internal_revenue_service department of the treasury number release date index numbers washington dc person to contact telephone number refer reply to cc fip 4-plr-105633-01 date date legend taxpayer x state a b number a number b number c number d number e number f number g number h number j number k number l number m number n policy a policy b policy c date date date system system system system year year year year year plr-105633-01 year year year year month month dear this responds to your letters dated date1 date and date in which you requested a ruling on taxpayer’s behalf concerning number b contracts policies that taxpayer issued intending that they meet the definition of a life_insurance_contract under sec_7702 of the internal_revenue_code specifically taxpayer asks for a waiver of a reasonable error under sec_7702 such that the policies will be treated as life_insurance contracts for federal tax purposes the policy numbers for the number b contracts are set forth in exhibit hereto facts taxpayer is a stock_life_insurance_company organized and operated under the laws of state a and is treated as a life_insurance_company for tax purposes pursuant to sec_816 taxpayer is licensed to engage in the life_insurance business in number a states and in b taxpayer’s request pertains to three types of flexible premium universal_life_insurance contracts policy a policy b and policy c policy a issued from year to year and policy b issued from year to year are flexible premium whole life contracts although policies a and b are in form flexible premium policies taxpayer marketed policies a and b as having planned periodic premiums ie taxpayer contemplated few unscheduled premiums policy c issued from year to year is a traditional flexible_premium_life_insurance_contract in which taxpayer contemplated both planned and unscheduled premium payments taxpayer’s ruling_request pertains to number b policies that did not meet the definition of a life_insurance_contract set forth in sec_7702 due to certain errors committed by its employees since when congress enacted sec_7702 sec_1 unless otherwise indicated section references are to the internal_revenue_code_of_1986 as amended and in effect during the years in issue sec_7702 provides a statutory definition that a life_insurance_policy must meet to be treated as a life_insurance_contract for federal tax purposes to be considered a life_insurance_contract a contract must be a life_insurance_contract under applicable law and must also meet either of two alternative tests the cash_value_accumulation_test of sec_7702 or the guideline premium and cash_value plr-105633-01 taxpayer has used different computer-based systems to administer its life_insurance contracts including procedures intended to assure compliance with that section’s requirements both policy a and policy b contracts were designed to have few unscheduled premiums thus taxpayer focused its initial sec_7702 compliance efforts to assure that scheduled premiums were proper when taxpayer first issued policy a it ensured that premiums would comply with the guideline premium limitations by employing an illustration system that set forth the guideline_single_premium and the sum of the guideline premium levels planned periodic premiums therefore would be in compliance with the guideline premium limitations if the premium was consistent with the amount set forth in the illustration nonetheless if taxpayer did receive a large unscheduled premium with respect to a policy a contract taxpayer’s procedures directed that the payment be referred to its actuarial department for examination from month year to month year taxpayer employed a software testing program system to test premiums received under policy a and b contracts under system each calendar_quarter the premiums_paid would be compared with the guideline_single_premium and the sum of the guideline level premiums for the contract when the system identified a policy where the premiums_paid exceeded the guideline premium limit the guideline premiums were examined manually to determine whether the policy had a qualified additional benefit or a substandard mortality rating in which case the guideline premiums were adjusted to include the appropriate charges from month year to month year taxpayer discontinued using system in anticipation of a new broader policy administration system developed by x an unrelated party a number of problems and delays ensued in implementing the system and taxpayer cancelled its contract with x and instead developed its own system system during the period in which taxpayer was developing system it used a another software system system to calculate the guideline_premium_limitation in similar fashion to previous years taxpayer required contracts under policies a and b to be issued with planned premium payments that satisfied the guideline premium limitations and its procedures required that large unscheduled premium payments be referred to its actuarial department for manual review taxpayer completed system in month year and the new system began administering policy a b and c contracts under system if an owner paid a premium that exceeded that guideline premium limitations the system was designed to reject the excessive portion of the premium and return it before it was credited to the policy the system generated a daily error report which required taxpayer’s customer service personnel to manually return the premiums the system tested each policy on its monthly anniversary date testing all premiums received during the previous month moreover under system when policyholders requested a change to the policy that affected the determination of guideline premium limitations taxpayer’s actuarial corridor test of sec_7702 and d each of the policies considered in this ruling were issued after date the effective date of sec_7702 plr-105633-01 department would calculate the new limitations and the customer service_department would report them to the policyholder when system began functioning it identified many policy a contracts as being out of compliance with the guideline premium test taxpayer discovered that the guideline premiums for policy a contracts that had been programmed into system were lower than the correct guideline premiums while correcting this error taxpayer reverted back to testing policy a contracts under system in year taxpayer began to replace system with a new system system taxpayer asserts that the system has fewer sec_7702 compliance deficiencies than its previous systems specifically taxpayer states that recent testing of the system revealed an accurate calculation of the guideline premiums with respect to a sample group of policies nevertheless under system taxpayer continues to manually monitor and administer post-issue changes to policy a and b contracts through its actuarial department in addition to enhancing its computer-based compliance system taxpayer has implemented manual procedures to assist its customer service personnel in testing post-issue changes and other service requests that may affect sec_7702 compliance by requiring the actuarial department to examine manually any such changes or requests taxpayer has recently created procedures for its management to use in monitoring taxpayer’s ongoing sec_7702 compliance efforts after a recent review of its policies taxpayer identified number b policies for which the sum of the premiums_paid exceeded the policy’s guideline_premium_limitation taxpayer has identified six types of errors that caused the failed policies error pertains to number c policy a contracts number d policy b contracts and number e policy c contracts in which the policyholder paid a premium when the policy was issued or within months thereafter that exceeded the guideline_single_premium for the policy taxpayer has identified two explanations for these failures either the sales agent did not properly prepare the sales illustration developed by taxpayer or the customer failed to follow the correct sales illustration and company personnel failed to note the discrepancy per instructions error pertains to number f policy a contracts and number g policy b contracts in which policyholders made unscheduled premium payments although taxpayer required employees processing unscheduled premium payments to refer the premium to taxpayer’s actuarial department to ensure compliance with the guideline premium limitations the clerks processing the payments in some cases failed to do so consequently taxpayer accepted premiums in excess of the guideline_premium_limitation error pertains to number h policy a contracts number j policy b contracts and number k policy c contracts in which the policyholder paid periodic_payments that plr-105633-01 exceeded the correct guideline_level_premium for the policy taxpayer offers two alternative explanations for these failures either the sales agent did not properly prepare the sales illustration developed by taxpayer or did not correctly check a planned periodic premium against the illustrated premium or in other instances taxpayer’s clerical personnel contrary to taxpayer’s procedures failed to report policies to taxpayer’s actuarial department upon learning of a change in the policy or failed to properly record new guideline premiums limits into taxpayer’s administration system upon occurrence of such changes in the policies error pertains to number l policy a contracts and number m policy b contracts in which policyholders requested that taxpayer increase its billed periodic premium in an amount that exceeded the correct guideline_level_premium in these cases taxpayer’s employees failed to check the requested new billed premium against the guideline premium or checked it incorrectly error pertains to number n policy b contracts issued with a family term rider the family term rider provided term life_insurance coverage on the life of a member_of_the_family of the individual insured under the policy taxpayer imposes a charge for the mortality risk that it assumes pursuant to the family term rider and deducts this charge monthly from the policy’s cash_value in computing the guideline premium for these policies under sec_7702 taxpayer treated the family term rider as a qualified additional benefit within the meaning of sec_7702 moreover pursuant to sec_7702 taxpayer treated the charges for the family term rider as future_benefits in determining the amount of the charges for such future_benefits that could be taken into account in calculating the guideline premiums taxpayer followed the reasonable mortality charge requirements of sec_7702 in accordance with notice_88_128 1988_2_cb_540 taxpayer in calculating guideline premiums used the full charge for the family term rider set forth in the commissioners’ standard ordinary cso mortality_table while reviewing its sec_7702 compliance system taxpayer recognized that it could have calculated the guideline premiums attributable to the family term rider under the reasonable expense charge requirements of sec_7702 rather than under the reasonable mortality charge requirements of sec_7702 if sec_7702 governs taxpayer should have reflected in the calculation of the guideline premiums only the current charges it imposed for the family term rider rather than the charges set forth in the cso table accordingly taxpayer has recalculated the guideline_premium_limitation for those policies taking into account only the current charges that it imposed for the family term rider in the case of number n policy b contracts the premiums_paid do not exceed taxpayer’s original guideline_premium_limitation calculated on the basis of sec_7702 but do exceed taxpayer’s recalculated guideline_premium_limitation calculated on the basis of sec_7702 taxpayer requests that in the event that we conclude that sec_7702 is the applicable standard we rule that taxpayer’s interpretation of the statute was reasonable and that taxpayer is entitled to a waiver under sec_7702 with respect to the number n failed contracts plr-105633-01 error pertains to number m policy a contracts that were issued with a spousal term rider the spousal term rider provides term life_insurance coverage on the life of the spouse of the individual insured under policy a the policy also set forth maximum premiums for the rider although taxpayer often imposed a charge for the rider that was less than the maximum premium in computing the guideline premiums for a policy to which the spousal term rider was attached taxpayer treated the rider in similar fashion to the manner in which it treated the family term rider discussed with respect to error particularly taxpayer treated the spousal term rider as a qualified additional benefit within the meaning of sec_7702 and treated the maximum premiums for the rider as a future benefit pursuant to sec_7702 taxpayer however first issued the rider prior to enactment of the technical miscellaneous revenue act of tamra the pertinent portions of which apply to contracts issued on or after date prior to that date taxpayer followed the specified charges rule in former sec_7702 to determine the amount of charges for the rider that could be taken into account in calculating the guideline premiums tamra amended sec_7702 and replaced the specified charges rule with the reasonable charges rule upon enactment of tamra taxpayer reviewed its contracts and modified the guideline premiums to reflect the new reasonable mortality charge standard during taxpayer’s review of its sec_7702 compliance system taxpayer realized that for contracts with spousal term riders issued after date the premiums for the rider should have been treated as future_benefits only to the extent of percent of the cso mortality_table as allowed by amended sec_7702 and notice_88_128 taxpayer’s employees who were assigned to review the contracts for compliance with tamra mistakenly failed to identify instances where the maximum premium for the spousal term rider exceeded the charges set forth in the cso taxpayer has recalculated the guideline_premium_limitation for policy a contracts containing the rider to reflect the lower mortality charges allowed under sec_7702 and notice_88_128 error pertains to number m policy a contracts where the premiums_paid exceed the correct guideline_premium_limitation assuming that sec_7702 was the proper standard thus in the event that we conclude that sec_7702 is the appropriate standard taxpayer requests that we grant waivers for both its employees’ failure to compare premiums received to the cso mortality_table and for its misinterpretation of the statute pub_l_no 102_stat_3342 prior to tamra sec_7702 and ii provided that the amount of charges to be taken into account in determining the guideline premium were the charges specified in the contract incorporating the changes enacted by tamra sec_7702 and ii presently provides that the amount of charges taken into account in determining the guideline premium are the reasonable charges plr-105633-01 in addition to the contracts that failed due to a particular error taxpayer has identified number k policy a contracts and number m policy b contracts that failed to comply with sec_7702 due to a combination of the types of errors described above particularly number k policy a contracts failed due to a combination of errors and number k policy b contracts failed due to a combination of errors and and number k policy b contracts failed due to a combination of errors and ruling requested the service waive pursuant to sec_7702 the failure of certain policies to comply with the general requirements of sec_7702 taxpayer further proposes to address these compliance failures by either increasing the death_benefits available under each failed policy or refunding to the policyholder the excess premiums and interest taxpayer proposes to implement these changes within days from the effective date of the requested waiver law and analysis as previously explained in order to qualify as a life_insurance_contract for federal_income_tax purposes sec_7702 requires that a contract must satisfy the cash_value_accumulation_test set forth in sec_7702 or both meet the guideline premium requirements of sec_7702 and fall within the cash_value corridor defined in sec_7702 with respect to the guideline premium requirements sec_7702 requires that the premiums_paid under the contract at any time must not exceed the greater of the guideline_single_premium or the sum of the guideline level premiums to that date the guideline_single_premium is the single premium at issue that is needed to fund the future_benefits under the contract determined on the basis of the following three elements enumerated in sec_7702 i - iii i ii iii reasonable mortality charges which meet the requirements if any prescribed in regulations and which except as provided in regulations do not exceed the mortality charges specified in the prevailing commissioners standard tables as defined in sec_807 as of the time the contract is issued any reasonable charges other than mortality charges which on the basis of the company’s experience if any with respect to similar contracts are reasonably expected to be actually paid and interest at the greater of an annual effective rate of percent or the rate or rates guaranteed on issuance of the contract plr-105633-01 the guideline_level_premium is the level annual equivalent of the guideline_single_premium payable until a deemed_maturity_date between the insured's attained ages and using a minimum interest rate of four percent rather than six percent accordingly the amount of both the guideline_single_premium and guideline_level_premium is proportional to the amount of future_benefits under the contract the computational rules of sec_7702 and the definitions of sec_7702 apply to both the guideline single and guideline_level_premium sec_7702 defines the term future_benefits to mean death_benefits and endowment benefits sec_7702 characterizes family term riders as qualified_additional_benefits and sec_7702 provides further that qualified_additional_benefits shall not be treated as future_benefits under the contract but the charges for such benefits shall be treated as future_benefits in computing the guideline premiums for a policy to which the family term rider or spousal term rider was attached taxpayer treated the charges for the rider as a future benefit and accordingly increased the guideline premium for each policy by that amount taxpayer however treated those charges under the reasonable mortality charge standard set forth in sec_7702 rather than under the reasonable expense charge standard set forth in sec_7702 charges contemplated by sec_7702 are deemed reasonable if they do not exceed the charges set forth in the cso mortality_table regardless of whether the charges actually set forth in the contract are less than the cso amount in contrast charges contemplated by sec_7702 are deemed reasonable only if they reflect the amount expected to be actually paid which will typically correlate to a company’s actual charges consequently in many instances the guideline premiums attributable to certain benefits will be higher if treated under sec_7702 rather than sec_7702 in treating the charges for the family term rider and spousal term rider under sec_7702 taxpayer reasoned that the risks insured by the rider were mortality risks and that c b i specifically applies to mortality charges in this regard sec_7702 expressly excludes mortality charges from its scope taxpayer further reasoned that there is no express provision in the code that requires a family term rider to be treated under sec_7702 in calculating the guideline premium we disagree with taxpayer’s legal analysis in this respect although the code in setting forth the guideline premium limitations does not specifically direct taxpayers to treat family term riders under sec_7702 rather than c b i the rules applicable to the cash_value_accumulation_test are controlling in this regard sec_7702 provides that a contract meets the cash_value_accumulation_test if the cash_surrender_value of the contract does not at any time exceed the net_single_premium which would have to be paid to fund the contract’s future_benefits plr-105633-01 particularly sec_7702 provides one of the computational rules for determining the net_single_premium used to ascertain compliance with the cash_value_accumulation_test sec_7702 states that such computation in the case of qualified_additional_benefits shall be made on the basis of sec_7702 thus for the purpose of the cash_value_accumulation_test family term riders as qualified_additional_benefits are treated under sec_7702 although the requirement set forth in sec_7702 refers only to the determination required for the cash_value_accumulation_test and does not expressly apply to the guideline premium limitations this provision is the only direction provided by congress as to how charges for qualified_additional_benefits are to considered from a computational standpoint the legislative_history moreover is absent of any indication that there be two separate standards for inclusion of such charges one for the cash_value_accumulation_test and one for the guideline_premium_limitation given congress’ indication that family term riders should be treated under sec_7702 for the purpose of the cash_value_accumulation_test and absent any indication to the contrary we conclude that sec_7702 implicitly requires family term rider benefits to be treated under c b ii for the purpose of the guideline premium limitations as well after considering all of the facts and circumstances we find that the failure of the number b policies to satisfy the requirements of sec_7702 was due to reasonable error and that taxpayer is taking reasonable steps to remedy the error in so doing we note that although errors and were due to taxpayer’s incorrect application of sec_7702 rather than c b ii taxpayer’s error in this regard was reasonable to remedy the compliance failure of the number b policies taxpayer will within days of receipt of this ruling either increase the death_benefits payable under any failed policy or refund any excess premium with interest at the contract crediting rate to further cure the errors attributable to taxpayer’s incorrect application of sec_7702 taxpayer will within days of receipt of this ruling conform its compliance system to take the charges for all qualified_additional_benefits into account under sec_7702 accordingly taxpayer is granted a waiver under sec_7702 for the failure of the policies listed in exhibit to satisfy the requirements of sec_7702 the legislative_history provides additional support for our conclusion see h_r rep no pt pincite ndollar_figure distinguishing mortality charges from charges for additional benefits senate comm on finance 98th cong 2d sess deficit_reduction_act_of_1984 explanation of provisions approved by the committee on date ndollar_figure s prt no comm print same staff of joint comm on taxation 98th cong 2d sess general explanation of the revenue provisions of the deficit_reduction_act_of_1984 ndollar_figure comm print stating that the discussions therein relating to mortality and other charges are generally applicable to both the cash_value accumulation and guideline premium tests plr-105633-01 the rulings in this letter are based on the information and representations taxpayer submitted under penalties of perjury while this office has not verified any of the material submitted in support of the request for the ruling it is subject_to verification on examination this ruling is directed only to the taxpayer requesting it sec_6110 of the code provides that it may not be used or cited as precedent sincerely yours donald j drees jr senior technician reviewer branch office of associate chief_counsel financial institutions products attachment exhibit cc


internal_revenue_service u ll department of the treasury cs washington dc jest iii iie fos ree esos iii io ion percemte gontagkirxscieees iii iii iir ri ir iai iiis et plgrrons nudag ea reenne wc p vatahahoiahahateahaahaieihdateiehalhehohstehahibstabatetelelobetatel refer reply to t ep ra t pate oct legend statute p statute q statute r err r hii reiki i riki rr eir i airs iiasa tainan eee eek eke hii a rene rrr arerr err etre rii reet iari iti it ari it tait statute s ssi iii ii ii ioi ree iiit ii arrreein deo ek jose rie rr rrr ie seek state a plan x te ec iii iii ici iat iii io itt iiis aia employer m eris iir rii ii iiit irian resolution n sers sii ii iiis iii iiit iii feso ei iiia iii it iiit iiit tit tta tti group n employees oi iii iir iii rii ieee tit iit oia rita iit dear ereekereekeekee this is in response to a ruling_request dated date submitted on your behalf by your authorized representative concerning the federal_income_tax treatment under sec_414 of the internal_revenue_code code of certain contributions to plan x the following facts and representations have been submitted by your authorized representative employer m a government employer in state a established and created plan x in accordance with statute p and statute q for the benefit of the group n employees you represent that plan x meets the qualification requirements set forth under sec_401 a of the code the foregoing statutes permit government employers such as employer m to reduce the current salaries paid to group n employees and pay these mandatory employee conttri- butions directly to plan x in lieu of such contributions by the group n employees pursuant to statutes p and q employer m has established plan x for the benefit of its group n employees statute r provides that nine percent of a group n employee's salary shall be withheld and paid to plan x foe raia iihr iii iir iia aire iit page -2- statute s provides that a municipality such as employer m may pick up the group n employees’ contributions required by statute r statute s further provides that if a municipality decides to pick up the contributions they shall be treated as employer contributions in determining tax treatment under the code statute s also provides that a municipality shall continue to withhold federal and state income taxes based on these contributions until the internal_revenue_service or the federal courts rule that pursuant to sec_414 of the code these contributions shall not be included as gross_income of the group n employees until such time as they are distributed or made available employer m may pick up these contributions by a reduction in the cash salary of the group n employees or by an offset against a future salary increase or by a combination of both to effectuate the pickup as provided for in statute s employer m on date passed resolution n resolution n provides that employer m will pick up the group n employees contributions to plan x in accordance with statute r and statute s the group n employees salaries will be reduced by an amount equal to the amount picked up by employer m employer m will cease to withhold federal and state income taxes on the picked-up contributions and the group n employees participating in plan x will not be given the option to receive cash directly in lieu of having such contributions paid to plan x based on the aforementioned facts you request the following rulings that the mandatory employee contributions picked up by employer m shall be excluded from the current gross_income of the group n employees until distributed or otherwise made available that the picked up contributions paid_by employer m are not wages for federal_income_tax withholding purposes and federal income taxes need not be withheld on the picked up contributions sec_414 of the code provides that contributions otherwise designated as employee contributions shall be treated as employer contributions if such contributions are made to a plan determined to be qualified under sec_401 established by a state government or a political_subdivision thereof and are picked up by the employing unit the federal_income_tax treatment to be accorded contributions which are picked up by the employer within the meaning of sec_414 of the code is specified in revrul_77_462 1977_2_cb_358 in that revenue_ruling the employer school district agreed to assume and pay the amounts employees were required by state law to contribute to a state pension_plan revrul_77_462 concluded that the school district's picked-up contributions to the plan are excluded from the employees’ gross_income until such time as they are distributed to the employees the revenue_ruling held further that under the provisions of sec_3401 of the code the school district's contributions to the plan are excluded from wages for purposes of the collection of income_tax at source on wages therefore no withholding is required from the employees' salaries with respect to such picked-up contributions y hair ik riki riaa iir ir iee i page the issue of whether contributions have been picked up by an employer within the meaning of sec_414 of the code is addressed in revrul_81_35 1981_1_cb_255 and revrul_81_36 1981_1_cb_255 these revenue rulings established that the following two criteria must be met the employer must specify that the contributions although designated as employee contributions are being paid_by the employer in lieu of contributions by the employee and the employee must not be given the option of choosing to receive the contributed amounts directly instead of having them paid_by the employer to the pension_plan in revrul_87_10 1987_1_cb_136 the internal_revenue_service considered whether contributions designated as employee contributions to a governmental_plan are excludable from the gross_income of the employee the service concluded that to satisfy the criteria set forth in revenue rulings and with respect to particular contributions the required specification of designated employee contributions must be completed before the period to which such contributions relate in this request resolution n satisfies the criteria set forth in revrul_81_35 and revrul_81_36 by providing in effect that employer m will make contributions to plan x in lieu of contributions by group n employees under resolution n group n employees participating in plan x have no option to receive any picked up contributions in cash in lieu of having such contributions paid to plan x accordingly we conclude with respect to ruling requests number sec_1 and that the amounts picked up by employer m on behalf of the group n employees who participate in plan x shall be treated as employer contributions and will not be includible in the group n employees’ gross_income in the year in which such amounts are contributed for federal_income_tax treatment these amounts will be includible in the gross_income of the group n employees or their beneficiaries only in the taxable_year in which they are distributed to the extent that the amounts represent contributions made by employer m because we have determined that the picked-up amounts are to be treated as employer contributions they are excepted from wages as defined in sec_3401 of the code for federal_income_tax withholding purposes in addition no part of the amounts picked up by employer m will constitute wages for federal_income_tax withholding purposes in the taxable_year in which they are contributed to plan x these rulings apply only if the effective date for the commencement of the pick-up is no earlier than the later of the date resolution n was signed or the date the pick-up is put into effect for purposes of the application of sec_414 of the code it is immaterial whether an employer picks up contributions through a reduction in salary an offset against future salary increases or a combination of both these rulings are based on the assumption that plan x will be qualified under sec_401 of the code at the time of the proposed contributions and distributions ‘ rraaare ikea ia eere eredar ee page no opinion is expressed as to whether the amounts in question are subject_to tax under the federal_insurance_contributions_act no opinion is expressed as to whether the amounts in question are paid pursuant to a salary reduction agreement within the meaning of sec_3121 these rulings are directed only to the taxpayer who requested them sec_6110 of the code provides that they may not be used or cited by others as precedent a copy of this letter has been sent to your authorized representative in accordance with the power_of_attorney on file with this office sincerely yours signed joyce b floyd joyce e fioyd manager employee_plans technical group tax_exempt_and_government_entities_division enclosures deleted copy of this letter and notice cc great lakes area internal_revenue_service manager ep great lakes area s dearborn street mail stop chi chicago il


internal_revenue_service national_office technical_advice_memorandum date third party communication none date of communication not applicable 263a 263a 263a tam-123771-05 cc ita b05 number release date index uil no case-mis no ---------- --------------------------------------------------- taxpayer's name taxpayer's address ----------------------------------------- ---------------- ----------------------------- ------------------ ------------------------------- ---------------- ------- ------------------- taxpayer's identification no year s involved date of conference legend ----------------------------------------------------------- ------------------------------------- -------------------------- ----------- ------------------- taxpayer systems service x date federal_agency -------------------------------------------------- y act year codes ----- -------------------------------------- ------- -------------------------------------- issue s are the labor costs of taxpayer’s engineering department mixed_service_costs that may be allocated between capitalizable activities and deductible activities tam-123771-05 are the costs of taxpayer’s procurement department mixed_service_costs that may be allocated between capitalizable activities and deductible activities conclusion s taxpayer’s engineering department is a service_department that to some extent incurs mixed_service_costs however to the extent the costs of the engineering department include costs of labor that can be identified or associated with particular units or groups of units of specific produced property such costs are direct_labor_costs and not mixed_service_costs the costs of taxpayer’s procurement department are mixed_service_costs facts taxpayer wholly owns subsidiaries that are regulated public_utilities these subsidiaries operate systems that provide services to customers in x states assets used by taxpayer in providing these services include self-constructed assets as defined by sec_1_263a-1 taxpayer is regulated by both the federal_agency and state regulatory agencies section y of the act as amended requires that the federal_agency prescribe a uniform system of accounts for use by companies that provide services in year the federal_agency revised the uniform system of accounts and incorporated the accounting rules into regulations the federal agency’s regulations require that taxpayer assign and allocate costs based on types or pools of cost the cost pools that are collected by taxpayer’s accounting system and subsequently allocated are described in a cost allocation manual cam that taxpayer has prepared the major cost pools listed in the cam include among others engineering labor costs for individuals involved in the planning design and implementation engineering of specific projects engineering supervisions and clerical support other engineering department costs and provisioning costs of material and supplies the statement of facts included in the request for technical_advice submitted by the director and reviewed by taxpayer provides that these cost pools are allocated to projects and ultimately to expense or capitalized to assets as follows cost drivers which determine how costs are driven to different projects or to different codes are collected either in direct reported hours of the project as is the case for plant and engineering personnel or in specific dollars of materials used as is the case for provisions personnel as previously mentioned certain plant and engineering employees are required to report their time to the specific project and or the specific codes that they are working on the monetary cost of the materials used in specific projects is also recorded to the specific project and to the specific codes the direct hours which were time reported to the project tam-123771-05 and the monetary dollars for materials used on the project and to each code are multiplied by the applicable standard rate and these additional calculated costs are then allocated to the project and the code by accounting entities these standard rates are developed by collecting incurred costs in appropriate cost pools each cost pool has certain cost drivers then using rolling twelve month totals the total cost of a cost pool is divided by the applicable cost driver equaling the standard rate the standard rates are developed at certain organization levels called responsibility centers rcs the rc is the organizational level that has control_over the amounts expended taxpayer’s engineering department provides project estimates project planning and project design to plant department personnel engaged in the construction maintenance repair and removal of taxpayer’s systems in addition to providing support to personnel engaged in the construction maintenance repair and removal of its systems taxpayer’s engineering department performs work for other departments for example on occasion the engineering department also assists with costs studies being evaluated by the sales and marketing departments according to taxpayer’s cam costs incurred by the engineering department are initially accounted for in one general ledger account and subsequently reassigned to various other general ledger accounts on a monthly basis each activity performed by taxpayer with regard to the repair maintenance removal and construction activities of its systems is assigned an authorized project number and an alpha code the alpha codes consist of the following c for construction activities r for repairs and maintenance m for rearrangements and x for removal activities for financial reporting purposes costs classified with a c are capitalized and costs classified with an r m or x are expensed in addition to the alpha code costs are also tracked using standard number codes a combination of the alpha code and the standard number code are referred to as codes codes are used by the taxpayer to record the specific activity being performed on the type of asset the activity involves the statement of facts included in the request for technical_advice also indicates that an employee reporting his time and who is repairing a pole records his labor and material to ------ with the ----representing the pole and the -----representing the activity being performed repairing the pole moreover an engineer who specifically reports her time and who is working on designing plans for a buried cable would record her hours to the specific authorized project and the specific code according to the director in the engineering example the engineer would record her time to ----------the --- would represent the asset worked on the buried cable and the c would indicate a construction_project taxpayer’s plant accounting handbook provides detailed descriptions of all codes along with guidance for the employees as to the usage of the codes according to the cam certain time reporting employees are required to report the hours they spend working each day the federal agency’s regulations identify the labor of a time reporting employee as either direct plant labor or direct engineering tam-123771-05 labor these engineers perform the design planning and implementation engineering functions associated with a specific project that has received authorization and are required to report of their time certain levels of supervisors and support employees in the engineering as indicated above taxpayer initially reviewed and agreed to the above department do not report their time instead the labor costs of these employees are collected in cost pools and allocated by cost drivers as provided in the cam federal agency’s regulations refer to the allocated costs of these non-time reporting employees as indirect engineering labor statement of facts however at the conference of right on date and in a subsequent letter taxpayer represented that time-reporting engineers do not specifically record their time to codes instead taxpayer asserted that time-reporting engineers record the hours worked on a specific project but do not specifically record their time to individual capital or expense activities codes within the project taxpayer further asserted that the engineers’ reported time is allocated to codes within a specific project based on allocation percentages that are established by a planning engineer who initiated the specific project based on the total projected cost of the project according to taxpayer engineering labor that is reported to a specific project is spread to the codes of projects based on the pre-determined allocation percentages in the following two ways first the time reported by the engineer to a specific project could be automatically allocated by the project accounting system based on the estimated code allocations established for the project by the planning engineer second the time reported by the engineer to a specific project may be manually allocated by the engineer using the estimated code allocations established for the project by the planning engineer after the project has been approved in other words according to taxpayer an engineer that spends all of his or her time working on issues concerning only one code in a project would not specifically report all of his or her time to the code but would allocate his or her time based on the total cost estimates that were established by the planning engineer the director does not agree with taxpayer’s rendition of the facts therefore since the parties have been unable to reach an agreement on the facts this technical_advice will resolve the issue of whether all of the costs of taxpayer’s engineering department are mixed_service_costs in the alternative see section dollar_figure of revproc_2005_2 2005_1_irb_86 personnel within taxpayer’s procurement department analyze and evaluate suppliers’ products select appropriate suppliers negotiate supply contracts place purchase orders develop standards for material purchases and administer vendor or user claims certain personnel within the procurement department engage in provisioning activities these provisioning personnel oversee the receiving stocking and requisitions of materials_and_supplies that are used in constructing repairing and maintaining taxpayer’s system accordingly taxpayer’s provisioning costs are the costs associated with the handling of materials_and_supplies that are used in the tam-123771-05 construction and maintenance of taxpayer’s system taxpayer’s cam indicates that the acquisition costs of major materials used in an authorized project are recorded directly to the project and the associated code involved poles buried cable etc for instance if a new pole is installed the pole will be charged to the appropriate code in contrast the provisioning costs are collected in a cost pool and allocated based upon the acquisition costs of the materials used taxable_year ending date to change its method of allocating mixed_service_costs according to the form_3115 taxpayer previously used the step-allocation_method taking into account applicable facts and circumstances to allocate its mixed_service_costs to self-constructed assets under its proposed method taxpayer sought approval to use the simplified_service_cost_method to allocate mixed_service_costs the form_3115 also discloses that for this purpose taxpayer would treat the costs of its engineering department and procurement department as mixed_service_costs taxpayer filed a form_3115 application_for change in accounting_method for its law sec_263a generally requires a taxpayer to capitalize the direct costs and an allocable share of the indirect_costs of real or tangible_personal_property that is produced_by_the_taxpayer the direct costs of produced property include direct materials costs and direct_labor_costs see sec_1_263a-1 direct_labor_costs include the costs of labor that can be identified or associated with particular units or groups of units of specific property produced see sec_1_263a-1 the indirect_costs of produced property are all costs other than direct_material_costs and direct_labor_costs see sec_1_263a-1 indirect_costs are properly allocable to produced property when the costs directly benefit or are incurred by reason of the performance of production activities id indirect_costs may be allocable to a production activity and other activities that are not subject_to sec_263a accordingly taxpayers must make a reasonable allocation of indirect_costs between production and other such activities see sec_1_263a-1 certain overhead costs and capitalizable service_costs see ' 263a-1 e the regulations define service_costs as indirect_costs eg general and administrative costs that can be identified specifically with a service_department or function or that directly benefit or are incurred by reason of a service_department or function see sec_1_263a-1 for this purpose service departments are defined as administrative service or support departments that incur service_costs see sec_1 263a- e i b the mere title of a department or function does not determine whether the department or function constitutes a service_department instead the facts and circumstances of the taxpayer’s activities and business organization control whether a department is a service_department id indirect_costs subject_to capitalization under sec_263a include indirect labor costs the regulations segregate service_costs into the following three separate tam-123771-05 categories capitalizable service_costs deductible service_costs and mixed_service_costs for this purpose capitalizable service_costs are service_costs that directly benefit or are incurred by reason of the performance of a production or resale activity of the taxpayer see sec_1_263a-1 deductible service_costs are service_costs that do not directly benefit or are not incurred by reason of the performance of a production or resale activity of the taxpayer see sec_1 263a- e ii b mixed_service_costs are service_costs that are partially allocable to production or resale activities and partially allocable to non-production or non-resale activities see sec_1_263a-1 the regulations generally require taxpayers to allocate indirect_costs using either a specific_identification_method a standard_cost_method a burden rate method or any other reasonable allocation method as defined under the principles of sec_1_263a-1 see sec_1_263a-1 with regard to mixed_service_costs the regulations generally require taxpayers to allocate mixed_service_costs using reasonable factors or relationships by applying a direct_reallocation_method a step-reallocation method or any other reasonable allocation method as defined under the principles of ' 263a- f see sec_1_263a-1 the regulations also provide a simplified_method the simplified_service_cost_method for determining capitalizable mixed_service_costs see ' 263a-1 h analysi sec_1 are the labor costs of taxpayer’s engineering department mixed_service_costs that may be allocated between capitalizable activities and deductible activities department are not mixed_service_costs the director argues that the costs incurred by the taxpayer’s engineering department are not mixed_service_costs because taxpayer’s engineering department is not a service_department and even if the engineering department is in some part a service_department all the costs of the department are not service_costs the director also contends that the definition of a service_department only includes general and administrative departments the director concludes that since taxpayer’s engineering department does not incur general and administrative expenses it is not a service_department and does not incur mixed_service_costs that may be allocated using the simplified_service_cost_method we disagree include the costs of general and administrative departments sec_1 263a- e i a provides that s ervice costs are defined as a type of indirect_costs eg general and administrative costs that can be identified specifically with a service_department or function or that directly benefit or are incurred by reason of a service_department or function according to the director the parenthetical after indirect_costs sec_1_263a-1 does not limit the definition of service_costs to only the director argues that the costs incurred by taxpayer’s engineering the regulations generally permit taxpayers to allocate mixed_service_costs using service_costs are a type of indirect_costs that can be identified specifically with a tam-123771-05 limits service_costs to only include general and administrative costs contrary to director’s argument the parenthetical does not limit service_costs to only include the costs of general and administrative departments the parenthetical phrase includes the abbreviation eg which stands for exempli gratia translated exempli gratia means for example accordingly the parenthetical only provides an example of indirect_costs that may be service_costs and does not provide an exhaustive list of indirect_costs that may be service_costs service_department or function or that directly benefit or are incurred by reason of a service_department or function see sec_1_263a-1 therefore in order to determine whether the costs of taxpayer’s engineering department are service_costs one must first determine whether taxpayer’s engineering department is a service_department sec_1_263a-1 defines service departments as administrative service or support departments that incur service_costs the regulations do not contain a definitive list of service departments instead the facts and circumstances of a taxpayer’s activities and business organization control whether a department is a service_department reasonable factors or relationships by applying a direct_reallocation_method a step- reallocation method or any other reasonable allocation method as defined under the principles of sec_1_263a-1 see sec_1_263a-1 in doing so the regulations also provide illustrations of mixed service cost allocations using reasonable factors or relationships in particular sec_1_263a-1 provides that the costs of an engineering or design department are generally directly allocable to the departments or activities benefited based on the ratio of the approximate number of hours of work performed with respect to the particular activity to the total number of hours of engineering or design work performed for all activities given this example it is clear that the regulations contemplate that the costs of an engineering department may be viewed as service_costs and allocated between capitalizable and deductible activities using various cost allocation_methods functional and that certain functions of the engineering department may in fact qualify as service functions but that all functions of the engineering department are not service functions according to the director the costs of those functions that are service functions may qualify as mixed_service_costs but the costs of those functions that are not service functions are not mixed_service_costs provided a large measure of flexibility to taxpayers to allocate costs inasmuch as they permitted any reasonable method of allocation authorized by traditional cost accounting when it enacted sec_263a congress recognized that existing tax_accounting rules the director also contends that taxpayer’s engineering department is multi- accordingly the treasury_department promulgated regulations under sec_263a tam-123771-05 principles accordingly congress expected that the treasury_department would take a similar approach and permit similar allocation_methods permitted by cost accounting principles congress also recognized that modifications of the rules may be necessary or appropriate in order to adapt such rules to the new capitalization requirements see s rep no vol c b that respected the flexibility provided by traditional cost accounting principles by permitting taxpayers to allocate direct costs and indirect_costs using a variety of methods moreover the regulations provide that direct_labor_costs can be allocated as indirect_costs provided such costs are capitalized to the extent required by the regulations see sec_1_263a-1 the regulations also respected traditional cost accounting principles by permitting taxpayers to allocate mixed_service_costs using reasonable factors or relationships by applying a direct_reallocation_method a step- reallocation method or any other reasonable allocation method as defined under the principles of sec_1_263a-1 see sec_1_263a-1 given the flexibility afforded by the regulations to allocate direct and indirect_costs using similar allocation_methods the categorization of a cost as either direct or indirect generally is not determinative of the method that may be used to allocate such costs however as explained below the simplified_service_cost_method provided by the regulations may not be used to allocate direct costs therefore in the context of the simplified_service_cost_method the determination of whether a cost is a direct or indirect_cost is important allocate direct costs sec_1_263a-1 provides that a taxpayer may use the simplified_service_cost_method to determine capitalizable mixed_service_costs incurred during the taxable_year with respect to eligible_property as defined in sec_1_263a-1 for this purpose mixed_service_costs are defined as service_costs that are partially allocable to production or resale activities capitalizable mixed_service_costs and partially allocable to non-production or non-resale activities deductible mixed_service_costs service_costs are a type of indirect_costs that can be identified specifically although the legislative_history only refers to the flexibility afforded the allocation of indirect_costs the regulations also provided such flexibility to labor costs see sec_1_263a-1 prior to the enactment of sec_263a the full absorption regulations provided in sec_1_471-11 recognized that many taxpayers may have classified a direct_production_cost as an item of overhead under the full absorption regulations a taxpayer that classified direct production_costs as overhead could continue its method of classifying direct productions costs provided the taxpayer treated the costs as overhead allocable to inventory cost see sec_1_471-11 see also leslie j schneider federal income_taxation of inventories dollar_figure the regulations generally leave considerable flexibility to taxpayers to categorize labor costs as either direct or indirect because there is not usually a great deal of significance to the distinction because both types of labor costs are subject_to capitalization under sec_263a see sec_1_263a-1 as long as a taxpayer’s cost accounting system is designed to assign the labor costs to units of output there should be no problem with categorizing the cost as either a direct_cost or an indirect_cost see schneider supra at sec_4 as is indicated above the simplified_service_cost_method can not be used to a close review of the temporary sec_263a regulations that preceded the final tam-123771-05 identified with a service_department or function or that directly benefit or are incurred by reason of a service_department or function emphasis added see sec_1 263a- e a accordingly the simplified_service_cost_method may only be used to allocate a certain type of indirect_costs mixed_service_costs and may not be used allocate direct costs moreover although sec_1_263a-1 provides that a taxpayer is not treated as using an erroneous method_of_accounting if direct_labor_costs are treated as indirect_costs under the taxpayer’s allocation method the section does not refer to the simplified_service_cost_method instead the section indicates that if direct_labor_costs are treated as indirect_costs they must be capitalized to the extent required by sec_1_263a-1 sec_1_263a-1 provides that indirect_costs must be allocated using either a specific_identification_method a burden rate method or any other reasonable allocation method as defined in sec_1_263a-1 sec_1_263a-1 does not refer to the simplified_service_cost_method sec_263a regulations also reveals that the drafters of the regulations were aware that a given department could incur a mix of direct costs indirect_costs and service_costs in particular sec_1_263a-1t b iii ii of the temporary regulations 1987_1_cb_98 provided the general_rule for allocating administrative service or support costs this rule provided that the total direct and indirect_costs service_costs of administrative service or support functions or departments service departments that directly benefit a particular production activity must be directly allocated to such activity but that service_costs that benefit production as well as other functions must be allocated to particular activities or functions on the basis of a factor or relationship that reasonably relates the incurring of the service_costs to the benefits received by the activity like the final regulations the temporary regulations permitted a taxpayer to allocate service_costs by consistently applying any reasonable cost allocation method including a direct_reallocation_method a step-allocation_method or any other reasonable method however the temporary regulations also cautioned that none of these methods would be considered a reasonable method if the method effectively allocates service_costs to other service departments in such a manner as to avoid the eventual reallocation of such costs to production activities if such reallocation was required under the principles of the regulations see sec_1_263a-1t b iii iii therefore under the general_rule for allocating service_costs provided by the temporary regulations service_costs that directly benefit a particular production activity were required to be allocated to the activity like the final regulations the temporary regulations also permitted a taxpayer to use the simplified_service_cost_method to allocate its mixed_service_costs however the temporary regulations clarified that for purposes of the simplified_service_cost_method mixed_service_costs did not include administrative support and service_costs that directly benefit or are incurred by reason of the performance of the taxpayer’s production activities if such costs do not benefit other activities of the taxpayer’s trade_or_business or if such costs were properly allocated to production activities under the taxpayer’s method_of_accounting prior to the effective date of sec_263a see sec_1 263a- at first blush this conclusion may appear to be contrary to sec_1_263a-1 this tam-123771-05 1t b i in other words under the simplified_service_cost_method as provided in the temporary regulations mixed_service_costs did not include the costs of a department that are direct costs of a production activity and costs that were properly allocated to production activities under the taxpayer’s method_of_accounting prior to the effective date of sec_263a given this regulatory background it is clear that the final sec_263a regulations purposely do not include direct costs within the definition of service_costs in other words because the final sec_263a regulations do not include direct costs within the definition of service_costs like the temporary sec_263a regulations the final sec_263a regulations do not permit a taxpayer to use the simplified_service_cost_method to allocate direct_labor_costs section provides that for purposes of the simplified_service_cost_method total mixed_service_costs are defined as the total costs incurred during the taxable_year in all departments or functions of the taxpayer’s trade_or_business that perform mixed service activities the section further provides that in determining the total mixed_service_costs of a trade_or_business the taxpayer must include all costs incurred in its mixed service_department and cannot exclude any otherwise deductible service_costs however a close reading of sec_1_263a-1 reveals that the method allocates only mixed_service_costs incurred by a mixed service_department first paragraph of sec_1_263a-1 states that this paragraph h provides a simplified_method for determining capitalizable mixed_service_costs incurred during the taxable_year emphasis added second after stating that total mixed_service_costs means all costs incurred by departments or functions performing mixed service activities paragraph of sec_1_263a-1 refers taxpayers to sec_1_263a-1 for a definition of mixed_service_costs that definition only includes indirect_costs thus it is obvious that the simplified_service_cost_method is a method for allocating indirect_costs that qualify as mixed_service_costs and does not apply to costs that are direct costs taxpayer’s engineering department are direct_labor_costs for example the director contends that one of the activities performed by taxpayer’s engineering department involves the selection or implementation of designs materials and methods for the production of specific plant assets according to the director the costs associated with this activity have always been considered by taxpayer as a direct_cost for financial_accounting purposes and until taxpayer filed its change in method_of_accounting a direct_cost for tax purposes the director further contends that taxpayer treats the costs of this activity as a direct_cost because taxpayer’s books_and_records for financial_accounting purposes directly identifies or associates these costs with particular units or groups of units of specific property produced the director also contends that certain engineers time reporting engineers directly report their time to codes and therefore the costs of these time reporting employees should be considered direct_labor_costs argued that engineering costs are categorically treated by the regulations as indirect initially in a brief attached to the director’s request for technical_advice taxpayer in the instant case the director contends that many of the costs incurred by taxpayer’s argument ignores the definition of direct_labor_costs contained in tam-123771-05 costs and not direct costs in support of its argument taxpayer cited sec_1 263a- d ii p which provides that engineering and design costs are an example of indirect_costs taxpayer further argued that direct_labor_costs only include the costs of production workers that are directly involved in the fabrication of the product in other words taxpayer argued that only the costs of personnel that touch the production process are direct_labor_costs for purposes of sec_1_263a-1 in support of its argument taxpayer cited the blue_book to the act which states that d irect production_costs required to be included in an inventory account included the costs of materials forming an integral part of the product or consumed in the manufacturing process and the costs of labor that were directly involved in fabrication of the product see joint_committee on taxation general explanation of the tax_reform_act_of_1986 99th cong comm print sec_1_263a-1 this section provides that direct_labor_costs include the costs of labor that can be identified or associated with particular units or groups of units of specific property produced using this definition it is clear that if time reporting engineers directly report their time to codes the costs of these time reporting employees are being identified or associated with particular units or groups of units of specific property produced and therefore are considered direct_labor_costs sec_1_263a-1 this section provides that indirect_costs are all costs other than direct_material_costs and direct_labor_costs sec_1_263a-1 which defines indirect labor costs also clearly provides that indirect labor includes all labor costs that cannot be directly identified or associated with particular units or groups of units of specific property produced ie direct_labor_costs concerning time reporting engineers that directly report their time to codes are in accord with traditional cost accounting principles traditional cost accounting principles recognize that different organizations may attach different meanings to the terms direct_labor_costs indirect labor costs and service_costs see national association of accountants statement of management accounting no 4c definition and measurement of direct_labor_cost management accounting management accounting date charles t horngren george foster cost accounting a managerial emphasis 6th ed direct labor has traditionally been defined as labor quantities that can be specifically identified with a cost object in an economically feasible manner see national association of accountants supra pincite horngren supra pincite for this purpose a cost objective is generally defined as a product contract project organizational subdivision or other unit for which costs are measured or estimated national association of accountants supra pincite although this definition has been widely accepted its application varies because the determination of whether it is economically feasible to directly relate costs must be performed on an entity by entity basis accordingly differences in the way organizations define their costs has in the definition of direct_labor_costs in sec_1_263a-1 and our conclusions taxpayer’s arguments also ignore the definition of indirect_costs provided in the california franchise tax board applied these traditional cost accounting tam-123771-05 practice resulted in variations in the amount recorded as direct labor and the amount recorded as overhead in other words whether a cost is considered a direct_cost must be viewed in the context of the company’s cost accounting system whether the company has determined that it is economically feasible to trace the subject costs directly to a cost objective and the use for which the term is being employed eg a cost reimbursement contract and income taxes see horngren supra pincite principles to analyze a situation where a taxpayer utilizes the services of its employees for the engineering and design of a new coker in legal ruling the california franchise tax board addressed whether certain capitalized costs of labor paid_or_incurred by a qualified_taxpayer for engineering and design services constitute qualified_costs for purposes of california’s manufacturers’ investment_credit mic according to the ruling the mic is allowable to qualified taxpayers who pay or incur qualified_costs on or after date for qualified_property that is placed_in_service qualified_costs for this purpose are limited to amounts that are properly chargeable to the capital_account of the qualified_taxpayer and includes capitalized costs of labor that are directly allocable to the construction or modification of qualified_property see cal rev tax code d and d for purposes of the mic the term capitalized labor means all direct costs of labor that can be identified or associated with and are properly allocable to the construction modification or installation of specific items of qualified_property see cal code regs tit b and b to determine whether direct costs of labor are properly allocable to the construction modification or installation of a specific item of qualified_property a taxpayer is required to use the same method of allocation that it is required to use under sec_1_263a-1 see cal code regs tit b and b using these criteria the california tax board analyzed a situation where a taxpayer utilizes the services of its employees for the engineering and design of a new coker see situation sec_2 and of legal ruling supra in situation the taxpayer does not keep separate records of the time spent by each of the employees performing engineering and design services for the new coker in this situation the board held that the wages of the engineers were not qualified_costs for purposes of the mic because the wages are not direct_labor_costs under sec_263a however in situation the taxpayer maintained separate records of the number of hours that each engineer spent engineering and designing the new coker in this situation the board held that the wages of the engineers are qualified_costs for purposes of the mic because these costs are properly treated as direct_labor_costs under sec_1_263a-1 statement as indicated above the blue_book in part states d irect production_costs required to be included in an inventory account includes the costs of materials forming an integral part of the product or consumed in the manufacturing process and the costs of labor that were directly involved in fabrication of the product see joint_committee on taxation supra this statement does not support taxpayer’s argument the statement only indicates that the costs of labor that are directly involved in fabrication of we also disagree with taxpayer’s interpretation of the cited blue_book in this case the director argues that some of the costs of taxpayer’s engineering tam-123771-05 the product ie labor that touches the product as it is being manufactured is included in the definition of direct labor and therefore must be capitalized contrary to taxpayer’s argument the statement does not limit the definition of direct_labor_costs to only include the costs of such labor moreover the blue_book statement does not purport to be a comprehensive definition of direct_labor_costs department are direct_labor_costs in particular the director contends that the labor costs of time reporting engineers are associated with particular assets because the time reporting engineers specifically assign their costs to a code using either a c r m or x where a c indicates that the cost is capitalizable taxpayer asserts that none of the labor costs incurred by its engineering department can be identified or associated with particular units or groups of units of specific property produced without the use of an allocation method in other words taxpayer asserts that the labor costs incurred by its engineering department are not specifically recorded to capitalizable projects according to taxpayer its time-reporting engineers record the hours worked on specific projects but do not specifically record the time spent on individual capital or expense activities codes within the project instead the engineers reported time is allocated to codes within a specific project based on allocation percentages established by the planning engineer who initiated the specific project and based on the total projected cost of the project for each code likewise the labor costs associated with supervisors and support employees in the engineering department are not directly associated with a capitalizable project but instead are collected in cost pools and allocated using cost drivers in alternative answers if the director determines that time reporting engineers specifically track time to codes such labor constitutes direct_labor_costs however if the director determines that the time reporting engineers do not specifically track time to codes such labor costs are not direct_labor_costs given this resolution of the issue the director must process the case consistent with this legal analysis as applied to the facts as they are ultimately determined see section dollar_figure of revproc_2005_2 supra are the costs of taxpayer’s procurement department mixed_service_costs that may be allocated between capitalizable activities and deductible activities department are not mixed_service_costs because its costs do not consist of only general and administrative costs alternatively the director contends that even if the procurement department is considered a service_department the provisioning costs of the department are not mixed_service_costs because taxpayer’s accounting system already partially identifies these costs with capital projects the director does not contend however that the provisioning costs are direct costs we believe that the two sets of facts provided by the director and taxpayer result the director contends that the costs incurred by taxpayer’s procurement tam-123771-05 as indicated above we do not accept the director’s narrow definition of a service_department sec_1_263a-1 does not limit the definition of service_costs to only include the costs of general and administrative departments contrary to director’s argument service_costs are a type of indirect_costs that can be identified specifically with a service_department or function or that directly benefit or are incurred by reason of a service_department or function therefore in order to determine whether the costs of taxpayer’s procurement department are service_costs one must first determine whether taxpayer’s procurement department is a service_department sec_1 263a- e i b defines service departments as administrative service or support departments that incur service_costs the regulations do not contain an exclusive list of service departments instead the facts and circumstances of a taxpayer’s activities and business organization control whether a department is a service_department however the regulations indicate that certain purchasing costs may constitute capitalizable service_costs in particular sec_1_263a-1 provides that the costs of purchasing operations including materials and equipment scheduling and coordinating delivery of materials and equipment to and from factories or job sites and expediting and follow-up is an example of capitalizable service_costs this example assumes that because the materials and equipment are delivered to a factory such materials and equipment will be used for production however in some instances purchased materials may not be used in an activity that requires capitalization of the purchasing costs under sec_263a accordingly it is clear that the regulations contemplate that the costs of a purchasing department may be viewed as service_costs and allocated between capitalizable and deductible activities using various cost allocation_methods that are incurred in the procurement department are not mixed_service_costs because such costs are properly allocated to property produced under taxpayer’s existing accounting_method the director’s argument is similar to the rules found in the temporary regulations under the temporary regulations a taxpayer was not permitted to use the simplified_service_cost_method to allocate administrative support and service_costs if such costs were properly allocated to production activities under the taxpayer’s method_of_accounting prior to the effective date of sec_263a see sec_1_263a-1t b i the rule provided by the temporary regulations is not contained in the final regulations see sec_1_263a-1 furthermore we do not accept the director’s argument that the provisioning cost sec_3 as indicated above the temporary regulations indicated that for purposes of the simplified_service_cost_method mixed_service_costs did not include administrative support and service_costs that directly benefit or are incurred by reason of the performance of the taxpayer’s production activities if such costs do not benefit other activities of the taxpayer’s trade_or_business or if such costs were properly allocated to production activities under the taxpayer’s method_of_accounting prior to the effective date of sec_263a see sec_1_263a-1t b i in our analysis of taxpayer’s engineering department we opined that this background made clear that the final sec_263a regulations did not include direct costs within the definition of service_costs this opinion was not only supported by the background provided by the temporary regulations but also the express wording of the definition of service_costs provided in sec_1 263a- e a the director’s present argument regarding costs that were properly allocated to production activities under the taxpayer’s method_of_accounting prior to the effective date of sec_263a unlike its having concluded that taxpayer’s procurement department is a service tam-123771-05 department we believe that all the indirect_costs incurred by the department constitute mixed_service_costs mixed_service_costs are service_costs that are partially allocable to production or resale activities capitalizable mixed_service_costs and partially allocable to non-production or non-resale activities deductible mixed_service_costs see sec_1_263a-1 in this case taxpayer’s provisioning costs relate to both production and non-production activities accordingly taxpayer’s provisioning costs must be allocated between capitalizable production activities and deductible activities under the final sec_263a regulations all the indirect_costs as opposed to direct costs incurred in a service_department that are partially allocable to production or resale activities or resale activities and partially allocable to non-production or non-resale activities ie mixed_service_costs can be allocated between capitalizable and deductible activities using the simplified_service_cost_method caveat s a copy of this technical_advice_memorandum is to be given to the taxpayer s sec_6110 of the code provides that it may not be used or cited as precedent argument regarding direct costs with relation to service_costs is not addressed by any analogous section in the final regulations


department of the treasury internal_revenue_service washington d c tax exempt and govern ment entities division contact person identification_number telephone number employer_identification_number uil number release date date date legend association x dear we have considered your ruling_request dated june as amended on january concerning your proposal to provide welfare benefits to certain actively employed and retired non-member staff of the state and local affiliates of association facts you are a voluntary employees' beneficiary association veba exempt under sec_501 c of internal_revenue_code the association established and controls you you provide certain life accidental death and dismemberment and other insurance benefits to the association's members the association your sponsor is a national labor_union recognized as exempt under sec_501 c the association operates through a network of affiliated state and local associations the association charters these affiliates and requires that they meet certain standards in order to retain their affiliation with association the association requires members of its state and local affiliates to join the association unless they are otherwise ineligible because of this structure nearly all members of the association's state and local affiliates are also members of the association you propose to amend your plan to allow participation by certain actively employed and retired staff of the association's state and local affiliates proposed participants the proposed participants are not members of and are not eligible for membership in the association or its state and local affiliates you estimate the number of proposed participates to be 2dollar_figure you certify that on at least one day of each quarter of your taxable_year percent of your total membership consists of members of the association and its affiliates rulings requested you have requested the following rulings the participation of non-member actively employed and retired staff of the association's state and local affiliates will not jeopardize your exempt status under sec_501 a as an organization described in sec_501 c law sec_501 c exempts vebas from federal income if no part of the net_earnings of such association inures other than through such payments to the benefit of any private_shareholder_or_individual tax a veba provides for the payment of life sick accident or other_benefits to the members of such association or their dependents or designated beneficiaries sec_1 c -1 provides that for an organization to be described in sec_501 c it must be an employees' association membership in the association must be voluntary the organization must provide for the payment of life sick accident or other_benefits to its members or their dependents or designated beneficiaries and substantially_all of its operations are in furtherance of providing such benefits and no part of the net_earnings of the organization can inure other than by payment of the permitted benefits to the benefit of any private_shareholder_or_individual sec_1 c -2 a provides that the membership of a veba must consist of individuals who become entitled to participate by reason of their being employees and whose eligibility for membership is defined by reference to objective standards that constitute an employment-related common bond among such individuals typically those eligible for membership in a veba are defined by reference to a common employer or affiliated employers to coverage under one or more collective bargaining agreements with respect to benefits provided by reason of such agreement s to membership in a labor_union or to membership in one or more locals of a national or international labor_union for example membership in veba might be open to all employees of a particular employer or to employees in specified job classifications working for certain employers at specified locations and who are entitled to benefits by reason of one or more collective bargaining agreements in addition employees of one or more employers engaged in the same line_of_business in the same geographic locale will be considered to share an employment-related bond for purposes of an organization through which their employers provide benefits employees of a labor_union also will be considered to share an employment-related common bond with members of the union and employees of a veba will be considered to share an employment-related common bond with members of the veba whether a group of individuals is defined by reference to a permissible standard or standards is a question to be determined with regard to all the facts and circumstances taking into account the guidelines set forth in this paragraph exemption will not be denied merely because the membership of an association includes some individuals who are not employees within the meaning of sec_1 c -2 b provided that such individuals share an employment-related bond with the employee-members such individuals may include for example the proprietor of a business whose employees are members of the association for purposes of the preceding two sentences an association will be considered to be composed of employees if percent of the total membership of the association on one day of each quarter of the association's taxable_year consists of employees within the meaning of sec_1 c b sec_1 c -2 b provides that whether an individual is an employee is determined by reference to the legal and bona_fide relationship of employer and employee the term employee includes the following an individual who is considered an employee i for employment_tax purposes under subtitle c of the internal_revenue_code and the regulations thereunder or ii for purposes of a collective bargaining agreement whether or not the individual could qualify as an employee under applicable common_law rules this would include any person who is considered an employee for purposes of the labor management relations act of stat as amended u s c an individual who became entitled to membership in the association by reason of being or having been an employee thus an individual who would otherwise qualify under this paragraph will continue to qualify as an employee even though such individual is on leave of absence works temporarily for another employer or as an independent_contractor or has been terminated by reason of retirement disability or layoff for example an individual who in the normal course of employment is employed intermittently by more than one employer in an industry characterized by short-term employment by several different employers will not by reason of temporary unemployment cease to be an employee within the meaning of this paragraph the surviving_spouse and dependents of an employee if for purposes of the percent test of sec_1 c -2 a they are considered to be members of the association in 795_f2d_1303 7th cir the court invalidated a regulation under sec_501 c that required all employees to be of the same geographic locale n nonetheless the court confirmed t hat the quintessential element of a sec_501 c tax-exempt veba is the commonality of interests among its employee members analysis your information establishes that you are a veba recognized under sec_501 c providing certain welfare benefits to the members of the association you propose to amend your governing instrument to provide benefits to certain active and retired staff of the association's state and local affiliates who are not members of the association or its state and local affiliates proposed participants the membership of a veba must consist of individuals who became entitled to participate by reason of their being employees and whose eligibility for membership is defined by reference to objective standards that constitute an employment-related common bond among such individuals sec_1 c -2 a the proposed participants are all active or retired employees of the association's state and local affiliates sec_1_501_c_9_-2 thus the issue is whether the proposed participants share an employment-related common bond with the members of the association and its state and local affiliates even though the proposed participants are not members of the association they share an employment-related common bond with members of the association and with members of the state and local affiliates of the association the purpose of requiring an employment-related common bond is to evidence a commonality of interests among the veba's employee members 795_f2d_1303 7th cir the regulations list several categories of individuals that will be considered to share an employment related common bond employees of one or more employers engaged in the same line_of_business in the same geographic locale employees of a labor_union with the members of that labor_union employees of a veba with the members of that veba sec_1 c -2 a the same commonality of interests that exists between the employees of the labor_union or veba and its respective members exists between the proposed participants and the members of the association's state and local affiliates accordingly the proposed participants share an employment-related common bond with the members of the state and local affiliates who are also the members of the association conclusion based on the foregoing we rule as follows the participation of non-member actively employed and retired staff of the association's state and local affiliates will not jeopardize your exempt status under sec_501 a as an organization described in sec_501 c this ruling is based on the representation that at least of your total membership consists of members the association and its state and local affiliates on one day of each quarter of your taxable_year see sec_1_501_c_9_-2 this ruling will be made available for public inspection under sec_6110 of the code after certain deletions of identifying information are made for details see enclosed notice notice of intention to disclose a copy of this ruling with deletions that we intend to make available for public inspection is attached to notice if you disagree with our proposed deletions you should follow the instructions in notice this ruling is directed only to the organization that requested it sec_611 k of the code provides that it may not be used or cited by others as precedent this ruling is based on the' facts as they were presented and on the understanding that there will be no material changes in these facts this ruling does not address the applicability of any section of the code or regulations to the facts submitted other than with respect to the sections described because it could help resolve questions concerning your federal_income_tax status this ruling should be kept in your permanent records if you have any questions about this ruling please contact the person whose name and telephone number are shown in the heading of this letter in accordance with the power_of_attorney currently on file with the internal_revenue_service we are sending a copy of this letter to your authorized representative sincerely theodore lieber manager exempt_organizations technical group enclosure notice


internal_revenue_service p o box cincinnati oh number release date date date department of the treasury employer_identification_number contact person - id number contact telephone number legend uil b name c area name d city e date dear you asked for advance approval of your educational grant procedures under internal_revenue_code sec_4945 this approval is required because you are a private_foundation that is exempt from federal_income_tax our determination we approved your procedures for awarding educational grants based on the information you submitted and assuming you will conduct your program as proposed we determined that your procedures for awarding educational grants meet the requirements of code sec_4945 as a result expenditures you make under these procedures won't be taxable description of your request you will operate an educational grant program called b the goal of b positive cultural impact on c in the city of d with respect to the arts through b you will make grants to any individual who can create an outdoor art installation such as a sculpture mural or other appropriate medium is to create a you will publicize the application process for b on your website as well as provide pertinent information to anyone who calls or emails to be eligible for consideration under b an individual must be able to create a sculpture or other work_of_art that is original durable and safe for public viewing in an unsupervised outdoor environment to apply for b an applicant must submit to you an artwork statement describing the proposed project the statement must also include the title of the proposed work the year the medium the size of the proposed work and the amount requested as well as a statement on how the proposed work will relate to or expand on current themes in their own work applicants will also need to submit high resolution images of the proposed artwork along with sketches and support images moreover applicants are required to include a plan for the transportation and installation of the proposed work as well as any details of any grants the applicant has received in the past for other installations a selection committee composed of your board members will select the recipient after your staff members have reviewed the application packages in selecting the recipient the selection committee will consider the applicant's biography and other examples of the applicant’s existing work furthermore relatives of members of the selection committee or of your officers directors or substantial contributors are not eligible for awards made under b you will base the number of grants upon how much money is available to award within your budget considering multi-year grants and your required_minimum_distribution you will determine the grant award amount using the overall budget of b and the amount requested as well as how much of your overall budget the grant would comprise recipients are required to submit a progress report at least twice a year generally about of the six months apart in addition recipients are required to submit a final report on e if a progress or following year after the grant term to provide pertinent information on b final report form is not submitted by requested due_date the recipient may not be eligible to receive future funding you represent that you will arrange to receive and review grantee reports annually and upon completion of the purpose for which the grant was awarded investigate diversions of funds from their intended purposes and take all reasonable and appropriate steps to recover diverted funds ensure other grant funds held by a grantee are used for their intended purposes and withhold further payments to grantees until you obtain grantees’ assurances that future diversions will not occur and that grantees will take extraordinary precautions to prevent future diversions from occurring you also represent that you will maintain all records relating to individual grants including information obtained to evaluate grantees identify whether a grantee is a disqualified_person establish the amount and purpose of each grant and establish that you undertook appropriate supervision and investigation of grants basis for our determination the law imposes certain excise_taxes on the taxable_expenditures of private_foundations code sec_4945 a taxable_expenditure is any amount a private_foundation pays as a grant to an individual for travel study or other similar purposes however a grant that meets all of the following requirements of code sec_4945 is not a taxable_expenditure letter catalog number 58222y the foundation awards the grant on an objective and nondiscriminatory basis the irs approves in advance the procedure for awarding the grant the grant is - - - ascholarship or fellowship subject_to sec_117 and is to be used for study at an educational_organization described in sec_170 or a prize or award subject_to the provisions of sec_74 if the recipient of the prize or award is selected from the general_public or to achieve a specific objective produce a report or similar product or improve or enhance a literary artistic musical scientific teaching or other similar skill or talent of the recipient to receive approval of its educational grant procedures sec_53_4945-4 requires that a private_foundation show e e e the grant procedure includes an objective and nondiscriminatory selection process the grant procedure results in the recipients performing the activities the grants were intended to finance the foundation plans to obtain reports to determine whether the recipients have performed the activities that the grants were intended to finance other conditions that apply to this determination e e e e e this determination covers only the grant program described above this approval will apply to succeeding grant programs only if their standards and procedures don’t differ significantly from those described in your original request this determination applies only to you it may not be cited as precedent you cannot rely on the conclusions in this letter if the facts you provided have changed substantially you must report any significant changes in your program to the cincinnati office of exempt_organizations at internal_revenue_service exempt_organizations determinations p o box cincinnati oh you cannot make grants to your creators officers directors trustees foundation managers or members of selection committees or their relatives all funds distributed to individuals must be made on a charitable basis and must further the purposes of your organization you cannot award grants for a purpose that is inconsistent with code sec_170 letter catalog number 58222y e you should keep adequate_records and case histories so that you can substantiate your grant distributions with the irs if necessary we've sent a copy of this letter to your representative as indicated in your power_of_attorney please keep a copy of this letter in your records if you have any questions please contact the person listed at the top of this letter sincerely stephen a martin director exempt_organizations rulings and agreements letter catalog number 58222y