Section 42(a) provides that, for purposes of section 38, the amount of the low-income housing credit determined under section 42 for any taxable year in the credit period is an amount equal to the applicable percentage of the qualified basis of each qualified low-income building. A qualified low-income building is defined in section 42(c)(2) as any building that is part of a qualified low-income housing project.

A qualified low-income housing project is defined in section 42(g)(1) as any project for residential rental property if the project meets one of the following tests elected by the taxpayer: (1) at least 20 percent of the residential units in the project are rent-restricted and occupied by individuals whose income is 50 percent or less of area median gross income; or (2) at least 40 percent of the residential units in the project are rent-restricted and occupied by individuals whose income is 60 percent or less of area median gross income. If a taxpayer does not meet the elected test, the project is not eligible for the section 42 credit.

Under section 42(g)(4), section 142(d)(2)(B) applies when determining whether any project is a qualified low-income housing project under section 42(g)(1). Section 142(d)(2)(B) provides that the income of individuals and area median gross income is determined by the Secretary in a manner consistent with determinations of lower income families and area median gross income under section 8 of the United States Housing Act of 1937. Under Rev. Rul. 94-57, 1994-2 C.B. 5, taxpayers may rely on a list of income limits released by the Department of Housing and Urban Development (HUD) until 45 days after HUD releases a new list of income limits, or until HUD’s effective date for the new list, whichever is later.

In order to qualify as a rent-restricted unit within the meaning of section 42(g)(2), the gross rent for the unit must not exceed 30 percent of the imputed income limitation applicable to the unit. Section 42(g)(2)(B)(ii) requires the inclusion in gross rent of a utility allowance determined by the Secretary after taking into account the determinations under section 8 of the United States Housing Act of 1937.

Section 1.42-10(a) provides that if utility costs (other than telephone) for a residential rental unit are paid directly by the tenant, then the gross rent for that unit includes the applicable utility allowance as determined under § 1.42-10. Section 1.42-10(b) provides rules for calculating the appropriate utility allowance based upon whether (1) the building receives rental assistance from the Farmers Home Administration (FmHA), now known as the Rural Housing Service; (2) the building has any tenant that receives FmHA rental assistance; (3) the building is not described in (1) or (2) above and the building’s rents and utility allowances are reviewed by HUD on an annual basis; or (4) the building is not described in (1), (2), or (3) above (other buildings).

Currently, under §1.42-10(b)(4), other buildings generally use the applicable Public Housing Authority (PHA) utility allowance established for the Section 8 Existing Housing Program or use a local utility company estimate. The local utility company estimate may be obtained by any interested party (including a low-income tenant, a building owner, or a State or local housing credit agency (Agency)).

The proposed regulations proposed two additional options for calculating utility allowances. The first option would permit a building owner to obtain a utility estimate for each unit in a building from the Agency that has jurisdiction over the building (the Agency estimate). The Agency estimate must take into account the local utility rates data, property type, climate variables by region in the State, taxes and fees on utility charges, and property building materials and mechanical systems. An Agency may also use actual utility company usage data and rates for the building. The second option would permit a building owner to calculate utility allowances using the “HUD Utility Schedule Model” found on the Low-Income Housing Tax Credits page at www.huduser.org/datasets/lihtc.html (or successor URL). The HUD Utility Schedule Model is based on data from the Residential Energy Consumption Survey (RECS) conducted by the Department of Energy. RECS data provides energy consumption by structure for heating, air conditioning, cooking, water heating, and other electric (lighting and refrigeration). The HUD Utility Schedule Model incorporates building location and climate.

Prior to these final regulations, §1.42-10(a) provided for the exclusion of telephone costs in determining the amount of the utility allowance to be included in gross rent. The proposed regulations excluded cable television costs as well as telephone costs. The final regulations retain the exclusions for cable television and telephone costs and also exclude Internet costs. The IRS and Treasury Department believe it is appropriate to exclude cable television and Internet costs as comparable to telephone costs.

Commentators stated that the Agency estimate in the proposed regulations may be administratively burdensome for some Agencies. As an alternative, commentators suggested adding an option that would allow utility estimates to be calculated by a state-certified engineer or other qualified professional. The commentators specified that, under this option, computer software could be developed that would estimate the energy or water and sanitary sewer service cost for each type of unit in a building. The estimates would be determined based on the applicable current local utility billing rate schedule and would be applied to all comparable units in the building using specific information about the design, materials, equipment, and location of the building.

A computer software model that incorporates specific information about the design and location of the building for which the utility allowances are being developed, and that can be updated with actual consumption data and with consumption estimates as new efficiency measures and improvements are undertaken, would provide more accurate estimates of utility consumption. Therefore, the final regulations also include a new option allowing building owners to retain the services of a qualified professional to calculate utility allowances based on an energy consumption model.

The use of this new option is subject to several special rules. First, the energy consumption model must, at a minimum, take into account specific factors including, but not limited to, unit size, building orientation, design and materials, mechanical systems, appliances, and characteristics of the building location. Second, the utility estimates must be calculated by either (1) a properly licensed engineer or (2) a qualified professional approved by the Agency that has jurisdiction over the building (together, qualified professional). The qualified professional and the building owner must not be related within the meaning of section 267(b) or 707(b). Third, the building owner must furnish a copy of the estimates derived from the energy consumption model to the Agency and make copies of the estimates available to all tenants in the building. Finally, the building owner must pay for all costs incurred in obtaining the utility estimates from the qualified professional and providing the estimates to the Agency and tenants.

One commentator suggested that the final regulations should provide a default option because, in the absence of a definitive standard for determining utility allowances, building owners would use the option that yields the lowest utility estimates. Commentators further requested clarification as to which option should be used when multiple options are available, whether building owners may use different options for different utilities, and whether owners may change the options used for calculating utilities from time to time.

An energy consumption model developed by a qualified professional that takes into account specific information about the design and location of the building for which the utility allowances are being developed should produce the most accurate utility estimates. It is expected that this more accurate model will be the model most commonly used by most building owners, particularly those with buildings that are not very old. However, if a building owner selects an option that yields higher utility allowances, the building owner should be free to accept a lower amount of rent from tenants. Therefore, there is no need for a stated default option or option ordering rule. Further, the final regulations neither prohibit using different options for different utilities nor prohibit changing the options used for calculating utilities. If an Agency determines that a building owner has understated the utility allowances for the building under the particular option chosen by the owner for calculating the utility allowance, and the building’s units are not rent-restricted units under section 42(g)(2) as a result, the Agency must report the noncompliance on Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition.

Under current §1.42-10(c) of the regulations, if the applicable utility allowance for units changes, the new utility allowance must be used to compute gross rent of rent-restricted units due 90 days after the change (the 90-day period). The proposed regulations limited the effective date of any new utility allowances to the earlier of the date the building has achieved 90 percent occupancy for a period of 90 consecutive days or the end of the first year of the credit period. The proposed regulations also modified §1.42-10(c) by requiring that a building owner must review at least annually the basis on which utility allowances have been established and must update the applicable utility allowance. The review must take into account any changes to the building such as any energy conservation measures that affect energy consumption and changes in utility rates.

Commentators suggested that building owners should be obligated to adjust utility allowances when utility rates increase by a stated percentage, for example, 10 percent, which is the rule for revising utility allowance schedules for PHAs under 24 CFR 982.517(c). This HUD rule provides that a PHA must review its schedule of utility allowances each year and revise its allowance for a utility category if the utility rate has changed by 10 percent or more since the utility allowance schedule was last revised. The commentators did not address decreases in utility rates. A commentator also suggested that the final regulations should require an Agency to review or have owners review local utility rates quarterly to determine if rates have increased sufficiently to require an adjustment. A different commentator suggested limiting reviews to no more than once per year.

The IRS and Treasury Department do not believe that fluctuations in utility rates within a given year should trigger recalculations of utility allowances more than once a year. The IRS and Treasury Department do not believe that the additional burden of updating the utility allowances more than once a year is warranted at this time. Utility rates generally do not change more than once a year, and yearly updated utility allowances would reflect average rates applicable to all tenants in a building from year to year. Therefore, the final regulations require building owners to calculate new utility allowances once during the calendar year regardless of any percentage change in utility rates. Building owners may choose, however, to calculate new utility allowances more frequently than once during the calendar year provided the owner complies with the requirements of these regulations, including the notification requirements to the Agency and tenants.

Another commentator suggested that new utility allowances should be implemented within 90 days after HUD publishes its annual income limits (which are used in determining section 42 rents), but in no case later than June 30 of any year. Section 42 rents under section 42(g)(2) may or may not increase depending on HUD’s calculation of area median gross income. Therefore, the IRS and Treasury Department do not believe that the rules should require that the effective date of any new utility allowance coincide with the section 42 effective date of HUD’s income lists. Building owners, however, may choose to implement any new utility allowances on the section 42 effective date of HUD’s income lists.

To bring financial stability to a project during the beginning of its operations, the final regulations clarify that the building owner is not required to review the utility allowances, or implement new utility allowances, until the earlier of the date the building has achieved 90 percent occupancy for a period of 90 consecutive days or the end of the first year of the credit period.

One commentator made several recommendations regarding procedural safeguards for tenants including: owners should be required to give tenants 30 days notice before the effective date of any utility allowance; tenants should be provided with all information used in calculating the utility allowances; tenants should be given the opportunity to comment on the proposed allowances; and owners should be required to review those comments prior to the utility allowances becoming effective. The commentator believed that the new options for determining utility allowances should be available only after one full year of occupancy and one full year after the building is placed in service. A commentator also recommended that a building owner should be allowed to use the new options only if the owner provides all data to the Agency no later than February 15 and the Agency informs the owner whether the proposed utility allowances are approved by March 31.

To provide tenants with the opportunity to comment on proposed utility allowances to the Agency and building owner, the final regulations apply the existing disclosure requirement under current §1.42-10(b)(4)(ii)(B) (regarding the utility company estimate) to an owner using a utility company estimate, the HUD Utility Schedule Model, or an energy consumption model. Therefore, an owner must submit copies of the proposed utility allowances to the Agency and make the proposed utility allowances available to all tenants in the building at the beginning of the 90-day period before the utility allowances are used in determining the gross rents of rent-restricted units. Similarly, the final regulations require that any utility estimates obtained under the Agency estimate option must be made available to all tenants in the building at the beginning of the 90-day period. An Agency may continue to require additional information from the owner during the 90-day period.

Commentators suggested that the final regulations should limit the use of the HUD Utility Schedule Model to data for a twelve-month period ending in the most recent calendar year and require the owner to certify the accuracy of the data and the calculations of the utility allowances. However, the HUD Utility Schedule Model already incorporates consumption data derived from RECS data. Thus, building owners using this option need not be required to use consumption data for any particular twelve-month period. These final regulations, however, provide that the use of the energy consumption model is limited to consumption data for a twelve-month period ending no earlier than 60 days prior to the beginning of the 90-day period. In the case of newly constructed or renovated buildings with less than twelve months of consumption data, the energy consumption model allows a qualified professional to use consumption data for the twelve-month period of units of similar size and construction in the geographic area in which the building containing the units is located. Further, the final regulations require that utility rates used for the HUD Utility Schedule Model, the Agency estimate option, and the energy consumption model must be no older than the rates in place 60 days prior to the beginning of the 90-day period.

In addition to these safeguards, if an Agency determines that a building owner has understated the utility allowances for the owner’s building under the particular option chosen, and, therefore, some or all of the units in the building are not rent-restricted units under section 42(g)(2), then the Agency must report the noncompliance to the Service on Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition.

Commentators requested that building owners should be required to certify the estimate and the accuracy of the data used under the new options. Because Agencies may request additional information at any time during their mandatory review of proposed utility allowances, and must report any noncompliance to the Service, the final regulations do not require building owners to provide such certification.

One commentator suggested that the calculation of utility allowances should take into account any special needs tenants such as people with disabilities who require high energy consumption equipment. Section 42 does not require that the owner’s calculation of utility allowances be based on a tenant’s particular use of utility services. If such a requirement were imposed, owners and Agencies would have to determine the utility allowance for the tenants in each unit, as opposed to allowances based on the size of the unit, which would greatly increase burden. Additionally, it is unclear whether it is appropriate to implement rules that might encourage tenants to be indifferent to their energy consumption. Such indifference could lead to cost overruns by owners, and the viability of low-income housing could be jeopardized. Therefore, the final regulations do not require the calculation of utility allowances based on consumption by particular tenants.

Section 1.42-10(b)(4)(ii)(B) currently provides that any interested party (including an owner, low-income tenant, or Agency) may obtain a local utility company estimate for a unit. The estimate is obtained when the interested party receives, in writing, information from a local utility company providing the estimated cost of that utility for a unit of similar size and construction for the geographic area in which the building containing the units is located. In light of utility services deregulation, the proposed regulations proposed to amend this option by requiring the interested party to obtain cost estimates from the local utility company that include combined rate charges from multiple utility companies.

Commentators thought this proposed amendment would require the interested party to obtain utility consumption estimates from every utility company providing the same utility service and stated that this would present an unworkable administrative burden in deregulated jurisdictions with multiple utility providers. In some jurisdictions, many utility providers may be available for a given building. The proposed amendment was not intended to require the interested party to obtain utility consumption estimates from every utility company providing the same utility service. The amendment was proposed to address deregulation by requiring the interested party to obtain estimates for all the components of the utility service if the service is divided between two or more types of service providers (for example, electric generation and electric transmission). The final regulations clarify that, in the case of deregulated utility services, the interested party is required to obtain an estimate from only one utility company even if multiple companies can provide the same utility service to a unit. However, the utility company furnishing the estimate must offer utility services to the building in order for that utility company’s rates to be used in calculating utility allowances. The estimate should include all component charges for providing the utility service.

One commentator requested that specific language be added to address when Agencies may charge a reasonable fee for making a determination pursuant to the Agency estimate option, and who bears the fee when a particular option is used. The proposed regulations provided that costs incurred in obtaining an Agency estimate are borne by the building owner. The final regulations adopt this provision, and further require building owners to pay for all costs incurred in obtaining the estimates under the HUD Utility Schedule Model and the energy consumption model and in providing estimates to Agencies and tenants.

The proposed regulations were proposed to be effective for taxable years beginning on or after the date of publication of the final regulations in the Federal Register. A commentator suggested that the final regulations be effective earlier on the basis that if they are published after 2007, they would not be effective until 2009 for calendar year taxpayers. The IRS and Treasury Department believe that the burden associated with an earlier effective date is not warranted. Therefore, the final regulations do not adopt this suggestion. However, in order to allow a building owner to implement the utility allowances as of the first day of the owner’s taxable year beginning on or after July 29, 2008, the final regulations provide that taxpayers may rely on the rules for determining utility allowances before the first day of the owner’s taxable year beginning on or after July 29, 2008 provided that any utility allowances so calculated are effective no earlier than the first day of the owner’s taxable year beginning on or after July 29, 2008.

(a) * * * If the cost of any utility (other than telephone, cable television, or Internet) for a residential rental unit is paid directly by the tenant(s), and not by or through the owner of the building, the gross rent for that unit includes the applicable utility allowance determined under this section. * * *

(b) Applicable utility allowances—(1) Buildings assisted by the Rural Housing Service. If a building receives assistance from the Rural Housing Service (RHS-assisted building), the applicable utility allowance for all rent-restricted units in the building is the utility allowance determined under the method prescribed by the Rural Housing Service (RHS) for the building (whether or not the building or its tenants also receive other state or federal assistance).

(2) Buildings with Rural Housing Service assisted tenants. If any tenant in a building receives RHS rental assistance payments (RHS tenant assistance), the applicable utility allowance for all rent-restricted units in the building (including any units occupied by tenants receiving rental assistance payments from the Department of Housing and Urban Development (HUD)) is the applicable RHS utility allowance.

(3) Buildings regulated by the Department of Housing and Urban Development. If neither a building nor any tenant in the building receives RHS housing assistance, and the rents and utility allowances of the building are reviewed by HUD on an annual basis (HUD-regulated building), the applicable utility allowance for all rent-restricted units in the building is the applicable HUD utility allowance.

(4) Other buildings. If a building is neither an RHS-assisted nor a HUD-regulated building, and no tenant in the building receives RHS tenant assistance, the applicable utility allowance for rent-restricted units in the building is determined under the following methods.

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(ii) * * * (A) * * * However, if a local utility company estimate is obtained for any unit in the building under paragraph (b)(4)(ii)(B) of this section, a State or local housing credit agency (Agency) provides a building owner with an estimate for any unit in a building under paragraph (b)(4)(ii)(C) of this section, a cost estimate is calculated using the HUD Utility Schedule Model under paragraph (b)(4)(ii)(D) of this section, or a cost estimate is calculated by an energy consumption model under paragraph (b)(4)(ii)(E) of this section, then the estimate under paragraph (b)(4)(ii)(B), (C), (D), or (E) becomes the applicable utility allowance for all rent-restricted units of similar size and construction in the building. Paragraphs (b)(4)(ii)(B), (C), (D), and (E) of this section do not apply to units to which the rules of paragraphs (b)(1), (2), (3), or (4)(i) of this section apply.

(B) * * * In the case of deregulated utility services, the interested party is required to obtain an estimate only from one utility company even if multiple companies can provide the same utility service to a unit. However, the utility company must offer utility services to the building in order for that utility company’s rates to be used in calculating utility allowances. The estimate should include all component deregulated charges for providing the utility service. * * *

(C) Agency estimate. A building owner may obtain a utility estimate for each unit in the building from the Agency that has jurisdiction over the building provided the Agency agrees to provide the estimate. The estimate is obtained when the building owner receives, in writing, information from the Agency providing the estimated per-unit cost of the utilities for units of similar size and construction for the geographic area in which the building containing the units is located. The Agency estimate may be obtained by a building owner at any time during the building’s extended use period (see section 42(h)(6)(D)). Costs incurred in obtaining the estimate are borne by the building owner. In establishing an accurate utility allowance estimate for a particular building, an Agency (or an agent or other private contractor of the Agency that is a qualified professional within the meaning of paragraph (b)(4)(ii)(E) of this section) must take into account, among other things, local utility rates, property type, climate and degree-day variables by region in the State, taxes and fees on utility charges, building materials, and mechanical systems. If the Agency uses an agent or other private contractor to calculate the utility estimates, the agent or contractor and the owner must not be related within the meaning of section 267(b) or 707(b). An Agency may also use actual utility company usage data and rates for the building. However, use of the Agency estimate is limited to the building’s consumption data for the twelve-month period ending no earlier than 60 days prior to the beginning of the 90-day period under paragraph (c)(1) of this section and utility rates used for the Agency estimate must be no older than the rates in place 60 days prior to the beginning of the 90-day period under paragraph (c)(1) of this section. In the case of newly constructed or renovated buildings with less than 12 months of consumption data, the Agency (or an agent or other private contractor of the Agency that is a qualified professional within the meaning of paragraph (b)(4)(ii)(E) of this section) may use consumption data for the 12-month period of units of similar size and construction in the geographic area in which the building containing the units is located.

(D) HUD Utility Schedule Model. A building owner may calculate a utility estimate using the “HUD Utility Schedule Model” that can be found on the Low-Income Housing Tax Credits page at www.huduser.org/datasets/lihtc.html (or successor URL). Utility rates used for the HUD Utility Schedule Model must be no older than the rates in place 60 days prior to the beginning of the 90-day period under paragraph (c)(1) of this section.

(E) Energy consumption model. A building owner may calculate utility estimates using an energy and water and sewage consumption and analysis model (energy consumption model). The energy consumption model must, at a minimum, take into account specific factors including, but not limited to, unit size, building orientation, design and materials, mechanical systems, appliances, and characteristics of the building location. The utility consumption estimates must be calculated by either a properly licensed engineer or a qualified professional approved by the Agency that has jurisdiction over the building (together, qualified professional), and the qualified professional and the building owner must not be related within the meaning of section 267(b) or 707(b). Use of the energy consumption model is limited to the building’s consumption data for the twelve-month period ending no earlier than 60 days prior to the beginning of the 90-day period under paragraph (c)(1) of this section, and utility rates used for the energy consumption model must be no older than the rates in place 60 days prior to the beginning of the 90-day period under paragraph (c)(1) of this section. In the case of newly constructed or renovated buildings with less than 12 months of consumption data, the qualified professional may use consumption data for the 12-month period of units of similar size and construction in the geographic area in which the building containing the units is located.

(c) Changes in applicable utility allowance—(1) In general. If, at any time during the building’s extended use period (as defined in section 42(h)(6)(D)), the applicable utility allowance for units changes, the new utility allowance must be used to compute gross rents of the units due 90 days after the change (the 90-day period). For example, if rent must be lowered because a local utility company estimate is obtained that shows a higher utility cost than the otherwise applicable PHA utility allowance, the lower rent must be in effect for rent due at the end of the 90-day period. A building owner using a utility company estimate under paragraph (b)(4)(ii)(B) of this section, the HUD Utility Schedule Model under paragraph (b)(4)(ii)(D) of this section, or an energy consumption model under paragraph (b)(4)(ii)(E) of this section must submit copies of the utility estimates to the Agency that has jurisdiction over the building and make the estimates available to all tenants in the building at the beginning of the 90-day period before the utility allowances can be used in determining the gross rent of rent-restricted units. An Agency may require additional information from the owner during the 90-day period. Any utility estimates obtained under the Agency estimate under paragraph (b)(4)(ii)(C) of this section must also be made available to all tenants in the building at the beginning of the 90-day period. The building owner must pay for all costs incurred in obtaining the estimates under paragraphs (b)(4)(ii)(B), (C), (D), and (E) of this section and providing the estimates to the Agency and the tenants. The building owner is not required to review the utility allowances, or implement new utility allowances, until the building has achieved 90 percent occupancy for a period of 90 consecutive days or the end of the first year of the credit period, whichever is earlier.

(2) Annual review. A building owner must review at least once during each calendar year the basis on which utility allowances have been established and must update the applicable utility allowance in accordance with paragraph (c)(1) of this section. The review must take into account any changes to the building such as any energy conservation measures that affect energy consumption and changes in utility rates.

(d) Record retention. The building owner must retain any utility consumption estimates and supporting data as part of the taxpayer’s records for purposes of §1.6001-1(a).

Par. 3. Section 1.42-12 is amended by adding paragraph (a)(4) to read as follows:

(a) * * *

(4) Utility allowances. The first sentence in §1.42-10(a), §1.42-10(b)(1), (2), (3), and (4), the last two sentences in §1.42-10(b)(4)(ii)(A), the third, fourth, and fifth sentences in §1.42-10(b)(4)(ii)(B), §1.42-10(b)(4)(ii)(C), (D), and (E), and §1.42-10(c) and (d) are applicable to a building owner’s taxable years beginning on or after July 29, 2008. Taxpayers may rely on these provisions before the beginning of the building owner’s taxable year beginning on or after July 29, 2008 provided that any utility allowances calculated under these provisions are effective no earlier than the first day of the building owner’s taxable year beginning on or after July 29, 2008. The utility allowances provisions that apply to taxable years beginning before July 29, 2008 are contained in §1.42-10 (see 26 CFR part 1 revised as of April 1, 2008).

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.

Approved July 20, 2008.

Eric Solomon,
Assistant Secretary of
the Treasury (Tax Policy).

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(h) Treatment of trusts resulting from a severance that is not a qualified severance.

* * * * *

Par. 3. Section 26.2642-6 is amended as follows:

1. Paragraphs (d)(4) and (d)(7) are revised.

2. Paragraph (h) is added.

3. Paragraph (j) Example 3 is revised.

4. Paragraph (j) Examples 6, 9, 12, and 13 are added.

5. Paragraph (k)(1) is revised.

The additions and revisions read as follows:

* * * * *

(d) * * *

(4) The single trust (original trust) is severed on a fractional basis, such that each new trust (resulting trust) is funded with a fraction or percentage of the original trust, and the sum of those fractions or percentages is one or one hundred percent, respectively. For this purpose, the fraction or percentage may be determined by means of a formula (for example, that fraction of the trust the numerator of which is equal to the transferor’s unused GST tax exemption, and the denominator of which is the fair market value of the original trust’s assets on the date of severance). The severance of a trust based on a pecuniary amount does not satisfy this requirement. For example, the severance of a trust is not a qualified severance if the trust is divided into two trusts, with one trust to be funded with $1,500,000 and the other trust to be funded with the balance of the original trust’s assets. With respect to the particular assets to be distributed to each separate trust resulting from the severance, each such trust may be funded with the appropriate fraction or percentage (pro rata portion) of each asset held by the original trust. Alternatively, the assets may be divided among the resulting trusts on a non-pro rata basis, based on the fair market value of the assets on the date of severance. However, if a resulting trust is funded on a non-pro rata basis, each asset received by a resulting trust must be valued, solely for funding purposes, by multiplying the fair market value of the asset held in the original trust as of the date of severance by the fraction or percentage of that asset received by that resulting trust. Thus, the assets must be valued without taking into account any discount or premium arising from the severance, for example, any valuation discounts that might arise because the resulting trust receives less than the entire interest held by the original trust. See paragraph (j), Example 6 of this section.

* * * * *

(7)(i) In the case of a qualified severance occurring after GST tax exemption has been allocated to the trust (whether by an affirmative allocation, a deemed allocation, or an automatic allocation pursuant to the rules contained in section 2632), if the trust has an inclusion ratio as defined in §26.2642-1 that is greater than zero and less than one, then either paragraph (d)(7)(ii) or (iii) of this section must be satisfied.

(ii) The trust is severed initially into only two resulting trusts. One resulting trust must receive that fractional share of the total value of the original trust as of the date of severance that is equal to the applicable fraction, as defined in §26.2642-1(b) and (c), used to determine the inclusion ratio of the original trust immediately before the severance. The other resulting trust must receive that fractional share of the total value of the original trust as of the date of severance that is equal to the excess of one over the fractional share described in the preceding sentence. The trust receiving the fractional share equal to the applicable fraction shall have an inclusion ratio of zero, and the other trust shall have an inclusion ratio of one. If the applicable fraction with respect to the original trust is .50, then, with respect to the two equal trusts resulting from the severance, the trustee may designate which of the resulting trusts will have an inclusion ratio of zero and which will have an inclusion ratio of one. Each separate trust resulting from the severance then may be further divided in accordance with the rules of this section. See paragraph (j), Example 7, of this section.

(iii) The trust is severed initially into more than two resulting trusts. One or more of the resulting trusts in the aggregate must receive that fractional share of the total value of the original trust as of the date of severance that is equal to the applicable fraction used to determine the inclusion ratio of the original trust immediately before the severance. The trust or trusts receiving such fractional share shall have an inclusion ratio of zero, and each of the other resulting trust or trusts shall have an inclusion ratio of one. (If, however, two or more of the resulting trusts each receives the fractional share of the total value of the original trust equal to the applicable fraction, the trustee may designate which of those resulting trusts will have an inclusion ratio of zero and which will have an inclusion ratio of one.) The resulting trust or trusts with an inclusion ratio of one must receive in the aggregate that fractional share of the total value of the original trust as of the date of severance that is equal to the excess of one over the fractional share described in the second sentence of this paragraph. See paragraph (j), Example 9, of this section.

* * * * *

(h) Treatment of trusts resulting from a severance that is not a qualified severance. Trusts resulting from a severance (other than a severance recognized for GST tax purposes under §26.2654-1) that does not meet the requirements of a qualified severance under paragraph (b) of this section will be treated, after the date of severance, as separate trusts for purposes of the GST tax, provided that the trusts resulting from such severance are recognized as separate trusts under applicable state law. The post-severance treatment of the resulting trusts as separate trusts for GST tax purposes generally permits the allocation of GST tax exemption, the making of various elections permitted for GST tax purposes, and the occurrence of a taxable distribution or termination with regard to a particular resulting trust, with no GST tax impact on any other trust resulting from that severance. Each trust resulting from a severance described in this paragraph (h), however, will have the same inclusion ratio immediately after the severance as that of the original trust immediately before the severance. (See §26.2654-1 for the inclusion ratio of each trust resulting from a severance described in that section.) Further, any trust resulting from a nonqualified severance may be severed subsequently, pursuant to a qualified severance described in this §26.2642-6.

* * * * *

(j) * * *

Example 3. Severance based on actuarial value of beneficial interests. In 2004, T establishes Trust, an irrevocable trust providing that income is to be paid to T’s child C during C’s lifetime. Upon C’s death, Trust is to terminate and the assets of Trust are to be paid to GC, C’s child, if living, or, if GC is not then living, to GC’s estate. T properly elects, under section 2632(c)(5), not to have the automatic allocation rules contained in section 2632(c) apply with respect to T’s transfers to Trust, and T does not otherwise allocate GST tax exemption with respect to Trust. Thus, Trust has an inclusion ratio of one. In 2009, the trustee of Trust, pursuant to applicable state law, divides Trust into two separate trusts, Trust 1 for the benefit of C (and on C’s death to C’s estate), and Trust 2 for the benefit of GC (and on GC’s death to GC’s estate). The document severing Trust directs that Trust 1 is to be funded with an amount equal to the actuarial value of C’s interest in Trust prior to the severance, determined under section 7520 of the Internal Revenue Code. Similarly, Trust 2 is to be funded with an amount equal to the actuarial value of GC’s interest in Trust prior to the severance, determined under section 7520. Trust 1 and Trust 2 do not provide for the same succession of interests as provided under the terms of the original trust. Therefore, the severance is not a qualified severance. Furthermore, because the severance results in no non-skip person having an interest in Trust 2, Trust 2 constitutes a skip person under section 2613 and, therefore, the severance results in a taxable termination subject to GST tax.

* * * * *

Example 6. Funding of severed trusts on a non-pro rata basis. (i) T’s will establishes an irrevocable trust (Trust) for the benefit of T’s descendants. As a result of the allocation of GST tax exemption, the applicable fraction with respect to Trust is .60 and Trust’s inclusion ratio is .40 [1 - .60]. Pursuant to authority granted under applicable state law, on August 1, 2008, the trustee executes a document severing Trust into two trusts, Trust 1 and Trust 2, each of which is identical to Trust. The instrument of severance provides that the severance is intended to qualify as a qualified severance within the meaning of section 2642(a)(3) and designates August 3, 2008, as the date of severance (within the meaning of paragraph (d)(3) of this section). The instrument further provides that Trust 1 and Trust 2 are to be funded on a non-pro rata basis with Trust 1 funded with assets having a fair market value on the date of severance equal to 40% of the value of Trust’s assets on that date and Trust 2 funded with assets having a fair market value equal to 60% of the value of Trust’s assets on that date. The fair market value of the assets used to fund each trust is to be determined in compliance with the requirements of paragraph (d)(4) of this section.

(ii) On August 3, 2008, the fair market value of the Trust assets totals $4,000,000, consisting of 52% of the outstanding common stock in Company, a closely-held corporation, valued at $3,000,000 and $1,000,000 in cash and marketable securities. Trustee proposes to divide the Company stock equally between Trust 1 and Trust 2, and thus transfer 26% of the Company stock to Trust 1 and 26% of the stock to Trust 2. In addition, the appropriate amount of cash and marketable securities will be distributed to each trust. In accordance with paragraph (d)(4) of this section, for funding purposes, the interest in the Company stock distributed to each trust is valued as a pro rata portion of the value of the 52% interest in Company held by Trust before severance, without taking into account, for example, any valuation discount that might otherwise apply in valuing the noncontrolling interest distributed to each resulting trust.

(iii) Accordingly, for funding purposes, each 26% interest in Company stock distributed to Trust 1 and Trust 2 is valued at $1,500,000 (.5 x $3,000,000). Therefore, Trust 1, which is to be funded with $1,600,000 (.40 x $4,000,000), receives $100,000 in cash and marketable securities valued as of August 3, 2008, in addition to the Company stock, and Trust 2, which is to be funded with $2,400,000 (.60 x $4,000,000), receives $900,000 in cash and marketable securities in addition to the Company stock. Therefore, the severance is a qualified severance, provided that all other requirements of section 2642(a)(3) and this section are satisfied.

* * * * *

Example 9. Regulatory qualified severance. (i) In 2004, T establishes an inter vivos irrevocable trust (Trust) providing that trust income is to be paid annually in equal shares to T’s children, A and B, for 10 years. Trust provides that the trustee has discretion to make additional distributions of principal to A and B during the 10-year term without adjustments to their shares of income or the trust remainder. If either (or both) dies prior to the expiration of the 10-year term, the deceased child’s share of trust income is to be paid to the child’s then living descendants, per stirpes, for the balance of the trust term. At the expiration of the 10-year term, the corpus is to be distributed equally to A and B; if A and B (or either or them) is not then living, then such decedent’s share is to be distributed instead to such decedent’s then living descendants, per stirpes. T allocates GST tax exemption to Trust such that Trust’s applicable fraction is .25 and its inclusion ratio is .75.

(ii) In 2006, pursuant to applicable state law, the trustee severs the trust into three trusts: Trust 1, Trust 2, and Trust 3. The instrument severing Trust provides that Trust 1 is to receive 50% of Trust’s assets, Trust 2 is to receive 25% of Trust’s assets, and Trust 3 is to receive 25% of Trust’s assets. All three resulting trusts are identical to Trust, except that each has different beneficiaries: A and A’s issue are designated as the beneficiaries of Trust 1, and B and B’s issue are designated as the beneficiaries of Trust 2 and Trust 3. The severance constitutes a qualified severance, provided that all other requirements of section 2642(a)(3) and this section are satisfied. Trust 1 will have an inclusion ratio of 1. Because both Trust 2 and Trust 3 have each received the fractional share of Trust’s assets equal to Trust’s applicable fraction of .25, trustee designates that Trust 2 will have an inclusion ratio of one and that Trust 3 will have an inclusion ratio of zero.

* * * * *

Example 12. Other severance that does not meet the requirements of a qualified severance. (i) In 2004, T establishes an irrevocable inter vivos trust (Trust) providing that Trust income is to be paid to T’s children, A and B, in equal shares for their joint lives. Upon the death of the first to die of A and B, all Trust income will be paid to the survivor of A and B. At the death of the survivor, the corpus is to be distributed in equal shares to T’s grandchildren, W and X (with any then-deceased grandchild’s share being paid in accordance with that grandchild’s testamentary general power of appointment). W is A’s child and X is B’s child. T elects under section 2632(c)(5) not to have the automatic allocation rules contained in section 2632(c) apply with respect to T’s transfers to Trust, but T allocates GST tax exemption to Trust resulting in Trust having an inclusion ratio of .30.

(ii) In 2009, the trustee of Trust, as permitted by applicable state law, divides Trust into two separate trusts, Trust 1 and Trust 2. Trust 1 provides that trust income is to be paid to A for life and, on A’s death, the remainder is to be distributed to W (or pursuant to W’s testamentary general power of appointment). Trust 2 provides that trust income is to be paid to B for life and, on B’s death, the remainder is to be distributed to X (or pursuant to X’s testamentary general power of appointment). Because Trust 1 and Trust 2 do not provide A and B with the contingent survivor income interests that were provided to A and B under the terms of Trust, Trust 1 and Trust 2 do not provide for the same succession of interests in the aggregate as provided by Trust. Therefore, the severance does not satisfy the requirements of this section and is not a qualified severance. Provided that Trust 1 and Trust 2 are recognized as separate trusts under applicable state law, Trust 1 and Trust 2 will be recognized as separate trusts for GST tax purposes pursuant to paragraph (h) of this section, prospectively from the date of the severance. However, Trust 1 and Trust 2 each have an inclusion ratio of .30 immediately after the severance, the same as the inclusion ratio of Trust prior to severance.

Example 13. Qualified severance following a non-qualified severance. Assume the same facts as in Example 12, except that, as of November 4, 2010, the trustee of Trust 1 severs Trust 1 into two trusts, Trust 3 and Trust 4, in accordance with applicable local law. The instrument severing Trust 1 provides that both resulting trusts have provisions identical to Trust 1. The terms of the instrument severing Trust 1 further provide that Trust 3 is to be funded on a pro rata basis with assets having a fair market value as of the date of severance equal to 70% of the value of Trust 1’s assets on that date, and Trust 4 is to be funded with assets having a fair market value as of the date of severance equal to 30% of the value of Trust 1’s assets on that date. The severance constitutes a qualified severance, provided that all other requirements of section 2642(a)(3) and this section are satisfied. Trust 3 will have an inclusion ratio of zero and Trust 4 will have an inclusion ratio of one.

(k) * * *

(1) In general. Except as otherwise provided in this paragraph (k), this section applies to severances occurring on or after August 2, 2007. Paragraph (d)(7)(iii), paragraph (h), and Examples 9, 12 and 13 of paragraph (j) of this section apply to severances occurring on or after September 2, 2008.

Par. 4. Section 26.2654-1 is amended as follows:

1. Paragraph (a)(1)(i) is revised.

2. Paragraph (a)(1)(iii) is added.

3. In paragraph (a)(5), Example 8 is revised.

4. Paragraph (d) is added.

The additions and revisions read as follows:

(a) * * *(1) * * *(i) * * * If a single trust consists solely of substantially separate and independent shares for different beneficiaries, the share attributable to each beneficiary (or group of beneficiaries) is treated as a separate trust for purposes of Chapter 13. The phrase “substantially separate and independent shares” generally has the same meaning as provided in §1.663(c)-3. However, except as provided in paragraph (a)(1)(iii) of this section, a portion of a trust is not a separate share unless such share exists from and at all times after the creation of the trust. For purposes of this paragraph (a)(1), a trust is treated as created at the date of death of the grantor if the trust is includible in its entirety in the grantor’s gross estate for Federal estate tax purposes. Further, except with respect to shares or trusts that are treated as separate trusts under local law, treatment of a single trust as separate trusts under this paragraph (a)(1) does not permit treatment of those portions as separate trusts for purposes of filing returns and payment of tax or for purposes of computing any other tax imposed under the Internal Revenue Code. Also, additions to, and distributions from, such trusts are allocated pro rata among the separate trusts, unless the governing instrument expressly provides otherwise. See §26.2642-6 and paragraph (b) of this section regarding the treatment, for purposes of Chapter 13, of separate trusts resulting from the discretionary severance of a single trust.

* * * * *

(iii) Mandatory severances. For purposes of this section, if the governing instrument of a trust requires the division or severance of a single trust into separate trusts upon the future occurrence of a particular event not within the discretion of the trustee or any other person, and if the trusts resulting from such a division or severance are recognized as separate trusts under applicable state law, then each resulting trust is treated as a separate trust for purposes of Chapter 13. For this purpose, the rules of paragraph (b)(1)(ii)(C) of this section apply with respect to the severance and funding of the trusts. Similarly, if the governing instrument requires the division of a single trust into separate shares under the circumstances described in this paragraph, each such share is treated as a separate trust for purposes of Chapter 13. The post-severance treatment of the resulting shares or trusts as separate trusts for GST tax purposes generally permits the allocation of GST tax exemption, the making of various elections permitted for GST tax purposes, and the occurrence of a taxable distribution or termination with regard to a particular resulting share or trust, with no GST tax impact on any other trust or share resulting from that severance. The treatment of a single trust as separate trusts under this paragraph (a)(1), however, does not permit treatment of those portions as separate trusts for purposes of filing returns and payment of tax or for purposes of computing any other tax imposed under the Internal Revenue Code, if those portions are not treated as separate trusts under local law. Also, additions to, and distributions from, such trusts are allocated pro rata among the separate trusts, unless the governing instrument expressly provides otherwise. Each separate share and each trust resulting from a mandatory division or severance described in this paragraph will have the same inclusion ratio immediately after the severance as that of the original trust immediately before the division or severance.

* * * * *

(5) * * *

Example 8. Subsequent mandatory division into separate trusts. T creates an irrevocable trust that provides the trustee with the discretionary power to distribute income or corpus to T’s children and grandchildren. The trust provides that, when T’s youngest child reaches age 21, the trust will be divided into separate shares, one share for each child of T. The income from a respective child’s share will be paid to the child during the child’s life, with the remainder passing on the child’s death to such child’s children (grandchildren of T). The separate shares that come into existence when the youngest child reaches age 21 will be recognized as of that date as separate trusts for purposes of Chapter 13. The inclusion ratio of the separate trusts will be identical to the inclusion ratio of the trust before the severance. Any allocation of GST tax exemption to the trust after T’s youngest child reaches age 21 may be made to any one or more of the separate shares. The result would be the same if the trust instrument provided that the trust was to be divided into separate trusts when T’s youngest child reached age 21, provided that the severance and funding of the separate trusts meets the requirements of this section.

* * * * *

(d) Effective date. Paragraph (a)(1)(i), paragraph (a)(1)(iii), and Example 8 of paragraph (a)(5) apply to severances occurring on or after September 2, 2008.

* * * * *

Sherri L. Brown,
(Acting) Deputy Commissioner for
Services and Enforcement.

Approved July 20, 2008.

Eric Solomon,
Assistant Secretary of
the Treasury (Tax Policy).

The definition of a construction contract under section 460(e) includes many transactions involving land developers and construction service providers in the home construction industry. For example, a construction contract under section 460(e) includes a contract for the provision of land by the taxpayer if the estimated total allocable contract costs attributable to the taxpayer’s construction activities (not including the cost of the land provided to the customer) are 10 percent or more of the contract’s total contract price.

As noted, section 460(a) requires that the income from any long-term contract be recognized using the percentage of completion method. However, taxpayers with contracts that meet the definition of a “home construction contract” are not required to use the percentage of completion method for those contracts and may use an exempt method. Exempt methods commonly used to account for home construction contracts include the completed contract method (CCM) and the accrual method.

Under section 460, a home construction contract includes any construction contract if 80 percent of the total estimated contract costs are reasonably expected to be attributable to the construction of improvements to real property directly related to qualifying dwelling units and located on the site of such dwelling units. Commentators have suggested that many contracts entered into by land developers in the home construction industry should fall within the definition of a home construction contract.

The proposed regulations expand the scope of the home construction contract exemption by providing that a contract for the construction of common improvements is considered a contract for the construction of improvements to real property directly related to the dwelling unit(s) and located on the site of such dwelling unit(s), even if the contract is not for the construction of any dwelling unit. Therefore, under the proposed regulations, a land developer that is selling individual lots (and its contractors and subcontractors) may have long-term construction contracts that qualify for the home construction contract exemption.

Under section 460, a home construction contract also includes any construction contract if 80 percent of the total contract costs are reasonably expected to be attributable to the construction of dwelling units contained in buildings containing four or fewer dwelling units. Section 460(e)(6) states that each townhouse or rowhouse shall be treated as a separate building, regardless of the number of townhouses or rowhouses physically attached to each other. In certain circumstances, the terms condominium and townhouse are used interchangeably to describe similar structures. Individual condominium units possess many of the characteristics generally associated with townhouses and rowhouses such as private ownership, shared portions of their structures, residential housing, and the economics of the underlying purchase transactions.

The proposed regulations expand what is considered a townhouse or rowhouse, for purposes of the home construction contract exemption, to include an individual condominium unit. This will have the effect of allowing each condominium unit to be treated as a separate building for purposes of determining whether the underlying contract qualifies as a home construction contract.

Under the current regulations under section 460, the appropriate severing of a home construction contract requires a facts and circumstances analysis based upon certain factors that are neither specific nor always relevant to home construction contracts. Likewise, the date a home construction contract is considered completed and accepted is determined using a facts and circumstances analysis.

The IRS and Treasury Department are aware of controversies related to the application of the existing facts and circumstances analyses for determining the appropriate severance and final completion and acceptance of home construction contracts accounted for using the completed contract method. Expanding the definition of a home construction contract as provided in these proposed regulations may heighten the significance of these issues. As a result, the IRS and Treasury Department expect to propose specific severing and completion rules for home construction contracts accounted for using the completed contract method. Taxpayers are encouraged to submit comments on the types of severing and completion rules that would result in the clear reflection of income for home construction contracts accounted for using the completed contract method. Specifically, the IRS and the Treasury Department request comments on the circumstances (if any) in which it would not be appropriate to require severing and completion of a home construction contract to be determined on a dwelling unit by dwelling unit or lot by lot basis or, when a contract is not for the sale of a dwelling unit or lot, on the basis of when the taxpayer receives payment(s) under the contract.

Currently, the regulations under section 460 provide that a taxpayer that uses the percentage-of-completion method (PCM), the exempt-contract percentage-of-completion method (EPCM), or elects the 10-percent method or special alternative minimum taxable income (AMTI) method, or that adopts or elects a cost allocation method of accounting (or changes to another method of accounting with the Commissioner’s consent) must apply the method(s) consistently for all similarly classified contracts until the taxpayer obtains the Commissioner’s consent under section 446 to change to another method of accounting. The regulations further provide that a taxpayer-initiated change in method of accounting will be permitted only on a cut-off basis (that is, for contracts entered into on or after the year of change), and thus, a section 481(a) adjustment will not be permitted nor required. The proposed regulations continue this cut-off method of implementation but only for taxpayer-initiated changes from a permissible PCM method to another permissible PCM method for long-term contracts for which PCM is required and for taxpayer-initiated changes from a cost allocation method of accounting that complies with the cost allocation rules of §1.460-5 to another cost allocation method of accounting that complies with the cost allocation rules of §1.460-5. Under the proposed regulations all other taxpayer-initiated changes in method of accounting under section 460 will be made with a section 481(a) adjustment.

The proposed regulations provide that in determining the hypothetical underpayment or overpayment of tax for any year as part of the look-back computation, amounts reported as section 481(a) adjustments shall generally be taken into account in the tax year or years they are reported. For purposes of determining whether there is a hypothetical underpayment or overpayment of tax under the look-back computation, a taxpayer would use amounts reported under its old method for the years the old method was used and would use amounts reported under its new method for the years the new method was used, netted against the amount of any section 481(a) adjustments required to be taken into account. Thus, a look-back computation would not be required upon contract completion simply because the taxpayer has changed its method of accounting. However, a look-back computation would be required upon contract completion if actual costs or the contract price differ from the estimated amounts notwithstanding the fact a change in method of accounting occurred. For example, if a taxpayer using PCM changed its method of accounting for construction costs incurred in a contract reported under PCM, the section 460 look-back would be computed using the costs recognized prior to the year of change (reported under the taxpayer’s old method of accounting) and the costs recognized in subsequent years using the new method of accounting, netted against any applicable section 481(a) adjustment. Similarly, for changes in methods of accounting where no costs were recognized under the old method of accounting (for example, a change in method of accounting from CCM to PCM), look-back would effectively only apply to years in which the taxpayer’s new method of accounting was used to the extent that no costs were recognized prior to the year of change under the old method of accounting. This approach to the look-back computation is consistent with the underlying purpose of look-back as well as the general accounting method change procedures. Comments are specifically requested with respect to issues that taxpayers may foresee with respect to the rules provided in these proposed regulations for taking into account section 481(a) adjustments in the year reported for purposes of the look-back computation.

* * * * *

(b) * * *

(1) * * *

(ii) Construction contract, other than a home construction contract, that a taxpayer estimates (when entering into the contract) will be completed within 2 years of the contract commencement date, provided the taxpayer satisfies the $10,000,000 gross receipts test described in paragraph (b)(3) of this section.

(2) * * *

(ii) Land improvements. For purposes of paragraph (b)(2)(i)(B) of this section, improvements to real property directly related to, and located on the site of, the dwelling units consist of improvements to land on which dwelling units (as described in paragraph (b)(2)(i)(A) of this section) are constructed, and common improvements as defined in paragraph (b)(2)(iv) of this section. A long-term construction contract is a home construction contract if a taxpayer (including a subcontractor working for a general contractor) meets the 80% test in paragraph (b)(2)(i) of this section as applied to either paragraph (b)(2)(i)(A) of this section or paragraph (b)(2)(i)(B) of this section, or both paragraphs (b)(2)(i)(A) and (b)(2)(i)(B) of this section, collectively.

(iii) Townhouses and rowhouses. For purposes of determining whether a long-term construction contract is a home construction contract under paragraph (b)(2) of this section, each townhouse or rowhouse is a separate building. For this purpose, the term townhouse and rowhouse includes an individual condominium unit.

(iv) Common improvements—(A) In general. A taxpayer includes in the cost of a dwelling unit or land its allocable share of the cost that the taxpayer incurs for any common improvements that benefit the dwelling unit or land.

(B) Definition. For purposes of this section, a common improvement is an improvement that the taxpayer is contractually obligated, or required by law, to construct within the tract or tracts of land containing the dwelling units (or the land on which dwelling units are to be constructed) and that benefits the dwelling units (or the land on which dwelling units are to be constructed). In general, a common improvement does not solely benefit any particular dwelling unit or any particular lot on which a dwelling unit is constructed. However, land clearing and grading are common improvements, even when performed on a particular lot. Other examples of common improvements are sidewalks, sewers, roads and clubhouses.

(v) Mixed use costs. If a contract involves the construction of both commercial units and dwelling units, a taxpayer must allocate the costs among the commercial units and dwelling units using a reasonable method or combination of reasonable methods. In general, the reasonableness of an allocation method will be based on facts and circumstances. Examples of methods that may be reasonable are specific identification, square footage, or fair market value.

* * * * *

Par. 3. Section 1.460-4 is amended by:

1. Revising the third sentence in paragraph (c)(1).

2. Redesignating paragraph (g) as paragraph (g)(1) and revising newly redesignated paragraph (g)(1).

3. Adding a paragraph (g)(2).

4. Revising Example 5. of paragraph (h).

The revisions and additions read as follows:

* * * * *

(c) * * *

(1) * * * Permissible exempt contract methods are the PCM, the EPCM described in paragraph (c)(2) of this section, the CCM described in paragraph (d) of this section, the accrual method, and any other permissible method. * * *

* * * * *

(g) Method of accounting—(1) In general. A taxpayer must apply its method(s) of accounting for long-term contracts consistently for all similarly classified long-term contracts until the taxpayer obtains the Commissioner’s consent under section 446(e) to change to another method of accounting.

(2) Taxpayer-initiated change in method of accounting—(i) Change to PCM for long-term contracts for which PCM is required. A taxpayer-initiated change in method of accounting for long-term contracts (or portion thereof) for which income must be determined using the PCM described in paragraph (b) of this section and the costs allocation rules described in §1.460-5(b) or (c) (required PCM contracts) from a method of accounting that does not comply with paragraph (b) of this section and §1.460-5(b) or (c) to a method that complies with paragraph (b) of this section and §1.460-5(b) or (c) must be applied to all required PCM contracts entered into before the year of change and not reported as completed as of the beginning of the year of change. Accordingly, a section 481(a) adjustment will be required.

(ii) Change from a permissible PCM method to another permissible PCM method for long-term contracts for which PCM is required. A taxpayer initiated change in method of accounting for required PCM contracts, as defined in paragraph (g)(2)(i) of this section (or a portion thereof), from a method of accounting that complies with paragraph (b) of this section and §1.460-5(b) or (c) to another method of accounting that complies with paragraph (b) of this section and §1.460-5(b) or (c) must be made on a cut-off basis and applied only to contracts entered into during and after the year of change. Accordingly, a section 481(a) adjustment will be neither permitted nor required.

(iii) Change to an exempt contract method for home construction contracts. A taxpayer-initiated change in method of accounting for home construction contracts, as defined in §1.460-3(b)(2), to a permissible exempt contract method, as described in paragraph (c)(1) of this section, must be applied to all home construction contracts entered into before the year of change and not reported as completed as of the beginning of the year of change. Accordingly, a section 481(a) adjustment will be required.

(iv) Change to an exempt contract method for exempt contracts other than home construction contracts. A taxpayer-initiated change in method of accounting for long-term contracts (or portion thereof) not described in paragraphs (g)(2)(i), (ii) and (iii) of this section to a permissible exempt contract method as described in paragraph (c)(1) of this section must be applied to all contracts that are eligible to use the exempt contract method entered into before the year of change and not reported as completed as of the beginning of the year of change. Accordingly, a section 481(a) adjustment will be required.

(h) * * *

* * * * *

Example 5. PCM—contract terminated. C, whose taxable year ends December 31, determines the income from long-term contracts using the PCM. During 2001, C buys land and begins constructing a building that will contain 50 apartment units on that land. C enters into a contract to sell the building to B for $2,400,000. B gives C a $50,000 deposit toward the purchase price. By the end of 2001, C has incurred $500,000 of allocable contract costs on the building and estimates that the total allocable contract costs on the building will be $1,500,000. Thus, for 2001, C reports gross receipts of $800,000 ($500,000 / $1,500,000 x $2,400,000), current-year costs of $500,000, and gross income of $300,000 ($800,000 - $500,000). In 2002, after C has incurred an additional $250,000 of allocable contract costs on the building, B files for bankruptcy protection and defaults on the contract with C, who is permitted to keep B’s $50,000 deposit as liquidated damages. In 2002, C reverses the transaction with B under paragraph (b)(7) of this section and reports a loss of $300,000 ($500,000 - $800,000). In addition, C obtains an adjusted basis in the building sold to B of $700,000 ($500,000 (current-year costs deducted in 2001) - $50,000 (B’s forfeited deposit) + $250,000 (current-year costs incurred in 2002). C may not apply the look-back method to this contract in 2002.

* * * * *

Par. 4. Section 1.460-5 is amended by:

1. Adding a new sentence to the end of paragraph (c)(2).

2. Revising paragraph (g).

The revision and addition read as follows:

* * * * *

(c) * * *

(2) * * * Further, this election is not available if a taxpayer is changing from a cost allocation method other than as prescribed in paragraph (b) of this section, in which case the taxpayer must follow the procedures under §1.446-1(e) for obtaining the Commissioner’s consent for the change in method of accounting.

* * * * *

(g) Method of accounting. A taxpayer that adopts, elects, or otherwise changes to a cost allocation method of accounting (or changes to another cost allocation method of accounting with the Commissioner’s consent) must apply that method consistently for all similarly classified contracts, until the taxpayer obtains the Commissioner’s consent under section 446 to change to another cost allocation method. A taxpayer-initiated change in cost allocation method from a method that does not comply with the cost allocation rules of this section to a method that complies with the cost allocation rules of this section must be applied to all long-term contracts to which the rules of this section apply, including contracts entered into before the year of change and not reported as completed as of the beginning of the year of change. Accordingly, a section 481(a) adjustment is required. Any other taxpayer-initiated change in cost allocation method to a method permitted under the rules of this section must be made on a cut-off basis and applied only to contracts entered into during and after the year of change, in which case a section 481(a) adjustment will be neither permitted nor required.

Par. 5. Section 1.460-6 is amended by:

1. Adding paragraph (c)(3)(vii).

2. Redesignating paragraph (d)(2)(iv) as paragraph (d)(2)(v).

3. Adding a new paragraph (d)(2)(iv).

The additions and revision read as follows:

* * * * *

(c) * * *

(3) * * *

(vii) Section 481(a) adjustments. For purposes of determining the hypothetical underpayment or overpayment of tax for any year, amounts reported as section 481(a) adjustments shall be taken into account in the tax year or years they are reported. However, any portion of a section 481(a) adjustment not yet reported as of the tax year in which the contract is completed shall be taken into account in the tax year the contract is completed for purposes of determining the hypothetical underpayment or overpayment of tax.

* * * * *

(d) * * *

(2) * * *

(iv) Section 481(a) adjustments. For purposes of determining the hypothetical underpayment or overpayment of tax for any year under the simplified marginal impact method, amounts reported as section 481(a) adjustments shall be taken into account in the tax year or years they are reported. However, any portion of a section 481(a) adjustment not yet reported as of the tax year in which the contract is completed shall be taken into account in the tax year the contract is completed for purposes of determining the hypothetical underpayment or overpayment of tax.

* * * * *

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.

Under §1.423-2(a)(1) of these proposed regulations, an employee stock purchase plan must meet the requirements of paragraphs (i) through (ix) of §1.423-2(a)(2). The terms of the plan, or an offering under the plan, must satisfy the requirements of paragraphs (iii) through (ix) of §1.423-2(a)(2). Consistent with §1.422-2(b)(1), §1.423-2(a)(1) of these proposed regulations would provide that the plan and the terms of an offering must be in writing or electronic form, provided that such writing or electronic form is adequate to establish the terms of the plan or offering.

Section 1.423-2(a)(2) of these proposed regulations lists the requirements that must be met for qualification as an employee stock purchase plan and provides cross references to the specific section of these regulations that addresses each requirement.

Under §1.423-2(a)(3) of these proposed regulations, if the terms of an option are inconsistent with the terms of the employee stock purchase plan or an offering under the plan, then the option will not be treated as granted under an employee stock purchase plan. (Section 1.423-2(a)(2) of the existing regulations has been re-numbered as §1.423-2(a)(3) of these proposed regulations.) If an option with terms that are inconsistent with the terms of the plan or an offering under the plan is granted to an employee who is entitled to the grant of an option under the terms of the plan or offering, and the employee is not granted an option under the offering that qualifies as an option granted under an employee stock purchase plan, then the offering will not meet the requirements of §1.423-2(e) of these proposed regulations, which generally requires that options be granted to all employees of any corporation whose employees are granted options under an employee stock purchase plan. As a result, none of the options granted under the offering will be eligible for the special tax treatment of section 421. Example 1 in §1.423-2(a)(4) illustrates this principle. Section 1.423-2(a)(4) of these proposed regulations contains additional examples to illustrate the principles of §1.423-2(a)(3).

If an option with terms that are inconsistent with the terms of the plan or an offering under the plan is granted to an individual who is not entitled to the grant of an option under the terms of the plan or offering, then the option will not be treated as an option granted under an employee stock purchase plan, and the grant of the option will not disqualify the options granted under the offering. Examples 2 and 3 in §1.423-2(a)(4) of these proposed regulations illustrate this principle.

If, at the time of grant, an option qualifies as an option granted under an employee stock purchase plan, but the terms of the option are not satisfied, then the option will not be treated as granted under an employee stock purchase plan. However, this failure to comply with the terms of the option will not disqualify the options granted under the plan or offering. Example 4 in §1.423-2(a)(4) of these proposed regulations illustrates this principle.

To qualify as an employee stock purchase plan, section 423(b)(2) requires that the plan be approved by the stockholders of the granting corporation within 12 months before or after the date the plan is adopted. These proposed regulations would provide the same basic requirements for stockholder approval as those included in the existing regulations. Consistent with §1.422-2(b)(2), these proposed regulations would provide additional guidance concerning the circumstances under which stockholder approval is required.

These proposed regulations, like the existing regulations, would require stockholder approval if there is a change in the aggregate number of shares or in the employees eligible to be granted options under the plan. The standard for determining when stockholder approval is required under these proposed regulations generally is the same as under the existing regulations. These proposed regulations would clarify the requirements for stockholder approval and would provide a more comprehensive list of situations that require new stockholder approval of the plan. In particular, these proposed regulations would clarify that new stockholder approval is required if there is a change in the shares with respect to which options are issued or a change in the granting corporation.

For example, assume that S, a wholly owned subsidiary of P, adopts an employee stock purchase plan under which options for S stock will be granted to S employees, and the plan is approved by the stockholder of S (in this case, P) within the applicable 24-month period. If S later amends the plan to provide for the grant of options to acquire P stock (rather than S stock), S must obtain approval from the stockholders of S (in this case, P) within 12 months before or after the date of the amendment of the plan because the amendment of the plan to allow the grant of options for P stock is considered the adoption of a new plan. See paragraph (iii) of Example 1 in §1.423-2(c)(5) of these proposed regulations. This conclusion differs from that in paragraph (iii) of Example 1 under §1.422-2(b)(6), which concludes that the stockholders of P rather than the stockholders of S must approve the plan as a result of its amendment to provide for the grant of options to acquire P stock. The IRS and the Treasury Department invite comment on this result and are proposing a conforming change to Example 1, paragraph (iii) under §1.422-2(b)(6).

These proposed regulations also would provide additional guidance regarding the application of the stockholder approval requirements where an employee stock purchase plan is assumed in connection with a corporate transaction. Example 3 in §1.423-2(c)(5) of these proposed regulations illustrates this principle.

Section 1.423-2(c)(3) of the existing regulations provides that an employee stock purchase plan must designate the maximum aggregate number of shares that may be issued under the plan. Consistent with §1.422-2(b)(3)(ii), these proposed regulations would provide that the plan may specify that the maximum aggregate number of shares available for grants under the plan may increase annually by a specified percentage of the authorized, issued, or outstanding shares at the date of the adoption of the plan. Further, a plan providing that the maximum aggregate number of shares issued subject to options under the plan may change based on any other specific circumstances will satisfy the requirements of §1.423-2(c)(3) only if the stockholders approve an immediately determinable maximum number of shares that may be issued under the plan in any event. Examples 4 and 5 in §1.423-2(c)(5) of these proposed regulations illustrate these principles.

Section 423(b)(4) permits an employer to exclude from participation one or more of the following categories of employees: Employees who have been employed less than two years; Employees who customarily work 20 hours or less per week; Employees who customarily work not more than five months in any calendar year; and Highly compensated employees (HCEs) within the meaning of section 414(q). Section 1.423-1(e)(1) of these proposed regulations has been updated to reflect the 1986 amendment of section 423(b)(4)(D) to substitute “highly compensated employees (within the meaning of section 414(q))” for “officers, persons whose principal duties consist of supervising the work of other employees, or highly compensated employees.” See Public Law 99-514, section 1114(b)(13).

One commentator suggested that the regulations clarify that an employer may exclude from participation a subset of one of the groups set forth in section 423(b)(4). For example, an employer should be permitted to exclude a subset of HCEs, such as officers, from participation in the plan. The commentator further suggested that the regulations clarify that an employer may impose shorter service requirements than those permitted. For example, an employer should be permitted to exclude employees who have been employed less than one year from participation in the plan.

The IRS and the Treasury Department agree that a more inclusive application of the rules of section 423(b)(4) is consistent with the intent of section 423. Accordingly, §1.423-2(e)(2) of these proposed regulations would provide that an employee stock purchase plan does not fail to satisfy the coverage provision of section 423(b)(4) merely because the plan excludes employees who have completed a shorter period of service or whose customary employment is for fewer hours per week or fewer months in a calendar year than is specified in subparts (A), (B) and (C) of section 423(b)(4), provided the exclusion is applied in an identical manner to all employees of every corporation whose employees are granted options under the plan. In addition, these proposed regulations would provide that the terms of an employee stock purchase plan may exclude HCEs: (a) with compensation above a certain level, or (b) who are officers or subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934, provided the exclusion is applied in an identical manner to all HCEs of every corporation whose employees are granted options under the plan. Examples 3, 4, 5, 6, and 7 in §1.423-2(e)(6) of these proposed regulations illustrate these principles. (The examples under §1.423-2(e)(3) of the existing regulations have been re-numbered as §1.423-2(e)(6) of these proposed regulations.)

Another commentator suggested that the regulations permit employers to exclude from plan participation employees who are nonresident aliens and who receive no earned income that constitutes income from sources within the United States. The IRS and the Treasury Department agree that it may be appropriate to exclude foreign employees from plan participation in certain limited circumstances. However, unlike section 410(b), section 423 does not provide an exclusion for such nonresident aliens. Accordingly, the IRS and the Treasury Department are constrained by statutory authority from providing a general exclusion from plan participation for employees who are nonresident aliens and who receive no United States source income. Therefore, §1.423-2(e)(3) of these proposed regulations would provide that employees who are citizens or residents of a foreign jurisdiction (without regard to whether they are also citizens of the United States or resident aliens (within the meaning of §7701(b)(1)(A))) may be excluded from the coverage of an employee stock purchase plan only if the grant of an option under the plan to a citizen or resident of the foreign jurisdiction is prohibited under the laws of such jurisdiction or if compliance with the laws of the foreign jurisdiction would cause the plan to violate the requirements of section 423. Example 8 in §1.423-2(e)(6) of these proposed regulations illustrates this principle.

Another commentator suggested that the regulations permit employers to exclude collectively bargained employees from plan participation. However, unlike section 410(b), section 423 does not provide an exclusion for collectively bargained employees. Accordingly, the IRS and the Treasury Department are again constrained by statutory authority from providing a general exclusion from plan participation for collectively bargained employees.

One commentator suggested that the regulations be amended to provide that an offering will not lose its tax-favored status due to the inadvertent exclusion of employees from plan participation. Rather, the commentator suggested that the granting corporation be permitted to correct certain errors in plan administration through a corrections program that would permit the excluded employees to participate in past offerings under a plan. Such a corrections program is beyond the scope of these regulations. However, the IRS and the Treasury Department invite comments on whether such a program is appropriate (including the statutory authority for such a program) and suggestions for the types of violations that might be covered and the methods of correction.

Section 1.423-2(e)(4) of these proposed regulations includes language that appears under §1.423-2(e)(1) of the existing regulations. Section 1.423-2(e)(2) of the existing regulations has been re-numbered as §1.423-2(e)(5) of these proposed regulations.

Section 423(b)(5) requires that, subject to certain exceptions, an employee stock purchase plan, by its terms, provide that all employees granted options under the plan have the same rights and privileges.

Section 1.423-2(f)(3) of these proposed regulations includes language that appears in §1.423-2(f)(1) of the existing regulations. (The examples in §1.423-2(f)(2) of the existing regulations have been relocated to Examples 1 and 2 of §1.423-2(f)(7) of these proposed regulations. The example in §1.423-2(f)(4) of the existing regulations has been relocated to Example 3 of §1.423-2(f)(7). Section 1.423-2(f)(4) of the existing regulations is re-numbered under these proposed regulations as §1.423-2(f)(6)).

One commentator suggested that a plan or offering should not fail to satisfy the equal rights and privileges provision of section 423(b)(5) if the provisions of the plan or offering applied to foreign employees are reasonably designed to avoid adverse consequences for such employee under foreign law as a result of plan participation. The IRS and the Treasury Department agree that in certain limited circumstances it may be appropriate for the terms of an employee stock purchase plan to be less favorable with respect to foreign employees than those terms are with respect to employees resident in the United States. Accordingly, §1.423-2(f)(4) of these proposed regulations would provide that a plan or offering will not fail to satisfy the requirements of section 423(b)(5) if, in order to comply with the laws of a foreign jurisdiction, the terms of an option granted under a plan or offering to citizens or residents of such foreign jurisdiction (without regard to whether they are also citizens of the United States or resident aliens (within the meaning of §7701(b)(1)(A))) are less favorable than the terms of options granted under the same plan or offering to employees resident in the United States. Example 4 in §1.423-2(f)(7) of these proposed regulations illustrates this principle.

A plan or offering will not satisfy the requirements of section 423(b)(5), however, if, in order to comply with the laws of a foreign jurisdiction, the terms of the plan or offering are more favorable with respect to citizens or residents of such foreign jurisdiction than the terms of the plan or offering are with respect to employees resident in the United States.

Another commentator suggested that the regulations addressing the carryover of amounts from one offering to another be clarified. In response to this comment, these proposed regulations would clarify §1.423-2(f)(3) of the existing regulations (which has been re-numbered as §1.423-2(f)(5)). Generally, a plan permitting one or more employees to carry forward amounts that were withheld but not applied toward the purchase of stock under an earlier plan or offering and apply such amounts toward the purchase of additional stock under a subsequent plan or offering will be a violation of the equal rights and privileges requirement under section 423(b)(5). However, the carry forward of amounts withheld but not applied toward the purchase of stock under an earlier plan or offering will not violate the equal rights and privileges requirement of section 423(b)(5) if all other employees participating in the current plan or offering are permitted to make direct payments toward the purchase of shares under a subsequent plan or offering in an amount equal to the excess of: (a) the greatest amount that any employee is allowed to carry forward from an earlier plan or offering over (b) the amount, if any, the employee will carry forward from an earlier plan or offering. Example 5 in §1.423-2(f)(7) of these proposed regulations illustrates this principle.

Further, a plan will not fail to satisfy the equal rights and privileges requirement of section 423(b)(5) merely because employees are permitted to carry forward amounts representing a fractional share which were withheld but not applied toward the purchase of stock under an earlier plan or offering and apply such amounts toward the purchase of additional stock under a subsequent plan or offering.

Under section 423(b)(6), the option price must not be less than the lesser of: (a) an amount equal to 85 percent of the fair market value of the stock at the time the option is granted, and (b) an amount not less than 85 percent of the fair market value of the stock at the time the option is exercised. Consistent with §1.422-2(e)(1), §1.423-2(g)(1) of these proposed regulations would provide that the option price may be determined in any reasonable manner, including the valuation methods permitted under §20.2031-2 (Estate Tax Regulations), so long as the option price meets the minimum pricing requirements of section 423(b)(6).

Section 1.421-1(c) provides, that for purposes of §§1.421-2 through 1.424-1, the language “the date of the granting of the option” and “the time such option is granted” and similar phrases refer to the date or time when the granting corporation completes the corporate action constituting an offer of stock for sale to an individual under the terms and conditions of a statutory option. The date of grant for an option granted under an employee stock purchase plan is important for several reasons. First, the favorable tax consequences under section 421 apply to the shares acquired pursuant to the exercise of an option granted under an employee stock purchase plan if the shares are not disposed of within two years from the date of grant of the option or within one year from the date of exercise of the option. Second, the $25,000 limitation under section 423(b)(8) is determined based on the fair market value of the stock measured on the date of grant of the option. The date of grant is also important for purposes of determining the employees eligible to participate in the plan and, in certain cases, determining the purchase price of stock under the plan.

Section 1.421-1(c) further provides that a corporate action constituting an offer of stock for sale is not considered complete until the date on which the maximum number of shares that can be purchased under the option and the minimum option price are fixed or determinable. Because options under an employee stock purchase plan may be priced at the lesser of an amount equal to 85 percent of the fair market value of the stock at the time the option is granted, and an amount not less than 85 percent of the fair market value of the stock at the time the option is exercised, it is not always possible to determine the minimum option price on the first day of an offering. However, many granting corporations intend for the first day of an offering to be the date of grant.

Accordingly, §1.423-2(h)(2) of these proposed regulations would provide that, for purposes of options granted under an employee stock purchase plan, the principles of §1.421-1(c) shall be applied without regard to the requirement that the minimum option price be fixed or determinable in order for the corporate action constituting an offer of stock to be considered complete. As a result, the first day of an offering could be the date of grant for an option issued under an employee stock purchase plan even though the minimum option price is not fixed or determinable on the first day of the offering. These proposed regulations include an amendment to §1.421-1(c).

One commentator questioned whether it is necessary for a plan to contain a limit on the number of shares that can be purchased by each participant during an offering in order for the date of grant of the option to be the first day of an offering. Section 1.423-2(h)(3) of these proposed regulations would provide that the date of grant will be the first day of an offering if the terms of an employee stock purchase plan or offering designate a maximum number of shares that may be purchased by each participant during the offering. Similarly, the date of grant will be the first day of an offering if the terms of the plan or offering require the application of a formula to establish, on the first day of the offering, the maximum number of shares that may be purchased by each participant during the offering.

However, §1.423-2(h)(3) of these proposed regulations does not require that an employee stock purchase plan or offering designate a maximum number of shares that may be purchased by each participant during the offering or incorporate a formula to establish a maximum number of shares that may be purchased by each participant during the offering. If the maximum number of shares that can be purchased under an option is not fixed or determinable until the date the option is exercised, then the date of exercise will be the date of grant of the option. The $25,000 limit under section 423(b)(8) and the limit on the aggregate number of shares that may be issued under an employee stock purchase plan are not sufficient to establish the maximum number of shares that can be purchased under an option so that the date of grant will be the first day of the offering. Examples 1, 2, 3 and 4 in §1.423-2(h)(4) of these proposed regulations illustrate these principles.

Section 1.423-2(h) of the existing regulations is re-numbered as §1.423-2(h)(1) of these proposed regulations.

Section 423(b)(8) provides that an employee stock purchase plan must, by its terms, provide that no employee may be permitted to purchase stock under all the employee stock purchase plans of his or her employer corporation and its related corporations at a rate which exceeds $25,000 in fair market value of the stock (determined on the date of grant) for each calendar year in which an option granted to the employee is outstanding and exercisable. Section 1.423-2(i) of these proposed regulations would provide guidance on the operation of the $25,000 limitation that incorporates and clarifies the guidance provided in the existing regulations.

One commentator suggested that the calculation of the amount of stock that may be purchased under an employee stock purchase plan be determined in a manner consistent with the $100,000 limitation for incentive stock options described in §1.422-4. The proposed regulations generally adopt this suggestion and would provide that the $25,000 limit for employee stock purchase plans is, to the extent possible, calculated in a manner consistent with the $100,000 limitation for incentive stock options. The timing of both measures is based on when the option first becomes exercisable and both measures are made based on the fair market value of the stock determined at the date of grant. Section 1.423-2(i) of these proposed regulations emphasizes that an employee may purchase up to $25,000 of stock (based on the fair market value of such stock on the date of grant) in each calendar year during which an option granted to the employee under an employee stock purchase plan is not only outstanding, but also exercisable. Example 5 in §1.423-2(i)(5) of these proposed regulations illustrates this principle.

For clarification, Example 1 in §1.423-2(i)(4) of the existing regulations has been separated into Example 1 and Example 4 in §1.423-2(i)(5) of these proposed regulations.

Section 423(c) provides a special rule for calculating the timing and amount of compensation income that must be recognized when the option price for a share is between 85 and 100 percent of the value of the share on the date of grant. Generally, the income recognized is the lesser of: (a) the excess of the fair market value of the share on the date of grant over the option price, and (b) the excess of the fair market value of the share at the time of disposition (or death) over the option price. The flush language of section 423(c) provides that if the exercise price is not known on the date of grant, the exercise price shall be determined as if the option were exercised on the date of grant.

One commentator suggested that it is unclear how this special rule and the flush language of section 423(c) apply when the option price is determined based on some percentage of the value of a share on the last day of an offering. Example 3 of §1.423-2(k)(3) of the existing regulations specifically addresses this issue and has been retained in §1.423-2(k)(3) of these proposed regulations. Example 4 has been added under §1.423-2(k)(3) to illustrate the tax consequences under an employee stock purchase plan that uses a look-back feature to determine the exercise price of the option.

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(c) Time and date of granting option. (1) For purposes of this section and §§1.421-2 through 1.424-1, the language “the date of the granting of the option” and “the time such option is granted,” and similar phrases refer to the date or time when the granting corporation completes the corporate action constituting an offer of stock for sale to an individual under the terms and conditions of a statutory option. Except as set forth in §1.423-2(h)(2), a corporate action constituting an offer of stock for sale is not considered complete until the date on which the maximum number of shares that can be purchased under the option and the minimum option price are fixed or determinable.

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(j) Effective/applicability date—(1) In general. Except for paragraph (c)(1), these regulations are effective on August 3, 2004. Upon the date of publication of the Treasury decision adopting paragraph (c)(1) of this section as a final regulation in the Federal Register, paragraph (c)(1) will apply as of January 1, 2010.

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Par. 3. Section 1.422-2, paragraph (b)(6), Example 1 (iii) is revised to read as follows:

* * * * *

(b) * * *

(6) * * *

Example (1). * * *

(iii) Assume the same facts as in paragraph (i) of this Example 1. Assume further that the plan was approved by the stockholders of S (in this case, P) on March 1, 2006. On January 1, 2008, S changes the plan to provide that incentive stock options for P stock will be granted to S employees under the plan. Because there is a change in the stock available for grant under the plan, the change is considered the adoption of a new plan that must be approved by the stockholder of S (in this case, P) within 12 months before or after January 1, 2008.

* * * * *

Par. 4. Section 1.422-5, paragraph (f)(1) is revised to read as follows:

§1.422-5 Permissible provisions.

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(f) Effective/applicability date—(1) In general. Except for §1.422-2(b)(6), Example 1 (iii), these regulations are effective on August 3, 2004. Upon the date of publication of the Treasury decision adopting Section 1.422-2(b)(6), Example 1 (iii) of this section as a final regulation in the Federal Register, Section 1.422-2(b)(6), Example 1 (iii) will apply as of January 1, 2010.

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Par. 5. Section 1.423-1 is revised to read as follows:

(a) General rule. Subject to the provisions of section 423(c) and paragraph (k) of §1.423-2, the special rules of income tax treatment provided in section 421(a) apply with respect to the transfer of a share of stock to an individual pursuant to the individual’s exercise of an option granted under an employee stock purchase plan if the following conditions are satisfied—

(1) The individual makes no disposition of such share before the later of the expiration of the two-year period from the date of the grant of the option pursuant to which such share was transferred or the expiration of the one-year period from the date of transfer of such share to the individual; and

(2) At all times during the period beginning on the date of the grant of the option and ending on the day three months before the date of exercise, the individual was an employee of the corporation granting the option, a related corporation, or a corporation (or a related corporation) substituting or assuming the stock option in a transaction to which section 424(a) applies.

(b) Cross-references. For rules relating to the requisite employment relationship, see paragraph (h) of §1.421-1. For rules relating to the effect of a disqualifying disposition, see section 421(b) and paragraph (b) of §1.421-2. For the definition of the term disposition, see section 424(c) and paragraph (c) of §1.424-1. For the definition of the term related corporation, see paragraph (i) of §1.421-1.

(c) Effective/applicability date. Upon the date of publication of the Treasury decision adopting the rules of this section as a final regulation in the Federal Register, these rules will apply as of January 1, 2010.

Par. 6. Section 1.423-2 is revised to read as follows:

(a) In general—(1) The term employee stock purchase plan means a plan that meets the requirements of paragraph (a)(2)(i) through (ix) of this section. If the terms of the plan do not satisfy the requirements of paragraph (a)(2)(iii) through (ix) of this section, such requirements may be satisfied by the terms of an offering made under the plan. However, where the requirements of paragraph (a)(2)(iii) through (ix) of this section are satisfied by the terms of an offering, such requirements will be treated as satisfied only with respect to options exercised under that offering. The plan and the terms of an offering must be in writing or electronic form, provided that such writing or electronic form is adequate to establish the terms of the plan or offering, as applicable.

(2) To qualify as an employee stock purchase plan under this section and §1.423-1, the plan must meet all of the following requirements—

(i) The plan must provide that options can be granted only to employees of the employer corporation or of a related corporation (as defined in paragraph (i) of §1.421-1) to purchase stock in any such corporation (see paragraph (b) of this section);

(ii) The plan must be approved by the stockholders of the granting corporation within 12 months before or after the date the plan is adopted (see paragraph (c) of this section);

(iii) Under the terms of the plan, an employee cannot be granted an option if, immediately after the option is granted, the employee owns stock possessing 5 percent or more of the total combined voting power or value of all classes of stock of the employer corporation or of a related corporation (see paragraph (d) of this section);

(iv) Under the terms of the plan, options must be granted to all employees of any corporation whose employees are granted any options by reason of their employment by the corporation (see paragraph (e) of this section);

(v) Under the terms of the plan, all employees granted options must have the same rights and privileges (see paragraph (f) of this section);

(vi) Under the terms of the plan, the option price cannot be less than the lesser of—

(A) An amount equal to 85 percent of the fair market value of the stock at the time the option is granted, or

(B) An amount not less than 85 percent of the fair market value of the stock at the time the option is exercised (see paragraph (g) of this section);

(vii) Under the terms of the plan, options cannot be exercised after the expiration of—

(A) Five years from the date the option is granted if, under the terms of such plan, the option price cannot be less than 85 percent of the fair market value of the stock at the time the option is exercised, or

(B) Twenty-seven months from the date the option is granted, if the option price is not determined in the manner described in paragraph (A) (see paragraph (h) of this section);

(viii) Under the terms of the plan, no employee may be granted an option that permits the employee’s rights to purchase stock under all employee stock purchase plans of the employer corporation and its related corporations to accrue at a rate that exceeds $25,000 of fair market value of the stock (determined at the time the option is granted) for each calendar year in which the option is outstanding at any time (see paragraph (i) of this section); and

(ix) Under the terms of the plan, options are not transferable by the optionee other than by will or the laws of descent and distribution, and are exercisable, during the lifetime of the optionee, only by the optionee (see paragraph (j) of this section).

(3) The determination of whether a particular option is an option granted under an employee stock purchase plan is made at the time the option is granted. If the terms of an option are inconsistent with the terms of the employee stock purchase plan or an offering under the plan, the option will not be treated as granted under an employee stock purchase plan. If an option with terms that are inconsistent with the terms of the plan or an offering under the plan is granted to an employee who is entitled to the grant of an option under the terms of the plan or offering, and the employee is not granted an option under the offering that qualifies as an option granted under an employee stock purchase plan, the offering will not meet the requirements of paragraph (e) of this section. Accordingly, none of the options granted under the offering will be eligible for the special tax treatment of section 421. However, if an option with terms that are inconsistent with the terms of the plan or an offering under the plan is granted to an individual who is not entitled to the grant of an option under the terms of the plan or offering, the option will not be treated as an option granted under an employee stock purchase plan, and the grant of the option will not disqualify the options granted under the plan or offering. If, at the time of grant, an option qualifies as an option granted under an employee stock purchase plan, but the terms of the option are not satisfied, the option will not be treated as granted under an employee stock purchase plan and this failure to comply with the terms of the option will not disqualify the options granted under the plan or offering.

(4) Examples. The following examples illustrate the principles of paragraph (a)(3):

Example 1. Corporation A operates an employee stock purchase plan under which options for A stock are granted to employees of A. The terms of an offering provide that the option price will be 90 percent of the fair market value of A stock on the date of exercise. A grants an option under the offering to Employee Z, an employee of A. The terms of the option provide that the option price will be 85 percent of the fair market value of A stock on the date of exercise. Because the terms of Z’s option are inconsistent with the terms of the offering, the option granted to Z will not be treated as an option granted under the employee stock purchase plan. Further, unless Z is granted an option under the offering that qualifies as an option granted under the employee stock purchase plan, the offering will not meet the requirements of paragraph (e) of this section and none of the options granted under the offering will be eligible for the special tax treatment of section 421.

Example 2. Corporation B operates an employee stock purchase plan that provides that options for B stock may only be granted to employees of B. Under the terms of the plan, options may not be granted to consultants and other non-employees. B grants an option under the plan to Consultant Y, a consultant of B. Because Y is ineligible to receive an option under the plan by reason of Y’s status as a non-employee, the grant of the option to Y is inconsistent with the terms of the plan and the option granted to Y will not be treated as an option granted under the employee stock purchase plan. However, the grant of the option to Y will not disqualify the options granted under the plan or offering because Y was not entitled to the grant of an option under the plan.

Example 3. Corporation C operates an employee stock purchase plan under which options for C stock are granted to employees of C. C grants an option under the plan to Employee X, an employee of C who is a highly compensated employee. The terms of the employee stock purchase plan exclude highly compensated employees from participation in the plan. Because X is ineligible to receive an option under the plan by reason of X’s exclusion from participation in the plan, the option granted to X will not be treated as an option granted under the employee stock purchase plan. However, the grant of the option to X will not disqualify the options granted under the plan or offering because X was not entitled to the grant of an option under the plan.

Example 4. Corporation D operates an employee stock purchase plan under which options for D stock are granted to employees of D. D grants an option under the plan to Employee W, an employee of D. The terms of the option provide that the option price will be 90 percent of the fair market value of D stock on the date of exercise. On the date of exercise, W pays only 85 percent of the fair market value of D stock. Because the terms of W’s option are not satisfied, the option granted to W will not be treated as an option granted under the employee stock purchase plan. However, the failure to comply with the terms of the option granted to W will not disqualify the options granted under the plan or offering.

(b) Options restricted to employees. An employee stock purchase plan must provide that options can be granted only to employees of the employer corporation (or employees of its related corporations) to purchase stock in the employer corporation (or one of its related corporations). If such a provision is not included in the terms of the plan, the plan will not be an employee stock purchase plan and options granted under the plan will not qualify for the special tax treatment of section 421. For rules relating to the employment requirement, see paragraph (h) of §1.421-1.

(c) Stockholder approval—(1) An employee stock purchase plan must be approved by the stockholders of the granting corporation within 12 months before or after the date such plan is adopted. The approval of the stockholders must comply with all applicable provisions of the corporate charter, bylaws and applicable State law prescribing the method and degree of stockholder approval required for the issuance of corporate stock or options. If the applicable State law does not prescribe a method and degree of stockholder approval, then an employee stock purchase plan must be approved—

(i) By a majority of the votes cast at a duly held stockholder’s meeting at which a quorum representing a majority of all outstanding voting stock is, either in person or by proxy, present and voting on the plan; or

(ii) By a method and in a degree that would be treated as adequate under applicable State law in the case of an action requiring stockholder approval (such as, an action on which stockholders would be entitled to vote if the action were taken at a duly held stockholders’ meeting).

(2) For purposes of the stockholder approval required by this paragraph (c), ordinarily, a plan is adopted when it is approved by the granting corporation’s board of directors, and the date of the board’s action is the reference point for determining whether stockholder approval occurs within the applicable 24-month period. However, if the board’s action is subject to a condition (such as stockholder approval) or the happening of a particular event, the plan is adopted on the date the condition is met or the event occurs, unless the board’s resolution fixes the date of approval as the date of the board’s action.

(3) An employee stock purchase plan, as adopted and approved, must designate the maximum aggregate number of shares that may be issued under the plan, and the corporations or class of corporations whose employees may be offered options under the plan. A plan that merely provides that the number of shares that may be issued under the plan may not exceed a stated percentage of the shares outstanding at the time of each offering or grant under the plan does not satisfy the requirements of this paragraph (c)(3). However, the maximum aggregate number of shares that may be issued under the plan may be stated in terms of a percentage of the authorized, issued, or outstanding shares on the date of the adoption of the plan. The plan may specify that the maximum aggregate number of shares available for grants under the plan may increase annually by a specified percentage of the authorized, issued, or outstanding shares on the date of the adoption of the plan. A plan that provides that the maximum aggregate number of shares that may be issued as options under the plan may change based on any other specific circumstances satisfies the requirements of this paragraph only if the stockholders approve an immediately determinable maximum number of shares that may be issued under the plan in any event. If there is more than one employee stock purchase plan under which options may be granted and stockholders of the granting corporation merely approve a maximum aggregate number of shares that are available for issuance under the plans, the stockholder approval requirements described in paragraph (c)(1) of this section are not satisfied. A separate maximum aggregate number of shares available for issuance pursuant to options must be specified and approved for each plan.

(4) Once an employee stock purchase plan is approved by the stockholders of the granting corporation, the plan need not be reapproved by the stockholders of the granting corporation within the prescribed 24-month period unless the plan is amended or changed in a manner that is considered the adoption of a new plan. Any increase in the aggregate number of shares that may be issued under the plan (other than an increase merely reflecting a change in the number of outstanding shares, such as a stock dividend or stock split) will be considered the adoption of a new plan requiring stockholder approval within the prescribed 24-month period. Similarly, a change in the designation of corporations whose employees may be offered options under the plan will be considered the adoption of a new plan requiring stockholder approval within the prescribed 24-month period unless the plan provides that designations of participating corporations may be made from time to time from among a group consisting of the granting corporation and its related corporations. The group from among which such changes and designations are permitted without additional stockholder approval may include corporations having become parents or subsidiaries of the granting corporation after the adoption and approval of the plan. In addition, a change in the granting corporation or the stock available for purchase under the plan will be considered the adoption of a new plan requiring stockholder approval within the prescribed 24-month period. Any other changes in the terms of an employee stock purchase plan are not considered the adoption of a new plan and, thus, do not require stockholder approval.

(5) Examples. The following examples illustrate the principles of this paragraph (c):

Example 1—(i) Corporation E is a subsidiary of Corporation F, a publicly traded corporation. On January 1, 2010, E adopts an employee stock purchase plan under which options for E stock are granted to E employees.

(ii) To meet the requirements of paragraph (c)(1) of this section, the plan must be approved by the stockholders of E (in this case, F) within 12 months before or after January 1, 2010.

(iii) Assume the same facts as in paragraph (i) of this Example 1, except that the plan was approved by the stockholders of E (in this case, F) on March 1, 2010. On January 1, 2012, E changes the plan to provide that options for F stock will be granted to E employees under the plan. Because there is a change in the stock available for grant under the plan, under paragraph (c)(4) of this section, the change is considered the adoption of a new plan that must be approved by the stockholders of E (in this case, F) within 12 months before or after January 1, 2012.

Example 2—(i) Assume the same facts as in paragraph (i) of Example 1, except that on March 15, 2011, F completely disposes of its interest in E. Thereafter, E continues to grant options for E stock to E employees under the plan.

(ii) The new E options are granted under a plan that meets the stockholder approval requirements of paragraph (c)(1) of this section without regard to whether E seeks approval of the plan from the stockholders of E after F disposes of its interest in E.

(iii) Assume the same facts as in paragraph (i) of this Example 2, except that under the plan as adopted on January 1, 2010, only options for F stock are granted to E employees. Assume further that, after F disposes of its interest in E, E changes the plan to provide for the grant of options for E stock to E employees. Because there is a change in the stock available for purchase or grant under the plan, under paragraph (c)(4) of this section, the stockholders of E must approve the plan within 12 months before or after the change to the plan to meet the stockholder approval requirements of paragraph (c) of this section.

Example 3—(i) Corporation G maintains an employee stock purchase plan. Corporation H does not maintain an employee stock purchase plan. On May 15, 2010, G and H consolidate under State law to form one corporation. The new corporation is named Corporation H. The consolidation agreement describes the G plan, including the maximum aggregate number of shares available for issuance under the plan after the consolidation. Additionally, the consolidation agreement states that the plan will be continued by H after the consolidation. The consolidation agreement is unanimously approved by the stockholders of G and H on May 1, 2010. H assumes the plan formerly maintained by G and continues to grant options under the plan to all eligible employees.

(ii) Because there is a change in the granting corporation (from G to H), under paragraph (c)(4) of this section, H is considered to have adopted a new plan. Because the plan is fully described in the consolidation agreement, including the maximum aggregate number of shares available for issuance under the plan, the approval of the consolidation agreement by the stockholders constitutes approval of the plan. Thus, the stockholder approval of the consolidation agreement satisfies the stockholder approval requirements of paragraph (c)(1) of this section, and the plan is considered to be adopted by H and approved by its stockholders on May 1, 2010.

Example 4. Corporation I adopts an employee stock purchase plan on November 1, 2010. On that date, there are two million shares of I stock outstanding. The plan provides that the maximum aggregate number of shares that may be issued under the plan may not exceed 15 percent of the number of shares of I stock outstanding on November 1, 2010. Because the maximum aggregate number of shares that may be issued under the plan is designated in the plan, the requirements of paragraph (c)(3) of this section are met.

Example 5—(i) Corporation J adopts an employee stock purchase plan on March 15, 2010. The plan provides that the maximum aggregate number of shares of J stock available for issuance under the plan is 50,000, increased on each anniversary date of the adoption of the plan by 5 percent of the then outstanding shares. Because the maximum aggregate number of shares is not designated under the plan, the requirements of paragraph (c)(3) of this section are not met.

(ii) Assume the same facts as in paragraph (i) of this Example 5, except that the plan provides that the maximum aggregate number of shares available under the plan is the lesser of (a) 50,000 shares, increased each anniversary date of the adoption of the plan by 5 percent of the then-outstanding shares, or (b) 200,000 shares. Because the maximum aggregate number of shares that may be issued under the plan is designated as the lesser of two numbers, one of which provides an immediately determinable maximum aggregate number of shares that may be issued under the plan in any event, the requirements of paragraph (c)(3) of this section are met.

(d) Options granted to certain shareholders—(1) An employee stock purchase plan must by its terms provide that an employee cannot be granted an option if the employee, immediately after the option is granted, owns stock possessing 5 percent or more of the total combined voting power or value of all classes of stock of the employer corporation or a related corporation. In determining whether the stock ownership of an employee equals or exceeds this 5 percent limit, the rules of section 424(d) (relating to attribution of stock ownership) shall apply, and stock that the employee may purchase under outstanding options (whether or not the options qualify for the special tax treatment afforded by section 421(a)) shall be treated as stock owned by the employee. An option is outstanding for purposes of this paragraph (d) although under its terms it may be exercised only in installments or after the expiration of a fixed period of time. If an option is granted to an employee whose stock ownership (as determined under this paragraph (d)) exceeds the limitation set forth in this paragraph (d), no portion of the option will be treated as having been granted under an employee stock purchase plan.

(2) The determination of the percentage of the total combined voting power or value of all classes of stock of the employer corporation (or a related corporation) that is owned by the employee is made by comparing the voting power or value of the shares owned (or treated as owned) by the employee to the aggregate voting power or value of all shares actually issued and outstanding immediately after the grant of the option to the employee. The aggregate voting power or value of all shares actually issued and outstanding immediately after the grant of the option does not include the voting power or value of treasury shares or shares authorized for issue under outstanding options held by the employee or any other person.

(3) Examples. The following examples illustrate the principles this paragraph (d):

Example 1. Employee V, an employee of Corporation K, owns 6,000 shares of K common stock, the only class of K stock outstanding. K has 100,000 shares of its common stock outstanding. Because V owns 6 percent of the combined voting power or value of all classes of K stock, K cannot grant an option to V under K’s employee stock purchase plan. If V’s father and brother each owned 3,000 shares of K stock and V did not own any K stock, then the result would be the same because, under section 424(d), an individual is treated as owning stock held by the person’s father and brother. Similarly, the result would be the same if, instead of actually owning 6,000 shares, V merely held an option on 6,000 shares of K stock, irrespective of whether the transfer of stock under the option could qualify for the special tax treatment of section 421, because this paragraph (d) provides that stock the employee may purchase under outstanding options is treated as stock owned by such employee.

Example 2. Assume the same facts as in Example 1, except that K is a subsidiary corporation of Corporation L. Irrespective of whether V owns any L stock, V cannot receive an option from L under L’s employee stock purchase plan because he owns 5 percent of the total combined voting power of all classes of stock of a subsidiary of L, in this example, K. An employee who owns (or is treated as owning) stock in excess of the limitation of this paragraph (d), in any corporation in a group of related corporations, consisting of a parent and its subsidiary corporations, cannot receive an option under an employee stock purchase plan from any corporation in the group.

Example 3. Employee U is an employee of Corporation M. M has only one class of stock, of which 100,000 shares are issued and outstanding. Assuming U does not own (and is not treated as owning) any stock in M or in any related corporation of M, M may grant an option to U under its employee stock purchase plan for 4,999 shares, because immediately after the grant of the option, U would not own 5 percent or more of the combined voting power or value of all classes of M stock actually issued and outstanding at such time. The 4,999 shares that U would be treated as owning under this paragraph (d) would not be added to the 100,000 shares actually issued and outstanding immediately after the grant for purposes of determining whether U’s stock ownership exceeds the limitation of this paragraph (d).

Example 4. Assume the same facts as in Example 3 but instead of an option for 4,999 shares, M grants U an option, purportedly under its employee stock purchase plan, for 5,000 shares. No portion of this option will be treated as granted under an employee stock purchase plan because U’s stock ownership exceeds the limitation of this paragraph (d).

(e) Employees covered by plan—(1) Subject to the provisions of this paragraph (e) and the limitations of paragraphs (d), (f) and (i) of this section, an employee stock purchase plan must, by its terms, provide that options are to be granted to all employees of any corporation whose employees are granted any of such options by reason of their employment by the corporation, except that one or more of the following categories of employees may be excluded from the coverage of the plan—

(i) Employees who have been employed less than two years;

(ii) Employees whose customary employment is 20 hours or less per week;

(iii) Employees whose customary employment is for not more than five months in any calendar year; and

(iv) Highly compensated employees (within the meaning of section 414(q)).

(2) An employee stock purchase plan does not fail to satisfy the coverage provision of paragraph (e)(1) of this section in the following circumstances—

(i) The plan excludes employees who have completed a shorter period of service or whose customary employment is for fewer hours per week or fewer months in a calendar year than is specified in paragraph (e)(1)(i), (ii) and (iii), provided the exclusion is applied in an identical manner to all employees of every corporation whose employees are granted options under the plan.

(ii) The plan excludes highly compensated employees (within the meaning of section 414(q)) with compensation above a certain level or who are officers or subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934, provided the exclusion is applied in an identical manner to all highly compensated employees of every corporation whose employees are granted options under the plan.

(3) Notwithstanding paragraph (e)(1) of this section, employees who are citizens or residents of a foreign jurisdiction (without regard to whether they are also citizens of the United States or resident aliens (within the meaning of section 7701(b)(1)(A))) may be excluded from the coverage of an employee stock purchase plan under the following circumstances—

(i) The grant of an option under the plan to a citizen or resident of the foreign jurisdiction is prohibited under the laws of such jurisdiction; or

(ii) Compliance with the laws of the foreign jurisdiction would cause the plan to violate the requirements of section 423.

(4) No option granted under a plan or offering that excludes from participation any employees, other than those who may be excluded under this paragraph (e), and those barred from participation by reason of paragraphs (d), (f) and (i) of this section, can be regarded as having been granted under an employee stock purchase plan. If an option is not granted to any employee who is entitled to the grant of an option under the terms of the plan or offering, none of the options granted under such offering will be treated as having been granted under an employee stock purchase plan. However, a plan that, by its terms, permits all eligible employees to elect to participate in an offering will not violate the requirements of this paragraph solely because eligible employees who elect not to participate in the offering are not granted options pursuant to such offering.

(5) For purposes of this paragraph (e), the existence of the employment relationship between an individual and the corporation participating under the plan will be determined under paragraph (h) of §1.421-1.

(6) Examples. The following examples illustrate the principles of this paragraph (e):

Example 1. Corporation N has a stock purchase plan that meets all the requirements of paragraph (a)(2) of this section except that options are not required to be granted to employees whose weekly rate of pay is less than $1,000. As a matter of corporate practice, however, N grants options under its plan to all employees, irrespective of their weekly rate of pay. Even though N’s plan is operated in compliance with the requirements of this paragraph (e), N’s plan is not an employee stock purchase plan because the terms of the plan exclude a category of employees that is not permitted under this paragraph (e).

Example 2. Assume the same facts as in Example 1, except that the first offering under N’s plan provides that options will be granted to all employees of N. The terms of the first offering will be treated as part of the terms of N’s plan, but only for purposes of the first offering. Because the terms of the first offering satisfy the requirements of this paragraph (e), stock transferred pursuant to options exercised under the first offering will be treated as stock transferred pursuant to the exercise of options granted under an employee stock purchase plan for purposes of section 421.

Example 3. Corporation O has a stock purchase plan that excludes from participation all employees who have been employed less than one year. Assuming all other requirements of paragraph (a)(2) of this section are satisfied, O’s plan qualifies as an employee stock purchase plan under section 423.

Example 4. Corporation P has a stock purchase plan that excludes from participation clerical employees who have been employed less than two years. However, non-clerical employees with less than two years of service are permitted to participate in the plan. P’s plan is not an employee stock purchase plan because the exclusion of employees who have been employed less than two years applies only to certain employees of P and is not applied in an identical manner to all employees of P. If, instead, P’s plan excludes from participation all employees (both clerical and non-clerical) who have been employed less than two years, then P’s plan would qualify as an employee stock purchase plan under section 423 assuming all other requirements of paragraph (a)(2) of this section are satisfied.

Example 5. Corporation Q has a stock purchase plan that excludes from participation all officers who are highly compensated employees (within the meaning of section 414(q)). Assuming all other requirements of paragraph (a)(2) of this section are satisfied, Q’s plan qualifies as an employee stock purchase plan under section 423.

Example 6. Corporation R maintains an employee stock purchase plan that excludes from participation all highly compensated employees (within the meaning of section 414(q)), except highly compensated employees who are officers of R. R’s plan is not an employee stock purchase plan because the exclusion of all highly compensated employees except highly compensated employees who are officers of R is not a permissible exclusion under paragraph (e)(2)(ii) of this section.

Example 7. Corporation S is the parent corporation of Subsidiary YY and Subsidiary ZZ. S maintains an employee stock purchase plan with both YY and ZZ participating under the plan. Under the terms of the plan, all employees of YY and ZZ are permitted to participate in the plan with the exception of ZZ’s highly compensated employees with annual compensation greater than $300,000. S’s plan is not an employee stock purchase plan because the exclusion of highly compensated employees with annual compensation greater than $300,000 is not applied in an identical manner to all employees of YY and ZZ.

Example 8. The laws of Country A require that options granted to residents of Country A be transferable during the lifetime of the option recipient. Corporation T has a stock purchase plan that excludes residents of Country A from participation in the plan. Because compliance with the laws of Country A would cause options granted to residents of Country A to violate paragraph (j) of this section, T may exclude residents of Country A from participation in the plan. Assuming all other requirements of paragraph (a)(2) of this section are satisfied, T’s plan qualifies as an employee stock purchase plan under section 423.

(f) Equal rights and privileges—(1) Except as otherwise provided in paragraphs (f)(2) through (f)(6) of this section, an employee stock purchase plan must, by its terms, provide that all employees granted options under the plan shall have the same rights and privileges. Thus, the provisions applying to one option under an offering (such as the provisions relating to the method of payment for the stock and the determination of the purchase price per share) must apply to all other options under the offering in the same manner. If all the options granted under a plan or offering do not, by their terms, give the respective optionees the same rights and privileges, none of the options will be treated as having been granted under an employee stock purchase plan for purposes of section 421.

(2) The requirements of this paragraph (f) do not prevent the maximum amount of stock that an employee may purchase from being determined on the basis of a uniform relationship to the total compensation, or the basic or regular rate of compensation, of all employees.

(3) A plan or offering will not fail to satisfy the requirements of this paragraph (f) because the plan or offering provides that no employee may purchase more than a maximum amount of stock fixed under the plan.

(4) A plan or offering will not fail to satisfy the requirements of this paragraph (f) if, in order to comply with the laws of a foreign jurisdiction, the terms of an option granted under a plan or offering to citizens or residents of such foreign jurisdiction (without regard to whether they are also citizens of the United States or resident aliens (within the meaning of section 7701(b)(1)(A))) are less favorable than the terms of options granted under the same plan or offering to employees resident in the United States.

(5)(i) Except as provided in this paragraph and paragraph (f)(5)(ii) of this section, a plan permitting one or more employees to carry forward amounts that were withheld but not applied toward the purchase of stock under an earlier plan or offering and apply the amounts towards the purchase of additional stock under a subsequent plan or offering will be a violation of the equal rights and privileges under paragraph (f)(1) of this section. However, the carry forward of amounts withheld but not applied toward the purchase of stock under an earlier plan or offering will not violate the equal rights and privileges requirement of paragraph (f)(1) of this section if all other employees participating in the current plan or offering are permitted to make direct payments toward the purchase of shares under a subsequent plan or offering in an amount equal to the excess of the greatest amount which any employee is allowed to carry forward from an earlier plan or offering over the amount, if any, the employee will carry forward from an earlier plan or offering.

(ii) A plan will not fail to satisfy the requirements of this section merely because employees are permitted to carry forward amounts representing a fractional share, that were withheld but not applied toward the purchase of stock under an earlier plan or offering and apply the amounts toward the purchase of additional stock under a subsequent plan or offering.

(6) Paragraph (f) does not prohibit the delaying of the grant of an option to any employee who is barred from being granted an option solely by reason of the employee’s failing to meet a minimum service requirement set forth in paragraph (e)(1) of this section until the employee meets such requirement.

(7) Examples. The following examples illustrate the principles of this paragraph (f):

Example 1. Corporation U has an employee stock purchase plan that provides that the maximum amount of stock that each employee may purchase under the offering is one share for each $100 of annual gross pay. The plan meets the requirements of this paragraph (f).

Example 2. Corporation V has an employee stock purchase plan that provides that the maximum amount of stock that each employee may purchase under the offering is one share for each $100 of annual gross pay up to and including $10,000, and two shares for each $100 of annual gross pay in excess of $10,000. The plan will not meet the requirements of this paragraph (f) because the amount of stock that may be purchased under the plan is not based on a uniform relationship to the total compensation of all employees.

Example 3. Corporation W has an employee stock purchase plan that provides that options to purchase stock in an amount equal to ten percent of an employee’s annual salary at a price equal to 85 percent of the fair market value on the first day of the offering will be granted to all employees other than those who have been employed less than 18 months. In addition, the plan provides that employees who have not yet met the minimum service requirements on the first day of the offering will be granted similar options on the date the 18 month service requirement has been attained. The plan meets the requirements of this paragraph (f).

Example 4. Corporation X has an employee stock purchase plan that provides that options to purchase stock at a price equal to 90 percent of the fair market value at the time the option is exercised will be granted to all employees. The laws of Country B provide that options granted to employees who are residents of Country B must have a purchase price not less than 95 percent of the fair market value at the time the option is exercised. The plan will not fail to satisfy the requirements of this paragraph (f) merely because the residents of Country B are granted options under the plan to purchase stock at a price equal to 95 percent of the fair market value at the time the option is exercised.

Example 5. Corporation Y maintains an employee stock purchase plan. Employee T is employed by Y. T is granted an option under the current offering to purchase a maximum of 100 shares of Y stock at an option price equal to 85 percent of the fair market value of the stock at exercise. The plan permits the carry forward of withheld but unused amounts from an earlier offering. Prior to the exercise date, $2000 of T’s salary has been withheld and is available to be applied toward the purchase of Y stock. On the exercise date, the fair market value of Y stock is $20 per share. T is able to purchase 100 shares of Y stock at $17 per share for an aggregate purchase price of $1700. T can carry forward $300 to the subsequent offering. Each employee in the subsequent offering other than T will be permitted to make direct payments toward the purchase of shares under the subsequent offering in a maximum amount of $300 less any amount the employee has carried forward from an earlier offering. The plan does not violate the equal rights and privileges requirement of this paragraph (f).

(g) Option price—(1) An employee stock purchase plan must, by its terms, provide that the option price will not be less than the lesser of—

(i) An amount equal to 85 percent of the fair market value of the stock at the time the option is granted, or

(ii) An amount that under the terms of the option may not be less than 85 percent of the fair market value of the stock at the time the option is exercised.

(2) The option price may be determined in any reasonable manner, including the valuation methods permitted under §20.2031-2, so long as the option price meets the minimum pricing requirements of this paragraph (g). For general rules relating to the option price, see paragraph (e) of §1.421-1. For rules relating to the determination of when an option is granted, see paragraph (c) of §1.421-1 and §1.423-2(h)(2). Any option that does not meet the minimum pricing requirements of this paragraph (g) will not be treated as an option granted under an employee stock purchase plan irrespective of whether the plan or offering satisfies those requirements. If an option that does not meet the minimum pricing requirements is granted to an employee who is entitled to the grant of an option under the terms of the plan or offering, and the employee is not granted an option under such offering that qualifies as an option granted under an employee stock purchase plan, the offering will not meet the requirements of paragraph (e) of this section. Accordingly, none of the options granted under the offering will be eligible for the special tax treatment of section 421.

(3) The option price may be stated either as a percentage or as a dollar amount. If the option price is stated as a dollar amount, then the requirement of this paragraph (g) can only be met by a plan or offering in which the price is fixed at not less than 85 percent of the fair market value of the stock at the time the option is granted. If the fixed price is less than 85 percent of the fair market value of the stock at grant, then the option cannot meet the requirement of this paragraph (g) even if a decline in the fair market value of the stock results in such fixed price being not less than 85 percent of the fair market value of the stock at the time the option is exercised, because that result was not certain to occur under the terms of the option.

(4) Examples. The following examples illustrate the principles of this paragraph (g):

Example 1. Corporation Z has an employee stock purchase plan that provides that the option price will be 85 percent of the fair market value of the stock on the first day of the offering (which is the date of grant in this case), or 85 percent of the fair market value of the stock at exercise, whichever amount is the lesser. Upon the exercise of an option issued under Z’s plan, Z agrees to accept an option price that is less than the minimum amount allowable under the terms of such plan. Notwithstanding that the option was issued under an employee stock purchase plan, the transfer of stock pursuant to the exercise of such option does not satisfy the requirement of this paragraph (g) and cannot qualify for the special tax treatment of section 421.

Example 2. Corporation AA has an employee stock purchase plan that provides that the option price is set at 85 percent of the fair market value of AA stock at exercise, but not less than $80 per share. On the first day of the offering (which is the date of grant in this case), the fair market value of AA stock is $100 per share. The option satisfies the requirement of this paragraph (g), and can qualify for the special tax treatment of section 421.

Example 3. Assume the same facts as in Example 2, except that the option price is set at 85 percent of the fair market value of AA stock at exercise, but not more than $80 per share. This option cannot satisfy the requirement of this paragraph (g) irrespective of whether, at the time the option is exercised, 85 percent of the fair market value of AA stock is $80 or less.

(h) Option period—(1) An employee stock purchase plan must, by its terms, provide that options granted under the plan cannot be exercised after the expiration of 27 months from the date of grant unless, under the terms of the plan, the option price is not less than 85 percent of the fair market value of the stock at the time of the exercise of the option. If the option price is not less than 85 percent of the fair market value of the stock at the time the option is exercised, then the option period provided under the plan must not exceed five years from the date of grant. If the requirements of this paragraph (h) are not met by the terms of the plan or offering, then options issued under such plan or offering will not be treated as options granted under an employee stock purchase plan irrespective of whether the options, by their terms, are exercisable beyond the period allowable under this paragraph (h). An option that provides that the option price is not less than 85 percent of the fair market value of the stock at exercise may have an option period of 5 years irrespective of whether the fair market value of the stock at exercise is more or less than the fair market value of the stock at grant. However, if the option provides that the option price is 85 percent of the fair market value of the stock at exercise, but not more than some other fixed amount determined in accordance with the provisions of paragraph (g) of this section, then irrespective of the price paid on exercise, the option period must not be more than 27 months.

(2) Section 1.421-1(c) provides that, for purposes of §§1.421-1 through 1.424-1, the language the date of the granting of the option and the time such option is granted, and similar phrases refer to the date or time when the granting corporation completes the corporate action constituting an offer of stock for sale to an individual under the terms and conditions of a statutory option. With respect to options granted under an employee stock purchase plan, the principles of §1.421-1(c) shall be applied without regard to the requirement that the minimum option price must be fixed or determinable in order for the corporate action constituting an offer of stock to be considered complete.

(3) The date of grant will be the first day of an offering if the terms of an employee stock purchase plan or offering designate a maximum number of shares that may be purchased by each employee during the offering. Similarly, the date of grant will be the first day of an offering if the terms of the plan or offering require the application of a formula to establish, on the first day of the offering, the maximum number of shares that may be purchased by each employee during the offering. It is not required that an employee stock purchase plan or offering designate a maximum number of shares that may be purchased by each employee during the offering or incorporate a formula to establish a maximum number of shares that may be purchased by each employee during the offering. If the maximum number of shares that can be purchased under an option is not fixed or determinable until the date the option is exercised, then the date of exercise will be the date of grant of the option.

(4) Examples. The following examples illustrate the principles of this paragraph (h):

Example 1—(i) Corporation BB has an employee stock purchase plan that provides that the option price will be the lesser of 85 percent of the fair market value of the stock on the first day of an offering or 85 percent of the fair market value of the stock on the last day of the offering. Options are exercised on the last day of the offering. One million shares of BB stock are reserved for issuance under the plan. The plan provides that no employee may be permitted to purchase stock under the plan at a rate that exceeds $25,000 in fair market value of the BB stock (determined on the date of grant) for each calendar year during which an option granted to the employee is outstanding and exercisable. The terms of each option granted under an offering provide that a maximum of 500 shares may be purchased by the option recipient during the offering. Because the maximum number of shares that can be purchased under the option is fixed and determinable on the first day of the offering, the date of grant for the option is the first day of the offering.

(ii) Assume the same facts as in paragraph (i) of Example 1 except that BB’s plan excludes all employees who have been employed less than 18 months. The plan provides that employees who have not yet met the minimum service requirements on the first day of an offering will be granted an option on the date the 18-month service requirement has been attained. With respect to those employees who have been employed less than 18 months on the first day of an offering, the date of grant for the option is the date the 18-month service requirement has been attained.

Example 2. Assume the same facts as in paragraph (i) of Example 1 except that the terms of each option granted do not provide that a maximum of 500 shares may be purchased by the option recipient during the offering. Notwithstanding the fixed number of shares reserved for issuance under the plan and the $25,000 limitation set forth in the plan, the maximum number of shares that can be purchased under the option is not fixed or determinable until the last day of the offering when the option is exercised. Therefore the date of grant for the option is the last day of the offering when the option is exercised.

Example 3. Corporation CC has an employee stock purchase plan that provides that the option price will be 85 percent of the fair market value of the stock on the last day of the offering. Options are exercised on the last day of the offering. Each offering under the plan begins on January 1 and ends on December 31 of the same calendar year. The terms of each option granted under an offering provide that the maximum number of shares that may be purchased by any employee during the offering equals $25,000 divided by the fair market value of the stock on the first day of the offering. The maximum number of shares that can be purchased under the option is fixed and determinable on the first day of the offering and therefore the date of grant for the option is the first day of the offering.

Example 4. Assume the same facts as in Example 3 except that the terms of each option granted under an offering provide that the maximum number of shares that may be purchased by any employee during the offering equals 10 percent of the employee’s annual salary (determined as of January 1 of the year in which the offering commences) divided by the fair market value of the stock on the first day of the offering. The maximum number of shares that can be purchased under the option is fixed and determinable on the first day of the offering and therefore the date of grant for the option is the first day of the offering.

(i) Annual $25,000 limitation—(1) An employee stock purchase plan must, by its terms, provide that no employee may be permitted to purchase stock under all the employee stock purchase plans of the employer corporation and its related corporations at a rate that exceeds $25,000 in fair market value of the stock (determined at the time the option is granted) for each calendar year in which any option granted to the employee is outstanding at any time. In applying the foregoing limitation—

(i) The right to purchase stock under an option is deemed to accrue when the option (or any portion thereof) first becomes exercisable during the calendar year;

(ii) The right to purchase stock under an option accrues at the rate provided in the option, but in no case may such rate exceed $25,000 of fair market value of such stock (determined at the time such option is granted) for any one calendar year; and

(iii) A right to purchase stock that has accrued under one option granted pursuant to the plan may not be carried over to any other option.

(2) If an option is granted under an employee stock purchase plan that satisfies the requirement of this paragraph (i), but the option gives the optionee the right to buy stock in excess of the maximum rate allowable under this paragraph (i), then no portion of the option will be treated as having been granted under an employee stock purchase plan. Furthermore, if the option was granted to an employee entitled to the grant of an option under the terms of the plan or offering, and the employee is not granted an option under the offering that qualifies as an option granted under an employee stock purchase plan, then the offering will not meet the requirements of paragraph (e) of this section. Accordingly, none of the options granted under the offering will be eligible for the special tax treatment of section 421.

(3) The limitation of this paragraph (i) applies only to options granted under employee stock purchase plans and does not limit the amount of stock that an employee may purchase under incentive stock options (as defined in section 422(b)) or any other stock options except those to which section 423 applies. Stock purchased under options to which section 423 does not apply will not limit the amount that an employee may purchase under an employee stock purchase plan, except for purposes of the 5-percent stock ownership provision of paragraph (d) of this section.

(4) Under the limitation of this paragraph (i), an employee may purchase up to $25,000 of stock (based on the fair market value of the stock at the time the option was granted) in each calendar year during which an option granted to the employee under an employee stock purchase plan is outstanding and exercisable. Alternatively, an employee may purchase more than $25,000 of stock (based on the fair market value of such stock at the time the option was granted) in a calendar year, so long as the total amount of stock that the employee purchases does not exceed $25,000 in fair market value of the stock (determined at the time the option was granted) for each calendar year in which the option was outstanding and exercisable. If, in any calendar year, the employee holds two or more outstanding and exercisable options granted under employee stock purchase plans of the employer corporation, or a related corporation, then the employee’s purchases of stock attributable to that year under all options granted under employee stock purchase plans must not exceed $25,000 in fair market value of the stock (determined at the time the options were granted). Under an employee stock purchase plan, an employee may not purchase stock in anticipation that the option will be outstanding and exercisable in some future year. Thus, the employee may purchase only the amount of stock that does not exceed the limitation of this paragraph (i) for the year of the purchase and for preceding years during which the option was outstanding and exercisable. Thus, the amount of stock that may be purchased under an option depends on the number of years in which the option is actually outstanding and exercisable. The amount of stock that may be purchased under an employee stock purchase plan may not be increased by reason of the failure to grant an option in an earlier year under such plan, or by reason of the failure to exercise an earlier option. For example, if an option is granted to an individual and expires without having been exercised at all, then the failure to exercise the option does not increase the amount of stock which such individual may be permitted to purchase under an option granted in a year following the year of such expiration. If an option granted under an employee stock purchase plan is outstanding and exercisable in more than one calendar year, then stock purchased pursuant to the exercise of such an option will be applied first, to the extent allowable under this paragraph (i), against the $25,000 limitation for the earliest year in which the option was outstanding and exercisable, then, against the $25,000 limitation for each succeeding year, in order.

(5) Examples. The following examples illustrate the principles of this paragraph (i):

Example 1. Assume that Corporation DD maintains an employee stock purchase plan and that Employee S is employed by DD. On June 1, 2010, DD grants S an option under the plan to purchase a total of 750 shares of DD stock at $85 per share. On that date, the fair market value of DD stock is $100 per share. The option provides that it may be exercised at any time but cannot be exercised after May 31, 2012. Under this paragraph (i), the option must not permit S to purchase more than 250 shares of DD stock during the calendar year 2010, because 250 shares are equal to $25,000 in fair market value of DD stock determined at the time of grant. During the calendar year 2011, S may purchase under the option an amount of DD stock equal to the difference between $50,000 in fair market value of DD stock (determined at the time the option was granted) and the fair market value of DD stock (determined at the time of grant of the option) purchased during the year 2010. During the calendar year 2012, S may purchase an amount of DD stock equal to the difference between $75,000 in fair market value of the stock (determined at the time of grant of the option) and the total amount of the fair market value of the stock (determined at the time of grant of the option) purchased under the option during the calendar years 2010 and 2011. S may purchase $25,000 of stock for the year 2010, and $25,000 of stock for the year 2012, although the option was outstanding and exercisable for only a part of each of such years. However, S may not be granted another option under an employee stock purchase plan of DD or a related corporation to purchase stock of DD or a related corporation during the calendar years 2010, 2011, and 2012, so long as the option granted June 1, 2010, is outstanding.

Example 2. Assume the same facts as in Example 1, except that the option granted to S in 2010 is terminated in 2011 without any part of the option having been exercised, and that subsequent to the termination and during 2011, S is granted another option under DD’s employee stock purchase plan. Under that option, S may be permitted to purchase $25,000 of stock for 2011. The failure of S to exercise the option granted to S in 2010, does not increase the amount of stock that S may be permitted to purchase under the option granted to S in 2011.

Example 3. Assume the same facts as in Example 1, except that, on May 31, 2012, S exercised the option granted to S in 2010, and purchased 600 shares of DD stock. Five hundred shares, the maximum amount of stock that could have been purchased in 2011, under the option, are treated as having been purchased for the years 2010 and 2011. Only 100 shares of the stock are treated as having been purchased for 2012. After S’s exercise of the option on May 31, 2012, S is granted another option under DD’s employee stock purchase plan. S may be permitted under the new option to purchase for 2012 stock having a fair market value of no more than $15,000 at the time the new option is granted.

Example 4. Corporation EE maintains an employee stock purchase plan and Employee R is employed by EE. On August 1, 2010, EE grants R an option under the plan to purchase 150 shares of EE stock at $85 per share during each of the calendar years 2010, 2011, and 2012. On that date, the fair market value of EE stock is $100 per share. The option provides that it may be exercised at any time during years 2010, 2011, and 2012. Because this option permits R to purchase only $15,000 of EE’s stock for each year the option is outstanding and exercisable, R could be granted another option by EE, or by a related corporation, in year 2010, permitting R to purchase an additional $10,000 of stock during each of the calendar years 2010, 2011, and 2012.

Example 5. Corporation FF maintains an employee stock purchase plan and Employee Q is employed by FF. On September 1, 2010, FF grants Q an option under the plan that will be automatically exercised on August 31, 2011, and August 31, 2012. On August 31, 2011, Q may purchase under the option an amount of FF stock equal to $25,000 in fair market value of FF stock (determined at the time the option was granted). On August 31, 2012, Q may purchase under the option an amount of FF stock equal to the difference between $50,000 in fair market value of Q stock (determined at the time the option was granted) and the fair market value of Q stock (determined at the time of grant of the option) purchased during year 2011.

(j) Restriction on transferability. An employee stock purchase plan must, by its terms, provide that options granted under the plan are not transferable by the optionee other than by will or the laws of descent and distribution, and must be exercisable, during the optionee’s lifetime, only by the optionee. For general rules relating to the restriction on transferability required by this paragraph (j), see paragraph (b)(2) of §1.421-1. For a limited exception to the requirement of this paragraph (j), see section 424(h)(3).

(k) Special rule where option price is between 85 percent and 100 percent of value of stock—(1)(i) If all the conditions necessary for the application of section 421(a) exist, this paragraph (k) provides additional rules that are applicable in cases where, at the time the option is granted, the option price per share is less than 100 percent (but not less than 85 percent) of the fair market value of the share. In that case, upon the disposition of the share by the employee after the expiration of the two-year and the one-year holding periods, or upon the employee’s death while owning the share (whether occurring before or after the expiration of such periods), there shall be included in the employee’s gross income as compensation (and not as gain upon the sale or exchange of a capital asset) the lesser of—

(A) The amount, if any, by which the price paid under the option was exceeded by the fair market value of the share at the time the option was granted, or

(B) The amount, if any, by which the price paid under the option was exceeded by the fair market value of the share at the time of such disposition or death.

(ii) For purposes of applying the rules of this paragraph (k), if the option price is not fixed or determinable at the time the option is granted, the option price will be computed as if the option had been exercised at such time. The amount of compensation resulting from the application of this paragraph (k) shall be included in the employee’s gross income for the taxable year in which the disposition occurs, or for the taxable year closing with the employee’s death, whichever event results in the application of this paragraph (k).

(iii) The application of the special rules provided in this paragraph (k) shall not affect the rules provided in section 421(a) with respect to the employee exercising the option, the employer corporation, or a related corporation. Thus, notwithstanding the inclusion of an amount as compensation in the gross income of an employee, as provided in this paragraph (k), no income results to the employee at the time the stock is transferred to the employee, and no deduction under section 162 is allowable at any time to the employer corporation or a related corporation with respect to such amount.

(iv) If, during the employee’s lifetime, the employee exercises an option granted under an employee stock purchase plan, but the employee dies before the stock is transferred to the employee pursuant to the exercise of the option, then the transfer of the stock to the employee’s executor, administrator, heir, or legatee is deemed, for the purpose of sections 421 and 423, to be a transfer of the stock to the employee exercising the option and a further transfer by reason of death from the employee to the employee’s executor, administrator, heir, or legatee.

(2) If the special rules provided in this paragraph (k) are applicable to the disposition of a share of stock by an employee, then the basis of the share in the employee’s hands at the time of the disposition, determined under section 1011, shall be increased by an amount equal to the amount includible as compensation in the employee’s gross income under this paragraph (k). However, the basis of a share of stock acquired after the death of an employee by the exercise of an option granted to the employee under an employee stock purchase plan shall be determined in accordance with the rules of section 421(c) and paragraph (c) of §1.421-2. If the special rules provided in this paragraph (k) are applicable to a share of stock upon the death of an employee, then the basis of the share in the hands of the estate or the person receiving the stock by bequest or inheritance shall be determined under section 1014, and shall not be increased by reason of the inclusion upon the decedent’s death of any amount in the decedent’s gross income under this paragraph (k). See Example (9) of this paragraph with respect to the determination of basis of the share in the hands of a surviving joint owner.

(3) Examples. The following examples illustrate the principles of this paragraph (k):

Example 1. On June 1, 2010, the Corporation GG grants to Employee P, an employee of GG, an option under GG’s employee stock purchase plan to purchase a share of GG stock for $85. The fair market value of GG stock on such date is $100 per share. On June 1, 2011, P exercises the option and on that date GG transfers the share of stock to P. On January 1, 2013, P sells the share for $150, its fair market value on that date. P’s income tax return is filed on the basis of the calendar year. The income tax consequences to P and GG are as follows—

(i) Compensation in the amount of $15 is includible in P’s gross income for the year 2013, the year of the disposition of the share. The $15 represents the difference between the option price ($85) and the fair market value of the share on the date the option was granted ($100), because the value is less than the fair market value of the share on the date of disposition ($150). For the purpose of computing P’s gain or loss on the sale of the share, P’s cost basis of $85 is increased by $15, the amount includible in P’s gross income as compensation. Thus, P’s basis for the share is $100. Because the share was sold for $150, P realizes a gain of $50, which is treated as long-term capital gain; and

(ii) GG is not entitled to any deduction under section 162 at any time with respect to the share transferred to P.

Example 2. Assume the same facts as in Example 1, except that P sells the share of GG stock on January 1, 2014, for $75, its fair market value on that date. Because $75 is less than the option price ($85), no amount in respect of the sale is includible as compensation in P’s gross income for the year 2014. P’s basis for determining gain or loss on the sale is $85. Because P sold the share for $75, P realized a loss of $10 on the sale that is treated as a long-term capital loss.

Example 3. Assume the same facts as in Example 1, except that the option provides that the option price shall be 90 percent of the fair market value of the stock on the day the option is exercised. On June 1, 2011, when the option is exercised, the fair market value of the stock is $120 per share so that P pays $108 for the share of the stock. Compensation in the amount of $10 is includible in P’s gross income for the year 2013, the year of the disposition of the share. This is determined in the following manner: the excess of the fair market value of the stock at the time of the disposition ($150) over the price paid for the share ($108) is $42; and the excess of the fair market value of the stock at the time the option was granted ($100) over the option price, computed as if the option had been exercised at such time ($90), is $10. Accordingly, $10, the lesser, is includible in gross income. In this situation, P’s cost basis of $108 is increased by $10, the amount includible in P’s gross income as compensation. Thus, P’s basis for the share is $118. Because the share was sold for $150, P realizes a gain of $32 that is treated as long-term capital gain.

Example 4. Assume the same facts as in Example 1, except that the option provides that the option price shall be the lesser of 95 percent of the fair market value of the stock on the first day of the offering period and 95 percent of the fair market value of the stock on the day the option is exercised. On June 1, 2011, when the option is exercised, the fair market value of the stock is $120 per share. P pays $95 for the share of the stock. Compensation in the amount of $5 is includible in P’s gross income for the year 2013, the year of the disposition of the share. This is determined in the following manner: the excess of the fair market value of the stock at the time of the disposition ($150) over the price paid for the share ($95) is $55; and the excess of the fair market value of the stock at the time the option was granted ($100) over the option price, computed as if the option had been exercised at such time ($95), is $5. Accordingly, $5, the lesser, is includible in gross income. In this situation, P’s cost basis of $95 is increased by $5, the amount includible in P’s gross income as compensation. Thus, P’s basis for the share is $100. Because the share was sold for $150, P realizes a gain of $50 that is treated as long-term capital gain.

Example 5. Assume the same facts as in Example 1, except that instead of selling the share on January 1, 2013, P makes a gift of the share on that day. In that case $15 is includible as compensation in P’s gross income for 2013. P’s cost basis of $85 is increased by $15, the amount includible in P’s gross income as compensation. Thus, P’s basis for the share is $100, which becomes the donee’s basis, as of the time of the gift, for determining gain or loss.

Example 6. Assume the same facts as in Example 2, except that instead of selling the share on January 1, 2014, P makes a gift of the share on that date. Because the fair market value of the share on that day ($75) is less than the option price ($85), no amount in respect of the disposition by way of gift is includible as compensation in P’s gross income for 2014. P’s basis for the share is $85, which becomes the donee’s basis, as of the time of the gift, for the purpose of determining gain. The donee’s basis for the purpose of determining loss, determined under section 1015(a), is $75 (fair market value of the share at the date of gift).

Example 7. Assume the same facts as in Example 1, except that after acquiring the share of stock on June 1, 2011, P dies on August 1, 2012, at which time the share has a fair market value of $150. Compensation in the amount of $15 is includible in P’s gross income for the taxable year closing with P’s death, $15 being the difference between the option price ($85) and the fair market value of the share when the option was granted ($100), because such value is less than the fair market value at date of death ($150). The basis of the share in the hands of P’s estate is determined under section 1014 without regard to the $15 includible in the decedent’s gross income.

Example 8. Assume the same facts as in Example 7, except that P dies on August 1, 2011, at which time the share has a fair market value of $150. Although P’s death occurred within six months after the transfer of the share to P, the income tax consequences are the same as in Example 7.

Example 9. Assume the same facts as in Example 1, except that the share of stock was issued in the names of P and P’s spouse jointly with right of survivorship, and that P and P’s spouse sold the share on June 15, 2012, for $150, its fair market value on that date. Compensation in the amount of $15 is includible in P’s gross income for the year 2012, the year of the disposition of the share. The basis of the share in the hands of P and P’s spouse for the purpose of determining gain or loss on the sale is $100, that is, the cost of $85 increased by the amount of $15 includible as compensation in P’s gross income. The gain of $50 on the sale is treated as long-term capital gain, and is divided equally between P and P’s spouse.

Example 10. Assume the same facts as in Example 1, except that the share of stock was issued in the names of P and P’s spouse jointly with right of survivorship, and that P predeceased P’s spouse on August 1, 2012, at which time the share had a fair market value of $150. Compensation in the amount of $15 is includible in P’s gross income for the taxable year closing with his death. See Example 7. The basis of the share in the hands of P’s spouse as survivor is determined under section 1014 without regard to the $15 includible in the decedent’s gross income.

Example 11. Assume the same facts as in Example 10, except that P’s spouse predeceased P on July 1, 2012. Section 423(c) does not apply in respect of the death of P’s spouse. Upon the subsequent death of P on August 1, 2012, the income tax consequences in respect of P’s taxable year closing with the date of P’s death, and in respect of the basis of the share in the hands of P’s estate, are the same as in Example 7. If P had sold the share on July 15, 2012 (after the death of P’s spouse), for $150, its fair market value at that time, the income tax consequences would be the same as in Example 1.

(l) Effective/applicability date. Upon the date of publication of the Treasury decision adopting the rules of this section as a final regulation in the Federal Register, these rules will apply as of January 1, 2010.

Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.