Title 26—Internal Revenue--Volume 1
PART 1—INCOME TAXES
§ 1.441-2   Election of taxable year consisting of 52-53 weeks.
(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.
§ 1.441-3   Taxable year of a personal service corporation.
(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:
§ 1.441-4   Effective date.
Sections 1.441-0 through 1.441-3 are applicable for taxable years ending on or after May 17, 2002.
§ 1.442-1   Change of annual accounting period.
(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.
§ 1.443-1   Returns for periods of less than 12 months.
(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.
§ 1.444-0T   Table of contents (temporary).
This section lists the captions that appear in the temporary regulations under section 444.
(a) General rules.
(1) Year other than required year.
(2) Effect of section 444 election.
(i) In general.
(ii) Duration of section 444 election.
(3) Section 444 election not required for certain years.
(4) Required taxable year.
(5) Termination of section 444 election.
(i) In general.
(ii) Effective date of termination.
(iii) Example.
(iv) Special rule for entity that liquidates or is sold prior to making a section 444 election, required return, or required payment.
(6) Re-activating certain S elections.
(i) Certain corporations electing S status that did not make a back-up calendar year request.
(ii) Certain corporations that revoked their S status.
(iii) Procedures for re-activating an S election.
(iv) Examples.
(b) Limitation on taxable years that may be elected.
(1) General rule.
(2) Changes in taxable year.
(i) In general.
(ii) Special rule for certain existing corporations electing S status.
(iii) Deferral period of the taxable year that is being changed.
(iv) Examples.
(3) Special rule for entities retaining 1986 taxable year.
(4) Deferral period.
(i) Retentions of taxable year.
(ii) Adoptions of and changes in taxable year.
(A) In general.
(B) Special rule.
(C) Examples.
(5) Miscellaneous rules.
(i) Special rule for determining the taxable year of a corporation electing S status.
(ii) Special procedure for cases where an income tax return is superseded.
(A) In general.
(B) Procedure for superseding return.
(iii) Anti-abuse rule.
(iv) Special rules for partial months and 52-53-week taxable years.
(c) Effective date.
(d) Examples.
(1) Changes in taxable year.
(2) Special rule for entities retaining their 1986 taxable year.
(a) General rule.
(b) Definition of a member of a tiered structure.
(1) In general.
(2) Deferral entity.
(i) In general.
(ii) Grantor trusts.
(3) Anti-abuse rule.
(c) De minimis rules.
(1) In general.
(2) Downstream de minimis rule.
(i) General rule.
(ii) Definition of testing period.
(iii) Definition of adjusted taxable income.
(A) Partnership.
(B) S corporation.
(C) Personal service corporation.
(iv) Special rules.
(A) Pro-forma rule.
(B) Reasonable estimates allowed.
(C) Newly formed entities.
( 1 ) Newly formed deferral entities.
( 2 ) Newly formed partnership, S corporation, or personal service corporation desiring to make a section 444 election.
(3) Upstream de minimis rule.
(d) Date for determining the existence of a tiered structure.
(1) General rule.
(2) Special rule for taxable years beginning in 1987.
(e) Same taxable year exception.
(1) In general.
(2) Definition of tiered structure.
(i) General rule.
(ii) Special flow-through rule for downstream controlled partnerships.
(3) Determining the taxable year of a partnership or S corporation.
(4) Special rule for 52-53-week taxable years.
(5) Interaction with de minimis rules.
(i) Downstream de minimis rule.
(A) In general.
(B) Special rule for members of a tiered structure directly owned by a downstream controlled partnership.
(ii) Upstream de minimis rule.
(f) Examples.
(g) Effective date.
(a) In general.
(b) Manner and time of making election.
(1) General rule.
(2) Special extension of time for making an election.
(3) Corporation electing to be an S corporation.
(i) In general.
(ii) Examples.
(4) Back-up section 444 election.
(i) General rule.
(ii) Procedures for making a back-up section 444 election.
(iii) Procedures for activating a back-up section 444 election.
(A) Partnership and S corporations.
( 1 ) In general.
( 2 ) Special rule if Form 720 used to satisfy return requirement.
(B) Personal service corporations.
(iv) Examples.
(c) Administrative relief.
(1) Extension of time to file income tax returns.
(i) Automatic extension.
(ii) Additional extensions.
(iii) Examples.
(2) No penalty for certain late payments.
(i) In general.
(ii) Example.
(d) Effective date.
§ 1.444-1T   Election to use a taxable year other than the required taxable year (temporary).
(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.
§ 1.444-2T   Tiered structure (temporary).
(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.
§ 1.444-3T   Manner and time of making section 444 election (temporary).
(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.
§ 1.444-4   Tiered structure.
(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.
§ 1.446-1   General rule for methods of accounting.
(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.
§ 1.446-2   Method of accounting for interest.
(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.
(ii) Amount of unstated interest. Under section 483, the agreement does not provide for adequate stated interest. Thus, the loan's yield is the test rate of interest determined under § 1.483-3. Assume that both A and B use annual accrual periods and that the test rate of interest is 9.2 percent, compounded annually. Under § 1.483-2, the present value of the deferred payments is $1,000,000. Thus, the agreement has unstated interest of $297,143.66.
(iii) First two accrual periods. Under paragraph (d)(1) of this section, the issue price at the beginning of the first accrual period is $1,000,000 (the amount described in § 1.483-2(a)(1)(i)). Under paragraph (c) of this section, the amount of interest that accrues for the first accrual period is $92,000 ($1,000,000 × .092) and the amount of interest that accrues for the second accrual period is $100,464 ($1,092,000 × .092). Thus, $192,464 of interest has accrued as of the end of the second accrual period. Under paragraph (e)(1) of this section, the $648,571.83 payment made on June 30, 1998, is treated first as a payment of interest to the extent of $192,464. The remainder of the payment ($456,107.83) is treated as a payment of principal. Both A and B take the payment of interest ($192,464) into account in 1998.
(iv) Second two accrual periods. The adjusted issue price at the beginning of the third accrual period is $543,892.17 ($1,092,000 + $100,464-$648,571.83). The amount of interest that accrues for the third accrual period is $50,038.08 ($543,892.17 × .092) and the amount of interest that accrues for the final accrual period is $54,641.58, the excess of the amount payable at maturity ($648,571.83), over the adjusted issue price at the beginning of the accrual period ($593,930.25). As of the date the second payment becomes due, $104,679.66 of interest has accrued. Thus, of the $648,571.83 payment made on June 30, 2000, $104,679.66 is treated as interest and $543,892.17 is treated as principal. Both A and B take the payment of interest ($104,679.66) into account in 2000.
(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.
§ 1.446-3   Notional principal contracts.
(a) Table of contents. This paragraph (a) lists captioned paragraphs contained in § 1.446-3.
(a) Table of contents.
(b) Purpose.
(c) Definitions and scope.
(1) Notional principal contract.
(i) In general.
(ii) Excluded contracts.
(iii) Transactions within section 475.
(iv) Transactions within section 988.
(2) Specified index.
(3) Notional principal amount.
(4) Special definitions.
(i) Related person and party to the contract.
(ii) Objective financial information.
(iii) Dealer in notional principal contracts.
(d) Taxable year of inclusion and deduction.
(e) Periodic payments.
(1) Definition.
(2) Recognition rules.
(i) In general.
(ii) Rate set in arrears.
(iii) Notional principal amount set in arrears.
(3) Examples.
(f) Nonperiodic payments.
(1) Definition.
(2) Recognition rules.
(i) In general.
(ii) General rule for swaps.
(iii) Alternative methods for swaps.
(A) Prepaid swaps.
(B) Other nonperiodic swap payments.
(iv) General rule for caps and floors.
(v) Alternative methods for caps and floors that hedge debt instruments.
(A) Prepaid caps and floors.
(B) Other caps and floors.
(C) Special method for collars.
(vi) Additional methods.
(3) Term of extendible or terminable contracts.
(4) Examples.
(g) Special rules.
(1) Disguised notional principal contracts.
(2) Hedged notional principal contracts.
(3) Options and forwards to enter into notional principal contracts.
(4) Swaps with significant nonperiodic payments.
(5) Caps and floors that are significantly in-the-money. [Reserved]
(6) Examples.
(h) Termination payments.
(1) Definition.
(2) Taxable year of inclusion and deduction by original parties.
(3) Taxable year of inclusion and deduction by assignees.
(4) Special rules.
(i) Assignment of one leg of a contract.
(ii) Substance over form.
(5) Examples.
(i) Anti-abuse rule.
(j) Effective date.
(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.
(b) This contract is a notional principal contract as defined by paragraph (c)(1) of this section, and both LIBOR and a fixed interest rate of 8% are specified indices under paragraph (c)(2) of this section. All of the payments to be made by A and B are periodic payments under paragraph (e)(1) of this section because each party's payments are based on a specified index described in paragraphs (c)(2)(iii) and (c)(2)(i) of this section, respectively, are payable at periodic intervals of one year or less throughout the term of the contract, and are based on a single notional principal amount.
(c) Under the terms of the swap agreement, on April 1, 1996, B is obligated to make a payment to A of $8,000,000 (8% × $100,000,000) and A is obligated to make a payment to B of $7,800,000 (7.80% × $100,000,000). Under paragraph (e)(2)(i) of this section, the ratable daily portions for 1995 are the amounts of these periodic payments that are attributable to A 's and B 's taxable year ending December 31, 1995. The ratable daily portion of the 8% fixed leg is $6,010,929 (275 days/366 days × $8,000,000), and the ratable daily portion of the floating leg is $5,860,656 (275 days/366 days × $7,800,000). The net amount for the taxable year is the difference between the ratable daily portions of the two periodic payments, or $150,273 ($6,010,929—$5,860,656). Accordingly, A has net income of $150,273 from this swap for 1995, and B has a corresponding net deduction of $150,273.
(d) The $49,727 unrecognized balance of the $200,000 net periodic payment that is made on April 1, 1996, is included in A 's and B 's net income or net deduction from the contract for 1996.
(e) If the parties had entered into the contract on February 1, 1995, the result would not change because no portion of either party's obligation to make a payment under the swap relates to the period prior to April 1, 1995. Consequently, under paragraph (e)(2) of this section, neither party would accrue any income or deduction from the swap for the period from February 1, 1995, through March 31, 1995.
(b) This contract is a notional principal contract as defined by paragraph (c)(1) of this section, and LIBOR and the fixed interest rate of 8% are each specified indices under paragraph (c)(2) of this section. All of the payments to be made by C and D are periodic payments under paragraph (e)(1) of this section because they are each based on appropriate specified indices, are payable at periodic intervals of one year or less throughout the term of the contract, and are based on a single notional principal amount.
(c) Under the terms of the swap agreement, D pays C $3,900,000 (0.5 × 7.8% × $100,000,000) on October 1, 1995. In addition, D is obligated to pay C $3,730,000 (0.5 × 7.46% × $100,000,000) on April 1, 1996. C is obligated to pay D $8,000,000 on April 1, 1996. Under paragraph (e)(2)(i) of this section, C 's and D 's ratable daily portions for 1995 are the amounts of the periodic payments that are attributable to their taxable year ending December 31, 1995. The ratable daily portion of the 8% fixed leg is $6,000,000 (270 days/360 days × $8,000,000), and the ratable daily portion of the floating leg is $5,765,000 ($3,900,000 + (90 days/180 days × $3,730,000)). Thus, C 's net deduction from the contract for 1995 is $235,000 ($6,000,000—$5,765,000) and D reports $235,000 of net income from the contract for 1995.
(d) The net unrecognized balance of $135,000 ($2,000,000 balance of the fixed leg—$1,865,000 balance of the floating leg) is included in C 's and D 's net income or net deduction from the contract for 1996.
(b) On December 31, 1995, the amount that A is obligated to pay B is not known because it will not become fixed until April 1, 1996. Under paragraph (e)(2)(ii) of this section, the ratable daily portion of the periodic payment from A to B for 1995 is based on the value of LIBOR on December 31, 1995 (unless A or B determines that the value of LIBOR on that day does not reasonably estimate the value of the specified index). Thus, the ratable daily portion of the floating leg is $6,198,770 (275 days/366 days × 8.25% × $100,000,000), while the ratable daily portion of the fixed leg is $6,010,929 (275 days/366 days × $8,000,000). The net amount for 1995 on this swap is $187,841 ($6,198,770—$6,010,929). Accordingly, B has $187,841 of net income from the swap in 1995, and A has a net deduction of $187,841.
(c) On April 1, 1996, A makes a net payment to B of $160,000 ($8,160,000 payment on the floating leg—$8,000,000 payment on the fixed leg). For purposes of determining their net income or net deduction from this contract for the year ended December 31, 1996, B and A must adjust the net income and net deduction they recognized in 1995 by $67,623 (275 days/366 days × ($8,250,000 presumed payment on the floating leg—$8,160,000 actual payment on the floating leg)).
(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.
(c) The Black-Scholes model is recognized in the financial industry as a standard technique for pricing interest rate cap agreements. Therefore, because E has used a reasonable option pricing model, the schedule generated by E is consistent with the economic substance of the cap, and may be used by both E and F for calculating their ratable daily portions of the cap premium. Under paragraph (f)(2)(iv) of this section, E recognizes the ratable daily portion of the cap premium as income, and F recognizes the ratable daily portion of the cap premium as a deduction based on the pricing schedule. Thus, E and F account for the contract as follows:
(b) E and F recognize $9,192 (61 days/365 days × $55,000) as the ratable daily portion of the nonperiodic payment for 1994, and include that amount in their net income or net deduction from the contract for 1994. If E 's pricing model allocated the cap premium to each quarter covered by the contract, the ratable daily portion would be 61 days/92 days times the premium allocated to the first quarter.
(c) Under paragraph (e)(2)(ii) of this section, E and F calculate the payments using LIBOR as of December 31, 1994. F recognizes as income the ratable daily portion of the presumed payment, or $4,144 (61 days/92 days × .25 × .001 × $25,000,000). Thus, E reports $5,048 of net income from the contract for 1994 ($9,192-$4,144), and F reports a net deduction from the contract of $5,048.
(d) On January 31, 1995, E pays F $9,375 (.25 × .0015 × $25,000,000) under the terms of the cap agreement. For purposes of determining their net income or net deduction from this contract for the year ended December 31, 1995, E and F must adjust their respective net income and net deduction from the cap by $2,072 (61 days/92 days × ($9,375 actual payment under the cap on January 31, 1995—$6,250 presumed payment under the cap on December 31, 1994)).
(b) This contract is a notional principal contract as defined by paragraph (c)(1) of this section. The yield adjustment fee is a nonperiodic payment as defined in paragraph (f)(1) of this section.
(c) Under the alternative method described in paragraph (f)(2)(iii)(A) of this section, the yield adjustment fee is recognized over the life of the agreement by assuming that the $3,790,786 is repaid in five level payments. Assuming a constant yield to maturity and annual compounding at 10%, the ratable daily portions are computed as follows:
(b) This contract is a notional principal contract as defined by paragraph (c)(1) of this section, and $2.35 and the spot price of corn are specified indices under paragraphs (c)(2)(i) and (iii) of this section, respectively. The $53,530 payment is a nonperiodic payment as defined by paragraph (f)(1) of this section.
(c) Assuming that I does not use the alternative methods provided under paragraph (f)(2)(iii) of this section, paragraph (f)(2)(ii) of this section requires that I recognize the nonperiodic payment over the term of the agreement by allocating the payment to each forward contract in accordance with the forward price of corn. Solely for timing purposes, I treats the $53,530 nonperiodic payment as a loan that J will repay in three installments of $5,000, $20,000, and $40,000, the expected payouts on the in-the-money forward contracts. With annual compounding at 8%, the ratable daily portions are computed as follows:
(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.
(b) K 's option agreements with L reduce risk with respect to F 's cap agreement with E. Accordingly, under paragraph (g)(2) of this section, F cannot use the alternative methods provided in paragraph (f)(2)(v) of this section to amortize the premium paid under the cap agreement. F must amortize the cap premium it paid in accordance with paragraph (f)(2)(iv) of this section.
(c) The method that E may use to account for its agreement with F is not affected by the application of paragraph (g)(2) of this section to F.
(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.
(b) The payment from P to Q extinguishes the swap contract and is a termination payment, as defined in paragraph (h)(1) of this section, for both parties. Accordingly, under paragraph (h)(2) of this section, P recognizes a loss of $1,895,393 in 1997 and Q recognizes $1,895,393 of gain in 1997.
(b) The payment from P to R terminates P 's interest in the swap contract with Q and is a termination payment, as defined in paragraph (h)(1) of this section, for P. Under paragraph (h)(2) of this section, P recognizes a loss of $1,895,393 in 1997. Whether Q also has a termination payment with respect to the payment from P to R is determined under section 1001.
(c) Under paragraph (h)(3) of this section, the assignment payment that R receives from P is a nonperiodic payment for an interest rate swap. Because the assignment payment is not a significant nonperiodic payment within the meaning of paragraph (g)(1) of this section, R amortizes the $1,895,393 over the five year term of the swap agreement under paragraph (f)(2) of this section.
(b) Under paragraph (h)(2) of this section, P recognizes a loss of $1,595,393 ($1,895,393-$300,000) in 1997. R accounts for the termination payment in the same way it did in Example 2 ; the existence of an unamortized payment with respect to the original swap has no effect on R.
(b) Because T has assigned to U its rights to the fixed rate payments, but not its floating rate obligations under the notional principal contract, U 's payment to T is not a termination payment as defined in paragraph (h)(1) of this section, but is covered by paragraph (h)(4)(i) of this section. The economic substance of the transaction between T and U is a loan that does not affect the way that S and T account for the notional principal contract under this section.
(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.
§ 1.446-3T   Notional principal contracts (temporary).
(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.
(ii) The exceptions in paragraphs (g)(4)(ii)(A) and (B) of this section do not apply. Under paragraph (g)(4)(i) of this section, the transaction is recharacterized as consisting of both a $15,163,147 loan from M to N that N repays in installments over the term of the contract and an interest rate swap between M and N in which M immediately pays the installment payments on the loan back to N as part of its fixed payments on the swap in exchange for the LIBOR payments by N.
(iii) The upfront payment is recognized over the life of the contract by treating the $15,163,147 as a loan that will be repaid with level payments over five years. Assuming a constant yield to maturity and annual compounding at 10%, M and N account for the principal and interest on the loan as follows:
(v) N also makes swap payments to M based on LIBOR and receives swap payments from M at a fixed rate that is equal to the sum of the stated fixed rate and the rate calculated by dividing the deemed level annual payments on the loan by the notional principal amount. Thus, the fixed rate on this swap is 10%, which is the sum of the stated rate of 6% and the rate calculated by dividing the annual loan payment of $4,000,000 by the notional principal amount of $100,000,000, or 4%. Using the methods provided in § 1.446-3(e)(2), the fixed swap payments from M to N of $10,000,000 (10% of $100,000,000) and the LIBOR swap payments from N to M are included in the parties' net income or net deduction from the contract for each taxable year.
(ii) Because the contract is subject to initial variation margin in an amount equal to the upfront payment and daily variation margin in an amount equal to the change in the fair market value of the contract on a daily basis for the entire term of the contract, the contract is described in paragraph (g)(4)(ii)(B)( 1 ) of this section and paragraph (g)(4)(i) of this section does not apply to the contract.
(ii) Because the contract is required to be collateralized in an amount equal to the upfront payment and changes in the fair market value of the contract on a daily basis for the entire term of the contract, the contract is described in paragraph (g)(4)(ii)(B)( 2 ) of this section and paragraph (g)(4)(i) of this section does not apply to the contract.
(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.