Tricks and traps to watch out for
including NOL filing tips

Planning, Review & Preparation

Electing Mark-to-Market

Trading through an entity

Trader definitions

Tax rules & latest news

Discussion Board, F.A.Q.,
Futures, Benefit Plans
& other info

Search this site add text to search window

 

Statutory elections: defined by statute.

Regulatory elections: defined by regulation.  The IRS has greater discretion to permit late filed regulatory elections.


You may search the U.S. Code for most all the laws of the United States here:
http://www4.law.cornell.edu/uscode/index.html#TITLES
 

Filing status elections
§1.6012-1(a)(5) Election for a person to sign a tax return on behalf of his/her spouse

§6013(a) Election to file an initial tax return for a given year jointly with your spouse

§1(d) Choosing to file an initial tax return for a given year separately from spouse

§1.6013-2 Election to file a joint return for a given year after filing separate return

§1.6013-1 Election to file a separate return for a given year after filing joint return

§761(f)(2) Spouses' Partnership May "Elect Out" of Partnership Rules

Rev. Proc. 2002-69 Spouses' "Partnership" has option to be treated as a disregarded entity

§1.761-2(b) Investment Partnership may "Elect Out"  of Subchapter K Partnership Rules



Deductions and losses
§461 What year to deduct an expense?

Deduction for water & sewer fees & assessments

§1031 Tax-Deferred Exchanges

§709(b)(1) election to deduct LLC, partnership and Sch C start-up expenditures

Net Operating Loss (NOL) Carryback / Carryforward elections

Net Operating Loss (NOL) Helpful Hints

Net Operating Loss (NOL) form 1045 and 1040X preparation (corporations use 1138, 1139 & 1120X)

Using form 1040X to deal with a CP2000 notification

Statute of Limitations limited to three years, not six years for traders that report each individual sale

Statute of Limitations limited to three years, not six years for partners who overstated basis

Rev. Rul. 87-115 regarding tiered partnerships §754 elections

Rev. Rul. 91-26 partner compensation (no form W-2 is to be issued to partners nor to sole-proprietors)

Rev. Rul. 73-361 and Rev. Rul. 82-83 stockholder-officer of s-corporation is an employee, form W-2 is to be issued

Partnership - Audit Technique Guide - Chapter 7 - Dispositions of Partnership Interest

Capital Loss Carryback / Carryforward election

LLC members' tax deductions based on actual capital contribution / basis



S-Corporations
Entity Classification Election

S-Corp election: Rev. Proc. 2007-62, 2007-166 I.R.B. (10/9/2007) late election of S-Corp status

S-Corp election: Rev. Proc. 2004-48, 2004-32 I.R.B. 172 (8/9/2004) for LLC's seeking S-Corp status

Rev. Proc. 2003-43, 2003-23 I.R.B. 998 (6/9/2003) for corporations or LLC's seeking S-Corp status

S-Corp shareholders' medical deductions IRC §105 & §106  (belong on form W-2)

S-Corp shareholders' tax deductions based on loans made - and the taxable income based on repayments of those loans



Trader Status / Trade or Business
Trader Status "election"

IRS Regs. §1.183-2(b) Trade or Business

IRS Regs. §1.469-1T(e)(6) Partnership has non-passive activity

IRS Code §446 General Rule For Methods Of Accounting

Mark-to-Market Accounting Method §475

Treatment of Mark-to-Market Gains of Electing Traders (SECA tax)

Treatment of Limited Liability Company members  (SECA tax)

IRS Code §475(f) Mark-to-Market election for taxpayers who have filed at least one federal income tax return

IRS Code §475(f) Mark-to-Market elections for newly formed entities that have not filed a tax return yet

Safe Harbor for Valuation Under Mark-to-Market Accounting Method

M2M losses are excluded from Reportable Transactions

IRS Code §481 elections

IRS Code §1256 Mark-to-Market election for dealers

IRS Code §1256 hedging election



Extensions for elections
Deadline to Be Extended for Elections Under Mark-to-Mark Accounting

Extensions of Time to Make Elections

§ 301.9100-1 Extensions of time to make elections.

§ 301.9100-2 Automatic extensions.

§ 301.9100-3 Other extensions



Interest and Depreciation
Interest Expense deduction paid for Debt-Financed Acquisition of a "trade or business" pass-thru entity

Election to treat debt as not secured by a qualified residence §163

Election to Capitalize Carrying Costs (property taxes) §266

Extension for forgotten rental election

Trick to catch-up for forgotten depreciation after the asset was sold

Fast depreciation under the "Whiteco test"

Does a principal residence converted to residential rental property still qualify for tax-free treatment?

Taxation of Israel Mozel Tov Bonds



Inventory and other special rules
Worthless Inventory Thor Power Tool Company v. Commissioner

IRS Regs. §1.132-6(a) de minimis rule

Hot Assets  under  IRS Code §751 are taxable as ordinary (earned) income

Hot Stock under IRS Code §355 are taxed as dividend income

Hot Interest rule under IRS Code §6621(c) after a 30-day letter

Tax Benefit Rule under IRS Code §111   (recoveries or refunds received by taxpayer in a year after the year of payment / year of deduction)

Claim of Right Doctrine under IRS Code §1341   (payments returned from taxpayer in a year after the year of receipt / year of income)

Spiffs & Incentive Payments are not subject to employment taxes



Penalties
Underpayment of withholding and estimated tax payments

Trick to waive penalties for late filing a partnership tax return

Trick to waive penalty for late payment of individual income tax

Trick to use when form W-2 is missing - new IRS/State crackdown starting 2007

Presumption of correctness of 1099-MISC forms (in CP2000 cases)

Replacement of the annual Social Security form 1099-SSA
 

§1.6012-1(a)(5) Election for a person to sign a tax return on behalf of his/her spouse:

Where one spouse is physically unable by reason of disease or injury to sign a joint return, the other spouse may, with the oral consent of the one who is incapacitated, sign the incapacitated spouse's name in the proper place on the return followed by the words "By ................... Husband (or Wife)," and by the signature of the signing spouse in his own right, provided that a dated statement signed by the spouse who is signing the return is attached to and made a part of the return stating:

• (i) The name of the return being filed,
• (ii) The taxable year,
• (iii) The reason for the inability of the spouse who is incapacitated to sign the return, and
• (iv) That the spouse who is incapacitated consented to the signing of the return.

The taxpayer and his agent, if any, are responsible for the return as made and incur liability for the penalties provided for erroneous, false, or fraudulent returns.

IRS Notice 89-7:

Q.2. Who is responsible for filing a child's return?
A.2. A child is responsible for filing his or her own return. If for any reason, such as age, the child is unable to file a return, the child's parent or guardian is responsible for filing the child's return on the child's behalf. The parent or guardian should sign the child's name on the return in the proper place followed by: " By (signature), Parent (or Guardian) for minor child."

Q.8. Under what circumstances may the parent or guardian of a child deal with the Internal Revenue Service concerning a notice, examination, or collection matter pertaining to the child's return?
A.8. A parent or guardian who signs a return on a child's behalf may deal with the Service concerning all matters arising in connection with the return. A parent or guardian who does not sign the child's return may provide the Service with information concerning the return and pay the child's tax, but is not entitled to receive information form or otherwise deal with the Service unless designated as the child's representative by the child or the person signing the return on the child's behalf. Such a designation is made on Form 2848-D, Tax Information Authorization and Declaration of Representative.

While entitled to receive notices and information concerning the child's return, a parent or guardian named in Form 2848-D may not legally bind the child with respect to a tax liability unless authorized to do so by the state in which the child resides.

§6013(a) Election to file an initial tax return for a given year jointly with your spouse:

A husband and wife may make a single return jointly of income taxes even though one of the spouses has neither gross income nor deductions, except as provided below:

• no joint return shall be made if either the husband or wife at any time during the taxable year is a nonresident alien;
• no joint return shall be made if the husband and wife have different taxable years; except that if such taxable years begin on the same day and end on different days because of the death of either or both, then the joint return may be made with respect to the taxable year of each. The above exception shall not apply if the surviving spouse remarries before the close of his taxable year, nor if the taxable year of either spouse is a fractional part of a year under section 443(a)(1);
• in the case of death of one spouse or both spouses the joint return with respect to the decedent may be made only by his executor or administrator; except that in the case of the death of one spouse the joint return may be made by the surviving spouse with respect to both himself and the decedent if no return for the taxable year has been made by the decedent, no executor or administrator has been appointed, and no executor or administrator is appointed before the last day prescribed by law for filing the return of the surviving spouse. If an executor or administrator of the decedent is appointed after the making of the joint return by the surviving spouse, the executor or administrator may disaffirm such joint return by making, within 1 year after the last day prescribed by law for filing the return of the surviving spouse, a separate return for the taxable year of the decedent with respect to which the joint return was made, in which case the return made by the survivor shall constitute his separate return.

§6013(f)(1) Joint Return Where Individual Is In Missing Status as a result of service in a combat zone the spouse of such individual is otherwise entitled to file a joint return for any taxable year which begins on or before the day which is 2 years after the date designated under section 112 as the date of termination of combatant activities in such zone, then such spouse may elect under subsection (a) to file a joint return for such taxable year.

§6013(f)(2)(A) such election shall be valid even if such individual died before the beginning of such year, and

§1(d) Choosing to file an initial tax return for a given year separately from spouse:

1(d) Married Individuals Filing Separate Returns. --

There is hereby imposed on the taxable income of every married individual (as defined in section 7703) who does not make a single return jointly with his spouse under section 6013, a tax as determined. 

§7703(a) General Rule
7703(a)(1) the determination of whether an individual is married shall be made as of the close of his taxable year; except that if his spouse dies during his taxable year such determination shall be made as of the time of such death; and

7703(a)(2) an individual legally separated from his spouse under a decree of divorce or of separate maintenance shall not be considered as married.

7703(b) Certain Married Individuals Living Apart

For purposes of those provisions of this title which refer to this subsection, if--

7703(b)(1) an individual who is married (within the meaning of subsection (a)) and who files a separate return maintains as his home a household which constitutes for more than one-half of the taxable year the principal place of abode of a child (within the meaning of section 152(f)(1)) with respect to whom such individual is entitled to a deduction for the taxable year under section 151 (or would be so entitled but for section 152(e)),

7703(b)(2) such individual furnishes over one-half of the cost of maintaining such household during the taxable year, and

7703(b)(3) during the last 6 months of the taxable year, such individual's spouse is not a member of such household, such individual shall not be considered as married.




Filing Status: Married Filing Separately and Allocation of Deductions and Expenses

Most married taxpayers can choose whether to file joint returns or separate returns. Most couples will pay less tax if they file joint returns, but in some situations they will benefit from filing separate returns.

A married individual filing a separate return must report on that return his or her own items of gross income, exemptions, deductions and credits.54 A married resident of a community property state must report half of the combined community income and deductions along with his or her separate income and deductions, unless the husband and wife live apart at all times during the tax year.55  If a husband and wife jointly own income-producing property, each must report a share of the income in proportion to the fractional ownership interest in the property.

IRS Publication 504, Divorced or Separated Individuals (2002), includes a chart showing how itemized deductions are allocated when separate returns are filed in community and noncommunity property states.

Allowable deductions may be taken by the individual who actually makes the expenditure.56 However, if the husband and wife maintain a joint bank account in a common-law jurisdiction, a rebuttable presumption treats payments of deductible items from the account by one spouse as though each spouse paid one half of the payment.57 Similarly, in community property jurisdictions, obligations discharged with community funds are treated as though one half is paid by each spouse.58 In addition, if either spouse itemizes deductions, the standard deduction for the other spouse is zero.59

54 IRS Publication 17, Your Federal Income Tax, 22 (2001).
55 Code Sec. 66(a); IRS Publication 555, Community Property, 4 (1999).
56 A.L. Zeeman v US, CA-2, 68-1 USTC ¶9406, 395 F2d 861; A.E. Calvin v US, DC Colo., 65-1 USTC ¶9112, 235 FSupp 594, aff'd, CA-10, 66-1 USTC ¶9108, 354 F2d 202.
57 Rev. Rul. 59-66, 1959-1 CB 60.
58 Rev. Rul. 55-479, 1955-2 CB 57; Commr v D. Newcombe, 10 TCM 152, Dec. 18,140(M) (1951), aff'd, CA-9, 53-1 USTC ¶9241, 203 F2d 128; M.V. Godchaux v US, DC La., 52-1 USTC ¶9183, 102 FSupp 266, appeal dism'd, CA-5, 53-1 USTC ¶9375.
59 Code Sec. 63(c)(6)(A).

Filing Status: When Married Taxpayers Should File Separate Returns

Married couples usually have a lower tax liability if they file a joint return than if they file separately because of the tax rates and other provisions which are generally more generous to married individuals filing joint returns. However, circumstances may be such that one spouse does not want to incur the potential liability for tax on a joint return and would therefore rather file a separate return even though the resulting tax liability may be higher.
Comment
Professor Dennis Calfee and Professor David Hudson, Holland Law Center, University of Florida, Gainesville, FL note that: There are a few, somewhat unusual situations when a married couple might have a lower combined tax liability by filing separate returns rather than by filing a joint return. When these fact patterns appear, computations of tax liability should be made under both the married filing separate returns rules and the married filing jointly provisions so that a comparison can be made.

• Miscellaneous Itemized Deductions
  Miscellaneous itemized deductions are allowed only to the extent they exceed 2 percent of an individual's adjusted gross income.84 Thus, if one spouse has a large amount of miscellaneous itemized deductions and a low adjusted gross income, while the other spouse has low miscellaneous itemized deductions and a high adjusted gross income, separate returns may result in lower combined tax liability. If one spouse itemizes deductions, however, the standard deduction for the other spouse is zero.85
  Example
  Husband and Wife has adjusted gross income of $100,000 and no miscellaneous deductions. Husband has $10,000 of gross income and $2,200 miscellaneous itemized deductions. If they file a joint return, no miscellaneous deductions would be allowed, because 2 percent of $110,000 combined adjusted gross income is $2,200. If separate returns are filed, Husband would be allowed to deduct $2,000 of the miscellaneous itemized deductions.
   
• Personal Casualty Gains and Losses
  The excess of personal casualty losses over personal casualty gains in a tax year is deductible only to the extent the excess is greater than 10 percent of adjusted gross income.86  If personal casualty gains exceed personal casualty losses in a tax year, all the gains and losses are treated as capital gains and capital losses.87 Thus, if one spouse has a large personal casualty loss while the other spouse has a large personal casualty gain in the same tax year, if they file joint returns the personal casualty gain is offset by the personal casualty loss. If they file separate returns the loss would be deducted from ordinary income, while the gain would be taxed at the rates for capital gains.88
  Example
  Husband has adjusted gross income of $100,000 and Wife has adjusted gross income of $10,000, without including personal casualty gains or losses. Husband has a personal casualty gain of $8,000. Wife has a personal casualty loss of $8,000. If they file a joint return, the personal casualty gain is offset by the personal casualty loss. If they file separate returns, Husband must include in gross income an additional $8,000 of capital gain and Wife may deduct $7,000 of the personal casualty loss from ordinary income.
   
• Medical Expenses
  The deduction for medical expenses is allowed only to the extent the expenses exceed 7.5 percent of a taxpayer's adjusted gross income.89 Thus, if one spouse has paid a large amount of qualifying medical expenses while the other spouse has not, it may be advantageous to file separate returns.
  Example
  Husband and Wife each have adjusted gross income of $50,000. Wife pays $10,000 of medical expenses. Husband does not have any medical expenses for the tax year. If Husband and Wife file a joint return, only $2,500 of the medical expenses are deductible. If they file separate returns, Wife may deduct $6,250 for medical expenses.
   
• Sales or Exchanges of Business Property and Involuntary Conversions
  Taxpayers treat gains and losses from the sale or exchange of property used in a trade or business, or from the involuntary conversion of capital assets held in connection with a trade or business, as long-term capital gains and losses when recognized gains in a current tax year exceed recognized losses. When the gains do not exceed the losses, the gains and losses are treated as ordinary.90 Gains or losses from the sale or exchange of depreciable property, real property held for more than one year and used in a taxpayer's trade or business, capital assets held in connection with a trade or business or a transaction entered into for profit that are compulsorily or involuntarily converted all result in Section 1231 gain or loss. Thus, if one spouse has a large gain and the other spouse has a large loss, it may be advantageous to file separate returns.
  Example
  Husband has a $20,000 Section 1231 gain and a $10,000 long-term capital loss from the sale of investment property. Wife has a $10,000 Section 1231 loss. If Husband and Wife file a joint return, their aggregate Section 1231 gains exceed their Section 1231 losses, so the Section 1231 gain is a long-term capital gain and the Section 1231 loss is a long-term capital loss. The aggregate long-term capital losses of $20,000 may be deducted from the $20,000 long-term capital gain, resulting in no net effect on their taxable income. If they file separate returns, however, Husband's Section 1231 gain will be treated as long-term capital gain, while Wife's Section 1231 loss will be treated an ordinary loss. Husband's net capital gain is $10,000, taxable at more favorable rates. Wife's $10,000 loss is not subject to the limitations on the deductibility of capital losses,91 and may be deducted in full.

84 Code Sec. 67(a).
85 Code Sec. 63(c)(6)(A).
86 Code Sec. 165(h)(2)(A).
87 Code Sec. 165(h)(2)(B).
88 Code Sec. 1(h).
89 Code Sec. 213(a).
90 Code Sec. 1231(a)(1), (2).
91 Code Sec. 1211(b).

Tax Consequences for Married Taxpayers Filing Separate Returns

Most married taxpayers can choose whether to file joint returns or separate returns. Most couples will pay less tax if they file joint returns, but in some situations they will benefit from filing separate returns.

Individuals who are married filing separate returns have smaller amounts of taxable income taxed at the lower tax rates than do individuals with any other filing status.60  A number of other provisions treat taxpayers with this filing status in a manner that is generally more onerous than treatment of other taxpayers. These include:

• the basic standard deduction is lower;61
• the standard deduction is reduced to zero if the other spouse itemizes deductions;62
• the credit for expenses for household and dependent care services necessary for gainful employment is disallowed;63
• the credit for the elderly and the permanently and totally disabled has a lower initial amount, a lower adjusted gross income limitation, and is disallowed if the spouses live together at any time during the tax year;64
• the credit for qualified adoption expenses is disallowed;65
• the Hope scholarship and lifetime learning credit are disallowed;66
• the earned income credit is disallowed;67
• the limitation on the general business credit may be halved;68
• the threshold for reducing the amount of otherwise allowable itemized deductions for higher-income taxpayers is halved;69
• the threshold for including social security benefits in gross income is reduced to zero if the spouses live together at any time during the tax year, and the entire amount of benefits is subject to inclusion at the higher 85-percent level;70
• the amount that can be excluded under the exclusion for gain on the sale of a principal residence is the lower amount generally available to single taxpayers, and one spouse's ownership and use are not attributed to the other spouse, as they are if a joint return is filed;71
• the amount which may be excluded from gross income under dependent care assistance programs is halved;72
• the exclusion from gross income provided for the proceeds of the redemption of U.S. savings bonds which are used to pay higher education tuition and fees is disallowed;73
• the phaseout of deductions for personal exemptions for higher-income taxpayers begins with a lower threshold amount, and phases out more rapidly;74
• the amount of acquisition indebtedness and home equity indebtedness which is deductible qualified residence interest is limited;75
• the limitation on the amount of deductible losses in insolvent financial institutions which may be treated as an ordinary loss is halved;76
• for purposes of the election to expense certain depreciable business assets, the two spouses are treated as one taxpayer in applying the dollar limitation and the reduction in the amount of the limitation;77
• the dollar limitation on the deduction and/or amortization of reforestation expenditures is halved;78
• the deduction for student loan interest is not allowed;79
• the exception to the passive activity losses and credits limitation for certain real estate activities is restricted and is eliminated if the spouses live together at any time during the tax year;80
• the amount of capital losses which may be offset by ordinary income is halved ;81
• the threshold amounts for applying the limitations on the use of the preceding year's tax liability in computing the amount of required installments of payment of tax to avoid the penalty for underpayment are affected;82 and
• tax tables are adjusted for inflation by rounding to the nearest $25, rather than to the nearest $50.83

60 Rev. Proc. 91-65, 1991-2 CB 867.
61 Code Sec. 63(c)(2)(D).
62 Code Sec. 63(c)(6)(A).
63 Code Sec. 21(e)(2).
64 Code Sec. 22(c)(2)(A)(iii), (d)(3), (e)(1).
65 Code Sec. 23(f)(1).
66 Code Sec. 25A(g)(6).
67 Code Sec. 32(d).
68 Code Sec. 38(c)(2)(A).
69 Code Sec. 68(b)(1); Code Sec. 68(f), (g), as added by the Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16, Act §103(a) (June 7, 2001).
70 Code Sec. 86.
71 Code Sec. 121.
72 Code Sec. 129(a)(2)(A).
73 Code Sec. 135(d)(2).
74 Code Sec. 151(d)(3)(A) through (D); Code Sec. 151(d)(3)(E), (F), as added by the Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16, Act §102(a) (June 7, 2001).
75 Code Sec. 163(h)(3)(B)(ii), (C)(ii).
76 Code Sec. 165(l)(5)(B)(ii).
77 Code Sec. 179(b)(4).
78 Code Sec. 194(b)(1), as amended by the American Jobs Creation Act of 2004, P.L. 108-357, Act §322(a) (October 22, 2004).
79 Code Sec. 221(b)(2).
80 Code Sec. 469(i)(5).
81 Code Sec. 1211(b)(1).
82 Code Sec. 6654(d)(1)(C)(ii).
83 Code Sec. 1(f)(6)(B).

§1.6013-2 Election to file a joint return for a given year after filing separate return:

Where an individual has filed a separate return for a taxable year for which a joint return could have been made by him and his spouse under section 6013(a), and the time prescribed by law for filing the return for such taxable year has expired, such individual and his spouse may, under conditions hereinafter set forth, make a joint return for such taxable year.

§1.6013-2(b) Limitations with respect to making of election.
A joint return shall not be made under section 6013(b)(1) with respect to a taxable year:

• After the expiration of three years from the last day prescribed by law for filing the return for such taxable year determined without regard to any extension of time granted to either spouse; or
• After there has been mailed to either spouse, with respect to such taxable year, a notice of deficiency under section 6212, if the spouse, as to such notice, files a petition with the Tax Court of the United States within the time prescribed in section 6213; or
• After either spouse has commenced a suit in any court for the recovery of any part of the tax for such taxable year; or
• After either spouse has entered into a closing agreement under section 7121 with respect to such taxable year, or after any civil or criminal case arising against either spouse with respect to such taxable year has been compromised under section 7122.

§1.6013-1 Election to file a separate return for a given year after filing joint return:

Where a couple files a joint return for a taxable year, they cannot later file separate returns after the last date prescribed for filing the return.

On the other hand, where a couple files separate returns, they may later change their minds and file a joint return, provided it is not filed after any of the following events:

• The expiration of three years from the last day for filing the return.
• The mailing to either spouse of a notice of deficiency if the spouse files a timely petition with the Tax Court.

1.6013-1(a)(1) For any taxable year with respect to which a joint return has been filed, separate returns shall not be made by the spouses after the time for filing the return of either has expired. See, however, paragraph (d)(5) of this section for the right of an executor to file a late separate return for a deceased spouse and thereby disaffirm a timely joint return made by the surviving spouse.

1.6013-1(a)(2) A joint return of a husband and wife (if not made by an agent of one or both spouses) shall be signed by both spouses. The provisions of paragraph (a)(5) of § 1.6012-1, relating to returns made by agents, shall apply where one spouse signs a return as agent for the other, or where a third party signs a return as agent for one or both spouses.

1.6013-1(d)(5) If the surviving spouse makes the joint return provided for in subparagraph (3) of this paragraph and thereafter an executor or administrator of the decedent is appointed, the executor or administrator may disaffirm such joint return. This disaffirmance, in order to be effective, must be made within one year after the last day prescribed by law for filing the return of the surviving spouse (including any extension of time for filing such return) and must be made in the form of a separate return for the taxable year of the decedent with respect to which the joint return was made. In the event of such proper disaffirmance the return made by the survivor shall constitute his separate return, that is, the joint return made by him shall be treated as his return and the tax thereon shall be computed by excluding all items properly includible in the return of the deceased spouse. The separate return made by the executor or administrator shall constitute the return of the deceased spouse for the taxable year.

§761(f)(2) Spouses' Partnership May "Elect Out" of Partnership Rules:

For tax years beginning after Dec. 31, 2006, a "qualified joint venture" that is conducted by a husband and wife who file a joint return for the tax year - may be elected out of and not treated as a partnership for tax purposes.

http://www.irs.gov/pub/irs-pdf/i1040sc.pdf

http://www.irs.gov/pub/irs-prior/i1040sc--2007.pdf

http://www.irs.gov/pub/irs-pdf/i1040c_06.pdf

Husband-wife business. Beginning in 2007, you and your spouse, if you are filing married filing jointly, may be able to make a joint election to be taxed as a qualified joint venture instead of a partnership.

Husband-wife business. If you and your spouse jointly own and operate a business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement. Do not use Schedule C or C-EZ. Instead, file Form 1065. See Pub. 541 for more details.

Exception - Qualified joint venture. If you and your spouse materially participate (see Material participation beginning on page C-2) as the only members of a jointly owned and operated business, and you file a joint return for the tax year, you can make a joint election to be taxed as a qualified joint venture instead of a partnership. To make this election, you must divide all items of income, gain, loss, deduction, and credit between you and your spouse in accordance with your respective interests in the venture. Each of you must file a separate Schedule C or C-EZ. On each line of your separate Schedule C or C-EZ, you must enter your share of the applicable income, deduction, or loss.

As long as you remain qualified, your election cannot be revoked without IRS consent.

Rev. Proc. 2002-69 Spouses' "Partnership" has option to be treated as a disregarded entity - when they reside in a Community Property State:

Generally for tax years beginning after Dec. 31, 2002, a "qualified entity" owned by a husband and wife in a community property state may be treated as a single Schedule C and not treated as a partnership for tax purposes at the discretion of the taxpayers.

http://www.irs.gov/pub/irs-prior/i1040sc--2003.pdf

§1.761-2(b) Investment Partnership may "Elect Out"  of Subchapter K Partnership Rules:

A "qualified investment partnership" - may be elected out of and not treated as a partnership for tax purposes, as follows:

Pursuant to Internal Revenue Code §761 all the members of ABC Associates elect to exclude the organization from the provisions of Subchapter K of the Internal Revenue Code. This election shall be effective beginning with the tax year ending December 31, ______. In connection with this election the members of ABC Associates represent the following:

1) ABC Associates is located at 100 Co-Ownership Road, Rockville, Maryland 20852. A copy of the operating agreement is available at that location.

2) ABC Associates qualifies for this election as an investing partnership that satisfies the requirements of Regulation §1.761-2(a)(1) & (2).

3) The members of ABC Associates are:

(a) Mr. W. Smith ###-##-####
100 Co-Ownership Road
Rockville, Maryland 20852

(b) Ms. J. Jones ###-##-####
102 Co-Ownership Road
Rockville, Maryland 20852

§461 What year to deduct an expense?:

see:
The 2½ month rule: Regs §1.404(b)-1T A-2(b)(1) regarding accrual of deferred compensation
The 3½ month rule: Regs §1.461-4(d)(6)(ii) regarding prepaid services  
The 8½ month rule: Regs §1.461-5(b)(1)(i) regarding accrual of reoccurring items



The 3½ month rule:
Regs §1.461-4(d)(6)(ii) A taxpayer is permitted to treat services or property as provided to the taxpayer as the taxpayer makes payment to the person providing the services or property (as defined in paragraph (g)(1)(ii) of this section), if the taxpayer can reasonably expect the person to provide the services or property within 3-1/2 months after the date of payment.

The 8½ month "recurring item" rule:
Under the recurring item exception, a liability is treated as incurred for a taxable year if --

1.461-5(b)(1)(i) As of the end of that taxable year, all events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy;

(ii) Economic performance with respect to the liability occurs on or before the earlier of

(ii)(A) The date the taxpayer files a timely (including extensions) return for that taxable year; or

(ii)(B) The 15th day of the 9th calendar month after the close of that taxable year;

(iii) The liability is recurring in nature; and

(iv) Either

(iv)(A) The amount of the liability is not material; or

(iv)(B) The accrual of the liability for that taxable year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

From IRS Publication 538

Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply.

1. The all-events test has been met. The test is met when:
   •  All events have occurred that fix the fact of liability, and
   •  The liability can be determined with reasonable accuracy.
2. Economic performance has occurred.

You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided or the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.

Example. You are a calendar year taxpayer. You buy office supplies in December 2003. You receive the supplies and the bill in December, but you pay the bill in January 2004. You can deduct the expense in 2003 because all events have occurred to fix the fact of liability, the liability can be determined, and economic performance occurred in 2003.

Your office supplies may qualify as a recurring item, discussed later. If so, you can deduct them in 2003, even if the supplies are not delivered until 2004 (when economic performance occurs).

Workers' compensation and tort liability. If you are required to make payments under workers' compensation laws or in satisfaction of any tort liability, economic performance occurs as you make the payments. If you are required to make payments to a special designated settlement fund established by court order for a tort liability, economic performance occurs as you make the payments.

Taxes. Economic performance generally occurs as estimated income tax, property taxes, employment taxes, etc. are paid. However, you can elect to treat taxes as a recurring item, discussed later. You can also elect to ratably accrue real estate taxes. See chapter 6 of Publication 535 for information about real estate taxes.

Other liabilities. Other liabilities for which economic performance occurs as you make payments include liabilities for breach of contract (to the extent of incidental, consequential, and liquidated damages), violation of law, rebates and refunds, awards, prizes, jackpots, insurance, and warranty and service contracts.

Interest. Economic performance occurs with the passage of time (as the borrower uses, and the lender forgoes use of, the lender's money) rather than as payments are made.

Compensation for services. Generally, economic performance occurs as an employee renders service to the employer. However, deductions for compensation or other benefits paid to an employee in a year subsequent to economic performance are subject to the rules governing deferred compensation, deferred benefits, and funded welfare benefit plans. For information on employee benefit programs, see Publication 15-B, Employer's Tax Guide to Fringe Benefits.

Vacation pay. You can take a current deduction for vacation pay earned by your employees if you pay it during the year or, if the amount is vested, within 2 months after the end of the year. If you pay it later than this, you must deduct it in the year actually paid. An amount is vested if your right to it cannot be nullified or cancelled.

Exception for recurring items. An exception to the economic performance rule allows certain recurring items to be treated as incurred during the tax year even though economic performance has not occurred. The exception applies if all the following requirements are met.

1. The all-events test, discussed earlier, is met.
2. Economic performance occurs by the earlier of the following dates.
   • 8½ months after the close of the year.
   • The date you file a timely return (including extensions) for the year.
3. The item is recurring in nature and you consistently treat similar items as incurred in the tax year in which the all-events test is met.
4. Either:
   • The item is not material, or
   • Accruing the item in the year in which the all-events test is met results in a better match against income than accruing the item in the year of economic performance.

This exception does not apply to workers' compensation or tort liabilities.

Amended return. You may be able to file an amended return and treat a liability as incurred under the recurring item exception. You can do so if economic performance for the liability occurs after you file your tax return for the year, but within 8 1/2 months after the close of the tax year.

Recurrence and consistency. To determine whether an item is recurring and consistently reported, consider the frequency with which the item and similar items are incurred (or expected to be incurred) and how you report these items for tax purposes. A new expense or an expense not incurred every year can be treated as recurring if it is reasonable to expect that it will be incurred regularly in the future.

Materiality. Factors to consider in determining the materiality of a recurring item include the size of the item (both in absolute terms and in relation to your income and other expenses) and the treatment of the item on your financial statements.

An item considered material for financial statement purposes is also considered material for tax purposes. However, in certain situations an immaterial item for financial accounting purposes is treated as material for purposes of economic performance.

Matching expenses with income. Costs directly associated with the revenue of a period are properly allocable to that period. To determine whether the accrual of an expense in a particular year results in a better match with the income to which it relates, generally accepted accounting principles are an important factor. For example, if you report sales income in the year of sale, but you do not ship the goods until the following year, the shipping costs are more properly matched to income in the year of sale than the year the goods are shipped. Expenses that cannot be practically associated with income of a particular period, such as advertising costs, should be assigned to the period the costs are incurred. However, the matching requirement is considered met for certain types of expenses. These expenses include taxes, payments under insurance, warranty, and service contracts, rebates and refunds, and awards, prizes, and jackpots.

An expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the "12-month rule." Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer that do not extend beyond the earlier of the following.

• 12 months after the right or benefit begins, or
• The end of the tax year after the tax year in which payment is made.

If you have not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies) and/or the 12-month rule to the expenses you paid in advance, you must get IRS approval before using the general rule and/or the 12-month rule. See Change in Accounting Method, later, for information on how to get IRS approval. See Expense paid in advance under Cash Method, earlier, for examples illustrating the application of the general and 12-month rules.

Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible until you make the payment and the corresponding amount is includible in the related person's gross income. Determine the relationship for this rule as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is denied, the rule will continue to apply even if your relationship with the person ends before the expense or interest is includible in the gross income of that person.

Related persons. For purposes of this rule, the following persons are related.

1. Members of a family, including only brothers and sisters (either whole or half), husband and wife, ancestors, and lineal descendants.
2. Two corporations that are members of the same controlled group as defined in section 26 USC 267(f).
3. The fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.
4. A tax-exempt educational or charitable organization and a person (if an individual, including the members of the individual's family) who directly or indirectly controls such an organization.
5. An individual and a corporation when the individual owns, directly or indirectly, more than 50% of the value of the outstanding stock of the corporation.
6. A fiduciary of a trust and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.
7. The grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
8. Any two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.
9. An S corporation and a corporation that is not an S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.
10. A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership.
11. A PSC and any employee-owner, regardless of the amount of stock owned by the employee-owner.

Ownership of stock. To determine whether an individual directly or indirectly owns any of the outstanding stock of a corporation, the following rules apply.

1. Stock owned directly or indirectly by or for a corporation, partnership, estate, or trust is treated as being owned proportionately by or for its shareholders, partners, or beneficiaries.
2. An individual is treated as owning the stock owned directly or indirectly by or for the individual's family (as defined in item (1) under Related persons ).
3. Any individual owning (other than by applying rule (2)) any stock in a corporation is treated as owning the stock owned directly or indirectly by that individual's partner.
4. To apply rule (1), (2), or (3), stock constructively owned by a person under rule (1) is treated as actually owned by that person. But stock constructively owned by an individual under rule (2) or (3) is not treated as actually owned by the individual for applying either rule (2) or (3) to make another person the constructive owner of that stock.

Reallocation of income and deductions. Where it is necessary to clearly show income or prevent tax evasion, the IRS can reallocate gross income, deductions, credits, or allowances between two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests.

If you use an accrual method of accounting and contest an asserted liability, you can deduct the liability either in the year you pay it (or transfer money or other property in satisfaction of it) or in the year you finally settle the contest. However, to take the deduction in the year of payment or transfer, you must meet certain conditions.

Conditions to be met. You must satisfy each of the following conditions to take the deduction in the year of payment or transfer.

Liability must be contested. You do not have to start a suit in a court of law to contest an asserted liability. However, you must deny its validity or accuracy by a positive act. A written protest included with payment of an asserted liability is enough to start a contest. Lodging a protest in accordance with local law is also enough to contest an asserted liability for taxes. You do not have to deny the validity or accuracy of an asserted liability in writing if you can show by all the facts and circumstances that you have asserted and contested the liability.

Contest must exist. The contest for the asserted liability must exist after the time of the transfer. If you make payment after the contest is settled, you must accrue the liability in the year in which the contest is settled.

Example. You are a calendar year taxpayer using an accrual method of accounting. You had a $500 liability asserted against you in 2000 for repair work completed that year. You contested the asserted liability and settled in 2002 for the full $500. You pay the $500 in January 2003. Since you did not make the payment until after the contest was settled, the liability accrues in 2002 and you can deduct it only in 2002.

Transfer to creditor. You must transfer to the creditor or other person money or other property to provide for the payment of the asserted liability. The money or other property transferred must be beyond your control. If you transfer it to an escrow agent, you have met this requirement if you give up all authority over the money or other property. However, buying a bond to guarantee payment of the asserted liability, making an entry on your books of account, transferring funds to an account within your control, transferring your indebtedness or your promise to provide services or property in the future, or transferring (except to the creditor) your stock or the stock or indebtedness of a related person will not meet this requirement.

Liability deductible. The liability must have been deductible in the year of payment, or in an earlier year when it would have accrued, if there had been no contest.

Economic performance rule satisfied. You generally cannot deduct contested liabilities until economic performance occurs. For workers' compensation or a tort liability, or a liability for breach of contract (to the extent of incidental, consequential, and liquidated damages), violation of law, rebates and refunds, awards, prizes, jackpots, insurance, warranty and service contracts, and taxes, economic performance occurs as payments are made to the person. The payment or transfer of money or other property into escrow to contest an asserted liability is generally not a payment to the claimant that discharges the liability. This payment does not satisfy the economic performance test, discussed earlier, except as provided in section 26 USC 468B or the regulations thereunder.

Recovered amounts. An adjustment is usually necessary when you recover any part of a contested liability. This occurs when you deduct the liability in the year of payment and recover any part of it in a later tax year when the contest is settled. Include in gross income in the year of final settlement the part of the recovered amount that, when deducted, decreased your tax for any tax year.

Also see:
http://www.traderstatus.com/prepaidexpenses.htm

Deduction for water & sewer fees & assessments:

Internal Revenue Code (IRC) section 164 permits a deduction for state and local real property taxes. Under Federal law, a tax is an enforced contribution, collected for the purpose of raising revenue to be used for governmental purposes, and not as a payment for a service rendered. In addition, Section 1.164-3(b) of the Treasury Regulations defines "real property taxes" as taxes imposed on interests in real property and levied for the general public welfare, but does not include taxes assessed against local benefits.

Charges for services - Itemized charges for trash collection, water, sewer, etc. are not deductible as real estate taxes.

Special assessments-principal portion - Charges for improvements that tend to increase the value of the property are added to the basis of the property and are not deductible.  Example: an assessment to build a new sidewalk or to connect up to a city sewer system.

Charges to repair or maintain existing public facilities already in service - are deductible as real estate taxes.  Example: repairs to an existing sidewalk.

Special assessments-interest portion - IR Regs. §1.164-4(b)(1) say that any interest charged to the property owner on his sewer assessment is deductible, not as interest, but as property taxes regardless if the assessment was for improvements or a repair.

Fees for water/sewer services are not imposed on an interest in real property nor levied for the general public welfare. The charges by a water/sewer authority to its customers for water and sewer services are simply fees for a service and do not qualify as a tax. Consequently, no portion of the fees would qualify as a deduction on the customer's income tax return.

The confusion may come from a misunderstanding of Treasury Regulation 1.164-4(b)(1). This regulation states that:
"Insofar as assessments against local benefits are made for the purposes of maintenance or repair or for the purpose of meeting interest charges with respect to such benefits, they are deductible. In such cases, the burden is on the taxpayer to show the allocation of the amounts assessed to the different purposes. If the allocation cannot be made, none of the amount so paid is deductible."

In some circumstances, the local governments are attempting to calculate the portion of the water/sewer fees that go to maintenance and interest expenses of their systems. That figure is then provided as being tax deductible. The problem is the service fees do not qualify as a tax to begin with so the provisions of 1.164-4(b)(1) do not apply.

Below are some common situations, with the relevant law that clarifies the issue:

1. A water authority charges its customers for water usage based on meter readings.
        The charges are not taxes but fees for receipts of water services.
        Revenue Ruling 79-201
    
2. A sewer utility imposes a flat charge for each quarter to all residential customers.
        The charges are not taxes but fees for sewer services.
        Revenue Ruling 75-346
    
3. Real estate taxes are increased on all property owners within a municipality to pay for a sewage disposal system.
        The taxes are levied for the general public welfare by the taxing authority at a like rate against all property over which the authority has jurisdiction.
        This is not a tax assessed against local benefits. The increased real estate taxes are deductible under section 164 of the IRC.
        Revenue Ruling 74-52
    
4. Improvements are made by a municipal water authority to expand the coverage area of the water services. Properties that are benefited by the improvements have an assessment added to their property taxes. The amount of the increase is based on the value of the property.
        This is an example of a tax assessed against local benefits. According to IRC 164(c)(1) such charges are not deductible except to the extent that they are properly allocable to maintenance or interest charges.
        Revenue Ruling 75-455, Revenue Ruling 76-45

In summary, most of the time water and sewer fees are simply fees for services and are not deductible.
http://apps.irs.gov/pub/irs-tege/p_4090_fed_1204_text.pdf

IRS-TE/GE is the Tax Exempt & Government Entities Division. The TE/GE Division was established in late 1999 as part of the IRS's modernization effort. This Division replaces the former Assistant Commissioner (Employee Plans and Exempt Organizations) function, which was established as a result of the Employee Retirement Income Security Act (ERISA) of 1974.

§1031 Tax-Deferred Exchanges:

http://www.1031.org/

§709(b)(1) election to deduct LLC, partnership and Sch C start-up expenditures:
(also see §195(b) and see §248(a) for corporations)

After October 22, 2004 a new law allows this election to be made for expenditures of $5,000 or less for start-up, §248 organizational, syndication and formation costs to be deducted  when it begins business. Otherwise, generally, these costs are amortized over a 15 year period starting with the month it begins business.

Prior to October 23, 2004 these costs were usually amortized straight-line over 60 months.

After September 8, 2008 the qualifying costs are expensed, by default.

How to make the election. You elect to deduct the start-up or organizational costs paid or incurred before 9/9/08 by claiming the deduction on the income tax return (filed by the due date including extensions) for the tax year in which the active trade or business begins. However, if you timely filed your return for the year without making the election, you can still make the election by filing an amended return within 6 months of the due date of the return (excluding extensions). Clearly indicate the election on your amended return and write "Filed pursuant to section 301.9100-2."   File the amended return at the same address you filed the original return. The election applies when computing taxable income for the current tax year and all subsequent years.

After September 8, 2008 - the election to capitalize start-up or organizational costs is made similar to the above.


Start-up costs are costs for creating an active trade or business or investigating the creation or acquisition of an active trade or business. Start-up costs include any amounts paid or incurred in connection with any activity engaged in for profit and for the production of income in anticipation of the activity becoming an active trade or business.

Qualifying costs. A start-up cost is amortizable if it meets both the following tests.

• It is a cost you could deduct if you paid or incurred it to operate an existing active trade or business (in the same field as the one you entered into).
• It is a cost you pay or incur before the day your active trade or business begins.

Start-up costs include costs for the following items.

• An analysis or survey of potential markets, products, labor supply, transportation facilities, etc.
• Advertisements for the opening of the business.
• Salaries and wages for employees who are being trained and their instructors.
• Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
• Salaries and fees for executives and consultants, or for similar professional services.

Disposition of business. If you completely dispose of your business before the end of the amortization period, you can deduct any remaining deferred start-up costs. However, you can deduct these deferred start-up costs only to the extent they qualify as a loss from a business.



A special note about educational seminars attended before you begin trading:
Education is deductible when it is not part of a program that will qualify you for a new trade or business.  Therefore for tax deduction purposes it is perhaps best to consider avoiding such controversy and defer your trader training seminars until after you have actually begun active trading. The trading needs to be done with appropriately significant dollars at stake - "paper trading" without dollars at stake does not necessarily qualify as a legitimate trade or business.

IRS Publication 17
Maintaining skills vs. qualifying for new job.
Education to maintain or improve skills needed in your present work is not qualifying education if it will also qualify you for a new trade or business.

IRS Publication 970
Temporary absence. If you stop working for a year or less in order to get education to maintain or improve skills needed in your present work and then return to the same general type of work, your absence is considered temporary. Education that you get during a temporary absence is qualifying work-related education if it maintains or improves skills needed in your present work.

Indefinite absence. If you stop work for more than a year, your absence from your job is considered indefinite. Education during an indefinite absence, even if it maintains or improves skills needed in the work from which you are absent, is considered to qualify you for a new trade or business. Therefore, it is not qualifying work-related education.
 

Net Operating Loss Carryback / Carryforward elections:

Individuals:
Planning stages: 2007 & 2008: Carry back five years (or elect to carry back two years), carryforward twenty years.
1998, 1999, 2000 and  2003 to present (2006): Carry back two years, carryforward twenty years.
2001 & 2002: Carry back five years (or elect to carry back two years), carryforward twenty years.
prior to 1998 Carry back three years, carryforward fifteen years.


Corporations:


Numerous special cases and exemptions exist for:
Losses on Sec 1256 contracts, futures, commodities
Losses of a Real Estate Investment Trust (REIT)
Losses from certain product liabilities and deferred statutory liabilities (ten year carryback)
Losses from certain Causalities, Thefts & Presidential Declared Disasters (three year carryback)
Farming Losses (five year carryback)
Certain timber losses (three & five year carrybacks)
Gulf Opportunity (GO) Zone losses (five year carryback)
Losses from a casualty or thief (three year carryback)
Losses from a Presidentially declared disaster for a qualified small business
Product liability (ten year carryback)
Reclamation of land (ten year carryback for accrual basis taxpayers three years after an act)
Dismantling of a drilling platform (ten year carryback for accrual basis taxpayers three years after an act)
Remediation of environmental contamination (ten year carryback for accrual basis taxpayers three years after an act)
Payment under any workers compensation act (ten year carryback for accrual basis taxpayers three years after an act)



The election to forgo the carrytback was added by the Tax Reform Act of 1976.  There are two basic requirements for elect to forgo the carryback: A properly worded election statement and a timing requirement. 

There has been litigation when ambiguous election statements have been made regarding the Regular Income Tax  NOL vs. the Alternative Minimum Tax (AMT) NOL.  Taxpayer may not make a split election (between regular and AMT NOL) but the election should refer to both to be valid.  Use language such as "net operating losses"  (Miller v. Comr., 99 F.3d 1042 11th Cir. 1996 Taxpayers' attempt to waive only carryback of their regular tax NOL rendered election invalid because attached statement was ambiguous on its face and thus invalid because taxpayer attempted to split election, rev'g, 104 T.C. 330 1995).

The irrevocable election must be filed no later than the due date (including extensions) for the filing of the tax return for the taxable year in which the net operating loss arises see IRC §172(b)(3).  There is much misunderstanding (general ignorance, or purposefully ignoring of the law) by many tax advisors regarding this requirement.

Once you choose to waive the carryback period, it is irrevocable. If you choose to waive the carryback period for more than one NOL, you must make a separate choice and attach a separate statement for each NOL year.

CAUTION: If you do not file this statement on time, you cannot waive the carryback period.


The form 1040 Election to Waive Net Operating Loss Carryback (NOL) under IRS Code Sec 172(b)(3) has a deadline for filing which is the due date including extensions of the tax return for the year of the NOL, which in no event generally would go beyond October 15, 2004 (or April 15, 2005 if filed pursuant to section 301.9100-2).

§172(b)(3). The right to choose to forgo the carryback period is lost if a timely election is not made. e.g., Young v. Comr., 83 T.C. 831 (1984), aff'd, 783 F.2d 1201 (5th Cir. 1986) (Statement electing to waive carryback made on an amended return for 1976 did not constitute a timely waiver where amended return was filed in 1980); Curran v. U.S., 88 AFTR2d 7172 (D. Md. 2001) (Election to waive carryback of a 1989 net operating loss untimely where the taxpayer filed the 1989 return more than four years late); Diesel Performance, Inc. v. Comr., T.C. Memo 1999-302, aff'd in unpub. opin., 2001-2 USTC ¶50,589 (9th Cir. 2001) (Statement electing to waive carryback on an amended return for 1992 did not constitute a timely waiver where amended return was filed in 1994); Menaged v. Comr., T.C. Memo 1991-079 (Statement of election to carry over unused net operating loss generated in 1979 made on amended return filed more than two years after due date of original return was not timely election to waive carryback period).

When the election is made on an amended return, the taxpayer must write "Filed pursuant to section 301.9100-2" on the election statement. IRS Pub. 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts. Regs. §301.9100-2(b) authorizes an automatic six-month extension to make a regulatory election or a statutory election with a due date of the return including extensions, provided the taxpayer timely filed its return for the year the election should have been made and the taxpayer takes corrective action within the six-month extension period.

Regs. §301.9100-3 provides for discretionary extensions for regulatory elections that do not meet the requirements of Regs. §301.9100-2, if the taxpayer acted reasonably and in good faith and granting relief will not prejudice the government's interests. PLRs 200124007 and 200123048 involved consolidated groups that inadvertently failed to file waivers of carryback for consolidated net operating losses on their tax returns for the loss year. Although §172(b)(3) provides the general deadline for waiving carryback, Regs. §1.1502-21T(b)(3)(i) specifically addresses requirements for waiver by consolidated groups. Treating the elections by the consolidated groups as regulatory elections, the IRS granted discretionary extensions for making the election under Regs. §301.9100-3. See also PLRs 200214023 (45-day extension granted to relinquish carryback); 200209002 (45-day extension granted to relinquish carryback period).

Absent application of Regs. §301.9100-2 or Regs. §301.9100-3, the IRS will not grant an extension of time to elect waiver of carryback. PLRs 9435004, 8549057, 8339056, 8229035; TAMs 8333001, 8107001. Additionally, the IRS may postpone the deadline for making the election for taxpayers affected by a Presidentially declared disaster or terroristic or military action (§7508A) or serving in or in support of the Armed Forces in a combat zone or qualifying deployment in a contingency operation (§7508). Rev. Proc. 2004-13, 2004-4 I.R.B. 335.



The general rule provides a two-year carryback period and a 20-year carryover period; provided, however, that a five-year carryback period applies for net operating losses for taxable years ending during 2001 or 2002 and is planned again for 2007 & 2008.  264 To provide flexibility, taxpayers incurring net operating losses may elect to waive carryback of the losses and carry them forward for the applicable carryover period. 265

/Footnote/ 264 §172(b)(1)(A), (H). The two-year carryback and 20-year carryover periods were implemented by the Taxpayer Relief Act of 1997, P.L. 105-34, §1082(a), effective for tax years beginning after Aug. 5, 1997. The five-year carryback period for net operating losses for taxable years ending during 2001 or 2002 was implemented by the Job Creation and Worker Assistance Act of 2002, P.L. 107-147, §102(a).

/Footnote/ 265 The waiver of the two-year carryback period is discussed at ¶2410.04.C., below. The waiver of the five-year carryback period is discussed at ¶2410.04.A.2.b., below.

Personal Income Tax Net Operating Losses are carried back using form 1045.  You must file Form 1045 within 1 year after the end of the year in which an NOL, unused credit, a net section 1256 contracts loss, or claim of right adjustment arose.   Alternatively form 1040X may be filed before three years from the date the form 1040 was filed.


Corporate Income Tax Net Operating Losses are carried back using form 1139.  The corporation must file Form 1139 within 12 months of the end of the tax year in which an NOL, net capital loss, unused credit, or claim of right adjustment arose.  Alternatively form 1120X may be filed before three years from the date the form 1120 was filed.

Delinquent filers:

Unless the timely-filed 2005 return has an election to relinquish the carryback, the NOL must first be carried back and then carried forward. The number of years of the carryback depends on the type of loss. it can be as much as 10 years under IRC 172(b)(1)(C).

Assuming the 1040X carryback is not timely filed, the amount of loss (if any) that can be carried forward is determined as if the 1040X carryback had been filed. The only difference is that the refunds from the carryback years are lost.

The interplay of the two and three year rules that are normally looked at basically relate to the situation where the refund is being claimed for the "current" year, not a carryback year.

First, Reg. 301.6511(a)-1(a)(1) says that a refund claim must be filed within 3 years of the time the original return is filed or, if later, 2 years from the time the tax was paid. Note that the original return may, in itself, be a refund claim. Note also that, if no return is filed, Reg. 301.6511(a)-1(a)(2) also allows a refund claim of taxes paid within two years, which presumably would refer to an adjustment by the IRS, since I can't think of any other way a refund could be claimed without filing a return.

IRC 6511(b)(1) says there will be no refund or credit based on that refund claim unless it is timely. Note that neither Reg. 301.6511(a)-1 nor 6511(B)(1) refer to the due date of the return. Both refer to the timeliness of the refund claim.

Second, assuming that the claim is timely under Reg. 301.6511(a)-1, IRC 6511(b)(2) limits the amount that can be refunded. If the claim was filed within 3 years of filing the original return, the limit under IRC 6511(b)(2)(A) is the tax paid within 3 years plus, if an extension of time was granted for the original return, the period of the extension, prior to filing the refund claim.

If the refund claim is not filed within 3 years of filing the original return, the limit is the tax paid within 2 years of filing the refund claim, per IRC 6511(b)(2) (B).

Note that none of the periods involved refer to the due date of the return except to the extent that IRC 6513 deems a tax paid before the due date to be paid on the due date of the return.

If a form 1040 has not yet been filed but it shows an overpayment of tax, filing it before the three year statute would constitute a valid refund claim for the overpayment of tax. Filing after the three year statute would constitute a valid refund claim only for the tax paid 3 years plus the period of any extension granted prior to the date of filing. (Since this is the original return and, simultaneously a refund claim, the refund claim is filed within 3 years of the original return.)

Net Operating Loss (NOL) Helpful Hints:

http://www.irs.gov/businesses/small/article/0,,id=128495,00.html

Net Operating Loss (NOL) Helpful Hints

Headliner Volume 98 - August 16, 2004

Tax practitioners can speed up the processing of net operating losses (NOLs) by avoiding some common errors. Individuals, estates and trusts may have an NOL if deductions exceed income for the year. Taxpayers can use an NOL by deducting it from income in another year or years.

If you carry back your NOL, you can use Form 1045, Application for Tentative Refund, or Form 1040X Amended U. S. Individual Income Tax Return. Form 1045, is an application for a quick refund, resulting from a tentative adjustment of tax in a carryback year. Generally, Form 1045 must be filed after the NOL year tax return was filed, but not later than one year after the NOL year. Any claims filed more than one year after the end of the NOL year must be filed on Form 1040X, or an amended Form 1041, U.S. Income Tax Return for Estates and Trusts.

Here are some common errors that resulted in an NOL rejection during processing:

Error: Failure to provide documentation to support the NOL calculation.

Solution: Review the checklist of "What to Attach" in the Form 1045 instructions. Be sure to include all forms or schedules for items refigured in the carryback year. Also, provide a copy of any examination reports if the IRS has previously audited the return.

Error: Failure to separate all items shown on the return and tax account when an allocation is required because of a change in filing status or marital status.

Solution: Attach a complete breakdown of each spouse's income; a detailed capital gain calculation; deductions, including a list of total Schedule A Itemized Deductions; exemptions; taxable income; credits; other taxes, including separate Forms 6251, Alternative Minimum Tax; federal tax withheld; payments; offsets; and refunds. For information about figuring the NOL carrybacks and carryovers for married people whose filing status changes for any tax year involved in figuring an NOL carryback or carryover, see Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.

Error: Incorrect "before carryback" figures on Form 1045 or Form 1040X.

Solution: "Before carryback" figures are the amounts from the original filed return. If there have been any adjustments made to the original tax return amounts, either by the taxpayer or the IRS, use personal records or order an IRS transcript of the tax account. To order a transcript, call (800) 829-1040 for Form 1040, U.S. Individual Income Tax Return, or (800) 829-4933 for business returns, or file Form 4506-T Request for Transcript of Tax Return.

Error: Incorrect use of Table 1. Worksheet for NOL Carryover From 2003 to 2004 (For an NOL Year Before 2003) in Publication 536 instead of Form 1045, Schedule B, NOL Carryover, to compute absorbed carryback.

Solution: Calculate the total NOL absorbed in each carryback year using Form 1045, Schedule B. Taxpayer should not use the carryforward worksheet shown in Publication 536 to calculate the absorbed NOL for carryback claims. The worksheet is used to figure the amount of an NOL from a prior year still remaining after applying it to the current year.

Error: Missing NOL and alternative tax net operating loss (ATNOL) calculations.

Solution: For NOL calculations attach Form 1045, Schedule A NOL. For ATNOL calculations attach the calculation and a Form 6251, Alternative Minimum Tax. If taxpayer did not file a Form 6251, with the loss year and/or carryover years' returns, IRS must have a copy of completed Forms 6251 to determine the total adjustments and preferences for the ATNOL deductions.

Error: Incorrect NOL and ATNOL calculations.

Solution: The NOL calculation on Form 1045, Schedule A and ATNOL calculations must include all non-business and business capital gains and losses equal to the net capital gains or losses from Form 1040, Schedule D Capitol Gains and Losses.

Error: Recalculating charitable contributions based on an NOL carryback.

Solution: The charitable contributions on Form 1040 Schedule A, Itemized Deductions, are not changed by an NOL carryback. Only carryforward losses (where the loss year occurred before the carryover year) will affect the adjusted gross income for computing the percentages for allowable contributions.

Deadline for NOL carryback elections:

Error: Election to waive carryback period filed late.

Solution: To make the election to carry an NOL and ATNOL forward without first carrying it back, the election must have been made with the original loss year return, or filed with a Form 1040X within six months of the original due date (excluding extensions) of the loss year return. If the election was not timely made, the NOL must be carried back before being carried forward. Remember to attach a copy of the timely election to the return where the NOL is carried forward.

Error: Failure to provide a breakdown of how each NOL changed the tax figures when combining multiple years' NOL carrybacks on the same Form1040X.

Solution: If you are carrying over more than one NOL, apply each one separately, starting with the earliest one to determine your NOL deduction. Attach a copy of each separate computation to your 1040X.

Error: Combining changes to other income/deductions on a prior year return that are not related to an NOL carryback adjustment.

Solution: NOLs have different processing dates and statutory requirements than regular tax changes. Therefore, non-NOL adjustments must be made on a separate amended return.

For additional information on net operating losses, see Publication 536, Form 1045 and instructions. Forms and publications are available by download from the IRS Web site, or by calling toll free 1-800-TAX-FORM (1-800-829-3676).

Deadline for NOL carryback refunds:

NOL carrybacks must be filed within three years of the original due date of the tax return for the tax year of the loss being carried back.  Otherwise the portion that must be carried back is in effect lost since any resulting refund is forfeited as a late filing penalty.  Any remaining carryback losses, that are then being carried forward are reduced by the portions used up in computing the forfeited refunds.

Net Operating Loss (NOL) form 1045 and 1040X preparation (corporations use 1138, 1139 & 1120X):

Instructions for form 1045:
http://www.irs.gov/pub/irs-pdf/i1045.pdf

What to Attach
Attach copies of the following, if applicable, to Form 1045 for the year of the loss or credit:

• If you are an individual, page 1 and 2 of your loss-year Form 1040 and Schedule A, D and J (Form 1040), if applicable.
• Any Form 4952, Investment Interest Expense Deduction, attached to your loss-year income tax return.
• All Schedules K-1 you received from partnerships, S corporations, estates, or trusts that contribute to the carryback.
• Any application for extension of time to file your loss-year income tax return
• All Forms 8271, Investor Reporting of Tax Shelter Registration Number, attached to your loss-year income tax return.
• All Form 8886 Reportable Transaction Disclosure Statement, attached to your loss-year income tax return.
• Forms 8302. Electronic Deposit of Tax Refund of $1 Million or More.
• All other forms and schedules from which the carryback results, such as Schedule C or F (Form 1040), Form 3800, General Business Credit, Form 6781, Gains and Losses Form 6781, gains and Losses From Section 1256 Contracts and Straddles, or Form 8586 Low-Income Housing Credit, and
   
• All forms and schedules for items refigured in the carryback year(s), such as Form 3800, Form 6251, Alternative Minimum Tax - Individuals, Form 6781, Form 8586, From 8844, Empowerment Zone and Renewal Community Employment Credit, or Form 8884, New York Liberty Zone Business Employee Credit.

Instructions for form 1040X:
http://www.irs.gov/pub/irs-pdf/i1040x.pdf

Net operating loss (NOL). Attach a computation of your NOL using Schedule A (Form 1045) and any carryover using Schedule B (Form 1045). A refund based on an NOL should not include a refund of self-employment tax reported on Form 1040X, line 9. See Pub. 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts, for details.

Carryback claims. You must attach copies of the following if Form 1040X is used as a carryback claim.

• Both pages of Form 1040 and Schedules A and D, if applicable, for the year in which the loss or credit originated. Enter "Attachment to Form 1040X - Copy Only - Do Not Process" at the top of these forms.
• Any Schedules K-1 you received from any partnership, S corporation, estate, or trust for the year of the loss or credit that contributed to the loss or credit carryback.
• Any form or schedule from which the carryback results, such as Form 3800, Form 6781 or Schedule C or F.
• Forms or schedule from which the carryback results, such as Form 6251, Form 3800, or Schedule A.

Using form 1040X to deal with a CP2000 notification:

CP2000 notices are sometimes so complicated that the preparation of an amended tax return, Form 1040X, is the best way to address any errors made on the original Form 1040. A problem in doing this is that the IRS mail room upon seeing a 1040X is not letting the CP2000 dept people see it, rather they reship it away to another dept that is very overworked.

The IRS CP2000 notices dept, fed up with the slow processing of 1040X's, now requests that you send them a full photocopy of the 1040X and it's supporting statements with the CP2000 notice firmly stapled on top of it (the trick is to hide the 1040X under the CP2000 paperwork).  ALSO in red ink across the top of the page #1 of the 1040X write "CP2000 RESPONSE" Send the package of materials to the address shown on the CP2000 notice.

Statute of Limitations limited to three years, not six years for traders that report each individual sale:

A taxpayer overstated the tax basis (cost) of sales that were made during the year.  In Bakersfield Energy Partners, 128 TC No. 17   6/14/07 the Tax Court decided that the IRS was not entitled to assess the underpaid tax by using the special six year look-back statute of limitations that is applicable when a taxpayer omits more than 25% of gross income pursuant to IR Code §6501(e).  The logic as stated by the court in denying the IRS the six year statute of limitations was that there was no "omission" since the sale was actually reported on the tax return (see IR Code §6501(e)(1)(A)(ii)).

Statute of Limitations limited to three years, not six years for partners who overstated basis:

Partners overstated their deductible basis on a  §754 election by their partnership (husband and wife partnership).  In Grapeview Imports Ltd v. U.S., No 05-296T Fed. Cl. 7/17/07 the Court decided that the IRS was not entitled to assess the underpaid tax by using the special six year look-back statute of limitations that is applicable when a taxpayer omits more than 25% of gross income pursuant to IR Code §6501(e)(1)(A).  The logic as stated by the court in denying the IRS the six year statute of limitations was based on US Supreme Court Colony Inc v. Comr, 357 U.S. 28 1958 and Bakersfield Energy Partners LP (above) - that there was no "omission" since the sale was actually reported on the tax return (see IR Code §6501(e)(1)(A)(ii))

Rev. Rul. 87-115 regarding tiered partnerships §754 elections:

Rev. Rul. 87-115, 1987-2 C.B. 163

ISSUES
Under section 26 USC 743(b) of the Internal Revenue Code, does a sale of an interest in an upper-tier partnership (UTP) result in an adjustment to the basis of the property of a lower-tier partnership (LTP) in which UTP has an interest if:

1. both UTP and LTP have made an election under section 26 USC 754?
2. Only UTP has made the election under section 26 USC 754?
3. only LTP has made the election under section 26 USC 754?

FACTS
UTP is a partnership in which A, B, C, and D are equal partners. A, B, C, and D each contributed 30x dollar interest in partnership capital and surplus. A's share of the adjusted basis of partnership property is 30x dollars, the sum of A's interest as a partner in partnership capital and surplus, plus A's share of partnership liabilities (neither UTP nor LTP have any liabilities). UTP is an equal partner in LTP, along with X and Y. LTP was formed by X, Y, and Z, who each contributed 110x dollars of cash to LTP upon its formation. UTP purchased its interest in LTP from Z for 80x dollars in a taxable year for which LTP did not have an election under section 26 USC 754 in effect. UTP, X, and Y each have a 110x dollar interest in partnership capital and surplus.

UTP has an adjusted basis of 120x dollars in its property as follows: an adjusted basis of 80 dollars in its partnership interest in LTP and an adjusted basis of 40x dollars in inventory. UTP's partnership interest in LTP has a fair market value of 120x dollars, and UTP's inventory has a fair market value of 80x dollars. LTP has only one asset, a capital asset that is not a section 26 USC 751 asset. LTP's asset has an adjusted basis of 330x dollars and a fair market value of 360x dollars.

In 1985, A sold A's entire interest in UTP to E for 50x dollars.

SITUATION 1
Both UTP and LTP have valid section 26 USC 754 elections in effect.

SITUATION 2
UTP has a section 26 USC 754 election in effect, but LTP does not.

SITUATION 3
UTP does not have a section 26 USC 754 election in effect, but LTP does.

LAW AND ANALYSIS
Section 26 USC 742 of the Code provides that the basis of an interest in a partnership acquired other than by contribution shall be determined under part II of subchapter O of chapter 1 (sections 26 USC 1011 through 26 USC 1015).

Section 26 USC 1012 of the Code provides, with certain exceptions, that the basis of property shall be the cost of such property.

Section 26 USC 754 of the Code provides that if a partnership files an election, in accordance with regulations prescribed by the Secretary, the basis of partnership property shall be adjusted, in the case of a transfer of a partnership interest, in the manner provided in section 26 USC 743(b). Such election shall apply with respect to all transfers of interests in the partnership during the taxable year with respect to which such election was filed and all subsequent years.

Section 26 USC 743(a) of the Code provides the general rule that the basis of partnership property shall not be adjusted as the result of a transfer of an interest in a partnership by sale or exchange or on the death of a partner unless the election provided by section 26 USC 754 is in effect with respect to such partnership.

Section 26 USC 743(b) of the Code provides that, in the case of a transfer of an interest in a partnership by sale or exchange or upon the death of a partner, a partnership with respect to which the election provided in section 26 USC 754 is in effect shall (1) increase the adjusted basis of partnership property by the excess of the basis to the transferee partner of such partner's interest in the partnership over the partner's proportionate share of the adjusted basis of partnership property; or (2) decrease the adjusted basis of partnership property by the excess of the transferee partner's proportionate share of the adjusted basis of partnership property over the basis of such partner's interest in the partnership. Section 26 USC 743(b) further provides that the increase or decrease shall be an adjustment to the basis of partnership property with respect to the transferee partner only.

Section 26 CFR 1.743-1(b)(1) of the Income Tax Regulations provides that, in general, a partner's share of the adjusted basis of partnership property is equal to the sum of that partner's interest as a partner in partnership capital and surplus, plus that partner's share of partnership liabilities.

Section 26 USC 755(a) of the Code requires that, in general, the amount of the basis adjustment be allocated among partnership assets in a manner which has the effect of reducing the difference between the fair market value and the adjusted basis of those assets, or in any other manner permitted by the regulations prescribed by the Secretary.

Section 26 USC 755(b) of the Code provides that in applying the allocation rules provided in section 26 USC 755(a), increases or decreases in the adjusted basis of partnership property arising from the transfer of an interest attributable to (1) capital assets and property described in section 26 USC 1231(b)("capital assets"), or (2) any other property of the partnership, shall in general be allocated to partnership property of like character.

Section 26 CFR 1.755-1(b)(2) of the Income Tax Regulations provides that to the extent an amount paid by a purchaser of a partnership interest is attributable to the value of capital assets, any difference between the amount so attributable and the transferee partner's share of the partnership basis of such property shall constitute a special basis adjustment with respect to partnership capital assets. Similarly, any such difference attributable to any other property of the partnership shall constitute a special basis adjustment with respect to such property.

Section 26 USC 741 of the Code provides that, except as provided in section 26 USC 751, the gain or loss on the exchange of an interest in a partnership shall be considered as a gain or loss from the sale of a capital asset.

Rev. Rul. 78-2, 1978-1 C.B. 202, concerns the transfer of an interest in an investment partnership, X, which is a partner of an operating partnership, Y. The ruling concludes that if elections under section 26 USC 754 of the Code are in effect for X and Y, the adjustment to the basis of partnership property under section 26 USC 743(b) includes (a) an adjustment to X's partnership interest in Y and (b) a corresponding basis adjustment to Y's property with respect to X and the transferee partner of X only.

In essence, if an election under section 26 USC 754 is not in effect, the partnership is treated as an independent entity, separate from its partners. Thus, absent a section 26 USC 754 election, even though the transferee receives a cost basis for the acquired partnership interest, the partnership does not adjust the transferee's share of the adjusted basis of partnership property. If, however, an election under section 26 USC 754 is in effect, the partnership is treated more like an aggregate of its partners, and the transferee's overall basis in the assets of the partnership is generally the same as it would have been had the transferee acquired a direct interest in its share of those assets. Nevertheless, the transferee's adjusted basis for specific partnership assets will not necessarily equal the basis the assets would have had if the transferee had acquired a direct interest in the assets. The difference is due to the fact that the transferee's basis in specific partnership assets is controlled by section 26 USC 755, which does not adopt a pure aggregate approach. See section 26 CFR 1.755-1(c) of the regulations.

SITUATION 1
E purchased A's interest for 50x dollars. Thus, under section 26 USC 742, E's basis in E's partnership interest is 50x dollars. Because UTP made a valid section 26 USC 754 election, under section 26 USC 743(b) UTP must increase the adjusted basis of its property by 20x dollars, the excess of the transferee partner's basis in the partnership interest (50x dollars) over the partner's share of the adjusted basis of such property. Under section 26 CFR 1.743-1(b)(1), E's share of the adjusted basis of partnership property is 30x dollars, because E succeeds to A's interest in partnership capital and surplus. See, e.g., section 26 CFR 1.743-1(b)(1) Example (2). The 20x dollar special basis adjustment raises UTP's adjusted basis in its partnership property to 140x dollars, but the additional 20x dollars must be segregated and allocated solely to E. Under section 26 USC 755, the 20x dollars must be allocated between capital assets (UTP's interest in LTP) and other assets (UTP's inventory).

Under section 26 CFR 1.755-1(b)(2) of the regulations, to the extent that an amount paid by a purchaser of a partnership interest (here, 50x dollars) is attributable to the value of capital assets (here, 120x dollars, the value of UTP's interest in LTP), any difference between the amount so attributable and the transferee partner's share of the partnership basis of such property constitutes a special basis adjustment with respect to such capital assets. In the instant case, 30x dollars (60 percent of 50x dollars) of E's purchase price is attributable to the value of UTP's interest in LTP, because 120x dollars, the value of UTP's interest in LTP, is 60 percent of 200x dollars, the total value of UTP's property. Thus, 10x dollars, the difference between the 30x dollars attributable to the value of UTP's interest in LTP and 20x dollars, E's proportionate share of UTP's basis in LTP, is a special basis adjustment to UTP's interest in LTP. This adjustment gives E an adjusted basis of 30x dollars in UTP's in LTP. The remaining 10x dollars of the 20x dollar special basis adjustment is allocated to the adjusted basis of UTP's inventory. This gives E a 20x dollar adjusted basis in UTP's inventory.

Because UTP made a section 26 USC 754 election manifesting an intent to be treated as an aggregate for purposes of sections 26 USC 754 and 26 USC 743, it is appropriate, for purposes of section 26 USC 743 and 26 USC 754, to treat the sale of A's partnership interest in UTP as a deemed sale of an interest in LTP. The selling price of E's share of UTP's interest in LTP is deemed to equal E's share of UTP's adjusted basis in LTP, 30x dollars (1/4 of 80x dollars plus 10x dollars, E's special basis adjustment). Further, this deemed sale of an interest in LTP triggers the application of section 26 USC 743(b) to LTP. Because LTP made a valid section 26 USC 754 election, under section 26 USC 743(b) LTP must increase the adjusted basis of its partnership property by 2.5x dollars, the excess of E's share of UTP's adjusted basis in LTP (30x dollars) over E's share of the adjusted basis of LTP's property (1/4 of 110x dollars, or 27.5 dollars). Section 26 USC 755 applies to LTP to allocate this basis adjustment, but because LTP has only one asset, no allocation is necessary. The 2.5x dollar adjustment must be segregated and allocated solely to UTP and E, the transferee partner of UTP.

SITUATION 2
UTP has made a valid section 26 USC 754 election. Thus, as in SITUATION 1, E gets an adjusted basis of 30x dollars in UTP's interest in LTP and an adjusted basis of 20x dollars in UTP's inventory. Also, as in SITUATION 1, because UTP made a section 26 USC 754 election, it is appropriate, for purposes of sections 26 USC 754 and 26 USC 743, to treat the sale of A's interest in UTP as the sale of an interest in LTP. However, in this situation, LTP does not have a section 26 USC 754 election in effect. That is, under section 26 USC 743(a), LTP chose not to have the basis of its property adjusted as the result of the transfer of an interest in it. Thus, E's purchase of a partnership interest in UTP has no effect on LTP's adjusted basis in its property.

SITUATION 3
LTP has made a valid election under section 26 USC 754, but UTP does not make a section 26 USC 754 election. On the sale by A of an interest in UTP, E succeeds to A's 20x dollar adjusted basis in UTP's interest in LTP and to A's 10x dollar adjusted basis in UTP's inventory. E succeeds to these bases because, by not making a section 26 USC 754 election, UTP chose not to have the basis of its property adjusted as the result of the transfer of an interest in UTP.

In addition, by not making a section 26 USC 754 election, UTP manifested an intent to be treated as an entity for purposes of sections 26 USC 754 and 26 USC 743. Thus, it is inappropriate, for purposes of sections 26 USC 754 and 26 USC 743, to treat A's sale of an interest in UTP as the sale of an interest in LTP. Consequently, UTP cannot increase E's share of the basis of LTP's property. Nevertheless, LTP's section 26 USC 754 election is not meaningless. If UTP were to sell its partnership interest in LTP, the purchaser's share of the adjusted basis of LTP's assets would be adjusted.

HOLDINGS

SITUATION 1
Upon the sale of A's partnership interest in UTP, the transferee's (E's) shares of UTP's adjusted basis in its assets is adjusted by the amount by which the basis in E's partnership interest differs from E's share of UTP's adjusted basis in its assets. In addition, E's share of LTP's adjusted basis in its assets is adjusted by the amount by which E's share of UTP's adjusted basis in LTP differs from E's share of the adjusted basis of LTP's property.

SITUATION 2
Upon the sale of A's partnership interest in UTP, E's share of UTP's adjusted basis in its assets is adjusted by the amount by which the basis in E's partnership interest differs from E's share of UTP's adjusted basis in its assets. However, because LTP did not make a section 26 USC 754 election, the transfer does not affect LTP's adjusted basis in its property.

SITUATION 3
The sale of A's partnership interest in UTP does not affect either UTP's adjusted basis in its property or LTP's adjusted basis in its property.

EFFECT ON OTHER REVENUE RULINGS.
Rev. Rul. 78-2 is clarified and amplified.
 

Rev. Rul. 91-26 partner compensation (no form W-2 is to be issued to partners nor to sole-proprietors):

Rev. Rul 91-26 "Section 26 USC 707(c) of the Code provides that payments to a partner for services, to the extent the payments are determined without regard to the income of the partnership, are considered as made to one who is not a member of the partnership, but only for purposes of section 26 USC 61(a) (relating to gross income)and, subject to section 26 USC 263 (prohibiting deductions for capital expenditures), for purposes of section 26 USC 162(a) (relating to trade or business expenses). These payments are termed 'guaranteed payments.'"

Regs. §1.707-1(c) "a partner who receives guaranteed payments is not regarded as an employee of the partnership for the purposes of withholding of tax at source, deferred compensation plans, etc."

Rev. Rul. 81-300  "the statutory test for a guaranteed payment, that it be 'determined without regard to the income of the partnership'"

Rev. Rul. 81-300  "Section 26 USC 707(c) of the Code provides that to the extent determined without regard to the income of the partnership, payments to a partner for services, termed "guaranteed payments", shall be considered as made to one who is not a member of the partnership, but only for purposes of section 26 USC 61(a) and, subject to section 26 USC 263, for purposes of section 26 USC 162(a)."

Rev. Rul. 81-301  "Section 26 USC 707(c) of the Code provides that to the extent determined without regard to the income of the partnership, payments to a partner for services shall be considered as made to one who is not a member of the partnership, but only for purposes of section 26 USC 61(a) and, subject to section 26 USC 263, for purposes of section 26 USC 162(a). "

Rev. Rul. 69-184  "26 CFR 31.3121(d)-1: Who are employees.   Bona fide members of a partnership are not employees of the partnership within the meaning of the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Collection of Income Tax at Source on Wages (chapters 21, 23, and 24, respectively, subtitle C, Internal Revenue Code of 1954).  Such a partner who devotes his time and energies in the conduct of the trade or business of the partnership, or in providing services to the partnership as an independent contractor, is, in either event, a self-employed individual rather than an individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee. Sections 26 USC 1402(a) and 26 USC 3121(d)(2) of the Code."

Rev. Rul. 69-184  "Remuneration received by a partner from the partnership is not "wages" with respect to "employment" and therefore is not subject to the taxes imposed by the Federal Insurance Contributions Act and the Federal Unemployment Tax Act. Such remuneration also is not subject to Federal income tax withholding."

Rev. Rul. 69-183  "An individual is an employee for Federal employment tax purposes if he has the status of employee under the usual common law rules applicable in determining the employer-employee relationship. Guides for determining that status are found in three substantially similar sections of the Employment Tax Regulations: namely, sections 26 CFR 31.3121(d)-1(c), 26 CFR 31.3306(i)-1, and 26 CFR 31.3401(c)-1."

Rev. Rul. 72-467  "The right to discharge is also an important factor indicating that the person possessing that right is an employer. If the relationship of employer and employee exists, the designation or description of the relationship by the parties as anything other than employer and employee is immaterial. Thus, if such relationship exists, it is of no consequence that the employee is designated as a partner, coadventurer, agent, independent contractor, or the like."

---

---

Rev. Rul. 73-361 and Rev. Rul. 82-83 stockholder-officer of s-corporation is an employee, form W-2 is to be issued:

Rev. Rul. 73-361

Advice has been requested whether a stockholder-officer of an electing small business corporation should be treated as a partner or as an employee for purposes of the Federal Insurance Contributions Act (chapter 21, subtitle C, Internal Revenue Code of 1954).

The corporation is a small business corporation, as defined in section 1371 of the Code, that has elected, pursuant to section 1372(a), not to be subject to the corporate income tax, but to have all its income taxed directly to its shareholders.

During 1972, the majority stockholder was an officer of the corporation, and performed substantial services for the corporation in that capacity for which he was paid a salary.

Section 3121(d)(1) of the Federal Insurance Contributions Act provides that, for purposes of the taxes imposed by this Act, the term "employee" means any officer of a corporation.   Section 31.3121(d)-1(b) of the Employment Tax Regulations provides that an officer who, as such, does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation.

Neither the election by the corporation as to the manner in which it will be taxed for Federal income tax purposes nor the consent thereto by the stockholder-officers has any effect in determining whether they are employees or whether payments made to them are "wages" for Federal employment tax purposes. A corporation does not lose its identity by reason of such an election but remains a legal corporate entity and is required, under section 6037 of the Code, to file a return containing information needed to comply with the provisions of Subchapter S of the Code.

Since the stockholder-officer in the instant case performed substantial services for the electing small business corporation, for which he received remuneration, he is an employee of the corporation.

Accordingly, the "wages" he received in 1972 for his services as an officer are subject to the taxes imposed by the Federal Insurance Contributions Act. This conclusion is also applicable for purposes of the Federal Unemployment Tax Act and the Collection of Income Tax at Source on Wages (chapters 23 and 24, respectively, subtitle C of the Code).

---

Rev. Rul. 82-83 EMPLOYER-EMPLOYEE; CORPORATE OFFICERS

ISSUE

Is a corporation that treats officers as independent contractors rather than as employees when they are performing duties normally within the scope of duties of a corporate officer entitled to relief under section 530 of the Revenue Act of 1978 (the Act), 1978-3 (Vol. 1) C.B. 1, 119, extended by section 9(d) of Pub. L. 96-167, 1980-1 C.B. 483, 486, and by section 1 of Pub. L. 96- 541, 1980-2 C.B. 596?

FACTS

A corporation, which is owned by its two officers (president and vice- president/treasurer, respectively) operates a summer theater. The officers perform substantial services for the corporation, including deciding on productions to be performed, setting admission prices, and hiring performers. The officers control and direct all of the operations of the theater and determine the amount of their own compensation, the hours of their employment, and the duties they will perform.

The corporation treats the officers as independent contractors rather than employees and pays them compensation characterized as 'draws' rather than 'salaries.' In treating the officers as independent contractors, the corporation does not rely on any basis that would fall within the 'safe haven' provisions of section 530(a)(2)(A), (B), or (C) of the Act.

LAW AND ANALYSIS

Section 530 of the Act provides relief from employment tax liability to eligible taxpayers who have failed to pay or withhold employment taxes on remuneration paid to workers because the taxpayers did not regard them as employees. Section 530(a)(1), as extended, provides, in general, that if a taxpayer did not treat an individual as an employee for any period ending before July 1, 1982, the individual will be deemed not to be an employee for purposes of applying employment taxes for the period unless the taxpayer had no reasonable basis for treating the individual as other than an employee.

Section 530(a)(2) provides several alternative standards that constitute 'safe havens' in determining whether a taxpayer has a 'reasonable basis' for not treating an individual as an employee. Reasonable reliance on any one of the following 'safe havens' is sufficient:

(A) Judicial precedent or published rulings (whether or not relating to the particular industry or business in which the taxpayer is engaged), technical advice, a letter ruling, or a determination letter pertaining to the taxpayer.

(B) A past Internal Revenue Service audit (not necessarily for employment tax purposes) of the taxpayer, if the audit entailed no assessment attributable to the taxpayer's employment tax treatment of individuals holding positions substantially similar to that held by the individual whose status is at issue. However, a taxpayer does not meet this test if, in the conduct of a prior audit, an assessment attributable to the taxpayer's treatment of the individual was offset by other claims asserted by the taxpayer.

(C) Long-standing recognized practice of a significant segment of the industry in which the individual was engaged. It is not necessary that the practice be uniform throughout an entire industry.

Taxpayers who fail to meet any of these three 'safe havens' may nevertheless be entitled to relief if they can demonstrate, in some other manner, a reasonable basis for not treating the individual as an employee. The term 'reasonable basis' should be construed liberally in favor of the taxpayer.

Sections 3121(d) and 3401(c) of the Internal Revenue Code, applicable to the Federal Insurance Contributions Act and income tax withholding, respectively, provide that the term 'employee' includes any officer of a corporation. Section 3306(i), applicable to the Federal Unemployment Tax Act, includes within the meaning of the term 'employee' the meaning assigned by section 3121(d).

Section 31.3121(d)-1(b) of the Employment Tax Regulations states that, generally, an officer of a corporation is an employee of the corporation. However, an officer of a corporation who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any pay is considered not to be an employee of the corporation. For instance, directors of corporations in their capacity as such are not employees of the corporations.

Rev. Rul. 71-86, 1971-1 C.B. 285, holds that when an individual who is the president and sole shareholder, except for qualifying shares, of a closely held corporation performs services as an officer of the corporation, the president is an employee for purposes of employment taxes and income tax withholding, even though all services performed and the amount of compensation for them are under the individual's complete control.

Rev. Rul. 73-361, 1973-2 C.B. 331, holds that a stockholder-officer of an electing small business corporation who performs substantial services as an officer of the corporation is its employee for purposes of the FICA, the FUTA, and income tax withholding.

In Royal Theatre Corp. v. United States, 66 F. Supp. 301 (D. Kan. 1946), the sole shareholder and president of two corporations contracted with each for him to manage each corporation's operations and to determine matters of policy for each corporation. The court observed that compensation an officer receives for services as an officer is subject to social security taxes, and held that the contracts by which the president of each corporation purportedly managed the affairs of each corporation as an independent contractor could be disregarded in determining the reality of the situation.

It is a question of fact in all cases whether officers of a corporation are performing services within the scope of their duties as officers or whether they are performing services as independent contractors. Here, the duties being performed customarily fall within the scope of duties of corporate officers. Involved are fundamental decisions regarding the operation of the corporation. Such decisions are rarely delegated to independent contractors, and are customarily made by corporate officers or other employees. Thus, since the officers are performing substantial services typical of officers and are paid for those services, they are employees of the corporation for purposes of federal tax law. Therefore, even though the corporation calls the officers' pay 'draws' rather than 'salaries,' there is no reasonable basis for treating the officers as other than employees, even under a liberal application of the reasonable basis rule of section 530 of the Act.

HOLDING

The corporation is not entitled to relief under section 530 of the Act.

---

---

Partnership - Audit Technique Guide - Chapter 7 - Dispositions of Partnership Interest:

http://www.irs.gov/businesses/partnerships/article/0,,id=134696,00.html

Supporting Law

Revenue Ruling 84-52, 1984-1 C.B. 157  -  The conversion of a general partner interest into a limited partner interest, and vice versa, within the same partnership, generally will result in no gain or loss recognition by the partner under section 741 or 1001 of the Code.

Revenue Ruling 84-53, 1984-1 C.B. 159  -  Rev. Rul. 84-53 illustrates basis allocations and adjustments that may occur when a partner owns multiple interests in a partnership and disposes of only a portion of such interests.

Revenue Ruling 95-37, 1995-1 C.B. 130  -  This ruling treats the conversion of a partnership interest into an LLC interest in much the same manner as conversions described in Rev. Rul. 84-52.

Crenshaw v. United States , 450 F.2d 472 (5th Cir. 1971)  -  The court found, in a case of substance versus form, that a series of transactions in which the taxpayer claimed tax-free liquidation treatment under IRC section 736(b) followed by a tax-free exchange of like-kind property under IRC section 1031 amounted to a sale of a partnership interest.

Pollack v. Commissioner, 69 T.C. 142 (1977)  -  The Tax Court ruled that the loss resulting from the disposition of a partner’s interest in a partnership should be characterized as a capital loss pursuant to IRC section 741 rather than an ordinary business loss, as the taxpayer had claimed. Characterization of a partnership interest as a capital asset neither depends on the taxpayer’s motive when acquiring the interest nor the fact that treatment would be different if the taxpayer had established the enterprise as a business other than a partnership.

---

---

Capital Loss Carryback  / Carryforward election:

TBA

LLC members' tax deductions based on actual capital contribution / basis:

Proposed IRS Regulation §1.465-6(d) says that an LLC member MAY NOT DEDUCT LLC K-1 LOSSES to the extent that they exceed his capital contribution. Even if that LLC member has guaranteed the debts of the LLC - UNLESS, that particular LLC member has actually paid the debt AND has no right to be reimbursed from the LLC or from the other members.

Search this link of an IRS Auditor Guide excerpt for the word * Guarantees * for the IRS position on this: http://www.irs.gov/businesses/partnerships/article/0,,id=134694,00.html

If you deposit additional cash into an LLC before the end of the year that should help cure this issue.
But be aware that there's also new 2008 rules regarding the old-school s-corp trick of removing the cash back out early in the following year.
These new rules became effective for any money loaned to the entity after October 20, 2008. While the rules deal specifically with s-corps the implications can be that LLC members trying to circumvent §1.465-6(d) should be cautious as well. http://www.irs.gov/irb/2008-47_IRB/ar09.html

Entity Classification Election:

Also see Rev. Proc. 2004-48, 2004-32 I.R.B. 172 (8/9/2004) below

S-Corp election: Rev. Proc. 2007-62, 2007-166 I.R.B. (10/9/2007) late election of S-Corp status:

Rev. Proc. 2007-62,

SECTION 1. PURPOSE
This revenue procedure provides an additional simplified method for taxpayers to request relief for late S corporation elections and supplements Rev. Proc. 2003-43, 2003-1 C.B. 998. In addition, this revenue procedure provides a simplified method for taxpayers to request relief for a late S corporation election and a late corporate classification election intended to be effective on the same date that the S corporation election was intended to be effective and supplements Rev. Proc. 2004-48, 2004-2, C.B. 172. Generally, this revenue procedure provides that certain eligible entities may be granted relief if the entity satisfies the requirements of sections 4 or 5 (as applicable) of this revenue procedure.

SECTION 2. BACKGROUND
.01 S Corporation Elections.
(1) In General. Section 1361(a)(1) of the Internal Revenue Code (Code) provides that the term "S corporation" means, with respect to any taxable year, a small business corporation for which an election under § 1362(a) is in effect for that year. Section 1362(b)(1) provides that a small business corporation may make an election to be an S corporation for any taxable year (A) at any time during the preceding taxable year, or (B) at any time during the taxable year and on or before the 15th day of the 3rd month of the taxable year. Section 1.1362-6(a)(2) of the Income Tax Regulations provides that a small business corporation makes an election to be an S corporation by filing a completed Form 2553, Election by a Small Business Corporation. Under ' 1362(b)(3), if an S corporation election is made after the 15th day of the 3rd month of the taxable year and on or before the 15th day of the 3rd month of the following taxable year, then the S corporation election is treated as made for the following taxable year.

(2) Late S Corporation Elections. Section 1362(b)(5) provides that if (A) an election under ' 1362(a) is made for any taxable year (determined without regard to ' 1362(b)(3)) after the date prescribed by ' 1362(b) for making the election for the taxable year or no election is made for any taxable year, and (B) the Secretary determines that there was reasonable cause for the failure to timely make the election, the Secretary may treat the election as timely made for the taxable year (and ' 1362(b)(3) shall not apply). Rev. Proc. 97-48, 1997-2 C.B. 521 provides special procedures to obtain automatic relief for certain late S corporation elections. Generally, relief is available in situations in which a corporation intends to be an S corporation, the corporation and its shareholders reported their income consistent with S corporation status for the taxable year the S corporation election should have been made and for every subsequent year, and the corporation did not receive notification from the Internal Revenue Service regarding any problem with the S corporation status within 6 months of the date on which the Form 1120S, U.S. Income Tax Return for an S Corporation, for the first year was timely filed.

Rev. Proc. 2003-43 provides, in part, a simplified method for a taxpayer to request relief for a late S corporation election where the entity fails to qualify as an S corporation solely because of the failure to file the election timely with the applicable campus. Under the revenue procedure, certain entities may be granted relief for failing to file the elections in a timely manner if the request for relief is filed within 24 months of the due date of the election.

.02 Entity Classification Elections.
(1) In General. Section 301.7701-2(a) of the Procedure and Administration Regulations defines a “business entity” as any entity recognized for federal tax purposes that is not properly classified as a trust under § 301.7701-4 or otherwise subject to special treatment under the Code. Section 301.7701-3(a) provides that a business entity that is not classified as a corporation under § 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)(1) provides that, except as otherwise provided in paragraph (b)(3) of the section, unless the entity elects otherwise, a domestic eligible entity is (i) a partnership if it has two or more members; or (ii) disregarded as an entity separate from its owner if it has a single owner. Section 301.7701-3(c)(1) provides that, except as provided in § 301.7701- 3(c)(1)(iv) and (v), an eligible entity may elect to be classified other than as provided in § 301.7701-3(b) by filing Form 8832, Entity Classification Election, with the campus designated on Form 8832. Section 301.7701-3(c)(iii) provides that the entity classification election will be effective on the date specified by the entity on the Form 8832 or on the date filed if no date is specified on the election form. The effective date specified on Form 8832 can not be more than 75 days prior to the date on which the election is filed and can not be more than 12 months after the date on which the election is filed. If an election specifies an effective date more than 75 days prior to the date on which the election is filed, the election will be effective 75 days prior to the date it was filed. If an election specifies an effective date more than 12 months from the date on which the election is filed, the election will be effective 12 months after the date the election was filed. (2) Late Entity Classification Elections. Under § 301.9100-1(c), the Commissioner may grant a reasonable extension of time under the rules set forth in §§ 301.9100-2 and 301.9100-3 to make a regulatory election, or a statutory election (but no more than 6 months except in the case of a taxpayer who is abroad), under all subtitles of the Code, except subtitles E, G, H, and I. Section 301.9100-1(b) defines the term “regulatory election” as an election whose due date is prescribed by a regulation published in the Federal Register, or a revenue ruling, revenue procedure, notice, or announcement published in the Internal Revenue Bulletin.

Requests for relief under § 301.9100-3 will be granted when the taxpayer provides the evidence to establish to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the Government. Rev. Proc. 2002-59, 2002-2 C.B. 615, provides guidance for an entity newly formed under local law that requests relief for a late initial classification election filed by the due date of the entity's first federal income tax return (excluding extensions). Under § 301.7701-3(c)(1)(v)(C), an eligible entity that timely elects to be an S corporation under § 1362(a)(1) is treated as having made an election to be classified as an association, provided that (as of the effective date of the election under § 1362(a)(1)) the entity meets all other requirements to qualify as a small business corporation under § 1361(b). Section 301.7701-3(c)(1)(v)(C) further provides that, subject to § 301.7701-3(c)(1)(iv), the deemed election to be classified as an association generally will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election under § 301.7701-3(c)(1)(i), to be classified as other than an association. Rev. Proc. 2004-48 provides a simplified method for taxpayers to request relief for a late S corporation election and a late corporate classification election which was intended to be effective on the same date the S corporation election was intended to be effective. Under Rev. Proc. 2004-48, generally, certain eligible entities may be granted relief if the requirements of section 4 of the revenue procedure are satisfied. To obtain relief under Rev. Proc. 2004-48, the entity must file a properly completed Form 2553 with the applicable campus within 6 months after the due date for the tax return, excluding extensions, for the first taxable year the entity intended to be an S corporation. Attached to the Form 2553 must be a statement explaining the reason for the failure to file timely the S corporation election and a statement explaining the reason for the failure to file timely the entity classification election.

SECTION 3. SCOPE

.01 In General. This revenue procedure supplements Rev. Proc. 2003-43 and provides an additional simplified method for obtaining relief for a late S corporation election, provided that the requirements of section 4 of this revenue procedure are satisfied. This revenue procedure also supplements Rev. Proc. 2004-48 and provides an additional simplified method for obtaining relief for a late S corporation election and a late corporate classification election, provided that the requirements of section 5 of this revenue procedure are satisfied. Section 4.01 of this revenue procedure provides the eligibility requirements for relief for a late S corporation election, and section 4.02 of this revenue procedure provides the procedural requirements for relief. Section 5.01 of this revenue procedure provides the eligibility requirements for relief for a late S corporation election and a late corporate classification election, and section 5.02 of this revenue procedure provides the procedural requirements for relief. This revenue procedure provides procedures in lieu of the letter ruling process ordinarily used to obtain relief for a late S corporation election and a late corporate classification election filed pursuant to ' 1362(b)(5), ' 301.9100-1 and ' 301.9100-3. Accordingly, user fees do not apply to corrective actions under this revenue procedure. .02 Entities T (1) Rev. Procs. 97-48, 2003-43, and 2004-48. An entity that does not meet the requirements for relief under this revenue procedure may request relief for a late S corporation election following the procedures of Rev. Proc. 97-48, or Rev. Proc. 2003- 43, or, for relief for a late S corporation election and a late corporate classification election following the procedures of Rev. Proc. 2004-48.

(2) Letter Rulings. If an entity does not qualify for relief for a late S corporation election, or relief for a late S corporation election and a late corporate classification election, under Rev. Proc. 97-48, Rev. Proc. 2003-43, or Rev. Proc. 2004-48, as appropriate, the entity may request relief by requesting a letter ruling. The Service will not ordinarily issue a letter ruling if the period of limitations on assessment under § 6501(a) has lapsed for any taxable year for which an election should have been made or any taxable year that would have been affected by the election had it been timely made. The procedural requirements for requesting a letter ruling are described in Rev. Proc. 2007-1, 2007-1 I.R.B. 1 (or its successor). SECTION 4. RELIEF FOR LATE S CORPORATION ELECTION UNDER THIS REVENUE PROCEDURE

.01 Eligibility for Relief. An entity may request relief under this revenue procedure if the following requirements are met: (1) The entity fails to qualify for its intended status as an S corporation on the first day that status was desired solely because of the failure to file a timely Form 2553 with the applicable campus; (2) The entity has reasonable cause for its failure to file a timely Form 2553; (3) The entity seeking to make the S corporation election has not filed a tax return for the first taxable year in which the election was intended; (4) The application for relief is filed under this revenue procedure no later than 6 months after the due date of the tax return (excluding extensions) of the entity seeking to make the election for the first taxable year in which the election was intended; and (5) No taxpayer whose tax liability or tax return would be affected by the S corporation election (including all shareholders of the S corporation) has reported inconsistently with the S corporation election, on any affected return for the year the S corporation election was intended.

.02 Procedural Requirements for Relief. An entity may request relief for a late S corporation election by filing with the applicable campus a properly completed Form 2553 (see Form 2553 and Instructions) with a Form 1120S for the first taxable year the entity intended to be an S corporation. A properly completed Form 2553 includes a statement establishing reasonable cause for the failure to file the S corporation election timely. The Form 2553 will be modified to allow for the inclusion of such statement. The forms must be filed together no later than 6 months after the due date of the tax return (excluding extensions) of the entity for the first taxable year in which the S corporation election was intended. These items constitute the application requesting relief.

.03 Relief for Late S Corporation Election. Upon receipt of a completed application requesting relief under section 4.02 of this revenue procedure, the Service will determine whether the requirements for granting relief for the late S corporation election have been satisfied.

SECTION 5. RELIEF FOR LATE S CORPORATION ELECTION AND LATE

CORPORATE CLASSIFICATION ELECTION UNDER THIS REVENUE PROCEDURE

.01 Eligibility for Relief. An entity may request relief under this revenue procedure if the following requirements are met:

(1) The entity is an eligible entity as defined in § 301.7701-3(a); (2) The entity intended to be classified as a corporation as of the intended effective date of the S corporation status; (3) The entity fails to qualify as a corporation solely because Form 8832 was not timely filed under § 301.7701-3(c)(1)(i), or Form 8832 was not deemed to have been filed under § 301.7701-3(c)(1)(v)(C);

(4) In addition to section 5.01(3) of this section, the entity fails to qualify as an S corporation on the intended effective date of the S corporation status solely because the S corporation election was not timely filed pursuant to § 1362(b); (5) The entity has reasonable cause for its failure to file a timely Form 2553 and a timely Form 8832; (6) The entity seeking to make the S corporation election has not filed a tax return for the first taxable year in which the election was intended; (7) The application for relief is filed under this revenue procedure no later than 6 months after the due date of the S corporation return (excluding extensions) of the entity seeking to make the election for the first taxable year in which the election was intended, and

(8) No taxpayer whose tax liability or tax return would be affected by the S corporation election (including all shareholders of the S corporation) has reported inconsistently with the S corporation election, on any affected return for the year the S corporation election was intended.

.02 Procedural Requirements for Relief. An entity may request relief for a late S corporation election and a late corporate classification election by filing a properly completed Form 2553 (see Form 2553 and Instructions) with a Form 1120S for the first taxable year the entity intended to be an S corporation. A properly completed Form 2553 includes a statement explaining the reason for the failure to file the S corporation election timely and a statement explaining the reason for the failure to file the entity classification election timely. The Form 2553 will be modified to allow for the inclusion of such statements. The forms must be filed together no later than 6 months after the due date of the tax return (excluding extensions) of the entity for the first taxable year in which the S corporation election was intended. These items constitute the application requesting relief. .03 Relief for Late S Corporation Election and Late Corporate Classification Election. Upon receipt of a completed application requesting relief under section 5.02 of this revenue procedure, the Service will determine whether the requirements for granting relief for the late S corporation election and late corporate classification election have been satisfied. An entity receiving relief under this revenue procedure is treated as having made an election to be classified as an association taxable as a corporation under § 301.7701-3(c) as of the effective date of the S corporation election.

SECTION 6. EFFECT ON OTHER DOCUMENTS

This revenue procedure supplements Rev. Procs. 2003-43 and 2004-48.

SECTION 7. EFFECTIVE DATE

This revenue procedure is effective for S corporation elections and corporate classification elections intended to be effective for taxable years that end on or after December 31, 2007.

SECTION 8. DRAFTING INFORMATION

The principal author of this revenue procedure is Jian H. Grant of the Office of the Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue procedure, contact Ms. Grant at (202) 622-3050 (not a toll free call).

S-Corp election: Rev. Proc. 2004-48, 2004-32 I.R.B. 172 (8/9/2004) for LLC's seeking S-Corp status:

Rev. Proc. 2004-48, 2004-32 I.R.B. 172 (8/9/2004)  for LLC's seeking S-Corp status

This revenue procedure provides a simplified method for taxpayers to request relief for a late S corporation election and a late corporate classification election which was intended to be effective on the same date that the S corporation election was intended to be effective. Generally, this revenue procedure provides that certain eligible entities may be granted relief if the entity satisfies the requirements of section 4 of this revenue procedure.

3.01 In General. An eligible entity that seeks to be classified as a subchapter S corporation must elect to be classified as an association under section 301.7701-3(c)(1)(i) by filing Form 8832 and must elect to be an S corporation under section 1362(a) by filing Form 2553, Election by a Small Business Corporation. In many situations, an entity may timely file Form 2553 but fail to file the Form 8832. Section 301.7701-3T(c)(1)(v)(C) applies to these situations and deems an eligible entity that timely files a Form 2553 to also have filed a Form 8832. In other situations, an eligible entity fails to file a timely Form 2553. In these situations, section 301.7701-3T(c)(1)(v)(C) does not apply and the entity would be required to obtain relief in a letter ruling. This revenue procedure provides a simplified method for requesting relief for those situations not covered by section 301.77013T , provided that the requirements of sections 4.01 and 4.02 of this revenue procedure are satisfied. The method provided in this revenue procedure is in lieu of to the letter ruling process ordinarily used to obtain relief for late elections under sections 1362(b)(5), 301.9100-1, and 301.9100-3. Accordingly, user fees do not apply to corrective action under this revenue procedure.

3.02 Relief if this Revenue Procedure is not Applicable. An entity that does not meet the requirements for relief or is denied relief under this revenue procedure may seek relief by requesting a letter ruling. The procedural requirements for requesting a letter ruling are described in Rev. Proc. 2004-1, 2004-1 I.R.B. 1., or its successors.


4.01 Eligibility for Relief. An entity may request relief under this revenue procedure if the following requirements are met:

(1) The entity is an eligible entity as defined in section 301.7701-3(a);

(2) The entity intended to be classified as a corporation as of the intended effective date of the S corporation status;

(3) The entity fails to qualify as a corporation solely because Form 8832 was not timely filed under section 301.7100-3(c)(1)(i), or Form 8832 was not deemed to have been filed under section 301.7701-3T(c)(1)(v)(C);

(4) In addition to section 4.01(3) of this section, the entity fails to qualify as an S corporation on the intended effective date of the S corporation status solely because the S corporation election was not filed timely pursuant to section 1362(b); and

(5) The entity has reasonable cause for its failure to file timely the S corporation election and the entity classification election.

4.02 Procedural Requirements for Relief. Within 6 months after the due date for the tax return, excluding extensions, for the first year the entity intended to be an S corporation), the corporation must file a properly completed Form 2553 with the applicable service center. The Form 2553 must state at the top of the document "FILED PURSUANT TO REV. PROC. 2004-48." Attached to the Form 2553 must be a statement explaining the reason for the failure to file timely the S corporation election and a statement explaining the reason for the failure to file timely the entity classification election.

4.03 Relief for Late S Corporation Election and Relief for a Late Corporate Classification Election. Upon receipt of a completed application requesting relief under section 4 of this revenue procedure, the Service will determine whether the requirements for granting additional time to file the elections have been satisfied and will notify the entity of the result of this determination. An entity receiving relief under this revenue procedure is treated as having made an election to be classified as an association taxable as a corporation under section 301.7701-3(c) as of the effective date of the S corporation election.

Rev. Proc. 2003-43, 2003-23 I.R.B. 998 (6/9/2003) for corporations or LLC's seeking S-Corp status:

This revenue procedure provides a simplified method for taxpayers to request relief for late S corporation elections, Electing Small Business Trust (ESBT) elections, Qualified Subchapter S Trust (QSST) elections and Qualified Subchapter S Subsidiary (QSub) elections. Generally, this revenue procedure provides that certain eligible entities may be granted relief for failing to file these elections in a timely manner if the request for relief is filed within 24 months of the due date of the election. Accompanying this document is a flowchart designed to aid taxpayers in applying this revenue procedure.

This revenue procedure provides procedures in lieu of the letter ruling process ordinarily used to obtain relief for a late Election Under Subchapter S filed pursuant to section 1362(b)(5), section 1362(f), or section 301.9100-1 and section 301.9100-3.

4.02 Eligibility for Relief. Relief is available under section 4.04 of this revenue procedure if the following requirements are met:

(1) The entity fails to qualify for its intended status as an S corporation, ESBT, QSST, or QSub on the first day that status was desired solely because of the failure to file the appropriate Election Under Subchapter S timely with the applicable service center;

(2) Less than 24 months have passed since the original Due Date of the Election Under Subchapter S;

(3) Either,

(a) the entity is seeking relief for a late S corporation or QSub election and the entity has reasonable cause for its failure to make the timely Election Under Subchapter S, or

(b) the S corporation and the entity are seeking relief for an inadvertent invalid S corporation election or an inadvertent termination of an S corporation election due to the failure to make the timely ESBT or QSST election and the failure to file the timely Election Under Subchapter S was inadvertent; and

(4) Either,

(a) all of the following requirements are met: (i) the entity seeking to make the election has not filed a tax return (in the case of QSubs, the parent has not filed a tax return) for the first year in which the election was intended, (ii) the application for relief is filed under this revenue procedure no later than 6 months after the due date of the tax return (excluding extensions) of the entity seeking to make the election (in the case of QSubs, the due date of the tax return of the parent) for the first year in which the election was intended, and, (iii) no taxpayer whose tax liability or tax return would be affected by the Election Under Subchapter S (including all shareholders of the S corporation) has reported inconsistently with the S corporation election (as well as any ESBT, QSST or QSub elections), on any affected return for the year the Election Under Subchapter S was intended; or

(b) all of the following requirements are met: (i) the entity seeking to make the election has filed a tax return (in the case of QSubs, the parent has filed a tax return) for the first year in which the election was intended within 6 months of the due date of the tax return (excluding extensions), and (ii) all taxpayers whose tax liability or tax returns would be affected by the Election Under Subchapter S (including all shareholders of the S corporation) have reported consistently with the S corporation election (as well as any ESBT, QSST or QSub elections), on all affected returns for the year the Election Under Subchapter S was intended, as well as for any subsequent years.

4.03 Procedural Requirements for Relief.

(1) Procedural Requirements When a Tax Return Has Not Been Filed for the First Year of the Intended Election Under Subchapter S. If the entity seeking the election has not filed a tax return for the first taxable year of the intended Election Under Subchapter S, the entity may request relief for the late Election Under Subchapter S by filing with the applicable service center the properly completed election form(s). The election form(s) must be filed within 18 months of the original Due Date of the intended Election Under Subchapter S (but in no event later than 6 months after the due date of the tax return (excluding extensions) of the entity (in the case of QSubs, the due date of the tax return of the parent) for the first year in which the election was intended) and must state at the top of the document "FILED PURSUANT TO REV. PROC. 2003-43." Attached to the election form must be a statement establishing either reasonable cause for the failure to file the Election Under Subchapter S timely (in the case of S corporation or QSub elections), or a statement establishing that the failure to file the Election Under Subchapter S timely was inadvertent (in the case of ESBT or QSST elections.)

(2) Procedural Requirements When a Tax Return Has Been Filed for the First Year of the Intended Election Under Subchapter S. If the entity seeking the election has filed a tax return for the first taxable year of the intended Election Under Subchapter S within 6 months of the due date of that tax return (excluding extensions), then the entity may request relief for the late Election Under Subchapter S by filing with the applicable service center the properly completed election form(s) and the supporting documents described below. The election form(s) must be filed within 24 months of the original Due Date for the Election Under Subchapter S and must state at the top of the document "FILED PURSUANT TO REV. PROC. 2003-43." Attached to the election form must be a statement establishing either reasonable cause for the failure to file the Election Under Subchapter S timely (in the case of S corporation or QSub elections), or a statement establishing that the failure to file the Election Under Subchapter S timely was inadvertent (in the case of ESBT or QSST elections.) The following additional documents must be attached to the election form (if applicable):

(a) S Corporations. An entity seeking relief for a late S corporation election must file a completed Form 2553, signed by an officer of the corporation authorized to sign and all persons who were shareholders at any time during the period that began on the first day of the taxable year for which the election is to be effective and ends on the day the election is made. The completed election form must include the following material:

(i) Statements from all shareholders during the period between the date the S corporation election was to have become effective and the date the completed election was filed that they have reported their income (on all affected returns) consistent with the S corporation election for the year the election should have been made and for all subsequent years; and

(ii) A dated declaration signed by an officer of the corporation authorized to sign which states: "Under penalties of perjury, I declare that, to the best of my knowledge and belief, the facts presented in support of this election are true, correct, and complete."

(b) ESBTs and QSSTs. The trustee of an ESBT or the current income beneficiary of a QSST must sign and file the appropriate election with the applicable service center. The completed election form must include the following material:

(i) A statement from the trustee of the ESBT or the current income beneficiary of the QSST that includes the information required by section 1.1361-1(m)(2)(ii) (in the case of ESBT elections) or section 1.1361-1(j)(6)(ii) (in the case of QSST elections);

(ii) In the case of a QSST, a statement from the trustee that the trust satisfies the QSST requirements of section 1361(d)(3) and that the income distribution requirements have been and will continue to be met;

(iii) In the case of an ESBT, a statement from the trustee that all potential current beneficiaries meet the shareholder requirements of section 1361(b)(1) and that the trust satisfies the requirements of an ESBT under section 1361(e)(1) other than the requirement to make an ESBT election;

(iv) A statement from the trustee of the ESBT or the current income beneficiary of the QSST that the beneficiary or trustee acted diligently to correct the mistake upon its discovery;

(v) Statements from all shareholders during the period between the date the S corporation election terminated or was to have become effective and the date the completed election was filed that they have reported their income (on all affected returns) consistent with the S corporation election for the year the election should have been made and for all subsequent years; and

(vi) A dated declaration, signed by the trustee of the ESBT or the current income beneficiary of the QSST which states: "Under penalties of perjury, I declare that, to the best of my knowledge and belief, the facts presented in support of this election are true, correct, and complete."

(c) QSubs. An S corporation seeking relief for a late QSub election for a subsidiary must file a completed Form 8869. The completed election form must include the following material:

(i) A statement that the corporation satisfies the QSub requirements of section 1361(b)(3)(B), and that all assets, liabilities, and items of income, deduction, and credit of the QSub have been treated as assets, liabilities, and items of income, deduction, and credit of the S corporation (on all affected returns) consistent with the QSub election for the year the election was intended and for all subsequent years;

(ii) A dated declaration signed by an officer of the S corporation authorized to sign which states: "Under penalties of perjury, I declare that, to the best of my knowledge and belief, the facts presented in support of this election are true, correct, and complete."

4.04 Relief for Late Election Under Subchapter S. Upon receipt of a completed application requesting relief under section 4.03 of this revenue procedure, the Service will determine whether the requirements for granting additional time to file the Election Under Subchapter S have been satisfied and will notify the entity of the result of this determination.

S-Corp shareholders' medical deductions IRC §105 & §106 (belong on form W-2):

Do not confuse §106 Health insurance  vs. §105 Medical expenses

How should the payments/reimbursements be reported on the employee's W-2 and form 1040  and the S-corp's form 1120S?

Are payments/reimbursements totally tax-free fringe benefits?

Are payments/reimbursements included in gross wages?

Are the wages subject to FICA/Medicare?

Common oversight - there are different rules for S corporation shareholders holding more than 2% (as opposed to exactly 2% or less than 2%) of the issued and outstanding stock.



Subject to the satisfaction of certain non-discrimination and other requirements, (see, e.g., §§79(d), 105(h) and 125(b))  an employer can provide certain types of fringe benefits to its employees on a tax-free basis while deducting the cost of the fringe benefit.  Shareholder-employees of S corporations qualify for the exclusion of these fringe benefit items from income, although a special restriction applies to greater-than-2% shareholders. Self-employed persons (i.e., sole proprietors or partners) generally are not entitled to exclude fringe benefits from income, because the exclusion is limited to employees, and a sole proprietor or partner is not considered an "employee" for this purpose.

For fringe benefit purposes, an S corporation is treated as a partnership, and each more-than-2% shareholder is treated as a partner under §1372(a).  Thus, certain fringe benefits that can be provided on a tax-free basis to shareholder-employees of C corporations cannot be provided on a tax-free basis to a more-than-2% shareholder in an S corporation. Other employees of an S corporation, however, are not affected by this rule and can exclude the fringe benefits from income.

Example of "Indirect Ownership" - Husband owns all of the stock of an S corporation. His wife is employed by the S-corp.  The wife is treated as a more-than-2% shareholder for purposes of the S corporation fringe benefit rules, pursuant to §1372(b) & §318.

IR Code §1372. Partnership Rules To Apply For Fringe Benefit Purposes
§1372(a) General Rule  -  For purposes of applying the provisions of this subtitle which relate to employee fringe benefits--
§1372(a)(1) the S corporation shall be treated as a partnership, and
§1372(a)(2) any 2-percent shareholder of the S corporation shall be treated as a partner of such partnership.
§1372(b) 2-Percent Shareholder Defined
For purposes of this section, the term "2-percent shareholder" means any person who owns (or is considered as owning within the meaning of section 318) on any day during the taxable year of the S corporation more than 2 percent of the outstanding stock of such corporation or stock possessing more than 2 percent of the total combined voting power of all stock of such corporation.  (Added Pub. L. 97-354, 2, Oct. 19, 1982, 96 Stat. 1682.)



Whether medical expenses and insurance premiums are subject to FICA/Medicare depends on whether the payments are made pursuant to a plan qualifying under IRC §3121(a)(2).

Medical expenses (see §105) and insurance premiums (see §106) paid for the benefit of 2%(exactly) S corporation shareholders and for persons holding less than 2% on the company's stock are separately deducted on Form 1120S (on page 1, line 18 "employee benefit programs") when the appropriate plan qualifying under IRC §3121(a)(2) has been established.

Medical expenses and insurance premiums paid for a more than 2% shareholder are not separately deducted Form 1120S page 1, line 18.   Rather, these items are included as a salary deduction on page 1, line 7 of Form 1120S, and are also included on the shareholder's Form W-2 as income . These items are only shown as supplemental information on form 1120S, Schedules K and K-1 so that the shareholder may be reminded to deduct the health insurance on Form 1040, page 1, line 29 (for 2007) and deduct the medical expenses on Schedule A, line 1.  For the W-2 wages to be excluded from Social Security and Medicare taxes the payments must be made pursuant to a plan qualifying under IRC §3121(a)(2) which is non-discriminatory pursuant to IRC §105(h).

Q. As is quite common, the corporation forgets to include medical expenses and insurance premiums for more than 2% shareholder on any payroll tax returns (forms 940, 941 W-2 and related State forms and disability insurance forms), or taken as a salary deduction on the books.  In this situation, may the corporation simply report these items as "Other Deductions" on Schedules K and K-1?

A. When the maximum amount of Social Security tax has already been paid or withheld by the shareholder, and otherwise reporting in this manner does not place the corporation or shareholder in jeopardy for underpaid payroll taxes, then this might be a solution.  Of course, an obvious problem remains: Medicaid tax would still be underpaid, and State withholding tax may be underwithheld.

But see below for another opinion:



Some "double talk" to be aware of:
Generally, fringe benefits which are treated as compensation to a 2%-or-more shareholder are subject to payroll (i.e., FICA and FUTA) withholding.  But see §3121(a)(2)(C). Section 3121(a)(2) provides that these amounts are not subject to Social Security and Medicare taxes if the payments are made under a plan or system for employees or a class of employees. See Announcement 92-16, 1992-5 I.R.B. 53.

Announcement 92-16, 1992-5 I.R.B. 53

FICA Taxation of Health Insurance Premiums for 2%-Shareholder-Employees of S Corporations

Announcement 92-16

In response to taxpayer questions, this Internal Revenue Service announcement is intended to clarify the social security and Medicare tax treatment of accident and health insurance premiums paid by an S corporation on behalf of 2%-shareholder-employees.

On April 15, 1991, the Service published Revenue Ruling 91-26, 1991-1 C.B. 184, regarding employer-provided accident and health insurance for S corporations and 2%-shareholder-employees. Revenue Ruling 91-26 indicates that amounts paid by an S corporation for accident and health insurance covering a 2%-shareholder-employee must be reported as wages on his or her Form W-2, Wage and Tax Statement.

Revenue Ruling 91-26 does not directly address the treatment of the amounts for such purposes. The Service has been asked whether these amounts are wages for purposes of social security and Medicare taxes. The facts presented in the ruling are insufficient to ascertain whether tax would be imposed in these circumstances. A basic analysis is provided below to assist taxpayers.

Like other employees of an S corporation, 2%-shareholder employees are subject to social security and Medicare taxes on "wages" paid to them by the corporation. The term "wages" generally includes fringe benefits provided in cash or in kind to an employee. However, under section 3121(a) of the Code certain payments are expressly excluded from "wages" for purpose of social security and Medicare taxes.

Section 3121(a)(2)(B) excludes from wages certain amounts paid by an employer to or on behalf of an employee (including amounts paid by an employer for insurance, annuities, or into a fund) for medical and hospitalization expense in connection with sickness or accident disability. For this exclusion to apply, the payments must be made under a plan or system for employees and their dependents generally or for a class (or classes) of employees and their dependents. Thus, whether amounts of this type are actually subject to social security or Medicare tax depends on whether in the particular case the taxpayer satisfies the requirements for the exclusion.

If the requirements for the exclusion under section 3121(a)(2)(B) are satisfied, amounts paid by an S corporation for accident and health insurance covering a 2%-shareholder-employee are not wages for social security and Medicare tax purposes, even though the amounts must be included in wages for income tax withholding purposes on the 2%-shareholder-employee's Form W-2.

On the other hand, if the requirements for an exclusion are not satisfied, amounts paid by an S corporation for accident and health insurance covering a 2%-shareholder-employee must be included in wages for social security and Medical tax purposes, as well as for income tax withholding purposes, and reported in the appropriate boxes on the 2%-shareholder-employee's Form W-2.

IRS Notice 2008-1, 2008-2 I.R.B. 251 (1/14/2008)
Part III - Administrative, Procedural, and Miscellaneous
Special Rules for Health Insurance Costs of 2-Percent Shareholder-Employees

PURPOSE
This notice provides rules under which a 2-percent (sic) shareholder-employee in an S corporation is entitled to the deduction under §26 USC 162(l) of the Internal Revenue Code for accident and health insurance premiums that are paid or reimbursed by the S corporation and included in the 2-percent shareholder-employee's gross income.

LAW AND ANALYSIS
Section 26 USC 1372(a) provides that, for purposes of applying the income tax provisions of the Code relating to employee fringe benefits, an S corporation shall be treated as a partnership, and any 2-percent shareholder of the S corporation shall be treated as a partner of such partnership. For purposes of §26 USC 1372, the term "2-percent shareholder" is any person who owns (or is considered as owning within the meaning of §26 USC 318)on any day during the taxable year of the S corporation more than 2 percent of the outstanding stock of such corporation or stock possessing more than 2 percent of the total combined voting power of all stock of such corporation. Section 26 USC 1372(b).

Accident and health insurance premiums paid or furnished by an S corporation on behalf of its 2-percent shareholders in consideration for services rendered are treated for income tax purposes like partnership guaranteed payments under §26 USC 707(c) of the Code. Rev. Rul. 91-26, 1991-1 C.B. 184. An S corporation is entitled to deduct the cost of such employee fringe benefits under §26 USC 162(a) if the requirements of that section are satisfied (taking into account the rules of §26 USC 263). The premium payments are included in wages for income tax withholding purposes on the shareholder-employee's Form W-2, Wage and Tax Statement, but are not wages subject to Social Security and Medicare taxes if the requirements for exclusion under section 26 USC 3121(a)(2)(B) are satisfied. See §26 USC 3121(a)(2)(B); Ann. 92-16, 1992-5 I.R.B. 53. The 2-percent shareholder is required to include the amount of the accident and health insurance premiums in gross income under §26 USC 61(a).

Section 26 USC 106 provides an exclusion from the gross income of an employee for employer-provided coverage under an accident and health plan. A 2-percent shareholder is not an employee for purposes of §26 USC 106. Treas. Reg. §26 CFR 1.106-1; section 26 USC 1372(a). Accordingly, the premiums are not excludible from the 2-percent shareholder-employee's gross income under §26 USC 106.

Section 26 USC 162(l)(1)(A) allows an individual who is an employee within the meaning of §26 USC 401(c)(1) to take a deduction in computing adjusted gross income for amounts paid during the taxable year for insurance that constitutes medical care for the taxpayer, his or her spouse, and dependents. The deduction is not allowed to the extent that the amount of the deduction exceeds the earned income (within the meaning of section 26 USC 401(c)(2)) derived by the taxpayer from the trade or business with respect to which the plan providing the medical care coverage is established. Section 26 USC 162(l)(2)(A). Also, the deduction is not allowed for amounts during a month in which the taxpayer is eligible to participate in any subsidized health plan maintained by an employer of the taxpayer or of the spouse of the taxpayer. Section 26 USC 162(l)(2)(B).

A 2-percent shareholder-employee in an S corporation, who otherwise meets the requirements of section 26 USC 162(l), is eligible for the deduction under section 26 USC 162(l) if the plan providing medical care coverage for the 2-percent shareholder-employee is established by the S corporation. Rev. Rul. 91-26, 1991-1 C.B. 184. A plan providing medical care coverage for the 2-percent shareholder-employee in an S corporation is established by the S corporation if:

1. the S corporation makes the premium payments for the accident and health insurance policy covering the 2-percent shareholder-employee (and his or her spouse or dependents, if applicable) in the current taxable year; or
    
2. the 2-percent shareholder makes the premium payments and furnishes proof of premium payment to the S corporation and then the S corporation reimburses the 2-percent shareholder-employee for the premium payments in the current taxable year.

If the accident and health insurance premiums are not paid or reimbursed by the S corporation and included in the 2-percent shareholder-employee's gross income, a plan providing medical care coverage for the 2-percent shareholder-employee is not established by the S corporation and the 2-percent shareholder-employee in an S corporation is not allowed the deduction under §26 USC 162(l).

In order for the 2-pecent shareholder-employee to deduct the amount of the accident and health insurance premiums, the S corporation must report the accident and health insurance premiums paid or reimbursed as wages on the 2-percent shareholder-employee's Form W-2 in that same year. In addition, the shareholder must report the premium payments or reimbursements from the S corporation as gross income on his or her Form 1040, U.S. Individual Income Tax Return.


EXAMPLES
The following examples illustrate these rules. The following examples assume that each shareholder is a 2-percent shareholder-employee in an S corporation, whose earned income from the S corporation exceeds the amount of the premiums for the accident and health insurance policies covering the shareholder, his or her spouse and dependents. None of the shareholders in the following examples are eligible to participate in any subsidized health plan maintained by an employer of the shareholder or the shareholder's spouse.

Example 1. (i) For 2008, shareholder A obtains an accident and health insurance policy in the name of shareholder A and makes the premium payments on the policy. The S corporation makes no payments or reimbursements with respect to the premiums.
(ii) A plan providing medical care for shareholder A is not established by the S corporation and shareholder A is not entitled to the deduction under §26 USC 162(l).

Example 2. (i) For 2008, the S corporation obtains an accident and health insurance plan in the name of the S corporation. The health plan provides coverage for shareholder B, B's spouse and dependents. The S corporation makes all the premium payments to the insurance company. The S corporation reports the amount of the premiums as wages on shareholder B's Form W-2 for 2008 and shareholder B reports that amount as gross income on Form 1040 for 2008.
(ii) A plan providing medical care for shareholder B has been established by the S corporation and shareholder B is allowed the deduction under §26 USC 162(l) for 2008.

Example 3. (i) For 2008, shareholder C obtains an accident and health insurance policy in the name of shareholder C. The S corporation makes all the premium payments to the insurance company. The S corporation reports the amount of the premiums as wages on shareholder C's Form W-2 for 2008 and shareholder C reports that amount as gross income on Form 1040 for 2008.
(ii) A plan providing medical care for shareholder C has been established by the S corporation and shareholder C is allowed the deduction under §26 USC 162(l) for 2008.

Example 4. (i) For 2008, shareholder D obtains an accident and health insurance policy in the name of shareholder D. Shareholder D makes the premium payments to the insurance company and furnishes proof of premium payment to the S corporation. The S corporation then reimburses shareholder D for the premium payments. The S corporation reports the amount of the premium reimbursements as wages on shareholder D's Form W-2 for 2008 and shareholder D reports that amount as gross income on Form 1040 for 2008.
(ii) A plan providing medical care for shareholder D has been established by the S corporation and shareholder D is allowed the deduction under §26 USC 162(l) for 2008.

Rev. Rul. 91-26, 1991-1 C.B. 184  Clarified by Ann. 92-16.

ISSUES

1. If a partner performs services in the capacity of a partner and the partnership pays accident and health insurance premiums for current year coverage on behalf of such partner without regard to partnership income, what is the Federal income tax treatment of the premium payments?

2. If an S corporation pays accident and health insurance premiums for current year coverage on behalf of a 2-percent shareholder-employee, what is the Federal income tax treatment of the premium payments?

FACTS

SITUATION 1. AB is a partnership in which individuals A and B are equal partners. During 1989, AB paid accident and health insurance premiums for 1989 coverage on behalf of each partner under AB's accident and health plan.

The premiums paid by AB on behalf of A and B were for services rendered by A and B in their capacities as partners and were payable without regard to partnership income. The premiums paid by AB would qualify as ordinary and necessary business expenses under section 26 USC 162(a) of the Code if paid by AB on behalf of individuals who were not partners of AB. The value of the premiums to A and B is equal to the cost of the premiums paid on behalf of A and B, respectively.

SITUATION 2. X corporation made a valid election to be an S corporation under section 26 USC 1362 of the Code effective for its taxable year beginning January 1, 1989. Three individuals own X's stock in the following proportions: C, 51 percent; D, 48 percent; and E, 1 percent. C, D, and E are also employees of X.

During 1989, X paid accident and health insurance premiums for 1989 coverage on behalf of each of its employees under X's accident and health plan. The premiums paid by X would qualify as ordinary and necessary business expenses under section 26 USC 162(a) of the Code if paid by X on behalf of individuals who were not "2-percent shareholders."The value of the premiums to C, D, and E is equal to the cost of the premiums paid on behalf of C, D, and E, respectively.

LAW AND ANALYSIS

Section 26 USC 106 of the Code excludes from the gross income of an employee coverage provided by an employer under an accident or health plan.

Section 26 USC 162(l) of the Code allows as a deduction, in the case of an individual who is an employee within the meaning of section 26 USC 401(c)(1), an amount equal to 25 percent of the amount paid during the taxable year for insurance that constitutes medical care for the individual and the individual's spouse and dependents. This provision applies to taxable years beginning after December 31, 1986, and before January 1, 1992.

Section 26 USC 401(c)(1) of the Code treats certain self-employed individuals as employees. Section 26 USC 401(c)(1)(B) defines a "self- employed individual,"with respect to any taxable year, as an individual who has earned income (as defined in section 26 USC 401(c)(2)) for the taxable year. Section 26 USC 401(c)(2) defines "earned income" as, in general, the net earnings from self-employment as defined in section 26 USC 1402(a). Under section 26 USC 1402(a), the term net earnings from self-employment is defined to include, with certain specified exceptions, a partner's distributive share of income or loss described in section 26 USC 702(a)(8) from any trade or business carried on by a partnership in which the individual is a partner. Guaranteed payments to a partner for services also are included in net earnings from self-employment. In addition, section 26 USC 162(l)(5)(A) provides that, for purposes of section 26 USC 162(l), if a shareholder owns more than 2 percent of the outstanding stock of an S corporation, the shareholder's wages (as defined in section 26 USC 3121) from the S corporation are treated as "earned income" within the meaning of section 26 USC 401(c)(1).

SITUATION 1. (Partnerships and most LLC's)

Section 26 USC 707(c) of the Code provides that payments to a partner for services, to the extent the payments are determined without regard to the income of the partnership, are considered as made to one who is not a member of the partnership, but only for purposes of section 26 USC 61(a) (relating to gross income) and, subject to section 26 USC 263 (prohibiting deductions for capital expenditures), for purposes of section 26 USC 162(a) (relating to trade or business expenses). These payments are termed "guaranteed payments."

Section 26 CFR 1.707-1(c) of the Income Tax Regulations provides that for a guaranteed payment under section 26 USC 707(c) of the Code to be deductible by the partnership, it must meet the same tests under section 26 USC 162(a) as it would if the payment had been made to a person who was not a member of the partnership. Generally, for purposes of Code provisions other than sections 26 USC 61(a) and 26 USC 162(a), guaranteed payments are treated as a partner's distributive share of ordinary income. The regulation states, by way of an illustration, that a partner who receives guaranteed payments is not entitled to exclude them from gross income as disability payments under section 26 USC 105(d) (as in effect prior to its repeal by section 122(b) of the Social Security Amendments of 1983, Pub. L. No. 98-21, 1983-2 C.B. 309, 315). The regulation also provides that a partner who receives guaranteed payments is not, by virtue of the payments, regarded as an employee of the partnership for purposes of withholding of tax at source, deferred compensation plans, and other purposes.

Amounts paid in cash or in kind by a partnership, without regard to its income, to or for the benefit of its partners, for services rendered in their capacities as partners, are guaranteed payments under section 26 USC 707(c) of the Code. A partnership is entitled to deduct such cash amounts, or the cost to the partnership of such in-kind benefits, under section 26 USC 162(a), if the requirements of that section are satisfied (taking into account the rules of section 26 USC 263). Under section 26 USC 61(a), the cash amount or the value of the benefit is included in the income of the recipient-partner. The cash amount or value of the benefit is not excludible from the partner's gross income under the general fringe benefit rules (except to the extent the Code provision allowing exclusion of a fringe benefit specifically provides that it applies to partners) because the benefit is treated as a distributive share of partnership income under section 26 CFR 1.707-1(c) of the regulations for purposes of all Code sections other than sections 26 USC 61(a) and 26 USC 162(a), and a partner is treated as self-employed to the extent of his or her distributive share of income. Section 26 USC 1402(a). See also Rev. Rul. 69-184, 1969-1 C.B. 256 (employment taxes); cf. section 26 USC 401(c), which recognizes that partners are self-employed individuals but treats them as employees for certain limited purposes.

Therefore, AB may deduct under section 26 USC 162(a) of the Code (subject to section 26 USC 263) the cost of the accident and health insurance premiums paid on behalf of A and B.  A and B may not exclude the cost of the premiums from their gross income under section 26 USC 106, but must include the cost of the premiums in gross income under section 26 USC 61(a). Provided all the requirements of section 26 USC 162(l) are met, however, A and B may deduct the cost of the premiums to the extent provided by section 26 USC 162(l).

A partnership may account for accident and health insurance premiums paid on behalf of a partner as a reduction in distributions to the partner. Under these circumstances, the premiums are not deductible by the partnership, so distributive shares of partnership income and deduction (and other payment items) are not affected by payment of the premiums. A partner may deduct the cost of the premiums paid on that partner's behalf to the extent allowed under section 26 USC 162(l).

SITUATION 2. (S-Corporations)

Section 26 USC 1372 of the Code provides that, for purposes of applying the income tax provisions of the Code relating to employee fringe benefits, an S corporation shall be treated as a partnership, and any person who is a "2-percent shareholder" of the S corporation shall be treated like a partner of a partnership. Section 26 USC 1372(b) defines a "2-percent shareholder" as any person who owns (or is considered as owning within the meaning of section 26 USC 318) on any day during the taxable year of the S corporation more than 2 percent of the outstanding stock of the corporation or stock possessing more than 2 percent of the total combined voting power of all stock in the corporation.

Under section 26 USC 1372 of the Code, for purposes of applying the provisions of the Code relating to employee fringe benefits, a 2- percent shareholder who is also an employee of an S corporation is treated like a partner of a partnership. Employee fringe benefits paid or furnished by an S corporation to or for the benefit of its 2- percent shareholder-employees in consideration for services rendered, therefore, are treated for income tax purposes like partnership guaranteed payments under section 26 USC 707(c). An S corporation is entitled to deduct the cost of such employee fringe benefits under section 26 USC 162(a) if the requirements of that section are satisfied (taking into account the rules of section 26 USC 263). Like a partner, a 2- percent shareholder is required to include the value of such benefits in gross income under section 26 USC 61(a) and is not entitled to exclude such benefits from gross income under provisions of the Code permitting the exclusion of employee fringe benefits (except to the extent the Code provision allowing exclusion of a fringe benefit specifically provides that it applies to partners).

Therefore, X may deduct under section 26 USC 162(a) of the Code the cost of the accident and health insurance premiums paid on behalf of C, D, and E. C and D may not exclude the cost of the premiums from their gross income under section 26 USC 106, but must include the cost of the premiums in gross income under section 26 USC 61(a). Provided all the requirements of section 26 USC 162(l) are met, however, C and D may deduct the cost of the premiums to the extent provided by section 26 USC 162(l). E (who does not own more than 2 percent of X's stock) may exclude from gross income under section 26 USC 106 the cost of the premiums paid by X on E's behalf.

Unlike a partnership, an S corporation may not account for accident and health insurance premiums paid on behalf of a shareholder-employee as a reduction in distributions to the shareholder-employee because the shareholder-employee's pro rata share of S corporation income would not be subject to employment taxes.

HOLDINGS

1. Accident and health insurance premiums paid by a partnership on behalf of a partner are guaranteed payments under section 26 USC 707(c) of the Code if the premiums are paid for services rendered in the capacity of partner and to the extent the premiums are determined without regard to partnership income. As guaranteed payments, the premiums are deductible by the partnership under section 26 USC 162 (subject to the capitalization rules of section 26 USC 263) and includible in the recipient-partner's gross income under section 26 USC 61. The premiums are not excludible from the recipient-partner's gross income under section 26 USC 106;however, provided all the requirements of section 26 USC 162(l) are met, the partner may deduct the cost of the premiums to the extent provided by section 26 USC 162(l).

A partnership must report the cost of accident and health insurance premiums that are guaranteed payments on its U.S. Partnership Return of Income (Form 1065) and the Schedule K-1s. A partnership is not required to file a Form 1099 or a Wage and Tax Statement (Form W-2) for accident and health insurance premiums that are guaranteed payments.

2. Under section 26 USC 1372 of the Code, accident and health insurance premiums paid by an S corporation on behalf of a 2-percent shareholder-employee as consideration for services rendered are treated like guaranteed payments under section 26 USC 707(c) of the Code. Therefore, the premiums are deductible by the corporation under section 26 USC 162 (subject to the capitalization rules of section 26 USC 263), and includible in the recipient shareholder-employee's gross income under section 26 USC 61. The premiums are not excludible from the recipient shareholder-employee's gross income under section 26 USC 106;however, provided all the requirements of section 26 USC 162(l) are met, the shareholder-employee may deduct the cost of the premiums to the extent provided by section 26 USC 162(l).

An S corporation may deduct as salary and wages accident and health insurance premiums paid on behalf of its 2-percent shareholder-employees on its U.S. Income Tax Return for an S Corporation. The S corporation is required to file a Wage and Tax Statement (Form W-2) for each 2-percent shareholder-employee. The Form W-2 must include for a 2-percent shareholder-employee the cost of accident and health insurance premiums paid on behalf of the shareholder-employee in the shareholder-employee's wages.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 72-596, 1972-2 C.B. 395, concerns the deductibility under section 162 of the Code of premiums paid by a partnership on behalf of its partners for workmen's compensation insurance. Rev. Rul. 72-596 relies on the general rule that a partner is not an employee and suggests that workmen's compensation premiums are deductible by the partnership only if paid on behalf of an employee.

The partners in Rev. Rul. 72-596 were acting in their capacities as partners and the workmen's compensation premiums were payable without regard to partnership income. Thus, the premiums are guaranteed payments under section 26 USC 707(c) of the Code, and as such are deductible by the partnership under section 26 USC 162 (if the requirements of that section are satisfied) and includible in the incomes of the partners under section 26 USC 61. Rev. Rul. 72-596 is incorrect to the extent it concludes otherwise. Rev. Rul. 72-596 is revoked.

ADMINISTRATIVE RELIEF

For S corporation tax years beginning before January 1, 1991, the Service will not challenge the treatment of accident and health insurance premiums paid by S corporations for 2-percent shareholder- employees in accordance with the instructions to the Form 1120S and Schedule K-1 to the Form 1120S. These instructions provide that such fringe benefits are nondeductible by the S corporation and cannot be treated as deductible or excludable employee fringe benefits (except for benefits allowed partners, such as section 26 USC 162(l)).

The Service does not consider payments of accident and health insurance premiums by an S corporation on behalf of 2-percent shareholder-employees to be distributions for purposes of the single class of stock requirement of section 26 USC 1361(b)(1)(D).

S-Corp shareholders' tax deductions based on loans made - and the taxable income based on repayments of those loans:

Income recapture can occur when debt basis is used to deduct corporate losses. When debt basis is reduced to zero due to corporate losses, and then payments are made against the zero-basis loam, income recapture may occur.

Generally:
For shareholder loans evidenced by a note, additional advances do not restore or prevent income recapture to zero-basis or low-basis loans repaid during the year. Because additional advances are deemed new loan, they provide the shareholder with additional basis for deducting additional losses, but do not prevent income recapture for the zero-basis or low-basis loans repaid during the period.

However, for open account debt, additional advances restore zero-basis or low-basis loans repaid during the year. Under Regs. Sec. 1.1367-2(b)(1), basis for open account debt is determined at the close of the year. Thus, advances and repayments are netted throughout the year; the final determination of debt basis for open account debt is determined at the dose of the year. This provision allows S shareholders time to make a corrective loan before the end of the year to restore debt basis.

In a court decision, Brooks, TC Memo 2005-204,  S shareholders advanced money to their S-corporation in one year, using those advances to enable them to deduct the corporate losses. Then at the beginning of the subsequent year the corporation repaid the loans.  Then before the end of the year, the shareholders made additional loans to restore debt basis. This situation continued over several years, allowing the shareholders to defer income recognition indefinitely.


Under Prop. Regs. Sec. 1.1367-2(a) (2)(ii), the shareholder must maintain a daily running log to account for the open account debt. If, at any point during the S corporation's tax year, the aggregate balance of the open account debt exceeds $10,000, it is treated in the same way as debt evidenced by a note. The resulting debt repayments are treated in this manner for the loan's remaining life; see Prop. Regs. Sec. 1.1367-2(d)(2)(ii).

Effect on open account debt: By limiting the definition of open account debt, the proposed regulations minimize S shareholders' ability to defer income recognition. Shareholders now must bear the administrative burden of maintaining a daily log to record advances and repayments on open account debt.


Below is a list of options that taxpayers can use in light of the proposed regulations:

1. Treat all advances as capital, rather than debt. Under this strategy, the shareholder treats advances as additional paid-in capital, rather than debt. This allows the shareholder to avoid the open account debt rules. The shareholder can take repayments in the form of distributions, then simply contribute additional funds to the corporation to avoid distributions in excess of basis at year-end. However, if the corporation has undistributed C corporation earnings and profits and an insufficient S corporation accumulated adjustments account (AAA), the income potential Hill continue to exist for distributions in excess of the AAA.
    
2. Keep open account debt balances under $10,000. This may seem to be more trouble than it is worth, but by reclassifying shareholder distributions to reduce the balance of the open account debt, a shareholder may be able to circumvent the $10,000 de minimis rule. Those looking to continue to use open account debt must keep a daily log, so there will be no more expended effort to track the account balance.
    
3. Set up a formal note for open account debt exceeding $10,000. The IRS has not clarified whether debt repayments on zero- or low-basis open account debt will be treated as ordinary income recapture or receive capital gain treatment similar to that afforded loans evidenced by a note. To ensure capital gain treatment, set up a formal note for any debt that no longer qualifies for open account treatment.
   • Actually, if the debt is an open account, the gain is ordinary because a collection on that type of indebtedness is not considered to be a sale or exchange.
   • Whereas, collection of a corporate note is deemed to be a sale or exchange, so if the note is a capital asset to the shareholder, the gain is a capital gain (IR Code §1271(a)(a) - see page 111 http://www.belkcollege.uncc.edu/haburton/S%20Corporations.pdf )

   • If loan basis has been reduced, but not to zero, a partial payment to the shareholder on the loan cannot be applied solely to the basis portion. Rather, the payment must be allocated proportionately to represent (a) return of basis, and (b) taxable income to the shareholder (Rev. Rul. 64-162, 1964-1 CB 304, Rev. Rul. 68-537, 1968-2 CB 372).

4. Use outside loans to increase the $10,000 limit. For S corporations with multiple shareholders, use outside loans between shareholders to circumvent the $10,000 limit.
    
5. Use multiple small loans evidenced by a formal note. Under the existing regulations, income earned by an S corporation in any year will first restore the basis in zero- or low-basis loans, before it increases shareholder stock basis. If a loan with reduced basis is repaid during a year in which net income is recognized by the S corporation, the income is first applied to restore the basis of the loan that is partially or fully repaid. By using multiple small notes, a taxpayer can more easily control income recognition on repayment of a zero- or low-basis loan.

Effective October 20, 2008 (T.D. 9428):
Regulations apply to any and all shareholder advances to the S corporation made on or after October 20, 2008, and repayments on those advances by the S corporation.

Treasury Department and the IRS have concluded that the aggregate principal threshold dollar amount for open account debt should be increased and that other changes are necessary. Therefore, the final regulations adopt a $25,000 aggregate principal threshold amount per shareholder for open account debt. For example, an S corporation with ten shareholders could receive up to $250,000 of open account debt as long as no single shareholder advanced more than $25,000. The Treasury Department and the IRS believe that the $25,000 threshold, together with certain other changes noted below, balances concerns over deferral potential with normal business practices. Under the final regulations, for any particular shareholder advances and repayments on those advances for which, as of the specified determination date, the aggregate principal balance exceeds the $25,000 aggregate principal threshold amount will no longer constitute open account debt, but instead will be treated as debt evidenced by a separate written instrument subject to the basis adjustment and repayment accounting rules applicable to S corporation shareholder debt generally.

Trader Status "election":

Each year s taxpayer chooses whether to take the position of "trader status" rather than the default position of "investor status" merely by filing a tax return using trader status concepts rather than investor status concepts.

The IRS has the right to challenge the taxpayer's choice on a year-by-year basis.  The documentation and support for taxpayer's choice of filing under trader status should show that the buying and selling of securities (and/or commodities, futures or forex) during the year was substantial. and was carried on with continuity and regularity.  The taxpayer also should be intending to "make a living" from the trading activity (see §1.183-2(b)(8)).

IRS Regs. §1.183-2(b) Trade or Business:

Nine nonexclusive factors under IRS Regs. §1.183-2(b) that the IRS looks to to determine if an activity is a "trade or business" are:

1. The manner in which the taxpayer carried on the activity;
2. the expertise of the taxpayer or his or her advisers;
3. the time and effort expended by the taxpayer in carrying on the activity;
4. the expectation that the assets used in the activity may appreciate in value;
5. the success of the taxpayer in carrying on other similar or dissimilar activities;
6. the taxpayer’s history of income or loss with respect to the activity;
7. the amount of occasional profits, if any, which are earned;
8. the financial status of the taxpayer; and  (ed note: does not have substantial income or capital from other sources)
9. whether elements of personal pleasure or recreation are involved. Id.

Nine nonexclusive factors listed in Publication 535 Business Expenses show what the IRS looks to to determine if an activity is a "trade or business:"

1. You carry on the activity in a businesslike manner,
2. The time and effort you put into the activity indicate you intend to make it profitable,
3. You depend on the income for your livelihood,
4. Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
5. You change your methods of operation in an attempt to improve profitability,
6. You (or your advisors) have the knowledge needed to carry on the activity as a successful business,
7. You were successful in making a profit in similar activities in the past,
8. The activity makes a profit in some years, and
9. You can expect to make a future profit from the appreciation of the assets used in the activity.

also see: http://www.traderstatus.com/entities.htm#parttime

IRS Regs. §1.469-1T(e)(6) Partnership has non-passive activity:

Non-Passive Income:
Once Trader Status is used by a pass-thru entity the income is not considered "passive income" pursuant to IRS Regs. §1.469-1T(e)(6) and IRS FSA 200111001   and is not considered "portfolio income" pursuant to IRS Regs. §1.469-2T(c)(3)(ii)(D).


§1.469-1T(e)(6) Activity of trading personal property

(i) In general. --An activity of trading personal property for the account of owners of interests in the activity is not a passive activity (without regard to whether such activity is a trade or business activity (within the meaning of paragraph (e)(2) of this section)).

(ii) Personal property. --For purposes of this paragraph (e)(6), the term "personal property" means personal property (within the meaning of section 1092(d), without regard to paragraph (3) thereof).

(iii) Example. --The following example illustrates the application of this paragraph (e)(6):

Example. A partnership is a trader of stocks, bonds, and other securities (within the meaning of section 1236(c)). The capital employed by the partnership in the trading activity consists of amounts contributed by the partners in exchange for their partnership interests, and funds borrowed by the partnership. The partnership derives gross income from the activity in the form of interest, dividends, and capital gains. Under these facts, the partnership is treated as conducting an activity of trading personal property for the account of its partners. Accordingly, under this paragraph (e)(6), the activity is not a passive activity.

§1.469-2T(c)(3) Items of portfolio income specifically excluded

§1.469-2T(c)(3)(i) In general. --Passive activity gross income does not include portfolio income. For purposes of the preceding sentence, portfolio income includes all gross income, other than income derived in the ordinary course of a trade or business (within the meaning of paragraph (c)(3)(ii) of this section), that is attributable to --


§1.469-2T(c)(3)(ii) Gross income derived in the ordinary course of a trade or business. --Solely for purposes of paragraph (c)(3)(i) of this section, gross income derived in the ordinary course of a trade or business includes only --

§1.469-2T(c)(3)(ii)(D) Income or gain derived in the ordinary course of an activity of trading or dealing in any property if such activity constitutes a trade or business (but see paragraph (c)(3)(iii)(A) of this section);


§1.469-2T(c)(3)(iii) Special rules
§1.469-2T(c)(3)(iii)(A) Income from property held for investment by dealer. --For purposes of paragraph (c)(3)(i) of this section, a dealer's income or gain from an item of property is not derived by the dealer in the ordinary course of a trade or business of dealing in such property if the dealer held the property for investment at any time before such income or gain is recognized.

IRS Code §446 General Rule For Methods Of Accounting:

§446(c) Permissible Methods
Subject to the provisions of subsections (a) and (b), a taxpayer may compute taxable income under any of the following methods of accounting--
§446(c)(1) the cash receipts and disbursements method;
§446(c)(2) an accrual method;
§446(c)(3) any other method permitted by this chapter; or
§446(c)(4) any combination of the foregoing methods permitted under regulations prescribed by the Secretary.
§446(d) Taxpayer Engaged In More Than One Business
A taxpayer engaged in more than one trade or business may, in computing taxable income, use a different method of accounting for each trade or business.
§446(e) Requirement Respecting Change Of Accounting Method
Except as otherwise expressly provided in this chapter, a taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary.


Rev. Proc. 2002-28:
2.02 Section 446(c) generally allows a taxpayer to select the method of accounting it will use to compute its taxable income. A taxpayer is entitled to adopt any one of the permissible methods for each separate trade or business...



IRS Code §446(a) General Rule:
Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.

IRS Regs. §1.446-1 General rule for methods of accounting.
§1.446-1(1)(a)(1) Section 446(a) provides that taxable income shall be computed under the method of accounting on the basis of which a taxpayer regularly computes his income in keeping his books.

§1.446-1(b)(2) A taxpayer whose sole source of income is wages need not keep formal books in order to have an accounting method. Tax returns, copies thereof, or other records may be sufficient to establish the use of the method of accounting used in the preparation of the taxpayer's income tax returns.

§1.446-1(c)(1)(iv)(b) A taxpayer using one method of accounting in computing items of income and deductions of his trade or business may compute other items of income and deductions not connected with his trade or business under a different method of accounting.

§1.446-1(c)(2)(ii) No method of accounting will be regarded as clearly reflecting income unless all items of gross profit and deductions are treated with consistency from year to year. The Commissioner may authorize a taxpayer to adopt or change to a method of accounting permitted by this chapter although the method is not specifically described in the regulations in this part if, in the opinion of the Commissioner, income is clearly reflected by the use of such method. Further, the Commissioner may authorize a taxpayer to continue the use of a method of accounting consistently used by the taxpayer, even though not specifically authorized by the regulations in this part, if, in the opinion of the Commissioner, income is clearly reflected by the use of such method. See section 446(a) and paragraph (a) of this section, which require that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books, and section 446(e) and paragraph (e) of this section, which require the prior approval of the Commissioner in the case of changes in accounting method.

§1.446-1(d) Taxpayer engaged in more than one business.
§1.446-1(d)(1) Where a taxpayer has two or more separate and distinct trades or businesses, a different method of accounting may be used for each trade or business, provided the method used for each trade or business clearly reflects the income of that particular trade or business. For example, a taxpayer may account for the operations of a personal service business on the cash receipts and disbursements method and of a manufacturing business on an accrual method, provided such businesses are separate and distinct and the methods used for each clearly reflect income. The method first used in accounting for business income and deductions in connection with each trade or business, as evidenced in the taxpayer's income tax return in which such income or deductions are first reported, must be consistently followed thereafter.
§1.446-1(d)(2) No trade or business will be considered separate and distinct for purposes of this paragraph unless a complete and separable set of books and records is kept for such trade or business.


§1.446-1(e) Requirement respecting the adoption or change of accounting method.
§1.446-1(e)(1) A taxpayer filing his first return may adopt any permissible method of accounting in computing taxable income for the taxable year covered by such return. See section 446(c) and paragraph (c) of this section for permissible methods. Moreover, a taxpayer may adopt any permissible method of accounting in connection with each separate and distinct trade or business, the income from which is reported for the first time. See section 446(d) and paragraph (d) of this section. See also section 446(a) and paragraph (a) of this section.

Mark-to-Market Accounting Method §475:

IRS Issues Procedures for Electing Mark-to-Market Method for Dealers, Traders
The IRS issued exclusive procedures for dealers in commodities and traders in securities or commodities to make an election to use the mark-to-market method of accounting under §475(e) or (f).

A. Elections effective for tax years for which the original federal tax return was filed before March 18, 1999. For a taxpayer to make a §475(e) or (f) election that is effective for a taxable year for which the original federal income tax return was filed before March 18, 1999, the taxpayer must either: (1) have properly reflected the application of §475 (including any required §481(a) adjustment) in the calculation of the taxpayer's tax liability on its original federal income tax return for the election year; or (2) have failed to properly reflect the application of §475 (including any required §481(a) adjustment) in the calculation of the taxpayer's tax liability on its original federal income tax return for the election year, but clearly demonstrated on that return its intent to make the election for that year (for example, by a statement on, or attachment to, the return), and file an amended return for the election year on or before June 16, 1999, that properly reflects the application of §475 (including any required §481(a) adjustment).

B. Elections effective for other taxable years beginning before January 1, 1999. For a taxpayer to make a §475(e) or (f) election that is effective for a taxable year which begins before January 1, 1999, and for which the original federal income tax return is filed on or after March 18, 1999, the taxpayer must make the election by attaching a statement to an original federal income tax return for the election year that is timely filed (including extensions). The required statement must describe the election being made, the first taxable year for which the election is effective, and, in the case on an election under §475(f), the trade or business for which the election is made.

C. Elections effective for a taxable year beginning on or after January 1, 1999.
(1) General procedure. Except for new taxpayers (discussed below), for a taxpayer to make a §475(e) or (f) election that is effective for a taxable year beginning on or after January 1, 1999, the taxpayer must file a required statement (described above). The statement must be filed not later than the due date (without regard to extensions) of the original federal income tax return for the taxable year immediately preceding the election year and must be attached either to that return or, if applicable, to a request for an extension of time to file that return.

(2) New taxpayers. A new taxpayer is a taxpayer for which no federal income tax return was required to be filed for the taxable year immediately preceding the election year. A new taxpayer makes the election by placing in its books and records no later than 2 months and 15 days after the first day of the election year a required statement (described above). The new taxpayer must attach a copy of the statement to its original federal income tax return for the election year.
This revenue procedure is effective February 8, 1999.
Rev. Proc. 99-17 is scheduled to appear in I.R.B. 1999-7, dated February. 16, 1999.
¨ Rev. Proc. 99-17, 1999-7 I.R.B. ___.

Treatment of Mark-to-Market Gains of Electing Traders (SECA tax):

TITLE VI. TECHNICAL CORRECTIONS (SECA portion as submitted to IRS Code draft writers by Colin M. Cody, CPA)
Technical Corrections to Taxpayer Relief Act of 1997
Effective Dates: The technical corrections of Title VI are effective as if included in the provisions of the Taxpayer Relief Act of 1997 to which they relate, unless otherwise indicated.

Treatment of Mark-to-Market Gains of Electing Traders

The Bill clarifies that, for securities or commodities traders, gain or loss that is treated as ordinary solely by reason of election of mark-to-market treatment is not treated as other than gain or loss from a capital asset for purposes of determining net-earnings from self-employment for Self-Employment Contributions Act tax purposes or for purposes of determining whether the passive type income exception to the publicly-traded partnership rules is met.

The provision applies to taxable years of electing securities and commodities traders ending after August 5, 1997, the date of enactment of the 1997 Act.

[Bill §6010(a)(3); Code §475(f)(1)(D)]

Treatment of Limited Liability Company members (SECA tax):

REG-209824-96   INTERNAL REVENUE SERVICE NOTICE OF PROPOSED RULEMAKING AND PUBLIC HEARING (REG-209824-96) ON DEFINITION OF LIMITED PARTNER FOR SELF-EMPLOYMENT TAX PURPOSES, ISSUED JAN. 10, 1997

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

SUMMARY: This document contains proposed amendments to the regulations relating to the self-employment income tax imposed under section 1402 of the Internal Revenue Code of 1986. These regulations permit individuals to determine whether they are limited partners for purposes of section 1402(a)(13), eliminating the uncertainty in calculating an individual's net earnings from self-employment under existing law. This document also contains a notice of public hearing on the proposed regulations.

Background

This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) under section 1402 of the Internal Revenue Code and replaces the notice of proposed rulemaking published in the Federal Register on December 29, 1994, at 59 FR 67253, that treated certain members of a limited liability company (LLC) as limited partners for self-employment tax purposes. Written comments responding to the proposed regulations were received, and a public hearing was held on June 23, 1995.

Under the 1994 proposed regulations, an individual owning an interest in an LLC was treated as a limited partner if (1) the individual lacked the authority to make management decisions necessary to conduct the LLC's business (the management test), and (2) the LLC could have been formed as a limited partnership rather than an LLC in the same jurisdiction, and the member could have qualified as a limited partner in the limited partnership under applicable law (the limited partner equivalence test). The intent of the 1994 proposed regulations was to treat owners of an LLC interest in the same manner as similarly situated partners in a state law partnership.

Public comments on the 1994 proposed regulations were mixed. While some commentators were pleased with the proposed regulations for attempting to conform the treatment of LLCs with state law partnerships, others criticized the 1994 proposed regulations based on a variety of arguments.

A number of commentators discussed administrative and compliance problems with the 1994 proposed regulations. For example, it was noted that both the management test and the limited partner equivalence test depend upon legal or factual determinations that may be difficult for taxpayers or the IRS to make with certainty.

Another commentator pointed out that basing the self-employment tax treatment of LLC members on state law limited partnership rules would lead to disparate treatment between members of different LLCs with identical rights based solely on differences in the limited partnership statutes of the states in which the members form their LLC. For example, State A's limited partnership act may allow a limited partner to participate in a partnership's business while State B's limited partnership act may not. Thus, an LLC member, who is not a manager, that participates in the LLC's business would be a limited partner under the proposed regulations if the LLC is formed in State A, but not if the LLC is formed in State B. Commentators asserted that this disparate treatment is inherently unfair for federal tax purposes.

Some commentators argued for a ``material participation'' test to determine whether an LLC member's distributive share is included in the individual's net earnings from self-employment. The proposed regulations did not contain a participation test. Commentators advocating a participation test stressed that such a test would eliminate uncertainty concerning many LLC members' limited partner status and would better implement the self-employment tax goal of taxing compensation for services.

Other commentators argued for a more uniform approach, stating that a single test should govern all business entities (i.e., partnerships, LLCs, LLPs, sole proprietorships, et al.) whose members may be subject to self-employment tax. These commentators generally recognized, however, that a change in the treatment of a sole proprietorship or an entity that is not characterized as a partnership for federal tax purposes would be beyond the scope of regulations to be issued under section 1402(a)(13).

Finally, some commentators focused on whether the Service would respect the ownership of more than one class of partnership interest for self-employment tax purposes (bifurcation of interests). The proposed regulations treated an LLC member as a limited partner with respect to his or her entire interest (if the member was not a manager and satisfied the limited partner equivalence test), or not at all (if either the management test or limited partner equivalence test was not satisfied). Commentators, however, pointed to the legislative history of section 1402(a)(13) to support their argument that Congress only intended to tax a partner's distributive share attributable to a general partner interest. Under this argument, a partner that holds both a general partner interest and a limited partner interest is only subject to self-employment tax on the distributive share attributable to the partner's general partner interest. This intent also may be inferred from the statutory language of section 1402(a) (13) that the self-employment tax does not apply to ``. . . the distributive share of any item of income or loss of a limited partner, as such . . . .'' Based on this evidence, these commentators requested that the proposed regulations be revised to allow the bifurcation of interests for self-employment tax purposes.

After considering the comments received, the IRS and Treasury have decided to withdraw the 1994 notice of proposed rulemaking and to re-propose amendments to the Income Tax Regulations (26 CFR part 1) under section 1402 of the Code.

Explanation of Provisions

The proposed regulations contained in this document define which partners of a federal tax partnership are considered limited partners for section 1402(a)(13) purposes. These proposed regulations apply to all entities classified as a partnership for federal tax purposes, regardless of the state law characterization of the entity. Thus, the same standards apply when determining the status of an individual owning an interest in a state law limited partnership or the status of an individual owning an interest in an LLC. In order to achieve this conformity, the proposed regulations adopt an approach which depends on the relationship between the partner, the partnership, and the partnership's business. State law characterizations of an individual as a ``limited partner'' or otherwise are not determinative.

Generally, an individual will be treated as a limited partner under the proposed regulations unless the individual (1) has personal liability (as defined in Section 301.7701-3(b)(2)(ii) of the Procedure and Administration Regulations) for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized; or, (3) participates in the partnership's trade or business for more than 500 hours during the taxable year. If, however, substantially all of the activities of a partnership involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, any individual who provides services as part of that trade or business will not be considered a limited partner.

By adopting these functional tests, the proposed regulations ensure that similarly situated individuals owning interests in entities formed under different statutes or in different jurisdictions will be treated similarly. The need for a functional approach results not only from the proliferation of new business entities such as LLCs, but also from the evolution of state limited partnership statutes. When Congress enacted the limited partner exclusion found in section 1402(a)(13), state laws generally did not allow limited partners to participate in the partnership's trade or business to the extent that state laws allow limited partners to participate today. Thus, even in the case of a state law limited partnership, a functional approach is necessary to ensure that the self-employment tax consequences to similarly situated taxpayers do not differ depending upon where the partnership organized.

The proposed regulations allow an individual who is not a limited partner for section 1402(a)(13) purposes to nonetheless exclude from net earnings from self-employment a portion of that individual's distributive share if the individual holds more than one class of interest in the partnership. Similarly, the proposed regulations permit an individual that participates in the trade or business of the partnership to bifurcate his or her distributive share by disregarding guaranteed payments for services. In each case, however, such bifurcation of interests is permitted only to the extent the individual's distributive share is identical to the distributive share of partners who qualify as limited partners under the proposed regulation (without regard to the bifurcation rules) and who own a substantial interest in the partnership. Together, these rules exclude from an individual's net earnings from self-employment amounts that are demonstrably returns on capital invested in the partnership.

* * * * *

1.1402(a)-2(d) * * * Except as otherwise provided in section 1402(a) and paragraph (g) of this section, an individual's net earnings from self-employment include the individual's distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by each partnership of which the individual is a partner.

* * * * * * * *

1.1402(a)-2(f) * * * For rules governing the classification of an organization as a partnership or otherwise, see Sections 301.7701-1, 301.7701-2, and 301.7701-3 of this chapter.

1.1402(a)-2(g) Distributive share of limited partner.

An individual's net earnings from self-employment do not include the individual's distributive share of income or loss as a limited partner described in paragraph (h) of this section. However, guaranteed payments described in section 707(c) made to the individual for services actually rendered to or on behalf of the partnership engaged in a trade or business are included in the individual's net earnings from self-employment.

1.1402(a)-2(h) Definition of limited partner--

1.1402(a)-2(h)(1) In general.

Solely for purposes of section 1402(a)(13) and paragraph (g) of this section, an individual is considered to be a limited partner to the extent provided in paragraphs (h)(2), (h)(3), (h)(4), and (h)(5) of this section.

1.1402(a)-2(h)(2) Limited partner.

An individual is treated as a limited partner under this paragraph (h)(2) unless the individual--

1.1402(a)-2(h)(2)(i) Has personal liability (as defined in Section 301.7701-3(b)(2)(ii) of this chapter for the debts of or claims against the partnership by reason of being a partner;

1.1402(a)-2(h)(2)(ii) Has authority (under the law of the jurisdiction in which the partnership is formed) to contract on behalf of the partnership; or

1.1402(a)-2(h)(2)(iii) Participates in the partnership's trade or business for more than 500 hours during the partnership's taxable year.

1.1402(a)-2(h)(3) Exception for holders of more than one class of interest.

An individual holding more than one class of interest in the partnership who is not treated as a limited partner under paragraph (h)(2) of this section is treated as a limited partner under this paragraph (h)(3) with respect to a specific class of partnership interest held by such individual if, immediately after the individual acquires that class of interest--

1.1402(a)-2(h)(3)(i) Limited partners within the meaning of paragraph (h) (2) of this section own a substantial, continuing interest in that specific class of partnership interest; and,

1.1402(a)-2(h)(3)(ii) The individual's rights and obligations with respect to that specific class of interest are identical to the rights and obligations of that specific class of partnership interest held by the limited partners described in paragraph (h)(3)(i) of this section.

1.1402(a)-2(h)(4) Exception for holders of only one class of interest.

An individual who is not treated as a limited partner under paragraph (h)(2) of this section solely because that individual participates in the partnership's trade or business for more than 500 hours during the partnership's taxable year is treated as a limited partner under this paragraph (h)(4) with respect to the individual's partnership interest if, immediately after the individual acquires that interest--

1.1402(a)-2(h)(4)(i) Limited partners within the meaning of paragraph (h)(2) of this section own a substantial, continuing interest in that specific class of partnership interest; and

1.1402(a)-2(h)(4)(ii) The individual's rights and obligations with respect to the specific class of interest are identical to the rights and obligations of the specific class of partnership interest held by the limited partners described in paragraph (h)(4)(i) of this section.

1.1402(a)-2(h)(5) Exception for service partners in service partnerships.

An individual who is a service partner in a service partnership may not be a limited partner under paragraphs (h)(2), (h)(3), or (h)(4) of this section.

1.1402(a)-2(h)(6) Additional definitions.

Solely for purposes of this paragraph (h)--

1.1402(a)-2(h)(6)(i) A class of interest is an interest that grants the holder specific rights and obligations. If a holder's rights and obligations from an interest are different from another holder's rights and obligations, each holder's interest belongs to a separate class of interest. An individual may hold more than one class of interest in the same partnership provided that each class grants the individual different rights or obligations. The existence of a guaranteed payment described in section 707(c) made to an individual for services rendered to or on behalf of a partnership, however, is not a factor in determining the rights and obligations of a class of interest.

1.1402(a)-2(h)(6)(ii) A service partner is a partner who provides services to or on behalf of the service partnership's trade or business. A partner is not considered to be a service partner if that partner only provides a de minimis amount of services to or on behalf of the partnership.

1.1402(a)-2(h)(6)(iii) A service partnership is a partnership substantially all the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting.

1.1402(a)-2(h)(6)(iv) A substantial interest in a class of interest is determined based on all of the relevant facts and circumstances. In all cases, however, ownership of 20 percent or more of a specific class of interest is considered substantial.

1.1402(a)-2(h)(6)(i) Example.

The following example illustrates the principles of paragraphs (g) and (h) of this section:

Example.

(i) A, B, and C form LLC, a limited liability company, under the laws of State to engage in a business that is not a service partnership described in paragraph (h)(6)(iii) of this section. LLC, classified as a partnership for federal tax purposes, allocates all items of income, deduction, and credit of LLC to A, B, and C in proportion to their ownership of LLC. A and C each contribute $1x for one LLC unit. B contributes $2x for two LLC units. Each LLC unit entitles its holder to receive 25 percent of LLC's tax items, including profits. A does not perform services for LLC; however, each year B receives a guaranteed payment of $6x for 600 hours of services rendered to LLC and C receives a guaranteed payment of $10x for 1000 hours of services rendered to LLC. C also is elected LLC's manager. Under State's law, C has the authority to contract on behalf of LLC.

(ii) Application of general rule of paragraph (h)(2) of this section. A is treated as a limited partner in LLC under paragraph (h)(2) of this section because A is not liable personally for debts of or claims against LLC, A does not have authority to contract for LLC under State's law, and A does not participate in LLC's trade or business for more than 500 hours during the taxable year. Therefore, A's distributive share attributable to A's LLC unit is excluded from A's net earnings from self-employment under section 1402(a)(13).

(iii) Distributive share not included in net earnings from self-employment under paragraph (h)(4) of this section. B's guaranteed payment of $6x is included in B's net earnings from self-employment under section 1402(a) (13). B is not treated as a limited partner under paragraph (h)(2) of this section because, although B is not liable for debts of or claims against LLC and B does not have authority to contract for LLC under State's law, B does participates in LLC's trade or business for more than 500 hours during the taxable year. Further, B is not treated as a limited partner under paragraph (h) (3) of this section because B does not hold more than one class of interest in LLC. However, B is treated as a limited partner under paragraph (h)(4) of this section because B is not treated as a limited partner under paragraph (h)(2) of this section solely because B participated in LLC's business for more than 500 hours and because A is a limited partner under paragraph (h)(2) of this section who owns a substantial interest with rights and obligations that are identical to B's rights and obligations. In this example, B's distributive share is deemed to be a return on B's investment in LLC and not remuneration for B's service to LLC. Thus, B's distributive share attributable to B's two LLC units is not net earnings from self-employment under section 1402(a)(13).

(iv) Distributive share included in net earnings from self-employment. C's guaranteed payment of $10x is included in C's net earnings from self-employment under section 1402(a). In addition, C's distributive share attributable to C's LLC unit also is net earnings from self-employment under section 1402(a) because C is not a limited partner under paragraphs (h)(2), (h)(3), or (h) (4) of this section. C is not treated as a limited partner under paragraph (h) (2) of this section because C has the authority under State's law to enter into a binding contract on behalf of LLC and because C participates in LLC's trade or business for more than 500 hours during the taxable year. Further, C is not treated as a limited partner under paragraph (h)(3) of this section because C does not hold more than one class of interest in LLC. Finally, C is not treated as a limited partner under paragraph (h)(4) of this section because C has the power to bind LLC. Thus, C's guaranteed payment and distributive share both are included in C's net earnings from self-employment under section 1402(a).

IRS Code §475(f) Mark-to-Market election for taxpayers who have filed at least one federal income tax return (normally the year immediately preceding the election year):

Normal


Defective

TBA

IRS Code §475(f) Mark-to-Market elections for newly formed entities that have not filed a tax return yet:

No extension is available.  No extension is required.

For those taxpayers who are filing their first ever tax return, no filing deadlines for a timely mark-to-market election have been established, other than that the properly drafted election statement be placed in its books and records immediately in the first year and that a copy also be attached to the first original federal income tax return filed.  Typically this pertains to taxpaying entities other than individuals, such as a newly formed corporation or LLC.

Normal


Defective

TBA

Treasury Proposes Regulations on Safe Harbor for Valuation Under Mark-to-Market Accounting Method:

The Treasury Department proposes regulations setting forth an elective safe harbor for dealers in securities and commodities, and traders in securities and commodities, permitting an election pursuant to which values of positions reported on certain financial statements are fair market values of those positions for purposes of §475.

On May 5, 2003, the Treasury Department and the IRS published an Advance Notice of Proposed Rulemaking (ANPRM), REG-100420-03, and Announcement 2003-35, 2003-21 C.B. 956, setting forth a possible safe harbor using values reported on an applicable financial statements for valuing securities for purposes of §475 and requesting comments on various aspects of such a safe harbor. After receiving comments from the public, the Treasury Department proposed these regulations, setting forth a safe harbor for valuing securities and commodities under §475.

Safe Harbor. Under the proposed safe harbor, eligible taxpayers generally would be permitted to elect to have the values that are reported for eligible positions on certain financial statements treated as the fair market values reported for those eligible positions for purposes of §475, if certain conditions were met. To ensure minimal divergence from fair market value under tax principles, certain restrictions would be imposed on the financial accounting methods and financial statements that are eligible for the safe harbor and also require certain adjustments to the values of the eligible positions on those financial statements that may be used under the safe harbor. Further, the safe harbor would require that financial statement values be adjusted to comply with the requirements of §482 or §482 principles when applicable.

Eligible Taxpayers and Eligible Positions. The safe harbor would be available to any taxpayer subject to the mark-to-mark regime under §475 and, further, that a revenue procedure will be issued enumerating the types of securities and commodities subject to the safe harbor.

The preamble cautions that the valuation methodology under the safe harbor would apply only for positions that are properly marked under §475. For example, it notes that: (1) if a security is not marked under §475 because it has been identified as held for investment, then under the safe harbor it may not be marked for federal income tax purposes even though it is properly marked on the financial statement in accordance with U.S. Generally Accepted Accounting Principles (U.S. GAAP); and (2) if a security is not marked on the applicable financial statement because it is a hedge but §475(a) applies because the security was not identified as a hedge, then the security must still be marked under §475.

Eligible Method. To qualify for the safe harbor, a financial accounting method would be required to satisfy four basic requirements—it would be required: (1) to mark eligible positions to market through valuations made as of the last business day of each taxable year; (2) to recognize into income on the income statement any gain or loss from marking eligible positions to market; (3) to recognize into income on the income statement any gain or loss on disposition of an eligible position as if a year-end mark occurred immediately before the disposition; and (4) to arrive at fair value in accordance with U.S. GAAP.

In addition to the basic requirements, the safe harbor would also impose certain limitations that ensure minimal divergence from fair market value. First, in the case of securities and commodities dealers, except for eligible positions that are traded on a qualified board or exchange (as defined in §1256(g)(7)), the financial accounting method must not result in values at or near the bid or ask values, even if the use of bid or ask values is permissible in accordance with U.S. GAAP. Second, if the method of valuation consists of determining the present value of projected cash flows from an eligible position or positions, then the method must not take into account any cash flows of income or expense that are attributable to a period or time before the valuation date. Third, no cost or risk may be accounted for more than once, either directly or indirectly.

Election and Revocation. The election to use the safe harbor would be made by filing a statement with the taxpayer's timely filed federal income tax return for the taxable year for which the election is first effective. Such statement: (1) would be required to declare that the taxpayer makes the safe harbor election for all of its eligible positions; and (2) in addition to any other information that the Commissioner may require, the statement would be required to describe the taxpayer's applicable financial statement for the first taxable year for which the election is effective and to state that the taxpayer agrees to timely provide upon the request of the Commissioner all information, records, and schedules required by the safe harbor. The election would continue to be in effect for all subsequent taxable years unless it is revoked.

A taxpayer would not be allowed to revoke the election without the consent of the Commissioner. However, the Commissioner would be permitted to revoke the election if: (1) the taxpayer fails to comply with any of the recordkeeping and production requirements and cannot show reasonable cause for the failure; (2) the taxpayer ceases to use an eligible method; (3) the taxpayer ceases to have an applicable financial statement, as described below; or (4) the taxpayer holds a de minimis quantity of eligible positions that are subject to the safe harbor. A revocation would not be required if the taxpayer ceased to qualify as an eligible taxpayer, or §475 did not otherwise apply, because the safe harbor would only be permitted to be used to determine values and could not be used unless §475 applied. Once revoked by either the Commissioner or the taxpayer, neither the taxpayer nor any of its successors would be permitted to make the election for any taxable year that begins before the date that is six years after the first day of the earliest taxable year affected by the revocation without the consent of the Commissioner.

Applicable Financial Statements. Three categories of financial statements would qualify under the safe harbor and are set forth in order of priority, from highest to lowest. In the first and highest category are those financial statements that must be filed with the Securities and Exchange Commission (SEC) (e.g., 10-Ks and the Annual Statements to Shareholders). In the second category are those financial statements that must be provided to the federal government or any of its agencies other than the IRS (e.g., statements filed by foreign-controlled financial institutions engaged in trade or business within the United States who report their mark-to-market results to the Federal Reserve or the Office of the Comptroller of the Currency). In the third category are certified audited financial statements that are provided to creditors to make lending decisions, that are provided to equity holders to evaluate their investment, or that are provided for other substantial non-tax purposes and are reasonably anticipated to be directly relied on for the purposes for which the statements were created. For a financial statement described in any of the three categories above to qualify as an applicable financial statement, it would be required to be prepared in accordance with U.S. GAAP. Further, if a taxpayer has two statements in the same category, each of which would qualify under the safe harbor, then the statement that results in the highest aggregate valuation of eligible positions would be the only financial statement that may qualify for the safe harbor.

The preamble to the proposed regulations notes that statements filed with the SEC provide a high degree of confidence that the values used on those statements reflect reasonable approximations of fair value, and, consequently, there would be no additional business use requirements for those statements. However, the for the second category (statements filed with other agencies of the federal government) and the third category of statements (the other certified audited financial statements), this degree of confidence is ensured by requiring some substantial non-tax use in the taxpayer's business. Accordingly, the safe harbor would require that the values for eligible positions contained in these financial statements be used by the taxpayer in most of the significant management functions of all or substantially all of its business. This use includes activities such as: (1) senior management review of business-unit profitability; (2) market risk measurement or management; (3) credit risk measurement or management; (4) internal allocation of capital; and (5) compensation of personnel but would not include either tax accounting or reporting the results of operations to other persons.

The preamble notes that the IRS and the Treasury Department understand that some dealers maintain internal books of account, not prepared in accordance with U.S. GAAP, for separate segments of their business and that these internal books of account may include a charge to each operating segment of an internal "cost of carry" calculated in the manner of interest (and the derivatives dealer book may be treated as a separate business segment for that purpose). The preamble states that the maintenance of these segmented accounts, which may apply an accounting approach that does not qualify as an eligible accounting method, does not prevent some other financial statement prepared in accordance with U.S. GAAP from qualifying as the taxpayer's applicable financial statement.

Record Retention and Production; Use of Different Values. The proposed regulations provide specific requirements for the types of records that would be required to be maintained and provided to enable ready verification. In general, electing taxpayers would be required to clearly show: (1) that the same value used for financial reporting was used on the federal income tax return; (2) that no eligible position subject to §475 is excluded from the application of the safe harbor; and (3) that only eligible positions subject to §475 are carried over to the federal income tax return under the safe harbor. The proposed regulations outline what records would be required to be retained and produced, including certain forms and schedules filed with the Federal income tax return, such as the Schedule M-1, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More; Schedule M-3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More; and Form 1120F, U.S. Income Tax Return of a Foreign Corporation. The proposed regulations also provide that the Commissioner would be permitted to enter into an advance agreement with a taxpayer on how records are to be maintained and how long the records are to be retained. All of the necessary records would be required to be retained as long as their contents may become material in the administration of any internal revenue law.

To encourage rapid examinations of the federal income tax returns of electing taxpayers, all necessary records would be required to be produced within 30 days after the Commissioner requests them. If the required records are not provided as required, the proposed regulations would permit the Commissioner to use his discretion to: (1) extend the 30-day period; (2) excuse minor or inadvertent failures to provide the requested records; (3) require use of values that clearly reflect income but which are different from those used on the applicable financial statement; or (4) revoke the election if a taxpayer does not demonstrate reasonable cause for the failure to maintain and produce the required records.

M2M losses are excluded from Reportable Transactions:

IRS Issues Revenue Procedure Excluding Certain Losses from Reportable Transactions

The IRS released a revenue procedure that provides that certain losses are not taken into account in determining whether a transaction is a reportable loss transaction for purposes of the tax shelter disclosure rules under Regs. §1.6011-4(b)(5).

The IRS stated that the revenue procedure applies to taxpayers required to disclose reportable transactions under Regs. §1.6011-4, material advisors required to disclose reportable transactions under §6111 (as amended by the 2004 American Jobs Creation Act, P.L. 108-357, §815), and material advisors required to maintain lists under former and new §6112.

Under the revenue procedure, stated the IRS, a loss under §165 from the sale or exchange of an asset is not taken into account if: (1) the basis of the asset (for purposes of determining the loss) is a "qualifying basis;" (2) the asset is not an interest in a passthrough entity under §1260(c)(2), other than regular interests in a REMIC as defined in §860G(a)(1); (3) the loss from the sale or exchange of the asset is not treated as ordinary under §988; (4) the asset has not been separated from any portion of the income it generates; and (5) the asset is not, and has never been, part of a straddle under §1092(c), excluding mixed straddles under Regs. §1.1092(b)-4T. The IRS provided further guidance on in what situations a taxpayer's basis in an asset is a "qualifying basis."

The IRS stated that the revenue procedure also provides that the following losses under §165 are also not taken into account under Regs. §1.6011-4(b)(5): (1) a loss under §165(c)(3) from fire, storm, shipwreck, or other casualty, or from theft; (2) a loss from a compulsory or involuntary conversion under §1231(a)(3)(A)(ii) or (4)(B); (3) a loss to which §475(a) or §1256(a) applies; (4) a loss arising from any mark-to-market treatment of an item under §475(f), §1296(a), Regs. §1.446-4(e), Regs. §1.988-5(a)(6), or Regs. §1.1275-6(d)(2), and any loss from a sale or disposition of an item to which one of the foregoing provisions applied, provided that the taxpayer computes its loss by using a qualifying basis or a basis resulting from previously marking the item to market, or computes its loss by making appropriate adjustments for previously determined mark-to-market gain or loss; (5) a loss arising from a §1221(b) hedging transaction, if the taxpayer properly identifies the transaction as a hedging transaction, or from a mixed straddle account under Regs. §1.1092(b)-4T; (6) a loss attributable to basis increases under §860C(d)(1) during the period of the taxpayer's ownership; (7) a loss attributable to the abandonment of depreciable tangible property that was used by the taxpayer in a trade or business and that has a qualifying basis; (8) a loss arising from the bulk sale of inventory if the basis of the inventory is determined under §263A; (9) a loss that is equal to, and is determined solely by reference to, a payment of cash by the taxpayer; (10) a loss from the sale to a person other than a related party under §267(b) or §707(b) of property described in §1221(a)(4) in a factoring transaction in the ordinary course of business; or (11) a loss arising from the disposition of an asset to the extent that the taxpayer's basis in the asset is determined under §338(b).
The revenue procedure modifies and supersedes Rev. Proc. 2003-24, 2003-11 I.R.B. 599.
Rev. Proc. 2004-66 is effective November 16, 2004, and applies to transactions that are entered into on or after January 1, 2003.
Rev. Proc. 2004-66 is scheduled to appear in I.R.B. 2004-50, dated December 13, 2004.

IRS Code §481 elections:

See lower portion of the form 3115 web page

IRS Code §1256 Mark-to-Market election for dealers:

TBA

IRS Code §1256 hedging election:

TBA

Deadline to Be Extended for Elections Under Mark-to-Mark Accounting:

Mark-to-Market Method §475

Deadline to Be Extended for Elections Under Mark-to-Mark Accounting
The IRS plans to issue additional guidance on how securities dealers may elect out of exemptions provided for in the final regulations under §475 tro The regulations contain elections out of certain exemptions, including the intragroup-customer election (Regs. §1.475(c)-1(a)(3)(iii)(B)), the customer paper election (Regs. §1.475(c)-1(b)(4)(i)), and the negligible sales election (Regs. §1.475(c)-1(c)(1)(ii)). Regs. §1.475(c)-1(b)(4)(i)(B) provides a June 23, 1997, deadline to make the customer paper election on an amended return.

The IRS intends to issue guidance that will address the interplay of the elections under Regs. §1.475(c)-1, the extent to which these elections are available on a retroactive basis, and the application of the §475(b)(2) identification requirements to taxpayers making these elections. The additional guidance will extend the filing deadline from June 23, 1997, to at least 45 days after that guidance is released.
Notice 97-37 is scheduled to appear in I.R.B. 1997-27, dated July 7, 1997.
¨ Notice 97-37, 1997-27 I.R.B. ___.

§ 301.9100-1 Extensions of time to make elections:

87428342837884818742
301.9100-1(a) Introduction.
The regulations under this section and Sections 301.9100-2 and 301.9100-3 provide the standards the Commissioner will use to determine whether to grant an extension of time to make a regulatory election. The regulations under this section and Section 301.9100-2 also provides an automatic extension of time to make certain statutory elections. An extension of time is available for elections that a taxpayer is otherwise eligible to make. However, the granting to an extension of time is not a determination that the taxpayer is otherwise eligible to make the election. Section 301.9100-2 provides automatic extensions of time for making regulatory and statutory elections when the deadline for making the election is the due date of the return or the due date of the return including extensions. Section 301.9100-3 provides extensions of time for making regulatory elections that do not meet the requirements of Section 301.9100-2.
301.9100-1(b) Terms.
The following terms have the meanings provided below -
Election includes an application for relief in respect of tax; a request to adopt, change, or retain an accounting method or accounting period; but does not include an application for an extension of time for filing a return under section 6081.
Regulatory election means an election whose due date is prescribed by a regulation published in the Federal Register, or a revenue ruling, revenue procedure, notice, or announcement published in the Internal Revenue Bulletin (see Section 601.601(d)(2) of this chapter).
Statutory election means an election whose due date is prescribed by statute.
Taxpayer means any person within the meaning of section 7701(a)(1).
301.9100-1(c) General standards for relief.
The Commissioner in exercising the Commissioner's discretion may grant a reasonable extension of time under the rules set forth in Sections 301.9100-2 and 301.9100-3 to make a regulatory election, or a statutory election (but no more than 6 months except in the case of a taxpayer who is abroad), under all subtitles of the Internal Revenue Code except subtitles E, G, H, and I.
301.9100-1(d) Exceptions.
Notwithstanding the provisions of paragraph (c) of this section, an extension of time will not be granted -
301.9100-1(d)(1) For elections under section 4980A(f)(5); or
301.9100-1(d)(2) For elections that are expressly excepted from relief or where alternative relief is provided by a statute, a regulation published in the Federal Register, or a revenue ruling, revenue procedure, notice, or announcement published in the Internal Revenue Bulletin (see Section 601.601(d)(2) of this chapter).
301.9100-1(e) Effective dates.
In general, this section and Sections 301.9100-2 and 301.9100-3 apply to all requests for an extension of time submitted to the Internal Revenue Service (IRS) on or after Dec. 31, 1997. However, the automatic 12-month and 6-month extensions provided in Section 301.9100-2 apply to elections for which corrective action is taken on or after Dec. 31, 1997. For other requests for an extension of time, see Sections 301.9100-1T through 301.9100-3T in effect prior to Dec. 31, 1997, (Sections 301.9100-1T through 301.9100-3T as contained in the 26 CFR part 1 edition revised as of April 1, 1997).
[T.D. 8342, 56 FR 14024, Apr. 5, 1991, as amended by T.D. 8378, 56 FR 64982, Dec. 13, 1991; T.D. 8481, 58 FR 34886-34887, June 30, 1993; as revised by T.D. 8742, 62 FR 68167-68173, Dec. 31, 1997.]
 

§ 301.9100-2 Automatic extensions:

874283428378848187428680871987428742
301.9100-2(a) Automatic 12-month extension -
301.9100-2(a)(1) In general.
An automatic extension of 12 months from the due date for making a regulatory election is granted to make elections described in paragraph (a)(2) of this section provided the taxpayer takes corrective action as defined in paragraph (c) of this section within that 12-month extension period. For purposes of this paragraph (a), the due date for making a regulatory election is the extended due date of the return if the due date of the election is the due date of the return or the due date of the return including extensions and the taxpayer has obtained an extension of time to file the return. This extension is available regardless of whether the taxpayer timely filed its return for the year the election should have been made.
301.9100-2(a)(2) Elections eligible for automatic 12-month extension.
The following regulatory elections are eligible for the automatic 12-month extension described in paragraph (a)(1) of this section -
301.9100-2(a)(2)(i) The election to use other than the required taxable year under section 444;
301.9100-2(a)(2)(ii) The election to use the last-in, first-out (LIFO) inventory method under section 472;
301.9100-2(a)(2)(iii) The 15-month rule for filing an exemption application for a section 501(c)(9), 501(c)(17), or 501(c)(20) organization under section 505;
301.9100-2(a)(2)(iv) The 15-month rule for filing an exemption application for a section 501(c)(3) organization under section 508;
301.9100-2(a)(2)(v) The election to be treated as a homeowners association under section 528;
301.9100-2(a)(2)(vi) The election to adjust basis on partnership transfers and distributions under section 754;
301.9100-2(a)(2)(vii) The estate tax election to specially value qualified real property (where the Internal Revenue Service (IRS) has not yet begun an examination of the filed return) under section 2032A(d)(1);
301.9100-2(a)(2)(Viii) The chapter 14 gift tax election to treat a qualified payment right as other than a qualified payment under section 2701(c)(3)(C)(i); and
301.9100-2(a)(2)(ix) The chapter 14 gift tax election to treat any distribution right as a qualified payment under section 2701(c)(3)(C)(ii).
301.9100-2(b) Automatic 6-month extension.
An automatic extension of 6 months from the due date of a return excluding extensions is granted to make regulatory or statutory elections whose due dates are the due date of the return or the due date of the return including extensions provided the taxpayer timely filed its return for the year the election should have been made and the taxpayer takes corrective action as defined in paragraph (c) of this section within that 6-month extension period. This paragraph (b) does not apply to regulatory or statutory elections that must be made by the due date of the return excluding extensions.
301.9100-2(c) Corrective action.
For purposes of this section, corrective action means taking the steps required to file the election in accordance with the statute or the regulation published in the Federal Register, or the revenue ruling, revenue procedure, notice, or announcement published in the Internal Revenue Bulletin (see Section 601.601(d)(2) of this chapter). For those elections required to be filed with a return, corrective action includes filing an original or an amended return for the year the regulatory or statutory election should have been made and attaching the appropriate form or statement for making the election. Taxpayers who make an election under an automatic extension (and all taxpayers whose tax liability would be affected by the election) must file their return in a manner that is consistent with the election and comply with all other requirements for making the election for the year the election should have been made and for all affected years; otherwise, the IRS may invalidate the election.
301.9100-2(d) Procedural requirements.
Any return, statement of election, or other form of filing that must be made to obtain an automatic extension must provide the following statement at the top of the document: "FILED PURSUANT TO Section 301.9100-2". Any filing made to obtain an automatic extension must be sent to the same address that the filing to make the election would have been sent had the filing been timely made. No request for a letter ruling is required to obtain an automatic extension. Accordingly, user fees do not apply to taxpayers taking corrective action to obtain an automatic extension.
301.9100-2(e) Examples.
The following examples illustrate the provisions of this section:
Example 1. Automatic 12-month extension.
Taxpayer A fails to make an election described in paragraph (a)(2) of this section when filing A's 1997 income tax return on March 16, 1998, the due date of the return. This election does not affect the tax liability of any other taxpayer. The applicable regulation requires that the election be made by attaching the appropriate form to a timely filed return including extensions. In accordance with paragraphs (a) and (c) of this section. A may make the regulatory election by taking the corrective action of filing an amended return with the appropriate form by March 15, 1999 (12 months from the March 16, 1998 due date of the return). If A obtained a 6-month extension to file its 1997 income tax return, A may make the regulatory election by taking the corrective action of filing an amended return with the appropriate form by September 15, 1999 (12 months from the September 15, 1998 extended due date of the return).
Example 2. Automatic 6-month extension.
Taxpayer B fails to make an election not described in paragraph (a)(2) of this section when filing B's 1997 income tax return on March 16, 1998, the due date of the return. This election does not affect the tax liability of any other taxpayer. The applicable regulation requires that the election be made by attaching the appropriate form to a timely filed return including extensions. In accordance with paragraphs (b) and (c) of this section, B may make the regulatory election by taking the corrective action of filing an amended return with the appropriate form by September 15, 1998 (6 months from the March 16, 1998 due date of the return).
[T.D. 8742, 62 FR 68167-68173, Dec. 31, 1997.]
 

From STEVEN A. AND PATRICIA A. KNISH, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent December 18, 2006
Relief under sec. 301.9100-2, Proced. & Admin. Regs., is unavailable for extensions of time to file mark-to-market elections under sec. 475(f) because it does not apply to elections, like the mark-to-market election, that must be made by the due date of the return without regard to extensions. Sec. 301.9100-2(b), Proced. & Admin. Regs.; Rev. Proc. 99-17, 1999-1 C.B. 503.

§ 301.9100-3 Other extensions:

874283428378848187428680871987428742868087428742
301.9100-3(a) In general.
Requests for extensions of time for regulatory elections that do not meet the requirements of Section 301.9100-2 must be made under the rules of this section. Requests for relief subject to this section will be granted when the taxpayer provides the evidence (including affidavits described in paragraph (e) of this section) to establish to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the Government.
301.9100-3(b) Reasonable action and good faith -
301.9100-3(b)(1) In general.
Except as provided in paragraphs (b)(3)(i) through (iii) of this section, a taxpayer is deemed to have acted reasonably and in good faith if the taxpayer -
301.9100-3(b)(1)(i) Requests relief under this section before the failure to make the regulatory election is discovered by the Internal Revenue Service (IRS);
301.9100-3(b)(1)(ii) Failed to make the election because of intervening events beyond the taxpayer's control;
301.9100-3(b)(1)(iii) Failed to make the election because, after exercising reasonable diligence (taking into account the taxpayer's experience and the complexity of the return or issue), the taxpayer was unaware of the necessity for the election;
301.9100-3(b)(1)(iv) Reasonably relied on the written advice of the Internal Revenue Service (IRS); or
301.9100-3(b)(1)(v) Reasonably relied on a qualified tax professional, including a tax professional employed by the taxpayer, and the tax professional failed to make, or advise the taxpayer to make, the election.
301.9100-3(b)(2) Reasonable reliance on a qualified tax professional.
For purposes of this paragraph (b), a taxpayer will not be considered to have reasonably relied on a qualified tax professional if the taxpayer knew or should have known that the professional was not -
301.9100-3(b)(2)(i) Competent to render advice on the regulatory election; or
301.9100-3(b)(2)(ii) Aware of all relevant facts.
301.9100-3(b)(3) Taxpayer deemed to have not acted reasonably or in good faith.
For purposes of this paragraph (b), a taxpayer is deemed to have not acted reasonably and in good faith if the taxpayer -
301.9100-3(b)(3)(i) Seeks to alter a return position for which an accuracy-related penalty has been or could be imposed under section 6662 at the time the taxpayer requests relief (taking into account any qualified amended return filed within the meaning of Section 1.6664-2(c)(3) of this chapter) and the new position requires or permits a regulatory election for which relief is requested;
301.9100-3(b)(3)(ii) Was informed in all material respects of the required election and related tax consequences, but chose not to file the election; or
301.9100-3(b)(3)(iii) Uses hindsight in requesting relief. If specific facts have changed since the due date for making the election that make the election advantageous to a taxpayer, the IRS will not ordinarily grant relief. In such a case, the IRS will grant relief only when the taxpayer provides strong proof that the taxpayer's decision to seek relief did not involve hindsight.
301.9100-3(c) Prejudice to the interests of the Government -
301.9100-3(c)(1) In general.
The Commissioner will grant a reasonable extension of time to make a regulatory election only when the interests of the Government will not be prejudiced by the granting of relief. This paragraph (c) provides the standards the Commissioner will use to determine when the interests of the Government are prejudiced.
301.9100-3(c)(1)(i) Lower tax liability.
The interests of the Government are prejudiced if granting relief would result in a taxpayer having a lower tax liability in the aggregate for all taxable years affected by the election than the taxpayer would have had if the election had been timely made (taking into account the time value of money). Similarly, if the tax consequences of more than one taxpayer are affected by the election, the Government's interests are prejudiced if extending the time for making the election may result in the affected taxpayers, in the aggregate, having a lower tax liability than if the election had been timely made.
301.9100-3(c)(1)(ii) Closed years.
The interests of the Government are ordinarily prejudiced if the taxable year in which the regulatory election should have been made or any taxable years that would have been affected by the election had it been timely made are closed by the period of limitations on assessment under section 6501(a) before the taxpayer's receipt of a ruling granting relief under this section. The IRS may condition a grant of relief on the taxpayer providing the IRS with a statement from an independent auditor (other than an auditor providing an affidavit pursuant to paragraph (e)(3) of this section) certifying that the interests of the Government are not prejudiced under the standards set forth in paragraph (c)(1)(i) of this section.
301.9100-3(c)(2) Special rules for accounting method regulatory elections.
The interests of the Government are deemed to be prejudiced except in unusual and compelling circumstances if the accounting method regulatory election for which relief is requested -
301.9100-3(c)(2)(i) Is subject to the procedure described in Section 1.446-1(e)(3)(i) of this chapter (requiring the advance written consent of the Commissioner);
301.9100-3(c)(2)(ii) Requires an adjustment under section 481(a) (or would require an adjustment under section 481(a) if the taxpayer changed to the method of accounting for which relief is requested in a taxable year subsequent to the taxable year the election should have been made);
301.9100-3(c)(2)(iii) Would permit a change from an impermissible method of accounting that is an issue under consideration by examination, an appeals office, or a federal court and the change would provide a more favorable method or more favorable terms and conditions than if the change were made as part of an examination; or
301.9100-3(c)(2)(iv) Provides a more favorable method of accounting or more favorable terms and conditions if the election is made by a certain date or taxable year.
301.9100-3(c)(3) Special rules for accounting period regulatory elections.
The interests of the Government are deemed to be prejudiced except in unusual and compelling circumstances if an election is an accounting period regulatory election (other than the election to use other than the required taxable year under section 444) and the request for relief is filed more than 90 days after the due date for filing the Form 1128, Application to Adopt, Change, or Retain a Tax Year (or other required statement).
301.9100-3(d) Effect of amended returns -
301.9100-3(d)(1) Second examination under section 7605(b).
Taxpayers requesting and receiving an extension of time under this section waive any objections to a second examination under section 7605(b) for the issue(s) that is the subject of the relief request and any correlative adjustments.
301.9100-3(d)(2) Suspension of the period of limitations under section 6501(a).
A request for relief under this section does not suspend the period of limitations on assessment under section 6501(a). Thus, for relief to be granted, the IRS may require the taxpayer to consent under section 6501(c)(4) to an extension of the period of limitations on assessment for the taxable year in which the regulatory election should have been made and any taxable years that would have been affected by the election had it been timely made.
301.9100-3(e) Procedural requirements -
301.9100-3(e)(1) In general.
Requests for relief under this section must provide evidence that satisfies the requirements in paragraphs (b) and (c) of this section, and must provide additional information as required by this paragraph (e).
301.9100-3(e)(2) Affidavit and declaration from taxpayer.
The taxpayer, or the individual who acts on behalf of the taxpayer with respect to tax matters: must submit a detailed affidavit describing the events that led to the failure to make a valid regulatory election and to the discovery of the failure. When the taxpayer relied on a qualified tax professional for advice, the taxpayer's affidavit must describe the engagement and responsibilities of the professional as well as the extent to which the taxpayer relied on the professional. The affidavit must be accompanied by a dated declaration, signed by the taxpayer, which states: "Under penalties of perjury, I declare that I have examined this request, including accompanying documents, and, to the best of my knowledge and belief, the request contains all the relevant facts relating to the request, and such facts are true, correct, and complete." The individual who signs for an entity must have personal knowledge of the facts and circumstances at issue.
301.9100-3(e)(3) Affidavits and declarations from other parties.
The taxpayer must submit detailed affidavits from the individuals having knowledge or information about the events that led to the failure to make a valid regulatory election and to the discovery of the failure. These individuals must include the taxpayer's return preparer, any individual (including an employee of the taxpayer) who made a substantial contribution to the preparation of the return, and any accountant or attorney, knowledgeable in tax matters, who advised the taxpayer with regard to the election. An affidavit must describe the engagement and responsibilities of the individual as well as the advice that the individual provided to the taxpayer. Each affidavit must include the name, current address, and taxpayer identification number of the individual, and be accompanied by a dated declaration, signed by the individual, which states: "Under penalties of perjury, I declare that I have examined this request, including accompanying documents, and, to the best of my knowledge and belief, the request contains all the relevant facts relating to the request, and such facts are true, correct, and complete."
301.9100-3(e)(4) Other information.
The request for relief filed under this section must also contain the following information -
301.9100-3(e)(4)(i) The taxpayer must state whether the taxpayer's return(s) for the taxable year in which the regulatory election should have been made or any taxable years that would have been affected by the election had it been timely made is being examined by a district director, or is being considered by an appeals office or a federal court. The taxpayer must notify the IRS office considering the request for relief if the IRS starts an examination of any such return while the taxpayer's request for relief is pending;
301.9100-3(e)(4)(ii) The taxpayer must state when the applicable return, form, or statement used to make the election was required to be filed and when it was actually filed;
301.9100-3(e)(4)(iii) The taxpayer must submit a copy of any documents that refer to the election;
301.9100-3(e)(4)(iv) When requested, the taxpayer must submit a copy of the taxpayer's return for any taxable year for which the taxpayer requests an extension of time to make the election and any return affected by the election; and
301.9100-3(e)(4)(v) When applicable, the taxpayer must submit a copy of the returns of other taxpayers affected by the election.
301.9100-3(e)(5) Filing instructions.
A request for relief under this section is a request for a letter ruling. Requests for relief should be submitted in accordance with the applicable procedures for requests for a letter ruling and must be accompanied by the applicable user fee.
301.9100-3(f) Examples.
The following examples illustrate the provisions of this section:
Example 1. Taxpayer discovers own error.
Taxpayer A prepares A's 1997 income tax return. A is unaware that a particular regulatory election is available to report a transaction in a particular manner. A files the 1997 return without making the election and reporting the transaction in a different manner. In 1999, A hires a qualified tax professional to prepare A's 1999 return. The professional discovers that A did not make the election. A promptly files for relief in accordance with this section. Assume paragraphs (b)(3)(i) through (iii) of this section do not apply. Under paragraph (b)(1)(i) of this section, A is deemed to have acted reasonably and in good faith because A requested relief before the failure to make the regulatory election was discovered by the IRS.
Example 2. Reliance on qualified tax professional.
Taxpayer B hires a qualified tax professional to advise B on preparing B's 1997 income tax return. The professional was competent to render advice on the election and B provided the professional with all the relevant facts. The professional fails to advise B that a regulatory election is necessary in order for B to report income on B's 1997 return in a particular manner. Nevertheless, B reports this income in a manner that is consistent with having made the election. In 2000, during the examination of the 1997 return by the IRS, the examining agent discovers that the election has not been filed. B promptly files for relief in accordance with this section, including attaching an affidavit from B's professional stating that the professional failed to advise B that the election was necessary. Assume paragraphs (b)(3)(i) through (iii) of this section do not apply. Under paragraph (b)(1)(v) of this section, B is deemed to have acted reasonably and in good faith because B reasonably relied on a qualified tax professional and the tax professional failed to advise B to make the election.
Example 3. Accuracy-related penalty.
Taxpayer C reports income on its 1997 income tax return in a manner that is contrary to a regulatory provision. In 2000, during the examination of the 1997 return, the IRS raises an issue regarding the reporting of this income on C's return and asserts the accuracy-related penalty under section 6662. C requests relief under this section to elect an alternative method of reporting the income. Under paragraph (b)(3)(i) of this section, C is deemed to have not acted reasonably and in good faith because C seeks to alter a return position for which an accuracy-related penalty could be imposed under section 6662.
Example 4. Election not requiring adjustment under section 481(a).
Taxpayer D prepares D's 1997 income tax return. D is unaware that a particular accounting method regulatory election is available. D files D's 1997 return without making the election and uses another permissible method of accounting. The applicable regulation provides that the election is made on a cut-off basis (without an adjustment under section 481(a)). In 1998, D requests relief under this section to make the election under the regulation. If D were granted an extension of time to make the election, D would pay no less tax than if the election had been timely made. Assume that paragraphs (c)(2)(i), (iii), and (iv) of this section do not apply. Under paragraph (c)(2)(ii) of this section, the interests of the Government are not deemed to be prejudiced because the election does not require an adjustment under section 481(a).
Example 5. Election requiring adjustment under section 481(a).
The facts are the same as in Example 4 of this paragraph (f) except that the applicable regulation provides that the election requires an adjustment under section 481(a). Under paragraph (c)(2)(ii) of this section, the interests of the Government are deemed to be prejudiced except in unusual or compelling circumstances.
Example 6. Under examination by the IRS.
A regulation permits an automatic change in method of accounting for an item on a cut-off basis. Taxpayer E reports income on E's 1997 income tax return using an impermissible method of accounting for the item. In 2000, during the examination of the 1997 return by the IRS, the examining agent notifies E in writing that its method of accounting for the item is an issue under consideration. Any change from the impermissible method made as part of an examination is made with an adjustment under section 481(a). E requests relief under this section to make the change pursuant to the regulation for 1997. The change on a cut-off basis under the regulation would be more favorable than if the change were made with an adjustment under section 481(a) as part of an examination. Under paragraph (c)(2)(iii) of this section, the interests of the Government are deemed to be prejudiced except in unusual and compelling circumstances because E seeks to change from an impermissible method of accounting that is an issue under consideration in the examination on a basis that is more favorable than if the change were made as part of an examination.
[T.D. 8742, 62 FR 68167-68173, Dec. 31, 1997.]

Interest Expense deduction paid for Debt-Financed Acquisition of a trade or business pass-thru entity:

IRS Notice 88-37, 1988-1 C.B. 522
Individuals should report interest expense paid or incurred in connection with debt-financed acquisitions on either Schedule E or Schedule A of Form 1040.

2. Interest expense allocated to trade or business expenditures
Interest expense allocated to a trade or business expenditure (within the meaning of Section 1.163-8T(b)(7)) of a passthrough entity should be reported in Part II of Schedule E. This interest expense should be identified on a separate line in column (a) as "business interest," followed by the name of the passthrough entity to which the interest expense relates, and the amount of such interest expense should be entered in column (h). This interest expense is deductible without limitation and should not be entered on Form 8582, relating to passive activity loss limitations, or Form 4952, relating to investment interest.
 

IRS Notice 89-35, 1989-1 C.B. 675
Individuals should report allowable interest expense paid or incurred in connection with debt-financed acquisitions on either Schedule E or Schedule A of Form 1040.
Taxpayers other than individuals should report interest expense on debt- financed acquisitions on the line for interest expense on their returns, in accordance with section IV.B. of Notice 88-37

Election to treat debt as not secured by a qualified residence §163:

A taxpayer can elect to treat any debt secured by a qualified residence as not secured by a qualified residence. The election is effective for the tax year when made and for all subsequent tax years.

Apparently, Congress intended that such interest would not be characterized as business interest without the election being made. The Conference Report accompanying TRA ‘86 noted, for example, that interest on a refinancing secured by the taxpayer's residence "is treated as qualified residence interest, regardless of the purpose for which the borrowed funds are used by the taxpayer." [H.R. Rep. No. 841, 99th Cong., 2d Sess. II-155 (1986)]

Temporary Regulation 1.163-8T(m)(3) provides: "... qualified residence interest (as defined in IRC Sec 163(h)(3) is not taken into account in determining the income or loss ... for purposes of (passive activities) ... or in determining the amount of investment interest ...".

This election may be advantageous when, for example, interest on the debt is otherwise deductible as investment interest. The election then preserves the taxpayer's ability to incur other debt that is secured by the qualified residence. (see IRS Letter Ruling 9335043, June 8, 1993).

Temporary Reg. §1.163-10T(o)(5) Election to treat debt as not secured by a qualified residence

(i) In general. --For purposes of this section, a taxpayer may elect to treat any debt that is secured by a qualified residence as not secured by the qualified residence. An election made under this paragraph shall be effective for the taxable year for which the election is made and for all subsequent taxable years unless revoked with the consent of the Commissioner.

(ii) Example. --T owns a principal residence with a fair market value of $75,000 and an adjusted purchase price of $40,000. In 1988, debt A, the proceeds of which were used to purchase the residence, has an average balance of $15,000. The proceeds of debt B, which is secured by a second mortgage on the property, are allocable to T's trade or business under §1.163-8T and has an average balance of $25,000. In 1988, T incurs debt C, which is also secured by T's principal residence and which has an average balance in 1988 of $5,000. In the absence of an election to treat debt B as unsecured, the applicable debt limit for debt C in 1988 under paragraph (e) of this section would be zero dollars ($40,000 - $15,000 - $25,000) and none of the interest paid on debt C would be qualified residence interest. If, however, T makes or has previously made an election pursuant to paragraph (o)(5)(i) of this section to treat debt B as not secured by the residence, the applicable debt limit for debt C would be $25,000 ($40,000 - $15,000), and all of the interest paid on debt C during the taxable year would be qualified residence interest. Since the proceeds of debt B are allocable to T's trade or business under §1.163-8T, interest on debt B may be deductible under other sections of the Internal Revenue Code.

How to elect
By deducting the interest on the appropriate lines of the tax return. Attaching a statement to the tax return is recommended, although not required.  Such as: "Taxpayer hereby elects for this tax year and all subsequent years to treat the following debt as not secured by a qualified residence $XXX,XXX  borrowed from ABC Bank & Trust Co."

Election to Capitalize Carrying Costs (property taxes) §266:

§1.266-1. Taxes and carrying charges chargeable to capital account and treated as capital items
§1.266-1(a)(1) In general. --In accordance with section 266, items enumerated in paragraph (b)(1) of this section may be capitalized at the election of the taxpayer. Thus, taxes and carrying charges with respect to property of the type described in this section are chargeable to capital account at the election of the taxpayer, notwithstanding that they are otherwise expressly deductible under provisions of subtitle A of the Code. No deduction is allowable for any items so treated.

§1.266-1(a)(2) See §§1.263A-8 through 1.263A-15 for rules regarding the requirement to capitalize interest, that apply prior to the application of this section. After applying §§1.263A-8 through 1.263A-15, a taxpayer may elect to capitalize interest under section 266 with respect to designated property within the meaning of §1.263A-8(b), provided a computation under any provision of the Internal Revenue Code is not thereby materially distorted, including computations relating to the source of deductions.

§1.266-1(b) Taxes and carrying charges

§1.266-1(b)(1) The taxpayer may elect, as provided in paragraph (c) of this section, to treat the items enumerated in this subparagraph which are otherwise expressly deductible under the provisions of subtitle A of the Code as chargeable to capital account either as a component of original cost or other basis, for the purposes of section 1012, or as an adjustment to basis, for the purpose of section 1016(a)(1). The items thus chargeable to capital account are --

§1.266-1(b)(i) In the case of unimproved and unproductive real property:

Annual taxes, interest on a mortgage, and other carrying charges.

§1.266-1(b)(ii) In the case of real property, whether improved or unimproved and whether productive or unproductive:

(a) Interest on a loan (but not theoretical interest of a taxpayer using his own funds),

(b) Taxes of the owner of such real property measured by compensation paid to his employees,

(c) Taxes of such owner imposed on the purchase of materials, or on the storage, use, or other consumption of materials, and

(d) Other necessary expenditures,

paid or incurred for the development of the real property or for the construction of an improvement or additional improvement to such real property, up to the time the development or construction work has been completed. The development or construction work with respect to which such items are incurred may relate to unimproved and unproductive real estate whether the construction work will make the property productive of income subject to tax (as in the case of a factory) or not (as in the case of a personal residence), or may relate to property already improved or productive (as in the case of a plant addition or improvement, such as the construction of another floor on a factory or the installation of insulation therein).

§1.266-1(b)(iii) In the case of personal property:

(a) Taxes of an employer measured by compensation for services rendered in transporting machinery or other fixed assets to the plant or installing them therein,

(b) Interest on a loan to purchase such property or to pay for transporting or installing the same, and

(c) Taxes of the owner thereof imposed on the purchase of such property or on the storage, use, or other consumption of such property, paid or incurred up to the date of installation or the date when such property is first put into use by the taxpayer, whichever date is later.

§1.266-1(b)(iv) Any other taxes and carrying charges with respect to property, otherwise deductible, which in the opinion of the Commissioner are, under sound accounting principles, chargeable to capital account.

§1.266-1(2) The sole effect of section 266 is to permit the items enumerated in subparagraph (1) of this paragraph to be chargeable to capital account notwithstanding that such items are otherwise expressly deductible under the provisions of subtitle A of the Code. An item not otherwise deductible may not be capitalized under section 266.

(3) In the absence of a provision in this section for treating a given item as a capital item, this section has no effect on the treatment otherwise accorded such item. Thus, items which are otherwise deductible are deductible notwithstanding the provisions of this section, and items which are otherwise treated as capital items are to be so treated. Similarly, an item not otherwise deductible is not made deductible by this section. Nor is the absence of a provision in this section for treating a given item as a capital item to be construed as withdrawing or modifying the right now given to the taxpayer under any other provisions of subtitle A of the Code, or of the regulations thereunder, to elect to capitalize or to deduct a given item.

§1.266-1(c) Election to charge taxes and carrying charges to capital account

§1.266-1(c)(1) If for any taxable year there are two or more items of the type described in paragraph (b)(1) of this section, which relate to the same project to which the election is applicable, the taxpayer may elect to capitalize any one or more of such items even though he does not elect to capitalize the remaining items or to capitalize items of the same type relating to other projects. However, if expenditures for several items of the same type are incurred with respect to a single project, the election to capitalize must, if exercised, be exercised as to all items of that type. For purposes of this section, a "project" means, in the case of items described in paragraph (b)(1)(ii) of this section, a particular development of, or construction of an improvement to, real property, and in the case of items described in paragraph (b)(1)(iii) of this section, the transportation and installation of machinery or other fixed assets.

§1.266-1(c)(2)(i) An election with respect to an item described in paragraph (b)(1)(i) of this section is effective only for the year for which it is made.

§1.266-1(c)(2)(ii) An election with respect to an item described in --

(a) Paragraph (b)(1)(ii) of this section is effective until the development or construction work described in that subdivision has been completed;

(b) Paragraph (b)(1)(iii) of this section is effective until the later of either the date of installation of the property described in that subdivision, or the date when such property is first put into use by the taxpayer;

(c) Paragraph (b)(1)(iv) of this section is effective as determined by the Commissioner.

Thus, an item chargeable to capital account under this section must continue to be capitalized for the entire period described in this subdivision applicable to such election although such period may consist of more than one taxable year.

§1.266-1(c)(3) If the taxpayer elects to capitalize an item or items under this section, such election shall be exercised by filing with the original return for the year for which the election is made a statement indicating the item or items (whether with respect to the same project or to different projects) which the taxpayer elects to treat as chargeable to capital account. Elections filed for taxable years beginning before January 1, 1954, and for taxable years ending before August 17, 1954, under section 24(a)(7) of the Internal Revenue Code of 1939, and the regulations thereunder, shall have the same effect as if they were filed under this section. See section 7807(b)(2).

Deadline as late as three years under §301.9100-1(c)
PLR 200629024 allowed retroactive election to capitalize property taxes not otherwise deductible due to the AMT.  Extension of time to elect granted under §§301.9100-1 and 301.9100-3.

Extension for forgotten rental election:

IRS Issues Private Letter Ruling extension time to make election to treat multiple rental properties and a single entity

To avoid the passive-loss rules landlords must send over half their working time and at least 750 hours a year being materially involved with the property.  Unless the election to treat multiple rental properties as a single entity is made few taxpayers would meet the time tests.  (Kiplinger Tax Letter Vol. 82 #15  7/27/2007)

Trick to catch-up for forgotten depreciation after the asset was sold:

Depreciation "Allowed or Allowable" overview: http://www.hoven.com/articles/pdf/allowedorallowable.pdf

IRS Publication 946 - How Do You Correct Depreciation Deductions?   

Terms you may need to know (see Glossary):

Basis
If you deducted an incorrect amount of depreciation in any year, you may be able to make a correction by filing an amended return for that year. See Filing an Amended Return, next. If you are not allowed to make the correction on an amended return, you may be able to change your accounting method to claim the correct amount of depreciation. See Changing Your Accounting Method, later.

Filing an Amended Return
You can file an amended return to correct the amount of depreciation claimed for any property in any of the following situations.

• You claimed the incorrect amount because of a mathematical error made in any year.
• You claimed the incorrect amount because of a posting error made in any year.
• You have not adopted a method of accounting for property placed in service by you in tax years ending after December 29, 2003.
• You claimed the incorrect amount on property placed in service by you in tax years ending before December 30, 2003.
   

Adoption of accounting method defined. Generally, you adopt a method of accounting for depreciation by using a permissible method of determining depreciation when you file your first tax return, or by using the same impermissible method of determining depreciation in two or more consecutively filed tax returns. For an exception to this 2-year rule, see Revenue Procedure 2002-9 on page 327 of Internal Revenue Bulletin 2002-3, available at www.irs.gov/pub/irs-irbs/irb02-03.pdf as modified by Revenue Procedure 2004-11 on page 311 of Internal Revenue Bulletin 2004-3, available at www.irs.gov/pub/irs-irbs/irb04-03.pdf.

When to file. If an amended return is allowed, you must file it by the later of the following.
 

• 3 years from the date you filed your original return for the year in which you did not deduct the correct amount. A return filed before an unextended due date is considered filed on that due date.
• 2 years from the time you paid your tax for that year.
   

Changing Your Accounting Method
Generally, you must get IRS approval to change your method of accounting. You generally must file Form 3115, Application for Change in Accounting Method, to request a change in your method of accounting for depreciation.

The following are examples of a change in method of accounting for depreciation.

• A change in the treatment of an asset from nondepreciable to depreciable or vice versa.
• A change in the depreciation method, period of recovery, or convention of a depreciable asset.
• A change from not claiming to claiming the special depreciation allowance if you did not make the election to not claim any special allowance.
• A change from claiming a 50% special depreciation allowance to claiming a 30% special depreciation allowance for qualified property (including property that is included in a class of property for which you elected a 30% special allowance instead of a 50%special allowance).
   

Changes in depreciation that are not a change in method of accounting (and may only be made on an amended return) include the following.

• An adjustment in the useful life of a depreciable asset for which depreciation is determined under section 167.
• A change in use of an asset in the hands of the same taxpayer.
• Making a late depreciation election or revoking a timely valid depreciation election (including the election not to deduct the special depreciation allowance). If you elected not to claim any special allowance, a change from not claiming to claiming the special allowance is a revocation of the election and is not an accounting method change. Also, if the property is qualified property, a change from not claiming to claiming any special allowance is a late election and is not an accounting method change.
• Any change in the placed-in-service date of a depreciable asset.
   

See section 1.446-1T(e)(2)(ii)(d) of the regulations for more information and examples.

IRS approval. In some instances, you may be able to get approval from the IRS to change your method of accounting for depreciation under the automatic change request procedures generally covered in Revenue Procedure 2002-9. If you do not qualify to use the automatic procedures to get approval, you must use the advance consent request procedures generally covered in Revenue Procedure 97-27, 1997-1 C.B. 680. Also see the Instructions for Form 3115 for more information on getting approval, including lists of scope limitations and automatic accounting method changes.

Additional guidance. For additional guidance and special procedures for changing your accounting method, automatic change procedures, amending your return, and filing Form 3115, see Revenue Procedure 2004-11, Revenue Procedure 2005-43 on page 107 of Internal Revenue Bulletin 2005-29, available at www.irs.gov/pub/irs-irbs/irb05-29.pdf, and Revenue Procedure 2006-12 on page 310 of Internal Revenue Bulletin 2006-3, available at www.irs.gov/pub/irs-irbs/irb06-03.pdf

Section 481(a) adjustment. If you file Form 3115 and change from an impermissible method to a permissible method of accounting for depreciation, you can make a section 481(a) adjustment for any unclaimed or excess amount of allowable depreciation. The adjustment is the difference between the total depreciation actually deducted for the property and the total amount allowable prior to the year of change. If no depreciation was deducted, the adjustment is the total depreciation allowable prior to the year of change. A negative section 481(a) adjustment results in a decrease in taxable income. It is taken into account in the year of change and is reported on your business tax returns as "other expenses." A positive section 481(a) adjustment results in an increase in taxable income. It is generally taken into account over 4 tax years and is reported on your business tax returns as "other income." However, you can elect to use a one-year adjustment period and report the adjustment in the year of change if the total adjustment is less than $25,000. Make the election by completing the appropriate line on Form 3115.

If you file a Form 3115 and change from one permissible method to another permissible method, the section 481(a) adjustment is zero.

Rev. Proc. 2004-11, 2004-3 I.R.B. 311 (1/20/2004)
Change in Method of Accounting For Depreciable or Amortizable Property After Disposition by Taxpayer

Part III

Administrative, Procedural, and Miscellaneous

26 CFR 601.204: Changes in accounting periods and in methods of accounting. (Also Part I, Sections 446, 1016; 1.446-1T, 1.1016-3T.)

Rev. Proc. 2004-11

SECTION 1. PURPOSE

This revenue procedure provides an automatic consent procedure allowing a taxpayer to make a change in method of accounting under section 446(e) of the Internal Revenue Code for depreciable or amortizable property after its disposition. This revenue procedure also waives the application of the two-year rule set forth in Rev. Rul. 90-38, 1990-1 C.B. 57, for certain changes in depreciation or amortization. Finally, this revenue procedure modifies Rev. Proc. 2002-9, 2002-1 C.B. 327 (as modified by Rev. Proc. 2002-54, 2002-2 C.B. 432, Rev. Proc. 2002-19, 2002-1 C.B. 696, Rev. Proc. 2002-33, 2002-1 C.B. 963, and as modified and clarified by Announcement 2002-17, 2002-1 C.B. 561), and other revenue procedures to conform with section 1.446-1T(e)(2)(ii)(d) of the temporary Income Tax Regulations.

SECTION 2. BACKGROUND

.01 Section 446(e) and section 1.446-1T(e) provide that, except as otherwise provided, a taxpayer must secure the consent of the Commissioner of Internal Revenue before changing a method of accounting for federal income tax purposes. Section 1.446-1T(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the limitations, terms, and conditions deemed necessary to permit a taxpayer to obtain consent to change a method of accounting.

.02 Concurrently with the issuance of this revenue procedure, sections 1.446-1T(e)(2)(ii)(d) and 1.1016-3T(h) have been promulgated. Section 1.446-1T(e)(2)(ii)(d) provides the changes in depreciation or amortization (hereinafter, both are referred to as "depreciation") that are (and are not) changes in method of accounting under section 446(e). Section 1.1016-3T(h) provides that the "allowed or allowable" rule under section 1016(a)(2) does not permanently affect a taxpayer's lifetime income for purposes of determining whether a change in depreciation or amortization is a change in method of accounting under section 446(e).

.03 If a taxpayer uses an impermissible method of determining depreciation for a depreciable or amortizable property, the taxpayer adopts that method of accounting for the property when the taxpayer treats the property in the same way in determining gross income or deductions in two or more consecutively filed federal tax returns. See Rev. Rul. 90-38. The Internal Revenue Service and Treasury Department recognize that this two-year rule increases administrative and compliance costs associated with changes in depreciation because many taxpayers changing from an impermissible to permissible method of accounting for depreciation used the impermissible method for depreciable or amortizable properties placed in service in two or more taxable years before the year of change as well as for depreciable and amortizable properties placed in service in the taxable year immediately preceding the year of change. Accordingly, in the interest of sound tax administration, the Service and Treasury Department have decided to waive the two-year rule in Rev. Rul. 90-38 for a change in depreciation to which section 1.446-1T(e)(2)(ii)(d) applies.

.04 If a depreciable or amortizable property is transferred in a transaction in which the transferee is treated as the transferor for purposes of computing the depreciation allowance for the property with respect to so much of the basis in the hands of the transferee as does not exceed the adjusted depreciable basis in the hands of the transferor (for example, in transactions subject to section 168(i)(7) or section 381(c)(6)), the transferee may file a Form 3115, Application for Change in Accounting Method, to change from an impermissible method of accounting adopted by the transferor for that portion of the basis of the property to a permissible method of accounting for depreciation for the same portion of the basis of the property, provided the impermissible method of accounting for that portion of the basis of the property has not been changed by the transferor (through filing, for example, a Form 3115 or an amended return) or by the Internal Revenue Service upon examination of the transferor's tax returns. In this case, the section 481 adjustment will include any necessary adjustments since the property's placed-in-service date by the transferor.

SECTION 3. METHOD CHANGE PROCEDURE FOR DISPOSED DEPRECIABLE OR AMORTIZABLE PROPERTY

.01 Scope.

(1) Applicability. Except as provided in section 3.01(2) of this revenue procedure, section 3 of this revenue procedure applies to a taxpayer that is changing from an impermissible method of accounting for depreciation to a permissible method of accounting for depreciation for any item of depreciable or amortizable property subject to section 1.446-1T(e)(2)(ii)(d):

(a) that has been disposed of by the taxpayer during the year of change (as defined in section 3.02(2)(b) of this revenue procedure); and

(b) for which the taxpayer did not take into account any depreciation allowance, or did take into account some depreciation but less than the depreciation allowable (hereinafter, both are referred to as "claimed less than the depreciation allowable"), in the year of change (as defined in section 3.02(2)(b) of this revenue procedure) or any prior taxable year.

(2) Inapplicability. Section 3 of this revenue procedure does not apply to:

(a) any property to which section 1016(a)(3) (regarding property held by a tax-exempt organization) applies;

(b) any property for which a taxpayer is revoking a timely valid depreciation election, or making a late depreciation election, under the Code or regulations thereunder, or under other guidance published in the Internal Revenue Bulletin (including under section 13261(g)(2) or (3) of the Revenue Reconciliation Act of 1993, 1993-3 C.B. 1, 128 (relating to amortizable section 197 intangibles));

(c) any property for which the taxpayer deducted the cost or other basis of the property as an expense; or

(d) any property disposed of by the taxpayer in a transaction to which a nonrecognition section of the Code applies (for example, section 1031, transactions subject to section 168(i)(7)(B)(i)). However, this section 3.01(2)(d) does not apply to property disposed of by the taxpayer in a section 1031 or section 1033 transaction if the taxpayer elects to treat the entire basis (that is, both the carryover and excess basis) of the acquired MACRS property as property placed in service by the taxpayer at the time of replacement and treat the adjusted depreciable basis of the exchanged or involuntarily converted MACRS property as being disposed of by the taxpayer at the time of disposition.

.02 Change in method of accounting.

(1) In general. A taxpayer within the scope of section 3 of this revenue procedure may change from an impermissible method of accounting for depreciation to a permissible method of accounting for depreciation for any item of depreciable or amortizable property within the scope of section 3 of this revenue procedure, provided:

(a) the taxpayer files the original Form 3115 in accordance with section 3.02(2)(c) of this revenue procedure, prior to the expiration of the period of limitation for assessment under section 6501(a) for the taxable year in which the item of depreciable or amortizable property was disposed of by the taxpayer; and

(b) the taxpayer files an amended federal tax return for the year of change (as defined in section 3.02(2)(b) of this revenue procedure) that includes the adjustments to taxable income and any collateral adjustments to taxable income or tax liability (for example, adjustments to the amount or character of the gain or loss of the disposed depreciable or amortizable property) resulting from the change in method of accounting for depreciation made by the taxpayer under this section 3.

(2) Application Procedures. A taxpayer making a change in method of accounting under section 3 of this revenue procedure must follow the automatic change in method of accounting provisions in Rev. Proc. 2002-9 (or its successor), with the following modifications:

(a) The scope limitations in section 4.02 of Rev. Proc. 2002-9 do not apply. If the taxpayer is under examination, before an appeals office, or before a federal court at the time that a copy of the Form 3115 is filed with the national office, the taxpayer must provide a copy of the Form 3115 to the examining agent, appeals officer, or counsel for the government, as appropriate, at the time the copy of the Form 3115 is filed with the national office. The Form 3115 must contain the name(s) and telephone number(s) of the examining agent, appeals officer, or counsel for the government, as appropriate.

(b) The year of change is the taxable year in which the item of depreciable or amortizable property was disposed of by the taxpayer.

(c) Section 6.02(3)(a) of Rev. Proc. 2002-9 is modified to require the original of the Form 3115 to be attached to the taxpayer's timely filed amended federal tax return for the year of change and a copy (with signature) of the Form 3115 to be filed with the national office no later than when the original Form 3115 is filed with the amended federal tax return for the year of change.

(d) For purposes of section 6.02(4)(a) of Rev. Proc. 2002-9, the taxpayer should include on line 1a of the Form 3115 (revised December 2003) the designated automatic accounting method change number for the change in method of accounting for depreciation made under this section 3. This number for this method change is "9."

SECTION 4. WAIVER OF TWO-YEAR RULE IN REV. RUL. 90-38

.01 In general. Notwithstanding Rev. Rul. 90-38, a taxpayer may file a Form 3115 under Rev. Proc. 97-27, 1997-1 C.B. 680 (or its successor), or Rev. Proc. 2002-9, as applicable, to change from an impermissible method of accounting for depreciation to a permissible method of accounting for depreciation under section 1.446-1T(e)(2)(ii)(d) for any depreciable or amortizable property subject to section 1.446-1T(e)(2)(ii)(d) and placed in service by the taxpayer in the taxable year immediately preceding the year of change (as defined in section 5.02(2) of Rev. Proc. 97-27 or section 5.02 of Rev. Proc. 2002-9, as applicable) (hereinafter, this property is referred to as "1-year depreciable property"), provided the additional term and condition in section 4.02 of this revenue procedure is satisfied. Alternatively, the taxpayer may make the change from the impermissible depreciation method to the permissible depreciation method for the 1-year depreciable property by filing an amended federal tax return for the placed-in-service year prior to the date the taxpayer files its federal tax return for the taxable year succeeding the placed-in-service year.

.02 Additional term and condition for filing a Form 3115. In addition to the terms and conditions provided in Rev. Proc. 97-27 or Rev. Proc. 2002-9, as applicable, the section 481 adjustment reported on a Form 3115 that is filed by a taxpayer in accordance with section 4.01 of this revenue procedure to make a change in method of accounting for depreciation under section 1.446-1T(e)(2)(ii)(d) for any 1-year depreciable property, must include the amount of any adjustment attributable to all property (including the 1-year depreciable property) subject to the Form 3115.

SECTION 5. EFFECT ON OTHER DOCUMENTS

.01 Rev. Proc. 2002-9 is modified and amplified to include the accounting method change provided under section 3 of this revenue procedure in section 2.05 of the APPENDIX. See section 4 of the APPENDIX of this revenue procedure for the text of section 2.05 of the APPENDIX of Rev. Proc. 2002-9.

.02 The heading for section 2 of the APPENDIX of Rev. Proc. 2002-9 is modified to read as follows: "SECTION 2. DEPRECIATION OR AMORTIZATION (section 56(a)(1), 56(g)(4)(A), 167, 168, 197, 1400I, OR 1400L, OR FORMER SECTION 168)".

.03 Rev. Proc. 2002-9 (as modified by Rev. Proc. 2002-33) is modified by deleting sections 2.01, 2.02, and 2B of the APPENDIX and replacing them with the text in, respectively, sections 1, 2, and 3 of the APPENDIX of this revenue procedure.

.04 Section 6.03 of Rev. Proc. 2000-38, 2000-2 C.B. 310, 313, is modified by deleting "See section 1.446-1(e)(2)(ii)(b)." and replacing it with "See section 1.446-1T(e)(2)(ii)(d)(3)(i)."

.05 Section 8.01 of Rev. Proc. 2000-50, 2000-2 C.B. 601, is modified to read as follows: "A change in a taxpayer's treatment of costs paid or incurred to develop, purchase, lease, or license computer software to a method described in section 5, 6, or 7 of this revenue procedure is a change in method of accounting to which §§446 and 481 apply. Further, a change in useful life under the method described in section 5.01(2) or 6.01(2) of this revenue procedure is a change in method of accounting. See section 1.446-1T(e)(2)(ii)(d)(3)(i) and, for the effective date, see section 1.446-1T(e)(4)(ii)(A)."

SECTION 6. EFFECTIVE DATE

.01 In general. Except as provided in section 6.02 of this revenue procedure, this revenue procedure is effective for a Form 3115 filed for taxable years ending on or after December 30, 2003.

.02 Transition rule for previously filed Forms 3115 for automatic consent.

(1) For a taxable year ending on or after December 30, 2003, a taxpayer may make a change in method of accounting previously authorized in section 2.01, 2.02, or 2B of the APPENDIX of Rev. Proc. 2002-9 before any amendments were made to those sections by this revenue procedure if:

(a) before December 30, 2003, the taxpayer filed a completed Form 3115 with the national office to make that change in method of accounting; and

(b) the taxpayer makes that change in method of accounting in compliance with all the applicable provisions of Rev. Proc. 2002-9 for the requested year of change (as defined in section 5.02 of Rev. Proc. 2002-9) on that Form 3115.

(2) If a taxpayer filed a Form 3115 with the national office to make a change in method of accounting previously authorized in section 2.01, 2.02, or 2B of the APPENDIX of Rev. Proc. 2002-9 before any amendments were made to those sections by this revenue procedure for a year of change for which this revenue procedure is effective (see section 6.01 of this revenue procedure) and the taxpayer's original federal tax return for that year of change was not filed before December 30, 2003, the taxpayer may make the change in method of accounting authorized under section 2.01, 2.02, or 2B, as applicable, of the APPENDIX of Rev. Proc. 2002-9 as revised by this revenue procedure. However, the Service will process the Form 3115 in accordance with the section of the APPENDIX of Rev. Proc. 2002-9 in effect on the date on which the Form 3115 was filed with the national office by the taxpayer unless on or before the due date (including extensions) of the taxpayer's federal tax return for the requested year of change (as defined in section 5.02 of Rev. Proc. 2002-9) on that Form 3115, the taxpayer completes a new Form 3115 to make the change under section 2.01, 2.02, or 2B, as applicable, of the APPENDIX of Rev. Proc. 2002-9 as revised by this revenue procedure and files this newly completed Form 3115 in duplicate in accordance with section 6.02(3)(a) of Rev. Proc. 2002-9. Additionally, the newly completed Form 3115 must include the statement: "Section [insert, as appropriate: 2.01, 2.02, or 2B] of the APPENDIX of Rev. Proc. 2002-9 as revised by Rev. Proc. 2004-11." This statement must be legibly printed or typed on the appropriate line on, or at the top of page 1 of, the Form 3115.

SECTION 7. DRAFTING INFORMATION

The principal author of this revenue procedure is Sara Logan of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue procedure, contact Ms. Logan or Douglas Kim at (202) 622-3110 (not a toll free call).

APPENDIX

SECTION 1. Section 2.01 of the APPENDIX of Rev. Proc 2002-9 is deleted and replaced with the following:

".01 Impermissible to permissible method of accounting for depreciation or amortization.

(1) Description of change and scope.

(a) Applicability. This change applies to a taxpayer that wants to change from an impermissible to a permissible method of accounting for depreciation or amortization (depreciation) for any item of depreciable or amortizable property:

(i) for which the taxpayer used the impermissible method of accounting in at least the two taxable years immediately preceding the year of change (but see section 2.01(1)(b) of this APPENDIX for property placed in service in the taxable year immediately preceding the year of change);

(ii) for which the taxpayer is making a change in method of accounting under section 1.446-1T(e)(2)(ii)(d);

(iii) for which depreciation is determined under section 56(a)(1), section 56(g)(4)(A), section 167, section 168, section 197, section 1400I, section 1400L(b), or section 1400L(c), or under section 168 prior to its amendment in 1986 (former section 168); and

(iv) that is owned by the taxpayer at the beginning of the year of change (but see section 2.05 of this APPENDIX for property disposed of before the year of change).

(b) Taxpayer has not adopted a method of accounting for the item of property. If a taxpayer does not satisfy section 2.01(1)(a)(i) of this APPENDIX for an item of depreciable or amortizable property because this item of property is placed in service by the taxpayer in the taxable year immediately preceding the year of change ("1-year depreciable property"), the taxpayer may change from the impermissible depreciation method to the permissible depreciation method for the 1-year depreciable property by filing a Form 3115 for this change, provided the section 481 adjustment reported on the Form 3115 includes the amount of any adjustment that is attributable to all property (including the 1-year depreciable property) subject to the Form 3115. Alternatively, the taxpayer may change from the impermissible depreciation method to the permissible depreciation method for a 1-year depreciable property by filing an amended federal tax return for the property's placed-in-service year prior to the date the taxpayer files its federal tax return for the taxable year succeeding the placed-in-service year.

(c) Certain scope limitations inapplicable. The scope limitations in sections 4.02(7) and 4.02(8) of this revenue procedure are not applicable to this change.

(d) Inapplicability. This change does not apply to:

(i) any property to which section 1016(a)(3) (regarding property held by a tax-exempt organization) applies;

(ii) any taxpayer that is subject to section 263A and that is required to capitalize the costs with respect to which the taxpayer wants to change its method of accounting under section 2.01 of this APPENDIX, if the taxpayer is not capitalizing the costs as required;

(iii) any property for which a taxpayer is making a change in depreciation under section 1.446-1T(e)(2)(ii)(d)(2)(vi) or (vii);

(iv) any property subject to section 167(g) (regarding property depreciated under the income forecast method);

(v) any section 1250 property that a taxpayer is reclassifying to an asset class of Rev. Proc. 87-56, 1987-2 C.B. 674, or Rev. Proc. 83-35, 1983-1 C.B. 745, as appropriate, that does not explicitly include section 1250 property (for example, asset class 57.0, Distributive Trades and Services);

(vi) any property for which a taxpayer is revoking a timely valid election, or making a late election, under section 167, section 168, section 1400I, section 1400L, former section 168, or section 13261(g)(2) or (3) of the Revenue Reconciliation Act of 1993 (1993 Act), 1993-3 C.B. 1, 128 (relating to amortizable section 197 intangibles). A taxpayer may request consent to revoke or make the election by submitting a request for a letter ruling under Rev. Proc. 2003-1, 2003-1 I.R.B. 1 (or any successor). See section 1.446-1T(e)(2)(ii)(d)(3)(iii);

(vii) any property for which depreciation is determined under section 56(g)(4)(A) or section 167 (other than under section 168, section 1400I, section 1400L, or former section 168) and a taxpayer is changing the useful life of the property. A change in the useful life of property is corrected by adjustments in the applicable taxable year provided under section 1.446-1T(e)(2)(ii)(d)(3)(i). However, this section 2.01(1)(d)(vii) of this APPENDIX does not apply if the taxpayer is changing to or from a useful life, recovery period, or amortization period that is specifically assigned by the Internal Revenue Code (for example, section 167(f)(1), section 168(c)), the regulations thereunder, or other guidance published in the Internal Revenue Bulletin and, therefore, this change is a change in method of accounting (unless section 2.01(1)(d)(xv) of this APPENDIX applies). See section 1.446-1T(e)(2)(ii)(d)(3)(i);

(viii) any depreciable property for which the use changes in the hands of the same taxpayer. See section 1.446-1T(e)(2)(ii)(d)(3)(ii);

(ix) any property for which depreciation is determined in accordance with section 1.167(a)-11 (regarding the Class Life Asset Depreciation Range System (ADR));

(x) any change in method of accounting involving a change from deducting the cost or other basis of any property as an expense to capitalizing and depreciating the cost or other basis;

(xi) any change in method of accounting involving a change from one permissible method of accounting for the property to another permissible method of accounting for the property. For example:

(A) a change from the straight-line method of depreciation to the income forecast method of depreciating for videocassettes. See Rev. Rul. 89-62, 1989-1 C.B. 78; or

(B) a change from charging the depreciation reserve with costs of removal and crediting the depreciation reserve with salvage proceeds to deducting costs of removal as an expense (provided the costs of removal are not required to be capitalized under any provision of the Code, such as, section 263(a)) and including salvage proceeds in taxable income (see section 2.02 of this APPENDIX for making this change for property for which depreciation is determined under section 167);

(xii) any change in method of accounting involving both a change from treating the cost or other basis of the property as nondepreciable or nonamortizable property to treating the cost or other basis of the property as depreciable or amortizable property and the adoption of a method of accounting for depreciation requiring an election under section 167, section 168, section 1400I, section 1400L(b), former section 168, or section 13261(g)(2) or (3) of the 1993 Act (for example, a change in the treatment of the space consumed in landfills placed in service in 1990 from nondepreciable to depreciable property (assuming section 2.01(1)(d)(xiii) of the APPENDIX does not apply) and the making of an election under section 168(f)(1) to depreciate this property under the unit of production method of depreciation under section 167);

(xiii) any change in method of accounting for any item of income or deduction other than depreciation, even if the change results in a change in computing depreciation under section 1.446-1T(e)(2)(ii)(d)(2)(i), (ii), (iii), (iv), (v), (vi), (vii), or (viii). For example, a change in method of accounting involving:

(A) a change in inventory costs (for example, when property is reclassified from inventory property to depreciable property, or vice versa) (but see section 3.02 of this APPENDIX for making a change from inventory property to depreciable property for unrecoverable line pack gas or unrecoverable cushion gas); or

(B) a change in the character of a transaction from sale to lease, or vice versa (but see section 2.03 of this APPENDIX for making this change);

(xiv) a change from determining depreciation under section 168 to determining depreciation under former section 168 for any property subject to the transition rules in section 203(b) or 204(a) of the Tax Reform Act of 1986, 1986-3 (Vol. 1) C.B. 1, 60-80; or

(xv) any change in the placed-in-service date of a depreciable or amortizable property. This change is corrected by adjustments in the applicable taxable year provided under section 1.446-1T(e)(2)(ii)(d)(3)(v).

(2) Additional requirements. A taxpayer also must comply with the following:

(a) Permissible method of accounting for depreciation. A taxpayer must change to a permissible method of accounting for depreciation for the item of depreciable or amortizable property. The permissible method of accounting is the same method that determines the depreciation allowable for the item of property (as provided in section 2.01(5) of this APPENDIX).

(b) Statements required. A taxpayer must provide the following statements, if applicable, and attach them to the completed application:

(i) a detailed description of the former and new methods of accounting. A general description of these methods of accounting is unacceptable (for example, MACRS to MACRS, erroneous method to proper method, claiming less than the depreciation allowable to claiming the depreciation allowable);

(ii) to the extent not provided elsewhere on the application, a statement describing the taxpayer's business or income-producing activities. Also, if the taxpayer has more than one business or income-producing activity, a statement describing the taxpayer's business or income-producing activity in which the item of property at issue is primarily used by the taxpayer;

(iii) to the extent not provided elsewhere on the application, a statement of the facts and law supporting the new method of accounting, new classification of the item of property, and new asset class in, as appropriate, Rev. Proc. 87-56 or Rev. Proc. 83-35. If the taxpayer is the owner and lessor of the item of property at issue, the statement of the facts and law supporting the new asset class also must describe the business or inco