In determining whether current earnings were accumulated for reasonable business purposes, the examiner must make a determination on whether prior accumulations were, in fact, sufficient to meet the taxpayer’s then current and reasonably anticipated future needs. See 26 CFR 1.537-1(a).

In making this determination, it is necessary to examine the character of the corporation's assets, since earnings used for the expansion of business plant or equipment, inventories, or accounts receivable cannot be readily distributed to the stockholders no matter how large the corporation's earned surplus may be.

This issue requires a thorough analysis of the corporation's business and financial status for each year, including:

The term "reasonable needs of the business" includes the reasonably anticipated future needs of the business.

The following items, while not exclusive, may indicate that the earnings and profits are being accumulated for the reasonable needs of the business and should be used as guides:

Apart from the grounds specifically mentioned above, accumulations may be justified by a range of business needs. Among these are the following:

Accumulations have been justified as a result of various forms of contingencies including the following:

A corporation cannot be required to resort to the borrowing of funds under any circumstances. Therefore, the current operations of the business or planned expansion may be financed fully by retained earnings.

An accumulation to retire a corporate indebtedness has in most cases been determined to be a reasonable need of the business, depending upon the reason the debt was created in the first place.

The examiner should determine if the debt to be retired by the accumulation was bona fide and was incurred in connection with the trade or business.

Events subsequent to the end of the taxable year may not be used to show that retention of earnings and profits was unreasonable at the close of such taxable year if all the events indicated a reasonable accumulation at the close of the taxable year.

Examiners may consider subsequent events to determine the taxpayer actually intended to carry out or has actually carried out the plans for which the earnings and profits were accumulated.

The fact that the corporation did not, in fact, use the accumulated funds as originally planned does not necessarily mean that the accumulation was not reasonable when made.

If the earnings are not used to accomplish the purpose for which they were to be used, this may indicate that the earnings were not to be used for the indicated purpose in the first place and will make any future accumulations more difficult to justify.

Working capital is defined as current assets minus current liabilities. Working capital is the liquidity of a business that is used in its day-to day operations.

The working capital needs of a business are justification of accumulating earnings and profits.

Inasmuch as the need for working capital has long been recognized as the main reason for accumulating earnings and profits, the examiner should compute the Bardahl formula as modified by the Empire Steel Casting, Inc. v. Commissioner, T.C. Memo. 1974-34, decision, on a preliminary basis by using the figures shown on the return to calculate reasonable working capital needs. If the taxpayer's net working capital exceeds the calculated reasonable working needs, then further analysis should be made following the procedures set forth in Exhibit 4.10.13-1. See also the Virtual Library in the Corporate/Business Issues & Credits Knowledge Base which contains an overview of accumulated earnings tax with links to published guidance and a Bardahl Formula worksheet job aid.

In an expanding business, the examiner should obtain the necessary financial information to compute the corporation's working capital needs in the years immediately preceding the year or years under examination and the years immediately succeeding the year or years under exam.

For seasonal business, the Bardahl International formula is considered more appropriate for peak inventory and receivable months. For service business, the formulas should be modified to consider the average length of time required to perform on a contract rather than use the operating inventory turnover concept. The Apollo formula (stemming from a court case: Apollo Industries v C.I.R, 358 F 2nd 867 (1966)) may have application to non-manufacturing businesses. See Exhibit 4.10.13-2.

As noted above, the Bardahl formula is "one test" and is not necessarily applicable to every IRC 531 case. Examiners who are considering IRC 531 should analyze each case with respect to specific facts before determining the type of operating cycle approach most appropriate.

The latest criteria relied on in current court decisions should be considered.

In an attempt to collect a tax liability, the Collection function may refer transferee cases to the Examination function for assistance.

Collection prepares Form 3031, Report of Investigation of Transferee Liability, to recommend a transferee assessment. The Advisory Section reviews the report to ensure that pertinent factual data and adequate evidence are obtained to sustain assertion of the transferee liability. Once approved, the original report is forwarded to Planning and Special Procedures (PSP) to establish the transferee case on AIMS non-master file and to forward the case to an Examination group. See IRM 5.1.14.2.1, Report of Investigation of Transferee Liability, which describes the preparation and presentation of the report and IRM 4.1.1.6.11.2, Collection Referrals-Form 3031, Report of Investigation of Transferee Liability, which discusses the PSP review.

Examiners are required to consider collectibility in every examination. IRM 4.20.1, Examination Collectibility Procedures, provides instructions and guidance to examiners for considering collectibility during the examination process and for soliciting payment at the conclusion of the examination.

As such, they must be able to identify situations in which the taxpayer has intentionally or inadvertently placed assets out of the legal reach of the IRS. Additionally, they must be able to identify situations in which asset transfers may not be conducted in a normal "business manner" because of the close relationship of the parties involved.

If the taxpayer gives an indication of insolvency, the examiner should try to learn about the disposition of the taxpayer's assets and/or the transferee's legal responsibility for payment of the transferor's tax liability. The examiner must consider whether the elements of a transferee examination, as described below, have been met.

A transferee case will be initiated once the examiner determines:

Examiners are responsible for the identification and development of potential transferee cases that arise during their examinations. For identification purposes the examiners should fill out Form 2045 Transferee Agreement. Examiners should not assume that Collection will develop a transferee case after the transferor's examination is concluded. By the time a case is routed to a Revenue Officer (RO) for collection, the transferee statute of limitations may prevent adequate consideration.

Transferee liability in equity is the most common form of transferee liability and is based on equity or fairness principles. A Transferee in equity is a person or entity who receives the transferor's assets for less than adequate consideration, leaving the transferor insolvent and unable to pay the tax liability. Transferee in equity cases are predicated on state or federal fraudulent conveyance statutes. See IRM 4.11.52.2.2, Transferee in Equity, and Hagaman v. Commissioner, 100 T.C. 180 (1993) which indicates the specific state statutes must be consulted to determine liability in equity for each particular case.

The liability of a transferee in equity is generally limited to the value of the property transferred. However, where transferee liability is based on state law, state law determines the extent of the liability, which may also include penalties or interest. Commissioner v. Stern, 37 U.S. 39, 44-45 (1940).

The Government must prove the value of the assets transferred. Where the assets transferred are subject to existing liabilities or assumed by the transferee, the value of the property received may be reduced by the associated liability in determining the limit of transferee liability.

It should be noted that the mere fact that the transferee uses assets which he receives to pay debts of the transferor will not relieve him of transferee liability. The transferee must also show that the debts paid had priority over the tax liability. A transferee does not cease to be a transferee merely by selling the transferred property. Additionally, the price at which the transferee sells the property is not an accurate measure of the transferee liability. Rather, the liability is measured by the value of the property that was transferred on the date of transfer.

Even though a taxpayer admits that the taxpayer is a transferee of assets of a dissolved corporation, unless he admits the extent of this liability, the Government must still prove the value of the assets so received in order that a court can determine the amount due from him.

Although specific elements will vary depending on the substantive law relied upon, the IRS generally must prove numerous things as delineated below.

Generally, the IRS must prove the transfer of assets from the transferor to the transferee for less than adequate consideration. In this regard, the Government must establish by evidence the value of the assets transferred in order to show that the transfer was for less than full and adequate consideration. Documentation must show:

Generally, the IRS must prove a transfer of assets from the transferor to the transferee for less than adequate consideration. In this regard, the Government must establish by evidence the value of the assets transferred in order to show that the transfer was for less than full and adequate consideration. Documentation must show:

Generally, the IRS must prove the transfer of assets must have been made after the liability for taxes accrued. Transferee liability was developed based on the principle that debtors may not transfer assets for less than adequate consideration if they are left unable to pay their liabilities. The chance to satisfy the debt out of the asset(s) transferred never existed where the transfer was made prior to the time the tax liability accrued. Therefore, no transferee liability can ordinarily arise when the transfer is made before the period in which the tax liability is created. However, the tax liability need not have been asserted prior to the transfer. In this connection, the tax liability need only accrue. The examiner should consult with Technical Services and/or Area Counsel in unusual circumstances. Documentation must show:

Generally, the IRS must prove the transferor is liable for the tax at the time of the transfer, or the transfer occurred in the year of liability, and the transferor remains liable for the tax. It would appear to be self-evident that unless the transferor is liable for the tax, there could be no liability asserted against the transferee.IRC 6902(a) states, in part, that the Government does not have the burden of proof in Tax Court proceedings to show that the transferor was liable for the tax. There is a presumption of correctness in the Commissioner's determination, and unless the transferee offers evidence as to the transferor's tax liability, the amount established by the Commissioner will be sustained. If the transferee contends that the transferor owes no tax, the burden of proving this rests on the transferee. If there has previously been a decision on the merits, the transferee is collaterally estopped from raising the issue of the transferor's tax liability. Under IRC 6902(a), however, the Government does have the burden in the Tax Court of showing that the petitioner is liable as a transferee of property of a taxpayer. Documentation must show the tax liability (i.e., transcript of account, Revenue Agent's Report (RAR), Notice of Deficiency, etc.).

Generally, the IRS must prove all reasonable efforts have been made to collect the tax liability from the transferor-taxpayer. Courts generally consider a transferee’s liability to be secondary to the primary liability of the transferor. Secondary liability means the transferee derives its liability from the transferor’s liability based on the receipt of property under circumstances that subject the transferee to the liabilities of the transferor. Before pursuing a transferee, the IRS must generally exhaust all legal remedies it may have against the transferor for collection of the tax. The general rule is that the IRS must show that all reasonable collection remedies against the transferor have been exhausted and that further collection efforts would be futile. See Gumm v. Commissioner, 93 T.C. 475, 480 (1989). The extent to which the IRS must proceed against the transferor depends on the facts and circumstances. For example, the IRS need not pursue a corporate taxpayer that has been stripped of its assets or a trust that has distributed its property to a beneficiary and terminated. Documentation should show that the transferor is in bankruptcy, has dissolved, or has distributed all of the assets and collection is not possible or that collection was pursued but could not be secured. A TXMOD will show the action taken by the Collection function.

Generally, the IRS must prove the transferor was insolvent when the transfer was made or the transfer of assets left the transferor insolvent.

See IRM 4.11.52.2.1, Transferee At Law, IRM 5.17.14, Legal Reference Guide for Revenue Officers, Fraudulent Transfers and Transferee and Other Third-Party Liability, and particularly IRM 5.17.14.3.3.1, Transferee Liability Directly imposed on the Transferee (At Law).

In determining the extent of the transferee's liability at law, the value of the assets received by the transferee is generally immaterial since the extent of such liability is determined by reference to the amount of tax liability of the transferor that the transferee has agreed to pay (determined by contract or statute). Some state statutes, however, may also limit liability to the value of assets received.

Documentation required for transferees at law must show:

Transactions such as statutory mergers are not transferee situations in the typical sense, but may result in liability for the successor corporation. See IRM 4.10.13.3.2.1 (6) and IRM 5.17.14.2.3.

If the period of limitations for assessment against a transferee has expired, action against the transferee under the trust fund doctrine for the collection of the unpaid tax assessed against the transferor should be considered.

The trust fund doctrine is most commonly used to impose transferee liability on a shareholder for taxes incurred by a corporation when the shareholder receives assets from a corporation. See Starnes v. Commissioner, 680 F. 3d 417 (4th Cir. 2012) and Benoit v. Commissioner, 238 F. 2d 485, 491 (1st Cir. 1956). Recovery under the doctrine is limited to the value of the property transferred. Many states have also enacted statutes to permit creditors of a corporation to sue shareholders. See IRM 5.17.14.3.3.3 Trust Fund Doctrine.

If timely assessments have been made against the transferor and the period for instituting a suit for collection provided in IRC 6502(a) has not expired, but the time for transferee proceeding has expired, the case, accompanied by a report containing facts in support of the transferee's liability, should be forwarded to Area Counsel through Technical Services.

In attempting to collect the transferor's tax liability through a transferee case, the transferor's tax liability should always be assessed or a statutory Notice of Deficiency issued prior to the expiration of the transferor's statute of limitations unless one of the exceptions below has been met:

If a liability in tax is determined in the case of the transferor and the statute of limitations has expired, the deficiency should be asserted against the transferee(s) within the period of limitations applicable to him or her.

Although it may appear unlikely that the IRS will be able to collect from the transferor, the Tax Court indicates that the IRS should attempt to exhaust its reasonable collection efforts before attempting to collect from a transferee, or otherwise show that collection from the transferor would be futile. Issuing a notice to the transferor helps establish this effort.

Transferee situations are common with dissolved corporations. If the corporation has been dissolved, there may be no assets against which to collect any proposed assessments. In that event, it may be necessary to utilize transferee liability provisions of IRC 6901 to collect the corporate liability. A transferee case will be developed concurrently with the corporate examination if the elements needed to establish a transferee case are present. Otherwise, the examiner may consider limiting the scope of the examination. See IRM 5.17.14, Legal Reference Guide for Revenue Officer - Fraudulent Transfers and Transferee and Other Third-Party Liability for additional information.

Federal law, not state law, sets the statute of limitations on assessment and collection of federal taxes for transferee liability cases, unless Congress provides otherwise. State corporate dissolution law does not shorten the assessment limitations period provided by IRC 6501. State law may, however, adversely affect the capacity of a dissolved corporation or its last board of directors to represent the dissolved corporation or to act on its behalf. This will affect the corporation's ability to extend the statute of limitations, to agree to tax liabilities or to litigate corporate liabilities.

State corporate dissolution law governs how a corporation may dissolve. The state law may provide a specific time period for a dissolved corporation to wind up its affairs. Some states have a specific period in which to wind up affairs, while others do not. Only the individuals named in the applicable state law are authorized to act for the dissolved corporation and only during the winding up period. Such appointment may divest others (the officers prior to dissolution) of authority to act on behalf of the corporation. A consent must be executed by the authorized officer of a dissolved corporation on or before the last date of the winding up period in order to be valid and to hold the period of limitations open after the end of the winding up period.

Caution should be exercised in obtaining waivers of restriction on assessment and extensions of the statutes of limitations in dissolved corporation and transferee cases. Examiners should not rely on any such agreements without the approval of Area Counsel.

The state law which governs the corporate dissolution is the law of the state in which the corporation was incorporated.

Examiners should consult the applicable state corporate dissolution law and identify which individuals (corporate officers, board of directors, etc.) are legally authorized to act for the dissolved corporate entity. Area Counsel may be contacted to request an opinion on whom is authorized to act for the corporation.

The examiner will also ensure that the individuals authorized to represent the dissolved corporation have been appointed to these duties by the corporation. Documentation will be obtained to satisfy this requirement and will be attached to any consent or waiver that the authorized individuals sign. A provision should be added below the signatures of the appointed individuals stating their title

The corporation and its authorized officers/directors may perform the following acts up to the end of the winding up period:

Precautions that should be taken in obtaining waivers of restriction on assessment and extensions of the statute of limitation in transferee and dissolved corporation cases.

Some state corporate dissolution law provides that the dissolution of a corporation may be revoked within stated periods. If this occurs, this may affect the authority of the corporation or its directors. Examiners should always inquire if a revocation of dissolution has occurred.

IRC 6901 is only applicable to income, estate, and gift taxes. Transferee liability procedures are not available to employment, excise, and other types of taxes in the Code unless they are involved in the liquidation of a corporation, partnership, or upon the reorganization of a corporation pursuant to IRC 368(a). See also 26 CFR 1.507-1(b)(8) regarding transferee liability for chapter 42 excise taxes in the case of reorganizations and transfers between private foundations described in IRC 507(b)(2). A liquidation is deemed to have occurred if the business entity has ceased to do business and the assets of the entity have been distributed to the owners.

Many state corporate merger and consolidation statutes provide that when a corporation is dissolved, the successor corporation is not a transferee. In states with such laws, the new or surviving corporation assumes primary liability for the debts of the merged or consolidated corporation. Action to assess the primary liability against the new/surviving corporation should be taken within the statutory period of limitations for assessment against the merged or consolidated corporation. If the period of limitations needs to be extended in order to make this assessment, Form 872 or Form 872-A must be executed by the new/surviving corporation before the expiration of the period of limitations for assessment against the merged or consolidated corporation. The corporate name on Form 872 or Form 872-A will be completed and signed as: "B Corporation, Inc., Successor in interest to A, Inc."

The examiner should ensure that the successor corporation is solely responsible for the liabilities of the dissolved entity. Many merger and consolidation agreements allocate some or all of the liabilities to other parties, including the sellers, with respect to the dissolved entity. Documents verifying the terms of sale should be scrutinized where possible to resolve any discrepancies.

If the transferee case was received from Collection, the examiner will determine whether all of the elements required in a transferee case have been documented by the Revenue Officer (RO) on Form 3031 Report of Investigation of Transferee Liability. If the elements required, as outlined earlier, have not been documented, the examiner will contact the transferee (and if needed, the transferor), to interview and obtain additional documentation to support the elements required in the transferee case.

If a transferee case is initiated during the examination of a transferor, the examiner will develop the elements required in a transferee case and obtain documentation to support each of the elements. The transferee will be advised that they are under examination as a transferee. An interview with the transferee will need to be scheduled and conducted in order to develop all elements and to obtain supporting documentation.

The examiner will charge time to activity code (AC) 812 - detail to the Collection function.

When all of the elements have been fully developed and documented, the examiner will prepare the applicable waivers, solicit an agreement and payment from the transferees, and hold a closing conference.

Form 870-T, Waiver of Restrictions on Assessment and Collection of Transferee or Fiduciary Liability and Acceptance of Overassessment (for income tax cases), or Form 2504, Agreement to Assessment and Collection of Additional Tax and Acceptance of Overassessment (Employment Tax Adjustments Not Subject to IRC 7436), modified with special language, should be used to solicit an agreement from the transferee for the amount of the transferor's tax, penalties, and interest. The waiver will be completed as follows:

Form 2045, Transferee Agreement, will be solicited. By signing this form, the transferee admits liability as a transferee of assets received from the transferor, and assumes and agrees to pay the tax liability of the transferor. The government is then relieved of the burden of proof regarding the transferee liability. To protect the government's interest solicit Form 2045 from each transferee. Form 2045 may be obtained from only one transferee provided that the assets received by the transferee are sufficient in amount to cover the total transferor's liability. If the transferee is a corporation, a copy of the minutes of the board of directors authorizing an officer to enter into this agreement should be attached to this form.

Each transferee should be a separate case file, as it is separate and distinct from the transferor examination. Whenever the transferee's name is written in the file, it should have the title "Transferee" after it to distinguish it from an income tax examination of the same entity.

Form 4665, Report Transmittal, should set forth all necessary facts of a confidential nature. This will include a clear statement of the present ability of the transferor and each transferee to pay, with names, addresses, amounts and nature of property held by each that may be subjected to use in payment of the tax.

Each transferee file will contain a transferee report, which is prepared in memorandum form. The memorandum will be very detailed if the case is unagreed. It will list the name, address, and Taxpayer Identification Number (TIN) of the transferee and the transferor. The memorandum will contain the following:

Documentation and workpapers will be attached to the memorandum. If it is voluminous, the workpapers and documentation will be attached to a Form 4318-A, Continuation Sheet for Form 4318, Examination Workpapers Index, which will be used to index the workpapers.

A Form 5344, Examination Closing Record, will not be completed for the transferee case file.

In cases in which the transferor is a corporation, the examiner will include the following information in the transferee report:

In cases in which the transferor is deceased, the examiner will include the following information in the transferee report:

If the transferee case is unagreed, the examiner will prepare the 30-day letter using Letter 955, 30 Day Letter - Straight Deficiencies of Both Deficiencies and Overpayments, modified as necessary.

Special language will be inserted as the opening paragraph to Letter 955, depending on the circumstances of the case. See IRM 4.10.13.3.6

If the transferee case is agreed, the case will be forwarded to Technical Services for special handling. Technical Services will prepare Form 1296, Assessment Against Transferee or Fiduciary, see IRM 4.8.8, Technical Services, Miscellaneous Responsibilities.

Technical Services will fax Form 1296 with agreement forms (Form 870-T, Form 2504) or Form 906, Closing Agreement On Final Determination Covering Specific Matters, and Form 3198 to Centralized Case Processing (CCP). The case will not be updated to CCP. Technical Services will also complete Form 10904, Request for Record Deletion from AIMS/ERCS, using disposal code 28 and include the form inside the case file. Technical Services will then forward the case file to their Planning and Special Programs (PSP), Audit information Management System (AIMS)/Examination Return Control System (ERCS) Analyst for deletion of the AIMS record.

If the transferee examination is within six months of the statute expiration date or if the transferee failed to file a valid protest to the 30-day letter (Letter 955), the transferee case will be forwarded to Technical Services for issuance of a Notice of Transferee Liability.

If the fair market value of the property transferred is less than the amount of the transferor’s unpaid tax liability, the transferee may if state law so allows, be liable for interest on the use of the property from the date the transferee receives the assets until the notice of transferee liability is issued, but the transferee is not liable for IRC 6601 interest or penalties on the tax itself. Interest under state law does not extend beyond the date of the notice of liability.

When closing a transferee case in which the assets transferred are less than the transferor's liability, Form 3198 should be annotated: "Transferee Case - Limited Liability" .

When Letter 950 is sent to transferees, the following opening pattern paragraphs will be used in straight deficiency cases (if employment tax is involved, the words "income tax" will be changed to "employment tax" and "years" will be changed to "periods" ).

When Letter 955 is sent to a fiduciary regarding his/her liability under IRC 6901 and Title 31 of the United States Code, Section 3713, because the fiduciary paid debts or distributed assets without first satisfying the tax due to the United States from the estate, one of the following opening paragraphs will be used:

In mixed deficiency and overassessment cases involving transferee or fiduciary liability, the opening paragraphs inserted in Letter 955 will be suitable revisions of pattern paragraphs P-30 to P-35 as shown above.

If the value of the assets received by a transferee is less than the unpaid tax liability of the transferor, the opening paragraphs P-30 to P-32 will be used, but modified by the following phrase:

The opening paragraph of the notice of transferee liability is dependent upon the circumstances of the case. The language for the various opening paragraphs is contained in IRM 4.8.9.17.5.2, Transferee Letter Opening Paragraphs.

The attachment to the letter is an explanation to the transferee as to where the proposed assessment originated. The attachment to the letter is divided into two parts:

The attachment to the letter will be prepared in the format, with the language, shown in IRM 4.8.9, Statutory Notices of Deficiency.

IRC 482 may apply to intercompany loans or advances. 26 CFR 1.482-2(a) states as follows: ""Where one member of a group of controlled entities makes a loan or advance directly or indirectly to, or otherwise becomes a creditor of, another member of such group and either charges no interest, or charges interest at a rate which is not equal to an arm's length rate of interest (as defined in paragraph (a)(2) of this section) with respect to such loan or advance, the district" (now Area Director) may make appropriate allocations to reflect an arm's length rate of interest for the use of such loan or advance."

The arm’s length rate of interest provisions under IRC 482 only applies to bona fide indebtedness between members of a controlled group of entities. Examples of such indebtedness include: (1) loans or advances of money or other consideration (whether or not evidenced by a written instrument); and (2) indebtedness arising in the ordinary course of business from sales, leases, or rendition of services by or between members of the group or any other similar extension of credit. 26 CFR 1.482-2(a)(1)(ii)(A). IRC 482 does not apply to indebtedness that is not bona fide such as contributions to capital or leases of property. 26 CFR 1.482-2(a)(1)(ii)(B).

Is an arm's length interest rate charged? An arm’s length rate of interest is the rate of interest that was charged, or would have been charged, at the time the indebtedness arose in independent transactions with or between unrelated parties under similar circumstances. To determine whether an interest rate is arm’s length, consider all relevant factors including the principal amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties. 26 CFR 1.482-2(a)(2)(i).

26 CFR 1.482-2(a)(2)(iii) provides safe harbor interest rates for intercompany loans and advances made after May 8, 1986. The rate of interest actually charged is considered arm’s length if it is between 100 percent and 130 percent of the applicable federal rate (AFR). See(26 CFR 1.482-2(a)(1)(iii)(B)(1)). If no interest is charged or if the interest charged is less than 100 percent of the AFR, then 100 percent of the AFR (compounded semi-annually) will be considered an arm’s length rate (26 CFR 1.482-2(a)(1)(iii)(B)(2)) . If the interest rate charged is higher than 130 percent of the AFR, then 130 percent of the AFR (compounded semi-annually) will be considered an arm’s length rate unless the taxpayer establishes a more appropriate rate of interest (26 CFR 1.482-2(a)(1)(iii)(B)(3)). Two exceptions to these safe harbor interest rate rules exist. First, the safe harbor rules do not apply if the lender is regularly engaged in the business of making loans to unrelated parties (26 CFR 1.482-2(a)(2)(iii)(D)). Second, the safe harbor rules do not apply to loans or advances when their principal or interest is expressed in a currency other than U.S. dollars (26 CFR 1.482-2(a)(2)(iii)(E)).

There are certain coordination rules with respect to interest adjustments required under certain other IRC provisions (26 CFR 1.482-2(a)(3)). For example, if IRC 7872 could apply in addition to IRC 482, then IRC 7872 should be used as the primary position. If there is a dispute over whether IRC 7872 applies, or if it is unclear whether it applies, then IRC 482 should be raised as an alternative position (Prop. Reg. 1.7872-2(a)(2)(iii)).

When considering loans between two related entities, the IRS is not necessarily bound to the position of “imputing” interest income under IRC 482. Under certain circumstances, the IRS may use IRC 482 to reallocate interest expense claimed by one entity to its affiliate. In Kahler Corp. v. Commissioner, 486 F.2d 1 (8th Cir. 1973), rev’d, 58 TC 496 (1972), the common parent of an affiliated group borrowed funds from third party lenders. Subsequently, the parent reloaned some of its borrowed funds to two of its subsidiaries. The loans from the parent to the subsidiaries were made on an interest-free basis. The affiliated group did not file a consolidated return. The parent was in a higher tax bracket than its subsidiaries, and thus, received a significant benefit from the interest expense deduction that it claimed. On the other hand, both of the subsidiaries were in much lower-tax brackets and would not have derived as much of a tax benefit from the interest deductions. The IRS imputed interest income to the parent and increased the interest expense deductions of the subsidiaries. The Court held that the IRS’s allocation was necessary under IRC 482 to clearly reflect the income of the parent and the subsidiaries.

Similarly, in Latham Park Manor, Inc v. Commissioner, 69 TC 199, 220-221 (1977), in his concurrence, Judge Scott stated:

The Treasury Department issued regulations covering service transactions between controlled entities in 1968. T.D. 6952, 1968-1 C.B. 218; 26 CFR 1.482-2(b) (1968). The 1968 controlled services regulations were partly amended in 1994 by T.D. 8552, 1994-2 C.B. 93, but remained relatively unchanged until 2006 when the IRS adopted new temporary regulations that covered controlled service transactions. T.D. 9278, 2006-2 C.B. 256; Temp. 26 CFR 1.482-9T (August 4, 2006); issued in final form in T.D. 9456, 2009-33 I.R.B. 188; 26 CFR 1.482-9 (August 4, 2009).

Prior to its amendment by 26 CFR 1.482-9T, 26 CFR 1.482-2(b) (referred to hereafter as “Former 26 CFR 1.482-2(b)”) required that where one member of a group of controlled entities performs marketing, managerial, administrative, technical, or other services for the benefit of, or on behalf of another member of the group at a charge that is not an arm’s length charge, the IRS may make allocations to reflect and arm’s length charge for the services.

Former 26 CFR 1.482-2(b)(2)(i). authorized the IRS to make allocations to reflect arm’s length charges for services undertaken for the joint benefit of the members of a controlled group, or services performed exclusively for the benefit of one member the controlled group. However, if the benefits to the other members were so indirect or remote that unrelated parties would not have charged for the services, the IRS was not authorized to make a section 482 allocation regarding those services.

In determining the amount of the arm’s length charge, Former 26 CFR 1.482-2(b)(3) provided that if services are not an “integral part” of the business activity of either the member rendering the services or the member receiving the benefit of the services, then the arm’s length charge shall be equal to costs of the service, unless the taxpayer establishes a more appropriate charge. However, if the services are an “integral part” of the business activity of either the member rendering the service or the member receiving the benefit of the service, then the arm’s length charge is the amount that would have been charged for the same or similar services in independent transactions between unrelated parties under similar circumstances. Former 26 CFR 1.482-2(b)(7) provided four separate tests for determining whether a particular service was considered to be an “integral part” of an entity’s business. If any of the four tests were satisfied, then the services at issue were considered to be an “integral part” of the business activity, and an arm’s length charge was not deemed equal to the costs or deductions of those services but instead required a determination of the actual amount that would have been charged between unrelated parties under similar circumstances for those services.

Some cases applying Former 26 CFR 1.482-2(b) to controlled service transactions are set forth below. This is not an exhaustive list of cases covering this area.

In Haag v. Commissioner, 88 TC 604, 622 (1987), the United States Tax Court held that IRC 482 may be used to allocate income from a professional service corporation to a shareholder/employee. In Haag, a physician assigned his interest in a medical partnership to his professional corporation. Although the doctor provided medical services to the corporation, he received either no salary or minimal salary for the years at issue. The court stated that “Petitioner would not have agreed to work for no compensation if he had bargained at arm's length with an uncontrolled entity” and upheld the government’s IRC 482 adjustment, which was “the difference between the amount of compensation petitioner would have received in each year absent of incorporation and the amount he actually received.”

In Keller v. Commissioner, 77 T.C. 1014 (1981), in determining the applicability of IRC 482 to a pathologist's compensation, his total compensation (salary, pension plan contributions, and medical benefits) was compared to what the petitioner would have bargained for in an arm's-length transaction with an unrelated party.

Due to employment tax considerations, it appears when inadequate compensation is paid to a shareholder/employee, consideration should be given to whether loans to the shareholder should be recharacterized as compensation instead of treating them as dividend distributions.

In Haber v. Commissioner, 52 T.C. 255 (1969), an S corporation made loans to one of its shareholder/employees over several years but reduced the shareholder/employee's salary by the amount of the loans. The loans were recharacterized as compensation for services.

Although raising an IRC 482 issue on compensation from an S corporation will usually have a wash effect on income tax, it should be considered when the shareholder otherwise has no earnings subject to FICA tax.

In Bell v. Commissioner, T.C. Memo 1982-660, three physicians formed a C corporation and a separate S corporation. The S corporation earned income from providing X-ray services to the C corporation. IRC 482 was used to allocate income from the S corporation to the C corporation. The income allocated was then treated as dividend distributions from the C corporation to its shareholders.

If an existing business is transferred to multiple corporations, the examiner, in addition to considering IRC 482, should consider the applicability of IRC 269 and IRC 1551.

In Rubin v. Commissioner, 460 F.2d 1216 (2d Cir. 1972), payments by Corporation A to Corporation B were allocated under IRC 482 to the shareholder of Corporation B who had performed the management services for Corporation A. The taxpayer's services constituted a trade or business separate from his interest in Corporation B and were subject to IRC 482.

In Ach v. Commissioner, 42 T.C. 114 (1964), the taxpayer sold her successful dress shop to her son's insolvent corporation for less than adequate consideration. Although the taxpayer continued to provide significant managerial services to the business, she was not remunerated for her services. The court upheld the IRS's use of IRC 482 to allocate 70% of the profits of the dress shop to the taxpayer. The court held the parties had not dealt at arm's length and the sole purpose for the transfer of the dress shop was for the corporation to utilize net operating losses it would have otherwise lost.

The Treasury Department issued proposed regulations in 2003 covering controlled service transactions. 68 Fed. Reg. 53448 (Sep. 10, 2003). In response to comments received on issues covered by the 2003 proposed regulations, the Treasury Department issued Temp. 26 CFR 1.482-9T. These temporary regulations were later clarified and the effective date modified by Notice 2007-5, 2007-1 C.B. 269. Rev. Proc. 2007-13, 2007-1 C.B. 295, also identified specified covered services within the meaning of Temp. 26 CFR 1.482-9T(b).

The 2006 temporary regulations generally apply for tax years beginning after December 31, 2006 through July 31, 2009. On July 31, 2009, the IRS adopted the final version of the Treasury Regulations covering controlled service transactions. The final 2009 services regulations generally apply to taxable years beginning after July 31, 2009; however, taxpayers may affirmatively elect to retroactively apply certain provisions of the 2009 services regulations to taxable years beginning after September 10, 2003. See 26 CFR 1.482-9(n).

26 CFR 1.482-9 provides methods to determine taxable income from a controlled services transaction. A controlled services transaction includes any activity by one member of a group of controlled taxpayers that results in a benefit to one or more other members of the controlled group. 26 CFR 1.482-9(l)(1). An activity includes: (1) the performance of functions; (2) assumptions of risks; (3) use by a renderer of tangible or intangible property or other resources, capabilities, or knowledge, such as knowledge of and ability to take advantage of particularly advantageous situations or circumstances; and (4) making available to the recipient any property or other resources of the renderer. 26 CFR 1.482-9(l)(2).

For an activity rendered by one member of a group of controlled taxpayers to be considered a controlled services transaction, the activity must result in a benefit to one or more other members of the controlled group. An activity is considered to provide a benefit to the recipient if the activity directly results in a reasonably identifiable increment of economic or commercial value that enhances the recipient’s commercial position, or that may reasonably be anticipated to do so. Further, an activity is generally considered to confer a benefit if an uncontrolled taxpayer in circumstances comparable to those of the recipient would be willing to pay an uncontrolled party to perform the same or similar activity. 26 CFR 1.482-9(l)(3)(i).

Rules on activities that may not confer a benefit.

The 2009 services regulations require that the amount charged in a controlled services transaction be determined under one of the following methods:

Each method must be applied in accordance with the best method rule of 26 CFR 1.482-1(c), the comparability analysis of 26 CFR 1.482-9(d), and the arm’s length range of 26 CFR 1.482-9(e). See 26 CFR 1.482-9(a).

A central part of Former 26 CFR 1.482-9(b) was that an arm’s length charge for services that were not “integral” were deemed equal to costs or deductions of rendering the services. 26 CFR 1.482-9 preserves aspects of this “deemed equal to the costs or deductions” treatment through the services cost method. The services cost method is designed to minimize compliance burdens for intragroup back-office services common across many industries. The services cost method as set forth in the 2009 services regulations may be applied if a taxpayer satisfies four conditions.

Under certain conditions, the 2009 services regulations also permit taxpayers to use shared service arrangements to allocate costs within a controlled group. 26 CFR 1.482-9(b)(7). A shared services arrangement must: (1) include two or more participants; (2) include as participants all controlled taxpayers that benefit from one or more covered services subject to the shared services agreement; and (3) be structured such that each covered service confers a benefit on at least one participant. 26 CFR 1.482-9(b)(7)(ii)(A). Examples illustrating the shared services arrangement rules are set forth in 26 CFR 1.482-9(b)(8).

The 2009 services regulations contain coordination rules for service transactions that contain elements of different types of transactions. For example, a transaction structured as a service transaction may also involve the transfer of tangible or intangible property. In evaluating whether to value these integrated transactions as a single transaction or whether to value each component separately, depends on which approach will provide the most reliable measure of an arm’s length result. 26 CFR 1.482-9(m).

Where possession, use, or occupancy of tangible property owned or leased by one member of a group of controlled entities is transferred by lease or other arrangement to another member of such group without charge or at a charge that is not equal to an arm’s length rental charge, the IRS may make appropriate allocations to properly reflect an arm’s length charge. 26 CFR 1.482-9(c)(1). Generally, an arm’s length charge equals the amount of rent that was charged, or would have been charged, for the use of the same or similar property, during the time it was in use, in independent transactions between unrelated parties under similar conditions. 26 CFR 1.482-9(c)(2).

If a taxpayer leases property from an unrelated party and then subleases the property to a related party, an arm’s length rental charge is equal to all the deductions claimed by the taxpayer for the period the property is used unless the taxpayer can establish a more appropriate arm’s length rental charge or the taxpayer or the related party subleasing the property were regularly engaged in the business of renting property of the same general type as the property in question to unrelated parties. 26 CFR 1.482-9(c)(2)(iii).

Some cases applying IRC 482 to the use of tangible property by lease are set forth below. This is not an exhaustive list of cases covering this area.

A shareholder's rental of a commercial building to her controlled corporation for a non-arm’s length rent is subject to IRC 482. See Peck v. Commissioner, T.C. Memo 1982-17; Fegan v. Commissioner, 71 T.C. 791 (1979); Thomas v. Commissioner, T.C. Memo. 1983-462.

This may be particularly abusive in situations where the corporation has a net operating loss. To the extent the shareholder has an allowable rental loss after applying IRC 482 and any other relevant provisions of the Code, IRC 469 should be considered to disallow any passive activity loss.

A partnership's rental of a building to a related corporation for a non-arm’s length rent is also subject to IRC 482. Boyer v. Commissioner, 58 T.C. 316 (1972).

The development of intangible assets may be funded by the use of a cost sharing arrangement if all legal requirements are satisfied. Generally, under a cost sharing arrangement, two or more cost sharing participants agree to jointly contribute to the costs of developing an intangible asset in proportion to their reasonably anticipated benefits.

Treasury Regulations issued in 1968 first governed cost sharing arrangements without providing detailed guidance. See 26 CFR 1.482-9(c)(1) (1968). However, during the early 1990s proposed and temporary Treasury Regulations were issued that provided more detailed guidance on cost sharing arrangements. Final Treasury Regulations covering cost sharing arrangements were issued in December of 1995 and then amended in May of 1996. See T.D. 8632, 1996-1 C.B. 85; T.D. 8670, 1996-1 C.B. 99. These regulations were amended again in 2003 to provide guidance on the treatment of stock-based compensation in cost sharing arrangements. See T.D. 9088, 2003-2 C.B. 841. The 1995 cost sharing regulations, as amended by T.D. 8670 and T.D. 9088, are currently designated as 26 CFR 1.482-7A. With the exception of 26 CFR 1.482-7A(a)(3), 26 CFR 1.482-7A(d)(2) , and 26 CFR 1.482-7A(j)(2)(i)(F) (addressing the requirement to share stock-based compensation costs), 26 CFR 1.482-7A applies to taxable years beginning after December 31, 1995 26 CFR 1.482-7A(a)(3), 26 CFR 1.482-7A(d)(2), and 26 CFR 1.482-7A(j)(2)(i)(F) apply for taxable years beginning after August 25, 2003) and remain applicable through January 4, 2009. Temporary Treasury Regulations were issued on January 5, 2009, which made significant changes to the prior 1995 cost sharing regulations. T.D. 9441, 2009-7 I.R.B. 460. The final cost sharing regulations were issued in December 2011 and are designated under 26 CFR 1.482-7. T.D. 9568, 2012-12 I.R.B. 499. The final cost sharing regulations are effective December 16, 2011.

Under 26 CFR 1.482-7A, “a cost sharing arrangement is an agreement under which the parties agree to share the costs of development of one or more intangibles in proportion to their shares of reasonably anticipated benefits from their individual exploitation of the interests in the intangibles assigned to them under the arrangement.” 26 CFR 1.482-7A(a)(1). Taxpayers may utilize cost sharing only for “qualified” cost sharing arrangements. To be “qualified,” a cost sharing arrangement must: (1) include two or more participants; (2) provide a method to calculate each controlled participant’s share of intangible development costs, based on factors that can reasonably be expected to reflect that participant’s share of anticipated benefits; (3) provide for adjustment to the controlled participants’ shares of intangible development costs to account for changes in economic conditions, the business operations, and practices of the participants, and the ongoing development of intangibles under the arrangement; and (4) be recorded in a document that is contemporaneous with the formation of the cost sharing arrangement.”

Participants in a cost sharing arrangement may be either controlled participants or uncontrolled participants. A controlled participant’s participation is only recognized if it: (1) reasonably anticipates that it will derive benefits from the use of covered intangibles; and (2) substantially complies with the accounting and administrative requirements of the cost sharing regulations. 26 CFR 1.482-7A(c)(1). The accounting requirements are that the controlled participants in a qualified cost sharing arrangement must use a consistent method of accounting to measure costs and benefits, and must translate foreign currencies on a consistent basis. 26 CFR 1.482-7A(i). The administrative requirements are that the controlled participant must maintain sufficient documentation as set forth in the cost sharing regulations and also must attach to its U.S. income tax return a statement indicating that it is a participant in a cost sharing arrangement, and listing the other controlled participants in the arrangement. 26 CFR 1.482-7A(j).

A qualified cost sharing arrangement must specify each participant’s share of the “intangible development costs.” 26 CFR 1.482-7A(b)(2). This share means all of the costs incurred by the participant relating to the intangible development area, plus all of the cost sharing payments it makes to other controlled and uncontrolled participants, minus all of the cost sharing payments it receives from other controlled and uncontrolled participants. 26 CFR 1.482-7A(d). Costs incurred related to the intangible development area include operating expenses, other than depreciation and amortization, and arm’s length charges for the use of tangible property that a participant makes available to the qualified cost sharing arrangement. Id.

Intangible development costs must be shared among the controlled participants in proportion to their shares of reasonably anticipated benefits. 26 CFR 1.482-7A(a)(1) and 26 CFR 1.482-7A(e). A controlled participant’s reasonably anticipated benefits are the aggregate benefits it reasonably anticipates that it will derive from the covered intangibles. 26 CFR 1.482-7A(e)(2). For that purpose, benefits are the additional income generated or costs saved by the use of the covered intangibles. 26 CFR 1.482-7A(e)(1). A controlled participant’s share of reasonably anticipated benefits is equal to its reasonably anticipated benefits divided by the reasonably anticipated benefits of all controlled participants. 26 CFR 1.482-7A(f)(3)(i).

Reasonably anticipated benefits must be determined using the most reliable estimate of reasonably anticipated benefits. In making that determination, the quality of the data and assumptions used in the analysis must be considered. 26 CFR 1.482-7A(f)(3)(i). Significant divergences between the projected and actual benefits may mean the projections are unreliable. 26 CFR 1.482-7A(f)(3)(iv)(B). Projections will not be considered unreliable based on a divergence between a controlled participant’s projected benefit share and actual benefit share if the amount of such divergence for every controlled participant is less than or equal to 20 percent of the participant’s projected benefit share. Id.

If a controlled participant makes pre-existing intangible property in which it owns an interest available to other controlled participants for purposes of the cost sharing arrangement, then each other controlled participant must make a buy-in payment to the owner of the pre-existing intangible property. 26 CFR 1.482-7A(g)(2).

Under the 2011 cost sharing regulations, a cost sharing arrangement in existence on January 5, 2009, and satisfying the legal requirements of the 1995 cost sharing regulations, will continue to be regarded as a cost sharing arrangement if certain conforming changes are made to the arrangement. 26 CFR 1.482-7(m). The cost sharing arrangement must have been amended by the parties to conform with 26 CFR 1.482-7(k) by July 6, 2009. In addition, taxpayers must have filed a cost sharing arrangement statement with the IRS no later than September 2, 2009. 26 CFR 1.482-7(m)(2)(viii). Cost sharing transactions and platform contributions taking place prior to January 5, 2009 are subject to the 26 CFR 1.482-7A. 26 CFR 1.482-7(m)(2)(i).

The 2011 cost sharing regulations were significantly changed from the 26 CFR 1.482-7. The 2011 cost sharing regulations are set out in 26 CFR 1.482-7. 26 CFR 1.482-7(g) provides methods to determine an arm’s length result for a platform contribution transaction, including the comparable uncontrolled transaction method, the income method, the acquisition price method, the market capitalization method, the residual profit split method, and unspecified methods. The 2011 cost sharing regulations also provide new rules on determining divisional interests (26 CFR 1.482-7(b)(4)) and reasonably anticipated benefits share (26 CFR 1.482-7(e)), along with many other provisions. Considering the complexity of the cost sharing regulations, consider contacting the Office of Associate Chief Counsel (International) and the Transfer Pricing Practice if you have questions regarding the examination of a taxpayer’s cost sharing arrangement.

The arm's length amount charged in a controlled transfer of intangible property must be determined under one of the four methods listed in 26 CFR 1.482-4:

Each of the methods must be applied in accordance with all of the provisions of 26 CFR 1.482-1, including:

The arm's length consideration for the transfer of an intangible determined under 26 CFR 1.482-4 must be commensurate with the income attributable to the intangible. See 26 CFR 1.482-4(f)(2) (Periodic adjustments).

Pursuant to 26 CFR 1.482-4(b), intangible property for purposes of IRC 482 is an asset that comprises any of the following items and has substantial value independent of the services of any individual:

Consideration for a transfer of intangible property shall be in the form of a royalty to the transferor where the transferor retains a substantial interest in the property and the transferee pays nominal or no consideration unless a different form is more appropriate. 26 CFR 1.482-4(f)(1)

The arm's length amount charged in a controlled transfer of tangible property must be determined under one of the six methods listed in 26 CFR 1.482-3(a). Each of the methods must be applied in accordance with all of the provisions of 26 CFR 1.482-1 including the best method rule of 26 CFR 1.482-1(c), the comparability analysis of 26 CFR 1.482-1(d), and the arm's length range of 26 CFR 1.482-1(e). 26 CFR 1.482-3(a), the transfer pricing methods are:

The value of tangible property may be affected by the value of intangible property associated with the tangible property’s transfer. Generally, the transfer of tangible property that has intangible property associated with the transfer will not be considered a transfer of intangible property if the purchaser does not acquire any rights to exploit the intangible property other than the rights relating to the resale of the tangible property under normal commercial practices. 26 CFR 1.482-3(f). In such a case, the embedded intangible must be accounted for in evaluating the comparability of the controlled transaction and uncontrolled transaction. If the transfer of tangible property conveys to the recipient a right to exploit an embedded intangible, then it may be necessary to determine the arm’s length consideration for the intangible property separately from the tangible property under the methods in 26 CFR 1.482-4

There are numerous cases involving the sale of goods between a controlled domestic corporation and a controlled foreign corporation. A referral to International Specialists is required in these cases.

In accordance with Rev. Rul. 69-630, 1969-2 C.B. 112, (as modified by Announcement 99-1, 1999-1 C.B. 302) in the cases of a bargain sale between two corporations owned by the same shareholder, the income of the seller will be increased to reflect the arm's-length price, and the basis of the property to the purchaser will be increased by a like amount. Additionally, the amount of the increase will be treated as a distribution by the selling corporation to the shareholder and as a capital contribution by the shareholder to the purchasing corporation, unless the transaction giving rise to the IRC 482 allocation did not have as one of its principal purposes the avoidance of income tax.

The sale of property by a shareholder to his controlled corporation is subject to IRC 482. Anderson v. Commissioner, T.C. Memo 1976-28. The sale of land by a partnership to its controlling corporate partner is also subject to IRC 482. Aladdin Industries v. Commissioner, T.C. Memo 1981-245.

In Dolese v. Commissioner, 82 T.C. 830 (1984), following a disproportionate distribution of property from their partnership, the partners contributed the land to a charitable organization. IRC 482 was applied to allocate the charitable contributions among the partners consistent with the percentage interests in the partnership.

Similarly, in Northwestern National Bank of Minneapolis, 556 F.2d 889 (8th Cir. 1977), the IRS successfully reallocated to a wholly-owned subsidiary a charitable deduction claimed by the parent consisting of assets acquired from the subsidiary by means of an upstream dividend. The subsidiary in this case acquired 10% of the stock of a company for a cost of $100,000. Over time the fair market value of the stock rose to $800,000. After consideration of various alternatives, the subsidiary declared a dividend to its 100% corporate parent of the stock. Within two weeks of receiving its dividend, the parent donated the stock to a charitable foundation. The taxpayer argued IRC 482 was inapplicable to a transaction that originated as a dividend distribution. In addressing this, the court stated (at 891-892):

IRC 482 controls when it conflicts with IRC 351 as long as the Commissioner does not abuse his discretion to reallocate income and expenses. Rooney v. United States, 305 F.2d 681 (9th Cir. 1962). In footnote 4, the court in Aladdin Industries v. Commissioner, T.C. Memo 1981-245, stated: "It has been routinely held, absent an abuse of discretion by the Commissioner, IRC 482 will override specific non-recognition provisions of the code. National Securities Corp. v. Commissioner, 137 F.2d 600 (3d Cir. 1943), cert. denied 320 U.S. 794 (1943); Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214 (2d Cir. 1952), cert. denied 344 U.S. 874 (1952)." These cases generally involve the transfer of an asset with built in gain or loss or the splitting of income from deductions to obtain an inappropriate or abusive tax benefit.

A statement will be made in the report to the primary taxpayer to the effect that:

The correlative allocation should not be made until the primary adjustment has been resolved. Pursuant to 26 CFR 1.482-1(g)(2)(iii), the primary adjustment may be resolved in one of the following ways:

To provide uniform treatment of all IRC 482 cases, agreed or unagreed, reports on the primary taxpayer and the correlative taxpayer should be prepared concurrently; kept together (not separate) and transmitted to the next function (i.e., Technical Services, Appeals Office, or campus processing center).

In cases with no tax effect of a correlative allocation (foreign entity, loss entity, etc.), the examiner should make a statement in the preliminary statement to the effect that the correlative allocation is deemed to have been made when and if the adjustments are agreed to and assessment has been made or deficiency has been paid. It is important that this statement included in all reports in order that the taxpayer to which the correlative allocations apply may not escape the effect of these adjustment in the event of a subsequent exam or carryback of losses or credits or other events that have a tax effect.

To ensure that overpayments resulting from the correlative allocations are not scheduled and refunded to the taxpayer, the examiner will note Form 3198 accordingly.

In order to have an agreed IRC 482 Allocation of income and deductions among taxpayers’ issue, all related parties must be in full agreement with the IRC 482 issue.

Obtain a signed agreement (Form 870 Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment.) or payment of the deficiency for the taxpayer to which the primary adjustment applies.

Make the correlative allocations and obtain agreements for the overassessment.

The taxpayers will be advised that their cases can be more expeditiously adjusted and closed if the taxpayer scheduled to receive refunds will voluntarily consent in writing to have the refunds applied against the proposed deficiencies.

The taxpayer's written statement can be incorporated in Form 870. The examiner's report in the overassessment cases must include a statement of whether consents as provided for in this paragraph have been furnished and, if not, the reason. The suggested format for the written statement is as follows: The undersigned taxpayer also consents and agrees to the application of so much of the overassessment as represents an overpayment, together with allowable interest thereon, as a credit to the deficiency in tax in the amount of ($amount), together with interest thereon, due from ________________ for the year ________. This is provided that the amount of the overpayment, if any, together with allowable interest, which is in excess of the said deficiency and interest, is otherwise credited or refunded in accordance with IRC 6402, or the corresponding provisions of prior revenue laws.

The examiner should refer to Rev. Proc. 99-32, in situations where the taxpayer requests permission to receive payment without further Federal income tax consequences from the taxpayer to which the correlative allocation applies.

The examiner will note Form 3198 Special Handling Notice for Examination Case Processing appropriately.

In unagreed IRC 482 cases where the correlative allocation is the only adjustment on the related entity, do not write a complete report for the correlative allocation. Submit the files on related entities with tax computation sheets in each case file. Prior to closing, the examiner will draft a letter inviting the related entities to file a claim.

In unagreed IRC 482 cases when there are other adjustments on the related entities do not make the correlative IRC 482 allocations, but explain fully the reason for not making the correlative allocation including any inconsistent positions. This explanation should be made in the taxpayer's portion of the Revenue Agent's Report (RAR).

In all unagreed IRC 482 issue cases, the taxpayer to which the correlative allocation applies should be advised of the period of limitations under IRC 6511 for filing a claim. If the period for filing a claim for refund expires in less than 180 days, the examiner should solicit a Form 843, Claim Refund and Request for Abatement, from the taxpayer. Such claims should be picked up and submitted with the case, if possible.

To ensure that overpayments resulting from the correlative allocations are not scheduled and refunded to the taxpayer, the examiner will appropriately note Form 3198.

When a return is examined in one office and an issue is the transfer of income or deduction to a related taxpayer under examination in another area office, the office making the initial examination will (except in cases arising out of partnership and/or fiduciary return or S corporations) immediately, upon identification of a potential IRC 482 adjustment advise the examiner of the issue(s) and amount involved.

Immediately upon conclusion of the examination, a notice should be issued to the outside office that will contain sufficient information to enable the receiving office to make the correlative allocation(s) to the related return(s). The initiating office examiner's case files will contain copies of the notification.

Upon receipt of notification, the receiving office will take prompt action to make adjustments for the transfer of income or deduction resulting from the initial examination. In the event the return has been examined and closed, reopening procedures will be considered.

If the corresponding return is not under examination, the examiner should secure the return and prepare the report.

Prepare the correlative taxpayer's report concurrently with the primary taxpayer's report. Solicit the agreement from the primary taxpayer, whose tax liability has been increased, prior to the agreement for the correlative taxpayer, whose tax liability has been reduced.

The primary taxpayer's report will include a statement that "a separate examination report reflects correlative Allocations to the taxable income of the correlative taxpayer(s)."

If agreements are secured from the primary and correlative taxpayers, note Form 3198 so that overassessments resulting from the correlative Allocations are not refunded to the taxpayer prematurely.

The correlative taxpayer(s) should be given the option of applying any overassessment against the deficiencies of the primary taxpayer as follows:

If the primary taxpayer whose report reflects a deficiency does not agree to the primary adjustment(s) and submits a protest to the 30-day letter, the correlative taxpayer(s) whose report(s) reflect an overassessment will remain associated.

Correlative allocation(s) that reduce the correlative taxpayer's tax liability will be advised of the nature of the adjustment(s), the reason the overpayment cannot be refunded at this time and the possible need to protect the statute of limitations from expiring.

Primary and correlative taxpayers will be forwarded together to Appeals for consideration.

Prior to sending the protested case to Appeals the following action must be taken:

If a statutory notice of deficiency is issued to the taxpayer whose tax liability is increased, due to the primary adjustments, and a timely petition is filed with the Tax Court, the Area will transfer the correlative taxpayer(s) cases (whose tax liability has been reduced) to Appeals to be associated with the case in which the petition has been filed with the Tax Court, if the procedures in item (4) of subsection IRM 4.10.13.5.2 , above, have been followed.

If a statutory notice of deficiency is to be issued to the taxpayer(s) with correlative allocation(s) that reduce the tax liability for other adjustments, do not include the correlative allocations in deficiency computation. The statutory notice of deficiency must contain an explanation of the correlative allocations so the taxpayer clearly understands the nature of the correlative allocation(s). If the correlative allocations completely offset the tax liability, you cannot issue a statutory notice because you have no deficiency.

The correlative allocation(s) that reduce the correlative taxpayer's tax liability will be held open until the additional tax for the primary taxpayer has been agreed.

The case(s) of the correlative taxpayer(s) whose adjustment(s) reduce tax liability will be held and placed in IRC 1254 suspense until the examination of the primary taxpayer whose tax liability was increased has been conducted. It will be held in suspense pending notice from the primary taxpayer's Area that the primary taxpayer's examination, whose tax liability was increased, has been concluded.

The following procedures must be completed before the correlative taxpayer's case can be placed in suspense, maintained, and controlled in the Area Office:

After the correlative taxpayer's Area has received notice from the primary Area on Form 5436, Examination Information Report and has contacted the taxpayer concerning the correlative allocations which result in a deficiency (instead of an overassessment), the correlative Area will notify the primary Area by letter of the correlative taxpayer's:

If the correlative Area also has control of the return of another correlative taxpayer whose correlative allocations produce an overassessment, the case will be associated with the related case containing a deficiency and the procedures in item (4) of subsection IRM 4.10.13.5.2.3 above will be followed.

When the primary Area receives notification that all correlative cases are agreed or have defaulted after issuance of the statutory notice of deficiency, then they will advise all correlative Areas to the process and close all related taxpayer cases consistent with the information that was previously sent to them.

If the primary Area receives notification that a related taxpayer has filed a petition with the Tax Court, the primary Area will advise all related Areas and will themselves suspense all correlative cases pending the final outcome of the taxpayer that filed a petition with the Tax Court. The instructions in subsection IRM 4.10.13.5.2.3 above will be followed in placing the case into suspense.

Once the case of the taxpayer that filed a petition with the Tax Court has been concluded, the Area will notify the primary Area of the resolution, which will in turn notify the correlative Areas.

If the deficiency of the correlative taxpayer becomes an overassessment:

Examiners should determine whether or not the activity is engaged in for profit from all available facts and circumstances without regard to the presumption under IRC 183(d) or the possible election under IRC 183(e). This determination should take into consideration the "relevant factors" listed in 26 CFR 1.183-2(b) as well as all other pertinent facts. See Exhibit 4.10.13-4 and Pub 5558, Activities Not Engaged in for Profit Internal Revenue Code Section 183 Audit Technique Guide, for more guidance.

The IRC 162 position (i.e., substantiation, personal use, etc.) must be developed before the case can be forwarded to Appeals or placed in suspense. Appeals has indicated concern about cases coming in with inadequate factual development of the issue. Discussion of IRC 183(d) and IRC 183(e) with the taxpayer should be postponed until, and if, the activity has been determined to be an activity not engaged in for profit.

The passive activity loss rules of IRC 469 should be also be considered. Since IRC 469 adjustments are timing adjustments while IRC 183 adjustments are permanent adjustments, the IRC 183 issue should generally be treated as the primary position and the IRC 469 issue should be treated as an alternative position when both issues are present.

If a potential IRC 183(a) issue exists, check with the Technical Services IRC 183 suspense coordinator. If the earlier years are not in suspense, and the activity is determined to be engaged in for profit, allow the deductions to the extent they are otherwise, allowable by the Code (i.e., IRC 162). If the activity is not engaged in for profit and IRC 183(e) is elected, the case must be placed in suspense.

IRC 183(b) provides for two types of deductions allowed with regard to activities not engaged in for profit. They are the IRC 183(b)(1) and IRC 183(b)(2) deductions.

Deductions under IRC 183 are allowable only on Schedule A as itemized deductions. Deductions under section IRC 183(b)(1) would appear in the proper places on Schedule A (e.g., as mortgage interest or taxes) and any deduction under IRC 183(b)(2) would be a miscellaneous Itemized Deduction subject to the 2% floor or limited to 2% of adjusted gross income (AGI). The hobby income limitation is applied before the 2% rule.

Requisition the returns for all open years not in the suspense file. Examine each of the years that have significant audit potential. If the returns for any years subsequent to the year of the initial IRC 183(a) election do not show significant audit potential, they may be forwarded, unaudited, to suspense along with the year(s) of the initial IRC 183(a) election.

Secure Audit Information Management System (AMDISA), IMFOLT/R on all open years.

Prepare a report showing the audit results including the IRC 183(a) issue. The cases examined must be completely worked prior to going into suspense.

Form 3198 should indicate that the case is an IRC 183(a) case and is related to a previously suspended case and should be routed directly to suspense.

Process the case in the normal manner.

All non-hobby loss issues must be resolved prior to putting the case in suspense. If that issue is unagreed refer to IRM 4.10.13.6.3(2). If needed, secure a statute extension for any non-hobby loss issue(s).

Determine if the taxpayer wants, and is eligible, to elect IRC 183(e). The election must be made before the statute of limitations of the return reporting the first year of the activity expires. If an election has not been made prior to the expiration of the statute on the initial year, an election cannot be accepted.

Inform the taxpayer of all the legal and procedural implications of the IRC 183(e) election. If the taxpayer does not wish to make the election, the case, and the issue should be processed based on the merits that have already been determined. When possible, a written statement should be obtained from the taxpayer or his representative stating that he does not elect the provisions of IRC 183 with respect to the tax year(s) containing the IRC 183(a) issue. (If the taxpayer declines to provide such a statement, the examiner should make appropriate comments in the workpapers.) Attach the statement to the return(s).

If the taxpayer wishes to make an IRC 183(e) election:

For tax years beginning before January 1, 2018, two revenue procedures provided exceptions to certain rules relating to accounting methods, as follows. If the taxpayer had gross receipts less than $1 million, the exceptions from mandatory use of an accrual method when inventory must be taken is waived by Rev. Proc. 2001-10 (modified by Rev. Proc. 2018-31 and successor). Under this revenue procedure, taxpayers with average annual gross receipts of $1 million or less were not required to use an accrual method of accounting under IRC 446 and are not required to account for inventories under IRC 471. A taxpayer had average annual gross receipts of $1 million or less if the taxpayer's average annual gross receipts for each prior three taxable year period ending with the applicable prior tax year did not exceed $1 million. Aggregation rules for gross receipts may have applied. See 26 CFR 1.448-1T(f)(2).

Qualifying taxpayers that do not want to account for inventories under IRC 471 must treat inventoriable items in the same manner as materials and supplies that are non incidental under 26 CFR 1.162-3. An inventoriable item is any item either purchased for resale to customers or a raw material purchase for use in producing finished goods.

Further, if an eligible small business has average annual gross receipts of $10 million or less, the exceptions from the mandatory use of an accrual method under Rev. Proc. 2002-28 (modified by Rev. Proc. 2018-31 and successor) which was effective for tax years beginning before January 1, 2018, may apply. Under this revenue procedure, eligible small businesses with average annual gross receipts of $10 million or less are not required to use an accrual method of accounting under IRC 446 and are not required to account for inventories under IRC 471 . This revenue procedure does not apply to any farming business. A taxpayer has average annual gross receipts of $10 million or less if, for each prior taxable year ending on or after December 31, 2000, the taxpayer’s average annual gross receipts for the three taxable-year period ending with the applicable prior tax year do not exceed $10 million. Aggregation rules for gross receipts may have applied. A taxpayer that satisfied the gross receipts criteria for each prior three-year period was required to determine whether its principal business activity code was an eligible code under the North American Industry Classification System (NAICS) at www.census.gov. Additionally, the following NAICS codes were ineligible for the qualifying small business exception:

A taxpayer could still qualify under Rev. Proc. 2002-28 in limited circumstances even if the NAICS code is ineligible.

A qualifying taxpayer may use the automatic consent procedures in Rev. Proc. 2015-13 and Rev. Proc. 2018-40 (and successors) depending on the year of change to make a voluntary change to the cash method of accounting. . Taxpayers treating as materials and supplies that are not incidental must deduct the cost of these items only in the year that they are actually consumed or used in operations. Inventory items that are sold are considered used or consumed when sold. When a cash basis taxpayer applies this regulation the inventory items are not deducted until the later of (1) the year used or consumed, or (2) the year the items were paid for.

Generally, a taxpayer that is required to maintain inventories must use an accrual method of accounting for purchases and sales of merchandise pursuant to 26 CFR 1.446-1(c)(2)(i).

If the taxpayer is a small business taxpayer (defined in IRM 4.10.13.7.2.2 (4), it can use the cash method of accounting and adopt or change its accounting method to account for inventories:

If the taxpayer accounts for inventories in the same manner as non-incidental materials and supplies, the taxpayer must deduct the cost of these items only in the year that the items are actually used or consumed in the taxpayer’s operations, or in the year in which the taxpayer actually pays for the goods, whichever is later. See 26 CFR 1.162-3(a)(1).

Small business taxpayer. For purposes of this section, a taxpayer is a small business taxpayer if it:

Small business taxpayers (defined in IRM 4.10.13.7.2.2 (4)) may use the automatic consent procedures in Rev. Proc. 2018-40 (or successor) to make a voluntary change to the cash method of accounting and account for inventoriable items as non-incidental materials and supplies, or to conform to its treatment of inventories in an applicable financial statement, or if the taxpayer does not have an applicable financial statement, the method of accounting it uses in its books and records.

The gross receipts test for tax years beginning after December 31, 2017, applies only to the three prior tax years. A taxpayer can exceed the limit in one year, but if gross receipts are under the three-year average in a subsequent year, the taxpayer is again a “Small Business Taxpayer”. The old rule of “fail once, fail forever” no longer applies.

To identify a long term contract issue:

To determine if the taxpayer is a service provider or a manufacturer:

To determine if the length of the contract exceeds 12 months:

To determine if the item is unique:

IRC 481(b)(1) provides a limitation on the Chapter 1 tax for the taxable year of change that is attributable to the adjustments required under IRC 481(a) if the entire amount of the IRC 481(a) adjustment is taken into account in the year of change. If such adjustment increases the taxpayer's taxable income for the year of the change by more than $3,000, then the Chapter 1 tax for such year that is attributable to the adjustment shall not exceed the lesser of:

IRC 481(b)(2) provides a second alternative limitation on the tax for the taxable year of change. If the taxpayer establishes from its books and records what its taxable income would have been under the new method of accounting for one or more consecutive taxable years immediately preceding the taxable year of the change, then the tax attributable to the IRC 481(a) adjustment will not exceed the smallest of the following amounts:

Steps for computing the tax limitation under IRC 481(b) :

For the purpose of computing the increase in taxes, net operating loss under IRC 172 or capital loss carryback or carryover under IRC 1212 should be considered. This would include the net increase or decrease in tax attributable to any taxable year preceding the year of change to which no adjustment is allocated under IRC 481(b)(1) or (b)(2), but which is affected by a net operating loss or by a capital loss carryback or carryover determined with reference to taxable years to which the adjustments under IRC 481(b)(1) or (b)(2) are allocated.

For additional guidance, refer to information located on the Virtual Library for changes in accounting methods.

In the case of a change in method of accounting by a partnership/S Corporation, the adjustments required by IRC 481(a) shall be made on the partnership/S corporation's return. However, the limitations on tax under IRC 481(b) apply to the individual partners/shareholders. IRC 481(b) applies to partners/shareholders whose taxable income is increased by more than $3,000 as a result of such adjustments to the flow-through entity's ordinary income. See IRM 4.10.8.4.4.3 and Exhibit 4.10.8-3 for report writing procedures.

The following illustrates a IRS-imposed change in accounting method from the overall cash method to the overall accrual method. Assume that 2018 is the earliest year under exam. This would be the year of change.

The IRC 481(a) adjustment is $200,000. This represents the net difference in the increase in income from the cash to accrual method. The current year adjustment is $50,000. This is the net difference between the balances at the beginning and the end of the year. It reflects an increase in income that would be reported under an accrual method of accounting. If it had been a taxpayer-initiated change, the taxpayer would have been required to report the $200,000 ratably into taxable income over four years ($50,000 per year).

In the preceding example, the IRC 481(b) tax limitation is applicable because the IRC 481(a) adjustment is over $3,000. For the IRC 481(b)(1) computation, the adjustment should be hypothetically spread evenly between the current year (2018) and the two prior tax years (2017 and 2016).

IRC 481(b) Computation: The IRC 481(a) adjustment is $200,000 and the current year adjustment is $50,000. The first computation is to calculate the Chapter 1 tax for 2018

The total Chapter 1 tax per IRC 481(b) is $62,001, which is considerably less than the Chapter 1 tax calculated on the entire IRC 481(a) adjustment in 2018, the year of change ($78,000). The taxpayer will be allowed a credit of $15,999 against the tax resulting from the IRC 481(a) adjustment in 2018.

If neither jeopardy assessment nor fraud is involved, and the taxpayer agrees to all adjustments including the liability for PHC tax in the amount proposed, the taxpayer may be relieved of the liability for the PHC tax by payment of "deficiency dividends" . If the corporation makes the payment of this deficiency dividend within 90 days following formal notification, the corporation is relieved of having to pay the PHC tax.

The examiner must notify the taxpayer regarding the deficiency dividend procedures of IRC 547. The proper sequence is:

A determination of the taxpayer's liability for PHC tax must be made in the manner prescribed by IRC 571(c). Three means of making a qualifying determination are:

The Code allows the real estate community, specifically personal holding, REIT and RIC, to reduce their taxable income by declaring a dividend and distributing it to their shareholders. The dividend would be substantially all the income earned for the year. If for some reason it was found out that not all the appropriate amount of income is declared the taxpayer may declare a deficiency dividend using a issue the dividend.

When and where to file:

The deficiency dividend must be of such a nature as would have permitted its inclusion in the computation of the deduction for dividends paid under IRC 561 for the tax year for which the tax liability exists if it had been distributed during that year.

If the taxpayer files a timely Form 976, the claim is date stamped and the case is returned to the examiner to verify the accuracy of the information reflected on the claim.

If Form 976 is filed after the 120-day period, the case will be returned to the examiner for disallowance of the claim.

The disallowance of a Form 976 claim is affected by the issuance of a certified notice of disallowance of claim, unless the taxpayer has executed Form 2297 (Waiver of Statutory Notification of Claim Disallowance). A letter of explanation may also accompany the notices. The tax is then assessed per the full amount reflected in the initial report.

If the Form 976 claim is determined to be allowable in full or in part, the examiner should prepare:

Form 3189 should be flagged to identify the case as a PHC case. The restricted interest box should also be checked and "IRC section 547" annotated.

See Notice 2003-19, 2003-1 C.B. 703, under IRC 860 and 26 CFR 1.860-2 concerning a deficiency dividend deduction for a "qualified investment entity" (RIC or REIT), which reflects the "place of filing" as "Ogden Submission Processing Center" .