The Families First Coronavirus Response Act (Families First Act), Public Law 116-127, 134 Stat. 178 (2020), enacted on March 18, 2020, and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Public Law 116-136, 134 Stat. 281 (2020), enacted on March 27, 2020, provide relief to taxpayers from economic hardships resulting from the Coronavirus Disease 2019 (COVID-19).

The Families First Act, through the enactment of the Emergency Paid Sick Leave Act and the Emergency Family and Medical Leave Expansion Act, generally requires employers with fewer than 500 employees to provide paid leave due to certain circumstances related to COVID-19.

Division E of the Families First Act, the Emergency Paid Sick Leave Act (EPSLA), requires certain employers to provide employees with up to 80 hours of paid sick leave if the employee is unable to work or telework because the employee:

(1) is subject to a Federal, State, or local quarantine or isolation order related to COVID-19;

(2) has been advised by a health care provider to self-quarantine due to concerns related to COVID-19;

(3) is experiencing symptoms of COVID-19 and seeking a medical diagnosis;

(4) is caring for an individual who is subject to a Federal, State, or local quarantine or isolation order related to COVID-19, or has been advised by a health care provider to self-quarantine due to concerns related to COVID-19;

(5) is caring for a son or daughter of such employee if the school or place of care of the son or daughter has been closed, or the child care provider of such son or daughter is unavailable, due to COVID-19 precautions; or

(6) is experiencing any other substantially similar condition specified by the Secretary of Health and Human Services in consultation with the Secretaries of the Treasury and Labor.¹

An employee who is unable to work or telework for reasons related to COVID-19 described in (1), (2), or (3) above is entitled to paid sick leave at the employee’s regular rate of pay or, if higher, the Federal minimum wage or any applicable State or local minimum wage, up to $511 per day and $5,110 in the aggregate. An employee who is unable to work or telework for reasons related to COVID-19 described in (4), (5), or (6) above is entitled to paid sick leave at two-thirds the employee’s regular rate of pay or, if higher, the Federal minimum wage or any applicable State or local minimum wage, up to $200 per day and $2,000 in the aggregate.

Division C of the Families First Act, the Emergency Family and Medical Leave Expansion Act (EFMLEA), amends the Family and Medical Leave Act of 1993 to require certain employers to provide expanded paid family and medical leave to employees who are unable to work or telework for reasons related to COVID-19. An employee can receive up to 10 weeks of paid family and medical leave at two-thirds the employee’s regular rate of pay, up to $200 per day and $10,000 in the aggregate if the employee is unable to work or telework because the employee is caring for a son or daughter whose school or place of care is closed or whose child care provider is unavailable for reasons related to COVID-19.

Sections 7001 and 7003 of the Families First Act generally provide that employers subject to the paid leave requirements under EPSLA and EFMLEA (“eligible employers”) are entitled to fully refundable tax credits to cover the cost of the leave required to be paid for those periods of time during which employees are unable to work or telework for reasons related to COVID-19.²

Eligible employers are entitled to receive a refundable credit equal to the amount of the qualified sick leave wages and qualified family leave wages (collectively “qualified leave wages”), plus allocable qualified health plan expenses. Under the respective provisions, qualified leave wages are defined to mean wages (as defined in section 3121(a) of the Internal Revenue Code (Code)) and compensation (as defined in section 3231(e) of the Code) paid by an employer which are required to be paid under the EPSLA and EFMLEA. See section 7001(c) and 7003(c). The credit is allowed against the taxes imposed on employers by section 3111(a) of the Code (the Old-Age, Survivors, and Disability Insurance tax (social security tax)), first reduced by any credits claimed under sections 3111(e) and (f) of the Code, and section 3221(a) of the Code (the Railroad Retirement Tax Act Tier 1 tax), on all wages and compensation paid to all employees. Under section 7005 of the Families First Act, the qualified leave wages are not subject to the taxes imposed on employers by sections 3111(a) and 3221(a) of the Code. In addition, section 7005 provides that the credits under sections 7001 and 7003 of the Families First Act are increased by the amount of the tax imposed by section 3111(b) of the Code (employer’s share of Medicare tax) on qualified leave wages.³

The CARES Act provides an additional credit for employers experiencing economic hardship related to COVID-19. Under section 2301 of the CARES Act, certain employers who pay qualified wages to their employees are eligible for an employee retention credit. Employers eligible for the employee retention credit are employers that carry on a trade or business during calendar year 2020 and tax-exempt organizations that either have a full or partial suspension of operations during any calendar quarter in 2020 due to an order from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19, or experience a significant decline in gross receipts during the calendar quarter.

Qualified wages are wages (as defined in section 3121(a) of the Code) and compensation (as defined in section 3231(e) of the Code) paid by an employer to some or all employees after March 12, 2020, and before January 1, 2021, and include the employer’s qualified health plan expenses that are properly allocable to such wages or compensation. For employers that averaged more than 100 full-time employees during 2019, qualified wages are wages and compensation (including allocable qualified health plan expenses), up to $10,000 per employee, paid to employees that are not providing services because operations were fully or partially suspended due to orders from an appropriate governmental authority or due to a decline in gross receipts. For employers who averaged 100 full-time employees or fewer during 2019, qualified wages are wages and compensation (including allocable qualified health plan expenses), up to $10,000 per employee, paid to any employee during the period operations were suspended due to orders from an appropriate governmental authority or due to a decline in gross receipts, regardless of whether its employees are providing services.

The employee retention credit is a fully refundable tax credit for employers equal to 50 percent of qualified wages. Because the maximum amount of qualified wages taken into account with respect to each employee is $10,000, the maximum employee retention credit for an eligible employer for qualified wages paid to any employee is $5,000. The credit is allowed against the taxes imposed on employers by section 3111(a) of the Code, first reduced by any credits allowed under sections 3111(e) and (f) of the Code and sections 7001 and 7003 of the Families First Act, and the taxes imposed under section 3221(a) of the Code that are attributable to the rate in effect under section 3111(a) of the Code, first reduced by any credits allowed under sections 7001 and 7003 of the Families First Act, on all wages and compensation paid to all employees. The same wages or compensation cannot be counted for both the Families First Act leave credits and the CARES Act employee retention credit.

Sections 7001(b)(4) and 7003(b)(3) of the Families First Act provide that if the amount of the paid sick and family leave credits under these sections exceeds the taxes imposed by section 3111(a) or 3221(a) of the Code for any calendar quarter, such excess shall be treated as an overpayment that shall be refunded under sections 6402(a) and 6413(b) of the Code. Section 2301(b)(3) of the CARES Act provides that if the amount of the employee retention credit exceeds the taxes imposed by section 3111(a) or 3221(a) (limited to the portion attributable to the rate in effect under section 3111(a)) of the Code for any calendar quarter, such excess shall be treated as an overpayment that shall be refunded under sections 6402(a) and 6413(b) of the Code.

Section 6402(a) of the Code provides that, within the applicable period of limitations, overpayments may be credited against any liability in respect of an internal revenue tax on the part of the person who made the overpayment and any remaining balance refunded to such person. Section 6413(b) provides that if more than the correct amount of employment tax imposed by sections 3101, 3111, 3201, 3221, or 3402 is paid or deducted and the overpayment cannot be adjusted under section 6413(a)⁴, the amount of the overpayment shall be refunded (subject to the applicable statute of limitations) as the Secretary may prescribe in regulations.

The IRS has revised Form 941, Employer’s Quarterly Federal Tax Return, and is revising Form 943, Employer’s Annual Federal Tax Return for Agricultural Employees, Form 944, Employer’s Annual Federal Tax Return, and Form CT-1, Employer’s Annual Railroad Retirement Tax Return, so that employers may use these returns to claim the paid sick and family leave credits under the Families First Act and the employee retention credit under the CARES Act. The revised employment tax returns will provide for any credits in excess of the taxes imposed under sections 3111(a) or 3221(a) (for the employee retention credit, only the taxes imposed under section 3221(a) that are attributable to the rate in effect under section 3111(a)) to be credited against other employment taxes and then for any remaining balance to be refunded to the employer (per section 6402(a) or section 6413(b)).⁵

Section 3606 of the CARES Act amends sections 7001(b)(4) and 7003(b)(3) of the Families First Act to provide that, in anticipation of the paid sick and family leave credits under these sections, including any refundable portions (which would include any increases in the credits under section 7005), these credits may be advanced, according to forms and instructions provided by the Secretary, up to the total allowable amount and subject to applicable limits for the calendar quarter. Section 2301(l)(1) of the CARES Act provides that the Secretary shall issue such forms, instructions, regulations, and guidance as are necessary to allow the advance payment of the employee retention credit under section 2301, subject to the limitations provided in section 2301 and based on such information as the Secretary shall require.

To implement the advance payment provisions of the Families First Act and the CARES Act, the IRS has created Form 7200, Advance Payment of Employer Credits Due To COVID-19, which employers may use to request an advance of the paid sick or family leave credits under the Families First Act, the employee retention credit under the CARES Act, or two or more of them. Employers are required to reconcile any advance payments claimed on Form 7200 with total credits claimed and total taxes due on their employment tax returns. A refund, a credit, or an advance of any portion of these credits to a taxpayer in excess of the amount to which the taxpayer is entitled is an erroneous refund for which the IRS must seek repayment.

Section 6201, in general, authorizes the Secretary to determine and assess tax liabilities including interest, additional amounts, additions to the tax, and assessable penalties. However, the general authority to assess tax liabilities under section 6201(a) does not allow the assessment of any non-rebate⁶ portion of an erroneous refund of a refundable credit. Instead, non-rebate refunds are generally recovered or recaptured through voluntary payment or litigation. The government by appropriate action can bring civil litigation to recover funds which its agents have wrongfully, erroneously, or illegally paid, and no statute is necessary to authorize the government to sue in such a case, since the right to sue is independent of statute. United States v. Wurts, 303 U.S. 414, 415 (1938), citing United States v. The Bank of the Metropolis, 40 U.S. 377 (1841). However, the statutory language of the Families First Act and the CARES Act provides for the administrative recapture of these non-rebate refunds by authorizing the promulgation of regulations or other guidance to do so.

Sections 7001 and 7003 of the Families First Act and section 2301 of the CARES Act grant authority to the Department of the Treasury (Treasury Department) and the IRS to issue regulations or other guidance to recapture an erroneous refund of the credits. Specifically, sections 7001(f) and 7003(f) of the Families First Act and section 2301(l) of the CARES Act authorize the Secretary to issue guidance to allow for the administrative reconciliation and recapture of erroneous refunds. Sections 7001(f) and 7003(f) of the Families First Act provide, in relevant part, that the Secretary (or the Secretary’s delegate) shall provide such regulations or other guidance as may be necessary to carry out the purposes of the credit, including regulations or other guidance: (1) to prevent the avoidance of the purposes of the limitations under this provision; (2) to minimize compliance and record-keeping burdens associated with the credit; (3) to provide for a waiver of penalties for failure to deposit amounts in anticipation of the allowance of the credit; (4) to recapture the benefit of the credit in cases where there is a subsequent adjustment to the credit; and (5) to ensure that the wages taken into account for the credit conform with the paid sick leave and paid family leave required to be provided under the Families First Act. Similarly, section 2301(l) of the CARES Act provides in relevant part that the Secretary shall issue such forms, instructions, regulations, and guidance as are necessary to provide for the reconciliation of an advance payment of the employee retention credit with the amount advanced at the time of filing the return of tax for the applicable calendar quarter or taxable year, and to provide for the recapture of the credit under section 2301 of the CARES Act if such credit is allowed to a taxpayer that receives a small business loan under section 1102 of the CARES Act during a subsequent quarter.

Accordingly, this document amends the Employment Tax Regulations (26 CFR Part 31) by adding temporary regulations under sections 3111 and 3221 of the Code. Concurrent with the publication of this Treasury decision, the Treasury Department and the IRS are publishing in the Proposed Rules section of this issue of the Federal Register a notice of proposed rulemaking (REG-111879-20) on this subject that cross-references the text of these temporary regulations. See section 7805(e)(1). Interested persons are directed to the ADDRESSES and COMMENTS AND REQUESTS FOR A PUBLIC HEARING sections of the preamble to REG-111879-20 for information on submitting public comments or requesting a public hearing on the proposed regulations.

The proposed regulations provide rules related to the exemption from air transportation excise tax for amounts paid by an aircraft owner for aircraft management services pursuant to section 4261(e)(5).

During the development of these proposed regulations, the Treasury Department and the IRS received various requests for guidance from stakeholders (referred to herein as “commenters”) related to the first five issues discussed in part 1 of this Explanation of Provisions.

a. Applicability of Possession, Command, and Control Test

Commenters requested clarification on the applicability of the possession, command, and control test in existing guidance to amounts paid for aircraft management services in light of section 4261(e)(5). The possession, command, and control test is a facts-and-circumstances analytical framework that is used to determine whether a person is providing taxable transportation to another person in cases where each of the parties contribute some, but not all, of the elements necessary for complete air transportation services. See e.g., Rev. Rul. 60-311 (1960-2 C.B. 341), Rev. Rul. 70-325 (1970-1 C.B. 231), and Rev. Rul. 76-394 (1976-2 C.B. 355). Section 4261(e)(5) directly addresses a situation that, but for section 4261(e)(5), would be analyzed using the possession, command, and control test. As a result, in situations to which the section 4261(e)(5) exemption applies, the possession, command, and control test is not relevant.

b. Related-Party Payments

The second issue for which commenters requested guidance relates to the treatment of payments for aircraft management services made by a person who has a close relationship to the aircraft owner, but is not itself the owner of the aircraft. The commenters suggested that payments that are made by certain parties related to the aircraft owner should be considered as though made by the aircraft owner.

First, the commenters suggested that the proposed regulations should treat payments made by one member of an affiliated group (as that term is used in section 4282) on behalf of an aircraft owner that is a member of the same affiliated group as being made by the aircraft owner.

Second, the commenters suggested that payments made by an owner of a special purpose entity should be treated as being made by the aircraft owner if the special purpose entity owns the aircraft. For example, individuals and corporations often create a single member limited liability company (SMLLC) to own an aircraft in order to comply with FAA regulations or limit liability exposure. In such cases, the owner of the SMLLC often makes payments for aircraft management services on behalf of the SMLLC.

Finally, the commenters suggested that payments made by an aircraft owner’s family members, as well as other persons and entities (for example, trusts, as well as the trust’s fiduciaries and beneficiaries) closely related to an aircraft owner be treated as being made by the aircraft owner. For this purpose, the commenters suggested that the proposed regulations should treat payments for aircraft management services made on behalf of the aircraft owner by a family member of the aircraft owner and by persons and entities bearing relationships to the aircraft owner described in sections 267(b) and 707(b) of the Code as amounts paid by the aircraft owner.

The Treasury Department and the IRS understand that it is common practice in the private aviation sector for persons that bear certain close relationships to an aircraft owner to make payments for aircraft management services on behalf of the aircraft owner. However, exceptions to tax, like deductions, are matters of legislative grace, and such provisions are construed narrowly. See Comm’r v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148-9 (1974) (“The propriety of a deduction [...] depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.” (citations omitted)); Shami v. Comm’r, 741 F.3d 560, 567 (5th Cir. 2014) (“Tax credits are a matter of legislative grace, are only allowed as clearly provided for by statute, and are narrowly construed.” (citation omitted)); Lettie Pate Whitehead Found., Inc. v. U.S., 606 F.2d 534, 539 (5th Cir. 1979) (“Deductions are matters of legislative grace and must be narrowly construed.” (citation omitted)); Chrysler Corp. v. Comm’r, 436 F.3d 644, 654 (6th Cir. 2006) (“While statutes imposing a tax are generally construed liberally in favor of the taxpayer, those granting a deduction are matters of legislative grace and are strictly construed in favor of the government.” (citations omitted)). Section 4261(e)(5) specifically states that the exemption applies to “amounts paid by an aircraft owner” and makes no reference to any other entity or arrangement. The Treasury Department and the IRS are concerned that if the regulations were to treat payments for aircraft management services made on behalf of an aircraft owner (other than in a principal-agent scenario in which the aircraft owner is the principal) as being made by the aircraft owner itself, the regulations would effectively expand the exemption in a manner not authorized by Congress.

Additionally, a qualified subchapter S subsidiary (QSub) (as defined in section 1361(b)(3)(B)) that is generally not treated as a separate corporation from its S corporation owner under section 1361(b)(3)(A), and a non-corporate, wholly-owned business entity, such as a SMLLC, that is disregarded as an entity separate from its owner for Federal income tax purposes (under §§301.7701-1 through 301.7701-3 of the Procedure and Administration Regulations), are each treated as an entity separate from its owner for certain Federal excise tax purposes. See §1.1361-4(a)(8) of the Income Tax Regulations and §301.7701-2(c)(2)(v). The rules under §§1.1361-4(a)(8) and 301.7701-2(c)(2)(v) were adopted because difficulties arose from the interaction of the rules in section 1361(b)(3)(A) and §§301.7701-1 through 301.7701-3 with the Federal excise tax rules. It would be contrary to the existing rules in §§1.1361-4(a)(8) and 301.7701-2(c)(2)(v) to treat a person or entity that is separate from the aircraft owner as the aircraft owner for purposes of the exemption from air transportation excise tax in section 4261(e)(5). For these reasons, the proposed regulations do not adopt the commenters’ suggestion to provide a related-party rule.

c. Choice of Flight Rules

The third issue for which commenters requested guidance relates to whether an aircraft owner’s decision to operate its aircraft under certain parts of the Federal Aviation Regulations (FARs) promulgated by the FAA affects the application of section 4261(e)(5). Part 91 of the FARs governs general aviation. However, some aircraft owners choose to operate their aircraft under Part 135 of the FARs (governing on-demand and commuter flights), which imposes additional FAA regulatory requirements related to operational safety and enhanced liability protection. Commenters suggested that the proposed regulations provide that if an aircraft owner elects to conduct flights on its own aircraft under Part 135 of the FARs (rather than under Part 91 of the FARs), then payments made by the aircraft owner for aircraft management services related to those flights qualify for the exemption provided in section 4261(e)(5) in the same manner as a flight conducted under Part 91 of the FARs.

It has long been the position of the Treasury Department and the IRS that rules promulgated by the FAA, including the FARs, do not control for Federal excise tax purposes. See Rev. Rul. 78-75 (1978-1 C.B. 340). Further, section 4261(e)(5) makes no reference to the FARs; under the plain language of section 4261(e)(5), its application does not depend upon the FAR flight rules under which an aircraft is operated. The Treasury Department and the IRS agree with the commenters’ suggestion. Accordingly, the proposed regulations provide that whether an aircraft owner operates its aircraft pursuant to the rules under FARs Part 91 or pursuant to the rules under FARs Part 135 does not affect the application of section 4261(e)(5).

d. Charters

The fourth issue for which commenters requested guidance relates to situations in which an aircraft owner permits an air charter operator (which may or may not be the same person as the person or persons providing aircraft management services to the aircraft owner) to use the aircraft owner’s aircraft to provide charter flights. It is common for an aircraft owner to permit an air charter operator to use the aircraft owner’s aircraft for a fee (in cash or in kind) when the aircraft would otherwise sit idle or when the aircraft is being repositioned and would otherwise not carry any passengers. In such instances, amounts paid for charter flights operated on the aircraft owner’s aircraft are subject to air transportation excise tax, unless otherwise exempt from the taxes (for example, in the case of an aircraft used as an air ambulance dedicated to acute care emergency medical services under section 4261(g)(2)). See §49.4261-7(h) for the rules regarding the taxation of charter flights.

The commenters suggested that the proposed regulations clarify that the application of section 4261(e)(5) is not affected by an aircraft owner permitting a charter operator to use the aircraft owner’s aircraft for charter flights. The Treasury Department and the IRS agree with the commenters that, in general, the application of section 4261(e)(5) should not be affected by an aircraft owner permitting an aircraft management services provider or other person to use the aircraft owner’s aircraft for for-hire flights (such as charter flights, air taxi flights, and flightseeing flights). Accordingly, the proposed regulations provide that whether an aircraft owner permits its aircraft to be used for for-hire flights does not affect the application of section 4261(e)(5) to amounts paid by the aircraft owner for aircraft management services.

The proposed regulations also clarify that to the extent such for-hire flights are subject to the tax imposed by section 4261 or 4271, taxable fuel (as defined in section 4083(a) of the Code) or any other liquid taxable under section 4041(c) of the Code that is used as fuel on such flights is used in commercial aviation, as that term is defined in section 4083(b). See sections 4081(a)(2) and 4041(c) for the applicable fuel tax rates.

e. Payment Arrangements

The fifth issue for which commenters requested guidance relates to business decisions made by a person providing aircraft management services regarding how to charge, invoice, or bill (referred to collectively herein as “bill” or “billed”) aircraft owners for their services. An aircraft owner may be billed for aircraft management services in a variety of ways. For example, an aircraft owner may be charged a monthly fee for aircraft management services and an hourly fee for each hour of flight time. Alternatively, an aircraft owner may be billed for specific costs related to the operation of the aircraft, plus a mark-up to compensate the aircraft management services provider. In addition to these two examples, there are many other possible arrangements that may be used to bill an aircraft owner based on the particular agreement between an aircraft owner and the aircraft management services provider. The commenters suggested that the proposed regulations should clarify that the manner in which an aircraft owner is billed for aircraft management services should not control whether the exemption from air transportation excise tax provided in section 4261(e)(5) applies to amounts paid for those services.

The Treasury Department and the IRS agree with the commenters that the manner in which an aircraft owner is billed for aircraft management services is a business decision that providers of aircraft management services and aircraft owners should be free to make with each other in order to satisfy their particular needs. Accordingly, the proposed regulations provide that the method or manner by which an aircraft owner is billed for aircraft management services does not affect whether the exemption from air transportation excise tax provided in section 4261(e)(5) applies to amounts paid for those services.

While the proposed regulations acknowledge that the manner in which an aircraft owner is billed for aircraft management services is a business decision, the proposed regulations require both the aircraft owner and the aircraft management services provider to maintain adequate records to show that amounts paid by the aircraft owner to the aircraft management services provider relate to aircraft management services specifically for the aircraft owner’s aircraft or for flights on the aircraft owner’s aircraft.

f. Other Proposed Aircraft Management Services Rules

The proposed regulations clarify that the exemption from air transportation excise tax in section 4261(e)(5) is limited to private aviation. Section 49.4261-10(b)(6) of the proposed regulations defines “private aviation” as the use of an aircraft for civilian flights except scheduled passenger service. This rule is consistent with the Conference Report, which explicitly states that section 4261(e)(5) “exempts certain payments related to the management of private aircraft from the excise taxes imposed on taxable transportation by air.” Conference Report at 536.

The proposed regulations also clarify the application of section 4261(e)(5)(D), which requires a pro rata allocation of the amounts paid for aircraft management services between services that relate to flights taken by an aircraft owner on the aircraft owner’s aircraft and services that relate to flights taken by an aircraft owner on an aircraft that is not owned by the aircraft owner. An aircraft that is not owned by the aircraft owner is referred to in the proposed regulations as a “substitute aircraft.” Section 4261(e)(5)(D) limits the section 4261(e)(5) exemption to amounts paid for aircraft management services related to flights taken by an aircraft owner on the aircraft owner’s aircraft. Therefore, the section 4261(e)(5) exemption does not extend to those amounts paid for aircraft management services that relate to flights taken by an aircraft owner on a substitute aircraft (that is, an aircraft not owned by the aircraft owner). The proposed regulations provide that the pro rata allocation is calculated by applying to the amount paid by the aircraft owner for aircraft management services the ratio of flight hours provided on substitute aircraft during the calendar quarter over the total flight hours flown by the aircraft owner on both the aircraft owner’s aircraft and substitute aircraft during the calendar quarter. The Treasury Department and the IRS request comments regarding whether the proposed flight hour ratio allocation method is fair and practicable or whether a different allocation method should be required (and if so, what exactly such required method should be).

In addition, the proposed regulations clarify that taxable fuel (as defined in section 4083(a)) or any other liquid taxable under section 4041(c) that is used as fuel on a flight for which amounts paid are exempt from the taxes imposed by sections 4261 and 4271 by reason of section 4261(e)(5) is not fuel used in commercial aviation, as that term is defined in section 4083(b). See sections 4081(a)(2) and 4041(c) for the applicable fuel tax rates.

Finally, the section 4043 fuel surtax applies to fuel used in fractional program aircraft operated under FARs Part 91K (14 CFR part 91K) but not to fuel used on flights for which amounts paid are exempt by reason of section 4261(e)(5). The Treasury Department and the IRS are concerned that this creates an incentive for persons to operate flights that would otherwise be subject to the section 4043 fuel surtax outside of FARs Part 91K in order to avoid the surtax. In these instances, such persons would likely also argue that amounts paid for aircraft management services related to the fractional program aircraft are exempt from air transportation excise tax under section 4261(e)(5).

To address this issue, the proposed regulations include an anti-abuse rule providing that the section 4261(e)(5) exemption does not apply to any amount paid for aircraft management services by a participant in any transaction or arrangement, or through other means, that seeks to circumvent the surtax imposed by section 4043. In addition, the proposed regulations clarify that the section 4261(e)(5) exemption does not apply to amounts paid for aircraft management services related to flights on fractional program aircraft operated (or required to be operated) under FARs Part 91K. The proposed regulations also provide that if an amount paid qualifies for both the exemption provided in section 4261(e)(5) and the exemption provided in section 4261(j), the section 4261(j) exemption applies to the amount paid and the surtax imposed by section 4043 applies to any liquid used in the fractional program aircraft as fuel. See sections 4261(j) and 4043. This provision is consistent with the Conference Report and the definition of “aircraft owner” in §49.4261-10(b)(3)(B) in the proposed regulations.

a. Changes to Part 40

The privilege to file consolidated returns under section 1501 applies only to income tax returns and not to excise tax returns. The proposed regulations add §40.0-1(d) to note this rule and also reflect the rules of §§1.1361-4(a)(8) and 301.7701-2(c)(2)(v) that treat QSubs and certain business entities as entities separate from their owners for Federal excise tax purposes. See also Revenue Ruling 2008-18 (2008-1 C.B. 674). Thus, proposed §40.0-1(d) treats each business unit that has, or is required to have, a separate Employer Identification Number as a separate person. In the context of air transportation excise tax, this rule applies with respect to both the person required to pay the tax under proposed §49.4261-1(b) and the person required to collect and pay over the tax under §40.6011(a)-1(a)(3) and section 4291 of the Code.

Proposed §40.0-1(d) was originally proposed on July 29, 2008, in a notice of proposed rulemaking (REG-155087-05) published in the Federal Register (73 FR 43890), but the rules in that regulation project have not been finalized. Because of the length of time that has passed since it was originally proposed, this document withdraws proposed §40.0-1(d) and re-proposes the provision as part of these proposed regulations.

Existing §40.6071(a)-3 provides excise tax return filing rules that apply only to the quarterly return required under §40.6011(a)-1(a) for the third calendar quarter of 2001. The proposed regulations remove §40.6071(a)-3 in its entirety because it is obsolete.

b. Changes to Part 49

The existing regulations under section 4261 have not been revised since 1962. The proposed regulations remove existing language relating to taxes on transportation by rail, motor vehicle, and water, which have been repealed, and otherwise update the existing regulations to conform to current law. The proposed regulations also remove references to exemptions that were repealed in 1970. More specifically, the proposed regulations update §49.4261-1 to reflect: (i) the enactment of the international travel facilities tax in 1970 (Airport and Airway Development Act of 1970 (AADA), Pub. L. No. 91-258, 84 Stat. 236 (1970)); (ii) the enactment of the domestic segment tax in 1997 (Taxpayer Relief Act of 1997, Pub. L. No. 105-34, 111 Stat. 788 (1997)), and (iii) the current statutory exemptions from tax under sections 4261(e)(5), 4261(f), 4261(g), 4261(h), 4261(j), 4281, 4282, and 4293 of the Code.

Section 49.4261-1(b)(1) of the proposed regulations incorporates the payment and collection rules in sections 4261(d) and 4291.

Section 49.4261-1(b)(2) of the proposed regulations reflects the statutory change to section 4263(c) under section 1031 of the Taxpayer Relief Act of 1997, and case law interpreting that revision. Under prior law, section 4263(c) provided that where any tax imposed by section 4261 was not paid at the time payment for transportation was made, the tax was paid by the person paying for the transportation or by the person using the transportation. In other words, the prior law placed no payment obligation on the air carrier. The current version of section 4263(c) provides that where any tax imposed by section 4261 is not paid at the time the payment for transportation is made, the air carrier providing the initial segment of transportation that begins and ends in the United States is liable for the tax. Several courts have rejected arguments that current section 4263(c) imposes only secondary liability for the applicable section 4261 tax on the air carrier if the tax is not otherwise collected. See Sundance Helicopters, Inc. v. U.S., 104 Fed. Cl. 1, 11 (2012) (“The plain language of IRC [section] 4263(c) provides that the air carrier is to pay the tax if it is not otherwise collected. There is no mention of primary versus secondary liability in the text of the statute [...] The language of IRC [section] 4263(c) clearly imposes a payment obligation on the air carrier.”); Temsco Helicopters, Inc. v. U.S., 409 F.App’x. 64, 67 (9^th Cir. 2010) (“nothing in [section] 4263(c) requires that the government first attempt to collect the [air transportation excise tax] from the purchasers...”); Papillon Airways, Inc. v. U.S., 105 Fed. Cl. 154, 163 (2012) (IRC 4263(c) makes “the carrier’s liability conditional on whether the tax was collected at the time payment for transportation was made, not whether the government is unsuccessful at collecting the tax.” (emphasis in original)).

Section 49.4261-1(d) of the proposed regulations generally incorporates the holdings of Revenue Ruling 71-126 (1971-1 C.B. 363) regarding the general applicability of the section 4261 taxes to the transportation of persons on all types of aircraft, and Revenue Ruling 67-414 (1967-2 C.B. 382) regarding the inapplicability of the section 4261 taxes to the transportation of persons on hovercraft.

Section 49.4261-2 of the proposed regulations generally updates the existing regulations to reflect the statutory additions of the domestic segment tax and the international travel facilities tax to section 4261. This section also incorporates the holdings in Revenue Ruling 72-309 (1972-1 C.B. 348) and Revenue Ruling 2002-34 (2002-1 C.B. 1150) regarding the computation of the domestic segment tax and the international travel facilities tax.

Section 49.4261-9(a) of the proposed regulations reflects the rule in section 4261(e)(3)(A) regarding the tax treatment of mileage awards. The Treasury Department and the IRS are currently considering whether to exercise their authority under section 4261(e)(3)(C) to prescribe rules for excluding from the tax base amounts attributable to mileage awards that are used other than for transportation of persons by air. See Notice 2015-76 (2015-46 I.R.B. 669). Nothing in these proposed regulations can be construed as an exercise of that authority. The proposed regulations reserve §49.4261-9(b) for the possible future exercise of the authority granted to the Secretary of the Treasury or his delegate under section 4261(e)(3)(C).

The regulations under sections 4262 and 4263 also have generally not been revised since the 1960s. Amendments to the Code since then, including the repeal of the seats and berths tax, a change to the definition of “uninterrupted international air transportation” under section 4262(c)(3), and a change to the rules in section 4263(c), have rendered certain provisions in the existing regulations obsolete. The proposed regulations remove obsolete provisions and generally update the existing regulations to conform to current law.

Section 4264 of the Code was redesignated as section 4263 in 1970 by Title II, section 205(c)(2), of the AADA. However, the regulations under section 4264 were not similarly redesignated. The proposed regulations redesignate the current section 4264 regulations as section 4263 regulations, remove obsolete provisions, and generally update the existing regulations to conform to current law.

The proposed regulations update the rule in §49.4263-5 (which the proposed regulations redesignate as §49.4281-1) relating to small aircraft on nonestablished lines to reflect statutory changes to the exemption. Specifically, the current regulation provides, in relevant part, that amounts paid to transport a person on a small aircraft are “exempt from the tax imposed under section 4261 provided the aircraft: (1) has a gross take-off weight of less than 12,500 pounds [...] and (2) has a passenger seating capacity of less than 10 adult passengers, including the pilot.” In 1970, the permissible aircraft weight to qualify for the exemption for small aircraft on nonestablished lines was reduced to a maximum certificated take-off weight of 6,000 pounds or less and the maximum passenger seating capacity rule was eliminated. AADA, Title II, section 205(a)(1). In 2005, Congress amended section 4281 to clarify that flights for which the sole purpose is sightseeing are not considered to be operated on an established line. Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users, Pub. L. No. 109-59, section 11124(a), 119 Stat 1144 (2005). In 2012, Congress amended section 4281 to exclude jet aircraft from the exemption. FAA Modernization and Reform Act of 2012, Pub. L. No. 112-95, section 1107(a), 126 Stat 11 (2012). The proposed regulations incorporate the changes to the exemption for small aircraft on nonestablished lines as described above.

Section 4282 provides an exemption from the taxes imposed by section 4261 and 4271 for certain transportation by air for members of an affiliated group. The Treasury Department and the IRS have not issued regulations regarding this provision. The proposed regulations reserve §49.4282-1 for future rules regarding the affiliated group exemption under section 4282.

The updates to part 49 in these proposed regulations are not comprehensive and do not fully update every provision and example that require modernization. The updates are intended to address only the most straightforward and well-settled issues; they are not intended to introduce new rules or address issues that may require a more nuanced approach. The Treasury Department and the IRS believe that these updates will help reduce the burden on taxpayers, collectors, and revenue agents by providing much needed basic updates to the part 49 regulations.

Par. 3. Section 40.6071(a)-3 is removed.

PART 49—FACILITIES AND SERVICES EXCISE TAX REGULATIONS

Par. 4. The authority citation for part 49 continues to read in part as follows:

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

Par. 5. Section 49.4261-1 is revised to read as follows:

(a) In general. Section 4261 of the Internal Revenue Code (Code) imposes three separate taxes on amounts paid for certain transportation of persons by air. Tax attaches at the time of payment for any transportation taxable under section 4261. The applicability of each section 4261 tax is generally determined on a flight-by-flight basis.

(1) Percentage tax. Section 4261(a) imposes a 7.5 percent tax on the amount paid for the taxable transportation of any person. See section 4262(a) of the Code and §49.4262-1(a) for the definition of the term taxable transportation.

(2) Domestic segment tax. Section 4261(b)(1) imposes a $3 tax (indexed annually for inflation pursuant to section 4261(e)(4)) on the amount paid for each domestic segment of taxable transportation. See section 4261(b)(2) for the definition of the term domestic segment. The domestic segment tax does not apply to a domestic segment beginning or ending at an airport that is a rural airport for the calendar year in which the segment begins or ends (as the case may be). See section 4261(e)(1)(B) for the definition of the term rural airport.

(3) International travel facilities tax. Section 4261(c) imposes a $12 tax (indexed annually for inflation pursuant to section 4261(e)(4)) on any amount paid (whether within or without the United States) for any transportation by air that begins or ends in the United States. The international travel facilities tax does not apply to any transportation that is entirely taxable under section 4261(a) (determined without regard to sections 4281 and 4282). See section 4261(c)(2). A special rule applies to Alaska and Hawaii flights. See section 4261(c)(3).

(b) Payment and collection obligations—(1) In general. The taxes imposed by section 4261 are collected taxes. In general, the person making the payment subject to tax is the taxpayer. See section 4261(d). The person receiving the payment is the collector (also commonly referred to as the collecting agent). See section 4291 of the Code. The collector must collect the applicable tax from the taxpayer, report the tax on Form 720, Quarterly Federal Excise Tax Return, and remit the tax to the Internal Revenue Service. See sections 4291, 6011, and 7501 of the Code. See §40.6011(a)-1 of this chapter and §49.4291-1. The collector must also make semimonthly deposits of the taxes imposed by section 4261. See section 6302(e) of the Code. See §§40.0-1(c), 40.6302(c)-1, and 40.6302(c)-3 of this chapter. See section 4263(a) and (c) of the Code for special rules relating to the payment and collection of tax.

(2) Failure to collect tax. Where any tax imposed by section 4261 is not paid at the time payment for transportation is made, then, to the extent the tax is not collected under any other provision of subchapter C of chapter 33 of the Code, the tax must be paid by the carrier providing the initial segment of transportation that begins or ends in the United States. See section 4263(c). In other words, if an amount paid for transportation is subject to tax under section 4261 and the applicable tax is not collected at the time the payment is made, the carrier providing the initial segment of transportation that begins or ends in the United States is liable for the tax. See section 6672 of the Code for rules relating to the application of the trust fund recovery penalty.

(c) Type of aircraft. The taxes imposed by section 4261 generally apply regardless of the type of aircraft on which the transportation is provided, provided all of the other conditions for liability are present and no specific statutory exemption applies. See paragraph (f) of this section for a list of statutory exemptions from tax. Amounts paid for the transportation of persons by air cushion vehicles, also known as hovercraft, are not subject to the taxes imposed by section 4261.

(d) Purpose of transportation. The purpose of the transportation (for example, business or pleasure) is not a factor in determining taxability under section 4261.

(e) Routes. Amounts paid for transportation may be taxable even if the transportation is not between two definite points. Unless otherwise exempt, a payment for continuous transportation that begins and ends at the same point is subject to tax. See section 4281 of the Code and §49.4282-1 for the exemption for small aircraft on nonestablished lines.

(f) Exemptions from tax; cross-references—(1) Aircraft management services. For the exemption for certain aircraft management services, see section 4261(e)(5) of the Code and §49.4261-10.

(2) Hard minerals, oil, and gas. For the exemption for certain uses related to the exploration, development, or removal of hard minerals, oil, or gas, see section 4261(f)(1).

(3) Trees and logging operations. For the exemption for certain uses related to trees and logging operations, see section 4261(f)(2).

(4) Air ambulances. For the exemption for air ambulances providing certain emergency medical transportation, see section 4261(g).

(5) Skydiving. For the exemption for certain skydiving uses, see section 4261(h).

(6) Seaplanes. For the exemption for certain seaplane segments, see section 4261(i).

(7) Fractionally-owned aircraft. For the exemption for certain aircraft in fractional ownership aircraft programs, see section 4261(j).

(8) Small aircraft on nonestablished lines. For the exemption for certain small aircraft on nonestablished lines, see section 4281 of the Code and §49.4281-1.

(9) Affiliated groups. For the exemption for certain transportation of members of an affiliated group, see section 4282.

(10) United States and territories. For exemptions authorized by the Secretary of the Treasury or his delegate for the exclusive use of the United States, see section 4293.

(g) Applicability date. This section applies on and after the later of [date these regulations are published as final regulations in the Federal Register] or January 1, 2021. For rules that apply before that date, see 26 CFR part 49, revised as of April 1, 2020.

Par. 6. Section 49.4261-2 is amended by:

1. Revising paragraphs (a) and (b).

2. Adding paragraph (d).

The revisions and addition read as follows:

(a) Tax on total amount paid. The tax imposed by section 4261(a) of the Internal Revenue Code (Code) is measured by the total amount paid for taxable transportation, whether paid in cash or in kind.

(b) Tax on transportation of each person. The taxes imposed by section 4261(b) and (c) of the Code are head taxes and, therefore, apply on a per-passenger basis. The taxes apply to each passenger for whom an amount is paid, regardless of whether the payment is made as a single lump sum or is made individually for each passenger. In the case of charter flights for which a fixed amount is paid, the section 4261(b) and (c) taxes are computed by multiplying the applicable rate of tax by the number of passengers transported on the aircraft.

* * * * *

(d) Applicability date. Paragraphs (a) and (b) of this section apply on and after the later of [date these regulations are published as final regulations in the Federal Register] or January 1, 2021. For rules that apply before that date, see 26 CFR part 49, revised as of April 1, 2020.

Par. 7. Section 49.4261-3 is amended by:

1. Removing “§49.4262(c)-1” wherever it appears and adding “§49.4262-3” in its place.

2. In the first sentence of paragraph (a), removing “The tax imposed by section 4261(a)” and adding “The taxes imposed by section 4261(a) and (b) of the Internal Revenue Code (Code)” in its place.

3. In the second sentence of paragraph (a), adding “under section 4261(a) and (b)” at the end of the sentence.

4. Removing (b) introductory text and (b)(1) and redesignating paragraph (b)(2) as paragraph (b).

5. Revising newly redesignated paragraph (b).

6. Revising paragraph (c).

7. In paragraph (d), removing “section 4262(b) and §49.4262(b)-1” and adding “section 4262(b) of the Code and §49.4262-2” in its place.

8. Adding paragraph (e).

The revisions and additions read as follows:

* * * * *

(b) Other transportation. In the case of transportation, other than that described in paragraph (a) of this section, for which payment is made in the United States, the taxes imposed by section 4261(a) and (b) apply with respect to the amount paid for that portion of such transportation by air which is directly or indirectly from one port or station in the United States to another port or station in the United States, but only if such portion is not a part of uninterrupted international air transportation within the meaning of section 4262(c)(3) of the Code and §49.4262-3(c). Transportation that:

(1) Begins in the United States or the 225–mile zone and ends outside such area,

(2) Begins outside the United States or the 225–mile zone and ends inside such area, or

(3) Begins outside the United States and ends outside such area, is taxable only with respect to such portion of the transportation by air which is directly or indirectly from one port or station in the United States to another port or station in the United States, but only if such portion is not a part of “uninterrupted international air transportation” within the meaning of section 4262(c)(3) and §49.4262-3(c). Thus, on a trip by air from Chicago to London, England, with a stopover at New York, for which payment is made in the United States, if the portion from Chicago to New York is not a part of “uninterrupted international air transportation” within the meaning of section 4262(c)(3) and §49.4262-3(c), the taxes would apply to the part of the payment which is applicable to the transportation from Chicago to New York. However, if the portion from Chicago to New York is a part of “uninterrupted international air transportation” within the meaning of section 4262(c)(3) and §49.4262-3(c), the taxes would not apply.

(c) Method of computing tax on taxable portion. Where a payment is made for transportation which is partially taxable under paragraph (b) of this section, the tax imposed by section 4261(a) may be computed on that proportion of the total amount paid which the mileage of the taxable portion of the transportation bears to the mileage of the entire trip.

* * * * *

(e) Applicability date. This section applies on and after the later of [the date these regulations are published as final regulations in the Federal Register] or January 1, 2021. For rules that apply before that date, see 26 CFR part 49, revised as of April 1, 2020.

Par. 8. Section 49.4261-4 is amended by:

1. In paragraph (a), removing the first “4261(a)” and add “4261 of the Internal Revenue Code (Code)” in its place.

2. In paragraph (a), removing “section 4261(a) (see section 4264(d))” and adding “section 4261 (see section 4263(d) of the Code)” in its place.

3. In paragraph (b), removing “§49.4262(c)-1” and adding “§49.4262-3” in its place.

4. In the first sentence of paragraph (d), removing “§49.4262(c)-1” and adding “§49.4262-3” in its place.

5. In the first sentence of paragraph (d), removing “six-hour” and adding “12-hour” in its place.

Par. 9. Section 49.4261-5 is amended as follows:

1. In paragraph (a), remove “4261(b)” wherever it appears and add “4261(a) and (b)” in its place.

2. In paragraph (c), remove “§49.4262(b)-1” and add “§49.4262-2” in its place.

Par. 10. Section 49.4261-7 is amended by:

1. In the introductory paragraph, removing “4263, 4292, 4293, or 4294” and adding “4261, 4281, 4282 or 4293 of the Internal Revenue Code” in its place.

2. Removing and reserving paragraphs (b), (d), (e), and (g).

3. Revising paragraph (h).

4. In paragraph (i), remove “paragraph (c) of §49.4261-2 and paragraph (f)(4) of §49.4261-8” and add “§§49.4261-2(c) and 49.4261-8(f)(4)” in its place.

5. Adding paragraph (k).

The revision and addition read as follows:

* * * * *

(h) Aircraft charters—(1) When no charge is made by the charterer of an aircraft to the persons transported, the amount paid by the charterer for the charter of the aircraft is subject to tax.

(2) The charterer of an aircraft who sells transportation to other persons must collect and account for the tax with respect to all amounts paid to the charterer by such other persons. In such case, no tax will be due on the amount paid by the charterer for the charter of the aircraft but it shall be the duty of the owner of the aircraft to advise the charterer of the charterer’s obligation for collecting, accounting for, and paying over the tax to the Internal Revenue Service.

* * * * *

(k) Applicability date. Paragraph (h) of this section applies on and after the later of [the date these regulations are published as final regulations in the Federal Register] or January 1, 2021. For rules that apply before that date, see 26 CFR part 49, revised as of April 1, 2020.

Par. 11. Section 49.4261-8 is amended as follows:

1. In the introductory paragraph, remove “4263, 4292, 4293, or 4294” and add “4261, 4281, 4282 or 4293 of the Internal Revenue Code” in its place.

2. Paragraphs (f)(2), (3), and (5) are removed and reserved.

Par. 12. Section 49.4261-9 is revised to read as follows:

(a) Tax imposed. Any amount paid (and the value of any other benefit provided) to an air carrier (or any related person) for the right to provide mileage awards for or other reductions in the cost of any transportation of persons by air is an amount paid for taxable transportation and is therefore subject to the tax imposed by section 4261(a) of the Internal Revenue Code. See section 4261(e)(3)(A).

(b) [Reserved]

(c) Applicability date. This section applies on and after the later of [date these regulations are published as final regulations in the Federal Register] or January 1, 2021.

Par. 13. Section 49.4261-10 is revised to read as follows:

(a) In general—(1) Overview. This section prescribes rules relating to the exemption from tax for amounts paid (in cash or in kind) by an aircraft owner to an aircraft management services provider for certain aircraft management services. Pursuant to section 4261(e)(5) of the Internal Revenue Code (Code), the taxes imposed by sections 4261 and 4271 of the Code do not apply to amounts paid by an aircraft owner to an aircraft management services provider for aircraft management services related to maintenance and support of the aircraft owner’s aircraft; or related to flights (flight services) on the aircraft owner’s aircraft. The exemption in section 4261(e)(5) applies to amounts paid by an aircraft owner to an aircraft management services provider for flight services on the aircraft owner’s aircraft, even if the aircraft owner is not on the flight. The exemption in section 4261(e)(5) does not apply to amounts paid to an aircraft management services provider on behalf of an aircraft owner (other than in a principal-agent scenario in which the aircraft owner is the principal). For example, amounts paid for aircraft management services by one member of an affiliated group (as that term is defined in section 4282 of the Code) for flights on an aircraft owned by another member of the affiliated group are not treated as amounts paid by the aircraft owner. See paragraph (b) of this section for definitions of terms used in this section.

(2) Private aviation. The exemption in section 4261(e)(5) is limited to aircraft management services related to aircraft used in private aviation.

(3) Adequate records required. In order to qualify for the exemption in section 4261(e)(5), an aircraft owner and aircraft management services provider must maintain adequate records to show that the amounts paid by the aircraft owner to the aircraft management services provider relate to aircraft management services specifically for the aircraft owner’s aircraft or for flights on the aircraft owner’s aircraft.

(b) Definitions. This paragraph provides definitions applicable to this section.

(1) Aircraft management services. The term aircraft management services means—

(i) Statutory services. The services listed in section 4261(e)(5)(B); and

(ii) Other services. Any service (including, but not limited to, purchasing fuel, purchasing aircraft parts, and arranging for the fueling of an aircraft owner’s aircraft) provided directly or indirectly by an aircraft management services provider to an aircraft owner, that is necessary to keep the aircraft owner’s aircraft in an airworthy state or to provide air transportation to the aircraft owner on the aircraft owner’s aircraft at a level and quality of service required under the agreement between the aircraft owner and the aircraft management services provider.

(2) Aircraft management services provider. The term aircraft management services provider means a person that provides aircraft management services, as defined in paragraph (b)(1) of this section, to an aircraft owner, as defined in paragraph (b)(3) of this section.

(3) Aircraft owner—(i) In general. The term aircraft owner means an individual or entity that leases or owns (that is, holds title to or substantial incidents of ownership in) an aircraft managed by an aircraft management services provider (commonly referred to as a managed aircraft). The term aircraft owner does not include a lessee of an aircraft under a disqualified lease, as defined in paragraph (b)(4) of this section. A person that owns stock in a commercial airline does not qualify as an aircraft owner of that commercial airline’s aircraft.

(ii) Fractional aircraft ownership and similar arrangements. A participant in a fractional aircraft ownership program, as defined in section 4043(c)(2) of the Code, does not qualify as an aircraft owner of the program’s managed aircraft if the amount paid for such person’s participation is exempt from the taxes imposed by sections 4261 and 4271 by reason of section 4261(j). Similarly, a participant in a business arrangement seeking to circumvent the surtax imposed by section 4043 by operating outside of subpart K of 14 CFR part 91, that allows an aircraft owner the right to use any of a fleet of aircraft (through an aircraft interchange agreement, through holding nominal shares in a fleet of aircraft, or any other similar arrangement), is not an aircraft owner with respect to any of the aircraft owned or leased as part of that business arrangement.

(4) Disqualified lease. The term disqualified lease has the meaning given to it by section 4261(e)(5)(C)(ii). A disqualified lease also includes any arrangement that seeks to circumvent the rule in section 4261(e)(5)(C)(ii) by providing a lease term that is greater than 31 days but does not provide the lessee with exclusive and uninterrupted access and use of the leased aircraft, as identified by the aircraft’s airframe serial number and tail number. For purposes of the preceding sentence, the fact that a lease permits the lessee to use the aircraft for for-hire flights, as defined in paragraph (b)(5) of this section, when the lessee is otherwise not using the aircraft does not, because of this fact alone, cause a lease with a term that is greater than 31 days to be a disqualified lease.

(5) For-hire flight. The term for-hire flight means the use of an aircraft to transport passengers for compensation that is paid in cash or in kind. The term includes, but is not limited to, charter flights, air taxi flights, and sightseeing flights (commonly referred to as flightseeing flights).

(6) Private aviation. The term private aviation means the use of an aircraft for civilian flights except scheduled passenger service.

(7) Substitute aircraft. The term substitute aircraft means an aircraft, other than the aircraft owner’s aircraft, that is provided by an aircraft management services provider to the aircraft owner when the aircraft owner’s aircraft is not available, regardless of the reason for the unavailability.

(c) Substitute Aircraft—(1) Allocation required. If an aircraft management services provider provides flight services to an aircraft owner on a substitute aircraft during a calendar quarter, the taxes imposed by section 4261 (including the taxes imposed by section 4261(b) or (c), as appropriate, on each passenger transported) or 4271, as the case may be, apply to that portion of the amounts paid by the aircraft owner to the aircraft management services provider, determined on a pro rata basis, as described in paragraph (c)(2) of this section, that are related to the flight services provided on the substitute aircraft.

(2) How calculated. The allocation described in paragraph (c)(1) of this section is calculated by applying to the total amount paid by an aircraft owner to an aircraft management services provider during the calendar quarter the ratio of—

(i) Substitute aircraft hours. The total flight hours provided on substitute aircraft during the calendar quarter; over

(ii) Total hours. The sum of—

(A) The total flight hours made on the aircraft owner’s aircraft during the calendar quarter; and

(B) The total flight hours provided to the aircraft owner on substitute aircraft during the calendar quarter.

(d) Choice of flight rules. Whether a flight on an aircraft owner’s aircraft operates pursuant to the rules under Federal Aviation Regulations prescribed by the Federal Aviation Administration (FARs) Part 91 (14 CFR part 91) or pursuant to the rules under FARs Part 135 (14 CFR part 135) does not affect the application of section 4261(e)(5).

(e) Aircraft available for hire—(1) In general. Whether an aircraft owner permits an aircraft management services provider or other person to use its aircraft to provide for-hire flights (for example, when the aircraft is not being used by the aircraft owner or when the aircraft is being moved in deadhead service) does not affect the application of section 4261(e)(5). However, an amount paid for for-hire flights on the aircraft owner’s aircraft does not qualify for the section 4261(e)(5) exemption. Therefore, an amount paid for a for-hire flight on an aircraft owner’s aircraft is subject to the tax imposed by section 4261 or 4271, as the case may be, unless the amount paid is otherwise exempt from the tax imposed by section 4261 or 4271 other than by reason of section 4261(e)(5). See §49.4261-7(h) for rules relating to the application of the tax imposed by section 4261 on amounts paid for charter flights.

(2) Fuel used on for-hire flights. To the extent amounts paid for for-hire flights are subject to the tax imposed by section 4261 or 4271, taxable fuel (as defined in section 4083(a) of the Code) or any liquid taxable under section 4041(c) of the Code that is used as fuel on such flights is used in commercial aviation, as that term is defined in section 4083(b). See sections 4081(a)(2) and 4041(c) for the applicable fuel tax rates.

(f) Billing methods. Except as provided in paragraph (a)(3) of this section (relating to adequate records), the method an aircraft management services provider bills, invoices, or otherwise charges an aircraft owner for aircraft management services, whether by specific itemization of costs, flat monthly or hourly fee, or otherwise, does not affect the application section 4261(e)(5).

(g) Coordination with fuel tax provisions. Taxable fuel (as defined in section 4083(a)) or any liquid taxable under section 4041(c) that is used as fuel on a flight for which amounts paid are exempt from the taxes imposed by sections 4261 and 4271 by reason of section 4261(e)(5) is not fuel used in commercial aviation, as that term is defined in section 4083(b). See sections 4081(a)(2) and 4041(c) for the applicable fuel tax rates.

(h) Multiple aircraft management services providers not disqualifying. Whether an aircraft owner pays amounts to more than one aircraft management services provider for aircraft management services does not affect the application of section 4261(e)(5).

(i) Coordination with exemption for aircraft in fractional ownership aircraft programs and fuel surtax; no choice of exemption; anti-abuse rule. The exemption in section 4261(e)(5) does not apply to any amount paid for aircraft management services by a participant in any transaction or arrangement, or through other means, that seeks to circumvent the surtax imposed by section 4043. Further, the exemption in section 4261(e)(5) does not apply to any amounts paid for aircraft management services related to flights that are (or are required to be) operated under FARs Part 91K (14 CFR part 91K). As a result, if an amount paid qualifies for both the exemption provided in section 4261(e)(5) and the exemption provided in section 4261(j), the exemption provided in section 4261(j) applies to the amount paid and the surtax imposed by section 4043 applies to any liquid used in the managed aircraft as fuel. See sections 4261(j) and 4043.

(j) Examples. The following examples illustrate the provisions of this section.

(1) Example 1—(i) Facts. An aircraft owner, which is organized as corporation under state law, pays a monthly fee of $1,000 to an aircraft management services provider for the provision of a pilot for flights on the aircraft owner’s aircraft to transport employees of the aircraft owner’s business to business meetings. The flights constitute taxable transportation, as that term is defined in section 4262(a), and no exemptions (other than section 4261(e)(5)) apply. During the first calendar quarter of 2020, the pilot provides 200 flight hours of service on the aircraft owner’s aircraft and 50 hours of service on a substitute aircraft.

(ii) Analysis. The tax imposed by section 4261(a) applies on a pro rata basis to the pilot’s flight hours on a substitute aircraft. The allocation is calculated by applying to the $3,000 total amount paid (3 months x $1,000 monthly fee) by the aircraft owner to the aircraft management services provider during the calendar quarter the ratio of: 50 (the total pilot flight hours provided on substitute aircraft during the calendar quarter) over 250 (the sum of the total pilot flight hours on the aircraft owner’s aircraft during the calendar quarter and the total pilot flight hours provided on substitute aircraft during the calendar quarter). The computation is as follows: $3,000 x (50/250) = $600 (amount subject to tax). The portion of the amount paid that is exempt from the section 4261 taxes by application of section 4261(e)(5) is $2,400. The portion of the amount paid that is subject to the tax imposed by section 4261(a) is $600. The tax imposed by section 4261(b) also applies to amounts paid for flights on substitute aircraft on a per-passenger basis. See §49.4261-2(b) for rules regarding the application of the tax imposed by section 4261(b).

(2) Example 2—(i) Facts. An aircraft owner pays a monthly fee to an aircraft management services provider for aircraft management services related to the aircraft owner’s aircraft. When the aircraft is not being used by the owner, the owner sometimes permits a charter company to use the aircraft for charter flights. At other times when the aircraft is not being used by the owner, the owner permits a tour operator to use the aircraft for flightseeing tours. All charter and flightseeing flights on the aircraft constitute taxable transportation, as that term is defined in section 4262(a), and no exemptions (other than section 4261(e)(5)) apply. The aircraft’s maximum certificated takeoff weight is 7,000 pounds and the aircraft uses kerosene as fuel.

(ii) Analysis. Amounts paid by the aircraft owner to the aircraft management services provider for aircraft management services related to the aircraft owner’s own aircraft are exempt under section 4261(e)(5). Amounts paid by the charterer or passengers for the charter flights are subject to tax under section 4261(a) and (b). See §49.4261-7(h) for rules relating to the application of the tax imposed by section 4261 on amounts paid for charter flights. See §49.4261-2(b) for rules regarding the application of the tax imposed by section 4261(b). Amounts paid by flightseeing customers for flightseeing tours are also subject to tax under section 4261(a) and (b). If a payment for a flightseeing tour includes charges for nontransportation services, the charges for the nontransportation services may be excluded in computing the tax payable provided the payments are separable and provided in exact amounts. See §49.4261-2(c). The kerosene used as fuel on the charter flights and the flightseeing flights is subject to the tax imposed by section 4081(a) at the commercial rate.

(k) Applicability date. This section applies on and after the later of [date these regulations are published as final regulations in the Federal Register] or January 1, 2021.

Par. 14. Section 49.4262(a)-1 is redesignated as §49.4262-1.

Par. 15. Newly redesignated §49.4262-1 is amended by:

1. In paragraph (a) introductory text, removing “section 4262(b) (see §49.4262(b)-1)” and adding “section 4262(b) of the Internal Revenue Code (Code) (see §49.4262-2)” in its place.

2. In the first sentence of paragraph (a)(1), removing “Transportation” and adding “Transportation by air” in its place.

3. In the first sentence of paragraph (a)(1), removing “(the “225-mile zone”)” and adding “(225-mile zone)” in its place.

4. Revising paragraphs (a)(2) and (b)(2).

5. In paragraph (b), removing “subparagraphs (1) and (5) of this paragraph” and adding “paragraph (b)(1) and (5) of this section” in its place.

6. In paragraph (b), removing “subject to the tax” and adding “subject to the taxes imposed by section 4261(a) and (b)” in its place.

7. Removing and reserving paragraph (c).

8. Revising introductory paragraph (d); designating Example (1) as paragraph (d)(1) and revising new paragraph (d)(1) Example 1.

9. In paragraph (d), designating Example (2) as (d)(2) and removing and reserving newly designated paragraph (d)(2) Example 2.

10. In paragraph (d), designating Example (3) as paragraph (d)(3) and removing “6 hours” wherever it appears and adding “12 hours” in its place and also removing “subject to tax” wherever it appears and adding “subject to the taxes imposed by section 4261(a) and (b)” in its place.

11. In paragraph (d), designating Example (4) as paragraph (d)(4), and removing “six hours” wherever it appears and adding “12 hours” in its place and also removing “subject to tax” wherever it appears and adding “subject to the taxes imposed by section 4261(a) and (b)” in its place.

12. Revising paragraph (e).

13. Adding paragraph (f).

The revisions and addition read as follows:

(a) * * *

(2) In the case of any other transportation by air, that portion of such transportation that is directly or indirectly from one port or station in the United States to another port or station in the United States, but only if such transportation is not part of uninterrupted international air transportation within the meaning of section 4262(c)(3) of the Code and §49.4262-3(c). Transportation from one port or station in the United States occurs whenever a carrier, after leaving any port or station in the United States, makes a regularly scheduled stop at another port or station in the United States irrespective of whether stopovers are permitted or whether passengers disembark.

* * * * *

(b) * * *

(2) New York to Vancouver, Canada, with a stop at Toronto, Canada;

* * * * *

(d) Examples. The following examples illustrate the application of section 4262(a)(2) and the taxes imposed by section 4261(a) and (b) of the Code:

(1) Example (i). A purchases in New York a ticket for air transportation from New York to Nassau, Bahamas, with a scheduled stopover of 14 hours in Miami. The part of the transportation from New York to Miami is taxable transportation as defined in section 4262(a) because such transportation is from one station in the United States to another station in the United States and the trip is not uninterrupted international air transportation (because the scheduled stopover interval in Miami is greater than 12 hours). Therefore, the amount paid for the transportation from New York to Miami is subject to the taxes imposed by section 4261(a) and (b).

* * * * *

(e) Examples of transportation that is not taxable transportation. The following examples illustrate transportation that is not taxable transportation:

(1) New York to Trinidad with no intervening stops;

(2) Minneapolis to Edmonton, Canada, with a stop at Winnipeg, Canada;

(3) Los Angeles to Mexico City, Mexico, with stops at Tijuana and Guadalajara, Mexico;

(4) New York to Whitehorse, Yukon Territory, Canada, by air with a scheduled stopover in Chicago of five hours. Amounts paid for the transportation referred to in examples set forth in paragraphs (e)(1), (2), and (3) of this section are not subject to the tax regardless of where payment is made, since none of the trips:

(i) Begin in the United States or in the 225–mile zone and end in the United States or in the 225–mile zone, nor

(ii) Contain a portion of transportation which is directly or indirectly from one port or station in the United States to another port or station in the United States. The amount paid within the United States for the transportation referred to in the example set forth in paragraph (4) of this section is not subject to tax since the entire trip (including the domestic portion thereof) is “uninterrupted international air transportation” within the meaning of section 4262(c)(3) and paragraph (c) of §49.4262-3. In the event the transportation is paid for outside the United States, no tax is due since the transportation does not begin and end in the United States.

* * * * *

(f) Applicability date. This section applies on and after the later of [date these regulations are published as final regulations in the Federal Register] or January 1, 2021. For rules that apply before that date, see 26 CFR part 49, revised as of April 1, 2020.

Par. 16. Section 49.4262(b)-1 is redesignated as §49.4262-2.

Par. 17. Newly redesignated §49.4262-2 is amended as follows:

1. In paragraph (a), “section 4262(b)” is removed and “section 4262(b) of the Internal Revenue Code” is added in its place.

2. In paragraph (b)(2), Example (2) is removed and reserved.

3. Revise paragraph (d). “Illustration” and add “Example” in its place.

The revisions and additions reads as follows:

* * * * *

(d) Example. The application of paragraph (c) of this section may be illustrated by the following example: A purchases in San Francisco a ticket for transportation by air to Honolulu, Hawaii. The portion of the transportation which is outside the continental United States and is outside Hawaii is excluded from taxable transportation. The tax applies to that part of the payment made by A which is applicable to the portion of the transportation between the airport in San Francisco and the three-mile limit off the coast of California (a distance of 15 miles) and between the three-mile limit off the coast of Hawaii and the airport in Honolulu (a distance of 5 miles). The part of the payment made by A which is applicable to the taxable portion of his transportation and the tax due thereon are computed in accordance with paragraph (c)(1) as follows:

(All distances and fares assumed for purposes of this example. This example only addresses the computation of the tax imposed by section 4261(a). It does not address the computation of any other tax imposed by section 4261 that may apply to these facts.)

Par. 18. Section 49.4262(c)-1 is redesignated as §49.4262-3.

Par. 19. Newly redesignated §49.4262-3 is amended as follows:

1. In the first sentence of paragraph (a), remove “includes only the 48 States existing on July 25, 1956 (the date of the enactment of the Act of July 25, 1956 (Pub. L. 796, 84th Cong., 70 Stat. 644) and the District of Columbia” and add “means the District of Columbia and the States other than Alaska and Hawaii” in its place.

2. In paragraph (a), the last sentence is removed.

3. In paragraph (c), remove “six hours” wherever it appears and add “12 hours” in its place.

4. In paragraph (c), remove “6 hours” wherever it appears and add “12 hours” in its place.

5. In paragraph (c), remove “six-hour” wherever it appears and add “12-hour” in its place.

6. In paragraph (c)(2), remove “paragraph (a)(2) of §49.4264(c)-1” and add “§49.4263-3(a)(2)” in its place.

7. Adding paragraphs (d) and (e).

The additions read as follows:

* * * * *

(d) Transportation. For purposes of the regulations in this subpart, the term transportation includes layover or waiting time and movement of the aircraft in deadhead service.

(e) Applicability date. This section applies on and after the later of [date these regulations are published as final regulations in the Federal Register] or January 1, 2021. For rules that apply before that date, see 26 CFR part 49, revised as of April 1, 2020.

Par. 20. Section 49.4263-5 is redesignated as §49.4281-1.

Par. 21. Newly redesignated §49.4281-1 is amended by:

1. Revising paragraphs (a) and (b).

2. In paragraph (c), adding a sentence at the end of the paragraph.

3. Adding paragraphs (d) and (e).

The revisions and additions read as follows:

(a) In general. Amounts paid for the transportation of persons on a small aircraft of the type sometimes referred to as air taxis shall be exempt from the tax imposed under section 4261 of the Internal Revenue Code provided the aircraft has a maximum certificated takeoff weight of 6,000 pounds or less determined as provided in paragraph (b) of this section. The exemption does not apply, however, when the aircraft is operated on an established line or when the aircraft is a jet aircraft.

(b) Maximum certificated takeoff weight. The term maximum certificated takeoff weight means the maximum certificated takeoff weight shown in the type certificate or airworthiness certificate issued by the Federal Aviation Administration.

(c) * * * An aircraft is not considered as operated on an established line at any time during which the aircraft is being operated on a flight the sole purpose of which is sightseeing.

(d) Jet aircraft. For purposes of this section, the term jet aircraft does not include any aircraft which is a rotorcraft (such as a helicopter) or propeller aircraft.

(e) Applicability date. This section applies on and after the later of [date these regulations are published as final regulations in the Federal Register] or January 1, 2021. For rules that apply before that date, see 26 CFR part 49, revised as of April 1, 2020.

Par. 22. Section 49.4264(a)-1 is redesignated as §49.4263-1.

Par. 23. Newly redesignated §49.4263-1 is revised to read as follows:

Where payment upon which tax is imposed by section 4261 of the Internal Revenue Code is made outside the United States for a prepaid order, exchange order, or similar order, the person furnishing the initial transportation pursuant to such order shall collect the applicable tax. See section 4291 and the regulations thereunder for cases where persons receiving payment must collect the tax.

Par. 24. Section 49.4264(b)-1 is redesignated as §49.4263-2.

Par. 25. Newly redesignated §49.4263-2 is amended as follows:

1. In the first sentence of paragraph (a), remove “4264(b)” and add “4263(b) of the Internal Revenue Code (Code)” in its place.

2. In the last sentence of paragraph (a), remove “office of the district director for the district in which the person making the report is located,” and add “Commissioner” in its place.

3. In paragraph (b), add “of the Code” at the end of the paragraph.

4. In paragraph (c), remove “Illustration.” and add “Example.” in its place.

5. In the last sentence of paragraph (c), remove “office of the district director of internal revenue for the district in which the carrier is located,” and add in its place “Commissioner”.

Par. 26. Section 49.4264(c)-1 is redesignated as §49.4263-3.

Par. 27. Newly redesignated §49.4263-3 is amended by:

1. Removing “a district director” wherever it appears and adding “Commissioner” in its place.

2. Revising paragraph (a).

3. In paragraph (b), removing the second sentence.

4. In paragraph (b), removing “4264” wherever it appears and adding “4263” in its place.

5. In paragraph (b), add “of the Code” after “4291”.

6. Removing and reserving paragraph (c).

The revisions read as follows:

(a) In general—(1) For the rules applicable under section 4263(c) of the Internal Revenue Code, see §49.4261-1(b).

* * * * *

Par. 28. Section 49.4264(d)-1 is redesignated as §49.4263-4.

Par. 29. Newly redesignated §49.4263-4 is amended by removing “4264(d)” and adding “4263(d)” in its place.

Par. 30. Section 49.4264(e)-1 is redesignated as §49.4263-5.

Par. 31. Section 49.4264(f)-1 is redesignated as §49.4263-6.

Par. 32. Newly redesignated §49.4263-6 is amended by removing and reserving paragraph (b).

Par. 33. In § 49.4271-1, revise paragraphs (a) and (b) to read as follows:

(a) Purpose of this section. Section 4271 of the Internal Revenue Code (Code) imposes a 6.25% tax on amounts paid within or without the United States for the taxable transportation of property (as defined in section 4272). This section sets forth rules as to the general applicability of the tax. This section also sets forth rules authorized by section 4272(b)(2) of the Code which exempt from tax payments for the transportation of property by air in the course of exportation (including shipment to a possession of the United States) by continuous movement, and in due course so exported.

(b) Imposition of tax. (1) The tax imposed by section 4271 applies only to amounts paid to persons engaged in the business of transporting property by air for hire.

(2) The tax imposed by section 4271 does not apply to amounts paid for the transportation of property by air if such transportation is furnished on an aircraft having a maximum certificated takeoff weight (as defined in section 4281(b) of the Code) of 6,000 pounds or less, unless such aircraft is operated on an established line or when such aircraft is a jet aircraft. The tax imposed by section 4271 also does not apply to any payment made by one member of an affiliated group (as defined in section 4282(b) of the Code) to another member of such group for services furnished in connection with the use of an aircraft if such aircraft is owned or leased by a member of the affiliated group and is not available for hire by persons who are not members of such group.

* * * * *

Par. 34. Section 49.4271-2 is added to read as follows:

For rules regarding the exemption for certain amounts paid by aircraft owners for aircraft management services, see §49.4261-10.

Par. 35. Add and reserve §49.4282-1.

Sunita Lough,

Deputy Commissioner for Services and Enforcement.

(Filed by the Office of the Federal Register on July 29, 2005, 11:15 a.m., and published in the issue of the Federal Register for July 31, 2020, 85 F.R. 46032)

The uniform capitalization (UNICAP) rules of section 263A provide that, in general, the direct costs and the properly allocable share of the indirect costs of real or tangible personal property produced, or real or personal property described in section 1221(a)(1) acquired for resale, cannot be deducted but must either be capitalized into the basis of the property or included in inventory costs, as applicable. Certain property is exempted from the capitalization requirements of section 263A. For example, section 263(A)(c)(4) provides an exemption to the capitalization requirements of section 263A for any property produced by a taxpayer pursuant to a long-term contract.

In addition, certain taxpayers are exempt from the capitalization requirements. Prior to the enactment of the TCJA, section 263A(b)(2)(B) and §1.263A-3(b)(1) provided that resellers with average annual gross receipts of $10,000,000 or less were not subject to the capitalization requirements (Section 263A small business reseller exemption). Section 13102(b) of the TCJA replaced the Section 263A small reseller exemption with a new general exemption from section 263A under new section 263A(i) for small business taxpayers (Section 263A small business taxpayer exemption). The Section 263A small business taxpayer exemption applies to any taxpayer (other than a tax shelter under section 448(a)(3)), meeting the gross receipts test of section 448(c), as amended by section 13102(a) of the TCJA and explained in greater detail in part 2 of this Explanation of Provisions (Section 448(c) gross receipts test).

The proposed regulations remove the now obsolete Section 263A small reseller exemption provided in existing §1.263A-3(a)(2)(ii) and (b). These proposed regulations also modify existing §§1.263A-1, 1.263A-2, 1.263A-3, 1.263A-4, 1.263A-7, and 1.263A-8 to incorporate the Section 263A small business taxpayer exemption.

A. Application of Section 448(c) Gross Receipts Test to Taxpayers That Are Not Corporations or Partnerships

For purposes of the Section 263A small business taxpayer exemption, section 263A(i)(2) provides that the Section 448(c) gross receipts test is applied in the same manner as if each trade or business of the taxpayer were a corporation or partnership. Proposed §1.263A-1(j)(2)(ii) provides that in the case of a taxpayer other than a corporation or partnership, the Section 448(c) gross receipts test is applied by taking into account the amount of gross receipts derived from all trades or businesses of that taxpayer. Under the proposed regulations, amounts not related to a trade or business of that taxpayer, such as inherently personal amounts of an individual taxpayer, are generally excluded from gross receipts. Such excluded amounts include, in the case of an individual, items such as Social Security benefits, personal injury awards and settlements, disability benefits, and wages received as an employee that are reported on Form W-2. The exclusion for wages does not extend to guaranteed payments, which are not generally equivalent to salaries and wages. See Revenue Ruling 69-184 (1969-1 CB 45). These proposed regulations implementing the Section 263A small business taxpayer exemption are consistent with the proposed regulations implementing the Section 460 small business taxpayer exemption and Section 471 small business taxpayer exemption discussed later in this Explanation of Provisions, which incorporate statutory language similar to that in section 263A(i).

A commenter responding to Revenue Procedure 2018-40 requested clarification on the application of the Section 448(c) gross receipts test to individuals, noting that it was unclear whether the individual owner is required to include the owner’s share of gross receipts from pass-through entities in the individual’s gross receipts. The commenter noted that including such amounts in the individual’s gross receipts would be distortive to the individual’s other trades or business reported on Schedules C, Profit or Loss From Business, Schedule E, Supplemental Income and Loss, and Schedule F, Profit or Loss From Farming, of the Form 1040, U.S. Individual Income Tax Return.

The Treasury Department and the IRS note that section 263A(i) refers to section 448(c), and section 448(c)(2) expressly requires the aggregation rules of sections 52(a) or (b) and 414(m) or (o) to apply. Thus, the aggregation rules under section 52(a) or (b) or section 414(m) or (o) will always apply in connection with applying section 263A(i)(2). Under section 52, an individual taxpayer with two or more trades or businesses reported on the individual’s Schedule C or Schedule E of the individual’s Form 1040 is required to aggregate the gross receipts of those trades or businesses. Proposed §1.263A-1(j)(2)(ii) is consistent with these rules. Additionally, under section 263A(i)(2), each trade or business of the taxpayer is treated as if it were a corporation or partnership, and it is well-established under §1.448-1T(f) that a corporation or partnership includes in its gross receipts all receipts that are properly recognized under that corporation’s or partnership’s accounting method in that taxable year, regardless of the source of the receipts. Since corporations and partnerships do not have inherently personal items, the exclusion of such items from the individual’s trade or business gross receipts is not inconsistent with § 1.448-1T(f)(2)(iv).

Consistent with section 263A(i), proposed §1.263A-1(j)(2)(iii) provides that when determining whether a taxpayer qualifies for the Section 263A small business taxpayer exemption, each partner in a partnership includes a share of partnership gross receipts in proportion to such partner’s distributive share of items of gross income that were taken into account by the partnership under section 703; similarly, each shareholder in an S corporation includes a pro rata share of the S corporation’s gross receipts taken into account by the S corporation under section 1363(b).

B. Removal of Small Reseller Exception

Prior to the TCJA, the Section 263A small reseller exception in section 263A(b)(2)(B) exempted from section 263A resellers with gross receipts of $10 million or less (small reseller gross receipts test). The TCJA removed the Section 263A small reseller exception provided in section 263A(b)(2)(B).

Consistent with the TCJA, these proposed regulations remove existing §1.263A-3(a)(2)(ii) and modify existing §1.263A-3(b) by removing the small reseller gross receipts test. The Treasury Department and the IRS expect that most taxpayers who previously satisfied the small reseller gross receipts test will meet the Section 448(c) gross receipts test due to the increased dollar threshold in section 448(c), and therefore would be eligible to apply the small business taxpayer exemption under section 263A(i).

The definition of gross receipts used for the small reseller gross receipts test under existing §1.263A-3(b) is applied for purposes of other simplifying conventions under the existing section 263A regulations. Since the TCJA removed the small reseller gross receipts test and added the Section 263A small business taxpayer exemption that refers to section 448(c), these proposed regulations update those simplifying conventions by cross referencing to the definition of gross receipts set forth in the proposed regulations under section 448 where applicable.

Specifically, proposed §1.263A-3(a)(5) modifies the definition of gross receipts that is used to determine whether a reseller has de minimis production activities and proposed §1.263A-1(d)(3)(ii)(B)(1) modifies the definition of gross receipts used to permit certain taxpayers to use the simplified production method under §1.263A-2(b) by cross referencing to the definition of “gross receipts” for purposes of the Section 448(c) gross receipts test.

C. Changes to the Uniform Interest Capitalization Rules

Prior to the TCJA, section 263A(f)(1) required the capitalization of interest if the taxpayer produced certain types of property (designated property). The Section 263A small business taxpayer exception applies for all purposes of section 263A, including the requirement to capitalize interest under section 263A(f). Accordingly, these proposed regulations modify §1.263A-7 and §1.263A-8 to add new paragraphs to implement the Section 263A(i) small business taxpayer exemption for purposes of the requirement to capitalize interest.

Additionally, existing §1.263A-9 contains an election that permits taxpayers whose average annual gross receipts do not exceed $10 million to use the highest applicable Federal rate as a substitute for the weighted average interest rate when tracing debt. Again, the Section 263A small business taxpayer exception applies for all purposes of section 263A, including the election for small business taxpayers who choose to capitalize interest under section 263A(f). Therefore, these proposed regulations modify §1.263A-9 to remove the $10 million gross receipts test in the definition of eligible taxpayer and replace it with the Section 448(c) gross receipts test. The Treasury Department and the IRS have determined that the use of a single gross receipts test under the section 263A (other than the pre-existing higher $50 million threshold for testing eligibility to apply the simplified production method) simplifies application of the UNICAP rules for taxpayers.

D. Changes to §1.263A-4 for Farming Trades or Businesses

Prior to the TCJA, section 263A(d)(3) permitted certain taxpayers to elect not to have the rules of section 263A apply to certain plants produced in a farming business conducted by the taxpayer. An electing taxpayer and any related person, as defined in §1.263A-4(d)(4)(iii), are required to apply the alternative depreciation system, as defined in section 168(g)(2), to property used in the taxpayer’s and any related persons’ farming business and placed in service in the taxable years in which the election was in effect.

The Treasury Department and the IRS are aware that taxpayers that made an election under section 263A(d)(3) may also qualify for the Section 263A small business taxpayer exemption, and may prefer to apply that exemption rather than the election under section 263A(d)(3). Proposed §1.263A-4(d)(5) permits a taxpayer to revoke its section 263A(d)(3) election for any taxable year in which the taxpayer is eligible for and wants to apply the Section 263A small business taxpayer exemption by following applicable administrative guidance, such as Revenue Procedure 2020-13 (2020-11 IRB 515). In addition, some taxpayers may be eligible to apply the election under section 263A(d)(3) in a taxable year in which they cease to qualify for the Section 263A small business taxpayer exemption. Therefore, proposed §1.263A-4(d)(6) permits such a taxpayer to change its method of accounting from the exemption under section 263A(i) by making a section 263A(d)(3) election in the same taxable year by following applicable administrative guidance, such as Revenue Procedure 2020-13.

Proposed §1.263A-4(d)(3)(i) is modified to remove the requirement that the election under section 263A(d)(3) by a partnership or S corporation be made by the partner, shareholder or member. The Treasury Department and the IRS believe that the inclusion of this requirement was a drafting error, as sections 703(b) and 1363(c) require the election to be made at the entity level.

The TCJA added new section 263A(d)(2)(C), which provides a special temporary rule for citrus plants lost by reason of casualty. The provision, which expires in 2027, provides that section 263A does not apply to replanting costs paid or incurred by a taxpayer other than the owner if certain conditions are met. Proposed §1.263A-4(e)(5) is added to incorporate this special temporary rule.

E. Costing Rules for Self-Constructed Assets

One commenter stated that the costing rules for self-constructed property used in a taxpayer’s trade or business prior to the enactment of section 263A, which would apply to small business taxpayers choosing to apply the Section 263A small business taxpayer exemption, are not clear. The commenter asked for clarification of what costs a small business taxpayer is required to capitalize to its depreciable property if the taxpayer has chosen to apply the Section 263A small business taxpayer exemption. The Treasury Department and the IRS request further comments on specific clarifications needed regarding the costing rules that existed prior to the enactment of the UNICAP rules under section 263A.

Section 448(a) generally prohibits C corporations, partnerships with a C corporation as a partner, and tax shelters from using the cash receipts and disbursements method of accounting (cash method). However, section 448(b)(3) provides that section 448(a) does not apply to C corporations and partnerships with a C corporation as a partner that meet the Section 448(c) gross receipts test. Prior to the TCJA’s enactment, a taxpayer met the gross receipts test of section 448(c) if, for all taxable years preceding the current taxable year, the average annual gross receipts of the taxpayer (or any predecessor) for any 3-taxable-year period did not exceed $5 million. If a taxpayer had not been in existence for the entire 3-taxable-year period, then the gross receipt test was applied on the basis of the period during which the taxpayer or trade or business was in existence. For a taxable year less than 12 months, the gross receipts of that short taxable year were annualized (short taxable year rule). Additionally, this gross receipts test also required the aggregation of gross receipts for all persons treated as a single employer under section 52(a) or (b) or section 414(m) or (o) (aggregation rule).

Section 13102(a) of the TCJA amended the Section 448(c) gross receipts test to permit a taxpayer (other than a tax shelter) to meet the test if the taxpayer’s average annual gross receipts for the 3-taxable-year period ending with the year preceding the current taxable year does not exceed $25 million and indexed the $25 million threshold for inflation (Section 448 small business taxpayer exemption). Other rules in section 448(c), such as the short taxable year rule and the aggregation rule, were not altered by section 13102(a) of the TCJA.

A. General rules of section 448(c) and Section 448(c) gross receipts test

These proposed regulations modify existing §1.448-1 to clarify that it applies to taxable years beginning before January 1, 2018 for purposes of applying the restrictions on the use of the cash method by C corporations and partnerships with C corporation partners. Proposed §1.448-2 provides rules applicable for taxable years beginning after December 31, 2017. These rules are generally similar to the existing regulations under §1.448-1 and §1.448-1T of the Temporary Income Tax Regulations, including the short taxable year rule and the aggregation rule. However, for taxable years beginning after December 31, 2017, the proposed regulations update the rules to reflect the post-TCJA Section 448(c) gross receipts test. These proposed regulations also clarify that the gross receipts of a C corporation partner are included in the gross receipts of a partnership if the aggregation rules apply to the C corporation partner and the partnership.

The Treasury Department and the IRS publish an annual revenue procedure for inflation-adjusted amounts and intend to include the inflation-adjusted section 448(c) dollar threshold in that revenue procedure. See, for example, Revenue Procedure 2019-44 (2019-47 IRB 1093).

B. Tax Shelters Defined in Section 448(d)(3)

Under section 448(a)(3), a tax shelter is prohibited from using the cash method. Section 448(d)(3) cross references section 461(i)(3) to define the term “tax shelter.” Section 461(i)(3)(B), in turn, includes a cross reference to the definition of “syndicate” in section 1256(e)(3)(B), which defines a syndicate as a partnership or other entity (other than a C corporation) if more than 35 percent of the losses of that entity during the taxable year are allocable to limited partners or limited entrepreneurs. Section 1.448-1T(b)(3) narrowed this definition by providing that a taxpayer is a syndicate only if more than 35 percent of its losses are allocated to limited partners or limited entrepreneurs. Consequently, a partnership or other entity (other than a C corporation) may be considered a syndicate only for a taxable year in which it has losses. These proposed regulations adopt the same definition of syndicate provided in §1.448-1T.

One commenter expressed concern that the definition of syndicate is difficult to administer because many small business taxpayers may fluctuate between taxable income and loss between taxable years, thus their status as tax shelters may change each tax year. The commenter suggested that the Treasury Department and the IRS exercise regulatory authority under section 1256(e)(3)(C)(v) to provide that all the interests held in entities that meet the definition of a syndicate but otherwise meet the Section 448(c) gross receipts test be deemed as held by individuals who actively participate in the management of the entity, so long as the entities do not qualify to make an election as an electing real property business or electing farm business under section 163(j)(7)(B) or (C), respectively. The Treasury Department and the IRS decline to adopt this recommendation. The recommendation would allow a taxpayer that meets the Section 448(c) gross receipts test to completely bypass the “syndicate” portion of the tax shelter definition under section 448(d)(3). Neither the statutory language of section 448 nor the legislative history of the TCJA support limiting the application of the existing definition of tax shelter in section 448(d)(3) in this manner.

The Treasury Department and the IRS are aware of practical concerns regarding the determination of tax shelter status for the taxable year. For example, a taxpayer may determine computationally that it is a syndicate under section 1256 after the close of the taxable year while preparing its Federal income tax return for the taxable year. However, a taxpayer that is a tax shelter is not permitted to use the cash method for that taxable year, but may no longer be able to timely file a Form 3115, Application for Change in Accounting Method, to change from the cash method to an appropriate method, such as an accrual method of accounting (accrual method) for that taxable year, or it may otherwise have time constraints in filing its Federal income tax return by the due date of the return (without extensions) for such taxable year. While these procedural constraints also existed prior to the TCJA, the TCJA’s modifications to several other sections of the Code to reference the section 448(d)(3) definition of tax shelter made the tax shelter status determination under section 448(c)(3) applicable to more taxpayers than prior to the TCJA, increasing the number of taxpayers affected by these procedural constraints.

In light of the increased relevance of the definition of tax shelter under section 448(d)(3) after enactment of the TCJA, proposed §1.448-2(b)(2)(iii)(B) permits a taxpayer to elect to use the allocated taxable income or loss of the immediately preceding taxable year to determine whether the taxpayer is a syndicate for purposes of section 448(d)(3) for the current taxable year. A taxpayer that makes this election will know at the beginning of the taxable year whether it is a tax shelter for the current taxable year, alleviating concerns about the difficulties in timely determining whether it is a tax shelter under section 448(d)(3) and filing changes in method of accounting, if necessary. A taxpayer that makes this election must apply the rule to all subsequent taxable years, and for all purposes for which status as a tax shelter under section 448(d)(3) is relevant, unless the Commissioner permits a revocation of the election.

Another commenter suggested a rule to provide relief to taxpayers that report negative taxable income in a taxable year solely because of a negative section 481(a) adjustment arising from an accounting method change and are consequently within the definition of tax shelter under section 448(d)(3), but that would otherwise meet the Section 448(c) gross receipts test. The suggested rule would deem such taxpayers to not be tax shelters for purposes of section 448(d)(3). The Treasury Department and the IRS decline to adopt this suggestion. No exception was provided in the TCJA to limit the application of the definition of tax shelter in section 448(d)(3) for taxpayers making an overall method change.

The Treasury Department and the IRS continue to study the definition of tax shelter under section 448(d)(3) and request comments on whether additional relief is necessary.

C. Procedures for Taxpayers Required to Change from the Cash Method

Prior to its amendment by the TCJA, a taxpayer met the gross receipts test of section 448(c) if its average annual gross receipts did not exceed $5 million for all prior 3-taxable-year periods. Once a taxpayer’s average annual gross receipts had exceeded $5 million (first section 448 year), a taxpayer was prohibited under section 448 from using the cash method for all subsequent taxable years.

The TCJA removed the requirement under section 448(c) that all prior taxable years of a taxpayer must satisfy the Section 448(c) gross receipts test for the taxpayer to qualify for the cash method for taxable years beginning after December 31, 2017. Thus, section 448 no longer permanently prevents a C corporation or a partnership with a C corporation partner from using the cash method for a year subsequent to a taxable year in which its gross receipts first exceed the dollar threshold for the Section 448(c) gross receipts test. Accordingly, the proposed regulations do not require taxpayers to meet the gross receipts test for all prior taxable years in order to satisfy the Section 448(c) gross receipts test.

The term “first section 448 year” used in existing §1.448-1 no longer reflects the statutory language of section 448 and these proposed regulations remove this term for taxable years beginning after December 31, 2017. Proposed §1.448-2(g)(1) uses the term “mandatory section 448 year” to describe the first taxable year that a taxpayer is prevented by section 448 from using the cash method, or a subsequent taxable year in which the taxpayer is again prevented by section 448 from using the cash method after previously making a change in method of accounting that complied with section 448.

Proposed §1.448-2(g)(3) requires a taxpayer that meets the Section 448(c) gross receipts test in the current taxable year to obtain the written consent of the Commissioner before changing to the cash method if the taxpayer had previously changed its overall method from the cash method during any of the five taxable years ending with the current taxable year. A taxpayer that makes multiple changes in its overall method of accounting within a short period of time may not be treating items of income and expense consistently from year to year, and a change back to the cash method within the five year period may not clearly reflect income, as required by §1.446-1(a)(2), even if section 448 otherwise does not prohibit the use of the cash method.

The proposed regulations also do not contain specific procedures to make a method change from the cash method to a permissible method. The Treasury Department and the IRS have determined that providing a single procedure in administrative guidance, such as Revenue Procedure 2015-13 (or successor) and Revenue Procedure 2019-43 (2019-48 IRB 1107) (or successor) will reduce confusion for taxpayers to make voluntary changes in method of accounting to comply with section 448. Consequently, the proposed regulations provide that a taxpayer in a mandatory section 448 year must follow the applicable administrative procedures to change from the cash method to a permissible method.

Section 460(a) provides that income from a long-term contract must be determined using the percentage-of-completion method (PCM). A long-term contract is defined in section 460(f) as generally any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into. Subject to special rules in section 460(b)(3), section 460(b)(1)(A) generally provides that the percentage of completion of a long-term contract is determined by comparing costs allocated to the contract under section 460(c) and incurred before the close of the taxable year with the estimated total contract costs. Section 460(b)(1)(B) generally provides that a taxpayer is required to pay or is entitled to receive interest determined under the look-back rules of section 460(b)(2) on the amount of any tax liability under chapter 1 of the Code that was deferred or accelerated as a result of overestimating or underestimating total allocable contract costs or contract price with respect to income from long-term contracts reported under the PCM. Section 56(a)(3) generally provides that for alternative minimum tax (AMT) purposes, the taxable income from a long-term contract (other than a home construction contract defined in section 460(e)(5)(A)) is determined under the PCM (as modified by section 460(b)).

Section 460(e)(1)(A) provides an exemption from the requirement to use the PCM for home construction contracts. Prior to the TCJA, section 460(e)(1)(B) provided a separate exemption from the PCM for a long-term construction contract of a taxpayer who estimated that the contract would be completed within the 2-year period from the commencement of the contract (two-year rule), and whose average annual gross receipts for the 3-taxable-year period ending with the year preceding the year the contract was entered into did not exceed $10 million (Section 460(e) gross receipts test). The flush language of section 460(e)(1) provides that a home construction contract with respect to which the two-year rule and Section 460(e) gross receipts test are not met will be subject to section 263A, notwithstanding the general exemption under section 263A(c)(4) for property produced pursuant to a long-term contract (large homebuilder rule). Additionally, for AMT purposes, section 56(a)(3) provides in the case of contract described in section 460(e)(1), other than a home construction contract, the percentage of the contract completed is determined under section 460(b)(1) by using the simplified procedures for allocation of costs prescribed under section 460(b)(3).

Section 13102(d) of the TCJA amended section 460(e)(1)(B) by removing the Section 460(e) gross receipts test and replacing it with the Section 448(c) gross receipts test, as amended by section 13102(a) of the TCJA, for the taxable year in which the contract is entered into. Thus, section 460(e)(1)(B), as modified by TCJA, provides a small contractor exemption for long-term construction contracts of a taxpayer other than a tax shelter that estimates that the contract will be completed within two years of the commencement of the contract and meets the Section 448(c) gross receipts test (Section 460 small contractor exemption). The Section 460 small contractor exemption. does not apply to home construction contracts, which remain exempt from required use of PCM under section 460(e)(1)(A).

A. Application of the Section 448(c) Gross Receipts Test and Rules Applicable to Taxpayers Other Than a Corporation or Partnership

Proposed §1.460-3(b) modifies the rules relating to the small contractor exemption by incorporating the requirement in section 460(e)(1)(B)(ii) that an eligible taxpayer must meet the Section 448(c) gross receipts test for the taxable year in which the contract is entered into.

Section 460(e)(2), which has statutory language identical to that in section 263A(i)(2), provides that for a taxpayer that is not a corporation or partnership, the Section 448(c) gross receipts test is applied in the same manner as if each trade or business of the taxpayer were a corporation or a partnership. Proposed §1.460-3(b)(3)(ii)(A) through (D) provide guidance under section 460(e)(2) consistent with the rules in proposed §1.263A-1(j)(2).

B. Home Construction Contract Rules

The large homebuilder rule under section 460(e)(1) exempts home construction contracts from PCM but requires capitalization of costs under the UNICAP rules under section 263A. Consistent with section 460(e)(1), proposed §1.460-5(d)(3) provides that a taxpayer must capitalize the costs of home construction contracts under section 263A and the regulations under section 263A, unless the taxpayer estimates, when entering into the contract, that it will be completed within two years of the contract commencement date and the taxpayer satisfies the Section 448(c) gross receipts test for the taxable year in which the contract is entered into.

C. Clarification of Method of Accounting Rules

Section 460(e)(2)(B) provides that any change in method of accounting made pursuant to section 460(e)(1)(B)(ii) is treated as initiated by the taxpayer and made with the consent of the Secretary of the Treasury or his delegate (Secretary). The change is made on a cut-off basis for all similarly classified contracts entered into on or after the year of change.

Revenue Ruling 92-28 (92-1 CB 153) held that within the same trade or business, a taxpayer may use different methods of accounting for contracts exempt under section 460(e)(1) and contracts subject to mandatory use of PCM under section 460(a). Accordingly, a taxpayer with both exempt contracts and nonexempt contracts within the same trade or business may use a method of accounting other than PCM for all exempt contracts, even though the taxpayer would be required to use PCM for the nonexempt contracts.

A commenter requested clarification on the interaction of Revenue Ruling 92-28 with section 460(e)(2)(B). The commenter asked for clarification because Revenue Ruling 92-28 describes situations in which a taxpayer is not required to obtain consent to a change in method of accounting because it is either adopting a method of accounting for a new item (Situation 1: PCM for nonexempt long-term contracts) or returning to the use of a previously adopted method (Situation 2: completed contract method for contracts exempt because taxpayer’s average annual gross receipts have fallen below the threshold for the small contractor exemption).

The Treasury Department and the IRS have determined that the holding in Revenue Ruling 92-28 remains correct, and that section 460(e)(2)(B) does not apply to Situations 1 and 2 in Revenue Ruling 92-28. In reconciling the statutory language of section 460(e)(2)(B) with section 446, the Treasury Department and the IRS interpret section 460(e)(2)(B) as applying to situations in which a taxpayer has been using PCM for exempt contracts and would like to change to a different exempt contract method. Accordingly, proposed §1.460-1(f)(3) incorporates the holding of Revenue Ruling 92-28 and provides that a taxpayer may adopt any permissible method of accounting for each classification of contract (that is, exempt and nonexempt).

D. Look-Back Rules

Section 460(b) provides that, upon the completion of any long-term contract, the look-back method is applied to amounts reported under the contract using PCM, whether for regular income tax purposes or for AMT purposes. Under the look-back method, taxpayers are required to pay interest if the taxpayer’s Federal income tax liability is deferred as a result of underestimating the total contract price or overestimating total contract costs. Alternatively, a taxpayer is entitled to receive interest if the taxpayer’s Federal income tax liability has been accelerated as a result of overestimating the total contract price or underestimating total contract costs. Any interest to be paid is based on a comparison of the difference between the Federal income tax liability actually reported by the taxpayer compared to the Federal income tax liability that would have been reported if the taxpayer had used actual contract prices and costs instead of estimated contract prices and costs in computing income under PCM.

i. Look-Back Rules and AMT

Section 12001 of the TCJA amended section 55(a) so that the AMT is no longer imposed on corporations for taxable years beginning after December 31, 2017. Consistent with section 12001 of the TCJA, proposed §1.460-6(c) reflects the changes to section 55(a) by providing that in applying the look-back method, alternative minimum taxable income is redetermined only for taxable years in which the AMT is applicable. Similarly, the recomputed tax liability for prior contract years includes the AMT only for the taxable years in which the AMT is applicable. Consequently, for taxable years beginning after December 31, 2017, for purposes of the look-back method, a corporation will not redetermine alternative minimum taxable income or recompute AMT liability. However, a corporation that has a contract that spans a period beginning before the TCJA (taxable years beginning before January 1, 2018) and ending after the TCJA (taxable years beginning after December 31, 2017), would be required to redetermine alternative minimum taxable income and recompute AMT for those taxable years beginning before January 1, 2018.

ii. De Minimis Exception to Look-Back Rules

Section 460(b)(3) provides an exception to the requirement to apply the look-back method. Under the exception, the look-back method need not be applied if the contract price does not exceed the lesser of $1,000,000 or one percent of the taxpayer’s average annual gross receipts for the prior 3-taxable-year period ending with the year preceding the taxable year in which the contract is completed, and the contract is completed within two years of the commencement of the contract. Proposed §1.460-3(b)(3) provides that, for purposes of this de minimis exception, gross receipts are determined in accordance with the regulations under section 448(c).

iii. Look-Back Rules and the BEAT

Proposed §1.460-6 is also updated to reflect the enactment of the base erosion anti-abuse tax (BEAT) imposed by section 59A. For any taxable year, the BEAT is a tax on each applicable taxpayer (see §1.59A-2) equal to the base erosion minimum tax amount (BEMTA) for that year. Generally, the taxpayer’s BEMTA equals the excess of (1) the applicable tax rate for the taxable year (BEAT rate) multiplied by the taxpayer’s modified taxable income under §1.59A-3(b) for the taxable year over (2) the taxpayer’s adjusted regular Federal income tax liability for that year.

Proposed §1.460-6 applies the look-back method to re-determine the taxpayer’s modified taxable income under §1.59-3(b) and the taxpayer’s BEMTA for the taxable year. Specifically, the taxpayer must determine its modified taxable income and BEMTA for each year prior to the filing year that is affected by contracts completed or adjusted in the filing year as if the actual total contract price and costs had been used in applying the percentage of completion method.

The Treasury Department and the IRS have proposed this rule because the income from long-term contracts determined using the PCM may be overestimated or underestimated, which may change the taxpayer’s modified taxable income or BETMA, or whether or not a taxpayer is an applicable taxpayer in a particular taxable year. Clarifying in the regulations under section 460 that the look-back method must take into account any application of the BEAT makes clear that section 460 provides taxpayers will pay or receive interest (whichever is the case) if their Federal income tax liability, including any BEAT liability, is deferred, eliminated, understated, or overstated as a result of the taxpayer’s estimation of the total contract price or total contract costs.

Section 471(a) requires inventories to be taken by a taxpayer when, in the opinion of the Secretary, taking an inventory is necessary to determine the income of the taxpayer. Section 1.471-1 requires the taking of an inventory at the beginning and end of each taxable year in which the production, purchase, or sale of merchandise is an income-producing factor. Additionally, when an inventory is required to be taken, §1.446-1(c)(1)(iv) and (c)(2) require that an accrual method be used for purchases and sales.

Section 13102(c) of the TCJA added new section 471(c) to remove the statutory requirement to take an inventory when the production, purchase, or sale of merchandise is an income-producing factor for a taxpayer (other than a tax shelter) meeting the Section 448(c) gross receipts test (Section 471 small business taxpayer exemption). The Section 471 small business taxpayer exemption provides that the requirements of section 471(a) do not apply to a taxpayer for that taxable year, and the taxpayer’s method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if the taxpayer either: (1) treats the taxpayer’s inventory as non-incidental materials and supplies, or (2) conforms the taxpayer’s inventory method to the taxpayer’s method of accounting for inventory reflected in an applicable financial statement as defined in section 451(b)(3) (AFS), or if the taxpayer does not have an AFS, in the taxpayer’s books and records prepared in accordance with the taxpayer’s accounting procedures.

Section 471(c)(3) provides that in the case of a taxpayer that is not a corporation or partnership, the Section 448(c) gross receipts test is determined in the same manner as if each trade or business of such taxpayer were a corporation or partnership.

A taxpayer’s method of accounting for inventory may not clearly reflect income if a taxpayer meets the Section 448(c) gross receipts test but does not take an inventory, and also does not either treat its inventory as non-incidental materials and supplies or in conformity with its AFS, or its books and records if it does not have an AFS. In such instances, the general rules under section 446 for analyzing whether a method of accounting clearly reflects income are applicable.

These proposed regulations modify existing §1.471-1 by adding proposed §1.471-1(b) to implement the Section 471 small business taxpayer exemption under section 471(c). Proposed §1.471-1(b) provides guidance on the application of the Section 448(c) gross receipts test to taxpayers other than a corporation or partnership, the treatment of inventory as non-incidental materials and supplies, and the conforming of inventory to an AFS or the taxpayer’s books and records.

A. Application of the Section 448(c) Gross Receipts Test to Taxpayers Other Than a Corporation or Partnership

These proposed regulations provide guidance under section 471(c)(3), which has statutory language identical to section 263A(i)(2), consistent with the rules in proposed §1.263A-1(j)(2). See part 1.A of this Explanation of Provisions for discussion of the application of the Section 448(c) gross receipts test to individuals and other taxpayers that are not a corporation or partnership.

B. Treatment of Inventory as Non-Incidental Materials and Supplies

Section 471(c)(1)(B)(i) provides that a taxpayer, other than a tax shelter, that meets the Section 448(c) gross receipts test can treat its inventory as non-incidental materials and supplies.

Prior to the TCJA, the Treasury Department and the IRS provided administrative relief for certain taxpayers from the requirements of section 471(a) with regard to purchases and sales of inventory. Under Revenue Procedure 2001-10 (2001-2 IRB 272), a taxpayer with average annual gross receipts that did not exceed $1 million was exempted from the requirements to use an accrual method under section 446 and to account for inventories under section 471. Similarly, under Revenue Procedure 2002-28 (2002-28 IRB 815), a “qualifying small business taxpayer,” as defined in section 4.01 of Revenue Procedure 2002-28, was also exempted from the requirements to use an accrual method under section 446 and to account for inventories under section 471. To qualify, a taxpayer must have had average annual gross receipts that did not exceed $10 million in certain industries, or reasonably determined that its principal business activity was the provision of services, or reasonably determined its principal business activity was the fabrication or modification of customized tangible personal property.

Under both revenue procedures, a taxpayer was permitted to account for its inventory in the same manner as non-incidental materials and supplies under §1.162-3. Under § 1.162-3, materials and supplies that are not incidental are deductible only in the year in which they are actually consumed and used in the taxpayer’s business. For purposes of these revenue procedures, inventoriable items treated as non-incidental materials and supplies were treated as consumed and used in the taxable year the taxpayer provided the items to a customer. Thus, the costs of such inventoriable items were recovered by a cash basis taxpayer only in that year, or in the year in which the taxpayer actually paid for the goods, whichever was later. See section 4.02 of Revenue Procedure 2001-10 and section 4.05 of Revenue Procedure 2002-28.

Section 471(c)(1)(B)(i) generally codified the treatment of inventory using the non-incidental materials and supplies method of accounting described in Revenue Procedure 2001-10 and Revenue Procedure 2002-28, with certain exceptions. Accordingly, proposed §1.471-1(b)(4) provides rules similar to the provisions of these revenue procedures, including that the items continue to be inventory property. The proposed regulations refer to inventory treated as non-incidental materials and supplies as “section 471(c) materials and supplies.”

i. Definition of the Term “Used and Consumed”

As explained previously and as noted in the Conference Report to the TCJA, an exception to the requirement to take an inventory was provided under Revenue Procedure 2001-10 and Revenue Procedure 2002-28. H.R. Rep. No. 115-466, at 378 fn. 638 and 639 (2017). Under that exception, a taxpayer was able to account for inventory as materials and supplies that are not incidental. The cost of non-incidental materials and supplies is deductible in the taxable year in which the materials and supplies are first used or consumed in the taxpayer’s operations. Id. at 378 fn. 640. As discussed in part 4.B of this Explanation of Provisions, the administrative guidance as in existence prior to the TCJA provided that inventory treated as non-incidental materials and supplies under §1.162-3 remained inventory property, the cost of which was recovered by a cash basis taxpayer when the items were provided to a customer, or when the taxpayer paid for the items, whichever was later. The Conference Report describes the TCJA as generally permitting the costs of non-incidental materials and supplies to be recovered in the taxable year that is “consistent with present law.” Id. at 380 fn. 657. The Treasury Department and IRS interpret section 471(c)(1)(B)(i) as generally codifying the administrative guidance existing at the time of enactment (that is, Revenue Procedure 2001-10 and Revenue Procedure 2002-28). Accordingly, proposed §1.471-1(b)(4)(i) provides that section 471(c) materials and supplies are used or consumed in the taxable year in which the taxpayer provides the item to a customer and the cost of such item is recovered in that year or the taxable year in which the taxpayer pays for or incurs (in the case of an accrual method taxpayer) such cost, whichever is later.

One commenter requested that raw materials used in the production of finished goods be deemed “used or consumed” when the raw material is used during production instead of when the finished product is provided to a customer. Under this approach, a producer would be able to recover production costs earlier than allowed under the administrative guidance of Revenue Procedure 2001-10 and Revenue Procedure 2002-28. Further, under this approach, a producer would be permitted to recover costs earlier than a reseller. The Treasury Department and the IRS decline to adopt this suggestion. As discussed previously, the Treasury Department and the IRS interpret section 471(c)(1)(B)(i) and its legislative history generally as codifying the rules provided in the administrative guidance existing at the time the Act was enacted. Accordingly, proposed §1.471-1(b)(4) provides that section 471(c) materials and supplies are “used and consumed” in the taxable year the taxpayer provides the goods to a customer, and that the cost of goods is recovered in that year or the taxable year in which such cost is paid or incurred (in accordance with the taxpayer’s method of accounting), whichever is later.

ii. De Minimis Safe Harbor under §1.263(a)-1(f)

Section 1.263(a)-1(f) provides a regulatory de minimis safe harbor election through which an electing taxpayer may choose not to treat as a material or supply under §1.162-3(a) any amount paid in the taxable year for tangible property if the amount paid meets certain requirements, and instead to deduct the de minimis amount in accordance with its AFS, or books and records, if the taxpayer has no AFS. Section 1.263(a)-1(f)(2)(i) provides that the de minimis safe harbor election does not apply to amounts paid for property that is or is intended to be included in inventory property.

Two commenters asked for clarification on whether a taxpayer using the non-incidental materials and supplies method under section 471(c)(1)(B)(i) may use the de minimis safe harbor election of §1.263(a)-1(f). As discussed in part 4.B of this Explanation of Provisions, the Treasury Department and the IRS continue to interpret inventory treated as non-incidental materials and supplies as remaining characterized as inventory property. Consequently, proposed §1.471-1(b)(4)(i) provides that inventory treated as section 471(c) non-incidental materials and supplies is not eligible for the de minimis safe harbor election under §1.263(a)-1(f). Extending the regulatory election under §1.263(a)-1(f) to encompass section 471(c) materials and supplies is outside the intended scope of the election and runs counter to section 471(c), which indicates section 471(c) materials and supplies are inventory property.

iii. Identification and Valuation of Section 471(c) Materials and Supplies

One commenter asked for guidance on how a taxpayer determines the cost basis of inventory items that are treated as non-incidental materials and supplies. Proposed §1.471-1(b)(4)(ii) provides guidance on how a taxpayer may identify and value section 471(c) materials and supplies. These identification and valuation methods would apply whether the taxpayer used the cash method or an accrual method.

Consistent with Revenue Procedure 2002-28, and the legislative history to section 471(c), proposed §1.471-1(b)(4)(ii) permits taxpayers to determine the amount of their section 471(c) materials and supplies by using either a specific identification method, a first-in, first-out (FIFO) method, or an average cost method, provided that the method is used consistently. Taxpayers may not identify their inventory using a last-in, first-out (LIFO) method or value section 471(c) materials and supplies using a lower-of-cost-or-market (LCM) method. The Treasury Department and the IRS are aware that the purpose of the section 471(c) materials and supplies method is to provide simplification. Accounting methods using LIFO and LCM require sophisticated computations and are allowed under the more complex inventory rules of sections 471(a) and 472. Accordingly, these proposed regulations do not permit a taxpayer using the section 471(c) materials and supplies method to use either a LIFO method or the LCM method.

iv. Direct Labor and Overhead Costs for Section 471(c) Materials and Supplies

Commenters asked for clarification as to the treatment of direct labor and overhead costs for section 471(c) materials and supplies. Revenue Procedure 2001-10 and Revenue Procedure 2002-28 did not directly address whether direct labor and overhead costs for inventory treated as non-incidental materials and supplies were immediately deductible. The commenters argue that if inventories are treated as non-incidental materials and supplies, then all of the direct labor and overhead costs incurred in producing the goods are deductible when incurred. One commenter noted that prior to the enactment of section 263A, the costing rules for inventoriable goods produced by a taxpayer were governed by the full absorption method under §1.471-11, and §1.471-3, in the case of a reseller of inventory.

The Treasury Department and the IRS have determined that under the section 471(c) materials and supplies method, the items retain their character as inventory property. Because the property remains characterized as inventory property, the costing rules in §1.471-11 and §1.471-3 are the applicable rules to determine which costs are to be included under the section 471(c) materials and supplies method. However, the Treasury Department and the IRS are aware that the purpose of section 471(c)(1)(A)(i) is to provide simplification for taxpayers. Accordingly, these proposed regulations provide that a taxpayer using the section 471(c) materials and supplies method is required to include only direct costs paid to produce or acquire the inventory treated as section 471(c) materials and supplies. These direct costs are not immediately deductible but are recovered in accordance with proposed §1.471-1(b)(4). Consistent with existing law, these proposed regulations provide that a taxpayer is not permitted to recover a cost that it otherwise would be neither permitted to recover nor deduct for Federal income tax purposes solely by reason of it being included in the costs of section 471(c) materials and supplies.

C. Treatment of Inventory for an AFS Taxpayer

A taxpayer, other than a tax shelter, that meets the Section 448(c) gross receipts test need not take an inventory under section 471(a) and may choose to treat its inventory as the inventory is reflected in the taxpayer’s AFS, or if the taxpayer does not have an AFS, as the inventory is treated in the taxpayer’s books and records prepared in accordance with the taxpayer’s accounting procedures. These proposed regulations provide guidance on the definition of AFS, the types and amounts of costs reflected in an AFS that can be recovered under section 471(c), and when such costs may be taken into account. The proposed regulations use the term “AFS section 471(c) method” to describe the permissible section 471(c)(1)(B)(ii) method for a taxpayer with an AFS (AFS taxpayer).

i. Definition of AFS

Section 471(c)(2) defines an AFS by cross-reference to section 451(b)(3). Consistent with the statute, proposed §1.471-1(b)(5)(ii) defines the term AFS in accordance with section 451(b)(3), and incorporates the definition provided in proposed §1.451-3(c)(1). The rules relating to additional AFS issues provided in §1.451-3(h) also apply to the AFS section 471(c) method. The proposed regulations also provide that a taxpayer has an AFS for the taxable year if all of the taxpayer’s taxable year is covered by an AFS.

If a taxpayer’s AFS is prepared on the basis of a financial accounting year that differs from the taxpayer’s taxable year, proposed §1.471-1(b)(5)(ii) provides that a taxpayer determines its inventory for the mismatched reportable period by using a method of accounting described in proposed §1.451-3(h)(4). The Treasury Department and the IRS propose to require a taxpayer with an AFS that uses the AFS section 471(c) method to consistently apply the same mismatched reportable period method provided in proposed §1.451-3(h)(4) for purposes of its AFS section 471(c) method of accounting that is used for section 451. The Treasury Department and the IRS request comments on the consistency requirement and other issues related to the application of proposed §1.451-3(h) to the AFS section 471(c) method.

ii. Types and Amounts of Costs Reflected in an AFS

Proposed §1.471-1(b)(5) provides rules relating to the AFS section 471(c) method, including a description of the costs included in this method. The proposed regulations provide that an AFS taxpayer, other than a tax shelter, that meets the Section 448(c) gross receipts test may use the AFS section 471(c) method to account for its inventory costs for that taxable year. The proposed regulations also clarify that a taxpayer using the AFS section 471(c) method is maintaining inventory, but generally recovers the costs of inventory in accordance with its AFS inventory method and not by using an inventory method specified under section 471(a) and the regulations under section 471.

Under the AFS section 471(c) method, the term “inventory costs” means the costs that a taxpayer capitalizes to property produced or property acquired for resale in its AFS. However, these proposed regulations clarify that the amount of an inventory cost in a taxpayer’s AFS may not properly reflect the amount recoverable under the taxpayer’s AFS section 471(c) method. These proposed regulations provide that a taxpayer is not permitted to recover a cost that it otherwise would be neither permitted to recover nor deduct for Federal income tax purposes solely by reason of it being an inventory cost in the taxpayer’s AFS inventory method. In addition, these proposed regulations provide that a taxpayer may not capitalize a cost to inventory any earlier than the taxable year in which the amount is paid or incurred under the taxpayer’s overall method of accounting for Federal income tax purposes (for example, if applicable, section 461(h) is met) or not permitted to be capitalized by another Code provision (for example, section 263(a)). As a result, a taxpayer may be required to reconcile any differences between its AFS and Federal income tax return treatment (book-tax adjustments) for all or a portion of a cost that was included in the taxpayer’s AFS inventory method under the AFS section 471(c) method.

The Treasury Department and the IRS are aware that some taxpayers may interpret section 471(c)(1)(B)(ii) as permitting a taxpayer to capitalize a cost to inventory for Federal income tax purposes when that cost is included in the taxpayer’s AFS inventory method irrespective of: (1) whether the amount is deductible or otherwise recoverable for Federal income tax purposes; or (2) when the amount is capitalizable under the taxpayer’s overall method of accounting used for Federal income tax purposes. The Treasury Department and the IRS do not agree with this interpretation because section 471 is a timing provision. Section 471 is in subchapter E of chapter 1, Accounting Periods and Methods of Accounting. It is not in subchapter B of chapter 1, Computation of Taxable Income. A method of accounting determines when an item of income or expense is recognized, not whether it is deductible or recoverable through cost of goods sold or basis.

Accordingly, the Treasury Department and the IRS view section 471(c)(1)(B)(ii) as an exemption from taking an inventory under section 471(a) for certain taxpayers that meet the Section 448(c) gross receipts test and not as an exemption from the application of Code provisions other than section 471(a). While Congress provided an exemption from the general inventory timing rules of section 471(a), Congress did not exempt these taxpayers from applying other Code provisions that determine the deductibility or recoverability of costs, or the timing of when costs are considered paid or incurred. For example, Congress did not modify or alter section 461 regarding when a liability is taken into account, or any of the provisions that disallow a deduction, in whole or in part, such as any disallowance under section 274, to exempt these taxpayers. Accordingly, these proposed regulations require an AFS taxpayer that uses the AFS section 471(c) method to make book-tax adjustments for costs capitalized in its AFS that are not deductible or otherwise recoverable, in whole or in part, for Federal income tax purposes or that are taken into account in a taxable year different than the year capitalized under the AFS as a result of another Code provision.

D. Treatment of Inventory by Taxpayers Without an AFS

Under section 471(c)(1)(B)(ii), a taxpayer, other than a tax shelter, that does not have an AFS and that meets the Section 448(c) gross receipts test is not required to take an inventory under section 471(a), and may choose to treat its inventory as reflected in the taxpayer’s books and records prepared in accordance with the taxpayer’s accounting procedures (non-AFS section 471(c) method). These proposed regulations permit a taxpayer without an AFS (non-AFS taxpayer) to follow its method of accounting for inventory used in its books and records that properly reflect its business activities for non-Federal income tax purposes. The proposed regulations clarify that a non-AFS taxpayer using the non-AFS section 471(c) method has inventory, but recovers the costs of inventory through its book method, rather than through an inventory method under section 471(a) and the regulations under section 471.

Two comments received requested a definition of “books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.” The Treasury Department and the IRS decline to define books and records in these proposed regulations. It is well-established under existing law that the books and records of a taxpayer comprise the totality of the taxpayer’s documents and electronically-stored data. See, for example, United States v. Euge, 444 U.S. 707 (1980). See also Digby v. Comm’r, 103 T.C. 441 (1994), and §1.6001-1(a). A commenter specifically asked for clarification on whether books and records of the taxpayer include the accountant’s workpapers (whether recorded on paper, electronically or on other media). The Treasury Department and the IRS note that under existing law, these workpapers are generally considered part of the books and records of the taxpayer. United States v. Arthur Young & Co., 465 U.S. 805 (1984).

The Treasury and the IRS interpret section 471(c)(1)(B)(ii) as a simplification of the inventory accounting rules in section 471(a) for certain small business taxpayers. Proposed §1.471-1(b)(6)(i) provides that under the non-AFS section 471(c) method, a taxpayer recovers the costs of inventory in accordance with the method used in its books and records and not by using an inventory method specified under section 471(a) and regulations under 471. A books and records method that determines ending inventory and cost of goods sold that properly reflects the taxpayer’s business activities for non-Federal income tax purposes is to be used under the taxpayer’s non-AFS section 471(a) method. For example, a taxpayer that performs a physical count that is used in determining inventory in the taxpayer’s books and records must use that count for purposes of the non-AFS section 471 method.

Consistent with the rules applicable to AFS taxpayers, proposed §1.471-1(b)(6)(ii) clarifies that a non-AFS taxpayer is not permitted to recover a cost that it otherwise would not be permitted to recover or deduct for Federal income tax purposes solely by reason of it being an inventory cost in the taxpayer’s non-AFS inventory method. These proposed regulations provide that a taxpayer may not capitalize a cost to inventory any earlier than the taxable year in which the amount is paid or incurred under the taxpayer’s overall method of accounting for Federal income tax purposes (for example, if applicable, section 461(h) is met) or not permitted to be capitalized by another Code provision (for example, section 263(a)). See section 4.C.ii of this Explanation of Provisions.

As noted in the Background section of this preamble, section 13221(a) of the TCJA added a new section 451(b) to the Code effective for taxable years beginning after December 31, 2017. This provision provides that, for an accrual method taxpayer with an AFS, the all events test with respect to any item of gross income (or portion thereof) is not treated as met any later than when the item (or portion thereof) is included in revenue for financial accounting purposes on an AFS. Section 451(b)(1)(A) sets forth the general AFS Income Inclusion Rule, providing that, for an accrual method taxpayer with an AFS, the all events test with respect to an item of gross income, or portion thereof, is met no later than when the item, or portion thereof, is included as revenue in an AFS (AFS Income Inclusion Rule). However, section 451(b)(2) provides that the AFS Income Inclusion Rule does not apply with respect to any item of gross income the recognition of which is determined using a special method of accounting, “other than any provision of part V of subchapter P (except as provided in clause (ii) of paragraph (1)(B)).” In addition, section 451(b)(4) provides that for purposes of section 451(b), in the case of a contract which contains multiple performance obligations, the allocation of the transaction price to each performance obligation is equal to the amount allocated to each performance obligation for purposes of including such item in revenue in the taxpayer’s AFS. Additionally, section 451(c)(4)(D), which provides rules for allocating payments to each performance obligation for purposes of applying the advance payment rules under section 451(c), provides that for purposes of section 451(c), “rules similar to section 451(b)(4) shall apply.”

The preamble to the proposed regulations under section 451(b) contained in REG-104870-18 (84 FR 47191) requested comments on the allocation of transaction price for contracts that include both income subject to section 451 and income subject to a special method of accounting provision (specifically section 460). One commenter suggested that the allocation provisions under section 460 and the regulations thereunder, and not section 451(b)(4), should control the amount of gross income from a long-term contract that is accounted for under section 460. The commenter notes that using this approach is appropriate in light of section 451(b)(2), which reflects Congress’s intent to not disturb the treatment of amounts for which a taxpayer uses a special method of accounting. The preamble to the proposed regulations under section 451(c) contained in REG-104554-18 (84 FR 47175) also included a similar request for comments for advance payment purposes; however, no comments were received in response to this request.

In light of the comment in the preceding paragraph and the questions received from taxpayers and practitioners regarding this issue in the context of other special methods of accounting (for example, section 467), the Treasury Department and the IRS are considering a rule that addresses the application of sections 451(b)(2) and (4) to contracts with income that is accounted for in part under section 451 and in part under a special method of accounting provision. The Treasury Department and the IRS are also considering a similar rule that addresses the application of section 451(c)(4)(D) to certain payments received under such contracts. The Treasury Department and the IRS have determined that these rules would benefit from further notice and public comment.

The Treasury Department and the IRS are considering a rule providing that if an accrual method taxpayer with an AFS has a contract with a customer that includes one or more items of gross income subject to a special method of accounting (as defined in proposed §1.451-3(c)(5)) and one or more items of gross income subject to section 451, the allocation rules under section 451(b)(4) do not apply to determine the amount of each item of gross income that is accounted for under the special method of accounting provision. Accordingly, the transaction price allocation rules in section 451(b)(4) and proposed §1.451-3(g)(1) (as contained in REG-104870-18) would apply to only the portion of the gross transaction price that is not accounted for under the special method of accounting provision (that is, the residual amount) and only to the extent the contract contains more than one performance obligation that is subject to section 451. To the extent such a contract contains more than one performance obligation that is subject to section 451, the residual amount would be allocated to each section 451 performance obligation in proportion to the amount allocated to each such performance obligation for purposes of including such item in revenue in the taxpayer’s AFS. The Treasury Department and the IRS request comments on this rule (section 451(b) special method allocation rule), including (i) whether taxpayers should be permitted to use the allocation rules under section 451(b)(4) to determine the amount of an item of gross income that is accounted for under a special method of accounting, (ii) whether a specific allocation standard should be provided for determining the amount of an item of gross income that is accounted for under a special method of accounting in situations where an allocation standard is not provided under the applicable special method of accounting rules, and (iii) whether alternative allocation options may be appropriate for allocating the residual amount to multiple performance obligations that are within the scope of section 451.

The Treasury Department and the IRS are also considering a similar allocation rule for purposes of applying the advance payment rules under section 451(c). Specifically, the Treasury Department and the IRS are considering a rule providing that if an accrual method taxpayer with an AFS receives a payment that is attributable to one or more items of gross income that are described in proposed §1.451-8(b)(1)(i)(C) and one or more items of gross income that are subject to a special method of accounting (as defined in proposed §1.451-3(c)(5)), then the taxpayer must determine the portion of the payment allocable to the item(s) of gross income that are described in proposed §1.451-8(b)(1)(i)(C) by using an objective criteria standard (consistent with objective criteria standard under section 5.02(4) of Revenue Procedure 2004-34 (2004-22 IRB 991)). Under this rule a taxpayer that allocates the payment to each item of gross income in proportion to the total amount of each such item of gross income (as determined under the section 451(b) special method allocation rule that is described in the preceding paragraph), will be deemed to have meet the objective criteria standard. The Treasury Department and the IRS request comments on this rule, including whether alternative payment allocation approaches may be more appropriate (for example, an approach that permits the taxpayer to follow its AFS allocation).

Proposed §1.448-2(b)(2)(iii)(B) imposes a collection of information for an election to use prior year’s allocated taxable income or loss to determine whether a partnership or other entity (other than a C corporation) is a “syndicate” for purposes of section 448(d)(3) for the current tax year. The election is made by attaching a statement to the taxpayer’s original Federal income tax return for the current tax year. The election is binding for all subsequent taxable years, and can only be revoked with the consent of the Commissioner. The collection of information is voluntary for purposes of obtaining a benefit under the proposed regulations. The likely respondents are businesses or other for-profit institutions, and small businesses or organizations.

Estimated total annual reporting burden: 199,289 hours

Estimated average annual burden hours per respondent: 1 hour

Estimated number of respondents: 199,289

Estimated annual frequency of responses: once.

Other than the election statement, these proposed regulations do not impose any additional information collection requirements in the form of reporting, recordkeeping requirements or third-party disclosure statements. However, because the exemptions in sections 263A, 448, 460 and 471 are methods of accounting under the statute, taxpayers are required to request the consent of the Commissioner for a change in method of accounting under section 446(e) to implement the statutory exemptions. The IRS expects that these taxpayers will request this consent by filing Form 3115, Application for Change in Accounting Method. Taxpayers may request these changes using reduced filing requirements by completing only certain parts of Form 3115. See Revenue Procedure 2018-40 (2018-34 I.R.B. 320). Revenue Procedure 2018-40 provides procedures for a taxpayer to make a change in method of accounting using the automatic change procedures of Revenue Procedure 2015-13 (2015-5 IRB 419) in order to use the exemptions provided in sections 263A, 460 and/or 471.

For purposes of the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(c)) (PRA), the reporting burden associated with the collection of information for the election statement and Form 3115 will be reflected in the PRA submission associated with the income tax returns under the OMB control number 1545-0074 (in the case of individual filers of Form 3115) and 1545-0123 (in the case of business filers of Form 3115).

In 2018, the IRS released and invited comment on a draft of Form 3115 in order to give members of the public the opportunity to benefit from certain specific provisions made to the Code. The IRS received no comments on the forms during the comment period. Consequently the IRS made the forms available in January 2019 for use by the public. The IRS notes that Form 3115 applies to changes of accounting methods generally and is therefore broader than sections 263A, 448, 460 and 471.

As discussed above, the reporting burdens associated with the proposed regulations are included in the aggregated burden estimates for OMB control numbers 1545-0074 (in the case of individual filers of Form 3115), 1545-0123 (in the case of business filers of Form 3115 subject to Revenue Procedure 2019-43 and business filers that make the election under proposed §1.448-2(b)(2)(iii)(B)). The overall burden estimates associated with the OMB control numbers below are aggregate amounts related to the entire package of forms associated with the applicable OMB control number and will include, but not isolate, the estimated burden of the tax forms that will be created or revised as a result of the information collections in these proposed regulations. These numbers are therefore not specific to the burden imposed by these proposed regulations. The burdens have been reported for other income tax regulations that rely on the same information collections and the Treasury Department and the IRS urge readers to recognize that these numbers are duplicates and to guard against overcounting the burdens imposed by tax provisions prior to the Act. No burden estimates specific to the forms affected by the proposed regulations are currently available. For the OMB control numbers discussed in the preceding paragraphs, the Treasury Department and the IRS estimate PRA burdens on a taxpayer-type basis rather than a provision-specific basis. Those estimates capture both changes made by the Act and those that arise out of discretionary authority exercised in the proposed regulations (when final) and other regulations that affect the compliance burden for that form.

The Treasury Department and IRS request comment on all aspects of information collection burdens related to the proposed regulations, including estimates for how much time it would take to comply with the paperwork burdens described above for each relevant form and ways for the IRS to minimize paperwork burden. In addition, when available, drafts of IRS forms are posted for comment at https://appsirs.gov/app/picklist/lit/draft TaxForms.htm. IRS forms are available at https://www.irs.gov/forms-instructions. Forms will not be finalized until after they have been approved by OMB under the PRA.

The Regulatory Flexibility Act (5 U.S.C. 601 et seq.) (RFA) imposes certain requirements with respect to federal rules that are subject to the notice and comment requirements of section 553(b) of the Administrative Procedure Act (5 U.S.C. 551 et seq.) and that are likely to have a significant economic impact on a substantial number of small entities. Unless an agency determines that a proposal is not likely to have a significant economic impact on a substantial number of small entities, section 603 of the RFA requires the agency to present an initial regulatory flexibility analysis (IRFA) of the proposed rules. The Treasury Department and the IRS have not determined whether the proposed rules, when finalized, will likely have a significant economic impact on a substantial number of small entities. The determination of whether the voluntary exemptions under sections 263A, 448, 460, and 471 will have a significant economic impact requires further study. However, because there is a possibility of significant economic impact on a substantial number of small entities, an IRFA is provided in these proposed regulations. The Treasury Department and the IRS invite comments on both the number of entities affected and the economic impact on small entities.

Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking has been submitted to the Chief Counsel of Advocacy of the Small Business Administration for comment on its impact on small business.

1. Need for and Objectives of the Rule

As discussed earlier in the preamble, these proposed regulations largely implement voluntary exemptions that relieve small business taxpayers from otherwise applicable restrictions and requirements under sections 263A, 448, 460, and 471.

Section 448 provides a general restriction for C corporations and partnerships with C corporation partners from using the cash method of accounting, and sections 263A, 460 and 471 impose specific rules on uniform capitalization of direct and indirect production costs, the percentage of completion method for long-term contracts, and accounting for inventory costs, respectively. Section 13102 of TCJA provided new statutory exemptions from certain of these rules and expanded the scope of existing statutory exemptions from certain of these rules to reduce compliance burdens for small taxpayers. The proposed regulations clarify the exemption qualification requirements and provide guidance with respect to the applicable methods of accounting should a taxpayer choose to apply one or more exemptions.

The objective of the proposed regulations is to provide clarity and certainty for small business taxpayers implementing the exemptions. Under the Code, small business taxpayers were able to implement these provisions for taxable years beginning after December 31, 2017 (or, in the case of section 460, for contracts entered into after December 31, 2017) even in the absence of these proposed regulations. Thus, the Treasury Department and the IRS expect that, at the time these proposed regulations are published, many small business taxpayers may have already implemented some aspects of the proposed regulations.

2. Affected Small Entities

The voluntary exemptions under sections 263A, 448, 460 and 471 generally apply to taxpayers that meet the $25 million (adjusted for inflation) gross receipts test in section 448(c) and are otherwise subject to general rules under sections 263A, 448, 460, or 471.

A. Section 263A

The Treasury Department and the IRS expect that the addition of section 263A(i) will expand the number of small business taxpayers exempted from the requirement to capitalize costs, including interest, under section 263A. Under section 263A(i), taxpayers (other than tax shelters) that meet the $25 million (adjusted for inflation) gross receipts test in section 448(c) can choose to deduct certain costs that are otherwise required to be capitalized to the basis of property. Section 263A applies to taxpayers that are producers, resellers, and taxpayers with self-constructed assets. The Treasury Department and the IRS estimate that there are between 38,100 and 38,900 respondents with gross receipts of not more than $25 million (adjusted for inflation) that are eligible to change their method of accounting to no longer capitalize costs under section 263A. These estimates come from information collected on: Form 1125-A, Cost of Goods Sold, and attached to Form 1120, U.S. Corporation Income Tax Return, Form 1065, U.S. Return of Partnership Income or Form 1120-S, U.S. Income Tax Return for an S Corporation, on which the taxpayer also indicated it had additional section 263A costs. The Treasury Department and the IRS do not have readily available data to measure the prevalence of entities with self-constructed assets. In addition, these data also do not include other business entities, such as a business reported on Schedule C, Profit or Loss Form Business, of an individual’s Form 1040, U.S. Individual Income Tax Return.

Under section 263A, as modified by the TCJA, small business entities that qualified for Section 263A small reseller exception will no longer be able to use this exception. The Treasury Department and the IRS estimate that nearly all taxpayers that qualified for the small reseller exception will qualify for the small business taxpayer exemption under section 263A(i) since the small reseller exception utilized a $10 million gross receipts test. The Treasury Department and the IRS estimate that there are between 38,100 and 38,900 respondents with gross receipts of not more than $25 million that are eligible for the exemption under section 263A(i). These estimates come from information collected on: Form 1125-A, Cost of Goods Sold, and attached to Form 1120, U.S. Corporation Income Tax Return, Form 1065, U.S. Return of Partnership Income or Form 1120-S, U.S. Income Tax Return for an S Corporation on which the taxpayer also indicated it had additional section 263A costs. These data provide an upper bound for the number of taxpayers affected by the repeal of the small reseller exception and enactment of section 263A(i) because the data includes taxpayers that were not previously eligible for the small reseller exception, such as producers and taxpayers with gross receipts of more than $10 million.

The proposed regulations modify the $50 million gross receipts test in §1.263A-1(d)(3)(ii)(B)(1) by using the section 448 gross receipts test. The $50 million gross receipts amount is used by taxpayers to determine whether they are eligible to treat negative adjustments as additional section 263A costs for purposes of the simplified production method (SPM) under section 263A. The Treasury Department and the IRS do not have readily available data to measure the prevalence of entities using the SPM.

Proposed §1.263A-9 modifies the current regulation to increase the eligibility threshold to $25 million for the election permitting taxpayers to use the highest applicable Federal rate as a substitute for the weighted average interest rate when tracing debt for purposes of capitalizing interest under section 263A(f). The Treasury Department and the IRS estimate that there are between 38,100 and 38,900 respondents with gross receipts of not more than $25 million that are eligible to make this election. These estimates come from information collected on: Form 1125-A, Cost of Goods Sold, attached to Form 1120, U.S. Corporation Income Tax Return, Form 1065, U.S. Return of Partnership Income or Form 1120-S, U.S. Income Tax Return for an S Corporation, on which the taxpayer also indicated it had additional section 263A costs. The Treasury Department and the IRS expect that many taxpayers eligible to make the election for purposes of section 263A(f) will instead elect the small business exemption under section 263A(i). Additionally, taxpayers who chose to apply section 263A even though they qualify for the small business exemption under 263A(i) may not have interest expense required to be capitalized under section 263A(f). As a result, although these data do not include taxpayers with self-constructed assets that are eligible for the election, the Treasury Department and the IRS estimate that this data provides an upper bound for the number of eligible taxpayers.

B. Section 448

The Treasury Department and the IRS expect that the changes to section 448(c) by the TCJA will expand the number of taxpayers permitted to use the cash method. Section 448(a) provides that C corporations, partnerships with C corporations as partners, and tax shelters are not permitted to use the cash method of accounting; however section 448(c), as amended by the TCJA, provides that C corporations or partnerships with C corporations as partners, other than tax shelters, are not restricted from using the cash method if their average annual gross receipts are $25 million (adjusted for inflation) or less. Prior to the amendments made by the TCJA, the applicable gross receipts threshold was $5 million. Section 448 does not apply to S corporations, partnerships without a C corporation partner, or any other business entities (including sole proprietorships reported on an individual’s Form 1040). The Treasury Department and the IRS estimate that there are between 587,000 and 595,000 respondents with gross receipts of not more than $5 million presently using an accrual method, and between 70,000 and 73,000 respondents with gross receipts of more than $5 million but not more than $25 million that are permitted to use to the cash method. These estimates come information collected on Form 1120, U.S. Corporation Income Tax Return, Form 1065, U.S. Return of Partnership Income and Form 1120-S, U.S. Income Tax Return for an S Corporation.

Under the proposed regulations, taxpayers that would meet the gross receipts test of section 448(c) and seem to be eligible to use the cash method but for the definition of “syndicate” under section 448(d)(3), may elect to use the allocated taxable income or loss of the immediately preceding taxable year to determine whether the taxpayer is a “syndicate” for purposes of section 448(d)(3) for the current taxable year. The Treasury Department and IRS estimate that 199,289 respondents may potentially make this election. This estimate comes from information collected on the Form 1065, U.S. Return of Partnership Income and Form 1120-S, U.S. Income Tax Return for an S Corporation, and the Form 1125-A, Cost of Goods Sold, attached to the Forms 1065 and 1120-S . The Treasury Department and the IRS estimate that these data provide an upper bound for the number of eligible taxpayers because not all taxpayers eligible to make the election will choose to do so.

C. Section 460

The Treasury Department and the IRS expect that the modification of section 460(e)(1)(B) by the TCJA will expand the number of taxpayers exempted from the requirement to apply the percentage-of-completion method to long-term construction contracts. Under section 460(e)(1)(B), as modified by the TCJA, taxpayers (other than a tax shelters) that meet the $25 million (adjusted for inflation) gross receipts test in section 448(c) are not required to use PCM to account for income from a long-term construction contract expected to be completed in two years. Prior to the modification of section 460(e)(1)(B) by the TCJA, a separate $10 million dollar gross receipts test applied. The Treasury Department and the IRS estimate that there are between 15,400 and 18,000 respondents with gross receipts of between $10 million and $25 million who are eligible to change their method of accounting to apply the modified exemption. This estimate comes from information collected on the Form 1120, U.S. Corporation Income Tax Return, Form 1065, U.S. Return of Partnership Income and Form 1120-S, U.S. Income Tax Return for an S Corporation in which the taxpayer indicated its principal business activity was construction (NAICS codes beginning with 23). These data available do not distinguish between long-term contracts and other contracts, and also do not include other business entities that do not file Form 1120, U.S. Corporation Income Tax Return, Form 1065, U.S. Return of Partnership Income, and Form 1120-S, U.S. Income Tax Return for an S Corporation, such as a business reported on Schedule C, Profit or Loss from Business, of an individual’s Form 1040, U.S. Individual Income Tax Return.

D. Section 471

The Treasury Department and the IRS expect that the addition of section 471(c) will expand the number of taxpayers exempted from the requirement to take inventories under section 471(a). Under section 471(c), taxpayers (other than tax shelters) that meet the $25 million (adjusted for inflation) gross receipts test in section 448(c) can choose to apply certain simplified inventory methods rather than those otherwise required by section 471(a). The Treasury Department and the IRS estimate that there are between 3,200,000 and 3,400,000 respondents with gross receipts of not more than $25 million that are exempted from the requirement to take inventories, and will treat their inventory either as non-incidental materials and supplies, or conform their inventory method to the method reflected in their AFS, or if they do not have an AFS, in their books and records. This estimate comes from data collected on the Form 1125-A, Cost of Goods Sold. Within that set of taxpayers, the Treasury Department and the IRS estimate that there are between 10,500 and 11,300 respondents that may choose to conform their method of accounting for inventories to their method for inventory reflected in their AFS. This estimate comes from IRS-collected data on taxpayers that filed the Form 1125-A, Cost of Goods Sold, in addition to a Schedule M3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More, that indicated they had an AFS. These data provide a lower bound because they do not include other business entities, such as a business reported on Schedule C, Profit or Loss from Business, of an individual’s Form 1040, U.S. Individual Income Tax Return, that are not required to file the Form 1125-A, Cost of Goods Sold.

3. Impact of the Rule

As discussed earlier in the preamble, section 448 provides a general restriction for C corporations, partnerships with C corporation partners, and tax shelters from using the cash method of accounting, and sections 263A, 460 and 471 impose specific rules on uniform capitalization of direct and indirect production costs, the percentage of completion method for long-term contracts, and accounting for inventory costs, respectively. Section 13102 of TCJA provided new statutory exemptions and expanded the scope of existing statutory exemptions from these rules to reduce compliance burdens for small taxpayers (e.g., reducing the burdens associated with applying complex accrual rules under section 451 and 461, maintaining inventories, identifying and tracking costs that are allocable to property produced or acquired for resale, identifying and tracking costs that are allocable to long-term contracts, applying the look-back method under section 460, etc.). For example, a small business taxpayer with average gross receipts of $20 million may pay an accountant an annual fee to perform a 25 hour analysis to determine the section 263A costs that are capitalized to inventory produced during the year. If this taxpayer chooses to apply the exemption under section 263A and these proposed regulations, it will no longer need to pay an accountant for the annual section 263A analysis.

The proposed regulations implementing these exemptions are completely voluntary because small business taxpayers may continue using an accrual method of accounting, and applying sections 263A, 460 and 471 if they so choose. Thus, the exemptions increase the flexibility small business taxpayers have regarding their accounting methods relative to other businesses. The proposed regulations provide clarity and certainty for small business taxpayers implementing the exemptions.

4. Projected Reporting, Recordkeeping, and Other Compliance Requirements

The Treasury Department and the IRS have not performed an analysis with respect to the projected reporting, recordkeeping, and other compliance requirements associated with the statutory exemptions under sections 263A, 448, 460, and 471 and the proposed regulations implementing these exemptions. However, the Treasury Department and the IRS anticipate that the statutory exemptions and the proposed regulations implementing these exemptions will reduce the reporting, recordkeeping, and other compliance requirements of affected taxpayers relative to the requirements that exist under the general rules in sections 263A, 448, 460, and 471.

5. Alternatives Considered

As described in more detail earlier in the preamble, the Treasury Department and the IRS considered a number of alternatives under the proposed regulations. For example, in providing rules related to inventory exemption in Section 471(c)(1)(B)(i), which permits the taxpayer to treat its inventory as non-incidental materials and supplies, the Treasury Department and the IRS considered whether inventoriable costs should be recovered by (i) using an approach similar to the approach set forth under Revenue Procedure 2001-10 (2001-2 IRB 272) and Revenue Procedure 2002-28 (2002-28 IRB 815), which provided that inventory treated as non-incidental materials and supplies was “used and consumed,” and thus recovered through costs of goods sold by a cash basis taxpayer, when the inventory items were provided to a customer, or when the taxpayer paid for the items, whichever was later, or (ii) using an alternative approach that treated inventory as “used and consumed” and thus recovered through costs of goods sold by the taxpayer, in a taxable year prior to the year in which the inventory item is provided to the customer (e.g., in the taxable year in which an inventory item is acquired or produced). The alternative approach described in (ii) would produce a savings equal the amount of the cost recovery multiplied by an applicable discount rate (determined based on the number of years the cost of goods sold recovery would be accelerated under this alternative). The Treasury Department and the IRS interpret section 471(c)(1)(B)(i) and its legislative history generally as codifying the rules provided in the administrative guidance existing at the time TCJA was enacted. Based on this interpretation, the Treasury Department and the IRS have determined that section 471(c) materials and supplies are “used and consumed” in the taxable year the taxpayer provides the goods to a customer, and are recovered through costs of goods sold in that year or the taxable year in which the cost of the goods is paid or incurred (in accordance with the taxpayer’s method of accounting), whichever is later. The Treasury Department and the IRS do not believe this approach creates or imposes undue burdens on taxpayers.

6. Duplicate, Overlapping, or Relevant Federal Rules

The proposed rules would not conflict with any relevant federal rules. As discussed above, the proposed regulations merely implement voluntary exemptions that relieve small business taxpayers from otherwise applicable restrictions and requirements under sections 263A, 448, 460, and 471.

Executive Order 13132 (entitled “Federalism”) prohibits an agency from publishing any rule that has federalism implications if the rule either imposes substantial, direct compliance costs on state and local governments, and is not required by statute, or preempts state law, unless the agency meets the consultation and funding requirements of section 6 of the Executive Order. This final rule does not have federalism implications and does not impose substantial, direct compliance costs on state and local governments or preempt state law within the meaning of the Executive Order.