This section lists the captions contained in §§ 1.441-1 through 1.441-4 as follows:

(a) Computation of taxable income—(1) In general. Taxable income must be computed and a return must be made for a period known as the taxable year. For rules relating to methods of accounting, the taxable year for which items of gross income are included and deductions are taken, inventories, and adjustments, see parts II and III (section 446 and following), subchapter E, chapter 1 of the Internal Revenue Code, and the regulations thereunder.

(2) Length of taxable year. Except as otherwise provided in the Internal Revenue Code and the regulations thereunder (e.g., § 1.441-2 regarding 52-53-week taxable years), a taxable year may not cover a period of more than 12 calendar months.

(b) General rules and definitions. The general rules and definitions in this paragraph (b) apply for purposes of sections 441 and 442 and the regulations thereunder.

(1) Taxable year. Taxable year means—

(i) The period for which a return is made, if a return is made for a period of less than 12 months (short period). See section 443 and the regulations thereunder;

(ii) Except as provided in paragraph (b)(1)(i) of this section, the taxpayer's required taxable year (as defined in paragraph (b)(2) of this section), if applicable;

(iii) Except as provided in paragraphs (b)(1)(i) and (ii) of this section, the taxpayer's annual accounting period (as defined in paragraph (b)(3) of this section), if it is a calendar year or a fiscal year; or

(iv) Except as provided in paragraphs (b)(1)(i) and (ii) of this section, the calendar year, if the taxpayer keeps no books, does not have an annual accounting period, or has an annual accounting period that does not qualify as a fiscal year.

(2) Required taxable year—(i) In general. Certain taxpayers must use the particular taxable year that is required under the Internal Revenue Code and the regulations thereunder (the required taxable year). For example, the required taxable year is—

(A) [Reserved]

(B) In the case of a personal service corporation (PSC), the taxable year determined under section 441(i) and § 1.441-3;

(C) In the case of a nuclear decommissioning fund, the taxable year determined under § 1.468A-4(c)(1);

(D) In the case of a designated settlement fund or a qualified settlement fund, the taxable year determined under § 1.468B-2(j);

(E) In the case of a common trust fund, the taxable year determined under section 584(i);

(F) In the case of certain trusts, the taxable year determined under section 644;

(G) In the case of a partnership, the taxable year determined under section 706 and § 1.706-1;

(H) In the case of an insurance company, the taxable year determined under section 843 and § 1.1502-76(a)(2);

(I) In the case of a real estate investment trust, the taxable year determined under section 859;

(J) In the case of a real estate mortgage investment conduit, the taxable year determined under section 860D(a)(5) and § 1.860D-1(b)(6);

(K) In the case of a specified foreign corporation, the taxable year determined under section 898(c)(1)(A);

(L) In the case of an S corporation, the taxable year determined under section 1378 and § 1.1378-1; or

(M) In the case of a member of an affiliated group that makes a consolidated return, the taxable year determined under § 1.1502-76.

(ii) Exceptions. Notwithstanding paragraph (b)(2)(i) of this section, the following taxpayers may have a taxable year other than their required taxable year:

(A) 52-53-week taxable years. Certain taxpayers may elect to use a 52-53-week taxable year that ends with reference to their required taxable year. See, for example, §§ 1.441-3 (PSCs), 1.706-1 (partnerships), 1.1378-1 (S corporations), and 1.1502-76(a)(1) (members of a consolidated group).

(B) Partnerships, S corporations, and PSCs. A partnership, S corporation, or PSC may use a taxable year other than its required taxable year if the taxpayer elects to use a taxable year other than its required taxable year under section 444, elects a 52-53-week taxable year that ends with reference to its required taxable year as provided in paragraph (b)(2)(ii)(A) of this section or to a taxable year elected under section 444, or establishes a business purpose to the satisfaction of the Commissioner under section 442 (such as a grandfathered fiscal year).

(C) Specified foreign corporations. A specified foreign corporation (as defined in section 898(b)) may use a taxable year other than its required taxable year if it elects a 52-53-week taxable year that ends with reference to its required taxable year as provided in paragraph (b)(2)(ii)(A) of this section or makes a one-month deferral election under section 898(c)(1)(B).

(3) Annual accounting period. Annual accounting period means the annual period (calendar year or fiscal year) on the basis of which the taxpayer regularly computes its income in keeping its books.

(4) Calendar year. Calendar year means a period of 12 consecutive months ending on December 31. A taxpayer who has not established a fiscal year must make its return on the basis of a calendar year.

(5) Fiscal year—(i) Definition. Fiscal year means—

(A) A period of 12 consecutive months ending on the last day of any month other than December; or

(B) A 52-53-week taxable year, if such period has been elected by the taxpayer. See § 1.441-2.

(ii) Recognition. A fiscal year will be recognized only if the books of the taxpayer are kept in accordance with such fiscal year.

(6) Grandfathered fiscal year. Grandfathered fiscal year means a fiscal year (other than a year that resulted in a three month or less deferral of income) that a partnership or an S corporation received permission to use on or after July 1, 1974, by a letter ruling (i.e., not by automatic approval).

(7) Books. Books include the taxpayer's regular books of account and such other records and data as may be necessary to support the entries on the taxpayer's books and on the taxpayer's return, as for example, a reconciliation of any difference between such books and the taxpayer's return. Records that are sufficient to reflect income adequately and clearly on the basis of an annual accounting period will be regarded as the keeping of books. See section 6001 and the regulations thereunder for rules relating to the keeping of books and records.

(8) Taxpayer. Taxpayer has the same meaning as the term person as defined in section 7701(a)(1) (e.g., an individual, trust, estate, partnership, association, or corporation) rather than the meaning of the term taxpayer as defined in section 7701(a)(14) (any person subject to tax).

(c) Adoption of taxable year—(1) In general. Except as provided in paragraph (c)(2) of this section, a new taxpayer may adopt any taxable year that satisfies the requirements of section 441 and the regulations thereunder without the approval of the Commissioner. A taxable year of a new taxpayer is adopted by filing its first Federal income tax return using that taxable year. The filing of an application for automatic extension of time to file a Federal income tax return (e.g., Form 7004, “Application for Automatic Extension of Time to File Corporation Income Tax Return”), the filing of an application for an employer identification number (i.e., Form SS-4, “Application for Employer Identification Number”), or the payment of estimated taxes, for a particular taxable year do not constitute an adoption of that taxable year.

(2) Approval required—(i) Taxpayers with required taxable years. A newly-formed partnership, S corporation, or PSC that wants to adopt a taxable year other than its required taxable year, a taxable year elected under section 444, or a 52-53-week taxable year that ends with reference to its required taxable year or a taxable year elected under section 444 must establish a business purpose and obtain the approval of the Commissioner under section 442.

(ii) Taxpayers without books. A taxpayer that must use a calendar year under section 441(g) and paragraph (f) of this section may not adopt a fiscal year without obtaining the approval of the Commissioner.

(d) Retention of taxable year. In certain cases, a partnership, S corporation, electing S corporation, or PSC will be required to change its taxable year unless it obtains the approval of the Commissioner under section 442, or makes an election under section 444, to retain its current taxable year. For example, a corporation using a June 30 fiscal year that either becomes a PSC or elects to be an S corporation and, as a result, is required to use the calendar year under section 441(i) or 1378, respectively, must obtain the approval of the Commissioner to retain its current fiscal year. Similarly, a partnership using a taxable year that corresponds to its required taxable year must obtain the approval of the Commissioner to retain such taxable year if its required taxable year changes as a result of a change in ownership. However, a partnership that previously established a business purpose to the satisfaction of the Commissioner to use a taxable year is not required to obtain the approval of the Commissioner if its required taxable year changes as a result of a change in ownership.

(e) Change of taxable year. Once a taxpayer has adopted a taxable year, such taxable year must be used in computing taxable income and making returns for all subsequent years unless the taxpayer obtains approval from the Commissioner to make a change or the taxpayer is otherwise authorized to change without the approval of the Commissioner under the Internal Revenue Code (e.g., section 444 or 859) or the regulations thereunder.

(f) Obtaining approval of the Commissioner or making a section 444 election. See § 1.442-1(b) for procedures for obtaining approval of the Commissioner (automatically or otherwise) to adopt, change, or retain an annual accounting period. See §§ 1.444-1T and 1.444-2T for qualifications, and 1.444-3T for procedures, for making an election under section 444.

(a) In general—(1) Election. An eligible taxpayer may elect to compute its taxable income on the basis of a fiscal year that—

(i) Varies from 52 to 53 weeks;

(ii) Ends always on the same day of the week; and

(iii) Ends always on—

(A) Whatever date this same day of the week last occurs in a calendar month; or

(B) Whatever date this same day of the week falls that is the nearest to the last day of the calendar month.

(2) Effect. In the case of a taxable year described in paragraph (a)(1)(iii)(A) of this section, the year will always end within the month and may end on the last day of the month, or as many as six days before the end of the month. In the case of a taxable year described in paragraph (a)(1)(iii)(B) of this section, the year may end on the last day of the month, or as many as three days before or three days after the last day of the month.

(3) Eligible taxpayer. A taxpayer is eligible to elect a 52-53-week taxable year if such fiscal year would otherwise satisfy the requirements of section 441 and the regulations thereunder. For example, a taxpayer that is required to use a calendar year under § 1.441-1(b)(2)(i)(D) is not an eligible taxpayer.

(4) Example. The provisions of this paragraph (a) are illustrated by the following example:

(b) Procedures to elect a 52-53-week taxable year—(1) Adoption of a 52-53-week taxable year—(i) In general. A new eligible taxpayer elects a 52-53-week taxable year by adopting such year in accordance with § 1.441-1(c). A newly-formed partnership, S corporation or personal service corporation (PSC) may adopt a 52-53-week taxable year without the approval of the Commissioner if such year ends with reference to either the taxpayer's required taxable year (as defined in § 1.441-1(b)(2)) or the taxable year elected under section 444. See §§ 1.441-3, 1.706-1, and 1.1378-1. Similarly, a newly-formed specified foreign corporation (as defined in section 898(b)) may adopt a 52-53-week taxable year if such year ends with reference to the taxpayer's required taxable year, or, if the one-month deferral election under section 898(c)(1)(B) is made, with reference to the month immediately preceding the required taxable year. See § 1.1502-76(a)(1) for special rules regarding subsidiaries adopting 52-53-week taxable years.

(ii) Filing requirement. A taxpayer adopting a 52-53-week taxable year must file with its Federal income tax return for its first taxable year a statement containing the following information—

(A) The calendar month with reference to which the 52-53-week taxable year ends;

(B) The day of the week on which the 52-53-week taxable year always will end; and

(C) Whether the 52-53-week taxable year will always end on the date on which that day of the week last occurs in the calendar month, or on the date on which that day of the week falls that is nearest to the last day of that calendar month.

(2) Change to (or from) a 52-53-week taxable year—(i) In general. An election of a 52-53-week taxable year by an existing eligible taxpayer with an established taxable year is treated as a change in annual accounting period that requires the approval of the Commissioner in accordance with § 1.442-1. Thus, a taxpayer must obtain approval to change from its current taxable year to a 52-53-week taxable year, even if such 52-53-week taxable year ends with reference to the same calendar month. Similarly, a taxpayer must obtain approval to change from a 52-53-week taxable year, or to change from one 52-53-week taxable year to another 52-53-week taxable year. However, a taxpayer may obtain approval for 52-53-week taxable year changes automatically to the extent provided in administrative procedures published by the Commissioner. See § 1.442-1(b) for procedures for obtaining such approval.

(ii) Special rules for the short period required to effect the change. If a change to or from a 52-53-week taxable year results in a short period (within the meaning of § 1.443-1(a)) of 359 days or more, or six days or less, the tax computation under § 1.443-1(b) does not apply. If the short period is 359 days or more, it is treated as a full taxable year. If the short period is six days or less, such short period is not a separate taxable year but instead is added to and deemed a part of the following taxable year. (In the case of a change to or from a 52-53-week taxable year not involving a change of the month with reference to which the taxable year ends, the tax computation under § 1.443-1(b) does not apply because the short period will always be 359 days or more, or six days or less.) In the case of a short period which is more than six days and less than 359 days, taxable income for the short period is placed on an annual basis for purposes of § 1.443-1(b) by multiplying such income by 365 and dividing the result by the number of days in the short period. In such case, the tax for the short period is the same part of the tax computed on such income placed on an annual basis as the number of days in the short period is of 365 days (unless § 1.443-1(b)(2), relating to the alternative tax computation, applies). For an adjustment in deduction for personal exemption, see § 1.443-1(b)(1)(v).

(3) Examples. The following examples illustrate paragraph (b)(2)(ii) of this section:

(c) Application of effective dates—(1) In general. Except as provided in paragraph (c)(3) of this section, for purposes of determining the effective date (e.g., of legislative, regulatory, or administrative changes) or the applicability of any provision of the internal revenue laws that is expressed in terms of taxable years beginning, including, or ending with reference to the first or last day of a specified calendar month, a 52-53-week taxable year is deemed to begin on the first day of the calendar month nearest to the first day of the 52-53-week taxable year, and is deemed to end or close on the last day of the calendar month nearest to the last day of the 52-53-week taxable year, as the case may be. Examples of provisions of this title, the applicability of which is expressed in terms referred to in the preceding sentence, include the provisions relating to the time for filing returns and other documents, paying tax, or performing other acts, and the provisions of part II, subchapter B, chapter 6 (section 1561 and following) relating to surtax exemptions of certain controlled corporations.

(2) Examples. The provisions of paragraph (c)(1) of this section may be illustrated by the following examples:

(3) Changes in tax rates. If a change in the rate of tax is effective during a 52-53-week taxable year (other than on the first day of such year as determined under paragraph (c)(1) of this section), the tax for the 52-53-week taxable year must be computed in accordance with section 15, relating to effect of changes, and the regulations thereunder. For the purpose of the computation under section 15, the determination of the number of days in the period before the change, and in the period on and after the change, is to be made without regard to the provisions of paragraph (b)(1) of this paragraph.

(4) Examples. The provisions of paragraph (c)(3) of this section may be illustrated by the following examples:

(d) Computation of taxable income. The principles of section 451, relating to the taxable year for inclusion of items of gross income, and section 461, relating to the taxable year for taking deductions, generally are applicable to 52-53-week taxable years. Thus, except as otherwise provided, all items of income and deduction must be determined on the basis of a 52-53-week taxable year. However, a taxpayer may determine particular items as though the 52-53-week taxable year were a taxable year consisting of 12 calendar months, provided that practice is consistently followed by the taxpayer and clearly reflects income. For example, an allowance for depreciation or amortization may be determined on the basis of a 52-53-week taxable year, or as though the 52-53-week taxable year is a taxable year consisting of 12 calendar months, provided the taxpayer consistently follows that practice with respect to all depreciable or amortizable items.

(e) Treatment of taxable years ending with reference to the same calendar month—(1) Pass-through entities. If a pass-through entity (as defined in paragraph (e)(3)(i) of this section) or an owner of a pass-through entity (as defined in paragraph (e)(3)(ii) of this section), or both, use a 52-53-week taxable year and the taxable year of the pass-through entity and the owner end with reference to the same calendar month, then, for purposes of determining the taxable year in which items of income, gain, loss, deductions, or credits from the pass-through entity are taken into account by the owner of the pass-through, the owner's taxable year will be deemed to end on the last day of the pass-through's taxable year. Thus, if the taxable year of a partnership and a partner end with reference to the same calendar month, then for purposes of determining the taxable year in which that partner takes into account items described in section 702 and items that are deductible by the partnership (including items described in section 707(c)) and includible in the income of that partner, that partner's taxable year will be deemed to end on the last day of the partnership's taxable year. Similarly, if the taxable year of an S corporation and a shareholder end with reference to the same calendar month, then for purposes of determining the taxable year in which that shareholder takes into account items described in section 1366(a) and items that are deductible by the S corporation and includible in the income of that shareholder, that shareholder's taxable year will be deemed to end on the last day of the S corporation's taxable year.

(2) Personal service corporations and employee-owners. If the taxable year of a PSC (within the meaning of § 1.441-3(c)) and an employee-owner (within the meaning of § 1.441-3(g)) end with reference to the same calendar month, then for purposes of determining the taxable year in which an employee-owner takes into account items that are deductible by the PSC and includible in the income of the employee-owner, the employee-owner's taxable year will be deemed to end on the last day of the PSC's taxable year.

(3) Definitions—(i) Pass-through entity. For purposes of this section, a pass-through entity means a partnership, S corporation, trust, estate, closely-held real estate investment trust (within the meaning of section 6655(e)(5)(B)), common trust fund (within the meaning of section 584(i)), controlled foreign corporation (within the meaning of section 957), foreign personal holding company (within the meaning of section 552), or passive foreign investment company that is a qualified electing fund (within the meaning of section 1295).

(ii) Owner of a pass-through entity. For purposes of this section, an owner of a pass-through entity generally means a taxpayer that owns an interest in, or stock of, a pass-through entity. For example, an owner of a pass-through entity includes a partner in a partnership, a shareholder of an S corporation, a beneficiary of a trust or an estate, an owner of a closely-held real estate investment trust (within the meaning of section 6655(e)(5)(A)), a participant in a common trust fund, a U.S. shareholder (as defined in section 951(b)) of a controlled foreign corporation, a U.S. shareholder (as defined in section 551(a)) of a foreign personal holding company, or a U.S. person that holds stock in a passive foreign investment company that is a qualified electing fund with respect to that shareholder.

(4) Examples. The provisions of paragraph (e)(2) of this section may be illustrated by the following examples:

(5) Transition rule. In the case of an owner of a pass-through entity (other than the owner of a partnership or S corporation) that is required by this paragraph (e) to include in income for its first taxable year ending on or after May 17, 2002 amounts attributable to two taxable years of a pass-through entity, the amount that otherwise would be required to be included in income for such first taxable year by reason of this paragraph (e) should be included in income ratably over the four-taxable-year period beginning with such first taxable year under principles similar to § 1.702-3T, unless the owner of the pass-through entity elects to include all such income in its first taxable year ending on or after May 17, 2002.

(a) Taxable year—(1) Required taxable year. Except as provided in paragraph (a)(2) of this section, the taxable year of a personal service corporation (PSC) (as defined in paragraph (c) of this section) must be the calendar year.

(2) Exceptions. A PSC may have a taxable year other than its required taxable year (i.e., a fiscal year) if it makes an election under section 444, elects to use a 52-53-week taxable year that ends with reference to the calendar year or a taxable year elected under section 444, or establishes a business purpose for such fiscal year and obtains the approval of the Commissioner under section 442.

(b) Adoption, change, or retention of taxable year—(1) Adoption of taxable year. A PSC may adopt, in accordance with § 1.441-1(c), the calendar year, a taxable year elected under section 444, or a 52-53-week taxable year ending with reference to the calendar year or a taxable year elected under section 444 without the approval of the Commissioner. See § 1.441-1. A PSC that wants to adopt any other taxable year must establish a business purpose and obtain the approval of the Commissioner under section 442.

(2) Change in taxable year. A PSC that wants to change its taxable year must obtain the approval of the Commissioner under section 442 or make an election under section 444. However, a PSC may obtain automatic approval for certain changes, including a change to the calendar year or to a 52-53-week taxable year ending with reference to the calendar year, pursuant to administrative procedures published by the Commissioner.

(3) Retention of taxable year. In certain cases, a PSC will be required to change its taxable year unless it obtains the approval of the Commissioner under section 442, or makes an election under section 444, to retain its current taxable year. For example, a corporation using a June 30 fiscal year that becomes a PSC and, as a result, is required to use the calendar year must obtain the approval of the Commissioner to retain its current fiscal year.

(4) Procedures for obtaining approval or making a section 444 election. See § 1.442-1(b) for procedures to obtain the approval of the Commissioner (automatically or otherwise) to adopt, change, or retain a taxable year. See §§ 1.444-1T and 1.444-2T for qualifications, and 1.444-3T for procedures, for making an election under section 444.

(5) Examples. The provisions of paragraph (b)(4) of this section may be illustrated by the following examples:

(c) Personal service corporation defined—(1) In general. For purposes of this section and section 442, a taxpayer is a PSC for a taxable year only if—

(i) The taxpayer is a C corporation (as defined in section 1361(a)(2)) for the taxable year;

(ii) The principal activity of the taxpayer during the testing period is the performance of personal services;

(iii) During the testing period, those services are substantially performed by employee-owners (as defined in paragraph (g) of this section); and

(iv) Employee-owners own (as determined under the attribution rules of section 318, except that the language “any” applies instead of “50 percent” in section 318(a)(2)(C)) more than 10 percent of the fair market value of the outstanding stock in the taxpayer on the last day of the testing period.

(2) Testing period—(i) In general. Except as otherwise provided in paragraph (c)(2)(ii) of this section, the testing period for any taxable year is the immediately preceding taxable year.

(ii) New corporations. The testing period for a taxpayer's first taxable year is the period beginning on the first day of that taxable year and ending on the earlier of—

(A) The last day of that taxable year; or

(B) The last day of the calendar year in which that taxable year begins.

(3) Examples. The provisions of paragraph (c)(2)(ii) of this section may be illustrated by the following examples:

(d) Performance of personal services—(1) Activities described in section 448(d)(2)(A). For purposes of this section, any activity of the taxpayer described in section 448(d)(2)(A) or the regulations thereunder will be treated as the performance of personal services. Therefore, any activity of the taxpayer that involves the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (as such fields are defined in § 1.448-1T) will be treated as the performance of personal services for purposes of this section.

(2) Activities not described in section 448(d)(2)(A). For purposes of this section, any activity of the taxpayer not described in section 448(d)(2)(A) or the regulations thereunder will not be treated as the performance of personal services.

(e) Principal activity—(1) General rule. For purposes of this section, the principal activity of a corporation for any testing period will be the performance of personal services if the cost of the corporation's compensation (the compensation cost) for such testing period that is attributable to its activities that are treated as the performance of personal services within the meaning of paragraph (d) of this section (i.e., the total compensation for personal service activities) exceeds 50 percent of the corporation's total compensation cost for such testing period.

(2) Compensation cost—(i) Amounts included. For purposes of this section, the compensation cost of a corporation for a taxable year is equal to the sum of the following amounts allowable as a deduction, allocated to a long-term contract, or otherwise chargeable to a capital account by the corporation during such taxable year—

(A) Wages and salaries; and

(B) Any other amounts, attributable to services performed for or on behalf of the corporation by a person who is an employee of the corporation (including an owner of the corporation who is treated as an employee under paragraph (g)(2) of this section) during the testing period. Such amounts include, but are not limited to, amounts attributable to deferred compensation, commissions, bonuses, compensation includible in income under section 83, compensation for services based on a percentage of profits, and the cost of providing fringe benefits that are includible in income.

(ii) Amounts excluded. Notwithstanding paragraph (e)(2)(i) of this section, compensation cost does not include amounts attributable to a plan qualified under section 401(a) or 403(a), or to a simplified employee pension plan defined in section 408(k).

(3) Attribution of compensation cost to personal service activity—(i) Employees involved only in the performance of personal services. The compensation cost for employees involved only in the performance of activities that are treated as personal services under paragraph (d) of this section, or employees involved only in supporting the work of such employees, are considered to be attributable to the corporation's personal service activity.

(ii) Employees involved only in activities that are not treated as the performance of personal services. The compensation cost for employees involved only in the performance of activities that are not treated as personal services under paragraph (d) of this section, or for employees involved only in supporting the work of such employees, are not considered to be attributable to the corporation's personal service activity.

(iii) Other employees. The compensation cost for any employee who is not described in either paragraph (e)(3)(i) or (ii) of this section (a mixed-activity employee) is allocated as follows—

(A) Compensation cost attributable to personal service activity. That portion of the compensation cost for a mixed activity employee that is attributable to the corporation's personal service activity equals the compensation cost for that employee multiplied by the percentage of the total time worked for the corporation by that employee during the year that is attributable to activities of the corporation that are treated as the performance of personal services under paragraph (d) of this section. That percentage is to be determined by the taxpayer in any reasonable and consistent manner. Time logs are not required unless maintained for other purposes;

(B) Compensation cost not attributable to personal service activity. That portion of the compensation cost for a mixed activity employee that is not considered to be attributable to the corporation's personal service activity is the compensation cost for that employee less the amount determined in paragraph (e)(3)(iii)(A) of this section.

(f) Services substantially performed by employee-owners—(1) General rule. Personal services are substantially performed during the testing period by employee-owners of the corporation if more than 20 percent of the corporation's compensation cost for that period attributable to its activities that are treated as the performance of personal services within the meaning of paragraph (d) of this section (i.e., the total compensation for personal service activities) is attributable to personal services performed by employee-owners.

(2) Compensation cost attributable to personal services. For purposes of paragraph (f)(1) of this section—

(i) The corporation's compensation cost attributable to its activities that are treated as the performance of personal services is determined under paragraph (e)(3) of this section; and

(ii) The portion of the amount determined under paragraph (f)(2)(i) of this section that is attributable to personal services performed by employee-owners is to be determined by the taxpayer in any reasonable and consistent manner.

(3) Examples. The provisions of this paragraph (f) may be illustrated by the following examples:

(g) Employee-owner defined—(1) General rule. For purposes of this section, a person is an employee-owner of a corporation for a testing period if—

(i) The person is an employee of the corporation on any day of the testing period; and

(ii) The person owns any outstanding stock of the corporation on any day of the testing period.

(2) Special rule for independent contractors who are owners. Any person who is an owner of the corporation within the meaning of paragraph (g)(1)(ii) of this section and who performs personal services for, or on behalf of, the corporation is treated as an employee for purposes of this section, even if the legal form of that person's relationship to the corporation is such that the person would be considered an independent contractor for other purposes.

(h) Special rules for affiliated groups filing consolidated returns—(1) In general. For purposes of applying this section to the members of an affiliated group of corporations filing a consolidated return for the taxable year—

(i) The members of the affiliated group are treated as a single corporation;

(ii) The employees of the members of the affiliated group are treated as employees of such single corporation; and

(iii) All of the stock of the members of the affiliated group that is not owned by any other member of the affiliated group is treated as the outstanding stock of that corporation.

(2) Examples. The provisions of this paragraph (h) may be illustrated by the following examples:

Sections 1.441-0 through 1.441-3 are applicable for taxable years ending on or after May 17, 2002.

(a) Approval of the Commissioner. A taxpayer that has adopted an annual accounting period (as defined in § 1.441-1(b)(3)) as its taxable year generally must continue to use that annual accounting period in computing its taxable income and for making its Federal income tax returns. If the taxpayer wants to change its annual accounting period and use a new taxable year, it must obtain the approval of the Commissioner, unless it is otherwise authorized to change without the approval of the Commissioner under either the Internal Revenue Code (e.g., section 444 and section 859) or the regulations thereunder (e.g., paragraph (c) of this section). In addition, as described in § 1.441-1(c) and (d), a partnership, S corporation, electing S corporation, or personal service corporation (PSC) generally is required to secure the approval of the Commissioner to adopt or retain an annual accounting period other than its required taxable year. The manner of obtaining approval from the Commissioner to adopt, change, or retain an annual accounting period is provided in paragraph (b) of this section. However, special rules for obtaining approval may be provided in other sections.

(b) Obtaining approval—(1) Time and manner for requesting approval. In order to secure the approval of the Commissioner to adopt, change, or retain an annual accounting period, a taxpayer must file an application, generally on Form 1128, “Application To Adopt, Change, or Retain a Tax Year,” with the Commissioner within such time and in such manner as is provided in administrative procedures published by the Commissioner.

(2) General requirements for approval. An adoption, change, or retention in annual accounting period will be approved where the taxpayer establishes a business purpose for the requested annual accounting period and agrees to the Commissioner's prescribed terms, conditions, and adjustments for effecting the adoption, change, or retention. In determining whether a taxpayer has established a business purpose and which terms, conditions, and adjustments will be required, consideration will be given to all the facts and circumstances relating to the adoption, change, or retention, including the tax consequences resulting therefrom. Generally, the requirement of a business purpose will be satisfied, and adjustments to neutralize any tax consequences will not be required, if the requested annual accounting period coincides with the taxpayer's required taxable year (as defined in § 1.441-1(b)(2)), ownership taxable year, or natural business year. In the case of a partnership, S corporation, electing S corporation, or PSC, deferral of income to partners, shareholders, or employee-owners will not be treated as a business purpose.

(3) Administrative procedures. The Commissioner will prescribe administrative procedures under which a taxpayer may be permitted to adopt, change, or retain an annual accounting period. These administrative procedures will describe the business purpose requirements (including an ownership taxable year and a natural business year) and the terms, conditions, and adjustments necessary to obtain approval. Such terms, conditions, and adjustments may include adjustments necessary to neutralize the tax effects of a substantial distortion of income that would otherwise result from the requested annual accounting period including: a deferral of a substantial portion of the taxpayer's income, or shifting of a substantial portion of deductions, from one taxable year to another; a similar deferral or shifting in the case of any other person, such as a beneficiary in an estate; the creation of a short period in which there is a substantial net operating loss, capital loss, or credit (including a general business credit); or the creation of a short period in which there is a substantial amount of income to offset an expiring net operating loss, capital loss, or credit. See, for example, Rev. Proc. 2002-39, 2002-22 I.R.B., procedures for obtaining the Commissioner's prior approval of an adoption, change, or retention in annual accounting period through application to the national office; Rev. Proc. 2002-37, 2002-22 I.R.B., automatic approval procedures for certain corporations; Rev. Proc. 2002-38, 2002-22 I.R.B., automatic approval procedures for partnerships, S corporations, electing S corporations, and PSCs; and Rev. Proc. 66-50, 1966-2 C.B. 1260, automatic approval procedures for individuals. For availability of Revenue Procedures and Notices, see § 601.601(d)(2) of this chapter.

(4) Taxpayers to whom section 441(g) applies. If section 441(g) and § 1.441-1(b)(1)(iv) apply to a taxpayer, the adoption of a fiscal year is treated as a change in the taxpayer's annual accounting period under section 442. Therefore, that fiscal year can become the taxpayer's taxable year only with the approval of the Commissioner. In addition to any other terms and conditions that may apply to such a change, the taxpayer must establish and maintain books that adequately and clearly reflect income for the short period involved in the change and for the fiscal year proposed.

(c) Special rule for change of annual accounting period by subsidiary corporation. A subsidiary corporation that is required to change its annual accounting period under § 1.1502-76, relating to the taxable year of members of an affiliated group that file a consolidated return, does not need to obtain the approval of the Commissioner or file an application on Form 1128 with respect to that change.

(d) Special rule for newly married couples. (1) A newly married husband or wife may obtain automatic approval under this paragraph (d) to change his or her annual accounting period in order to use the annual accounting period of the other spouse so that a joint return may be filed for the first or second taxable year of that spouse ending after the date of marriage. Such automatic approval will be granted only if the newly married husband or wife adopting the annual accounting period of the other spouse files a Federal income tax return for the short period required by that change on or before the 15th day of the 4th month following the close of the short period. See section 443 and the regulations thereunder. If the due date for any such short-period return occurs before the date of marriage, the first taxable year of the other spouse ending after the date of marriage cannot be adopted under this paragraph (d). The short-period return must contain a statement at the top of page one of the return that it is filed under the authority of this paragraph (d). The newly married husband or wife need not file Form 1128 with respect to a change described in this paragraph (d). For a change of annual accounting period by a husband or wife that does not qualify under this paragraph (d), see paragraph (b) of this section.

(2) The provisions of this paragraph (d) may be illustrated by the following example:

(e) Effective date. The rules of this section are applicable for taxable years ending on or after May 17, 2002.

(a) Returns for short period. A return for a short period, that is, for a taxable year consisting of a period of less than 12 months, shall be made under any of the following circumstances:

(1) Change of annual accounting period. In the case of a change in the annual accounting period of a taxpayer, a separate return must be filed for the short period of less than 12 months beginning with the day following the close of the old taxable year and ending with the day preceding the first day of the new taxable year. However, such a return is not required for a short period of six days or less, or 359 days or more, resulting from a change from or to a 52-53-week taxable year. See section 441(f) and § 1.441-2. The computation of the tax for a short period required to effect a change of annual accounting period is described in paragraph (b) of this section. In general, a return for a short period resulting from a change of annual accounting period shall be filed and the tax paid within the time prescribed for filing a return for a taxday of the short period. For rules applicable to a subsidiary corporation which becomes a member of an affiliated group which files a consolidated return, see § 1.1502-76.

(2) Taxpayer not in existence for entire taxable year. If a taxpayer is not in existence for the entire taxable year, a return is required for the short period during which the taxpayer was in existence. For example, a corporation organized on August 1 and adopting the calendar year as its annual accounting period is required to file a return for the short period from August 1 to December 31, and returns for each calendar year thereafter. Similarly, a dissolving corporation which files its returns for the calendar year is required to file a return for the short period from January 1 to the date it goes out of existence. Income for the short period is not required to be annualized if the taxpayer is not in existence for the entire taxable year, and, in the case of a taxpayer other than a corporation, the deduction under section 151 for personal exemptions (or deductions in lieu thereof) need not be reduced under section 443(c). In general, the requirements with respect to the filing of returns and the payment of tax for a short period where the taxpayer has not been in existence for the entire taxable year are the same as for the filing of a return and the payment of tax for a taxable year of 12 months ending on the last day of the short period. Although the return of a decedent is a return for the short period beginning with the first day of his last taxable year and ending with the date of his death, the filing of a return and the payment of tax for a decedent may be made as though the decedent had lived throughout his last taxable year.

(b) Computation of tax for short period on change of annual accounting period—(1) General rule. (i) If a return is made for a short period resulting from a change of annual accounting period, the taxable income for the short period shall be placed on an annual basis by multiplying such income by 12 and dividing the result by the number of months in the short period. Unless section 443(b)(2) and subparagraph (2) of this paragraph apply, the tax for the short period shall be the same part of the tax computed on the annual basis as the number of months in the short period is of 12 months.

(ii) If a return is made for a short period of more than 6 days, but less than 359 days, resulting from a change from or to a 52-53-week taxable year, the taxable income for the short period shall be annualized and the tax computed on a daily basis, as provided in section 441(f)(2)(B)(iii) and § 1.441-2(b)(2)(ii).

(iii) For method of computation of income for a short period in the case of a subsidiary corporation required to change its annual accounting period to conform to that of its parent, see § 1.1502-76(b).

(iv) An individual taxpayer making a return for a short period resulting from a change of annual accounting period is not allowed to take the standard deduction provided in section 141 in computing his taxable income for the short period. See section 142(b)(3).

(v) In computing the taxable income of a taxpayer other than a corporation for a short period (which income is to be annualized in order to determine the tax under section 443(b)(1)) the personal exemptions allowed individuals under section 151 (and any deductions allowed other taxpayers in lieu thereof, such as the deduction under section 642(b)) shall be reduced to an amount which bears the same ratio to the full amount of the exemptions as the number of months in the short period bears to 12. In the case of the taxable income for a short period resulting from a change from or to a 52-53-week taxable year to which section 441(f)(2)(B)(iii) applies, the computation required by the preceding sentence shall be made on a daily basis, that is, the deduction for personal exemptions (or any deduction in lieu thereof) shall be reduced to an amount which bears the same ratio to the full deduction as the number of days in the short period bears to 365.

(vi) If the amount of a credit against the tax (for example, the credits allowable under section 34 (for dividends received on or before December 31, 1964), and 35 (for partially tax-exempt interest)) is dependent upon the amount of any item of income or deduction, such credit shall be computed upon the amount of the item annualized separately in accordance with the foregoing rules. The credit so computed shall be treated as a credit against the tax computed on the basis of the annualized taxable income. In any case in which a limitation on the amount of a credit is based upon taxable income, taxable income shall mean the taxable income computed on the annualized basis.

(vii) The provisions of this subparagraph may be illustrated by the following examples:

(2) Exception: computation based on 12-month period. (i) A taxpayer whose tax would otherwise be computed under section 443(b)(1) (or section 441(f)(2)(B)(iii) in the case of certain changes from or to a 52-53-week taxable year) for the short period resulting from a change of annual accounting period may apply to the district director to have his tax computed under the provisions of section 443(b)(2) and this subparagraph. If such application is made, as provided in subdivision (v) of this subparagraph, and if the taxpayer establishes the amount of his taxable income for the 12-month period described in subdivision (ii) of this subparagraph, then the tax for the short period shall be the greater of the following—

(a) An amount which bears the same ratio to the tax computed on the taxable income which the taxpayer has established for the 12-month period as the taxable income computed on the basis of the short period bears to the taxable income for such 12-month period; or

(b) The tax computed on the taxable income for the short period without placing the taxable income on an annual basis.

(ii) The term “12-month period” referred to in subdivision (i) of this subparagraph means the 12-month period beginning on the first day of the short period. However, if the taxpayer is not in existence at the end of such 12-month period, or if the taxpayer is a corporation which has disposed of substantially all of its assets before the end of such 12-month period, the term “12-month period” means the 12-month period ending at the close of the last day of the short period. For the purposes of the preceding sentence, a corporation which has ceased business and distributed so much of the assets used in its business that it cannot resume its customary operations with the remaining assets, will be considered to have disposed of substantially all of its assets. In the case of a change from a 52-53-week taxable year, the term “12-month period” means the period of 52 or 53 weeks (depending on the taxpayer's 52-53-week taxable year) beginning on the first day of the short period.

(iii)(a) The taxable income for the 12-month period is computed under the same provisions of law as are applicable to the short period and is computed as if the 12-month period were an actual annual accounting period of the taxpayer. All items which fall in such 12-month period must be included even if they are extraordinary in amount or of an unusual nature. If the taxpayer is a member of a partnership, his taxable income for the 12-month period shall include his distributive share of partnership income for any taxable year of the partnership ending within or with such 12-month period, but no amount shall be included with respect to a taxable year of the partnership ending before or after such 12-month period. If any other item partially applicable to such 12-month period can be determined only at the end of a taxable year which includes only part of the 12-month period, the taxpayer, subject to review by the Commissioner, shall apportion such item to the 12-month period in such manner as will most clearly reflect income for the 12-month period.

(b) In the case of a taxpayer permitted or required to use inventories, the cost of goods sold during a part of the 12-month period included in a taxable year shall be considered, unless a more exact determination is available, as such part of the cost of goods sold during the entire taxable year as the gross receipts from sales for such part of the 12-month period is of the gross receipts from sales for the entire taxable year. For example, the 12-month period of a corporation engaged in the sale of merchandise, which has a short period from January 1, 1956, to September 30, 1956, is the calendar year 1956. The three-month period, October 1, 1956, to December 31, 1956, is part of the taxpayer's taxable year ending September 30, 1957. The cost of goods sold during the three-month period, October 1, 1956, to December 31, 1956, is such part of the cost of goods sold during the entire fiscal year ending September 30, 1957, as the gross receipts from sales for such three-month period are of the gross receipts from sales for the entire fiscal year.

(c) The Commissioner may, in granting permission to a taxpayer to change his annual accounting period, require, as a condition to permitting the change, that the taxpayer must take a closing inventory upon the last day of the 12-month period if he wishes to obtain the benefits of section 443(b)(2). Such closing inventory will be used only for the purposes of section 443(b)(2), and the taxpayer will not be required to use such inventory in computing the taxable income for the taxable year in which such inventory is taken.

(iv) The provisions of this subparagraph may be illustrated by the following examples:

(v)(a) A taxpayer who wishes to compute his tax for a short period resulting from a change of annual accounting period under section 443(b)(2) must make an application therefor. Except as provided in (b) of this subdivision, the taxpayer shall first file his return for the short period and compute his tax under section 443(b)(1). The application for the benefits of section 443(b)(2) shall subsequently be made in the form of a claim for credit or refund. The claim shall set forth the computation of the taxable income and the tax thereon for the 12-month period and must be filed not later than the time (including extensions) prescribed for filing the return for the taxpayer's first taxable year which ends on or after the day which is 12 months after the beginning of the short period. For example, assume that a taxpayer changes his annual accounting period from the calendar year to a fiscal year ending September 30, and files a return for the short period from January 1, 1956, to September 30, 1956. His application for the benefits of section 443(b)(2) must be filed not later than the time prescribed for filing his return for his first taxable year which ends on or after the last day of December 1956, the twelfth month after the beginning of the short period. Thus, the taxpayer must file his application not later than the time prescribed for filing the return for his fiscal year ending September 30, 1957. If he obtains an extension of time for filing the return for such fiscal year, he may file his application during the period of such extension. If the district director determines that the taxpayer has established the amount of his taxable income for the 12-month period, any excess of the tax paid for the short period over the tax computed under section 443(b)(2) will be credited or refunded to the taxpayer in the same manner as in the case of an overpayment.

(b) If at the time the return for the short period is filed, the taxpayer is able to determine that the 12-month period ending with the close of the short period (see section 443(b)(2)- (B)(ii) and subparagraph (2)(ii) of this paragraph) will be used in the computations under section 443(b)(2), then the tax on the return for the short period may be determined under the provisions of section 443(b)(2). In such case, a return covering the 12-month period shall be attached to the return for the short period as a part thereof, and the return and attachment will then be considered as an application for the benefits of section 443(b)(2).

(c) Adjustment in deduction for personal exemption. For adjustment in the deduction for personal exemptions in computing the tax for a short period resulting from a change of annual accounting period under section 443(b)(1) (or under section 441(f)(2)(B)(iii) in the case of certain changes from or to a 52-53-week taxable year), see paragraph (b)(1)(v) of this section.

(d) Adjustments in exclusion of computing minimum tax for tax preferences. (1) If a return is made for a short period on account of any of the reasons specified in subsection (a) of section 443, the $30,000 amount specified in section 56 (relating to minimum tax for tax preferences), modified as provided by section 58 and the regulations thereunder, shall be reduced to the amount which bears the same ratio to such specified amount as the number of days in the short period bears to 365.

(2) Example. The provisions of this paragraph may be illustrated by the following example:

(120/365) × $30,000 = $9,835.89.

(e) Cross references. For inapplicability of section 443(b) and paragraph (b) of this section in computing—

(1) Accumulated earnings tax, see section 536 and the regulations thereunder;

(2) Personal holding company tax, see section 546 and the regulations thereunder;

(3) Undistributed foreign personal holding company income, see section 557 and the regulations thereunder;

(4) The taxable income of a regulated investment company, see section 852(b)(2)(E) and the regulations thereunder; and

(5) The taxable income of a real estate investment trust, see section 857(b)(2)(C) and the regulations thereunder.

This section lists the captions that appear in the temporary regulations under section 444.

(a) General rules—(1) Year other than required year. Except as otherwise provided in this section and § 1.444-2T, a partnership, S corporation, or personal service corporation (as defined in § 1.441-3(c)) may make or continue an election (a “section 444 election”) to have a taxable year other than its required taxable year. See paragraph (b) of this section for limitations on the taxable year that may be elected. See § 1.444-2T for rules that generally prohibit a partnership, S corporation, or personal service corporation that is a member of a tiered structure from making or continuing a section 444 election. See § 1.444-3T for rules explaining how and when to make a section 444 election.

(2) Effect of section 444 election—(i) In general. A partnership or S corporation that makes or continues a section 444 election shall file returns and make payments as required by §§ 1.7519-1T and 1.7519-2T. A personal service corporation that makes or continues a section 444 election is subject to the deduction limitation of § 1.280H-1T.

(ii) Duration of section 444 election. A section 444 election shall remain in effect until the election is terminated pursuant to paragraph (a)(5) of this section.

(3) Section 444 election not required for certain years. A partnership, S corporation, or personal service corporation is not required to make a section 444 election to use—

(i) A taxable year for which such entity establishes a business purpose to the satisfaction of the Commissioner (i.e., approved under section 4 or 6 of Rev. Proc. 87-32, 1987-28 I.R.B. 14, or any successor revenue ruling or revenue procedure), or

(ii) A taxable year that is a “grandfathered fiscal year,” within the meaning of section 5.01(2) of Rev. Proc. 87-32 or any successor revenue ruling or revenue procedure.

(4) Required taxable year. For purposes of this section, the term “required taxable year” means the taxable year determined under section 706(b), 1378, or 441(i) without taking into account any taxable year which is allowable either—

(i) By reason of business purpose (i.e., approved under section 4 or 6 of Rev. Proc. 87-32 or any successor revenue ruling or procedure), or

(ii) As a “grandfathered fiscal year” within the meaning of section 5.01(2) of Rev. Proc. 87-32, or any successor revenue ruling or procedure.

(5) Termination of section 444 election—(i) In general. A section 444 election is terminated when—

(A) A partnership, S corporation, or personal service corporation changes to its required taxable year; or

(B) A partnership, S corporation, or personal service corporation liquidates (including a deemed liquidation of a partnership under § 1.708-1 (b)(1)(iv)); or

(C) A partnership, S corporation, or personal service corporation willfully fails to comply with the requirements of section 7519 or 280H, whichever is applicable; or

(D) A partnership, S corporation, or personal service corporation becomes a member of a tiered structure (within the meaning of § 1.444-2T), unless it is a partnership or S corporation that meets the same taxable year exception under § 1.444-2T (e); or

(E) An S corporation's S election is terminated; or

(F) A personal service corporation ceases to be a personal service corporation.

(ii) Effective date of termination. A termination of a section 444 election shall be effective—

(A) In the case of a change to the required year, on the first day of the short year caused by the change;

(B) In the case of a liquidating entity, on the date the liquidation is completed for tax purposes;

(C) In the case of willful failure to comply, on the first day of the taxable year (determined as if a section 444 election had never been made) determined in the discretion of the District Director;

(D) In the case of membership in a tiered structure, on the first day of the taxable year in which the entity is considered to be a member of a tiered structure, or such other taxable year determined in the discretion of the District Director;

(E) In the case of termination of S status, on the first day of the taxable year for which S status no longer exists;

(F) In the case of a personal service corporation that changes status, on the first day of the taxable year, for which the entity is no longer a personal service corporation.

(iii) Example. The provisions of paragraph (a)(5)(ii) of this section may be illustrated by the following example.

(iv) Special rule for entity that liquidates or is sold prior to making a section 444 election, required return, or required payment. A partnership, S corporation, or personal service corporation that is liquidated or sold for tax purposes before a section 444 election, required return, or required payment is made for a particular year may, nevertheless, make or continue a section 444 election, if otherwise qualified. (See §§ 1.7519-2T (a)(2) and 1.7519-1T (a)(3), respectively, for a description of the required return and a definition of the term “required payment.”) However, the partnership, S corporation, or personal service corporation (or a trustee or agent thereof) must comply with the requirements for making or continuing a section 444 election. Thus, if applicable, required payments must be made and a subsequent claim for refund must be made in accordance with § 1.7519-2T(a)(6). The following examples illustrate the application of this paragraph (a)(5)(iv).

(6) Re-activating certain S elections—(i) Certain corporations electing S status that did not make a back-up calendar year request. If a corporation that timely filed Form 2553, Election by a Small Business Corporation, effective for its first taxable year beginning in 1987—

(A) Requested a fiscal year based on business purpose,

(B) Did not agree to use a calendar year in the event its business purpose request was denied, and

(C) Such business purpose request is denied or withdrawn,

(ii) Certain corporations that revoked their S status. If a corporation that used a fiscal year revoked its S election (pursuant to section 1362(d)(1)) for its first taxable year beginning in 1987, such corporation may retroactively re-activate its S election (i.e. rescind its revocation) by making a valid section 444 election for its first taxable year beginning in 1987 and complying with the procedures in paragraph (a)(6)(iii) of this section.

(iii) Procedures for re-activating an S election. A corporation re-activating its S election pursuant to paragraph (a)(6) (i) or (ii) of this section must—

(A) Obtain the consents of all shareholders who have owned stock in the corporation since the first day of the first taxable year of the corporation beginning after December 31, 1986,

(B) Include the following statement at the top of the first page of the corporation's Form 1120S for its first taxable year beginning in 1987—“SECTION 444 ELECTION—RE-ACTIVATES S STATUS,” and

(C) Include the following statement with Form 1120S—“RE-ACTIVATION CONSENTED TO BY ALL SHAREHOLDERS WHO HAVE OWNED STOCK AT ANY TIME SINCE THE FIRST DAY OF THE FIRST TAXABLE YEAR OF THIS CORPORATION BEGINNING AFTER DECEMBER 31, 1986.”

(iv) Examples. The provisions of this paragraph (a)(6) may be illustrated by the following examples.

(b) Limitation on taxable years that may be elected—(1) General rule. Except as provided in paragraphs (b)(2) and (3) of this section, a section 444 election may be made only if the deferral period (as defined in paragraph (b)(4) of this section) of the taxable year to be elected is not longer than three months.

(2) Changes in taxable year—(i) In general. In the case of a partnership, S corporation, or personal service corporation changing its taxable year, such entity may make a section 444 election only if the deferral period of the taxable year to be elected is not longer than the shorter of—

(A) Three months, or

(B) The deferral period of the taxable year that is being changed, as defined in paragraph (b)(2)(iii) of this section.

(ii) Special rule for certain existing corporations electing S status. If a corporation with a taxable year other than the calendar year—

(A) Elected after September 18, 1986, and before January 1, 1988, under section 1362 of the Code to be an S corporation, and

(B) Elected to have the calendar year as the taxable year of the S corporation,

(iii) Deferral period of the taxable year that is being changed. For purposes of paragraph (b)(2)(i)(B) of this section, the phrase “deferral period of the taxable year that is being changed” means the deferral period of the taxable year immediately preceding the taxable year for which the taxpayer desires to make a section 444 election. Furthermore, the deferral period of such year will be determined by using the required taxable year of the taxable year for which the taxpayer desires to make a section 444 election. For example, assume P, a partnership that has historically used a March 31 taxable year, desires to change to a September 30 taxable year by making a section 444 election for its taxable year beginning April 1, 1987. Furthermore, assume that pursuant to paragraph (a)(4) of this section, P's required taxable year for the taxable year beginning April 1, 1987 is a year ending December 31. Based on these facts the deferral period of the taxable year being changed is nine months (the period from March 31 to December 31).

(iv) Examples. See paragraph (d)(1) of this section for examples that illustrate the provisions of this paragraph (b)(2).

(3) Special rule for entities retaining 1986 taxable year. Notwithstanding paragraph (b)(2) of this section, a partnership, S corporation, or personal service corporation may, for its first taxable year beginning after December 31, 1986, if otherwise qualified, make a section 444 election to have a taxable year that is the same as the entity's last taxable year beginning in 1986. See paragraph (d)(2) of this section for examples that illustrate the provisions of this paragraph (b)(3).

(4) Deferral period—(i) Retentions of taxable year. For a partnership, S corporation, or personal service corporation that desires to retain its taxable year by making a section 444 election, the term “deferral period” means the months between the beginning of such year and the close of the first required taxable year (as defined in paragraph (a)(4) of this section). The following example illustrates the application of this paragraph (b)(4)(i).

(ii) Adoptions of and changes in taxable year—(A) In general. For a partnership, S corporation, or personal service corporation that desires to adopt or change its taxable year by making a section 444 election, the term “deferral period” means the months that occur after the end of the taxable year desired under section 444 and before the close of the required taxable year.

(B) Special rule. If a partnership, S corporation or personal service corporation is using the required taxable year as its taxable year, the deferral period is deemed to be zero.

(C) Examples. The provisions of this paragraph (b)(4)(ii) may be illustrated by the following examples.

(5) Miscellaneous rules—(i) Special rule for determining the taxable year of a corporation electing S status. For purposes of this section, and only for purposes of this section, a corporation that elected to be an S corporation for a taxable year beginning in 1987 or 1988 and which elected to be an S corporation prior to September 26, 1988, will not be considered to have adopted or changed its taxable year by virtue of information included on Form 2553, Election by a Small Business Corporation. See Example 8 in paragraph (d) of this section.

(ii) Special procedure for cases where an income tax return is superseded—(A) In general. In the case of a partnership, S corporation, or personal service corporation that filed an income tax return for its first taxable year beginning after December 31, 1986, but subsequently makes a section 444 election that would result in a different year end for such taxable year, the income tax return filed pursuant to the section 444 election will supersede the original return. However, any payments of income tax made with respect to such superseded return will be credited to the taxpayer's superseding return and the taxpayer may file a claim for refund for such payments. See examples (5) and (7) in paragraph (d)(2) of this section.

(B) Procedure for superseding return. In order to allow the Service to process the affected income tax returns in an efficient manner, a partnership, S corporation, or personal service corporation that desires to supersede an income tax return in accordance with paragraph (b)(5)(ii)(A) of this section, should type or legibly print at the top of the first page of the income tax return for the taxable year elected—“SECTION 444 ELECTION—SUPERSEDES PRIOR RETURN.”

(iii) Anti-abuse rule—If an existing partnership, S corporation or personal service corporation (“predecessor entities”), or the owners thereof, transfer assets to a related party and the principal purpose of such transfer is to—

(A) Create a deferral period greater than the deferral period of the predecessor entity's taxable year, or

(B) Make a section 444 election following the termination of the predecessor entity's section 444 election,

(iv) Special rules for partial months and 52-53-week taxable years. Except as otherwise provided in § 1.280H-1T(c)(2)(i)(A), for purposes of this section and §§ 1.7519-1T, 1.7519-2T and 1.280H-1T—

(A) A month of less than 16 days is disregarded, and a month of more than 15 days is treated as a full month; and

(B) A 52-53-week taxable year with reference to the end of a particular month will be considered to be the same as a taxable year ending with reference to the last day of such month.

(c) Effective date. This section is effective for taxable years beginning after December 31, 1986.

(d) Examples—(1) Changes in taxable year. The following examples illustrate the provisions of paragraph (b)(2) of this section.

(2) Special rule for entities retaining their 1986 taxable year. The following examples illustrate the provisions of paragraph (b)(3) of this section.

(a) General rule. Except as provided in paragraph (e) of this section, no section 444 election shall be made or continued with respect to a partnership, S corporation, or personal service corporation that is a member of a tiered structure on the date specified in paragraph (d) of this section. For purposes of this section, the term “personal service corporation” means a personal service corporation as defined in § 1.441-3(c).

(b) Definition of a member of a tiered structure—(1) In general. A partnership, S corporation, or personal service corporation is considered a member of a tiered structure if—

(i) The partnership, S corporation, or personal service corporation directly owns any portion of a deferral entity, or

(ii) A deferral entity directly owns any portion of the partnership, S corporation, or personal service corporation.

(2) Deferral entity—(i) In general. For purposes of this section, the term “deferral entity” means an entity that is a partnership, S corporation, personal service corporation, or trust. In the case of an affiliated group of corporations filing a consolidated income tax return that is treated as a personal service corporation pursuant to § 1.441-4T (i), such affiliated group is considered to be a single deferral entity.

(ii) Grantor trusts. The term “deferral entity” does not include a trust (or a portion of a trust) which is treated as owned by the grantor or beneficiary under Subpart E, part I, subchapter J, chapter 1, of the Code (relating to grantor trusts), including a trust that is treated as a grantor trust pursuant to section 1361(d)(1)(A) of the Code (relating to qualified subchapter S trusts). Thus, any taxpayer treated under subpart E as owning a portion of a trust shall be treated as owning the assets of the trust attributable to that ownership. The following examples illustrate the provisions of this paragraph (b)(2)(ii).

(3) Anti-abuse rule. Notwithstanding paragraph (b)(1) of this section, a partnership, S corporation, or personal service corporation is considered a member of a tiered structure if the partnership, S corporation, personal service corporation, or related taxpayers have organized or reorganized their ownership structure or operations for the principal purpose of obtaining a significant unintended tax benefit from making or continuing a section 444 election. For purposes of the preceding sentence, a significant unintended tax benefit results when a partnership, S corporation, or personal service corporation makes a section 444 election and, as a result, a taxpayer (not limited to the entity making the election) obtains a significant deferral of income substantially all of which is not eliminated by a required payment under section 7519. See examples (15) through (19) in paragraph (f) of this section.

(c) De minimis rules—(1) In general. For rules relating to a de minimis exception to paragraph (b)(1)(i) of this section (the “downstream de minimis rule”), see paragraph (c)(2) of this section. For rules relating to a de minimis exception to paragraph (b)(1)(ii) of this section (the “upstream de minimis rule”), see paragraph (c)(3) of this section. For rules relating to the interaction of the de minimis rules provided in this paragraph (c) and the “same taxable year exception” provided in paragraph (e) of this section, see paragraph (e)(5) of this section.

(2) Downstream de minimis rule—(i) General rule. If a partnership, S corporation, or personal service corporation directly owns any portion of one or more deferral entities as of the date specified in paragraph (d) of this section, such ownership is disregarded for purposes of paragraph (b)(1)(i) of this section if, in the aggregate, all such deferral entities accounted for—

(A) Not more than 5 percent of the partnership's, S corporation's, or personal service corporation's adjusted taxable income for the testing period (“5 percent adjusted taxable income test”), or

(B) Not more than 2 percent of the partnership's, S corporation's, or personal service corporation's gross income for the testing period (“2 percent gross income test”). See section 702 (c) for rules relating to the determination of gross income of a partner in a partnership.

(ii) Definition of testing period. For purposes of this paragraph (c)(2), the term “testing period” means the taxable year that ends immediately prior to the taxable year for which the partnership, S corporation, or personal service corporation desires to make or continue a section 444 election. However, see the special rules provided in paragraph (c)(2)(iv) of this section for certain special cases (e.g., the partnership, S corporation, personal service corporation or deferral entity was not in existence during the entire testing period). The following example illustrates the application of this paragraph (c)(2)(ii).

(iii) Definition of adjusted taxable income—(A) Partnership. In the case of a partnership, adjusted taxable income for purposes of paragraph (c)(2) of this section is an amount equal to the sum of the—

(1) Aggregate amount of the partnership items described in section 702(a) (other than credits and tax-exempt income),

(2) Applicable payments defined in section 7519(d)(3) that are deducted in determining the amount described in paragraph (c)(2)(iii)(A)(1) of this section, and

(3) Guaranteed payments defined in section 707(c) that are deducted in determining the amount described in paragraph (c)(2)(iii)(A)(1) of this section and are not otherwise included in paragraph (c)(2)(iii)(A)(2) of this section. For purposes of determining the aggregate amount of partnership items under paragraph (c)(2)(iii)(A)(1) of this section, deductions and losses are treated as negative income. Thus, for example, if under section 702(a) a partnership has $1,000 of ordinary taxable income, $500 of specially allocated deductions, and $300 of capital loss, the partnership's aggregate amount of partnership items under paragraph (c)(2)(iii)(A)(1) of this section is $200 ($1,000-$500-$300).

(B) S corporation. In the case of an S corporation, adjusted taxable income for purposes of paragraph (c)(2) of this section is an amount equal to the sum of the—

(1) Aggregate amount of the S corporation items described in section 1366(a) (other than credits and tax-exempt income), and

(2) Applicable payments defined in section 7519(d)(3) that are deducted in determining the amount described in paragraph (c)(2)(iii)(B)(1) of this section.

(C) Personal service corporation. In the case of a personal service corporation, adjusted taxable income for purposes of paragraph (c)(2) of this section is an amount equal to the sum of the—

(1) Taxable income of the personal service corporation, and

(2) Applicable amounts defined in section 280H(f)(1) that are deducted in determining the amount described in paragraph (c)(2)(iii)(C)(1) of this section.

(iv) Special rules—(A) Pro-forma rule. Except as provided in paragraph (c)(iv)(C)(2) of this section, if a partnership, S corporation, or personal service corporation directly owns any interest in a deferral entity as of the date specified in paragraph (d) of this section and such ownership interest is different in amount from the partnership's, S corporation's, or personal service corporation's interest on any day during the testing period, the 5 percent adjusted taxable income test and the 2 percent gross income test must be applied on a pro-forma basis (i.e., adjusted taxable income and gross income must be calculated for the testing period assuming that the partnership, S corporation, or personal service corporation owned the same interest in the deferral entity that it owned as of the date specified in paragraph (d) of this section). The following example illustrates the application of this paragraph (c)(2)(iv)(A).

(B) Reasonable estimates allowed. If the information necessary to complete the pro-forma calculation described in paragraph (c)(2)(iv)(A) of this section is not readily available, the partnership, S corporation, or personal service corporation may make a reasonable estimate of such information.

(C) Newly formed entities—(1) Newly formed deferral entities. If a partnership, S corporation, or personal service corporation owns any portion of a deferral entity on the date specified in paragraph (d) of this section and such deferral entity was not in existence during the entire testing period (hereinafter referred to as a “newly formed deferral entity”), both the 5 percent adjusted taxable income test and the 2 percent gross income test are modified as follows. First, the partnership, S corporation, or personal service corporation shall calculate the percentage of its adjusted taxable income or gross income that is attributable to deferral entities, excluding newly formed deferral entities. Second, the partnership, S corporation, or personal service corporation shall calculate (on the date specified in paragraph (d) of this section) the percentage of the tax basis of its assets that are attributable to its tax basis with respect to its ownership interests in all newly formed deferral entities. If the sum of the two percentages is 5 percent or less, the deferral entities are considered de minimis and are disregarded for purposes of paragraph (b)(1)(i) of this section. If the sum of the two percentages is greater than 5 percent, the deferral entities do not qualify for the de minimis rule provided in paragraph (c)(2) of this section and thus the partnership, S corporation, or personal service corporation is considered to be a member of a tiered structure for purposes of this section.

(2) Newly formed partnership, S corporation, or personal service corporation desiring to make a section 444 election. If a partnership, S corporation, or personal service corporation desires to make a section 444 election for the first taxable year of its existence, the 5 percent adjusted taxable income test and the 2 percent gross income test are replaced by a 5 percent of assets test. Thus, if on the date specified in paragraph (d) of this section, 5 percent or less of the assets (measured by reference to the tax basis of the assets) of the newly formed partnership, S corporation, or personal service corporation are attributable to the tax basis with respect to its ownership interests in the deferral entities, the deferral entities will be considered de minimis and will be disregarded for purposes of paragraph (b)(1)(i) of this section.

(3) Upstream de minimis rule. If a partnership, S corporation, or personal service corporation is directly owned by one or more deferral entities as of the date specified in paragraph (d) of this section, such ownership is disregarded for purposes of paragraph (b)(1)(ii) of this section if on the date specified in paragraph (d) of this section the deferral entities directly own, in the aggregate, 5 percent or less of—

(i) An interest in the current profits of the partnership, or

(ii) The stock (measured by value) of the S corporation or personal service corporation.

(d) Date for determining the existence of a tiered structure—(1) General rule. For purposes of paragraph (a) of this section, a partnership, S corporation, or personal service corporation will be considered a member of a tiered structure for a particular taxable year if the partnership, S corporation, or personal service corporation is a member of a tiered structure on the last day of the required taxable year (as defined in section 444 (e) of the Code) ending within such year. If a particular taxable year does not include the last day of the required taxable year for such year, the partnership, S corporation, or personal service corporation will not be considered a member of a tiered structure for such year. The following examples illustrate the application of this paragraph (d)(1).

(2) Special rule for taxable years beginning in 1987. For purposes of paragraph (a) of this section, a partnership, S corporation, or personal service corporation will not be considered a member of a tiered structure for a taxable year beginning in 1987 if the partnership, S corporation, or personal service corporation is not a member of a tiered structure on the day the partnership, S corporation, or personal service corporation timely files its section 444 election for such year. The following examples illustrate the application of this paragraph (d)(2).

(e) Same taxable year exception—(1) In general. Although a partnership or S corporation is a member of a tiered structure as of the date specified in paragraph (d) of this section, the partnership, S corporation may make or continue a section 444 election if the tiered structure (as defined in paragraph (e)(2) of this section) consists entirely of partnerships or S corporations (or both), all of which have the same taxable year as determined under paragraph (e)(3) of this section. However, see paragraph (e)(5) of this section for the interaction of the de minimis rules provided in paragraph (c) of this section with the same taxable year exception. For purposes of this paragraph (e), two or more entities are considered to have the same taxable year if their taxable years end on the same day, even though they begin on different days. See examples (8) through (14) in paragraph (f) of this section.

(2) Definition of tiered structure—(i) General rule. For purposes of the same taxable year exception, the members of a tiered structure are defined to include the following entities—

(A) The partnership or S corporation that desires to qualify for the same taxable year exception,

(B) A deferral entity (or entities) directly owned (in whole or in part) by the partnership or S corporation that desires to qualify for the same taxable year exception,

(C) A deferral entity (or entities) directly owning any portion of the partnership or S corporation that desires to qualify for the same taxable year exception, and

(D) A deferral entity (or entities) directly owned (in whole or in part) by a “downstream controlled partnership,” as defined in paragraph (e)(2)(ii) of this section.

(ii) Special flow-through rule for downstream controlled partnerships. If more than 50 percent of a partnership's profits and capital are owned by a partnership or S corporation that desires to qualify for the same taxable year exception, such owned partnership is considered a downstream controlled partnership for purposes of paragraph (e)(2)(i) of this section. Furthermore, if more than 50 percent of a partnership's profits and capital are owned by a downstream controlled partnership, such owned partnership is considered a downstream controlled partnership for purposes of paragraph (e)(2)(i) of this section.

(3) Determining the taxable year of a partnership or S corporation. The taxable year of a partnership or S corporation to be taken into account for purposes of paragraph (e)(1) of this section is the taxable year ending with or prior to the date specified in paragraph (d) of this section. Furthermore, the determination of such taxable year will take into consideration any section 444 elections made by the partnership or S corporation. See examples (10) and (11) in paragraph (f) of this section.

(4) Special rule for 52-53-week taxable years. For purposes of this paragraph (e), a 52-53-week taxable year with reference to the end of a particular month will be considered to be the same as a taxable year ending with reference to the last day of such month.

(5) Interaction with de minimis rules—(i) Downstream de minimis rule—(A) In general. If a partnership or S corporation that desires to make or continue a section 444 election is a member of a tiered structure (as defined in paragraph (e)(2) of this section) and directly owns any member (or members) of the tiered structure with a taxable year different from the taxable year of the partnership or S corporation, such ownership is disregarded for purposes of the same taxable year exception of paragraph (e)(1) of this section provided that, in the aggregate, the de minimis rule of paragraph (c)(2) of this section is satisfied with respect to such owned member (or members). The following example illustrates the application of this paragraph (e)(5)(i)(A).

(B) Special rule for members of a tiered structure directly owned by a downstream controlled partnership. For purposes of paragraph (e)(5)(i)(A) of this section, a partnership or S corporation desiring to make or continue a section 444 election is considered to directly own any member of the tiered structure (as defined in paragraph (e)(2) of this section) directly owned by a downstream controlled partnership (as defined in paragraph (e)(2)(ii) of this section). The adjusted taxable income or gross income of the partnership or S corporation that is attributable to a member of a tiered structure directly owned by a downstream controlled partnership equals the adjusted taxable income or gross income of such member multiplied by the partnership's or S corporation's indirect ownership percentage of such member. The following example illustrates the application of this paragraph (e)(5)(i)(B).

(ii) Upstream de minimis rule. If a partnership or S corporation that desires to make or continue a section 444 election is a member of a tiered structure (as defined in paragraph (e)(2) of this section) and is owned directly by a member (or members) of the tiered structure with taxable years different from the taxable year of the partnership or S corporation, such ownership is disregarded for purposes of the same taxable year exception of paragraph (e)(1) of this section provided that, in the aggregate, the de minimis rule of paragraph (c)(3) of this section is satisfied with respect to such owning member (or members). See Example 12 of paragraph (f) of this section.

(f) Examples. The provisions of this section may be illustrated by the following examples.

(g) Effective date. This section is effective for taxable years beginning after December 31, 1986.

(a) In general. A section 444 election shall be made in the manner and at the time provided in this section.

(b) Manner and time of making election—(1) General rule. A section 444 election shall be made by filing a properly prepared Form 8716, “Election to Have a Tax Year Other Than a Required Tax Year,” with the Service Center indicated by the instructions to Form 8716. Except as provided in paragraphs (b) (2) and (4) of this section, Form 8716 must be filed by the earlier of—

(i) The 15th day of the fifth month following the month that includes the first day of the taxable year for which the election will first be effective, or

(ii) The due date (without regard to extensions) of the income tax return resulting from the section 444 election.

(2) Special extension of time for making an election. If, pursuant to paragraph (b)(1) of this section, the due date for filing Form 8716 is prior to July 26, 1988, such date is extended to July 26, 1988. The provisions of this paragraph (b)(2) may be illustrated by the following examples.

(3) Corporation electing to be an S corporation—(i) In general. A corporation electing to be an S corporation is subject to the same time and manner rules for filing Form 8716 as any other taxpayer making a section 444 election. Thus, a corporation electing to be an S corporation that desires to make a section 444 election is not required to file Form 8716 with its Form 2553, “Election by a Small Business Corporation.” However, a corporation electing to be an S corporation after September 26, 1988, is required to state on Form 2553 its intention to—

(A) Make a section 444 election, if qualified, or

(B) Make a “back-up section 444 election” as described in paragraph (b)(4) of this section.

(ii) Examples. The provisions of this paragraph (b)(3) may be illustrated by the following examples.

(4) Back-up section 444 election—(i) General rule. A taxpayer that has requested (or is planning to request) permission to use a particular taxable year based upon business purpose, may, if otherwise qualified, file a section 444 election (referred to as a “back-up section 444 election”). If the Commissioner subsequently denies the business purpose request, the taxpayer will, if otherwise qualified, be required to activate the back-up section 444 election. See examples (1) and (2) in paragraph (b)(4)(iv) of this section.

(ii) Procedures for making a back-up section 444 election. In addition to following the general rules provided in this section, a taxpayer making a back-up section 444 election should, in order to allow the Service to process the affected returns in an efficient manner, type or legibly print the words “BACK-UP ELECTION” at the top of Form 8716, “Election to Have a Tax Year Other Than a Required Tax Year.” However, if such Form 8716 is filed on or after the date a Form 1128, Application for Change in Accounting Period, is filed with respect to a period that begins on the same date, the words “FORM 1128 BACK-UP ELECTION” should be typed or legibly printed at the top of Form 8716.

(iii) Procedures for activating a back-up section 444 election—(A) Partnerships and S corporations—(1) In general. A back-up section 444 election made by a partnership or S corporation is activated by filing the return required in § 1.7519-2T (a)(2)(i) and making the payment required in § 1.7519-1T. The due date for filing such return and payment will be the later of—

(i) The due dates provided in § 1.7519-2T, or

(ii) 60 days from the date the Commissioner denies the business purpose request.

(2) Special rule if Form 720 used to satisfy return requirement. If, pursuant to § 1.7519-2T (a)(3), a partnership or S corporation must use Form 720, “Quarterly Federal Excise Tax Return,” to satisfy the return requirement of § 1.7519-2T (a)(2), then in addition to following the general rules provided in § 1.7519-2T, the partnership or S corporation must type or legibly print the words “ACTIVATING BACK-UP ELECTION” on the top of Form 720. A partnership or S corporation that would otherwise file a Form 720 on or before the date specified in paragraph (b)(4)(iii)(A)(1) of this section may satisfy the return requirement by including the necessary information on such Form 720. Alternatively, such partnership or S corporation may file an additional Form 720 (i.e., a Form 720 separate from the Form 720 it would otherwise file). Thus, for example, if the due date for activating an S corporation's back-up election is November 15, 1988, and the S corporation must file a Form 720 by October 31, 1988, to report manufacturers excise tax for the third quarter of 1988, the S corporation may use that Form 720 to activate its back-up election. Alternatively, the S corporation may file its regular Form 720 that is due October 31, 1988, and file an additional Form 720 by November 15, 1988, activating its back-up election.

(B) Personal service corporations. A back-up section 444 election made by a personal service corporation is activated by filing Form 8716 with the personal service corporation's original or amended income tax return for the taxable year in which the election is first effective, and typing or legibly printing the words—“ACTIVATING BACK-UP ELECTION” on the top of such income tax return.

(iv) Examples. The provisions of this paragraph (b)(4) may be illustrated by the following examples. Also see Example 2 in paragraph (b)(3) of this section.

(c) Administrative relief—(1) Extension of time to file income tax returns—(i) Automatic extension. If a partnership, S corporation, or personal service corporation makes a section 444 election (or does not make a section 444 election, either because it is ineligible or because it decides not to make the election, and therefore changes to its required taxable year) for its first taxable year beginning after December 31, 1986, the due date for filing its income tax return for such year shall be the later of—

(A) The due date established under—

(1) Section 6072, in the case of Form 1065,

(2) § 1.6037-1 (b), in the case of Form 1120S,

(3) Section 6072 (b), in the case of other Form 1120 series form; or

(B) August 15, 1988.

(ii) Additional extensions. If the due date of the income tax return for the first taxable year beginning after December 31, 1986, extended as provided in paragraph (c)(1)(i)(B) of this section, occurs before the date that is 6 months after the date specified in paragraph (c)(1)(i)(A) of this section, the partnership, S corporation, or personal service corporation may request an additional extension or extensions of time (up to 6 months after the date specified in paragraph (c)(1)(i)(A) of this section) to file its income tax return for such first taxable year. The request must be made by the later of the date specified in paragraph (c)(1)(i)(A) or (c)(1)(i)(B) of this section and must be made on Form 7004, “Application for Automatic Extension of Time To File Corporation Income Tax Return”, or Form 2758, “Application for Extension of Time to File U.S. Partnership, Fiduciary, and Certain Other Returns,” whichever is applicable, in accordance with the form and its instructions. In addition, the following words should be typed or legibly printed at the top of the form—“SECTION 444 REQUEST FOR ADDITIONAL EXTENSION.”

(iii) Examples. The provisions of paragraph (c)(1) of this section may be illustrated by the following examples.

(2) No penalty for certain late payments—(i) In general. In the case of a personal service corporation or S corporation described in paragraph (c)(1)(i) of this section, no penalty under section 6651 (a)(2) will be imposed for failure to pay income tax (if any) for the first taxable year beginning after December 31, 1986, but only for the period beginning with the last date for payment and ending with the later of the date specified in paragraph (c)(1)(i) or paragraph (c)(1)(ii) of this section.

(ii) Example. The provisions of paragraph (c)(2)(i) of this section may be illustrated by the following example.

(d) Effective date. This section is effective for taxable years beginning after December 31, 1986.

(a) Electing small business trusts. For purposes of § 1.444-2T, solely with respect to an S corporation shareholder, the term deferral entity does not include a trust that is treated as an electing small business trust under section 1361(e). An S corporation with an electing small business trust as a shareholder may make an election under section 444. This paragraph is applicable to taxable years beginning on and after December 29, 2000; however, taxpayers may voluntarily apply it to taxable years of S corporations beginning after December 31, 1996.

(b) Certain tax-exempt trusts. For purposes of § 1.444-2T, solely with respect to an S corporation shareholder, the term deferral entity does not include a trust that is described in section 401(a) or 501(c)(3), and is exempt from taxation under section 501(a). An S corporation with a trust as a shareholder that is described in section 401(a) or section 501(c)(3), and is exempt from taxation under section 501(a) may make an election under section 444. This paragraph is applicable to taxable years beginning on and after December 29, 2000; however taxpayers may voluntarily apply it to taxable years of S corporations beginning after December 31, 1997.

(c) Certain terminations disregarded—(1) In general. An S corporation that is described in this paragraph (c)(1) may request that a termination of its election under section 444 be disregarded, and that the S corporation be permitted to resume use of the year it previously elected under section 444, by following the procedures of paragraph (c)(2) of this section. An S corporation is described in this paragraph if the S corporation is otherwise qualified to make a section 444 election, and its previous election was terminated under § 1.444-2T(a) solely because—

(i) In the case of a taxable year beginning after December 31, 1996, a trust that is treated as an electing small business trust became a shareholder of such S corporation; or

(ii) In the case of a taxable year beginning after December 31, 1997, a trust that is described in section 401(a) or 501(c)(3), and is exempt from taxation under section 501(a) became a shareholder of such S corporation.

(2) Procedure—(i) In general. An S corporation described in paragraph (c)(1) of this section that wishes to make the request described in paragraph (c)(1) of this section must do so by filing Form 8716, “Election To Have a Tax Year Other Than a Required Tax Year,” and typing or printing legibly at the top of such form—“CONTINUATION OF SECTION 444 ELECTION UNDER § 1.444-4.” In order to assist the Internal Revenue Service in updating the S corporation's account, on Line 5 the Box “Changing to” should be checked. Additionally, the election month indicated must be the last month of the S corporation's previously elected section 444 election year, and the effective year indicated must end in 2002.

(ii) Time and place for filing Form 8716. Such form must be filed on or before October 15, 2002, with the service center where the S corporation's returns of tax (Forms 1120S) are filed. In addition, a copy of the Form 8716 should be attached to the S corporation's short period Federal income tax return for the first election year beginning on or after January 1, 2002.

(3) Effect of request—(i) Taxable years beginning on or after January 1, 2002. An S corporation described in paragraph (c)(1) of this section that requests, in accordance with this paragraph, that a termination of its election under section 444 be disregarded will be permitted to resume use of the year it previously elected under section 444, commencing with its first taxable year beginning on or after January 1, 2002. Such S corporation will be required to file a return under § 1.7519-2T for each taxable year beginning on or after January 1, 2002. No payment under section 7519 will be due with respect to the first taxable year beginning on or after January 1, 2002. However, a required payment will be due on or before May 15, 2003, with respect to such S corporation's second continued section 444 election year that begins in calendar year 2002.

(ii) Taxable years beginning prior to January 1, 2002. An S corporation described in paragraph (c)(1) of this section that requests, in accordance with this paragraph, that a termination of its election under section 444 be disregarded will not be required to amend any prior Federal income tax returns, make any required payments under section 7519, or file any returns under § 1.7519-2T, with respect to taxable years beginning on or after the date the termination of its section 444 election was effective and prior to January 1, 2002.

(iii) Section 7519: required payments and returns. The Internal Revenue Service waives any requirement for an S corporation described in paragraph (c)(1) of this section to file the federal tax returns and make any required payments under section 7519 for years prior to the taxable year of continuation as described in paragraph (c)(3)(i) of this section, if for such years the S corporation filed its federal income tax returns on the basis of its required taxable year.

(a) General rule. (1) Section 446(a) provides that taxable income shall be computed under the method of accounting on the basis of which a taxpayer regularly computes his income in keeping his books. The term “method of accounting” includes not only the overall method of accounting of the taxpayer but also the accounting treatment of any item. Examples of such over-all methods are the cash receipts and disbursements method, an accrual method, combinations of such methods, and combinations of the foregoing with various methods provided for the accounting treatment of special items. These methods of accounting for special items include the accounting treatment prescribed for research and experimental expenditures, soil and water conservation expenditures, depreciation, net operating losses, etc. Except for deviations permitted or required by such special accounting treatment, taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. For requirement respecting the adoption or change of accounting method, see section 446(e) and paragraph (e) of this section.

(2) It is recognized that no uniform method of accounting can be prescribed for all taxpayers. Each taxpayer shall adopt such forms and systems as are, in his judgment, best suited to his needs. However, no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. A method of accounting which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income, provided all items of gross income and expense are treated consistently from year to year.

(3) Items of gross income and expenditures which are elements in the computation of taxable income need not be in the form of cash. It is sufficient that such items can be valued in terms of money. For general rules relating to the taxable year for inclusion of income and for taking deductions, see sections 451 and 461, and the regulations thereunder.

(4) Each taxpayer is required to make a return of his taxable income for each taxable year and must maintain such accounting records as will enable him to file a correct return. See section 6001 and the regulations thereunder. Accounting records include the taxpayer's regular books of account and such other records and data as may be necessary to support the entries on his books of account and on his return, as for example, a reconciliation of any differences between such books and his return. The following are among the essential features that must be considered in maintaining such records:

(i) Except in the case of a taxpayer qualifying as a small business taxpayer for the taxable year under section 471(c), in all cases in which the production, purchase or sale of merchandise of any kind is an income-producing factor, merchandise on hand (including finished goods, work in progress, raw materials, and supplies) at the beginning and end of the year shall be taken into account in computing the taxable income of the year. (For rules relating to computation of inventories, see section 263A, 471, and 472 and the regulations thereunder.)

(ii) Expenditures made during the year shall be properly classified as between capital and expense. For example, expenditures for such items as plant and equipment, which have a useful life extending substantially beyond the taxable year, shall be charged to a capital account and not to an expense account.

(iii) In any case in which there is allowable with respect to an asset a deduction for depreciation, amortization, or depletion, any expenditures (other than ordinary repairs) made to restore the asset or prolong its useful life shall be added to the asset account or charged against the appropriate reserve.

(b) Exceptions. (1) If the taxpayer does not regularly employ a method of accounting which clearly reflects his income, the computation of taxable income shall be made in a manner which, in the opinion of the Commissioner, does clearly reflect income.

(2) A taxpayer whose sole source of income is wages need not keep formal books in order to have an accounting method. Tax returns, copies thereof, or other records may be sufficient to establish the use of the method of accounting used in the preparation of the taxpayer's income tax returns.

(c) Permissible methods—(1) In general. Subject to the provisions of paragraphs (a) and (b) of this section, a taxpayer may compute his taxable income under any of the following methods of accounting:

(i) Cash receipts and disbursements method. Generally, under the cash receipts and disbursements method in the computation of taxable income, all items which constitute gross income (whether in the form of cash, property, or services) are to be included for the taxable year in which actually or constructively received. Expenditures are to be deducted for the taxable year in which actually made. For rules relating to constructive receipt, see § 1.451-2. For treatment of an expenditure attributable to more than one taxable year, see section 461(a) and paragraph (a)(1) of § 1.461-1.

(ii) Accrual method. (A) Generally, under an accrual method, income is to be included for the taxable year when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. (See § 1.451-1 for rules relating to the taxable year of inclusion.) Under such a method, a liability is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. (See paragraph (a)(2)(iii)(A) of § 1.461-1 for examples of liabilities that may not be taken into account until after the taxable year incurred, and see §§ 1.461-4 through 1.461-6 for rules relating to economic performance.) Applicable provisions of the Code, the Income Tax Regulations, and other guidance published by the Secretary prescribe the manner in which a liability that has been incurred is taken into account. For example, section 162 provides that a deductible liability generally is taken into account in the taxable year incurred through a deduction from gross income. As a further example, under section 263 or 263A, a liability that relates to the creation of an asset having a useful life extending substantially beyond the close of the taxable year is taken into account in the taxable year incurred through capitalization (within the meaning of § 1.263A-1(c)(3)) and may later affect the computation of taxable income through depreciation or otherwise over a period including subsequent taxable years, in accordance with applicable Internal Revenue Code sections and related guidance.

(B) The term “liability” includes any item allowable as a deduction, cost, or expense for Federal income tax purposes. In addition to allowable deductions, the term includes any amount otherwise allowable as a capitalized cost, as a cost taken into account in computing cost of goods sold, as a cost allocable to a long-term contract, or as any other cost or expense. Thus, for example, an amount that a taxpayer expends or will expend for capital improvements to property must be incurred before the taxpayer may take the amount into account in computing its basis in the property. The term “liability” is not limited to items for which a legal obligation to pay exists at the time of payment. Thus, for example, amounts prepaid for goods or services and amounts paid without a legal obligation to do so may not be taken into account by an accrual basis taxpayer any earlier than the taxable year in which those amounts are incurred.

(C) No method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. The method used by the taxpayer in determining when income is to be accounted for will generally be acceptable if it accords with generally accepted accounting principles, is consistently used by the taxpayer from year to year, and is consistent with the Income Tax Regulations. For example, a taxpayer engaged in a manufacturing business may account for sales of the taxpayer's product when the goods are shipped, when the product is delivered or accepted, or when title to the goods passes to the customers, whether or not billed, depending on the method regularly employed in keeping the taxpayer's books.

(iii) Other permissible methods. Special methods of accounting are described elsewhere in chapter 1 of the Code and the regulations thereunder. For example, see the following sections and the regulations thereunder: Sections 61 and 162, relating to the crop method of accounting; section 453, relating to the installment method; section 460, relating to the long-term contract methods. In addition, special methods of accounting for particular items of income and expense are provided under other sections of chapter 1. For example, see section 174, relating to research and experimental expenditures, and section 175, relating to soil and water conservation expenditures.

(iv) Combinations of the foregoing methods. (a) In accordance with the following rules, any combination of the foregoing methods of accounting will be permitted in connection with a trade or business if such combination clearly reflects income and is consistently used. Where a combination of methods of accounting includes any special methods, such as those referred to in subdivision (iii) of this subparagraph, the taxpayer must comply with the requirements relating to such special methods. A taxpayer using an accrual method of accounting with respect to purchases and sales may use the cash method in computing all other items of income and expense. However, a taxpayer who uses the cash method of accounting in computing gross income from his trade or business shall use the cash method in computing expenses of such trade or business. Similarly, a taxpayer who uses an accrual method of accounting in computing business expenses shall use an accrual method in computing items affecting gross income from his trade or business.

(b) A taxpayer using one method of accounting in computing items of income and deductions of his trade or business may compute other items of income and deductions not connected with his trade or business under a different method of accounting.

(2) Special rules. (i) In any case in which it is necessary to use an inventory, the accrual method of accounting must be used with regard to purchases and sales unless:

(A) The taxpayer qualifies as a small business taxpayer for the taxable year under section 471(c), or

(B) Otherwise authorized under paragraph (c)(2)(ii) of this section.

(ii) No method of accounting will be regarded as clearly reflecting income unless all items of gross profit and deductions are treated with consistency from year to year. The Commissioner may authorize a taxpayer to adopt or change to a method of accounting permitted by this chapter although the method is not specifically described in the regulations in this part if, in the opinion of the Commissioner, income is clearly reflected by the use of such method. Further, the Commissioner may authorize a taxpayer to continue the use of a method of accounting consistently used by the taxpayer, even though not specifically authorized by the regulations in this part, if, in the opinion of the Commissioner, income is clearly reflected by the use of such method. See section 446(a) and paragraph (a) of this section, which require that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books, and section 446(e) and paragraph (e) of this section, which require the prior approval of the Commissioner in the case of changes in accounting method.

(iii) The timing rules of § 1.1502-13 are a method of accounting for intercompany transactions (as defined in § 1.1502-13(b)(1)(i)), to be applied by each member of a consolidated group in addition to the member's other methods of accounting. See § 1.1502-13(a)(3)(i). This paragraph (c)(2)(iii) is applicable to consolidated return years beginning on or after November 7, 2001.

(3) Applicability date. The first sentence of paragraph (a)(4)(i) of this section and paragraph (c)(2)(i) of this section apply to taxable years beginning on or after January 5, 2021. However, for a taxable year beginning after December 31, 2017, and before January 5, 2021, a taxpayer may apply the rules provided in the first sentence of this paragraph (c)(3), provided that the taxpayer follows all the applicable rules contained in the regulations under section 446 for such taxable year and all subsequent taxable years.

(d) Taxpayer engaged in more than one business. (1) Where a taxpayer has two or more separate and distinct trades or businesses, a different method of accounting may be used for each trade or business, provided the method used for each trade or business clearly reflects the income of that particular trade or business. For example, a taxpayer may account for the operations of a personal service business on the cash receipts and disbursements method and of a manufacturing business on an accrual method, provided such businesses are separate and distinct and the methods used for each clearly reflect income. The method first used in accounting for business income and deductions in connection with each trade or business, as evidenced in the taxpayer's income tax return in which such income or deductions are first reported, must be consistently followed thereafter.

(2) No trade or business will be considered separate and distinct for purposes of this paragraph unless a complete and separable set of books and records is kept for such trade or business.

(3) If, by reason of maintaining different methods of accounting, there is a creation or shifting of profits or losses between the trades or businesses of the taxpayer (for example, through inventory adjustments, sales, purchases, or expenses) so that income of the taxpayer is not clearly reflected, the trades or businesses of the taxpayer will not be considered to be separate and distinct.

(e) Requirement respecting the adoption or change of accounting method. (1) A taxpayer filing his first return may adopt any permissible method of accounting in computing taxable income for the taxable year covered by such return. See section 446(c) and paragraph (c) of this section for permissible methods. Moreover, a taxpayer may adopt any permissible method of accounting in connection with each separate and distinct trade or business, the income from which is reported for the first time. See section 446(d) and paragraph (d) of this section. See also section 446(a) and paragraph (a) of this section.

(2)(i) Except as otherwise expressly provided in chapter 1 of the Code and the regulations thereunder, a taxpayer who changes the method of accounting employed in keeping his books shall, before computing his income upon such new method for purposes of taxation, secure the consent of the Commissioner. Consent must be secured whether or not such method is proper or is permitted under the Internal Revenue Code or the regulations thereunder.

(ii) (a) A change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. Although a method of accounting may exist under this definition without the necessity of a pattern of consistent treatment of an item, in most instances a method of accounting is not established for an item without such consistent treatment. A material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. Changes in method of accounting include a change from the cash receipts and disbursement method to an accrual method, or vice versa, a change involving the method or basis used in the valuation of inventories (see sections 471 and 472 and the regulations under sections 471 and 472), a change from the cash or accrual method to a long-term contract method, or vice versa (see § 1.460-4), certain changes in computing depreciation or amortization (see paragraph (e)(2)(ii)(d) of this section), a change involving the adoption, use or discontinuance of any other specialized method of computing taxable income, such as the crop method, and a change where the Internal Revenue Code and regulations under the Internal Revenue Code specifically require that the consent of the Commissioner must be obtained before adopting such a change.

(b) A change in method of accounting does not include correction of mathematical or posting errors, or errors in the computation of tax liability (such as errors in computation of the foreign tax credit, net operating loss, percentage depletion, or investment credit). Also, a change in method of accounting does not include adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction. For example, corrections of items that are deducted as interest or salary, but that are in fact payments of dividends, and of items that are deducted as business expenses, but that are in fact personal expenses, are not changes in method of accounting. In addition, a change in the method of accounting does not include an adjustment with respect to the addition to a reserve for bad debts. Although such adjustment may involve the question of the proper time for the taking of a deduction, such items are traditionally corrected by adjustment in the current and future years. For the treatment of the adjustment of the addition to a bad debt reserve (for example, for banks under section 585 of the Internal Revenue Code), see the regulations under section 166 of the Internal Revenue Code. A change in the method of accounting also does not include a change in treatment resulting from a change in underlying facts. For further guidance on changes involving depreciable or amortizable assets, see paragraph (e)(2)(ii)(d) of this section and § 1.1016-3(h).

(c) A change in an overall plan or system of identifying or valuing items in inventory is a change in method of accounting. Also a change in the treatment of any material item used in the overall plan for identifying or valuing items in inventory is a change in method of accounting.

(d) Changes involving depreciable or amortizable assets—(1) Scope. This paragraph (e)(2)(ii)(d) applies to property subject to section 167, 168, 197, 1400I, 1400L(c), to section 168 prior to its amendment by the Tax Reform Act of 1986 (100 Stat. 2121) (former section 168), or to an additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d)).

(2) Changes in depreciation or amortization that are a change in method of accounting. Except as provided in paragraph (e)(2)(ii)(d)(3) of this section, a change in the treatment of an asset from nondepreciable or nonamortizable to depreciable or amortizable, or vice versa, is a change in method of accounting. Additionally, a correction to require depreciation or amortization in lieu of a deduction for the cost of depreciable or amortizable assets that had been consistently treated as an expense in the year of purchase, or vice versa, is a change in method of accounting. Further, except as provided in paragraph (e)(2)(ii)(d)(3) of this section, the following changes in computing depreciation or amortization are a change in method of accounting:

(i) A change in the depreciation or amortization method, period of recovery, or convention of a depreciable or amortizable asset.

(ii) A change from not claiming to claiming the additional first year depreciation deduction provided by, for example, section 168(k), 1400L(b), or 1400N(d), for, and the resulting change to the amount otherwise allowable as a depreciation deduction for the remaining adjusted depreciable basis (or similar basis) of, depreciable property that qualifies for the additional first year depreciation deduction (for example, qualified property, 50-percent bonus depreciation property, qualified New York Liberty Zone property, or qualified Gulf Opportunity Zone property), provided the taxpayer did not make the election out of the additional first year depreciation deduction (or did not make a deemed election out of the additional first year depreciation deduction; for further guidance, for example, see Rev. Proc. 2002-33 (2002-1 C.B. 963), Rev. Proc. 2003-50 (2003-2 C.B. 119), Notice 2006-77 (2006-40 I.R.B. 590), and § 601.601(d)(2)(ii)(b) of this chapter) for the class of property in which the depreciable property that qualifies for the additional first year depreciation deduction (for example, qualified property, 50-percent bonus depreciation property, qualified New York Liberty Zone property, or qualified Gulf Opportunity Zone property) is included.

(iii) A change from claiming the 30-percent additional first year depreciation deduction to claiming the 50-percent additional first year depreciation deduction for depreciable property that qualifies for the 50-percent additional first year depreciation deduction, provided the property is not included in any class of property for which the taxpayer elected the 30-percent, instead of the 50-percent, additional first year depreciation deduction (for example, 50-percent bonus depreciation property or qualified Gulf Opportunity Zone property), or a change from claiming the 50-percent additional first year depreciation deduction to claiming the 30-percent additional first year depreciation deduction for depreciable property that qualifies for the 30-percent additional first year depreciation deduction, including property that is included in a class of property for which the taxpayer elected the 30-percent, instead of the 50-percent, additional first year depreciation deduction (for example, qualified property or qualified New York Liberty Zone property), and the resulting change to the amount otherwise allowable as a depreciation deduction for the property's remaining adjusted depreciable basis (or similar basis). This paragraph (e)(2)(ii)(d)(2)(iii) does not apply if a taxpayer is making a late election or revoking a timely valid election under the applicable additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d)) (see paragraph (e)(2)(ii)(d)(3)(iii) of this section).

(iv) A change from claiming to not claiming the additional first year depreciation deduction for an asset that does not qualify for the additional first year depreciation deduction, including an asset that is included in a class of property for which the taxpayer elected not to claim any additional first year depreciation deduction (for example, an asset that is not qualified property, 50-percent bonus depreciation property, qualified New York Liberty Zone property, or qualified Gulf Opportunity Zone property), and the resulting change to the amount otherwise allowable as a depreciation deduction for the property's depreciable basis.

(v) A change in salvage value to zero for a depreciable or amortizable asset for which the salvage value is expressly treated as zero by the Internal Revenue Code (for example, section 168(b)(4)), the regulations under the Internal Revenue Code (for example, § 1.197-2(f)(1)(ii)), or other guidance published in the Internal Revenue Bulletin.

(vi) A change in the accounting for depreciable or amortizable assets from a single asset account to a multiple asset account (pooling), or vice versa, or from one type of multiple asset account (pooling) to a different type of multiple asset account (pooling).

(vii) For depreciable or amortizable assets that are mass assets accounted for in multiple asset accounts or pools, a change in the method of identifying which assets have been disposed. For purposes of this paragraph (e)(2)(ii)(d)(2)(vii), the term mass assets means a mass or group of individual items of depreciable or amortizable assets that are not necessarily homogeneous, each of which is minor in value relative to the total value of the mass or group, numerous in quantity, usually accounted for only on a total dollar or quantity basis, with respect to which separate identification is impracticable, and placed in service in the same taxable year.

(viii) Any other change in depreciation or amortization as the Secretary may designate by publication in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter).

(3) Changes in depreciation or amortization that are not a change in method of accounting. Section 1.446-1(e)(2)(ii)(b) applies to determine whether a change in depreciation or amortization is not a change in method of accounting. Further, the following changes in depreciation or amortization are not a change in method of accounting:

(i) Useful life. An adjustment in the useful life of a depreciable or amortizable asset for which depreciation is determined under section 167 (other than under section 168, section 1400I, section 1400L(c), former section 168, or an additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d))) is not a change in method of accounting. This paragraph (e)(2)(ii)(d)(3)(i) does not apply if a taxpayer is changing to or from a useful life (or recovery period or amortization period) that is specifically assigned by the Internal Revenue Code (for example, section 167(f)(1), section 168(c), section 168(g)(2) or (3), section 197), the regulations under the Internal Revenue Code, or other guidance published in the Internal Revenue Bulletin and, therefore, such change is a change in method of accounting (unless paragraph (e)(2)(ii)(d)(3)(v) of this section applies). See paragraph (e)(2)(ii)(d)(5)(iv) of this section for determining the taxable year in which to correct an adjustment in useful life that is not a change in method of accounting.

(ii) Change in use. A change in computing depreciation or amortization allowances in the taxable year in which the use of an asset changes in the hands of the same taxpayer is not a change in method of accounting.

(iii) Elections. Generally, the making of a late depreciation or amortization election or the revocation of a timely valid depreciation or amortization election is not a change in method of accounting, except as otherwise expressly provided by the Internal Revenue Code, the regulations under the Internal Revenue Code, or other guidance published in the Internal Revenue Bulletin. This paragraph (e)(2)(ii)(d)(3)(iii) also applies to making a late election or revoking a timely valid election made under section 13261(g)(2) or (3) of the Revenue Reconciliation Act of 1993 (107 Stat. 312, 540) (relating to amortizable section 197 intangibles). A taxpayer may request consent to make a late election or revoke a timely valid election by submitting a request for a private letter ruling. For making or revoking an election under section 179 of the Internal Revenue Code, see section 179(c) and § 1.179-5.

(iv) Salvage value. Except as provided under paragraph (e)(2)(ii)(d)(2)(v) of this section, a change in salvage value of a depreciable or amortizable asset is not treated as a change in method of accounting.

(v) Placed-in-service date. Except as otherwise expressly provided by the Internal Revenue Code, the regulations under the Internal Revenue Code, or other guidance published in the Internal Revenue Bulletin, any change in the placed-in-service date of a depreciable or amortizable asset is not treated as a change in method of accounting. For example, if a taxpayer changes the placed-in-service date of a depreciable or amortizable asset because the taxpayer incorrectly determined the date on which the asset was placed in service, such a change is a change in the placed-in-service date of the asset and, therefore, is not a change in method of accounting. However, if a taxpayer incorrectly determines that a depreciable or amortizable asset is nondepreciable property and later changes the treatment of the asset to depreciable property, such a change is not a change in the placed-in-service date of the asset and, therefore, is a change in method of accounting under paragraph (e)(2)(ii)(d)(2) of this section. Further, a change in the convention of a depreciable or amortizable asset is not a change in the placed-in-service date of the asset and, therefore, is a change in method of accounting under paragraph (e)(2)(ii)(d)(2)(i) of this section. See paragraph (e)(2)(ii)(d)(5)(v) of this section for determining the taxable year in which to make a change in the placed-in-service date of a depreciable or amortizable asset that is not a change in method of accounting.

(vi) Any other change in depreciation or amortization as the Secretary may designate by publication in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter).

(4) Item being changed. For purposes of a change in depreciation or amortization to which this paragraph (e)(2)(ii)(d) applies, the item being changed generally is the depreciation treatment of each individual depreciable or amortizable asset. However, the item is the depreciation treatment of each vintage account with respect to a depreciable asset for which depreciation is determined under § 1.167(a)-11 (class life asset depreciation range (CLADR) property). Similarly, the item is the depreciable treatment of each general asset account with respect to a depreciable asset for which general asset account treatment has been elected under section 168(i)(4) or the item is the depreciation treatment of each mass asset account with respect to a depreciable asset for which mass asset account treatment has been elected under former section 168(d)(2)(A). Further, a change in computing depreciation or amortization under section 167 (other than under section 168, section 1400I, section 1400L(c), former section 168, or an additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d))) is permitted only with respect to all assets in a particular account (as defined in § 1.167(a)-7) or vintage account.

(5) Special rules. For purposes of a change in depreciation or amortization to which this paragraph (e)(2)(ii)(d) applies—

(i) Declining balance method to the straight line method for MACRS property. For tangible, depreciable property subject to section 168 (MACRS property) that is depreciated using the 200-percent or 150-percent declining balance method of depreciation under section 168(b)(1) or (2), a taxpayer may change without the consent of the Commissioner from the declining balance method of depreciation to the straight line method of depreciation in the first taxable year in which the use of the straight line method with respect to the adjusted depreciable basis of the MACRS property as of the beginning of that year will yield a depreciation allowance that is greater than the depreciation allowance yielded by the use of the declining balance method. When the change is made, the adjusted depreciable basis of the MACRS property as of the beginning of the taxable year is recovered through annual depreciation allowances over the remaining recovery period (for further guidance, see section 6.06 of Rev. Proc. 87-57 (1987-2 C.B. 687) and § 601.601(d)(2)(ii)(b) of this chapter).

(ii) Depreciation method changes for section 167 property. For a depreciable or amortizable asset for which depreciation is determined under section 167 (other than under section 168, section 1400I, section 1400L(c), former section 168, or an additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d))), see § 1.167(e)-1(b), (c), and (d) for the changes in depreciation method that are permitted to be made without the consent of the Commissioner. For CLADR property, see § 1.167(a)-11(c)(1)(iii) for the changes in depreciation method for CLADR property that are permitted to be made without the consent of the Commissioner. Further, see § 1.167(a)-11(b)(4)(iii)(c) for how to correct an incorrect classification or characterization of CLADR property.

(iii) Section 481 adjustment. Except as otherwise expressly provided by the Internal Revenue Code, the regulations under the Internal Revenue Code, or other guidance published in the Internal Revenue Bulletin, no section 481 adjustment is required or permitted for a change from one permissible method of computing depreciation or amortization to another permissible method of computing depreciation or amortization for an asset because this change is implemented by either a cut-off method (for further guidance, for example, see section 2.06 of Rev. Proc. 97-27 (1997-1 C.B. 680), section 2.06 of Rev. Proc. 2002-9 (2002-1 C.B. 327), and § 601.601(d)(2)(ii)(b) of this chapter) or a modified cut-off method (under which the adjusted depreciable basis of the asset as of the beginning of the year of change is recovered using the new permissible method of accounting), as appropriate. However, a change from an impermissible method of computing depreciation or amortization to a permissible method of computing depreciation or amortization for an asset results in a section 481 adjustment. Similarly, a change in the treatment of an asset from nondepreciable or nonamortizable to depreciable or amortizable (or vice versa) or a change in the treatment of an asset from expensing to depreciating (or vice versa) results in a section 481 adjustment.

(iv) Change in useful life. This paragraph (e)(2)(ii)(d)(5)(iv) applies to an adjustment in the useful life of a depreciable or amortizable asset for which depreciation is determined under section 167 (other than under section 168, section 1400I, section 1400L(c), former section 168, or an additional first year depreciation deduction provision of the Internal Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d))) and that is not a change in method of accounting under paragraph (e)(2)(ii)(d) of this section. For this adjustment in useful life, no section 481 adjustment is required or permitted. The adjustment in useful life, whether initiated by the Internal Revenue Service (IRS) or a taxpayer, is corrected by adjustments in the taxable year in which the conditions known to exist at the end of that taxable year changed thereby resulting in a redetermination of the useful life under § 1.167(a)-1(b) (or if the period of limitation for assessment under section 6501(a) has expired for that taxable year, in the first succeeding taxable year open under the period of limitation for assessment), and in subsequent taxable years. In other situations (for example, the useful life is incorrectly determined in the placed-in-service year), the adjustment in the useful life, whether initiated by the IRS or a taxpayer, may be corrected by adjustments in the earliest taxable year open under the period of limitation for assessment under section 6501(a) or the earliest taxable year under examination by the IRS but in no event earlier than the placed-in-service year of the asset, and in subsequent taxable years. However, if a taxpayer initiates the correction in useful life, in lieu of filing amended Federal tax returns (for example, because the conditions known to exist at the end of a prior taxable year changed thereby resulting in a redetermination of the useful life under § 1.167(a)-1(b)), the taxpayer may correct the adjustment in useful life by adjustments in the current and subsequent taxable years.

(v) Change in placed-in-service date. This paragraph (e)(2)(ii)(d)(5)(v) applies to a change in the placed-in-service date of a depreciable or amortizable asset that is not a change in method of accounting under paragraph (e)(2)(ii)(d) of this section. For this change in placed-in-service date, no section 481 adjustment is required or permitted. The change in placed-in-service date, whether initiated by the IRS or a taxpayer, may be corrected by adjustments in the earliest taxable year open under the period of limitation for assessment under section 6501(a) or the earliest taxable year under examination by the IRS but in no event earlier than the placed-in-service year of the asset, and in subsequent taxable years. However, if a taxpayer initiates the change in placed-in-service date, in lieu of filing amended Federal tax returns, the taxpayer may correct the placed-in-service date by adjustments in the current and subsequent taxable years.

(iii) Examples. The rules of this paragraph (e) are illustrated by the following examples:

(3)(i) Except as otherwise provided under the authority of paragraph (e)(3)(ii) of this section, to secure the Commissioner's consent to a taxpayer's change in method of accounting the taxpayer generally must file an application on Form 3115, “Application for Change in Accounting Method,” with the Commissioner during the taxable year in which the taxpayer desires to make the change in method of accounting. See §§ 1.381(c)(4)-1(d)(2) and 1.381(c)(5)-1(d)(2) for rules allowing additional time, in some circumstances, for the filing of an application on Form 3115 with respect to a transaction to which section 381(a) applies. To the extent applicable, the taxpayer must furnish all information requested on the Form 3115. This information includes all classes of items that will be treated differently under the new method of accounting, any amounts that will be duplicated or omitted as a result of the proposed change, and the taxpayer's computation of any adjustments necessary to prevent such duplications or omissions. The Commissioner may require such other information as may be necessary to determine whether the proposed change will be permitted. Permission to change a taxpayer's method of accounting will not be granted unless the taxpayer agrees to the Commissioner's prescribed terms and conditions for effecting the change, including the taxable year or years in which any adjustment necessary to prevent amounts from being duplicated or omitted is to be taken into account. See section 481 and the regulations thereunder, relating to certain adjustments resulting from accounting method changes, and section 472 and the regulations thereunder, relating to adjustments for changes to and from the last-in, first-out inventory method. For any Form 3115 filed on or after May 15, 1997, see § 1.446-1T(e)(3)(i)(B).

(ii) Notwithstanding the provisions of paragraph (e)(3)(i) of this section, the Commissioner may prescribe administrative procedures under which taxpayers will be permitted to change their method of accounting. The administrative procedures shall prescribe those terms and conditions necessary to obtain the Commissioner's consent to effect the change and to prevent amounts from being duplicated or omitted. The terms and conditions that may be prescribed by the Commissioner may include terms and conditions that require the change in method of accounting to be effected on a cut-off basis or by an adjustment under section 481(a) to be taken into account in the taxable year or years prescribed by the Commissioner.

(iii) This paragraph (e)(3) applies to Forms 3115 filed on or after December 31, 1997. For other Forms 3115, see § 1.446-1(e)(3) in effect prior to December 31, 1997 (§ 1.446-1(e)(3) as contained in the 26 CFR part 1 edition revised as of April 1, 1997).

(4) Effective date—(i) In general. Except as provided in paragraphs (e)(3)(iii), (e)(4)(ii), and (e)(4)(iii) of this section, paragraph (e) of this section applies on or after December 30, 2003. For the applicability of regulations before December 30, 2003, see § 1.446-1(e) in effect prior to December 30, 2003 (§ 1.446-1(e) as contained in 26 CFR part 1 edition revised as of April 1, 2003).

(ii) Changes involving depreciable or amortizable assets. With respect to paragraph (e)(2)(ii)(d) of this section, paragraph (e)(2)(iii) Examples 9 through 19 of this section, and the language “certain changes in computing depreciation or amortization (see paragraph (e)(2)(ii)(d) of this section)” in the last sentence of paragraph (e)(2)(ii)(a) of this section—

(A) For any change in depreciation or amortization that is a change in method of accounting, this section applies to such a change in method of accounting made by a taxpayer for a depreciable or amortizable asset placed in service by the taxpayer in a taxable year ending on or after December 30, 2003; and

(B) For any change in depreciation or amortization that is not a change in method of accounting, this section applies to such a change made by a taxpayer for a depreciable or amortizable asset placed in service by the taxpayer in a taxable year ending on or after December 30, 2003.

(iii) Effective/applicability date for paragraph (e)(3)(i). The rules of paragraph (e)(3)(i) of this section apply to corporate reorganizations and tax-free liquidations described in section 381(a) that occur on or after August 31, 2011.

(a) Applicability—(1) In general. This section provides rules for determining the amount of interest that accrues during an accrual period (other than interest described in paragraph (a)(2) of this section) and for determining the portion of a payment that consists of accrued interest. For purposes of this section, interest includes original issue discount and amounts treated as interest (whether stated or unstated) in any lending or deferred payment transaction. Accrued interest determined under this section is taken into account by a taxpayer under the taxpayer's regular method of accounting (e.g., an accrual method or the cash receipts and disbursements method). Application of an exception described in paragraph (a)(2) of this section to one party to a transaction does not affect the application of this section to any other party to the transaction.

(2) Exceptions—(i) Interest included or deducted under certain other provisions. This section does not apply to interest that is taken into account under—

(A) Sections 1272(a), 1275, and 163(e) (income and deductions relating to original issue discount);

(B) Section 467(a)(2) (certain payments for the use of property or services);

(C) Sections 1276 through 1278 (market discount);

(D) Sections 1281 through 1283 (discount on certain short-term obligations);

(E) Section 7872(a) (certain loans with below-market interest rates);

(F) Section 1.1272-3 (an election by a holder to treat all interest on a debt instrument as original issue discount); or

(G) Section 1.451-3(j) (special ordering rule for specified fees).

(ii) De minimis original issue discount. This section does not apply to de minimis original issue discount (other than de minimis original issue discount treated as qualified stated interest) as determined under § 1.1273-1(d). See § 1.163-7 for the treatment of de minimis original issue discount by the issuer and §§ 1.1273-1(d) and 1.1272-3 for the treatment of de minimis original issue discount by the holder.

(b) Accrual of qualified stated interest. Qualified stated interest (as defined in § 1.1273-1(c)) accrues ratably over the accrual period (or periods) to which it is attributable and accrues at the stated rate for the period (or periods).

(c) Accrual of interest other than qualified stated interest. Subject to the modifications in paragraph (d) of this section, the amount of interest (other than qualified stated interest) that accrues for any accrual period is determined under rules similar to those in the regulations under sections 1272 and 1275 for the accrual of original issue discount. The preceding sentence applies regardless of any contrary formula agreed to by the parties.

(d) Modifications—(1) Issue price. The issue price of the loan or contract is equal to—

(i) In the case of a contract for the sale or exchange of property to which section 483 applies, the amount described in § 1.483-2(a)(1)(i) or (ii), whichever is applicable;

(ii) In the case of a contract for the sale or exchange of property to which section 483 does not apply, the stated principal amount; or

(iii) In any other case, the amount loaned.

(2) Principal payments that are not deferred payments. In the case of a contract to which section 483 applies, principal payments that are not deferred payments are ignored for purposes of determining yield and adjusted issue price.

(e) Allocation of interest to payments—(1) In general. Except as provided in paragraphs (e)(2), (e)(3), and (e)(4) of this section, each payment under a loan (other than payments of additional interest or similar charges provided with respect to amounts that are not paid when due) is treated as a payment of interest to the extent of the accrued and unpaid interest determined under paragraphs (b) and (c) of this section as of the date the payment becomes due.

(2) Special rule for points deductible under section 461(g)(2). If a payment of points is deductible by the borrower under section 461(g)(2), the payment is treated by the borrower as a payment of interest.

(3) Allocation respected in certain small transactions. [Reserved]

(4) Pro rata prepayments. Accrued but unpaid interest is allocated to a pro rata prepayment under rules similar to those for allocating accrued but unpaid original issue discount to a pro rata prepayment under § 1.1275-2(f). For purposes of the preceding sentence, a pro rata prepayment is a payment that is made prior to maturity that—

(i) Is not made pursuant to the contract's payment schedule; and

(ii) Results in a substantially pro rata reduction of each payment remaining to be paid on the contract.

(f) Aggregation rule. For purposes of this section, all contracts calling for deferred payments arising from the same transaction (or a series of related transactions) are treated as a single contract. This rule, however, generally only applies to contracts involving a single borrower and a single lender.

(g) Debt instruments denominated in a currency other than the U.S. dollar. This section applies to a debt instrument that provides for all payments denominated in, or determined by reference to, the functional currency of the taxpayer or qualified business unit of the taxpayer (even if that currency is other than the U.S. dollar). See § 1.988-2(b) to determine interest income or expense for debt instruments that provide for payments denominated in, or determined by reference to, a nonfunctional currency.

(h) Example. The following example illustrates the rules of this section.

(i) [Reserved]

(j) Effective date. This section applies to debt instruments issued on or after April 4, 1994, and to lending transactions, sales, and exchanges that occur on or after April 4, 1994. Taxpayers, however, may rely on this section for debt instruments issued after December 21, 1992, and before April 4, 1994, and for lending transactions, sales, and exchanges that occur after December 21, 1992, and before April 4, 1994.

(a) Table of contents. This paragraph (a) lists captioned paragraphs contained in § 1.446-3.

(b) Purpose. The purpose of this section is to enable the clear reflection of the income and deductions from notional principal contracts by prescribing accounting methods that reflect the economic substance of such contracts.

(c) Definitions and scope—(1) Notional principal contract—(i) In general. A notional principal contract is a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. An agreement between a taxpayer and a qualified business unit (as defined in section 989(a)) of the taxpayer, or among qualified business units of the same taxpayer, is not a notional principal contract because a taxpayer cannot enter into a contract with itself. Notional principal contracts governed by this section include interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps, and similar agreements. A collar is not itself a notional principal contract, but certain caps and floors that comprise a collar may be treated as a single notional principal contract under paragraph (f)(2)(v)(C) of this section. A contract may be a notional principal contract governed by this section even though the term of the contract is subject to termination or extension. Each confirmation under a master agreement to enter into agreements governed by this section is treated as a separate notional principal contract.

(ii) Excluded contracts. A contract described in section 1256(b), a futures contract, a forward contract, and an option are not notional principal contracts. An instrument or contract that constitutes indebtedness under general principles of Federal income tax law is not a notional principal contract. An option or forward contract that entitles or obligates a person to enter into a notional principal contract is not a notional principal contract, but payments made under such an option or forward contract may be governed by paragraph (g)(3) of this section.

(iii) Transactions within section 475. To the extent that the rules provided in paragraphs (e) and (f) of this section are inconsistent with the rules that apply to any notional principal contract that is governed by section 475 and regulations thereunder, the rules of section 475 and the regulations thereunder govern.

(iv) Transactions within section 988. To the extent that the rules provided in this section are inconsistent with the rules that apply to any notional principal contract that is also a section 988 transaction or that is integrated with other property or debt pursuant to section 988(d), the rules of section 988 and the regulations thereunder govern.

(2) Specified index. A specified index is—

(i) A fixed rate, price, or amount;

(ii) A fixed rate, price, or amount applicable in one or more specified periods followed by one or more different fixed rates, prices, or amounts applicable in other periods;

(iii) An index that is based on objective financial information (as defined in paragraph (c)(4)(ii) of this section); and

(iv) An interest rate index that is regularly used in normal lending transactions between a party to the contract and unrelated persons.

(3) Notional principal amount. For purposes of this section, a notional principal amount is any specified amount of money or property that, when multiplied by a specified index, measures a party's rights and obligations under the contract, but is not borrowed or loaned between the parties as part of the contract. The notional principal amount may vary over the term of the contract, provided that it is set in advance or varies based on objective financial information (as defined in paragraph (c)(4)(ii) of this section).

(4) Special definitions—(i) Related person and party to the contract. A related person is a person related (within the meaning of section 267(b) or 707(b)(1)) to one of the parties to the notional principal contract or a member of the same consolidated group (as defined in § 1.1502-1(h)) as one of the parties to the contract. For purposes of this paragraph (c), a related person is considered to be a party to the contract.

(ii) Objective financial information. For purposes of this paragraph (c), objective financial information is any current, objectively determinable financial or economic information that is not within the control of any of the parties to the contract and is not unique to one of the parties' circumstances (such as one party's dividends, profits, or the value of its stock). Thus, for example, a notional principal amount may be based on a broadly-based equity index or the outstanding balance of a pool of mortgages, but not on the value of a party's stock.

(iii) Dealer in notional principal contracts. A dealer in notional principal contracts is a person who regularly offers to enter into, assume, offset, assign, or otherwise terminate positions in notional principal contracts with customers in the ordinary course of a trade or business.

(d) Taxable year of inclusion and deduction. For all purposes of the Code, the net income or net deduction from a notional principal contract for a taxable year is included in or deducted from gross income for that taxable year. The net income or net deduction from a notional principal contract for a taxable year equals the total of all of the periodic payments that are recognized from that contract for the taxable year under paragraph (e) of this section and all of the nonperiodic payments that are recognized from that contract for the taxable year under paragraph (f) of this section.

(e) Periodic payments—(1) Definition. Periodic payments are payments made or received pursuant to a notional principal contract that are payable at intervals of one year or less during the entire term of the contract (including any extension periods provided for in the contract), that are based on a specified index described in paragraph (c)(2)(i), (iii), or (iv) of this section (appropriately adjusted for the length of the interval), and that are based on either a single notional principal amount or a notional principal amount that varies over the term of the contract in the same proportion as the notional principal amount that measures the other party's payments. Payments to purchase or sell a cap or a floor, however, are not periodic payments.

(2) Recognition rules—(i) In general. All taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a periodic payment for the taxable year to which that portion relates.

(ii) Rate set in arrears. If the amount of a periodic payment is not determinable at the end of a taxable year because the value of the specified index is not fixed until a date that occurs after the end of the taxable year, the ratable daily portion of a periodic payment that relates to that taxable year is generally based on the specified index that would have applied if the specified index were fixed as of the last day of the taxable year. If a taxpayer determines that the value of the specified index as of the last day of the taxable year does not provide a reasonable estimate of the specified index that will apply when the payment is fixed, the taxpayer may use a reasonable estimate of the specified index each year, provided that the taxpayer (and any related person that is a party to the contract) uses the same method to make the estimate consistently from year to year and uses the same estimate for purposes of all financial reports to equity holders and creditors. The taxpayer's treatment of notional principal contracts with substantially similar specified indices will be considered in determining whether the taxpayer's estimate of the specified index is reasonable. Any difference between the amount that is recognized under this paragraph (e)(2)(ii) and the corresponding portion of the actual payment that becomes fixed under the contract is taken into account as an adjustment to the net income or net deduction from the notional principal contract for the taxable year during which the payment becomes fixed.

(iii) Notional principal amount set in arrears. Rules similar to the rules of paragraph (e)(2)(ii) of this section apply if the amount of a periodic payment is not determinable at the end of a taxable year because the notional principal amount is not fixed until a date that occurs after the end of the taxable year.

(3) Examples. The following examples illustrate the application of paragraph (e) of this section.

(f) Nonperiodic payments—(1) Definition. A nonperiodic payment is any payment made or received with respect to a notional principal contract that is not a periodic payment (as defined in paragraph (e)(1) of this section) or a termination payment (as defined in paragraph (h) of this section). Examples of nonperiodic payments are the premium for a cap or floor agreement (even if it is paid in installments), the payment for an off-market swap agreement, the prepayment of part or all of one leg of a swap, and the premium for an option to enter into a swap if and when the option is exercised.

(2) Recognition rules—(i) In general. All taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a nonperiodic payment for the taxable year to which that portion relates. Generally, a nonperiodic payment must be recognized over the term of a notional principal contract in a manner that reflects the economic substance of the contract.

(ii) General rule for swaps. A nonperiodic payment that relates to a swap must be recognized over the term of the contract by allocating it in accordance with the forward rates (or, in the case of a commodity, the forward prices) of a series of cash-settled forward contracts that reflect the specified index and the notional principal amount. For purposes of this allocation, the forward rates or prices used to determine the amount of the nonperiodic payment will be respected, if reasonable. See paragraph (f)(4) Example 7 of this section.

(iii) Alternative methods for swaps. Solely for purposes of determining the timing of income and deductions, a nonperiodic payment made or received with respect to a swap may be allocated to each period of the swap contract using one of the methods described in this paragraph (f)(2)(iii). The alternative methods may not be used by a dealer in notional principal contracts (as defined in paragraph (c)(4)(iii) of this section) for swaps entered into or acquired in its capacity as a dealer.

(A) Prepaid swaps. An upfront payment on a swap may be amortized by assuming that the nonperiodic payment represents the present value of a series of equal payments made throughout the term of the swap contract (the level payment method), adjusted as appropriate to take account of increases or decreases in the notional principal amount. The discount rate used in this calculation must be the rate (or rates) used by the parties to determine the amount of the nonperiodic payment. If that rate is not readily ascertainable, the discount rate used must be a rate that is reasonable under the circumstances. Under this method, an upfront payment is allocated by dividing each equal payment into its principal recovery and time value components. The principal recovery components of the equal payments are treated as periodic payments that are deemed to be made on each of the dates that the swap contract provides for periodic payments by the payor of the nonperiodic payment or, if none, on each of the dates that the swap contract provides for periodic payments by the recipient of the nonperiodic payment. The time value component is needed to compute the amortization of the nonperiodic payment, but is otherwise disregarded. See paragraph (f)(4) Example 5 of this section.

(B) Other nonperiodic swap payments. Nonperiodic payments on a swap other than an upfront payment may be amortized by treating the contract as if it provided for a single upfront payment (equal to the present value of the nonperiodic payments) and a loan between the parties. The discount rate (or rates) used in determining the deemed upfront payment and the time value component of the deemed loan is the same as the rate (or rates) used in the level payment method. The single upfront payment is then amortized under the level payment method described in paragraph (f)(2)(iii)(A) of this section. The time value component of the loan is not treated as interest, but, together with the amortized amount of the deemed upfront payment, is recognized as a periodic payment. See paragraph (f)(4) Example 6 of this section. If both parties make nonperiodic payments, this calculation is done separately for the nonperiodic payments made by each party.

(iv) General rule for caps and floors. A payment to purchase or sell a cap or floor must be recognized over the term of the agreement by allocating it in accordance with the prices of a series of cash-settled option contracts that reflect the specified index and the notional principal amount. For purposes of this allocation, the option pricing used by the parties to determine the total amount paid for the cap or floor will be respected, if reasonable. Only the portion of the purchase price that is allocable to the option contract or contracts that expire during a particular period is recognized for that period. Thus, under this paragraph (f)(2)(iv), straight-line or accelerated amortization of a cap premium is generally not permitted. See paragraph (f)(4) Examples 1 and 2 of this section.

(v) Alternative methods for caps and floors that hedge debt instruments. Solely for purposes of determining the timing of income and deductions, if a cap or floor is entered into primarily to reduce risk with respect to a specific debt instrument or group of debt instruments held or issued by the taxpayer, the taxpayer may amortize a payment to purchase or sell the cap or floor using the methods described in this paragraph (f)(2)(v), adjusted as appropriate to take account of increases or decreases in the notional principal amount. The alternative methods may not be used by a dealer in notional principal contracts (as defined in paragraph (c)(4)(iii) of this section) for caps or floors entered into or acquired in its capacity as a dealer.

(A) Prepaid caps and floors. A premium paid upfront for a cap or a floor may be amortized using the “level payment method” described in paragraph (f)(2)(iii)(A) of this section. See paragraph (f)(4) Example 3 of this section.

(B) Other caps and floors. Nonperiodic payments on a cap or floor other than an upfront payment are amortized by treating the contract as if it provided for a single upfront payment (equal to the present value of the nonperiodic payments) and a loan between the parties as described in paragraph (f)(2)(iii)(B) of this section. Under the level payment method, a cap or floor premium paid in level annual installments over the term of the contract is effectively included or deducted from income ratably, in accordance with the level payments. See paragraph (f)(4) Example 4 of this section.

(C) Special method for collars. A taxpayer may also treat a cap and a floor that comprise a collar as a single notional principal contract and may amortize the net nonperiodic payment to enter into the cap and floor over the term of the collar in accordance with the methods prescribed in this paragraph (f)(2)(v).

(vi) Additional methods. The Commissioner may, by a revenue ruling or a revenue procedure published in the Internal Revenue Bulletin, provide alternative methods for allocating nonperiodic payments that relate to a notional principal contract to each year of the contract. See § 601.601(d)(2)(ii)(b) of this chapter.

(3) Term of extendible or terminable contracts. For purposes of this paragraph (f), the term of a notional principal contract that is subject to extension or termination is the reasonably expected term of the contract.

(4) Examples. The following examples illustrate the application of paragraph (f) of this section.

(g) Special rules—(1) Disguised notional principal contracts. The Commissioner may recharacterize all or part of a transaction (or series of transactions) if the effect of the transaction (or series of transactions) is to avoid the application of this section.

(2) Hedged notional principal contracts. If a taxpayer, either directly or through a related person (as defined in paragraph (c)(4)(i) of this section), reduces risk with respect to a notional principal contract by purchasing, selling, or otherwise entering into other notional principal contracts, futures, forwards, options, or other financial contracts (other than debt instruments), the taxpayer may not use the alternative methods provided in paragraphs (f)(2)(iii) and (v) of this section. Moreover, where such positions are entered into to avoid the appropriate timing or character of income from the contracts taken together, the Commissioner may require that amounts paid to or received by the taxpayer under the notional principal contract be treated in a manner that is consistent with the economic substance of the transaction as a whole.

(3) Options and forwards to enter into notional principal contracts. An option or forward contract that entitles or obligates a person to enter into a notional principal contract is subject to the general rules of taxation for options or forward contracts. Any payment with respect to the option or forward contract is treated as a nonperiodic payment for the underlying notional principal contract under the rules of paragraphs (f) and (g)(4) or (g)(5) of this section if and when the underlying notional principal contract is entered into.

(4) Swaps with significant nonperiodic payments—(i) General rule. Except as provided in paragraph (g)(4)(ii) of this section, a swap with significant nonperiodic payments is treated as two separate transactions consisting of an on-market, level payment swap and a loan. The loan must be accounted for by the parties to the contract independently of the swap. The time value component associated with the loan, determined in accordance with paragraph (f)(2)(iii)(A) of this section, is recognized as interest expense to the payor and interest income to the recipient.

(ii) Exception for cleared swaps and non-cleared swaps subject to margin or collateral requirements. Paragraph (g)(4)(i) of this section does not apply to a swap if the contract is described in paragraph (g)(4)(ii)(A) or (B) of this section.

(A) The swap is cleared by a derivatives clearing organization, as such term is defined in section 1a of the Commodity Exchange Act (7 U.S.C. 1a), or by a clearing agency, as such term is defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c), that is registered as a derivatives clearing organization under the Commodity Exchange Act or as a clearing agency under the Securities Exchange Act of 1934, respectively, and the derivatives clearing organization or clearing agency requires the parties to the swap to post and collect margin or collateral.

(B) The swap is a non-cleared swap that requires the parties to meet the margin or collateral requirements of a federal regulator or that provides for margin or collateral requirements that are substantially similar to a cleared swap or a non-cleared swap subject to the margin or collateral requirements of a federal regulator. For purposes of this paragraph (g)(4)(ii)(B), the term federal regulator means the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), or a prudential regulator, as defined in section 1a(39) of the Commodity Exchange Act (7 U.S.C. 1a), as amended by section 721 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Public Law 111-203, 124 Stat. 1376, Title VII.

(iii) Coordination with section 163(j). For the treatment of swaps with significant nonperiodic payments under section 163(j), see § 1.163(j)-1(b)(22)(ii).

(5) Caps and floors that are significantly in-the-money. [Reserved]

(6) Examples. The following examples illustrate the application of paragraph (g) of this section.

(h) Termination payments—(1) Definition. A payment made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of any party under a notional principal contract is a termination payment to the party making the termination payment and the party receiving the payment. A termination payment includes a payment made between the original parties to the contract (an extinguishment), a payment made between one party to the contract and a third party (an assignment), and any gain or loss realized on the exchange of one notional principal contract for another. Where one party assigns its remaining rights and obligations to a third party, the original nonassigning counterparty realizes gain or loss if the assignment results in a deemed exchange of contracts and a realization event under section 1001.

(2) Taxable year of inclusion and deduction by original parties. Except as otherwise provided (for example, in section 453, section 1092, or § 1.446-4), a party to a notional principal contract recognizes a termination payment in the year the contract is extinguished, assigned, or exchanged. When the termination payment is recognized, the party also recognizes any other payments that have been made or received pursuant to the notional principal contract, but that have not been recognized under paragraph (d) of this section. If only a proportionate part of a party's rights and obligations is extinguished, assigned, or exchanged, then only that proportion of the unrecognized payments is recognized under the previous sentence.

(3) Taxable year of inclusion and deduction by assignees. A termination payment made or received by an assignee pursuant to an assignment of a notional principal contract is recognized by the assignee under the rules of paragraphs (f) and (g)(4) or (g)(5) of this section as a nonperiodic payment for the notional principal contract that is in effect after the assignment.

(4) Special rules—(i) Assignment of one leg of a contract. A payment is not a termination payment if it is made or received by a party in exchange for assigning all or a portion of one leg of a notional principal contract at a time when a substantially proportionate amount of the other leg remains unperformed and unassigned. The payment is either an amount loaned, an amount borrowed, or a nonperiodic payment, depending on the economic substance of the transaction to each party. This paragraph (h)(4)(i) applies whether or not the original notional principal contract is terminated as a result of the assignment.

(ii) Substance over form. Any economic benefit that is given or received by a taxpayer in lieu of a termination payment is a termination payment.

(5) Examples. The following examples illustrate the application of this paragraph (h). The contracts in the examples are not hedging transactions as defined in § 1.1221-2(b), and all of the examples assume that no loss-deferral rules apply.

(i) Anti-abuse rule. If a taxpayer enters into a transaction with a principal purpose of applying the rules of this section to produce a material distortion of income, the Commissioner may depart from the rules of this section as necessary to reflect the appropriate timing of income and deductions from the transaction.

(j)(1) Effective/applicability date. These regulations are effective for notional principal contracts entered into on or after December 13, 1993.

(2) The rules provided in paragraph (g)(4) of this section apply to notional principal contracts entered into on or after September 14, 2021. Taxpayers may choose to apply the rules provided in paragraph (g)(4) of this section to notional principal contracts entered into before September 14, 2021.

(a) through (g)(3) [Reserved]. For further guidance, see § 1.446-3(a) through (g)(3).

(4) Notional principal contracts with nonperiodic payments—(i) General rule. Except as provided in paragraph (g)(4)(ii) of this section, a notional principal contract with one or more nonperiodic payments is treated as two separate transactions consisting of an on-market, level payment swap and one or more loans. The loan(s) must be accounted for by the parties to the contract independently of the swap. The time value component associated with the loan(s) is not included in the net income or net deduction from the swap under § 1.446-3(d), but it is recognized as interest for all purposes of the Internal Revenue Code. See paragraph (g)(6) Example 2 of this section.

(ii) Exceptions—(A) Notional principal contract with a term of one year or less—(1) General rule. Except for purposes of sections 514 and 956, paragraph (g)(4)(i) of this section does not apply to a notional principal contract if the term of the contract is one year or less. For purposes of this paragraph (g)(4)(ii)(A), the term of a notional principal contract is the stated term of the contract, inclusive of any extensions (optional or otherwise) provided for in the terms of the contract, without regard to whether any extension is unilateral, is subject to approval by one or both parties to the contract, or is based on the occurrence or non-occurrence of a specified event.

(2) Anti-abuse rule. For purposes of determining the term of a contract under paragraph (g)(4)(ii)(A)(1) of this section, the Commissioner may treat two or more contracts as a single contract if a principal purpose of entering into separate contracts is to qualify for the exception set forth in paragraph (g)(4)(ii)(A)(1) of this section. A purpose may be a principal purpose even though it is outweighed by other purposes (taken together or separately).

(B) Notional principal contract subject to margin or collateral requirements. Subject to the requirements in paragraph (g)(4)(ii)(C) of this section, paragraph (g)(4)(i) of this section does not apply to a notional principal contract if the contract is described in paragraph (g)(4)(ii)(B)(1) or (2) of this section. See § 1.956-2T(b)(1)(xi) for a related exception under section 956.

(1) The contract is cleared by a derivatives clearing organization (as such term is defined in section 1a of the Commodity Exchange Act (7 U.S.C. 1a)) or by a clearing agency (as such term in defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c)) that is registered as a derivatives clearing organization under the Commodity Exchange Act or as a clearing agency under the Securities Exchange Act of 1934, respectively, and the derivatives clearing organization or clearing agency requires the parties to the contract to post and collect margin or collateral to fully collateralize the mark-to-market exposure on the contract (including the exposure on the nonperiodic payment) on a daily basis for the entire term of the contract. The mark-to-market exposure on a contract will be fully collateralized only if the contract is subject to both initial variation margin in an amount equal to the nonperiodic payment (except for variances permitted by intraday price changes) and daily variation margin in an amount equal to the daily change in the fair market value of the contract. See paragraph (g)(6) Example 3 of this section.

(2) The parties to the contract are required, pursuant to the terms of the contract or the requirements of a federal regulator, to post and collect margin or collateral to fully collateralize the mark-to-market exposure on the contract (including the exposure on the nonperiodic payment) on a daily basis for the entire term of the contract. The mark-to-market exposure on a contract will be fully collateralized only if the contract is subject to both initial variation margin or collateral in an amount equal to the nonperiodic payment (except for variances permitted by intraday price changes) and daily variation margin or collateral in an amount equal to the daily change in the fair market value of the contract. For purposes of this paragraph (g)(4)(ii)(B)(2), the term “federal regulator” means the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), or a prudential regulator, as defined in section 1a(39) of the Commodity Exchange Act (7 U.S.C. 1a), as amended by section 721 of the Dodd-Frank Act. See paragraph (g)(6) Example 4 of this section.

(C) Limitations and special rules—(1) Cash requirement. A notional principal contract is described in paragraph (g)(4)(ii)(B) of this section only to the extent the parties post and collect margin or collateral to fully collateralize the mark-to-market exposure on the contract (including the exposure on the nonperiodic payment) by paying and receiving the required margin or collateral in cash. The term “cash” includes U.S. dollars or cash in any currency in which payment obligations under the notional principal contract are denominated.

(2) Excess margin or collateral. For purposes of paragraph (g)(4)(ii)(B)(2) of this section, if the amount of cash margin or collateral posted and collected is in excess of the amount necessary to fully collateralize the mark-to-market exposure on the contract (including the exposure on the nonperiodic payment) on a daily basis for the entire term of the contract, any excess is subject to the rule in paragraph (g)(4)(i) of this section.

(3) Margin or collateral paid and received in cash and other property. If the parties to the contract post and collect both cash and other property to satisfy margin or collateral requirements to collateralize the mark-to-market exposure on the contract (including the exposure on the nonperiodic payment), any excess of the nonperiodic payment over the cash margin or collateral posted and collected is subject to the rule in paragraph (g)(4)(i) of this section.

(5) [Reserved]. For further guidance, see § 1.446-3(g)(5).

(6) Examples through Example 1. [Reserved]. For further guidance, see § 1.446-3(g)(6), Examples through Example 1.

(h) through (j)(1) [Reserved]. For further guidance, see § 1.446-3(h) through (j)(1).

(2) Application of § 1.446-3T(g)(4). Paragraph (g)(4)(i) of this section and paragraph (g)(6) Example 2 of this section apply to notional principal contracts entered into on or after the later of January 1, 2017, or 180 days after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register. Paragraph (g)(4)(ii) of this section applies to notional principal contracts entered into on or after May 8, 2015. However, before the later of January 1, 2017, or 180 days after the date of publication of the Treasury decision adopting paragraph (g)(4)(i) of this section as final regulations in the Federal Register, taxpayers may rely on the provision in § 1.446-3(g)(4), as contained in 26 CFR part 1, revised April 1, 2015, which (except for purposes of section 956) limits the application of the embedded loan rule to nonperiodic payments that are significant, even if the requirements for the exceptions in paragraph (g)(4)(ii) of this section are not met. Taxpayers may apply paragraph (g)(4)(i) of this section, paragraph (g)(4)(ii) of this section, or both to notional principal contracts entered into before the dates set forth in this paragraph (j)(2).

(k) Expiration date. The applicability of paragraph (g)(4) of this section and paragraph (g)(6) Examples 2, 3 and 4 of this section expires May 7, 2018.

(a) In general. Except as provided in this paragraph (a), a hedging transaction as defined in § 1.1221-2(b) (whether or not the character of gain or loss from the transaction is determined under § 1.1221-2) must be accounted for under the rules of this section. To the extent that provisions of any other regulations governing the timing of income, deductions, gain, or loss are inconsistent with the rules of this section, the rules of this section control.

(1) Trades or businesses excepted. A taxpayer is not required to account for hedging transactions under the rules of this section for any trade or business in which the cash receipts and disbursements method of accounting is used or in which § 1.471-6 is used for inventory valuations if, for all prior taxable years ending on or after September 30, 1993, the taxpayer met the $5,000,000 gross receipts test of section 448(c) (or would have met that test if the taxpayer were a corporation or partnership). A taxpayer not required to use the rules of this section may nonetheless use a method of accounting that is consistent with these rules.

(2) Coordination with other sections. This section does not apply to—

(i) Any position to which section 475(a) applies;

(ii) An integrated transaction subject to § 1.1275-6;

(iii) Any section 988 hedging transaction if the transaction is integrated under § 1.988-5 or if other regulations issued under section 988(d) (or an advance ruling described in 1.988-5(e)) govern when gain or loss from the transaction is taken into account; or

(iv) The determination of the issuer's yield on an issue of tax-exempt bonds for purposes of the arbitrage restrictions to which § 1.148-4(h) applies.

(b) Clear reflection of income. The method of accounting used by a taxpayer for a hedging transaction must clearly reflect income. To clearly reflect income, the method used must reasonably match the timing of income, deduction, gain, or loss from the hedging transaction with the timing of income, deduction, gain, or loss from the item or items being hedged. Taking gains and losses into account in the period in which they are realized may clearly reflect income in the case of certain hedging transactions. For example, where a hedge and the item being hedged are disposed of in the same taxable year, taking realized gain or loss into account on both items in that taxable year may clearly reflect income. In the case of many hedging transactions, however, taking gains and losses into account as they are realized does not result in the matching required by this section.

(c) Choice of method and consistency. For any given type of hedging transaction, there may be more than one method of accounting that satisfies the clear reflection requirement of paragraph (b) of this section. A taxpayer is generally permitted to adopt a method of accounting for a particular type of hedging transaction that clearly reflects the taxpayer's income from that type of transaction. See paragraph (e) of this section for requirements and limitations on the taxpayer's choice of method. Different methods of accounting may be used for different types of hedging transactions and for transactions that hedge different types of items. Once a taxpayer adopts a method of accounting, however, that method must be applied consistently and can only be changed with the consent of the Commissioner, as provided by section 446(e) and the regulations and procedures thereunder.

(d) Recordkeeping requirements—(1) In general. The books and records maintained by a taxpayer must contain a description of the accounting method used for each type of hedging transaction. The description of the method or methods used must be sufficient to show how the clear reflection requirement of paragraph (b) of this section is satisfied.

(2) Additional identification. In addition to the identification required by § 1.1221-2(f), the books and records maintained by a taxpayer must contain whatever more specific identification with respect to a transaction is necessary to verify the application of the method of accounting used by the taxpayer for the transaction. This additional identification may relate to the hedging transaction or to the item, items, or aggregate risk being hedged. The additional identification must be made at the time specified in § 1.1221-2(f)(2) and must be made on, and retained as part of, the taxpayer's books and records.

(3) Transactions in which character of gain or loss is not determined under § 1.1221-2. A section 988 transaction, as defined in section 988(c)(1), or a qualified fund, as defined in section 988(c)(1)(E)(iii), is subject to the identification and recordkeeping requirements of § 1.1221-2(f). See § 1.1221-2(a)(4).

(e) Requirements and limitations with respect to hedges of certain assets and liabilities. In the case of certain hedging transactions, this paragraph (e) provides guidance in determining whether a taxpayer's method of accounting satisfies the clear reflection requirement of paragraph (b) of this section. Even if these rules are satisfied, however, the taxpayer's method, as actually applied to the taxpayer's hedging transactions, must clearly reflect income by meeting the matching requirement of paragraph (b) of this section.

(1) Hedges of aggregate risk—(i) In general. The method of accounting used for hedges of aggregate risk must comply with the matching requirements of paragraph (b) of this section. Even though a taxpayer may not be able to associate the hedging transaction with any particular item being hedged, the timing of income, deduction, gain, or loss from the hedging transaction must be matched with the timing of the aggregate income, deduction, gain, or loss from the items being hedged. For example, if a notional principal contract hedges a taxpayer's aggregate risk, taking into account income, deduction, gain, or loss under the provisions of § 1.446-3 may clearly reflect income. See paragraph (e)(5) of this section.

(ii) Mark-and-spread method. The following method may be appropriate for taking into account income, deduction, gain, or loss from hedges of aggregate risk:

(A) The hedging transactions are marked to market at regular intervals for which the taxpayer has the necessary data, but no less frequently than quarterly; and

(B) The income, deduction, gain, or loss attributable to the realization or periodic marking to market of hedging transactions is taken into account over the period for which the hedging transactions are intended to reduce risk. Although the period over which the hedging transactions are intended to reduce risk may change, the period must be reasonable and consistent with the taxpayer's hedging policies and strategies.

(2) Hedges of items marked to market. In the case of a transaction that hedges an item that is marked to market under the taxpayer's method of accounting, marking the hedge to market clearly reflects income.

(3) Hedges of inventory—(i) In general. If a hedging transaction hedges purchases of inventory, gain or loss on the hedging transaction may be taken into account in the same period that it would be taken into account if the gain or loss were treated as an element of the cost of inventory. Similarly, if a hedging transaction hedges sales of inventory, gain or loss on the hedging transaction may be taken into account in the same period that it would be taken into account if the gain or loss were treated as an element of sales proceeds. If a hedge is associated with a particular purchase or sales transaction, the gain or loss on the hedge may be taken into account when it would be taken into account if it were an element of cost incurred in, or sales proceeds from, that transaction. As with hedges of aggregate risk, however, a taxpayer may not be able to associate hedges of inventory purchases or sales with particular purchase or sales transactions. In order to match the timing of income, deduction, gain, or loss from the hedge with the timing of aggregate income, deduction, gain, or loss from the hedged purchases or sales, it may be appropriate for a taxpayer to account for its hedging transactions in the manner described in paragraph (e)(1)(ii) of this section, except that the gain or loss that is spread to each period is taken into account when it would be if it were an element of cost incurred (purchase hedges), or an element of proceeds from sales made (sales hedges), during that period.

(ii) Alternative methods for certain inventory hedges. In lieu of the method described in paragraph (e)(3)(i) of this section, other simpler, less precise methods may be used in appropriate cases where the clear reflection requirement of paragraph (b) of this section is satisfied. For example:

(A) Taking into account realized gains and losses on both hedges of inventory purchases and hedges of inventory sales when they would be taken into account if the gains and losses were elements of inventory cost in the period realized may clearly reflect income in some situations, but does not clearly reflect income for a taxpayer that uses the last-in, first-out method of accounting for the inventory; and

(B) Marking hedging transactions to market with resulting gain or loss taken into account immediately may clearly reflect income even though the inventory that is being hedged is not marked to market, but only if the inventory is not accounted for under either the last-in, first-out method or the lower-of-cost-or-market method and only if items are held in inventory for short periods of time.

(4) Hedges of debt instruments. Gain or loss from a transaction that hedges a debt instrument issued or to be issued by a taxpayer, or a debt instrument held or to be held by a taxpayer, must be accounted for by reference to the terms of the debt instrument and the period or periods to which the hedge relates. A hedge of an instrument that provides for interest to be paid at a fixed rate or a qualified floating rate, for example, generally is accounted for using constant yield principles. Thus, assuming that a fixed rate or qualified floating rate instrument remains outstanding, hedging gain or loss is taken into account in the same periods in which it would be taken into account if it adjusted the yield of the instrument over the term to which the hedge relates. For example, gain or loss realized on a transaction that hedged an anticipated fixed rate borrowing for its entire term is accounted for, solely for purposes of this section, as if it decreased or increased the issue price of the debt instrument. Similarly, gain or loss realized on a transaction that hedges a contingent payment on a debt instrument subject to § 1.1275-4(c) (a contingent payment debt instrument issued for nonpublicly traded property) is taken into account when the contingent payment is taken into account under § 1.1275-4(c).

(5) Notional principal contracts. The rules of § 1.446-3 govern the timing of income and deductions with respect to a notional principal contract unless, because the notional principal contract is part of a hedging transaction, the application of those rules would not result in the matching that is needed to satisfy the clear reflection requirement of paragraph (b) and, as applicable, (e)(4) of this section. For example, if a notional principal contract hedges a debt instrument, the method of accounting for periodic payments described in § 1.446-3(e) and the methods of accounting for nonperiodic payments described in § 1.446-3(f)(2)(iii) and (v) generally clearly reflect the taxpayer's income. The methods described in § 1.446-3(f)(2)(ii) and (iv), however, generally do not clearly reflect the taxpayer's income in that situation.

(6) Disposition of hedged asset or liability. If a taxpayer hedges an item and disposes of, or terminates its interest in, the item but does not dispose of or terminate the hedging transaction, the taxpayer must appropriately match the built-in gain or loss on the hedging transaction to the gain or loss on the disposed item. To meet this requirement, the taxpayer may mark the hedge to market on the date it disposes of the hedged item. If the taxpayer intends to dispose of the hedging transaction within a reasonable period, however, it may be appropriate to match the realized gain or loss on the hedging transaction with the gain or loss on the disposed item. If the taxpayer intends to dispose of the hedging transaction within a reasonable period and the hedging transaction is not actually disposed of within that period, the taxpayer must match the gain or loss on the hedge at the end of the reasonable period with the gain or loss on the disposed item. For purposes of this paragraph (e)(6), a reasonable period is generally 7 days.

(7) Recycled hedges. If a taxpayer enters into a hedging transaction by recycling a hedge of a particular hedged item to serve as a hedge of a different item, as described in § 1.1221-2(d)(4), the taxpayer must match the built-in gain or loss at the time of the recycling to the gain or loss on the original hedged item, items, or aggregate risk. Income, deduction, gain, or loss attributable to the period after the recycling must be matched to the new hedged item, items, or aggregate risk under the principles of paragraph (b) of this section.

(8) Unfulfilled anticipatory transactions—(i) In general. If a taxpayer enters into a hedging transaction to reduce risk with respect to an anticipated asset acquisition, debt issuance, or obligation, and the anticipated transaction is not consummated, any income, deduction, gain, or loss from the hedging transaction is taken into account when realized.

(ii) Consummation of anticipated transaction. A taxpayer consummates a transaction for purposes of paragraph (e)(8)(i) of this section upon the occurrence (within a reasonable interval around the expected time of the anticipated transaction) of either the anticipated transaction or a different but similar transaction for which the hedge serves to reasonably reduce risk.

(9) Hedging by members of a consolidated group—(i) General rule: single-entity approach. In general, a member of a consolidated group must account for its hedging transactions as if all of the members were separate divisions of a single corporation. Thus, the timing of the income, deduction, gain, or loss on a hedging transaction must match the timing of income, deduction, gain, or loss from the item or items being hedged. Because all of the members are treated as if they were divisions of a single corporation, intercompany transactions are neither hedging transactions nor hedged items for these purposes.

(ii) Separate-entity election. If a consolidated group makes an election under § 1.1221-2(e)(2), then paragraph (e)(9)(i) of this section does not apply. Thus, in that case, each member of the consolidated group must account for its hedging transactions in a manner that meets the requirements of paragraph (b) of this section. For example, the income, deduction, gain, or loss from intercompany hedging transactions (as defined in § 1.1221-2(e)(2)(ii)) is taken into account under the timing rules of § 1.446-4 rather than under the timing rules of § 1.1502-13.

(iii) Definitions. For definitions of consolidated group, divisions of a single corporation, intercompany transaction, and member, see section 1502 and the regulations thereunder.

(iv) Effective date. This paragraph (e)(9) applies to transactions entered into on or after March 8, 1996.

(f) Type or character of income and deduction. The rules of this section govern the timing of income, deduction, gain, or loss on hedging transactions but do not affect the type or character of income, deduction, gain, or loss produced by the transaction. Thus, for example, the rules of paragraph (e)(3) of this section do not affect the computation of cost of goods sold or sales proceeds for a taxpayer that hedges inventory purchases or sales. Similarly, the rules of paragraph (e)(4) of this section do not increase or decrease the interest income or expense of a taxpayer that hedges a debt instrument or a liability.

(g) Effective date. This section applies to hedging transactions entered into on or after October 1, 1994.

(h) Consent to change methods of accounting. The Commissioner grants consent for a taxpayer to change its methods of accounting for transactions that are entered into on or after October 1, 1994, and that are described in paragraph (a) of this section. This consent is granted only for changes for the taxable year containing October 1, 1994. The taxpayer must describe its new methods of accounting in a statement that is included in its Federal income tax return for that taxable year.

(a) In general. This section provides rules for allocating debt issuance costs over the term of the debt. For purposes of this section, the term debt issuance costs means those transaction costs incurred by an issuer of debt (that is, a borrower) that are required to be capitalized under § 1.263(a)-5. If these costs are otherwise deductible, they are deductible by the issuer over the term of the debt as determined under paragraph (b) of this section.

(b) Method of allocating debt issuance costs—(1) In general. Solely for purposes of determining the amount of debt issuance costs that may be deducted in any period, these costs are treated as if they adjusted the yield on the debt. To effect this, the issuer treats the costs as if they decreased the issue price of the debt. See § 1.1273-2 to determine issue price. Thus, debt issuance costs increase or create original issue discount and decrease or eliminate bond issuance premium.

(2) Original issue discount. Any resulting original issue discount is taken into account by the issuer under the rules in § 1.163-7, which generally require the use of a constant yield method (as described in § 1.1272-1) to compute how much original issue discount is deductible for a period. However, see § 1.163-7(b) for special rules that apply if the total original issue discount on the debt is de minimis.

(3) Bond issuance premium. Any remaining bond issuance premium is taken into account by the issuer under the rules of § 1.163-13, which generally require the use of a constant yield method for purposes of allocating bond issuance premium to accrual periods.

(c) Examples. The following examples illustrate the rules of this section:

(d) Effective date. This section applies to debt issuance costs paid or incurred for debt instruments issued on or after December 31, 2003.

(e) Accounting method changes—(1) Consent to change. An issuer required to change its method of accounting for debt issuance costs to comply with this section must secure the consent of the Commissioner in accordance with the requirements of § 1.446-1(e). Paragraph (e)(2) of this section provides the Commissioner's automatic consent for certain changes.

(2) Automatic consent. The Commissioner grants consent for an issuer to change its method of accounting for debt issuance costs incurred for debt instruments issued on or after December 31, 2003. Because this change is made on a cut-off basis, no items of income or deduction are omitted or duplicated and, therefore, no adjustment under section 481 is allowed. The consent granted by this paragraph (e)(2) applies provided—

(i) The change is made to comply with this section;

(ii) The change is made for the first taxable year for which the issuer must account for debt issuance costs under this section; and

(iii) The issuer attaches to its federal income tax return for the taxable year containing the change a statement that it has changed its method of accounting under this section.

(a) Purpose. This section provides specific timing rules for the clear reflection of income from an inducement fee received in connection with becoming the holder of a noneconomic REMIC residual interest. An inducement fee must be included in income over a period reasonably related to the period during which the applicable REMIC is expected to generate taxable income or net loss allocable to the holder of the noneconomic residual interest.

(b) Definitions. For purposes of this section:

(1) Applicable REMIC. The applicable REMIC is the REMIC that issued the noneconomic residual interest with respect to which the inducement fee is paid.

(2) Inducement fee. An inducement fee is the amount paid to induce a person to become the holder of a noneconomic residual interest in an applicable REMIC.

(3) Noneconomic residual interest. A REMIC residual interest is a noneconomic residual interest if it is a noneconomic residual interest within the meaning of § 1.860E-1(c)(2).

(4) Remaining anticipated weighted average life. The remaining anticipated weighted average life is the anticipated weighted average life determined using the methodology set forth in § 1.860E-1(a)(3)(iv) applied as of the date of acquisition of the noneconomic residual interest.

(5) REMIC. The term REMIC has the same meaning in this section as given in § 1.860D-1.

(c) General rule. All taxpayers, regardless of their overall method of accounting, must recognize an inducement fee over the remaining expected life of the applicable REMIC in a manner that reasonably reflects, without regard to this paragraph, the after-tax costs and benefits of holding that noneconomic residual interest.

(d) Special rule on disposition of a residual interest. If any portion of an inducement fee received with respect to becoming the holder of a noneconomic residual interest in an applicable REMIC has not been recognized in full by the holder as of the time the holder transfers, or otherwise ceases to be the holder for Federal tax purposes of, that residual interest in the applicable REMIC, then the holder must include the unrecognized portion of the inducement fee in income at that time. This rule does not apply to a transaction to which section 381(c)(4) applies.

(e) Safe harbors. If inducement fees are recognized in accordance with a method described in this paragraph (e), that method complies with the requirements of paragraph (c) of this section.

(1) The book method. Under the book method, an inducement fee is recognized in accordance with the method of accounting, and over the same period, used by the taxpayer for financial reporting purposes (including consolidated financial statements to shareholders, partners, beneficiaries, and other proprietors and for credit purposes), provided that the inducement fee is included in income for financial reporting purposes over a period that is not shorter than the period during which the applicable REMIC is expected to generate taxable income.

(2) The modified REMIC regulatory method. Under the modified REMIC regulatory method, the inducement fee is recognized ratably over the remaining anticipated weighted average life of the applicable REMIC as if the inducement fee were unrecognized gain being included in gross income under § 1.860F-2(b)(4)(iii).

(3) Additional safe harbor methods. The Commissioner, by revenue ruling or revenue procedure (see § 1.601(d)(2) of this chapter), may provide additional safe harbor methods for recognizing inducement fees relating to noneconomic REMIC residual interests.

(f) Method of accounting. The treatment of inducement fees is a method of accounting to which the provisions of sections 446 and 481 and the regulations thereunder apply. A taxpayer is generally permitted to adopt a method of accounting for inducement fees that satisfies the requirements of paragraph (c) of this section. Once a taxpayer adopts a method of accounting for inducement fees, that method must be applied consistently to all inducement fees received in connection with noneconomic REMIC residual interests and may be changed only with the consent of the Commissioner, as provided by section 446(e) and the regulations and procedures thereunder.

(g) Effective date. This section is applicable for taxable years ending on or after May 11, 2004.

(a) In general. This section provides a permissible method of accounting (the net asset value method, or NAV method) for gain or loss on shares in a money market fund (or MMF).

(b) Definitions. For purposes of this section—

(1) Computation period. Computation periods are the periods (of either equal or varying length) that a taxpayer selects for computing gain and loss under the NAV method for shares in an MMF. Computation periods must possess all of the following attributes:

(i) Every day during the taxable year falls within one, and only one, computation period;

(ii) Each computation period contains days from only one taxable year; and

(iii) If the taxpayer is a regulated investment company (RIC) that is not described in section 4982(f)—

(A) The same computation periods are used for purposes of both income tax accounting under chapter 1 and excise tax computations under section 4982; and

(B) The requirements in paragraphs (b)(1)(i) and (ii) of this section are also satisfied if applied by substituting the RIC's section 4982 period for the RIC's taxable year.

(2) Ending value. The ending value of a taxpayer's shares in an MMF for a computation period is the aggregate fair market value of the taxpayer's shares at the end of that computation period.

(3) Fair market value. The fair market value of a share in an MMF is determined as follows:

(i) Presumption based on applicable published redemption amount. For purposes of this section, the fair market value of a share in an MMF is presumed to be the applicable published redemption amount for the share.

(ii) Published redemption amount. The published redemption amount for a share in an MMF is the published amount for which the MMF would redeem the share (usually, the net asset value per share (NAV)), taking into account any corrections and not taking into account any liquidity fee described in Rule 2a-7(c)(2) under the Investment Company Act of 1940 (17 CFR 270.2a-7(c)(2)).

(iii) Applicable published redemption amount. The applicable published redemption amount is—

(A) For purposes of determining the ending value of a taxpayer's shares in an MMF for a computation period under paragraph (b)(2) of this section, the last published redemption amount on the last day of that computation period;

(B) For purposes of determining the value of MMF shares received in a redemption or exchange described in paragraph (b)(5)(ii)(A) of this section, the published redemption amount for such MMF shares used to determine the consideration received in the redemption or exchange, or if the consideration received is not based on a published redemption amount, the first published redemption amount for such MMF shares after the redemption or exchange;

(C) For purposes of determining the amount received in a redemption or exchange described in paragraph (b)(5)(ii)(B) of this section in which the consideration received is based on a published redemption amount for the redeemed shares, that published redemption amount; and

(D) For purposes of determining the amount received in an exchange described in paragraph (b)(5)(ii)(B) of this section that is not described in paragraph (b)(3)(iii)(C) of this section, or the amount of any adjustment resulting from a disposition transaction described in paragraph (b)(5)(iii) of this section, the first published redemption amount for the exchanged or disposed of MMF shares after the exchange or other transaction.

(iv) Facts and circumstances determination. If there is no applicable published redemption amount or if circumstances indicate that the amount does not represent the fair market value of a share in the MMF, the fair market value is determined on the basis of all of the facts and circumstances.

(4) Money market fund (or MMF). An MMF is a regulated investment company that is permitted to hold itself out to investors as a money market fund under Rule 2a-7 under the Investment Company Act of 1940 (17 CFR 270.2a-7). See paragraph (c)(5) of this section for the treatment of shares in a single MMF held in more than one account.

(5) Net investment—(i) In general. The net investment in an MMF for a computation period may be a positive amount, a negative amount, or zero. Except as provided in paragraph (b)(5)(iii) of this section, the net investment is equal to—

(A) The aggregate cost of shares in the MMF purchased during the computation period (including purchases through reinvestment of dividends); minus

(B) The aggregate amount received during the computation period in redemption of (or otherwise in exchange for) shares in the MMF in transactions in which gain or loss would be recognized if the taxpayer did not apply the NAV method to the shares.

(ii) Aggregate amount received. For purposes of paragraph (b)(5)(i)(B) of this section, the amount received in a redemption or exchange of an MMF share is—

(A) If no property other than cash and shares in one or more other MMFs is received, the amount of any cash plus the fair market value of any MMF shares received; or

(B) If any property other than cash or shares in one or more other MMFs is received, the fair market value of the redeemed MMF share.

(iii) Adjustments—(A) Dispositions in which gain or loss is not recognized. If, during the computation period, any shares in an MMF are disposed of in transactions in which gain or loss would not be recognized if the taxpayer did not apply the NAV method to the shares, the net investment in the MMF for the computation period is decreased by the fair market value of each such share at the time of its disposition.

(B) Acquisitions other than by purchase. If, during the computation period, any shares in an MMF are acquired other than by purchase, the net investment in the MMF for the computation period is increased by the adjusted basis (for purposes of determining loss) of each such share immediately after its acquisition. If the adjusted basis of an acquired share would be determined by reference to the basis of a share or shares in an MMF that are being disposed of by the taxpayer in a transaction that is governed by paragraph (b)(5)(iii)(A) of this section, then the adjusted basis of each such disposed share is treated for purposes of this section as being the fair market value of that share at the time of its disposition. If the adjusted basis of an acquired share would be determined by reference to the basis of that share in the hands of the person from whom the share is acquired and that person was applying the NAV method to the share at the time of the transaction, then the adjusted basis of the share in the hands of the person from whom the share is acquired is treated for purposes of this section as being the fair market value of that share at the time of the transaction.

(6) Section 4982 period. If a taxpayer using the NAV method is a RIC to which section 4982 applies, the section 4982 period is the one-year period with respect to which gain or loss is determined for purposes of section 4982(e)(2) and (e)(6). The preceding sentence is applied taking into account the application of section 4982(e)(4). See paragraph (c)(8) of this section regarding the application of section 4982(e)(6).

(7) Starting basis. The starting basis of a taxpayer's shares in an MMF for a computation period is—

(i) Except as provided in paragraph (b)(7)(ii) of this section, the ending value of the taxpayer's shares in the MMF for the immediately preceding computation period; or

(ii) For the first computation period in a taxable year, if the taxpayer did not use the NAV method for shares in the MMF for the immediately preceding taxable year, the aggregate adjusted basis of the taxpayer's shares in the MMF at the end of the immediately preceding taxable year.

(c) NAV method—(1) Scope. A taxpayer may use the NAV method described in this section to determine the gain or loss for a taxable year on the taxpayer's shares in an MMF. A taxpayer may have different methods of accounting, different computation periods, and gains or losses of differing character, for its shares in different MMFs. See paragraph (c)(5) of this section for the treatment of shares in a single MMF held in more than one account. See paragraph (c)(6) of this section for rules applicable to RICs to which section 4982 applies. See paragraph (c)(8) of this section for rules applicable to accounting method changes.

(2) Net gain or loss for a taxable year—(i) Determination for each computation period. Subject to any adjustment under paragraph (c)(2)(ii) of this section, the net gain or loss for each computation period with respect to the shares in an MMF to which the NAV method applies equals the ending value, minus the starting basis, minus the net investment in the MMF for the computation period. If the computation produces a result that is greater than zero, the taxpayer has a gain for the computation period with respect to the shares in the MMF; if the computation produces a result that is less than zero, the taxpayer has a loss for the computation period with respect to the shares in the MMF; and if the computation produces a result that is equal to zero, the taxpayer has no gain or loss for the computation period with respect to the shares in the MMF.

(ii) Adjustment of gain or loss to reflect any basis adjustments. If, during a computation period, there is any downward (or upward) adjustment to the taxpayer's basis in the shares in the MMF under any provision of internal revenue law, then the net gain or loss for the computation period on shares in the MMF determined under paragraph (c)(2)(i) of this section is increased (or decreased) by the amount of the adjustment.

(iii) Timing of gains and losses. Gain or loss determined under the NAV method with respect to a taxpayer's shares in an MMF during a computation period is treated as arising on the last day of the computation period.

(iv) Determination of net gain or loss for each taxable year. The taxpayer's net gain or loss for a taxable year on shares in an MMF is the sum of the net gains or losses on shares in the MMF for the computation period (or computation periods) that comprise the taxable year.

(3) Character—(i) In the case of a taxpayer that applies the NAV method to shares in an MMF, the gain or loss with respect to those shares for a computation period is treated as gain or loss from a sale or exchange of a capital asset provided the sale or exchange of one or more of those shares during the computation period would give rise to capital gain or loss if the taxpayer did not apply the NAV method to the shares.

(ii) In the case of a taxpayer that applies the NAV method to shares in an MMF, the gain or loss with respect to those shares for a computation period is treated as ordinary gain or loss provided the sale or exchange of every one of those shares during the computation period would give rise to ordinary gain or loss if the taxpayer did not apply the NAV method to the shares.

(iii) See paragraph (c)(5) of this section for the treatment of shares in a single MMF held in more than one account.

(4) Holding period. Capital gains and losses determined under the NAV method are treated as short-term capital gains and losses.

(5) More than one account. If a taxpayer holds shares in an MMF through more than one account, the taxpayer must treat its holdings in each account as a separate MMF for purposes of this section. A taxpayer therefore may have different methods of accounting, different computation periods, and gains or losses of differing character, for its shares of a single MMF held in different accounts.

(6) Consistency requirement for MMF shareholders that are RICs. If the taxpayer is a RIC that is not described in section 4982(f) (and therefore is subject to the section 4982 excise tax), then, for each MMF, the taxpayer must use the NAV method for both income tax and excise tax computations or for neither computation. See paragraph (c)(5) of this section for the treatment of shares in a single MMF held in more than one account. See paragraph (c)(8)(ii) of this section for changes to or from the NAV method by a RIC.

(7) Treatment of ordinary gains and losses under section 4982(e)(6). Under section 4982(e)(6)(B), this section is a specified mark to market provision, and therefore any ordinary gains and losses determined under the NAV method are governed by section 4982(e)(6)(A).

(8) Accounting method changes—(i) In general. A change to or from the NAV method is a change in method of accounting to which the provisions of section 446 and the accompanying regulations apply. A taxpayer seeking to change to or from the NAV method must secure the consent of the Commissioner in accordance with § 1.446-1(e) and follow the administrative procedures issued under § 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to change the taxpayer's accounting method. Any such change will be made on a cut-off basis. Because there will be no duplication or omission of amounts as a result of such a change to or from the NAV method, no adjustment under section 481(a) will be required or permitted.

(ii) RICs—(A) In general. A RIC that is subject to the excise tax under section 4982 and that changes to or from the NAV method for its shares in an MMF for income tax purposes must apply the new method for excise tax purposes starting with the first day of the RIC's income tax year of change. If that first day is not the first day of the RIC's section 4982 period that ends in or with the RIC's income tax year, then solely for purposes of applying the NAV method to compute the RIC's required distribution for the calendar year that ends with or within the RIC's income tax year of change, the section 4982 period is bifurcated into two portions, each of which is treated as a separate taxable year. The first portion begins on the first day of the section 4982 period and ends on the last day of the RIC's income tax year that precedes the year of change. The second portion begins on the first day of the income tax year of change and ends on the last day of the section 4982 period.

(B) Example. If a RIC that holds MMF shares as capital assets changes from a realization method to the NAV method for its income tax year ending January 31, 2019, the section 4982 period is bifurcated into two portions that are treated as separate taxable years solely for purposes of applying this section. For the portion starting on November 1, 2017, and ending on January 31, 2018, the RIC applies its realization method for excise tax purposes. For the portion starting on February 1, 2018, and ending on October 31, 2018, the RIC applies the NAV method for excise tax purposes, treating February 1, 2018, as the first day of the RIC's tax year for purposes of paragraphs (b)(1) and (6) of this section. The RIC's net gain or loss for this later portion is determined under paragraph (c)(2)(iii) of this section. This net gain or loss and any gains and losses for the earlier portion determined under the realization method are taken into account in determining the RIC's capital gain net income for the full one-year period described in section 4982(b)(1)(B).

(d) Example. The provisions of this section may be illustrated by the following example:

(e) Effective/applicability date. Except as provided in the following sentence, this section applies to taxable years ending on or after July 8, 2016. For taxable years ending on or after July 28, 2014, and beginning before July 8, 2016, however, shareholders of MMFs may rely either on this section or on § 1.446-7 of the 2014 proposed regulations REG-107012-14 (79 FR 43694).

(a)-(f) [Reserved]

(g) Treatment of accounting method change and timing rules for section 481(a) adjustment—(1) Treatment of change in accounting method. The rules provided in paragraph (g) of this section apply to taxable years beginning before January 1, 2018. See § 1.448-2 for rules relating to taxable years beginning after December 31, 2017. Notwithstanding any other procedure published prior to January 7, 1991, concerning changes from the cash method, any taxpayer to whom section 448 applies must change its method of accounting in accordance with the provisions of this paragraph (g) and paragraph (h) of this section. In the case of any taxpayer required by this section to change its method of accounting for any taxable year, the change shall be treated as a change initiated by the taxpayer. The adjustments required under section 481(a) with respect to the change in method of accounting of such a taxpayer shall not be reduced by amounts attributable to taxable years preceding the Internal Revenue Code of 1954. Paragraph (h)(2) of this section provides procedures under which a taxpayer may change to an overall accrual method of accounting for the first taxable year the taxpayer is subject to this section (“first section 448 year”). If the taxpayer complies with the provisions of paragraph (h)(2) of this section for its first section 448 year, the change shall be treated as made with the consent of the Commissioner. Paragraph (h)(3) of this section provides procedures under which a taxpayer may change to other than an overall accrual method of accounting for its first section 448 year. Unless the taxpayer complies with the provisions of paragraph (h)(2) or (h)(3) of this section for its first section 448 year, the taxpayer must comply with the provisions of paragraph (h)(4) of this section. See paragraph (h) of this section for rules to effect a change in method of accounting.

(2) Timing rules for section 481(a) adjustment—(i) In general. Except as otherwise provided in paragraphs (g)(2)(ii) and (g)(3) of this section, a taxpayer required by this section to change from the cash method must take the net section 481(a) adjustment into account over the section 481(a) adjustment period as determined under the applicable administrative procedures issued under § 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to a change in accounting method (for example, see Rev. Proc. 2002-9 (2002-1 C.B. 327) and Rev. Proc. 97-27 (1997-1 C.B. 680) (also see § 601.601(d)(2) of this chapter)), provided the taxpayer complies with the provisions of paragraph (h)(2) or (3) of this section for its first section 448 year.

(ii) Hospital timing rules—(A) In general. In the case of a hospital that is required by this section to change from the cash method, the section 481(a) adjustment shall be taken into account ratably (beginning with the year of change) over 10 years, provided the taxpayer complies with the provisions of paragraph (h)(2) or (h)(3) of this section for its first section 448 year.

(B) Definition of hospital. For purposes of paragraph (g) of this section, a hospital is an institution—

(1) Accredited by the Joint Commission on Accreditation of Healthcare Organizations or its predecessor (the JCAHO) (or accredited or approved by a program of the qualified governmental unit in which such institution is located if the Secretary of Health and Human Services has found that the accreditation or comparable approval standards of such qualified governmental unit are essentially equivalent to those of the JCAHO);

(2) Used primarily to provide, by or under the supervision of physicians, to inpatients diagnostic services and therapeutic services for medical diagnosis, treatment, and care of injured, disabled, or sick persons;

(3) Requiring every patient to be under the care and supervision of a physician; and

(4) Providing 24-hour nursing services rendered or supervised by a registered professional nurse and having a licensed practical nurse or registered nurse on duty at all times.

(C) Dual function facilities. With respect to any taxpayer whose operations consist both of a hospital, and other facilities not qualifying as a hospital, the portion of the adjustment required by section 481(a) that is attributable to the hospital shall be taken into account in accordance with the rules of paragraph (g)(2) of this section relating to hospitals. The portion of the adjustment required by section 481(a) that is not attributable to the hospital shall be taken into account in accordance with the rules of paragraph (g)(2) of this section not relating to hospitals.

(iii) Untimely change in method of accounting to comply with this section. Unless a taxpayer (including a hospital and a cooperative) required by this section to change from the cash method complies with the provisions of paragraph (h)(2) or (h)(3) of this section for its first section 448 year within the time prescribed by those paragraphs, the taxpayer must take the section 481 (a) adjustment into account under the provisions of any applicable administrative procedure that is prescribed by the Commissioner after January 7, 1991, specifically for purposes of complying with this section. Absent such an administrative procedure, a taxpayer must request a change under § 1.446-1(e)(3) and shall be subject to any terms and conditions (including the year of change) as may be imposed by the Commissioner.

(3) Special timing rules for section 481(a) adjustment—(i)Cessation of trade or business. If the taxpayer ceases to engage in the trade or business to which the section 481(a) adjustment relates, or if the taxpayer operating the trade or business terminates existence, and such cessation or termination occurs prior to the expiration of the adjustment period described in paragraph (g)(2)(i) or (ii) of this section, the taxpayer must take into account, in the taxable year of such cessation or termination, the balance of the adjustment not previously taken into account in computing taxable income. For purposes of this paragraph (g)(3)(i), the determination as to whether a taxpayer has ceased to engage in the trade or business to which the section 481(a) adjustment relates, or has terminated its existence, is to be made under the principles of § 1.446-1(e)(3)(ii) and its underlying administrative procedures.

(ii) De minimis rule for a taxpayer other than a cooperative. Notwithstanding paragraph (g)(2)(i) and (ii) of this section, a taxpayer other than a cooperative (within the meaning of section 1381(a)) that is required to change from the cash method by this section may elect to use, in lieu of the adjustment period described in paragraph (g)(2)(i) and (ii) of this section, the adjustment period for de minimis section 481(a) adjustments provided in the applicable administrative procedure issued under § 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to a change in accounting method. A taxpayer may make an election under this paragraph (g)(3)(ii) only if—

(A) The taxpayer's entire net section 481(a) adjustment (whether positive or negative) is a de minimis amount as determined under the applicable administrative procedure issued under § 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to a change in accounting method,

(B) The taxpayer complies with the provisions of paragraph (h)(2) or (3) of this section for its first section 448 year,

(C) The return for such year is due (determined with regard to extensions) after December 27, 1993, and

(D) The taxpayer complies with any applicable instructions to Form 3115 that specify the manner of electing the adjustment period for de minimis section 481(a) adjustments.

(4) Additional rules relating to section 481(a) adjustment. In addition to the rules set forth in paragraph (g) (2) and (3) of this section, the following rules shall apply in taking the section 481(a) adjustment into account—

(i) Any net operating loss and tax credit carryforwards will be allowed to offset any positive section 481(a) adjustment,

(ii) Any net operating loss arising in the year of change or in any subsequent year that is attributable to a negative section 481(a) adjustment may be carried back to earlier taxable years in accordance with section 172, and

(iii) For purposes of determining estimated income tax payments under sections 6654 and 6655, the section 481(a) adjustment will be recognized in taxable income ratably throughout a taxable year.

(5) Outstanding section 481(a) adjustment from previous change in method of accounting. If a taxpayer changed its method of accounting to the cash method for a taxable year prior to the year the taxpayer was required by this section to change from the cash method (the section 448 year), any section 481(a) adjustment from such prior change in method of accounting that is outstanding as of the section 448 year shall be taken into account in accordance with the provisions of this paragraph (g)(5). A taxpayer shall account for any remaining portion of the prior section 481(a) adjustment outstanding as of the section 448 year by continuing to take such remaining portion into account under the provisions and conditions of the prior change in method of accounting, or, at the taxpayer's option, combining or netting the remaining portion of the prior section 481(a) adjustment with the section 481(a) adjustment required under this section, and taking into account under the provisions of this section the resulting net amount of the adjustment. Any taxpayer choosing to combine or net the section 481(a) adjustments as described in the preceding sentence shall indicate such choice on the Form 3115 required to be filed by such taxpayer under the provisions of paragraph (h) of this section.

(h) Procedures for change in method of accounting—(1) Applicability. The rules provided in paragraph (h) of this section apply to taxable years beginning before January 1, 2018. See § 1.448-2 for rules relating to taxable years beginning after December 31, 2017. Paragraph (h) of this section applies to taxpayers who change from the cash method as required by this section. Paragraph (h) of this section does not apply to a change in accounting method required by any Code section (or regulations thereunder) other than this section.

(2) Automatic rule for changes to an overall accrual method—(i) Timely changes in method of accounting. Notwithstanding any other available procedures to change to the accrual method of accounting, a taxpayer to whom paragraph (h) of this section applies who desires to make a change to an overall accrual method for its first section 448 year must make that change under the provisions of this paragraph (h)(2). A taxpayer changing to an overall accrual method under this paragraph (h)(2) must file a current Form 3115 by the time prescribed in paragraph (h)(2)(ii). In addition, the taxpayer must set forth on a statement accompanying the Form 3115 the period over which the section 481(a) adjustment will be taken into account and the basis for such conclusion. Moreover, the taxpayer must type or legibly print the following statement at the top of page 1 of the Form 3115: “Automatic Change to Accrual Method—Section 448.” The consent of the Commissioner to the change in method of accounting is granted to taxpayers who change to an overall accrual method under this paragraph (h)(2). See paragraph (g)(2)(i), (g)(2)(ii), or (g)(3) of this section, whichever is applicable, for rules to account for the section 481(a) adjustment.

(ii) Time and manner for filing Form 3115—(A) In general. Except as provided in paragraph (h)(2)(ii)(B) of this section, the Form 3115 required by paragraph (h)(2)(i) must be filed no later than the due date (determined with regard to extensions) of the taxpayer's federal income tax return for the first section 448 year and must be attached to that return.

(B) Extension of filing deadline. Notwithstanding paragraph (h)(2)(ii)(A) of this section, the filing of the Form 3115 required by paragraph (h)(2)(i) shall not be considered late if such Form 3115 is attached to a timely filed amended income tax return for the first section 448 year, provided that—

(1) The taxpayer's first section 448 year is a taxable year that begins (or, pursuant to § 1.441-2(c), is deemed to begin) in 1987, 1988, 1989, or 1990,

(2) The taxpayer has not been contacted for examination, is not before appeals, and is not before a federal court with respect to an income tax issue (each as defined in applicable administrative pronouncements), unless the taxpayer also complies with any requirements for approval in those applicable administrative pronouncements, and

(3) Any amended return required by this paragraph (h)(2)(ii)(B) is filed on or before July 8, 1991.

(3) Changes to a method other than overall accrual method—(i) In general. A taxpayer to whom paragraph (h) of this section applies who desires to change to a special method of accounting must make that change under the provisions of this paragraph (h)(3), except to the extent other special procedures have been promulgated regarding the special method of accounting. Such a taxpayer includes taxpayers who change to both an accrual method of accounting and a special method of accounting such as a long-term contract method. In order to change an accounting method under this paragraph (h)(3), a taxpayer must submit an application for change in accounting method under the applicable administrative procedures in effect at the time of change, including the applicable procedures regarding the time and place of filing the application for change in method. Moreover, a taxpayer who changes an accounting method under this paragraph (h)(3) must type or legibly print the following statement on the top of page 1 of Form 3115: “Change to a Special Method of Accounting—Section 448.” The filing of a Form 3115 by any taxpayer requesting a change of method of accounting under this paragraph (h)(3) for its taxable year beginning in 1987 will not be considered late if the form is filed with the appropriate office of the Internal Revenue Service on or before the later of: the date that is the 180th day of the taxable year of change; or September 14, 1987. If the Commissioner approves the taxpayer's application for change in method of accounting, the timing of the adjustment required under section 481 (a), if applicable, will be determined under the provisions of paragraph (g)(2)(i), (g)(2)(ii), or (g)(3) of this section, whichever is applicable. If the Commissioner denies the taxpayer's application for change in accounting method, or if the taxpayer's application is untimely, the taxpayer must change to an overall accrual method of accounting under the provisions of either paragraph (h)(2) or (h)(4) of this section, whichever is applicable.

(ii) Extension of filing deadline. Notwithstanding paragraph (h)(3)(i) of this section, if the events or circumstances which under section 448 disqualify a taxpayer from using the cash method occur after the time prescribed under applicable procedures for filing the Form 3115, the filing of such form shall not be considered late if such form is filed on or before 30 days after the close of the taxable year.

(4) Untimely change in method of accounting to comply with this section. Unless a taxpayer to whom paragraph (h) of this section applies complies with the provisions of paragraph (h)(2) or (h)(3) of this section for its first section 448 year, the taxpayer must comply with the requirements of § 1.446-1 (e)(3) (including any applicable administrative procedure that is prescribed thereunder after January 7, 1991 specifically for purposes of complying with this section) in order to secure the consent of the Commissioner to change to a method of accounting that is in compliance with the provisions of this section. The taxpayer shall be subject to any terms and conditions (including the year of change) as may be imposed by the Commissioner.

(i) Effective date—(1) In general. Except as provided in paragraph (i)(2), (3), (4), and (5) of this section, this section applies to any taxable year beginning after December 31, 1986.

(2) Election out of section 448—(i) In general. A taxpayer may elect not to have this section apply to any (A) transaction with a related party (within the meaning of section 267(b) of the Internal Revenue Code of 1954, as in effect on October 21, 1986), (B) loan, or (C) lease, if such transaction, loan, or lease was entered into on or before September 25, 1985. Any such election described in the preceding sentence may be made separately with respect to each transaction, loan, or lease. For rules relating to the making of such election, see § 301.9100-7T (temporary regulations relating to elections under the Tax Reform Act of 1986). Notwithstanding the provisions of this paragraph (i)(2), the gross receipts attributable to a transaction, loan, or lease described in this paragraph (i)(2) shall be taken into account for purposes of the $5,000,000 gross receipts test described in paragraph (f) of this section.

(ii) Special rules for loans. If the taxpayer makes an election under paragraph (i)(2)(i) of this section with respect to a loan entered into on or before September 25, 1985, the election shall apply only with respect to amounts that are attributable to the loan balance outstanding on September 25, 1985. The election shall not apply to any amounts advanced or lent after September 25, 1985, regardless of whether the loan agreement was entered into on or before such date. Moreover, any payments made on outstanding loan balances after September 25, 1985, shall be deemed to first extinguish loan balances outstanding on September 25, 1985, regardless of any contrary treatment of such loan payments by the borrower and lender.

(3) Certain contracts entered into before September 25, 1985. This section does not apply to a contract for the acquisition or transfer of real property or a contract for services related to the acquisition or development of real property if—

(i) The contract was entered into before September 25, 1985; and

(ii) The sole element of the contract which was not performed as of September 25, 1985, was payment for such property or services.

(4) Transitional rule for paragraphs (g) and (h) of this section. To the extent the provisions of paragraphs (g) and (h) of this section were not reflected in paragraphs (g) and (h) of § 1.448-1T (as set forth in 26 CFR part 1 as revised on April 1, 1993), paragraphs (g) and (h) of this section will not be adversely applied to a taxpayer with respect to transactions entered into before December 27, 1993.

(5) Effective date of paragraph (g)(2)(i). Paragraph (g)(2)(i) of this section applies to taxable years ending on or after June 16, 2004.

(a) Limitation on accounting method—(1) In general. This section prescribes regulations under section 448 relating to the limitation on the use of the cash receipts and disbursements method of accounting (the cash method) by certain taxpayers.

(2) Limitation rule. Except as otherwise provided in this section, the computation of taxable income using the cash method is prohibited in the case of a—

(i) C corporation,

(ii) Partnership with a C corporation as a partner, or

(iii) Tax shelter.

(3) Meaning of C corporation. For purposes of this section, the term “C corporation” includes any corporation that is not an S corporation. For example, a regulated investment company (as defined in section 851) or a real estate investment trust (as defined in section 856) is a C corporation for purposes of this section. In addition, a trust subject to tax under section 511 (b) shall be treated, for purposes of this section, as a C corporation, but only with respect to the portion of its activities that constitute an unrelated trade or business. Similarly, for purposes of this section, a corporation that is exempt from federal income taxes under section 501 (a) shall be treated as a C corporation only with respect to the portion of its activities that constitute an unrelated trade or business. Moreover, for purposes of determining whether a partnership has a C corporation as a partner, any partnership described in paragraph (a)(2)(ii) of this section is treated as a C corporation. Thus, if partnership ABC has a partner that is a partnership with a C corporation, then, for purposes of this section, partnership ABC is treated as a partnership with a C corporation partner.

(4) Treatment of a combination of methods. For purposes of this section, the use of a method of accounting that records some, but not all, items on the cash method shall be considered the use of the cash method. Thus, a C corporation that uses a combination of accounting methods including the use of the cash method is subject to this section.

(b) Tax shelter defined—(1) In general. For purposes of this section, the term “tax shelter” means any—

(i) Enterprise (other than a C corporation) if at any time (including taxable years beginning before January 1, 1987) interests in such enterprise have been offered for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale,

(ii) Syndicate (within the meaning of paragraph (b)(3) of this section), or

(iii) Tax shelter within the meaning of section 6662(d)(2)(C).

(2) Requirement of registration. For purposes of paragraph (b)(1)(i) of this section, an offering is required to be registered with a federal or state agency if, under the applicable federal or state law, failure to register the offering would result in a violation of the applicable federal or state law (regardless of whether the offering is in fact registered). In addition, an offering is required to be registered with a federal or state agency if, under the applicable federal or state law, failure to file a notice of exemption from registration would result in a violation of the applicable federal or state law (regardless of whether the notice is in fact filed).

(3) Meaning of syndicate. For purposes of paragraph (b)(1)(ii) of this section, the term “syndicate” means a partnership or other entity (other than a C corporation) if more than 35 percent of the losses of such entity during the taxable year (for taxable years beginning after December 31, 1986) are allocated to limited partners or limited entrepreneurs. For purposes of this paragraph (b)(3), the term “limited entrepreneur” has the same meaning given such term in section 464 (e)(2). In addition, in determining whether an interest in a partnership is held by a limited partner, or an interest in an entity or enterprise is held by a limited entrepreneur, section 464 (c)(2) shall apply in the case of the trade or business of farming (as defined in paragraph (d)(2) of this section), and section 1256 (e)(3)(C) shall apply in any other case. Moreover, for purposes of this paragraph (b)(3), the losses of a partnership, entity, or enterprise (the enterprise) means the excess of the deductions allowable to the enterprise over the amount of income recognized by such enterprise under the enterprise's method of accounting used for federal income tax purposes (determined without regard to this section). For this purpose, gains or losses from the sale of capital assets or section 1221 (2) assets are not taken into account.

(4) Presumed tax avoidance. For purposes of paragraph (b)(1)(iii) of this section, marketed arrangements in which persons carrying on farming activities using the services of a common managerial or administrative service will be presumed to have the principal purpose of tax avoidance if such persons use borrowed funds to prepay a substantial portion of their farming expenses (e.g., payment for farm supplies that will not be used or consumed until a taxable year subsequent to the taxable year of payment).

(5) Taxable year tax shelter must change accounting method. A partnership, entity, or enterprise that is a tax shelter must change from the cash method for the later of (i) the first taxable year beginning after December 31, 1986, or (ii) the taxable year that such partnership, entity, or enterprise becomes a tax shelter.

(c) Effect of section 448 on other provisions. Nothing in section 448 shall have any effect on the application of any other provision of law that would otherwise limit the use of the cash method, and no inference shall be drawn from section 448 with respect to the application of any such provision. For example, nothing in section 448 affects the requirement of section 447 that certain corporations must use an accrual method of accounting in computing taxable income from farming, or the requirement of § 1.446-1(c)(2) that an accrual method be used with regard to purchases and sales of inventory. Similarly, nothing in section 448 affects the authority of the Commissioner under section 446(b) to require the use of an accounting method that clearly reflects income, or the requirement under section 446(e) that a taxpayer secure the consent of the Commissioner before changing its method of accounting. For example, a taxpayer using the cash method may be required to change to an accrual method of accounting under section 446(b) because such method clearly reflects that taxpayer's income, even though the taxpayer is not prohibited by section 448 from using the cash method. Similarly, a taxpayer using an accrual method of accounting that is not prohibited by section 448 from using the cash method may not change to the cash method unless the taxpayer secures the consent of the Commissioner under section 446(e), and, in the opinion of the Commissioner, the use of the cash method clearly reflects that taxpayer's income under section 446(b).

(d) Exception for farming business—(1) In general. Except in the case of a tax shelter, this section shall not apply to any farming business. A taxpayer engaged in a farming business and a separate nonfarming business is not prohibited by this section from using the cash method with respect to the farming business, even though the taxpayer may be prohibited by this section from using the cash method with respect to the nonfarming business.

(2) Meaning of farming business. For purposes of paragraph (d) of this section, the term “farming business” means—

(i) The trade or business of farming as defined in section 263A(e)(4) (including the operation of a nursery or sod farm, or the raising or harvesting of trees bearing fruit, nuts, or other crops, or ornamental trees), or

(ii) The raising, harvesting , or growing of trees described in section 263A(c)(5) (relating to trees raised, harvested, or grown by the taxpayer other than trees described in paragraph (d)(2)(i) of this section).

(e) Exception for qualified personal service corporation—(1) In general. Except in the case of a tax shelter, this section does not apply to a qualified personal service corporation.

(2) Certain treatment for qualified personal service corporation. For purposes of paragraph (a)(2)(ii) of this section (relating to whether a partnership has a C corporation as a partner), a qualified personal service corporation shall be treated as an individual.

(3) Meaning of qualified personal service corporation. For purposes of this section, the term “qualified personal service corporation” means any corporation that meets—

(i) The function test paragraph (e)(4) of this section, and

(ii) The ownership test of paragraph (e)(5) of this section.

(4) Function test—(i) In general. A corporation meets the function test if substantially all the corporation's activities for a taxable year involve the performance of services in one or more of the following fields—

(A) Health,

(B) Law,

(C) Engineering (including surveying and mapping),

(D) Architecture,

(E) Accounting,

(F) Actuarial science,

(G) Performing arts, or

(H) Consulting.

(ii) Meaning of services performed in the field of health. For purposes of paragraph (e)(4)(i)(A) of this section, the performance of services in the field of health means the provision of medical services by physicians, nurses, dentists, and other similar healthcare professionals. The performance of services in the field of health does not include the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient. For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers.

(iii) Meaning of services performed in the field of performing arts. For purposes of paragraph (e)(4)(i)(G) of this section, the performance of services in the field of the performing arts means the provision of services by actors, actresses, singers, musicians, entertainers, and similar artists in their capacity as such. The performance of services in the field of the performing arts does not include the provision of services by persons who themselves are not performing artists (e.g., persons who may manage or promote such artists, and other persons in a trade or business that relates to the performing arts). Similarly, the performance of services in the field of the performing arts does not include the provision of services by persons who broadcast or otherwise disseminate the performances of such artists to members of the public (e.g., employees of a radio station that broadcasts the performances of musicians and singers). Finally, the performance of services in the field of the performing arts does not include the provision of services by athletes.

(iv) Meaning of services performed in the field of consulting—(A) In general. For purposes of paragraph (e)(4)(i)(H) of this section, the performance of services in the field of consulting means the provision of advice and counsel. The performance of services in the field of consulting does not include the performance of services other than advice and counsel, such as sales or brokerage services, or economically similar services. For purposes of the preceding sentence, the determination of whether a person's services are sales or brokerage services, or economically similar services, shall be based on all the facts and circumstances of that person's business. Such facts and circumstances include, for example, the manner in which the taxpayer is compensated for the services provided (e.g., whether the compensation for the services is contingent upon the consummation of the transaction that the services were intended to effect).

(B) Examples. The following examples illustrate the provisions of paragraph (e)(4)(iv)(A) of this section. The examples do not address all types of services that may or may not qualify as consulting. The determination of whether activities not specifically addressed in the examples qualify as consulting shall be made by comparing the service activities in question to the types of service activities discussed in the examples. With respect to a corporation which performs services which qualify as consulting under this section, and other services which do not qualify as consulting, see paragraph (e)(4)(i) of this section which requires that substantially all of the corporation's activities involve the performance of services in a qualifying field.

(5) Ownership test—(i) In general. A corporation meets the ownership test, if at all times during the taxable year, substantially all the corporation's stock, by value, is held, directly or indirectly, by—

(A) Employees performing services for such corporation in connection with activities involving a field referred to in paragraph (e)(4) of this section,

(B) Retired employees who had performed such services for such corporation,

(C) The estate of any individual described in paragraph (e)(5)(i) (A) or (B) of this section, or

(D) Any other person who acquired such stock by reason of the death of an individual described in paragraph (e)(5)(i) (A) or (B) of this section, but only for the 2-year period beginning on the date of the death of such individual.

(ii) Definition of employee. For purposes of the ownership test of this paragraph (e)(5) of this section, a person shall not be considered an employee of a corporation unless the services performed by that person for such corporation, based on the facts and circumstances, are more than de minimis. In addition, a person who is an employee of a corporation shall not be treated as an employee of another corporation merely by reason of the employer corporation and the other corporation being members of the same affiliated group or otherwise related.

(iii) Attribution rules. For purposes of this paragraph (e)(5) of this section, a corporation's stock is considered held indirectly by a person if, and to the extent, such person owns a proportionate interest in a partnership, S corporation, or qualified personal service corporation that owns such stock. No other arrangement or type of ownership shall constitute indirect ownership of a corporation's stock for purposes of this paragraph (e)(5) of this section. Moreover, stock of a corporation held by a trust is considered held by a person if, and to the extent, such person is treated under subpart E, part I, subchapter J, chapter 1 of the Code as the owner of the portion of the trust that consists of such stock.

(iv) Disregard of community property laws. For purposes of this paragraph (e)(5) of this section, community property laws shall be disregarded. Thus, in determining the stock ownership of a corporation, stock owned by a spouse solely by reason of community property laws shall be treated as owned by the other spouse.

(v) Treatment of certain stock plans. For purposes of this paragraph (e)(5) of this section, stock held by a plan described in section 401 (a) that is exempt from tax under section 501 (a) shall be treated as held by an employee described in paragraph (e)(5)(i)(A) of this section.

(vi) Special election for certain affiliated groups. For purposes of determining whether the stock ownership test of this paragraph (e)(5) of this section has been met, at the election of the common parent of an affiliated group (within the meaning of section 1504 (a)), all members of such group shall be treated as one taxpayer if substantially all (within the meaning of paragraph (e)(4)(i) of this section) the activities of all such members (in the aggregate) are in the same field described in paragraph (e)(4)(i)(A)-(H) of this section. For rules relating to the making of the election, see 26 CFR 5h.5 (temporary regulations relating to elections under the Tax Reform Act of 1986).

(vii) Examples. The following examples illustrate the provisions of paragraph (e) of this section:

(6) Application of function and ownership tests. A corporation that fails the function test of paragraph (e)(4) of this section for any taxable year, or that fails the ownership test of paragraph (e)(5) of this section at any time during any taxable year, shall change from the cash method effective for the year in which the corporation fails to meet the function test or the ownership test. For example, if a personal service corporation fails the function test for taxable year 1987, such corporation must change from the cash method effective for taxable year 1987. A corporation that fails the function or ownership test for a taxable year shall not be treated as a qualified personal service corporation for any part of that taxable year.

(f) Exception for entities with gross receipts of not more than $5 million—(1) In general. Except in the case of a tax shelter, this section shall not apply to any C corporation or partnership with a C corporation as a partner for any taxable year if, for all prior taxable years beginning after December 31, 1985, such corporation or partnership (or any predecessor thereof) meets the $5,000,000 gross receipts test of paragraph (f)(2) of this section.

(2) The $5,000,000 gross receipts test—(i) In general. A corporation meets the $5,000,000 gross receipts test of this paragraph (f)(2) for any prior taxable year if the average annual gross receipts of such corporation for the 3 taxable years (or, if shorter, the taxable years during which such corporation was in existence) ending with such prior taxable year does not exceed $5,000,000. In the case of a C corporation exempt from federal income taxes under section 501(a), or a trust subject to tax under section 511(b) that is treated as a C corporation under paragraph (a)(3) of this section, only gross receipts from the activities of such corporation or trust that constitute unrelated trades or businesses are taken into account in determining whether the $5,000,000 gross receipts test is satisfied. A partnership with a C corporation as a partner meets the $5,000,000 gross receipts test of this paragraph (f)(2) for any prior taxable year if the average annual gross receipts of such partnership for the 3 taxable years (or, if shorter, the taxable years during which such partnership was in existence) ending with such prior year does not exceed $5,000,000. The gross receipts of the corporate partner are not taken into account in determining whether the partnership meets the $5,000,000 gross receipts test.

(ii) Aggregation of gross receipts. For purposes of determining whether the $5,000,000 gross receipts test has been satisfied, all persons treated as a single employer under section 52 (a) or (b), or section 414 (m) or (o) (or who would be treated as a single employer under such sections if they had employees) shall be treated as one person. Gross receipts attributable to transactions between persons who are treated as a common employer under this paragraph shall not be taken into account in determining whether the $5,000,000 gross receipts test is satisified.

(iii) Treatment of short taxable year. In the case of any taxable year of less than 12 months (a short taxable year), the gross receipts shall be annualized by (A) multiplying the gross receipts for the short period by 12 and (B) dividing the result by the number of months in the short period.

(iv) Determination of gross receipts—(A) In general. The term “gross receipts” means gross receipts of the taxable year in which such receipts are properly recognized under the taxpayer's accounting method used in that taxable year (determined without regard to this section) for federal income tax purposes. For this purpose, gross receipts include total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments, and from incidental or outside sources. For example, gross receipts include interest (including original issue discount and tax-exempt interest within the meaning of section 103), dividends, rents, royalties, and annuities, regardless of whether such amounts are derived in the ordinary course of the taxpayer's trade of business. Gross receipts are not reduced by cost of goods sold or by the cost of property sold if such property is described in section 1221 (1), (3), (4) or (5). With respect to sales of capital assets as defined in section 1221, or sales of property described in 1221 (2) (relating to property used in a trade or business), gross receipts shall be reduced by the taxpayer's adjusted basis in such property. Gross receipts do not include the repayment of a loan or similar instrument (e.g., a repayment of the principal amount of a loan held by a commercial lender). Finally, gross receipts do not include amounts received by the taxpayer with respect to sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority. If, in contrast, the tax is imposed on the taxpayer under the applicable law, then gross receipts shall include the amounts received that are allocable to the payment of such tax.

(3) Examples. The following examples illustrate the provisions of paragraph (f) of this section:

(a) Limitation on method of accounting—(1) In general. The rules of this section relate to the limitation on the use of the cash receipts and disbursements method of accounting (cash method) by certain taxpayers applicable for taxable years beginning after December 31, 2017. For rules applicable to taxable years beginning before January 1, 2018, see §§ 1.448-1 and 1.448-1T.

(2) Limitation rule. Except as otherwise provided in this section, the computation of taxable income using the cash method is prohibited in the case of a:

(i) C corporation;

(ii) Partnership with a C corporation as a partner, or a partnership that had a C corporation as a partner at any time during the partnership's taxable year beginning after December 31, 1986; or

(iii) Tax shelter.

(3) Treatment of combination methods—(i) In general. For purposes of this section, the use of a method of accounting that records some, but not all, items on the cash method is considered the use of the cash method. Thus, a C corporation that uses a combination of accounting methods including the use of the cash method is subject to this section.

(ii) Example. The following example illustrates the operation of this paragraph (a)(3). In 2020, A is a C corporation with average annual gross receipts for the prior three taxable years of greater than $30 million, is not a tax shelter under section 448(a)(3) and does not qualify as a qualified personal service corporation, as defined in paragraph (e) of this section. For the last 20 years, A used an accrual method for items of income and expenses related to purchases and sales of inventory, and the cash method for items related to its provision of services. A is using a combination of accounting methods that include the cash method. Thus, A is subject to section 448. A is prohibited from using the cash method for any item for 2020 and is required to change to a permissible method.

(b) Definitions. For purposes of this section—

(1) C corporation—(i) In general. The term C corporation means any corporation that is not an S corporation (as defined in section 1361(a)(1)). For example, a regulated investment company (as defined in section 851) or a real estate investment trust (as defined in section 856) is a C corporation for purposes of this section. In addition, a trust subject to tax under section 511(b) is treated, for purposes of this section, as a C corporation, but only with respect to the portion of its activities that constitute an unrelated trade or business. Similarly, for purposes of this section, a corporation that is exempt from Federal income taxes under section 501(a) is treated as a C corporation only with respect to the portion of its activities that constitute an unrelated trade or business. Moreover, for purposes of determining whether a partnership has a C corporation as a partner, any partnership described in paragraph (a)(2)(ii) of this section is treated as a C corporation. Thus, if partnership ABC has a partner that is a partnership with a C corporation, then, for purposes of this section, partnership ABC is treated as a partnership with a C corporation partner.

(ii) [Reserved]

(2) Tax shelter—(i) In general. The term tax shelter means any—

(A) Enterprise, other than a C corporation, if at any time, including taxable years beginning before January 1, 1987, interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or state agency having the authority to regulate the offering of securities for sale;

(B) Syndicate, within the meaning of paragraph (b)(2)(iii) of this section; or

(C) Tax shelter, within the meaning of section 6662(d)(2)(C).

(ii) Requirement of registration. For purposes of paragraph (b)(2)(i)(A) of this section, an offering is required to be registered with a Federal or state agency if, under the applicable Federal or state law, failure to register the offering would result in a violation of the applicable Federal or state law. This rule applies regardless of whether the offering is in fact registered. In addition, an offering is required to be registered with a Federal or state agency if, under the applicable Federal or state law, failure to file a notice of exemption from registration would result in a violation of the applicable Federal or state law, regardless of whether the notice is in fact filed. However, an S corporation is not treated as a tax shelter for purposes of section 448(d)(3) or this section merely by reason of being required to file a notice of exemption from registration with a state agency described in section 461(i)(3)(A), but only if all corporations offering securities for sale in the state must file such a notice in order to be exempt from such registration.

(iii) Syndicate—(A) In general. For purposes of paragraph (b)(2)(i)(B) of this section, the term syndicate means a partnership or other entity (other than a C corporation) if more than 35 percent of the losses of such entity during the taxable year (for taxable years beginning after December 31, 1986) are allocated to limited partners or limited entrepreneurs. For purposes of this paragraph (b)(2)(iii), the term limited entrepreneur has the same meaning given such term in section 461(k)(4). In addition, in determining whether an interest in a partnership is held by a limited partner, or an interest in an entity or enterprise is held by a limited entrepreneur, section 461(k)(2) applies in the case of the trade or business of farming (as defined in paragraph (d)(2) of this section), and section 1256(e)(3)(C) applies in all other cases. Moreover, for purposes of paragraph (b)(2) of this section, the losses of a partnership, entity, or enterprise (entities) means the excess of the deductions allowable to the entities over the amount of income recognized by such entities under the entities' method of accounting used for Federal income tax purposes (determined without regard to this section). For this purpose, gains or losses from the sale of capital assets or assets described in section 1221(a)(2) are not taken into account.

(B) Irrevocable annual election to test the allocation of losses from prior taxable year—(1) In general. For purposes of paragraph (b)(2)(iii)(A) of this section, to determine if more than 35 percent of the losses of a venture are allocated to limited partners or limited entrepreneurs, entities may elect to use the allocations made in the immediately preceding taxable year instead of using the current taxable year's allocation. An election under this paragraph (b)(2)(iii)(B) applies only to the taxable year for which the election is made. Except as otherwise provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter), a taxpayer that makes an election under this paragraph (b)(2)(iii)(B) must apply this election for other provisions of the Code that specifically apply the definition of tax shelter in section 448(a)(3).

(2) Time and manner of making election. A taxpayer makes this election for the taxable year by attaching a statement to its timely filed original Federal income tax return (including extensions) for such taxable year. The statement must state that the taxpayer is making the election under § 1.448-2(b)(2)(iii)(B). In the case of an S corporation or partnership, the election is made by the S corporation or the partnership and not by the shareholders or partners. An election under this paragraph (b)(2)(iii)(B) may not be made by the taxpayer in any other manner. For example, the election cannot be made through a request under section 446(e) to change the taxpayer's method of accounting. A taxpayer may not revoke an election under this paragraph (b)(2)(iii)(B).

(3) Administrative guidance. The IRS may publish procedural guidance in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter) that provides alternative procedures for complying with paragraph (b)(2)(iii)(B)(2) of this section.

(C) Examples. The following examples illustrate the rules of paragraph (b)(2)(iii) of this section. For purposes of the examples, the term “losses” has the meaning stated in paragraph (b)(2)(iii)(A) of this section.

(1) Example 1. Taxpayer B is a calendar year limited partnership, with no active management from its limited partner. For 2019, B is profitable and has no losses to allocate to its limited partner. For 2020, B is not profitable and allocates 60 percent of its losses to its general partner and 40 percent of its losses to its limited partner. For 2021, B is not profitable and allocates 50 percent of its losses to its general partner and 50 percent of its losses to its limited partner. For taxable year 2020, B makes an election under paragraph (b)(2)(iii)(B) of this section to use its prior year allocated amounts. Accordingly, for 2020, B is not a syndicate because B was profitable for 2019 and did not allocate any losses to its limited partner in 2019. For 2021, B is a syndicate because B allocated 50 percent of its 2021 losses to its limited partner under paragraph (b)(2)(ii)(3)(A) of this section. Even if B made an election under paragraph (b)(2)(iii)(B) of this section to use prior year allocated amounts, B is a syndicate for 2021 because B allocated 40 percent of its 2020 losses to its limited partner in 2020. Because B is a syndicate under paragraph (b)(2)(iii)(A) of this section for 2021, B is a tax shelter prohibited from using the cash method for taxable year 2021 under paragraph (b)(2)(i)(B) of this section.

(2) Example (2). Same facts as Example (1) in paragraph (b)(2)(iii)(C)(1) of this section, except for 2021, B is profitable and has no losses to allocate to its limited partner. For 2020, B makes an election under paragraph (b)(2)(iii)(B) of this section to use its prior year allocated amounts. Accordingly, for 2020, B is not a syndicate because it did not any allocate any losses to its limited partner in 2019. For 2021, B chooses not to make the election under paragraph (b)(2)(iii)(B) of this section. For 2021, B is not a syndicate because it does not have any 2021 losses to allocate to a limited partner. For taxable years 2019, 2020 and 2021, B is not a syndicate under paragraph (b)(2)(iii)(A) of this section and is not prohibited from using the cash method for taxable years 2019, 2020 or 2021 under paragraph (b)(2)(i)(B) of this section.

(iv) Presumed tax avoidance. For purposes of (b)(2)(i)(C) of this section, marketed arrangements in which persons carrying on farming activities using the services of a common managerial or administrative service will be presumed to have the principal purpose of tax avoidance if such persons use borrowed funds to prepay a substantial portion of their farming expenses. Payments for farm supplies that will not be used or consumed until a taxable year subsequent to the taxable year of payment are an example of one type of such prepayment.

(v) Taxable year tax shelter must change accounting method. A tax shelter must change from the cash method for the taxable year that it becomes a tax shelter, as determined under paragraph (b)(2) of this section.

(vi) Determination of loss amount. For purposes of section 448(d)(3), the amount of losses to be allocated under section 1256(e)(3)(B) is calculated without regard to section 163(j).

(c) Exception for entities with gross receipts not in excess of the amount provided in section 448(c)—(1) In general. Except in the case of a tax shelter, this section does not apply to any C corporation or partnership with a C corporation as a partner for any taxable year if such corporation or partnership (or any predecessor thereof) meets the gross receipts test of paragraph (c)(2) of this section.

(2) Gross receipts test—(i) In general. A corporation meets the gross receipts test of this paragraph (c)(2) if the average annual gross receipts of such corporation for the 3 taxable years (or, if shorter, the taxable years during which such corporation was in existence, annualized as required) ending with such prior taxable year does not exceed the gross receipts test amount provided in paragraph (c)(2)(v) of this section (section 448(c) gross receipts test). In the case of a C corporation exempt from Federal income taxes under section 501(a), or a trust subject to tax under section 511(b) that is treated as a C corporation under paragraph (b)(1) of this section, only gross receipts from the activities of such corporation or trust that constitute unrelated trades or businesses are taken into account in determining whether the gross receipts test is satisfied. A partnership with a C corporation as a partner meets the gross receipts test of paragraph (c)(2) of this section if the average annual gross receipts of such partnership for the 3 taxable years (or, if shorter, the taxable years during which such partnership was in existence annualized as required) ending with such prior year does not exceed the gross receipts test amount of paragraph (c)(2)(v) of this section. Except as provided in paragraph (c)(2)(ii) of this section, the gross receipts of the corporate partner are not taken into account in determining whether a partnership meets the gross receipts test of paragraph (c)(2) of this section.

(ii) Aggregation of gross receipts. The aggregation rules in § 1.448-1T(f)(2)(ii) apply for purposes of aggregating gross receipts for purposes of this section.

(iii) Treatment of short taxable year. The short taxable year rules in § 1.448-1T(f)(2)(iii) apply for purposes of this section.

(iv) Determination of gross receipts. The determination of gross receipts rules in § 1.448-1T(f)(2)(iv) apply for purposes of this section.

(v) Gross receipts test amount—(A) In general. For purposes of paragraph (c) of this section, the term gross receipts test amount means $25,000,000, adjusted annually for inflation in the manner provided in section 448(c)(4). The inflation adjusted gross receipts test amount is published annually in guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii) of this chapter).

(B) Example. Taxpayer A, a C corporation, is a plumbing contractor that installs plumbing fixtures in customers' homes or businesses. A's gross receipts for the 2017-2019 taxable years are $20 million, $16 million, and $30 million, respectively. A's average annual gross receipts for the three taxable-year period preceding the 2020 taxable year is $22 million (($20 million + $16 million + $30 million)/3) = $22 million. A may use the cash method for its trade or business for the 2020 taxable year because its average annual gross receipts for the preceding three taxable years is not more than the gross receipts test amount of paragraph (c)(2)(vi) of this section, which is $26 million for 2020.

(d) Exception for farming businesses—(1) In general. Except in the case of a tax shelter, this section does not apply to any farming business. A taxpayer engaged in a farming business and a separate non-farming business is not prohibited by this section from using the cash method with respect to the farming business, even though the taxpayer may be prohibited by this section from using the cash method with respect to the non-farming business.

(2) Farming business—(i) In general. For purposes of paragraph (d) of this section, the term farming business means—

(A) The trade or business of farming as defined in section 263A(e)(4) (including the operation of a nursery or sod farm, or the raising or harvesting of trees bearing fruit, nuts or other crops, or ornamental trees),

(B) The raising, harvesting, or growing of trees described in section 263A(c)(5) (relating to trees raised, harvested, or grown by the taxpayer other than trees described in paragraph (d)(2)(i)(A) of this section),

(C) The raising of timber, or

(D) Processing activities which are normally incident to the growing, raising, or harvesting of agricultural products.

(ii) Example. Assume a taxpayer is in the business of growing fruits and vegetables. When the fruits and vegetables are ready to be harvested, the taxpayer picks, washes, inspects, and packages the fruits and vegetables for sale. Such activities are normally incident to the raising of these crops by farmers. The taxpayer will be considered to be in the business of farming with respect to the growing of fruits and vegetables, and the processing activities incident to the harvest.

(iii) Processing activities excluded from farming businesses—(A) In general. For purposes of this section, a farming business does not include the processing of commodities or products beyond those activities normally incident to the growing, raising, or harvesting of such products.

(B) Examples. (1) Example 1. Assume that a C corporation taxpayer is in the business of growing and harvesting wheat and other grains. The taxpayer processes the harvested grains to produce breads, cereals, and similar food products which it sells to customers in the course of its business. Although the taxpayer is in the farming business with respect to the growing and harvesting of grain, the taxpayer is not in the farming business with respect to the processing of such grains to produce breads, cereals, and similar food products which the taxpayer sells to customers.

(2) Example 2. Assume that a taxpayer is in the business of raising livestock. The taxpayer uses the livestock in a meat processing operation in which the livestock are slaughtered, processed, and packaged or canned for sale to customers. Although the taxpayer is in the farming business with respect to the raising of livestock, the taxpayer is not in the farming business with respect to the meat processing operation.

(e) Exception for qualified personal service corporation. The rules in § 1.448-1T(e) relating to the exception for qualified personal service corporations apply for taxable years beginning after December 31, 2017.

(f) Effect of section 448 on other provisions. Except as provided in paragraph (b)(2)(iii)(B) of this section, nothing in section 448 shall have any effect on the application of any other provision of law that would otherwise limit the use of the cash method, and no inference shall be drawn from section 448 with respect to the application of any such provision. For example, nothing in section 448 affects the requirement of section 447 that certain corporations must use an accrual method of accounting in computing taxable income from farming, or the requirement of § 1.446-1(c)(2) that, in general, an accrual method be used with regard to purchases and sales of inventory. Similarly, nothing in section 448 affects the authority of the Commissioner under section 446(b) to require the use of an accounting method that clearly reflects income, or the requirement under section 446(e) that a taxpayer secure the consent of the Commissioner before changing its method of accounting. For example, a taxpayer using the cash method may be required to change to an accrual method of accounting under section 446(b) because such method clearly reflects the taxpayer's income, even though the taxpayer is not prohibited by section 448 from using the cash method. Similarly, a taxpayer using an accrual method of accounting that is not prohibited by section 448 from using the cash method may not change to the cash method unless the taxpayer secures the consent of the Commissioner under section 446(e).

(g) Treatment of accounting method change and rules for section 481(a) adjustment—(1) In general. Any taxpayer to whom section 448 applies must change its method of accounting in accordance with the provisions of this paragraph (g). In the case of any taxpayer required by this section to change its method of accounting, the change shall be treated as a change initiated by the taxpayer to compute the adjustment required under section 481. A taxpayer must change to an overall accrual method of accounting for the first taxable year the taxpayer is subject to this section or a subsequent taxable year in which the taxpayer is newly subject to this section after previously making a change in method of accounting that complies with section 448 (mandatory section 448 year). A taxpayer may have more than one mandatory section 448 year. For example, a taxpayer may exceed the gross receipts test of section 448(c) in non-consecutive taxable years. If the taxpayer complies with the provisions of paragraph (g) of this section for its mandatory section 448 year, the change shall be treated as made with the consent of the Commissioner. The change shall be implemented pursuant to the applicable administrative procedures to obtain the automatic consent of the Commissioner to change a method of accounting under section 446(e) as published in the Internal Revenue Bulletin (see Revenue Procedure 2015-13 (2015-5 IRB 419) (or successor) (see also § 601.601(d)(2) of this chapter)). This paragraph (g) applies only to a taxpayer who changes from the cash method as required by this section. This paragraph (g) does not apply to a change in method of accounting required by any Code section (or applicable regulation) other than this section.

(2) Section 481(a) adjustment. The amount of the net section 481(a) adjustment and the adjustment period necessary to implement a change in method of accounting required under this section are determined under § 1.446-1(e) and the applicable administrative procedures to obtain the Commissioner's consent to change a method of accounting as published in the Internal Revenue Bulletin (see Revenue Procedure 2015-13 (2015-5 IRB 419) (or successor) (see also § 601.601(d)(2) of this chapter).

(h) Applicability dates. The rules of this section apply for taxable years beginning on or after January 5, 2021. However, for a taxable year beginning after December 31, 2017, and before January 5, 2021, a taxpayer may apply the rules provided in this section provided that the taxpayer follows all the applicable rules contained in the regulations under section 448 for such taxable year and all subsequent taxable years.

(a) In general. This section applies to taxpayers qualified to use a nonaccrual-experience method of accounting provided for in section 448(d)(5) with respect to amounts to be received for the performance of services. A taxpayer that satisfies the requirements of this section is not required to accrue any portion of amounts to be received from the performance of services that, on the basis of the taxpayer's experience, and to the extent determined under the computation or formula used by the taxpayer and allowed under this section, will not be collected. Except as otherwise provided in this section, a taxpayer is qualified to use a nonaccrual-experience method of accounting if the taxpayer uses an accrual method of accounting with respect to amounts to be received for the performance of services by the taxpayer and either—

(1) The services are in fields referred to in section 448(d)(2)(A) and described in § 1.448-1T(e)(4) (health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting); or

(2) The taxpayer meets the gross receipts test of section 448(c) and § 1.448-1T(f)(2) (in the case of taxable years beginning before January 1, 2018), or § 1.448-2(c) (in the case of taxable years beginning after December 31, 2017) for all prior taxable years.

(b) Application of method and treatment as method of accounting. The rules of section 448(d)(5) and the regulations are applied separately to each taxpayer. For purposes of section 448(d)(5), the term taxpayer has the same meaning as the term person defined in section 7701(a)(1) (rather than the meaning of the term defined in section 7701(a)(14)). The nonaccrual of amounts to be received for the performance of services is a method of accounting (a nonaccrual-experience method). A change to a nonaccrual-experience method, from one nonaccrual-experience method to another nonaccrual-experience method, or to a periodic system (for example, see Notice 88-51 (1988-1 C.B. 535) and § 601.601(d)(2)(ii)(b) of this chapter), is a change in method of accounting to which the provisions of sections 446 and 481 and the regulations apply. See also paragraphs (c)(2)(i), (c)(5), (d)(4), and (e)(3)(i) of this section. Except as provided in other published guidance, a taxpayer who wishes to adopt or change to any nonaccrual-experience method other than one of the safe harbor methods described in paragraph (f) of this section must request and receive advance consent from the Commissioner in accordance with the applicable administrative procedures issued under § 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent.

(c) Definitions and special rules—(1) Accounts receivable—(i) In general. Accounts receivable include only amounts that are earned by a taxpayer and otherwise recognized in income through the performance of services by the taxpayer. For purposes of determining a taxpayer's nonaccrual-experience under any method provided in this section, amounts described in paragraph (c)(1)(ii) of this section are not taken into account. Except as otherwise provided, for purposes of this section, accounts receivable do not include amounts that are not billed (such as for charitable or pro bono services) or amounts contractually not collectible (such as amounts in excess of a fee schedule agreed to by contract). See paragraph (g) Examples 1 and 2 of this section for examples of this rule.

(ii) Method not available for certain receivables—(A) Amounts not earned and recognized through the performance of services. A nonaccrual-experience method of accounting may not be used with respect to amounts that are not earned by a taxpayer and otherwise recognized in income through the performance of services by the taxpayer. For example, a nonaccrual-experience method may not be used with respect to amounts owed to the taxpayer by reason of the taxpayer's activities with respect to lending money, selling goods, or acquiring accounts receivable or other rights to receive payment from other persons (including persons related to the taxpayer) regardless of whether those persons earned the amounts through the provision of services. However, see paragraph (d)(3) of this section for special rules regarding acquisitions of a trade or business or a unit of a trade or business.

(B) If interest or penalty charged on amounts due. A nonaccrual-experience method of accounting may not be used with respect to amounts due for which interest is required to be paid or for which there is any penalty for failure to timely pay any amounts due. For this purpose, a taxpayer will be treated as charging interest or penalties for late payment if the contract or agreement expressly provides for the charging of interest or penalties for late payment, regardless of the practice of the parties. If the contract or agreement does not expressly provide for the charging of interest or penalties for late payment, the determination of whether the taxpayer charges interest or penalties for late payment will be made based on all of the facts and circumstances of the transaction, and not merely on the characterization by the parties or the treatment of the transaction under state or local law. However, the offering of a discount for early payment of an amount due will not be regarded as the charging of interest or penalties for late payment under this section, if—

(1) The full amount due is otherwise accrued as gross income by the taxpayer at the time the services are provided; and

(2) The discount for early payment is treated as an adjustment to gross income in the year of payment, if payment is received within the time required for allowance of the discount. See paragraph (g) Example 3 of this section for an example of this rule.

(2) Applicable period—(i) In general. The applicable period is the number of taxable years on which the taxpayer bases its nonaccrual-experience method. A change in the number of taxable years included in the applicable period is a change in method of accounting to which the procedures of section 446 apply. A change in the inclusion or exclusion of the current taxable year in the applicable period is a change in method of accounting to which the procedures of section 446 apply. A change in the number of taxable years included in the applicable period or the inclusion or exclusion of the current taxable year in the applicable period is made on a cut-off basis.

(ii) Applicable period for safe harbors. For purposes of the safe harbors under paragraph (f) of this section the applicable period may consist of at least three but not more than six of the immediately preceding consecutive taxable years. Alternatively, the applicable period may consist of the current taxable year and at least two but not more than five of the immediately preceding consecutive taxable years. A period shorter than six taxable years is permissible only if the period contains the most recent preceding taxable years and all of the taxable years in the applicable period are consecutive.

(3) Bad debts. Bad debts are accounts receivable determined to be uncollectible and charged off.

(4) Charge-offs. Amounts charged off include only those amounts that would otherwise be allowable under section 166(a).

(5) Determination date. The determination date in safe harbor 2 provided in paragraph (f)(2) of this section is used as a cut-off date for determining all known data to be taken into account in the computation of the taxable year's uncollectible amount. The determination date may not be later than the earlier of the due date, including extensions, for filing the taxpayer's Federal income tax return for that taxable year or the date on which the taxpayer timely files the return for that taxable year. The determination date may be different in each taxable year. However, once a determination date is selected and used for a particular taxable year, it may not be changed for that taxable year. The choice of a determination date is not a method of accounting.

(6) Recoveries. Recoveries are amounts previously excluded from income under a nonaccrual-experience method or charged off that the taxpayer recovers.

(7) Uncollectible amount. The uncollectible amount is the portion of any account receivable amount due that, under the taxpayer's nonaccrual-experience method, will be not collected.

(d) Use of experience to estimate uncollectible amounts—(1) In general. In determining the portion of any amount due that, on the basis of experience, will not be collected, a taxpayer may use any nonaccrual-experience method that clearly reflects the taxpayer's nonaccrual-experience. The determination of whether a nonaccrual-experience method clearly reflects the taxpayer's nonaccrual-experience is made in accordance with the rules under paragraph (e) of this section. Alternatively, the taxpayer may use any one of the five safe harbor nonaccrual-experience methods of accounting provided in paragraphs (f)(1) through (f)(5) of this section, which are presumed to clearly reflect a taxpayer's nonaccrual-experience.

(2) Application to specific accounts receivable. The nonaccrual-experience method is applied with respect to each account receivable of the taxpayer that is eligible for this method. With respect to a particular account receivable, the taxpayer determines, in the manner prescribed in paragraphs (d)(1) or (f)(1) through (f)(5) of this section (whichever applies), the uncollectible amount. The determination is required to be made only once with respect to each account receivable, regardless of the term of the receivable. The uncollectible amount is not recognized as gross income. Thus, the amount recognized as gross income is the amount that would otherwise be recognized as gross income with respect to the account receivable, less the uncollectible amount. A taxpayer that excludes an amount from income during a taxable year as a result of the taxpayer's use of a nonaccrual-experience method may not deduct in any subsequent taxable year the amount excluded from income. Thus, the taxpayer may not deduct the excluded amount in a subsequent taxable year in which the taxpayer actually determines that the amount is uncollectible and charges it off. If a taxpayer using a nonaccrual-experience method determines that an amount that was not excluded from income is uncollectible and should be charged off (for example, a calendar-year taxpayer determines on November 1st that an account receivable that was originated on May 1st of the same taxable year is uncollectible and should be charged off), the taxpayer may deduct the amount charged off when it is charged off, but must include any subsequent recoveries in income. The reasonableness of a taxpayer's determination that amounts are uncollectible and should be charged off may be considered on examination. See paragraph (g) Example 12 of this section for an example of this rule.

(3) Acquisitions and dispositions—(i) Acquisitions. If a taxpayer acquires the major portion of a trade or business of another person (predecessor) or the major portion of a separate unit of a trade or business of a predecessor, then, for purposes of applying this section for any taxable year ending on or after the acquisition, the experience from preceding taxable years of the predecessor attributable to the portion of the trade or business acquired, if available, must be used in determining the taxpayer's experience.

(ii) Dispositions. If a taxpayer disposes of a major portion of a trade or business or the major portion of a separate unit of a trade or business, and the taxpayer furnished the acquiring person the information necessary for the computations required by this section, then, for purposes of applying this section for any taxable year ending on or after the disposition, the experience from preceding taxable years attributable to the portion of the trade or business disposed may not be used in determining the taxpayer's experience.

(iii) Meaning of terms. For the meaning of the terms acquisition, separate unit, and major portion, see paragraph (b) of § 1.52-2. The term acquisition includes an incorporation or a liquidation.

(4) New taxpayers. The rules of this paragraph (d)(4) apply to any newly formed taxpayer to which the rules of paragraph (d)(3)(i) of this section do not apply. Any newly formed taxpayer that wants to use a safe harbor nonaccrual-experience method of accounting described in paragraph (f)(1), (f)(2), (f)(3), (f)(4), or (f)(5) of this section applies the methods by using the experience of the actual number of taxable years available in the applicable period. A newly formed taxpayer that wants to use one of the safe harbor nonaccrual-experience methods of accounting described in paragraph (f)(2), (f)(4), or (f)(5) of this section in its first taxable year and does not have any accounts receivable upon formation may not exclude any portion of its year-end accounts receivable from income for its first taxable year. The taxpayer must begin creating its moving average in its second taxable year by tracking the accounts receivable as of the first day of its second taxable year. The use of one of the safe harbor nonaccrual-experience methods of accounting described in paragraph (f)(2), (f)(4), or (f)(5) of this section in a taxpayer's second taxable year in this situation is not a change in method of accounting. Although the taxpayer must maintain the books and records necessary to perform the computations under the adopted safe harbor nonaccrual-experience method, the taxpayer is not required to affirmatively elect the method on its Federal income tax return for its first taxable year.

(5) Recoveries. Regardless of the nonaccrual-experience method of accounting used by a taxpayer under this section, the taxpayer must take recoveries into account. If, in a subsequent taxable year, a taxpayer recovers an amount previously excluded from income under a nonaccrual-experience method or charged off, the taxpayer must include the recovered amount in income in that subsequent taxable year. See paragraph (g) Example 13 of this section for an example of this rule.

(6) Request to exclude taxable years from applicable period. A period shorter than the applicable period generally is permissible only if the period consists of consecutive taxable years and there is a change in the type of a substantial portion of the outstanding accounts receivable such that the risk of loss is substantially increased. A decline in the general economic conditions in the area, which substantially increases the risk of loss, is a relevant factor in determining whether a shorter period is appropriate. However, approval to use a shorter period will not be granted unless the taxpayer supplies evidence that the accounts receivable outstanding at the close of the taxable years for the shorter period requested are more comparable in nature and risk to accounts receivable outstanding at the close of the current taxable year. A substantial increase in a taxpayer's bad debt experience is not, by itself, sufficient to justify the use of a shorter period. If approval is granted to use a shorter period, the experience for the excluded taxable years may not be used for any subsequent taxable year. A request for approval to exclude the experience of a prior taxable year must be made in accordance with the applicable procedures for requesting a letter ruling and must include a statement of the reasons the experience should be excluded. A request will not be considered unless it is sent to the Commissioner at least 30 days before the close of the first taxable year for which the approval is requested.

(7) Short taxable years. A taxpayer with a short taxable year that uses a nonaccrual-experience method that compares accounts receivable balance to total bad debts during the taxable year should make appropriate adjustments.

(8) Recordkeeping requirements—(i) A taxpayer using a nonaccrual-experience method of accounting must keep sufficient books and records to establish the amount of any exclusion from gross income under section 448(d)(5) for the taxable year, including books and records demonstrating—

(A) The nature of the taxpayer's nonaccrual-experience method;

(B) Whether, for any particular taxable year, the taxpayer qualifies to use its nonaccrual-experience method (including the self-testing requirements of paragraph (e) of this section (if applicable));

(C) The taxpayer's determination that amounts are uncollectible;

(D) The proper amount that is excludable under the taxpayer's nonaccrual-experience method; and

(E) The taxpayer's determination date under paragraph (c)(5) of this section (if applicable).

(ii) If a taxpayer does not maintain records of the data that are sufficient to establish the amount of any exclusion from gross income under section 448(d)(5) for the taxable year, the Internal Revenue Service may change the taxpayer's method of accounting on examination. See § 1.6001-1 for rules regarding records.

(e) Requirements for nonaccrual method to clearly reflect experience—(1) In general. A nonaccrual-experience method clearly reflects the taxpayer's experience if the taxpayer's nonaccrual-experience method meets the self-test requirements described in this paragraph (e). If a taxpayer is using one of the safe harbor nonaccrual-experience methods described in paragraphs (f)(1) through (f)(4) of this section, its method is deemed to clearly reflect its experience and is not subject to the self-testing requirements in paragraphs (e)(2) and (e)(3) of this section.

(2) Requirement to self-test—(i) In general. A taxpayer using, or desiring to use, a nonaccrual-experience method must self-test its nonaccrual-experience method for its first taxable year for which the taxpayer uses, or desires to use, that nonaccrual-experience method (first-year self-test) and every three taxable years thereafter (three-year self-test). Each self-test must be performed by comparing the uncollectible amount (under the taxpayer's nonaccrual-experience method) with the taxpayer's actual experience. A taxpayer using the safe harbor under paragraph (f)(5) of this section must self-test using the safe harbor comparison method in paragraph (e)(3) of this section.

(ii) First-year self-test. The first-year self-test must be performed by comparing the uncollectible amount with the taxpayer's actual experience for its first taxable year for which the taxpayer uses, or desires to use, that nonaccrual-experience method. If the uncollectible amount for the first-year self-test is less than or equal to the taxpayer's actual experience for its first taxable year for which the taxpayer uses, or desires to use, that nonaccrual-experience method, the taxpayer's nonaccrual-experience method is treated as clearly reflecting its experience for the first taxable year. If, as a result of the first-year self-test, the uncollectible amount for the test period is greater than the taxpayer's actual experience, then—

(A) The taxpayer's nonaccrual-experience method is treated as not clearly reflecting its experience;

(B) The taxpayer is not permitted to use that nonaccrual-experience method in that taxable year; and

(C) The taxpayer must change to (or adopt) for that taxable year either—

(1) Another nonaccrual-experience method that clearly reflects experience, that is, a nonaccrual-experience method that meets the first-year self-test requirement; or

(2) A safe harbor nonaccrual-experience method described in paragraphs (f)(1) through (f)(5) of this section.

(iii) Three-year self-test—(A) In general. The three-year self-test must be performed by comparing the sum of the uncollectible amounts for the current taxable year and prior two taxable years (cumulative uncollectible amount) with the sum of the taxpayer's actual experience for the current taxable year and prior two taxable years (cumulative actual experience amount).

(B) Recapture. If the cumulative uncollectible amount for the test period is greater than the cumulative actual experience amount for the test period, the taxpayer's uncollectible amount is limited to the cumulative actual experience amount for the test period. Any excess of the taxpayer's cumulative uncollectible amount over the taxpayer's cumulative actual nonaccrual-experience amount excluded from income during the test period must be recaptured into income in the third taxable year of the three-year self-test period.

(C) Determination of whether method is permissible or impermissible. If the cumulative uncollectible amount is less than 110 percent of the cumulative actual experience amount, the taxpayer's nonaccrual-experience method is treated as a permissible method and the taxpayer may continue to use its alternative nonaccrual-experience method, subject to the three-year self-test requirement of this paragraph (e)(2)(iii). If the cumulative uncollectible amount is greater than or equal to 110 percent of the cumulative actual experience amount, the taxpayer's nonaccrual-experience method is treated as impermissible in the taxable year subsequent to the three-year self-test year and does not clearly reflect its experience. The taxpayer must change to another nonaccrual-experience method that clearly reflects experience, including, for example, one of the safe harbor nonaccrual-experience methods described in paragraphs (f)(1) through (f)(5) of this section, for the subsequent taxable year. A change in method of accounting from an impermissible method under this paragraph (e)(2)(iii)(C) to a permissible method in the taxable year subsequent to the three-year self-test year is made on a cut-off basis.

(iv) Determination of taxpayer's actual experience. [Reserved]

(3) Safe harbor comparison method—(i) In general. A taxpayer using, or desiring to use, a nonaccrual-experience method under the safe harbor in paragraph (f)(5) of this section must self-test its nonaccrual-experience method for its first taxable year for which the taxpayer uses, or desires to use, that nonaccrual-experience method (first-year self-test) and every three taxable years thereafter (three-year self-test). A nonaccrual-experience method under the safe harbor in paragraph (f)(5) of this section is deemed to clearly reflect experience provided all the requirements of the safe harbor comparison method of this paragraph (e)(3) are met. Each self-test must be performed by comparing the uncollectible amount (under the taxpayer's nonaccrual-experience method) with the uncollectible amount that would have resulted from use of one of the safe harbor methods described in paragraph (f)(1), (f)(2), (f)(3), or (f)(4) of this section. A change from a nonaccrual-experience method that uses the safe harbor comparison method for self-testing to a nonaccrual-experience method that does not use the safe harbor comparison method for self-testing, and vice versa, is a change in method of accounting to which the provisions of sections 446 and 481 and the regulations apply. A change solely to use or discontinue use of the safe harbor comparison method for purposes of determining whether the nonaccrual-experience method clearly reflects experience must be made on a cut-off basis and without audit protection.

(ii) Requirements to use safe harbor comparison method—(A) First-year self-test. The first-year self-test must be performed by comparing the uncollectible amount with the uncollectible amount determined under any of the safe harbor methods described in paragraph (f)(1), (f)(2), (f)(3), or (f)(4) of this section (safe harbor uncollectible amount) for its first taxable year for which the taxpayer uses, or desires to use, that nonaccrual-experience method. If the uncollectible amount for the first-year self-test is less than or equal to the safe harbor uncollectible amount, then the taxpayer's nonaccrual-experience method is treated as clearly reflecting its experience for the first taxable year. If, as a result of the first-year self-test, the uncollectible amount for the test period is greater than the safe harbor uncollectible amount, then—

(1) The taxpayer's nonaccrual-experience method is treated as not clearly reflecting its experience;

(2) The taxpayer is not permitted to use that nonaccrual-experience method in that taxable year; and

(3) The taxpayer must change to (or adopt) for that taxable year either—

(i) Another nonaccrual-experience method that clearly reflects experience, that is, a nonaccrual-experience method that meets the first-year self-test requirement; or

(ii) A safe harbor nonaccrual-experience method described in paragraphs (f)(1) through (f)(5) of this section.

(B) Three-year self-test. The three-year self-test must be performed by comparing the sum of the uncollectible amounts for the current taxable year and prior two taxable years (cumulative uncollectible amount) with the sum of the uncollectible amount determined under any of the safe harbor methods described in paragraph (f)(1), (f)(2), (f)(3), or (f)(4) of this section for the current taxable year and prior two taxable years (cumulative safe harbor uncollectible amounts). If the cumulative uncollectible amount for the three-year self-test is less than or equal to the cumulative safe harbor uncollectible amount for the test period, then the taxpayer's nonaccrual-experience method is treated as clearly reflecting its experience for the test period and the taxpayer may continue to use that nonaccrual-experience method, subject to a requirement to self-test again after three taxable years. If the cumulative uncollectible amount for the test period is greater than the cumulative safe harbor uncollectible amount for the test period, the taxpayer's uncollectible amount is limited to the cumulative safe harbor uncollectible amount for the test period. Any excess of the taxpayer's cumulative uncollectible amount over the taxpayer's cumulative safe harbor uncollectible amount excluded from income during the test period must be recaptured into income in the third taxable year of the three-year self-test period. If the cumulative uncollectible amount is less than 110 percent of the cumulative safe harbor uncollectible amount, the taxpayer's nonaccrual-experience method is treated as a permissible method and the taxpayer may continue to use its alternative nonaccrual-experience method, subject to the three-year self-test requirement of this paragraph (e)(3)(ii)(B). If the cumulative uncollectible amount is greater than or equal to 110 percent of the cumulative safe harbor uncollectible amount, the taxpayer's nonaccrual-experience method is treated as impermissible in the taxable year subsequent to the three-year self-test year and does not clearly reflect its experience. The taxpayer must change to another nonaccrual-experience method that clearly reflects experience, including, for example, one of the safe harbor nonaccrual-experience methods described in paragraphs (f)(1) through (f)(5) of this section, for the subsequent taxable year. A change in method of accounting from an impermissible method under this paragraph (e)(3)(ii)(B) to a permissible method in the taxable year subsequent to the three-year self-test year is made on a cut-off basis.

(4) Methods that do not clearly reflect experience. [Reserved]

(5) Contemporaneous documentation. For purposes of this paragraph (e), including the safe harbor comparison method of paragraph (e)(3) of this section, a taxpayer must document in its books and records, in the taxable year any first-year or three-year self-test is performed, the method used to conduct the self-test, including appropriate documentation and computations that resulted in the determination that the taxpayer's nonaccrual-experience method clearly reflected the taxpayer's nonaccrual-experience for the applicable test period.

(f) Safe harbors—(1) Safe harbor 1: revenue-based moving average method. A taxpayer may use a nonaccrual-experience method under which the taxpayer determines the uncollectible amount by multiplying its accounts receivable balance at the end of the current taxable year by a percentage (revenue-based moving average percentage). The revenue-based moving average percentage is computed by dividing the total bad debts sustained, adjusted by recoveries received, throughout the applicable period by the total revenue resulting in accounts receivable earned throughout the applicable period. See paragraph (g) Example 4 of this section for an example of this method. Thus, the uncollectible amount under the revenue-based moving average method is computed:

(2) Safe harbor 2: actual experience method—(i) Option A: single determination date. A taxpayer may use a nonaccrual-experience method under which the taxpayer determines the uncollectible amount by multiplying its accounts receivable balance at the end of the current taxable year by a percentage (moving average nonaccrual-experience percentage) and then increasing the resulting amount by 5 percent. See paragraph (g) Example 5 of this section for an example of safe harbor 2 in general, and paragraph (g) Example 6 of this section for an example of the single determination date option of safe harbor 2. The taxpayer's moving average nonaccrual-experience percentage is computed by dividing the total bad debts sustained, adjusted by recoveries that are allocable to the bad debts, by the determination date of the current taxable year related to the taxpayer's accounts receivable balance at the beginning of each taxable year during the applicable period by the sum of the accounts receivable at the beginning of each taxable year during the applicable period. Thus, the uncollectible amount under Option A of the actual experience method is computed:

(ii) Option B: multiple determination dates. Alternatively, in computing its bad debts related to the taxpayer's accounts receivable balance at the beginning of each taxable year during the applicable period, a taxpayer may use the original determination date for each taxable year during the applicable period. That is, the taxpayer may use bad debts sustained, adjusted by recoveries received that are allocable to the bad debts, by the determination date of each taxable year during the applicable period rather than the determination date of the current taxable year. See paragraph (g) Example 7 of this section for an example of the multiple determination date option of safe harbor 2. Thus, the uncollectible amount under Option B of the actual experience method is computed:

(iii) Tracing of recoveries—(A) In general. Bad debts related to the taxpayer's accounts receivable balance at the beginning of each taxable year during the applicable period must be adjusted by the portion, if any, of recoveries received that are properly allocable to the bad debts.

(B) Specific tracing. If a taxpayer, without undue burden, can trace all recoveries to their corresponding charge-offs, the taxpayer must specifically trace all recoveries.

(C) Recoveries cannot be traced without undue burden. If a taxpayer has any recoveries that cannot, without undue burden, be traced to corresponding charge-offs, the taxpayer may allocate those or all recoveries between charge-offs of amounts in the relevant beginning accounts receivable balances and other charge-offs using an allocation method that is reasonable under all of the facts and circumstances.

(1) Reasonable allocations. An allocation method is reasonable if there is a cause and effect relationship between the allocation base or ratio and the recoveries. A taxpayer may elect to trace recoveries that are traceable and allocate all untraceable recoveries to charge-offs of amounts in the relevant beginning accounts receivable balances. Such an allocation method will be deemed to be reasonable under all the facts and circumstances.

(2) Allocations that are not reasonable. Allocation methods that generally will not be considered reasonable include, for example, methods in which there is not a cause and effect relationship between the allocation base or ratio and methods in which receivables for which the nonaccrual-experience method is not allowed to be used are included in the allocation. See paragraph (c)(1)(ii) of this section for examples of receivables for which the nonaccrual-experience method is not allowed.

(3) Safe harbor 3: modified Black Motor method. A taxpayer may use a nonaccrual-experience method under which the taxpayer determines the uncollectible amount by multiplying its accounts receivable balance at the end of the current taxable year by a percentage (modified Black Motor moving average percentage) and then reducing the resulting amount by the bad debts written off during the current taxable year relating to accounts receivable generated during the current taxable year. The modified Black Motor moving average percentage is computed by dividing the total bad debts sustained, adjusted by recoveries received, during the applicable period by the sum of accounts receivable at the end of each taxable year during the applicable period. See paragraph (g) Example 8 of this section for an example of this method. Thus, the uncollectible amount under the modified Black Motor method is computed:

(4) Safe harbor 4: modified moving average method. A taxpayer may use a nonaccrual-experience method under which the taxpayer determines the uncollectible amount by multiplying its accounts receivable balance at the end of the current taxable year by a percentage (modified moving average percentage). The modified moving average percentage is computed by dividing the total bad debts sustained, adjusted by recoveries received, during the applicable period other than bad debts that were written off in the same taxable year the related accounts receivable were generated by the sum of accounts receivable at the beginning of each taxable year during the applicable period. See paragraph (g) Example 9 of this section for an example of this method. Thus, the uncollectible amount under the modified moving average method is computed:

(5) Safe harbor 5: alternative nonaccrual-experience method. A taxpayer may use an alternative nonaccrual-experience method that clearly reflects the taxpayer's actual nonaccrual-experience, provided the taxpayer's alternative nonaccrual-experience method meets the self-test requirements described in paragraph (e)(3) of this section.

(g) Examples. The following examples illustrate the provisions of this section. In each example, the taxpayer uses a calendar year for Federal income tax purposes and an accrual method of accounting, does not require the payment of interest or penalties with respect to past due accounts receivable (except in the case of Example 3) and, in the case of Examples 5 through 7, selects an appropriate determination date for each taxable year. The examples are as follows:

(h) Applicability dates. (1) Except as provided in paragraph (h)(2) of this section, this section is applicable for taxable years ending on or after August 31, 2006.

(2) The rules of paragraph (a)(2) of this section apply for taxable years beginning on or after January 5, 2021. However, for a taxable year beginning after December 31, 2017, and before January 5, 2021, a taxpayer may apply the paragraph described in the first sentence of this paragraph (h)(2), provided that the taxpayer follows all the applicable rules contained in the regulations under section 448 for such taxable year and all subsequent taxable years.

(a) General rule. Gains, profits, and income are to be included in gross income for the taxable year in which they are actually or constructively received by the taxpayer unless includible for a different year in accordance with the taxpayer's method of accounting. Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy (all events test). Therefore, under such a method of accounting if, in the case of compensation for services, no determination can be made as to the right to such compensation or the amount thereof until the services are completed, the amount of compensation is ordinarily income for the taxable year in which the determination can be made. Under the cash receipts and disbursements method of accounting, such an amount is includible in gross income when actually or constructively received. Where an amount of income is properly accrued on the basis of a reasonable estimate and the exact amount is subsequently determined, the difference, if any, shall be taken into account for the taxable year in which such determination is made. To the extent that income is attributable to the recovery of bad debts for accounts charged off in prior years, it is includible in the year of recovery in accordance with the taxpayer's method of accounting, regardless of the date when the amounts were charged off. For treatment of bad debts and bad debt recoveries, see sections 166 and 111 and the regulations thereunder. For rules relating to the treatment of amounts received in crop shares, see section 61 and the regulations thereunder. For the year in which a partner must include his distributive share of partnership income, see section 706(a) and paragraph (a) of § 1.706-1. If a taxpayer ascertains that an item should have been included in gross income in a prior taxable year, he should, if within the period of limitation, file an amended return and pay any additional tax due. Similarly, if a taxpayer ascertains that an item was improperly included in gross income in a prior taxable year, he should, if within the period of limitation, file claim for credit or refund of any overpayment of tax arising therefrom.

(b) Timing of income inclusion for accrual method taxpayers with an applicable financial statement. For the timing of income inclusion for taxpayers that have an applicable financial statement, as defined in § 1.451-3(b)(1), and that use an accrual method of accounting, see section 451(b) and § 1.451-3.

(c) Special rule for timing of income inclusion from advance payments. For the timing of income inclusion for taxpayers that receive advance payments, as defined in § 1.451-8(a)(1), and that use an accrual method of accounting, see section 451(c) and § 1.451-8.

(d) Special rule in case of death. (1) A taxpayer's taxable year ends on the date of his death. See section 443(a)(2) and paragraph (a)(2) of § 1.443-1. In computing taxable income for such year, there shall be included only amounts properly includible under the method of accounting used by the taxpayer. However, if the taxpayer used an accrual method of accounting, amounts accrued only by reason of his death shall not be included in computing taxable income for such year. If the taxpayer uses no regular accounting method, only amounts actually or constructively received during such year shall be included. (For rules relating to the inclusion of partnership income in the return of a decedent partner, see subchapter K, chapter 1 of the Code, and the regulations thereunder.)

(2) If the decedent owned an installment obligation the income from which was taxable to him under section 453, no income is required to be reported in the return of the decedent by reason of the transmission at death of such obligation. See section 453(d)(3). For the treatment of installment obligations acquired by the decedent's estate or by any person by bequest, devise, or inheritance from the decedent, see section 691(a)(4) and the regulations thereunder.

(e) Special rule for employee tips. Tips reported by an employee to his employer in a written statement furnished to the employer pursuant to section 6053(a) shall be included in gross income of the employee for the taxable year in which the written statement is furnished the employer. For provisions relating to the reporting of tips by an employee to his employer, see section 6053 and § 31.6053-1 of this chapter (Employment Tax Regulations).

(f) Special rule for ratable inclusion of original issue discount. For ratable inclusion of original issue discount in respect of certain corporate obligations issued after May 27, 1969, see section 1232(a)(3).

(g) Special rule for inclusion of qualified tax refund effected by allocation. For rules relating to the inclusion in income of an amount paid by a taxpayer in respect of his liability for a qualified State individual income tax and allocated or reallocated in such a manner as to apply it toward the taxpayer's liability for the Federal income tax, see paragraph (f)(1) of § 301.6361-1 of this chapter (Regulations on Procedure and Administration).

(h) Timing of income from notional principal contracts. For the timing of income with respect to notional principal contracts, see § 1.446-3.

(i) Timing of income from section 467 rental agreements. For the timing of income with respect to section 467 rental agreements, see section 467 and the regulations thereunder.

(a) General rule. Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. Thus, if a corporation credits its employees with bonus stock, but the stock is not available to such employees until some future date, the mere crediting on the books of the corporation does not constitute receipt. In the case of interest, dividends, or other earnings (whether or not credited) payable in respect of any deposit or account in a bank, building and loan association, savings and loan association, or similar institution, the following are not substantial limitations or restrictions on the taxpayer's control over the receipt of such earnings:

(1) A requirement that the deposit or account, and the earnings thereon, must be withdrawn in multiples of even amounts;

(2) The fact that the taxpayer would, by withdrawing the earnings during the taxable year, receive earnings that are not substantially less in comparison with the earnings for the corresponding period to which the taxpayer would be entitled had he left the account on deposit until a later date (for example, if an amount equal to three months' interest must be forfeited upon withdrawal or redemption before maturity of a one year or less certificate of deposit, time deposit, bonus plan, or other deposit arrangement then the earnings payable on premature withdrawal or redemption would be substantially less when compared with the earnings available at maturity);

(3) A requirement that the earnings may be withdrawn only upon a withdrawal of all or part of the deposit or account. However, the mere fact that such institutions may pay earnings on withdrawals, total or partial, made during the last three business days of any calendar month ending a regular quarterly or semiannual earnings period at the applicable rate calculated to the end of such calendar month shall not constitute constructive receipt of income by any depositor or account holder in any such institution who has not made a withdrawal during such period;

(4) A requirement that a notice of intention to withdraw must be given in advance of the withdrawal. In any case when the rate of earnings payable in respect of such a deposit or account depends on the amount of notice of intention to withdraw that is given, earnings at the maximum rate are constructively received during the taxable year regardless of how long the deposit or account was held during the year or whether, in fact, any notice of intention to withdraw is given during the year. However, if in the taxable year of withdrawal the depositor or account holder receives a lower rate of earnings because he failed to give the required notice of intention to withdraw, he shall be allowed an ordinary loss in such taxable year in an amount equal to the difference between the amount of earnings previously included in gross income and the amount of earnings actually received. See section 165 and the regulations thereunder.

(b) Examples of constructive receipt. Amounts payable with respect to interest coupons which have matured and are payable but which have not been cashed are constructively received in the taxable year during which the coupons mature, unless it can be shown that there are no funds available for payment of the interest during such year. Dividends on corporate stock are constructively received when unqualifiedly made subject to the demand of the shareholder. However, if a dividend is declared payable on December 31 and the corporation followed its usual practice of paying the dividends by checks mailed so that the shareholders would not receive them until January of the following year, such dividends are not considered to have been constructively received in December. Generally, the amount of dividends or interest credited on savings bank deposits or to shareholders of organizations such as building and loan associations or cooperative banks is income to the depositors or shareholders for the taxable year when credited. However, if any portion of such dividends or interest is not subject to withdrawal at the time credited, such portion is not constructively received and does not constitute income to the depositor or shareholder until the taxable year in which the portion first may be withdrawn. Accordingly, if, under a bonus or forfeiture plan, a portion of the dividends or interest is accumulated and may not be withdrawn until the maturity of the plan, the crediting of such portion to the account of the shareholder or depositor does not constitute constructive receipt. In this case, such credited portion is income to the depositor or shareholder in the year in which the plan matures. However, in the case of certain deposits made after December 31, 1970, in banks, domestic building and loan associations, and similar financial institutions, the ratable inclusion rules of section 1232(a)(3) apply. See § 1.1232-3A. Accrued interest on unwithdrawn insurance policy dividends is gross income to the taxpayer for the first taxable year during which such interest may be withdrawn by him.

(a) Definitions. The following definitions apply for this section:

(1) AFS income inclusion amount. The term AFS income inclusion amount means the amount of an item of gross income that is required to be included in gross income under the AFS income inclusion rule in paragraph (b)(1) of this section.

(2) AFS income inclusion rule. The term AFS income inclusion rule has the meaning provided in paragraph (b)(1) of this section.

(3) AFS inventory inclusion amount. The term AFS inventory inclusion amount has the meaning provided in paragraph (c)(2)(i)(A) of this section.

(4) AFS revenue. The term AFS revenue means revenue reported in the taxpayer's AFS. The characterization of an amount in the AFS is not determinative of whether the amount is AFS revenue. For example, AFS revenue can include amounts reported as other comprehensive income or adjustments to retained earnings in an AFS. See paragraph (b) of this section for adjustments to AFS revenue that may need to be made to apply the rules of this section.

(5) Applicable financial statement (AFS). Subject to the rules in paragraph (a)(5)(iv) of this section, the terms applicable financial statement and AFS are synonymous and mean the taxpayer's financial statement listed in paragraph (a)(5)(i) through (iii) of this section that has the highest priority, including priority within paragraphs (a)(5)(i)(B) and (a)(5)(ii)(B) of this section. The financial statements are, in order of descending priority:

(i) GAAP statements. A financial statement that is certified as being prepared in accordance with United States generally accepted accounting principles (GAAP) and is:

(A) A Form 10-K (or successor form), or annual statement to shareholders, filed with the United States Securities and Exchange Commission (SEC);

(B) An audited financial statement of the taxpayer that is used for:

(1) Credit purposes;

(2) Reporting to shareholders, partners, or other proprietors, or to beneficiaries; or

(3) Any other substantial non-tax purpose; or

(C) A financial statement, other than a tax return, filed with the Federal Government or any Federal agency, other than the SEC or the Internal Revenue Service (IRS);

(ii) IFRS statements. A financial statement that is certified as being prepared in accordance with international financial reporting standards (IFRS) and is:

(A) Filed by the taxpayer with an agency of a foreign government that is equivalent to the SEC, and has financial reporting standards not less stringent than the standards required by the SEC;

(B) An audited financial statement of the taxpayer that is used for:

(1) Credit purposes;

(2) Reporting to shareholders, partners, or other proprietors, or to beneficiaries; or

(3) Any other substantial non-tax purpose; or

(C) A financial statement, other than a tax return, filed with the Federal Government, Federal agency, a foreign government, or agency of a foreign government, other than the SEC, IRS, or an agency that is equivalent to the SEC or the IRS; or

(iii) Other statements. A financial statement, other than a tax return, filed with the Federal Government or any Federal agency, a state government or state agency, or a self-regulatory organization including, for example, a financial statement filed with a state agency that regulates insurance companies or the Financial Industry Regulatory Authority. Additional financial statements beyond those included in this paragraph (a)(5)(iii) may be provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d) of this chapter).

(iv) Additional rules for determining priority. If a taxpayer restates AFS revenue for a taxable year prior to the date that the taxpayer files its Federal income tax return for such taxable year, the restated AFS must be used instead of the original AFS. If using the restated AFS revenue results in a change in method of accounting, the preceding sentence applies only if the taxpayer receives permission to change its method of accounting to use the restated AFS revenue. In addition, if a taxpayer with different financial accounting and taxable years is required to file both annual financial statements and periodic financial statements covering less than a year with a government or government agency, the taxpayer must prioritize the annual financial statement in accordance with this paragraph (a)(5).

(6) Cost of goods. The term cost of goods means the costs that are properly capitalized and included in inventory under sections 471 and 263A or any other applicable provision of the Internal Revenue Code (Code) and that are allocable to an item of inventory for which an AFS inventory inclusion amount is calculated. See paragraph (c)(5)(iii) of this section for specific rules for taxpayers using simplified methods under section 263A.

(7) Cost of goods in progress offset. The term cost of goods in progress offset has the meaning provided in paragraph (c)(3) of this section.

(8) Cumulative cost of goods in progress offset. The term cumulative cost of goods in progress offset means the cumulative cost of goods in progress offset amounts under paragraph (c) of this section for a specific item of inventory that have reduced an AFS inventory inclusion amount attributable to such item of inventory in prior taxable years.

(9) Enforceable right. The term enforceable right means any right that a taxpayer has under the terms of a contract or under applicable Federal, state, or international law, including rights to amounts recoverable in equity and liquidated damages. A contract can include, but is not limited to, a statement of work, purchase order, or invoice.

(10) Equity method. The term equity method means a method of accounting for financial accounting purposes under which an investment is initially recorded at cost and subsequently increased or decreased in carrying value by the investor's proportionate share of income and losses and such income or losses are reported as separate items on the investor's statement of income.

(11) Performance obligation. The term performance obligation means a promise in a contract with a customer to transfer to the customer a distinct good, service, or right; or a series of distinct goods, services, or rights, or a combination thereof, that are substantially the same and that have the same pattern of transfer to the customer. A performance obligation includes a promise to grant or transfer a right to use or access intangible property. Performance obligations in a contract are identified by applying the accounting standards the taxpayer uses to prepare its AFS. Additionally, to the extent the contract with the customer provides the taxpayer with an enforceable right to payment, the revenue from which is not allocated to a performance obligation described in the first two sentences of this paragraph (a)(11) in the taxpayer's AFS but is accounted for as a separate source of revenue in the taxpayer's AFS, such right shall be treated as a separate performance obligation under this section. A fee described in paragraph (j)(2) of this section is an example of an enforceable right that is treated as a separate performance obligation.

(12) Prior income inclusion amounts. The term prior income inclusion amounts means amounts of an item of gross income that were required to be included in the taxpayer's gross income under this section or § 1.451-8 in prior taxable years.

(13) Special method of accounting. The term special method of accounting means a method of accounting expressly permitted or required under any provision of the Code, the regulations in this part, or other guidance published in the Internal Revenue Bulletin (see § 601.601(d) of this chapter) under which the time for taking an item of gross income into account in a taxable year is not determined under the all events test in § 1.451-1(a). See, however, paragraph (j) of this section relating to certain items of income for debt instruments. The term special method of accounting does not include any method of accounting expressly permitted or required under this section. The following are examples of special methods of accounting to which the AFS income inclusion rule does not apply:

(i) The crop method of accounting under sections 61 and 162;

(ii) Methods of accounting provided in sections 453 through 460;

(iii) Methods of accounting for notional principal contracts under § 1.446-3;

(iv) Methods of accounting for hedging transactions under § 1.446-4;

(v) Methods of accounting for REMIC inducement fees under § 1.446-6;

(vi) Methods of accounting for gain on shares in a money market fund under § 1.446-7;

(vii) Methods of accounting for certain rental payments under section 467;

(viii) The mark-to-market method of accounting under section 475;

(ix) Timing rules for income and gain associated with a transaction that is integrated under § 1.988-5, and income and gain under the nonfunctional currency contingent payment debt instrument rules in § 1.988-6;

(x) Except as otherwise provided in paragraph (j) of this section, timing rules for original issue discount (OID) under section 811(b)(3) or 1272 (and the regulations in this part under section 1272 of the Code), income under the contingent payment debt instrument rules in § 1.1275-4, income under the variable rate debt instrument rules in § 1.1275-5, income and gain associated with a transaction that is integrated under § 1.1275-6, and income under the inflation-indexed debt instrument rules in § 1.1275-7;

(xi) Timing rules for de minimis OID under § 1.1273-1(d) and for de minimis market discount (as defined in section 1278(a)(2)(C));

(xii) Timing rules for accrued market discount under sections 1276 and 1278(b);

(xiii) Timing rules for short-term obligations under sections 1281 through 1283;

(xiv) Timing rules for stripped bonds under section 1286; and

(xv) Methods of accounting provided in sections 1502 and 1503 and the regulations thereunder, including the method of accounting relating to intercompany transactions under § 1.1502-13.

(14) Transaction price amount. The term transaction price amount means the total amount of consideration to which a taxpayer is, or expects to be, entitled from all performance obligations under a contract. The transaction price amount is determined under the standards the taxpayer uses to prepare its AFS.

(b) AFS income inclusion rule—(1) In general. Except as otherwise provided in this section, if a taxpayer uses an accrual method of accounting for Federal income tax purposes and has an AFS, the all events test under § 1.451-1(a) for any item of gross income, or portion thereof, is met no later than when that item, or portion thereof, is taken into account as AFS revenue (AFS income inclusion rule). See paragraph (b)(2) of this section for rules regarding when an item of gross income, or portion thereof, is treated as taken into account as AFS revenue under the AFS income inclusion rule. See paragraph (c) of this section for optional rules to determine the AFS income inclusion amount for an item of gross income from the sale of inventory. See paragraph (d) of this section for rules regarding the allocation of the transaction price amount to multiple items of gross income. See paragraph (e) of this section for rules to determine the AFS income inclusion amount for an item of gross income from a multi-year contract. See paragraphs (f) and (g) of this section for limitations of the AFS income inclusion rule. See paragraph (h) of this section for special rules that may affect the determination of AFS revenue under the AFS income inclusion rule. See paragraph (j) of this section for special ordering rules for certain items of income with respect to debt instruments.

(2) Amounts taken into account as AFS revenue—(i) General rule. Unless the taxpayer uses the alternative AFS revenue method described in paragraph (b)(2)(ii) of this section, the amount of the item of gross income that is treated as taken into account as AFS revenue under paragraph (b)(1) of this section is determined by making adjustments to AFS revenue for the amounts described in paragraphs (b)(2)(i)(A) through (D) of this section.

(A) If AFS revenue reflects a reduction for amounts described in paragraph (b)(2)(i)(A)(1) or (2) of this section, AFS revenue is increased by the amount of the reduction.

(1) Cost of goods sold and liabilities that are required to be accounted for under other provisions of the Code such as section 461, including liabilities for allowances, rebates, chargebacks, rewards issued in credit card transactions and other reward programs, and refunds, regardless of when any amount described in this paragraph (b)(2)(i)(A)(1) is incurred.

(2) Amounts anticipated to be in dispute or anticipated to be uncollectable.

(B) If AFS revenue includes an amount the taxpayer does not have an enforceable right to recover if the customer were to terminate the contract on the last day of the taxable year (regardless of whether the customer actually terminates the contract), AFS revenue is reduced by such amount.

(C) If the transaction price was increased because a significant financing component is deemed to exist under the standards the taxpayer uses to prepare its AFS, then any AFS revenue attributable to such increase is disregarded.

(D) AFS revenue may be increased or reduced by additional amounts as provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d) of this chapter).

(ii) Alternative AFS revenue method. A taxpayer that chooses to apply the AFS income inclusion rule by using the alternative AFS revenue method described in this paragraph (b)(2)(ii) in lieu of the rules in paragraph (b)(2)(i) of this section, determines the amount of the item of gross income that is treated as taken into account as AFS revenue under paragraph (b)(1) of this section by making adjustments to AFS revenue for only the amounts described in paragraphs (b)(2)(i)(A), (C), and (D) of this section. A taxpayer that uses the alternative AFS revenue method for a trade or business must apply the method to all items of gross income in the trade or business that are subject to the AFS income inclusion rule.

(3) Exceptions. The AFS income inclusion rule in paragraph (b)(1) of this section does not apply to:

(i) Any item of gross income, or portion thereof, if the timing of income inclusion for that item, or portion thereof, is determined using a special method of accounting;

(ii) Any item of gross income, or portion thereof, in connection with a mortgage servicing contract; or

(iii) Any taxable year that is not covered for the entire year by one or more AFS.

(4) Examples. The following examples illustrate the provisions of paragraph (b) of this section. Unless the facts specifically state otherwise, the taxpayer has an AFS, is on a calendar year for Federal income tax purposes and AFS purposes, and uses an accrual method of accounting for Federal income tax purposes. Further, the taxpayer does not use the alternative AFS revenue method under paragraph (b)(2)(ii) of this section or the AFS cost offset method under paragraph (d) of this section, and does not use a special method of accounting:

(i) Example 1: Provision of installation services—(A) Facts. In 2021, B enters into a 2-year service contract with a customer to install the customer's manufacturing equipment for $100,000. Throughout the term of the contract, the customer retains control of the equipment. B begins providing the installation services in 2021 and completes the installation services in 2022. Under the contract, B bills the customer $55,000 in 2021 when installation begins, but does not have a fixed right to receive the remaining $45,000 until installation is complete and approved by the customer. However, if the customer were to terminate the contract prior to completion, B would have an enforceable right to payment for all services performed prior to the termination date. For its AFS, B reports $60,000 of AFS revenue for 2021 and $40,000 of AFS revenue for 2022, in accordance with the services performed in each respective year.

(B) Analysis. Under the all events test in § 1.451-1(a), B is required to include $55,000 in gross income in 2021 as B has a fixed right to receive $55,000 as of the end of 2021. However, under the AFS income inclusion rule, because B has an enforceable right to recover the entire $60,000 that was reported in AFS revenue for 2021 had the customer terminated the contract on the last day of 2021, the entire $60,000 is treated as taken into account as AFS revenue in 2021. Accordingly, the all events test is met for the $60,000 of gross income no later than the end of 2021 and B is required to include $60,000 in gross income in 2021.

(ii) Example 2: Provision of goods included in AFS with enforceable right—(A) Facts. In November 2021, C enters into a contract with a customer to provide 50 customized computers for $80,000. Under the contract, C can bill $80,000 after the customer accepts delivery of the computers. However, the contract provides that C has an enforceable right to be paid for work performed to date if the customer were to terminate the contract prior to delivery. C produces and ships all of the computers in 2021. In 2022, the customer accepts delivery of the computers and C bills the customer. For its AFS, C reports $80,000 of AFS revenue for 2021.

(B) Analysis. Under the all events test in § 1.451-1(a), C does not have a fixed right to receive the $80,000 until the customer accepts delivery of the computers in 2022. However, under the AFS income inclusion rule, because C has an enforceable right to recover the entire $80,000 of AFS revenue that was reported for 2021 had the customer terminated the contract on the last day of 2021, the entire $80,000 is treated as “taken into account as AFS revenue” in 2021. Accordingly, the all events test is met for the $80,000 no later than in 2021 and C is required to include $80,000 in gross income in 2021.

(iii) Example 3: Provision of services included in AFS with enforceable right—(A) Facts. In 2021, D, an engineering services provider, enters into a 4-year contract with a customer to provide services for a total of $100x. Under the contract, D bills and receives $25x for each year of the contract. If the customer were to terminate the contract prior to completion, D has an enforceable right to only the billed amounts. For its AFS, D reports $60x, $0, $20x, and $20x of AFS revenue from the contract for 2021, 2022, 2023, and 2024, respectively.

(B) Analysis. Under the all events test in § 1.451-1(a), D is required to include $25x in gross income in 2021 as D has a fixed right to receive $25x as of the end of 2021. Although D reports $60x of AFS revenue from the provision of services for 2021, D has an enforceable right to recover only $25x if the customer were to terminate the contract on the last day of 2021. Accordingly, pursuant to paragraph (b)(2)(i)(B) of this section, of the $60x of AFS revenue reported for 2021, only $25x is treated as “taken into account as AFS revenue” under the AFS income inclusion rule. As a result, D is required to include only $25x in gross income in 2021. Similarly, in 2022, 2023 and 2024, D includes in gross income only the yearly $25x contract payments under the all events test as only the billed amounts are treated as “taken into account as AFS revenue” under the AFS income inclusion rule.

(iv) Example 4: Sale of good under cost-plus contract—(A) Facts. In 2021, E, a manufacturer, enters into a contract with Fire Department for the manufacture and delivery of a fire truck. The fire truck takes 10 months to manufacture at an estimated cost of $60,000. The contract provides E with an enforceable right to recover costs incurred in manufacturing the fire truck regardless of whether the Fire Department accepts delivery of the fire truck or terminates the contract, and an enforceable right to an additional $20,000 if the fire truck is accepted by the Fire Department. E does not have an enforceable right to recover any portion of the additional $20,000 if the Fire Department were to terminate the contract before it accepts the fire truck. E has an obligation to cure any defects if the customer rejects the fire truck. In August 2021, E begins manufacturing the fire truck ordered by Fire Department and incurs $30,000 of costs for materials and labor for the contract. For its AFS, E reports $40,000 of AFS revenue for 2021 ($30,000 costs plus $10,000 expected profit on the sale of the fire truck).

(B) Analysis for 2021 taxable year. Under the all events test in § 1.451-1(a), E is required to include $30,000 in gross income in 2021 as E has a fixed right to receive $30,000 as of the end of 2021. Although E reports $40,000 of AFS revenue for 2021, E has an enforceable right to recover only $30,000 if the Fire Department were to terminate the contract on the last day of 2021. Accordingly, pursuant to paragraph (b)(2)(i)(B) of this section, of the $40,000 of AFS revenue reported for 2021, only $30,000 is treated as “taken into account as AFS revenue” under the AFS income inclusion rule. As a result, E is required to include only $30,000 in gross income in 2021.

(v) Example 5: Sale of goods with AFS revenue adjustments—(A) Facts. In July 2021, F, a manufacturer of automobile parts, enters into a contract to sell 1,000 parts to a customer for $10 per part, for a total of $10,000 (1,000 × $10). The contract also provides that F will receive a $200 bonus if it delivers all the parts to the customer by February 1, 2022. F delivers 500 non-defective parts to the customer on December 31, 2021 and schedules the remaining 500 parts for delivery to the customer on January 1, 2022. F does not have an enforceable right to recover any portion of the $200 bonus if the customer were to terminate the contract before all 1,000 parts are delivered. F expects to earn the $200 bonus and have 5% of the non-defective parts returned. For its AFS, F reports $4,850 ($5,000 + $100−$250) of AFS revenue for 2021, which includes a $100 (50% × $200) adjustment to increase AFS revenue for the expected bonus and a $250 (5% × $5,000) adjustment to decrease AFS revenue for anticipated returns.

(B) Analysis. Under the all events test in § 1.451-1(a), F is required to include $5,000, less the corresponding cost of goods sold under sections 263A and 471 as applicable, in gross income in 2021 as F has a fixed right to receive $5,000 from the delivery of 500 parts to the customer in 2021. However, F does not have a fixed right to receive any portion of the $200 delivery bonus as of the end of 2021 as the remaining 500 parts had yet to be delivered. Under the AFS income inclusion rule and, specifically, paragraphs (b)(2)(i)(A)(1) and (b)(2)(i)(B) of this section, the amount treated as “taken into account as AFS revenue” for 2021 is also $5,000, calculated as $4,850 of AFS revenue that was reported for 2021, decreased by $100 for the expected delivery bonus that F does not have an enforceable right to recover if the customer were to terminate the contract as of the end of 2021 and increased by $250 for anticipated return liabilities that are accounted for under section 461 ($4,850−$100 + $250 = $5,000). Accordingly, F is required to include $5,000, less the corresponding cost of goods sold determined under sections 263A and 471 as applicable, in gross income in 2021.

(vi) Example 6: Chargebacks—(A) Facts. In November 2021, G, a pharmaceutical manufacturer, enters into a contract to sell 1,000 units to W, a wholesaler, for $10 per unit, totaling $10,000 (1,000 × $10). The contract also provides that G will credit or pay W $4 per unit (a 40% “chargeback”) for sales W makes to certain qualifying customers. G delivers 600 units to W on December 31, 2021, and bills W $6,000 under the contract. W does not make any sales to qualifying customers in 2021. For its AFS, G reports $3,600 ($6,000−$2,400) of AFS revenue for 2021, which includes a reduction of the $6,000 of sales revenue by $2,400 (40% × $6,000) for anticipated chargebacks.

(B) Analysis. Under the all events test in § 1.451-1(a), G is required to include $6,000, less the corresponding cost of goods sold under sections 263A and 471 as applicable, in gross income in 2021 as G has a fixed right to receive $6,000 from the delivery of 600 units to W in 2021. The anticipated chargebacks are liabilities that are accounted for under section 461. Under the AFS income inclusion rule and, specifically, paragraph (b)(2)(i)(A)(1) of this section, the amount treated as “taken into account as AFS revenue” for 2021 is also $6,000, calculated as $3,600 of AFS revenue reported for 2021, increased by $2,400 of anticipated chargeback liabilities that are accounted for under section 461 ($3,600 + $2,400 = $6,000). Accordingly, G is required to include $6,000, less the corresponding cost of goods sold under sections 263A and 471 as applicable, in gross income in 2021.

(vii) Example 7: Sale of property using a special method of accounting. In 2021, H, a financial services provider, sells a building for $100,000, payable in five annual payments of $20,000 together with adequate stated interest, starting in 2021. For its AFS, H reports $100,000 of AFS revenue for 2021 from the sale of the building. For Federal income tax purposes, H uses the installment method under section 453 for the sale of the building. Because the installment method under section 453 is a special method of accounting under paragraphs (a)(13)(ii) and (b)(3)(i) of this section, the AFS income inclusion rule does not apply to H's sale of the building. Accordingly, the gain from the sale is included in income as prescribed in section 453.

(viii) Example 8: Insurance contract renewals—(A) Facts. J, an insurance agent, is engaged by an insurance carrier to sell insurance. Pursuant to the contract between J and the insurance carrier, J is entitled to receive a $50 commission from the insurance carrier at the time a policy is sold to a customer. The contract also provides that J is entitled to receive an additional $25 commission each time a policy is renewed. J does not have an enforceable right to a renewal commission if the insurance carrier terminates the contract before a policy is renewed. J sells 1,000 one-year policies in 2021, of which 800 are expected to be renewed in 2022 and 700 are expected to be renewed in 2023. J does not have any ongoing obligation to provide additional services to the insurance carrier or the customers after the initial sale of the policy. For its AFS, J reports $87,500 of AFS revenue for 2021, which includes $50,000 ($50 × 1,000) of commission income for policies sold in 2021 and an estimate of $37,500 ($25 × 1,500) of commission income for the policies expected to be renewed in 2022 and 2023.

(B) Analysis. Under the all events test in § 1.451-1(a), J is required to include $50,000 in gross income in 2021 as J has a fixed right to receive $50,000 of commission income for the policies it sold during 2021. However, as of the end of 2021, J does not have a fixed right to receive any commission income from anticipated policy renewals. Under the AFS income inclusion rule, although J reports $87,500 of AFS revenue for 2021, J does not have an enforceable right to recover the $37,500 of anticipated commission income from future policy renewals if the insurance carrier were to terminate the contract on the last day of 2021. Accordingly, pursuant to paragraph (b)(2)(i)(B) of this section, of the $87,500 of AFS revenue reported for 2021, only $50,000 is treated as “taken into account as AFS revenue” under the AFS income inclusion rule. As a result, J is required to include $50,000 in gross income in 2021. Alternatively, if J uses the alternative AFS revenue method in paragraph (b)(2)(ii) of this section, all $87,500 of AFS revenue reported for 2021 would be treated as “taken into account as AFS revenue” under the AFS income inclusion rule and J would be required to include $87,500 of commission income in gross income in 2021.

(ix) Example 9: Escalating rents—(A) Facts. (1) K is a landlord in the business of leasing office space. On January 1, 2021, K enters into a 5-year lease with a tenant that provides for annual rent of $30,000 for 2021 and increases by 5% each year over the lease term. The annual rents are due at the end of each year. Accordingly, the rent for each year (rounded to the nearest dollar) is as follows:

(2) The lease is not a section 467 rental agreement as defined under section 467(d). If the tenant terminates the lease early, the tenant must pay K the balance of the rent due for the remainder of the termination year. On its AFS, K reports AFS revenue from rents on a straight-line basis over the term of the lease, or approximately $33,154 per year ($165,769 total rent/5 years). Accordingly, for its AFS, K reports $33,154 of AFS revenue for 2021.

(B) Analysis. Under the all events test in § 1.451-1(a), K is required to include $30,000 in gross income in 2021 as K has a fixed right to receive $30,000 for the 2021 rental period under the terms of the lease agreement. Under the AFS income inclusion rule, although K reports $33,154 of AFS revenue for 2021, K has an enforceable right to recover only $30,000 if the tenant were to cancel the lease on the last day of 2021. Accordingly, pursuant to paragraph (b)(2)(i)(B) of this section, of the $33,154 of AFS revenue reported for 2021, only $30,000 is treated as “taken into account in AFS revenue” under the AFS income inclusion rule. As a result, K is required to include $30,000 in gross income in 2021.

(x) Example 10: Licensing income from digital services—(A) Facts. M is engaged in the business of licensing media entertainment content packages. M licenses content packages to customers by entering into subscription plans with customers. In January 2021, M enters into a two-year subscription plan with Customer. M charges Customer $40 per month billed monthly in arrears. If Customer terminates the plan prior to the two-year term, it must pay the balance of the subscription fee for the remaining term of the contract. For its AFS, M reports $960 ($40 × 24 months) of AFS revenue for 2021.

(B) Analysis. Under the all events test in § 1.451-1(a), M is required to include $480 in gross income in 2021 as M has a fixed right to receive $480 ($40 × 12) for the 12 months of media content licensed to Customer in 2021. M does not have a fixed right to receive any portion of the 2022 subscription fee as of the end of 2021 as such fee is not due under the terms of the subscription agreement until 2022 and M has yet to provide the media content for the 2022 subscription period. However, under the AFS income inclusion rule, because M has an enforceable right to recover all $960 of AFS revenue reported for 2021 if Customer were to terminate the contract at the end of 2021, all $960 is treated as “taken into account as AFS revenue” in 2021. Accordingly, M is required to include $960 in gross income in 2021.

(c) Cost offsets—(1) In general. This paragraph (c) provides an optional method of accounting that may be used to determine the AFS income inclusion amount for an item of gross income from the sale of inventory (AFS cost offset method). A taxpayer that uses the AFS cost offset method for a trade or business must apply this method to all items of gross income in the trade or business that meet the criteria in this paragraph (c). Additionally, a taxpayer that uses this method for a trade or business must also use the advance payment cost offset method described in § 1.451-8(e) to account for all advance payments received by such trade or business that meet the criteria in § 1.451-8(e), if applicable. A taxpayer that uses the AFS cost offset method to account for gross income from the sale of an item of inventory, but not the advance payment cost offset method because it does not receive any advance payments for such item, determines the corresponding AFS income inclusion amount for a taxable year by following the rules in paragraph (c)(2) of this section. A taxpayer that uses the AFS cost offset method and the advance payment cost offset method to account for gross income, including advance payments, from the sale of an item of inventory, determines the corresponding AFS income inclusion amount and the advance payment income inclusion amount, as defined in § 1.451-8(a)(2), for a taxable year by following the rules in paragraph (c)(2) of this section rather than the rules under § 1.451-8(e). However, if all payments received for the sale of an item of inventory meet the definition of an advance payment under § 1.451-8(a)(1), a taxpayer that uses the advance payment cost offset method determines the corresponding advance payment income inclusion amount for a taxable year by following the rules in § 1.451-8(e).

(2) AFS cost offset method. A taxpayer that uses the AFS cost offset method and, if applicable, the advance payment cost offset method, to account for gross income from the sale of an item of inventory determines the AFS income inclusion amount, or, if applicable, the advance payment income inclusion amount, for a taxable year prior to the taxable year in which ownership of the item of inventory is transferred to the customer by following the rules in paragraph (c)(2)(i) of this section, subject to the additional rules and limitations in paragraphs (c)(4) through (6) of this section. Such taxpayer determines the AFS income inclusion amount or, if applicable, the advance payment income inclusion amount, for the taxable year in which ownership of the item of inventory is transferred to the customer by following the rules in paragraph (c)(2)(ii) of this section. A taxpayer described in this paragraph (c)(2) that receives advance payments for the sale of the item of inventory may be required to include in gross income for a taxable year an amount that is comprised of both an AFS income inclusion amount and an advance payment income inclusion amount. In such case, it is not necessary to determine the portion of the total inclusion that is comprised of the AFS income inclusion amount and the portion of the total inclusion that is comprised of the advance payment income inclusion amount.

(i) Determining gross income for a year prior to the year of sale. To determine the amount required to be included in gross income from the sale of an item of inventory for a taxable year prior to the taxable year in which ownership of the item of inventory is transferred to the customer, a taxpayer must first determine the AFS inventory inclusion amount for such item for such year by applying the steps in paragraph (c)(2)(i)(A) of this section. This AFS inventory inclusion amount is then reduced by the cost of goods in progress offset for the taxable year, as determined under paragraphs (c)(3) through (5) of this section. This net amount is required to be included in gross income for the taxable year.

(A) AFS inventory inclusion amount for a taxable year. To determine the AFS inventory inclusion amount for an item of inventory for a taxable year:

(1) The taxpayer first takes the greater of the amount described in paragraph (c)(2)(i)(A)(1)(i) of this section, or the amount described in paragraph (c)(2)(i)(A)(1)(ii) of this section (or if the two amounts are equal, the equal amount).

(i) The cumulative amount of revenue from the item of inventory that satisfies the all events test under § 1.451-1(a) through the last day of the taxable year, less any advance payment inventory inclusion amount, as defined in § 1.451-8(a)(3), with respect to a subsequent taxable year.

(ii) The cumulative amount of revenue from the item of inventory that is treated as “taken into account as AFS revenue” under paragraph (b)(2) of this section through the last day of the taxable year.

(2) The taxpayer then reduces the amount determined under paragraph (c)(2)(i)(A)(1) of this section by the amount computed under paragraph (c)(2)(i)(A)(1) of this section for that item of inventory for the immediately preceding taxable year.

(B) [Reserved]

(ii) Determining the gross income for the year of sale. To determine the amount required to be included in gross income from the sale of an item of inventory for the taxable year in which ownership of the item of inventory is transferred to the customer:

(A) The taxpayer first takes the greater of the amount described in paragraph (c)(2)(ii)(A)(1) of this section, or the amount described in paragraph (c)(2)(ii)(A)(2) of this section (or if the two amounts are equal, the equal amount).

(1) The cumulative amount of revenue from the item of inventory that satisfies the all events test under § 1.451-1(a) through the last day of the taxable year, including the full amount of any advance payment received for the item of inventory.

(2) The cumulative amount of revenue from the item of inventory that is treated as “taken into account as AFS revenue” under paragraph (b)(2) of this section through the last day of the taxable year.

(B) The taxpayer then reduces such amount by any prior income inclusion amounts with respect to such item of inventory. This net amount is required to be included in gross income for the taxable year. The taxpayer does not further reduce such amount by a cost of goods in progress offset under paragraph (c)(3) of this section. However, the taxpayer is entitled to recover the costs capitalized to the item of inventory as cost of goods sold in accordance with sections 471 and 263A or any other applicable provision of the Internal Revenue Code. See § 1.61-3.

(3) Cost of goods in progress offset for a taxable year. The cost of goods in progress offset for the taxable year is calculated as:

(i) The cost of goods allocable to the item of inventory through the last day of the taxable year; reduced by

(ii) The cumulative cost of goods in progress offset attributable to the item of inventory, if any.

(4) Limitations to the cost of goods in progress offset. The cost of goods in progress offset is determined separately for each item of inventory. Further, the cost of goods in progress offset attributable to one item of inventory cannot reduce the AFS inventory inclusion amount attributable to a separate item of inventory. The cost of goods in progress offset cannot reduce the AFS inventory inclusion amount for the taxable year below zero.

(5) Inventory methods—(i) Inventory costs not affected by cost of goods in progress offset. The cost of goods comprising the cost of goods in progress offset does not reduce the costs that are capitalized to the items of inventory produced or items of inventory acquired for resale by the taxpayer. While the cost of goods in progress offset reduces the AFS inventory inclusion amount, the cost of goods in progress offset does not affect how and when costs are capitalized to inventory under sections 471 and 263A or any other applicable provision of the Internal Revenue Code or when those capitalized costs will be recovered.

(ii) Consistency between inventory methods and AFS cost offset method. The costs of goods comprising the cost of goods in progress offset must be determined by applying the taxpayer's method of accounting for inventory for Federal income tax purposes. A taxpayer using the AFS cost offset method and, if applicable, the advance payment cost offset method must calculate its cost of goods in progress offset by reference to all costs that the taxpayer has permissibly capitalized and allocated to items of inventory under its method of accounting for inventory for Federal income tax purposes, but including no more costs than what the taxpayer has permissibly capitalized and allocated to items of inventory.

(iii) Allocation of “additional section 263A costs” for taxpayers using simplified methods. If a taxpayer uses the simplified production method as defined under § 1.263A-2(b), the modified simplified production method as defined under § 1.263A-2(c), or the simplified resale method as defined under § 1.263A-3(d) to determine the amount of its additional section 263A costs, as defined under § 1.263A-1(d)(3), to be included in ending inventory, then solely to compute the cost of goods in progress offset, the taxpayer must determine the portion of additional section 263A costs allocable to an item of inventory by multiplying its total additional section 263A costs accounted for under the simplified method for all items of inventory subject to the simplified method by the following ratio:

Section 471 costs allocable to the specific item of inventory

Total section 471 costs for all items of inventory subject to the simplified method

(6) Acceleration of gross income. A taxpayer that uses the AFS cost offset method or the advance payment cost offset method must include in gross income for a taxable year prior to the taxable year in which an item of inventory is transferred to the customer, all payments received for the item of inventory that were not previously included in gross income:

(i) If, in that taxable year, the taxpayer either dies or ceases to exist in a transaction other than a transaction to which section 381(a) applies; or

(ii) If, and to the extent that, in that taxable year, the taxpayer's obligation to the customer with respect to the item of inventory ends other than in:

(A) A transaction to which section 381(a) applies; or

(B) A section 351(a) transfer that is part of a section 351 transaction in which:

(1) Substantially all assets of the trade or business, including the item of inventory, are transferred;

(2) The transferee adopts or uses, in the year of the transfer, the same methods of accounting for the item of inventory under this section and § 1.451-8 as those used by the transferor; and

(3) The transferee and the transferor are members of the same consolidated group, as defined in § 1.1502-1(h).

(7) Additional procedural guidance. The IRS may publish procedural guidance in the Internal Revenue Bulletin (see § 601.601(d) of this chapter) that provides alternative procedures for complying with the rules under this paragraph (c), including alternative methods of accounting for cost offsets.

(8) Examples. The following examples illustrate the AFS cost offset method. Unless the facts specifically state otherwise, the taxpayer has an AFS, is on a calendar year for both Federal income tax purposes and AFS purposes, uses an accrual method of accounting for Federal income tax purposes, and does not use a special method of accounting. Further, the taxpayer properly applies its inventory accounting method, uses the AFS cost offset method under paragraph (c) of this section, and, except as otherwise provided, does not receive advance payments. Lastly, the taxpayer does not produce unique items, as described in § 1.460-2(a)(1) and (b), or any item that normally requires more than 12 calendar months to complete, as determined under § 1.460-2(a)(2) and (c). Any production period that exceeds 12 calendar months is due to unforeseen production delays.

(i) Example 1—(A) Facts. During 2021, A enters into a contract with Customer to manufacture and deliver a good with a total contract price of $100x. The costs to produce the good are required to be capitalized under sections 471 and 263A as the good is inventory in the hands of A. Ownership of the good is transferred from A to Customer upon its delivery in 2022. A determines, under paragraph (c)(2)(i)(A) of this section, that its AFS inventory inclusion amount for 2021 is $20x. A incurs $12x of costs in 2021, and $48x of costs in 2022 ($60x in total) that are permissibly capitalized and allocated to the produced good under sections 471 and 263A. A has a fixed right to receive the $100x contract price when it delivers the good in 2022. A does not receive any payments from Customer prior to delivery. Further, all $100x is treated as “taken into account as AFS revenue” as of the last day of 2022.

(B) Analysis for 2021. For 2021, A's AFS income inclusion amount, as determined under paragraph (c)(2)(i) of this section, is $8x ($20x AFS inventory inclusion amount less $12x cost of goods in progress offset, which is the cost of goods incurred through December 31, 2021).

(C) Analysis for 2022. During 2022, ownership of the good is transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii) of this section, A determines the AFS income inclusion amount for 2022 by:

(1) First taking the greater of:

(i) The cumulative amount of revenue that satisfies the all events test under § 1.451-1(a) through the last day of 2022 ($100x); or

(ii) The cumulative amount of revenue that is treated as “taken into account as AFS revenue” through the last day of 2022 ($100x) (or if the two amounts are equal, the equal amount).

(2) Then subtracting from such amount ($100x) the prior income inclusion amounts attributable to the transferred good ($8x). This net amount of $92x is the AFS income inclusion amount for 2022. Although A does not reduce such amount by a cost of goods in progress offset under this paragraph (c), A is entitled to recover the $60x of costs capitalized to the good as cost of goods sold in 2022 in accordance with sections 471 and 263A. See § 1.61-3. Accordingly, A's gross income for 2022 is $32x.

(ii) Example 2—(A) Facts. In December of 2021, A enters into a contract with Customer to manufacture and deliver 10 items of inventory at a price of $10x per item by the end of 2023. A determines, under paragraph (c)(2)(i)(A) of this section, that the AFS inventory inclusion amount attributable to each item of inventory under the contract is $3x for 2021. A also incurs $10x of inventory costs during 2021. Such costs are permissibly capitalized and allocated under sections 471 and 263A and are allocated equally to each item of inventory under the contract ($1x per item). During 2022, the taxpayer incurs $18x of costs to finish manufacturing 6 of the 10 items and delivers such items to Customer in October of 2022. Such costs are permissibly capitalized and allocated under sections 471 and 263A and are allocated equally to each of the 6 items delivered in October of 2022 ($3x per item). Upon delivering the 6 items, ownership of the delivered items transfers to Customer, A has a fixed right to receive $60x of the total contract price, and all $60x is treated as “taken into account as AFS revenue.” A does not incur any inventory costs during 2022 that are allocable to the 4 remaining undelivered items, nor does the taxpayer have an AFS inventory inclusion amount attributable to such items for 2022. During 2023, A incurs $12x of costs to finish manufacturing the 4 remaining items and delivers such items to Customer. Such costs are permissibly capitalized and allocated under sections 471 and 263A and are allocated equally to each of the 4 items delivered in 2023 ($3x per item). Upon delivering the 4 remaining items, ownership of the items transfers to Customer, A has a fixed right to receive the remaining $40x contract price, and all $40x is treated as “taken into account as AFS revenue.”

(B) Analysis for 2021 A's AFS income inclusion amount for 2021 is $2x per item ($3x AFS inventory inclusion amount per item less $1x cost of goods in progress offset per item, which is the cost of goods as of December 31, 2021). Accordingly, A's total gross income inclusion for 2021 is $20x.

(C) Analysis for 2022. During 2022, ownership of 6 of the 10 items is transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii) of this section, A determines the AFS income inclusion amount for 2022 by:

(1) First taking the greater of:

(i) The cumulative amount of revenue that satisfies the all events test under § 1.451-1(a) through the last day of 2022 ($10x per item); or

(ii) The cumulative amount of revenue that is treated as taken into account as AFS revenue through the last day of 2022 ($10x per item) (or if the two amounts are equal, the equal amount).

(2) Then subtracting from such amount ($10x per item) the prior income inclusion amounts attributable to each transferred item ($2x per item). This net amount of $8x per item is the AFS income inclusion amount for each transferred item for 2022. Although A does not reduce such amount by a cost of goods in progress offset under this paragraph (c), A is entitled to recover the $4x of costs capitalized to each item delivered as cost of goods sold in 2022 in accordance with sections 471 and 263A. Accordingly, on an aggregate basis, A's gross income for 2022 is $24x (aggregate AFS income inclusion amount for the 6 items delivered in 2022 of $ 48x less aggregate cost of goods sold of $24x). A does not include any amounts in gross income for 2022 with respect to the 4 items of inventory that were not delivered to Customer until 2023 as A does not have an AFS inventory inclusion amount attributable to such items for 2022.

(D) Analysis for 2023. During 2023, ownership of the 4 remaining items are transferred to Customer. Based on the facts, A did not have an AFS inventory inclusion amount attributable to the 4 remaining items for 2022, nor did it incur any cost for such items in 2022 so the analysis for the 4 remaining items for 2023 is similar to the analysis for the 6 items transferred to the customer in 2022 on a per item basis. Pursuant to paragraph (c)(2)(ii) of this section, A determines the AFS income inclusion amount for 2023 by:

(1) First taking the greater of:

(i) The cumulative amount of revenue that satisfies the all events test under § 1.451-1(a) through the last day of 2023 ($10x per item); or

(ii) The cumulative amount of revenue that is treated as taken into account as AFS revenue through the last day of 2023 ($10x per item) (or if the two amounts are equal, the equal amount).

(2) Then subtracting from such amount ($10x per item) the prior income inclusion amounts attributable to each transferred item ($2x per item). This net amount of $8x per item is the AFS income inclusion amount for each transferred item for 2023. Although A does not reduce such amount by a cost of goods in progress offset under this paragraph (c), A is entitled to recover the $4x of costs capitalized to each item delivered as cost of goods sold in 2023 in accordance with sections 471 and 263A. On an aggregate basis, A's gross income for 2023 is $16x (aggregate AFS income inclusion amount for the 4 items delivered in 2023 of $32x less aggregate cost of goods sold of $16x).

(iii) Example 3—(A) Facts. In December of 2021, A enters into a contract with Customer to manufacture and deliver a good with a total contract price of $100x. The costs to produce the good are required to be capitalized under sections 471 and 263A as the good is inventory in the hands of the taxpayer. Ownership of the good is transferred from A to Customer upon its delivery in January of 2023. A determines, under paragraph (c)(2)(i)(A) of this section, that its AFS inventory inclusion amount for 2021 and 2022 is $40x per year. A incurs $25x of costs each year ($75x in total) that are permissibly capitalized and allocated to the manufactured good under sections 471 and 263A. A has a fixed right to receive the $100x contract price when it delivers the good in January of 2023. A does not receive any payments from Customer prior to delivery. Further, all $100x is treated as “taken into account as AFS revenue” as of the last day of 2023.

(B) Analysis for 2021 and 2022. For 2021, A's AFS income inclusion amount, as determined under paragraph (c)(2)(i) of this section, is $15x ($40x AFS inventory inclusion amount for 2021 less the $25x cost of goods in progress offset for 2021, which is equal to the cost of goods as of December 31, 2021). For 2022, A's AFS income inclusion amount is $15x ($40x AFS inventory inclusion amount for 2022 less the $25x cost of goods in progress offset for 2022, which is the $50x cost of goods as of December 31, 2022 less the 25x cumulative cost of goods in progress offset amount taken into account in 2021).

(C) Analysis for 2023. During 2023, ownership of the good is transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii) of this section, A determines the AFS income inclusion amount for 2023 by:

(1) First taking the greater of:

(i) The cumulative amount of revenue that satisfies the all events test under § 1.451-1(a) through the last day of 2023 ($100x); or

(ii) The cumulative amount of revenue that is treated as “taken into account as AFS revenue” through the last day of 2023 ($100x) (or if the two amounts are equal, the equal amount).

(2) Then subtracting from such amount ($100x) the prior income inclusion amounts attributable to the transferred good of $30x ($15x for 2021 and $15x for 2022). This net amount of $70x is the AFS income inclusion amount for 2023. Although A does not reduce such amount by a cost of goods in progress offset under this paragraph (c), A is entitled to recover the $75x of costs capitalized to the good as cost of goods sold in 2023 in accordance with sections 471 and 263A. See § 1.61-3. Accordingly, A's gross income for 2025 is −$5x.

(iv) Example 4—(A) Facts. In December 2021, A enters into a contract with Customer to manufacture and deliver a good with a total contract price of $100x. A reports $5x of AFS revenue for 2021, $90x of cumulative AFS revenue through the end of 2022, and $100x of cumulative AFS revenue through the end of 2023. A has an enforceable right to recover all AFS revenue reported through the end of each contract year if Customer were to terminate the contract on the last day of each year. Under the terms of the contract, A is entitled to and receives a payment of $40x in 2021 and a payment of $60x when Customer accepts delivery of the good in 2023, which is also when ownership of the good transfers to Customer. The costs to produce the good are required to be capitalized under sections 471 and 263A as the good is inventory in the hands of A. A incurs $10x of costs in 2021, $55x of costs in 2022, and $5x of costs in 2023 ($70x in total). Such costs are permissibly capitalized and allocated to the produced good under sections 471 and 263A. A uses the AFS cost offset method under paragraph (c) of this section and accounts for advance payments, as defined in § 1.451-8(a)(1), under the deferral method and advance payment cost offset method under § 1.451-8(c) and (e), respectively.

(B) Analysis for 2021. The $40x payment A receives in 2021 meets the definition of an advance payment under § 1.451-8(a)(1) as the full inclusion of $40x in gross income in the year of receipt is a permissible method of accounting, a portion of the payment ($35x) is “taken into account as AFS revenue” in a subsequent year, and the payment is for a good. Pursuant to § 1.451-8(a)(3), A's advance payment inventory inclusion amount for 2022 is $35x (the portion of the payment deferred for AFS purposes). Pursuant to paragraph (c)(2)(i) of this section, A must first determine the AFS inventory inclusion amount for 2021 by applying the rules in paragraph (c)(2)(i)(A) of this section. A then reduces such amount by the cost of goods in progress offset for 2021, as determined under paragraphs (c)(3) through (5) of this section.

(1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first takes the greater of:

(i) The cumulative amount of revenue that satisfies the all events test under § 1.451-1(a) through the last day of 2021, less any advance payment inventory inclusion amount attributable to a subsequent year ($5x, determined as the $40x under the all events test, less the $35x of advance payment inventory inclusion amount attributable to 2022); or

(ii) The cumulative amount of revenue that is treated as “taken into account as AFS revenue” through the last day of 2021 ($5x) (or if the two amounts are equal, the equal amount).

(2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then subtracts from such amount ($5x) the amount determined under paragraph (c)(2)(i)(A)(1) of this section for the item of inventory for the immediately preceding year ($0). This net amount of $5x is the AFS inventory inclusion amount for 2021.

(3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this $5x AFS inventory inclusion amount by the cost of goods in progress offset for 2021 of $5x, determined as the cost of goods as of December 31, 2021 of $10x, less the cumulative cost of goods in progress offset taken into account in prior years of $0, less 5x for the AFS inventory inclusion amount limitation under paragraph (c)(4) of this section. Accordingly, A is required to include $0 in gross income for 2021.

(C) Analysis for 2022. Pursuant to paragraph (c)(2)(i) of this section, A must first determine the AFS inventory inclusion amount for 2022 by applying the rules in paragraph (c)(2)(i)(A) of this section. A then reduces such amount by the cost of goods in progress offset for 2022, as determined under paragraphs (c)(3) through (5) of this section.

(1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first takes the greater of:

(i) The cumulative amount of revenue that satisfies the all events test under § 1.451-1(a) through the last day of 2022 ($40x); or

(ii) The cumulative amount of revenue that is treated as “taken into account as AFS revenue” through the last day of 2022 ($90x).

(2) Pursuant to (c)(2)(i)(A)(2) of this section, A then subtracts from such amount ($90x) the amount determined under paragraph (c)(2)(i)(A)(1) of this section for the item of inventory for 2021 ($5x). This net amount of $85x is the AFS inventory inclusion amount for 2022.

(3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this $85x AFS inventory inclusion amount by the cost of goods in progress offset for 2022 of $60x, determined as the cost of goods as of December 31, 2022 of $65x, less the cumulative cost of goods in progress offset taken into account in prior years of $5x. Accordingly, A is required to include $25x in gross income for 2022.

(D) Analysis for 2023. During 2023, ownership of the good is transferred to Customer. Accordingly, pursuant to paragraph (c)(2)(ii) of this section, A determines its gross income inclusion for 2023 by:

(1) First taking the greater of:

(i) The cumulative amount of revenue that satisfies the all events test under § 1.451-1(a) through the last day of 2023 ($100x); or

(ii) The cumulative amount of revenue that is treated as “taken into account as AFS revenue” through the last day of 2023 ($100x) (or if the two amounts are equal, the equal amount).

(2) Then subtracting from such amount ($100x) the prior income inclusion amounts attributable to the transferred good of $25x ($0 for 2021 plus $25x for 2022). A is required to include this net amount of $75x in gross income for 2023. Although A does not reduce such amount by a cost of goods in progress offset under this paragraph (c), A is entitled to recover the $70x of costs capitalized to the good as cost of goods sold in 2023 in accordance with sections 471 and 263A. See § 1.61-3. Accordingly, A's gross income for 2023 is $5x.

(v) Example 5—(A) Facts. The same facts as in paragraph (c)(8)(iv) of this section (Example 4) apply, except that in 2022, A's obligation to Customer with respect to the good ends other than in a transaction to which section 381(a) applies, or a section 351 transaction described in paragraph (c)(6)(ii)(B) of this section. A does not receive any additional payments in 2022.

(B) Analysis for 2021. The analysis for 2021 is the same as in paragraph (c)(8)(iv) of this section (Example 4).

(C) Analysis for 2022. Because, in 2022, A's obligation to Customer with respect to the good ends in a transaction other than a transaction described in paragraph (c)(6)(ii)(A) or (B) of this section, A is required to apply the acceleration rules in paragraph (c)(6) of this section. Accordingly, because A received $40x of payments as of the date of the transaction, but did not include any portion of such payments in gross income in prior years, A is required to include the remaining $40x of the payments received in gross income in 2022 pursuant to paragraph (c)(6) of this section. A is not permitted to further reduce the $40x income inclusion by a cost of goods in progress offset under this paragraph (c).

(vi) Example 6—(A) Facts. In 2021, A enters into a contract with Customer to produce and deliver a good. The contract provides that A will receive payments equal to AFS costs plus a 100% mark-up, however, A can only bill the customer on December 31, 2022 and, if the good is not delivered by December 31, 2022, A can also bill Customer upon delivery of the good, for the AFS costs (plus markup) incurred to date, less any amounts previously billed. A recognizes AFS revenue based on a percentage of completion (cost to cost) method. A recognizes AFS revenue of $100 through the last day of 2021, $150 through the last day of 2022, and $300 through the last day of 2023, and has an enforceable right to all AFS revenue reported as of the end of each year if the customer were to terminate the contract on the last day of the year. A bills the customer $150 on December 31 of 2022 and $150 in 2023 when A delivers the good and ownership transfers to Customer. The costs to produce the good are required to be capitalized under sections 471 and 263A as the good is inventory in the hands of the taxpayer. A incurs the following costs each year that are permissibly capitalized and allocated to the produced good under sections 471 and 263A: $125 in 2021; $0 in 2022; and $25 in year 2023.

(B) Analysis for taxable year 2021. Pursuant to paragraph (c)(2)(i) of this section, A must first determine the AFS inventory inclusion amount for 2021 by applying the rules in paragraph (c)(2)(i)(A) of this section. A then reduces such amount by the cost of goods in progress offset for 2021, as determined under paragraphs (c)(3) through (5) of this section.

(1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first takes the greater of:

(i) The cumulative amount of revenue that satisfies the all events test under § 1.451-1(a) through the last day of 2021 ($0); or

(ii) The cumulative amount of revenue that is treated as “taken into account as AFS revenue” through the last day of 2021 ($100).

(2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then subtracts from such amount ($100) the amount determined under paragraph (c)(2)(i)(A)(1) of this section for the item of inventory for the immediately preceding year ($0). This net amount of $100 is the AFS inventory inclusion amount for 2021.

(3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this $100 AFS inventory inclusion amount by the cost of goods in progress offset for 2021 of $100. Although A's cost of goods in progress as of the end of 2021 is $125, the cost of goods in progress offset is limited to $100, the amount of A's AFS inventory inclusion amount for 2021. Accordingly, A is required to include $0 in gross income in 2021.

(C) Analysis for taxable year 2022. Pursuant to paragraph (c)(2)(i) of this section, A must first determine the AFS inventory inclusion amount for 2022 by applying the rules in paragraph (c)(2)(i)(A) of this section. A then reduces such amount by the cost of goods in progress offset for 2022, as determined under paragraphs (c)(3) through (5) of this section.

(1) Pursuant to paragraph (c)(2)(i)(A)(1) of this section, A first takes the greater of:

(i) The cumulative amount of revenue that satisfies the all events test under § 1.451-1(a) through the last day of 2022 ($150 due under the terms of the contract); or

(ii) The cumulative amount of revenue that is treated as “taken into account as AFS revenue” through the last day of 2022 ($150) (or if the two amounts are equal, the equal amount).

(2) Pursuant to paragraph (c)(2)(i)(A)(2) of this section, A then subtracts from such amount ($150) the amount determined under paragraph (c)(2)(i)(A)(1) of this section for the item of inventory for the immediately preceding year ($100). This net amount of $50 is the AFS inventory inclusion amount for 2022.

(3) Pursuant to paragraph (c)(2)(i) of this section, A reduces this $50 AFS inventory inclusion amount by the cost of goods in progress offset for 2022 of $25, determined as $125 cost of goods as of December 31, 2022 minus $100 cumulative cost of goods in progress offset amount taken into account in 2021. Accordingly, A is required to include $25 in gross income for 2022.

(D) Analysis for taxable year 2023. During 2023, ownership of the good is transferred to the customer. Accordingly, pursuant to paragraph (c)(2)(ii) of this section, A determines its gross income inclusion for 2023 by:

(1) First taking the greater of:

(i) The cumulative amount of revenue that satisfies the all events test under § 1.451-1(a) through the last day of 2023 ($300x); or

(ii) The cumulative amount of revenue that is treated as “taken into account as AFS revenue” through the last day of 2025 ($300x) (or if the two amounts are equal, the equal amount).

(2) Then subtracting from such amount ($300x) the prior income inclusion amounts attributable to the transferred good of $25 ($0 for 2021 plus $25 for 2022). This net amount of $275 is the AFS income inclusion amount for 2023. Although A does not reduce such amount by a cost of goods in progress offset under this paragraph (c), A is entitled to recover the $150 of costs capitalized to the good as cost of goods sold in 2023 in accordance with sections 471 and 263A. See § 1.61-3. Accordingly, A's gross income for 2023 is $125 ($275 AFS income inclusion amount less $150 cost of goods sold).

(d) Contracts with multiple performance obligations—(1) In general. Each performance obligation generally yields a corresponding item of gross income that must be accounted for separately under the AFS income inclusion rule in paragraph (b)(1) of this section. Except as provided in paragraph (d)(5) of this section, if a contract contains more than one performance obligation, and thus yields more than one corresponding item of gross income, the transaction price amount shall be allocated to each corresponding item of gross income in accordance with the transaction price amount allocated to each performance obligation for AFS purposes, subject to the adjustments to the transaction price amount and special allocation rules in paragraph (d)(3) of this section.

(2) Single performance obligation with more than one item of gross income. If a single performance obligation yields more than one corresponding item of gross income, the transaction price amount allocated to the single performance obligation for AFS purposes must be further allocated among the corresponding items of gross income using any reasonable method.

(3) Adjustments to transaction price amount and special allocation rules—(i) Increases to transaction price amount. If the transaction price amount includes a reduction for amounts described in paragraph (b)(2)(i)(A)(1) or (2) of this section, or has been reduced because a significant financing component is deemed to exist under the standards the taxpayer uses to prepare its AFS, the taxpayer must determine the specific performance obligation to which such reduction relates and increase the transaction price amount allocable to the corresponding item of gross income by the amount of such reduction (specific identification approach). If it is impracticable from the taxpayer's records to use the specific identification approach, the taxpayer may use any reasonable method to allocate the reduction amount to the items of gross income in the contract. A pro-rata allocation of the reduction amount across all items of gross income under the contract based on the relative transaction price amounts allocated to such items under paragraph (d)(1) of this section is a reasonable method.

(ii) Decrease to transaction price amount. If the transaction price amount has been increased because a significant financing component is deemed to exist under the standards the taxpayer uses to prepare its AFS, the taxpayer must determine the specific performance obligation to which such amount relates and decrease the transaction price amount allocable to the corresponding item of gross income by such amount (specific identification approach). If it is impracticable from the taxpayer's records to use the specific identification approach, the taxpayer may use any reasonable method to allocate such amount to the items of gross income in the contract. A pro-rata allocation of such amount across all items of gross income under the contract based on the relative transaction price amounts allocated to such items under paragraph (d)(1) of this section is a reasonable method.

(4) Examples. The following examples illustrate the rules of paragraph (d)(1) through (3) of this section. Unless the facts specifically state otherwise, the taxpayer has an AFS, is on a calendar year for Federal income tax purposes and AFS purposes, and uses an accrual method of accounting for Federal income tax purposes.

(i) Example 1—(A) Facts. On November 1, 2021, A, a software developer, enters into a contract with a customer to transfer a software license, perform software installation services, and provide technical support for a two-year period for $100x. The installation service does not significantly modify the software and the software remains functional without the technical support. A receives an additional $10x bonus if the installation service is performed before February 1, 2022, which A expects to receive. Further, the customer is entitled to a refund of $2x if technical support does not meet performance standards set forth in the contract, which A expects it will pay to the customer. For its AFS, A identifies three performance obligations in the contract:

(1)(i) The software license;

(ii) The installation service; and

(iii) Technical support.

(2) Also, for its AFS, A determines that the transaction price amount is $108x, determined as $100x contract price plus $10x bonus for installation services minus $2x customer refund. Finally, for its AFS, A allocates the $108x transaction price amount to the three performance obligations as follows: $60x to the software license; $40x to the installation service ($30x + $10x bonus); and $8x to technical support ($10x−$2x refund).

(B) Analysis. Pursuant to paragraph (d)(1) of this section, A's contract with the customer has three performance obligations, and each performance obligation yields a corresponding item of gross income that is accounted for separately. Pursuant to paragraph (d)(1) of this section, A is required to allocate the $108x transaction price amount to each corresponding item of gross income in accordance with the transaction price amount allocated to each respective performance obligation for AFS purposes. Accordingly, A initially allocates $60x to the software license item, $40x to the installation service item, and $8 to the technical support item. However, because the transaction price amount was reduced by the anticipated refund of $2x, which relates specifically to the technical support item, A must increase the transaction price allocable to that item of gross income pursuant to the specific identification approach in paragraph (d)(3) of this section. Accordingly, the amount allocated to the item of gross income related to technical support is $10x.

(ii) Example 2—(A) Facts. In 2021, B, a manufacturer and servicer of airplane parts, enters into a contract with a customer to sell airplane parts in 2021 and to service those parts, as necessary, in 2021, 2022, and 2023 for $100x. B regularly sells the airline parts and the services separately. For its AFS, B identifies two performance obligations in the contract:

(1)(i) The sale of airplane parts; and

(ii) The services for those parts.

(2) The customer receives a refund of $5x if it does not require a specified level of service for the parts, which B expects it will pay to the customer. Also, for its AFS, B determines that the transaction price amount is $95x, determined as the $100x contract price minus the $5x refund that it expects to pay the customer. Finally, for its AFS, B allocates the $95x transaction price amount to the two performance obligations as follows: $40x to the sale of parts and $55x to the provision of services ($60x−$5x refund).

(B) Analysis. Pursuant to paragraph (d)(1) of this section, B's contract with the customer has two performance obligations, and each performance obligation yields a corresponding item of gross income that is accounted for separately. Pursuant to paragraph (d)(1) of this section, B is required to allocate the $95x transaction price amount to each corresponding item of gross income in accordance with the transaction price amount allocated to each respective performance obligation for AFS purposes. Accordingly, B initially allocates $40x to the sale of parts item and $55x to the provision of services item. However, because the transaction price amount was reduced by the anticipated refund of $5x, which relates specifically to provision of services item, B must increase the transaction price allocable to that item of gross income pursuant to the specific identification approach in paragraph (d)(3) of this section. Accordingly, the amount allocated to the item of gross income related to servicing the parts is $60x.

(iii) Example 3: Reward points—(A) Facts. On December 31, 2021, U, in the business of selling consumer electronics, sells a new TV for $1,000 and gives the customer 50 reward points. Each reward point is redeemable for a $1 discount on any future purchase of U's products. For its AFS, U identifies two performance obligations from the transaction:

(1)(i) The sale of the TV; and

(ii) The provision of rewards points.

(2) Also, for its AFS, U allocates $950 of transaction price amount to the sale of the TV and the remaining $50 of the transaction price amount to the reward points.

(B) Analysis. Pursuant to paragraph (d)(1) of this section, U's contract with the customer has two performance obligations, and each performance obligation yields a corresponding item of gross income that is accounted for separately. Pursuant to paragraph (d)(1) of this section, U is required to allocate the $1,000 transaction price amount to each corresponding item of gross income in accordance with the transaction price amount allocated to each respective performance obligation for AFS purposes. Accordingly, U allocates the transaction price amount as follows: $950 to the TV sale item and $50 to the reward points item. If U reports any portion of the $50 payment allocated to the reward points as AFS revenue for 2022, or later, the payment is an advance payment, as defined in § 1.451-8(a)(1), and may be accounted for under the deferral method if U satisfies the criteria in § 1.451-8(c).

(iv) Example 4: Airline reward miles—(A) Facts. On January 1, 2021, W, a passenger airline company, sells a customer a $700 airline ticket to fly roundtrip in 2021. As part of the purchase, the customer receives 7,000 points (air miles) from W to be redeemed for future air travel. For its AFS, W identifies two performance obligations in the contract:

(1)(i) The sale of the airline ticket; and

(ii) The provision of air miles.

(2) W also anticipates that it will issue a rebate to the customer for $10. Also, for its AFS, W determines that the transaction price amount is $690, determined as the $700 ticket price minus the anticipated $10 rebate. Finally, for its AFS, W allocates the $690 transaction price amount to the separate performance obligations as follows: $660 to the ticket ($670−$10 rebate = $660) and $30 to the air miles.

(B) Analysis. Pursuant to paragraph (d)(1) of this section, W's contract with the customer has two performance obligations, and each performance obligation yields a corresponding item of gross income that is accounted for separately. Pursuant to paragraph (d)(1) of this section, W must allocate the $690 transaction price amount to each corresponding item of gross income in accordance with the transaction price amount allocated to each respective performance obligation for AFS purposes. Accordingly, W initially allocates $660 to the ticket sale item and $30 to the air miles item. However, because the transaction price amount was reduced by the anticipated rebate of $10x, which relates to the ticket sale item, W must increase the transaction price allocable to that item of gross income pursuant to paragraph (d)(3) of this section. Accordingly, the amount allocated to the item of gross income related to the ticket sale is $670. If W reports any portion of the $30 payment allocated to the air miles item as AFS revenue for 2022, or later, the payment is an advance payment, as defined in § 1.451-8(a)(1), and may be accounted for under the deferral method if W satisfies the criteria in § 1.451-8(c).

(v) Example 5: Contract with significant financing component amounts—(A) Facts. On January 1, 2021, C, a manufacturer and servicer of airline parts, enters into a contract with a customer to sell airline parts in December 2022, and to service those parts, as necessary, through 2024. The contract contains two alternative payment options: payment of $5,000 in December 2022 when the customer obtains control of the parts or payment of $4,000 when the contract is signed. The customer pays $4,000 when the contract is signed, which reflects an implicit interest rate of 11.8% and is C's incremental borrowing rate. C regularly sells the airline parts and the services separately. For its AFS, C identifies two performance obligations in the contract:

(1)(i) The sale of airplane parts; and

(ii) The services for those parts.

(2) Also, for its AFS, although the contract only requires the customer to pay $4,000, the transaction price is increased by $1,000 to $5,000 because the customer is deemed to provide financing to C under the standards C uses to prepare its AFS. The $1,000 increase is attributable to a significant financing component. Finally, for its AFS, C allocates the $5,000 transaction price amount to the separate performance obligations as follows: $3,750 to the sale of parts ($3,000 upfront payment plus $750 financing component) and $1,250 ($1,000 upfront payment plus $250 financing component) to the provision of services.

(B) Analysis. Pursuant to paragraph (d)(1) of this section, C's contract with the customer has two performance obligations, and each performance obligation yields a corresponding item of gross income that is accounted for separately. Pursuant to paragraph (d)(1) of this section, C must allocate the $5,000 transaction price amount to each corresponding item of gross income in accordance with the transaction price amount allocated to each respective performance obligation for AFS purposes. Accordingly, C initially allocates $3,750 to the sale of the parts item and $1,250 to the provision of services item. However, because the transaction price was increased by a significant financing component of $1,000, $750 of which was allocated to sale of the parts item and $250 of which was allocated to the provision of services item, pursuant to paragraph (d)(3) of this section, C must decrease the transaction price amount allocable to the sale of parts item from $3,750 to $3,000 and must decrease the transaction price allocable to the provision of services from $1,250 to $1,000.

(5) Contracts accounted for in part under this section and in part under a special method of accounting—(i) In general. If a taxpayer has a contract with a customer that includes one or more items of gross income that are subject to a special method of accounting and one or more items of gross income that are subject to this section (special method/451 contract), the transaction price allocation rule in paragraph (d)(1) of this section does not apply to determine the amount of each item of gross income that is subject to a special method of accounting. For purposes of this paragraph (d)(5)(i), a special method of accounting has the meaning set forth in paragraph (a)(13) of this section, except as otherwise provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d) of this chapter). For special method/451 contracts, paragraphs (d)(5)(ii) and (iii) of this section apply to determine the transaction price amount and the portion of such amount that is allocated to each item of gross income that is subject to this section.

(ii) Transaction price adjustments. If the transaction price amount for the special method/451 contract includes a reduction for amounts described in paragraph (b)(2)(i)(A)(1) or (2) of this section, or has been reduced because a significant financing component is deemed to exist under the standards the taxpayer uses to prepare its AFS, the taxpayer must increase the transaction price amount by the amount of such reduction. If the transaction price amount for the special method/451 contract has been increased because a significant financing component is deemed to exist under the standards the taxpayer uses to prepare its AFS, the taxpayer must decrease the transaction price amount by the amount of such increase.

(iii) Transaction price allocation. After the taxpayer determines the adjusted transaction price amount for the special method/451 contract under paragraph (d)(5)(ii) of this section, the taxpayer first allocates such amount to the item(s) of gross income subject to a special method of accounting and then allocates the remainder (residual amount) to the item(s) of gross income that are subject to this section. If the contract contains more than one item of gross income that is subject to this section, the taxpayer allocates the residual amount to such items in proportion to the amounts allocated to the corresponding performance obligations for AFS purposes or as otherwise provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d) of this chapter).

(iv) Example—(1) Facts. B is a calendar-year accrual method taxpayer with an AFS. In 2020, B enters into a $100x contract to design, build, operate and maintain a toll road. The contract meets the definition of a long-term contract under § 1.460-1(b)(1). B determines that the obligations to design and build the toll road are long-term contract activities under § 1.460-1(d)(1) and accounts for the gross income from these activities under section 460 and the regulations in this part under section 460 of the Code. In addition, B determines that the obligations to operate and maintain the toll road are non-long-term contract activities under § 1.460-1(d)(2) and that the gross income attributable to these activities is required to be accounted for under this section. B determines that of the $100x transaction price amount, $60x is properly allocable to the items of gross income that are subject to section 460 and the regulations in this part under section 460 of the Code. However, for its AFS, B allocates $55x of the transaction price amount to performance obligations that are long-term contract activities, $30x to the toll road operation performance obligation and $15x to the toll road maintenance performance obligation.

(2) Analysis. A method of accounting under section 460 is a special method of accounting that is within the scope of paragraph (d)(5) of this section. Pursuant to paragraph (d)(5) of this section, B first allocates $60x of the transaction price amount to the items of gross income that are subject to section 460 and the regulations in this part under section 460 of the Code and then allocates the residual amount of $40x to the two items of gross income that are required to be accounted for under this section in proportion to the amounts allocated to the corresponding performance obligations for AFS purposes. Accordingly, B allocates $26.7 × ($30x/$45x × $40x residual amount) to the toll road operations item of gross income and $13.3x ($15x/$45x × $40x residual amount) to the toll road maintenance item of gross income.

(e) Cumulative rule for multi-year contracts—(1) In general. In the case of an item of gross income from a multi-year contract, a taxpayer determines the AFS income inclusion amount for a taxable year by applying the steps in paragraph (e)(1)(i) or (ii) of this section. For this paragraph (e), the term multi-year contract means a contract that spans more than one taxable year.

(i) Inventory items. If the item of gross income is from the sale of an item of inventory and the taxpayer uses the cost offset method under paragraph (c) of this section, see paragraph (c) of this section.

(ii) Other items of gross income. For all other items of gross income, the taxpayer first compares the cumulative amount of the item of gross income that satisfies the all events test under § 1.451-1(a) through the last day of the taxable year, including the full amount of any advance payment received for such item in a prior taxable year, with the cumulative amount of the item of gross income that is treated as “taken into account as AFS revenue” under paragraph (b)(2) of this section through the last day of the taxable year and identifies the larger of the two amounts (or, if the two amounts are equal, the equal amount). The taxpayer then reduces such amount by all prior year inclusion amounts attributable to the item of gross income, if any, to determine the AFS income inclusion amount for the current taxable year. If, however, the taxpayer receives an advance payment, as defined in § 1.451-8(a)(1), that is allocable to an item of gross income from a multi-year contract, the taxpayer applies the applicable rules in § 1.451-8, rather than the rules in this paragraph (e)(1)(ii), to determine the amount of the item of gross income that is required to be included in gross income in the taxable year in which such advance payment is received, or, if applicable, in a short taxable year described in § 1.451-8(c)(6).

(2) Examples. The following examples illustrate the rules of paragraph (e)(1) of this section. Unless the facts specifically state otherwise, the taxpayer has an AFS, is on a calendar year for both Federal income tax purposes and AFS purposes and uses an accrual method of accounting for Federal income tax purposes. Further, the taxpayer does not use a special method of accounting.

(i) Example 1: Provision of services included in AFS revenue with full inclusion method for advance payments—(A) Facts. In 2021, D, an engineering services provider, enters into a nonseverable contract with a customer to provide engineering services through 2024 for a total of $100x. Under the contract, D receives payments of $25x in each calendar year of the contract. For its AFS, D reports $50x, $0, $20x, and $30x of AFS revenue from the contract for 2021, 2022, 2023, and 2024, respectively. D has an enforceable right to recover all amounts reported as AFS revenue through the end of a given contract year if the customer were to terminate the contract on the last day of such year. The $25x payment received in 2023 is an advance payment, as defined in § 1.451-8(a)(1), because $5x of the $25x payment is reported as AFS revenue for 2024. D uses the full inclusion method for advance payments.

(B) Taxable year 2021. Under the all events test in § 1.451-1(a), D is required to include $25x in gross income in 2021 as $25x is due under the terms of the contract and received by D during 2021. D does not have a fixed right to receive any portion of the remaining $75 as such amount is not due under the terms of the contract until future years and is also contingent on D's completion of the nonseverable services. Under the AFS income inclusion rule, because D has an enforceable right to recover all $50x reported as AFS revenue for 2021 if the customer were to terminate the contract on the last day of such year, all $50x is treated as “taken into account as AFS revenue” in 2021. Accordingly, D is required to include $50x in gross income in 2021.

(C) Taxable year 2022. Under the all events test in § 1.451-1(a), D is required to include $50x in gross income through the end of 2022 as $50x is due under the terms of the contract and received by D as of the end of 2022. D does not have a fixed right to receive any portion of the remaining $50 as such amount is not due under the terms of the contract until future years and is also contingent on D's completion of the nonseverable services. Under the AFS income inclusion rule, because D has an enforceable right to recover all $50x reported as AFS revenue through the end of 2022 if the customer were to terminate the contract on the last day of such year, all $50x is treated as “taken into account as AFS revenue” as of the last day of 2022. Under the cumulative rule in paragraph (e)(1)(ii) of this section, D compares the cumulative all events test amount of $50x with the cumulative AFS revenue amount of $50x and selects the larger of the two amounts (or if the two amounts are equal, the equal amount). From this equal amount of $50x, D subtracts the prior income inclusion amount of $50x. Accordingly, under the cumulative rule D is not required to include any amount in gross income in 2022.

(D) Taxable year 2023. The payment received during 2023 meets the definition of an advance payment under § 1.451-8(a)(1). Accordingly, pursuant to paragraph (e)(1)(ii) of this section, D must determine the amount that is required to be included in gross income in 2023 under the rules in § 1.451-8. Because D uses the full inclusion method under § 1.451-8(b), D is required to include the $25x that was due and received during 2023 in gross income in 2023.

(E) Taxable year 2024. Under the all events test in § 1.451-1(a), D is required to include $100x in gross income through the end of 2024 as $100x is due under the terms of the contract and received by D as of the end of 2024. Under the AFS income inclusion rule, because D has an enforceable right to recover all $100x reported as AFS revenue through the end of 2024 if the customer were to terminate the contract on the last day of such year, all $100x is treated as “taken into account as AFS revenue” through the last day of 2024. Under the cumulative rule in paragraph (e)(1)(ii) of this section, D compares the cumulative all events test amount of $100x with the cumulative AFS revenue amount of $100x and selects the larger of the two amounts (or, if the two amounts are equal, the equal amount). From this equal amount of $100x, D subtracts the prior income inclusion amount of $75x ($50x from 2021 plus $0x from 2022 plus $25x from 2023). Accordingly, under the cumulative rule D is required to include $25 in gross income in 2024. The example in this paragraph (e)(2)(i)(E) is summarized in the following table:

(ii) Example 2: Provision of services included in AFS revenue with deferral method for advance payments—(A) Facts. The facts are the same as in paragraph (e)(2)(i) of this section (Example 1), except D elects to use the deferral method under § 1.451-8(c) to account for advance payments.

(B) Taxable years 2021 and 2022. The analysis for tax years 2021 and 2022 is the same as in paragraph (e)(2)(i) of this section (Example 1).

(C) Taxable year 2023. The payment received during 2023 meets the definition of an advance payment under § 1.451-8(a)(1). Accordingly, pursuant to paragraph (e)(1)(ii) of this section, D must determine the amount that is required to be included in gross income in 2023 under the rules in § 1.451-8. Because D uses the deferral method under § 1.451-8(b), D is required to include $20x of the $25x payment in gross income in 2023 as $20x of such payment was treated as “taken into account as AFS revenue” as of the end of 2023.

(D) Taxable year 2024. Under the all events test in § 1.451-1(a), D is required to include $100x in gross income through the end of 2024. Under the AFS income inclusion rule, because D has an enforceable right to recover all $100x reported as AFS revenue through the end of 2024 if the customer were to terminate the contract on the last day of such year, all $100x is treated as “taken into account as AFS revenue” through the last day of 2024. Under the cumulative rule in paragraph (e)(1)(ii) of this section, D compares the cumulative all events test amount of $100x, which includes the full amount of the $25 advance payment received in 2023, with the cumulative AFS revenue amount of $100x and selects the larger of the two amounts (or, if the two amounts are equal, the equal amount). From this equal amount of $100x, D subtracts the prior income inclusion amount of $70x ($50x from 2021 plus $0x from 2022 plus $20x from 2023). Accordingly, under the cumulative rule D is required to include $30x in gross income in 2024. The example in this paragraph (e)(2)(ii)(D) is summarized in the following table:

(f) No change in the treatment of a transaction. Except as provided in paragraph (j) of this section and § 1.1275-2(l), the AFS income inclusion rule does not change the treatment of a transaction or the character of an item for Federal income tax purposes. The following are examples of transactions where the treatment or character for AFS purposes does not change the treatment of the transaction or character of the item for Federal income tax purposes:

(1) A transaction treated as a lease, license, or similar transaction for Federal income tax purposes that is treated as a sale or financing for AFS purposes, and vice versa;

(2) A transaction or instrument that is not required to be marked-to-market for Federal income tax purposes but that is marked-to-market for AFS purposes;

(3) Asset sale and liquidation treatment under section 336(e) or 338(h)(10);

(4) A distribution of a corporation or the allocable share of partnership items or an income inclusion under section 951, 951A, or 1293(a) for Federal income tax purposes that is accounted for under the equity method for AFS purposes;

(5) A distribution of previously taxed earnings and profits of a foreign corporation; and

(6) A deposit, return of capital, or conduit payment that is not gross income for Federal income tax purposes that is treated as AFS revenue.

(g) No change to exclusion provisions and the treatment of non-recognition transactions—(1) In general. The AFS income inclusion rule accelerates the time at which the all events test under § 1.451-1(a) is treated as satisfied, and therefore does not change the applicability of any exclusion provision, or the treatment of non-recognition transactions, in the Code, the regulations in this part, or other guidance published in the Internal Revenue Bulletin (see § 601.601(d) of this chapter). The following are examples of exclusion provisions and non-recognition transactions that are not affected by the AFS income inclusion rule:

(i) Any non-recognition transaction, within the meaning of section 7701(a)(45), including, for example, a liquidation described in sections 332 and 337, an exchange described in section 351, a distribution described in section 355, a reorganization described in section 368, a contribution described in section 721, or transactions described in sections 1031 through 1045; and

(ii) Items specifically excluded from income under sections 101 through 140.

(2) Example: Non-recognition provisions not changed for Federal income tax purposes—(i) Facts. Taxpayer (Distributing) is a calendar-year accrual method C corporation with an AFS. On December 31, 2021, Distributing:

(A)(1) Contributes assets to a wholly owned subsidiary (Controlled) in exchange for Controlled stock and $100x; and

(2) Distributes all the Controlled stock pro rata to its shareholders.

(B) The transaction qualifies as a reorganization under section 368(a)(1)(D) and a distribution to which section 355 applies (D reorganization). Distributing's realized gain on the transferred assets for book and tax purposes is $150x. On January 15, 2022, in pursuance of the plan of reorganization, Distributing distributes the $100x to its shareholders. Consequently, no gain to Distributing is recognized under section 361(b)(1)(A). On Distributing's 2021 AFS, Distributing recognizes revenue of $150x related to the D reorganization.

(ii) Analysis. For Federal income tax purposes, under section 361, Distributing does not recognize gain on Distributing's:

(A)(1) Contribution of assets to Controlled;

(2) Receipt of Controlled stock and cash; and

(3) Distribution of Controlled stock and cash to Distributing's shareholders.

(B) Pursuant to paragraph (g) of this section, the AFS income inclusion rule does not change the result of this paragraph (g)(2).

(h) Additional AFS issues—(1) AFS covering groups of entities—(i) In general. If a taxpayer's financial results are reported on the AFS for a group of entities (consolidated AFS), the taxpayer's AFS is the consolidated AFS. However, if the taxpayer's financial results are also reported on a separate AFS that is of equal or higher priority to the consolidated AFS under paragraph (a)(5) of this section, then the taxpayer's AFS is the separate AFS.

(ii) Example. Taxpayer B, a reseller of computers and electronics, is a calendar-year accrual method taxpayer. In 2021, B's financial results are included in P's consolidated financial statement, which is certified as being prepared in accordance with GAAP, and is a Form 10-K filed with the SEC. B also has a separate audited financial statement prepared in accordance with GAAP that is used for credit purposes. B must use its parent corporation's consolidated Form 10-K as its AFS.

(2) Separately listed items. If a consolidated AFS is treated as the taxpayer's AFS, the taxpayer must include the amount of any items listed separately in the consolidated AFS, including any notes or other supplementary data that is considered part of the consolidated AFS, in determining the amount of AFS revenue allocated to the taxpayer.

(3) Non-separately listed items. If a consolidated AFS does not separately list items for the taxpayer, the portion of the AFS revenue allocable to the taxpayer is determined by relying on the taxpayer's separate source documents that were used to create the consolidated AFS and includes amounts subsequently eliminated in the consolidated AFS. Whether a taxpayer that changes the source documents it uses for this purpose from one taxable year to another taxable year has changed its method of accounting is determined under the rules of section 446.

(4) Computation of AFS revenue for the taxable year when the AFS covers mismatched reportable periods—(i) In general. If a taxpayer's AFS is prepared on the basis of a financial accounting year that differs from the taxpayer's taxable year, the taxpayer must use one of the following permissible methods of accounting described in paragraph (h)(4)(i)(A) through (C) of this section to determine the AFS income inclusion amount for the taxable year:

(A) The taxpayer computes AFS revenue as if its financial reporting period is the same as its taxable year by conducting an interim closing of its books using the accounting principles it uses to prepare its AFS.

(B) The taxpayer computes AFS revenue by including a pro rata portion of AFS revenue for each financial accounting year that includes any part of the taxpayer's taxable year. If the taxpayer's AFS for part of the taxable year is not available by the due date of the return (with extension), the taxpayer must make a reasonable estimate of AFS revenue for the pro rata portion of the taxable year for which an AFS is not yet available. See § 1.451-1(a) for adjustments after actual amounts are determined.

(C) If a taxpayer's financial accounting year ends five or more months after the end of its taxable year, the taxpayer computes AFS revenue for the taxable year based on the AFS revenue reported on the AFS prepared for the financial accounting year ending within the taxpayer's taxable year. For this paragraph (h)(4)(i)(C), if a taxpayer uses a 52-53 week year for financial accounting or Federal income tax purposes, the last day of such year shall be deemed to occur on the last day of the calendar month ending closest to the end of such year.

(ii) Examples. The following examples illustrate the principles of paragraph (j)(4) of this section.

(A) Example 1: Interim closing of the books. A is a calendar year taxpayer. For its AFS, A's financial results are reported on a June 30 fiscal year. Using the method described in paragraph (h)(4)(i)(A) of this section, for the taxable year 2021, A uses the financial results reported on its June 30, 2021 AFS to determine whether an item of gross income is treated as “taken into account as AFS revenue” from January 1, 2021, through June 30, 2021, and uses financial data and accounting procedures from its June 30, 2022 AFS to prepare an interim closing of the books as of December 31, 2021 to determine whether an item of gross income is treated as “taken into account as AFS revenue” from July 1, 2021, through December 31, 2021.

(B) Example 2: Pro rata approach. A is a calendar year taxpayer. For its AFS, A's financial results are reported on a June 30 fiscal year. Using the method described in paragraph (h)(4)(i)(B) of this section, for the taxable year 2021, A computes AFS revenue for the 2021 tax year by taking the AFS revenue for the financial accounting year ending June 30, 2021 and multiplying it by a ratio equal to the number of days in the financial accounting year that are part of the 2021 tax year/365 and then adding to that amount the AFS revenue for the financial accounting year ending June 30, 2022 multiplied by the number of days in the financial accounting year that are part of the 2021 tax year/365.

(C) Example 3: AFS revenue for the taxable year based on AFS ending in taxpayer's taxable year. The same facts as in paragraph (h)(4)(ii)(B) of this section (Example 2) apply, except that A uses the method described in paragraph (h)(4)(i)(C) of this section. For the taxable year 2021, A uses the financial results reported on its June 30, 2021 AFS to determine whether an item of gross income is treated as “taken into account as AFS revenue” as of the end of its 2021 taxable year. Accordingly, any AFS revenue reported on the taxpayer's June 30, 2022 AFS is disregarded when determining whether an item of gross income is treated as “taken into account as AFS revenue” as of the end of the 2021 taxable year.

(i) [Reserved]

(j) Special ordering rule for certain items of income for debt instruments—(1) In general. If an item of income, or portion thereof, with respect to a debt instrument is described in paragraph (j)(2) of this section, the rules of this section apply before the rules in sections 1271 through 1275 and §§ 1.1271-1 through 1.1275-7 (OID rules). Therefore, an item of income, or portion thereof, described in paragraph (j)(2) of this section may not be included in income later than when that item, or portion thereof, is treated as taken into account as AFS revenue, as determined under paragraph (b)(2) of this section, regardless of whether the timing of income inclusion for that item is normally determined using a special method of accounting. See also § 1.1275-2(l) for the treatment of the items described in paragraph (j)(2) of this section under the OID rules.

(2) Specified fees. Paragraph (j)(1) of this section applies to fees (specified fees) that are not spread over a period of time as discount or as an adjustment to the yield of a debt instrument (such as points) in the taxpayer's AFS and, but for paragraph (j) of this section and § 1.1275-2(l), would be treated as creating or increasing OID for Federal income tax purposes. For example, the following specified fees (specified credit card fees) are described in this paragraph (j)(2):

(i) A payment of additional interest or a similar charge provided with respect to amounts that are not paid when due on a credit card account (for example, credit card late fees);

(ii) Amounts charged under a credit card agreement when the cardholder uses the credit card to conduct a cash advance transaction (for example, credit card cash advance fees); and

(iii) Amounts a credit or debit card issuer is entitled to upon a purchase of goods or services by one of its cardholders (for example, interchange fees, which are sometimes labeled merchant discount in certain private label credit card transactions).

(3) Example. C, a credit card issuer, is a calendar-year accrual method taxpayer with a calendar year AFS. In 2021, a cardholder uses C's credit card to purchase $100 of merchandise from a merchant and the cardholder earns a reward of 1% of the purchase price of $100 ($1) as part of C's cardholder loyalty program. Upon purchase, C becomes entitled to an interchange fee equal to 2% of the purchase price of $100 ($2). For its AFS, C reports the $2 of interchange fees as AFS revenue for 2021. C's $2 of interchange fees is described in paragraph (j)(2)(iii) of this section. Under paragraph (j)(1) of this section, C must apply the rules in this section before applying the OID rules. See also § 1.1275-2(l). Therefore, C's $2 of interchange fees is included in gross income in 2021, the year it is treated as “taken into account as AFS revenue.” Under paragraph (b)(2)(i)(A) of this section, the $2 of interchange revenue is not reduced by the $1 reward. Even if C reports interchange fees net of rewards in its AFS for 2021 ($2 of interchange fee minus $1 reward liability), under paragraph (b)(2)(i)(A) of this section, C includes $2 of interchange revenue in gross income in 2021. See sections 162 and 461(h) for the treatment of the reward by C.

(k) Treatment of adjustments to deferred revenue in an AFS—(1) In general. If a taxpayer treats an item of gross income as deferred revenue in its AFS and writes down or adjusts that item, or portion thereof, to an equity account (for example, retained earnings) or otherwise writes down or adjusts that item of deferred revenue in a subsequent taxable year, AFS revenue for that subsequent taxable year is increased or decreased, as applicable by the amount of that item, or portion thereof, that is written down or adjusted. See § 1.451-8(c)(5).

(2) Example—(i) Facts. D, a remanufacturer of industrial equipment, is a calendar-year, accrual method taxpayer with a calendar year AFS. On January 1, 2021, D enters into a contract with a customer and receives a payment of $100x to remanufacture equipment in 2021 and 2022. The contract is not a long-term contract under section 460. For its AFS 2021, D performs remanufacturing services and reports $40x of the $100x payment as AFS revenue for 2021, and treats $60x of the $100x payment as deferred revenue.

(ii) Facts for taxable year 2022. On January 1, 2022, all of the stock of D is acquired by an unrelated third party and D adjusts deferred AFS revenue to $50x (the expected cost to provide the services) by charging $10x ($60x−$50× = $10x) to retained earnings. In addition, for 2022, D performs remanufacturing services and reports $50x of the deferred revenue as AFS revenue.

(iii) Analysis for taxable year 2022. Under paragraph (k)(1) of this section, D's $10x write down to deferred revenue for 2022 is treated as “taken into account as AFS revenue” for 2022.

(l) Methods of accounting—(1) In general. Except as otherwise provided in this section, a change to comply with this section is a change in method of accounting to which the provisions of sections 446 and 481 and the regulations in this part under sections 446 and 481 of the Code apply. A taxpayer seeking to change to a method of accounting permitted in this section must secure the consent of the Commissioner in accordance with § 1.446-1(e) and follow the administrative procedures issued under § 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to change its accounting method. For example, the use of the AFS income inclusion rule under paragraph (b)(1) of this section under which the taxpayer determines the amount of the item of gross income that is treated as “taken into account as AFS revenue” by making the adjustments provided in paragraph (b)(2)(i) of this section, the use of the AFS income inclusion rule under paragraph (b)(1) of this section under which the taxpayer determines the amount of the item of gross income that is treated as “taken into account as AFS revenue” by making only the adjustments provided in paragraph (b)(2)(ii) of this section (the alternative AFS revenue method), the AFS cost offset method under paragraph (c) of this section, the use of a method of determining AFS revenue under paragraph (i)(4) of this section, are methods of accounting under section 446 and the regulations in this part under section 446 of the Code. In addition, a change in the manner of recognizing revenue in an AFS that changes or could change the timing of the inclusion of income for Federal income tax purposes is generally a change in method of accounting under section 446 and the regulations in this part under section 446 of the Code. However, a change resulting from the restatement of AFS revenue may not always constitute a change in method of accounting under section 446 and the regulations in this part under section 446 of the Code. For example, a restatement of AFS revenue to correct an error described in § 1.446-1(e)(2)(ii)(b) does not constitute a change in method of accounting under section 446.

(2) Transition rule for changes in method of accounting—(i) In general. Except as provided in paragraph (l)(2)(ii) of this section, a taxpayer that makes a qualified change in method of accounting for the taxpayer's first taxable year beginning after December 31, 2017, is treated as making a change in method of accounting initiated by the taxpayer under section 481(a)(2). A taxpayer obtains the consent of the Commissioner to make the change in method of accounting by using the applicable administrative procedures that govern changes in method of accounting under section 446(e). See § 1.446-1(e)(3).

(ii) Special rules for OID and specified credit card fees. The rules of paragraph (l)(2)(i) of this section apply to a qualified change in method of accounting for the taxpayer's first taxable year beginning after December 31, 2018, if the change relates to a specified credit card fee as defined in paragraph (j)(2) of this section. For paragraph (l) of this section, the section 481(a) adjustment period for any adjustment under section 481(a) for a change in method of accounting described in the preceding sentence is six taxable years.

(iii) Qualified change in method of accounting. For paragraph (l)(2) of this section, a qualified change in method of accounting means any change in method of accounting that is required by section 13221 of Public Law 115-97, 131 Stat. 2054 (2017) (TCJA), or was prohibited under the Internal Revenue Code of 1986 prior to TCJA section 13221 and is now permitted as a result of TCJA section 13221.

(m) Applicability date—(1) In general. Except as provided in paragraph (m)(2) of this section, this section applies for taxable years beginning on or after January 1, 2021.

(2) Delayed application with respect to certain fees. Notwithstanding paragraph (m)(1) of this section, paragraph (j) of this section applies to specified fees (as defined in paragraph (j)(2) of this section) that are not specified credit card fees (as defined in paragraph (j)(2) of this section) for taxable years beginning on or after January 6, 2022.

(3) Early application of this section—(i) In general. Except as provided in paragraph (m)(3)(ii) of this section, taxpayers and their related parties, within the meaning of sections 267(b) and 707(b), may apply both the rules in this section and, to the extent relevant, the rules in § 1.451-8, in their entirety and in a consistent manner, to a taxable year beginning after December 31, 2017, and before January 1, 2021, provided that, once applied to a taxable year, the rules in this section and, to the extent relevant, the rules in § 1.451-8, are applied in their entirety and in a consistent manner to all subsequent taxable years. See section 7508(b)(7) and § 1.451-8(h).

(ii) Certain fees—(A) Specified credit card fees. In the case of specified credit card fees, a taxpayer and its related parties, within the meaning of sections 267(b) and 707(b), may apply both the rules in this section and the rules in § 1.1275-2(l), in their entirety and in a consistent manner, to a taxable year beginning after December 31, 2018, and before January 1, 2021, provided that, once applied to a taxable year, the rules in this section and § 1.1275-2(l) that apply to specified credit card fees are applied in their entirety and in a consistent manner to all subsequent taxable years (other than the rules applicable to specified fees that are not specified credit card fees). See section 7508(b)(7) and § 1.1275-2(l)(2).

(B) Specified fees. Paragraphs (m)(3)(i) and (m)(3)(ii)(A) of this section do not apply to specified fees that are not specified credit card fees.

(a) In general—(1) Subtraction from receipts. If an accrual method taxpayer issues trading stamps or premium coupons with sales, or an accrual method taxpayer is engaged in the business of selling trading stamps or premium coupons, and such stamps or coupons are redeemable by such taxpayer in merchandise, cash, or other property, the taxpayer should, in computing the income from such sales, subtract from gross receipts with respect to sales of such stamps or coupons (or from gross receipts with respect to sales with which trading stamps or coupons are issued) an amount equal to—

(i) The cost to the taxpayer of merchandise, cash, and other property used for redemptions in the taxable year,

(ii) Plus the net addition to the provision for future redemptions during the taxable year (or less the net subtraction from the provision for future redemptions during the taxable year).

(2) Trading stamp companies. For purposes of this section, a taxpayer will be considered as being in the business of selling trading stamps or premium coupons if—

(i) The trading stamps or premium coupons sold by him are issued by purchasers to promote the sale of their merchandise or services,

(ii) The principal activity of the trade or business is the sale of such stamps or coupons,

(iii) Such stamps or coupons are redeemable by the taxpayer for a period of at least 1 year from the date of sale, and

(iv) Based on his overall experience, it is estimated that not more than two-thirds of the stamps or coupons sold which it is estimated, pursuant to paragraph (c) of this section, will be ultimately redeemed, will be redeemed within 6 months of the date of sale.

(b) Computation of the net addition to or subtraction from the provision for future redemptions—(1) Determination of the provision for future redemptions. (i) The provision for future redemptions as of the end of a taxable year is computed by multiplying “estimated future redemptions” (as defined in subdivision (ii) of this subparagraph) by the estimated average cost of redeeming each trading stamp or coupon (computed in accordance with subdivision (iii) of this subparagraph).

(ii) For purposes of this section, the term “estimated future redemptions” as of the end of a taxable year means the number of trading stamps or coupons outstanding as of the end of such year that it is reasonably estimated will ultimately be presented for redemption. Such estimate shall be determined in accordance with the rules contained in paragraph (c) of this section.

(iii) For purposes of this section, the estimated average cost of redeeming each trading stamp or coupon shall be computed by including only the costs to the taxpayer of acquiring the merchandise, cash, or other property needed to redeem such stamps or coupons. The term “the costs to the taxpayer of acquiring the merchandise, cash, or other property needed to redeem such stamps or coupons” includes only the price charged by the seller (less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer provided a consistent course is followed) plus transportation or other necessary charges in acquiring possession of the goods. Items such as the costs of advertising, catalogs, operating redemption centers, transporting merchandise or other property from a central warehouse to a branch warehouse (or from a warehouse to a redemption center), and storing the merchandise or other property used to redeem stamps or coupons should not be included in costs of redeeming stamps or premium coupons, but rather should be accounted for in accordance with the provisions of sections 162 and 263.

(2) Changes in provision for future redemptions. For purposes of this section, a “net addition to” or “net subtraction from” the provision for future redemptions for a taxable year is computed as follows:

(i) Carry over the provision for future redemptions (if any) as of the end of the preceding taxable year,

(ii) Compute the provision for future redemptions as of the end of the taxable year in accordance with subparagraph (1) of this paragraph, and

(iii) If the amount referred to in subdivision (ii) of this subparagraph exceeds the amount referred to in subdivision (i) of this subparagraph, such excess is the net addition to the provision for future redemptions for the taxable year. On the other hand, if the amount referred to in such subdivision (i) exceeds the amount referred to in such subdivision (ii), such excess is the net subtraction from the provision for future redemptions for the taxable year.

(3) Example. The provisions of this paragraph and paragraph (a)(1) of this section may be illustrated by the following example:

(c) Estimated future redemptions—(1) In general. A taxpayer may use any method of determining the estimated future redemptions as of the end of a year so long as—

(i) Such method results in a reasonably accurate estimate of the stamps or coupons outstanding at the end of such year that will ultimately be presented for redemption,

(ii) Such method is used consistently, and

(iii) Such taxpayer complies with the requirements of this paragraph and paragraphs (d) and (e) of this section.

(2) Utilization of prior redemption experience. Normally, the estimated future redemptions of a taxpayer shall be determined on the basis of such taxpayer's prior redemption experience. However, if the taxpayer does not have sufficient redemption experience to make a reasonable determination of his “estimated future redemptions,” or if because of a change in his mode of operation or other relevant factors the determination cannot reasonably be made completely on the basis of the taxpayer's own experience, the experiences of similarly situated taxpayers may be used to establish an experience factor.

(3) One method of determining estimated future redemptions. One permissible method of determining the estimated future redemptions as of the end of the current taxable year is as follows:

(i) Estimate for each preceding taxable year and the current taxable year the number of trading stamps or coupons issued for each such year which will ultimately be presented for redemption.

(ii) Determine the sum of the estimates under subdivision (i) of this subparagraph for each taxable year prior to and including the current taxable year.

(iii) The difference between the sum determined under subdivision (ii) of this subparagraph and the total number of trading stamps or coupons which have already been presented for redemption is the estimated future redemptions as of the end of the current taxable year.

(4) Determination of an “estimated redemption percentage.” For purposes of applying subparagraph (3)(i) of this paragraph, one permissible method of estimating the number of trading stamps or coupons issued for a taxable year that will ultimately be presented for redemption is to multiply such number of stamps issued for such year by an “estimated redemption percentage.” For purposes of this section the term “estimated redemption percentage” for a taxable year means a fraction, the numerator of which is the number of trading stamps or coupons issued during a taxable year that it is reasonably estimated will ultimately be redeemed, and the denominator of which is the number of trading stamps or coupons issued during such year. Consequently, the product of such percentage and the number of stamps issued for such year equals the number of trading stamps or coupons issued for such year that it is estimated will ultimately be redeemed.

(5) Five-year rule. (i) One permissible method of determining the “estimated redemption percentage” for a taxable year is to—

(a) Determine the percentage which the total number of stamps or coupons redeemed in the taxable year and the 4 preceding taxable years is of the total number of stamps or coupons issued or sold in such 5 years; and

(b) Multiply such percentage by an appropriate growth factor as determined pursuant to guidelines published by the Commissioner.

(ii) If a taxpayer uses the method described in subdivision (i) of this subparagraph for a taxable year, it will normally be presumed that such taxpayer's “estimated redemption percentage” is reasonably accurate.

(6) Other methods of determining estimated future redemptions. (i) If a taxpayer uses a method of determining his “estimated future redemptions” (other than a method which applies the 5-year rule as described in subparagraph (5)(i) of this paragraph) such as a probability sampling technique, the appropriateness of the method (including the appropriateness of the sampling technique, if any) and the accuracy and reliability of the results obtained must, if requested, be demonstrated to the satisfaction of the district director.

(ii) No inference shall be drawn from subdivision (i) of this subparagraph that the use of any method to which such subdivision applies is less acceptable than the method described in subparagraph (5)(i) of this paragraph. Therefore, certain probability sampling techniques used in determining estimated future redemptions may result in reasonably accurate and reliable estimates. Such a sampling technique will be considered appropriate if the sample is—

(a) Taken in accordance with sound statistical sampling principles,

(b) In accordance with such principles, sufficiently broad to produce a reasonably accurate result, and

(c) Taken with sufficient frequency as to produce a reasonably accurate result.

(d) Consistency with financial reporting—(1) Estimated future redemptions. For taxable years beginning after August 22, 1972, the estimated future redemptions must be no greater than the estimate that the taxpayer uses for purposes of all reports (including consolidated financial statements) to shareholders, partners, beneficiaries, other proprietors, and for credit purposes.

(2) Average cost of redeeming stamps. For taxable years beginning after August 22, 1972, the estimated average cost of redeeming each stamp or coupon must be no greater than the average cost of redeeming each stamp or coupon (computed in accordance with paragraph (b)(1)(iii) of this section) that the taxpayer uses for purposes of all reports (including consolidated financial statements) to shareholders, partners, beneficiaries, other proprietors, and for credit purposes.

(e) Information to be furnished with return—(1) In general. For taxable years beginning after August 22, 1972, a taxpayer described in paragraph (a) of this section who uses a method of determining the “estimated future redemptions” other than that described in paragraph (c)(5)(i) of this section shall file a statement with his return showing such information as is necessary to establish the correctness of the amount subtracted from gross receipts in the taxable year.

(2) Taxpayers using the 5-year rule. If a taxpayer uses the method of determining estimated future redemptions described in paragraph (c)(5)(i) of this section, he shall file a statement with his return showing, with respect to the taxable year and the 4 preceding taxable years—

(i) The total number of stamps or coupons issued or sold during each year, and

(ii) The total number of stamps or coupons redeemed in each such year.

(3) Trading stamp companies. In addition to the information required by subparagraph (1) or (2) of this paragraph, a taxpayer engaged in the trade or business of selling trading stamps or premium coupons shall include with the statement described in subparagraph (1) or (2) of this paragraph such information as may be necessary to satisfy the requirements of paragraph (a)(2)(iv) of this section.

(a) In general. (1) For taxable years ending after December 30, 1969, a taxpayer reporting gross income on the cash receipts and disbursements method of accounting may elect to include insurance proceeds received as a result of the destruction of, or damage to, crops in gross income for the taxable year following the taxable year of the destruction or damage, if the taxpayer establishes that, under the taxpayer's normal business practice, the income from those crops would have been included in gross income for any taxable year following the taxable year of the destruction or damage. However, if the taxpayer receives the insurance proceeds in the taxable year following the taxable year of the destruction or damage, the taxpayer shall include the proceeds in gross income for the taxable year of receipt without having to make an election under section 451(d) and this section. For the purposes of this section only, federal payments received as a result of destruction or damage to crops caused by drought, flood, or any other natural disaster, or the inability to plant crops because of such a natural disaster, shall be treated as insurance proceeds received as a result of destruction or damage to crops. The preceding sentence shall apply to payments that are received by the taxpayer after December 31, 1973.

(2) In the case of a taxpayer who receives insurance proceeds as a result of the destruction of, or damage to, two or more specific crops, if such proceeds may, under section 451(d) and this section, be included in gross income for the taxable year following the taxable year of such destruction or damage, and if such taxpayer makes an election under section 451(d) and this section with respect to any portion of such proceeds, then such election will be deemed to cover all of such proceeds which are attributable to crops representing a single trade or business under section 446(d). A separate election must be made with respect to insurance proceeds attributable to each crop which represents a separate trade or business under section 446(d).

(b)(1) Time and manner of making election. The election to include in gross income insurance proceeds received as a result of destruction of, or damage to, the taxpayer's crops in the taxable year following the taxable year of such destruction or damage shall be made by means of a statement attached to the taxpayer's return (or an amended return) for the taxable year of destruction or damage. The statement shall include the name and address of the taxpayer (or his duly authorized representative), and shall set forth the following information:

(i) A declaration that the taxpayer is making an election under section 451(d) and this section;

(ii) Identification of the specific crop or crops destroyed or damaged;

(iii) A declaration that under the taxpayer's normal business practice the income derived from the crops which were destroyed or damaged would have been included in this gross income for a taxable year following the taxable year of such destruction or damage;

(iv) The cause of destruction or damage of crops and the date or dates on which such destruction or damage occurred;

(v) The total amount of payments received from insurance carriers, itemized with respect to each specific crop and with respect to the date each payment was received;

(vi) The name(s) of the insurance carrier or carriers from whom payments were received.

(2) Scope of election. Once made, an election under section 451(d) is binding for the taxable year for which made unless the district director consents to a revocation of such election. Requests for consent to revoke an election under section 451(d) shall be made by means of a letter to the district director for the district in which the taxpayer is required to file his return, setting forth the taxpayer's name, address, and identification number, the year for which it is desired to revoke the election, and the reasons therefor.

(a) In general. Section 451(e) provides that for taxable years beginning after December 31, 1975, a taxpayer whose principal trade or business is farming (within the meaning of § 6420 (c)(3)) and who reports taxable income on the cash receipts and disbursements method of accounting may elect to defer for one year a certain portion of income. The income which may be deferred is the amount of gain realized during the taxable year from the sale or exchange of that number of livestock sold or exchanged solely on account of a drought which caused an area to be designated as eligible for assistance by the Federal Government (regardless of whether the designation is made by the President or by an agency or department of the Federal Government). That number is equal to the excess of the number of livestock sold or exchanged over the number which would have been sold or exchanged had the taxpayer followed its usual business practices in the absence of such drought. For example, if in the past it has been a taxpayer's practice to sell or exchange annually 400 head of beef cattle but due to qualifying drought conditions 550 head were sold in a given taxable year, only income from the sale of 150 head may qualify for deferral under this section. The election is not available with respect to livestock described in section 1231(b)(3) (relating to cattle, horses (and other livestock) held by the taxpayer for 24 months (12 months) and used for draft, breeding, dairy, or sporting purposes).

(b) Usual business. The determination of the number of animals which a taxpayer would have sold if it had followed its usual business practice in the absence of drought will be made in light of all facts and circumstances. In the case of taxpayers who have not established a usual business practice, reliance will be placed upon the usual business practice of similarly situated taxpayers in the same general region as the taxpayer.

(c) Special rules—(1) Connection with drought area. To qualify under section 451(e) and this section, the livestock need not be raised, and the sale or exchange need not take place, in a drought area. However, the sale or exchange of the livestock must occur solely on account of drought conditions, the existence of which affected the water, grazing, or other requirements of the livestock so as to necessitate their sale or exchange.

(2) Sale prior to designation of area as eligible for Federal assistance. The provisions of this section will apply regardless of whether all or a portion of the excess number of animals were sold or exchanged before an area becomes eligible for Federal assistance, so long as the drought which caused such dispositions also caused the area to be designated as eligible for Federal assistance.

(d) Classifications of livestock with respect to which the election may be made. The election to have the provisions of section 451(e) apply must be made separately for each broad generic classification of animals (e.g., hogs, sheep, cattle) for which the taxpayer wishes the provisions to apply. Separate elections shall not be made solely by reason of the animals' age, sex, or breed.

(e) Computation—(1) Determination of amount deferred. The amount of income which may be deferred for a classification of livestock pursuant to this section shall be determined in the following manner. The total amount of income realized from the sale or exchange of all livestock in the classification during the taxable year shall be divided by the total number of all such livestock sold. The resulting quotient shall then be multiplied by the excess number of such livestock sold on account of drought.

(2) Example. The provisions of this paragraph may be illustrated by the following example:

(f) Successive elections. If a taxpayer makes an election under section 451(e) for successive years, the amount deferred from one year to the next year shall not be deemed to have been received from the sale or exchange of livestock during the later year. In addition, in determining the taxpayer's normal business practice for the later year, earlier years for which an election under section 451(e) was made shall not be considered.

(g) Time and manner of making election. The election provided for in this section must be made by the later of (1) the due date for filing the income tax return (determined with regard to any extensions of time granted the taxpayer for filing such return) for the taxable year in which the early sale of livestock occurs, or (2) (the 90th day after the date these regulations are published as a Treasury decision in the Federal Register). The election must be made separately for each taxable year to which it is to apply. It must be made by attaching a statement to the return or an amended return for such taxable year. The statement shall include the name and address of the taxpayer and shall set forth the following information for each classification of livestock for which the election is made:

(1) A declaration that the taxpayer is making an election under section 451(e);

(2) Evidence of the existence of the drought conditions which forced the early sale or exchange of the livestock and the date, if known, on which an area was designated as eligible for assistance by the Federal Government as a result of the drought conditions.

(3) A statement explaining the relationship of the drought area to the taxpayer's early sale or exchange of the livestock;

(4) The total number of animals sold in each of the three preceding years;

(5) The number of animals which would have been sold in the taxable year had the taxpayer followed its normal business practice in the absence of drought;

(6) The total number of animals sold, and the number sold on account of drought, during the taxable year; and

(7) A computation, pursuant to paragraph (e) of this section, of the amount of income to be deferred for each such classification.

(h) Revocation of election. Once an election under this section is made for a taxable year, it may be revoked only with the approval of the Commissioner.

(i) Cross reference. For provisions relating to the involuntary conversion of livestock sold on account of drought see section 1033(e) and the regulations thereunder.

(a) Definitions. Except as otherwise provided in this section, the following definitions apply for this section:

(1) Advance payment—(i) In general. An advance payment is a payment received by a taxpayer if:

(A) The full inclusion of the payment in the gross income of the taxpayer for the taxable year of receipt is a permissible method of accounting, without regard to this section;

(B) Any portion of the payment is taken into account as AFS revenue for a subsequent taxable year, or, if the taxpayer does not have an applicable financial statement any portion of the payment is earned by the taxpayer in a subsequent taxable year. To determine the amount of the payment that is treated as “taken into account as AFS revenue,” the taxpayer must adjust AFS revenue for any amounts described in § 1.451-3(b)(2)(i)(A), (C), and (D);

(C) The payment is for:

(1) Services;

(2) The sale of goods;

(3) The use, including by license or lease, of intellectual property, including copyrights, patents, trademarks, service marks, trade names, and similar intangible property rights, such as franchise rights and arena naming rights;

(4) The occupancy or use of property if the occupancy or use is ancillary to the provision of services, for example, advance payments for the use of rooms or other quarters in a hotel, booth space at a trade show, campsite space at a mobile home park, and recreational or banquet facilities, or other uses of property, so long as the use is ancillary to the provision of services to the property user;

(5) The sale, lease, or license of computer software;

(6) Guaranty or warranty contracts ancillary to an item or items described in paragraph (a)(1)(i)(C)(1), (2), (3), (4), or (5) of this section;

(7) Subscriptions in tangible or intangible format. Subscriptions for which an election under section 455 is in effect is not included in this paragraph (a)(1)(i)(C)(7);

(8) Memberships in an organization. Memberships for which an election under section 456 is in effect are not included in this paragraph (a)(1)(i)(C)(8);

(9) An eligible gift card sale;

(10) Any other payment identified by the Secretary of the Treasury or his delegate (Secretary) under section 451(c)(4)(A)(iii), including in guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter); or

(11) Any combination of items described in paragraphs (a)(1)(i)(C)(1) through (10) of this section.

(ii) Exclusions from the definition of advance payment. An advance payment does not include:

(A) Rent, except for amounts paid for an item or items described in paragraph (a)(1)(i)(C)(3), (4), or (5) of this section;

(B) Insurance premiums, to the extent the inclusion of those premiums is governed by Subchapter L of the Internal Revenue Code;

(C) Payments with respect to financial instruments (for example, debt instruments, deposits, letters of credit, notional principal contracts, options, forward contracts, futures contracts, foreign currency contracts, credit card agreements (including rewards or loyalty points under such agreements), financial derivatives, or similar items), including purported prepayments of interest;

(D) Payments with respect to service warranty contracts for which the taxpayer uses the accounting method provided in Revenue Procedure 97-38, 1997-2 C.B. 479 (see § 601.601(d)(2) of this chapter);

(E) Payments with respect to warranty and guaranty contracts under which a third party is the primary obligor;

(F) Payments subject to section 871(a), 881, 1441, or 1442;

(G) Payments in property to which section 83 applies;

(H) Payments received in a taxable year earlier than the taxable year immediately preceding the taxable year of the contractual delivery date for a specified good (specified good exception) unless the taxpayer uses the method under paragraph (f) of this section;

(I) Any other payment identified by the Secretary under section 451(c)(4)(B)(vii), including in guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter); and

(J) Any combination of items described in paragraphs (a)(1)(ii)(A) through (I) of this section.

(2) Advance payment income inclusion amount. The term advance payment income inclusion amount means the amount of the advance payment that is required to be included in gross income for the taxable year under the applicable rules in this section.

(3) Advance payment inventory inclusion amount. The term advance payment inventory inclusion amount means the amount of the advance payment from the sale of an item of inventory that, but for the cost of goods in progress offset, would be includable in gross income under paragraph (b), (c), or (d) of this section, as applicable, for the taxable year.

(4) AFS revenue. The term AFS revenue has the same meaning as provided in § 1.451-3(a)(4).

(5) Applicable financial statement. The term applicable financial statement (AFS) has the same meaning as provided in § 1.451-3(a)(5).

(6) Contractual delivery date. The term contractual delivery date means the month and year of delivery listed in the original written contract to the transaction entered into between the parties prior to initial receipt of any payments.

(7) Cost of goods. The term cost of goods means the costs that are properly capitalized and included in inventory under sections 471 and 263A or any other applicable provision of the Internal Revenue Code and that are allocable to an item of inventory for which an advance payment inventory inclusion amount is calculated. See paragraph (e)(6) of this section for specific rules for a taxpayer using the simplified methods under section 263A.

(8) Cost of goods in progress offset. The term cost of goods in progress offset has the meaning provided in paragraph (e)(4) of this section.

(9) Cumulative cost of goods in progress offset. The term cumulative cost of goods in progress offset means the cumulative cost of goods in progress offset amounts under paragraph (e) of this section for a specific item of inventory that have reduced an advance payment inventory inclusion amount attributable to such item of inventory in prior taxable years.

(10) Eligible gift card sale. The term eligible gift card sale means the sale of a gift card or gift certificate if:

(i) The taxpayer is primarily liable to the customer, or holder of the gift card, for the value of the card until redemption or expiration; and

(ii) The gift card is redeemable by the taxpayer or by any other entity that is legally obligated to the taxpayer to accept the gift card from a customer as payment for items listed in paragraphs (a)(1)(i)(C)(1) through (11) of this section.

(11) Enforceable right. The term enforceable right has the same meaning as provided in § 1.451-3(a)(9).

(12) Performance obligation. The term performance obligation has the same meaning as provided in § 1.451-3(a)(11).

(13) Prior income inclusion amounts. The term prior income inclusion amounts means the amount of an item of gross income that was included in the taxpayer's gross income under this section or § 1.451-3 in a prior taxable year.

(14) Received. An item of gross income is received by the taxpayer if it is actually or constructively received, or if it is due and payable to the taxpayer.

(15) Specified good. The term specified good means a good for which:

(i) During the taxable year a payment is received, the taxpayer does not have on hand, or available to it in such year through its normal source of supply, goods of a substantially similar kind and in a sufficient quantity to satisfy the contract to transfer the good to the customer; and

(ii) All the revenue from the sale of the good is recognized in the taxpayer's AFS in the year of delivery.

(16) Transaction price. The term transaction price has the same meaning as provided in § 1.451-3(a)(14).

(b) In general. Except as provided in paragraph (c) or (d) of this section, an accrual method taxpayer shall include an advance payment in gross income no later than in the taxable year in which the taxpayer receives the advance payment.

(c) Deferral method for taxpayers with an applicable financial statement (AFS)—(1) In general. An accrual method taxpayer with an AFS that receives an advance payment may elect the deferral method described in this paragraph (c) if the taxpayer can determine the extent to which the advance payment is taken into account as AFS revenue as of the end of the taxable year of receipt and, if applicable, a short taxable year described in paragraph (c)(6) of this section. Except as otherwise provided in this section, a taxpayer that uses the deferral method described in this paragraph (c) must:

(i) Include the advance payment, or any portion thereof, in gross income in the taxable year of receipt to the extent taken into account as AFS revenue as of the end of such taxable year, as determined under paragraph (c)(2) of this section; and

(ii) Include the remaining portion of such advance payment in gross income in the taxable year following the taxable year in which such payment is received (next succeeding year).

(2) Adjustments to AFS revenue. The amount of an advance payment that is treated as “taken into account as AFS revenue” as of the end of the taxable year of receipt under paragraph (c)(1)(i) of this section is determined by adjusting AFS revenue by amounts described in § 1.451-3(b)(2)(i)(A), (C), and (D), as applicable.

(3) Examples. The following examples demonstrate the rules in paragraphs (c)(1) and (2) of this section.

(i) Example 1: Gift cards not eligible for deferral method. E, a hair styling salon, receives advance payments for gift cards that may later be redeemed at the salon for hair styling services or hair care products at the face value of the gift card. The gift cards may not be redeemed for cash and have no expiration date. E does not track the sale date of the gift cards and includes advance payments for gift cards in AFS revenue when redeemed. Because E is unable to determine the extent to which advance payments are taken into account as AFS revenue for the taxable year of receipt, E cannot use the deferral method for these advance payments.

(ii) Example 2: Gift cards eligible for deferral method. The same facts as in paragraph (c)(3)(i) of this section (Example 1) apply, except that the gift cards have an expiration date 12 months from the date of sale, E does not accept expired gift cards, and E includes unredeemed gift cards in AFS revenue for the taxable year in which the cards expire. Because E tracks the sale date and the expiration date of the gift cards for its AFS, E can determine the extent to which advance payments are taken into account as AFS revenue for the taxable year of receipt. Therefore, E meets the requirement of paragraph (c)(1) of this section and may elect the deferral method for these advance payments.

(4) Acceleration of advance payments—(i) In general. A taxpayer that uses the deferral method described in this paragraph (c) must include in gross income for the taxable year, all advance payments not previously included in gross income:

(A) If, in that taxable year, the taxpayer either dies or ceases to exist in a transaction other than a transaction to which section 381(a) applies; or

(B) If, and to the extent that, in that taxable year, the taxpayer's obligation for the advance payments is satisfied or otherwise ends other than in:

(1) A transaction to which section 381(a) applies; or

(2) A section 351(a) transfer that is part of a section 351 transaction in which:

(i) Substantially all assets of the trade or business, including advance payments, are transferred;

(ii) The transferee adopts or uses the deferral method in the year of transfer; and

(iii) The transferee and the transferor are members of the same consolidated group, as defined in § 1.1502-1(h).

(ii) Examples. The following examples illustrate the rules in paragraph (c)(4) of this section. In each of the following examples, the taxpayer is a C corporation, uses an accrual method of accounting for Federal income tax purposes and files its returns on a calendar year basis. In addition, the taxpayer has an AFS and uses the deferral method in paragraph (c) of this section.

(A) Example 1: Ceasing to exist. A is in the business of selling and licensing off the shelf, fully customized, and semi-customized computer software and providing customer support. On July 1, 2021, A enters into a 2-year software maintenance contract and receives an advance payment. Under the contract, A will provide software updates if it develops an update within the contract period, as well as online and telephone customer support. A ceases to exist on December 1, 2021, in a transaction that does not involve a section 351(a) transfer described in paragraph (c)(4)(i)(B)(2) of this section and is not a transaction to which section 381(a) applies. For Federal income tax purposes, A must include the entire advance payment in gross income in its 2021 taxable year.

(B) Example 2: Satisfaction of obligation—(1) Facts. On November 1, 2021, J, a travel agent, receives payment from a customer for an airline flight that will take place in April 2022. J purchases and delivers the airline ticket to the customer on November 14, 2021. J retains the excess of the customer's payment over the cost of the airline ticket as its commission. The customer may cancel the flight and receive a refund from J only to the extent the airline itself provides refunds. In its AFS, J includes its commission in revenue for 2022.

(2) Analysis. The payment for commission income is an advance payment. Because J is not required to provide any services after the ticket is delivered to the customer on November 14, 2021, J satisfies its obligation to the customer for its commission when the airline ticket is delivered. Thus, for Federal income tax purposes, J must include the commission in gross income for 2021.

(5) Financial statement adjustments—(i) In general. If a taxpayer treats an advance payment as an item of deferred revenue in its AFS and writes-down or adjusts that item, or portion thereof, to an equity account such as retained earnings, or otherwise writes-down or adjusts that item of deferred revenue in a subsequent taxable year, AFS revenue for that subsequent taxable year is increased or decreased, as applicable, by the amount that is written down or adjusted. See § 1.451-3(k).

(ii) Examples. The following examples illustrate the rules in paragraph (c)(5) of this section. In each of the following examples, the taxpayer is a C corporation, uses an accrual method of accounting for Federal income tax purposes and files its returns on a calendar year basis. In addition, the taxpayer has an AFS and uses the deferral method in paragraph (c) of this section.

(A) Example 1—(1) Facts. On May 1, 2021, A received $100 as an advance payment for a 2-year contract to provide services. For financial accounting purposes, A recorded $100 as a deferred revenue liability in its AFS, expecting to report 1/4 ($25) of the advance payment in AFS revenue for 2021, 1/2 ($50) for 2022, and 1/4 ($25) for 2023. On August 31, 2021, C, an unrelated corporation that files its Federal income tax return on a calendar year basis and that is a member of a consolidated group, acquired all of the stock of A, and A joined C's consolidated group. A's short taxable year ended on August 31, 2021, and, as of that date, A had included 1/4 ($25) of the advance payment in AFS revenue. On September 1, 2021, after the stock acquisition, and in accordance with purchase accounting rules, C wrote down A's deferred revenue liability to its fair value of $10 as of the date of the acquisition. The $10 is included in revenue on A's AFS in accordance with the method of accounting A uses for financial accounting purposes.

(2) Analysis. For Federal income tax purposes, A must take 1/4 ($25) of the advance payment into income for its short taxable year ending August 31, 2021 and must include the remainder of the advance payment ($75) ($65 write down + $10 future financial statement revenue) in income for its next succeeding taxable year.

(B) Example 2—(1) Facts. On May 1, 2021, B received $100 as an advance payment for a contract to be performed in 2021, 2022, and 2023. On August 31, 2021, D, a corporation that is not a member of a consolidated group for Federal income tax purposes, acquired all of the stock of B. Before the stock acquisition, for 2021, B included $40 of the advance payment in AFS revenue, and $60 as a deferred revenue liability. On September 1, 2021, after the stock acquisition and in accordance with purchase accounting rules, B, at D's direction, wrote down its $60 deferred revenue liability to $10 (its fair value) as of the date of the acquisition. After the acquisition, B does not take into account as AFS revenue any of the $10 deferred revenue liability in its 2021 AFS. B does include $5 in revenue in 2022, and $5 in revenue in 2023.

(2) Analysis. For Federal income tax purposes, B must include $40 of the advance payment into income in 2021 and must include the remainder of the advance payment ($60) ($50 write down plus $10 future financial statement revenue) in income for the 2022 taxable year.

(6) Short taxable year rule—(i) In general. If the taxpayer's next succeeding taxable year is a short taxable year, other than a taxable year in which the taxpayer dies or ceases to exist in a transaction other than a transaction to which section 381(a) applies, and the short taxable year consists of 92 days or less, a taxpayer using the deferral method must include the portion of the advance payment not included in the taxable year of receipt in gross income for the short taxable year to the extent taken into account as AFS revenue as of the end of such taxable year, as determined under paragraph (c)(2) of this section. Any amount of the advance payment not included in gross income in the taxable year of receipt or the short taxable year, must be included in gross income for the taxable year immediately following the short taxable year.

(ii) Example 1—(A) Facts. A is a calendar year taxpayer and is in the business of selling and licensing off the shelf, fully customized, and semi-customized computer software and providing customer support. On July 1, 2021, A enters into a 2-year software maintenance contract and receives an advance payment of $240 under the contract. Under the contract, A will provide software updates if it develops an update within the contract period, as well as provides online and telephone customer support. A changes its taxable period to a fiscal year ending March 31. As a result, A has a short taxable year beginning January 1, 2022, and ending March 31, 2022. In its AFS, A includes 6/24 ($60) of the payment in revenue for the taxable year ending December 31, 2021 to account for the six-month period July 1 through December 31, 2021; 3/24 ($30) in revenue for the short taxable year ending March 31, 2022 to account for the three-month period January 1 through March 31, 2022; 12/24 ($120) in revenue for the taxable year ending March 31, 2023; and 3/24 ($30) in revenue for the taxable year ending March 31, 2024.

(B) Analysis. Because the taxable year ending March 31, 2021, is 92 days or less, A must include 6/24 ($60) of the payment in gross income for the taxable year ending December 31, 2021, 3/24 ($30) in gross income for the short taxable year ending March 31, 2022, and 15/24 ($150), the remaining amount, in gross income for the taxable year ending March 31, 2023.

(iii) Example 2—(A) Facts. On May 1, 2021, B received $100 as an advance payment for a contract to be performed in 2021, 2022, and 2023. On October 31, 2021, C, an unrelated corporation that files its federal income tax return on a calendar year basis and that is a member of a consolidated group, acquired all the stock of B and B joined C's consolidated group. Before the stock acquisition, for 2021, B included $40 of the advance payment in AFS revenue, and $60 as a deferred revenue liability. On November 1, 2021, after the stock acquisition and in accordance with purchase accounting rules, C wrote down B's $60 deferred revenue liability to $10 (its fair value) as of the date of the acquisition. After the acquisition, B does not include in revenue any of the $10 deferred revenue liability in its 2021 AFS. B includes $5 in revenue in 2022, and $5 in revenue in 2023.

(B) Analysis. For Federal income tax purposes, B must take $40 of the advance payment into income in its short tax year ending October 31, 2021. B's subsequent tax year, the short tax year ending December 31, 2021, is a tax year that is 92 days or less. Therefore, under paragraph (c)(6)(i) of this section, B generally will include the portion of the advance payment not included in the taxable year of receipt in gross income for this short taxable year to the extent taken into account as AFS revenue. Although for AFS purposes, no amount is recognized in revenue for the short period beginning November 1, 2021 and ending on December 31, 2021, under paragraph (c)(5)(i) of this section, B must treat the amount of the write-down as AFS revenue in the taxable year in which the write-down occurs. Therefore, B must include $50 of the advance payment into income in the short tax year ending December 31, 2021 (equal to the $50 write down plus $0 recognized in B's AFS for the period beginning on November 1, 2021 and ending December 31, 2021), and must include the remainder of the advance payment ($10) in income for the 2022 taxable year.

(7) Financial statement conformity requirement. A taxpayer that uses an AFS to apply the rules under § 1.451-3 must use the same AFS and, if applicable, the same method of accounting under § 1.451-3(h)(4), to apply the deferral method in paragraph (c) of this section. Additionally, the AFS rules under § 1.451-3(h) also apply for purposes of this section.

(8) Contracts with multiple performance obligations—(i) General rule. If a taxpayer is using the deferral method under this paragraph (c) and the taxpayer's contract with a customer has more than one performance obligation, then any payments received under the contract are allocated to the corresponding item of gross income in the same manner as such payments are allocated to the performance obligations in the taxpayer's AFS.

(ii) Example: Computer software subscription with multiple performance obligations—(A) Facts. P is in the business of licensing off the shelf, fully customized, and semi-customized computer software and providing customer support. P uses an accrual method of accounting for Federal income tax purposes, files its returns on a calendar year basis, and has an AFS. On July 1, 2021, P receives an advance payment of $100 for a 2-year software subscription comprised of:

(1)(i) A 1-year “software maintenance contract” under which P will provide software updates within the contract period; and

(ii) A “customer support agreement” for online and telephone customer support.

(2) P reflects the software maintenance contract and the customer support agreement as two separate performance obligations in its AFS and allocates $80 of the payment to the software maintenance contract and $20 to the customer support agreement. P includes the $80 allocable to the software maintenance payment in AFS revenue as follows: 1/4 ($20) in AFS revenue for 2021; 1/2 ($40) in AFS revenue for 2022; and the remaining 1/4 ($20) in AFS revenue for 2023. Regarding the $20 allocable to the customer support payment, P includes 1/2 ($10) in AFS revenue for 2021, and the remaining 1/2 ($10) in AFS revenue for 2022 regardless of when P provides the customer support.

(B) Analysis. Since the software maintenance contract and the customer support agreement are two separate performance obligations, each yielding a separate item of gross income, paragraph (c)(8) of this section requires P to allocate the $100 payment to each item of gross income in the same manner as the payment is allocated to each performance obligation in P's AFS. For Federal income tax purposes, P must include $30 in gross income for 2021 ($20 allocable to the software maintenance contract and $10 allocable to the customer support agreement) and the remaining $70 is included in gross income for 2022.

(iii) Contracts with advance payments that include items subject to a special method of accounting—(A) In general. The portion of the payment allocable to the items of gross income described in paragraph (a)(1)(i)(C) of this section from a contract that includes one or more items of gross income subject to a special method of accounting and one or more items of gross income described in paragraph (a)(1)(i)(C) of this section must be determined based on objective criteria.

(B) Allocation deemed to be based on objective criteria. A taxpayer's allocation method is based on objective criteria if an allocation of the payment to each item of gross income is in proportion to the amounts determined in § 1.451-3(d)(5) or as otherwise provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d) of this chapter).

(iv) Example—(A) Facts. B is a calendar-year accrual method taxpayer with an AFS. In 2020, B enters into a $100x contract to design, build, operate and maintain a toll road and receives an up-front payment of $100x. The contract meets the definition of a long-term contract under § 1.460-1(b)(1). B properly determines that the obligations to design and build the toll road are long-term contract activities under § 1.460-1(d)(1) and accounts for the gross income from these activities under section 460. In addition, B properly determines that the obligations to operate and maintain the toll road are non-long-term contract activities under § 1.460-1(d)(2) and that the gross income attributable to these activities is accounted for under section 451(b). B allocates $60x of the transaction price amount to the long-term contract activities and the remaining $40x to the non-long-term contract activity pursuant to § 1.451-3(d)(5). For AFS purposes, B allocates $55x of the transaction price amount to the performance obligations that are long-term contract activities and $45x to the non-long-term contract activities. B uses the deferral method of accounting.

(B) Analysis. For Federal income tax purposes, a method of accounting under section 460 is a special method of accounting under paragraph (c)(8)(iv) of this section. Pursuant to paragraph (c)(8)(iv) of this section, B must allocate the payment among the item(s) of gross income that are subject to section 460 and the item(s) of gross income described in paragraph (a)(1)(i)(C) of this section based on objective criteria. B's allocation is deemed to be based on objective criteria if it allocates the payment in proportion to the amounts determined under § 1.451-3(d)(5). That is, $60x to the items of gross income subject to section 460 and $40x to the items of gross income described in paragraph (a)(1)(i)(C) of this section.

(9) Special rule relating to eligible gift card sales. For paragraphs (a)(1)(i)(B) and (c)(1) of this section, if an eligible gift card is redeemable by an entity described in paragraph (a)(10)(ii) of this section whose financial results are not included in the taxpayer's AFS, a payment will be treated as included by the taxpayer in its AFS revenue to the extent the gift card is redeemed by such entity during the taxable year.

(10) Examples. The following examples illustrate the rules of paragraph (c) of this section. In each of the following examples, the taxpayer uses an accrual method of accounting for Federal income tax purposes and files its returns on a calendar year basis. In addition, the taxpayer in each example has an AFS and uses the deferral method under paragraph (c) of this section. Further, the taxpayer does not use the advance payment cost offset method in paragraph (e) of this section.

(i) Example 1: Services. On November 1, 2021, A, in the business of giving dancing lessons, receives an advance payment of $480 for a 1-year contract commencing on that date and providing for up to 48 individual, 1-hour lessons. A provides eight lessons in 2021 and another 35 lessons in 2022. A takes into account 1/6 ($80) of the payment as AFS revenue for 2021, and 5/6 ($400) of the payment as AFS revenue for 2022. For Federal income tax purposes, under the deferral method in paragraph (c) of this section, A must include 1/6 ($80) of the payment in gross income for 2021, and the remaining 5/6 ($400) of the payment in gross income for 2022.

(ii) Example 2: Services. The same facts as in paragraph (c)(10)(i) of this section (Example 1) apply. A receives an advance payment of $960 for a 3-year contract under which A provides up to 96 lessons. A provides eight lessons in 2021, 48 lessons in 2022, and 40 lessons in 2023. A takes into account 1/12 ($80) of the payment as AFS revenue for 2021, 1/2 ($480) of the payment as AFS revenue for 2022, and 5/12 ($400) of the payment as AFS revenue for 2023. For Federal income tax purposes, under the deferral method in paragraph (c) of this section, A must include 1/12 ($80) of the payment in gross income for 2021, and the remaining 11/12 ($880) of the payment in gross income for 2022.

(iii) Example 3: Services. On June 1, 2021, B, a landscape architecture firm, receives an advance payment of $100 for landscape services that, under the terms of the agreement, must be provided by December 2022. On December 31, 2021, B estimates that 3/4 of the work under the agreement has been completed. B takes into account 3/4 ($75) of the payment as AFS revenue for 2021, and 1/4 ($25) of the payment as AFS revenue for 2022. For Federal income tax purposes, under the deferral method in paragraph (c) of this section, B must include 3/4 ($75) of the payment in gross income for 2021, and the remaining 1/4 ($25) of the payment in gross income for 2022, regardless of whether B completes the job in 2022.

(iv) Example 4: Repair contracts. On July 1, 2021, C, in the business of selling and repairing television sets, receives an advance payment of $100 for a 2-year contract under which C agrees to repair the customer's television set. C takes into account 1/4 ($25) of the payment as AFS revenue for 2021, 1/2 ($50) of the payment as AFS revenue for 2022, and 1/4 ($25) of the payment as AFS revenue for 2023. For Federal income tax purposes, under the deferral method in paragraph (c) of this section, C must include 1/4 ($25) of the payment in gross income for 2021 and the remaining 3/4 ($75) of the payment in gross income for 2022.

(v) Example 5: Online website design. On July 20, 2021, D, a website designer, receives an online payment of $75 to design a website for Customer to be completed on February 1, 2023. D designs and completes Customer's website on February 1, 2023. D takes into account the $75 payment for Customer's website as AFS revenue for 2023. The $75 payment D receives for Customer's website is an advance payment. For Federal income tax purposes, under the deferral method in paragraph (c) of this section, D must include the $75 payment for the website in gross income for 2022.

(vi) Example 6: Online subscriptions. G is in the business of compiling and providing business information for a particular industry in an online format accessible over the internet. On September 1, 2021, G receives an advance payment from a subscriber for 1 year of access to its online database, beginning on that date. G takes into account 1/3 of the payment as AFS revenue for 2021 and the remaining 2/3 as AFS revenue for 2022. For Federal income tax purposes, under the deferral method in paragraph (c) of this section, G must include 1/3 of the payment in gross income for 2021 and the remaining 2/3 of the payment in gross income for 2022.

(vii) Example 7: Membership fees. On December 1, 2021, H, in the business of operating a chain of “shopping club” retail stores, receives advance payments for membership fees. The membership fees are not prepaid dues income subject to section 456. Upon payment of the fee, a member is allowed access for a 1-year period to H's stores, which offer discounted merchandise and services. H takes into account 1/12 of the payment as AFS revenue for 2021 and 11/12 of the payment as AFS revenue for 2022. For Federal income tax purposes, under the deferral method in paragraph (c) of this section, H must include 1/12 of the payment in gross income for 2021, and the remaining 11/12 of the payment in gross income for 2022.

(viii) Example 8: Cruise. In 2021, I, in the business of operating tours, receives $20x payments from customers for a 10-day cruise that will take place in April 2022. Under the agreement, I charters a cruise ship, hires a crew and a tour guide, and arranges for entertainment and shore trips for the customers. I takes into account the $20x payments as AFS revenue for 2022. For Federal income tax purposes, I must include the $20x payments in gross income for 2022.

(ix) Example 9: Broadcasting rights—(A) Facts. K, a professional sports franchise, is a member of a sports league that enters into contracts with television networks for the right to broadcast games to be played between teams in the league. The league entered into a 2-year broadcasting contract beginning October 1, 2021. K receives two payments of $100x on October 1 of each contract year, beginning in 2021. K estimates that for each contract year, 25% of the broadcasting rights are transferred by December 31 of the year of payment, and the remaining 75% of the broadcasting rights are transferred in the following year. K takes into account 1/4 ($25x) of the first installment payment as AFS revenue for 2021 and 3/4 ($75x) as AFS revenue for 2022. K takes into account 1/4 ($25x) of the second payment as AFS revenue for 2022 and 3/4 ($75x) as AFS revenue for 2023.

(B) Analysis. Each installment payment is an advance payment under paragraph (a)(1) of this section because a portion of each payment is included in AFS revenue for a subsequent taxable year and the payment relates to the use of intellectual property. For Federal income tax purposes, under the deferral method in paragraph (c) of this section, K must include 1/4 ($25x) of the first $100x installment payment in gross income for 2021 and 3/4 ($75x) of the first installment payment in gross income for 2022. In addition, K must include 1/4 ($25x) of the second $100x payment in gross income for 2022 and 3/4 ($75x) of the second installment payment in gross income for 2023.

(x) Example 10: Insurance claims administration—(A) Facts. L is in the business of negotiating, placing, and servicing insurance coverage and administering claims for insurance companies. On December 1, 2021, L enters into a contract with an insurance company to provide property and casualty claims administration services for a 4-year period beginning January 1, 2022. Pursuant to the contract, the insurance company makes four equal annual payments to L; each payment relates to a year of service and is made during the month prior to the service year. Since L does not perform any services related to the payment prior to the service year, L does not meet the requirements of § 1.451-1(a) for the payment prior to the service year. For example, L is paid on December 1, 2021, for the service year beginning January 1, 2022. L takes into account the first payment as AFS revenue for 2022; the second payment as AFS revenue for 2023; the third payment as AFS revenue for 2024; and the fourth payment as AFS revenue for 2025.

(B) Analysis. Each annual payment is an advance payment under paragraph (a)(1) of this section because each payment is taken into account as AFS revenue for a subsequent taxable year and the payment relates to services. For Federal income tax purposes, under the deferral method in paragraph (c) of this section, L must include: The first payment in gross income for 2022; the second payment in gross income for 2023; the third payment in gross income for 2024; and the fourth payment in gross income for 2025.

(xi) Example 11: internet services—(A) Facts. M is a cable internet service provider that enters into contracts with subscribers to provide internet services for a monthly fee that is paid prior to the service month. For those subscribers who do not own a compatible modem, M provides a rental cable modem for an additional monthly charge, that is also paid prior to the service month. Pursuant to the contract, M will replace or repair the cable modem if it proves defective during the contract period. In December 2021, M receives $100x payments from subscribers for January 2022 internet service and cable modem use. M takes into account the entire $100x payments as AFS revenue for 2022.

(B) Analysis. For Federal income tax purposes, the $100x payments are advance payments. Because M uses the deferral method in paragraph (c) of this section, M must include $100x in gross income for 2022.

(xii) Example 12: License agreement—(A) Facts. On January 1, 2021, N receives a payment of $250 for entering into a 3-year license agreement for the use of N's trademark throughout the term of the agreement. The $250 payment reflects the first year (2021) license fee of $100 and the third year (2023) license fee of $150. The fee of $125 for the second year is payable on January 1, 2022. N takes into account $100 of the $250 upfront payment as AFS revenue for 2021, $125 as AFS revenue for 2022, and $150 of the $250 payment as AFS revenue for 2023.

(B) Analysis. For Federal income tax purposes, N received an advance payment of $150, the 2023 license fee, in 2021. Because N uses the deferral method in paragraph (c) of this section, N must defer the $150 payment and include it in gross income for 2022.

(xiii) Example 13: Computer software subscription with one performance obligation—(A) Facts. On July 1, 2021, O, in the business of licensing off the shelf, fully customized, and semi-customized computer software and providing customer support, receives a payment of $100 for a 2-year “software subscription contract” under which O will provide software updates if it develops an update within the contract period, as well as online and telephone customer support. O determines that its obligations under the software subscription contract are one performance obligation for financial accounting purposes, which yields one item of gross income. O takes into account 1/4 ($25) of the payment as AFS revenue for 2021, 1/2 ($50) as AFS revenue for 2022, and the remaining 1/4 ($25) as AFS revenue for 2023, regardless of when O provides updates or customer support.

(B) Analysis. For Federal income tax purposes, the $100 payment is an advance payment. Because O uses the deferral method in paragraph (c) of this section, O must include 1/4 ($25) of the payment in gross income for 2021 and 3/4 ($75) in gross income for 2022.

(xiv) Example 14: Gift cards administered by another—(A) General facts. Q is a corporation that operates department stores and is the common parent of a consolidated group (the Q group). U, V, and W are domestic corporations wholly owned by Q and members of the Q group. X is a foreign corporation wholly owned by Q and not a member of the Q group. U sells Brand A goods, V sells Brand B goods, X sells Brand C goods, and Z is an unrelated entity that sells Brand D goods. W administers a gift card program for the members of the Q group, X, and Z. Pursuant to the underlying agreements, W issues gift cards that are redeemable for goods or services offered by U, V, X, and Z. In addition, U, V, X, and Z sell gift cards to customers on behalf of W and remit amounts received to W. The agreements provide that W is primarily liable to the customer for the value of the gift card until redemption, and U, V, X, and Z are obligated to accept the gift card as payment for goods or services. When a customer purchases goods or services with a gift card at U, V, X, or Z, W reimburses that entity for the sales price of the goods or services purchased with the gift card, up to the total gift card value.

(B) Facts for taxable year 2021. In 2021, W sells gift cards with a total value of $900, and, at the end of 2021, the unredeemed balance of the gift cards is $100. In Q group's AFS, the group includes revenue from the sale of a gift card when the gift card is redeemed. Accordingly, of the $900 of gift cards sold in 2021, $800 were redeemed and taken into account as AFS revenue for 2021. W tracks sales and redemptions of gift cards electronically, determines the extent to which advance payments are taken into account as AFS revenue in Q group's AFS for the taxable year of receipt and meets the requirements of paragraph (c)(1) of this section.

(C) Analysis. The payments W receives from the sale of gift cards are advance payments because they are payments for eligible gift cards. Under the deferral method, W must include $800 of the payments from gift card sales in gross income in 2021 and the remaining $100 of the payments in gross income in 2022.

(xv) Example 15: Gift cards of affiliates—(A) Facts. R is a Subchapter S corporation that operates an affiliated restaurant corporation and manages other affiliated restaurants. These other restaurants are owned by other Subchapter S corporations, partnerships, and limited liability companies. R has a partnership interest or an equity interest in some of the restaurants. R administers a gift card program for participating restaurants. Each participating restaurant operates under a different trade name. Under the gift card program, R and each of the participating restaurants sell gift cards, which are issued with R's brand name and are redeemable at all participating restaurants. Participating restaurants sell the gift cards to customers and remit the proceeds to R, R is primarily liable to the customer for the value of the gift card until redemption, and the participating restaurants are obligated under an agreement with R to accept the gift card as payment for food, beverages, taxes, and gratuities. When a customer uses a gift card to make a purchase at a participating restaurant, R is obligated to reimburse that restaurant for the amount of the purchase, up to the total gift card value. In R's AFS, R includes revenue from the sale of a gift card when a gift card is redeemed at a participating restaurant. R tracks sales and redemptions of gift cards electronically, is able to determine the extent to which advance payments are taken into account as AFS revenue for the taxable year of receipt and meet the requirements of paragraph (c)(1) of this section.

(B) Analysis. The payments R receives from the sale of gift cards are advance payments because they are payments for eligible gift card sales. For Federal income tax purposes, R is eligible to use the deferral method. Using the deferral method, in the taxable year of receipt, R must include the advance payment in income to the extent taken into account as AFS revenue and must include any remaining amount in income in the taxable year following the taxable year of receipt. Under paragraph (c)(9) of this section, R is treated as taking into account revenue from the sale of a gift card as AFS revenue when a gift card is redeemed at a participating restaurant.

(xvi) Example 16: Gift cards for domestic and international hotels—(A) Facts. S is a corporation that operates for the benefit of its franchisee members, who own and operate domestic and international individual member hotels. S administers a gift card program for its members by selling gift cards that may be redeemed for hotel rooms and food or beverages provided by any member hotel. The agreements underlying the gift card program provide that S is entitled to the proceeds from the sale of the gift cards, must reimburse the member hotel for the value of a gift card redeemed, and until redemption remains primarily liable to the customer for the value of the card. In S's AFS, S includes payments from the sale of a gift card when the card is redeemed. S tracks sales and redemptions of gift cards electronically, determines the extent to which advance payments are included in AFS revenue for the taxable year of receipt and meets the requirements of paragraph (c)(1) of this section.

(B) Analysis. The payments S receives from the sale of gift cards are advance payments because they are payments for eligible gift card sales. Thus, for Federal income tax purposes, S is eligible to use the deferral method. Under the deferral method, in the taxable year of receipt, S must include in income the advance payment to the extent taken into account as AFS revenue and must include any remaining amount in income in the taxable year following the taxable year of receipt.

(xvii) Example 17: Discount voucher—(A) Facts. On December 10, 2021, T, in the business of selling home appliances, sells a washing machine for $500. As part of the sale, T gives the customer a 40% discount voucher for any future purchases of T's goods up to $100 in the next 60 days. In its AFS, T treats the discount voucher as a separate performance obligation and allocates $30 of the $500 sales price to the discount voucher. T takes into account $12 of the amount allocated to the discount voucher as AFS revenue for 2021 and includes $18 of the discount voucher as AFS revenue for 2022.

(B) Analysis. For Federal income tax purposes, the $30 payment allocated to the discount voucher is an advance payment. Using the deferral method, T must include the $12 allocable to the discount voucher in gross income in 2021 and the remaining $18 allocated to the discount voucher in gross income in 2022.

(xviii) Example 18: Rewards—(A) Facts. On December 31, 2021, U, in the business of selling consumer electronics, sells a new TV for $1,000 and gives the customer 50 reward points. Each reward point is redeemable for a $1 discount on any future purchase of U's products. The reward points are not redeemable for cash and have a 2-year expiration date. U tracks the issue date, redemption date, and expiration date of each customer's reward points. Under the terms of U's reward program, when the customer redeems reward points they are deemed to use the earliest issued points first. In its AFS, U treats the rewards points as a separate performance obligation and allocates $50 of the $1,000 sales price to the rewards points. U is able to determine the extent to which a payment that is allocated to a reward point is taken into account in AFS revenue in the year of receipt. U does not take any of the amount allocated to the reward points into account as AFS revenue for 2021. U takes into account $25 of the reward points as AFS revenue for 2022 and $25 of the reward points as AFS revenue for 2023.

(B) Analysis. For Federal income tax purposes, U's treatment of the reward points as a separate performance obligation for AFS purposes yields an item of gross income that must be accounted for separately. The $50 payment allocated to the reward points item is an advance payment as the full inclusion of the payment in gross income in the year of receipt is a permissible method of accounting without regard to this section, a portion of the payment is taken into account as AFS revenue in a subsequent taxable year, and the reward points are redeemable for an item described in paragraph (a)(1)(i)(C) of this section (goods). Because the entire amount of the $50 advance payment is taken into account as AFS revenue in tax years following the year of receipt, U defers the payment and includes the $50 payment in gross income in 2022.

(xix) Example 19: Credit card rewards—(A) Facts. V issues credit cards and has a loyalty program under which cardholders earn reward points when they use V's credit card to make purchases. Each reward point is redeemable for $1 on any future purchases.

(B) Analysis. Payments under credit card agreements, including rewards for credit card purchases, are excluded from the definition of an advance payment under paragraph (a)(1)(ii)(C) of this section. Accordingly, V cannot use the deferral method for these amounts.

(xx) Example 20: Airline reward miles—(A) Facts. On January 1, 2021, W, a passenger airline company, sells a customer a $700 airline ticket to fly roundtrip in 2021. As part of the purchase, the customer receives 7,000 reward points (air miles) from W to be used for future air travel. The reward points are not redeemable for cash and have a 2-year expiration date. W tracks the issue date, redemption date, and expiration date of each customer's reward points. Under the terms of U's reward program, when the customer redeems reward points they are deemed to use the earliest issued points first. In its AFS, W treats the rewards points as a separate performance obligation and allocates $35 of the $700 ticket price to the reward points. W is able to determine the extent to which a payment that is allocated to a reward point is taken into account in AFS revenue in the year of receipt. W takes into account all $35 as AFS revenue in 2023 when the customer redeems the air miles.

(B) Analysis. For Federal income tax purposes, W's treatment of the reward points as a separate performance obligation for AFS purposes yields an item of gross income that must be accounted for separately. The $35 allocated to the reward points item is an advance payment as the full inclusion of the payment in gross income in the taxable year of receipt is a permissible method of accounting without regard to this section, a portion of the payment is taken into account as AFS revenue in a subsequent taxable year, and the reward points are redeemable for an item described in paragraph (a)(1)(i)(C) of this section (services). Because the entire amount of the $35 advance payment is taken into account as AFS revenue in a tax year following the year of receipt, W defers the payment and includes the $35 payment in gross income in 2022.

(xxi) Example 21: Chargebacks—(A) Facts. In 2021, X, a manufacturer of pharmaceuticals, enters into a contract to sell 1,000 units to W, a wholesaler, for $10 per unit, totaling $10,000 (1,000 × $10 = $10,000). The contract also provides that X will credit W $4 per unit (chargeback) for sales W makes to qualifying customers. X delivers 600 units to W on December 31, 2021, and bills W $6,000 under the contract. X anticipates that all of W's sales will be to qualifying customers and subject to chargeback. For AFS purposes, X adjusts its 2021 AFS revenue of $6,000 by $2,400, the anticipated chargebacks, and reports $3,600 of AFS revenue.

(B) Analysis. For Federal income tax purposes, under paragraph (a)(1)(i)(B) of this section, for a payment to qualify as an advance payment, a portion of the payment must be taken into account as AFS revenue for a subsequent taxable year. Under paragraph (a)(1)(i)(B) of this section, the amount of the payment included in AFS revenue for a subsequent taxable year is $0, calculated as the $6,000 payment reduced by $6,000 that is treated as taken into account as AFS revenue for 2021 ($3,600 of AFS revenue for 2021 + $2,400 of anticipated chargebacks (section 461 liabilities) which had reduced AFS revenue for 2021). Because no portion of the $6,000 is taken into account as AFS revenue in a subsequent taxable year (that is, on an AFS after 2021), the $6,000 payment received in 2021 is not an advance payment under paragraph (a)(1)(i) of this section.

(d) Deferral method for taxpayers without an AFS (non-AFS deferral method)—(1) In general. Only a taxpayer described in paragraph (d)(2) of this section may elect to use the non-AFS deferral method of accounting described in paragraph (d)(4) of this section.

(2) Taxpayers eligible to use the non-AFS deferral method. A taxpayer is eligible to use the non-AFS deferral method if the taxpayer does not have an applicable financial statement and can determine the extent to which advance payments are earned in the taxable year of receipt and, if applicable, a short taxable year described in paragraph (d)(6) of this section. The determination whether the advance payment is earned in the taxable year of receipt, or a short taxable year described in paragraph (d)(6) of this section, if applicable, is determined on an item by item basis.

(3) Deferral of advance payments based on when payment is earned—(i) In general. Except as otherwise provided in this section, a taxpayer that uses the non-AFS deferral method of accounting includes the advance payment in gross income for the taxable year of receipt to the extent that it is earned in that taxable year and includes the remaining portion of the advance payment in gross income in the next succeeding taxable year.

(ii) When payment is earned. Under the non-AFS deferral method, a payment is earned when the all events test described in § 1.451-1(a) is met, without regard to when the amount is received, as defined under paragraph (a)(14) of this section, by the taxpayer. If a taxpayer is unable to determine the extent to which a payment is earned in the taxable year of receipt, or a short taxable year described in paragraph (d)(6) of this section, if applicable, the taxpayer may calculate the amount:

(A) On a statistical basis if adequate data are available to the taxpayer;

(B) On a straight-line basis over the term of the agreement if the taxpayer receives the advance payment under a fixed term agreement and if it is reasonable to anticipate at the end of the taxable year of receipt that the advance payment will be earned ratably over the term of the agreement; or

(C) Using any other method that may be provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d) of this chapter).

(4) Contracts with multiple items of gross income—(i) In general. If a taxpayer receives a payment that is attributable to one or more items described in paragraph (a)(1)(i)(C) of this section, the taxpayer must determine the portion of the payment that is allocable to such item(s) by using an allocation method that is based on objective criteria.

(ii) Objective criteria. A taxpayer's allocation method for a payment described in paragraph (d)(4)(i) of this section is deemed to be based on objective criteria if the allocation method is based on payments the taxpayer receives for an item or items it regularly sells or provides separately or any method that may be provided in guidance published in the Internal Revenue Bulletin (see § 601.601(d) of this chapter).

(5) Acceleration of advance payments. The acceleration rules in paragraph (c)(4) of this section also apply to a taxpayer that uses the non-AFS deferral method under paragraph (d) of this section.

(6) Short taxable year rule. If the taxpayer's next succeeding taxable year is a short taxable year, other than a taxable year in which the taxpayer dies or ceases to exist in a transaction other than a transaction to which section 381(a) applies, and the short taxable year consists of 92 days or less, a taxpayer using the non-AFS deferral method must include the portion of the advance payment not included in the taxable year of receipt in gross income for the short taxable year to the extent earned in such taxable year. Any amount of the advance payment not included in gross income in the taxable year of receipt, or the short taxable year, must be included in gross income for the taxable year immediately following the short taxable year.

(7) Eligible gift card sale. For paragraphs (a)(1)(i)(B) and (d)(3) of this section, if an eligible gift card is redeemable by an entity described in paragraph (a)(10)(ii) of this section, including an entity whose financial results are not included in the taxpayer's financial statement, a payment will be treated as earned by the taxpayer to the extent the gift card is redeemed by such entity during the taxable year.

(8) Examples. The following examples illustrate the rules of paragraph (d) of this section. In the examples in this paragraph (d)(8), the taxpayer is a calendar year taxpayer that uses the non-AFS deferral method described in paragraph (d) of this section. None of the taxable years are short taxable years.

(i) Example 1—(A) Facts. A, a video arcade operator, receives payments in 2021 for tokens that customers use to play A's arcade games. The tokens cannot be redeemed for cash, are imprinted with the name of the arcade, but are not individually marked for identification. A completed a study on a statistical basis, based on adequate data available to A, and concluded that for payments received in 2021, 70% of tokens are expected to be used in 2021, 20% of tokens are expected to be used in 2022, and 10% of tokens are expected to never be used. Based on the study, under paragraph (d)(3)(ii)(A) of this section, A determines that 80% of the advance payments are earned for 2021 (70% for tokens expected to be used in 2021 plus 10% for tokens that are expected to never be used).

(B) Analysis. For Federal income tax purposes, A must include 80% of the advance payments in gross income for 2021 and 20% of the advance payments in gross income for 2022.

(ii) Example 2—(A) Facts. B is in the business of providing internet services. On September 1, 2021, B receives an advance payment from a customer for a 2-year term for access to its internet services, beginning on that date. B does not have an AFS. B is unable to determine the extent to which the payment is earned in the taxable year of receipt. However, at the close of the 2021 taxable year, it is reasonable for B to anticipate that the advance payment will be earned ratably over the term of the agreement.

(B) Analysis. For Federal income tax purposes, pursuant to paragraph (d)(3)(ii)(B) of this section, B determines the extent to which the payment is earned in tax year 2021 on a straight-line basis over the term of the agreement and takes that amount into income in 2021. The remaining amount of the advance payment is taken into gross income in the 2022 taxable year.

(e) Advance payment cost offset method—(1) In general. This paragraph (e) provides an optional method of accounting for advance payments from the sale of inventory (advance payment cost offset method). A taxpayer that chooses to use the advance payment cost offset method for a trade or business must use the method of accounting for all advance payments received by that trade or business that meet the criteria in this paragraph (e). Additionally, a taxpayer that chooses to use this method for a trade or business and that has an AFS must also use the AFS cost offset method described in § 1.451-3(c). A taxpayer that uses the AFS cost offset method and the advance payment cost offset method to account for gross income, including advance payments, from the sale of an item of inventory, determines the corresponding AFS income inclusion amount, as defined in § 1.451-3(a)(1), and the advance payment income inclusion amount for a taxable year by following the rules in § 1.451-3(c)(2) rather than the rules under this paragraph (e). However, if all payments received for the sale of item of inventory meet the definition of an advance payment under paragraph (a)(1) of this section, a taxpayer that uses the advance payment cost offset method determines the corresponding advance payment income inclusion amount for a taxable year by:

(i) Following the rules in paragraph (e)(2) of this section, subject to the additional rules and limitations in paragraphs (e)(5) through (8) of this section, if the taxable year is a taxable year prior to the taxable year in which ownership of the item of inventory is transferred to the customer; and

(ii) Following the rules in paragraph (e)(3) of this section, subject to the additional rules and limitations in paragraphs (e)(5) through (8) of this section, if the taxable year is the taxable year in which ownership of the item of inventory is transferred to the customer.

(2) Determining the advance payment income inclusion amount in a year prior to the year of sale. To determine the advance payment income inclusion amount for a taxable year prior to the year in which ownership of the item of inventory is transferred to the customer, the taxpayer must first determine the advance payment inventory inclusion amount for such item for such year. This advance payment inventory inclusion amount is then reduced by the cost of goods in progress offset for the taxable year, as determined under paragraphs (e)(4), (5), and (8) of this section. This net amount is the advance payment income inclusion amount for the taxable year.

(3) Determining the advance payment income inclusion amount in the year of sale. The advance payment income inclusion amount for the taxable year in which ownership of the item of inventory is transferred to the customer is equal to the portion of any advance payment for such item that was not required to be included in gross income in a prior taxable year. This amount is not reduced by a cost of goods in progress offset under paragraph (e)(4) of this section. However, the taxpayer is entitled to recover the costs capitalized to the item of inventory as cost of goods sold in accordance with sections 471 and 263A or any other applicable provision of the Internal Revenue Code. See § 1.61-3.

(4) Cost of goods in progress offset. The cost of goods in progress offset for the taxable year is calculated as:

(i) The cost of goods allocable to the item of inventory through the last day of the taxable year; reduced by

(ii) The cumulative cost of goods in progress offset attributable to the item of inventory, if any.

(5) Limitations to the cost of goods in progress offset. The cost of goods in progress offset is determined separately for each item of inventory. The cost of goods in progress offset attributable to one item of inventory cannot reduce the advance payment inventory inclusion amount attributable to a different item of inventory. Further, the cost of goods in progress offset cannot reduce the advance payment inventory inclusion amount for the taxable year below zero.

(6) Exception for gift cards. The cost of goods in progress offset in this paragraph (e) does not apply to eligible gift card sales or payments received for customer reward points.

(7) Acceleration of advance payments. The acceleration rules in paragraph (c)(4) of this section also apply to a taxpayer that uses the advance payment cost offset method under this paragraph (e), regardless of whether the taxpayer uses such method in connection with the full inclusion method under paragraph (b) of this section, or the deferral method under paragraph (c) or (d) of this section. If an advance payment is subject to the acceleration rules, paragraph (e)(2) of this section does not apply to determine the advance payment income inclusion amount for the taxable year described in paragraph (c)(4) of this section. Further, a taxpayer that uses the advance payment cost offset method under this paragraph (e) applies paragraph (c)(4)(i)(B)(2)(ii) of this section by substituting “same advance payment method as the transferor” for “deferral method.”

(8) Inventory costs for the advance payment cost offset method—(i) Inventory costs not affected by cost of goods in progress offset. The cost of goods comprising the cost of goods in progress offset does not reduce the costs that are capitalized to the items of inventory produced or items of inventory acquired for resale by the taxpayer. While the cost of goods in progress offset reduces the amount of the advance payment inventory inclusion amount, the cost of goods in progress offset does not affect how and when costs are capitalized to inventory under sections 471 and 263A or any other applicable provision of the Internal Revenue Code or when those capitalized costs will be recovered.

(ii) Consistency between inventory methods and advance payment cost offset method. The costs of goods comprising the cost of goods in progress offset must be determined by applying the taxpayer's methods of accounting for inventory for Federal income tax purposes. A taxpayer using the advance payment cost offset method must calculate its cost of goods in progress offset by reference to all costs that the taxpayer has permissibly capitalized and allocated to items of inventory under its methods of accounting for inventory for Federal income tax purposes, but including no more costs than what the taxpayer has permissibly capitalized and allocated to items of inventory.

(iii) Allocation of “additional section 263A costs” for taxpayers using simplified methods. If a taxpayer uses the simplified production method as defined under § 1.263A-2(b), the modified simplified production method as defined under § 1.263A-2(c), or the simplified resale method as defined under § 1.263A-3(d) to determine the amount of its “additional section 263A costs,” as defined under § 1.263A-1(d)(3), to be included in ending inventory, then solely for computing the cost of goods in progress offset, the taxpayer must determine the portion of additional section 263A costs allocable to an item of inventory by multiplying its total additional section 263A costs accounted for under the simplified method for all items of inventory subject to the simplified method by the following ratio:

(9) Additional procedural guidance. The IRS may publish procedural guidance in the Internal Revenue Bulletin (see § 601.601(d) of this chapter) that provides alternative procedures for complying with the rules under this paragraph (e), including alternative methods of accounting for cost offsets.

(10) Examples. The following examples illustrate the rules of paragraph (e) of this section. In each of the following examples, the taxpayer is a C corporation, has an AFS, uses an accrual method of accounting for Federal income tax purposes, and uses a calendar year for Federal income tax purposes and AFS purposes. In addition, in each example, the taxpayer uses the deferral method and the advance payment cost offset method under paragraph (e) of this section. Lastly, the taxpayer does not produce unique items, as described in § 1.460-2(a)(1) and (b), or any item that normally requires more than 12 calendar months to complete, as determined under § 1.460-2(a)(2) and (c). Any production period that exceeds 12 calendar months is due to unforeseen production delays.

(i) Example 1—(A) Facts. In December 2021, A enters into a contract with Customer to manufacture and deliver a good in 2024, with a total contract price of $100x. The costs to produce the good are required to be capitalized under sections 471 and 263A as the good is inventory in the hands of A. On the same day, A receives a payment of $40x from the customer. For its AFS, A reports all of the revenue from the sale of the good as AFS revenue in the year of delivery, which is also the year in which ownership of the good transfers from A to Customer. As of December 31, 2021, A has not incurred any cost to manufacture the good. The payment of $40x does not satisfy the specified good exception in paragraph (a)(1)(ii)(H) of this section, and thus qualifies as an advance payment. During 2022, A does not receive any additional payments on the contract and incurs $10x of costs to manufacture the good. A properly capitalizes and allocates such costs to the manufactured good under sections 471 and 263A.

(B) Analysis. Because no portion of the $40x advance payment is taken into account as AFS revenue as of the end of 2021, A is not required to include any portion of the advance payment in gross income for 2021. For 2022, A's advance payment inventory inclusion amount is $40x, which is the amount of the advance payment that, but for the cost of goods in progress offset, would be includable in gross income in 2022 under the deferral method. Pursuant to paragraph (e)(2) of this section, A reduces such amount by the $10x cost of goods in progress offset, determined as the costs of goods through the end of 2022 ($0 costs incurred in 2021 plus 10x of costs incurred in 2022 = $10x). A is required to include this net amount of $30x in gross income in 2022. The remaining portion of the payment ($10x) is deferred and included in gross income in 2024, the taxable year in which ownership of the good is transferred to Customer.

(ii) Example 2—(A) Facts. The same facts as in paragraph (e)(10)(i) of this section (Example 1) apply. In addition, in 2023, A incurs costs of $20x to manufacture the good but does not receive any additional payments from Customer.

(B) Analysis. A includes $0 in gross income in 2023. A's cost of goods in progress offset for 2023 is $20x under paragraph (e)(4) of this section ($30x costs of goods through the last day of 2023 ($10x for 2022 plus $20x for 2023 = $30x) less $10x cumulative cost of goods in progress offset amounts taken in prior taxable years). However, because A's advance payment inventory inclusion amount for 2023 is $0, which is the amount of the advance payment that, but for the cost of goods in progress offset, would be includable in gross income in 2023 under the deferral method, paragraph (e)(5) of this section limits the cost offset to $0.

(iii) Example 3—(A) Facts. The same facts as in paragraph (e)(10)(i) of this section (Example 1) apply, except that in taxable year 2022, A incurs additional costs of $25x to manufacture the good, resulting in total costs of $35x to manufacture the good in taxable year 2022.

(B) Analysis. For 2022, A's advance payment inventory inclusion amount is $40x, which is the amount of the advance payment that, but for the cost of goods in progress offset, would be includable in gross income in 2022 under the deferral method. Pursuant to paragraph (e)(2) of this section A reduces such amount by the $35x cost of goods in progress offset, determined as the costs of goods through the end of 2022 ($0 costs incurred in 2021 plus $35x costs incurred in 2022 = $35x). A is required to include this net amount of $5x in gross income in 2022. The remaining portion of the payment ($35x) is deferred and included in gross income in 2024, the taxable year in which ownership of the good is transferred to the customer.

(iv) Example 4—(A) Facts. The same facts as in paragraph (e)(10)(iii) of this section (Example 3) apply, except that for tax year 2023, A receives an additional advance payment of $60x, and does not incur any costs to manufacture the good in 2023. In 2024, A incurs the remaining $10x to manufacture the good, and delivers the good to Customer.

(B) Analysis for 2023. Because no portion of the $60x advance payment is taken into account as AFS revenue as of the end of 2023, A is not required to include any portion of the $60x advance payment in gross income for 2023.

(C) Analysis for 2024. In 2024, the ownership of the good is transferred to Customer. Accordingly, pursuant to paragraph (e)(3) of this section, A is required to include $95x, the remaining portion of all advance payments that were not required to be included in gross income in a prior taxable year ($100x of total advance payments received less $5x that was required to be included in gross income in 2022). Although A does not reduce such amount by a cost offset, it reduces gross income in 2024 by recovering the $45x of costs capitalized to inventory as cost of goods sold ($35x costs incurred in 2022 plus $10x costs incurred in 2024) in accordance with sections 471 and 263A. Accordingly, A's gross income for 2024 is $50x.

(f) Method treating payments qualifying for the specified goods exception as advance payments—(1) In general. A taxpayer may choose to use the specified good section 451(c) method to treat all payments that qualify for the specified goods exception in paragraph (a)(1)(ii)(H) of this section as advance payments that are eligible to be accounted for under this section. Under the specified good section 451(c) method, an advance payment is a payment received by the taxpayer in a taxable year earlier than the taxable year immediately preceding the taxable year of the contractual delivery date for a specified good. A taxpayer that chooses to use the specified good section 451(c) method for a trade or business must apply this method of accounting for all advance payments that meet the criteria described in paragraph (a)(1)(ii)(H) of this section.

(2) Example: Method for the specified goods exception to not apply. On May 1, 2021, A, a corporation that files its Federal income tax return on the calendar year basis, receives a prepayment for $100x, for a contract to manufacture and deliver a good in September of 2023. All of the revenue from the sale of the good is recognized in A's AFS in the year of delivery. During 2021, A does not have on hand, or available to it in such year through its normal source of supply, goods of a substantially similar kind and in a sufficient quantity to satisfy the contract to transfer the good to the customer. The payment of $100x satisfies the specified good exception. A uses the method under paragraph (f) of this section to treat all payments that otherwise satisfy the specified good exception as advance payments under this section. For Federal income tax purposes, A must treat the payment of $100x as an advance payment and account for such payment under the full inclusion method in paragraph (b) of this section, or the deferral method in paragraph (c) of this section, as applicable. Additionally, the taxpayer may choose to apply the advance payment cost offset method in paragraph (e) of this section.

(g) Election and methods of accounting—(1) Procedures for making election under section 451(c)(1)(B). An election to apply the deferral method under section 451(c)(1)(B) is made by the taxpayer filing a Federal income tax return reflecting the deferral method in computing its taxable income. If the application of the deferral method under section 451(c)(1)(B) results in the taxpayer changing its method of accounting, the election may only be made by the taxpayer complying with the method change procedures under this paragraph (g).

(2) Methods of accounting. A change to comply with this section is a change in method of accounting to which the provisions of sections 446 and 481 and the regulations in this part under sections 446 and 481 of the Code apply. A taxpayer seeking to change to a method of accounting permitted in this section must secure the consent of the Commissioner in accordance with § 1.446-1(e) and follow the administrative procedures issued under § 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to change its accounting method. For example, use of the full inclusion method under paragraph (b) of this section, the AFS deferral method under paragraph (c) of this section, the non-AFS deferral method under paragraph (d) of this section, the advance payment cost offset method under paragraph (e) of this section, and the specified good section 451(c) method under paragraph (f) of this section are adoptions of, or changes in, a method of accounting under section 446 of the Internal Revenue Code or the regulations in this part under section 446 of the Code. In addition, a change in the manner of recognizing advance payments in revenue in an AFS that changes or could change the timing of the inclusion of income for Federal income tax purposes is a change in method of accounting under section 446 and the regulations in this part under section 446 of the Code.

(h) Applicability date—(1) In general. The rules of this section apply to taxable years beginning on or after January 1, 2021.

(2) Early application. Taxpayers and their related parties, within the meaning of sections 267(b) and 707(b), may apply both the rules in this section and, to the extent relevant, the rules in § 1.451-3, in their entirety and in a consistent manner, to a taxable year beginning after December 31, 2017, and before January 1, 2021, provided that, once applied to a taxable year, the rules in this section and, to the extent relevant, the rules in § 1.451-3, are applied in their entirety and in a consistent manner to all subsequent taxable years. See section 7805(b)(7) and § 1.451-3(m).

(a) In general. A bond or other evidence of indebtedness (hereinafter in this section referred to as an obligation) issued by any person and payable on demand shall not be treated as an evidence of indebtedness of the purchaser in applying section 453(b) to a sale or other disposition of real property or to a casual sale or other casual disposition of personal property. In addition, an obligation issued by a corporation or a government or political subdivision thereof—

(1) With interest coupons attached (whether or not the obligation is readily tradable in an established securities market),

(2) In registered form (other than an obligation issued in registered form which the taxpayer establishes will not be readily tradable in an established securities market), or

(3) In any other form designed to render such obligation readily tradable in an established securities market shall not be treated as an evidence of indebtedness of the purchaser in applying section 453(b) to a sale or other disposition of real property or to a casual sale or other casual disposition of personal property. For purposes of this section, an obligation is to be considered in registered form if it is registered as to principal, interest, or both and if its transfer must be effected by the surrender of the old instrument and either the reissuance by the corporation of the old instrument to the new holder or the issuance by the corporation of a new instrument to the new holder.

(b) Treatment as payment. If under section 453(b)(3) an obligation is not treated as an evidence of indebtedness of the purchaser, then—

(1) For purposes of determining whether the payments received in the taxable year of the sale or disposition exceed 30 percent of the selling price, and

(2) For purposes of returning income on the installment method during the taxable year of the sale or disposition or in a subsequent taxable year, the receipt by the seller of such obligation shall be treated as a payment. The rules stated in this paragraph may be illustrated by the following examples:

(c) Payable on demand. Under section 453(b)(3), an obligation shall be treated as payable on demand only if the obligation is treated as payable on demand under applicable state or local law.

(d) Designed to be readily tradable in an established securities market—(1) In general. Obligations issued by a corporation or government or political subdivision thereof will be deemed to be in a form designed to render such obligations readily tradable in an established securities market if—

(i) Steps necessary to create a market for them are taken at the time of issuance (or later, if taken pursuant to an expressed or implied agreement or understanding which existed at the time of issuance),

(ii) If they are treated as readily tradable in an established securities market under subparagraph (2) of this paragraph, or

(iii) If they are convertible obligations to which paragraph (e) of this section applies.

(2) Readily tradable in an established securities market. An obligation will be treated as readily tradable in an established securities market if—

(i) The obligation is part of an issue or series of issues which are readily tradable in an established securities market, or

(ii) The corporation issuing the obligation has other obligations of a comparable character which are described in subdivision (i) of this subparagraph.

(3) Readily tradable. For purposes of subparagraph (2)(i) of this paragraph, an obligation shall be treated as readily tradable if it is regularly quoted by brokers or dealers making a market in such obligation or is part of an issue a portion of which is in fact traded in an established securities market.

(4) Established securities market. For purposes of this paragraph, the term established securities market includes (i) a national securities exchange which is registered under section 6 of the Securities and Exchange Act of 1934 (15 U.S.C. 78f), (ii) an exchange which is exempted from registration under section 5 of the Securities Exchange Act of 1935 (15 U.S.C. 78e) because of its limited volume of transactions, and (iii) any over-the-counter market. For purposes of this subparagraph, an over-the-counter market is reflected by the existence of an interdealer quotation system. An interdealer quotation system is any system of general circulation to brokers and dealers which regularly disseminates quotations of obligations by identified brokers or dealers, other than a quotation sheet prepared and distributed by a broker or dealer in the regular course of his business and containing only quotations of such broker or dealer.

(5) Examples. The rules stated in this paragraph may be illustrated by the following examples:

(e) Special rule for convertible securities—(1) General rule. For purposes of paragraph (d)(1) of this section, if an obligation contains a right whereby the holder of such obligation may convert it directly or indirectly into another obligation which would be treated as a payment under paragraph (b) of this section or may convert it directly or indirectly into stock which would be treated as readily tradable or designed to be readily tradable in an established securities market under paragraph (d) of this section, the convertible obligation shall be considered to be in a form designed to render such obligation readily tradable in an established securities market unless such obligation is convertible only at a substantial discount. In determining whether the stock or obligation, into which an obligation is convertible, is readily tradable or designed to be readily tradable in an established securities market, the rules stated in paragraph (d) of this section shall apply, and for purposes of such paragraph (d) if such obligation is convertible into stock then the term “stock” shall be substituted for the term “obligation” wherever it appears in such paragraph (d).

(2) Substantial discount rule. Whether an obligation is convertible at a substantial discount depends upon the particular facts and circumstances. A substantial discount shall be considered to exist if at the time the convertible obligation is issued, the fair market value of the stock or obligation into which the obligation is convertible is less than 80 percent of the fair market value of the obligation (determined by taking into account all relevant factors, including proper discount to reflect the fact that the convertible obligation is not readily tradable in an established securities market and any additional consideration required to be paid by the taxpayer). Also, if a privilege to convert an obligation into stock or an obligation which is readily tradable in an established securities market may not be exercised within a period of 1 year from the date the obligation is issued, a substantial discount shall be considered to exist.

(f) Effective date. The provisions of this section shall apply to sales or other dispositions occurring after May 27, 1969, which are not made pursuant to a binding written contract entered into on or before such date. No inference shall be drawn from this section as to any question of law concerning the application of section 453 to sales or other dispositions occurring on or before May 27, 1969.

(a) In general. Subject to the exceptions contained in section 453(d)(4) and paragraph (c) of this section, the entire amount of gain or loss resulting from any disposition or satisfaction of installment obligations, computed in accordance with section 453(d), is recognized in the taxable year of such disposition or satisfaction and shall be considered as resulting from the sale or exchange of the property in respect of which the installment obligation was received by the taxpayer.

(b) Computation of gain or loss. (1) The amount of gain or loss resulting under paragraph (a) of this section is the difference between the basis of the obligation and (i) the amount realized, in the case of satisfaction at other than face value or in the case of a sale or exchange, or (ii) the fair market value of the obligation at the time of disposition, if such disposition is other than by sale or exchange.

(2) The basis of an installment obligation shall be the excess of the face value of the obligation over an amount equal to the income which would be returnable were the obligation satisfied in full.

(3) The application of subparagraphs (1) and (2) of this paragraph may be illustrated by the following examples:

(c) Disposition from which no gain or loss is recognized. (1)(i) Under section 453(d)(4)(A), no gain or loss shall be recognized to a distributing corporation with respect to the distribution made after November 13, 1966, of installment obligations if (a) the distribution is made pursuant to a plan for the complete liquidation of a subsidiary under section 332, and (b) the basis of the such obligations in the hands of the distributee is determined under section 334(b)(1).

(ii) Under section 453(d)(4)(B), no gain or loss shall be recognized to a distributing corporation with respect to the distribution of installment obligations if the distribution is made, pursuant to a plan for the complete liquidation of a corporation which meets the requirements of section 337, under conditions whereby no gain or loss would have been recognized to the corporation had such installment obligations been sold or exchanged on the day of the distribution. The preceding sentence shall not apply to the extent that under section 453(d)(1) gain to the distributing corporation would be considered as gain to which section 341(f)(2), 617(d)(1), 1245(a)(1), 1250(a)(1), 1251(c)(1), 1252(a)(1), or 1254(a)(1) applies, computed under the principles of the regulations under such provisions. See paragraph (d) of § 1.1245-6, paragraph (c)(6) of § 1.1250-1, paragraph (e)(6) of § 1.1251-1, paragraph (d)(3) of § 1.1252-1, and paragraph (d) of § 1.1254-1.

(2) Where the Code provides for exceptions to the recognition of gain or loss in the case of certain dispositions, no gain or loss shall result under section 453(d) in the case of a disposition of an installment obligation. Such exceptions include: Certain transfers to corporations under sections 351 and 361; contributions of property to a partnership by a partner under section 721; and distributions by a partnership to a partner under section 731 (except as provided by section 736 and section 751).

(3) Any amount received by a person in payment or settlement of an installment obligation acquired in a transaction described in subparagraphs (1) or (2) of this paragraph (other than an amount received by a stockholder with respect to an installment obligation distributed to him pursuant to section 337) shall be considered to have the character it would have had in the hands of the person from whom such installment obligation was acquired.

(d) Carryover of installment method. For the treatment of income derived from installment obligations received in transactions to which section 381 (a) is applicable, see section 381(c)(8) and the regulations thereunder.

(e) Installment obligations transmitted at death. Where installment obligations are transmitted at death, see section 691(a)(4) and the regulations thereunder for the treatment of amounts considered income in respect of a decedent.

(f) Losses. See subchapter P (section 1201 and following), chapter 1 of the Code, as to the limitation on capital losses sustained by corporations and the limitation as to both capital gains and capital losses of individuals.

(g) Disposition of installment obligations to life insurance companies. (1) Notwithstanding the provisions of section 453(d)(4) and paragraph (c) of this section or any provision of subtitle A relating to the nonrecognition of gain, the entire amount of any gain realized on the disposition of an installment obligation by any person, other than a life insurance company (as defined in section 801(a) and paragraph (b) of § 1.801-3), to a life insurance company or to a partnership of which a life insurance company is a partner shall be recognized and treated in accordance with section 453(d)(1) and paragraphs (a) and (b) of this section. If a corporation which is a life insurance company for the taxable year was a corporation which was not a life insurance company for the preceding taxable year, such corporation shall be treated, for purposes of section 453(d)(1) and this paragraph, as having transferred to a life insurance company, on the last day of the preceding taxable year, all installment obligations which it held on such last day. The gain, if any, realized by reason of the installment obligations being so transferred shall be recognized and treated in accordance with section 453(d)(1) and paragraphs (a) and (b) of this section. Similarly, a partnership of which a life insurance company becomes a partner shall be treated, for purposes of section 453(d)(1) and this paragraph, as having transferred to a life insurance company, on the last day of the preceding taxable year of such partnership, all installment obligations which it holds at the time such life insurance company becomes a partner. The gain, if any, realized by reason of the installment obligations being so transferred shall be recognized and treated in accordance with section 453(d)(1) and paragraphs (a) and (b) of this section.

(2) The provisions of section 453(d)(5) and subparagraph (1) of this paragraph shall not apply to losses sustained in connection with the disposition of installment obligations to a life insurance company.

(3) For the effective date of the provisions of section 453(d)(5) and this paragraph, see paragraph (f) of § 1.453-10.

(4) Application of the provisions of this paragraph may be illustrated by the following examples:

(a) In general—(1) Overview. Except as provided in section 453(h)(1)(C) (relating to installment sales of depreciable property to certain closely related persons), a qualifying shareholder (as defined in paragraph (b) of this section) who receives a qualifying installment obligation (as defined in paragraph (c) of this section) in a liquidation that satisfies section 453(h)(1)(A) treats the receipt of payments in respect of the obligation, rather than the receipt of the obligation itself, as a receipt of payment for the shareholder's stock. The shareholder reports the payments received on the installment method unless the shareholder elects otherwise in accordance with § 15a.453-1(d) of this chapter.

(2) Coordination with other provisions—(i) Deemed sale of stock for installment obligation. Except as specifically provided in section 453(h)(1)(C), a qualifying shareholder treats a qualifying installment obligation, for all purposes of the Internal Revenue Code, as if the obligation is received by the shareholder from the person issuing the obligation in exchange for the shareholder's stock in the liquidating corporation. For example, if the stock of a corporation that is liquidating is traded on an established securities market, an installment obligation distributed to a shareholder of the corporation in exchange for the shareholder's stock does not qualify for installment reporting pursuant to section 453(k)(2).

(ii) Special rules to account for the qualifying installment obligation—(A) Issue price. A qualifying installment obligation is treated by a qualifying shareholder as newly issued on the date of the distribution. The issue price of the qualifying installment obligation on that date is equal to the sum of the adjusted issue price of the obligation on the date of the distribution (as determined under § 1.1275-1(b)) and the amount of any qualified stated interest (as defined in § 1.1273-1(c)) that has accrued prior to the distribution but that is not payable until after the distribution. For purposes of the preceding sentence, if the qualifying installment obligation is subject to § 1.446-2 (e.g., a debt instrument that has unstated interest under section 483), the adjusted issue price of the obligation is determined under § 1.446-2(c) and (d).

(B) Variable rate debt instrument. If the qualifying installment obligation is a variable rate debt instrument (as defined in § 1.1275-5), the shareholder uses the equivalent fixed rate debt instrument (within the meaning of § 1.1275-5(e)(3)(ii)) constructed for the qualifying installment obligation as of the date the obligation was issued to the liquidating corporation to determine the accruals of original issue discount, if any, and interest on the obligation.

(3) Liquidating distributions treated as selling price. All amounts distributed or treated as distributed to a qualifying shareholder incident to the liquidation, including cash, the issue price of qualifying installment obligations as determined under paragraph (a)(2)(ii)(A) of this section, and the fair market value of other property (including obligations that are not qualifying installment obligations) are considered as having been received by the shareholder as the selling price (as defined in § 15a.453-1(b)(2)(ii) of this chapter) for the shareholder's stock in the liquidating corporation. For the proper method of reporting liquidating distributions received in more than one taxable year of a shareholder, see paragraph (d) of this section. An election not to report on the installment method an installment obligation received in the liquidation applies to all distributions received in the liquidation.

(4) Assumption of corporate liability by shareholders. For purposes of this section, if in the course of a liquidation a shareholder assumes secured or unsecured liabilities of the liquidating corporation, or receives property from the corporation subject to such liabilities (including any tax liabilities incurred by the corporation on the distribution), the amount of the liabilities is added to the shareholder's basis in the stock of the liquidating corporation. These additions to basis do not affect the shareholder's holding period for the stock. These liabilities do not reduce the amounts received in computing the selling price.

(5) Examples. The provisions of this paragraph (a) are illustrated by the following examples. Except as otherwise provided, assume in each example that A, an individual who is a calendar-year taxpayer, owns all of the stock of T corporation. A's adjusted tax basis in that stock is $100,000. On February 1, 1998, T, an accrual method taxpayer, adopts a plan of complete liquidation that satisfies section 453(h)(1)(A) and immediately sells all of its assets to unrelated B corporation in a single transaction. The examples are as follows:

(b) Qualifying shareholder. For purposes of this section, qualifying shareholder means a shareholder to which, with respect to the liquidating distribution, section 331 applies. For example, a creditor that receives a distribution from a liquidating corporation, in exchange for the creditor's claim, is not a qualifying shareholder as a result of that distribution regardless of whether the liquidation satisfies section 453(h)(1)(A).

(c) Qualifying installment obligation—(1) In general. For purposes of this section, qualifying installment obligation means an installment obligation (other than an evidence of indebtedness described in § 15a.453-1(e) of this chapter, relating to obligations that are payable on demand or are readily tradable) acquired in a sale or exchange of corporate assets by a liquidating corporation during the 12-month period beginning on the date the plan of liquidation is adopted. See paragraph (c)(4) of this section for an exception for installment obligations acquired in respect of certain sales of inventory. Also see paragraph (c)(5) of this section for an exception for installment obligations attributable to sales of certain property that do not generally qualify for installment method treatment.

(2) Corporate assets. Except as provided in section 453(h)(1)(C), in paragraph (c)(4) of this section (relating to certain sales of inventory), and in paragraph (c)(5) of this section (relating to certain tax avoidance transactions), the nature of the assets sold by, and the tax consequences to, the selling corporation do not affect whether an installment obligation is a qualifying installment obligation. Thus, for example, the fact that the fair market value of an asset is less than the adjusted basis of that asset in the hands of the corporation; or that the sale of an asset will subject the corporation to depreciation recapture (e.g., under section 1245 or section 1250); or that the assets of a trade or business sold by the corporation for an installment obligation include depreciable property, certain marketable securities, accounts receivable, installment obligations, or cash; or that the distribution of assets to the shareholder is or is not taxable to the corporation under sections 336 and 453B, does not affect whether installment obligations received in exchange for those assets are treated as qualifying installment obligations by the shareholder. However, an obligation received by the corporation in exchange for cash, in a transaction unrelated to a sale or exchange of noncash assets by the corporation, is not treated as a qualifying installment obligation.

(3) Installment obligations distributed in liquidations described in section 453(h)(1)(E)—(i) In general. In the case of a liquidation to which section 453(h)(1)(E) (relating to certain liquidating subsidiary corporations) applies, a qualifying installment obligation acquired in respect of a sale or exchange by the liquidating subsidiary corporation will be treated as a qualifying installment obligation if distributed by a controlling corporate shareholder (within the meaning of section 368(c)) to a qualifying shareholder. The preceding sentence is applied successively to each controlling corporate shareholder, if any, above the first controlling corporate shareholder.

(ii) Examples. The provisions of this paragraph (c)(3) are illustrated by the following examples:

(4) Installment obligations attributable to certain sales of inventory—(i) In general. An installment obligation acquired by a corporation in a liquidation that satisfies section 453(h)(1)(A) in respect of a broken lot of inventory is not a qualifying installment obligation. If an installment obligation is acquired in respect of a broken lot of inventory and other assets, only the portion of the installment obligation acquired in respect of the broken lot of inventory is not a qualifying installment obligation. The portion of the installment obligation attributable to other assets is a qualifying installment obligation. For purposes of this section, the term broken lot of inventory means inventory property that is sold or exchanged other than in bulk to one person in one transaction involving substantially all of the inventory property attributable to a trade or business of the corporation. See paragraph (c)(4)(ii) of this section for rules for determining what portion of an installment obligation is not a qualifying installment obligation and paragraph (c)(4)(iii) of this section for rules determining the application of payments on an installment obligation only a portion of which is a qualifying installment obligation.

(ii) Rules for determining nonqualifying portion of an installment obligation. If a broken lot of inventory is sold to a purchaser together with other corporate assets for consideration consisting of an installment obligation and either cash, other property, the assumption of (or taking property subject to) corporate liabilities by the purchaser, or some combination thereof, the installment obligation is treated as having been acquired in respect of a broken lot of inventory only to the extent that the fair market value of the broken lot of inventory exceeds the sum of unsecured liabilities assumed by the purchaser, secured liabilities which encumber the broken lot of inventory and are assumed by the purchaser or to which the broken lot of inventory is subject, and the sum of the cash and fair market value of other property received. This rule applies solely for the purpose of determining the portion of the installment obligation (if any) that is attributable to the broken lot of inventory.

(iii) Application of payments. If, by reason of the application of paragraph (c)(4)(ii) of this section, a portion of an installment obligation is not a qualifying installment obligation, then for purposes of determining the amount of gain to be reported by the shareholder under section 453, payments on the obligation (other than payments of qualified stated interest) shall be applied first to the portion of the obligation that is not a qualifying installment obligation.

(iv) Example. The following example illustrates the provisions of this paragraph (c)(4). In this example, assume that all obligations bear adequate stated interest within the meaning of section 1274(c)(2) and that the fair market value of each nonqualifying installment obligation equals its face amount. The example is as follows:

(5) Installment obligations attributable to sales of certain property—(i) In general. An installment obligation acquired by a liquidating corporation, to the extent attributable to the sale of property described in paragraph (c)(5)(ii) of this section, is not a qualifying obligation if the corporation is formed or availed of for a principal purpose of avoiding section 453(b)(2) (relating to dealer dispositions and certain other dispositions of personal property), section 453(i) (relating to sales of property subject to recapture), or section 453(k) (relating to dispositions under a revolving credit plan and sales of stock or securities traded on an established securities market) through the use of a party bearing a relationship, either directly or indirectly, described in section 267(b) to any shareholder of the corporation.

(ii) Covered property. Property is described in this paragraph (c)(5)(ii) if, within 12 months before or after the adoption of the plan of liquidation, the property was owned by any shareholder and—

(A) The shareholder regularly sold or otherwise disposed of personal property of the same type on the installment plan or the property is real property that the shareholder held for sale to customers in the ordinary course of a trade or business (provided the property is not described in section 453(l)(2) (relating to certain exceptions to the definition of dealer dispositions));

(B) The sale of the property by the shareholder would result in recapture income (within the meaning of section 453(i)(2)), but only if the amount of the recapture income is equal to or greater than 50 percent of the property's fair market value on the date of the sale by the corporation;

(C) The property is stock or securities that are traded on an established securities market; or

(D) The sale of the property by the shareholder would have been under a revolving credit plan.

(iii) Safe harbor. Paragraph (c)(5)(i) of this section will not apply to the liquidation of a corporation if, on the date the plan of complete liquidation is adopted and thereafter, less than 15 percent of the fair market value of the corporation's assets is attributable to property described in paragraph (c)(5)(ii) of this section.

(iv) Example. The provisions of this paragraph (c)(5) are illustrated by the following example:

(d) Liquidating distributions received in more than one taxable year. If a qualifying shareholder receives liquidating distributions to which this section applies in more than one taxable year, the shareholder must reasonably estimate the gain attributable to distributions received in each taxable year. In allocating basis to calculate the gain for a taxable year, the shareholder must reasonably estimate the anticipated aggregate distributions. For this purpose, the shareholder must take into account distributions and other relevant events or information that the shareholder knows or reasonably could know up to the date on which the federal income tax return for that year is filed. If the gain for a taxable year is properly taken into account on the basis of a reasonable estimate and the exact amount is subsequently determined the difference, if any, must be taken into account for the taxable year in which the subsequent determination is made. However, the shareholder may file an amended return for the earlier year in lieu of taking the difference into account for the subsequent taxable year.

(e) Effective date. This section is applicable to distributions of qualifying installment obligations made on or after January 28, 1998.

(a) General rule. Unrecaptured section 1250 gain, as defined in section 1(h)(7), is reported on the installment method if that method otherwise applies under section 453 or 453A and the corresponding regulations. If gain from an installment sale includes unrecaptured section 1250 gain and adjusted net capital gain (as defined in section 1(h)(4)), the unrecaptured section 1250 gain is taken into account before the adjusted net capital gain.

(b) Installment payments from sales before May 7, 1997. The amount of unrecaptured section 1250 gain in an installment payment that is properly taken into account after May 6, 1997, from a sale before May 7, 1997, is determined as if, for all payments properly taken into account after the date of sale but before May 7, 1997, unrecaptured section 1250 gain had been taken into account before adjusted net capital gain.

(c) Installment payments received after May 6, 1997, and on or before August 23, 1999. If the amount of unrecaptured section 1250 gain in an installment payment that is properly taken into account after May 6, 1997, and on or before August 23, 1999, is less than the amount that would have been taken into account under this section, the lesser amount is used to determine the amount of unrecaptured section 1250 gain that remains to be taken into account.

(d) Examples. In each example, the taxpayer, an individual whose taxable year is the calendar year, does not elect out of the installment method. The installment obligation bears adequate stated interest, and the property sold is real property held in a trade or business that qualifies as both section 1231 property and section 1250 property. In all taxable years, the taxpayer's marginal tax rate on ordinary income is 28 percent. The following examples illustrate the rules of this section:

(e) Effective date. This section applies to installment payments properly taken into account after August 23, 1999.

This section lists the paragraphs and subparagraphs contained in §§ 1.453A-1 through 1.453A-3.

(a) In general. A dealer (as defined in paragraph (c)(1) of this section) may elect to return the income from the sale of personal property on the installment method if such sale is a sale on the installment plan (as defined in paragraphs (c)(3) and (d) of this section). Under the installment method of accounting, a taxpayer may return as income from installment sales in any taxable year that proportion of the installment payments actually received in that year which the gross profit realized or to be realized when the property is paid for bears to the total contract price. For this purpose, gross profit means sales less cost of goods sold. See paragraph (d) of this section for additional rules relating to the computation of income under the installment method of accounting.

(b) Effect of security. A dealer may adopt (but is not required to do so) one of the following four ways of protecting against loss in case of default by the purchaser:

(1) An agreement that title is to remain in the vendor until performance of the purchaser's part of the transaction is completed;

(2) A form of contract in which title is conveyed to the purchaser immediately, but subject to a lien for the unpaid portion of the selling price;

(3) A present transfer of title to the purchaser, who at the same time executes a reconveyance in the form of a chattel mortgage to the vendor; or

(4) A conveyance to a trustee pending performance of the contract and subject to its provisions.

(c) Definitions of dealer, sale, and sale on the installment plan. For purposes of the regulations under section 453A—

(1) The term “dealer” means a person who regularly sells or otherwise disposes of personal property on the installment plan;

(2) The term “sale” includes sales and other dispositions; and

(3) Except as provided in paragraph (d)(2) of this section, the term “sale on the installment plan” means—

(i) A sale of personal property by the taxpayer under any plan for the sale of personal property, which plan, by its terms and conditions, contemplates that each sale under the plan will be paid for in two or more payments; or

(ii) A sale of personal property by the taxpayer under any plan for the sale of personal property—

(A) Which plan, by its terms and conditions, contemplates that such sale will be paid for in two or more payments; and

(B) Which sale is in fact paid for in two or more payments.

(d) Installment plans—(1) Traditional installment plans. A traditional installment plan usually has the following characteristics:

(i) The execution of a separate installment contract for each sale or disposition of personal property; and

(ii) The retention by the dealer of some type of security interest in such property.

(2) Revolving credit plans. Sales under a revolving credit plan (within the meaning of § 1.453A-2(c)(1))—

(i) Are treated, for taxable years beginning on or before December 31, 1986, as sales on the installment plan to the extent provided in § 1.453A-2, which provides for the application of the requirements of paragraph (c)(3)(ii) of this section to sales under revolving credit plans; and

(ii) Are not treated as sales on the installment plan for taxable years beginning after December 31, 1986.

(e) Installment income of dealers in personal property—(1) In general. The income from sales on the installment plan of a dealer may be ascertained by treating as income that proportion of the total payments received in the taxable year from sales on the installment plan (such payments being allocated to the year against the sales of which they apply) which the gross profit realized or to be realized on the total sales on the installment plan made during each year bears to the total contract price of all such sales made during that respective year. However, if the dealer demonstrates to the satisfaction of the district director that income from sales on the installment plan is clearly reflected, the income from such sales may be ascertained by treating as income that proportion of the total payments received in the taxable year from sales on the installment plan (such payments being allocated to the year against the sales of which they apply) which either:

(i) The gross profit realized or to be realized on the total credit sales made during each year bears to the total contract price of all credit sales during that respective year, or

(ii) The gross profit realized or to be realized on all sales made during each year bears to the total contract price of all sales made during that respective year.

(2) Gross profit and total contract price. For purposes of paragraph (e)(1) of this section, in computing the gross profit realized or to be realized on the total sales on the installment plan, there shall be included in the total selling price and, thus, in the total contract price of all such sales.

(i) The amount of carrying charges or interest which is determined at the time of each sale and is added to the established cash selling price of such property and is treated as part of the selling price for customer billing purposes, and

(ii) In the case of sales made in taxable years beginning on or after January 1, 1960, the amount of carrying charges or interest determined with respect to such sales which are added contemporaneously with the sale on the books of account of the seller but are treated as periodic service charges for customer billing purposes.

(3) Carrying charges not included in total contract price. In the case of sales by dealers in personal property made during taxable years beginning after December 31, 1963, the income from which is returned on the installment method, if the carrying charges or interest with respect to such sales is not included in the total contract price, payments received with respect to such sales shall be treated as applying first against such carrying charges or interest.

(f) Other accounting methods. If the vendor chooses as a matter of consistent practice to return the income from installment sales on an accrual method (,) such a course is permissible.

(g) Records. In adopting the installment method of accounting the seller must maintain such records as are necessary to clearly reflect income in accordance with this section, section 446 and § 1.446-1.

(h) Effective date. This section applies for taxable years beginning after December 31, 1953, and ending after August 16, 1954, but generally does not apply to sales made after December 31, 1987, in taxable years ending after such date. For sales made after December 31, 1987, sales made by a dealer in personal or real property shall not be treated as sales on the installment plan. (However, see section 453(l)(2) for exceptions to this rule.)

(a) In general. A dealer (within the meaning of § 1.453A-1(c)(1)) may adopt or change to the installment method for a type or types of sales on the installment plan (within the meaning of § 1.453A-1(c)(3) and (d)) in the manner prescribed in this section. This section applies only to dealers and only with respect to their sales on the installment plan.

(b) Time and manner of electing installment method reporting—(1) Time for election. An election to adopt or change to the installment method for a type or types of sales must be made on an income tax return for the taxable year of the election, filed on or before the time specified (including extensions thereof) for filing such return.

(2) Adoption of installment method. A taxpayer who adopts the installment method for the first taxable year in which sales are made on an installment plan of any kind must indicate in the income tax return for that taxable year that the installment method of accounting is being adopted and specify the type or types of sales included within the election. If a taxpayer in the year of the initial election made only one type of sale on the installment plan, but during a subsequent taxable year makes another type of sale on the installment plan and adopts the installment method for that other type of sale, the taxpayer must indicate in the income tax return for the subsequent year that an election is being made to adopt the installment method of accounting for the additional type of sale.

(3) Change to installment method. A taxpayer who changes to the installment method for a particular type or types of sales on the installment plan in acordance with this section must, for each type of sale on the installment plan for which the installment method is to be used, attach a separate statement to the income tax return for the taxable year with respect to which the change is made. Each statement must show the method of accounting used in computing taxable income before the change and the type of sale on the installment plan for which the installment method is being elected.

(4) Deemed elections. A dealer (including a person who is a dealer as a result of the recharacterization of transactions as sales) is deemed to have elected the installment method if the dealer treats a sale on the installment plan as a transaction other than a sale and fails to report the full amount of gain in the year of the sale. For example, if a transaction treated by a dealer as a lease is recharacterized by the Internal Revenue Service as a sale on the installment plan, the dealer will be deemed to have elected the installment method assuming the dealer failed to report the full amount of gain in the year of the transaction.

(c) Consent. A dealer may adopt or change to the installment method for sales on the installment plan without the consent of the Commissioner. However, a dealer may not change from the installment method to the accrual method of accounting or to any other method of accounting without the consent of the Commissioner.

(d) Cut-off method for amounts previously accrued. An election to change to the installment method for a type of sale applies only with respect to sales made on or after the first day of the taxable year of change. Thus, payments received in the taxable year of the change, or in subsequent years, in respect of an installment obligation which arose in a taxable year prior to the taxable year of change are not taken into account on the installment method, but rather must be accounted for under the taxpayer's method of accounting in use in the prior year.

(e) Effective date. This section applies to sales by dealers in taxable years ending after October 19, 1980, but generally does not apply to sales made after December 31, 1987. For sales made after December 31, 1987, sales by a dealer in personal or real property shall not be treated as sales on the installment plan. (However, see section 453(l)(2) for certain exceptions to this rule.) For rules relating to sales by dealers in taxable years ending before October 20, 1980, see 26 CFR 1.453-7 and 1.453-8 (rev. as of April 1, 1987).

(a) Certain non-interest-bearing obligations issued at discount—(1) Election to include increase in income currently. If a taxpayer owns—

(i) A non-interest-bearing obligation issued at a discount and redeemable for fixed amounts increasing at stated intervals (other than an obligation issued by a corporation after May 27, 1969, as to which ratable inclusion of original issue discount is required under section 1232(a)(3)), or

(ii) An obligation of the United States, other than a current income obligation, in which he retains his investment in a matured series E U.S. savings bond, or

(iii) A nontransferable obligation (whether or not a current income obligation) of the United States for which a series E U.S. savings bond was exchanged (whether or not at final maturity) in an exchange upon which gain is not recognized because of section 1037(a) (or so much of section 1031(b) as relates to section 1037),

(2) Amount of increase in case of non-interest-bearing obligations. In any case in which an election is made under section 454, the amount which accrues in any taxable year to which the election applies is measured by the actual increase in the redemption price occurring in that year. This amount does not accrue ratably between the dates on which the redemption price changes. For example, if two dates on which the redemption price increases (February 1 and August 1) fall within a taxable year and if the redemption price increases in the amount of 50 cents on each such date, the amount accruing in that year would be $1 ($0.50 on February 1 and $0.50 on August 1). If the taxpayer owns a non-interest-bearing obligation of the character described in subdivision (i), (ii), or (iii) of subparagraph (1) of this paragraph acquired prior to the first taxable year to which his election applies, he must also include in gross income for such first taxable year (i) the increase in the redemption price of such obligation occurring between the date of acquisition of the obligation and the first day of such first taxable year and (ii), in a case where a series E bond was exchanged for such obligation, the increase in the redemption price of such series E bond occurring between the date of acquisition of such series E bond and the date of the exchange.

(3) Amount of increase in case of current income obligations. If an election is made under section 454 and the taxpayer owns, at the beginning of the first taxable year to which the election applies, a current income obligation of the character described in subparagraph (1)(iii) of this paragraph acquired prior to such taxable year, he must also include in gross income for such first taxable year the increase in the redemption price of the series E bond which was surrendered to the United States in exchange for such current income obligation; the amount of the increase is that occurring between the date of acquisition of the series E bond and the date of the exchange.

(4) Illustrations. The application of this paragraph may be illustrated by the following examples:

(b) Short-term obligations issued on a discount basis. In the case of obligations of the United States or any of its possessions, or of a State, or Territory, or any political subdivision thereof, or of the District of Columbia, issued on a discount basis and payable without interest at a fixed maturity date not exceeding one year from the date of issue, the amount of discount at which such obligation originally sold does not accrue until the date on which such obligation is redeemed, sold, or otherwise disposed of. This rule applies regardless of the method of accounting used by the taxpayer. For examples illustrating rules for computation of income from sale or other disposition of certain obligations of the type described in this paragraph, see section 1221 and the regulations thereunder.

(c) Matured U.S. savings bonds—(1) Inclusion of increase in income upon redemption or final maturity. If a taxpayer (other than a corporation) holds—

(i) A matured series E U.S. savings bond,

(ii) An obligation of the United States, other than a current income obligation, in which he retains his investment in a matured series E U.S. savings bond, or

(iii) A nontransferable obligation (whether or not a current income obligation) of the United States for which a series E U.S. savings bond was exchanged (whether or not at final maturity) in an exchange upon which gain is not recognized because of section 1037(a) (or so much of section 1031(b) as relates to section 1037(a)),

(2) Illustrations. The application of this paragraph may be illustrated by the following examples, in which it is assumed that the taxpayer uses the cash receipts and disbursements method of accounting and the calendar year as his taxable year:

Effective with respect to taxable years beginning after December 31, 1957, section 455 permits certain taxpayers to elect with respect to a trade or business in connection with which prepaid subscription income is received, to include such income in gross income for the taxable years during which a liability exists to furnish or deliver a newspaper, magazine, or other periodical. If a taxpayer does not elect to treat prepaid subscription income under the provisions of section 455, such income is includible in gross income for the taxable year in which received by the taxpayer, unless under the method or practice of accounting used in computing taxable income such amount is to be properly accounted for as of a different period.

(a) If a taxpayer makes an election under section 455 and § 1.455-6 with respect to a trade or business, all prepaid subscription income from such trade or business shall be included in gross income for the taxable years during which the liability exists to furnish or deliver a newspaper, magazine, or other periodical. Such election shall be applicable to all prepaid subscription income received in connection with the trade or business for which the election is made; except that the taxpayer may further elect to include in gross income for the taxable year of receipt (as described in section 455(d)(3) and paragraph (c) of § 1.455-5) the entire amount of any prepaid subscription income if the liability from which it arose is to end within 12 months after the date of receipt, hereinafter sometimes referred to as “within 12 months” election.

(b) If the taxpayer is engaged in more than one trade or business in which a liability is incurred to furnish or deliver a newspaper, magazine, or other periodical, a separate election 455 with respect to each such trade or business. In addition, a taxpayer may make a separate “within 12 months” election for each separate trade or business for which it has made an election under section 455.

(c) An election made under section 455 shall be binding for the first taxable year for which the election is made and for all subsequent taxable years, unless the taxpayer secures the consent of the Commissioner to the revocation of such election. Thus, in any case where the taxpayer has elected a method prescribed by section 455 for the inclusion of prepaid subscription income in gross income, such method of reporting income may not be changed without the prior approval of the Commissioner. In order to secure the Commissioner's consent to the revocation of such election, an application must be filed with the Commissioner in accordance with section 446(e) and the regulations thereunder. For purposes of subtitle A of the Code, the computation of taxable income under an election made under section 455 shall be treated as a method of accounting. For adjustments required by changes in method of accounting, see section 481 and the regulations thereunder.

(d) An election made under section 455 shall not apply to any prepaid subscription income received before the first taxable year to which the election applies. For example, Corporation M, which computes its taxable income under an accrual method of accounting and files its income tax returns on the calendar year basis, publishes a monthly magazine and customarily sells subscriptions on a 3-year basis. In 1958 it received $135,000 of 3-year prepaid subscription income for subscriptions beginning during 1958, and in 1959 it received $142,000 of prepaid subscription income for subscriptions beginning after December 31, 1958. In February 1959 it elected, with the consent of the Commissioner, to report its prepaid subscription income under the provisions of section 455 for the year 1959 and subsequent taxable years. The $135,000 received in 1958 from prepaid subscriptions must be included in gross income in full in that year, and no part of such 1958 income shall be allocated to the years 1959, 1960, and 1961 during which M was under a liability to deliver its magazine. The $142,000 received in 1959 from prepaid subscriptions shall be allocated to the years 1959, 1960, 1961, and 1962.

(e) No election may be made under section 455 with respect to a trade or business if, in computing taxable income, the cash receipts and disbursements method of accounting is used with respect to such trade or business. However, if the taxpayer is on a “combination” method of accounting under section 446(c)(4) and the regulations thereunder, it may elect the benefits of section 455 if it uses an accrual method of accounting for subscription income

(a) Prepaid subscription income to which section 455 applies shall be included in gross income for the taxable years during which the liability to which the income relates is discharged or is deemed to be discharged on the basis of the taxpayer's experience.

(b) For purposes of determining the period or periods over which the liability of the taxpayer extends, and for purposes of allocating prepaid subscription income to such periods, the taxpayer may aggregate similar transactions during the taxable year in any reasonable manner, provided the method of aggregation and allocation is consistently followed.

(a) If a taxpayer has elected to apply the provisions of section 455 to a trade or business in connection with which prepaid subscription income is received, and if its liability to furnish or deliver a newspaper, magazine, or other periodical ends for any reason, then so much of the prepaid subscription income attributable to such liability as was not includible in its gross income under section 455 for preceding taxable years shall be included in its gross income for the taxable year in which such liability ends. A taxpayer's liability may end, for example, because of the cancellation of a subscription. See section 381(c)(4) and the regulations thereunder for the treatment of prepaid subscription income in a transaction to which section 381(a) applies.

(b) If a taxpayer who has elected to apply the provisions of section 455 to a trade or business dies or ceases to exist, then so much of the prepaid subscription income attributable to such trade or business which was not includible in its gross income under section 455 for preceding taxable years shall be included in its gross income for the taxable year in which such death or cessation of existence occurs. See section 381(c)(4) and the regulations thereunder for the treatment of prepaid subscription income in a transaction to which section 381(a) applies.

(a) Prepaid subscription income. (1) The term “prepaid subscription income” means any amount includible in gross income which is received in connection with, and is directly attributable to, a liability of the taxpayer which extends beyond the close of the taxable year in which such amount is received and which is income from a newspaper, magazine, or other periodical. For example where Corporation X, a publisher of newspapers, magazines, and other periodicals makes sales on a subscription basis and the purchaser pays the subscription price in advance, prepaid subscription income would include the amounts actually received by X in connection with its liability to furnish or deliver the newspaper, magazine, or other periodical.

(2) For purposes of section 455, prepaid subscription income does not include amounts received by a taxpayer in connection with sales of subscriptions on a prepaid basis where such taxpayer does not have the liability to furnish or deliver a newspaper, magazine, or other periodical. The provisions of this subparagraph may be illustrated by the following example. Corporation D has a contract with each of several large publishers which grants it the right to sell subscriptions to their periodicals. Corporation D collects the subscription price from the subscribers, retains a portion thereof as its commission and remits the balance to the publishers. The amount retained by Corporation D represents commissions on the sale of subscriptions, and is not prepaid subscription income for purposes of section 455 since the commissions represent compensation for services rendered and are not directly attributable to a liability of Corporation D to furnish or deliver a newspaper, magazine, or other periodical.

(b) Liability. The term “liability” means a liability of the taxpayer to furnish or deliver a newspaper, magazine, or other periodical.

(c) Receipt of prepaid subscription income. For purposes of section 455, prepaid subscription income shall be treated as received during the taxable year for which it is includible in gross income under section 451, relating to general rule for taxable year of inclusion, without regard to section 455.

(d) Treatment of prepaid subscription income under an established accounting method. Notwithstanding the provisions of section 455 and § 1.455-1, any taxpayer who, for taxable years beginning before January 1, 1958, has reported prepaid subscription income for income tax purposes under an established and consistent method or practice of deferring such income may continue to report such income in accordance with such method or practice for all subsequent taxable years to which section 455 applies without making an election under section 455.

(a) Election without consent. (1) A taxpayer may, without consent, elect to treat prepaid subscription income of a trade or business under section 455 for the first taxable year—

(i) Which begins after December 31, 1957, and

(ii) In which there is received prepaid subscription income from the trade or business for which the election is made. Such an election shall be made not later than the time prescribed by law for filing the income tax return for such year (including extensions thereof), and shall be made by means of a statement attached to such return.

(2) The statement shall indicate that the taxpayer is electing to apply the provisions of section 455 to his trade or business, and shall contain the following information:

(i) The name and a description of the taxpayer's trade or business to which the election is to apply;

(ii) The method of accounting used in such trade or business;

(iii) The total amount of prepaid subscription income from such trade or business for the taxable year;

(iv) The period or periods over which the liability of the taxpayer to furnish or deliver a newspaper, magazine, or other periodical extends;

(v) The amount of prepaid subscription income applicable to each such period; and

(vi) A description of the method used in allocating the prepaid subscription income to each such period.

(3) See paragraph (c) of this section for additional information required to be submitted with the statement if the taxpayer also elects to include in gross income for the taxable year of receipt the entire amount of prepaid subscription income attributable to a liability which is to end within 12 months after the date of receipt.

(b) Election with consent. A taxpayer may, with the consent of the Commissioner, elect at any time to apply the provisions of section 455 to any trade or business in which it receives prepaid subscription income. The request for such consent shall be in writing, signed by the taxpayer or its authorized representative, and shall be addressed to the Commissioner of Internal Revenue, Attention: T:R:C, Washington, D.C. 20224. The request must be filed on or before the later of the following dates:

(1) 90 days after the beginning of the first taxable year to which the election is to apply or

(2) May 28, 1962, and must contain the information described in paragraph (a)(2) of this section.

(c) “Within 12 months” election. (1) A taxpayer who elects to apply the provisions of section 455 to any trade or business may also elect to include in gross income for the taxable year of receipt (as described in section 455(d)(3) and paragraph (c) of § 1.455-5) the entire amount of any prepaid subscription income from such trade or business if the liability from which it arose is to end within 12 months after the date of receipt. Any such election is binding for the first taxable year for which it is effective and for all subsequent taxable years, unless the taxpayer secures permission from the Commissioner to treat such income differently. Application to revoke or change a “within 12 months” election shall be made in accordance with the provisions of section 446(e) and the regulations thereunder.

(2) The “within 12 months” election shall be made by including in the statement required by paragraph (a) of this section or the request described in paragraph (b) of this section, whichever is applicable, a declaration that the taxpayer elects to include such income in gross income in the taxable year of receipt, and the amount of such income. If the taxpayer is engaged in more than one trade or business for which the election under section 455 is made, it must include, in such statement or request, a declaration for each trade or business for which it makes the “within 12 months” election. See also paragraph (e) of § 1.455-2.

(3) If the taxpayer does not make the “within 12 months” election for its trade or business at the time prescribed for making the election to include prepaid subscription income in gross income for the taxable years during which its liability to furnish or deliver a newspaper, magazine, or other periodical exists for such trade or business, but later wishes to make such election, it must apply for permission from the Commissioner. Such application shall be made in accordance with the provisions of section 446(e) and the regulations thereunder.

Effective for taxable years beginning after December 31, 1960, a taxpayer which is a membership organization (as described in paragraph (c) of § 1.456-5) and which receives prepaid dues income as described in paragraph (a) of § 1.456-5 in connection with its trade or business of rendering services or making available membership privileges may elect under section 456 to include such income in gross income ratably over the taxable years during which its liability (as described in paragraph (b) of § 1.456-5) to render such services or extend such privileges exists, if such liability does not extend over a period of time in excess of 36 months. If the taxpayer does not elect to treat prepaid dues income under section 456, or if such income may not be reported under section 456, as for example, where the income relates to a liability to render services or make available membership privileges which extends beyond 36 months, then such income is includible in gross income for the taxable year in which it is received (as described in paragraph (d) of § 1.456-5).

(a) An election made under section 456 and § 1.456-6, shall be applicable to all prepaid dues income received in connection with the trade or business for which the election is made. However, the taxpayer may further elect to include in gross income for the taxable year of receipt the entire amount of any prepaid dues income attributable to a liability extending beyond the close of the taxable year but ending within 12 months after the date of receipt, hereinafter referred to as the “within 12 months” election.

(b) If the taxpayer is engaged in more than one trade or business in connection with which prepaid dues income is received, a separate election may be made under section 456 with respect to each such trade or business. In addition, a taxpayer may make a separate “within 12 months” election for each separate trade or business for which it has made an election under section 456.

(c) A section 456 election and a “within 12 months” election shall be binding for the first taxable year for which the election is made and for all subsequent taxable years, unless the taxpayer secures the consent of the Commissioner to the revocation of either election. In order to secure the Commissioner's consent to the revocation of the section 456 election or the “within 12 months” election, an application must be filed with the Commissioner in accordance with section 446(e) and the regulations thereunder. However, an application for consent to revoke the section 456 election or the “within 12 months” election in the case of all taxable years which end before November 30, 1967 must be filed on or before February 28, 1968. For purposes of Subtitle A of the Code, the computation of taxable income under an election made under section 456 or under the “within 12 months” election shall be treated as a method of accounting. For adjustments required by changes in method of accounting, see section 481 and the regulations thereunder.

(d) Except as provided in section 456(d) and § 1.456-7, an election made under section 456 shall not apply to any prepaid dues income received before the first taxable year to which the election applies. For example, Corporation X, a membership organization which files its income tax returns on a calendar year basis, customarily sells 3-year memberships, payable in advance. In 1961 it received $160,000 of prepaid dues income for 3-year memberships beginning during 1961, and in 1962 it received $185,000 of prepaid dues income for 3-year memberships beginning on January 1, 1962. In March 1962 it elected, with the consent of the Commissioner, to report its prepaid dues income under the provisions of section 456 for the year 1962 and subsequent taxable years. The $160,000 received in 1961 from prepaid dues must be included in gross income in full in that year, and except as provided in section 456(d) and § 1.456-7, no part of such income shall be allocated to the taxable years 1962, 1963, and 1964 during which X was under a liability to make available its membership privileges. The $185,000 received in 1962 from prepaid dues income shall be allocated to the years 1962, 1963, and 1964.

(e) No election may be made under section 456 with respect to a trade or business if, in computing taxable income, the cash receipts and disbursements method (or a hybrid thereof) of accounting is used with respect to such trade or business, unless the combination of the section 456 election and the taxpayer's hybrid method of accounting does not result in a material distortion of income.

(a) Prepaid dues income for which an election has been made under section 456 shall be included in gross income over the period of time during which the liability to render services or make available membership privileges exists. The liability to render the services or make available the membership privileges shall be deemed to exist ratably over the period of time such services are required to be rendered, or such membership privileges are required to be made available. Thus, the prepaid dues income shall be included in gross income ratably over the period of the membership contract. For example, Corporation X, a membership organization, which files its income tax returns on a calendar year basis, elects, for its taxable year beginning January 1, 1961, to report its prepaid dues income in accordance with the provisions of section 456. On March 31, 1961, it sells a 2-year membership for $48 payable in advance, the membership to extend from May 1, 1961, to April 30, 1963. X shall include in its gross income for the taxable year 1961 8/24 of the $48, or $16, and for the taxable year 1962 12/24 of the $48, or $24, and for the taxable year 1963 4/24 of the $48, or $8.

(b) For purposes of determining the period or periods over which the liability of the taxpayer exists, and for purposes of allocating prepaid dues income to such periods, the taxpayer may aggregate similar transactions during the taxable year in any reasonable manner, provided the method of aggregation and allocation is consistently followed.

(a) If a taxpayer has elected to apply the provisions of section 456 to a trade or business in connection with which prepaid dues income is received, and if the taxpayer's liability to render services or make available membership privileges ends for any reason, as for example, because of the cancellation of a membership then so much of the prepaid dues income attributable to such liability as was not includible in the taxpayer's gross income under section 456 for preceding taxable years shall be included in gross income for the taxable year in which such liability ends. This paragraph shall not apply to amounts includible in gross income under § 1.456-7.

(b) If a taxpayer which has elected to apply the provisions of section 456 ceases to exist, then the prepaid dues income which was not includible in gross income under section 456 for preceding taxable years shall be included in the taxpayer's gross income for the taxable year in which such cessation of existence occurs. This paragraph shall not apply to amounts includible in gross income under § 1.456-7.

(c) If a taxpayer is a party to a transaction to which section 381(a) applies and the taxpayer's method of accounting with respect to prepaid dues income is used by the acquiring corporation under the provisions of section 381(c)(4), then neither the liability nor the existence of the taxpayer shall be deemed to have ended or ceased. In such cases see section 381(c)(4) and the regulations thereunder for the treatment of the portion of prepaid dues income which was not included in gross income under section 456 for preceding taxable years.

(a) Prepaid dues income. (1) The term “prepaid dues income” means any amount for membership dues includible in gross income which is received by a membership organization in connection with, and is directly attributable to, a liability of the taxpayer to render services or make available membership privileges over a period of time which extends beyond the close of the taxable year in which such amount is received.

(2) For purposes of section 456, prepaid dues income does not include amounts received by a taxpayer in connection with sales of memberships on a prepaid basis where the taxpayer does not have the liability to furnish the services or make available the membership privileges. For example, where a taxpayer has a contract with several membership organizations to sell memberships in such organizations and retains a portion of the amounts received from the sale of such memberships and remits the balance to the membership organizations, the amounts retained by such taxpayer represent commissions and do not constitute prepaid dues income for purposes of section 456.

(b) Liability. The term “liability” means a liability of the taxpayer to render services or make available membership privileges over a period of time which does not exceed 36 months. Thus, if during the taxable year a taxpayer sells memberships for more than 36 months and also memberships for 36 months or less, section 456 does not apply to the income from the sale of memberships for more than 36 months. For the purpose of determining the duration of a liability, a bona fide renewal of a membership shall not be considered to be a part of the existing membership.

(c) Membership organization. (1) The term “membership organization” means a corporation, association, federation, or other similar organization meeting the following requirements:

(i) It is organized without capital stock of any kind.

(ii) Its charter, bylaws, or other written agreement or contract expressly prohibits the distribution of any part of the net earnings directly or indirectly, in money, property, or services, to any member, and

(iii) No part of the net earnings of which is in fact distributed to any member either directly or indirectly, in money, property, or services.

(2) For purposes of this paragraph an increase in services or reduction in dues to all members shall generally not be considered distributions of net earnings.

(3) If a corporation, association, federation, or other similar organization subsequent to the time it elects to report its prepaid dues income in accordance with the provisions of section 456, (i) issues any kind of capital stock either to any member or nonmember, (ii) amends its charter, bylaws, or other written agreement or contract to permit distributions of its net earnings to any member or, (iii) in fact, distributes any part of its net earnings either in money, property, or services to any member, then immediately after such event the organization shall not be considered a membership organization within the meaning of section 456(e)(3).

(d) Receipt of prepaid dues income. For purposes of section 456, prepaid dues income shall be treated as received during the taxable year for which it is includible in gross income under section 451, relating to the general rule for taxable year of inclusion, without regard to section 456.

(a) Election without consent. A taxpayer may make an election under section 456 without the consent of the Commissioner for the first taxable year beginning after December 31, 1960, in which it receives prepaid dues income in the trade or business for which such election is made. The election must be made not later than the time prescribed by law for filing the income tax return for such year (including extensions thereof). The election must be made by means of a statement attached to such return. In addition, there should be attached a copy of a typical membership contract used by the organization and a copy of its charter, bylaws, or other written agreement or contract of organization or association. The statement shall indicate that the taxpayer is electing to apply the provisions of section 456 to the trade or business, and shall contain the following information:

(1) The taxpayer's name and a description of the trade or business to which the election is to apply.

(2) The method of accounting used for prepaid dues income in the trade or business during the first taxable year for which the election is to be effective and during each of 3 preceding taxable years, and if there was a change in the method of accounting for prepaid dues income during such 3-year period, a detailed explanation of such change including the adjustments necessary to prevent duplications or omissions of income.

(3) Whether any type of deferral method for prepaid dues income has been used during any of the 3 taxable years preceding the first taxable year for which the election is effective. Where any type of such deferral method has been used during this period, an explanation of the method and a schedule showing the amounts received in each such year and the amounts deferred to each succeeding year.

(4) A schedule with appropriate explanations showing:

(i) The total amount of prepaid dues income received in the trade or business in the first taxable year for which the election is effective and the amount of such income to be included in each taxable year in accordance with the election,

(ii) The total amount, if any, of prepayments of dues received in the first taxable year for which the election is effective which are directly attributable to a liability of the taxpayer to render services or make available membership privileges over a period of time in excess of 36 months, and

(iii) The total amount, if any, of prepaid dues income received in the trade or business in—

(a) The taxable year preceding the first taxable year for which the election is effective if all memberships sold by the taxpayer are for periods of 1 year or less,

(b) Each of the 2 taxable years preceding the first taxable year for which the election is effective if any memberships are sold for periods in excess of 1 year but none are sold for periods in excess of 2 years, or

(c) Each of the 3 taxable years preceding the first taxable year for which the election is effective if any memberships are sold for periods in excess of 2 years.

(b) Election with consent. A taxpayer may elect with the consent of the Commissioner, to apply the provisions of section 456 to any trade or business in which it receives prepaid dues income. The request for such consent shall be in writing, signed by the taxpayer or its authorized representative, and shall be addressed to the Commissioner of Internal Revenue, Washington, D.C. 20224. The request must be filed on or before the later of the following dates:

(1) 90 days after the beginning of the first taxable year to which the election is to apply, or

(2) February 28, 1968 and should contain the information described in paragraph (a) of this section.

(c) “Within 12 months” election. (1) The “within 12 months” election shall be made by including in the statement required by paragraph (a) of this section or the request described in paragraph (b) of this section, whichever is applicable, a declaration that the taxpayer elects to include such income in gross income in the taxable year of receipt, and the amount of such income for each taxable year to which the election is to apply which has ended prior to the time such statement or request is filed. If the taxpayer is engaged in more than one trade or business for which the election under section 456 is made, it must include, in such statement or request, a declaration for each trade or business for which it wishes to make the “within 12 months” election.

(2) If the taxpayer does not make the “within 12 months” election for a trade or business at the time it makes the election under paragraph (a) or (b) of this section, but later wishes to make such election, it must apply for permission from the Commissioner. Such application shall be made in accordance with the provisions of section 446(e).

(a) Under section 456(d)(1), a taxpayer making an election under section 456 shall include in its gross income for the first taxable year to which the election applies and for each of the 2 succeeding taxable years not only that portion of prepaid dues income which is includible in gross income for each such taxable year under section 456(a), but also an additional amount equal to that portion of the total prepaid dues income received in each of the 3 taxable years preceding the first taxable year to which the election applies which would have been includible in gross income for such first taxable year and such 2 succeeding taxable years had the election under section 456 been effective during such 3 preceding taxable years. In computing such additional amounts—

(1) In the case of taxpayers who did not include in gross income for the taxable year preceding the first taxable year for which the election is effective, that portion of the prepaid dues income received in such year attributable to a liability which is to end within 12 months after the date of receipt, no effect shall be given to a “within 12 months” election made under paragraph (c) of § 1.456-6, and

(2) There shall be taken into account only prepaid dues income arising from a trade or business with respect to which an election is made under section 456 and § 1.456-6.

(b) A taxpayer who makes an election with respect to prepaid dues income, and who includes in gross income for any taxable year to which the election applies an additional amount computed under section 456(d)(1) and paragraph (a) of this section, shall be permitted under section 456(d)(2) to deduct for such taxable year and for each of the 4 succeeding taxable years an amount equal to one-fifth of such additional amount, but only to the extent that such additional amount was also included in the taxpayer's gross income for any of the 3 taxable years preceding the first taxable year to which such election applies. The taxpayer shall maintain books and records in sufficient detail to enable the district director to determine upon audit that the additional amounts were included in the taxpayer's gross income for any of the 3 taxable years preceding such first taxable year. If, however, the taxpayer ceases to exist, as described in paragraph (b) of § 1.456-4, and there is included in gross income, under such paragraph, of the year of cessation the entire portion of prepaid dues income not previously includible in gross income under section 456 for preceding taxable years (other than for amounts received prior to the first year for which an election was made), all the amounts not previously deducted under this paragraph shall be permitted as a deduction in the year of cessation of existence.

(c) The provisions of this section may be illustrated by the following example:

Section 457 provides rules for nonqualified deferred compensation plans established by eligible employers as defined under § 1.457-2(d). Eligible employers can establish either deferred compensation plans that are eligible plans and that meet the requirements of section 457(b) and §§ 1.457-3 through 1.457-10, or deferred compensation plans or arrangements that do not meet the requirements of section 457(b) and §§ 1.457-3 through 1.457-10 and that are subject to tax treatment under section 457(f) and § 1.457-11.

This section sets forth the definitions that are used under §§ 1.457-1 through 1.457-11.

(a) Amount(s) deferred. Amount(s) deferred means the total annual deferrals under an eligible plan in the current and prior years, adjusted for gain or loss. Except as provided at §§ 1.457-4(c)(1)(iii) and 1.457-6(a), amount(s) deferred includes any rollover amount held by an eligible plan as provided under § 1.457-10(e).

(b) Annual deferral(s)—(1) Annual deferral(s) means, with respect to a taxable year, the amount of compensation deferred under an eligible plan, whether by salary reduction or by nonelective employer contribution. The amount of compensation deferred under an eligible plan is taken into account as an annual deferral in the taxable year of the participant in which deferred, or, if later, the year in which the amount of compensation deferred is no longer subject to a substantial risk of forfeiture.

(2) If the amount of compensation deferred under the plan during a taxable year is not subject to a substantial risk of forfeiture, the amount taken into account as an annual deferral is not adjusted to reflect gain or loss allocable to the compensation deferred. If, however, the amount of compensation deferred under the plan during the taxable year is subject to a substantial risk of forfeiture, the amount of compensation deferred that is taken into account as an annual deferral in the taxable year in which the substantial risk of forfeiture lapses must be adjusted to reflect gain or loss allocable to the compensation deferred until the substantial risk of forfeiture lapses.

(3) If the eligible plan is a defined benefit plan within the meaning of section 414(j), the annual deferral for a taxable year is the present value of the increase during the taxable year of the participant's accrued benefit that is not subject to a substantial risk of forfeiture (disregarding any such increase attributable to prior annual deferrals). For this purpose, present value must be determined using actuarial assumptions and methods that are reasonable (both individually and in the aggregate), as determined by the Commissioner.

(4) For purposes solely of applying § 1.457-4 to determine the maximum amount of the annual deferral for a participant for a taxable year under an eligible plan, the maximum amount is reduced by the amount of any deferral for the participant under a plan described at paragraph (k)(4)(i) of this section (relating to certain plans in existence before January 1, 1987) as if that deferral were an annual deferral under another eligible plan of the employer.

(c) Beneficiary. Beneficiary means a person who is entitled to benefits in respect of a participant following the participant's death or an alternate payee as described in § 1.457-10(c).

(d) Catch-up. Catch-up amount or catch-up limitation for a participant for a taxable year means the annual deferral permitted under section 414(v) (as described in § 1.457-4(c)(2)) or section 457(b)(3) (as described in § 1.457-4(c)(3)) to the extent the amount of the annual deferral for the participant for the taxable year is permitted to exceed the plan ceiling applicable under section 457(b)(2) (as described in § 1.457-4(c)(1)).

(e) Eligible employer. Eligible employer means an entity that is a State that establishes a plan or a tax-exempt entity that establishes a plan. The performance of services as an independent contractor for a State or local government or a tax-exempt entity is treated as the performance of services for an eligible employer. The term eligible employer does not include a church as defined in section 3121(w)(3)(A), a qualified church-controlled organization as defined in section 3121(w)(3)(B), or the Federal government or any agency or instrumentality thereof. Thus, for example, a nursing home which is associated with a church, but which is not itself a church (as defined in section 3121(w)(3)(A)) or a qualified church-controlled organization as defined in section 3121(w)(3)(B)), would be an eligible employer if it is a tax-exempt entity as defined in paragraph (m) of this section.

(f) Eligible plan. An eligible plan is a plan that meets the requirements of §§ 1.457-3 through 1.457-10 that is established and maintained by an eligible employer. An eligible governmental plan is an eligible plan that is established and maintained by an eligible employer as defined in paragraph (l) of this section. An arrangement does not fail to constitute a single eligible governmental plan merely because the arrangement is funded through more than one trustee, custodian, or insurance carrier. An eligible plan of a tax-exempt entity is an eligible plan that is established and maintained by an eligible employer as defined in paragraph (m) of this section.

(g) Includible compensation. Includible compensation of a participant means, with respect to a taxable year, the participant's compensation, as defined in section 415(c)(3), for services performed for the eligible employer. The amount of includible compensation is determined without regard to any community property laws.

(h) Ineligible plan. Ineligible plan means a plan established and maintained by an eligible employer that is not maintained in accordance with §§ 1.457-3 through 1.457-10. A plan that is not established by an eligible employer as defined in paragraph (e) of this section is neither an eligible nor an ineligible plan.

(i) Nonelective employer contribution. A nonelective employer contribution is a contribution made by an eligible employer for the participant with respect to which the participant does not have the choice to receive the contribution in cash or property. Solely for purposes of section 457 and §§ 1.457-2 through 1.457-11, the term nonelective employer contribution includes employer contributions that would be described in section 401(m) if they were contributions to a qualified plan.

(j) Participant. Participant in an eligible plan means an individual who is currently deferring compensation, or who has previously deferred compensation under the plan by salary reduction or by nonelective employer contribution and who has not received a distribution of his or her entire benefit under the eligible plan. Only individuals who perform services for the eligible employer, either as an employee or as an independent contractor, may defer compensation under the eligible plan.

(k) Plan. Plan includes any agreement or arrangement between an eligible employer and a participant or participants (including an individual employment agreement) under which the payment of compensation is deferred (whether by salary reduction or by nonelective employer contribution). The following types of plans are not treated as agreements or arrangements under which compensation is deferred: a bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, or death benefit plan described in section 457(e)(11)(A)(i) and any plan paying length of service awards to bona fide volunteers (and their beneficiaries) on account of qualified services performed by such volunteers as described in section 457(e)(11)(A)(ii). Further, the term plan does not include any of the following (and section 457 and §§ 1.457-2 through 1.457-11 do not apply to any of the following)—

(1) Any nonelective deferred compensation under which all individuals (other than those who have not satisfied any applicable initial service requirement) with the same relationship with the eligible employer are covered under the same plan with no individual variations or options under the plan as described in section 457(e)(12), but only to the extent the compensation is attributable to services performed as an independent contractor;

(2) An agreement or arrangement described in § 1.457-11(b);

(3) Any plan satisfying the conditions in section 1107(c)(4) of the Tax Reform Act of 1986 (100 Stat. 2494) (TRA '86) (relating to certain plans for State judges); and

(4) Any of the following plans or arrangements (to which specific transitional statutory exclusions apply)—

(i) A plan or arrangement of a tax-exempt entity in existence prior to January 1, 1987, if the conditions of section 1107(c)(3)(B) of the TRA '86, as amended by section 1011(e)(6) of the Technical and Miscellaneous Revenue Act of 1988 (102 Stat. 3700) (TAMRA), are satisfied (see § 1.457-2(b)(4) for a special rule regarding such plan);

(ii) A collectively bargained nonelective deferred compensation plan in effect on December 31, 1987, if the conditions of section 6064(d)(2) of TAMRA are satisfied;

(iii) Amounts described in section 6064(d)(3) of TAMRA (relating to certain nonelective deferred compensation arrangements in effect before 1989); and

(iv) Any plan satisfying the conditions in section 1107(c)(4) or (5) of TRA '86 (relating to certain plans for certain individuals with respect to which the Service issued guidance before 1977).

(l) State. State means a State (treating the District of Columbia as a State as provided under section 7701(a)(10)), a political subdivision of a State, and any agency or instrumentality of a State.

(m) Tax-exempt entity. Tax-exempt entity includes any organization exempt from tax under subtitle A of the Internal Revenue Code, except that a governmental unit (including an international governmental organization) is not a tax-exempt entity.

(n) Trust. Trust means a trust described under section 457(g) and § 1.457-8. Custodial accounts and contracts described in section 401(f) are treated as trusts under the rules described in § 1.457-8(a)(2).

(a) Compliance in form and operation. An eligible plan is a written plan established and maintained by an eligible employer that is maintained, in both form and operation, in accordance with the requirements of §§ 1.457-4 through 1.457-10. An eligible plan must contain all the material terms and conditions for benefits under the plan. An eligible plan may contain certain optional features not required for plan eligibility under section 457(b), such as distributions for unforeseeable emergencies, loans, plan-to-plan transfers, additional deferral elections, acceptance of rollovers to the plan, and distributions of smaller accounts to eligible participants. However, except as otherwise specifically provided in §§ 1.457-4 through 1.457-10, if an eligible plan contains any optional provisions, the optional provisions must meet, in both form and operation, the relevant requirements under section 457 and §§ 1.457-2 through 1.457-10.

(b) Treatment as single plan. In any case in which multiple plans are used to avoid or evade the requirements of §§ 1.457-4 through 1.457-10, the Commissioner may apply the rules under §§ 1.457-4 through 1.457-10 as if the plans were a single plan. See also § 1.457-4(c)(3)(v) (requiring an eligible employer to have no more than one normal retirement age for each participant under all of the eligible plans it sponsors), the second sentence of § 1.457-4(e)(2) (treating deferrals under all eligible plans under which an individual participates by virtue of his or her relationship with a single employer as a single plan for purposes of determining excess deferrals), and § 1.457-5 (combining annual deferrals under all eligible plans).

(a) Taxation of annual deferrals. Annual deferrals that satisfy the requirements of paragraphs (b) and (c) of this section are excluded from the gross income of a participant in the year deferred or contributed and are not includible in gross income until paid to the participant in the case of an eligible governmental plan, or until paid or otherwise made available to the participant in the case of an eligible plan of a tax-exempt entity. See § 1.457-7.

(b) Agreement for deferral. In order to be an eligible plan, the plan must provide that compensation may be deferred for any calendar month by salary reduction only if an agreement providing for the deferral has been entered into before the first day of the month in which the compensation is paid or made available. A new employee may defer compensation payable in the calendar month during which the participant first becomes an employee if an agreement providing for the deferral is entered into on or before the first day on which the participant performs services for the eligible employer. An eligible plan may provide that if a participant enters into an agreement providing for deferral by salary reduction under the plan, the agreement will remain in effect until the participant revokes or alters the terms of the agreement. Nonelective employer contributions are treated as being made under an agreement entered into before the first day of the calendar month.

(c) Maximum deferral limitations—(1) Basic annual limitation. (i) Except as described in paragraphs (c)(2) and (3) of this section, in order to be an eligible plan, the plan must provide that the annual deferral amount for a taxable year (the plan ceiling) may not exceed the lesser of—

(A) The applicable annual dollar amount specified in section 457(e)(15): $11,000 for 2002; $12,000 for 2003; $13,000 for 2004; $14,000 for 2005; and $15,000 for 2006 and thereafter. After 2006, the $15,000 amount is adjusted for cost-of-living in the manner described in paragraph (c)(4) of this section; or

(B) 100 percent of the participant's includible compensation for the taxable year.

(ii) The amount of annual deferrals permitted by the 100 percent of includible compensation limitation under paragraph (c)(1)(i)(B) of this section is determined under section 457(e)(5) and § 1.457-2(g).

(iii) For purposes of determining the plan ceiling under this paragraph (c), the annual deferral amount does not include any rollover amounts received by the eligible plan under § 1.457-10(e).

(iv) The provisions of this paragraph (c)(1) are illustrated by the following examples:

(2) Age 50 catch-up—(i) In general. In accordance with section 414(v) and the regulations thereunder, an eligible governmental plan may provide for catch-up contributions for a participant who is age 50 by the end of the year, provided that such age 50 catch-up contributions do not exceed the catch-up limit under section 414(v)(2) for the taxable year. The maximum amount of age 50 catch-up contributions for a taxable year under section 414(v) is as follows: $1,000 for 2002; $2,000 for 2003; $3,000 for 2004; $4,000 for 2005; and $5,000 for 2006 and thereafter. After 2006, the $5,000 amount is adjusted for cost-of-living. For additional guidance, see regulations under section 414(v).

(ii) Coordination with special section 457 catch-up. In accordance with sections 414(v)(6)(C) and 457(e)(18), the age 50 catch-up described in this paragraph (c)(2) does not apply for any taxable year for which a higher limitation applies under the special section 457 catch-up under paragraph (c)(3) of this section. Thus, for purposes of this paragraph (c)(2)(ii) and paragraph (c)(3) of this section, the special section 457 catch-up under paragraph (c)(3) of this section applies for any taxable year if and only if the plan ceiling taking into account paragraph (c)(1) of this section and the special section 457 catch-up described in paragraph (c)(3) of this section (and disregarding the age 50 catch-up described in this paragraph (c)(2)) is larger than the plan ceiling taking into account paragraph (c)(1) of this section and the age 50 catch-up described in this paragraph (c)(2) (and disregarding the special section 457 catch-up described in paragraph (c)(3) of this section). Thus, if a plan so provides, a participant who is eligible for the age 50 catch-up for a year and for whom the year is also one of the participant's last three taxable years ending before the participant attains normal retirement age is eligible for the larger of—

(A) The plan ceiling under paragraph (c)(1) of this section and the age 50 catch-up described in this paragraph (c)(2) (and disregarding the special section 457 catch-up described in paragraph (c)(3) of this section) or

(B) The plan ceiling under paragraph (c)(1) of this section and the special section 457 catch-up described in paragraph (c)(3) of this section (and disregarding the age 50 catch-up described in this paragraph (c)(2)).

(iii) Examples. The provisions of this paragraph (c)(2) are illustrated by the following examples:

(3) Special section 457 catch-up—(i) In general. Except as provided in paragraph (c)(2)(ii) of this section, an eligible plan may provide that, for one or more of the participant's last three taxable years ending before the participant attains normal retirement age, the plan ceiling is an amount not in excess of the lesser of—

(A) Twice the dollar amount in effect under paragraph (c)(1)(i)(A) of this section; or

(B) The underutilized limitation determined under paragraph (c)(3)(ii) of this section.

(ii) Underutilized limitation. The underutilized amount determined under this paragraph (c)(3)(ii) is the sum of—

(A) The plan ceiling established under paragraph (c)(1) of this section for the taxable year; plus

(B) The plan ceiling established under paragraph (c)(1) of this section (or under section 457(b)(2) for any year before the applicability date of this section) for any prior taxable year or years, less the amount of annual deferrals under the plan for such prior taxable year or years (disregarding any annual deferrals under the plan permitted under the age 50 catch-up under paragraph (c)(2) of this section).

(iii) Determining underutilized limitation under paragraph (c)(3)(ii)(B) of this section. A prior taxable year is taken into account under paragraph (c)(3)(ii)(B) of this section only if it is a year beginning after December 31, 1978, in which the participant was eligible to participate in the plan, and in which compensation deferred (if any) under the plan during the year was subject to a plan ceiling established under paragraph (c)(1) of this section. This paragraph (c)(3)(iii) is subject to the special rules in paragraph (c)(3)(iv) of this section.

(iv) Special rules concerning application of the coordination limit for years prior to 2002 for purposes of determining the underutilized limitation—(A) General rule. For purposes of determining the underutilized limitation for years prior to 2002, participants remain subject to the rules in effect prior to the repeal of the coordination limitation under section 457(c)(2). Thus, the applicable basic annual limitation under paragraph (c)(1) of this section and the special section 457 catch-up under this paragraph (c)(3) for years in effect prior to 2002 are reduced, for purposes of determining a participant's underutilized amount under a plan, by amounts excluded from the participant's income for any prior taxable year by reason of a nonelective employer contribution, salary reduction or elective contribution under any other eligible section 457(b) plan, or a salary reduction or elective contribution under any 401(k) qualified cash or deferred arrangement, section 402(h)(1)(B) simplified employee pension (SARSEP), section 403(b) annuity contract, and section 408(p) simple retirement account, or under any plan for which a deduction is allowed because of a contribution to an organization described in section 501(c)(18) (pre-2002 coordination plans). Similarly, in applying the section 457(b)(2)(B) limitation for includible compensation for years prior to 2002, the limitation is 33 1/3 percent of the participant's compensation includible in gross income.

(B) Coordination limitation applied to participant. For purposes of determining the underutilized limitation for years prior to 2002, the coordination limitation applies to pre-2002 coordination plans of all employers for whom a participant has performed services, whether or not those are plans of the participant's current eligible employer. Thus, for purposes of determining the amount excluded from a participant's gross income in any prior taxable year under paragraph (c)(3)(ii)(B) of this section, the participant's annual deferrals under an eligible plan, and salary reduction or elective deferrals under all other pre-2002 coordination plans, must be determined on an aggregate basis. To the extent that the combined deferrals for years prior to 2002 exceeded the maximum deferral limitations, the amount is treated as an excess deferral under paragraph (e) of this section for those prior years.

(C) Special rule where no annual deferrals under the eligible plan. A participant who, although eligible, did not defer any compensation under the eligible plan in any year before 2002 is not subject to the coordinated deferral limit, even though the participant may have deferred compensation under one of the other pre-2002 coordination plans. An individual is treated as not having deferred compensation under an eligible plan for a prior taxable year if all annual deferrals under the plan are distributed in accordance with paragraph (e) of this section. Thus, to the extent that a participant participated solely in one or more of the other pre-2002 coordination plans during a prior taxable year (and not the eligible plan), the participant is not subject to the coordinated limitation for that prior taxable year. However, the participant is treated as having deferred an amount in a prior taxable year, for purposes of determining the underutilized limitation for that prior taxable year under this paragraph (c)(3)(iv)(C), to the extent of the participant's aggregate salary reduction contributions and elective deferrals under all pre-2002 coordination plans up to the maximum deferral limitations in effect under section 457(b) for that prior taxable year. To the extent an employer did not offer an eligible plan to an individual in a prior given year, no underutilized limitation is available to the individual for that prior year, even if the employee subsequently becomes eligible to participate in an eligible plan of the employer.

(D) Examples. The provisions of this paragraph (c)(3)(iv) are illustrated by the following examples:

(v) Normal retirement age—(A) General rule. For purposes of the special section 457 catch-up in this paragraph (c)(3), a plan must specify the normal retirement age under the plan. A plan may define normal retirement age as any age that is on or after the earlier of age 65 or the age at which participants have the right to retire and receive, under the basic defined benefit pension plan of the State or tax-exempt entity (or a money purchase pension plan in which the participant also participates if the participant is not eligible to participate in a defined benefit plan), immediate retirement benefits without actuarial or similar reduction because of retirement before some later specified age, and that is not later than age 70 1/2. Alternatively, a plan may provide that a participant is allowed to designate a normal retirement age within these ages. For purposes of the special section 457 catch-up in this paragraph (c)(3), an entity sponsoring more than one eligible plan may not permit a participant to have more than one normal retirement age under the eligible plans it sponsors.

(B) Special rule for eligible plans of qualified police or firefighters. An eligible plan with participants that include qualified police or firefighters as defined under section 415(b)(2)(H)(ii)(I) may designate a normal retirement age for such qualified police or firefighters that is earlier than the earliest normal retirement age designated under the general rule of paragraph (c)(3)(i)(A) of this section, but in no event may the normal retirement age be earlier than age 40. Alternatively, a plan may allow a qualified police or firefighter participant to designate a normal retirement age that is between age 40 and age 70 1/2.

(vi) Examples. The provisions of this paragraph (c)(3) are illustrated by the following examples:

(4) Cost-of-living adjustment. For years beginning after December 31, 2006, the $15,000 dollar limitation in paragraph (c)(1)(i)(A) of this section will be adjusted to take into account increases in the cost-of-living. The adjustment in the dollar limitation is made at the same time and in the same manner as under section 415(d) (relating to qualified plans under section 401(a)), except that the base period is the calendar quarter beginning July 1, 2005 and any increase which is not a multiple of $500 will be rounded to the next lowest multiple of $500.

(d) Deferrals after severance from employment, including sick, vacation, and back pay under an eligible plan—(1) In general. An eligible plan may provide that a participant who has not had a severance from employment may elect to defer accumulated sick pay, accumulated vacation pay, and back pay under an eligible plan if the requirements of section 457(b) are satisfied. For example, the plan must provide, in accordance with paragraph (b) of this section, that these amounts may be deferred for any calendar month only if an agreement providing for the deferral is entered into before the beginning of the month in which the amounts would otherwise be paid or made available and the participant is an employee on the date the amounts would otherwise be paid or made available. For purposes of section 457, compensation that would otherwise be paid for a payroll period that begins before severance from employment is treated as an amount that would otherwise be paid or made available before an employee has a severance from employment. In addition, deferrals may be made for former employees with respect to compensation described in § 1.415(c)-2(e)(3)(i) (relating to certain compensation paid by the later of 2 1/2 months after severance from employment or the end of the limitation year that includes the date of severance from employment). For this purpose, the calendar year is substituted for the limitation year. In addition, compensation described in § 1.415(c)-2(e)(4), (g)(4), or (g)(7) (relating to compensation paid to participants who are permanently and totally disabled or compensation relating to qualified military service under section 414(u)), provided those amounts represent compensation described in § 1.415(c)-2(e)(3)(i).

(2) Examples. The provisions of this paragraph (d) are illustrated by the following examples:

(e) Excess deferrals under an eligible plan—(1) In general. Any amount deferred under an eligible plan for the taxable year of a participant that exceeds the maximum deferral limitations set forth in paragraphs (c)(1) through (3) of this section, and any amount that exceeds the individual limitation under § 1.457-5, constitutes an excess deferral that is taxable in accordance with § 1.457-11 for that taxable year. Thus, an excess deferral is includible in gross income in the taxable year deferred or, if later, the first taxable year in which there is no substantial risk of forfeiture.

(2) Excess deferrals under an eligible governmental plan other than as a result of the individual limitation. In order to be an eligible governmental plan, the plan must provide that any excess deferral resulting from a failure of a plan to apply the limitations of paragraphs (c)(1) through (3) of this section to amounts deferred under the eligible plan (computed without regard to the individual limitation under § 1.457-5) will be distributed to the participant, with allocable net income, as soon as administratively practicable after the plan determines that the amount is an excess deferral. For purposes of determining whether there is an excess deferral resulting from a failure of a plan to apply the limitations of paragraphs (c)(1) through (3) of this section, all plans under which an individual participates by virtue of his or her relationship with a single employer are treated as a single plan (without regard to any differences in funding). An eligible governmental plan does not fail to satisfy the requirements of paragraphs (a) through (d) of this section or §§ 1.457-6 through 1.457-10 (including the distribution rules under § 1.457-6 and the funding rules under § 1.457-8) solely by reason of a distribution made under this paragraph (e)(2). If such excess deferrals are not corrected by distribution under this paragraph (e)(2), the plan will be an ineligible plan under which benefits are taxable in accordance with § 1.457-11.

(3) Excess deferrals under an eligible plan of a tax-exempt employer other than as a result of the individual limitation. If a plan of a tax-exempt employer fails to comply with the limitations of paragraphs (c)(1) through (3) of this section, the plan will be an ineligible plan under which benefits are taxable in accordance with § 1.457-11. However, a plan may distribute to a participant any excess deferrals (and any income allocable to such amount) not later than the first April 15 following the close of the taxable year of the excess deferrals. In such a case, the plan will continue to be treated as an eligible plan. However, any excess deferral is included in the gross income of a participant for the taxable year of the excess deferral. If the excess deferrals are not corrected by distribution under this paragraph (e)(3), the plan is an ineligible plan under which benefits are taxable in accordance with § 1.457-11. For purposes of determining whether there is an excess deferral resulting from a failure of a plan to apply the limitations of paragraphs (c)(1) through (3) of this section, all eligible plans under which an individual participates by virtue of his or her relationship with a single employer are treated as a single plan.

(4) Excess deferrals arising from application of the individual limitation. An eligible plan may provide that an excess deferral that is a result solely of a failure to comply with the individual limitation under § 1.457-5 for a taxable year may be distributed to the participant, with allocable net income, as soon as administratively practicable after the plan determines that the amount is an excess deferral. An eligible plan does not fail to satisfy the requirements of paragraphs (a) through (d) of this section or §§ 1.457-6 through 1.457-10 (including the distribution rules under § 1.457-6 and the funding rules under § 1.457-8) solely by reason of a distribution made under this paragraph (e)(4). Although a plan will still maintain eligible status if excess deferrals are not distributed under this paragraph (e)(4), a participant must include the excess amounts in income as provided in paragraph (e)(1) of this section.

(5) Examples. The provisions of this paragraph (e) are illustrated by the following examples:

(a) General rule. The individual limitation under section 457(c) and this section equals the basic annual deferral limitation under § 1.457-4(c)(1)(i)(A), plus either the age 50 catch-up amount under § 1.457-4(c)(2), or the special section 457 catch-up amount under § 1.457-4(c)(3), applied by taking into account the combined annual deferral for the participant for any taxable year under all eligible plans. While an eligible plan may include provisions under which it will limit deferrals to meet the individual limitation under section 457(c) and this section, annual deferrals by a participant that exceed the individual limit under section 457(c) and this section (but do not exceed the limits under § 1.457-4(c)) will not cause a plan to lose its eligible status. However, to the extent the combined annual deferrals for a participant for any taxable year exceed the individual limitation under section 457(c) and this section for that year, the amounts are treated as excess deferrals as described in § 1.457-4(e).

(b) Limitation applied to participant. The individual limitation in this section applies to eligible plans of all employers for whom a participant has performed services, including both eligible governmental plans and eligible plans of a tax-exempt entity and both eligible plans of the employer and eligible plans of other employers. Thus, for purposes of determining the amount excluded from a participant's gross income in any taxable year (including the underutilized limitation under § 1.457-4 (c)(3)(ii)(B)), the participant's annual deferral under an eligible plan, and the participant's annual deferrals under all other eligible plans, must be determined on an aggregate basis. To the extent that the combined annual deferral amount exceeds the maximum deferral limitation applicable under § 1.457-4 (c)(1)(i)(A), (c)(2), or (c)(3), the amount is treated as an excess deferral under § 1.457-4(e).

(c) Special rules for catch-up amounts under multiple eligible plans. For purposes of applying section 457(c) and this section, the special section 457 catch-up under § 1.457-4 (c)(3) is taken into account only to the extent that an annual deferral is made for a participant under an eligible plan as a result of plan provisions permitted under § 1.457-4 (c)(3). In addition, if a participant has annual deferrals under more than one eligible plan and the applicable catch-up amount under § 1.457-4 (c)(2) or (3) is not the same for each such eligible plan for the taxable year, section 457(c) and this section are applied using the catch-up amount under whichever plan has the largest catch-up amount applicable to the participant.

(d) Examples. The provisions of this section are illustrated by the following examples:

(a) In general. Except as provided in paragraph (c) of this section (relating to distributions on account of an unforeseeable emergency), paragraph (e) of this section (relating to distributions of small accounts), § 1.457-10(a) (relating to plan terminations), or § 1.457-10(c) (relating to domestic relations orders), amounts deferred under an eligible plan may not be paid to a participant or beneficiary before the participant has a severance from employment with the eligible employer or when the participant attains age 70 1/2, if earlier. For rules relating to loans, see paragraph (f) of this section. This section does not apply to distributions of excess amounts under § 1.457-4(e). However, except to the extent set forth by the Commissioner in revenue rulings, notices, and other guidance published in the Internal Revenue Bulletin (see § 601.601(d) of this chapter), this section applies to amounts held in a separate account for eligible rollover distributions maintained by an eligible governmental plan as described in § 1.457-10(e)(2).

(b) Severance from employment—(1) Employees. An employee has a severance from employment with the eligible employer if the employee dies, retires, or otherwise has a severance from employment with the eligible employer. See regulations under section 401(k) for additional guidance concerning severance from employment.

(2) Independent contractors—(i) In general. An independent contractor is considered to have a severance from employment with the eligible employer upon the expiration of the contract (or in the case of more than one contract, all contracts) under which services are performed for the eligible employer if the expiration constitutes a good-faith and complete termination of the contractual relationship. An expiration does not constitute a good faith and complete termination of the contractual relationship if the eligible employer anticipates a renewal of a contractual relationship or the independent contractor becoming an employee. For this purpose, an eligible employer is considered to anticipate the renewal of the contractual relationship with an independent contractor if it intends to contract again for the services provided under the expired contract, and neither the eligible employer nor the independent contractor has eliminated the independent contractor as a possible provider of services under any such new contract. Further, an eligible employer is considered to intend to contract again for the services provided under an expired contract if the eligible employer's doing so is conditioned only upon incurring a need for the services, the availability of funds, or both.

(ii) Special rule. Notwithstanding paragraph (b)(2)(i) of this section, the plan is considered to satisfy the requirement described in paragraph (a) of this section that no amounts deferred under the plan be paid or made available to the participant before the participant has a severance from employment with the eligible employer if, with respect to amounts payable to a participant who is an independent contractor, an eligible plan provides that—

(A) No amount will be paid to the participant before a date at least 12 months after the day on which the contract expires under which services are performed for the eligible employer (or, in the case of more than one contract, all such contracts expire); and

(B) No amount payable to the participant on that date will be paid to the participant if, after the expiration of the contract (or contracts) and before that date, the participant performs services for the eligible employer as an independent contractor or an employee.

(c) Rules applicable to distributions for unforeseeable emergencies—(1) In general. An eligible plan may permit a distribution to a participant or beneficiary for an unforeseeable emergency. The distribution must satisfy the requirements of paragraph (c)(2) of this section.

(2) Requirements—(i) Unforeseeable emergency defined. An unforeseeable emergency must be defined in the plan as a severe financial hardship of the participant or beneficiary resulting from an illness or accident of the participant or beneficiary, the participant's or beneficiary's spouse, or the participant's or beneficiary's dependent (as defined in section 152, and, for taxable years beginning on or after January 1, 2005, without regard to section 152(b)(1), (b)(2), and (d)(1)(B)); loss of the participant's or beneficiary's property due to casualty (including the need to rebuild a home following damage to a home not otherwise covered by homeowner's insurance, such as damage that is the result of a natural disaster); or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant or the beneficiary. For example, the imminent foreclosure of or eviction from the participant's or beneficiary's primary residence may constitute an unforeseeable emergency. In addition, the need to pay for medical expenses, including non-refundable deductibles, as well as for the cost of prescription drug medication, may constitute an unforeseeable emergency. Finally, the need to pay for the funeral expenses of a spouse or a dependent (as defined in section 152, and, for taxable years beginning on or after January 1, 2005, without regard to section 152(b)(1), (b)(2), and (d)(1)(B)) of a participant or beneficiary may also constitute an unforeseeable emergency. Except as otherwise specifically provided in this paragraph (c)(2)(i), the purchase of a home and the payment of college tuition are not unforeseeable emergencies under this paragraph (c)(2)(i).

(ii) Unforeseeable emergency distribution standard. Whether a participant or beneficiary is faced with an unforeseeable emergency permitting a distribution under this paragraph (c) is to be determined based on the relevant facts and circumstances of each case, but, in any case, a distribution on account of unforeseeable emergency may not be made to the extent that such emergency is or may be relieved through reimbursement or compensation from insurance or otherwise, by liquidation of the participant's assets, to the extent the liquidation of such assets would not itself cause severe financial hardship, or by cessation of deferrals under the plan.

(iii) Distribution necessary to satisfy emergency need. Distributions because of an unforeseeable emergency must be limited to the amount reasonably necessary to satisfy the emergency need (which may include any amounts necessary to pay for any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution).

(d) Minimum required distributions for eligible plans. In order to be an eligible plan, a plan must meet the distribution requirements of section 457(d)(1) and (2). Under section 457(d)(2), a plan must meet the minimum distribution requirements of section 401(a)(9). See section 401(a)(9) and the regulations thereunder for these requirements. For taxable years beginning on or after January 1, 2025, if an eligible plan is subject to the rules of § 1.401(a)(9)-5, then the plan must meet the requirements of section 401(a)(9)(H). The preceding sentence applies to an eligible plan maintained by any eligible employer (including an eligible plan of a tax-exempt entity).

(e) Distributions of smaller accounts—(1) In general. An eligible plan may provide for a distribution of all or a portion of a participant's benefit if this paragraph (e)(1) is satisfied. This paragraph (e)(1) is satisfied if the participant's total amount deferred (the participant's total account balance) which is not attributable to rollover contributions (as defined in section 411(a)(11)(D)) is not in excess of the dollar limit under section 411(a)(11)(A), no amount has been deferred under the plan by or for the participant during the two-year period ending on the date of the distribution, and there has been no prior distribution under the plan to the participant under this paragraph (e). An eligible plan is not required to permit distributions under this paragraph (e).

(2) Alternative provisions possible. Consistent with the provisions of paragraph (e)(1) of this section, a plan may provide that the total amount deferred for a participant or beneficiary will be distributed automatically to the participant or beneficiary if the requirements of paragraph (e)(1) of this section are met. Alternatively, if the requirements of paragraph (e)(1) of this section are met, the plan may provide for the total amount deferred for a participant or beneficiary to be distributed to the participant or beneficiary only if the participant or beneficiary so elects. The plan is permitted to substitute a specified dollar amount that is less than the total amount deferred. In addition, these two alternatives can be combined; for example, a plan could provide for automatic distributions for up to $500, but allow a participant or beneficiary to elect a distribution if the total account balance is above $500.

(f) Loans from eligible plans—(1) Eligible plans of tax-exempt entities. If a participant or beneficiary receives (directly or indirectly) any amount deferred as a loan from an eligible plan of a tax-exempt entity, that amount will be treated as having been paid or made available to the individual as a distribution under the plan, in violation of the distribution requirements of section 457(d).

(2) Eligible governmental plans. The determination of whether the availability of a loan, the making of a loan, or a failure to repay a loan made from a trustee (or a person treated as a trustee under section 457(g)) of an eligible governmental plan to a participant or beneficiary is treated as a distribution (directly or indirectly) for purposes of this section, and the determination of whether the availability of the loan, the making of the loan, or a failure to repay the loan is in any other respect a violation of the requirements of section 457(b) and the regulations, depends on the facts and circumstances. Among the facts and circumstances are whether the loan has a fixed repayment schedule and bears a reasonable rate of interest, and whether there are repayment safeguards to which a prudent lender would adhere. Thus, for example, a loan must bear a reasonable rate of interest in order to satisfy the exclusive benefit requirement of section 457(g)(1) and § 1.457-8(a)(1). See also § 1.457-7(b)(3) relating to the application of section 72(p) with respect to the taxation of a loan made under an eligible governmental plan, and § 1.72(p)-1 relating to section 72(p)(2).

(3) Example. The provisions of paragraph (f)(2) of this section are illustrated by the following example:

(a) General rules for when amounts are included in gross income. The rules for determining when an amount deferred under an eligible plan is includible in the gross income of a participant or beneficiary depend on whether the plan is an eligible governmental plan or an eligible plan of a tax-exempt entity. Paragraph (b) of this section sets forth the rules for an eligible governmental plan. Paragraph (c) of this section sets forth the rules for an eligible plan of a tax-exempt entity.

(b) Amounts included in gross income under an eligible governmental plan—(1) Amounts included in gross income in year paid under an eligible governmental plan. Except as provided in paragraphs (b)(2) and (3) of this section (or in § 1.457-10(c) relating to payments to a spouse or former spouse pursuant to a qualified domestic relations order), amounts deferred under an eligible governmental plan are includible in the gross income of a participant or beneficiary for the taxable year in which paid to the participant or beneficiary under the plan.

(2) Rollovers to individual retirement arrangements and other eligible retirement plans. A trustee-to-trustee transfer in accordance with section 401(a)(31) (generally referred to as a direct rollover) from an eligible government plan is not includible in gross income of a participant or beneficiary in the year transferred. In addition, any payment made from an eligible government plan in the form of an eligible rollover distribution (as defined in section 402(c)(4)) is not includible in gross income in the year paid to the extent the payment is transferred to an eligible retirement plan (as defined in section 402(c)(8)(B)) within 60 days, including the transfer to the eligible retirement plan of any property distributed from the eligible governmental plan. For this purpose, the rules of section 402(c)(2) through (7) and (9) apply. Any trustee-to-trustee transfer under this paragraph (b)(2) from an eligible government plan is a distribution that is subject to the distribution requirements of § 1.457-6.

(3) Amounts taxable under section 72(p)(1). In accordance with section 72(p), the amount of any loan from an eligible governmental plan to a participant or beneficiary (including any pledge or assignment treated as a loan under section 72(p)(1)(B)) is treated as having been received as a distribution from the plan under section 72(p)(1), except to the extent set forth in section 72(p)(2) (relating to loans that do not exceed a maximum amount and that are repayable in accordance with certain terms) and § 1.72(p)-1. Thus, except to the extent a loan satisfies section 72(p)(2), any amount loaned from an eligible governmental plan to a participant or beneficiary (including any pledge or assignment treated as a loan under section 72(p)(1)(B)) is includible in the gross income of the participant or beneficiary for the taxable year in which the loan is made. See generally § 1.72(p)-1.

(4) Examples. The provisions of this paragraph (b) are illustrated by the following examples:

(c) Amounts included in gross income under an eligible plan of a tax-exempt entity—(1) Amounts included in gross income in year paid or made available under an eligible plan of a tax-exempt entity. Amounts deferred under an eligible plan of a tax-exempt entity are includible in the gross income of a participant or beneficiary for the taxable year in which paid or otherwise made available to the participant or beneficiary under the plan. Thus, amounts deferred under an eligible plan of a tax-exempt entity are includible in the gross income of the participant or beneficiary in the year the amounts are first made available under the terms of the plan, even if the plan has not distributed the amounts deferred. Amounts deferred under an eligible plan of a tax-exempt entity are not considered made available to the participant or beneficiary solely because the participant or beneficiary is permitted to choose among various investments under the plan.

(2) When amounts deferred are considered to be made available under an eligible plan of a tax-exempt entity—(i) General rule. Except as provided in paragraphs (c)(2)(ii) through (iv) of this section, amounts deferred under an eligible plan of a tax-exempt entity are considered made available (and, thus, are includible in the gross income of the participant or beneficiary under this paragraph (c)) at the earliest date, on or after severance from employment, on which the plan allows distributions to commence, but in no event later than the date on which distributions must commence pursuant to section 401(a)(9). For example, in the case of a plan that permits distribution to commence on the date that is 60 days after the close of the plan year in which the participant has a severance from employment with the eligible employer, amounts deferred are considered to be made available on that date. However, distributions deferred in accordance with paragraphs (c)(2)(ii) through (iv) of this section are not considered made available prior to the applicable date under paragraphs (c)(2)(ii) through (iv) of this section. In addition, no portion of a participant or beneficiary's account is treated as made available (and thus currently includible in income) under an eligible plan of a tax-exempt entity merely because the participant or beneficiary under the plan may elect to receive a distribution in any of the following circumstances:

(A) A distribution in the event of an unforeseeable emergency to the extent the distribution is permitted under § 1.457-6(c).

(B) A distribution from an account for which the total amount deferred is not in excess of the dollar limit under section 411(a)(11)(A) to the extent the distribution is permitted under § 1.457-6(e).

(ii) Initial election to defer commencement of distributions—(A) In general. An eligible plan of a tax-exempt entity may provide a period for making an initial election during which the participant or beneficiary may elect, in accordance with the terms of the plan, to defer the payment of some or all of the amounts deferred to a fixed or determinable future time. The period for making this initial election must expire prior to the first time that any such amounts would be considered made available under the plan under paragraph (c)(2)(i) of this section.

(B) Failure to make initial election to defer commencement of distributions. Generally, if no initial election is made by a participant or beneficiary under this paragraph (c)(2)(ii), then the amounts deferred under an eligible plan of a tax-exempt entity are considered made available and taxable to the participant or beneficiary in accordance with paragraph (c)(2)(i) of this section at the earliest time, on or after severance from employment (but in no event later than the date on which distributions must commence pursuant to section 401(a)(9)), that distribution is permitted to commence under the terms of the plan. However, the plan may provide for a default payment schedule that applies if no election is made. If the plan provides for a default payment schedule, the amounts deferred are includible in the gross income of the participant or beneficiary in the year the amounts deferred are first made available under the terms of the default payment schedule.

(iii) Additional election to defer commencement of distribution. An eligible plan of a tax-exempt entity is permitted to provide that a participant or beneficiary who has made an initial election under paragraph (c)(2)(ii)(A) of this section may make one additional election to defer (but not accelerate) commencement of distributions under the plan before distributions have commenced in accordance with the initial deferral election under paragraph (c)(2)(ii)(A) of this section. Amounts payable to a participant or beneficiary under an eligible plan of a tax-exempt entity are not treated as made available merely because the plan allows the participant to make an additional election under this paragraph (c)(2)(iii). A participant or beneficiary is not precluded from making an additional election to defer commencement of distributions merely because the participant or beneficiary has previously received a distribution under § 1.457-6(c) because of an unforeseeable emergency, has received a distribution of smaller amounts under § 1.457-6(e), has made (and revoked) other deferral or method of payment elections within the initial election period, or is subject to a default payment schedule under which the commencement of benefits is deferred (for example, until a participant is age 65).

(iv) Election as to method of payment. An eligible plan of a tax-exempt entity may provide that an election as to the method of payment under the plan may be made at any time prior to the time the amounts are distributed in accordance with the participant or beneficiary's initial or additional election to defer commencement of distributions under paragraph (c)(2)(ii) or (iii) of this section. Where no method of payment is elected, the entire amount deferred will be includible in the gross income of the participant or beneficiary when the amounts first become made available in accordance with a participant's initial or additional elections to defer under paragraphs (c)(2)(ii) and (iii) of this section, unless the eligible plan provides for a default method of payment (in which case amounts are considered made available and taxable when paid under the terms of the default payment schedule). A method of payment means a distribution or a series of periodic distributions commencing on a date determined in accordance with paragraph (c)(2)(ii) or (iii) of this section.

(3) Examples. The provisions of this paragraph (c) are illustrated by the following examples:

(a) Eligible governmental plans—(1) In general. In order to be an eligible governmental plan, all amounts deferred under the plan, all property and rights purchased with such amounts, and all income attributable to such amounts, property, or rights, must be held in trust for the exclusive benefit of participants and their beneficiaries. A trust described in this paragraph (a) that also meets the requirements of §§ 1.457-3 through 1.457-10 is treated as an organization exempt from tax under section 501(a), and a participant's or beneficiary's interest in amounts in the trust is includible in the gross income of the participants and beneficiaries only to the extent, and at the time, provided for in section 457(a) and §§ 1.457-4 through 1.457-10.

(2) Trust requirement. (i) A trust described in this paragraph (a) must be established pursuant to a written agreement that constitutes a valid trust under State law. The terms of the trust must make it impossible, prior to the satisfaction of all liabilities with respect to participants and their beneficiaries, for any part of the assets and income of the trust to be used for, or diverted to, purposes other than for the exclusive benefit of participants and their beneficiaries.

(ii) Amounts deferred under an eligible governmental plan must be transferred to a trust within a period that is not longer than is reasonable for the proper administration of the participant accounts (if any). For purposes of this requirement, the plan may provide for amounts deferred for a participant under the plan to be transferred to the trust within a specified period after the date the amounts would otherwise have been paid to the participant. For example, the plan could provide for amounts deferred under the plan at the election of the participant to be contributed to the trust within 15 business days following the month in which these amounts would otherwise have been paid to the participant.

(3) Custodial accounts and annuity contracts treated as trusts—(i) In general. For purposes of the trust requirement of this paragraph (a), custodial accounts and annuity contracts described in section 401(f) that satisfy the requirements of this paragraph (a)(3) are treated as trusts under rules similar to the rules of section 401(f). Therefore, the provisions of § 1.401(f)-1(b) will generally apply to determine whether a custodial account or an annuity contract is treated as a trust. The use of a custodial account or annuity contract as part of an eligible governmental plan does not preclude the use of a trust or another custodial account or annuity contract as part of the same plan, provided that all such vehicles satisfy the requirements of section 457(g)(1) and (3) and paragraphs (a)(1) and (2) of this section and that all assets and income of the plan are held in such vehicles.

(ii) Custodial accounts—(A) In general. A custodial account is treated as a trust, for purposes of section 457(g)(1) and paragraphs (a)(1) and (2) of this section, if the custodian is a bank, as described in section 408(n), or a person who meets the nonbank trustee requirements of paragraph (a)(3)(ii)(B) of this section, and the account meets the requirements of paragraphs (a)(1) and (2) of this section, other than the requirement that it be a trust.

(B) Nonbank trustee status. The custodian of a custodial account may be a person other than a bank only if the person demonstrates to the satisfaction of the Commissioner that the manner in which the person will administer the custodial account will be consistent with the requirements of section 457(g)(1) and (3). To do so, the person must demonstrate that the requirements of § 1.408-2(e)(2) through (6) (relating to nonbank trustees) are met. The written application must be sent to the address prescribed by the Commissioner in the same manner as prescribed under § 1.408-2(e). To the extent that a person has already demonstrated to the satisfaction of the Commissioner that the person satisfies the requirements of § 1.408-2(e) in connection with a qualified trust (or custodial account or annuity contract) under section 401(a), that person is deemed to satisfy the requirements of this paragraph (a)(3)(ii)(B).

(iii) Annuity contracts. An annuity contract is treated as a trust for purposes of section 457(g)(1) and paragraph (a)(1) of this section if the contract is an annuity contract, as defined in section 401(g), that has been issued by an insurance company qualified to do business in the State, and the contract meets the requirements of paragraphs (a)(1) and (2) of this section, other than the requirement that it be a trust. An annuity contract does not include a life, health or accident, property, casualty, or liability insurance contract.

(4) Combining assets. [Reserved]

(b) Eligible plans maintained by tax-exempt entity—(1) General rule. In order to be an eligible plan of a tax-exempt entity, the plan must be unfunded and plan assets must not be set aside for participants or their beneficiaries. Under section 457(b)(6) and this paragraph (b), an eligible plan of a tax-exempt entity must provide that all amounts deferred under the plan, all property and rights to property (including rights as a beneficiary of a contract providing life insurance protection) purchased with such amounts, and all income attributable to such amounts, property, or rights, must remain (until paid or made available to the participant or beneficiary) solely the property and rights of the eligible employer (without being restricted to the provision of benefits under the plan), subject only to the claims of the eligible employer's general creditors.

(2) Additional requirements. For purposes of paragraph (b)(1) of this section, the plan must be unfunded regardless of whether or not the amounts were deferred pursuant to a salary reduction agreement between the eligible employer and the participant. Any funding arrangement under an eligible plan of a tax-exempt entity that sets aside assets for the exclusive benefit of participants violates this requirement, and amounts deferred are generally immediately includible in the gross income of plan participants and beneficiaries. Nothing in this paragraph (b) prohibits an eligible plan from permitting participants and their beneficiaries to make an election among different investment options available under the plan, such as an election affecting the investment of the amounts described in paragraph (b)(1) of this section.

(a) Eligible governmental plans. A plan of a State ceases to be an eligible governmental plan on the first day of the first plan year beginning more than 180 days after the date on which the Commissioner notifies the State in writing that the plan is being administered in a manner that is inconsistent with one or more of the requirements of §§ 1.457-3 through 1.457-8 or 1.447-10. However, the plan may correct the plan inconsistencies specified in the written notification before the first day of that plan year and continue to maintain plan eligibility. If a plan ceases to be an eligible governmental plan, amounts subsequently deferred by participants will be includible in income when deferred, or, if later, when the amounts deferred cease to be subject to a substantial risk of forfeiture, as provided at § 1.457-11. Amounts deferred before the date on which the plan ceases to be an eligible governmental plan, and any earnings thereon, will be treated as if the plan continues to be an eligible governmental plan and will not be includible in participant's or beneficiary's gross income until paid to the participant or beneficiary.

(b) Eligible plans of tax-exempt entities. A plan of a tax-exempt entity ceases to be an eligible plan on the first day that the plan fails to satisfy one or more of the requirements of §§ 1.457-3 through 1.457-8, or § 1.457-10. See § 1.457-11 for rules regarding the treatment of an ineligible plan.

(a) Plan terminations and frozen plans—(1) In general. An eligible employer may amend its plan to eliminate future deferrals for existing participants or to limit participation to existing participants and employees. An eligible plan may also contain provisions that permit plan termination and permit amounts deferred to be distributed on termination. In order for a plan to be considered terminated, amounts deferred under an eligible plan must be distributed to all plan participants and beneficiaries as soon as administratively practicable after termination of the eligible plan. The mere provision for, and making of, distributions to participants or beneficiaries upon a plan termination will not cause an eligible plan to cease to satisfy the requirements of section 457(b) or the regulations.

(2) Employers that cease to be eligible employers—(i) Plan not terminated. An eligible employer that ceases to be an eligible employer may no longer maintain an eligible plan. If the employer was a tax-exempt entity and the plan is not terminated as permitted under paragraph (a)(2)(ii) of this section, the tax consequences to participants and beneficiaries in the previously eligible (unfunded) plan of an ineligible employer are determined in accordance with either section 451 if the employer becomes an entity other than a State or § 1.457-11 if the employer becomes a State. If the employer was a State and the plan is neither terminated as permitted under paragraph (a)(2)(ii) of this section nor transferred to another eligible plan of that State as permitted under paragraph (b) of this section, the tax consequences to participants in the previously eligible governmental plan of an ineligible employer, the assets of which are held in trust pursuant to § 1.457-8(a), are determined in accordance with section 402(b) (section 403(c) in the case of an annuity contract) and the trust is no longer to be treated as a trust that is exempt from tax under section 501(a).

(ii) Plan termination. As an alternative to determining the tax consequences to the plan and participants under paragraph (a)(2)(i) of this section, the employer may terminate the plan and distribute the amounts deferred (and all plan assets) to all plan participants as soon as administratively practicable in accordance with paragraph (a)(1) of this section. Such distribution may include eligible rollover distributions in the case of a plan that was an eligible governmental plan. In addition, if the employer is a State, another alternative to determining the tax consequences under paragraph (a)(2)(i) of this section is to transfer the assets of the eligible governmental plan to an eligible governmental plan of another eligible employer within the same State under the plan-to-plan transfer rules of paragraph (b) of this section.

(3) Examples. The provisions of this paragraph (a) are illustrated by the following examples:

(b) Plan-to-plan transfers—(1) General rule. An eligible governmental plan may provide for the transfer of amounts deferred by a participant or beneficiary to another eligible governmental plan if the conditions in paragraphs (b)(2), (3), or (4) of this section are met. An eligible plan of a tax-exempt entity may provide for transfers of amounts deferred by a participant to another eligible plan of a tax-exempt entity if the conditions in paragraph (b)(5) of this section are met. In addition, an eligible governmental plan may accept transfers from another eligible governmental plan as described in the first sentence of this paragraph (b)(1), and an eligible plan of a tax-exempt entity may accept transfers from another eligible plan of a tax-exempt entity as described in the preceding sentence. However, a State may not transfer the assets of its eligible governmental plan to a tax-exempt entity's eligible plan and the plan of a tax-exempt entity may not accept such a transfer. Similarly, a tax-exempt entity may not transfer the assets of its eligible plan to an eligible governmental plan and an eligible governmental plan may not accept such a transfer. In addition, if the conditions in paragraph (b)(4) of this section (relating to permissive past service credit and repayments under section 415) are met, an eligible governmental plan of a State may provide for the transfer of amounts deferred by a participant or beneficiary to a qualified plan (under section 401(a)) maintained by a State. However, a qualified plan may not transfer assets to an eligible governmental plan or to an eligible plan of a tax-exempt entity, and an eligible governmental plan or the plan of a tax-exempt entity may not accept such a transfer.

(2) Requirements for post-severance plan-to-plan transfers among eligible governmental plans. A transfer under paragraph (b)(1) of this section from an eligible governmental plan to another eligible governmental plan is permitted if the following conditions are met—

(i) The transferor plan provides for transfers;

(ii) The receiving plan provides for the receipt of transfers;

(iii) The participant or beneficiary whose amounts deferred are being transferred will have an amount deferred immediately after the transfer at least equal to the amount deferred with respect to that participant or beneficiary immediately before the transfer; and

(iv) In the case of a transfer for a participant, the participant has had a severance from employment with the transferring employer and is performing services for the entity maintaining the receiving plan.

(3) Requirements for plan-to-plan transfers of all plan assets of eligible governmental plan. A transfer under paragraph (b)(1) of this section from an eligible governmental plan to another eligible governmental plan is permitted if the following conditions are met—

(i) The transfer is from an eligible governmental plan to another eligible governmental plan within the same State;

(ii) All of the assets held by the transferor plan are transferred;

(iii) The transferor plan provides for transfers;

(iv) The receiving plan provides for the receipt of transfers;

(v) The participant or beneficiary whose amounts deferred are being transferred will have an amount deferred immediately after the transfer at least equal to the amount deferred with respect to that participant or beneficiary immediately before the transfer; and

(vi) The participants or beneficiaries whose deferred amounts are being transferred are not eligible for additional annual deferrals in the receiving plan unless they are performing services for the entity maintaining the receiving plan.

(4) Requirements for plan-to-plan transfers among eligible governmental plans of the same employer. A transfer under paragraph (b)(1) of this section from an eligible governmental plan to another eligible governmental plan is permitted if the following conditions are met—

(i) The transfer is from an eligible governmental plan to another eligible governmental plan of the same employer (and, for this purpose, the employer is not treated as the same employer if the participant's compensation is paid by a different entity);

(ii) The transferor plan provides for transfers;

(iii) The receiving plan provides for the receipt of transfers;

(iv) The participant or beneficiary whose amounts deferred are being transferred will have an amount deferred immediately after the transfer at least equal to the amount deferred with respect to that participant or beneficiary immediately before the transfer; and

(v) The participant or beneficiary whose deferred amounts are being transferred is not eligible for additional annual deferrals in the receiving plan unless the participant or beneficiary is performing services for the entity maintaining the receiving plan.

(5) Requirements for post-severance plan-to-plan transfers among eligible plans of tax-exempt entities. A transfer under paragraph (b)(1) of this section from an eligible plan of a tax-exempt employer to another eligible plan of a tax-exempt employer is permitted if the following conditions are met—

(i) The transferor plan provides for transfers;

(ii) The receiving plan provides for the receipt of transfers;

(iii) The participant or beneficiary whose amounts deferred are being transferred will have an amount deferred immediately after the transfer at least equal to the amount deferred with respect to that participant or beneficiary immediately before the transfer; and

(iv) In the case of a transfer for a participant, the participant has had a severance from employment with the transferring employer and is performing services for the entity maintaining the receiving plan.

(6) Treatment of amount transferred following a plan-to-plan transfer between eligible plans. Following a transfer of any amount between eligible plans under paragraphs (b)(1) through (b)(5) of this section—

(i) The transferred amount is subject to the restrictions of § 1.457-6 (relating to when distributions are permitted to be made to a participant under an eligible plan) in the receiving plan in the same manner as if the transferred amount had been originally been deferred under the receiving plan if the participant is performing services for the entity maintaining the receiving plan, and

(ii) In the case of a transfer between eligible plans of tax-exempt entities, except as otherwise determined by the Commissioner, the transferred amount is subject to § 1.457-7(c)(2) (relating to when amounts are considered to be made available under an eligible plan of a tax-exempt entity) in the same manner as if the elections made by the participant or beneficiary under the transferor plan had been made under the receiving plan.

(7) Examples. The provisions of paragraphs (b)(1) through (6) of this section are illustrated by the following examples:

(8) Purchase of permissive service credit by plan-to-plan transfers from an eligible governmental plan to a qualified plan—(i) General rule. An eligible governmental plan of a State may provide for the transfer of amounts deferred by a participant or beneficiary to a defined benefit governmental plan (as defined in section 414(d)), and no amount shall be includible in gross income by reason of the transfer, if the conditions in paragraph (b)(8)(ii) of this section are met. A transfer under this paragraph (b)(8) is not treated as a distribution for purposes of § 1.457-6. Therefore, such a transfer may be made before severance from employment.

(ii) Conditions for plan-to-plan transfers from an eligible governmental plan to a qualified plan. A transfer may be made under this paragraph (b)(8) only if the transfer is either—

(A) For the purchase of permissive service credit (as defined in section 415(n)(3)(A)) under the receiving defined benefit governmental plan; or

(B) A repayment to which section 415 does not apply by reason of section 415(k)(3).

(iii) Example. The provisions of this paragraph (b)(8) are illustrated by the following example:

(c) Qualified domestic relations orders under eligible plans—(1) General rule. An eligible plan does not become an ineligible plan described in section 457(f) solely because its administrator or sponsor complies with a qualified domestic relations order as defined in section 414(p), including an order requiring the distribution of the benefits of a participant to an alternate payee in advance of the general rules for eligible plan distributions under § 1.457-6. If a distribution or payment is made from an eligible plan to an alternate payee pursuant to a qualified domestic relations order, rules similar to the rules of section 402(e)(1)(A) shall apply to the distribution or payment.

(2) Examples. The provisions of this paragraph (c) are illustrated by the following examples:

(d) Death benefits and life insurance proceeds. A death benefit plan under section 457(e)(11) is not an eligible plan. In addition, no amount paid or made available under an eligible plan as death benefits or life insurance proceeds is excludable from gross income under section 101.

(e) Rollovers to eligible governmental plans—(1) General rule. An eligible governmental plan may accept contributions that are eligible rollover distributions (as defined in section 402(c)(4)) made from another eligible retirement plan (as defined in section 402(c)(8)(B)) if the conditions in paragraph (e)(2) of this section are met. Amounts contributed to an eligible governmental plan as eligible rollover distributions are not taken into account for purposes of the annual limit on annual deferrals by a participant in § 1.457-4(c) or § 1.457-5, but are otherwise treated in the same manner as amounts deferred under section 457 for purposes of §§ 1.457-3 through 1.457-9 and this section.

(2) Conditions for rollovers to an eligible governmental plan. An eligible governmental plan that permits eligible rollover distributions made from another eligible retirement plan to be paid into the eligible governmental plan is required under this paragraph (e)(2) to provide that it will separately account for any eligible rollover distributions it receives. A plan does not fail to satisfy this requirement if it separately accounts for particular types of eligible rollover distributions (for example, if it maintains a separate account for eligible rollover distributions attributable to annual deferrals that were made under other eligible governmental plans and a separate account for amounts attributable to other eligible rollover distributions), but this requirement is not satisfied if any such separate account includes any amount that is not attributable to an eligible rollover distribution.

(3) Example. The provisions of this paragraph (e) are illustrated by the following example:

(f) Deemed IRAs under eligible governmental plans. See regulations under section 408(q) for guidance regarding the treatment of separate accounts or annuities as individual retirement plans (IRAs).

(a) In general. Under section 457(f), if an eligible employer provides for a deferral of compensation under any agreement or arrangement that is an ineligible plan—

(1) Compensation deferred under the agreement or arrangement is includible in the gross income of the participant or beneficiary for the first taxable year in which there is no substantial risk of forfeiture (within the meaning of section 457(f)(3)(B)) of the rights to such compensation;

(2) If the compensation deferred is subject to a substantial risk of forfeiture, the amount includible in gross income for the first taxable year in which there is no substantial risk of forfeiture includes earnings thereon to the date on which there is no substantial risk of forfeiture;

(3) Earnings credited on the compensation deferred under the agreement or arrangement that are not includible in gross income under paragraph (a)(2) of this section are includible in the gross income of the participant or beneficiary only when paid or made available to the participant or beneficiary, provided that the interest of the participant or beneficiary in any assets (including amounts deferred under the plan) of the entity sponsoring the agreement or arrangement is not senior to the entity's general creditors; and

(4) Amounts paid or made available to a participant or beneficiary under the agreement or arrangement are includible in the gross income of the participant or beneficiary under section 72, relating to annuities.

(b) Exceptions. Paragraph (a) of this section does not apply with respect to—

(1) A plan described in section 401(a) which includes a trust exempt from tax under section 501(a);

(2) An annuity plan or contract described in section 403;

(3) That portion of any plan which consists of a transfer of property described in section 83;

(4) That portion of any plan which consists of a trust to which section 402(b) applies; or

(5) A qualified governmental excess benefit arrangement described in section 415(m).

(c) Amount included in income. The amount included in gross income on the applicable date under paragraphs (a)(1) and (a)(2) of this section is equal to the present value of the compensation (including earnings to the extent provided in paragraph (a)(2) of this section) on that date. For purposes of applying section 72 on the applicable date under paragraphs (a)(3) and (4) of this section, the participant is treated as having paid investment in the contract (or basis) to the extent that the deferred compensation has been taken into account by the participant in accordance with paragraphs (a)(1) and (a)(2) of this section.

(d) Coordination of section 457(f) with section 83—(1) General rules. Under paragraph (b)(3) of this section, section 457(f) and paragraph (a) of this section do not apply to that portion of any plan which consists of a transfer of property described in section 83. For this purpose, a transfer of property described in section 83 means a transfer of property to which section 83 applies. Section 457(f) and paragraph (a) of this section do not apply if the date on which there is no substantial risk of forfeiture with respect to compensation deferred under an agreement or arrangement that is not an eligible plan is on or after the date on which there is a transfer of property to which section 83 applies. However, section 457(f) and paragraph (a) of this section apply if the date on which there is no substantial risk of forfeiture with respect to compensation deferred under an agreement or arrangement that is not an eligible plan precedes the date on which there is a transfer of property to which section 83 applies. If deferred compensation payable in property is includible in gross income under section 457(f), then, as provided in section 72, the amount includible in gross income when that property is later transferred or made available to the service provider is the excess of the value of the property at that time over the amount previously included in gross income under section 457(f).

(2) Examples. The provisions of this paragraph (d) are illustrated in the following examples:

(a) General effective date. Except as otherwise provided in this section, §§ 1.457-1 through 1.457-11 apply for taxable years beginning after December 31, 2001.

(b) Transition period for eligible plans to comply with EGTRRA. For taxable years beginning after December 31, 2001, and before January 1, 2004, a plan does not fail to be an eligible plan as a result of requirements imposed by the Economic Growth and Tax Relief Reconciliation Act of 2001 (115 Stat. 385) (EGTRRA) (Public Law 107-16) June 7, 2001, if it is operated in accordance with a reasonable, good faith interpretation of EGTRRA.

(c) Special rule for distributions from rollover accounts. The last sentence of § 1.457-6(a) (relating to distributions of amounts held in a separate account for eligible rollover distributions) applies for taxable years beginning after December 31, 2003.

(d) Special rule for options. Section 1.457-11(d) does not apply with respect to an option without a readily ascertainable fair market value (within the meaning of section 83(e)(3)) that was granted on or before May 8, 2002.

(e) Special rule for qualified domestic relations orders. Section 1.457-10(c) (relating to qualified domestic relations orders) applies for transfers, distributions, and payments made after December 31, 2001.

(a) In general—(1) Introduction. For taxable years beginning after September 30, 1979, section 458 allows accrual basis taxpayers to elect to use a method of accounting that excludes from gross income some or all of the income attributable to qualified sales during the taxable year of magazines, paperbacks, or records, that are returned before the close of the applicable merchandise return period for that taxable year. Any amount so excluded cannot be excluded or deducted from gross income for the taxable year in which the merchandise is returned to the taxpayer. For the taxable year in which the taxpayer first uses this method of accounting, the taxpayer is not allowed to exclude from gross income amounts attributable to merchandise returns received during the taxable year that would have been excluded from gross income for the prior taxable year had the taxpayer used this method of accounting for that prior year. (See paragraph (e) of this section for rules describing how this amount should be taken into account.) The election to use this method of accounting shall be made in accordance with the rules contained in section 458(c) and in § 1.458-2 and this section. A taxpayer that does not elect to use this method of accounting can reduce income for returned merchandise only for the taxable year in which the merchandise is actually returned unsold by the purchaser.

(2) Effective date. While this section is generally effective only for taxable years beginning after August 31, 1984, taxpayers may rely on the provisions of paragraphs (a) through (f) of this section in taxable years beginning after September 30, 1979.

(b) Definitions—(1) Magazine. “Magazine” means a publication, usually paper-backed and sometimes illustrated, that is issued at regular intervals and contains stories, poems, articles, features, etc. This term includes periodicals, but does not include newspapers or volumes of a single publication issued at various intervals. However, volumes of a single publication that are issued at least annually, are related by title or subject matter to a magazine, and would otherwise qualify as a magazine, will be treated as a magazine.

(2) Paperback. “Paperback” means a paperback book other than a magazine. Unlike a hardback book, which usually has stiff front and back covers that enclose pages bound to a separate spine, a paperback book is characterized by a flexible outer cover to which the pages of the book are directly affixed.

(3) Record. “Record” means a disc, tape, or similar item on which music, spoken or other sounds are recorded. However, the term does not include blank records, tapes, etc., on which it is expected the ultimate purchaser will record. The following items, provided they carry pre-recorded sound, are examples of “records”: audio and video cassettes, eight-track tapes, reel-to-reel tapes, cylinders, and flat, compact, and laser discs.