Section 6661 of the Code, as in effect before its repeal in 1989, imposed an addition to tax equal to 25 percent of the amount of the underpayment of tax attributable to any substantial understatement of income tax liability for a taxable year. Sections 1.6661-1 through 1.6661-6 of the Income Tax Regulations (26 CFR Part 1) provided rules for determining whether an addition to tax should be imposed and for computing the amount of any such addition.

The Omnibus Budget Reconciliation Act of 1989, Public Law 101-239 (103 Stat. 2106), repealed section 6661 effective for tax returns due after December 31, 1989 (determined without regard to extensions) and substituted, in section 6662, an accuracy-related penalty applicable to those returns. The repeal of section 6661 has rendered §§1.6661-1 through 1.6661-6 obsolete. This Treasury decision removes those provisions and corrects an obsolete cross reference to section 6661 in the regulations under section 448 (relating to the limitation on the use of the cash method of accounting).

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. In addition, because these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this document has been submitted to the Small Business Administration for comment on its impact on small business.

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

Authority: 26 U.S.C. 7805 * * *

Par. 2. In §1.448-1T, paragraph (b)(1)(iii) is revised to read as follows:

Par. 4. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 5. In §602.101, paragraph (b) is amended by removing the entries for “1.6661-3” and “1.6661-4” from the table.

Approved December 9, 2004.

On the closing date of January 1, 2003 (“Closing Date”), X and FP enter into a purported sale-leaseback transaction under which FP sells the property to X, and X immediately leases the property back to FP under a lease (“Lease”). The purchase and sale agreement and the Lease are nominally separate legal documents. Both agreements, however, are executed pursuant to a comprehensive participation agreement, which provides that the parties’ rights and obligations under any of the agreements are not enforceable before the execution of all transaction documents.

The Lease requires FP to make rental payments over the term of the Lease (“Lease Term”). As described below, the Lease also provides that under certain conditions, X has the option (“Service Contract Option”) to require FP to identify a party (“Service Recipient”) willing to enter into a contract with X to receive services provided using the leased property (“Service Contract”) that commences immediately after the expiration of the Lease Term. The Service Recipient must meet certain financial qualifications, including credit rating and net capital requirements, and provide defeasance or other credit support to satisfy certain of its obligations under the Service Contract. If FP cannot locate a qualified third party to enter into the Service Contract, FP or an affiliate of FP must enter into the Service Contract. The aggregate of the Lease Term plus the term of the Service Contract (“Service Contract Term”) is less than 80 percent of the assumed remaining useful life of the property.

On the Closing Date, the property has a fair market value of $105x and X makes a single payment of $105x to FP. To fund the $105x payment, X provides $15x in equity and borrows $81x from BK1 and $9x from BK2. Both loans are nonrecourse and provide for payments during the Lease Term. Accrued but unpaid interest is capitalized as additional principal. As of the Closing Date, the documents reflect that the sum of the outstanding principal on the loans at any given time will be less than the projected fair market value of the property at that time. The amount and timing of the debt service payments closely match the amount and timing of the Lease payments due during the Lease Term.

FP intends to utilize only a small portion of the proceeds of the purported sale-leaseback for operational expenses or to finance or refinance the acquisition of new assets. Upon receiving the $105x purchase price payment, FP sets aside substantially all of the $105x to satisfy its lease obligations. FP deposits $81x with BK3 and $9x with BK4. BK3 may be an affiliate of BK1, and BK4 may be an affiliate of BK2. The deposits with BK3 and BK4 earn interest sufficient to fund FP’s rent obligations as described below. BK3 pays annual amounts equal to 90 percent of FP’s annual rent obligation under the Lease (that is, amounts sufficient to satisfy X’s debt service obligation to BK1). Although FP directs BK3 to pay those amounts to BK1, the parties treat these amounts as having been paid from BK3 to FP, then from FP to X as rental payments, and finally from X to BK1 as debt service payments. In addition, FP pledges the deposit with BK3 to X as security for FP’s obligations under the Lease, while X, in turn, pledges its interest in FP’s pledge to BK1 as security for X’s obligations under the loan from BK1. Similarly, BK4 pays annual amounts equal to 10 percent of FP’s rent obligation under the Lease (that is, amounts sufficient to satisfy X’s debt service obligation to BK2). Although FP directs BK4 to pay these amounts to BK2, the parties treat these amounts as having been paid from BK4 to FP, then from FP to X as rental payments, and finally from X to BK2 as debt service payments. Although FP’s deposit with BK4 is not pledged, the parties expect that the amounts deposited with BK4 will remain available to pay the remaining 10 percent of FP’s annual rent obligation under the Lease. FP may incur economic costs, such as an early withdrawal penalty, in accessing the BK4 deposit.

FP is not legally released from its rent obligations. X’s exposure to the risk that FP will not make the rent payments, however, is substantially limited by the arrangements with BK3 and BK4. In the case of the loan from BK1, X’s economic risk is remote due to the deposit arrangement with BK3. In the case of the loan from BK2, X’s economic risk is substantially reduced through the deposit arrangement with BK4. X’s obligation to make debt service payments on the loans from BK1 and BK2 is completely offset by X’s right to receive Lease rentals from FP. As a result, neither bank bears a significant risk of nonpayment.^[2]

FP has an option (“Purchase Option”) to purchase the property from X on the last day of the Lease Term (“Exercise Date”). Exercise of the Purchase Option allows FP to repurchase the property for a fixed exercise price (“Exercise Price”) that, on the Closing Date, exceeds the projected fair market value of the property on the Exercise Date. The Purchase Option price is sufficient to repay X’s entire loan balances and X’s initial equity investment plus provide X with a predetermined after-tax rate of return on its equity investment.

At the inception of the transaction, X requires FP to invest $9x of the $105x payment in highly rated debt securities (“Equity Collateral”), and to pledge the Equity Collateral to X to satisfy a portion of FP’s obligations under the lease.^[3] Although the Equity Collateral is pledged to X, it is not among the items of collateral pledged to BK1 or BK2 in support of the nonrecourse loans to X. The Equity Collateral upon maturity, when combined with the balance of the deposits made with BK3 and BK4 and the interest on those deposits, fully funds the amount due if FP exercises the Purchase Option. This arrangement ensures that FP is able to make the payment under the Purchase Option without an independent source of funds. Having economically defeased both its rental obligations under the Lease and its payment obligations under the Purchase Option, FP keeps the remaining $6x, subject to its obligation to pay the Termination Value (described below) upon the happening of certain events specified under the Lease.

If FP does not exercise the Purchase Option, X may elect to (1) take back the property, or (2) exercise the Service Contract Option and compel FP either to (a) identify a qualified Service Recipient, or (b) enter (or compel an affiliate of FP to enter) into the Service Contract as the Service Recipient for the Service Contract Term. If X exercises the Service Contract Option, the Service Recipient must pay X predetermined minimum capacity payments sufficient to provide X with a minimum after-tax rate of return on its equity investment. The Service Recipient also must reimburse X for X’s operating and maintenance costs for providing the services.

As a practical matter, the Purchase Option and the Service Contract Option collar X’s exposure to changes in the value of the property. If the value of the property is at least equal to the Purchase Option Exercise Price, FP likely will exercise the Purchase Option. Likewise, FP likely will exercise the Purchase Option if FP concludes that the costs of the Service Contract Option exceed the costs of the Purchase Option. Moreover, FP may exercise the Purchase Option even if the fair market value of the property is less than the Purchase Option Exercise Price because the Purchase Option is fully funded, and the excess of the Exercise Price over the projected value may not fully reflect the costs to FP of modifying, interrupting, or relocating its operations. If the Purchase Option is exercised, X will recover its equity investment plus a predetermined after-tax rate of return. Conversely, if the Purchase Option is not exercised, X may compel FP to locate a Service Recipient to enter into the Service Contract in return for payments sufficient to provide X with a minimum after-tax rate of return on its equity investment, regardless of the value of the property.

Throughout the Lease Term, X has several remedies in the event of a default by FP, including a right to (1) take possession of the property or (2) cause FP to pay X specified damages (“Termination Value”). Likewise, throughout the Service Contract Term, X has similar remedies in the event of a default by the Service Recipient. On the Closing Date, the amount of the Termination Value is slightly greater than the purchase price of the property. The Termination Value fluctuates over the Lease Term and Service Contract Term, but at all times is sufficient to repay X’s entire loan balances and X’s initial equity investment plus a predetermined after-tax rate of return. The BK3 deposit, the BK4 deposit and the Equity Collateral are available to satisfy the Termination Value during the Lease Term. If the sum of the deposits plus the Equity Collateral is less than the Termination Value, X may require FP to maintain a letter of credit. During the Service Contract Term, the Service Recipient will be required to provide defeasance or other credit support that would be available to satisfy the Termination Value. As a result, X in almost all events will recover its investment plus a pre-tax rate of return.

For tax purposes, X claims deductions for interest on the loans and for depreciation on the property. X does not include the optional Service Contract Term in the lease term for purposes of calculating the property’s recovery period under §§ 168(g)(3)(A) and 168(i)(3). X includes in gross income the rents received on the Lease. If the Purchase Option is exercised, X also includes the Exercise Price in calculating its gain or loss realized on disposition of the property.

The form of the sale from FP to X may be a head lease for a term in excess of the assumed remaining useful life of the property and an option for X to purchase the property for a nominal amount at the conclusion of the head lease term. In some variations of this transaction, the participation agreement provides that if X refinances the nonrecourse loans, FP has a right to participate in the savings attributable to the reduced financing costs by allowing FP to renegotiate certain terms of the transaction, including the Lease rents and the Purchase Option price.

The facts are the same as in Situation 1 except for the following.

The Lease does not provide a Service Contract Option. In lieu of the Purchase Option described in Situation 1, FP has an option (“Early Termination Option”) to purchase the property from X on the date (“ETO Exercise Date”) that is 30 months before the end of the Lease Term. Exercise of the Early Termination Option allows FP to terminate the Lease and repurchase the property for a fixed exercise price (“ETO Exercise Price”) that on the Closing Date, exceeds the projected fair market value of the property on the ETO Exercise Date. The Early Termination Option price is sufficient to repay X’s entire loan balances and X’s initial equity investment plus a predetermined after-tax rate of return on its equity investment. The balance of the Equity Collateral combined with the balance of the deposits made with BK3 and BK4 and the interest on those deposits fully fund the amount due under the Early Termination Option.

If FP does not exercise the Early Termination Option, FP is required to obtain residual value insurance for the benefit of X, pay rents for the remaining Lease Term, and return the property to X at the end of the Lease Term (“Return Option”). The residual value insurance must be issued by a third party having a specified minimum credit rating and must provide that if the actual residual value of the property is less than a fixed amount (“Residual Value Insurance Amount”) at the end of the Lease Term, the insurer will pay X the shortfall. On the Closing Date, the Residual Value Insurance Amount is less than the projected fair market value of the property at the end of the Lease Term. If FP does not maintain the residual value insurance coverage for the entire Lease Term remaining after the ETO Exercise Date, FP will default and be obligated to pay X the Termination Value. If FP does not exercise the Early Termination Option, the rents for the remaining Lease Term plus the Residual Value Insurance Amount are sufficient to provide X with a minimum after-tax rate of return on the property, regardless of the value of the property. As a practical matter, the Early Termination Option and the Return Option collar X’s exposure to changes in the value of the property. At the end of the Lease Term, FP also may have the option to purchase the property for the greater of its fair market value or the Residual Value Insurance Amount.

For tax purposes, X claims deductions for interest on the loans and for depreciation on the property. X treats a portion of the property as qualified technological equipment within the meaning of § 168(i)(2). X depreciates that portion of the property over five years under § 168(g)(3)(C). X treats a portion of the property as software. X depreciates that portion of the property over 36 months under § 167(f)(1)(A).

X includes in gross income the rents received on the Lease. If the Early Termination Option is exercised, X also includes the ETO Exercise Price in calculating its gain or loss realized on disposition of the property.

In some variations of this transaction, if the Early Termination Option is not exercised, the Lease rents payable to X may increase for the portion of the Lease Term remaining after the ETO Exercise Date.

Section 172(b)(1)(C) provides that the portion of any NOL that qualifies as a specified liability loss may be carried back to each of the 10 taxable years preceding the taxable year of the loss. For NOLs arising in taxable years ending prior to October 22, 1998, former § 172(f)(1)(B) treats as a specified liability loss the portion of the NOL generated by:

For this purpose, a liability is not taken into account unless the taxpayer used an accrual method of accounting throughout the period or periods during which the acts or failures to act giving rise to the liability occurred.

In Sealy Corp. v. Commissioner, 107 T. C. 177 (1996), aff’d, 171 F.3d 655 (9^th Cir. 1999), the Tax Court held that the portion of NOLs generated by deductions for the following liabilities did not result in former § 172(f)(1)(B) specified liability losses:

(1) professional fees incurred to comply with current reporting, filing, and disclosure requirements imposed by the Securities and Exchange Act of 1934;

(2) professional fees incurred to comply with current ERISA reporting requirements; and

(3) professional fees incurred in connection with an income tax audit by the Service for a prior taxable year.

The Tax Court gave three reasons for its conclusion that these liabilities did not arise under a federal or state law within the meaning of former § 172(f)(1)(B). First, the federal laws cited by the taxpayers did not establish their liability to pay the amounts at issue. Instead, the taxpayers’ liabilities did not arise until the services were contracted for and received and the taxpayers’ choice of the means of compliance, rather than the cited provisions, determined the nature and amount of their costs. Sealy at 184. Second, Congress intended former §172(f)(1)(B) to apply only to liabilities for which a deduction is deferred because of the economic performance requirement of § 461(h). The economic performance requirement did not delay the taxpayers’ accrual of the deductions at issue. Sealy at 185-86. Third, invoking the statutory construction rule of ejusdem generis, the court concluded that Congress intended the 10-year carryback to apply to a relatively narrow class of liabilities similar to other liabilities referred to in former § 172(f). Sealy at 186.

In affirming the Tax Court’s judgment, the Ninth Circuit stated that the acts giving rise to the liabilities at issue in Sealy were contractual acts by which Sealy engaged lawyers or accountants and did not occur at least 3 years before the beginning of the taxable year of the related deductions as required by former § 172(f)(1)(B)(i).

In Host Marriott Corp. v. United States, 113 F. Supp. 2d 790 (D. Md. 2000), aff’d, 267 F.3d 363 (4^th Cir. 2001), the district court concluded that interest liabilities on federal tax deficiencies arise under federal law within the meaning of former §172(f)(1)(B). The court pointed out that § 6601(a) imposes interest on due but unpaid federal taxes. The court noted that, in contrast to the situation in Sealy, the interest liabilities were set by federal law, not by the taxpayer’s choice.

In Intermet Corp. v. Commissioner, 117 T.C. 133 (2001), the Tax Court cited Host Marriot and concluded that liabilities for state tax deficiencies, interest on state tax deficiencies, and interest on a federal income tax deficiency arise under federal or state law within the meaning of former § 172(f)(1)(B). In distinguishing Sealy, the Tax Court only referred to the first reason (i.e., federal law did not establish the liability to pay the amounts at issue) that it gave in Sealy for concluding that the professional fee liabilities at issue in that case did not arise under federal or state law.

In addition, in both Host Marriot and Intermet, the courts concluded that the filing of an erroneous tax return, resulting in the initial failure to timely pay the entire amount of tax due, constitutes the act giving rise to the entire compound interest liability on unpaid tax.

In Major Paint Co. v. United States, 334 F.3d 1042 (Fed. Cir. 2003), aff’g Standard Brands Liquidating Creditor Trust v. United States, 53 Fed. Cl. 25 (2002), the Federal Circuit held that liabilities for capitalized legal, accounting, and other professional fees and expenses incurred pursuant to a reorganization bankruptcy under Chapter 11 of Title 11 of the United States Code did not arise under federal law for purposes of former § 172(f)(1)(B). The fees included those incurred by the taxpayer on its own behalf as well as fees incurred on behalf of the unsecured creditors’ committee but required to be paid from the bankruptcy estate. The taxpayer capitalized a portion of the fees incurred as a result of the reorganization bankruptcy and later deducted the capitalized fees upon a subsequent voluntary liquidating bankruptcy.

The Bankruptcy Code requires the appointment of an unsecured creditors’ committee and allows the committee, with court approval, to employ various professionals to perform services for the committee. The Bankruptcy Code also requires the bankruptcy court to approve the employment of the professionals, the terms of their employment, and the amounts paid to them. In Major Paint, a local court rule required the bankrupt taxpayer to employ counsel.

The Federal Circuit analyzed the opinions in Sealy, Host Marriot, and Intermet, from which it concluded two principles could be derived. First, “‘arising out of a federal law’ means more than just that the liability is incurred with respect to an obligation under a federal law.” 334 F.3d at 1046. Second, “the nature and amount of the liability must be traceable to a specific law and cannot be the result of choices made by the taxpayer or others.” Id. As in Sealy, the statutory provisions did not establish a liability to pay the amounts at issue. Rather, the decisions of the taxpayer and the creditors’ committee, subject to final approval by the bankruptcy judge, as to the means of compliance determined the nature and amount of the costs. The court concluded that the connection between the Bankruptcy Code and the liabilities for the fees was “too attenuated to meet the level of ‘arise under’ necessary to qualify as a specified liability loss.” Id. at 1047.

Q-1. What tests must a liability satisfy to arise under federal or state law within the meaning of former § 172(f)(1)(B)?

A-1. To arise under federal or state law the liability must be directly imposed by federal or state law and must not be the result of decisions made by the taxpayer or others. See Sealy and Major Paint.

Q-2. May a tort liability satisfy the requirements of former § 172(f)(1)(B)(i)?

A-2. Yes. A tort liability may be directly imposed under either federal or state law. If the act or failure to act giving rise to the tort liability occurs at least 3 years before the beginning of the taxable year of the liability’s deduction, the requirements of former § 172(f)(1)(B)(i) are satisfied.

Q-3. What is a tort liability that arises out of a series of actions (or failures to act) over an extended period of time?

A-3. A tort liability that arises out of a series of actions (or failures to act) over an extended period of time within the meaning of former § 172(f)(1)(B)(ii) is a liability that arises only from multiple acts or failures to act over an extended period of time. An example is a tort liability for causing someone to develop a disease because of repeated exposures to chemicals or other toxic substances. This liability would be a tort liability within the meaning of former § 172(f)(1)(B)(ii) if a substantial portion of the exposures occur at least 3 years before the beginning of the taxable year of the liability’s deduction.

On the other hand, what may appear to be a tort liability involving multiple acts, such as a tort liability arising from a continuing trespass, is actually a number of separate liabilities, each arising from separate acts or failures to act resulting in separate causes of action. The Internal Revenue Service will not treat this type of liability as a multiple act or failure to act liability that satisfies the requirements of former § 172(f)(1)(B)(ii). Instead, to generate a specified liability loss, the separate liabilities must independently satisfy the 3-year act or failure to act requirement of former § 172(f)(1)(B)(i).

Q-4. Which act in the chain of causation leading to the creation of a liability constitutes “the act or failure to act” giving rise to that liability within the meaning of former § 172(f)(1)(B)(i)?

A-4. The act or failure to act resulting in the establishment of a legal liability constitutes the act or failure to act within the meaning of former § 172(f)(1)(B)(i). For example, in the case of a trespass, the act of trespassing constitutes the relevant act for purposes of former § 172(f)(1)(B)(i), not the judgment of a court.

In the case of interest on unpaid federal or state taxes, the Service continues to believe that a taxpayer’s use of the government’s money over discrete periods, such as days, months or portions of a month, is an essential element that creates the liability. Therefore, the Service believes that the courts in Host Marriott and Intermet incorrectly concluded that the initial failure to pay the taxes when due constituted the act or failure to act giving rise to any interest that economically accrued during the taxable year such interest was deductible and the 3-year period prior to the beginning of that taxable year. Consequently, the Service will continue to assert that interest that economically accrues on a liability for unpaid taxes in the taxable year such interest is deductible and the 3-year period prior to the beginning of that taxable year does not satisfy the 3-year act or failure to act requirement of former § 172(f)(1)(B)(i).

Q-5. For purposes of former § 172(f)(1)(B), does a deduction allowable “with respect to” a liability include other items, such as legal and professional fees to contest the liability or court costs incurred to litigate the liability?

A-5. A deduction allowable with respect to a liability includes only a deduction for the liability itself. Therefore, legal fees, court costs, and similar items do not generate a former § 172(f)(1)(B) specified liability loss even if the liabilities are incurred in determining the amount of a liability that does satisfy the requirements of former § 172(f)(1)(B).

In Sealy, the Tax Court and Ninth Circuit held that deductions for accounting and legal fees incurred in connection with a federal income tax audit did not generate a specified liability loss under former § 172(f)(1)(B). Federal law directly imposed only the federal income tax liability and did not impose the taxpayer’s liability for the accounting and legal fees. The taxpayer’s liabilities for the accounting and legal fees arose as a result of decisions made by the taxpayer, and such liabilities were incurred when the services were contracted for and performed. Implicit in the Tax Court’s holding is the conclusion that the deduction for the legal and professional fees was not, within the meaning of § 172(f)(1)(B), allowable “with respect to” the federal tax liability that was the subject of the audit.

Q-6. For purposes of § 172(f)(1)(B), are depreciation deductions allowable with respect to the liability giving rise to the depreciable basis of a depreciable asset?

A-6. Depreciation deductions are not allowable with respect to the liability giving rise to the depreciable basis of a depreciable asset. Depreciation deductions may be allowable with respect to liabilities satisfied through the use of the depreciable asset.

Liabilities arising under federal or state law may be treated as part of the cost basis of property if the liabilities are properly chargeable to a capital account. For example, § 164(a) requires sales taxes imposed on the purchase of equipment used in a taxpayer’s trade or business to be capitalized into the cost basis of the equipment. If an NOL is incurred for a taxable year and the sales tax liability was incurred at least 3 years before the beginning of that taxable year, some taxpayers have asserted that any portion of the NOL generated by depreciation deductions for the portion of the property’s depreciable basis attributable to the capitalized sales tax constitutes a former § 172(f)(1)(B) specified liability loss irrespective of how the property is used. Likewise, taxpayers may be required to place certain equipment into service to comply with requirements of federal or state law, for example, clean water standards. Some of these taxpayers have asserted that if the equipment was acquired by the taxpayer at least 3 years prior to the beginning of the taxable year, the portion of any NOL generated for the taxable year by depreciation deductions attributable to the equipment qualifies as a former § 172(f)(1)(B) specified liability loss. The Service disagrees with both of these assertions.

Section 167(a) allows a depreciation deduction only for property that is either used in a trade or business or held for the production of income. Whether a depreciation deduction is allowable “with respect to” a liability depends upon the property’s actual use. For example, if a taxpayer uses equipment to satisfy an environmental cleanup liability imposed by federal law, the portion of the equipment’s depreciation allocable to satisfying the environmental cleanup liability is allowable with respect to the environmental cleanup liability. If the environmental cleanup liability arose as a result of a chemical spill that occurred at least 3 years before the beginning of the taxable year and the environmental cleanup liability is otherwise deductible, the depreciation deductions may generate a specified liability loss. However, if a taxpayer uses equipment to satisfy environmental cleanup liabilities that arise during the same taxable year the depreciation deductions are allowable, for example, by preventing the discharge of pollutants resulting from manufacturing activities during the current taxable year, the act giving rise to the taxpayer’s environmental cleanup liability will not satisfy the 3-year act or failure to act requirement of former § 172(f)(1)(B)(i), irrespective of when the taxpayer placed the cleanup equipment in service.

The collections of information contained in this notice of proposed rulemaking have been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collections of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collections of information should be received by March 14, 2005. Comments are specifically requested concerning:

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

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

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

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

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

The collections of information in this proposed regulation are in §§301.6103(n)-1(d) and 301.6103(n)-1(e)(3). This information is required and will be used to ensure compliance with the internal revenue laws and regulations, and to protect the privacy of American taxpayers. The collections of information are required to obtain a benefit. The likely respondents are state or local governments, business or other for-profit institutions, federal agencies, and/or small businesses or organizations.

Estimated total annual reporting burden: 250 hours. Estimated average annual burden per respondent: 6 minutes.

Estimated number of respondents: 2500.

Estimated annual frequency of responses: Annually.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and return information are confidential, as required by 26 U.S.C. 6103.

Under section 6103(a), returns and return information are confidential unless the Code authorizes disclosure. Section 6103(n) authorizes, pursuant to regulations prescribed by the Secretary, returns and return information to be disclosed to any person, including any person described in section 7513(a), for purposes of tax administration, to the extent necessary in connection with: (1) the processing, storage, transmission, and reproduction of returns and return information; (2) the programming, maintenance, repair, testing, and procurement of equipment; and (3) the providing of other services.

Clarification is needed with respect to whether the existing regulations permit redisclosures by persons authorized to receive the returns and return information to their agents or subcontractors, and if so, whether certain penalty provisions, written notification requirements, and safeguard requirements are applicable to these agents and subcontractors. The proposed regulations make these clarifications. The existing regulations provide that any person, or officer or employee of the person, who receives returns or return information under the existing regulations, may redisclose the returns or return information when authorized in writing by the IRS. The proposed regulations clarify that redisclosures to agents or subcontractors are permissible provided that the IRS authorizes the redisclosures in writing. The proposed regulations clarify that agents and subcontractors are persons described in section 6103(n) and, accordingly, are subject to the civil and criminal penalty provisions of sections 7431, 7213, and 7213A for the unauthorized inspection or disclosure of returns or return information. The proposed regulations clarify that agents and subcontractors are required to comply with any written notification requirements and safeguard restrictions that may be imposed by the IRS.

Finally, the proposed regulations clarify that section 6103(n) applies to written contracts or agreements that are entered into to obtain property or services for tax administration purposes, including contracts that are not awarded under the FAR.

The structure of the proposed regulations is very similar to that of the existing regulations, with the exception of modifications to clarify: the redisclosure authority of contractors, especially to agents or subcontractors; the applicability to agents and subcontractors of written notification requirements, safeguard requirements, and the civil and criminal penalty provisions of sections 7431, 7213, and 7213A; and the applicability of section 6103(n) to written contracts or agreements for tax administration purposes, including contracts that are not awarded under the FAR. The proposed regulations also elaborate on the safeguard protections that the IRS may require. Finally, the proposed regulations contain other minor changes for organizational and clarity purposes.

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collections of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that any burden on taxpayers is minimal in that the estimated average burden per respondent for complying with the collections of information imposed by these regulations is 6 minutes. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f), this notice of proposed rulemaking will be submitted to the Chief Counsel of the Small Business Administration for comment on its impact on small businesses.

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

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

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 301.6103(n)-1 is revised to read as follows:

The collection of information contained in this notice of proposed rulemaking has been previously reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545-0928.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Section 417(a) provides rules under which a participant (with spousal consent) may waive payment of the participant’s benefit in the form of qualified joint and survivor annuity (QJSA). Specifically, section 417(a)(3) provides that a plan must provide to each participant, within a reasonable period before the annuity starting date, a written explanation that includes the following information: (1) the terms and conditions of the QJSA; (2) the participant’s right to make an election to waive the QJSA form of benefit; (3) the effect of such an election; (4) the rights of the participant’s spouse; and (5) the right to revoke an election to waive the QJSA form of benefit.

Section 205 of the Employee Retirement Income Security Act of 1974 (ERISA), Public Law 93-406 (88 Stat. 829) as subsequently amended, provides rules that are parallel to the rules of sections 401(a)(11) and 417 of the Internal Revenue Code. In particular, section 205(c)(3) of ERISA provides a rule parallel to the rule of section 417(a)(3) of the Code.

Section 1.401(a)-20, which provides rules governing the requirements for a waiver of the QJSA, was published in the Federal Register on August 19, 1988 (T.D. 8219, 1988-2 C.B. 48 [53 FR 31837]). Section 1.401(a)-20, Q&A-36, as published in 1988, set forth requirements for the explanation that must be provided under section 417(a)(3) as a prerequisite to waiver of a QJSA. Under those requirements, such a written explanation must contain a general description of the eligibility conditions and other material features of the optional forms of benefit and sufficient additional information to explain the relative values of the optional forms of benefit available under the plan (e.g., the extent to which optional forms are subsidized relative to the normal form of benefit or the interest rates used to calculate the optional forms). In addition, §1.401(a)-20, Q&A-36, as published in 1988, provided that the written explanation must comply with the requirements set forth in §1.401(a)-11(c)(3). Section 1.401(a)-11(c)(3) was issued prior to the enactment of section 417, and provides rules relating to written explanations that were required prior to a participant’s election of a preretirement survivor annuity or election to waive a joint and survivor annuity. Section 1.401(a)-11(c)(3)(i)(C) provides that such a written explanation must contain a general explanation of the relative financial effect of these elections on a participant’s annuity.

For a married participant, the QJSA must be at least as valuable as any other optional form of benefit payable under the plan at the same time. See §1.401(a)-20, Q&A-16. Further, the anti-forfeiture rules of section 411(a) prohibit a participant’s benefit under a defined benefit plan from being satisfied through payment of a form of benefit that is actuarially less valuable than the value of the participant’s accrued benefit expressed in the form of an annual benefit commencing at normal retirement age. These determinations must be made using reasonable actuarial assumptions. However, see section 417(e)(3) and §1.417(e)-1(d) for actuarial assumptions required for use in certain present value calculations.

Final regulations under section 417(a)(3) regarding disclosure of the relative value and financial effect of optional forms of benefit as part of QJSA explanations provided to participants receiving qualified retirement plan distributions were published in the Federal Register on December 17, 2003. See §1.417(a)(3)-1 (T.D. 9099, 2004-2 I.R.B. 255 [68 FR 70141]). The 2003 regulations are generally effective for QJSA explanations provided with respect to annuity starting dates beginning on or after October 1, 2004.

The 2003 regulations were issued in response to concerns that, in certain cases, the information provided to participants under section 417(a)(3) regarding available distribution forms pursuant to §1.401(a)-20, Q&A-36, does not adequately enable them to compare those distribution forms without professional advice. In particular, participants who are eligible for early retirement benefits in the form of both subsidized annuity distributions and unsubsidized single-sum distributions may be receiving explanations that do not adequately disclose the value of the subsidy that is foregone if the single-sum distribution is elected. In such a case, merely disclosing the amount of the single-sum distribution and the amount of the annuity payments would not adequately enable a participant to make an informed comparison of the relative values of those distribution forms. The 2003 regulations address this problem, as well as the problem of disclosure in other cases where there are significant differences in value among optional forms, and also clarify the rules regarding the disclosure of the financial effect of benefit payments.

A number of commentators requested that the effective date of the 2003 regulations be postponed. Among the reasons cited is the need in some plans for sponsors to complete an extensive review and analysis of optional forms of benefit in order to prepare proper comparisons of the relative values of those optional forms to the QJSA. They noted that recently proposed regulations under section 411(d)(6) would permit elimination of certain optional forms of benefit and that many plan sponsors can be expected to engage in a thorough review of all of the optional forms of benefit under their plans following publication of those regulations in final form. See §1.411(d)-3, 69 FR 13769 (March 24, 2004) (REG-128309-03, 2004-16 I.R.B. 800). These commentators argued that it would be inefficient for plans to be required to incur the costs of two such extensive analyses in succession, rather than a single analysis of optional forms that might serve to some extent for purposes of both the relative value regulations and the section 411(d)(6) regulations. After consideration of these comments, Treasury and the IRS issued Announcement 2004-58, 2004-29 I.R.B. 66, which postponed the effective date of the 2003 regulations under §1.417(a)(3)-1 for certain QJSA explanations.

Under section 101 of Reorganization Plan No. 4 of 1978 (43 FR 47713), the Secretary of the Treasury has interpretive jurisdiction over ERISA provisions that are parallel to the Code provisions addressed in these regulations. Therefore, these proposed regulations would apply for purposes of the parallel rules in section 205(c)(3) of ERISA, as well as for section 417(a)(3) of the Code.

Consistent with Announcement 2004-58, these proposed regulations would modify the 2003 regulations to provide that the 2003 regulations are generally effective for QJSA explanations provided with respect to annuity starting dates beginning on or after February 1, 2006. In the interim, plans that do not comply with §1.417(a)(3)-1 would be required to comply with the 1988 regulations regarding disclosure of relative value and financial effect.

However, the existing effective date under §1.417(a)(3)-1 of the 2003 regulations is retained for explanations with respect to any optional form of benefit that is subject to the requirements of section 417(e)(3) (e.g., single sums, social security level income options, distributions in the form of partial single sums in combination with annuities, or installment payment options) if the actuarial present value of that optional form is less than the actuarial present value (as determined under section 417(e)(3)) of the QJSA. Thus, for example, a QJSA explanation provided with respect to an annuity starting date beginning on or after October 1, 2004, must comply with §1.417(a)(3)-1 to the extent that the plan provides for payment to that participant in the form of a single sum that does not reflect an early retirement subsidy available under the QJSA. Where the existing effective date is retained, the plan must disclose the relative value of the QJSA for the participant even if the plan provides a disclosure of relative values that is not tailored to the participant’s marital status. Accordingly, if a plan provides a relative value disclosure based on the single life annuity (the QJSA for a single participant) to a married participant, the plan must also include a comparison of the value of the QJSA to the value of the single life annuity.

The proposed regulations include a special rule that would enable a plan to use the delayed effective date rule even if there are minor differences between the value of an optional form and the value of the QJSA for a married participant that are caused by the calculation of the amount of the optional form of benefit based on the life annuity rather than on the QJSA. Under this special rule, solely for purposes of the effective date provisions, the actuarial present value of an optional form is treated as not being less than the actuarial present value of the QJSA if the following two conditions are met. First, using the applicable interest rate and applicable mortality table under §§1.417(e)-1(d)(2) and (3), the actuarial present value of that optional form is not less than the actuarial present value of the QJSA for an unmarried participant. Second, using reasonable actuarial assumptions, the actuarial present value of the QJSA for an unmarried participant is not less than the actuarial present value of the QJSA for a married participant.

These proposed regulations would also modify the 2003 regulations in several other respects. First, for purposes of disclosing the normal form of benefit as part of a disclosure made in the form of generally applicable information, reasonable estimates of the type permitted to be used to disclose participant-specific information may be used to determine the normal form of benefit, but only if the plan follows the requirements applicable to reasonable estimates used in disclosing participant-specific information (such as offering a more precise calculation upon request and revising previously offered information consistent with the more precise information). Second, a QJSA explanation does not fail to satisfy the requirements for QJSA explanations made in the form of disclosures of generally applicable information merely because the QJSA explanation contains an item of participant-specific information in place of the corresponding generally applicable information.

In addition, the proposed regulations would modify §1.401(a)-20, Q&A-16, to clarify the interaction of the rule prohibiting a plan from providing an option to a married individual that is worth more than the QJSA with the requirement that certain optional forms of benefit be calculated using specified actuarial assumptions. Under that clarification, a plan would not fail to satisfy the requirements of §1.401(a)-20, Q&A-16, merely because the amount payable under an optional form of benefit that is subject to the minimum present value requirement of section 417(e)(3) is calculated using the applicable interest rate (and, for periods when required, the applicable mortality table) under section 417(e)(3).

The changes to §1.401(a)-20, A-36, and §1.417(a)(3)-1 are proposed to apply as if they had been included in T.D. 9099 (68 FR 70141). The change to §1.401(a)-20, Q&A-16, is proposed to apply as if it had been included in T.D. 8219 (53 FR 31837). Taxpayers may rely on these proposed regulations for guidance pending the issuance of final regulations.

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

Before these proposed regulations are adopted as final regulations, consideration will be given to any electronic or written comments (preferably a signed original and eight (8) copies) that are submitted timely to the IRS. In addition to the other requests for comments set forth in this document, the IRS and Treasury also request comments on the clarity of the proposed rule and how it may be made easier to understand. All comments will be available for public inspection and copying. A public hearing will be scheduled if one is requested.

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

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.401(a)-20 is amended by:

1. Adding a sentence to the end of Q&A-16.

2. Adding a sentence to the end of Q&A-36.

The additions read as follows: