate property to satisfy Liable Spouse’s separate tax liability. In Situation 1, Situation 2, and Situation 3, no part of the overpayment is from a separate property source. Accordingly, there is no separate property that the Service may offset against the Liable Spouse’s separate tax liability.

HOLDING

  Situation 1. The Service may offset $1,000 of the overpayment against Liable Spouse’s separate tax liability.

  Situation 2. The Service may offset $1,000 of the overpayment against Liable Spouse’s separate tax liability.

  Situation 3. The Service may offset $1,000 of the overpayment against Liable Spouse’s separate tax liability.

EFFECT ON OTHER REVENUE RULINGS

  Revenue Ruling 80-7 and Rev. Rul. 85-70 are amplified and clarified.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Michael A. Skeen of the Office of the Associate Chief Counsel (Procedure and Administration), Administrative Provisions and Judicial Practice Division. For further information regarding this revenue ruling, contact Michael A. Skeen at (202) 622-4910 (not a toll-free call).

 Rev. Rul. 2004-72, 2004-30 I.R.B. 77

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Revenue Ruling 2004-73

Rev. Rul. 2004-73
Rev. Rul. 2004-73, 2004-30 I.R.B. 80
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
       OFFSETS UNDER SECTION 6402; NEVADA, NEW MEXICO, AND WASHINGTON LAW
                            Published: July 26, 2004

 26 CFR 301.6402-1: Authority to make credits or refunds.

  Offsets under section 6402; Nevada, New Mexico, and Washington law. This ruling provides guidance regarding the amount of an overpayment from a joint tax return that the IRS may offset against a spouse’s separate tax liability for taxpayers domiciled in Nevada, New Mexico, and Washington. Nevada, New Mexico, and Washington are community property states and, under the respective state laws, each spouse has an undivided 50-percent interest in all community property. Rev. Ruls. 80-7 and 85-70 amplified and clarified.

  Offsets under section 6402; Nevada, New Mexico, and Washington law. This ruling provides guidance regarding the amount of an overpayment from a joint tax return that the IRS may offset against a spouse’s separate tax liability for taxpayers domiciled in Nevada, New Mexico, and Washington. Nevada, New Mexico, and Washington are community property states and, under the respective state laws, each spouse has an undivided 50-percent interest in all community property. Rev. Ruls. 80-7 and 85-70 amplified and clarified.

ISSUE

  What amount of an overpayment reported on a joint return may the Internal Revenue Service apply against one spouse’s separate tax liability if the spouses are domiciled in Nevada, New Mexico, or Washington?

  This ruling addresses how offsets apply for taxpayers filing joint returns and domiciled in Nevada, New Mexico, or Washington. Because these states have similar community property laws, Nevada, New Mexico, and Washington are addressed in one ruling. This ruling makes assumptions about the operation of state community property laws which are highly dependent on facts and circumstances. Therefore, taxpayers are cautioned to check current state law and apply it to their particular facts. Taxpayers domiciled in Arizona or Wisconsin should refer to Rev. Rul. 2004-71; taxpayers domiciled in California, Idaho, or Louisiana should refer to Rev. Rul. 2004-72; and taxpayers domiciled in Texas should refer to Rev. Rul. 2004-74.

FACTS

  Situation 1, Nevada. In Year 1, Liable Spouse, who is single, incurs a tax liability of $20,000. Liable Spouse does not pay this tax liability. In Year 2, Liable Spouse and Non-Liable Spouse marry. In Year 4, Liable Spouse and Non-Liable Spouse file a joint return for Year 3, reporting an overpayment of $1,000. The overpayment results from income taxes withheld from Liable Spouse’s and Non-Liable Spouse’s wages during Year 3. Liable Spouse and Non-Liable Spouse are domiciled in Nevada at all relevant times.

  Nevada law presumes that property acquired during marriage by either husband, wife, or both, is community property, subject to limited exceptions. See Nev. Rev. Stat. section 123.220 (2003). This presumption may be rebutted. Forrest v. Forrest, 668 P.2d 275, 277 (Nev. 1983). Further, during marriage, each spouse has a 50 percent interest in the community property. See Nev. Rev. Stat. section 123.225 (2003). Generally, property owned by one spouse before marriage, or acquired during marriage by gift, bequest, devise, descent, or an award for personal damages, is separate property, and each spouse has a 100 percent interest in his or her separate property. See Nev. Rev. Stat. section 123.130 (2003).

  Nevada law provides that a creditor may reach all of a liable spouse’s separate property and all of the community property to satisfy the liable spouse’s debts that arose during the marriage. See Hardy v. United States, Civil No. CV-N-94-0824 (D. Nev. 1997); Nelson v. United States, Civil No. CV-N-89-659 (D. Nev. 1993), aff’d, 53 F.3d 339 (9th Cir. 1995); United States v. ITT Consumer Financial Corp, 816 F.2d 487, n. 12 (9th Cir. 1987). However, a creditor may not reach any of the non-liable spouse’s separate property to satisfy the liable spouse’s debt that arose during the marriage. See Hardy v. United States, Civil No. CV-N-94-0824 (D. Nev. 1997). In addition, Nevada law provides that a creditor may not reach the non-liable spouse’s separate property or the non-liable spouse’s share of the community property to satisfy the liable spouse’s separate debts incurred or contracted prior to marriage. See Nev. Rev. Stat. section 123.050 (2003).

  Situation 2, New Mexico. In Year 1, Liable Spouse, who is single, incurs a tax liability of $20,000. Liable Spouse does not pay this tax liability. In Year 2, Liable Spouse and Non-Liable Spouse marry. In Year 4, Liable Spouse and Non-Liable Spouse file a joint return for Year 3, reporting an overpayment of $1,000. The overpayment results from income taxes withheld from Liable Spouse’s and Non-Liable Spouse’s wages during Year 3. Liable Spouse and Non-Liable Spouse are domiciled in New Mexico at all relevant times, and Liable Spouse’s tax liability is a separate debt as defined by New Mexico law.

  New Mexico law provides that property acquired during marriage by the husband, wife, or both is presumed to be community property, and each spouse has a 50 percent interest in community property. See N.M. Stat. Ann. section 40-3-12(A)(2002); Central Adjustment Bureau, Inc. v. Thevenet, 686 P.2d 954, 957-958 (N.M. 1984). This presumption may be rebutted. C & L Lumber and Supply, Inc. v. Texas American Bank/Galeria, 795 P.2d 502, 505 (N.M. 1990). Generally, property owned by a spouse before marriage is separate property, and each spouse has a 100 percent interest in all of his or her separate property. See N.M. Stat. Ann. section 40-3-8 (2002).

  New Mexico law provides that a creditor may reach all of the separate property of the spouse or spouses who contracted or incurred the debt, and all of the community property to satisfy a community debt. See N.M. Stat. Ann. section 40-3-11(A) (2002). However, a creditor may not reach any of one spouse’s separate property to satisfy a community debt incurred by the other spouse. See Id. New Mexico law provides that a creditor may reach all of the liable spouse’s separate property and all of the liable spouse’s share of community property to satisfy a separate debt. See N.M. Stat. Ann. section 40-3-10(A) (2002). However, a creditor may not reach any of the non-liable spouse’s separate property to satisfy the liable spouse’s separate debt. See Id.

  Under New Mexico law, a separate debt is defined as: (1) a debt contracted or incurred either before marriage or after entry of a decree of dissolution of marriage; (2) a debt contracted or incurred after a court has entered a decree pursuant to N.M. Stat. Ann. section 40-4-3 (proceeding for division of property, disposition of children or alimony without dissolution of marriage); (3) a debt designated by a court as a separate debt; (4) a debt contracted by a spouse during marriage which, at the time of creation, is identified to the creditor in writing as the separate debt of the contracting spouse; (5) a debt that arises from a tort committed either before marriage or after entry of a decree of dissolution of marriage; or (6) a debt declared unreasonable pursuant to N.M. Stat. Ann. section 40-3-10.1 (certain debts that did not contribute to the benefit of both spouses or their dependents). See N.M. Stat. Ann. section 40-3-9(A)(1) through (6) (2002). Community debt is defined as a debt, which is not a separate debt, contracted or incurred by one or both spouses during the marriage. See N.M. Stat. Ann. section 40-3-9(B) (2002). New Mexico law presumes that a debt incurred during marriage is community debt. See In re Fingado, 113 B.R. 37, 42 (Bankr. D.N.M. 1990), aff’d, 995 F.2d 175 (10th Cir. 1993).

  Situation 3, Washington. In Year 1, Liable Spouse, who is single, incurs a tax liability of $20,000. Liable Spouse does not pay this tax liability. In Year 2, Liable Spouse and Non-Liable Spouse marry. In Year 4, Liable Spouse and Non-Liable Spouse file a joint return for Year 3, reporting an overpayment of $1,000. The overpayment results from income taxes withheld from Liable Spouse’s and Non-Liable Spouse’s wages during Year 3. Liable Spouse and Non-Liable Spouse are domiciled in Washington state at all relevant times, and Liable Spouse’s tax liability is a separate debt as defined by Washington state law.

  Washington state law defines community property as any property acquired during marriage, by one or both spouses, that is not separate property. See Wash. Rev. Code section 26.16.030 (2003). There is a rebuttable presumption under Washington state law that all property acquired during marriage is community property. See Dean v. Lehman, 18 P.3d 523, 528 (Wash. 2001)(en banc). Each spouse has an undivided 50-percent interest in all community property. See In re Towey’s Estate, 155 P.2d 273, 275 (Wash. 1945). Washington state law defines separate property as property owned by a spouse before marriage and property acquired during marriage by a spouse by gift, bequest, devise, or descent. See Wash. Rev. Code sections 26.16.010, 26.16.020 (2003). In addition, Washington state law defines as separate property any profits or income derived from separate property during marriage. See Wash. Rev. Code sections 26.16.010, 26.16.020 (2003).

  Under Washington state law, a creditor may reach all of the community property, including the earnings of both spouses, to satisfy a community debt. See Pacific Gamble Robinson Co. v. Lapp, 622 P.2d 850, 854 (Wash. 1980). A creditor may reach all of a spouse’s separate property to satisfy a community debt incurred by that spouse; however, a creditor of a community debt may not reach the other spouse’s separate property. See Wash. Rev. Code sections 6.15.040, 26.16.010, 26.16.020 (2003). In general, under Washington state law, a creditor may not reach any of the community property to satisfy a separate debt. See Wash. Rev. Code section 26.16.200 (2003); Pacific Gamble Robinson Co., 622 P.2d at 854. However, under United States v. Overman, 424 F.2d 1142 (9th Cir. 1970), the Service may reach the liable spouse’s 50-percent interest in the community property to satisfy a separate tax liability of the liable spouse. See also Draper v. United States, 243 F. Supp. 563 (W.D. Wash. 1965).

  Under Washington state law, a debt incurred during marriage, for the benefit of the community, is a community debt. See In re Marriage of Hurd, 848 P.2d 185, 195-196 (Wash. App. 1993). Washington state law presumes that a debt is a community debt. See Pacific Gamble Robinson Co., 622 P.2d at 854. If a debt is not a community debt, then it is a separate debt. See Id.

LAW

  Section 6402(a) of the Internal Revenue Code provides that, in the case of any overpayment, the Service may credit the amount of the overpayment, including interest, against any internal revenue tax liability on the part of the person who made the overpayment and shall refund the balance to the person.

  Revenue Ruling 74-611, 1974-2 C.B. 399, holds that if a husband and wife file a joint return, each spouse has a separate interest in the jointly reported income and a separate interest in any overpayment. However, filing a joint return does not create a new property interest for the husband or the wife. Id.

  Revenue Ruling 80-7, 1980-1 C.B. 296, holds that if a husband and wife file a joint return showing an overpayment, the Service may credit one spouse’s interest in the overpayment against that spouse’s separate tax liability. The amount of the spouse’s interest in the overpayment is calculated by subtracting the spouse’s share of the joint tax liability, determined under a separate tax formula, from the spouse’s contribution towards the joint tax liability. Under the separate tax formula, a spouse’s share of the joint tax liability is calculated as follows:

——————————————————————————
       Spouse’s Separate Tax
___________________________________  x  Joint Tax Liability Reported on Return
Total of Both Spouses’ Separate Tax
——————————————————————————

  Revenue Ruling 85-70, 1985-1 C.B. 361, provides a two-step process to determine the amount of a joint overpayment that the Service may offset against one spouse’s separate tax liability if the spouses are domiciled in a community property state. First, if the joint overpayment is from wages that are community property income, then each spouse is considered to be the recipient of one-half of the aggregated wages regardless of whether the spouses may have earned different amounts of wages (the one-half rule). Accordingly, each spouse has a one-half interest in the overpayment, and the Service may offset the liable spouse’s one-half interest in the overpayment against the liable spouse’s separate federal tax liability regardless of whether state law provides that creditors may reach community property to satisfy the separate debts of a spouse. Id. Rev. Rul. 85-70 does not specifically address what portion of each spouse’s actual wages is treated as having been offset as a result of applying the one-half rule. Under the facts of Rev. Rul. 85-70, and specifically the assumed state laws, that analysis was not necessary. However, applying the second step of Rev. Rul. 85-70 in other cases may require a determination of the amount of each spouse’s actual wages that were offset after applying the one-half rule. For that purpose, each spouse under the first step of Rev. Rul. 85-70 is treated as receiving one half of the wages from each community property source (or, collectively, one-half of the aggregated wages) and as

such being entitled to receive one-half of the income tax withheld from each community property source.

  Second, Rev. Rul. 85-70 provides that state law may enable the Service to offset an additional portion of the joint overpayment from community property sources to satisfy a spouse’s separate federal tax liability. This additional right of offset is available if state law provides that creditors may reach community property to satisfy the separate debts of a spouse. (The amount potentially available to be offset under the second step of Rev. Rul. 85-70 is the amount remaining after application of the first step of that revenue ruling.) However, if state law provides that community property may not be reached to satisfy the premarital or other separate debts of either spouse, then the Service may not offset any portion of the non-liable spouse’s share of the overpayment from community property sources against the liable spouse’s separate tax liability. Id.

  Five-step process to determine amount of joint overpayment that the Service may offset against separate federal tax liability of one spouse.

  A five-step process is required to determine the amount of a joint overpayment that the Service may, pursuant to section 6402(a), offset against the separate federal tax liability of one spouse.

  The first step is to identify the underlying source of the overpayment. The Service looks to the tax payments made by the spouses, including income tax withholding and estimated tax payments and other credits, such as the earned income tax credit, that gave rise to the overpayment. If the earned income tax credit is a source of the overpayment, see Rev. Rul. 87-52, 1987-1 C.B. 347, for guidance.

  The second step is to characterize the underlying source of the overpayment as either separate or community property. Because an overpayment will be characterized in the same manner as the source of the overpayment, an overpayment will be characterized as community property, separate property, or as part community property and part separate property, depending on the character of the source of the overpayment. If the overpayment is part community property and part separate property, the portion of the overpayment attributable to a separate property source must be subtracted from the remainder of the overpayment. The portion of the overpayment attributable to a separate property source is calculated as follows:

———————————————————–
Tax Payment From a Separate Property Source
___________________________________________  x  Overpayment
            Total Tax Payments
———————————————————–

  The third step is to offset the liable spouse’s share of the overpayment from a community property source against the liable spouse’s separate tax liability. Under Rev. Rul. 85-70, the Service may offset the liable spouse’s 50-percent interest in the overpayment from a community property source to satisfy the liable spouse’s separate tax liability.

  The fourth step is to determine whether, under state law, the Service may reach the non-liable spouse’s share of the overpayment from a community property source. See Rev. Rul. 85-70.

  The fifth step is to determine whether the Service may, under state law, reach a portion of the overpayment from a separate property source of the liable spouse or the non-liable spouse.

ANALYSIS

  Apply the five-step process to each situation.

  (1) Step 1.

  In Situation 1, Situation 2, and Situation 3, the overpayment is from income taxes withheld in Year 3 from Liable Spouse’s and Non-Liable Spouse’s wages.

  (2) Step 2.

  Nevada, New Mexico, and Washington state law presume that all property acquired during marriage by either spouse or both spouses, including wages, is community property. In Situation 1, Situation 2, and Situation 3, the overpayment results from income tax withholding from Liable Spouse’s and Non-Liable Spouse’s wages. Because state law presumes that wages are community property, the entire overpayment in Situation 1, Situation 2, and Situation 3 is assumed to be from a community property source.

  (3) Step 3.

  Under Nevada, New Mexico, and Washington state law, each spouse has a present and equal interest in all community property. In Situation 1, Situation 2, and Situation 3, the Service may offset Liable Spouse’s $500 share of the overpayment against Liable Spouse’s separate tax liability.

  (4) Step 4.

  Under Nevada, New Mexico, and Washington state law, the amount of community property that a creditor may reach depends on the character of the debt. In Situation 1, Liable Spouse’s tax liability arose before marriage. Nevada law distinguishes between debts that arose before or during the marriage. For debts that arose before marriage, a creditor may not reach either Non-Liable Spouse’s portion of community property or Non-Liable Spouse’s separate property. Accordingly, the Service may not offset any portion of Non-Liable Spouse’s share of the overpayment against Liable Spouse’s tax liability.

  In Situation 2, Liable Spouse’s tax liability is a separate debt under New Mexico law. In Situation 3, Liable Spouse’s tax liability is a separate debt under Washington state law. New Mexico and Washington state law distinguish between community debts and separate debts. For a community debt (e.g., a tax liability of one spouse that arose during the marriage by filing separate returns), a creditor may reach Liable Spouse’s and Non-Liable Spouse’s share of community property to satisfy the Liable Spouse’s separate tax liability. However, if the debt is a separate debt (e.g., a tax liability of one spouse that arose before marriage), a creditor may reach Liable Spouse’s share of community property, but a creditor may not reach Non-Liable Spouse’s share of community property. Because Liable Spouse’s tax liability is a separate debt in Situation 2 and Situation 3, the Service may not offset any portion of Non-Liable Spouse’s share of the overpayment against Liable Spouse’s separate tax liability.

  (5) Step 5.

  Under Nevada, New Mexico, and Washington state law, a creditor may reach all of Liable Spouse’s separate property to satisfy

Liable Spouse’s separate tax liability. A creditor may not, however, reach any of Non-Liable Spouse’s separate property to satisfy Liable Spouse’s separate tax liability. In Situation 1, Situation 2, and Situation 3, no part of the overpayment is from a separate property source. Accordingly, there is no separate property that the Service may offset against the Liable Spouse’s separate tax liability.

HOLDING

  Situation 1. The Service may offset $500 of the overpayment against Liable Spouse’s separate tax liability.

  Situation 2. The Service may offset $500 of the overpayment against Liable Spouse’s separate tax liability.

  Situation 3. The Service may offset $500 of the overpayment against Liable Spouse’s separate tax liability.

EFFECT ON OTHER REVENUE RULINGS

  Revenue Ruling 80-7 and Rev. Rul. 85-70 are amplified and clarified.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Michael A. Skeen of the Office of the Associate Chief Counsel (Procedure and Administration), Administrative Provisions and Judicial Practice Division. For further information regarding this revenue ruling, contact Michael A. Skeen at (202) 622-4910 (not a toll-free call).

 Rev. Rul. 2004-73, 2004-30 I.R.B. 80

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July 26th, 2004 | No Comments »

Revenue Ruling 2004-74

Rev. Rul. 2004-74
Rev. Rul. 2004-74, 2004-30 I.R.B. 84
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
                      OFFSETS UNDER SECTION 6402; TEXAS LAW
                            Published: July 26, 2004

 26 CFR 301.6402-1: Authority to make credits or refunds.

  Offsets under section 6402; Texas law. This ruling provides guidance regarding the amount of an overpayment from a joint tax return that the IRS may offset against a spouse’s separate tax liability for taxpayers domiciled in Texas. Texas is a community property state and, under the state law, each spouse has an undivided 50-percent interest in all community property. Rev. Ruls. 80-7 and 85-70 amplified and clarified.

  Offsets under section 6402; Texas law. This ruling provides guidance regarding the amount of an overpayment from a joint tax return that the IRS may offset against a spouse’s separate tax liability for taxpayers domiciled in Texas. Texas is a community property state and, under the state law, each spouse has an undivided 50-percent interest in all community property. Rev. Ruls. 80-7 and 85-70 amplified and clarified.

ISSUE

  What amount of an overpayment reported on a joint return may the Internal Revenue Service apply against one spouse’s separate tax liability if the spouses are domiciled in Texas?

  This ruling addresses how offsets apply for taxpayers filing joint returns and domiciled in Texas. This ruling makes assumptions about the operation of Texas community property laws which are highly dependent on facts and circumstances. Therefore, taxpayers are cautioned to check current state law and apply it to their particular facts. Taxpayers domiciled in Arizona or Wisconsin should refer to Rev. Rul. 2004-71; taxpayers domiciled in California, Idaho, or Louisiana should refer to Rev. Rul. 2004-72; and taxpayers domiciled in Nevada, New Mexico or Washington should refer to Rev. Rul. 2004-73.

FACTS

  Situation 1. In Year 1, Liable Spouse, who is single, incurs a federal tax liability of $20,000. Liable Spouse does not pay this tax liability. In Year 2, Liable Spouse and Non-Liable Spouse marry. In Year 4, Liable Spouse and Non-Liable Spouse file a joint return for Year 3, claiming an overpayment of $1,000. This overpayment results from income taxes withheld from Liable Spouse’s and Non-Liable Spouse’s wages during Year 3. Liable Spouse and Non-Liable Spouse are domiciled in Texas at all relevant times.

  Applying Rev. Rul. 80-7, 1980-1 C.B. 296, the Service determines that $750 of the overpayment is attributable to community property subject to Liable Spouse’s sole management, control, and disposition, and $250 of the overpayment is attributable to community property subject to Non-Liable Spouse’s sole management, control, and disposition.

  Texas law defines separate property as property owned by a spouse before marriage; property acquired by spouse during marriage by gift, devise or descent; and any damages recovered by a spouse for personal injuries that do not represent loss of earning capacity during marriage. See Tex. Fam. Code Ann. section 3.001 (2002). Texas law defines community property as property, other than separate property, acquired by either spouse during marriage. See Tex. Fam. Code Ann. section 3.002 (2002). Each spouse has a 50-percent interest in community property. See Broday v. United States, 455 F.2d 1097 (5th Cir. 1972). There is a rebuttable presumption under Texas law that all property acquired during marriage is community property. See Tex. Fam. Code Ann. section 3.003 (2002).

  Texas law distinguishes between community property subject to the joint management, control, and disposition of both spouses, and community property subject to one spouse’s sole management, control, and disposition. See Tex. Fam. Code Ann. section 3.102 (2002). A spouse has sole management, control, and disposition over community property that spouse would have owned if that spouse were single. See Tex. Fam. Code Ann. section 3.102(a) (2002). This community property includes personal earnings; revenue from separate property; damages recovered from personal injuries; and the increase in value, mutations and revenue of all property subject to a spouse’s sole management, control, and disposition. See Tex. Fam. Code Ann. section 3.102(a)(1) through (4) (2002). Texas law defines community property subject to joint management, control, and disposition as all community property that is not subject to a spouse’s sole management, control, and disposition, and is not otherwise subject to an agreement of the spouses. See Tex. Fam. Code Ann. section 3.102(c) (2002).

  Although each spouse has a 50 percent interest in the community property, Texas law limits the types of community property that a creditor may reach to satisfy a spouse’s separate liability. See Tex. Fam. Code Ann. section 3.202 (2002). Texas law allows a creditor to reach all of the community property subject to the liable spouse’s sole management, control, and disposition to satisfy the spouse’s separate liability. See Tex. Fam. Code Ann. section 3.202(c) (2002). In addition, a creditor may reach all community property subject to the spouses’ joint management, control, and disposition, and all of the liable spouse’s separate property, whether the debt was incurred before or during marriage. See Tex. Fam. Code Ann. section 3.202(c) (2002). A creditor may not reach any portion of the community property subject to the non-liable spouse’s sole management, control, and disposition, or the non-liable spouse’s separate property. See Tex. Fam. Code Ann. section 3.202(c) (2002). However, under Medaris v. United States, 884 F.2d 832 (5th Cir. 1989), the Service may reach the liable spouse’s 50-percent interest in the non-liable spouse’s sole management community property to satisfy a separate federal tax liability of the liable spouse.

  Situation 2. Same facts as Situation 1, except that $250 of the overpayment is attributable to community property subject to Liable Spouse’s sole management, control, and disposition, and $750 of the overpayment is attributable to community property subject to Non-Liable Spouse’s sole management, control, and disposition.

  Situation 3. Same facts as Situation 1, except that the entire overpayment resulted solely from income tax withholding from Non-Liable Spouse’s wages, and the entire overpayment is attributable to community property subject to Non-Liable Spouse’s sole

management, control, and disposition.

LAW

  Section 6402(a) of the Internal Revenue Code provides that, in the case of any overpayment, the Service may credit the amount of the overpayment, including interest, against any internal revenue tax liability on the part of the person who made the overpayment and shall refund the balance to the person.

  Revenue Ruling 74-611, 1974-2 C.B. 399, holds that if a husband and wife file a joint return, each spouse has a separate interest in the jointly reported income and a separate interest in any overpayment. However, filing a joint return does not create a new property interest for the husband or the wife. Id.

  Revenue Ruling 80-7, 1980-1 C.B. 296, holds that if a husband and wife file a joint return showing an overpayment, the Service may credit one spouse’s interest in the overpayment against that spouse’s separate tax liability. The amount of the spouse’s interest in the overpayment is calculated by subtracting the spouse’s share of the joint tax liability, determined under a separate tax formula, from the spouse’s contribution towards the joint tax liability. Under the separate tax formula, a spouse’s share of the joint tax liability is calculated as follows:

——————————————————————————
       Spouse’s Separate Tax
___________________________________  x  Joint Tax Liability Reported on Return
Total of Both Spouses’ Separate Tax
——————————————————————————

  Revenue Ruling 85-70, 1985-1 C.B. 361, provides a two-step process to determine the amount of a joint overpayment that the Service may offset against one spouse’s separate tax liability if the spouses are domiciled in a community property state. First, if the joint overpayment is from wages that are community property income, then each spouse is considered to be the recipient of one-half of the aggregated wages regardless of whether the spouses may have earned different amounts of wages (the one-half rule). Accordingly, each spouse has a one-half interest in the overpayment, and the Service may offset the liable spouse’s one-half interest in the overpayment against the liable spouse’s separate federal tax liability regardless of whether state law provides that creditors may reach community property to satisfy the separate debts of a spouse. Id. Rev. Rul. 85-70 does not specifically address what portion of each spouse’s actual wages is treated as having been offset as a result of applying the one-half rule. Under the facts of Rev. Rul. 85-70, and specifically the assumed state laws, that analysis was not necessary. However, applying the second step of Rev. Rul. 85-70 in other cases may require a determination of the amount of each spouse’s actual wages that were offset after applying the one-half rule. For that purpose, each spouse under the first step of Rev. Rul. 85-70 is treated as receiving one half of the wages from each community property source (or, collectively, one-half of the aggregated wages) and as such being entitled to receive one-half of the income tax withheld from each community property source.

  Second, Rev. Rul. 85-70 provides that state law may enable the Service to offset an additional portion of the joint overpayment from community property sources to satisfy a spouse’s separate federal tax liability. This additional right of offset is available if state law provides that creditors may reach community property to satisfy the separate debts of a spouse. (The amount potentially available to be offset under the second step of Rev. Rul. 85-70 is the amount remaining after application of the first step of that revenue ruling.) However, if state law provides that community property may not be reached to satisfy the premarital or other separate debts of either spouse, then the Service may not offset any portion of the non-liable spouse’s share of the overpayment from community property sources against the liable spouse’s separate tax liability. Id.

  Five-step process to determine amount of joint overpayment that the Service may offset against separate federal tax liability of one spouse.

  A five-step process is required to determine the amount of a joint overpayment that the Service may, pursuant to section 6402(a), offset against the separate federal tax liability of one spouse.

  The first step is to identify the underlying source of the overpayment. The Service looks to the tax payments made by the spouses, including income tax withholding and estimated tax payments and other credits. If the earned income tax credit is a source of the overpayment, see Rev. Rul. 87-52, 1987-1 C.B. 347, for guidance.

  The second step is to characterize the underlying source of the overpayment as either separate or community property. Because an overpayment will be characterized in the same manner as the source of the overpayment, an overpayment will be characterized as community property, separate property, or as part community property and part separate property, depending on the character of the source of the overpayment. If the overpayment is part community property and part separate property, the portion of the overpayment attributable to a separate property source must be subtracted from the remainder of the overpayment. The portion of the overpayment attributable to a separate property source is calculated as follows:

———————————————————–
Tax Payment From a Separate Property Source
___________________________________________  x  Overpayment
            Total Tax Payments
———————————————————–

  The third step is to offset the liable spouse’s share of the overpayment from a community property source against the liable spouse’s separate tax liability. Under Rev. Rul. 85-70, the Service may offset the liable spouse’s 50-percent interest in the overpayment from a community property source to satisfy the liable spouse’s separate tax liability.

  The fourth step is to determine whether, under state law, the Service may reach any other portion of the overpayment from a community property source. See Rev. Rul. 85-70.

  The fifth step is to determine whether the Service may, under state law, reach any portion of the overpayment from a separate

property source of the liable spouse or the non-liable spouse.

ANALYSIS

  Apply the five-step process to each situation.

  (1) Step 1.

  In Situation 1, Situation 2, and Situation 3, the Year 3 joint overpayment is from income taxes withheld in Year 3 from Liable Spouse’s and Non-Liable Spouse’s wages.

  (2) Step 2.

  Texas law presumes that all property acquired during marriage by either spouse or both spouses, including wages, is community property. In Situation 1, Situation 2, and Situation 3, the overpayment results from income tax withholding from Liable Spouse’s and Non-Liable Spouse’s wages. Because Texas law presumes that wages are community property, the entire overpayment in Situation 1, Situation 2, and Situation 3 is assumed to be from a community property source.

  (3) Step 3.

  Under Texas law, each spouse has a present and equal interest in all community property. In Situation 1, the Service applies Rev. Rul. 80-7 and determines that $750 of the overpayment is attributable to community property subject to Liable Spouse’s sole management, control, and disposition, and $250 of the overpayment is attributable to community property subject to Non-Liable Spouse’s sole management, control, and disposition. Applying Rev. Rul. 85-70 and Medaris v. United States, 884 F.2d 832 (5th Cir. 1989), the Service may offset $375 of the income tax withholding attributable to Liable Spouse’s wages and $125 of the income tax withholding attributable to Non-Liable Spouse’s wages. Accordingly, in Situation 1, the Service may offset $500 of the overpayment against Liable Spouse’s Year 1 tax liability.

  In Situation 2, the Service applies Rev. Rul. 80-7 and determines that  $250 of the overpayment is attributable to community property subject to Liable Spouse’s sole management, control, and disposition, and $750 of the overpayment is attributable to community property subject to Non-Liable Spouse’s sole management, control, and disposition. Applying Rev. Rul. 85-70 and Medaris, the Service may offset $125 of the income tax withholding attributable to Liable Spouse’s wages and $375 of the income tax withholding attributable to Non-Liable Spouse’s wages. Accordingly, in Situation 2, the Service may offset $500 of the overpayment against Liable Spouse’s Year 1 tax liability.

  In Situation 3, the Service applies Rev. Rul. 80-7 and determines that none of the overpayment is attributable to community property subject to Liable Spouse’s sole management, control, and disposition, and $1,000 of the overpayment is attributable to community property subject to Non-Liable Spouse’s sole management, control, and disposition. Applying Rev. Rul. 85-70 and Medaris, the Service may offset $500 of the income tax withholding attributable to Non-Liable Spouse’s wages. Accordingly, in Situation 3, the Service may offset $500 of the overpayment against Liable Spouse’s Year 1 tax liability.

  (4) Step 4.

  Under Texas law, the amount of community property that a creditor may reach depends on the nature of the property. In Situation

1, Situation 2, and Situation 3, under Texas law, the Service may reach all community property subject to Liable Spouse’s sole management, control, and disposition, and all community property subject to Liable Spouse’s and Non-Liable Spouse’s joint management, control, and disposition.

  In Situation 1, $750 of the overpayment is attributable to community property subject to Liable Spouse’s sole management, control, and disposition. Applying Texas law in Step 4, and in addition to the amount offset in Step 3, the Service may offset the remaining $375 of the $750 overpayment that is attributable to community property subject to Liable Spouse’s sole management, control, and disposition.

  Further, $250 of the overpayment is attributable to community property subject to Non-Liable Spouse’s sole management, control, and disposition. Applying Texas law in Step 4, in addition to the amount offset in Step 3, the Service may not offset the remaining portion of the overpayment from community property sources subject to Non-Liable Spouse’s sole management, control, and disposition.

  In Situation 2, $250 of the overpayment is attributable to community property subject to Liable Spouse’s sole management, control, and disposition. Applying Texas law in Step 4, and in addition to the amount offset in Step 3, the Service may offset the remaining $125 of the $250 overpayment that is attributable to community property subject to Liable Spouse’s sole management, control, and disposition.

  Further, $750 of the overpayment is attributable to community property subject to Non-Liable Spouse’s sole management, control, and disposition. Applying Texas law in Step 4, in addition to the amount offset in Step 3, the Service may not offset the remaining portion of the overpayment from community property sources subject to Non-Liable Spouse’s sole management, control, and disposition.

  In Situation 3, none of the overpayment is attributable to community property subject to Liable Spouse’s sole management, control, and disposition. Applying Texas law in Step 4, in addition to the amount offset in Step 3, the Service may not offset the remaining portion of the overpayment from community property sources.

  (5) Step 5.

  Under Texas state law, a creditor may reach 100 percent of Liable Spouse’s separate property to satisfy Liable Spouse’s separate tax liability. A creditor may not, however, reach any of Non-Liable Spouse’s separate property to satisfy Liable Spouse’s separate tax liability. In Situation 1, Situation 2, and Situation 3, no part of the overpayment is from a separate property source. Accordingly, there is no separate property that the Service may offset against the Liable Spouse’s separate tax liability.

HOLDING

  Situation 1. The Service may offset $875 of the overpayment against Liable Spouse’s separate tax liability.

  Situation 2. The Service may offset $625 of the overpayment against Liable Spouse’s separate tax liability.

  Situation 3. The Service may offset $500 of the overpayment against Liable Spouse’s separate tax liability.

EFFECT ON OTHER REVENUE RULINGS

  Revenue Ruling 80-7 and Rev. Rul. 85-70 are amplified and clarified.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Michael A. Skeen of the Office of the Associate Chief Counsel (Procedure and Administration), Administrative Provisions and Judicial Practice Division. For further information regarding this revenue ruling,

contact Michael A. Skeen at (202) 622-4910 (not a toll-free call).

 Rev. Rul. 2004-74, 2004-30 I.R.B. 84

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Revenue Ruling 2004-86

Rev. Rul. 2004-86
Rev. Rul. 2004-86, 2004-33 I.R.B. 191
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
                   CLASSIFICATION OF DELAWARE STATUTORY TRUST
                             Released: July 20, 2004
                           Published: August 16, 2004

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

  How will certain Delaware statutory trusts be classified for federal tax purposes and may a taxpayer acquire an interest in certain Delaware statutory trusts without recognition of gain or loss under section 1031 of the Internal Revenue Code.

Section 677.–Income for Benefit of Grantor

  How will certain Delaware statutory trusts be classified for federal tax purposes and may a taxpayer acquire an interest in certain Delaware statutory trusts without recognition of gain or loss under section 1031 of the Internal Revenue Code.

Section 761.–Terms Defined

  How will certain Delaware statutory trusts be classified for federal tax purposes and may a taxpayer acquire an interest in certain Delaware statutory trusts without recognition of gain or loss under section 1031 of the Internal Revenue Code.

Section 1031.–Exchange of Property Held for Productive Use or Investment

  How will certain Delaware statutory trusts be classified for federal tax purposes and may a taxpayer acquire an interest in certain Delaware statutory trusts without recognition of gain or loss under section 1031 of the Internal Revenue Code.

26 CFR 301.7701-1: Classification of organizations for federal tax purposes.

  Classification of Delaware statutory trust. This ruling explains how a Delaware statutory trust described in the ruling will be classified for federal tax purposes and whether a taxpayer may acquire an interest in the Delaware statutory trust without recognition of gain or loss under section 1031 of the Code. Rev. Ruls. 78-371 and 92-105 distinguished.

  Classification of Delaware statutory trust. This ruling explains how a Delaware statutory trust described in the ruling will be classified for federal tax purposes and whether a taxpayer may acquire an interest in the Delaware statutory trust without recognition of gain or loss under section 1031 of the Code. Rev. Ruls. 78-371 and 92-105 distinguished.

ISSUE(S)

  (1) In the situation described below, how is a Delaware statutory trust, described in Del. Code Ann. title 12, ss 3801 - 3824, classified for federal tax purposes?

  (2) In the situation described below, may a taxpayer exchange real property for an interest in a Delaware statutory trust without recognition of gain or loss under s 1031 of the Internal Revenue Code?

FACTS

  On January 1, 2005, A, an individual, borrows money from BK, a bank, and signs a 10-year note bearing adequate stated interest, within the meaning of s 483. On January 1, 2005, A uses the proceeds of the loan to purchase Blackacre, rental real property. The note is secured by Blackacre and is nonrecourse to A.

  Immediately following A’s purchase of Blackacre, A enters into a net lease with Z for a term of 10 years. Under the terms of the lease, Z is to pay all taxes, assessments, fees, or other charges imposed on Blackacre by federal, state, or local authorities. In addition, Z is to pay all insurance, maintenance, ordinary repairs, and utilities relating to Blackacre. Z may sublease Blackacre. Z’s rent is a fixed amount that may be adjusted by a formula described in the lease agreement that is based upon a fixed rate or an

objective index, such as an escalator clause based upon the Consumer Price Index, but adjustments to the rate or index are not within the control of any of the parties to the lease. Z’s rent is not contingent on Z’s ability to lease the property or on Z’s gross sales or net profits derived from the property.

  Also on January 1, 2005, A forms DST, a Delaware statutory trust described in the Delaware Statutory Trust Act, Del. Code Ann. title 12, ss 3801 - 3824, to hold property for investment. A contributes Blackacre to DST. Upon contribution, DST assumes A’s rights and obligations under the note with BK and the lease with Z. In accordance with the terms of the note, neither DST nor any of its beneficial owners are personally liable to BK on the note, which continues to be secured by Blackacre.

  The trust agreement provides that interests in DST are freely transferable. However, DST interests are not publicly traded on an established securities market. DST will terminate on the earlier of 10 years from the date of its creation or the disposition of Blackacre, but will not terminate on the bankruptcy, death, or incapacity of any owner or on the transfer of any right, title, or interest of the owners. The trust agreement further provides that interests in DST will be of a single class, representing undivided beneficial interests in the assets of DST.

  Under the trust agreement, the trustee is authorized to establish a reasonable reserve for expenses associated with holding Blackacre that may be payable out of trust funds. The trustee is required to distribute all available cash less reserves quarterly to each beneficial owner in proportion to their respective interests in DST. The trustee is required to invest cash received from Blackacre between each quarterly distribution and all cash held in reserve in short-term obligations of (or guaranteed by) the United States, or any agency or instrumentality thereof, and in certificates of deposit of any bank or trust company having a minimum stated surplus and capital. The trustee is permitted to invest only in obligations maturing prior to the next distribution date and is required to hold such obligations until maturity. In addition to the right to a quarterly distribution of cash, each beneficial owner has the right to an in-kind distribution of its proportionate share of trust property.

  The trust agreement provides that the trustee’s activities are limited to the collection and distribution of income. The trustee may not exchange Blackacre for other property, purchase assets other than the short-term investments described above, or accept additional contributions of assets (including money) to DST. The trustee may not renegotiate the terms of the debt used to acquire Blackacre and may not renegotiate the lease with Z or enter into leases with tenants other than Z, except in the case of Z’s bankruptcy or insolvency. In addition, the trustee may make only minor non-structural modifications to Blackacre, unless otherwise

required by law. The trust agreement further provides that the trustee may engage in ministerial activities to the extent required to maintain and operate DST under local law.

  On January 3, 2005, B and C exchange Whiteacre and Greenacre, respectively, for all of A’s interests in DST through a qualified intermediary, within the meaning of s 1.1031(k)-1(g). A does not engage in a s 1031 exchange. Whiteacre and Greenacre were held for investment and are of like kind to Blackacre, within the meaning of s 1031.

  Neither DST nor its trustee enters into a written agreement with A, B, or C, creating an agency relationship. In dealings with third parties, neither DST nor its trustee is represented as an agent of A, B, or C.

  BK is not related to A, B, C, DST’s trustee or Z within the meaning of s 267(b) or s 707(b). Z is not related to B, C, or DST’s trustee within the meaning of s 267(b) or s 707(b).

LAW

  Delaware law provides that a Delaware statutory trust is an unincorporated association recognized as an entity separate from its owners. A Delaware statutory trust is created by executing a governing instrument and filing an executed certificate of trust. Creditors of the beneficial owners of a Delaware statutory trust may not assert claims directly against the property in the trust. A Delaware statutory trust may sue or be sued, and property held in a Delaware statutory trust is subject to attachment or execution as if the trust were a corporation. Beneficial owners of a Delaware statutory trust are entitled to the same limitation on personal liability because of actions of the Delaware statutory trust that is extended to stockholders of Delaware corporations. A Delaware statutory trust may merge or consolidate with or into one or more statutory entities or other business entities.

  Section 671 provides that, where the grantor or another person is treated as the owner of any portion of a trust (commonly referred to as a “grantor trust”), there shall be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that the items would be taken into account under chapter 1 in computing taxable income or credits against the tax of an individual.

  Section 1.671-2(e)(1) of the Income Tax Regulations provides that, for purposes of subchapter J, a grantor includes any person to the extent such person either creates a trust or directly or indirectly makes a gratuitous transfer of property to a trust.

  Under s 1.671-2(e)(3), the term “grantor” includes any person who acquires an interest in a trust from a grantor of the trust if the interest acquired is an interest in certain investment trusts described in s 301.7701-4(c).

  Under s 677(a), the grantor is treated as the owner of any portion of a trust whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be distributed, or held or accumulated for future distribution, to the grantor or the grantor’s spouse.

  A person that is treated as the owner of an undivided fractional interest of a trust under subpart E of part I, subchapter J of the Code (ss 671 and following), is considered to own the trust assets attributable to that undivided fractional interest of the trust for federal income tax purposes. See Rev. Rul. 88-103, 1988-2 C.B. 304; Rev. Rul. 85-45, 1985-1 C.B. 183; and Rev. Rul. 85-13, 1985-1 C.B. 184. See also s 1.1001-2(c), Example 5.

  Section 761(a) provides that the term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and that is not a corporation or a trust or estate. Under regulations the Secretary may, at the election of all the members of the unincorporated organization, exclude such organization from the application of all or part of subchapter K, if the income of the members of the organization may be adequately determined without the computation of partnership taxable income and the organization is availed of (1) for investment purposes only and not for the active conduct of a business, (2) for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted, or (3) by dealers in securities for a short period for the purpose of underwriting, selling, or distributing a particular issue of securities.

  Section 1.761-2(a)(2) provides the requirements that must be satisfied for participants in the joint purchase, retention, sale, or exchange of investment property to elect to be excluded from the application of the provisions of subchapter K. One of these requirements is that the participants own the property as coowners.

  Section 1031(a)(1) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment.

  Section 1031(a)(2) provides that s 1031(a) does not apply to any exchange of stocks, bonds or notes, other securities or evidences of indebtedness or interest, interests in a partnership, or certificates of trust or beneficial interests. It further provides that an interest in a partnership that has in effect a valid election under s 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of the partnership and not as an interest in a partnership.

  Under s 301.7701-1(a)(1) of the Procedure and Administration Regulations, whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.

  Generally, when participants in a venture form a state law entity and avail themselves of the benefits of that entity for a valid business purpose, such as investment or profit, and not for tax avoidance, the entity will be recognized for federal tax purposes. See Moline Properties, Inc. v. Comm’r, 319 U.S. 436 (1943); Zmuda v. Comm’r, 731 F.2d 1417 (9th Cir. 1984); Boca Investerings P’ship v. United States, 314 F.3d 625 (D.C. Cir. 2003); Saba P’ship v. Comm’r, 273 F.3d 1135 (D.C. Cir. 2001); ASA Investerings

P’ship v. Comm’r, 201 F.3d 505 (D.C. Cir. 2000); Markosian v. Comm’r, 73 T.C. 1235 (1980).

  Section 301.7701-2(a) defines the term “business entity” as any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under s 301.7701- 3) that is not properly classified as a trust under s 301.7701-4 or otherwise subject to special treatment under the Code. A business entity with two or more owners is classified for federal tax purposes as either a corporation or a partnership. A business entity with only one owner is classified as a corporation or is disregarded.

  Section 301.7701-3(a) provides that an eligible entity can elect its classification for federal tax purposes. Under s 301.7701-3(b)(1), unless the entity elects otherwise, a domestic eligible entity is a partnership if it has two or more owners or is disregarded as an entity separate from its owner if it has a single owner.

  Section 301.7701-4(a) provides that the term “trust” refers to an arrangement created either by will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting and conserving it for the beneficiaries. Usually the beneficiaries of a trust do no more than accept the benefits thereof and are not voluntary planners or creators of the trust arrangement. However, the beneficiaries of a trust may be the persons who create it, and it will be recognized as a trust if it was created for the purpose of protecting and conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them.

  Section 301.7701-4(b) provides that there are other arrangements known as trusts because the legal title to property is conveyed to trustees for the benefit of beneficiaries, but that are not classified as trusts for federal tax purposes because they are not simply arrangements to protect or conserve the property for the beneficiaries. These trusts, which are often known as business or commercial trusts, generally are created by the beneficiaries simply as a device to carry on a profit-making business that normally would have been carried on through business organizations that are classified as corporations or partnerships.

  Section 301.7701-4(c)(1) provides that an “investment” trust will not be classified as a trust if there is a power under the trust agreement to vary the investment of the certificate holders. See Comm’r v. North American Bond Trust, 122 F.2d 545 (2d Cir. 1941), cert. denied, 314 U.S. 701 (1942). An investment trust with a single class of ownership interests, representing undivided beneficial interests in the assets of the trust, will be classified as a trust if there is no power to vary the investment of the certificate holders.

  A power to vary the investment of the certificate holders exists where there is a managerial power, under the trust instrument, that enables a trust to take advantage of variations in the market to improve the investment of the investors. See Comm’r v. North American Bond Trust, 122 F.2d at 546.

  Rev. Rul. 75-192, 1975-1 C.B. 384, discusses the situation where a provision in the trust agreement requires the trustee to invest cash on hand between the quarterly distribution dates. The trustee is required to invest the money in short-term obligations of (or guaranteed by) the United States, or any agency or instrumentality thereof, and in certificates of deposit of any bank or trust company having a minimum stated surplus and capital. The trustee is permitted to invest only in obligations maturing prior to the next distribution date and is required to hold such obligations until maturity. Rev. Rul. 75- 192 concludes that, because the restrictions on the types of permitted investments limit the trustee to a fixed return similar to that earned on a bank account and eliminate any opportunity to profit from market fluctuations, the power to invest in the specified kinds of short-term investments is not a power to vary the trust’s investment.

  Rev. Rul. 78-371, 1978-2 C.B. 344, concludes that a trust established by the heirs of a number of contiguous parcels of real estate is an association taxable as a corporation for federal tax purposes where the trustees have the power to purchase and sell contiguous or adjacent real estate, accept or retain contributions of contiguous or adjacent real estate, raze or erect any building or structure, make any improvements to the land originally contributed, borrow money, and mortgage or lease the property. Compare Rev. Rul. 79-77, 1979-1 C.B. 448 (concluding that a trust formed by three parties to hold a single parcel of real estate is classified as a trust for federal income tax purposes when the trustee has limited powers that do not evidence an intent to carry on a profit making business).

  Rev. Rul. 92-105, 1992-2 C.B. 204, addresses the transfer of a taxpayer’s interest in an Illinois land trust under s 1031. Under the facts of the ruling, a single taxpayer created an Illinois land trust and named a domestic corporation as trustee. Under the deed of trust, the taxpayer transferred legal and equitable title to real property to the trust, subject to the provisions of an accompanying land trust agreement. The land trust agreement provided that the taxpayer retained exclusive control of the management, operation, renting, and selling of the real property, together with an exclusive right to the earnings and proceeds from the real property. Under the agreement, the taxpayer was required to file all tax returns, pay all taxes, and satisfy any other liabilities with respect to the real property. Rev. Rul 92-105 concludes that, because the trustee’s only responsibility was to hold and transfer title at the direction of the taxpayer, a trust, as defined in s 301.7701-4(a), was not established. Moreover, there were no other arrangements between the taxpayer and the trustee (or between the taxpayer and any other person) that would cause the overall arrangement to be classified as a partnership (or any other type of entity). Instead, the trustee was a mere agent for the holding and transfer of title to real property, and the taxpayer retained direct ownership of the real property for federal income tax purposes.

ANALYSIS

  Under Delaware law, DST is an entity that is recognized as separate from its owners. Creditors of the beneficial owners of DST may not assert claims directly against Blackacre. DST may sue or be sued, and the property of DST is subject to attachment and execution as if it were a corporation. The beneficial owners of DST are entitled to the same limitation on personal liability because of actions of DST that is extended to stockholders of Delaware corporations. DST may merge or consolidate with or into one or more statutory entities or other business entities. DST is formed for investment purposes. Thus, DST is an entity for federal tax purposes.

  Whether DST or its trustee is an agent of DST’s beneficial owners depends upon the arrangement between the parties. The beneficiaries of DST do not enter into an agency agreement with DST or its trustee. Further, neither DST nor its trustee acts as an agent for A, B, or C in dealings with third parties. Thus, neither DST nor its trustee is the agent of DST’s beneficial owners. Cf. Comm’r v. Bollinger, 485 U.S. 340 (1988).

  This situation is distinguishable from Rev. Rul. 92-105. First, in Rev. Rul. 92-105, the beneficiary retained the direct obligation to pay liabilities and taxes relating to the property. DST, in contrast, assumed A’s obligations on the lease with Z and on the loan with BK, and Delaware law provides the beneficial owners of DST with the same limitation on personal liability extended to shareholders of Delaware corporations. Second, unlike A, the beneficiary in Rev. Rul. 92-105 retained the right to manage and control the trust property.

Issue 1. Classification of Delaware Statutory Trust

  Because DST is an entity separate from its owner, DST is either a trust or a business entity for federal tax purposes. To determine whether DST is a trust or a business entity for federal tax purposes, it is necessary, under s 301.7701-4(c)(1), to determine whether there is a power under the trust agreement to vary the investment of the certificate holders.

  Prior to, but on the same date as, the transfer of Blackacre to DST, A entered into a 10-year nonrecourse loan secured by Blackacre. A also entered into the 10-year net lease agreement with Z. A’s rights and obligations under the loan and lease were assumed by DST. Because the duration of DST is 10 years (unless Blackacre is disposed of prior to that time), the financing and leasing arrangements related to Blackacre that were made prior to the inception of DST are fixed for the entire life of DST. Further, the trustee may only invest in short-term obligations that mature prior to the next distribution date and is required to hold these obligations until maturity. Because the trust agreement requires that any cash from Blackacre, and any cash earned on short-term obligations held by DST between distribution dates, be distributed quarterly, and because the disposition of Blackacre results in the termination of DST, no reinvestment of such monies is possible.

  The trust agreement provides that the trustee’s activities are limited to the collection and distribution of income. The trustee may not exchange Blackacre for other property, purchase assets other than the short-term investments described above, or accept additional contributions of assets (including money) to DST. The trustee may not renegotiate the terms of the debt used to acquire Blackacre and may not renegotiate the lease with Z or enter into leases with tenants other than Z, except in the case of Z’s bankruptcy or insolvency. In addition, the trustee may make only minor non-structural modifications to Blackacre, unless otherwise required by law.

  This situation is distinguishable from Rev. Rul. 78-371, because DST’s trustee has none of the powers described in Rev. Rul. 78-371, which evidence an intent to carry on a profit making business. Because all of the interests in DST are of a single class representing undivided beneficial interests in the assets of DST and DST’s trustee has no power to vary the investment of the certificate holders to benefit from variations in the market, DST is an investment trust that will be classified as a trust under s 301.7701-4(c)(1).

Issue 2. Exchange of Real Property for Interests under s 1031

  B and C are treated as grantors of the trust under s 1.671-2(e)(3) when they acquire their interests in the trust from A. Because they have the right to distributions of all trust income attributable to their undivided fractional interests in the trust, B and C are each treated, by reason of s 677, as the owner of an aliquot portion of the trust and all income, deductions, and credits attributable to that portion are includible by B and C under s 671 in computing their taxable income. Because the owner of an undivided fractional interest of a trust is considered to own the trust assets attributable to that interest for federal income tax purposes, B and C are each considered to own an undivided fractional interest in Blackacre for federal income tax purposes. See Rev. Rul. 85-13.

  Accordingly, the exchange of real property by B and C for an interest in DST through a qualified intermediary is the exchange of real property for an interest in Blackacre, and not the exchange of real property for a certificate of trust or beneficial interest under s 1031(a)(2)(E). Because Whiteacre and Greenacre are of like kind to Blackacre, and provided the other requirements of s 1031 are satisfied, the exchange of real property for an interest in DST by B and C will qualify for nonrecognition of gain or loss under s 1031. Moreover, because DST is a grantor trust, the outcome to the parties will remain the same, even if A transfers interests in Blackacre directly to B and C, and B and C immediately form DST by contributing their interests in Blackacre.

  Under the facts of this case, if DST’s trustee has additional powers under the trust agreement such as the power to do one or more of the following: (i) dispose of Blackacre and acquire new property; (ii) renegotiate the lease with Z or enter into leases with tenants other than Z; (iii) renegotiate or refinance the obligation used to purchase Blackacre; (iv) invest cash received to profit from market fluctuations; or (v) make more than minor non-structural modifications to Blackacre not required by law, DST will be a business entity which, if it has two or more owners, will be classified as a partnership for federal tax purposes, unless it is treated as a corporation under s 7704 or elects to be classified as a corporation under s 301.7701-3. In addition, because the assets of DST will not be owned by the beneficiaries as coowners under state law, DST will not be able to elect to be excluded from the application of subchapter K. See s 1.761-2(a)(2)(i).

HOLDINGS

  (1) The Delaware statutory trust described above is an investment trust, under s 301.7701-4(c), that will be classified as a trust for federal tax purposes.

  (2) A taxpayer may exchange real property for an interest in the Delaware statutory trust described above without recognition of gain or loss under s 1031, if the other requirements of s 1031 are satisfied.

EFFECT ON OTHER REVENUE RULINGS

  Rev. Rul. 78-371 and Rev. Rul. 92-105 are distinguished.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Christopher L. Trump of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Christopher L. Trump at (202) 622-3070 (not a toll-free call).

 Rev. Rul. 2004-86, 2004-33 I.R.B. 191

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Revenue Ruling 2004-84

Rev. Rul. 2004-84
Rev. Rul. 2004-84, 2004-32 I.R.B. 163
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
      FEDERAL RATES; ADJUSTED FEDERAL RATES; ADJUSTED FEDERAL LONG-TERM RATE
                          AND THE LONG-TERM EXEMPT RATE
                             Released: July 19, 2004
                            Published: August 9, 2004

 Section 42.–Low-Income Housing Credit

  The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

Section 280G.–Golden Parachute Payments

  Federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

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

  The adjusted applicable federal long-term rate is set forth for the month of August 2004.

Section 412.–Minimum Funding Standards

  The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

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

  The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

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

  The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

Section 482.–Allocation of Income and Deductions Among Taxpayers

  Federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

Section 483.–Interest on Certain Deferred Payments

  The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

Section 642.–Special Rules for Credits and Deductions

  Federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

Section 807.–Rules for Certain Reserves

  The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

Section 846.–Discounted Unpaid Losses Defined

  The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

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

  The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

Section 7520.–Valuation Tables

  The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

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

  The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of August 2004.

Section 1274.–Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property

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

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

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

——————————————————
              REV. RUL. 2004-84 TABLE 1
    Applicable Federal Rates (AFR) for August 2004
                Period for Compounding
            Annual     Semiannual  Quarterly  Monthly
Short-Term
       AFR  2.37%      2.36%       2.35%      2.35%

  110% AFR  2.62%      2.60%       2.59%      2.59%
  120% AFR  2.85%      2.83%       2.82%      2.81%
  130% AFR  3.09%      3.07%       3.06%      3.05%
  Mid-Term
       AFR  4.00%      3.96%       3.94%      3.93%
  110% AFR  4.41%      4.36%       4.34%      4.32%
  120% AFR  4.81%      4.75%       4.72%      4.70%
  130% AFR  5.22%      5.15%       5.12%      5.10%
  150% AFR  6.03%      5.94%       5.90%      5.87%
  175% AFR  7.05%      6.93%       6.87%      6.83%
 Long-Term
       AFR  5.21%      5.14%       5.11%      5.09%
  110% AFR  5.73%      5.65%       5.61%      5.58%
  120% AFR  6.27%      6.17%       6.12%      6.09%
  130% AFR  6.79%      6.68%       6.63%      6.59%
——————————————————

—————————————————————
                   REV. RUL. 2004-84 TABLE 2
                 Adjusted AFR for August 2004
                    Period for Compounding
                         Annual  Semiannual  Quarterly  Monthly
Short-term adjusted AFR  1.71%   1.70%       1.70%      1.69%
Mid-term adjusted AFR    3.30%   3.27%       3.26%      3.25%
Long-term adjusted AFR   4.64%   4.59%       4.56%      4.55%
—————————————————————

——————————————————————————-
                           REV. RUL. 2004-84 TABLE 3
                    Rates Under Section 382 for August 2004
Adjusted federal long-term rate for the current month                     4.64%
Long-term tax-exempt rate for ownership changes during the current month  4.72%
  (the highest of the adjusted federal long-term rates for the current
  month and the prior two months.)
——————————————————————————-

——————————————————————————-
                           REV. RUL. 2004-84 TABLE 4
        Appropriate Percentages Under Section 42(b)(2) for August 2004
Appropriate percentage for the 70% present value low-income housing       8.07%
  credit
Appropriate percentage for the 30% present value low-income housing       3.46%
  credit
——————————————————————————-

——————————————————————————-

                           REV. RUL. 2004-84 TABLE 5
                    Rate Under Section 7520 for August 2004
Applicable federal rate for determining the present value of an annuity,   4.8%
  an interest for life or a term of years, or a remainder or reversionary
  interest
——————————————————————————-

 Rev. Rul. 2004-84, 2004-32 I.R.B. 163

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Revenue Ruling 2004-87

Rev. Rul. 2004-87
Rev. Rul. 2004-87, 2004-32 I.R.B. 154
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
                      BANKRUPTCY; GOLDEN PARACHUTE PAYMENTS
                             Released: July 19, 2004
                            Published: August 9, 2004

 26 CFR 601.105: Examination of returns and claims for refund, credit, or abatement; determination of correct tax liability.

  Bankruptcy; golden parachute payments. This ruling provides rules for the application of section 280G of the Code, concerning golden parachute payments, in the context of a bankruptcy. Specifically, this ruling addresses whether the acquisition of stock by the former creditors results in a change in ownership or control, whether a corporation whose stock is de-listed is eligible for the exemption for certain corporations whose stock is not readily tradeable on an established securities market if the shareholder approval and disclosure requirements described in the final regulations are satisfied, and whether stock that is de-listed from a securities market is considered readily tradeable if it is traded on an over-the-counter market (such as the pink sheets).

  Bankruptcy; golden parachute payments. This ruling provides rules for the application of section 280G of the Code, concerning golden parachute payments, in the context of a bankruptcy. Specifically, this ruling addresses whether the acquisition of stock by the former creditors results in a change in ownership or control, whether a corporation whose stock is de-listed is eligible for the exemption for certain corporations whose stock is not readily tradeable on an established securities market if the shareholder approval and disclosure requirements described in the final regulations are satisfied, and whether stock that is de-listed from a securities market is considered readily tradeable if it is traded on an over-the-counter market (such as the pink sheets).

ISSUE

  In the situations described below, has there been a change in ownership or control for purposes of ss 280G and 4999 of the Internal Revenue Code? If so, are any contingent payments potentially exempt under s 280G(b)(5)(A)(ii) (concerning payments from certain corporations that are approved by its shareholders)?

FACTS

  Situation 1. On March 1, 2005, Corporation A, files a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. See 11 U.S.C. s 1101, et seq. Corporation A common stock is widely held and actively traded on the New York Stock Exchange. There are no other shares of Corporation A outstanding. Committees of creditors holding unsecured claims and equity security holders are appointed pursuant to 11 U.S.C. s 1102.

  After negotiations between the unsecured creditors’ committee, the equity committee, and Corporation A, a plan of reorganization is presented to the bankruptcy court and approved. Under the plan of reorganization, all of the existing shares of Corporation A common stock are cancelled and new shares of common stock are authorized. Under the plan of reorganization, the unsecured creditors of Corporation A will receive 75% of the new common stock, distributed in proportion to their claims. Certain shareholders will receive 25% of the new common stock, distributed in proportion to their pre-re-organization stock holdings. No single unsecured creditor will receive 20% or more of the outstanding shares of Corporation A after the reorganization.

  Under the plan of reorganization, the existing Board of Directors is replaced by a new Board of Directors that is endorsed by the pre-reorganization Board of Directors.

  Situation 2. Assume the same facts as in Situation 1 except that after the reorganization the largest creditor of Corporation A will receive 25% of the outstanding shares of Corporation A.

  Situation 3. Common stock of Corporation B is widely-held and actively traded on the New York Stock Exchange. No other shares of Corporation B are outstanding. Since January 2000, Corporation B has experienced financial difficulties.

  On June 15, 2005, Corporation B determines that it is insolvent and files a voluntary petition for relief under Chapter 11 of the

Bankruptcy Code. Committees of creditors holding unsecured claims and equity security holders are appointed pursuant to 11 U.S.C. s 1102.

  On January 15, 2006, Corporation B’s stock is de-listed from the New York Stock Exchange and is thereafter no longer tradeable on any established securities market (as defined in s 1.897-1(m)). No trading occurred with respect to stock in Corporation B on any other market, including any over-the-counter market (e.g., the pink sheets, the over-the-counter-bulletin board (OTCBB), the automated confirmation transaction service (ACT), or any similar market).

  In March 2006, Corporation C proposes to purchase more than one-third of the total gross fair market value of the assets of Corporation B. Corporation B files a motion in the bankruptcy court for approval of the sale. Pursuant to an employment contract, the sale would trigger certain payments to Executive E, a disqualified individual with respect to Corporation B. E files a request in the bankruptcy court to allow Corporation B to make the payments as administrative expenses of the bankruptcy estate under 11 U.S.C. s 503(a). The request specifies that the payments will be made because of the sale of assets to Corporation C, the total amount of each payment, and a brief description of each payment. The request also explains why the payments are actual, necessary costs and expenses of preserving the bankruptcy estate.

  After notice and hearing, the bankruptcy court approves the sale of assets and the request for payment of administrative expense by orders dated September 15, 2006.

  On October 1, 2006, Corporation C acquires the assets from Corporation B, and the payments are made to E.

  Situation 4. Assume the same facts as in Situation 3 except that the stock of Corporation B is tradcable on an over-the-counter market after de-listing from the New York Stock Exchange.

LAW

  Section 280G of the Code was enacted to discourage substantial payments to top executives and other personnel of a target

corporation in connection with an acquisition. In some situations, the existence of golden parachute arrangements could encourage executives and other key personnel to favor a proposed takeover that may not be in the best interests of the shareholders. To the extent amounts must be paid to executives and other key personnel of the target corporation because of golden parachutes or similar arrangements, there is less for the shareholders of that corporation. See, S. Prt. No. 98-169, at 195 (1984); JOINT COMMITTEE ON TAXATION, 98th CONG., GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984, at 199-200 (1984).

  Section 280G denies a deduction for any excess parachute payment.  Section 4999 imposes a nondeductible 20-percent excise tax on the recipient of any excess parachute payment, within the meaning of s 280G(b).

  An excess parachute payment is defined in s 280G(b)(1) as an amount equal to the excess of any parachute payment over the portion of the disqualified individual’s base amount that is allocated to such payment.

  Section 280G(b)(2)(A) defines a parachute payment as any payment in the nature of compensation to (or for the benefit of) a disqualified individual if (i) such payment is contingent on a change in the ownership of a corporation, the effective control of a corporation, or the ownership of a substantial portion of the assets of a corporation (a change in ownership or control), and (ii) the aggregate present value of the payments in the nature of compensation which are contingent on such change equals or exceeds an amount equal to 3 times the base amount.

  Section 280G(b)(5)(A)(ii) of the Code provides, in part, that a parachute payment does not include any payment to a disqualified individual with respect to a corporation (other than a small business corporation as defined in s 1361(b) but without regard to paragraph (1)(C) thereof) if (I) immediately before the change described in s 280G(b)(2)(A) no stock in such corporation was readily tradeable on an established securities market or otherwise, and (II) the shareholder approval requirements of s 280G(b)(5)(B) are met with respect to such payment.

  Section 280G(b)(5)(B)(ii) of the Code provides that the shareholder approval requirements of s 280G(b)(5) are met with respect to any payment if (i) such payment was approved by a vote of the persons who owned, immediately before the change described in s 280G(b)(2)(A)(i), more than 75 percent of the voting power of all outstanding stock of the corporation, and (ii) there was adequate disclosure to shareholders of all material facts concerning all payments which (but for this paragraph) would be parachute payments with respect to a disqualified individual.

  Under s1.280G-1 of the Income Tax Regulations, Q/A-6(a), a parachute payment does not include any payment to a disqualified individual with respect to a corporation if (1) immediately before the change in ownership or control, no stock in such corporation was readily tradeable on an established securities market or otherwise, and (2) the shareholder approval requirements of Q/A-7 are met with respect to such payment. Under s1.280G-1, Q/A-6(e) of the regulations, stock is treated as readily tradeable if it is regularly quoted by brokers or dealers making a market in such stock. Section 1.280G-1 of the regulations, Q/A-6(f) provides that an established securities market means an established securities market as defined in s 1.897-1(m) of the regulations.

  Section 1.280G-1, Q/A-7(a), of the regulations provides that the shareholder approval requirements are met with respect to the payment if (1) the payment is approved by more than 75% of the voting power of all outstanding stock entitled to vote (as described in Q/A-7) immediately before the change in ownership or control, and (2) before the vote there is adequate disclosure to all persons entitled to vote (as described in Q/A-7) of all material facts concerning all material payments which (but for Q/A-6) would be parachute payments with respect to the disqualified individual.

  Section 1.280G-1 of the regulations, Q/As 27, 28, and 29 provides guidance concerning when a corporation is considered to have undergone a change in ownership of a corporation, a change in effective control of a corporation, or a change in the ownership of a substantial portion of the assets of a corporation (a change in ownership or control).

  Q/A-27(a) provides that a change in the ownership of a corporation occurs on the date that any one person, or more than one person acting as a group, acquires ownership of stock of the corporation that, to-gether with stock held by such person (or more than one person acting as a group under Q/A-27(b)) possesses more than 50 percent of the total fair market value or total voting power of the stock of such corporation. Q/A-27(b) provides that persons will not be considered to be acting as a group merely because they happen to purchase or own stock of the same corporation at the same time, or as a result of the same public offering.

  Q/A-28(a) provides, in part, that a change in the effective control of a corporation is presumed to occur on the date that either (1) any one person, or more than one person acting as a group (as defined in Q/A-28(d)), acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) ownership of stock of the corporation possessing 20 percent or more of the total voting power of the stock of such corporation; or (2) a majority of the members of the corporation’s board of directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the members of the corporation’s board of directors prior to the date of the appointment or election. The presumption may be rebutted by showing that the acquisition of stock or replacement of the board does not transfer the power to control (directly or indirectly) from any one person (or more than one person acting as a group) to another person (or group). Q/A-28(d) contains the same language as Q/A-27(b) concerning when more than one person is considered to be acting as a group.

  Q/A-29 provides that a change in the ownership of a substantial portion of a corporation’s assets occurs on the date that any one person, or more than one person acting as a group (as defined in Q/A-29(c)) acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) assets from the corporation that have a total gross fair market value equal to or more than one-third of the total gross fair market value of all of the assets of the corporation immediately prior to such acquisition or acquisitions. For this purpose, gross fair market value means the value of the assets of the corporation, or the value of the assets being disposed of, determined without regard to any liabilities associated with such assets. Q/A-29(c) contains the same language as Q/A-27(b) concerning when person will be considered to be acting as a group.

  In a bankruptcy case, an entity may file a request for payment of an administrative expense of the bankruptcy estate. See 11 U.S.C. s 503(a). Pursuant to 11 U.S.C. s 503(b)(1)(A), after notice and hearing, the bankruptcy court shall allow the payment of administrative expenses which were actual, necessary costs and expenses of preserving the estate, including wages, salaries, or commissions for services rendered after the commencement of the case. 11 U.S.C. s 503(b)(1)(A).

ANALYSIS — Situation 1

  The receipt of stock by a creditor under a bankruptcy plan of reorganization is often involuntary in that the creditors of a bankrupt estate typically would prefer that the debt be paid in cash rather than in stock of the debtor. The fact that unsecured

creditors are represented by a committee and that the plan of reorganization of the debtor provides for the creditors to receive stock instead of cash is ordinarily a function of the financial resources of the estate and is not necessarily indicative of any intention of the creditors to act as a group to acquire control of the debtor. In this situation, Corporation A filed a voluntary petition for relief in the bankruptcy court and the pre-bankruptcy creditors did not act to-gether to force Corporation A into bankruptcy. The fact that the pre-bankruptcy creditors were appointed to a committee of creditors and received stock in proportion to their pre-bankruptcy debt does not indicate that the creditors acted together to acquire stock in Corporation A. Thus, the creditors are not acting as a group, within the meaning of Q/A-27(b) or Q/A-28(d), to acquire the stock of Corporation A.

ANALYSIS — Situation 2

  Because one creditor acquired 20 percent or more of Corporation A’s stock within a 12-month period, Corporation A is presumed, under Q/A-28(a), to have experienced a change in effective control. However, this presumption may be rebutted by a showing that the largest creditor will not act to control the management and policies of Corporation A.

ANALYSIS — Situation 3

  Because Corporation C acquired more than one third of the total gross fair market value of all of the assets of Corporation B, there is a change in ownership of Corporation B under Q/A-29. However, if Corporation B qualifies as a corporation described in s 280G(b)(5)(A)(ii)(I), concerning payments from corporations that meet certain shareholder approval and disclosure requirements, and the requirements of s 280G(b)(5)(A)(ii)(II) are satisfied, the payments are exempt from the definition of parachute payment.

  Under these facts, the stock of Corporation B was de-listed from an established securities market and was not otherwise readily tradeable on the date of the change in control. Further, no trading occurred on any market (including any over-the-counter market). Thus, Corporation B is a corporation described in s 280G(b)(5)(A)(ii)(I) on the date of the change in control.

  In order to satisfy the requirements of s 280G(b)(5)(A)(ii)(II) outside of the bankruptcy context, generally, Q/A-7(a) of the regulations requires that the payment must be adequately disclosed to shareholders and then approved by more than 75% of the voting power of all out-standing stock entitled to vote immediately before the change in ownership or control. However, for a corporation in bankruptcy, the continuing interests of equity owners can be difficult to determine or predict. Through the bankruptcy process, the pre-bankruptcy shareholders may end up with a continuing equity interest in the company or the equity may end up partially or fully transferred to creditors. Correspondingly, the pre-bankruptcy shareholders may lack a material continuing equity interest in the affairs of the corporation and therefore also lack the corresponding motivation to appropriately evaluate the payments at issue.

  In Situation 3, the payments to E were approved by the bankruptcy court pursuant to 11 U.S.C. s 503(b)(1)(A). The bankruptcy court therefore made a factual finding that the payments were actual, necessary costs and expenses of preserving the bankruptcy estate. The legislative history of s 280G indicates that the golden parachute rules were enacted to discourage excessive payments to executives and other key personnel in order to protect the shareholders. See S. Rpt. No. 98-169 at 195. The bankruptcy court approval serves to protect the estate and the ultimate owners from unnecessary or excessive payments made to executives. Consequently, for purposes of s 280G, the shareholder approval and disclosure requirements of s 280G(b)(5)(A)(i)(II) and Q/A-7 are deemed satisfied, and the payments to E are not parachute payments.

ANALYSIS — Situation 4

  Similar to Situation 3, there has been a change in ownership of Corporation B under Q/A-29. Additionally, if Corporation B qualifies as a corporation described in s 280G(b)(5)(A)(ii)(I) (concerning payments from corporations that meet certain shareholder approval and disclosure requirements) on the date of the change in control and the requirements of s 280G(b)(5)(A)(ii)(II) are satisfied, the payments are exempt from the definition of parachute payment.

  The trading of stock on an over-the-counter market (e.g., the pink sheets, the OTCBB, the ACT, or any similar market) when the corporation is a debtor in a case under the Bankruptcy Code is impaired, and therefore, the stock is not considered “readily tradeable” for purposes of s 280G.

  Accordingly, for the reasons discussed in Situation 3, the payments to E are not parachute payments.

HOLDINGS — Situation 1

  In Situation 1, because no person (or persons acting as a group) acquired more than 50 percent of the total fair market value or total voting power of Corporation A (Q/A-27); because no person (or persons acting as a group) acquired within a 12-month period 20% or more of the outstanding stock of Corporation B and the new Board of Directors is approved by the pre-reorganization Board of Directors (Q/A-28); and because there is no acquisition of the assets of Corporation A (Q/A-29), Corporation A did not undergo a change in ownership or control under s 280G.

HOLDINGS — Situation 2

  Corporation A is presumed to have experienced a change in effective control under s 280G. The presumption may be rebutted in accordance with Q/A-28(b).

HOLDINGS — Situation 3

  Because Corporation C acquired more than one third of the total gross fair market value of all of the assets of Corporation B, there is a change in ownership of Corporation B under Q/A-29. However, Corporation B is eligible for the exemption provided in s 280G(b)(5)(A)(ii). Under these facts, the shareholder approval and disclosure requirements described in s 280G(b)(5)(B) and Q/A-7 are deemed to be satisfied, and thus, the payments to E are exempt from the definition of parachute payment.

HOLDINGS — Situation 4

  For purposes of s280G, the trading of stock on an over-the-counter market when the corporation is a debtor in a case under the Bankruptcy Code is impaired, and therefore, the stock is not considered “readily tradeable.” Thus, Corporation B is eligible for the exemption provided in s 280G(b)(5)(A)(ii). Under these facts, the shareholder approval and disclosure requirements described in s 280G(b)(5)(B) and Q/A-7 are deemed to be satisfied, and the payments to E are exempt from the definition of parachute payment.

EFFECTIVE DATE

  This revenue ruling applies to any payment that is contingent on a change in ownership or control if the change of ownership or control occurs on or after July 19, 2004. Notwithstanding the foregoing, where a corporation is a debtor in a case under the Bankruptcy Code, its securities traded on an over-the-counter market also are not considered “readily tradeable” for purposes of s 280G(b)(5)(A)(ii) with respect to a change in ownership or control that occurred before July 19, 2004.

COMMENTS REQUESTED

  Comments are requested concerning whether, or to what extent, the definition of “readily tradeable” under s 280G(b)(5)(A)(ii) should exclude stock of a corporation that is tradeable on an over-the-counter market (e.g., the pink sheets, the OTCBB, the ACT, or any similar market).

  Comments should be submitted by October 18, 2004, to CC:PA:LPD:PR (Revenue Ruling 2004-87), Room 5203, Internal Revenue Service, POB 7604 Ben Franklin Station, Washington, D.C. 20044. Comments may be hand delivered between the hours of 8 a.m. and 4 p.m., Monday through Friday to CC:PA:LPD:PR (Revenue Ruling 2004-87), Courier’s Desk, Internal Revenue Service, 1111 Constitution Ave., NW, Washington, D.C. Alternatively, comments may be submitted via the Internet at Notice.Comments@irscounsel.treas.gov. All comments will be available for public inspection.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Erinn Madden of the Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and Treasury Department participated in its development. For further information regarding this revenue ruling, contact Ms. Madden at (202) 622-6030 (not a toll-free call).

 Rev. Rul. 2004-87, 2004-32 I.R.B. 154

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Revenue Ruling 2004-83

Rev. Rul. 2004-83
Rev. Rul. 2004-83, 2004-32 I.R.B. 157
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
                            CORPORATE REORGANIZATIONS
                             Released: July 16, 2004
                            Published: August 9, 2004

 Section 304.–Redemption Through Use of Related Corporations, 26 CFR 1.304- 2: Acquisition by related corporation (other than subsidiary).

  If, pursuant to an integrated plan, a parent corporation sells the stock of a wholly owned subsidiary for cash to another wholly owned subsidiary and the acquired subsidiary completely liquidates into the acquiring subsidiary, the transaction is treated as a reorganization under s 368(a)(1)(D).

Section 368.–Definitions Relating to Corporate Reorganizations, 26 CFR 1.368-1: Purpose and scope of exception of reorganization exchanges.

  Corporate reorganizations. This ruling provides that if, pursuant to an integrated plan, a parent corporation sells the stock of a subsidiary to another subsidiary and the acquired subsidiary liquidates into the acquiring subsidiary, the transaction is a reorganization under section 368(a)(1)(D) of the Code.

  Corporate reorganizations. This ruling provides that if, pursuant to an integrated plan, a parent corporation sells the stock of a subsidiary to another subsidiary and the acquired subsidiary liquidates into the acquiring subsidiary, the transaction is a reorganization under section 368(a)(1)(D) of the Code.

ISSUE

  Under the facts described below, what is the proper tax treatment if, pursuant to an integrated plan, a parent corporation sells the stock of a wholly owned subsidiary for cash to another wholly owned subsidiary and the acquired subsidiary completely liquidates into the acquiring subsidiary.

FACTS

Situation 1

  Corporation P owns all the stock of Corporation S and Corporation T. P, S, and T are members of a consolidated group. As part of an integrated plan, S purchases all the stock of T from P for cash and T completely liquidates into S. Assume that if T had sold its assets directly to S and T had completely liquidated into P, the transaction would have qualified as a reorganization under s 368(a)(1)(D) of the Internal Revenue Code.

Situation 2

  The facts are the same as in Situation 1 except that P, S, and T are not members of a consolidated group.

LAW

  Section 368(a)(1)(D) provides that a reorganization includes a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under s 354, 355, or 356.

  In Rev. Rul. 70-240, 1970-1 C.B. 81, B owned all the outstanding stock of Corporation X and Corporation Y. X sold its operating assets to Y for cash equal to their fair market value and used its remaining assets to pay its debts. X then liquidated and B received a liquidating distribution in exchange for his X stock. The ruling concludes that the transfer by X of its operating assets to Y is regarded as the acquisition by Y of substantially all the assets of X and is a reorganization under s 368(a)(1)(D). Accord Atlas Tool Co. v. Commissioner, 70 T.C. 86 (1978), aff’d, 614 F.2d 860 (3rd Cir. 1980), cert. denied, 449 U.S. 836 (1980); Armour v. Commissioner, 43 T.C. 295 (1964).

  In determining whether a transaction qualifies as a reorganization under s 368(a), the transaction must be evaluated under relevant provisions of law, including the step transaction doctrine. Section 1.368-1(a) of the Income Tax Regulations. The step transaction doctrine “treats a series of formally separate ’steps’ as a single transaction if such steps are in substance integrated, interdependent, and focused toward a particular result.” Penrod v. Commissioner, 88 T.C. 1415, 1428 (1987).

  In Rev. Rul. 67-274, 1967-2 C.B. 141, pursuant to a plan of reorganization, Corporation Y acquired all the stock of Corporation X in exchange for voting stock of Y. Thereafter, X completely liquidated into Y. The ruling concludes that the two steps do not qualify as a reorganization under s 368(a)(1)(B) followed by a liquidation under s 332, but instead qualify as a single acquisition of X’s assets in a reorganization under s 368(a)(1)(C). See also Rev. Rul. 72-405, 1972-2 C.B. 217 (treating the acquisition of the assets of a target corporation in a forward triangular merger followed by the liquidation of the acquiring subsidiary as a reorganization under s 368(a)(1)(C)); Rev. Rul. 2001-46, 2001-2 C.B. 321 (applying the approach reflected in Rev. Rul. 67-274 to a stock acquisition followed by a merger of the acquired corporation into the acquiring corporation).

  Section 1.1361-4(a)(2) provides that if an S corporation makes a QSub election with respect to a subsidiary (an election to disregard a subsidiary as an entity separate from its S corporation parent), the subsidiary is deemed to have liquidated into the S corporation. In Example 3 of s 1.1361-4(a)(2)(ii), pursuant to a plan, Individual A contributes all the outstanding stock of Y to his wholly owned S corporation, X, and immediately causes X to make a QSub election for Y. The example concludes that the transaction is a reorganization under s 368(a)(1)(D), assuming the other conditions for reorganization treatment are satisfied.

  Section 304(a)(1) provides, in general, for purposes of ss 302 and 303, if one or more persons are in control of each of two corporations and, in return for property, one of the corporations acquires stock in the other corporation from the person (or

persons) so in control, then such property shall be treated as a distribution in redemption of the stock of the corporation acquiring such stock.

  Section 1.1502-80(b), which relates to consolidated returns, provides that s 304 does not apply to any acquisition of stock of a corporation in an intercompany transaction.

ANALYSIS

  In Situation 1, because P, S, and T are members of a consolidated group, and S’s purchase of the T stock from P is an intercompany transaction under s 1.1502-80(b), s 304 cannot apply to P’s sale of T stock to S. As described above, if T had transferred its assets directly to S and T had completely liquidated into P, the stock sale and liquidation would have qualified as a reorganization under s 368(a)(1)(D). Consistent with Rev. Ruls. 67-274 and 72-405 and Example 3 of s 1.1361-4(a)(2)(ii), the step transaction doctrine applies to treat the stock sale and liquidation as a reorganization under s 368(a)(1)(D). Authorities that reject the application of the step transaction doctrine based on the policy of s 338, such as s 1.338-3(d) and Rev. Rul. 90-95, 1990-2 C.B. 67, are not relevant in this case because there is no purchase of T stock within the meaning of s 338(h)(3)(A) and s 1.338- 3(b).

  Situation 2 differs from Situation 1 only in that P, S, and T are not members of a consolidated group. As a result, if the step transaction doctrine does not apply to step together the stock sale and liquidation, the stock sale would be treated as a distribution in redemption of the S stock under s 304(a)(1) and the liquidation of T into S would qualify as a liquidation under s 332.

  There is no policy that requires s 304 to be applied when s 368(a)(1)(D) would otherwise apply. See J. Comm. on Tax’n., 98th Cong. 2nd Sess., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 192 (Comm. Print 1984). Moreover, the legislative history to the Deficit Reduction Act of 1984, P.L. 98-369, 1984-3 (Vol. 1) C.B. 1, indicates that s 304 was not intended to override reorganization treatment. See H.R. Rep. No. 98- 432 Pt. 2, 1624 (1984). Accordingly, in Situation 2, as in Situation 1, the step transaction doctrine applies to treat the stock sale and liquidation as a reorganization under s 368(a)(1)(D).

HOLDING

  Under the facts presented, if, pursuant to an integrated plan, a parent corporation sells the stock of a wholly owned subsidiary for cash to another wholly owned subsidiary and the acquired subsidiary completely liquidates into the acquiring subsidiary, the transaction is treated as a reorganization under s 368(a)(1)(D).

DRAFTING INFORMATION

  The principal author of this revenue ruling is Lisa S. Dobson of the Office of Associate Chief Counsel (Corporate). For further information regarding this revenue ruling, contact Ms. Dobson at (202) 622-7790 (not a toll-free call).

 Rev. Rul. 2004-83, 2004-32 I.R.B. 157

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Revenue Ruling 2004-85

Rev. Rul. 2004-85
Rev. Rul. 2004-85, 2004-33 I.R.B. 189
                       Internal Revenue Service (I.R.S.)
                                 Revenue Ruling
     EFFECT OF MERGERS ON QUALIFIED SUBCHAPTER S SUBSIDIARY (QSUB) ELECTIONS
                             Released: July 16, 2004
                           Published: August 16, 2004

 Section 368.–Definitions Relating to Corporate Reorganizations

  Does an election to treat a wholly owned subsidiary of an S corporation as a qualified subchapter S subsidiary (QSub) or an entity classification election of a subsidiary terminate when the subsidiary’s interest is transferred pursuant to certain section 368(a)(1) reorganizations or otherwise?

Section 7701.–Definitions, 26 CFR 301.7701-3: Classification of certain business entities.

  Does an election to treat a wholly owned subsidiary of an S corporation as a qualified subchapter S subsidiary (QSub) or an entity classification election of a subsidiary terminate when the subsidiary’s interest is transferred pursuant to certain section 368(a)(1) reorganizations or otherwise?

Section 1361.–S Corporation Defined, 26 CFR 1.1361-5: Termination of QSub election.

(Also s 1361, 1.1361-3, 1.1361-4, 1.1361-5.)

  Effect of mergers on qualified subchapter S subsidiary (QSub) elections. This ruling discusses the effect certain interest transfers have on QSub and entity classification elections.

  Effect of mergers on qualified subchapter S subsidiary (QSub) elections. This ruling discusses the effect certain interest transfers have on QSub and entity classification elections.

ISSUES

  (1) Does an election to treat a wholly owned subsidiary of an S corporation as a qualified subchapter S subsidiary (QSub), as described in s 1361(b)(3)(B) of the Internal Revenue Code, terminate solely because the S corporation engages in a transaction that qualifies as a reorganization under s 368(a)(1)(F)?

  (2) Does an election to treat a subsidiary as a QSub terminate if the S corporation (whether by sale or reorganization under s 368(a)(1)(A), (C), or (D)) transfers 100 percent of the QSub stock to another S corporation in a transaction that does not qualify as a reorganization under s368(a)(1)(F)?

  (3) Does an entity classification election of an eligible entity, as described in s 301.7701-3(b) of the Procedure and Administration Regulations, terminate solely because the owner transfers (whether by sale, reorganization under s 368(a)(1)(A), (C), (D), or (F), or otherwise) all of the membership interest in the eligible entity to another person?

FACTS

  Situation 1. X is a State A S corporation that owns 100 percent of the stock of Sub 1, a corporation that X has elected to treat as a QSub. The shareholders of X form U, a State B corporation. X merges with and into U in a transaction qualifying as a reorganization under s 368(a)(1)(F). The shareholders of X own 100 percent of the stock of U and U is eligible to be an S corporation under s 1361(b)(1).

  Situation 2. Y is an S corporation that owns 100 percent of the stock of Sub 2, a corporation that Y has elected to treat as a QSub. Y (whether by sale or reorganization under s 368(a)(1)(A), (C), or (D)) transfers Y’s assets, including 100 percent of Sub 2 stock, to M, an S corporation, in a transaction that is not a reorganization under s 368(a)(1)(F).

  Situation 3. Z is a corporation that owns 100 percent of the membership interests in LLC1, an eligible entity that elected to be classified for federal tax purposes as an association, contrary to its default classification. Z (whether by sale, reorganization under s 368(a)(1)(A), (C), (D), or (F), or otherwise) transfers all of the membership interests in LLC1 to N, another person.

LAW AND ANALYSIS

Situations 1 and 2

  Section 1361(a)(1) provides that the term “S corporation” means, with respect to a taxable year, a small business corporation (as defined in s 1361(b)(1)) for which an election under s 1362(a) is in effect for the year.

  Section 1361(b)(3)(B) allows an S corporation to elect to treat any domestic corporation that is not an ineligible corporation (as defined in s 1361(b)(2)) as a QSub if 100 percent of the stock of the corporation is held by the S corporation. Section 1.1361-3(a) of the Income Tax Regulations provides the time and manner of making a QSub election.

  Under s 1361(b)(3)(A), a corporation that is a QSub is not treated as a separate corporation. Instead, all assets, liabilities, and items of income, deduction and credit of a QSub are treated as assets, liabilities, and such items (as the case may be) of the S corporation.

  Section 1.1361-4(a)(2) provides that, if an S corporation makes a valid QSub election with respect to a subsidiary, the subsidiary is deemed to have liquidated into the S corporation. Under s 1.1361-4(b), this liquidation is generally deemed to occur at the close of the day before the QSub election is effective.

  Under s 1.1361-5(a)(1)(ii), if a QSub election terminates as a result of the termination of its parent’s S corporation election, then the termination of the QSub election is effective at the close of the last day of the parent’s last taxable year as an S corporation. Under s 1.1361-5(a)(1)(iii), if a QSub election terminates as the result of any other event, then the termination of a QSub election is effective at the close of the day on which the event causing the termination occurs.

  Sections 1361(b)(3)(C) and 1.1361-5(b)(1) provide that if a QSub election terminates, the former QSub is treated as a new corporation that, immediately before the termination, acquires all of its assets (and assumes all of its liabilities) from the S corporation in exchange for stock of the new corporation. The tax treatment of this transaction or of a larger transaction that

includes this transaction is determined under the Internal Revenue Code and general principles of tax law, including the step transaction doctrine.

  Section 1.1361-5(b)(3), Example 9, describes the tax consequences of a transfer by an S corporation (X) of 100 percent of the stock of a QSub (Y) to a C corporation (Z). The example provides that the deemed formation of Y by X (as a consequence of the termination of Y’s QSub election) is disregarded for federal income tax purposes. The transaction is treated as a transfer of the assets of Y to Z, followed by Z’s transfer of those assets to the capital of Y in exchange for Y stock. If, instead, Z is an S corporation, and Z makes a QSub election for Y effective as of the date of Z’s acquisition of Y, then Z’s transfer of the assets of Y in exchange for Y stock, followed by the immediate liquidation of Y as a consequence of the QSub election are disregarded for federal income tax purposes.

  Sections 1361(b)(3)(D) and 1.1361-5(c)(1) provide that, absent the consent of the Commissioner, a corporation whose QSub status terminates (and any successor corporation as defined in s 1.1362-5(b)) may not make an S election or have a QSub election made with respect to it before its fifth taxable year which begins after the first taxable year for which the termination was effective.

  Section 1.1361-5(c)(2) provides that in the case of S and QSub elections effective after December 31, 1996, if a corporation’s QSub election terminates, the corporation may make an S election or have a QSub election made with respect to it before the expiration of the five-year period described in s 1361(b)(3)(D) provided that (i) immediately following the termination, the corporation (or its successor corporation) is otherwise eligible to make an S election or have a QSub election made for it; and (ii) the relevant election is made effective immediately following the termination of the QSub election.

  Section 368(a)(1)(F) provides that the term “reorganization” means, among other things, a mere change in identity, form, or place of organization of one corporation, however effected.

  Section 1.381(b)-1(a)(2) provides that, in the case of a reorganization qualifying under s 368(a)(1)(F) (whether or not such reorganization also qualifies under any other provision of s 368(a)(1)), the acquiring corporation shall be treated (for purposes of s 381) just as the transferor corporation would have been treated if there had been no reorganization.

  Rev. Rul. 64-250, 1964-2 C.B. 333, concludes that when an S corporation merges into a newly formed corporation in a transaction qualifying as a reorganization under s 368(a)(1)(F), and the newly formed surviving corporation also meets the requirements of an S corporation, the reorganization does not terminate the S election. Thus, the S election remains in effect for the new corporation.

  In Situation 1, X (an S corporation) merges into U (a corporation that meets the requirements to be a small business corporation under s 1361(b)(1)) in a transaction qualifying as a reorganization under s 368(a)(1)(F). Under Rev. Rul. 64-250, U will be treated as a continuation of X. U, therefore, will be an S corporation immediately after the merger. Because U is treated as a continuation of X, the reorganization does not terminate X’s election to treat Sub 1 as a QSub.

  In Situation 2, Y (an S corporation) transfers its assets, including 100 percent of the stock of Sub 2 (a QSub), to M (an S corporation). Because the transaction does not qualify as a reorganization under s 368(a)(1)(F), M will not be treated just as Y would have been treated if there had been no reorganization. After the transaction, Y no longer owns Sub 2, and Y’s QSub election for Sub 2 does not carry over to M. Therefore, the QSub election of Sub 2 terminates at the close of the day on which Y transfers its assets, including 100 percent of the Sub 2 stock to M, unless M makes a QSub election for Sub 2, effective immediately following the termination. See s 1.1361- 5(a)(1)(iii) and 1.1361-5(c)(2).

  If M makes a QSub election for Sub 2, effective immediately following the termination of Sub 2’s QSub election, then M’s deemed transfer of the assets of Sub 2 in exchange for the stock of Sub 2 and the immediate liquidation of Sub 2 as a consequence of the QSub election are disregarded for federal income tax purposes. See ss 1.1361-4(b)(3)(ii) and 1361-5(b)(3), Example 9. There will be no period between the termination of Sub 2’s QSub election and the deemed liquidation of Sub 2 during which Sub 2 is a C corporation.

  If M does not make a QSub election for Sub 2, effective immediately following the termination, then the transaction will be treated as a transfer of the assets of Sub 2 to M, followed by M’s contribution of Sub 2’s assets to Sub 2 in exchange for Sub 2 stock. See s 1.1361-5(b)(3), Example 9. Sub 2 will not be eligible to be treated as a QSub or an S corporation before the expiration of the period described in s 1361(b)(3)(D).

Situation 3

  Section 301.7701-3(a) of the Procedure and Administration Regulations provides that a business entity that is not classified as a corporation under s 301.7701-2(b)(1), (3), (4), (5), (6), (7), or (8) (an eligible entity) can elect its classification for federal tax purposes.

  Section 301.7701-3(b) provides default classifications for eligible entities. Under s 301.7701-3(b)(1), unless a domestic eligible entity elects otherwise, it is disregarded as an entity separate from its owner if it has a single owner and is a partnership if it has more than one owner. Under s 301.7701-3(b)(2)(i), unless a foreign eligible entity elects otherwise, it is: (A) a partnership if it has two or more owners and at least one owner does not have limited liability, (B) an association if all owners have limited liability, or (C) disregarded as an entity separate from its owner if it has a single owner that does not have limited liability.

  Section 301.7701-3(c)(1)(i) provides that an eligible entity may elect to be classified other than as provided under s 301.7701-3(b) by filing Form 8832, Entity Classification Election, with the applicable service center.

  In Situation 3, Z transfers to N 100 percent of the membership interests in LLC1, an eligible entity that has elected to be classified as an association. Under s 301.7701-3(c)(1), LLC1 elects its own classification. LLC1’s classification continues until LLC1 elects otherwise or no longer remains eligible for that classification. Therefore, the sale or transfer of the LLC1 membership interests to N does not affect LLC1’s election to be classified as an association.

HOLDINGS

  (1) An election to treat a wholly owned subsidiary of an S corporation as a QSub, as described in s 1361(b)(3)(B), does not terminate solely because the S corporation engages in a transaction that qualifies as a reorganization under s 368(a)(1)(F).

  (2) An election to treat a subsidiary as a QSub terminates if the S corporation transfers 100 percent of the QSub stock (whether by sale or reorganization under s 368(a)(1)(A), (C), or (D)), to another S corporation in a transaction that does not qualify as a reorganization under s368(a)(1)(F).

  (3) An entity classification election of an eligible entity, as described in  s 301.7701-3(b), does not terminate solely because the owner (whether by sale, reorganization under s368(a)(1)(A), (C), (D), or (F), or otherwise) transfers all of the membership interest in the eligible entity to another person.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Charles J. Langley, Jr. of the Office of Associate Chief Counsel (Passthroughs & Special Industries). For further information regarding this revenue ruling, contact Mr. Langley at 202- 622-3060 (not a toll-free call).

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July 16th, 2004 | No Comments »