Section 199(a)(1) allows a deduction equal to 9 percent (3 percent in the case of taxable years beginning in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the lesser of (A) the qualified production activities income (QPAI) of the taxpayer for the taxable year, or (B) taxable income (determined without regard to section 199) for the taxable year (or, in the case of an individual, adjusted gross income (AGI)).

Section 199(b)(1) limits the deduction for a taxable year to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year. For this purpose, section 199(b)(2)(A) defines the term W-2 wages to mean, with respect to any person for any taxable year of such person, the sum of the amounts described in section 6051(a)(3) and (8) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year. Section 514(a) of TIPRA added new section 199(b)(2)(B), which provides that the term W-2 wages does not include any amount which is not properly allocable to domestic production gross receipts (DPGR) for purposes of section 199(c)(1). Section 199(b)(2)(C) provides that the term W-2 wages does not include any amount that is not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for the return. Section 199(b)(3) provides that the Secretary shall prescribe rules for the application of section 199(b) in the case of an acquisition or disposition of a major portion of either a trade or business or a separate unit of a trade or business during the taxable year.

Section 199(d)(1)(A) provides that, in the case of a partnership or S corporation, (i) section 199 shall be applied at the partner or shareholder level, (ii) each partner or shareholder shall take into account such person’s allocable share of each item described in section 199(c)(1)(A) or (B) (determined without regard to whether the items described in section 199(c)(1)(A) exceed the items described in section 199(c)(1)(B)), and (iii), as amended by section 514(b) of TIPRA, each partner or shareholder shall be treated for purposes of section 199(b) as having W-2 wages for the taxable year in an amount equal to such person’s allocable share of the W-2 wages of the partnership or S corporation for the taxable year (as determined under regulations prescribed by the Secretary).

Section 199(d)(1)(B) provides that, in the case of a trust or estate, (i) the items referred to in section 199(d)(1)(A)(ii) (as determined therein) and the W-2 wages of the trust or estate for the taxable year shall be apportioned between the beneficiaries and the fiduciary (and among the beneficiaries) under regulations prescribed by the Secretary, and (ii) for purposes of section 199(d)(2), AGI of the trust or estate shall be determined as provided in section 67(e) with the adjustments described in such section.

Section 199(d)(1)(C) provides that the Secretary may prescribe rules requiring or restricting the allocation of items and wages under section 199(d)(1) and may prescribe such reporting requirements as the Secretary determines appropriate.

Section 199(d)(4)(A) provides that all members of an expanded affiliated group (EAG) are treated as a single corporation for purposes of section 199. Section 199(d)(4)(B) provides that an EAG is an affiliated group as defined in section 1504(a), determined by substituting “more than 50 percent” for “at least 80 percent” each place it appears and without regard to section 1504(b)(2) and (4).

Section 199(d)(8) authorizes the Secretary to prescribe such regulations as are necessary to carry out the purposes of section 199, including regulations that prevent more than one taxpayer from being allowed a deduction under section 199 with respect to any activity described in section 199(c)(4)(A)(i).

Section 514(a) of TIPRA amended section 199(b)(2) to provide that the term W-2 wages does not include any amount that is not properly allocable to DPGR for purposes of section 199(c)(1). The Secretary is authorized to provide rules for the proper allocation of items (including wages) in determining QPAI. See section 199(d)(8). The temporary regulations provide that for taxable years beginning after May 17, 2006, the term W-2 wages includes only amounts described in §1.199-2(e)(1) (paragraph (e)(1) wages) that are properly allocable to DPGR. The temporary regulations provide that a taxpayer may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances.

The temporary regulations provide safe harbors for determining the amount of paragraph (e)(1) wages that is properly allocable to DPGR. Under the wage expense safe harbor for taxpayers using either the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e), a taxpayer may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR by multiplying the amount of paragraph (e)(1) wages by the ratio of the taxpayer’s wage expense included in calculating QPAI for the taxable year to the taxpayer’s total wage expense used in calculating the taxpayer’s taxable income (or AGI, if applicable) for the taxable year. For purposes of determining the amount of wage expense in cost of goods sold (CGS) under this safe harbor, a taxpayer may determine its wage expense included in CGS using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances. For example, a reasonable method would include a taxpayer using direct labor included in CGS as wage expense included in CGS. Additionally, a reasonable method would include a taxpayer using the section 263A labor costs used by the taxpayer in its simplified service cost method with labor-based allocation ratio under §1.263-1(h)(4)(ii) as wage expense included in CGS. Because CGS frequently includes goods manufactured in prior years, and thus would frequently include paragraph (e)(1) wages from prior years attributable to DPGR, the amount of paragraph (e)(1) wages in CGS that is properly allocable to DPGR may be difficult to determine. The IRS and Treasury Department request comments on appropriate safe harbors for determining the amount of paragraph (e)(1) wages in CGS that are properly allocable to DPGR.

A taxpayer that uses the small business simplified overall method of cost allocation under §1.199-4(f) may use the small business simplified overall method safe harbor for determining the amount of paragraph (e)(1) wages that is properly allocable to DPGR. Under that safe harbor, the amount of paragraph (e)(1) wages that is properly allocable to DPGR is equal to the same proportion of paragraph (e)(1) wages that the amount of DPGR bears to the taxpayer’s total gross receipts.

As a consequence of the amendment to section 199(b)(2) made by TIPRA and its interplay with the rules in §1.199-7(a) and (b) for the computation of an EAG’s section 199 deduction, the section 199 deduction for the members of an EAG may be reduced if one member of an EAG uses employees of another member of the EAG to perform activities attributable to DPGR and does not have paragraph (e)(1) wages. In general, §1.199-7(a) and (b) provides that each member of an EAG calculates its own taxable income or loss, QPAI, and W-2 wages, which are then aggregated in determining the EAG’s section 199 deduction. Therefore, prior to the amendment to section 199(b)(2), in determining the wage limitation under section 199(b)(1) (the W-2 wage limitation), it was irrelevant which member of an EAG had the paragraph (e)(1) wages, because there was no requirement that paragraph (e)(1) wages be properly allocable to DPGR to qualify as W-2 wages, and the W-2 wages of all the members of an EAG are aggregated.

For example, assume that X and Y are members of an EAG and do not join in the filing of a consolidated Federal income tax return. X has paragraph (e)(1) wages incurred in connection with Y’s DPGR activities, but X has no DPGR itself. Further assume that Y has no paragraph (e)(1) wages. Prior to the amendment to section 199(b)(2), notwithstanding that X has no DPGR, X would have W-2 wages, because there was no requirement that paragraph (e)(1) wages be properly allocable to DPGR. Thus, the EAG would have W-2 wages, the same as if Y, rather than X, had the paragraph (e)(1) wages. Assuming the EAG had QPAI and taxable income, the EAG would receive a section 199 deduction.

After the amendment to section 199(b)(2), to qualify as W-2 wages within the meaning of §1.199-2T(e)(2), paragraph (e)(1) wages must be properly allocable to DPGR to qualify as W-2 wages. Because each member of an EAG separately calculates its own items before they are aggregated by the EAG, the member having the paragraph (e)(1) wages must itself have DPGR to which the wages are properly allocable in order to qualify those wages as W-2 wages. Paragraph (e)(1) wages that are not properly allocable to DPGR of the member having the paragraph (e)(1) wages do not qualify as W-2 wages, even if the paragraph (e)(1) wages were paid in connection with another member’s DPGR activities. Thus, after the amendment to section 199(b)(2), X’s paragraph (e)(1) wages do not qualify as W-2 wages, because X has no DPGR to which the paragraph (e)(1) wages would be properly allocable. Accordingly, as neither X nor Y has W-2 wages, the EAG has no W-2 wages and no section 199 deduction. If Y had the paragraph (e)(1) wages rather than X, the EAG would have W-2 wages and a section 199 deduction.

However, if X and Y join in the filing of a consolidated Federal income tax return, the results may differ. Section 1.1502-13(c)(1)(i) and (c)(4) requires that the separate entity attributes of X’s and Y’s intercompany items or corresponding items be redetermined to the extent necessary to produce the effect as if X and Y were divisions of a single corporation. Thus, §1.1502-13(c)(1)(i) and (c)(4) may apply to treat the paragraph (e)(1) wages incurred by X as W-2 wages. The temporary regulations provide examples to demonstrate the described scenarios.

Section 514(b) of TIPRA amended section 199(d)(1)(A)(iii) regarding a partner’s or shareholder’s share of W-2 wages from a partnership or S corporation for taxable years beginning after May 17, 2006. After TIPRA, the section 199(d)(1)(A)(iii) wage limitation for pass-thru entities no longer includes the second prong of a two-prong standard, by which a partner’s or shareholder’s share of W-2 wages from the partnership or S corporation was limited to the lesser of that person’s allocable share of W-2 wages from the entity or a specified percentage of the person’s QPAI, computed by taking into account only the items of the entity allocated to that person for the taxable year of the entity.

Section 1.199-5T(b)(3) and (c)(3) provides guidance regarding a partner’s or shareholder’s share of W-2 wages of a partnership or an S corporation after the effective date of TIPRA. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b)), the partnership or S corporation must allocate its paragraph (e)(1) wages (including any such wages from a lower-tier partnership of which the partnership or S corporation is a partner) among its partners or shareholders in the same manner that wage expense is allocated among those partners or shareholders. The partner or shareholder must add its share of the paragraph (e)(1) wages from the partnership or S corporation to the partner’s or shareholder’s paragraph (e)(1) wages from other sources, if any. The partner (other than a partner that itself is a partnership or S corporation) or shareholder then must calculate its W-2 wages (as defined in §1.199-2T(e)(2)) by determining the amount of its paragraph (e)(1) wages properly allocable to DPGR. See §1.199-2T(e)(2) for the computation of W-2 wages.

Section 1.199-5T(e) requires a non-grantor trust or estate to calculate each beneficiary’s share (as well as the trust’s or estate’s share, if any) of QPAI and W-2 wages from the trust or estate at the trust or estate level. The QPAI of a trust or estate and W-2 wages of the trust or estate are allocated to each beneficiary and to the trust or estate based on the relative proportion of the trust’s or estate’s distributable net income (DNI), as defined by section 643(a), for the taxable year that is distributed or required to be distributed to the beneficiary or is retained by the trust or estate.

Because the second prong of the wage limitation of section 199(d)(1)(A)(iii) was prospectively repealed by TIPRA, there is no longer any need for a special rule for tiered structures (where a pass-thru entity owns an interest in another pass-thru entity). Accordingly, the rule in §1.199-9(g) of the final regulations regarding the section 199(d)(1)(A)(iii) wage limitation and tiered structures has not been included in these temporary regulations.

The temporary regulations provide a transition rule for the situation in which a partner (or shareholder) and a partnership (or S corporation) have different taxable years, only one of which begins on or before the effective date of TIPRA. Under §1.199-5T(b)(4) and (c)(4), the beginning date of the taxable year of the partnership (or S corporation) determines which definition of W-2 wages and which W-2 wage limitation for pass-thru entities apply.

After issuance of the final regulations, it was brought to the attention of the IRS and Treasury Department that the combination of the aggregation rules for determining the taxable income of an EAG in §1.199-7(b)(1) and the rules of section 172 for net operating loss (NOL) deductions can result in the same loss being used twice in determining the taxable income limitation under section 199(a)(1)(B). That is, in determining the taxable income limitation under section 199(a)(1)(B), a loss sustained by a member of an EAG could be used in the year the loss is sustained to offset the taxable income of another member of the EAG in determining the EAG’s taxable income limitation. However, because the EAG is not a separate taxpaying entity that files its own tax return, the member that sustained the loss would still have an NOL carryover or carryback. Thus, the loss could be used again as an NOL deduction of the member that sustained the loss in a previous or subsequent year to offset its own income, either as a member of the same EAG, a different EAG, or on a stand-alone basis. Because the section 199 deduction is a percentage of the lesser of QPAI or taxable income (subject to the W-2 wage limitation), the use of the same loss twice could potentially reduce the section 199 deduction that should be allowable.

For example, assume that corporations X and Y are the only two members of an EAG and that X and Y do not file a consolidated Federal income tax return. In 2010, X and Y each have $100 of QPAI which, under §1.199-7(b), are aggregated in determining the EAG’s QPAI. X has $100 of taxable income and Y has a $100 NOL, which are also aggregated in determining the EAG’s taxable income for purposes of the taxable income limitation of section 199(a)(1)(B). Further assume that the EAG has sufficient W-2 wages so that the section 199 deduction is not limited under section 199(b)(1). Thus, although in 2010 the EAG has $200 of QPAI and sufficient W-2 wages so that the section 199 deduction is not limited under section 199(b)(1), as a result of the use of Y’s NOL, the EAG has $0 of taxable income and no section 199 deduction. However, because the EAG is not a separate taxpaying entity, Y has an NOL of $100 which is available for carryover or carryback. In 2011, X has $100 of taxable income and Y, before the deduction allowed under section 172, has $300 of taxable income. Under section 172, Y reduces its 2011 taxable income of $300 by its 2010 NOL of $100, thus reducing Y’s taxable income to $200. Y’s loss was effectively used twice, first in 2010 to reduce the EAG’s taxable income for purposes of the taxable income limitation of section 199(a)(1)(B) and then in 2011 to reduce Y’s own taxable income, which reduces the EAG’s aggregate taxable income for purposes of the taxable income limitation.

This result was not intended. Accordingly, §1.199-7T(b)(4) has been added to provide that, to the extent that an NOL was used in the year it was sustained in determining any EAG’s taxable income for purposes of the taxable income limitation of section 199(a)(1)(B), such NOL is not treated as an NOL carryover or NOL carryback to any taxable year in determining the taxable income limitation under section 199(a)(1)(B). Thus, in the previous example, solely for purposes of determining the EAG’s 2011 taxable income limitation under section 199(a)(1)(B), Y would not have an NOL carryover from 2010, because the entire $100 NOL was used in 2010 to reduce the EAG’s taxable income. Therefore, for purposes of determining the EAG’s taxable income limitation in 2011, Y would have taxable income of $300 and the EAG would have aggregate taxable income of $400. The temporary regulations provide examples to illustrate this provision.

* * * * *

* * * * *

(b) * * *

(4) Losses used to reduce taxable income of expanded affiliated group. [Reserved].

* * * * *

* * * * *

(i) * * *

(5) Tax Increase Prevention and Reconciliation Act of 2005. [Reserved].

(6) Losses used to reduce taxable income of expanded affiliated group. [Reserved].

* * * * *

Par. 3. Section 1.199-2 is amended by adding a sentence at the end of paragraph (e)(2) to read as follows:

* * * * *

(e) * * *

(2) Limitation on W-2 wages for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005. * * * For further guidance, see §1.199-2T(e)(2).

* * * * *

Par. 4. Section 1.199-2T is added to read as follows:

(a) through (d) [Reserved]. For further guidance, see §1.199-2(a) through (d).

(e) Definition of W-2 wages—(1) In general. [Reserved]. For further guidance, see §1.199-2(e)(1).

(2) Limitation on W-2 wages for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005—(i) In general. The term W-2 wages includes only amounts described in §1.199-2(e)(1) (paragraph (e)(1) wages) that are properly allocable to domestic production gross receipts (DPGR) (as defined in §1.199-3) for purposes of section 199(c)(1). A taxpayer may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances.

(ii) Wage expense safe harbor—(A) In general. A taxpayer using either the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e) may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR for a taxable year by multiplying the amount of paragraph (e)(1) wages for the taxable year by the ratio of the taxpayer’s wage expense included in calculating qualified production activities income (QPAI) (as defined in §1.199-1(c)) for the taxable year to the taxpayer’s total wage expense used in calculating the taxpayer’s taxable income (or adjusted gross income, if applicable) for the taxable year, without regard to any wage expense disallowed by section 465, 469, 704(d), or 1366(d). A taxpayer that uses the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e) to determine QPAI must use the same expense allocation and apportionment methods that it uses to determine QPAI to allocate and apportion wage expense for purposes of this safe harbor. For purposes of this paragraph (e)(2)(ii), the term wage expense means wages (that is, compensation paid by the employer in the active conduct of a trade or business to its employees) that are properly taken into account under the taxpayer’s method of accounting.

(B) Wage expense included in cost of goods sold. For purposes of paragraph (e)(2)(ii)(A) of this section, a taxpayer may determine its wage expense included in cost of goods sold (CGS) using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances, such as using the amount of direct labor included in CGS or using section 263A labor costs (as defined in §1.263A-1(h)(4)(ii)) included in CGS.

(iii) Small business simplified overall method safe harbor. A taxpayer that uses the small business simplified overall method under §1.199-4(f) may use the small business simplified overall method safe harbor for determining the amount of paragraph (e)(1) wages that is properly allocable to DPGR. Under this safe harbor, the amount of paragraph (e)(1) wages that is properly allocable to DPGR is equal to the same proportion of paragraph (e)(1) wages that the amount of DPGR bears to the taxpayer’s total gross receipts.

(iv) Examples. The following examples illustrate the application of this paragraph (e)(2). See §1.199-5T for an example of the application of paragraph (e)(2)(ii) of this section to a trust or estate.

Example 1. Section 861 method and no EAG. (i) Facts. X, a United States corporation that is not a member of an expanded affiliated group (EAG) (as defined in §1.199-7) or an affiliated group as defined in the regulations under section 861, engages in activities that generate both DPGR and non-DPGR. X’s taxable year ends on April 30, 2011. For X’s taxable year ending April 30, 2011, X has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2. All of X’s production activities that generate DPGR are within Standard Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of X’s production activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). X is able to specifically identify CGS allocable to DPGR and to non-DPGR. X incurs $900 of research and experimentation expenses (R&E) that are deductible under section 174, $300 of which are performed with respect to SIC AAA and $600 of which are performed with respect to SIC BBB. None of the R&E is legally mandated R&E as described in §1.861-17(a)(4) and none of the R&E is included in CGS. X incurs section 162 selling expenses that are not includible in CGS and are definitely related to all of X’s gross income. For X’s taxable year ending April 30, 2011, the adjusted basis of X’s assets is $50,000, $40,000 of which generate gross income attributable to DPGR and $10,000 of which generate gross income attributable to non-DPGR. For X’s taxable year ending April 30, 2011, the total square footage of X’s headquarters is 8,000 square feet, of which 2,000 square feet is set aside for domestic production activities. For its taxable year ending April 30, 2011, X’s taxable income is $1,380 based on the following Federal income tax items:

(ii) X’s QPAI. X allocates and apportions its deductions to gross income attributable to DPGR under the section 861 method in §1.199-4(d). In this case, the section 162 selling expenses and overhead expense are definitely related to all of X’s gross income. Based on the facts and circumstances of this specific case, apportionment of the section 162 selling expenses between DPGR and non-DPGR on the basis of X’s gross receipts is appropriate. In addition, based on the facts and circumstances of this specific case, apportionment of the headquarters overhead expense between DPGR and non-DPGR on the basis of the square footage of X’s headquarters is appropriate. For purposes of apportioning R&E, X elects to use the sales method as described in §1.861-17(c). X elects to apportion interest expense under the tax book value method of §1.861-9T(g). X has $2,400 of gross income attributable to DPGR (DPGR of $3,000 − CGS of $600 allocated based on X’s books and records). X’s QPAI for its taxable year ending April 30, 2011, is $1,395, as shown in the following table:

(iii) W-2 wages. X chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps:

(A) Step one. X determines that $625 of wage expense were taken into account in determining its QPAI in paragraph (ii) of this Example 1, as shown in the following table:

(B) Step two. X determines that $1,042 of the $3,000 in paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation:

(iv) Section 199 deduction determination. X’s tentative deduction under §1.199-1(a) (section 199 deduction) is $124 (.09 x (lesser of QPAI of $1,395 or taxable income of $1,380)) subject to the wage limitation under section 199(b)(1) (W-2 wage limitation) of $521 (50% x $1,042). Accordingly, X’s section 199 deduction for its taxable year ending April 30, 2011, is $124.

Example 2. Section 861 method and EAG. (i) Facts. The facts are the same as in Example 1 except that X owns stock in Y, a United States corporation, equal to 75% of the total voting power of stock of Y and 80% of the total value of stock of Y. X and Y are not members of an affiliated group as defined in section 1504(a). Accordingly, the rules of §1.861-14T do not apply to X’s and Y’s selling expenses, R&E, and charitable contributions. X and Y are, however, members of an affiliated group for purposes of allocating and apportioning interest expense (see §1.861-11T(d)(6)) and are also members of an EAG. Y’s taxable year ends April 30, 2011. For Y’s taxable year ending April 30, 2011, Y has $2,000 of paragraph (e)(1) wages reported on 2010 Forms W-2. For Y’s taxable year ending April 30, 2011, the adjusted basis of Y’s assets is $50,000, $20,000 of which generate gross income attributable to DPGR and $30,000 of which generate gross income attributable to non-DPGR. All of Y’s activities that generate DPGR are within SIC Industry Group AAA (SIC AAA). All of Y’s activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). None of X’s and Y’s sales are to each other. Y is not able to specifically identify CGS allocable to DPGR and non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of Y’s gross receipts, apportionment of CGS between DPGR and non-DPGR based on gross receipts is appropriate. For Y’s taxable year ending April 30, 2011, the total square footage of Y’s headquarters is 8,000 square feet, of which, 2,000 square feet is set aside for domestic production activities. Y incurs section 162 selling expenses that are not includible in CGS and are definitely related to all of Y’s gross income. For Y’s taxable year ending April 30, 2011, Y’s taxable income is $1,710 based on the following Federal income tax items:

(ii) QPAI. (A) X’s QPAI. Determination of X’s QPAI is the same as in Example 1 except that interest is apportioned to gross income attributable to DPGR based on the combined adjusted bases of X’s and Y’s assets. See §1.861-11T(c). Accordingly, X’s QPAI for its taxable year ending April 30, 2011, is $1,455, as shown in the following table:

(B) Y’s QPAI. Y makes the same elections under the section 861 method as does X. Y has $1,800 of gross income attributable to DPGR (DPGR of $3,000 − CGS of $1,200 allocated based on Y’s gross receipts). Y’s QPAI for its taxable year ending April 30, 2011, is $905, as shown in the following table:

(iii) W-2 wages. (A) X’s W-2 wages. X’s W-2 wages are $1,042, the same as in Example 1.

(B) Y’s W-2 wages. Y chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps:

(1) Step one. Y determines that $480 of wage expense were taken into account in determining its QPAI in paragraph (ii)(B) of this Example 2, as shown in the following table:

(2) Step two. Y determines that $941 of the $2,000 paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation:

(iv) Section 199 deduction determination. The section 199 deduction of the X and Y EAG is determined by aggregating the separately determined taxable income, QPAI, and W-2 wages of X and Y. See §1.199-7(b). Accordingly, the X and Y EAG’s tentative section 199 deduction is $212 (.09 x (lesser of combined QPAI of X and Y of $2,360 (X’s QPAI of $1,455 plus Y’s QPAI of $905) or combined taxable incomes of X and Y of $3,090 (X’s taxable income of $1,380 plus Y’s taxable income of $1,710)) subject to the combined W-2 wage limitation of X and Y of $992 (50% x ($1,042 (X’s W-2 wages) + $941 (Y’s W-2 wages)))). Accordingly, the X and Y EAG’s section 199 deduction is $212. The $212 is allocated to X and Y in proportion to their QPAI. See §1.199-7(c).

Example 3. Simplified deduction method. (i) Facts. Z, a corporation that is not a member of an EAG, engages in activities that generate both DPGR and non-DPGR. Z is able to specifically identify CGS allocable to DPGR and to non-DPGR. Z’s taxable year ends on April 30, 2011. For Z’s taxable year ending April 30, 2011, Z has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2, and Z’s taxable income is $1,380 based on the following Federal income tax items:

(ii) Z’s QPAI. Z uses the simplified deduction method under §1.199-4(e) to apportion deductions between DPGR and non-DPGR. Z’s QPAI for its taxable year ending April 30, 2011, is $1,290, as shown in the following table:

(iii) W-2 wages. Z chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps:

(A) Step one. Z determines that $700 of wage expense were taken into account in determining its QPAI in paragraph (ii) of this Example 3, as shown in the following table:

(B) Step two. Z determines that $1,167 of the $3,000 paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation:

(iv) Section 199 deduction determination. Z’s tentative section 199 deduction is $116 (.09 x (lesser of QPAI of $1,290 or taxable income of $1,380)) subject to the W-2 wage limitation of $584 (50% x $1,167). Accordingly, Z’s section 199 deduction for its taxable year ending April 30, 2011, is $116.

Example 4. Small business simplified overall method. (i) Facts. Z, a corporation that is not a member of an EAG, engages in activities that generate both DPGR and non-DPGR. Z’s taxable year ends on April 30, 2011. For Z’s taxable year ending April 30, 2011, Z has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2, and Z’s taxable income is $1,380 based on the following Federal income tax items:

(ii) Z’s QPAI. Z uses the small business simplified overall method under §1.199-4(f) to apportion CGS and deductions between DPGR and non-DPGR. Z’s QPAI for its taxable year ending April 30, 2011, is $690, as shown in the following table:

(iii) W-2 wages. Z’s W-2 wages under paragraph (e)(2)(iii) of this section are $1,500, as shown in the following calculation:

(iv) Section 199 deduction determination. Z’s tentative section 199 deduction is $62 (.09 x (lesser of QPAI of $690 or taxable income of $1,380)) subject to the W-2 wage limitation of $750 (50% x $1,500). Accordingly, Z’s section 199 deduction for its taxable year ending April 30, 2011, is $62.

Example 5. Corporation uses employees of non-consolidated EAG member. (i) Facts. Corporations S and B are members of the same EAG but are not members of a consolidated group. S and B are both calendar year taxpayers. All the activities described in this example take place during the same taxable year and they are the only activities of S and B. S and B each use the section 861 method described in §1.199-4(d) for allocating and apportioning their deductions. B is a manufacturer but has only three employees of its own. S employs the remainder of the personnel who perform the manufacturing activities for B. S’s only receipts are from supplying employees to B. In 2010, B manufactures qualifying production property (QPP) (as defined in §1.199-3(j)(1)), using its three employees and S’s employees, and sells the QPP for $10,000,000. B’s total CGS and other deductions are $6,000,000, including $1,000,000 paid to S for the use of S’s employees and $100,000 paid to its own employees. B reports the $100,000 paid to its employees on the 2010 Forms W-2 issued to its employees. S pays its employees $800,000 that is reported on the 2010 Forms W-2 issued to the employees.

(ii) B’s W-2 wages. In determining its W-2 wages, B utilizes the wage expense safe harbor described in paragraph (e)(2)(ii) of this section. The entire $100,000 paid by B to its employees is included in B’s wage expense included in calculating its QPAI and is the only wage expense used in calculating B’s taxable income. Thus, under the wage expense safe harbor described in paragraph (e)(2)(ii) of this section, B’s W-2 wages are $100,000 ($100,000 (paragraph (e)(1) wages) x ($100,000 (wage expense used in calculating B’s QPAI)/$100,000 (wage expense used in calculating B’s taxable income))).

(iii) S’s W-2 wages. In determining its W-2 wages, S utilizes the wage expense safe harbor described in paragraph (e)(2)(ii) of this section. Because S’s $1,000,000 in receipts from B do not qualify as DPGR and are S’s only gross receipts, none of the $800,000 paid by S to its employees is included in S’s wage expense included in calculating its QPAI. However, the entire $800,000 is included in calculating S’s taxable income. Thus, under the wage expense safe harbor described in paragraph (e)(2)(ii)(A) of this section, S’s W-2 wages are $0 ($800,000 (paragraph (e)(1) wages) x ($0 (wage expense used in calculating S’s QPAI)/$800,000 (wage expense used in calculating S’s taxable income))).

(iv) Determination of EAG’s section 199 deduction. The section 199 deduction of the S and B EAG is determined by aggregating the separately determined taxable income or loss, QPAI, and W-2 wages of S and B. See §1.199-7(b). B’s taxable income and QPAI are each $4,000,000 ($10,000,000 DPGR − $6,000,000 CGS and other deductions). S’s taxable income is $200,000 ($1,000,000 gross receipts − $800,000 total deductions). S’s QPAI is $0 ($0 DPGR − $0 CGS and other deductions). B’s W-2 wages (as calculated in paragraph (ii) of this Example 5) are $100,000 and S’s W-2 wages (as calculated in paragraph (iii) of this Example 5) are $0. The EAG’s tentative section 199 deduction is $360,000 (.09 x (lesser of combined QPAI of $4,000,000 (B’s QPAI of $4,000,000 + S’s QPAI of $0) or combined taxable income of $4,200,000 (B’s taxable income of $4,000,000 + S’s taxable income of $200,000)) subject to the W-2 wage limitation of $50,000 (50% x ($100,000 (B’s W-2 wages) + $0 (S’s W-2 wages))). Accordingly, the S and B EAG’s section 199 deduction for 2010 is $50,000. The $50,000 is allocated to S and B in proportion to their QPAI. See §1.199-7(c). Because S has no QPAI, the entire $50,000 is allocated to B.

Example 6. Corporation using employees of consolidated EAG member. The facts are the same as in Example 5 except that B and S are members of the same consolidated group. Ordinarily, as demonstrated in Example 5, S’s $1,000,000 of receipts would not be DPGR and its $800,000 paid to its employees would not be W-2 wages (because the $800,000 would not be properly allocable to DPGR). However, because S and B are members of the same consolidated group, §1.1502-13(c)(1)(i) provides that the separate entity attributes of S’s intercompany items or B’s corresponding items, or both, may be redetermined in order to produce the same effect as if S and B were divisions of a single corporation. If S and B were divisions of a single corporation, S and B would have QPAI and taxable income of $4,200,000 ($10,000,000 DPGR received from the sale of the QPP − $5,800,000 CGS and other deductions) and, under the wage expense safe harbor described in paragraph (e)(2)(ii) of this section, would have $900,000 of W-2 wages ($900,000 (combined paragraph (e)(1) wages of S and B) x ($900,000 (wage expense used in calculating QPAI)/$900,000 (wage expense used in calculating taxable income))). The single corporation would have a tentative section 199 deduction equal to 9% of $4,200,000, or $378,000, subject to the W-2 wage limitation of 50% of $900,000, or $450,000. Thus, the single corporation would have a section 199 deduction of $378,000. To obtain this same result for the consolidated group, S’s $1,000,000 of receipts from the intercompany transaction are redetermined as DPGR. Thus, S’s $800,000 paid to its employees are costs properly allocable to DPGR and S’s W-2 wages are $800,000. Accordingly, the consolidated group has QPAI and taxable income of $4,200,000 ($11,000,000 DPGR (from the sale of the QPP and the redetermined intercompany transaction) − $6,800,000 CGS and other deductions) and W-2 wages of $900,000. The consolidated group’s section 199 deduction is $378,000, the same as the single corporation. However, for purposes of allocating the section 199 deduction between S and B, the redetermination of S’s income as DPGR under §1.1502-13(c)(1)(i) is not taken into account. See §1.199-7(d)(5). Accordingly, the consolidated group’s entire section 199 deduction of $378,000 is allocated to B.

Par. 5. Section 1.199-3 is amended by adding a sentence at the end of each of paragraphs (i)(7) and (8) to read as follows:

* * * * *

(i) * * *

(7) Qualifying in-kind partnership for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005. * * * For further guidance, see §1.199-3T(i)(7).

(8) Partnerships owned by members of a single expanded affiliated group for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005. * * * For further guidance, see §1.199-3T(i)(8).

* * * * *

Par. 6. Section 1.199-3T is amended by adding paragraphs (i)(7) and (8) to read as follows:

* * * * *

(i) * * *

(7) Qualifying in-kind partnership for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005—(i) In general. If a partnership is a qualifying in-kind partnership described in paragraph (i)(7)(ii) of this section, then each partner is treated as having manufactured, produced, grown, or extracted (MPGE) (as defined in §1.199-3(e)) or produced the property MPGE or produced by the partnership that is distributed to that partner. If a partner of a qualifying in-kind partnership derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of the property that was MPGE or produced by the qualifying in-kind partnership and distributed to that partner, then, provided such partner is a partner of the qualifying in-kind partnership at the time the partner disposes of the property, the partner is treated as conducting the MPGE or production activities previously conducted by the qualifying in-kind partnership with respect to that property. With respect to a lease, rental, or license, the partner is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts derived from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the partner is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account.

(ii) Definition of qualifying in-kind partnership. For purposes of this paragraph (i)(7), a qualifying in-kind partnership is a partnership engaged solely in—

(A) The extraction, refining, or processing of oil, natural gas (as described in §1.199-3(l)(2)), petrochemicals, or products derived from oil, natural gas, or petrochemicals in whole or in significant part within the United States;

(B) The production or generation of electricity in the United States; or

(C) An activity or industry designated by the Secretary by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter).

(iii) Other rules. Except as provided in this paragraph (i)(7), a qualifying in-kind partnership is treated the same as other partnerships for purposes of section 199. Accordingly, a qualifying in-kind partnership is subject to the rules of this section regarding the application of section 199 to pass-thru entities, including application of the section 199(d)(1)(A)(iii) wage limitation under §1.199-5T(b)(3). In determining whether a qualifying in-kind partnership or its partners MPGE qualifying production property (QPP) (as defined in §1.199-3(j)) in whole or in significant part within the United States (as defined in §1.199-3(h)), see §1.199-3(g)(2) and (3).

(iv) Example. The following example illustrates the application of this paragraph (i)(7). Assume that PRS and X are calendar year taxpayers.

Example. X, Y and Z are partners in PRS, a qualifying in-kind partnership described in paragraph (i)(7)(ii) of this section. X, Y, and Z are corporations. In 2007, PRS distributes oil to X that PRS derived from its oil extraction. PRS incurred $600 of CGS extracting the oil distributed to X, and X’s adjusted basis in the distributed oil is $600. X incurs $200 of CGS in refining the oil within the United States. In 2007, X, while it is a partner in PRS, sells the oil to a customer for $1,500. X is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes. Under paragraph (i)(7)(i) of this section, X is treated as having extracted the oil. The extraction and refining of the oil qualify as an MPGE activity under §1.199-3(e)(1). Therefore, X’s $1,500 of gross receipts qualify as DPGR. X subtracts from the $1,500 of DPGR the $600 of CGS incurred by PRS and the $200 of refining costs it incurred. Thus, X’s QPAI is $700 for 2007.

(8) Partnerships owned by members of a single expanded affiliated group for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005—(i) In general. For purposes of this section, if all of the interests in the capital and profits of a partnership are owned by members of a single expanded affiliated group (EAG) at all times during the taxable year of the partnership (EAG partnership), then the EAG partnership and all members of that EAG are treated as a single taxpayer for purposes of section 199(c)(4) during that taxable year.

(ii) Attribution of activities—(A) In general. If a member of an EAG (disposing member) derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE or produced by an EAG partnership, all the partners of which are members of the same EAG to which the disposing member belongs at the time that the disposing member disposes of such property, then the disposing member is treated as conducting the MPGE or production activities previously conducted by the EAG partnership with respect to that property. The previous sentence applies only for those taxable years in which the disposing member is a member of the EAG of which all the partners of the EAG partnership are members for the entire taxable year of the EAG partnership. With respect to a lease, rental, or license, the disposing member is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the disposing member is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account. Likewise, if an EAG partnership derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE or produced by a member (or members) of the same EAG (the producing member) to which all the partners of the EAG partnership belong at the time that the EAG partnership disposes of such property, then the EAG partnership is treated as conducting the MPGE or production activities previously conducted by the producing member with respect to that property. The previous sentence applies only for those taxable years in which the producing member is a member of the EAG of which all the partners of the EAG partnership are members for the entire taxable year of the EAG partnership. With respect to a lease, rental, or license, the EAG partnership is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts derived from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the EAG partnership is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account. See paragraph (i)(8)(iv) Example 3 of this section.

(B) Attribution between EAG partnerships. If an EAG partnership (disposing partnership) derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE or produced by another EAG partnership (producing partnership), then the disposing partnership is treated as conducting the MPGE or production activities previously conducted by the producing partnership with respect to that property, provided that each of these partnerships (the producing partnership and the disposing partnership) is owned for its entire taxable year in which the disposing partnership disposes of such property by members of the same EAG. With respect to a lease, rental, or license, the disposing partnership is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the disposing partnership is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account.

(C) Exceptions to attribution. Attribution of activities does not apply for purposes of the construction of real property under §1.199-3(m)(1) and the performance of engineering and architectural services under §1.199-3(n)(2) and (3), respectively.

(iii) Other rules. Except as provided in this paragraph (i)(8), an EAG partnership is treated the same as other partnerships for purposes of section 199. Accordingly, an EAG partnership is subject to the rules of this section regarding the application of section 199 to pass-thru entities, including the section 199(d)(1)(A)(iii) wage limitation under §1.199-5T(b)(3). In determining whether a member of an EAG or an EAG partnership MPGE QPP in whole or in significant part within the United States or produced a qualified film or produced utilities within the United States, see §1.199-3(g)(2) and (3) and Example 5 of paragraph (i)(8)(iv) of this section.

(iv) Examples. The following examples illustrate the rules of this paragraph (i)(8). Assume that PRS, X, Y, and Z all are calendar year taxpayers.

Example 1. Contribution. X and Y are the only partners in PRS, a partnership, for PRS’s entire 2007 taxable year. X and Y are both members of a single EAG for the entire 2007 year. In 2007, X MPGE QPP within the United States and contributes the QPP to PRS. In 2007, PRS sells the QPP for $1,000. Under this paragraph (i)(8), PRS is treated as having MPGE the QPP within the United States, and PRS’s $1,000 gross receipts constitute DPGR. PRS, X, and Y must apply the rules of this section regarding the application of section 199 to pass-thru entities with respect to the activity of PRS, including the section 199(d)(1)(A)(iii) wage limitation under §1.199-5T(b)(3).

Example 2. Sale. X, Y, and Z are the only members of a single EAG for the entire 2007 year. X and Y each own 50% of the capital and profits interests in PRS, a partnership, for PRS’s entire 2007 taxable year. In 2007, PRS MPGE QPP within the United States and then sells the QPP to X for $6,000, its fair market value at the time of the sale. PRS’s gross receipts of $6,000 qualify as DPGR. In 2007, X sells the QPP to customers for $10,000, incurring selling expenses of $2,000. Under paragraph (i)(8)(ii)(A) of this section, X is treated as having MPGE the QPP within the United States, and X’s $10,000 of gross receipts qualify as DPGR. PRS, X and Y must apply the rules of this section regarding the application of section 199 to pass-thru entities with respect to the activity of PRS, including application of the section 199(d)(1)(A)(iii) wage limitation under §1.199-5T(b)(3). The results would be the same if PRS sold the QPP to Z rather than to X. However, if PRS did sell the QPP to Z, and Z was not a member of the EAG for PRS’s entire taxable year, the activities previously conducted by PRS with respect to the QPP would not be attributed to Z, and none of Z’s $10,000 of gross receipts would qualify as DPGR.

Example 3. Lease. X, Y, and Z are the only members of a single EAG for the entire 2007 year. X and Y each own 50% of the capital and profits interests in PRS, a partnership, for PRS’s entire 2007 taxable year. In 2007, PRS MPGE QPP within the United States and then sells the QPP to X for $6,000, its fair market value at the time of the sale. PRS’s gross receipts of $6,000 qualify as DPGR. In 2007, X rents the QPP it acquired from PRS to customers unrelated to X. X takes the gross receipts attributable to the rental of the QPP into account under its method of accounting in 2007 and 2008. On July 1, 2008, X ceases to be a member of the same EAG to which Y, the other partner in PRS, belongs. For 2007, X is treated as having MPGE the QPP within the United States under paragraph (i)(8)(ii)(A) of this section, and its gross receipts derived from the rental of the QPP qualify as DPGR. For 2008, however, because X and Y, partners in PRS, are no longer members of the same EAG for the entire year, the gross rental receipts X takes into account in 2008 do not qualify as DPGR.

Example 4. Distribution. X and Y are the only partners in PRS, a partnership, for PRS’s entire 2007 taxable year. X and Y are both members of a single EAG for the entire 2007 year. In 2007, PRS MPGE QPP within the United States, incurring $600 of CGS, and then distributes the QPP to X. X’s adjusted basis in the QPP is $600. X incurs $200 of directly allocable costs to further MPGE the QPP within the United States. In 2007, X sells the QPP for $1,500 to an unrelated customer. X is treated as having disposed of the QPP on the date it ceases to own the QPP for Federal income tax purposes. Under paragraph (i)(8)(ii)(A) of this section, X is treated as having MPGE the QPP within the United States, and X’s $1,500 of gross receipts qualify as DPGR.

Example 5. Multiple sales. (i) Facts. X and Y are the only partners in PRS, a partnership, for PRS’s entire 2007 taxable year. X and Y are both non-consolidated members of a single EAG for the entire 2007 year. PRS produces in bulk form in the United States the active ingredient for a drug. Assume that PRS’s own MPGE activity with respect to the active ingredient is not substantial in nature, taking into account all of the facts and circumstances, and PRS’s direct labor and overhead to MPGE the active ingredient within the United States are $15 and account for 15% of PRS’s $100 CGS of the active ingredient. In 2007, PRS sells the active ingredient in bulk form to X. X uses the active ingredient to produce the finished dosage form drug. Assume that X’s own MPGE activity with respect to the drug is not substantial in nature, taking into account all of the facts and circumstances, and X’s direct labor and overhead to MPGE the drug within the United States are $12 and account for 10% of X’s $120 CGS of the drug. In 2007, X sells the drug in finished dosage to Y and Y sells the drug to customers. Assume that Y’s own MPGE activity with respect to the drug is not substantial in nature, taking into account all of the facts and circumstances, and Y incurs $2 of direct labor and overhead and Y’s CGS in selling the drug to customers is $130.

(ii) Analysis. PRS’s gross receipts from the sale of the active ingredient to X are non-DPGR because PRS’s MPGE activity is not substantial in nature and PRS does not satisfy the safe harbor described in §1.199-3(g)(3) because PRS’s direct labor and overhead account for less than 20% of PRS’s CGS of the active ingredient. X’s gross receipts from the sale of the drug to Y are DPGR because X is considered to have MPGE the drug in significant part in the United States pursuant to the safe harbor described in §1.199-3(g)(3) because the $27 ($15 + $12) of direct labor and overhead incurred by PRS and X equals or exceeds 20% of X’s total CGS ($120) of the drug at the time X disposes of the drug to Y. Similarly, Y’s gross receipts from the sale of the drug to customers are DPGR because Y is considered to have MPGE the drug in significant part in the United States pursuant to the safe harbor described in §1.199-3(g)(3) because the $29 ($15 + $12 + $2) of direct labor and overhead incurred by PRS, X, and Y equals or exceeds 20% of Y’s total CGS ($130) of the drug at the time Y disposes of the drug to Y’s customers.

Par. 7. Section 1.199-5 is amended by adding a sentence at the end to read as follows:

Par. 8. Section 1.199-5T is added to read as follows:

(a) In general. The provisions of this section apply solely for purposes of section 199 of the Internal Revenue Code (Code).

(b) Partnerships—(1) In general—(i) Determination at partner level. The deduction with respect to the qualified production activities of the partnership allowable under §1.199-1(a) (section 199 deduction) is determined at the partner level. As a result, each partner must compute its deduction separately. The section 199 deduction has no effect on the adjusted basis of the partner’s interest in the partnership. Except as provided by publication pursuant to paragraph (b)(1)(ii) of this section, for purposes of this section, each partner is allocated, in accordance with sections 702 and 704, its share of partnership items (including items of income, gain, loss, and deduction), cost of goods sold (CGS) allocated to such items of income, and gross receipts that are included in such items of income, even if the partner’s share of CGS and other deductions and losses exceeds domestic production gross receipts (DPGR) (as defined in §1.199-3(a)). A partnership may specially allocate items of income, gain, loss, or deduction to its partners, subject to the rules of section 704(b) and the supporting regulations. Guaranteed payments under section 707(c) are not considered allocations of partnership income for purposes of this section. Guaranteed payments under section 707(c) are deductions by the partnership that must be taken into account under the rules of §1.199-4. See §1.199-3(p) and paragraph (b)(6) Example 5 of this section. Except as provided in paragraph (b)(1)(ii) of this section, to determine its section 199 deduction for the taxable year, a partner aggregates its distributive share of such items, to the extent they are not otherwise disallowed by the Code, with those items it incurs outside the partnership (whether directly or indirectly) for purposes of allocating and apportioning deductions to DPGR and computing its qualified production activities income (QPAI) (as defined in §1.199-1(c)).

(ii) Determination at entity level. The Secretary may, by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), permit a partnership to calculate a partner’s share of QPAI and W-2 wages as defined in §1.199-2T(e)(2) (W-2 wages) at the entity level, instead of allocating to the partner, in accordance with sections 702 and 704, the partner’s share of partnership items (including items of income, gain, loss, and deduction) and amounts described in §1.199-2(e)(1) (paragraph (e)(1) wages). If a partnership does calculate QPAI at the entity level—

(A) Each partner is allocated its share of QPAI (subject to the limitations of paragraph (b)(2) of this section) and W-2 wages from the partnership, which are combined with the partner’s QPAI and W-2 wages from other sources, if any;

(B) For purposes of computing QPAI under §§1.199-1 through 1.199-8, a partner does not take into account the items from the partnership (for example, a partner does not take into account items from the partnership in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions in calculating its QPAI from other sources);

(C) A partner generally does not recompute its share of QPAI from the partnership using another method; however, the partner might have to adjust its share of QPAI from the partnership to take into account certain disallowed losses or deductions, or the allowance of suspended losses or deductions; and

(D) A partner’s distributive share of QPAI from a partnership may be less than zero.

(2) Disallowed losses or deductions. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), losses or deductions of a partnership are taken into account in computing the partner’s section 199 deduction for a taxable year only if, and to the extent that, the partner’s distributive share of those losses or deductions from all of the partnership’s activities is not disallowed by section 465, 469, or 704(d), or any other provision of the Code. If only a portion of the partner’s distributive share of the losses or deductions from a partnership is allowed for a taxable year, a proportionate share of those allowable losses or deductions that are allocated to the partnership’s qualified production activities, determined in a manner consistent with sections 465, 469, and 704(d), and any other applicable provision of the Code, is taken into account in computing QPAI for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year under section 465, 469, or 704(d), or any other provision of the Code, the partner takes into account a proportionate share of those allowed losses or deductions that are allocated to the partnership’s qualified production activities in computing the partner’s QPAI for that later taxable year. Losses or deductions of the partnership that are disallowed for taxable years beginning on or before December 31, 2004, are not taken into account in a later taxable year for purposes of computing the partner’s QPAI for that later taxable year, whether or not the losses or deductions are allowed for other purposes.

(3) Partner’s share of paragraph (e)(1) wages. Under section 199(d)(1)(A)(iii), a partner’s share of paragraph (e)(1) wages of a partnership for purposes of determining the partner’s wage limitation under section 199(b)(1) (W-2 wage limitation) equals the partner’s allocable share of those wages. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), the partnership must allocate the amount of paragraph (e)(1) wages among the partners in the same manner it allocates wage expense among those partners. The partner must add its share of the paragraph (e)(1) wages from the partnership to the partner’s paragraph (e)(1) wages from other sources, if any. The partner (other than a partner that itself is a partnership or S corporation) then must calculate its W-2 wages by determining the amount of the partner’s total paragraph (e)(1) wages properly allocable to DPGR. If the partner is a partnership or S corporation, the partner must allocate its paragraph (e)(1) wages (including the paragraph (e)(1) wages from a lower-tier partnership) among its partners or shareholders in the same manner it allocates wage expense among those partners or shareholders. See §1.199-2T(e)(2) for the computation of W-2 wages and for the proper allocation of any such wages to DPGR.

(4) Transition rule for definition of W-2 wages and for W-2 wage limitation. If a partnership and any partner in that partnership have different taxable years, only one of which begins on or before May 17, 2006, the definition of W-2 wages of the partnership and the section 199(d)(1)(A)(iii) limitation on W-2 wages from that partnership is determined under the law applicable to partnerships based on the beginning date of the partnership’s taxable year. Thus, for example, for the taxable year of a partnership beginning on or before May 17, 2006, a partner’s share of W-2 wages from the partnership is determined under section 199(d)(1)(A)(iii) as in effect for taxable years beginning on or before May 17, 2006, even if the taxable year of that partner in which those wages are taken into account begins after May 17, 2006.

(5) Partnerships electing out of subchapter K. For purposes of §§1.199-1 through 1.199-8, the rules of paragraph (b) of this section apply to all partnerships, including those partnerships electing under section 761(a) to be excluded, in whole or in part, from the application of subchapter K of chapter 1 of the Code.

(6) Examples. The following examples illustrate the application of this paragraph (b). Assume that each partner has sufficient adjusted gross income or taxable income so that the section 199 deduction is not limited under section 199(a)(1)(B). Assume also that the partnership and each of its partners (whether individual or corporate) are calendar year taxpayers.

Example 1. Section 861 method with interest expense. (i) Partnership Federal income tax items. X and Y, unrelated United States corporations, are each 50% partners in PRS, a partnership that engages in production activities that generate both DPGR and non-DPGR. X and Y share all items of income, gain, loss, deduction, and credit equally. Both X and Y are engaged in a trade or business. PRS is not able to identify from its books and records CGS allocable to DPGR and non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of PRS’s gross receipts, apportionment of CGS between DPGR and non-DPGR based on gross receipts is appropriate. For 2010, the adjusted basis of PRS’s business assets is $5,000, $4,000 of which generate gross income attributable to DPGR and $1,000 of which generate gross income attributable to non-DPGR. For 2010, PRS has the following Federal income tax items:

(ii) Allocation of PRS’s Federal income tax items. X and Y each receive the following distributive share of PRS’s Federal income tax items, as determined under the principles of §1.704-1(b)(1)(vii):

(iii) Determination of QPAI. (A) X’s QPAI. Because the section 199 deduction is determined at the partner level, X determines its QPAI by aggregating its distributive share of PRS’s Federal income tax items with all other such items from all other, non-PRS-related activities. For 2010, X does not have any other such items. For 2010, the adjusted basis of X’s non-PRS assets, all of which are investment assets, is $10,000. X’s only gross receipts for 2010 are those attributable to the allocation of gross income from PRS. X allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of §1.199-4(d). In this case, the section 162 selling expenses are not included in CGS and are definitely related to all of PRS’s gross income. Based on the facts and circumstances of this specific case, apportionment of those expenses between DPGR and non-DPGR on the basis of PRS’s gross receipts is appropriate. X elects to apportion its distributive share of interest expense under the tax book value method of §1.861-9T(g). X’s QPAI for 2010 is $366, as shown in the following table:

(B) Y’s QPAI. (1) For 2010, in addition to the activities of PRS, Y engages in production activities that generate both DPGR and non-DPGR. Y is able to identify from its books and records CGS allocable to DPGR and to non-DPGR. For 2010, the adjusted basis of Y’s non-PRS assets attributable to its production activities that generate DPGR is $8,000 and to other production activities that generate non-DPGR is $2,000. Y has no other assets. Y has the following Federal income tax items relating to its non-PRS activities:

(2) Y determines its QPAI in the same general manner as X. However, because Y has other trade or business activities outside of PRS, Y must aggregate its distributive share of PRS’s Federal income tax items with its own such items. Y allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of §1.199-4(d). In this case, Y’s distributive share of PRS’s section 162 selling expenses, as well as those selling expenses from Y’s non-PRS activities, are definitely related to all of its gross income. Based on the facts and circumstances of this specific case, apportionment of those expenses between DPGR and non-DPGR on the basis of Y’s gross receipts (including Y’s share of PRS’s gross receipts) is appropriate. Y elects to apportion its distributive share of interest expense under the tax book value method of §1.861-9T(g). Y has $1,290 of gross income attributable to DPGR ($3,000 DPGR ($1,500 from PRS and $1,500 from non-PRS activities) − $1,710 CGS ($810 from PRS and $900 from non-PRS activities)). Y’s QPAI for 2010 is $642, as shown in the following table:

(iv) Determination of section 199 deduction. X’s tentative section 199 deduction is $33 (.09 x $366, that is, QPAI determined at the partner level) subject to the W-2 wage limitation (50% of W-2 wages). Y’s tentative section 199 deduction is $58 (.09 x $642) subject to the W-2 wage limitation.

Example 2. Section 861 method with R&E expense. (i) Partnership Federal income tax items. X and Y, unrelated United States corporations each of which is engaged in a trade or business, are partners in PRS, a partnership that engages in production activities that generate both DPGR and non-DPGR. Neither X nor Y is a member of an affiliated group. X and Y share all items of income, gain, loss, deduction, and credit equally. All of PRS’s domestic production activities that generate DPGR are within Standard Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of PRS’s production activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). PRS is not able to identify from its books and records CGS allocable to DPGR and to non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of PRS’s gross receipts, apportionment of CGS between DPGR and non-DPGR based on gross receipts is appropriate. PRS incurs $900 of research and experimentation expenses (R&E) that are deductible under section 174, $300 of which are performed with respect to SIC AAA and $600 of which are performed with respect to SIC BBB. None of the R&E is legally mandated R&E as described in §1.861-17(a)(4) and none is included in CGS. For 2010, PRS has the following Federal income tax items:

(ii) Allocation of PRS’s Federal income tax items. X and Y each receive the following distributive share of PRS’s Federal income tax items, as determined under the principles of §1.704-1(b)(1)(vii):

(iii) Determination of QPAI. (A) X’s QPAI. Because the section 199 deduction is determined at the partner level, X determines its QPAI by aggregating its distributive share of PRS’s Federal income tax items with all other such items from all other, non-PRS-related activities. For 2010, X does not have any other such tax items. X’s only gross receipts for 2010 are those attributable to the allocation of gross income from PRS. As stated, all of PRS’s domestic production activities that generate DPGR are within SIC AAA. X allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of §1.199-4(d). In this case, the section 162 selling expenses are definitely related to all of PRS’s gross income. Based on the facts and circumstances of this specific case, apportionment of those expenses between DPGR and non-DPGR on the basis of PRS’s gross receipts is appropriate. For purposes of apportioning R&E, X elects to use the sales method as described in §1.861-17(c). Because X has no direct sales of products, and because all of PRS’s SIC AAA sales attributable to X’s share of PRS’s gross income generate DPGR, all of X’s share of PRS’s section 174 R&E attributable to SIC AAA is taken into account for purposes of determining X’s QPAI. Thus, X’s total QPAI for 2010 is $540, as shown in the following table:

(B) Y’s QPAI. (1) For 2010, in addition to the activities of PRS, Y engages in domestic production activities that generate both DPGR and non-DPGR. With respect to those non-PRS activities, Y is not able to identify from its books and records CGS allocable to DPGR and to non-DPGR. In this case, because non-PRS CGS is definitely related under the facts and circumstances to all of Y’s non-PRS gross receipts, apportionment of non-PRS CGS between DPGR and non-DPGR based on Y’s non-PRS gross receipts is appropriate. For 2010, Y has the following non-PRS Federal income tax items:

(2) Because Y has DPGR as a result of activities outside PRS, Y must aggregate its distributive share of PRS’s Federal income tax items with such items from all its other, non-PRS-related activities. Y allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of §1.199-4(d). In this case, the section 162 selling expenses are definitely related to all of Y’s gross income. Based on the facts and circumstances of the specific case, apportionment of such expenses between DPGR and non-DPGR on the basis of Y’s gross receipts (including Y’s share of PRS’s gross receipts) is appropriate. For purposes of apportioning R&E, Y elects to use the sales method as described in §1.861-17(c).

(3) With respect to sales that generate DPGR, Y has gross income of $2,400 ($4,500 DPGR ($1,500 from PRS and $3,000 from non-PRS activities) − $2,100 CGS ($600 from sales of products by PRS and $1,500 from non-PRS activities)). Because all of the sales in SIC AAA generate DPGR, all of Y’s share of PRS’s section 174 R&E attributable to SIC AAA and the section 174 R&E attributable to SIC AAA that Y incurs in its non-PRS activities are taken into account for purposes of determining Y’s QPAI. Because only a portion of the sales within SIC BBB generate DPGR, only a portion of the section 174 R&E attributable to SIC BBB is taken into account in determining Y’s QPAI. Thus, Y’s QPAI for 2010 is $1,282, as shown in the following table:

(iv) Determination of section 199 deduction. X’s tentative section 199 deduction is $49 (.09 x $540, that is, QPAI determined at the partner level) subject to the W-2 wage limitation (50% of W-2 wages). Y’s tentative section 199 deduction is $115 (.09 x $1,282) subject to the W-2 wage limitation.

Example 3. Partnership with special allocations. (i) In general. X and Y are unrelated corporate partners in PRS and each is engaged in a trade or business. PRS is a partnership that engages in a domestic production activity and other activities. In general, X and Y share all partnership items of income, gain, loss, deduction, and credit equally, except that 80% of the wage expense of PRS and 20% of PRS’s other expenses are specially allocated to X. Under all the facts and circumstances, these special allocations have substantial economic effect under section 704(b). In the 2010 taxable year, PRS’s only wage expense is $2,000 for marketing, which is not included in CGS. PRS has $8,000 of gross receipts ($6,000 of which is DPGR), $4,000 of CGS ($3,500 of which is allocable to DPGR), and $3,000 of deductions (comprised of $2,000 of wage expense for marketing and $1,000 of other expenses). X qualifies for and uses the simplified deduction method under §1.199-4(e). Y does not qualify to use that method and, therefore, must use the section 861 method under §1.199-4(d). In the 2010 taxable year, X has gross receipts attributable to non-partnership trade or business activities of $1,000 and wage expense of $200. None of X’s non-PRS gross receipts is DPGR. For purposes of this example, with regard to both X and PRS, paragraph (e)(1) wages equal wage expense for the 2010 taxable year.

(ii) Allocation and apportionment of costs. Under the partnership agreement, X’s distributive share of the Federal income tax items of PRS is $1,250 of gross income attributable to DPGR ($3,000 DPGR − $1,750 allocable CGS), $750 of gross income attributable to non-DPGR ($1,000 non-DPGR − $250 allocable CGS), and $1,800 of deductions (comprised of X’s special allocations of $1,600 of wage expense ($2,000 x 80%) for marketing and $200 of other expenses ($1,000 x 20%)). Under the simplified deduction method, X apportions $1,200 of other deductions to DPGR ($2,000 ($1,800 from the partnership and $200 from non-partnership activities) x ($3,000 DPGR/$5,000 total gross receipts)). Accordingly, X’s QPAI is $50 ($3,000 DPGR − $1,750 CGS − $1,200 of deductions). X has $1,800 of paragraph (e)(1) wages ($1,600 (X’s 80% share) from PRS + $200 (X’s own non-PRS paragraph (e)(1) wages)). To calculate its W-2 wages, X must determine how much of this $1,800 is properly allocable under §1.199-2T(e)(2) to X’s total DPGR (including X’s share of DPGR from PRS). Thus, X’s tentative section 199 deduction for the 2010 taxable year is $5 (.09 x $50), subject to the W-2 wage limitation (50% of X’s W-2 wages).

Example 4. Partnership with no paragraph (e)(1) wages. (i) Facts. A and B, both individuals, are partners in PRS. PRS is a partnership that engages in manufacturing activities that generate both DPGR and non-DPGR. A and B share all items of income, gain, loss, deduction, and credit equally. For the 2010 taxable year, PRS has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of $400 and deductions of $800. PRS has no paragraph (e)(1) wages. Each partner’s distributive share of PRS’s Federal income tax items is $500 DPGR, $500 non-DPGR, $200 CGS, and $400 of deductions. A has trade or business activities outside of PRS (non-PRS activities). With respect to those activities, A has total gross receipts of $1,000 ($500 of which is DPGR), CGS of $400 (including $50 of paragraph (e)(1) wages), and deductions of $200 for the 2010 taxable year. B has no trade or business activities outside of PRS. A and B each use the small business simplified overall method under §1.199-4(f).

(ii) A’s QPAI. A’s total CGS and deductions apportioned to DPGR equal $600 (($1,200 ($200 PRS CGS + $400 non-PRS CGS + $400 PRS deductions + $200 non-PRS trade or business deductions)) x ($1,000 total DPGR ($500 from PRS + $500 from non-PRS activities)/$2,000 total gross receipts ($1,000 from PRS + $1,000 from non-PRS activities))). Accordingly, A’s QPAI is $400 ($1,000 DPGR ($500 from PRS + $500 from non-PRS activities) − $600 CGS and deductions).

(iii) A’s W-2 wages and section 199 deduction. A has $50 of paragraph (e)(1) wages ($0 from PRS + $50 from A’s non-PRS activities). To calculate A’s W-2 wages, A determines, under a reasonable method satisfactory to the Secretary, that $40 of this $50 is properly allocable under §1.199-2T(e)(2) to A’s DPGR from PRS and non-PRS activities. A’s tentative section 199 deduction is $36 (.09 x $400), subject to the W-2 wage limitation of $20 (50% of W-2 wages of $40). Thus, A’s section 199 deduction is $20.

(iv) B’s QPAI and section 199 deduction. B’s CGS and deductions apportioned to DPGR equal $300 (($200 PRS CGS + $400 PRS deductions) x ($500 DPGR from PRS/$1,000 total gross receipts from PRS)). Accordingly, B’s QPAI is $200 ($500 DPGR − $300 CGS and deductions). B’s tentative section 199 deduction is $18 (.09 x $200), subject to the W-2 wage limitation. In this case, however, the limitation is $0, because B has no paragraph (e)(1) wages. Thus, B’s section 199 deduction is $0.

Example 5. Guaranteed payment. (i) Facts. The facts are the same as in Example 4, except that in 2010 PRS also makes a guaranteed payment of $200 to A for services rendered by A (see section 707(c)), and PRS incurs $200 of wage expense for employees’ salary, which is included within the $400 of CGS (in this case the wage expense of $200 equals PRS’s paragraph (e)(1) wages). The guaranteed payment is taxable to A as ordinary income and is properly deducted by PRS under section 162. Pursuant to §1.199-3(p), A may not treat any part of this payment as DPGR. Accordingly, PRS has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of $400 (including $200 of wage expense) and deductions of $1,000 (including the $200 guaranteed payment) for the 2010 taxable year. Each partner’s distributive share of the items of the partnership is $500 DPGR, $500 non-DPGR, $200 CGS (including $100 of wage expense), and $500 of deductions.

(ii) A’s QPAI and W-2 wages. A’s total CGS and deductions apportioned to DPGR equal $591 ($1,300 ($200 PRS CGS + $400 non-PRS CGS + $500 PRS deductions + $200 non-PRS trade or business deductions) x ($1,000 total DPGR ($500 from PRS + $500 from non-PRS activities)/$2,200 total gross receipts ($1,000 from PRS + $200 guaranteed payment + $1,000 from non-PRS activities))). Accordingly, A’s QPAI is $409 ($1,000 DPGR − $591 CGS and other deductions). A’s total paragraph (e)(1) wages are $150 ($100 from PRS + $50 from non-PRS activities). To calculate its W-2 wages, A must determine how much of this $150 is properly allocable under §1.199-2T(e)(2) to A’s total DPGR from PRS and non-PRS activities. A’s tentative section 199 deduction is $37 (.09 x $409), subject to the W-2 wage limitation (50% of W-2 wages).

(iii) B’s QPAI and W-2 wages. B’s QPAI is $150 ($500 DPGR − $350 CGS and other deductions). B has $100 of paragraph (e)(1) wages (all from PRS). To calculate its W-2 wages, B must determine how much of this $100 is properly allocable under §1.199-2T(e)(2) to B’s total DPGR. B’s tentative section 199 deduction is $14 (.09 x $150), subject to the W-2 wage limitation (50% of B’s W-2 wages).

(c) S corporations—(1) In general—(i) Determination at shareholder level. The section 199 deduction with respect to the qualified production activities of an S corporation is determined at the shareholder level. As a result, each shareholder must compute its deduction separately. The section 199 deduction has no effect on the adjusted basis of a shareholder’s stock in an S corporation. Except as provided by publication pursuant to paragraph (c)(1)(ii) of this section, for purposes of this section, each shareholder is allocated, in accordance with section 1366, its pro rata share of S corporation items (including items of income, gain, loss, and deduction), CGS allocated to such items of income, and gross receipts included in such items of income, even if the shareholder’s share of CGS and other deductions and losses exceeds DPGR. Except as provided by publication under paragraph (c)(1)(ii) of this section, to determine its section 199 deduction for the taxable year, the shareholder aggregates its pro rata share of such items, to the extent they are not otherwise disallowed by the Code, with those items it incurs outside the S corporation (whether directly or indirectly) for purposes of allocating and apportioning deductions to DPGR and computing its QPAI.

(ii) Determination at entity level. The Secretary may, by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), permit an S corporation to calculate a shareholder’s share of QPAI and W-2 wages at the entity level, instead of allocating to the shareholder, in accordance with section 1366, the shareholder’s pro rata share of S corporation items (including items of income, gain, loss, and deduction) and paragraph (e)(1) wages. If an S corporation does calculate QPAI at the entity level—

(A) Each shareholder is allocated its share of QPAI (subject to the limitations of paragraph (c)(2) of this section) and W-2 wages from the S corporation, which are combined with the shareholder’s QPAI and W-2 wages from other sources, if any;

(B) For purposes of computing QPAI under §§1.199-1 through 1.199-8, a shareholder does not take into account the items from the S corporation (for example, a shareholder does not take into account items from the S corporation in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions in calculating its QPAI from other sources);

(C) A shareholder generally does not recompute its share of QPAI from the S corporation using another method; however, the shareholder might have to adjust its share of QPAI from the S corporation to take into account certain disallowed losses or deductions, or the allowance of suspended losses or deductions; and

(D) A shareholder’s share of QPAI from an S corporation may be less than zero.

(2) Disallowed losses or deductions. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), losses or deductions of the S corporation are taken into account in computing the shareholder’s section 199 deduction for a taxable year only if, and to the extent that, the shareholder’s pro rata share of the losses or deductions from all of the S corporation’s activities is not disallowed by section 465, 469, or 1366(d), or any other provision of the Code. If only a portion of the shareholder’s share of the losses or deductions from an S corporation is allowed for a taxable year, a proportionate share of those allowable losses or deductions that are allocated to the S corporation’s qualified production activities, determined in a manner consistent with sections 465, 469, and 1366(d), and any other applicable provision of the Code, is taken into account in computing QPAI for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year under section 465, 469, or 704(d), or any other provision of the Code, the shareholder takes into account a proportionate share of those allowed losses or deductions that are allocated to the S corporation’s qualified production activities in computing the shareholder’s QPAI for that later taxable year. Losses or deductions of the S corporation that are disallowed for taxable years beginning on or before December 31, 2004, are not taken into account in a later taxable year for purposes of computing the shareholder’s QPAI for that later taxable year, whether or not the losses or deductions are allowed for other purposes.

(3) Shareholder’s share of paragraph (e)(1) wages. Under section 199(d)(1)(A)(iii), an S corporation shareholder’s share of the paragraph (e)(1) wages of the S corporation for purposes of determining the shareholder’s W-2 wage limitation equals the shareholder’s allocable share of those wages. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), the S corporation must allocate the paragraph (e)(1) wages among the shareholders in the same manner it allocates wage expense among those shareholders. The shareholder then must add its share of the paragraph (e)(1) wages from the S corporation to the shareholder’s paragraph (e)(1) wages from other sources, if any, and then must determine the portion of those total paragraph (e)(1) wages allocable to DPGR to compute the shareholder’s W-2 wages. See §1.199-2T(e)(2) for the computation of W-2 wages and for the proper allocation of such wages to DPGR.

(4) Transition rule for definition of W-2 wages and for W-2 wage limitation. If an S corporation and any of its shareholders have different taxable years, only one of which begins on or before May 17, 2006, the definition of W-2 wages of the S corporation and the section 199(d)(1)(A)(iii) limitation on W-2 wages from that S corporation is determined under the law applicable to S corporations based on the beginning date of the S corporation’s taxable year. Thus, for example, for the short taxable year of an S corporation beginning after May 17, 2006, and ending in 2006, a shareholder’s share of W-2 wages from the S corporation is determined under section 199(d)(1)(A)(iii) for taxable years beginning after May 17, 2006, even if that shareholder’s taxable year began on or before May 17, 2006.

(d) Grantor trusts. To the extent that the grantor or another person is treated as owning all or part (the owned portion) of a trust under sections 671 through 679, such person (owner) computes its QPAI with respect to the owned portion of the trust as if that QPAI had been generated by activities performed directly by the owner. Similarly, for purposes of the W-2 wage limitation, the owner of the trust takes into account the owner’s share of the paragraph (e)(1) wages of the trust that are attributable to the owned portion of the trust. The provisions of paragraph (e) of this section do not apply to the owned portion of a trust.

(e) Non-grantor trusts and estates—(1) Allocation of costs. The trust or estate calculates each beneficiary’s share (as well as the trust’s or estate’s own share, if any) of QPAI and W-2 wages from the trust or estate at the trust or estate level. The beneficiary of a trust or estate may not recompute its share of QPAI or W-2 wages from the trust or estate by using another method to reallocate the trust’s or estate’s qualified production costs or paragraph (e)(1) wages, or otherwise. Except as provided in paragraph (d) of this section, the QPAI of a trust or estate must be computed by allocating expenses described in section 199(d)(5) in one of two ways, depending on the classification of those expenses under §1.652(b)-3. Specifically, directly attributable expenses within the meaning of §1.652(b)-3 are allocated pursuant to §1.652(b)-3, and expenses not directly attributable within the meaning of §1.652(b)-3 (other expenses) are allocated under the simplified deduction method of §1.199-4(e) (unless the trust or estate does not qualify to use the simplified deduction method, in which case it must use the section 861 method of §1.199-4(d) with respect to such other expenses). For this purpose, depletion and depreciation deductions described in section 642(e) and amortization deductions described in section 642(f) are treated as other expenses described in section 199(d)(5). Also for this purpose, the trust’s or estate’s share of other expenses from a lower-tier pass-thru entity is not directly attributable to any class of income (whether or not those other expenses are directly attributable to the aggregate pass-thru gross income as a class for purposes other than section 199). A trust or estate may not use the small business simplified overall method for computing its QPAI. See §1.199-4(f)(5).

(2) Allocation among trust or estate and beneficiaries—(i) In general. The QPAI of a trust or estate (which will be less than zero if the CGS and deductions allocated and apportioned to DPGR exceed the trust’s or estate’s DPGR) and W-2 wages of a trust or estate are allocated to each beneficiary and to the trust or estate based on the relative proportion of the trust’s or estate’s distributable net income (DNI), as defined by section 643(a), for the taxable year that is distributed or required to be distributed to the beneficiary or is retained by the trust or estate. To the extent that the trust or estate has no DNI for the taxable year, any QPAI and W-2 wages are allocated entirely to the trust or estate. A trust or estate is allowed the section 199 deduction in computing its taxable income to the extent that QPAI and W-2 wages are allocated to the trust or estate. A beneficiary of a trust or estate is allowed the section 199 deduction in computing its taxable income based on its share of QPAI and W-2 wages from the trust or estate, which are aggregated with the beneficiary’s QPAI and W-2 wages from other sources, if any.

(ii) Treatment of items from a trust or estate reporting qualified production activities income. When, pursuant to this paragraph (e), a taxpayer must combine QPAI and W-2 wages from a trust or estate with the taxpayer’s total QPAI and W-2 wages from other sources, the taxpayer, when applying §§1.199-1 through 1.199-8 to determine the taxpayer’s total QPAI and W-2 wages from such other sources, does not take into account the items from such trust or estate. Thus, for example, a beneficiary of an estate that receives QPAI from the estate does not take into account the beneficiary’s distributive share of the estate’s gross receipts, gross income, or deductions when the beneficiary determines whether a threshold or de minimis rule applies or when the beneficiary allocates and apportions deductions in calculating its QPAI from other sources. Similarly, in determining the portion of the beneficiary’s paragraph (e)(1) wages from other sources that is attributable to DPGR (thus, the W-2 wages from other sources), the beneficiary does not take into account DPGR and non-DPGR from the trust or estate.

(3) Transition rule for definition of W-2 wages and for W-2 wage limitation. The definition of W-2 wages of a trust or estate and the section 199(d)(1)(A)(iii) limitation on W-2 wages from that trust or estate, and thus the beneficiary’s share of W-2 wages from that trust or estate, is determined under the law applicable to pass-thru entities based on the beginning date of the taxable year of the trust or estate, regardless of the beginning date of the taxable year of the beneficiary.

(4) Example. The following example illustrates the application of this paragraph (e). Assume that the partnership, trust, and trust beneficiary all are calendar year taxpayers.

Example. (i) Computation of DNI and inclusion and deduction amounts. (A) Trust’s distributive share of partnership items. Trust, a complex trust, is a partner in PRS, a partnership that engages in activities that generate DPGR and non-DPGR. In 2010, PRS distributes $10,000 cash to Trust. PRS properly allocates (in the same manner as wage expense) paragraph (e)(1) wages of $3,000 to Trust. Trust’s distributive share of PRS items, which are properly included in Trust’s DNI, is as follows:

(B) Trust’s direct activities. Trust has direct paragraph (e)(1) wages of $2,000 for the 2010 taxable year. In addition to its cash distribution in 2010 from PRS, Trust also directly has the following items which are properly included in Trust’s DNI:

(C) Allocation of deductions under §1.652(b)-3. (1) Directly attributable expenses. In computing Trust’s DNI for the taxable year, the distributive share of expenses of PRS are directly attributable under §1.652(b)-3(a) to the distributive share of income of PRS. Accordingly, the $5,000 of CGS, $3,000 of selling expenses, and $2,000 of other expenses are subtracted from the gross receipts from PRS ($20,000), resulting in net income from PRS of $10,000. With respect to the Trust’s direct expenses, $1,000 of the trustee commissions, the $1,000 of real estate taxes, and the $2,000 of wage expense are directly attributable under §1.652(b)-3(a) to the rental income.

(2) Non-directly attributable expenses. Under §1.652(b)-3(b), the trustee must allocate a portion of the sum of the balance of the trustee commissions ($2,000), state income and personal property taxes ($5,000), and the other business expenses ($1,000) to the $10,000 of tax-exempt interest. The portion to be attributed to tax-exempt interest is $2,222 ($8,000 x ($10,000 tax exempt interest/$36,000 gross receipts net of direct expenses)), resulting in $7,778 ($10,000 − $2,222) of net tax-exempt interest. Pursuant to its authority recognized under §1.652(b)-3(b), the trustee allocates the entire amount of the remaining $5,778 of trustee commissions, state income and personal property taxes, and other business expenses to the $6,000 of net rental income, resulting in $222 ($6,000 − $5,778) of net rental income.

(D) Amounts included in taxable income. For 2010, Trust has DNI of $28,000 (net dividend income of $10,000 + net PRS income of $10,000 + net rental income of $222 + net tax-exempt income of $7,778). Pursuant to Trust’s governing instrument, Trustee distributes 50%, or $14,000, of that DNI to B, an individual who is a discretionary beneficiary of Trust. Assume that there are no separate shares under Trust, and no distributions are made to any other beneficiary that year. Consequently, with respect to the $14,000 distribution B receives from Trust, B properly includes in B’s gross income $5,000 of income from PRS, $111 of rents, and $5,000 of dividends, and properly excludes from B’s gross income $3,889 of tax-exempt interest. Trust includes $20,222 in its adjusted total income and deducts $10,111 under section 661(a) in computing its taxable income.

(ii) Section 199 deduction. (A) Simplified deduction method. For purposes of computing the section 199 deduction for the taxable year, assume Trust qualifies for the simplified deduction method under §1.199-4(e). The determination of Trust’s QPAI under the simplified deduction method requires multiple steps to allocate costs. First, the Trust’s expenses directly attributable to DPGR under §1.652(b)-3(a) are subtracted from the Trust’s DPGR. In this step, the directly attributable $5,000 of CGS and selling expenses of $3,000 are subtracted from the $15,000 of DPGR from PRS. Second, the Trust’s expenses directly attributable under §1.652(b)-3(a) to non-DPGR from a trade or business are subtracted from the Trust’s trade or business non-DPGR. In this step, $4,000 of Trust expenses directly allocable to the real property rental activity ($1,000 of real estate taxes, $1,000 of Trustee commissions, and $2,000 of wages) are subtracted from the $10,000 of rental income. Third, Trust must identify the portion of its other expenses that is attributable to Trust’s trade or business activities, if any, because expenses not attributable to trade or business activities are not taken into account in computing QPAI. In this step, in this example, the portion of the trustee commissions not directly attributable to the rental operation ($2,000) are directly attributable to non-trade or business activities. In addition, the state income and personal property taxes are not directly attributable under §1.652(b)-3(a) to either trade or business or non-trade or business activities, so the portion of those taxes not attributable to either the PRS interests or the rental operation are not trade or business expenses and, thus, are not taken into account in computing QPAI. The portion of the state income and personal property taxes that is treated as other trade or business expenses is $3,000 ($5,000 x $30,000 total trade or business gross receipts/$50,000 total gross receipts). Fourth, Trust then allocates its other trade or business expenses (not directly attributable under §1.652(b)-3(a)) between DPGR and non-DPGR on the basis of its total gross receipts from the conduct of a trade or business ($20,000 from PRS + $10,000 rental income). Thus, Trust combines its non-directly attributable (other) business expenses ($2,000 from PRS + $4,000 ($1,000 of other business expenses + $3,000 of income and property taxes allocated to a trade or business) from its own activities) and then apportions this total ($6,000) between DPGR and other receipts on the basis of Trust’s total trade or business gross receipts ($6,000 of such expenses x $15,000 DPGR/$30,000 total trade or business gross receipts = $3,000). Thus, for purposes of computing Trust’s and B’s section 199 deduction, Trust’s QPAI is $4,000 ($7,000 − $3,000). Because the distribution of Trust’s DNI to B equals one-half of Trust’s DNI, Trust and B each has QPAI from PRS for purposes of the section 199 deduction of $2,000. B has $1,000 of QPAI from non-Trust activities that is added to the $2,000 QPAI from Trust for a total of $3,000 of QPAI.

(B) W-2 wages. For the 2010 taxable year, Trust chooses to use the wage expense safe harbor under §1.199-2T(e)(2)(ii) to determine its W-2 wages. For its taxable year ending December 31, 2010, Trust has $5,000 of paragraph (e)(1) wages reported on 2010 Forms W-2. Trust’s W-2 wages are $2,917, as shown in the following table:

(C) Section 199 deduction computation. (1) B’s computation. B is eligible to use the small business simplified overall method. Assume that B has sufficient adjusted gross income so that the section 199 deduction is not limited under section 199(a)(1)(B). Because the $14,000 Trust distribution to B equals one-half of Trust’s DNI, B has W-2 wages from Trust of $1,459 (50% x $2,917). B has W-2 wages of $100 from non-Trust trade or business activities (computed without regard to B’s interest in Trust pursuant to §1.199-2(e)) for a total of $1,559 of W-2 wages. B has $1,000 of QPAI from non-Trust activities that is added to the $2,000 QPAI from Trust for a total of $3,000 of QPAI. B’s tentative deduction is $270 (.09 x $3,000), limited under the W-2 wage limitation to $780 (50% x $1,559 W-2 wages). Accordingly, B’s section 199 deduction for 2010 is $270.

(2) Trust’s computation. Trust has sufficient adjusted gross income so that the section 199 deduction is not limited under section 199(a)(1)(B). Because the $14,000 Trust distribution to B equals one-half of Trust’s DNI, Trust has W-2 wages of $1,459 (50% x $2,917). Trust’s tentative deduction is $180 (.09 x $2,000 QPAI), limited under the W-2 wage limitation to $730 (50% x $1,459 W-2 wages). Accordingly, Trust’s section 199 deduction for 2010 is $180.

(f) Gain or loss from the disposition of an interest in a pass-thru entity. DPGR generally does not include gain or loss recognized on the sale, exchange, or other disposition of an interest in a pass-thru entity. However, with respect to a partnership, if section 751(a) or (b) applies, then gain or loss attributable to assets of the partnership giving rise to ordinary income under section 751(a) or (b), the sale, exchange, or other disposition of which would give rise to DPGR, is taken into account in computing the partner’s section 199 deduction. Accordingly, to the extent that cash or property received by a partner in a sale or exchange of all or part of its partnership interest is attributable to unrealized receivables or inventory items within the meaning of section 751(c) or (d), respectively, and the sale or exchange of the unrealized receivable or inventory items would give rise to DPGR if sold, exchanged, or otherwise disposed of by the partnership, the cash or property received by the partner is taken into account by the partner in determining its DPGR for the taxable year. Likewise, to the extent that a distribution of property to a partner is treated under section 751(b) as a sale or exchange of property between the partnership and the distributee partner, and any property deemed sold or exchanged would give rise to DPGR if sold, exchanged, or otherwise disposed of by the partnership, the deemed sale or exchange of the property must be taken into account in determining the partnership’s and distributee partner’s DPGR to the extent not taken into account under the qualifying in-kind partnership rules. See §§1.751-1(b) and 1.199-3T(i)(7).

(g) No attribution of qualified activities. Except as provided in §1.199-3T(i)(7) regarding qualifying in-kind partnerships and §1.199-3T(i)(8) regarding EAG partnerships, an owner of a pass-thru entity is not treated as conducting the qualified production activities of the pass-thru entity, and vice versa. For example, if a partnership manufactures QPP within the United States, or produces a qualified film or produces utilities in the United States, and distributes or leases, rents, licenses, sells, exchanges, or otherwise disposes of such property to a partner who then, without performing its own qualifying activity, leases, rents, licenses, sells, exchanges, or otherwise disposes of such property, then the partner’s gross receipts from this latter lease, rental, license, sale, exchange, or other disposition are treated as non-DPGR. In addition, if a partner manufactures QPP within the United States, or produces a qualified film or produces utilities in the United States, and contributes or leases, rents, licenses, sells, exchanges, or otherwise disposes of such property to a partnership which then, without performing its own qualifying activity, leases, rents, licenses, sells, exchanges, or otherwise disposes of such property, then the partnership’s gross receipts from this latter disposition are treated as non-DPGR.

Par. 9. Section 1.199-7 is amended by adding new paragraph (b)(4) to read as follows:

* * * * *

(b) * * *

(4) Losses used to reduce taxable income of expanded affiliated group. [Reserved]. For further guidance, see §1.199-7T(b)(4).

* * * * *

Par. 10. Section 1.199-7T is added to read as follows:

(a) [Reserved]. For further guidance, see §1.199-7(a).

(b) Computation of expanded affiliated group’s section 199 deduction.

(1) through (3) [Reserved]. For further guidance, see §1.199-7(b)(1) through (3).

(4) Losses used to reduce taxable income of expanded affiliated group—(i) In general. The amount of a net operating loss (NOL) sustained by any member of an expanded affiliated group (EAG) (as defined in §1.199-7) that is used in the year sustained in determining an EAG’s taxable income limitation under section 199(a)(1)(B) is not treated as an NOL carryover or NOL carryback to any taxable year in determining the taxable income limitation under section 199(a)(1)(B). For purposes of this paragraph (b)(4), an NOL is considered to be used if it reduces an EAG’s aggregate taxable income, regardless of whether the use of the NOL actually reduces the amount of the deduction under §1.199-1(a) (section 199 deduction) that the EAG would otherwise derive. An NOL is not considered to be used to the extent that it reduces an EAG’s aggregate taxable income to an amount less than zero. If more than one member of an EAG has an NOL used in the same taxable year to reduce the EAG’s taxable income, the members’ respective NOLs are deemed used in proportion to the amount of their NOLs.

(ii) Examples. The following examples illustrate the application of this paragraph (b)(4). For purposes of these examples, assume that all relevant parties have sufficient W-2 wages so that the section 199 deduction is not limited under section 199(b)(1).

Example 1. (i) Facts. Corporations A and B are the only two members of an EAG. A and B are both calendar year taxpayers and they do not join in the filing of a consolidated Federal income tax return. Neither A nor B had taxable income or loss prior to 2010. In 2010, A has qualified production activities income (QPAI) (as defined in §1.199-1(c)) and taxable income of $1,000 and B has QPAI of $1,000 and an NOL of $1,500. In 2011, A has QPAI of $2,000 and taxable income of $1,000 and B has QPAI of $2,000 and taxable income prior to the NOL deduction allowed under section 172 of $2,000.

(ii) Section 199 deduction for 2010. In determining the EAG’s section 199 deduction for 2010, A’s $1,000 of QPAI and B’s $1,000 of QPAI are aggregated, as are A’s $1,000 of taxable income and B’s $1,500 NOL. Thus, for 2010, the EAG has QPAI of $2,000 and taxable income of ($500). The EAG’s section 199 deduction for 2010 is 9% of the lesser of its QPAI or its taxable income. Because the EAG has a taxable loss in 2010, the EAG’s section 199 deduction is $0.

(iii) Section 199 deduction for 2011. In determining the EAG’s section 199 deduction for 2011, A’s $2,000 of QPAI and B’s $2,000 of QPAI are aggregated, giving the EAG QPAI of $4,000. Also, $1,000 of B’s NOL from 2010 was used in 2010 to reduce the EAG’s taxable income to $0. The remaining $500 of B’s 2010 NOL is not considered to have been used in 2010 because it reduced the EAG’s taxable income below $0. Accordingly, for purposes of determining the EAG’s taxable income limitation under section 199(a)(1)(B) in 2011, B is deemed to have only a $500 NOL carryover from 2010 to offset a portion of its 2011 taxable income. Thus, B’s taxable income in 2011 is $1,500 which is aggregated with A’s $1,000 of taxable income. The EAG’s taxable income limitation in 2011 is $2,500. The EAG’s section 199 deduction is 9% of the lesser of its QPAI of $4,000 or its taxable income of $2,500. Thus, the EAG’s section 199 deduction in 2011 is 9% of $2,500, or $225. The results would be the same if neither A nor B had QPAI in 2010.

Example 2. The facts are the same as in Example 1 except that in 2010 B was not a member of the same EAG as A, but instead was a member of an EAG with Corporation X, which had QPAI and taxable income of $1,000 in 2010, and had neither taxable income nor loss in any other year. There were no other members of the EAG in 2010 besides B and X, and B and X did not file a consolidated Federal income tax return. As $1,000 of B’s NOL was used in 2010 to reduce the B and X EAG’s taxable income to $0, B is considered to have only a $500 NOL carryover from 2010 to offset a portion of its 2011 taxable income for purposes of the taxable income limitation under section 199(a)(1)(B), just as in Example 1. Accordingly, the results for the A and B EAG in 2011 are the same as in Example 1.

Example 3. The facts are the same as in Example 1 except that B is not a member of any EAG in 2011. Because $1,000 of B’s NOL was used in 2010 to reduce the EAG’s taxable income to $0, B is considered to have only a $500 NOL carryover from 2010 to offset a portion of its 2011 taxable income for purposes of the taxable income limitation under section 199(a)(1)(B), just as in Example 1. Thus, for purposes of determining B’s taxable income limitation in 2011, B is considered to have taxable income of $1,500, and B has a section 199 deduction of 9% of $1,500, or $135.

Example 4. Corporations A, B, and C are the only members of an EAG. A, B, and C are all calendar year taxpayers and they do not join in the filing of a consolidated Federal income tax return. None of the EAG members (A, B, or C) had taxable income or loss prior to 2010. In 2010, A has QPAI of $2,000 and taxable income of $1,000, B has QPAI of $1,000 and an NOL of $1,000, and C has QPAI of $1,000 and an NOL of $3,000. In 2011, prior to the NOL deduction allowed under section 172, A and B each has taxable income of $200 and C has taxable income of $5,000. In determining the EAG’s section 199 deduction for 2010, A’s QPAI of $2,000, B’s QPAI of $1,000, and C’s QPAI of $1,000 are aggregated, as are A’s taxable income of $1,000, B’s NOL of $1,000, and C’s NOL of $3,000. Thus, for 2010, the EAG has QPAI of $4,000 and taxable income of ($3,000). In determining the EAG’s taxable income limitation under section 199(a)(1)(B) in 2011, $1,000 of B’s and C’s aggregate NOLs in 2010 of $4,000 are considered to have been used in 2010 to reduce the EAG’s taxable income to $0, in proportion to their NOLs. Thus, $250 of B’s NOL from 2010 ($1,000 x $1,000/$4,000) and $750 of C’s NOL from 2010 ($1,000 x $3,000/$4,000) are deemed to have been used in 2010. The remaining $750 of B’s NOL and the remaining $2,250 of C’s NOL are not deemed to have been used because so doing would have reduced the EAG’s taxable income in 2010 below $0. Accordingly, for purposes of determining the EAG’s taxable income limitation in 2011, B is deemed to have a $750 NOL carryover from 2010 and C is deemed to have a $2,250 NOL carryover from 2010. Thus, for purposes of determining the EAG’s taxable income limitation, B’s taxable income in 2011 is $0 and C’s taxable income in 2011 is $2,750, which are aggregated with A’s $200 taxable income. B’s unused NOL carryover from 2010 cannot be used to reduce either A’s or C’s 2011 taxable income. Thus, the EAG’s taxable income limitation in 2011 is $2,950, A’s taxable income of $200 plus B’s taxable income of $0 plus C’s taxable income of $2,750.

Par. 11. Section 1.199-8 is amended by adding new paragraphs (i)(5) and (6) to read as follows:

* * * * *

(i) * * *

(5) Tax Increase Prevention and Reconciliation Act of 2005. [Reserved]. For further guidance, see §1.199-8T(i)(5).

(6) Losses used to reduce taxable income of expanded affiliated group. [Reserved]. For further guidance, see §1.199-8T(i)(6).

Par. 12. Section 1.199-8T is amended by adding new paragraphs (i)(5) and (6) to read as follows:

* * * * *

(i) * * *

(5) Tax Increase Prevention and Reconciliation Act of 2005. Sections 1.199-2T(e)(2), 1.199-3T(i)(7) and (8), and 1.199-5T are applicable for taxable years beginning on or after October 19, 2006. A taxpayer may apply §§1.199-2T(e)(2), 1.199-3T(i)(7) and (8), and 1.199-5T to taxable years beginning after May 17, 2006, and before October 19, 2006 regardless of whether the taxpayer otherwise relied upon Notice 2005-14, 2005-1 C.B. 498 (see §601.601(d)(2) of this chapter), the provisions of REG-105847-05, 2005-47 I.R.B. 987 (see §601.601(d)(2) of this chapter), or §§1.199-1 through 1.199-8. The applicability of §§1.199-2T(e)(2), 1.199-3T(i)(7) and (8), and 1.199-5T expires on October 16, 2009.

(6) Losses used to reduce taxable income of expanded affiliated group. Section 1.199-7T(b)(4) is applicable for taxable years beginning on or after October 19, 2006. A taxpayer may apply §1.199-7T(b)(4) to taxable years beginning after December 31, 2004, and before October 19, 2006 regardless of whether the taxpayer otherwise relied upon Notice 2005-14, 2005-1 C.B. 498 (see §601.601(d)(2) of this chapter), the provisions of REG-105847-05, 2005-47 I.R.B. 987 (see §601.601(d)(2) of this chapter), or §§1.199-1 through 1.199-9. The applicability of §1.199-7T(b)(4) expires on October 16, 2009.

Approved October 12, 2006.

E-SIGN, signed into law on June 30, 2000, generally provides that electronic records and signatures are given the same legal effect as their paper counterparts. Section 101(a) of E-SIGN provides that, with respect to a transaction in or affecting interstate or foreign commerce, notwithstanding any statute, regulation, or rule of law, a signature, contract, or other record may not be denied legal effect, validity, or enforceability solely because it is in electronic form and a contract relating to such transaction may not be denied legal effect, validity, or enforceability solely because an electronic signature or electronic record was used in its formation.^[1]

Section 101(b) of E-SIGN provides that E-SIGN does not limit, alter, or otherwise affect any requirement imposed by a statute, regulation, or rule of law relating to a person’s rights or obligations under any statute, regulation, or rule of law except with respect to a requirement that contracts or other records be written, signed, or in non-electronic form, and also provides that E-SIGN generally does not require any person to agree to use or accept electronic signatures or records.

Section 101(c) of E-SIGN sets forth special protections that apply when a statute, regulation, or other rule of law requires that information relating to a transaction be provided or made available to a consumer^[2] in writing. Under section 101(c) of E-SIGN, before the required information can be provided or made available electronically, a consumer must first affirmatively consent to receive the information electronically and the consent must be made in a manner that reasonably demonstrates the consumer’s ability to access the information in electronic form (or, if the consent is not provided in such a manner, confirmation of the consent must be made electronically in a manner that reasonably demonstrates the consumer’s ability to access the information in electronic form). Prior to consent, the consumer must receive certain specified disclosures. The disclosures must include, among other items, the hardware or software requirements for access to, and retention of, the electronic records, the consumer’s right to withdraw his or her consent to receive the information electronically (and the consequences that follow the withdrawal of consent), the procedures for requesting a paper copy of the electronic record, and the cost, if any, of obtaining a paper copy. Section 101(c)(6) of E-SIGN generally provides that, for purposes of the consumer consent rules of section 101(c), an oral communication or a recording of an oral communication does not qualify as an electronic record.

Section 101(e) of E-SIGN provides rules relating to the electronic retention of contracts and other records that are required to be written or in writing. Section 101(e) of E-SIGN provides that if a statute, regulation, or other rule of law requires that a contract or other record relating to a transaction in or affecting interstate or foreign commerce be in writing, the legal effect, validity, or enforceability of an electronic record of the contract or other record may be denied if the contract or other record is not in a form that is capable of being retained and accurately reproduced for later reference by all parties or persons who are entitled to retain the contract or other record.

Section 104(b)(1) of E-SIGN generally provides that a Federal regulatory or State regulatory agency that is responsible for rulemaking under any other statute has interpretative authority to issue guidance interpreting section 101 of E-SIGN with respect to that other statute. However, as a limitation on that authority, section 104(b)(2) of E-SIGN prohibits the issuance of any guidance that is not consistent with section 101 or that adds to the requirements of that section. Section 104(b)(2) of E-SIGN also requires that any agency issuing guidance interpreting E-SIGN find that there is a substantial justification for the guidance and that the methods selected to carry out the purpose of the guidance are substantially equivalent to the requirements imposed on records that are not electronic, do not impose unreasonable costs on the acceptance and use of electronic records, and do not require or accord greater legal status to a specific technology.

Section 104(d)(1) of E-SIGN authorizes a Federal regulatory agency to exempt, without condition, a specified category or type of record from the consumer consent requirements in section 101(c). The exemption may be issued only if the exemption is necessary to eliminate a substantial burden on electronic commerce and will not increase the material risk of harm to consumers.

In accordance with section 104(b)(2)(C) of E-SIGN, the Treasury Department and IRS find that there is substantial justification for these final regulations, that, for the reasons explained below, the requirements imposed on the use of electronic media under these regulations are substantially equivalent to those imposed on non-electronic records, that the requirements will not impose unreasonable costs on the acceptance and use of electronic records, and that these regulations do not require (or accord greater legal status or effect to) the use of any specific technology.

The Treasury Department and IRS have issued several items of guidance relating to the use of electronic media with respect to retirement plans and individual retirement plans.^[3] Section 1510 of the Taxpayer Relief Act of 1997, Public Law 105-34 (111 Stat. 788, 1068) (TRA ’97), provides for the Secretary of Treasury to issue guidance designed to interpret the notice, election, consent, disclosure, and timing requirements (include related recordkeeping requirements) under the Code and ERISA relating to retirement plans as applied to the use of new technologies by plan sponsors and administrators. Section 1510 of TRA ’97 further provides that the guidance should maintain the protection of the rights of participants and beneficiaries.

Final regulations (T.D. 8873) relating to the use of electronic media for transmissions of participant notices and consents under sections 402(f), 411(a)(11), and 3405(e)(10)(B) were published in the Federal Register (65 FR 6001) on February 8, 2000 (the 2000 regulations). The 2000 regulations set forth standards for the electronic transmission of certain notices and consents that are required in connection with distributions from retirement plans.

Those regulations provide that a plan may provide a notice required under section 402(f), 411(a)(11), or 3405(e)(10)(B) either on a written paper document or through an electronic medium that is reasonably accessible to the participant. In addition, the 2000 regulations provide that any electronic system must be reasonably designed to provide the notice in a manner no less understandable to the participant than a written paper document. Furthermore, the participant must be advised of the right to request and receive a paper copy of the written paper document at no charge, and, upon request, the document must be provided to the participant without charge.

The 2000 regulations also permit an electronic system to satisfy the requirement of section 411(a)(11) that a participant provide written consent to a distribution if certain requirements are satisfied. First, the electronic medium must be reasonably accessible to the participant. Second, the electronic system must be reasonably designed to preclude anyone other than the participant from giving the consent. Third, the system must provide the participant with a reasonable opportunity to review and to confirm, modify, or rescind the terms of the consent before it becomes effective. Fourth, the system must provide the participant, within a reasonable time after the consent is given, a confirmation of the terms (including the form) of the distribution through either a written paper document or in an electronic format that satisfies the requirements for providing applicable notices. Thus, the participant must be advised of the right to request and to receive a confirmation copy of the consent on a written paper document without charge. The 2000 regulations did not permit the use of electronic media for any notice or election required under section 417 with respect to a waiver of a qualified joint and survivor annuity (QJSA).

The Treasury Department and IRS have issued other guidance applying the standards set forth in the 2000 regulations to other retirement plan notices and elections. For example, §1.7476-2(c)(2) provides that a notice to an interested party is deemed to be provided in a manner that satisfies the delivery requirements of §1.7476-2(c)(1) if the notice is delivered using an electronic medium under a system that satisfies the requirements of §1.402(f)-1, Q&A-5. Q&A-7 of Notice 2000-3, 2000-1 C.B. 413, provides that, until the issuance of further guidance, a plan is permitted to use electronic media to provide notices required under sections 401(k)(12) and 401(m)(11) (relating to safe harbors for section 401(k) and section 401(m) plans) if the employee receives the notice through an electronic medium that is reasonably accessible, the system is designed to provide the notice in a manner no less understandable to the employee than a written paper document, and, at the time the notice is provided, the employee is advised that the employee may request and receive the notice on a written paper document at no charge. Similarly, §1.72(p)-1, Q&A-3(b), requires a loan from a plan to a participant to be set forth in a written paper document, in an electronic medium that satisfies standards that are the same as the standards in the 2000 regulations, or in such other form as may be approved by the Commissioner. In addition, Notice 99-1, 1999-1 C.B. 269, provides guidance relating to qualified retirement plans permitting the use of electronic media for plan participants or beneficiaries conducting account transactions for which there is no specific writing requirement, such as plan enrollments, direct rollover elections, beneficiary designations, investment change allocations, elective and after-tax contribution designations, and general plan or specific account inquiries.

In 2003, final regulations (T.D. 9052) under section 4980F were published in the Federal Register (68 FR 17277). Under Q&A-13 of §54.4980F-1, for a plan to provide a section 204(h) notice electronically, the section 204(h) notice must actually be received by the applicable individual or the plan administrator must take appropriate and necessary measures reasonably calculated to ensure that the method for providing the section 204(h) notice results in actual receipt. Further, the plan administrator must provide the applicable individual with a clear and conspicuous statement that the individual has a right to receive a paper version of the section 204(h) notice without the imposition of fees and, if the individual requests a paper copy of the section 204(h) notice, the paper copy must be provided without charge. The regulations under section 4980F also provide a safe harbor method for delivering a section 204(h) notice electronically, which is substantially the same as the consumer consent rules of E-SIGN.

The Department of Labor (DOL) and the Pension Benefit Guaranty Corporation (PBGC) have also issued regulations relating to the use of electronic media to furnish notices, reports, statements, disclosures, and other documents to participants, beneficiaries, and other individuals under titles I and IV of ERISA. See 29 CFR 2520.104b-1 and 29 CFR 4000.14.

On July 14, 2005, a notice of proposed rulemaking (REG-138362-04) under section 401 of the Code was published in the Federal Register (70 FR 40675) (the 2005 proposed regulations). On November 2, 2005, the IRS held a public hearing on the proposed regulations. Written comments responding to the notice of proposed rulemaking were also received. Although commentators raised issues with respect to certain provisions in the 2005 proposed regulations, the comments were generally positive. After consideration of all the comments, the 2005 proposed regulations are adopted, as amended by this Treasury Decision. The significant revisions are discussed below.

A. In General.

This Treasury Decision adds §1.401(a)-21 and modifies a number of existing regulations (including the 2000 regulations and other regulations described above). These regulations set forth the standards by which a retirement plan, an employee benefit arrangement, or an individual retirement plan is permitted to use an electronic medium to provide applicable notices or for individuals in such a plan to make participant elections.

For any requirement under the Code or regulations that an employee benefit notice or election be in writing or in written form, the standards set forth in these regulations are generally the exclusive rules for providing such communication through the use of an electronic medium. Thus, for example, a retirement plan providing a section 402(f) notice through the use of an electronic medium must satisfy the rules set forth in these regulations.

For any employee benefit notice or election that is not required to be in writing or in written form, the standards set forth in these regulations function as a safe harbor. Thus, a retirement plan, an employee benefit arrangement, or individual retirement plan is permitted to satisfy either these regulations or any other applicable guidance issued by the IRS. For example, with respect to creating an electronic system to accept electronic transmissions of beneficiary designations, a retirement plan is permitted to use the rules under these regulations or continue to follow the standards set forth in Notice 99-1, which is not affected by E-SIGN.

B. Application of Standards.

Like the 2005 proposed regulations, these regulations apply to any notice, election, or similar communication provided to or made by a participant or beneficiary in the following retirement plans: a section 401(a) plan; a section 403(a) plan; a section 403(b) plan; a simplified employee pension (SEP) under section 408(k); a simple retirement plan under section 408(p); and an eligible governmental plan under section 457(b). In response to a comment, these regulations also provide that they apply to any notice, election, or similar communication provided to or made by an individual entitled to benefits in an individual retirement plan, including a Roth IRA under section 408A or a deemed IRA under section 408(q).

In addition, these final regulations apply to any notice, election, or similar communication provided to or made by a participant or beneficiary under the following employee benefit arrangements: an accident or health plan or arrangement under sections 104(a)(3) or 105; a cafeteria plan under section 125; an educational assistance program under section 127; a qualified transportation fringe program under section 132; an Archer MSA under section 220; and a health savings account under section 223.

These regulations do not apply to any notice, election, consent, disclosure, or obligation required under the provisions of title I or IV of ERISA over which the DOL or the PBGC has interpretative and enforcement authority.^[4] For example, the rules in 29 CFR 2520.104b-1 of the Labor Regulations apply with respect to an employee benefit plan furnishing disclosure documents, such as a summary plan description or a summary annual report. These regulations also do not apply to Code section 411(a)(3)(B) (relating to suspension of benefits), Code section 4980B(f)(6) (relating to an individual’s COBRA rights), or any other Code provision over which the DOL or the PBGC has similar interpretative authority.

In addition, the rules in these regulations apply only with respect to notices and elections relating to an individual’s rights under a retirement plan, an employee benefit arrangement, or an individual retirement plan. Thus, these regulations do not apply with respect to other requirements under the Code, such as requirements relating to tax reporting, tax records, or substantiation of expenses.^[5]

C. Requirements for Using Electronic Media to Provide Notices and Make Elections.

These final regulations generally retain from the 2005 proposed regulations the requirement that any communication that is provided using an electronic medium satisfy all the otherwise applicable requirements (including the applicable timing and content rules) relating to that communication. Thus, for example, a section 204(h) notice provided using an electronic medium must be delivered on or before the time period required under Q&A-9 of §54.4980F-1, must satisfy the content requirements set forth in Q&A-11 of §54.4980F-1, and must satisfy the delivery requirements under these regulations.

These regulations provide that an electronic system used to provide a notice or to make an election must satisfy certain requirements. First, with respect to the content of an applicable notice, the electronic system must be reasonably designed to provide the information to a recipient in a manner no less understandable to the recipient than if provided on a written paper document. For example, a plan delivering a lengthy section 402(f) notice would not satisfy this requirement if the plan chose to provide the notice through a pre-recorded message on an automated phone system.^[6] However, a plan with few distribution options is permitted to provide a section 411(a)(11) notice through the use of a pre-recorded message on an automated phone system. Second, the regulations require that the electronic system be reasonably designed to alert the recipient, at the time the applicable notice is provided, to the significance of the information in the notice (including the identification of the subject matter of the notice), and provide any instructions needed to access the notice, in a manner that is as readily understandable and accessible as an applicable notice provided using a written paper document. These requirements are necessary in order for the notice to fulfill their intended purpose, are substantially equivalent to the requirements imposed on nonelectronic notices, and do not impose unreasonable costs on the acceptance or use of electronic records. Moreover, they do not require or accord greater legal status to a particular technology since each technology must satisfy the same standards with respect to each notice. Third, the final regulations clarify that, pursuant to section 101(e) of E-SIGN, if an electronic record of an applicable notice or a participant election is not maintained in a form that is capable of being retained and accurately reproduced for later reference, then the legal effect, validity, or enforceability of such electronic record may be denied.

A. Two Methods for Providing Applicable Notices. These regulations provide two methods by which a retirement plan, employee benefit arrangement, or an individual retirement plan is permitted to provide an applicable notice to a recipient through the use of an electronic medium. Under the first method, an applicable notice is permitted to be provided to a recipient using an electronic medium after the recipient consents to the electronic delivery of the notice (the consumer consent method). The rules under the consumer consent method reflect the consumer consent requirements at section 101(c) in E-SIGN. The Treasury Department and IRS continue to believe that an individual entitled to benefits under a retirement plan, an employee benefit arrangement, or an individual retirement plan is generally a consumer, within the meaning of section 106(1) of E-SIGN, when receiving a notice that could affect the individual’s benefits or other rights.^[7] The second method (the alternative method) provides rules that are intended generally to replicate the requirements in the 2000 regulations that apply to notices required under sections 402(f), 411(a)(11), and 3405, and thereby allow plans to continue to provide these notices electronically using electronic systems that satisfy the standards in the 2000 regulations.

B. Consumer Consent Method for Providing Applicable Notices.

Under the consumer consent method, before an applicable notice is provided to a recipient using an electronic medium, the participant must consent to receive the communication electronically. The consent generally must be made in a manner that reasonably demonstrates that the participant can access the notice in the electronic form that will be used to provide the notice. Alternatively, the consent may be made using a written paper document, but only if the participant confirms the consent in a manner that reasonably demonstrates that the participant can access the notice in the electronic form to be provided. Prior to consenting, the participant must receive a disclosure statement that outlines the scope of the consent, the participant’s right to withdraw his or her consent to receive the communication electronically (including any conditions, consequences, or fees in the event of the withdrawal), and the right to receive the communication using paper and any fees imposed for receiving paper. The disclosure must also specify the hardware and software requirements for accessing the electronic media and the procedures for updating information to contact the participant electronically. In the event the hardware or software requirements change, new consent must be obtained from the participant, generally following the rules of section 101(c) of E-SIGN. In addition, under the consumer consent method, the applicable notice cannot be provided through the use of oral communication or a recording of an oral communication.^[8]

Commentators requested several modifications to the rules under the consumer consent method in these regulations, including requiring plans to give recipients the opportunity to review their consumer consent elections every five years and permitting plans to use oral communications or recordings of oral communications when providing applicable notices under the consumer consent rules. Other commentators recommended that the regulations be revised to provide that, under the consumer consent method, if a participant does not have the effective ability to access the electronic medium used to provide an applicable notice or if the participant does not consent to receive the notice through the use of an electronic medium, such participant would have the right to a free paper copy of the notice.

The consumer consent method under these regulations interprets the rules of section 101(c) of E-SIGN, and section 104(b)(2) of E-SIGN restricts an agency’s ability to interpret E-SIGN in any manner that is inconsistent with section 101 of E-SIGN or that adds to the requirements of that section. Accordingly, the rules under the consumer consent method of these final regulations are retained without substantive change. However, many of the issues raised by the commentators are ameliorated by the availability of the alternative method for providing applicable notices, as discussed below in Alternative Method for Providing Applicable Notices.

C. Alternative Method for Providing Applicable Notices.

These regulations exempt applicable notices from the consumer consent requirements of E-SIGN and provide an alternative method of complying with the requirement that an applicable notice be in writing or in written form if certain conditions are satisfied. This alternative method of compliance, which is based on the 2000 regulations previously issued under section 1510 of TRA ’97, satisfies the requirements of section 104(d)(1) of E-SIGN, including the requirement that any exemption from the consumer consent requirements not increase the material risk of harm to consumers.

This exemption is based on the judgment that, if the consumer consent method were the only method available to satisfy the requirements for providing an applicable notice through the use of an electronic medium, it would impose a substantial burden on electronic commerce with respect to retirement plans, employee benefit arrangements, and individual retirement plans, and that the requirements and safeguards in the 2000 regulations provide a less burdensome method without increasing the material risk of harm to recipients.

Under the alternative method, at the time the applicable notice is provided, the recipient must be advised that he or she may request and receive the applicable notice in writing on paper at no charge. In addition, any recipient of the notice must be “effectively able” to access the electronic medium used to provide the notice. This is a change in wording from the 2000 regulations, which required that the electronic medium be “reasonably accessible” to the recipient. As explained in the preamble to the 2005 proposed regulations, this change is not intended to reflect a substantive change in the rules, but rather to avoid confusion with Department of Labor Regulations interpreting the words reasonably accessible as used in section 101(i)(2)(D) of ERISA, as added by section 306 of the Sarbanes-Oxley Act of 2002, Public Law 107-204 (116 Stat. 745).^[9]

One commentator requested that the regulations provide a rule under which an e-mail sent to the last known e-mail address would be deemed to have been successfully delivered. These regulations do not include such a rule.

A. In General.

These regulations also set forth the requirements that apply if a consent or election is made by a person using an electronic system. The participant election rules, which are also based on the standards in the 2000 regulations, generally retain the requirements that (1) the participant be effectively able to access the electronic medium in order to make the participant election, (2) the electronic system be reasonably designed to preclude any person other than the appropriate individual from making a participant election, (3) the electronic system provide the participant making a participant election with a reasonable opportunity to review, confirm, modify, or rescind the terms of the election before it becomes effective, and (4) the individual making a participant election, within a reasonable time period, receive a confirmation of the election through either a written paper document or an electronic medium under a system that satisfies the applicable notice requirements of either the consumer consent delivery method or the alternative delivery method. Section 101(c) of E-SIGN does not apply to participant elections.

These regulations require that a participant be effectively able to access the electronic medium under an electronic system used to make a participant election, but, like the 2000 regulations, do not require that a plan also permit the election to be made by paper as an alternative to using an electronic system that is available to the participant. However, these regulations do not apply with respect to a participant who is not effectively able to access the electronic medium or media in order to make a participant election. Accordingly, the plan must offer each such participant the right to make an election in another medium that is accessible to the participant (such as a paper election). A plan that fails to offer paper or an electronic medium that a participant is effectively able to access will fail to comply with the participant election requirements and would likely violate other qualification requirements, such as the requirements that a plan to operate in accordance with its terms (by actually making available all distribution options provided by the plan) and the requirements of §1.401(a)(4)-4 under which benefits, rights, and features (including the right to early distribution) must be made available in a nondiscriminatory manner.

B. Use of Electronic Media for QJSA Notices and Elections.

The participant election rules in these regulations extend the use of electronic media to the notice and election rules applicable to plans that are subject to the QJSA requirements of section 417. Accordingly, a plan subject to the QJSA requirements is permitted to provide the notice required by section 417 to a participant through the use of electronic media as long as the plan complies with either of the two methods described above for providing electronic notices. Similarly, a participant’s consent to a distribution is permitted to be provided through the use of electronic media if the plan complies with the standards described below, subject to obtaining a valid spousal consent.

Section 417 requires any spousal consent to a waiver of a QJSA to be witnessed by a plan representative or a notary public. In accordance with section 101(g) of E-SIGN, these regulations authorize the use of an electronic acknowledgment or notarization if the standards of section 101(g) of E-SIGN and State law applicable to notary publics are satisfied. These regulations retain the requirement from the 2005 proposed regulations that the signature of a spouse be witnessed in the physical presence of the plan representative or notary public. Several comments were received on the participant election rules, particularly as they relate to spousal consents. The comments generally fall into two categories: (1) commentators who favored retaining the pen-and-ink signature and physical presence requirements for spousal consents; and (2) commentators who favored extending the use of electronic media to spousal consents, and eliminating the physical presence requirement.

Commentators in the first category raised issues with rules in the 2005 proposed regulations relating to the authentication requirement and the requirement that a spousal consent of a waiver of a QJSA be witnessed in the physical presence of a notary public or a plan representative. In general, these commentators recommended that the regulations be revised to provide additional safeguards for spousal consents because, unlike other participant elections, a spousal consent could involve a conflict of interest between the parties involved in the election. With respect to the authentication requirement, these commentators argued that the authentication requirement would be vague and not require an evidentiary record. According to the commentators, requiring a pen-and-ink signature and maintaining the physical presence requirement would provide necessary additional safeguards for spousal consents by creating an evidentiary record for later disputes regarding the validity of the consent and reducing the likelihood of fraud.

Commentators who favored extending the use of electronic media for all participant elections, including spousal consents, generally recommended that the final regulations eliminate the physical presence requirement for spousal consents. These commentators argued that protections are already available to protect a spouse making a participant election using electronic media. For example, a retirement plan could require a separate PIN for the spouse to which the participant would not have access.

In light of these comments, these regulations clarify that the determination of whether an electronic system used in making participant elections is reasonably designed to preclude any person other than the appropriate individual from making a participant election is based on facts and circumstances, and that a relevant factor is whether the participant election has the potential for a conflict of interest between the individuals involved in the election. See Example 3 in §1.401(a)-21(f) of these regulations for an illustration of the participant election rules when a spousal consent is required. These regulations also clarify that if an applicable notice or participant election is recorded electronically, the electronic record must be in a form that is capable of being reproduced for later reference (see discussion of the general rules under the heading Requirements for Using Electronic Media to Provide Notices and Make Elections).

The requirement that the signature of a spouse to be witnessed in the physical presence of a plan representative or notary public coordinates with the authentication requirement because the physical presence requirement increases the likelihood that the electronic system is reasonably designed to preclude any person other than the appropriate individual from making the election. In contrast, an electronic system that permits the use of a spousal PIN to sign a spousal consent electronically creates greater risk that the spousal consent may be fraudulently signed. Because of the potential risk that two spouses could share information regarding PINs, the Treasury Department and IRS believe that any electronic system that relies solely on separate PINs would not provide the same level of safeguards as provided by the physical presence requirement and would not be reasonably designed to preclude any person other than the appropriate individual from making the election. Accordingly these regulations do not adopt the suggestion that spousal PINs be permitted in lieu of the physical presence requirement, and instead retain from the 2005 proposed regulations the physical presence requirement for electronic notarization of spousal consents. The Treasury Department and IRS believe that permitting electronic notarization of spousal consents under the participant election rules, in conjunction with the physical presence requirement, reflects the appropriate interpretation of section 417 and properly balances minimizing the burden of plan administration with protecting the rights of spouses.

Technology is constantly evolving and, at some point in the future, technology could exist that would provide the same safeguards as the physical presence requirement. Therefore, in light of the comments received, these regulations add a delegation to the Commissioner. Under this delegation, the Commissioner may provide that the use of procedures under an electronic system with respect to an electronic medium is deemed to satisfy the physical presence requirement, but only if those procedures with respect to the electronic system provide the same safeguards for participant elections as provided through the physical presence requirement.

C. Conforming Amendments to Other Rules in Law.

These regulations modify a number of existing regulations (including the 2000 regulations) that have previously provided rules relating to the use of new technologies in providing applicable notices or making participant elections that are required to be in writing or in written form. These modifications, which merely add the consumer consent requirements of E-SIGN, are not expected to affect adversely the existing administrative practices of plan sponsors designed to comply with the 2000 regulations.

In addition, these regulations apply to categories of applicable notices that were not previously addressed in the 2000 regulations or subsequent regulations. As such, these regulations apply whenever there is a requirement that an applicable notice under one of the covered sections be provided in written form or in writing, without regard to whether that other requirement specifically cross-references these regulations. Thus, safe harbor notices under sections 401(k)(12)(D) and 401(m)(11), which are required to be in writing, can be provided electronically if the requirements of section 1.401(a)-21 of this chapter are satisfied.

* * * * *

A-3. * * *

(b) * * * A loan does not satisfy the requirements of this paragraph unless the loan is evidenced by a legally enforceable agreement (which may include more than one document) and the terms of the agreement demonstrate compliance with the requirements of section 72(p)(2) and this section. Thus, the agreement must specify the amount and date of the loan and the repayment schedule. The agreement does not have to be signed if the agreement is enforceable under applicable law without being signed. The agreement must be set forth either—

(1) In a written paper document; or

(2) In a document that is delivered through an electronic medium under an electronic system that satisfies the requirements of §1.401(a)-21 of this chapter.

* * * * *

Par. 3. Section 1.132-9(b), Q&A-12, is amended by adding a sentence to the end of the text in paragraph (b) to read as follows:

* * * * *

A-12. * * *

(b) * * * See §1.401(a)-21 of this chapter for rules permitting the use of electronic media to make participant elections with respect to employee benefit arrangements.

* * * * *

Par. 4. Section 1.401(a)-21 is added to read as follows:

(a) Introduction—(1) In general—(i) Permission to use an electronic medium. This section provides rules relating to the use of an electronic medium to provide applicable notices and to make participant elections as defined in paragraph (e)(1) and (6) of this section with respect to retirement plans, employee benefit arrangements, and individual retirement plans described in paragraph (a)(2) of this section. The rules in this section reflect the provisions of the Electronic Signatures in Global and National Commerce Act, Public Law 106-229 (114 Stat. 464 (2000) (E-SIGN)).

(ii) Notices and elections required to be in writing or in written form—(A) In general. The rules of this section must be satisfied in order to use an electronic medium to provide an applicable notice or to make a participant election if the notice or election is required to be in writing or in written form under the Internal Revenue Code, Department of Treasury regulations, or other guidance issued by the Commissioner.

(B) Rules relating to applicable notices. An applicable notice that is provided using an electronic medium is treated as being provided in writing or in written form if and only if the requirements of paragraph (a)(5) of this section are satisfied and either the consumer consent requirements of paragraph (b) of this section or the requirements for exemption from the consumer consent requirements under paragraph (c) of this section are satisfied. For example, in order to provide a section 402(f) notice electronically, a qualified plan must satisfy either the consumer consent requirements of paragraph (b) of this section or the requirements for exemption under paragraph (c) of this section. If a plan fails to satisfy either of these requirements, the plan must provide the section 402(f) notice using a written paper document in order to satisfy the requirements of section 402(f).

(C) Rules relating to participant elections. A participant election that is made using an electronic medium is treated as being provided in writing or in written form if and only if the requirements of paragraphs (a)(5) and (d) of this section are satisfied.

(iii) Safe harbor method for applicable notices and participant elections that are not required to be in writing or written form. For an applicable notice or a participant election that is not required to be in writing or in written form, the rules of this section provide a safe harbor method for using an electronic medium to provide the applicable notice or to make the participant election.

(2) Application of rules—(i) Notices, elections, or consents under retirement plans. The rules of this section apply to any applicable notice or any participant election relating to the following retirement plans: a qualified retirement plan under section 401(a) or 403(a); a section 403(b) plan; a simplified employee pension (SEP) under section 408(k); a simple retirement plan under section 408(p); or an eligible governmental plan under section 457(b).

(ii) Notices, elections, or consents under other employee benefit arrangements. The rules of this section also apply to any applicable notice or any participant election relating to the following employee benefit arrangements: an accident and health plan or arrangement under sections 104(a)(3) and 105; a cafeteria plan under section 125; an educational assistance program under section 127; a qualified transportation fringe program under section 132; an Archer MSA under section 220; or a health savings account under section 223.

(iii) Notices, elections, or consents under individual retirement plans. The rules of this section also apply to any applicable notice or any participant election relating to individual retirement plans, including a Roth IRA under section 408A; or a deemed IRA under a qualified employer plan described in section 408(q).

(3) Limitation on application of rules—(i) In general. The rules of this section do not apply to any notice, election, consent, disclosure, or obligation required under the provisions of title I or IV of the Employee Retirement Income Security Act of 1974, as amended (ERISA), over which the Department of Labor or the Pension Benefit Guaranty Corporation has interpretative and enforcement authority. For example, the rules in 29 CFR 2520.104b-1 of the Department of Labor Regulations apply with respect to an employee benefit plan providing disclosure documents, such as a summary plan description or a summary annual report. The rules in this section also do not apply to Internal Revenue Code section 411(a)(3)(B) (relating to suspension of benefits), Internal Revenue Code section 4980B(f)(6) (relating to an individual’s COBRA rights), or any other Internal Revenue Code provision over which Department of Labor or the Pension Benefit Guaranty Corporation has similar interpretative authority.

(ii) Recordkeeping and other requirements. The rules in this section only apply with respect to applicable notices and participant elections relating to an individual’s rights under a retirement plan, an employee benefit arrangement, or an individual retirement plan. Thus, the rules in this section do not alter the otherwise applicable requirements under the Internal Revenue Code, such as the requirements relating to tax reporting, tax records, or substantiation of expenses. See section 6001 for rules relating to the maintenance of records, statements, and special returns. See also section 101(e) of E-SIGN, which provides that if an electronic record of an applicable notice or a participant election is not maintained in a form that is capable of being retained and accurately reproduced for later reference, then the legal effect, validity, or enforceability of such electronic record may be denied.

(4) General requirements related to applicable notices and participant elections. The rules of this section supplement the general requirements related to each applicable notice and participant election. Thus, in addition to satisfying the rules for timing and content, the rules in this section must be satisfied.

(5) Requirements related to the design of an electronic system used to deliver applicable notices and to make participant elections—(i) The electronic system must take into account the content of a notice. With respect to the content of an applicable notice, the electronic system must be reasonably designed to provide the information in the notice to a recipient in a manner that is no less understandable to the recipient than a written paper document.

(ii) Identification of the significance of information in the notice. The electronic system must be designed to alert the recipient, at the time an applicable notice is provided, to the significance of the information in the notice (including identification of the subject matter of the notice), and provide any instructions needed to access the notice, in a manner that is readily understandable.

(b) Consumer consent requirements—(1) Requirements. With respect to an applicable notice, the consumer consent requirements of this paragraph (b) are satisfied if—

(i) The requirements in paragraphs (b)(2) through (4) of this section are satisfied; and

(ii) In accordance with section 101(c)(6) of E-SIGN, the applicable notice is not provided through the use of oral communication or a recording of an oral communication.

(2) Consent—(i) In general. The recipient must affirmatively consent to the delivery of the applicable notice using an electronic medium. This consent must be either—

(A) Made electronically in a manner that reasonably demonstrates that the recipient can access the applicable notice in the electronic medium in the form that will be used to provide the notice; or

(B) Made using a written paper document (or using another form not described in paragraph (b)(2)(i)(A) of this section), but only if the recipient confirms the consent electronically in a manner that reasonably demonstrates that the recipient can access the applicable notice in the electronic medium in the form that will be used to provide the notice.

(ii) Withdrawal of consumer consent. The consent to receive electronic delivery requirement of this paragraph (b)(2) is not satisfied if the recipient withdraws his or her consent before the applicable notice is delivered.

(3) Required disclosure statement. The recipient, prior to consenting under paragraph (b)(2)(i) of this section, must be provided with a clear and conspicuous statement containing the disclosures described in paragraphs (b)(3)(i) through (v) of this section:

(i) Right to receive paper document—(A) In general. The statement informs the recipient of any right to have the applicable notice be provided using a written paper document or other nonelectronic form.

(B) Post-consent request for paper copy. The statement informs the recipient how, after having provided consent to receive the applicable notice electronically, the recipient may, upon request, obtain a paper copy of the applicable notice and whether any fee will be charged for such copy.

(ii) Right to withdraw consumer consent. The statement informs the recipient of the right to withdraw consent to receive electronic delivery of an applicable notice on a prospective basis at any time and explains the procedures for withdrawing that consent and any conditions, consequences, or fees in the event of the withdrawal.

(iii) Scope of the consumer consent. The statement informs the recipient whether the consent to receive electronic delivery of an applicable notice applies only to the particular transaction that gave rise to the applicable notice or to other identified transactions that may be provided or made available during the course of the parties’ relationship. For example, the statement may provide that a recipient’s consent to receive electronic delivery will apply to all future applicable notices of the recipient relating to the employee benefit arrangement until the recipient is no longer a participant in the employee benefit arrangement (or withdraws the consent).

(iv) Description of the contact procedures. The statement describes the procedures to update information needed to contact the recipient electronically.

(v) Hardware or software requirements. The statement describes the hardware and software requirements needed to access and retain the applicable notice.

(4) Post-consent change in hardware or software requirements. If, after a recipient provides consent to receive electronic delivery, there is a change in the hardware or software requirements needed to access or retain the applicable notice and such change creates a material risk that the recipient will not be able to access or retain the applicable notice in electronic format—

(i) The recipient must receive a statement of—

(A) The revised hardware or software requirements for access to and retention of the applicable notice; and

(B) The right to withdraw consent to receive electronic delivery without the imposition of any fees for the withdrawal and without the imposition of any condition or consequence that was not previously disclosed in paragraph (b)(3) of this section; and

(ii) The recipient must reaffirm consent to receive electronic delivery in accordance with the requirements of paragraph (b)(2) of this section.

(c) Exemption from consumer consent requirements—(1) In general. This paragraph (c) is satisfied if the conditions in paragraphs (c)(2) and (3) of this section are satisfied. This paragraph (c) constitutes an exemption from the consumer consent requirements of section 101(c) of E-SIGN pursuant to the authority granted in section 104(d)(1) of E-SIGN.

(2) Effective ability to access. For purposes of this paragraph (c), the electronic medium used to provide an applicable notice must be a medium that the recipient has the effective ability to access.

(3) Free paper copy of applicable notice. At the time the applicable notice is provided, the recipient must be advised that he or she may request and receive the applicable notice in writing on paper at no charge, and, upon request, that applicable notice must be provided to the recipient at no charge.

(d) Special rules for participant elections—(1) In general. This paragraph (d) is satisfied if the conditions described in the following paragraphs (d)(2) through (6) are satisfied:

(2) Effective ability to access. The electronic medium under an electronic system used to make a participant election must be a medium that the person who is eligible to make the election is effectively able to access. If the appropriate individual is not effectively able to access the electronic medium for making the participant election, the participant election will not be treated as made available to that individual. Thus, for example, the participant election will not be treated as made available to that individual for purposes of the rules under section 401(a)(4).

(3) Authentication. The electronic system used in making participant elections is reasonably designed to preclude any person other than the appropriate individual from making the election. Whether this condition is satisfied is based on facts and circumstances, including whether the participant election has the potential for a conflict of interest between the individuals involved in the election. See Examples 3, 4, and 5 of paragraph (f) of this section for illustrations of electronic systems that satisfy the authentication requirement of this paragraph (d)(3).

(4) Opportunity to review. The electronic system used in making participant elections provides the person making the participant election with a reasonable opportunity to review, confirm, modify, or rescind the terms of the election before the election becomes effective.

(5) Confirmation of action. The person making the participant election receives, within a reasonable time, a confirmation of the effect of the election under the terms of the plan or arrangement through either a written paper document or an electronic medium under a system that satisfies the requirements of either paragraph (b) or (c) of this section (as if the confirmation were an applicable notice).

(6) Participant elections, including spousal consents, that are required to be witnessed by a plan representative or a notary public—(i) In general. In the case of a participant election which is required to be witnessed by a plan representative or a notary public (such as a spousal consent under section 417), the signature of the individual making the participant election is witnessed in the physical presence of a plan representative or a notary public.

(ii) Electronic notarization permitted. If the requirements of paragraph (d)(6)(i) of this section are satisfied, an electronic notarization acknowledging a signature (in accordance with section 101(g) of E-SIGN and state law applicable to notary publics) will not be denied legal effect if the signature of the individual is witnessed in the physical presence of a notary public.

(iii) Delegation to Commissioner. In guidance published in the Internal Revenue Bulletin, the Commissioner may provide that the use of procedures under an electronic system is deemed to satisfy the physical presence requirement under paragraph (d)(6)(i) of this section, but only if those procedures with respect to the electronic system provide the same safeguards for participant elections as are provided through the physical presence requirement. See §601.601(d)(2)(ii)(b) of this chapter.

(e) Definitions. The definitions in this paragraph (e) apply for purposes of this section.

(1) Applicable notice. The term applicable notice includes any notice, report, statement, or other document required to be provided to a recipient under a retirement plan, employee benefit arrangement, or individual retirement plan as described in paragraph (a)(2) of this section.

(2) Electronic. The term electronic means technology having electrical, digital, magnetic, wireless, optical, electromagnetic, voice-recording systems, or similar capabilities.

(3) Electronic medium. The term electronic medium means an electronic method of communication (e.g., website, electronic mail, telephonic system, magnetic disk, and CD-ROM).

(4) Electronic record. The term electronic record means an applicable notice or a participant election that is created, generated, sent, communicated, received, or stored by electronic media.

(5) Electronic system. The term electronic system means a system designed for creating, generating, sending, receiving, storing, retrieving, displaying, or processing information that makes use of any electronic medium.

(6) Participant election. The term participant election includes any consent, election, request, agreement, or similar communication made by or from a participant, beneficiary, alternate payee, or an individual entitled to benefits under a retirement plan, employee benefit arrangement, or individual retirement plan as described in paragraph (a)(2) of this section.

(7) Recipient. The term recipient means a plan participant, beneficiary, employee, alternate payee, or any other person to whom an applicable notice is to be provided.

(f) Examples. The following examples illustrate the rules of this section. Examples 1, 2, 3, and 6 assume that the requirements of paragraph (a)(4) and (5) of this section are satisfied.

Example 1. (i) Facts involving using the consumer consent requirements to deliver a section 402(f) notice via e-mail. Plan A, a qualified plan, permits participants to request benefit distributions from the plan on Plan A’s Internet website. Under Plan A’s system for such transactions, a participant must enter his or her account number, personal identification number (PIN), and his or her e-mail address to which the notice is to be sent. The participant’s PIN and account number must match the information in Plan A’s records in order for the transaction to proceed. Participant H requests a distribution from Plan A on Plan A’s website, and, at the time of the request for distribution, a disclosure statement appears on the computer screen that explains that Participant H can consent to receive the section 402(f) notice electronically. The disclosure statement provides information relating to the consent, including how to receive a paper copy of the notice, how to withdraw consent, the hardware and software requirements, and the procedures for accessing the section 402(f) notice, which is in a file format from a specific spreadsheet program. After reviewing the disclosure statement, which satisfies the requirements of paragraph (b)(3) of this section, Participant H consents to receive the section 402(f) notice via e-mail by selecting the consent button at the end of the disclosure statement. As a part of the consent procedure, an e-mail is sent to Participant H’s e-mail address in order to demonstrate that Participant H can access the spreadsheet program. In the e-mail, Participant H is prompted to answer a question from the spreadsheet program, which is in an attachment to the e-mail. Once Participant H correctly answers the question, the section 402(f) notice is then delivered to Participant H via e-mail.

(ii) Conclusion. In this Example 1, Plan A’s delivery of the section 402(f) notice to Participant H satisfies the requirements of paragraph (b) of this section.

Example 2. (i) Facts—(A) Facts involving using the alternative method to deliver a section 411(a)(11) notice via e-mail. Plan B, a qualified plan, permits participants to request benefit distributions from the plan on Plan B’s Internet website. Under Plan B’s system for such transactions, a participant must enter his or her account number and personal identification number (PIN), and his or her e-mail address to which the notice is to be sent. The participant’s PIN and account number must match the information in Plan B’s records in order for the transaction to proceed. After Participant K, a single employee, requests a distribution from Plan B on Plan B’s Internet website, the plan administrator provides Participant K with a section 411(a)(11) notice in an attachment to an e-mail. Plan B sends the e-mail with a request for a computer generated notification that the message was received and opened. The e-mail instructs Participant K to read the attachment for important information regarding the request for a distribution. In addition, the e-mail also states that Participant K may request the section 411(a)(11) notice on a written paper document and that, if Participant K requests the notice on a written paper document, it will be provided at no charge. Plan B receives notification indicating that the e-mail was received and opened by Participant K.

(B) Facts involving making a participant’s consent to a distribution. In order to consent to a distribution, Plan B requires a participant to enter the participant’s account number and PIN in order to preclude any person other than the participant from making the election. After the authentication process, Participant K completes a distribution request form on the website. After completing the request form, the website provides a summary of the information entered on the form and gives Participant K an opportunity to review or modify the distribution request form before the transaction is completed. Within a reasonable period of time after Participant K consents to the distribution, the plan administrator, by e-mail, sends confirmation of the terms (including the form) of the distribution to Participant K and advises Participant K that, upon request, the confirmation may be provided to Participant K on a written paper document at no charge. Plan B retains an electronic copy of the consent to the distribution in a form that is capable of being retained and accurately reproduced for later reference by Participant K.

(ii) Conclusion. In this Example 2, Plan B’s delivery of the section 411(a)(11) notice and the electronic system used to make Participant K’s consent to a distribution satisfy the requirements of paragraphs (a), (c), and (d) of this section.

Example 3. (i) Facts involving the transmission of a spousal consent via electronic notarization. Plan C, a qualified money purchase pension plan, permits a married participant to request a plan loan through the Plan C’s Internet website with the notarized consent of the spouse. Under Plan C’s system for requesting a plan loan, a participant must enter his or her account number, personal identification number (PIN), and his or her e-mail address. The information entered by the participant must match the information in Plan C’s records in order for the transaction to proceed. Participant M, a married participant, is effectively able to access the website available to apply for a plan loan. In order to apply for a loan, Plan C requires a participant to enter the participant’s account number and PIN in order to preclude any person other than the participant from making the election. Participant M completes the loan application on Plan C’s website. Within a reasonable period of time after submitting the plan loan application, the plan administrator, by e-mail, sends Participant M the loan application, including all attachments setting forth the terms of the loan agreement and all other required information. In the e-mail, Plan C also notifies Participant M that, upon request, the loan application may be provided to Participant M on a written paper document at no charge. Plan C then instructs Participant M that, in order for the loan application to proceed, Participant M must submit to the plan administrator a notarized spousal consent form. Participant M and M’s spouse go to a notary public and the notary witnesses Participant M’s spouse signing the spousal consent for the loan agreement on an electronic signature capture pad with adequate security. After witnessing M’s spouse signing the spousal consent, the notary public sends an e-mail with an electronic acknowledgement that is attached to or logically associated with the signature of M’s spouse to the plan administrator. The electronic acknowledgement is in accordance with section 101(g) of E-SIGN and the relevant state law applicable to notary publics. After the plan receives the e-mail, Plan C sends an e-mail to Participant M, giving M a reasonable period to review and confirm the completed loan application and to determine whether the loan application should be modified or rescinded. In addition, the e-mail to Participant M also provides that M may request the completed loan application on a written paper document and that, if M requests the written paper document, it will be provided at no charge. Plan C retains an electronic copy of the loan agreement, including the spousal consent, in a form that is capable of being retained and accurately reproduced for later reference by all parties.

(ii) Conclusion. In this Example 3, the transmission of the plan loan agreement satisfies the requirements of paragraphs (a), (c), and (d) of this section. By requiring that the spouse sign the spousal consent on an electronic signature capture pad in the physical presence of a notary public, the electronic system satisfies the requirement that the system be reasonably designed to preclude any person other than the appropriate individual from making the election. Thus, the electronic notarization of spousal consent satisfies the requirements of paragraphs (a) and (d) of this section.

Example 4. (i) Facts—(A) Facts involving using the alternative method of compliance to deliver a section 411(a)(11) notice via an automated telephone system. A qualified profit-sharing plan (Plan D) permits participants to request distributions through an automated telephone system. Under Plan D’s system for such transactions, a participant must enter his or her account number and personal identification number (PIN); this information must match the information in Plan D’s records in order for the transaction to proceed. Plan D provides only the following distribution options: single-sum payment; and annual installments over 5, 10, or 20 years. Participant N, a single participant, requests a distribution from Plan D by following the applicable instructions on the automated telephone system. After Participant N has requested the distribution, the automated telephone system recites the section 411(a)(11) notice over the phone. The automated telephone system also advises Participant N that, upon request, the notice may be provided on a written paper document and that, if Participant N so requests, the notice will be provided on a written paper document at no charge.

(B) Facts involving making a participant’s consent to a distribution via an automated telephone system. In order to consent to a distribution, Plan D requires a participant to enter the participant’s account number and PIN in order to preclude any person other than the participant from making the election. Participant N requests a distribution by entering information on the automated telephone system. After completing the request, the automated telephone system provides a oral summary of the information entered and gives Participant N an opportunity to review or modify the distribution request before the transaction is completed. Plan D’s automated telephone system confirms the distribution request to Participant N and advises Participant N that, upon request, a confirmation may be provided on a written paper document at no charge. Plan D retains an electronic copy of the consent to the distribution in a form that is capable of being retained and accurately reproduced for later reference by Participant N.

(ii) Conclusion. In this Example 4, because Plan D has relatively few and simple distribution options, the provision of the section 411(a)(11) notice through the automated telephone system is no less understandable to the participant than a written paper notice for purposes of paragraph (a)(5)(i) of this section. In addition, the automated telephone procedures of Plan D satisfy the applicable requirements of paragraphs (a), (c), and (d) of this section.

Example 5. (i) Facts. Same facts as Example 4 of this paragraph (f), except that, pursuant to Plan D’s system for processing such transactions, a participant who so requests is transferred to a customer service representative whose conversation with the participant is recorded. The customer service representative provides the section 411(a)(11) notice from a prepared text and processes the participant’s distribution in accordance with the predetermined instructions from the plan administrator.

(ii) Conclusion. As in Example 4 of this paragraph (f), because Plan D has relatively few and simple distribution options, the provision of the section 411(a)(11) notice through the automated telephone system is no less understandable to the participant than a written paper notice for purposes of paragraph (a)(4) of this section. Further, in this Example 5, the customer service telephone procedures of Plan D satisfy the requirements of paragraphs (a), (c), and (d) of this section.

Example 6. (i) Facts. Plan E, a qualified plan, permits participants to request distributions by e-mail on the employer’s e-mail system. Under this system, a participant must enter his or her account number, personal identification number (PIN), and e-mail address. This information must match that in Plan E’s records in order for the transaction to proceed. If a participant requests a distribution by e-mail, the plan administrator provides the participant with a section 411(a)(11) notice by e-mail. The plan administrator also advises the participant by e-mail that he or she may request the section 411(a)(11) notice on a written paper document and that, if the participant requests the notice on a written paper document, it will be provided at no charge. Participant Q requests a distribution and receives the section 411(a)(11) notice from the plan administrator by reply e-mail. However, before Participant Q elects a distribution, Q terminates employment. Following termination of employment, Participant Q no longer has access to the employer’s e-mail system.

(ii) Conclusion. In this Example 6, Plan E does not satisfy the participant election requirements under paragraph (d) of this section because Participant Q is not effectively able to access the electronic medium used to make the participant election. Plan E must provide Participant Q with the opportunity to make the participant election through a written paper document or another system that Participant Q is effectively able to access, such as the automated telephone systems described in Example 4 and Example 5 of this paragraph (f).

(g) Effective date. The rules provided in this section apply to applicable notices provided, and to participant elections made, on or after January 1, 2007. However, a retirement plan, an employee benefit arrangement, or an individual retirement plan that provides an applicable notice or makes a participant election that complies with the requirements set forth in these regulations on or after October 1, 2000, and before January 1, 2007, will not be treated as failing to provide an applicable notice or to make a participant election merely because the notice or election was not in writing or written form.

Par. 5. Section 1.401(k)-3 is amended by adding a sentence to the end of the text of paragraph (d)(1) to read as follows:

* * * * *

(d) * * *

(1) * * * See §1.401(a)-21 of this chapter for rules permitting the use of electronic media to provide applicable notices to recipients with respect to retirement plans.

* * * * *

Par. 6. Section 1.402(f)-1 is amended by:

(1) Revising A-5.

(2) Removing Q&A-6.

The revision reads as follows:

* * * * *

A-5. Yes. See §1.401(a)-21 of this chapter for rules permitting the use of electronic media to provide applicable notices to recipients with respect to retirement plans.

Par. 7. Section 1.411(a)-11 is amended by:

(1) Revising the text of paragraphs (f)(1) and (2).

(2) Removing paragraph (g).

The revisions read as follows.

* * * * *

(f) * * *

(1) * * * The notice of a participant’s rights described in paragraph (c)(2) of this section or the summary of that notice described in paragraph (c)(2)(iii)(B)(2) of this section must be provided on a written paper document. However, see §1.401(a)-21 of this chapter for rules permitting the use of electronic media to provide applicable notices to recipients with respect to retirement plans.

(2) * * * The consent described in paragraphs (c)(2) and (3) of this section must be given on a written paper document. However, see §1.401(a)-21 of this chapter for rules permitting the use of electronic media to make participant elections with respect to retirement plans.

Par. 8. Section 1.417(a)(3)-1 is amended by adding a sentence to the end of the text of paragraph (a)(3) to read as follows:

(a) * * *

(3) * * *But see §1.401(a)-21 of this chapter for rules permitting the use of electronic media to provide applicable notices to recipients with respect to retirement plans.

* * * * *

Par. 9. Section 1.7476-2 is amended by revising paragraph (c)(2) to read as follows:

* * * * *

(c) * * *

(2) If the notice to interested parties is delivered using an electronic medium under an electronic system that satisfies the applicable notice requirements of §1.401(a)-21 of this chapter, the notice is deemed to be provided in a manner that satisfies the requirements of paragraph (c)(1) of this section.

* * * * *

* * * * *

d-35. * * *

A. A payor may provide the notice required under section 3405 (including the abbreviated notice described in d-27 of §35.3405-1T and the annual notice described in d-31 of §35.3405-1T) to a payee on a written paper document. However, see §1.401(a)-21 of this chapter for rules permitting the use of electronic media to provide applicable notices to recipients with respect to retirement plans and individual retirement plans.

* * * * *

A-13. * * *

(c) * * *

(1) * * *

(ii) The section 204(h) notice is delivered using an electronic medium (other than an oral communication or a recording of an oral communication) under an electronic system that satisfies the applicable notice requirements of §1.401(a)-21.

(iii) Special effective date. For plan years beginning prior to January 1, 2007, Q&A-13 of this section, as it appeared in the April 1, 2006 edition of 26 CFR part 1, applies.

(2) * * * The following examples illustrate the requirement in paragraph (c)(1)(i) of this Q&A-13. In these examples, it is assumed that the notice satisfies the requirements in paragraphs (c)(1)(ii) of this section. The examples are as follows:

* * * * *

Approved October 10, 2006.

In general, these proposed regulations apply to transfers of net built-in loss property within the U.S. tax system in which the Code otherwise would duplicate the net built-in asset loss in the stock of the transferee. Such transfers include exchanges subject to section 351, capital contributions, and transfers of paid-in surplus. However, these proposed regulations do not apply to a transfer where the duplicated loss is imported into the U.S. tax system and the transfer is subject to section 362(e)(1), which addresses certain loss importation transactions. Property is net built-in loss property if the transferee corporation’s aggregate basis in the property, but for the application of section 362(e)(2), would exceed the aggregate fair market value of such property immediately after the transfer.

If section 362(e)(2) applies to a transfer, the transferee corporation receives the property with an aggregate basis not exceeding the aggregate fair market value of the property immediately after the transfer. The transferee allocates the basis reduction among the transferred loss properties in proportion to the amount of loss in each such property immediately before the transfer.

Taxpayers have questioned the effect of any gain taken into account as a result of the transfer. The IRS and Treasury Department have determined that any gain recognized by the transferor that increases the transferee corporation’s basis in the transferred property must be taken into account in order to determine the full amount of loss duplication. Accordingly, these proposed regulations provide that in determining whether the transferred property has a net built-in loss in the hands of the transferee, the bases of such property first must be increased under section 362(a) or (b) for any gain recognized by the transferor on the transfer of the property.

There also have been questions about the application of section 362(e)(2) in the case of multiple transferors. The legislative history to section 362(e)(2) contains some potentially conflicting language that refers to the aggregate adjusted basis of property contributed by a transferor or a control group of which the transferor is a member. See Conf. Rep. No. 108-755, 108th Cong., 2d Sess. 635 (2004). However, because the basis rules in section 362 and section 358 are applied on a transferor-by-transferor basis, applying section 362(e)(2) to an aggregated group of transferors would undermine Congress’ intent to prevent loss duplication. Further, section 362(e)(2) specifically refers to property “transferred by a transferor.” Accordingly, these proposed regulations clarify that section 362(e)(2) applies separately to each transferor. Thus, each transferor’s transfer is measured separately, and the determination of whether that transfer is subject to these provisions is made solely by reference to the property transferred by such transferor. Consequently, the treatment of one transferor is unaffected by the transfer of property by any other transferor for purposes of section 362(e)(2).

In addition, these proposed regulations clarify that, even if part of a transaction is subject to section 362(e)(1), section 362(e)(2) can apply to the portion of the transaction that is not described in section 362(e)(1).

Under general principles of law, the Code applies to all transactions without regard to whether such application has any current U.S. tax consequences. In the case of transfers that are wholly outside the U.S. tax system, section 362(e)(2) applies but does not have relevance unless and until the assets transferred or the stock received in the exchange enter the U.S. tax system. Such assets or stock may subsequently enter the U.S. tax system either directly or indirectly. For example, the assets or stock could directly enter the U.S. tax system through a transfer of all or a portion of such assets or stock to a U.S. person, or as a result of the original transferor or original transferee becoming a U.S. person. Further, the assets or stock could indirectly enter the U.S. tax system, for example, through a transfer of all or a portion of such assets or stock to a CFC, or as a result of the original transferor or original transferee becoming a CFC. However, in many cases the U.S. tax treatment of a transfer that is wholly outside the U.S. tax system will never become relevant. The IRS and Treasury Department recognize that, if a transferor does not anticipate the transfer becoming U.S. tax relevant, it is not likely to undertake the valuation and record-keeping that section 362(e)(2) would generally require. If circumstances change at some later date, the administrative burden of reconstructing appropriate records may be substantial.

The IRS and Treasury Department have determined that relief is appropriate when transactions are consummated with no plan or intention to enter the U.S. tax system. Thus, if assets are transferred in a transaction that is potentially subject to section 362(e)(2) more than two years before entering the U.S. tax system, then, solely for purposes of section 362(e)(2), these proposed regulations generally presume that the aggregate fair market value of the transferred assets equals their aggregate adjusted basis in the hands of the transferee immediately after the transfer. This presumption applies only if neither the original transfer nor the later entry of any portion of the assets into the U.S. tax system was undertaken with a view to reducing the U.S. tax liability of any person or duplicating loss by avoiding the application of section 362(e)(2).

If a transfer subject to section 362(e)(2) occurs within the two-year period immediately before becoming U.S. tax relevant, the IRS and Treasury Department do not believe that relief from the administrative burden is either necessary or appropriate. Thus, in such a case, the fair market value presumption does not apply, and section 362(e)(2) applies to the original transfer. The proposed regulations provide the relevant parties a means by which to make an election under section 362(e)(2)(C), if desired, at the time of entry into the U.S. tax system.

Taxpayers have questioned whether a transaction described in both sections 362(a) and 362(b) may be subject to section 362(e)(2). The IRS and Treasury Department believe that, if there is a duplication of loss in a transaction described in section 362(a) (and not subject to section 362(e)(1)), Congressional intent requires that the transaction be recognized as described in section 362(a) notwithstanding that it is also described in section 362(b). The proposed regulations clarify that section 362(e)(2) can apply to such transactions.

In certain transactions, the transferor’s duplicated basis in the transferee stock or securities is eliminated by operation of statute without recognition or benefit. For example, in a transaction meeting the requirements of both sections 351 and 368(a)(1)(D), the transferor ordinarily receives stock with an aggregate basis equal to that of the transferred property. As a result, where the transferred property has a net built-in loss, but for section 362(e)(2), the transferor would receive the transferee stock with an adjusted basis that duplicates the built-in loss in the transferred property. However, if the transferor distributes the transferee stock pursuant to a section 368(a)(1)(D) acquisitive reorganization or pursuant to section 355, no taxpayer will recognize the duplicated loss because the distributee will determine its basis in the transferee stock by reference to its basis in surrendered stock of the transferor.

The IRS and Treasury Department have concluded that, even if a transaction is described in section 362(e)(2), if there is no duplicated loss that can be recognized, section 362(e)(2) should not apply. Accordingly, these proposed regulations provide that section 362(e)(2) will not apply to transactions to the extent that loss duplication is prevented or eliminated where the transferor distributes the transferee stock and/or securities received in the transaction without recognizing gain or loss, and, upon completion of the transaction, no person holds any asset with a basis determined in whole or in part by reference to the transferor’s basis in the transferee stock and/or securities.

In certain transactions, net built-in loss also can be duplicated in securities received without the recognition of gain or loss. For example, a U.S. transferor duplicates a net built-in loss when it transfers property with a net built-in loss to a U.S. controlled corporation in exchange for stock and securities and all or part of the securities are retained following the distribution of the stock of the controlled corporation pursuant to section 355. Such a transaction is described in section 362(a) but not section 362(e)(1) and, accordingly, may be subject to section 362(e)(2).

Although the statute is silent about the treatment of securities received in such a property transfer, the IRS and Treasury Department have concluded that Congressional intent would be circumvented if section 362(e)(2) were treated as not applying to both stock and securities received in transactions to which section 362(e)(2) applies. Accordingly, these proposed regulations apply section 362(e)(2) to transfers in exchange for both stock and securities to the extent necessary to eliminate loss duplication.

Because the section applies equally to transfers in exchange for both stock and securities, the IRS and Treasury Department have concluded that taxpayers must be allowed to make an election under section 362(e)(2)(C) for both stock and securities. Accordingly, these proposed regulations allow the transferor and transferee to elect to apply section 362(e)(2)(C) to the transferee stock and securities received in the exchange.

Section 362(e)(2)(C) permits transferors and transferees that engage in transactions to which section 362(e)(2) applies to elect to reduce the transferor’s basis in the stock received instead of reducing the transferee corporation’s basis in the property transferred. As described in this preamble, section 362(e)(2)(C) provides that if the election is made, section 362(e)(2)(A) shall not apply, and the transferor’s basis in the transferee stock received in the exchange shall not exceed its fair market value immediately after the exchange. The statutory language might be interpreted to require the transferor to reduce its basis in the stock received by an amount that is larger than the amount by which the transferee otherwise would have been required to reduce its aggregate basis in the assets under section 362(e)(2)(A). For example, assume a corporation, P, contributes a trade or business to a subsidiary, S, in a transaction to which section 351 applies. The assets of the business have an aggregate adjusted basis of $100 and a value of $90, and the business has $20 of associated contingent liabilities. Even if section 358(h)(2)(A) applies to prevent section 358 from reducing P’s basis in the S stock by the amount of the contingent liabilities, section 362(e)(2)(C) might be interpreted to limit P’s basis in the S stock to $70 (notwithstanding that section 362(e)(2)(A) would only require a $10 reduction in the basis of the assets in the hands of S). Thus, a section 362(e)(2)(C) election might result in a larger basis reduction in the stock than would be required in the assets absent an election.

The IRS and Treasury Department believe that, because section 362(e)(2) is intended to prevent the duplication of net built-in loss in the transferred assets, the amount of basis reduction resulting from an election under section 362(e)(2)(C) should not be any larger than what is necessary to eliminate the duplication of loss in the transferred assets. Therefore, these proposed regulations clarify that the amount of the reduction in the basis of the transferee stock (and securities) as a result of an election to apply section 362(e)(2)(C) is equal to the net built-in loss in the transferred assets in the hands of the transferee. In other words, under the proposed regulations, the amount of the reduction in the basis of the transferee stock (and securities) resulting from such an election equals the amount of the reduction in the basis of the assets required by section 362(e)(2)(A) absent the election.

These proposed regulations also implement Notice 2005-70, 2005-41 I.R.B. 694, see §601.601(d)(2), which instructs taxpayers how to elect to apply section 362(e)(2)(C). These proposed regulations revise and expand upon the procedures in Notice 2005-70 to provide more methods and time periods in which to make the section 362(e)(2)(C) election. Specifically, the regulations expand the classifications of persons who can attach the required election statement to a tax return (including an information return).

The “protective election” referenced in Notice 2005-70 also is included in the proposed regulations because the IRS and Treasury Department anticipate that, at the time of the transaction, taxpayers may not always be able to determine with reasonable certainty whether section 362(e)(2) applies to a transfer.

The IRS and Treasury Department request comments on whether the instructions provided in these proposed regulations adequately address the needs of taxpayers. In particular, the IRS and Treasury Department invite comments regarding whether, alternatively, a separate form should be developed and made available to enable taxpayers to make the section 362(e)(2)(C) election prior to and apart from filing it with a U.S. return.

The basis tracing provisions in §1.358-2 apply to certain transfers to which section 351 and either section 354 or section 356 apply. However, the IRS and Treasury Department believe that the basis tracing provisions in §1.358-2 should not apply to a transfer to which section 362(e)(2) also applies if the transferor and transferee make an election to apply section 362(e)(2)(C). The IRS and Treasury Department believe that the statutory language in section 362(e)(2)(C) and the policy of preventing loss duplication precludes the application of the basis tracing provisions because basis tracing could allow the transferor to hold transferee stock or securities with a basis in excess of fair market value even after a reduction under section 362(e)(2)(C). Accordingly, these proposed regulations provide that the provisions of §1.358-2(a)(2) will not apply to a transaction to which section 362(e)(2) applies if the transferor and transferee elect to apply section 362(e)(2)(C). The IRS and Treasury Department request comments regarding whether this treatment is appropriate.

The proposed regulations also provide that, where the transferor is a partnership and a section 362(e)(2)(C) election is made, any reduction to the partnership’s basis in the transferee stock received is treated as an expenditure of the partnership, as described in section 705(a)(2)(B). The proposed regulations provide a similar rule applicable to transfers by S corporations that elect to apply section 362(e)(2)(C).

The IRS and Treasury Department are further exploring how the provisions of section 362(e)(2) apply to partnerships. The IRS and Treasury Department invite comments on this general issue and specifically invite comments regarding the transfer of a partnership interest in exchange for stock in a section 351 transaction to which section 362(e)(2) applies. For example, individuals A and B contribute cash to form a partnership, PRS. PRS purchases property that subsequently decreases in value. A contributes his PRS interest to a corporation in a transaction that qualifies under section 351. PRS does not make an election under section 754. Comments are invited regarding the interaction of section 362(e)(2) and the partnership provisions under these and similar facts.

Commentators have questioned how section 362(e)(2) interacts with other Code sections. Specifically, some have asked how section 362(e)(2) applies when section 336(d) might be implicated. Section 336(d) provides various limitations on a liquidating corporation’s ability to recognize loss when it distributes property acquired in a section 351 transaction or as a contribution to capital. The IRS and Treasury Department believe that, generally, sections 336(d) and 362(e)(2) are fully compatible where the parties do not make an election to apply section 362(e)(2)(C). However, where an election has been made, the two sections may operate to deny part or all of an economic loss. The IRS and Treasury Department invite comments regarding this issue.

In response to inquiries, the proposed regulations contain an example demonstrating how section 362(e)(2) applies to a section 351 transaction treated as occurring under section 304. The IRS and Treasury Department are considering whether the regulations should deem an election to apply section 362(e)(2)(C) to have been made in section 304 transactions. The IRS and Treasury Department invite comments regarding this issue.

(a) * * *

(2) * * *

(viii) This paragraph (a)(2) shall not apply to determine the basis of a share of stock or security received by a shareholder or security holder in an exchange described in both section 351 and either section 354 or section 356, if, in connection with the exchange, the shareholder or security holder exchanges property for stock or securities in an exchange to which neither section 354 nor section 356 applies, the shareholder or security holder exchanges property for stock or securities to which it elects to apply section 362(e)(2)(C), or liabilities of the shareholder or security holder are assumed.

* * * * *

(d) * * * Paragraph (a)(2)(viii) of this section applies to exchanges and distributions of stock occurring after the date these regulations are published as final regulations in the Federal Register.

Par. 3. In §1.362-3, the section heading is added and reserved to read as follows:

Par. 4. Section 1.362-4 is added to read as follows:

(a) Purpose and scope. The purpose of this section is to prevent the duplication of net built-in loss in transactions described in section 362(e)(2). Section 362(e)(2) applies to transfers of net built-in loss property described in section 362(a) but only to the extent not described in section 362(e)(1).

(b) Application—(1) In general. If property is transferred in any transaction described in section 362(a) but not section 362(e)(1), and, in the hands of the transferee, the transferred property would otherwise have a net built-in loss immediately after the transfer, then the transferee corporation receives such property with an aggregate adjusted basis not exceeding the aggregate fair market value of such property immediately after the transfer. If multiple built-in loss properties are transferred, the aggregate reduction in basis shall be allocated among the built-in loss properties so transferred in proportion to the relative amount of built-in loss in each property.

(2) Multiple transferors. If more than one transferor transfers property to a corporation in a transaction described in section 362(a), whether and the extent to which this section applies is determined separately for each transferor.

(3) Transactions described in section 362(e)(1). A transfer of property to a corporation is described in section 362(e)(1) only if and to the extent that the transferred property described in section 362(e)(1)(B) (section 362(e)(1)(B) property) would otherwise have a net built-in loss in the hands of the transferee. Thus, if a transferor transfers net built-in loss section 362(e)(1)(B) property together with property not described in section 362(e)(1)(B), the transfer of the net built-in loss section 362(e)(1)(B) property is described in section 362(e)(1). Accordingly, the net built-in loss section 362(e)(1)(B) property is not taken into account for purposes of determining whether section 362(e)(2) applies to the transfer of the other property. Alternatively, if a transferor transfers net built-in gain section 362(e)(1)(B) property together with property not described in section 362(e)(1)(B), no portion of the transfer is described in section 362(e)(1).

(4) Net built-in loss— (i) In general. Transferred property has a net built-in loss if its aggregate adjusted basis exceeds its aggregate fair market value.

(ii) Basis adjustments for gain recognized on the transfer. For purposes of determining whether the transferred property has a net built-in loss in the hands of the transferee, the bases of such property first must be increased under section 362(a) or (b) for any gain recognized by the transferor on the transfer of such property.

(5) Application of section 362(e)(2) to reorganizations. Section 362(e)(2) can apply to a transfer regardless of whether the basis of the property would, but for section 362(e)(2), be determined under section 362(b).

(6) Exception for transactions in which net built-in loss is eliminated without recognition. Section 362(e)(2) does not apply to a transfer of property to the extent that—

(i) The transferor distributes, without recognizing gain or loss, all of the transferee stock received in exchange for the transferred property; and

(ii) Upon completion of the transaction, no person holds transferee stock or any other asset with a basis determined in whole or in part by reference to the transferor’s basis in the transferee stock.

(7) Transfers where neither party is a U.S. person, a person otherwise required to file a U.S. return, or a CFC. If property is transferred in a transaction described in section 362(a) but not section 362(e)(1), then, solely for purposes of section 362(e)(2), the aggregate fair market value of the transferred property shall be deemed to equal the aggregate adjusted basis of such property in the hands of the transferee immediately after the transfer if—

(i) Neither party to the transfer was a United States (U.S.) person (as defined in section 7701(a)(30)) on the date of the transfer;

(ii) Neither party to the transfer was required to file a return of tax under Subtitle A of the Internal Revenue Code (including an information return) for the year of the transfer;

(iii) Neither party to the transfer was a controlled foreign corporation (CFC), as defined in section 957, on the date of the transfer;

(iv) The transfer occurred more than two years prior to the date on which the transferor, transferee, or transferred assets are first described in paragraph (c)(5)(iii) of this section; and

(v) Neither the transfer nor the later entry into the U.S. tax system was entered into with a view to reducing the U.S. Federal income tax liability of any person or duplicating loss by avoiding the application of section 362(e)(2).

(c) Section 362(e)(2)(C) election to apply limitation to transferor’s stock basis—(1) In general. If section 362(e)(2) applies to a transfer, the transferor and the transferee may make a joint election to reduce the transferor’s basis in the transferee stock instead of reducing the transferee’s basis in the property received under paragraph (b) of this section. Once made, the election is irrevocable. If the election is made, the transferor’s basis in the transferee stock is reduced upon receipt by the transferor. The transferor and the transferee may make a protective election under this section, which will have no effect if section 362(e)(2) does not apply to the transfer, but which will otherwise be binding and irrevocable.

(2) Stock and securities to which this section applies. For purposes of this section, the term stock means stock and securities received without the recognition of gain or loss in a transaction to which section 362(e)(2) applies. See, for example, transactions described in sections 368(a)(1)(D) and 355.

(3) Amount of basis reduction. If an election is made pursuant to paragraph (c)(1) of this section, the amount of the basis reduction in the transferee stock received by the transferor in the transaction is equal to the total amount by which the aggregate basis of the transferred property would have been reduced under paragraph (b) of this section had such election not been made.

(4) Allocation of basis reduction. The transferor shall allocate the amount of the basis reduction under this paragraph (c) among all transferee stock received in the transaction in proportion to fair market value.

(5) Procedures for making the election—(i) In general. To make an election to apply section 362(e)(2)(C)—

(A) Prior to filing the election statement as described in paragraph (c)(5)(ii) or (c)(5)(iii) of this section, the transferor and transferee must execute a written, binding agreement electing to apply section 362(e)(2)(C); and

(B) An election statement must be filed pursuant to paragraph (c)(5)(ii) or (c)(5)(iii) of this section.

(ii) Election statement where the transferor or transferee is a U.S. person, a person otherwise required to file a U.S. return for the year of the transfer, or a CFC on the date of the transfer—(A) Transferor is a U.S. person or a person otherwise required to file a U.S. return for the year of the transfer. If the transferor is a U.S. person on the date of the transfer or a person otherwise required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return) for the year of the transfer, the election statement is filed by including the following statement on or with the transferor’s timely filed original return (including extensions) for the taxable year in which the transfer occurred: “[insert name and tax identification number of transferor] certifies that [insert name and tax identification number of transferor] and [insert name and tax identification number, if any, of transferee] elect to apply section 362(e)(2)(C) with respect to a transfer of property described in section 362(e)(2)(A) on [insert date(s) of transfer(s)].”

(B) Transferor is a CFC on the date of the transfer. If, on the date of the transfer, the transferor is a CFC that is not required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return) for the year of the transfer, the election statement is filed by including the following statement on or with the timely filed original return (including extensions) of each one of the transferor’s controlling U.S. shareholders, as defined in §1.964-1(c)(5), for the taxable year within which the transfer occurred: “[insert name and tax identification number of controlling U.S. shareholder filing return] certifies that [insert name and tax identification number, if any, of transferor (the CFC)] and [insert name and tax identification number, if any, of transferee] elect to apply section 362(e)(2)(C) with respect to a transfer of property described in section 362(e)(2)(A) on [insert date(s) of transfer(s)]. [insert name(s) and tax identification number(s) of any other controlling U.S. shareholder(s) of the CFC, or, if none, state that there are no other controlling U.S. shareholders of the CFC].”

(C) Transferor is not a U.S. person on the date of the transfer, a person otherwise required to file a U.S. return for the year of the transfer, or a CFC on the date of the transfer, and transferee is a U.S. person on the date of the transfer or a person otherwise required to file a U.S. return for the year of the transfer. If the transferor is not described in paragraph (c)(5)(ii)(A) or (c)(5)(ii)(B) of this section and the transferee is a U.S. person on the date of the transfer or otherwise required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return) for the year of the transfer, the election statement is filed by including the following statement on or with the transferee’s timely filed original return (including extensions) for the taxable year in which the transfer occurred: “[insert name and tax identification number of transferee] certifies that [insert name and tax identification number, if any, of transferor] and [insert name and tax identification number of transferee] elect to apply section 362(e)(2)(C) with respect to a transfer of property described in section 362(e)(2)(A) on [insert date(s) of transfer(s)].”

(D) Transferor is not a U.S. person on the date of the transfer, a person otherwise required to file a U.S. return for the year of the transfer, or a CFC on the date of the transfer, and transferee is a CFC on the date of the transfer. If the transferor is not described in paragraph (c)(5)(ii)(A) or (c)(5)(ii)(B) of this section, and, on the date of the transfer, the transferee is a CFC that is not required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return) for the year of the transfer, the election statement is filed by including the following statement on or with the timely filed original return (including extensions) of each one of the transferee’s controlling U.S. shareholders as defined in §1.964-1(c)(5) for the taxable year within which the transfer occurred: “[insert name and tax identification number of controlling U.S. shareholder filing return] certifies that [insert name and tax identification number, if any, of transferor] and [insert name and tax identification number, if any, of transferee (the CFC)] elect to apply section 362(e)(2)(C) with respect to a transfer of property described in section 362(e)(2)(A) on [insert date(s) of transfer(s)]. [insert name(s) and tax identification number(s) of any other controlling U.S. shareholder(s) of the CFC, or, if none, state that there are no other controlling U.S. shareholders of the CFC].”

(iii) Election where neither the transferor nor the transferee is a U.S. person on the date of the transfer, a person otherwise required to file a U.S. return for the year of the transfer, or a CFC on the date of the transfer. If the parties to a transfer to which section 362(e)(2) applies are not described in any of the classifications set forth in paragraph (c)(5)(ii) of this section, then the election statement under this paragraph (c) is made as described in this paragraph (c)(5)(iii).

(A) Transferor later becomes a U.S. person, a person otherwise required to file a U.S. return, or a CFC. If the transferor later becomes a U.S. person, a person otherwise required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return), or a CFC, an election statement under this paragraph (c) is filed as described in this paragraph (c)(5)(iii)(A).

(1) If the transferor becomes a U.S. person or a person otherwise required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return), the election statement is filed by including the statement described in paragraph (c)(5)(ii)(A) of this section on or with the transferor’s timely filed original return (including extensions) for the taxable year in which the transferor first becomes a U.S. person or a person otherwise required to make a return.

(2) If the transferor becomes a CFC that is not required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return), the election statement is filed by including the statement described in paragraph (c)(5)(ii)(B) of this section on or with the timely filed original return (including extensions) of each one of the transferor’s controlling U.S. shareholders, as defined in §1.964-1(c)(5), for the taxable year within which the transferor becomes a CFC.

(B) Transferee later becomes a U.S. person, a person otherwise required to file a U.S. return, or a CFC. If the transferor is not described in paragraph (c)(5)(iii)(A) of this section, and the transferee later becomes a U.S. person, a person otherwise required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return), or a CFC, an election statement under this paragraph (c) is filed as described in this paragraph (c)(5)(iii)(B).

(1) If the transferee becomes a U.S. person or a person otherwise required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return), the election statement is filed by including the statement described in paragraph (c)(5)(ii)(C) of this section on or with the transferee’s timely filed original return (including extensions) for the taxable year in which the transferee first becomes required to make a return.

(2) If the transferee becomes a CFC that is not required to make any return of tax under Subtitle A of the Internal Revenue Code (including an information return), the election statement is filed by including the statement described in paragraph (c)(5)(ii)(D) of this section on or with the timely filed original return (including extensions) of each one of the transferee’s controlling U.S. shareholders as defined in §1.964-1(c)(5) for the taxable year within which the transferee becomes a CFC.

(C) A U.S. person, a person otherwise required to file a U.S. return, or a CFC later acquires the transferred assets or transferee stock in a transferred basis transaction. If neither the transferor nor the transferee is described in paragraph (c)(5)(iii)(A) or (c)(5)(iii)(B) of this section and a U.S. person, a person otherwise required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return), or a CFC not required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return) later acquires, in a transferred basis transaction, any portion of the assets that were transferred in a prior transaction to which section 362(e)(2) applied (section 362(e)(2) assets) or stock of the transferee corporation received in such prior transaction (section 362(e)(2) stock), then the election statement under this paragraph (c) is filed as described in this paragraph (c)(5)(iii)(C).

(1) If a U.S. person or a person otherwise required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return) later acquires, in a transferred basis transaction, any portion of the section 362(e)(2) assets or section 362(e)(2) stock, the election statement is filed by including the following statement on or with such acquiror’s timely filed original return (including extensions) for the taxable year in which the acquiror first acquires any portion of the section 362(e)(2) assets or section 362(e)(2) stock: “[insert name and tax identification number of the acquiror] certifies that [insert name and tax identification number, if any, of transferor] and [insert name and tax identification number, if any, of transferee] elect to apply section 362(e)(2)(C) with respect to a transfer of property described in section 362(e)(2)(A) on [insert date(s) of transfer(s)].”

(2) If no person described in paragraph (c)(5)(iii)(C)(1) of this section has acquired any portion of the section 362(e)(2) assets or section 362(e)(2) stock, and a CFC not required to make a return of tax under Subtitle A of the Internal Revenue Code (including an information return) later acquires, in a transferred basis transaction, any portion of the section 362(e)(2) assets or section 362(e)(2) stock, the election statement is filed by including the following statement on or with each of the CFC’s controlling U.S. shareholders’ timely filed original returns (including extensions) for the taxable year within which the CFC first acquires any portion of the section 362(e)(2) assets or section 362(e)(2) stock: “[insert name and tax identification number of controlling U.S. shareholder filing return] certifies that [insert name and tax identification number, if any, of transferor] and [insert name and tax identification number, if any, of transferee] elect to apply section 362(e)(2)(C) with respect to a transfer of property described in section 362(e)(2)(A) on [insert date(s) of transfer(s)]. [insert name(s) and tax identification number(s) of any other controlling U.S. shareholder(s) of the CFC, or, if none, state that there are no other controlling U.S. shareholders of the CFC].”

(6) Transfers by partnerships. If the transferor is a partnership, for purposes of applying section 705 (determination of basis of partner’s interest), any reduction under this section to the transferor’s basis in the stock received in exchange for the transferred property is treated as an expenditure of the partnership described in section 705(a)(2)(B).

(7) Transfers by S corporations. If the transferor is an S corporation, for purposes of applying section 1367 (adjustments to basis of stock of shareholders, etc.), any reduction under this section to the transferor’s basis in the stock received in exchange for the transferred property is treated as an expense of the S corporation described in section 1367(a)(2)(D).

(d) Examples. The following examples illustrate paragraphs (a) through (c) of this section. Unless otherwise indicated, all transferred property is subject to tax under Subtitle A of the Internal Revenue Code in the hands of the transferor, and, accordingly, section 362(e)(1) does not apply to the transaction. In addition, all assets are capital assets in the hands of the transferor and have been held for more than one year.

Example 1. Property transfer qualifying under section 351. (i) Facts. Individual A owns Asset 1 with a basis of $90 and a fair market value of $60, and Asset 2 with a basis of $110 and a fair market value of $120. In a transaction qualifying under section 351, A transfers Asset 1 and Asset 2 to newly formed corporation X in exchange for all of the X common stock. A and X do not elect to apply section 362(e)(2)(C) to reduce A’s basis in the X stock received.

(ii) Analysis. Under section 362(a), X would otherwise receive Asset 1 and Asset 2 with an aggregate basis of $200 ($90+$110), which exceeds their aggregate fair market value of $180 ($60+$120). As a result, the assets have a net built-in loss of $20, and this section applies to the transfer. Under paragraph (b)(1) of this section, X reduces its basis in Asset 1 by $20 to $70 and, under section 362(a), takes a basis in Asset 2 of $110. Under section 358(a), A receives X stock with a basis of $200.

(iii) Election to apply section 362(e)(2)(C). The facts are the same as in paragraph (i) of this Example 1, except that A and X elect to apply section 362(e)(2)(C) to reduce A’s basis in the X stock received. Under paragraph (c)(3) of this section, A reduces its basis in the X stock received by the amount X would have been required to reduce its basis in the transferred assets had the election to apply section 362(e)(2)(C) not been made. Accordingly, A receives X stock with an aggregate basis of $180, and, under section 362(a), X receives Asset 1 with a basis of $90 and Asset 2 with a basis of $110.

Example 2. Property transfer qualifying under section 351 and described in section 368(a)(1)(B). (i) Facts. Corporation P owns all of the outstanding stock of corporations S1 and S2. In a transaction qualifying under section 351 and described in section 368(a)(1)(B), P transfers all 10 shares of its S2 stock to S1 in exchange for an additional 10 shares of S1 voting stock. At the time of the transfer, each share of the S2 stock has a basis of $10 and a fair market value of $7. P and S1 do not elect to apply section 362(e)(2)(C) to reduce P’s basis in its S1 stock.

(ii) Analysis. Under section 362, S1 would otherwise receive the 10 shares of S2 stock with a basis of $10 per share, which exceeds their fair market value of $7 per share. As a result, the S2 stock has a net built-in loss of $30, and this section applies to the transfer. Under paragraph (b)(1) of this section, S1 reduces its basis in the S2 stock by $30 to $70. Under section 358(a), P receives the additional 10 shares of S1 stock with a basis of $10 per share.

(iii) Election under section 362(e)(2)(C). (A) The facts are the same as in paragraph (i) of this Example 2, except that P and S1 elect to apply section 362(e)(2)(C) to reduce P’s basis in its S1 stock received. Under paragraph (c)(3) of this section, P reduces its basis in the S1 stock received by the amount S1 would have been required to reduce its basis in the transferred S2 stock had the election to apply section 362(e)(2)(C) not been made. Accordingly, under paragraph (c)(4) of this section, P receives the additional 10 shares of S1 stock each with a basis of $7. Under section 362, S1 receives the 10 shares of S2 stock each with a basis of $10.

(B) The facts are the same as in paragraph (i) of this Example 2, except that five shares of the S2 stock have a basis of $10 each, five shares have a basis of $5 each, and P and S1 elect to apply section 362(e)(2)(C) to reduce P’s basis in its S1 stock. The $75 ((5 X $10) + (5 x $5)) aggregate basis in the S2 stock exceeds the $70 aggregate fair market value of the S2 stock, and this section applies to the transfer. Under paragraph (c)(3) of this section, P reduces its basis in the S1 stock received by the amount S1 would have been required to reduce its basis in the transferred S2 stock had the election to apply section 362(e)(2)(C) not been made. Accordingly, under paragraph (c)(4) of this section and §1.358-2(a)(2)(viii), P receives the additional 10 shares of S1 stock each with a basis of $7. Under section 362, S1 receives five shares of the S2 stock with a basis of $10 each and five shares of the S2 stock with a basis of $5 each.

Example 3. Property transfer qualifying under section 351 and described in section 368(a)(1)(A). (i) Facts. Individual A owns all of the outstanding stock of corporation X and corporation Y, which owns Asset 1 with an adjusted basis of $250 and a fair market value of $210. A also owns Asset 2 with an adjusted basis of $120 and a fair market value of $130. In a transaction qualifying as a reorganization described in section 368(a)(1)(A), Y merges with and into X. Pursuant to the same plan, A transfers Asset 2 to X in exchange for additional X stock. Y’s transfer of Asset 1 to X in the merger coupled with A’s transfer of Asset 2 to X in exchange for X stock qualifies as a section 351 contribution.

(ii) Analysis. Under paragraph (b)(2) of this section, the potential application of section 362(e)(2) is determined separately for each transferor. Y is treated as having transferred Asset 1 to X in exchange for X stock, and X would otherwise take Asset 1 with a basis of $250, which exceeds its fair market value of $210. As a result, Asset 1 has a built-in loss of $40. Under paragraph (b)(6) of this section, section 362(e)(2) does not apply to Y’s transfer of property to X because Y distributes all of the X stock received in the exchange without recognizing gain or loss pursuant to section 361(c), and, upon completion of the transaction, no person holds X stock or any other asset with a basis determined in whole or in part by reference to Y’s basis in the X stock received in the exchange. As a result, under section 362, X receives Asset 1 with a basis of $250. A’s transfer of Asset 2 to X is not subject to section 362(e)(2) because X receives Asset 2 with a basis of $120, which is less than its fair market value of $130.

Example 4. Property transfers qualifying under section 351 and described in section 368(a)(1)(D), followed by a section 355 distribution. (i) Facts. Individual A and individual B each own 50 percent of corporation X. X owns Asset 1 with an adjusted basis of $120 and a fair market value of $70, Asset 2 with an adjusted basis of $160 and a fair market value of $110, and Asset 3 with an adjusted basis of $220 and a fair market value of $240. In a transaction qualifying under section 351(a) and described in section 368(a)(1)(D), X transfers Asset 1, Asset 2, and Asset 3 to Y, a newly formed corporation, in exchange for all of the Y stock, and then distributes all of the Y stock to A in exchange for all of A’s X stock in a distribution qualifying under section 355. At the time of the transaction, A has no plan or intention to dispose of his Y stock, and B has no plan or intention to dispose of his X stock.

(ii) Analysis. The aggregate adjusted basis of the properties transferred to Y ($120+$160+$220=$500) exceeds their aggregate fair market value ($70+$110+$240=$420). As a result, the assets have a total net built-in loss of $80. Under paragraph (b)(6) of this section, section 362(e)(2) does not apply to this transfer of property because X distributes all of the Y stock received in the exchange without recognizing gain or loss under section 361(c), and, upon completion of the transaction, no person holds Y stock or any other asset with a basis determined in whole or in part by reference to X’s basis in the Y stock received in the exchange. A’s basis in the Y stock is determined under section 358 by reference to his basis in the X stock he surrenders.

(iii) Section 355(e). (A) The facts are the same as in paragraph (i) of this Example 4, except that, one year after the section 355 distribution, Y is acquired pursuant to a plan, resulting in the application of section 355(e) to the transaction. X and Y do not elect to apply section 362(e)(2)(C).

(B) Analysis. Due to the application of section 355(e), section 361(c) will not apply and X will not be granted nonrecognition treatment on the distribution of the Y stock. As a result, paragraph (b)(6) of this section does not apply, and section 362(e)(2) applies to X’s transfer of assets to Y. Under paragraph (b)(1) of this section, Y reduces its basis in Asset 1 and Asset 2 by the amount of the net built-in loss in the transferred assets, or $80 ($500−$420). The $80 basis reduction is allocated between Asset 1 and Asset 2 in proportion to their respective built-in losses. Prior to reduction, Asset 1 had a built-in loss of $50 ($120−$70), and Asset 2 had a built-in loss of $50 ($160−$110). As a result, the basis of Asset 1 is reduced by $40 (50/100 x $80), and the basis of Asset 2 is reduced by $40 (50/100 x $80), and Y receives Asset 1 with a basis of $80 ($120−$40) and Asset 2 with a basis of $120 ($160−$40).

(iv) Retained stock and securities without a section 362(e)(2)(C) election. (A) The facts are the same as in paragraph (i) of this Example 4, except that X transfers Asset 1, Asset 2, and Asset 3 to Y in exchange for an equal amount of Y stock and Y securities. For a valid business purpose, X retains Y stock and Y securities each worth 1 percent of the total consideration. X and Y do not elect to apply section 362(e)(2)(C).

(B) Analysis. The aggregate basis of the properties transferred ($120+$160+$220=$500) exceeds their aggregate fair market value ($70+$110+$240=$420) by $80 ($500−$420), and this section applies to the transfer. Under paragraph (b)(6) of this section, section 362(e)(2) applies to X’s transfer of assets to Y in exchange for the Y stock and the Y securities to the extent X does not distribute the Y stock and Y securities without the recognition of gain or loss. Accordingly, section 362(e)(2)(A) applies to the extent property was exchanged for the retained Y stock and Y securities (2 percent of the total). Under paragraph (b)(1) of this section, Y reduces its basis in Asset 1 and in Asset 2 by 2 percent of the amount of the net built-in loss in the transferred assets ($80), or $1.60. The $1.60 basis reduction is allocated between Asset 1 and Asset 2 in proportion to their respective built-in losses before reduction under paragraph (b)(1) of this section. Prior to reduction, Asset 1 had a built-in loss of $50 ($120−$70), and Asset 2 had a built-in loss of $50 ($160−$110). As a result, the basis of Asset 1 is reduced by $.80 (50/100 x $1.60), the basis of Asset 2 is reduced by $.80 (50/100 x $1.60), and Y receives Asset 1 with a basis of $119.20 ($120−$.80) and Asset 2 with a basis of $159.20 ($160−$.80).

(v) Retained stock and securities with a section 362(e)(2)(C) election.

(A) The facts are the same as in paragraph (iv)(A) of this Example 4, except that X and Y elect to apply section 362(e)(2)(C) to reduce X’s basis in its retained Y stock and retained Y securities.

(B) Analysis. Under paragraph (b)(6) of this section, section 362(e)(2) applies to X’s transfer of assets to Y in exchange for the Y stock and the Y securities to the extent X does not distribute the Y stock and Y securities without the recognition of gain or loss. Under paragraph (c) of this section, the election to apply section 362(e)(2)(C) applies to both the retained Y stock and the retained Y securities. Accordingly, under paragraph (c)(3) of this section, X reduces its basis in the retained Y stock and the retained Y securities by the amount Y would have been required to reduce its basis in the transferred assets had the election to apply section 362(e)(2)(C) not been made. As described in paragraph (iv)(B) of this Example 4, under paragraphs (b)(1) and (b)(6) of this section, Y would have been required to reduce its basis in the transferred assets by $1.60. Accordingly, X is required to reduce its basis in the retained Y stock and Y securities by $1.60, and, under paragraph (c)(4) of this section, this $1.60 basis reduction is allocated between the retained Y stock and Y securities in proportion to fair market value. Because X retained Y stock and Y securities with equal values, X holds the retained Y stock with an adjusted basis of $1.70 ((($500/2) x .01)−$.80) and the retained Y securities with an adjusted basis of $1.70 ((($500/2) x .01)−$.80).

Example 5. Transfer of contingent liabilities subject to section 358(h)(2)(A) with section 362(e)(2)(C) election. (i) Facts. Corporation P owns Asset 1 with a basis of $800 and a fair market value of $700. Asset 1 constitutes a trade or business for purposes of section 358(h)(2)(A). Contingent liabilities of $200 are associated with the Asset 1 business. P transfers Asset 1 to newly formed corporation S in exchange for all of the S stock and assumption of the contingent liabilities in a transaction qualifying under section 351. P and S elect to apply section 362(e)(2)(C).

(ii) Analysis. Under section 362(a), S would otherwise receive Asset 1 with a basis of $800, which exceeds it fair market value of $700. As a result, Asset 1 has a net built-in loss of $100, and this section applies to the transfer. Under paragraph (c)(3) of this section, P reduces its basis in the S stock received by the amount S would have been required to reduce its basis in Asset 1 had the election to apply section 362(e)(2)(C) not been made ($100). Accordingly, A receives S stock with an aggregate basis of $700, and, under section 362(a), S receives Asset 1 with a basis of $800.

Example 6. Property transfer qualifying under section 351 with boot. (i) Facts. Individual A owns Asset 1 with a basis of $80 and a fair market value of $100, and Asset 2 with a basis of $30 and a fair market value of $25. In a transaction qualifying under section 351, A transfers Asset 1 and Asset 2 to newly formed corporation N in exchange for 10 shares of N stock and $25. A and N do not elect to apply section 362(e)(2)(C) to reduce A’s basis in the N stock received.

(ii) Analysis. Under paragraph (b)(4)(iii) of this section, for purposes of determining whether the transferred property has a net built-in loss in the hands of the transferee, the transferee’s basis in the transferred property must be adjusted for any gain recognized by the transferor on the transfer. Section 351(b) requires transferors in transactions otherwise qualifying under section 351(a) for nonrecognition treatment to recognize gain (but not loss) to the extent the transferor receives other property or money in addition to the stock permitted to be received. For purposes of computing the amount of gain recognized under section 351(b), the consideration is allocated pro rata among the transferred properties according to their fair market values. As a result, to compute the amount of gain recognized on the transfer, A is treated as having received eight shares of N stock and $20 in exchange for Asset 1, and two shares of N stock and $5 in exchange for Asset 2. Under section 351(b), A must recognize $20 of gain for the cash received in exchange for Asset 1. Thus, under section 362(a), N would otherwise have a basis of $100 in Asset 1 and $30 in Asset 2. N’s total basis in Asset 1 and Asset 2 of $130 ($100 + $30) would exceed the total fair market value of Asset 1 and Asset 2 of $125 ($100 + $25). As a result, this section applies to the transfer. Under paragraph (b)(1) of this section, N reduces its basis in Asset 2 by $5 to $25 and, under section 362(a), takes a basis in Asset 1 of $100. Under section 358(a), A receives N stock with a basis of $105.

Example 7. Property transfer subject to both sections 362(e)(1) and 362(e)(2). (i) Facts. Foreign corporation FP transfers Asset 1 and Asset 2 to a domestic corporation DS in a transaction that qualifies under section 351. Asset 1 is not property described in section 362(e)(1)(B) and has a basis of $80 and a fair market value of $50. Asset 2 is property described in section 362(e)(1)(B) and has a basis of $120 and a value of $110. Section 367(b) does not apply to the transfer of Asset 1 or Asset 2.

(ii) Analysis. Under paragraphs (b)(1) and (b)(3) of this section, a transfer is described in section 362(e)(1), and thus not subject to this section, only if and to the extent there is a transfer of property described in section 362(e)(1)(B) that otherwise would have a net built-in loss in the hands of the transferee. Because Asset 2 is property described in section 362(e)(1)(B) and DS would otherwise receive Asset 2 with a basis of $120 and a value of $110, FP’s transfer of property to DS is described in section 362(e)(1) only to the extent of the transfer of Asset 2. Asset 1 is not property described in section 362(e)(1)(B), and under section 362(a), DS would receive Asset 1 with a basis ($80) in excess of its fair market value ($50). Accordingly, this section applies solely to the transfer of Asset 1. Under paragraph (b)(1) of this section, DS reduces its basis in Asset 1 by $30 to $50. Under section 358(a), FP receives the DS stock with a basis of $200.

Example 8. Section 304 sale of built-in loss stock. (i) Facts. Individual A owns all the stock of corporation X and corporation Y. A sells all his X stock to Y for $60. Under section 304, A is treated as though he transferred the X stock to Y in exchange for Y stock in a transaction to which section 351 applies. Then, Y is treated as redeeming the Y stock it was treated as having issued to A in the section 351 transaction. At the time of the transaction, A holds X stock with a basis of $90 and a fair market value of $60. A and Y do not elect to apply section 362(e)(2)(C) to reduce A’s basis in the Y stock deemed received.

(ii) Analysis. Under section 362(a), Y would otherwise receive X stock with an aggregate basis of $90, which exceeds its aggregate fair market value of $60. As a result, the X stock has a net built-in loss of $30, and, under paragraph (b)(1) of this section, Y reduces its basis in the X stock received by $30 to $60. Under section 358(a), A receives the deemed issued Y stock with a basis of $90.

(e) Effective date. This section applies to transactions occurring after the date these regulations are published as final regulations in the Federal Register.

Par. 5. Section 1.705-1(a)(9) is added to read as follows:

(a) * * *

(9) For basis adjustments necessary to coordinate sections 705 and 362(e)(2), see §1.362-4(c)(6).

* * * * *

Par. 6. In §1.1367-1, a new sentence is added at the end of paragraph (c)(2) to read as follows:

* * * * *

(c) * * *

(2) * * * For basis adjustments necessary to coordinate sections 1367 and 362(e)(2), see §1.362-4(c)(7).

* * * * *

[The text of proposed §1.199-2 is the same as the text of §1.199-2T published elsewhere in this issue of the Bulletin.]

Par. 3. Section 1.199-3 is amended to read as follows:

[The text of proposed §1.199-3 is the same as the text of §1.199-3T published elsewhere in this issue of the Bulletin.]

Par. 4. Section 1.199-5 is amended to read as follows:

[The text of proposed §1.199-5 is the same as the text of §1.199-5T published elsewhere in this issue of the Bulletin.]

Par. 5. Section 1.199-7 is amended to read as follows:

[The text of proposed §1.199-7 is the same as the text of §1.199-7T published elsewhere in this issue of the Bulletin.]

Par. 6. Section 1.199-8 is amended to read as follows:

[The text of proposed §1.199-8 is the same as the text of §1.199-8T published elsewhere in this issue of the Bulletin.]