Internal Revenue Bulletin 2005-3 (PDF rendition): IRS Announcements

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing. Whole bulletin rendition: numbered items are identified below; other legal material and publisher context remain included. This is not a new standalone advance release.

Bulletin No. 200
5-3
January 18, 2005
HIGHLIGHTS
OF THIS ISSUE
These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied upon as authoritative interpretations.
INCOME TAX
Rev. Rul. 2005–3, page 334.
Section 901(j)(5) Presidential waiver; Libya.Pursuant to
a section 901(j)(5) Presidential waiver, section 901(j)(1) of the
Code ceased to apply to Libya effective December 10, 2004.
Section 911(d)(8) is not applicable to Libya after September
20, 2004, and Iraq after July 29, 2004. Rev. Ruls. 92–63
and 95–63 modified and superseded. Rev. Rul. 2004–103
superseded.
Notice 20
05–2, page 337.
This noti
ce provides guidance to qualifying vessel operators on
the proce
dure for electing into the tonnage tax regime under
section 1
354(a) of the Code, which was added by section 248
of the Ame
rican Jobs Creation Act of 2004.
EMPLOYEE PLANS
T.D. 9164, page 320.
REG–129709–03, page 351.
Temporary and proposed regulations under section 409(p) of
the Code provide guidance on the definition and effects of a
prohibited allocation under section 409(p), identification of dis-
qualified persons and determination of a nonallocation year, cal-
culation of synthetic equity under section 409(p)(5), and stan-
dards for determining whether a transaction is an avoidance or
evasion of section 409(p). A public hearing on the proposed
regulations is scheduled for April 20, 2005.
Notice
2005–5, page 337.
Automa
tic rollover; section 657 of Economic Growth Tax
Relief
and Reconciliation Act of 2001.This notice pro-
vides g
uidance in question and answer format on the auto-
matic r
ollover provisions of section 401(a)(31)(B) of the Code
as amended by section 657 of the Economic Growth and Tax
Relief Reconciliation Act of 2001.
EMPLOYMENT TAX
Announcement 2005–5, page 353.
This announcement advises employers about a new Code Z
for use on the 2005 Form W–2. This code will be used to
identify income recognized due to participation in a nonqualified
deferred compensation plan that fails to meet the requirements
of section 409A of the Code. Similar reporting is required on
Form 1099–MISC for nonemployees.
ADMINISTRATIVE
Notice 2005–7, page 340.
This notice addresses the applicability of section 6043A of
the Code and requests public comments on issues relating to
information reporting for acquisitions under section 6043A by
March 1, 2005. The notice provides that taxpayers required to
report under regulations sections 1.6043–4T and 1.6045–3T
must continue to report pursuant to those regulations.
Rev. Proc. 2005–10, page 341.
Per diem allowances.This procedure provides optional rules
for deeming substantiated the amount of certain reimbursed
traveling expenses of an employee as well as determining
the amount of deductible meal and incidental expenses while
traveling away from home. It updates Rev. Proc. 2004–60,
2004–42 I.R.B. 682, to revise the high-low substantiation
method to conform to changes in theper diemrates made
by the General Services Administration. Rev. Proc. 2004–60
superseded.
Announcements of Disbarments and Suspensions begin on page 352.
Fi
nding Lists begin on page ii.

The IRS Mission
Provide America’s taxpayers top quality service by helping
them understand and meet their tax responsibilities and by
applying the tax law with integrity and fairness to all.
Introduction
The Internal Revenue Bulletin is the authoritative instrument of
the Commissioner of Internal Revenue for announcing official
rulings and procedures of the Internal Revenue Service and for
publishing Treasury Decisions, Executive Orders, Tax Conven-
tions, legislation, court decisions, and other items of general
interest. It is published weekly and may be obtained from the
Superintendent of Documents on a subscription basis. Bulletin
contents are compiled semiannually into Cumulative Bulletins,
which are sold on a single-copy basis.
It is the policy of the Service to publish in the Bulletin all sub-
stantive rulings necessary to promote a uniform application of
the tax laws, including all rulings that supersede, revoke, mod-
ify, or amend any of those previously published in the Bulletin.
All published rulings apply retroactively unless otherwise indi-
cated. Procedures relating solely to matters of internal man-
agement are not published; however, statements of internal
practices and procedures that affect the rights and duties of
taxpayers are published.
Revenue rulings represent the conclusions of the Service on the
application of the law to the pivotal facts stated in the revenue
ruling. In those based on positions taken in rulings to taxpayers
or technical advice to Service field offices, identifying details
and information of a confidential nature are deleted to prevent
unwarranted invasions of privacy and to comply with statutory
requirements.
Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be
relied on, used, or cited as precedents by Service personnel in
the disposition of other cases. In applying published rulings and
procedures, the effect of subsequent legislation, regulations,
court decisions, rulings, and procedures must be considered,
and Service personnel and others concerned are cautioned
against reaching the same conclusions in other cases unless
the facts and circumstances are substantially the same.
The Bulletin is divided into four parts as follows:
Part I.—19
86 Code.
This part i
ncludes rulings and decisions based on provisions of
the Intern
al Revenue Code of 1986.
Part II.—Treaties and Tax Legislation.
This part is divided into two subparts as follows: Subpart A,
Tax Conventions and Other Related Items, and Subpart B, Leg-
islation and Related Committee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to these
subjects are contained in the other Parts and Subparts. Also
included in this part are Bank Secrecy Act Administrative Rul-
ings. Bank Secrecy Act Administrative Rulings are issued by
the Department of the Treasury’s Office of the Assistant Sec-
retary (Enforcement).
Part IV
.—Items of General Interest.
This par
t includes notices of proposed rulemakings, disbar-
ment an
d suspension lists, and announcements.
The last Bulletin for each month includes a cumulative index
for the matters published during the preceding months. These
monthly indexes are cumulated on a semiannual basis, and are
published in the last Bulletin of each semiannual period.
The c
ontents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.
For sale by the Superintendent of Documents, U.S.Government Printing Office, Washington, DC 20402.
January 18, 20052005–3 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Code
of 1986
Section 62.—Adjusted
Gross Income Defined
26 CFR 1.62–2: Reimbursement
s and other expense
allowance arrangements.
Rules are provided under whi
ch a reimbursement
or other expense allowance a
rrangement for the cost
of lodging, meal, and incide
ntal expenses, of meal
and incidental expenses, or
of incidental expenses
only, incurred by an employ
ee while traveling away
from home will satisfy the r
equirements of § 62(c) of
the Code as to substantiati
on of the amount of the ex-
penses. See Rev. Proc. 200
5-10, page 341.
Section 162.—Trade or
Business Expenses
26 CFR 1.162–17: Reporting and substantiation of
certain business expenses of employees.
Rules are provided for substantiating the amount
of a deduction of an expense for meal and incidental
expenses, or for incidentalexpenses only, incurred
while traveling away from home. See Rev. Proc.
2005-10, page 341.
Section 267.—Losses,
Expenses, and Interest With
Respect to Transactions
Between Related Taxpayers
26 CFR 1.267(a)–1: Deductions disallowed.
Optional rules for substantiating the amount of or-
dinary and necessary business expenses of an em-
ployee for lodging, meal, and incidental expenses,
for meal and incidental expenses, or for incidental
expenses only, incurred while traveling away from
home when a payor provides aper diemallowance
under a reimbursement or other expense allowance
arrangement do not apply if a payor and an employee
are related within the meaning of § 267(b). See Rev.
Proc. 2005-10, page 341.
Section 274.—Disallowance
of Certain Entertainment,
etc., Expenses
26 CFR 1.274–5: Substantiation requirements.
Rules are provided for an optional method for
substantiating the amount of ordinary and necessary
business expenses of an employee for lodging, meal,
and incidental expenses,for meal and incidental
expenses, or for incidentalexpenses only, incurred
while traveling away from home when a payor pro-
vides aper diemallowance under a reimbursement
or other expense allowance arrangement. Rules are
also provided for an optional method for employees
and self-employed individuals to use in computing
the deductible costs of business meal and incidental
expenses, or incidental expenses only, paid or in-
curred while traveling away from home. See Rev.
Proc. 2005-10, page 341.
Section 409.—Qualifi-
cations for Tax Credit
Employee Stock Own-
ership Plans
26 CFR 1.409(p)–1T: Prohibited allocations of secu-
rities in an S corporation (temporary).
T.D. 9164
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Part 1
Prohibited Allocations of
Securities in an S Corporation
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Temporary regulations.
SUMMARY: This document contains
temporary regulations concerning require-
ments for employee stock ownership plans
(ESOPs) holding stock of Subchapter S
corporations. The temporary regulations
provide guidance on the definition and ef-
fects of a prohibited allocation under sec-
tion 409(p), identification of disqualified
persons and determination of a nonalloca-
tion year, calculation of synthetic equity
under section 409(p)(5), and standards for
determining whether a transaction is an
avoidance or evasion of section 409(p).
These temporary regulations generally
affect plan sponsors of, and participants
in, ESOPs holding stock of Subchapter S
corporations. The text of the temporary
regulations also serves as the text of the
proposed regulations (REG–129709–03)
set forth in the notice of proposed rule-
making on this subject in this issue of the
Bulletin.
DATES:Effective Date: These regulations
are effective December 17, 2004.
Applicability Dates: These temporary
regulations are applicable with respect to
plan years beginning on or after January 1,
2005, but see §1.409–1T(i)(2) for specific
exceptions.
FOR FURTHER INFORMATION
CONTACT: John T. Ricotta at (202)
622–6060 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
Section 409(p) wasenacted as part of
the Economic Growth and Tax Relief Rec-
onciliation Act of 2001 (EGTRRA) (115
Stat. 38) (2001) to address concerns about
ownership structures involving S corpora-
tions and ESOPs that concentrate the ben-
efits of the ESOP, directly or indirectly,
in a small number of persons. Under the
statute, an ESOP is generally permitted to
hold S corporation stock, provided that the
ESOP benefits a sufficiently broad-based
group of employees.
Section 4975(e)(7) provides that an
ESOP is a defined contribution plan that is
designed to invest primarily in qualifying
employer securities and that is either a
stock bonus plan which is qualified, or
a stock bonus plan and money purchase
pension plan both of which are qualified,
under section 401(a). A plan is not treated
as an ESOP under the Internal Revenue
Code (Code) unless it meets the following
requirements, to the extent applicable:
section 409(e) (relating to participants’
voting rights if the employer has a reg-
istration-type class of securities); section
409(h) (relating to participants’ right to
receive employer securities; put options);
section 409(o) (relating to participants’
distribution rights and payment require-
ments); section 409(n) (relating to secu-
rities received in transactions to which
section 1042 applies); section 409(p)
(relating to prohibited allocations of se-
curities in an S corporation); and section
664(g) (relating to qualified gratuitous
transfers of qualified employer securi-
ties). As authorized bysection 4975(e)(7),
additional requirements for ESOPs are
imposed under §54.4975–11 of the Excise
Tax Regulations.
2005–3 I.R.B.320January 18, 2005

Section 511 imposes an income tax
on unrelated business taxable income
(UBTI), as defined in section 512. Sec-
tion 512(e)(1) generally provides that an
interestinanScorporationheldbyanor-
ganization described in section 1361(c)(6),
including a qualified plan, is treated as an
interest in an unrelated trade or business.
However, section 512(e)(3) has an ex-
ception for employer securities held by an
ESOP,sothatanESOPofanScorporation
generally does not have UBTI under sec-
tion 512 with respect to the S corporation
stockheldbytheESOP.
Section 409(p)(1) requires an ESOP
holding employer securities consisting
ofstockinanScorporationtoprovide
that no portion of the assets of the plan
attributable to (or allocable in lieu of)
such employer securities may, during a
nonallocation year, accrue (or be allocated
directly or indirectly under any plan of
the employer meeting the requirements
of section 401(a)) for the benefit of any
disqualified person, as defined in section
409(p). Section 409(p)(3)(A) provides
that a “nonallocation year” includes any
plan year during which the ownership
of the S corporation is so concentrated
among disqualified persons that they own
or are deemed to own at least 50 percent
of its shares. Section 409(p)(4) provides,
in general, that whether someone is a “dis-
qualified person” depends on a person’s
deemed-owned shares of S corporation
stock held by an ESOP (deemed-owned
ESOP shares). Section 409(p)(4) provides,
in general, that a “disqualified person”
means any person whose deemed-owned
ESOP shares are at least 10 percent of the
number of deemed-owned ESOP shares
or for whom the aggregate number of
deemed-owned ESOP shares of such per-
son and the members of such person’s
family is at least 20 percent of the number
of deemed-owned ESOP shares.
The determination of whether someone
is a disqualified person and whether a plan
year is a nonallocation year is also made
separately taking into account synthetic
equity. Synthetic equity is a general clas-
sification unique to section 409(p). The
provisions relating to synthetic equity do
not modify the rules relating to S corpo-
rations,e.g., the circumstances in which
options or similar interests are treated as
creating a second class of stock. H.R.
Conf. Rep. No. 107–84, at 102 n. 52. Un-
der the rules for the treatment of synthetic
equity at section 409(p)(5), if a person
owns synthetic equity in an S corporation,
then the shares of stock in such corpo-
ration on which such synthetic equity is
based are treated as outstanding stock in
such corporation, and as deemed-owned
shares of such person, “if such treatment
of synthetic equityof 1 or more such per-
sonsresults in ... the treatment of any
person as a disqualified person or ... the
treatment of any year as a nonallocation
year.” [Emphasis added.]
Section 409(p)(7)(A) authorizes the
Secretary to prescribe such regulations as
may be necessary to carry out the purposes
of section 409(p). Section 409(p)(7)(B)
provides that the Secretary may, by regu-
lation or other guidance of general appli-
cability, provide that a nonallocation year
occurs in any case in which the principal
purpose of the ownership structure of an
S corporation constitutes an avoidance or
evasion of section 409(p).
Section 4979A imposes a 50 percent
excise tax on certain prohibited alloca-
tions in an ESOP, including any allocation
of employer securities that violates sec-
tion 409(p), and on any synthetic equity
owned by a disqualified person during a
nonallocation year under section 409(p).
In addition, section 4979A includes spe-
cial rules for the first nonallocation year
of an ESOP under which the excise tax
applies with respect to all deemed-owned
ESOP shares and all synthetic equity of
disqualified persons, even if there is no
prohibited allocation in that year. Sec-
tion 4979A(a)(3), (a)(4), and (e)(2)(C).
Thus, for example, any unallocated shares
in an ESOP loan suspense account that
are treated as deemed-owned shares of
a disqualified person pursuant to section
409(p)(4)(C) are taken into account in
determining the amount involved under
4979A(e)(2)(C). In addition, under sec-
tion 4979A(e)(3)(D), a special statute of
limitations applies to the first year of an
ESOP that is a nonallocation year.
Temporary regulations under section
409(p) were issued on July 21, 2003 (T.D.
9081, 2003–2 C.B. 420 [68 FR 42970]).
The text of those temporary regulations
also served as the text of a notice of
proposed rulemaking (REG–129709–03,
2003–2 C.B. 506) published at 68 FR
43058. The 2003 regulations provide
guidance on identifying disqualified per-
sons, determining whether an ESOP has a
nonallocation year, and on the definition of
synthetic equity under section 409(p)(5).
In January 2004, the IRS issued Rev.
Rul. 2004–4, 2004–6 I.R.B. 414, which
addresses three factual situations involv-
ing an S corporation with qualified sub-
chapter S subsidiaries (QSUBs). Pursuant
to the authority of section 409(p)(7)(B)
and §1.409(p)–1T(c)(3) of the 2003 regu-
lations, Rev. Rul. 2004–4 states that a non-
allocation year occurs and the individual is
a disqualified person in any case in which
(i) shares of an S corporation are employer
securities held by an ESOP, (ii) the prof-
its of the S corporation generated by the
business activities of a specific individual
are accumulated and held for the benefit of
that individual in a QSUB or similar en-
tity (such as a limited liability company),
(iii) these profits are not paid to the indi-
vidual as compensation within 2
1
/2months
after the end of the year in which earned,
and (iv) the individual has rights to ac-
quire shares of stock (or similar interests)
of the QSUB or similar entity representing
50 percent or more of the fair market value
of the stock of such QSUB or similar en-
tity. Rev. Rul. 2004–4 also provides that
such individual’s right to acquire shares of
stock(orsimilarinterests)oftheQSUB
or similar entity is synthetic equity. Ac-
cordingly, Rev. Rul. 2004–4 holds in each
of the three factual situations that, for pur-
poses of sections 409(p) and 4979A, cer-
tain individuals are disqualified persons,
the ESOP has a nonallocation year, and the
disqualified persons are treated as owning
synthetic equity in the form of their op-
tions to acquire shares of the correspond-
ing QSUB.
1
1
Rev. Rul. 2004–4 also states that arrangements that are the same as, or substantially similar to, the following transaction are identified as “listedtransactions” for purposes of §§1.6011–4(b)(2),
301.6111–2(b)(2) and 301.6112–1(b)(2), effective January 23, 2004: any transaction in which (i) at least 50 percent of the outstanding shares of an Scorporation are employer securities held
by an ESOP, (ii) the profits of the S corporation generated by the business activities of a specific individual are accumulated and held for the benefitof that individual in a QSUB or similar
entity (such as a limited liability company), (iii) these profits are not paid to the individual as compensation within 2
1
/2months after the end of the year in which earned, and (iv) the individual
has rights to acquire shares of stock (or similar interests) of the QSUB or similar entity representing 50 percent or more of the fair market value of thestock of such QSUB or similar entity.
January 18, 20053212005–3 I.R.B.

Rev. Rul. 2004–4 also stated that
Treasury and the IRS intend to reflect the
guidance in that revenue ruling in regu-
lations under section 409(p), effective for
plan years ending after October 20, 2003,
and that it is expected that the regulations
would apply to similar transactions that
have the effect of reserving profits from an
individual’s business activities to provide
similar tax benefits to the individual, either
with the use of a QSUB or through the use
of another method.
Comments were received on the 2003
regulations. A public hearing on the 2003
regulations was held on November 17,
2003. After consideration of comments
received and views expressed at the hear-
ing, and taking into account Rev. Rul.
2004–4 and that section 409(p) applies to
all ESOPs for plan years beginning on or
after January 1, 2005, these new tempo-
rary regulations are being issued effective
generally for plan years that begin on or
after January 1, 2005, subject to a number
of special effective date and transition
rules that are described in this preamble
under the headingEffective date.
Explanation of Provisions
Definition of Prohibited Allocation
In order to satisfy section 409(p), an
ESOP holding employer securities consist-
ing of stock in an S corporation must pro-
vide that no portion of the assets of the plan
attributable to (or allocable in lieu of) such
employer securities may, during a nonal-
location year, accrue under the ESOP, or
be allocated directly or indirectly under
any plan of the employer (including the
ESOP) meeting the requirements of sec-
tion 401(a), for the benefit of any disqual-
ified person. This requirement has two el-
ements; it prohibits accruals and alloca-
tions. These regulations provide two new
terms, impermissible accrual and imper-
missible allocation, to reflect these two el-
ements. Under the regulations, if there is
an impermissible accrual or an impermis-
sible allocation, then there is a prohibited
allocation in violation of this requirement.
Under the definition of impermissible
accrual in these regulations, there is a pro-
hibited allocation to the extent (and only
to the extent) that employer securities con-
sisting of stock in an S corporation owned
by the ESOP and any assets attributable
thereto are held under the ESOP for the
benefit of a disqualified person during a
nonallocation year. This rule was recom-
mended by a commentator. For this pur-
pose, assets attributable to S corporation
securities include not only S corporation
stock held in a disqualified person’s ac-
count in the ESOP, but also any distribu-
tions, within the meaning of section 1368,
made on S corporation stock held in a dis-
qualified person’s account in the ESOP
(including earnings thereon), plus any pro-
ceeds from the sale of S corporation secu-
rities held for a disqualified person’s ac-
count in the ESOP (including any earnings
thereon).
Under the definition of impermissible
allocation, prohibited allocations include
any allocation for a disqualified person di-
rectly or indirectly under any plan of the
employer qualified under section 401(a)
that occurs during a nonallocation year to
the extent that a contribution or other an-
nual addition is made, or the disqualified
person otherwise accrues additional ben-
efits, under the ESOP or any other plan
of the employer qualified under section
401(a) (including a release and allocation
of assets from a suspense account, as de-
scribed at §54.4975–11(c) and (d)) that, for
the nonallocation year, would otherwise
have been added to the account of the dis-
qualified person under the ESOP and in-
vested in employer securities consisting of
stockinanScorporationownedbythe
ESOP but for a provision in the ESOP to
comply with section 409(p).
Effect of a Prohibited Allocation
Under section 409(p)(2) and these reg-
ulations, if there is a prohibited allocation,
then the amount of the prohibited alloca-
tion is treated as distributed to the disqual-
ified person at the time of the prohibited
allocation. Accordingly, the fair market
value of the disqualified person’s account
under the ESOP would generally be in-
cluded in his or her gross income (to the
extent in excess of his or her allocable in-
vestment in the contract, if any, under sec-
tion 72). The additional income tax im-
posed by section 72(t) would also apply
if the disqualified person is less than age
59
1
/2(and no other exception applies).
Like a deemed distribution under sec-
tion 72(p),
2
a deemed distribution under
section 409(p) is not an actual distribu-
tion from the ESOP. Thus, the amount of
the prohibited allocation is not an eligible
rollover distribution and, for purposes of
applying sections 72 and 402 with respect
to any subsequent distribution from the
ESOP, the amount previously taken into
account by the disqualified person as in-
come as a result of the deemed distribution
is treated as an investment in the contract.
Under these regulations, if there is a
nonallocation year and there are prohib-
ited allocations in that year, the plan would
fail to satisfy the requirements of section
4975(e)(7) and would cease to be an ESOP.
As a result, not only would the plan lose the
prohibited transaction exemption for loans
to an ESOP under section 4975(d)(3) of
the Code and section 408(b)(3) of Title I
of the Employee Retirement Income Se-
curity Act of 1974, as amended (ERISA),
but also the exception in section 512(e)(3)
would cease to apply to the plan, so that
theplanwouldoweincometaxasare-
sult of unrelated business taxable income
under section 512 with respect to S corpo-
ration stock held by the plan from and af-
ter the date of the prohibited allocation.
3
Other consequences include imposition of
an excise tax under section 4979A and, as-
suming that the plan’s provisions do not
permit a prohibited allocation under sec-
tion 409(p), loss of tax qualification for
failure to operate the plan in accordance
with its terms.
Prevention of a Nonallocation Year
As part of the regulations that were pro-
posed in 2003, comments were requested
with respect to issues raised by S corpo-
ration ESOPs established by March 14,
2001, that will need to comply with the
requirements of section 409(p) beginning
in 2005, including transition approaches
2
See §1.72(p)–1, Q&A–11 and 12.
3
It should be noted that transactions that give rise to loss of the prohibited transaction exemptions under section 4975(d)(3) of the Internal RevenueCode and section 408(b)(3) of Title I
of ERISA for loans to an ESOP could also give rise to other prohibited transactions under section 4975 of the Internal Revenue Code, as well as violations of Title I of ERISA, including
prohibited transactions under section 406 of Title I of ERISA, resulting in, among other things, the assessment of additional excise taxes under section 4975(a) and (b) of the Internal Revenue
Code, as well as civil penalties under section 502(i) of ERISA.
2005–3 I.R.B.322January 18, 2005

for ESOPs that become subject to section
409(p) in 2005. One commentator re-
quested a transition rule under which non-
qualified deferred compensation would be
disregarded if it was granted at a time when
it was not synthetic equity and was dis-
tributed within 12 months after it became
synthetic equity.
These issues are particularly important
because compliance with the requirements
of section 409(p) is required on a current
operational basis, as well as a plan docu-
ment basis. Thus, for example, if S cor-
poration shares are held in a disqualified
person’s account during a nonallocation
year, then there is a failure to satisfy sec-
tion 409(p), without regard to whether the
terms of the ESOP prohibit such actions
or require preventative action to be taken.
Factors that might be considered in deter-
mining whether there has been a failure to
comply with the requirements of section
409(p) on a current operational basis in-
clude, for example, the exercise of voting
rights of shares in the disqualified person’s
account, distributions from the S corpora-
tion to the disqualified person’s account,
and plan account statements showing al-
locations to the disqualified person’s ac-
count.
A plan might choose to take a number of
steps before the beginning of a year in or-
der to ensure that the year is not a nonallo-
cation year, such as steps to prevent an in-
dividual from becoming a disqualified per-
son. These include:
•Reduction of synthetic equity,e.g.,by
cancellation or distribution of the syn-
thetic equity.
•A sale of the S corporation securities
held in the participant’s ESOP account
so that the account is not invested in S
corporation stock.
•A distribution of the S corporation se-
curities held in the participant’s ac-
count from the ESOP to the participant.
Such a distribution is only permissi-
ble to the extent the amount is other-
wise permitted to be distributed (e.g.,
for amounts that are subject to section
401(k), the distribution does not vio-
late the distribution restrictions of sec-
tion 401(k)(2)(B)(i)).
•A transfer of the S corporation securi-
ties held for the participant under the
ESOP into a separate portion of the
plan that is not an ESOP (as permitted
under §54.4975–11(a)(5) of the Excise
Tax Regulations) or to another quali-
fied plan of the employer that is not an
ESOP.
Any of these steps must satisfy ap-
plicable legal and qualification require-
ments, including the nondiscrimination
requirements of section 401(a)(4).
4
These
regulations provide that, if a transfer is
made from an ESOP to a separate por-
tion of the plan or to another qualified
plan of the employer that is not an ESOP
in order to prevent a nonallocation year,
then both the ESOP and the plan that is
not an ESOP will not fail to satisfy the
requirements of §1.401(a)(4)–4 merely
because of the transfer. Further, subse-
quent to the transfer, the plan that is not an
ESOP will not fail to satisfy the require-
ments of §1.401(a)(4)–4 merely because
of the benefits, rights, or features with
respect to the transferred benefits if those
benefits, rights, or features would satisfy
the requirements of §1.401(a)(4)–4 if the
mandatory disaggregation rule for ESOPs
at §1.410(b)–7(c)(2) did not apply.
In the event of such a transfer, the trans-
feree plan would be subject to tax on unre-
lated business taxable income with respect
to itspro ratashareofincomefromthe
S corporation securities, with that expense
to be charged to the account holding the
transferred amount. However, the ESOP
would be able to continue to satisfy the re-
quirements of section 4975(e)(7) and the
allocations could be made for the partici-
pant for the year.
Determination of Nonallocation Year
Under section 409(p), a nonallocation
year generally means a plan year during
which on any date disqualified persons
own50percentormoreofthestockinthe
S corporation, separately applied by taking
into account all outstanding shares of stock
in the S corporation (including shares held
by the ESOP) and by taking into account
all outstanding shares of stock in the S cor-
poration and synthetic equity. These reg-
ulations include some changes from the
rules in the 2003 regulations for purposes
of determining whether there is a nonallo-
cation year.
The 2003 regulations generally treat a
person as owning outstanding non-ESOP
stock that the person has the right to ac-
quire, but only in very limited cases. These
regulations treat a person as owning out-
standing non-ESOP stock that the person
has the right to acquire unless the actual
owner is a person who is subject to fed-
eral income tax, the right is one that would
not be taken into account in determining
whether an S corporation has a second
class of stock under §1.1361–1(l)(2)(iii) or
(l)(4)(iii)(C), and a principal purpose of the
right is not to avoid or evade a nonalloca-
tion year under section 409(p).
Other differences from the 2003 regula-
tions include a change relating to synthetic
equity (discussed in this preamble under
the headingDetermination of disqualified
persons on person-by-person basis) and, in
response to comments, clarification that, if
any share is treated as owned by more than
one person, then that share is counted as
a single share and that share is treated as
owned by disqualified persons if any of the
owners is a disqualified person.
Determination of Disqualified Persons on
Person-by-person Basis
Under the 2003 regulations, a person’s
synthetic equity shares are added to his
or her deemed-owned ESOP shares to de-
termine whether he or she is a disquali-
fied person. This total number of shares
is then compared withthe total outstand-
ing synthetic equity shares in determining
whether that person is a disqualified per-
son. The 2003 regulations were criticized
for this approach inthe case of options
because it allowed options held by other
shareholders to dilute the interests of the
person being tested and prevent them from
being treated as a disqualified person.
These regulations change this approach
by looking only at the synthetic equity of
the person being tested to determine if he
or she is a disqualified person. In addition,
a nonallocation year occurs as a result of
syntheticequityifthetotalshareowner-
ship of disqualified persons (actual own-
ership, deemed-owned ESOP shares, plus
synthetic equity) is at least 50 percent of
the total shares outstanding plus the syn-
4
Further, any sale or transfer of plan assets must comply with the requirements of Part 4 of Subtitle B of Title I of ERISA.
January 18, 20053232005–3 I.R.B.

thetic equity of disqualified persons. This
‘person-by-person approach’ is more con-
sistent with the statutory rule that synthetic
equity is counted for one person if it results
in any person being treated as a disquali-
fied person.
The person-by-person approach applies
to synthetic equity in the form of nonqual-
ified deferred compensation, as well as in
the form of options or other rights related
to stock. This approach prevents dilution
of the disqualified person’s ownership and
also addresses a known abuse identified by
several commentators involving stock op-
tions or stock appreciation rights that are
unlikely to be exercised. In this abuse,
the S corporation issues a large number of
stock options or stock appreciation rights
to lower paid employees which are only
exercisable at a strike price far exceeding
even the likely future value of the shares
or the strike price is periodically reset to
exceed the expected value during the term
of the option or right. These options or
rights would never be exercised by the
employees, but are designed to count as
synthetic equity shares in order to prevent
shareholders who actually have the right to
own 10 percent or more of the S corpora-
tion from being treated as disqualified per-
sons. Several commentators urged Trea-
sury and the IRS to prevent this abuse. Un-
der the person-by person approach adopted
in these regulations, these options or rights
would be ignored in determining whether
other shareholders were disqualified per-
sons and would not prevent persons who
have actual rights to become 10 percent
shareholders from being treated as disqual-
ified persons.
Synthetic Equity
These regulations are generally simi-
lar to the 2003 regulations regarding what
constitutes synthetic equity. Differences
include the expansion of the definition of
synthetic equity to include the right to ac-
quire stock or assets of a related entity
andanexclusionfornonqualified deferred
compensation that was taken into account
before January 1, 2005, for purposes of
the Federal Insurance Contributions Act
(FICA) and that was outstanding before
the first date on which the ESOP acquired
any employer securities.
Determination of Number of Shares of
Synthetic Equity
The 2003 regulations include rules un-
der which the number of synthetic equity
shares attributed for a stock option is based
on the number of shares that are subject
to that option. The same rule also applies
to any other synthetic equity that is deter-
mined by reference to shares of stock of
the S corporation but for which payment
is made in cash or other property. These
regulations provide that in the case of syn-
thetic equity determined by reference to
shares of stock in the S corporation, the
number of shares of synthetic equity de-
pends on the gross number of shares de-
liverable pursuant to the synthetic equity.
In the case of synthetic equity determined
by reference to S corporation shares but
payable in cash or other property (other
than S corporation shares), the number of
synthetic equity shares treated as owned is
equal to the number of shares of stock hav-
ing a fair market value equal to the cash or
other property paid (disregarding lapse re-
strictions as described in §1.83–3(i)). Ac-
cordingly, the number of shares of syn-
thetic equity attributed for a stock appre-
ciation right (payable in stock or in cash)
equals the number of shares having a value
equal to the appreciation at the time of
measurement (determined without regard
to lapse restrictions).
In addition, the 2003 regulations pro-
vide that rights to acquire stock or interests
in an entity related to the S corporation are
treated as synthetic equity if the interests
in the related entity are the only significant
assets of the S corporation and the S corpo-
ration is the only significant owner of the
related entity. These regulations broaden
that rule by providing that synthetic equity
includes all rights toacquire stock or simi-
lar interests in a related entity to the extent
of the S corporation’s ownership. The reg-
ulations provide that synthetic equity also
includes a right to acquire assets of an S
corporation or a related entity other than
either rights to acquire goods, services, or
property at fair market value in the ordi-
nary course of business or fringe benefits
excluded from gross income under section
132.
In the case of synthetic equity that is
not determined by reference to shares of
stock of the S corporation (or shares of
stock or similar interests in a related en-
tity), the 2003 regulations provided that
the person who is entitled to the synthetic
equity is treated as owning a number of
shares of stock in the S corporation equal
to the present value of the synthetic equity
(with such value determined without re-
gard to any lapse restriction as defined un-
der the section 83 regulations) divided by
the fair market value of a share of the S cor-
poration’s stock as of the same date. These
regulations include a similar rule, but in-
clude three rules that were not in the 2003
regulations.
First, these regulations include a special
rule with respect to voting rights. While
sections 409(l) and 4975(e)(7) generally
require that the employer securities of an
ESOP have voting rights at least equal to
the voting rights of that class of common
stock having the greatest voting rights (as-
suming the employer has no stock readily
traded on an established securities market),
there might be rights to acquire a class of
shares that are not currently outstanding
and that have greater voting rights. Un-
der these regulations, if a synthetic eq-
uity right includes (directly or indirectly)
a right to purchase or receive shares of S
corporation stock that have per-share vot-
ing rights greater than the per-share vot-
ing rights of one or more shares of S cor-
poration stock held by the ESOP, then the
number of shares of deemed owned syn-
thetic equity attributable to such right is
at least equal to the number of shares that
would have the same voting rights if such
shares had the same per-share voting rights
as shares held by the ESOP.
Second, like the 2003 regulations, these
regulations permit the number of synthetic
equity shares for nonqualified deferred
compensation (that is not determined by
reference to shares of stock of the S corpo-
ration or shares of stock or similar interests
in a related entity) to be determined as of
the first day of the ESOP’s plan year, or
any other reasonable determination date or
dates during a plan year that is consistently
used by the ESOP for this purpose for all
persons. These regulations require that
the date used be reasonably representative
of the share value of the S corporation’s
stock. The number of shares of synthetic
equity treated as owned for any period
from a determination date through the date
immediately preceding the next following
determination date is the number of shares
treated as owned on the first day of that pe-
2005–3 I.R.B.324January 18, 2005

riod. In addition, these regulations include
a new rule intended to address concerns
expressed in the comments regarding ad-
ministrative and planning difficulties that
arise from a daily, or even annual, determi-
nation of synthetic equity shares where the
number is affected both by the potential
volatility of the S corporation stock value
and separately by the potential volatility
of the nonqualified deferred compensa-
tion. Under these regulations, the ESOP
may provide, on a reasonable and con-
sistent basis used by the ESOP for this
purpose for all persons, that the number
of shares of synthetic equity treated as
owned on an identified determination date
remain constant for the period from that
determination date until the date that is im-
mediately preceding the third anniversary
of the identified determination date. As
new grants are made during this three-year
period, the appropriate number of shares
of synthetic equity resulting from the new
grant would be determined at the next
determination date, which would likewise
remain constant during the remainder of
the same three-year period. However,
the ESOP must recalculate the number
of shares of this type of synthetic equity
at least every three years, based on the S
corporation share value on the applica-
ble determination date and the aggregate
present value of nonqualified deferred
compensation on thatdetermination date.
The regulations include an example illus-
trating this rule.
Third, these regulations include a new
rule for cases in which the ESOP does not
own all of the stock of the S corporation.
This rule reflects the view that the dilutive
effect of synthetic equity only affects an
ESOP to the extent of the ESOP’s owner-
ship interest in the S corporation. Under
this rule, the number of synthetic shares
otherwise determined is reduced ratably to
the extent that shares of the S corpora-
tion are owned by a person who is not an
ESOP (and who is subject to federal in-
come taxes). For example, if an S cor-
poration has 200 outstanding shares, of
which individual A owns 50 shares and the
ESOP owns the other 150 shares, and indi-
vidual B would be treated as owning 200
synthetic equity shares of the S corpora-
tion but for the special rule for cases in
which the ESOP does not own all of the
stock of the S corporation, then the num-
ber of synthetic shares treated as owned by
B is decreased from 200 to 150 (because
the ESOP only owns 75% of the outstand-
ing stock of the S corporation, rather than
100%).
Avoidance or Evasion of Section 409(p)
These regulations include a standard for
determining whether the principal purpose
of the ownership structure of an S corpora-
tion involving synthetic equity constitutes
an avoidance or evasion of section 409(p).
Under this standard, whether the principal
purpose of the ownership structure of an
S corporation involving synthetic equity
constitutes an avoidance or evasion of sec-
tion 409(p) is determined by taking into ac-
count all the surrounding facts and circum-
stances. An avoidance or evasion of sec-
tion 409(p) does not occur where the ESOP
receives the economic benefits of owner-
ship in the S corporation, taking into ac-
count all features of the ownership of the
S corporation’s outstanding stock and re-
lated obligations (including synthetic eq-
uity), any shareholders who are taxable en-
tities, and the rights of the ESOP, to deter-
mine whether, to the extent of the ESOP’s
stock ownership, the ESOP receives the
economic benefits of ownership in the S
corporation that occur during the period
that stock of the S corporation is owned
by the ESOP. Among the factors indicat-
ing that the ESOP receives these economic
benefits include shareholder voting rights,
the right to receive distributions made to
shareholders, and the right to benefit from
the profits earned by the S corporation, in-
cluding the extent to which actual distribu-
tions of profits are made from the S corpo-
rationtotheESOPandtheextenttowhich
the ESOP’s ownership interest in undis-
tributed profits and future profits is sub-
ject to dilution as a result of synthetic eq-
uity, for example, the ESOP’s ownership
interest is not subject to dilution if the total
amount of synthetic equity is a relatively
small portion of the total number of shares
and deemed-owned shares of the S corpo-
ration.
This standard is promulgated pursuant
to the authority of Treasury and the IRS to
act promptly to issue guidance to prevent
ownership structures that deny an ESOP
the economic benefits of ownership and,
in addition, these regulations identify cer-
tain specific ownership structures that con-
stitute an avoidance or evasion of section
409(p). Specifically, the regulations iden-
tify the transactions described in Rev. Rul.
2004–4 as being an avoidance or evasion
of section 409(p) and provide that there is
a nonallocation year notonlyinthesitu-
ations described in the revenue ruling but
also in situations in which profits are seg-
regated using a method other than QSUBs.
Under the regulations, the principal pur-
pose of the ownership structure of an S cor-
poration constitutes an avoidance or eva-
sion of section 409(p), and a nonallocation
year results, in any case in which (i) the
profits of the S corporation generated by
the business activities of a specific indi-
vidual or individuals are substantially ac-
cumulated and held for the benefit of that
individual or individuals on a tax-deferred
basis within an entity related to the S cor-
poration, such as a partnership, trust, or
corporation (such as in a subsidiary that is
a disregarded entity), or through any other
method that has the same effect of segre-
gating profits for the benefit of such in-
dividual or individuals (such as nonqual-
ified deferred compensation), (ii) the indi-
vidual or individuals for whom profits are
segregated have rights to acquire 50 per-
cent or more of those profits directly or in-
directly (for example, by purchase of the
subsidiary), and (iii) a nonallocation year
would occur if this section were separately
applied with respect to either the separate
entity or whatever method has the effect
of segregating profits of the individual or
individuals, treating such entity as a sepa-
rate S corporation owned by an ESOP (or
in the case of any other method of segre-
gation of profits by treating those profits
as the only assets of a separate S corpo-
ration owned by an ESOP). This conclu-
sion both reflects the holding in Rev. Rul.
2004–4 (discussed in this preamble under
the headingBackground) and treats similar
transactions as resulting in a nonallocation
year, as Rev. Rul. 2004–4 indicated would
be reflected in these regulations.
Effective Dates
These temporary regulations are appli-
cable for plan years beginning on or af-
ter January 1, 2005. However, there are a
number of special effective date and tran-
sition rules.
These regulations preserve the rules of
the 2003 temporary regulations with re-
spect to plan years beginning before Jan-
January 18, 20053252005–3 I.R.B.

uary 1, 2005, with the new rules in these
regulations to apply thereafter. However,
as described in this section, the rules in
these regulations dealing with ownership
structures that constitute an avoidance or
evasion of section 409(p), including the
rules relating to structures similar to those
addressed in Rev. Rul. 2004–4, apply for
plan years ending on or after December 31,
2004.
Under the transition rules, ESOP shares
that are held for a disqualified person be-
fore the first plan year beginning on or af-
ter January 1, 2005, will not be treated
as an impermissible accrual in 2005 if the
shares are disposed of before July 1, 2005
(e.g., by distribution or transfer to a non-
ESOP) and no amount is contributed for
the benefit of the disqualified person under
any plan of the employer intended to meet
the requirements of section 401(a) (includ-
ing the ESOP) during the period from the
first day of the first plan year beginning on
or after January 1, 2005, through June 30,
2005. However, even if no amount is al-
located to a disqualified person during this
period, but this period is part of the first
nonallocation year of the ESOP, an excise
tax will apply under section 4979A with
respect to either ESOP shares held for a
disqualified person or synthetic equity that
is treated as owned under these regulations
on the first day of the plan year, regard-
less of whether there is an impermissible
accrual or impermissible allocation. See
section 4979A(a)(3), (a)(4), and (e)(2)(C).
Under another transition rule, the new
person-by-person rules in these regula-
tions on how to determine whether a per-
son is a disqualified person and whether
a year is a nonallocation year generally
do not go into effect until July 1, 2005.
However, comments indicated that the
2003 regulations could be easily avoided
or evaded by granting options or stock
appreciation rights with artificially high
strike prices or where the strike price is
periodically increased to exceed the ex-
pected value before the option or right is
to expire. Thus, with respect to the period
from (and including) December 31, 2004,
through June 30, 2005, the new rules ap-
ply to plans under which a nonallocation
year would occur under the 2003 tempo-
rary regulations if synthetic equity were to
exclude stock options, stock appreciation
rights, or similar rights to acquire shares of
the S corporation or a related entity where
the facts and circumstances indicate that
there is no reasonable likelihood that the
holder of the right will receive the shares
(or equivalent value),e.g., cases in which
the option is based on an exercise price
that is more than 200% of the fair market
value of the shares on the date of grant or
a stock appreciation right is payable only
if the appreciation exceeds 100% of the
fair market value of the shares on the date
of grant. This special rule applies for plan
years ending on or after December 31,
2004, in order to ensure that an employer
cannot avoid or evade the purposes of sec-
tion 409(p) — even for the calendar year
2004 — by using artificial grants that are
unlikely to ever be paid.
Under a third transition rule, the new
rules in these regulations, including the
rules relating to the right to receive shares
with disproportional voting rights, do not
go into effect until July 1, 2005, if there
wouldbenoprohibitedallocationbefore
then under these regulations if the new
rules in these regulations relating to the
right to receive shares with disproportional
voting rights were disregarded.
Further, the IRS will permit plans to
rely on the exception for pre-ESOP non-
qualified deferred compensation for peri-
ods before January 1, 2005, (described in
this preamble under the headingSynthetic
Equity).
Special Analyses
It has been determined that this Trea-
sury decision is not a significant regula-
tory action as defined in Executive Order
12866. Therefore, a regulatory assessment
is not required. It also has been deter-
mined that section 553(b) of the Admin-
istrative Procedure Act (5 U.S.C. chapter
5) does not apply to these regulations. For
the applicability of the Regulatory Flexi-
bility Act (5 U.S.C. chapter 6) refer to the
Special Analyses section of the preamble
to the cross-referencing notice of proposed
rulemaking published in this issue of the
Bulletin. Pursuant to section 7805(f) of
the Internal Revenue Code, these tempo-
rary regulations will be submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment on
their impact.
Drafting Information
The principal author of these regula-
tions is John T. Ricotta of the Office of the
Division Counsel/Associate Chief Coun-
sel (Tax Exempt and Government Enti-
ties). However, other personnel from the
IRS and Treasury participated in their de-
velopment.
*****
Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended
as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.409(p)–1T is also issued un-
der 26 U.S.C. 409(p)(7). * * *
Par. 2. Section 1.409(p)–1T is revised
to read as follows:
§1.409(p)–1T Prohibited allocations of
securities in an S corporation (temporary).
(a)Organization of this section. Sec-
tion 409(p) applies if a nonallocation
year occurs in an employee stock owner-
ship plan (ESOP), as defined in section
4975(e)(7), that holds shares of stock
of an S corporation, as defined in sec-
tion 1361, that are employer securities
as defined in section 409(l). Paragraph
(b) of this section sets forth the general
rule under section 409(p)(1) and (2) pro-
hibiting any accrual or allocation to a
disqualified person in a nonallocation
year. Paragraph (c) of this section sets
forth rules under section 409(p)(3), (5),
and (7) for determining whether a year is
a nonallocation year, generally based on
whether disqualified persons own at least
50 percent of the shares of the S corpo-
ration, either taking into account only the
outstanding shares of the S corporation
(including shares held by the ESOP) or
taking into account both the outstanding
shares and synthetic equity of the S cor-
poration. Paragraphs (d), (e), and (f) of
this section contain definitions of disqual-
ified person under section 409(p)(4) and
(5), deemed-owned ESOP shares under
section 409(p)(4)(C), and synthetic equity
under section 409(p)(6)(C). Paragraph (g)
2005–3 I.R.B.326January 18, 2005

of this section contains a standard for de-
termining when the principal purpose of
the ownership structure of an S corpora-
tion constitutes an avoidance or evasion
of section 409(p). The definitions used
in section 409(p) and this section are also
applicable for purposes of section 4979A,
which imposes an excise tax on certain
events, including a nonallocation year un-
der section 409(p).
(b)Prohibited allocation in a nonallo-
cation year—(1)General rule.AnESOP
holding employer securities consisting of
stockinanScorporationmustprovidethat
no portion of the assets of the plan at-
tributable to (or allocable in lieu of) such
employer securities may, during a nonal-
location year, accrue under the ESOP, or
be allocated directly or indirectly under
any plan of the employer (including the
ESOP) meeting the requirements of sec-
tion 401(a), for the benefit of any disqual-
ifiedperson(aprohibitedallocation).
(2)Additional rules—(i)Prohibited al-
location definition. For purposes of sec-
tion 409(p)(2)(A) and paragraph (b)(1) of
this section, there is a prohibited allocation
(i.e., assets accrue or are allocated as pro-
hibited under paragraph (b)(1) of this sec-
tion) if there is either an impermissible ac-
crual as defined in paragraph (b)(2)(ii) of
this section or an impermissible allocation
as defined in paragraph (b)(2)(iii) of this
section. The amount of the prohibited al-
location is equal to the sum of the imper-
missible accrual plus the amount of the im-
permissible allocation (if any).
(ii)Impermissible accrual.Thereisan
impermissible accrual to the extent (and
only to the extent) that employer securi-
ties consisting of stock in an S corpora-
tionownedbytheESOPandanyassetsat-
tributable thereto are held under the ESOP
for the benefit of a disqualified person dur-
ing a nonallocation year. For this purpose,
assets attributable to S corporation secu-
rities include any distributions, within the
meaning of section 1368, made on S cor-
poration stock held in a disqualified per-
son’s account in the ESOP (including earn-
ings thereon), plus any proceeds from the
sale of S corporation securities held for a
disqualified person’s account in the ESOP
(including any earnings thereon). Thus,
for example, in the event of a nonalloca-
tion year, all S corporation shares and all
other ESOP assets attributable to S corpo-
ration stock, including distributions, sales
proceeds, and earnings on either the dis-
tribution or proceeds, held for the account
of such disqualified person in the ESOP
during that year are an impermissible ac-
crual for the benefit of that person, whether
attributable to contributions in the current
year or in prior years.
(iii)Impermissible allocation.Anim-
permissible allocation means any alloca-
tion for a disqualified person directly or
indirectly under any plan of the employer
qualified under section 401(a) that occurs
during a nonallocation year to the extent
that a contribution or other annual addi-
tion is made, or the disqualified person oth-
erwise accrues additional benefits, under
the ESOP or any other plan of the em-
ployer qualified under section 401(a) (in-
cluding a release and allocation of assets
from a suspense account, as described at
§54.4975–11(c) and (d) of this chapter)
that, for the nonallocation year, would oth-
erwise have been added to the account of
the disqualified person under the ESOP
and invested in employer securities con-
sisting of stock in an S corporation owned
by the ESOP but for a provision in the
ESOP to comply with section 409(p).
(iv)Effects of prohibited allocation—
(A)Deemed distribution. If there is a pro-
hibited allocation, the amount of the pro-
hibited allocation, as determined under this
paragraph (b)(2), is treated as distributed
from the ESOP (or other plan of the em-
ployer) to the disqualified person on the
first day of the plan year on which there
is an impermissible accrual or on the date
of the allocation in the case of an addi-
tional impermissible accrual or impermis-
sible allocation during the plan year but af-
ter the first day of the plan year. Thus, the
fair market value of assets in the disqual-
ified person’s account that constitutes an
impermissible accrual or allocation is in-
cluded in gross income (to the extent in
excess of any investment in the contract
allocable to such amount) and is subject
to any additional income tax that applies
under section 72(t). A deemed distribu-
tion under this paragraph (b)(2)(iv)(A) is
not an actual distribution from the ESOP.
Thus, the amount of the prohibited allo-
cation is not an eligible rollover distribu-
tion under section 402(c). However, for
purposes of applying sections 72 and 402
with respect to any subsequent distribution
from the ESOP, the amount that the dis-
qualifiedpersonpreviouslytookintoac-
count as income as a result of the deemed
distribution is treated as an investment in
the contract.
(B)Other effects. If there is a prohib-
ited allocation, then the plan fails to satisfy
the requirements of section 4975(e)(7) and
ceases to be an ESOP. In such a case, the
exemption from the excise tax on prohib-
ited transactions for loans to leveraged
ESOPs contained in section 4975(d)(3)
would cease to apply to any loan (with
the result that the employer would owe an
excise tax with respect to the previously
exempt loan) and, further, the exception
in section 512(e)(3) would not apply to
the plan (with the result that the plan may
owe income tax as a result of unrelated
business taxable income under section 512
with respect to S corporation stock held
by the plan). See also section 4979A(a)
which imposes an excise tax in certain
events, including a prohibited allocation
under section 409(p).
(v)Prevention of prohibited allo-
cation.—(A)Transfer of account to
non-ESOP. An ESOP may prevent a non-
allocation year or a prohibited allocation
during a nonallocation year by permitting
assets (including S corporation securities)
allocated to the account of a disqualified
person (or a person reasonably expected
to become a disqualified person absent
a transfer described in this paragraph
(b)(2)(v)(A)) to be transferred into a sep-
arate portion of the plan that is not an
ESOP, as described in §54.4975–11(a)(5)
of this chapter, or to another plan of the
employer that satisfies the requirements of
section 401(a) (and that is not an ESOP).
In the event of such a transfer involving
S corporation securities, the recipient plan
is subject to tax on unrelated business tax-
able income under section 512.
(B)Relief from nondiscrimination re-
quirement. Pursuant to this paragraph
(b)(2)(v)(B), if a transfer described in
paragraph (b)(2)(v)(A) of this section is
made from an ESOP to a separate portion
of the plan or to another qualified plan of
the employer that is not an ESOP, then
both the ESOP and the plan or portion of
aplanthatisnotanESOPwillnotfailto
satisfy the requirements of §1.401(a)(4)–4
merely because of the transfer. Further,
subsequent to the transfer, that plan will
not fail to satisfy the requirements of
§1.401(a)(4)–4 merely because of the
benefits, rights, or features with respect
January 18, 20053272005–3 I.R.B.

to the transferred benefits if those ben-
efits, rights, or features would satisfy
the requirements of §1.401(a)(4)–4 if the
mandatory disaggregation rule for ESOPs
at §1.410(b)–7(c)(2) did not apply.
(c)Nonallocation year—(1)Defini-
tion generally. For purposes of section
409(p) and this section, anonallocation
yearmeans a plan year of an ESOP dur-
ing which, at any time, the ESOP holds any
employer securities that are shares of an S
corporation and either —
(i) Disqualified persons own at least
50 percent of the number of outstanding
shares of stock in the S corporation (in-
cluding deemed-owned ESOP shares); or
(ii) Disqualified persons own at least 50
percent of the sum of:
(A) The outstanding shares of
stock in the S corporation (including
deemed-owned ESOP shares); plus
(B) The shares of synthetic equity in
the S corporation owned by disqualified
persons.
(2)Attribution rules. For purposes of
this paragraph (c), the rules of section
318(a) apply to determine ownership of
shares in the S corporation (including
deemed-owned ESOP shares) and syn-
thetic equity. However, for this purpose,
section 318(a)(4) (relating to options to
acquire stock) is disregarded and, in ap-
plying section 318(a)(1), the members of
an individual’s family include members
of the individual’s family under paragraph
(d)(2) of this section. In addition, an indi-
vidual is treated as owning deemed-owned
ESOP shares of that individual notwith-
standing the employee trust exception in
section 318(a)(2)(B)(i). If the attribution
rules in paragraph (f)(1) of this section
apply, then the rules of paragraph (f)(1) of
this section are applied before the rules of
this paragraph (c)(2).
(3)Special rule for avoidance or eva-
sion. (i) The ownership structures de-
scribed in paragraph (g)(3) of this section
result in a nonallocation year. In addition,
under the ownership structures described
in paragraph (g)(3) of this section, the in-
dividual referred to in paragraph (g)(3) of
this section is treated as a disqualified per-
son and that person’s interest in the sepa-
rate entity is treated as synthetic equity.
(ii) Under section 409(p)(7)(B), the
Commissioner, in revenue rulings, no-
tices, and other guidance published
in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(b)ofthischapter),may
provide that a nonallocation year occurs
in any case in which the principal pur-
pose of the ownership structure of an S
corporation constitutes an avoidance or
evasion of section 409(p). For any year
that is a nonallocation year under this para-
graph (c)(3), the Commissioner may treat
anypersonasadisqualifiedperson. See
paragraph (g) of this section for guidance
regarding when the principal purpose of
an ownership structure of an S corporation
involving synthetic equity constitutes an
avoidance or evasion of section 409(p).
(4)Special rule for certain stock rights.
(i) For purposes of paragraph (c)(1) of this
section, a person is treated as owning stock
that the person has a right to acquire if, at
all times during the period when such right
is effective, the stock that the person has
the right to acquire is both issued and out-
standing and is held by persons other than
the ESOP, the S corporation, or a related
entity (as defined in paragraph (f)(3) of this
section).
(ii) This paragraph (c)(4) applies only
if treating persons as owning the shares
described in paragraph (c)(4)(i) of this
section results in a nonallocation year.
This paragraph (c)(4) does not apply to a
right to acquire stock of an S corporation
held by a shareholder subject to Federal
income tax that, under §1.1361–1(l)(2)(iii)
or (l)(4)(iii)(C), would not be taken into
account in determining if an S corporation
has a second class of stock provided that
a principal purpose of the right is not the
avoidance or evasion of section 409(p).
Under the last sentence of paragraph
(f)(2)(i) of this section, this paragraph
(c)(4)(ii) does not apply for purposes of
determining ownership of deemed-owned
ESOP shares or whether an interest con-
stitutes synthetic equity.
(5)Application with respect to shares
treated as owned by more than one person.
For purposes of applying paragraph (c)(1)
of this section, if, by application of the
rules of paragraph (c)(2), (c)(4), or (f)(1) of
this section, any share is treated as owned
by more than one person, then that share is
counted as a single share and that share is
treated as owned by disqualified persons if
any of the owners is a disqualified person.
(6)Effect of nonallocation year.See
paragraph (b) of this section for a pro-
hibition applicable during a nonallocation
year. See also section 4979A for an ex-
cise tax applicable in certain cases, includ-
ing section 4979A(a)(3) and (4) which ap-
plies during a nonallocation year (whether
or not there is a prohibited allocation dur-
ing the year).
(d)Disqualified persons—(1)Gen-
eral definition. For purposes of section
409(p) and this section, adisqualified per-
sonmeans any person for whom —
(i) The number of such person’s
deemed-owned ESOP shares of the S cor-
poration is at least 10 percent of the num-
ber of the deemed-owned ESOP shares of
the S corporation;
(ii) The aggregate number of such per-
son’s deemed-owned ESOP shares and
synthetic equity shares of the S corpora-
tion is at least 10 percent of the sum of:
(A) The total number of deemed-owned
ESOP shares; and
(B) The person’s synthetic equity
shares of the S corporation;
(iii) The aggregate number of the S cor-
poration’s deemed-owned ESOP shares of
such person and of the members of such
person’s family is at least 20 percent of the
number of deemed-owned ESOP shares of
the S corporation; or
(iv) The aggregate number of the S cor-
poration’s deemed-owned ESOP shares
and synthetic equity shares of such person
and of the members of such person’s fam-
ily is at least 20 percent of the sum of:
(A) The total number of deemed-owned
ESOP shares; and
(B) The synthetic equity shares of the S
corporation owned by such person and the
members of such person’s family.
(2)Treatment of family members; def-
inition—(i)Rule. Each member of the
family of any person who is a disqualified
person under paragraph (d)(1)(iii) or (iv)
of this section is a disqualified person.
(ii)General definition. For purposes of
section 409(p) and this section,member
of the familymeans, with respect to an
individual —
(A) The spouse of the individual;
(B) An ancestor or lineal descendant of
the individual or the individual’s spouse;
(C) A brother or sister of the individual
or of the individual’s spouse and any lineal
descendant of the brother or sister; and
(D) The spouse of any individual de-
scribed in paragraph (d)(2)(ii)(B) or (C) of
this section.
(iii)Spouse. A spouse of an individual
who is legally separated from such individ-
2005–3 I.R.B.328January 18, 2005

ual under a decree of divorce or separate
maintenance is not treated as such individ-
ual’s spouse under paragraph (d)(2)(ii)(A)
of this section.
(iv)Attribution rules. For purposes
of this paragraph (d), the rules of section
318(a) apply to determine ownership of
shares in the S corporation (including
deemed-owned ESOP shares) and syn-
thetic equity. However, for this purpose,
section 318(a)(4) (relating to options to
acquire stock) is disregarded and, in ap-
plying section 318(a)(1), the members
of an individual’s family include mem-
bers of the individual’s family under
paragraph (d)(2)(ii) of this section. In ad-
dition, an individualis treated as owning
deemed-owned ESOP shares of that indi-
vidual notwithstanding the employee trust
exception in section 318(a)(2)(B)(i). If the
attribution rules in paragraph (f)(1) of this
section apply, then the rules of paragraph
(f)(1) of this section are applied before the
rulesofthisparagraph(d)(2).
(3)Special rule for certain nonalloca-
tion years. See paragraph (c)(3) of this
section(relatingtoavoidance or evasion of
section 409(p)) for special rules permitting
certain persons to be treated as disqualified
persons in certainnonallocation years.
(4)Example. The rules of this para-
graph (d) are illustrated by the following
example:
Example.(i)Facts. An S corporation has 800 out-
standing shares of which 100 are owned by individ-
ual O and 700 are held in an employee stock owner-
ship plan (ESOP) during 2005, including 200 shares
held in the ESOP account of O, 65 shares held in the
ESOP account of participant P, and 40 shares held in
the ESOP account of participant Q who is P’s spouse.
The S corporation has no synthetic equity.
(ii)Conclusion. O is a disqualified person during
2005 because O’s account in the ESOP holds at least
10 percent of the shares owned by the ESOP (200 is
28.6 percent of 700). In addition, P is a disqualified
person during 2005 because, under paragraph (d)(2)
of this section, P is treated as owning the shares held
by Q and P’s total deemed-owned shares are thus at
least 10 percent of the shares owned by the plan (65
plus 40 is more than 10 percent of 700). In addition,
Q is a disqualified person as a result of the rules in
paragraph (d)(2) of this section. As a result, disquali-
fied persons own at least 50 percent of the outstanding
shares of the S corporationduring2005(O’s100di-
rectly owned shares, O’s 200 deemed-owned shares,
P’s 65 deemed-owned shares, plus Q’s 40 deemed
owned shares are 50.6 percent of 800).
(e)Deemed-owned ESOP shares.For
purposes of section 409(p) and this section,
a person is treated as owning his or her
deemed-owned ESOP shares.Deemed-
owned ESOP sharesmean, with respect to
any person —
(1) Any shares of stock in the S corpo-
ration constituting employer securities that
are allocated to such person’s account un-
der the ESOP; and
(2) Such person’s share of the stock in
the S corporation that is held by the ESOP
but is not allocated to the account of any
participant or beneficiary (with such per-
son’s share to be determined in the same
proportion as the shares released and al-
located from a suspense account, as de-
scribed at §54.4975–11(c) and (d) of this
chapter, under the ESOP for the most re-
cently ended plan year for which there
were shares released and allocated from
a suspense account, or if there has been
no such prior release and allocation from
a suspense account, then determined in
proportion to a reasonable estimate of the
shares that would be released and allocated
in the first year of loan repayment).
(f)Synthetic equity—(1)Ownership
of synthetic equity. For purposes of sec-
tion 409(p) and this section, synthetic eq-
uity is treated as owned by a person in the
same manner as stock is treated as owned
by a person, directly or under the rules of
section 318(a)(2) and (3).Synthetic equity
means the rights described in paragraph
(f)(2) of this section.
(2)Synthetic equity—(i)Rights to ac-
quire stock of the S corporation. Synthetic
equity includes any stock option, warrant,
restricted stock, deferred issuance stock
right, stock appreciation right payable in
stock, or similar interest or right that gives
the holder the right to acquire or receive
stock of the S corporation in the future.
RightstoacquirestockinanScorporation
with respect to stock that is, at all times
during the period when such rights are ef-
fective, both issued and outstanding and
held by persons (who are subject to federal
income taxes) other than the ESOP, the S
corporation, or a related entity are not syn-
thetic equity (but see paragraph (c)(4) of
this section).
(ii)Special rule for certain stock rights.
Synthetic equityalso includes a right to
a future payment (payable in cash or any
other form other than stock of the S corpo-
ration) from an S corporation that is based
on the value of the stock of the S corpo-
ration, such as appreciation in such value.
Thus, synthetic equity includes a stock ap-
preciation right with respect to stock of an
S corporation that is payable in cash or a
phantom stock unit with respect to stock
of an S corporation that is payable in cash.
(iii)Rights to acquire interests in or as-
sets of an S corporation or a related entity.
Synthetic equity includes a right to acquire
stock or other similar interests in a related
entity to the extent of the S corporation’s
ownership. Synthetic equity also includes
a right to acquire assets of an S corporation
or a related entity other than either rights
to acquire goods, services, or property at
fair market value in the ordinary course of
business or fringe benefits excluded from
gross income under section 132.
(iv)Special rule for nonqualified de-
ferred compensation. (A) Synthetic equity
also includes any of the following with re-
spect to an S corporation or a related en-
tity: any remuneration to which section
404(a)(5) applies; remuneration for which
a deduction would be permitted under sec-
tion 404(a)(5) if separate accounts were
maintained; any right to receive property
to which section 83 applies (including a
payment to a trust described in section
402(b) or to an annuity described in sec-
tion 403(c)) in a future year for the perfor-
mance of services; any transfer of property
(to which section 83 applies) in connection
with the performance of services to the ex-
tent that the property is not substantially
vested within the meaning of §1.83–3(i)
by the end of the plan year in which trans-
ferred; and a split-dollar life insurance ar-
rangement under §1.61–22(b) entered into
in connection with the performance of ser-
vices (other than one under which, at all
times, the only economic benefit that will
be provided under the arrangement is cur-
rent life insurance protection as described
in §1.61–22(d)(3)). Synthetic equity also
includes any other remuneration for ser-
vices under a plan, or method or arrange-
ment, deferring the receipt of compensa-
tion to a date that is after the 15th day of the
3
rd
calendar month after the end of the en-
tity’s taxable year in which the related ser-
vices are rendered. However, synthetic eq-
uity does not include benefits under a plan
that is an eligible retirement plan within
the meaning of section 402(c)(8)(B).
(B) For purposes of applying paragraph
(f)(2)(iv)(A) of this section with respect to
an ESOP, synthetic equity does not include
any interest described in such paragraph
(f)(2)(iv)(A) of this section to the extent
that—
January 18, 20053292005–3 I.R.B.

(1) The interest is nonqualified deferred
compensation (within the meaning of sec-
tion 3121(v)(2)) that was outstanding on
December 17, 2004;
(2) The interest is an amount that was
taken into account (within the meaning of
§31.3121(v)(2)–1(d) of this chapter) prior
to January 1, 2005, for purposes of taxation
under chapter 21 of the Internal Revenue
Code (or income attributable thereto); and
(3) The interest was held before the first
date on which the ESOP acquires any em-
ployer securities.
(v)No overlap among shares of
deemed-owned ESOP shares or synthetic
equity. Synthetic equity under this para-
graph (f)(2) does not include shares that
are deemed-owned ESOP shares (or any
rights with respect to deemed-owned
ESOP shares to the extent such rights
are specifically permitted under section
409(h)). In addition, synthetic equity
under a specific subparagraph of this para-
graph (f)(2) does not include anything
that is synthetic equity under paragraph
(f)(2)(i), (ii), (iii) or (iv) of this section.
(3)Related entity. For purposes of this
paragraph (f),related entitymeans any en-
tity in which the S corporation holds an in-
terest and which is a partnership, a trust, an
eligible entity that is disregarded as an en-
tity that is separate from its owner under
§301.7701–3 of this chapter, or a Quali-
fied Subchapter S Subsidiary under section
1361(b)(3).
(4)Number of synthetic shares—(i)
Synthetic equity determined by reference
toScorporationshares. In the case of
synthetic equity that is determined by ref-
erence to shares of stock of the S corpo-
ration, the person who is entitled to the
synthetic equity is treated as owning the
number of shares of stock deliverable pur-
suant to such synthetic equity. In the case
of synthetic equity that is determined by
reference to shares of stock of the S cor-
poration, but for which payment is made
in cash or other property (besides stock of
the S corporation), the number of shares of
synthetic equity treated as owned is equal
to the number of shares of stock having
a fair market value equal to the cash or
other property (disregarding lapse restric-
tions as described in §1.83–3(i)). Where
such synthetic equity is a right to purchase
or receive S corporation shares, the corre-
sponding number of shares of synthetic eq-
uity is determined without regard to lapse
restrictions as described in §1.83–3(i) or
toanyamountrequiredtobepaidinex-
change for the shares. Thus, for example,
if a corporation grants an employee of an
S corporation an option to purchase 100
shares of the corporation’s stock, exercis-
able in the future only after the satisfac-
tion of certain performance conditions, the
employee is the deemed owner of 100 syn-
thetic equity shares of the corporation as of
the date the option is granted. If the same
employee were granted 100 shares of re-
stricted S corporation stock (or restricted
stock units), subject to forfeiture until the
satisfaction of performance or service con-
ditions, the employee would likewise be
the deemed owner of 100 synthetic equity
shares from the grant date. However, if the
same employee were granted a stock ap-
preciation right with regard to 100 shares
of S corporation stock (whether payable in
stock or in cash), the number of synthetic
equity shares the employee is deemed to
own equals the number of shares having a
value equal to the appreciation at the time
of measurement (determined without re-
gard to lapse restrictions).
(ii)Synthetic equity determined by ref-
erence to shares in a related entity.Inthe
case of synthetic equity that is determined
by reference to shares of stock (or similar
interests) in a related entity, the person who
is entitled to the synthetic equity is treated
as owning shares of stock of the S corpora-
tion with the same aggregate value as the
number of shares of stock (or similar inter-
ests) of the related entity (with such value
determined without regard to any lapse re-
striction as defined at §1.83–3(i)).
(iii)Other synthetic equity—(A)Gen-
eral rule. In the case of any synthetic eq-
uity to which neither paragraph (f)(4)(i)
nor paragraph (f)(4)(ii) of this section ap-
ply, the person who is entitled to the syn-
thetic equity is treated as owning on any
date a number of shares of stock in the S
corporation equal to the present value (on
that date) of the synthetic equity (with such
value determined without regard to any
lapse restriction as defined at §1.83–3(i))
divided by the fair market value of a share
of the S corporation’s stock as of that date.
(B)Special rules—(1)Use of annual
or more frequent determination dates.For
purposes of this paragraph (f)(4)(iii), while
the determination of whether there is a
nonallocation year depends on day-by-day
determinations under paragraph (c) of this
section, the number of shares of S cor-
poration stock treated as owned by a per-
son who is entitled to synthetic equity to
which this paragraph (f)(4)(iii) applies is
permitted to be determined only annually
(or more frequently), as of the first day of
the ESOP’s plan year or as of any other
reasonable determination date or dates dur-
ing a plan year. If the ESOP so provides,
the number of shares of synthetic equity
to which this paragraph(f)(4)(iii) applies
that are treated as owned by that person
for any period from a given determination
date through the date immediately preced-
ing the next following determination date
is the number of shares treated as owned
on the given determination date.
(2)Use of triannual recalculations.
In addition, if the terms of the ESOP so
provide, then the number of shares of
synthetic equity with respect to grants of
synthetic equity to which this paragraph
(f)(4)(iii) applies may be fixed for a spec-
ified period from a determination date
identified under the ESOP through a date
that is not later than the day before the
determination date that is on or immedi-
ately preceding the third anniversary of the
identified determination date. Additional
accruals, allocations, or grants (to which
this paragraph (f)(4)(iii) applies) that are
made during such three-year period are
taken into account on each determination
date during that period, based on the num-
ber of synthetic equity shares resulting
from the additional accrual, allocation, or
grant (determined as of the determination
date on or next following the date of the
accrual, allocation, or grant). However,
the ESOP must provide for the number
of shares of synthetic equity to which this
paragraph (f)(4)(iii) applies to be re-de-
termined not less frequently than every
three years, based on the S corporation
share value on a determination date that
is not later than the third anniversary of
the identified determination date and the
aggregate present value of the synthetic
equity to which this paragraph (f)(4)(iii)
applies (including all grants made during
the three-year period) on that determina-
tion date. SeeExample 3of paragraph (h)
of this section for an example illustrating
this paragraph (f)(4)(iii)(B)(2).
(3)Conditions for application of rules.
Paragraph (f)(4)(iii)(B) of this section
only applies with respect to grants of
synthetic equity to which this paragraph
2005–3 I.R.B.330January 18, 2005

(f)(4)(iii) applies. In addition, paragraph
(f)(4)(iii)(B)(1) of this section applies
only if the fair market value of a share
of the S corporation securities on any
determination date is not unrepresenta-
tive of the value of the S corporation
securities throughout the rest of the plan
year and only if the terms of the ESOP
include provisions conforming to para-
graph (f)(4)(iii)(B)(1)ofthissection
which are consistently used by the ESOP
for all persons. In addition, paragraph
(f)(4)(iii)(B)(2) of this section applies only
if the terms of the ESOP include provisions
conforming to paragraphs (f)(4)(iii)(B)(1)
and (2) of this section which are consis-
tently used by the ESOP for all persons.
(iv)Adjustment of number of synthetic
equity shares where ESOP owns less than
100% of S corporation. Under this para-
graph (f)(4)(iv), the number of synthetic
shares otherwise determined under this
paragraph (f)(4) is decreased ratably to
the extent that shares of the S corpora-
tion are owned by a person who is not
an ESOP (and who is subject to federal
income taxes). For example, if an S cor-
poration has 200 outstanding shares, of
which individual A owns 50 shares and
the ESOP owns the other 150 shares, and
individual B would be treated under this
paragraph (f)(4) as owning 200 synthetic
equity shares of the S corporation but for
this paragraph (f)(4)(iv), then, under the
rule of this paragraph (f)(4)(iv), the num-
ber of synthetic shares treated as owned by
B under this paragraph (f)(4) is decreased
from 200 to 150 (because the ESOP only
owns 75% of the outstanding stock of the
S corporation, rather than 100%).
(v)Special rule for shares with greater
voting power than ESOP shares. Notwith-
standing any other provision of this para-
graph (f)(4), if a synthetic equity right in-
cludes (directly or indirectly) a right to
purchase or receive shares of S corpora-
tion stock that have per-share voting rights
greater than the per-share voting rights of
one or more shares of S corporation stock
held by the ESOP, then the number of
shares of deemed owned synthetic equity
attributable to such right is not less than the
number of shares that would have the same
voting rights if the shares had the same
per-share voting rights as shares held by
the ESOP with the least voting rights. For
example, if shares of S corporation stock
held by the ESOP have one voting right per
share, then an individual who holds an op-
tion to purchase one share with 100 voting
rights is treated as owning 100 shares of
synthetic equity.
(g)Avoidance or evasion of section
409(p) involving synthetic equity—(1)
General rule. Paragraph (g)(2) of this
section sets forth a standard for determin-
ing whether the principal purpose of the
ownership structure of an S corporation
involving synthetic equity constitutes an
avoidance or evasion of section 409(p).
Paragraph (g)(3) of this section identi-
fies certain specific ownership structures
that constitute an avoidance or evasion of
section 409(p). See also paragraph (c)(3)
of this section for a rule under which the
ownership structures in paragraph (g)(3)
result in a nonallocation year for purposes
of section 409(p).
(2)Standard for determining when
there is an avoidance or evasion of section
409(p) involving synthetic equity—For
purposes of section 409(p) and this sec-
tion, whether the principal purpose of the
ownership structure of an S corporation
involving synthetic equity constitutes an
avoidance or evasion of section 409(p)
is determined by taking into account all
the surrounding facts and circumstances,
including all features of the ownership of
the S corporation’s outstanding stock and
related obligations (including synthetic
equity), any shareholders who are taxable
entities, and the cash distributions made to
shareholders, to determine whether, to the
extent of the ESOP’s stock ownership, the
ESOP receives the economic benefits of
ownership in the S corporation that occur
during the period that stock of the S corpo-
ration is owned by the ESOP. Among the
factors indicating that the ESOP receives
these economic benefits include share-
holder voting rights,the right to receive
distributions made to shareholders, and
the right to benefit from the profits earned
by the S corporation, including the extent
to which actual distributions of profits
are made from the S corporation to the
ESOP and the extent to which the ESOP’s
ownership interest in undistributed profits
and future profits is subject to dilution as a
result of synthetic equity, for example, the
ESOP’s ownership interest is not subject
to dilution if the total amount of synthetic
equity is a relatively small portion of the
total number of shares and deemed-owned
shares of the S corporation.
(3)Specific transactions that constitute
an avoidance or evasion of section 409(p)
involving segregated profits.Takinginto
account the standard in paragraph (g)(2)
of this section, the principal purpose of
the ownership structure of an S corporation
constitutes an avoidance or evasion of sec-
tion 409(p) in any case in which—
(i) The profits of the S corporation gen-
erated by the business activities of a spe-
cific individual or individuals are not pro-
vided to the ESOP, but are instead substan-
tially accumulated and held for the ben-
efit of that individual or individuals on a
tax-deferred basis within an entity related
to the S corporation, such as a partner-
ship, trust, or corporation (such as in a sub-
sidiary that is a disregarded entity), or any
other method that has the same effect of
segregating profits for the benefit of such
individual or individuals (such as nonqual-
ified deferred compensation described in
paragraph (f)(2)(iv) of this section);
(ii) The individual or individuals for
whom profits are segregated have rights to
acquire 50 percent or more of those profits
directly or indirectly (for example, by pur-
chase of the subsidiary); and
(iii) A nonallocation year would oc-
cur if this section were separately applied
with respect to either the separate entity or
whatever method has the effect of segre-
gating profits of the individual or individu-
als, treating such entity as a separate S cor-
poration owned by an ESOP (or in the case
of any other method of segregation of prof-
its by treating those profits as the only as-
sets of a separate S corporation owned by
an ESOP).
(h)Examples. The rules of this section
are illustrated by the following examples:
Example 1. Relating to determination of disquali-
fied persons and nonallocation year if there is no syn-
thetic equity.(i)Facts. Corporation X is a calendar
year S corporation that maintains an ESOP. X has a
single class of common stock, of which there are a
total of 1,200 shares outstanding. X has no synthetic
equity. In 2006, individual A, who is not an employee
of X (and is not related to any employee of X), owns
100 shares directly, individual B owns 100 shares di-
rectly, and the remaining 1,000 shares are owned by
an ESOP maintained by X for its employees. The
ESOP’s 1,000 shares are allocated to the accounts of
individuals who are employees of X (none of whom
are related), as set forthin columns 1 and 2 in the fol-
lowing table:
January 18, 20053312005–3 I.R.B.

1234
ShareholdersDeemed-Owned ESOP Shares
(total of 1,000)
Percentage Deemed-Owned
ESOP Shares
Disqualified Person
B33033%Yes
C
14514.5%
Yes
D
757.5%
No
E303%No
F202%No
Other participants400 (none exceed 10 shares)1% or lessNo
(ii)Conclusion with respect to disqualified per-
sons. As shown in column 4 in the table above,
individuals B and C are disqualified persons for
2006 under paragraph (d)(1) of this section because
each owns at least 10% of X’s deemed-owned ESOP
shares.
(iii)Conclusion with respect to nonallocation
year. However, 2006 is not a nonallocation year
under section 409(p) because disqualified per-
sons do not own at least 50% of X’s outstanding
shares (the 100 shares owned directly by B, B’s
330 deemed-owned ESOPshares, plus C’s 145
deemed-owned ESOP shares equal only 47.9% of
the 1,200 outstanding shares of X).
Example 2. Relating to determination of disqual-
ified persons and nonallocation year if there is syn-
thetic equity.(i)Facts. The facts are the same as in
Example 1, except that, as shown in column 4 of the
table in thisexample 2, individuals E and F have op-
tions to acquire 110 and 130 shares, respectively, of
the common stock of X from X:
1234
5
6
ShareholdersDeemed-Owned
ESOP Shares (total
of 1,000)
Percentage
Deemed-Owned
ESOP Shares
Options (240)Shareholder
Percentage of
Deemed-Owned
ESOP plus
Synthetic Equity
Shares
Disqualified Person
B33033%Yes (col. 3)
C
14514.5%
Yes (col. 3)
D
757.5%
No
E303%11011.1% ([30+ 91.7]
divided by 1,091.7)
Yes (col. 5)
F202%13011.6% ([20 +108.3]
divided by 1,108.3)
Yes (col. 5)
Other participants400 (none exceeds 10
shares)
1% or lessNo
(ii)Conclusion with respect to disqualified per-
sons. Applying the rule of paragraph (f)(4)(iv) of
this section, E’s option to acquire 110 shares of the S
corporation converts into 91.7 shares of synthetic eq-
uity (110 times the ratio of the 1,000 deemed-owned
ESOP shares to the sum of the 1,000 deemed-owned
ESOP shares plus the 200 shares held outside the
ESOP by A and B). Similarly, F’s option to acquire
130 shares of the S corporation converts into 108.3
shares of synthetic equity (130 times the ratio of
the 1,000 deemed-owned ESOP shares to the sum
of the 1,000 deemed-owned ESOP shares plus the
200 shares held outside the ESOP by A and B). Ac-
cordingly, as shown in column 6 in the table above,
individual E’s synthetic equity shares are counted in
determining whether E is a disqualified person for
2006, and individual F’s synthetic equity shares are
counted in determining whether F is a disqualified
person for 2006, but the synthetic equity shares
owned by any person do not affect the calculation for
any other person’s ownership of shares. Accordingly,
individuals B, C, E, and F are disqualified persons
for 2006.
(iii)Conclusion with respect to nonalloca-
tion year. The 100 shares owned directly by B,
B’s 330 deemed-owned ESOP shares, C’s 145
deemed-owned ESOP shares, E’s 30 deemed-owned
ESOP shares, E’s 91.7 synthetic equity shares, F’s
20 deemed-owned ESOP shares, plus F’s 108.3 syn-
thetic equity shares total 825, which equals 58.9%
of 1,400, which is the sum of the 1,200 outstanding
shares of X and the 200 shares of synthetic equity
shares of X held by disqualified persons. Thus, 2006
is a nonallocation year for X’s ESOP under section
409(p) because disqualified persons own at least
50% of the total shares of outstanding stock of X
and the total synthetic equity shares of X held by
disqualified persons. In addition, independent of
the preceding conclusion, 2006 would be a nonal-
location year because disqualified persons own at
least 50% of X’s outstanding shares because the 100
shares owned directly byB, B’s 330 deemed-owned
ESOP shares, C’s 145 deemed-owned ESOP shares,
E’s 30 deemed-owned ESOP shares, plus F’s 20
deemed-owned ESOP shares equal 52.1% of the
1,200 outstanding shares of X.
Example 3. Relating to determination of number
of shares of synthetic equity.(i)Facts. Corporation
Y is a calendar year S corporation that maintains an
ESOP. Y has a single class of common stock, of which
there are a total of 1,000 shares outstanding, all of
which are owned by the ESOP. Y has no synthetic
equity, except for four grants of nonqualified deferred
compensation that are made to an individual during
the period from 2005 through 2011, as set forth in
column 2 in the following table, and the ESOP uses
the special rules in paragraph (f)(4)(iii) of this section
to determine the number of shares of synthetic equity
owned by that individual, as shown in columns 4 and
5:
2005–3 I.R.B.332January 18, 2005

1234
5
Determination DatePresent Value of
Nonqualified Deferred
Compensation on
Determination Date
Share Value on
Determination Date
New Shares of Synthetic
Equity on Determination
Date
Aggregate Number of
Synthetic Equity Shares
on Determination Date
January 1, 2005
A grant is made on January
1, 2005, with a present value
of $1,000. An additional
grant of nonqualified deferred
compensation with a present
value of $775 is made on
March 1, 2005.
$10 per share
100100
January 1, 2006An additional grant is made
on December 31, 2005, which
has a present value of $800 on
January 1, 2006. The March
1, 2005, grant has a present
value on January 1, 2006, of
$800.
$8 per share
200300
January 1, 2007No new grants made.
$12 per share
300
January 1, 2008An additional grant is made
on December 31, 2007,
which has a present value of
$3,000 on January 1, 2008.
The grants made during
2005 through 2007 have an
aggregate present value on
January 1, 2008, of $3,750.
$15 per share
200
450
January 1, 2009No new grants are made.
$11 per share
450
January 1, 2010No new grants are made.
$22 per share
450
January 1, 2011No new grants are made.
The grants made during
2005 through 2008 have an
aggregate present value on
January 1, 2011, of $7,600.
$20 per share
380
(ii)Conclusion. The grant made on January 1,
2005, is treated as 100 shares until the determination
da
te in 2008. The grant made on March 1, 2005, is
not taken into account until the 2006 determination
date and its present value on that date, along with
th
e then present value of the grant made on the pre-
ceding day, is treated as a number of shares that are
based on the $8 per share value on the 2006 determi-
n
ation date, with the resulting number of shares con-
tinuing to apply until the determination date in 2008.
On the January 1, 2008, determination date, the grant
m
ade on the preceding day is taken into account at
its present value of $3,000 on January 1, 2008, and
the $15 per share value on that date with the resulting
n
umber of shares (200) continuing to apply until the
next determination date. In addition, on the January
1, 2008, determination date, the number of shares de-
termined under other grants made between January
1, 2005, and December 31, 2007, must be revalued.
Accordingly, the aggregate value of all nonqualified
deferred compensation granted during that period is
determined to be $3750 on January 1, 2008, and the
corresponding number of shares of synthetic equity
based on the $15 per share value is determined to
be 250 shares on the 2008 determination date, with
the resulting aggregate number of shares (450) con-
tinuing to apply until the determination date in 2011.
On the January 1, 2011, determination date, the ag-
gregate value of all nonqualified deferred compensa-
tion is determined to be $7,600 and the corresponding
nu
mber of shares of synthetic equity based on the $20
per share value on the 2011 determination date is de-
termined to be 380 shares (with the resulting number
of
shares continuing to apply until the determination
date in 2014, assuming no further grants are made).
(i)Effective dates—(1)Statutory effec-
tive date. (i) Except as otherwise provided
in paragraph (i)(1)(ii) of this section, sec-
tion 409(p) applies for plan years ending
after March 14, 2001.
(ii) If an ESOP holding stock in an S
corporation was established on or before
March 14, 2001, and the election under
section 1362(a) with respect to that S cor-
poration was in effect on March 14, 2001,
section 409(p) applies for plan years be-
ginning on or after January 1, 2005.
(2)Regulation effective date—(i)Gen-
eral effective date. Except as otherwise
provided in paragraph (i)(2)(ii) of this sec-
tion, this section applies for plan years be-
ginning on or after January 1, 2005.
(ii)Rules for plan years beginning
before January 1, 2005. (A) Except
as provided in this paragraph (i)(2)(ii),
§1.409(p)–1T as in effect prior to Decem-
ber 17, 2004, (see §1.409(p)–1T in 26
CFR Part 1 revised as of April 1, 2004)
applies for plan years ending after October
20, 2003, and beginning before January 1,
2005.
(B)Paragraphs(c)(3)and(g)ofthis
section apply for plan years ending on or
after December 31, 2004, but do not apply
with respect to an interest held in a qual-
ified subchapter S subsidiary (QSUB) of
an S corporation or another entity to which
paragraph (g)(3) of this section applies be-
fore March 15, 2004 if:
(1) All interests in the entity held by in-
dividuals who would be disqualified per-
sons under paragraph (g)(3) of this sec-
tion or under guidance issued by the Com-
missioner before March 15, 2004, are dis-
January 18, 20053332005–3 I.R.B.

tributed to those individuals as compensa-
tion on or before March 15, 2004; and
(2) No such individual has been a par-
ticipant in the ESOP of the S corporation
at any time after October 20, 2003, and be-
fore March 15, 2004.
(C) Paragraph (f)(2)(iv)(B) of this sec-
tion (providing that synthetic equity does
not include certain preexisting nonqual-
ified deferred compensation) applies for
plan years ending before January 1, 2005.
(D) Paragraph (f)(4)(iv) of this section
(permitting an adjustment of the number
of synthetic equity shares where an ESOP
owns less than 100% of an S corporation)
applies for plan years ending before Jan-
uary 1, 2005.
(E) In no event does this paragraph
(i)(2)(ii) apply for any plan year ending
before January 1, 2005, for an ESOP hold-
ing stock in an S corporation that was
established on or before March 14, 2001,
if the election under section 1362(a) with
respect to that S Corporation was in effect
on March 14, 2001.
(iii)Transition rules. (A) Assets held
in the account of a disqualified person as
of the last day of the first plan year begin-
ning before January 1, 2005, will not be
treated as an impermissible accrual with
respect to that disqualified person under
paragraph (b)(2)((ii) of this section for the
first plan year beginning on or after Jan-
uary 1, 2005, to the extent those assets are
not held in that person’s account on or af-
ter July 1, 2005. Thus, for example, to
the extent the assets allocated to the ac-
count of a disqualified person as of the last
day of the first plan year beginning be-
fore January 1, 2005, are transferred to a
non-ESOP portion of the plan as described
in paragraph (b)(2)(v)(A) of this section
before July 1, 2005, those assets will not
be treated as an impermissible accrual un-
der paragraph (b)(2)((ii) of this section for
the period from the first day of the first
plan year beginning on or after January
1, 2005, through June 30, 2005. How-
ever, see section 4979A(a)(3), (a)(4), and
(e)(2)(C) for excise tax provisions that ap-
ply to all deemed-owned shares during the
first nonallocation year for the ESOP.
(B) An individual is not treated as a
disqualified person during the period from
the first day of the first plan year begin-
ning on or after January 1, 2005, through
June 30, 2005, if that person would not
be a disqualified person during that pe-
riod under the modified rules of this para-
graph (i)(2)(iii)(B) as of any date during
that same period. Further, solely for the
purpose of determining whether the first
plan year beginning on or after January 1,
2005, is a nonallocation year under sec-
tion 409(p) and this section, if that plan
year would not have been a nonalloca-
tion year under the modified rules of this
paragraph (i)(2)(iii)(B), then synthetic eq-
uity that is not owned by a person on July
1, 2005, is disregarded during the period
from the first day of the first plan year
beginning on or after January 1, 2005,
through June 30, 2005. For purposes of
this paragraph (i)(2)(iii)(B), themodified
rules of this paragraph (i)(2)(iii)(B)are the
rules in §1.409(p)–1T as in effect prior to
December 17, 2004 (see §1.409(p)–1T in
26 CFR Part 1 revised as of April 1, 2004),
modified to exclude from the definition of
synthetic equity any stock option, stock ap-
preciation right (payable in cash or stock),
or similar rights with respect to shares of
the S corporation or a related entity where
the facts and circumstances indicate that
there is no reasonable likelihood that the
holder of the right will receive the shares
(or equivalent value). For this purpose,
there is no reasonable likelihood that the
holder of the right will receive the shares
(or equivalent value) in any case in which
the option is based on an exercise price
that is more than 200% of the fair market
value of the shares on the date of grant or
the right (in the case of a stock apprecia-
tion right or similar right to acquire shares
of the S corporation or a related entity) is
payable only if the appreciation exceeds
100% of the fair market value of the shares
onthedateofgrant.
(C) For the period from the first day of
the first plan year beginning on or after
January 1, 2005, through June 30, 2005,
there is no nonallocation year under this
section if there would be no nonallocation
year under this section during that period if
this section were applied without regard to
paragraph (f)(4)(v) of this section (relating
to voting rights).
(D) This paragraph (iii) does not apply
to an ESOP for which the first plan year
beginning on or after January 1, 2005, be-
gins after June 30, 2005.
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
Approved December 7, 2004.
Gregory F. Jenner,
Acting Assistant Secretary of the
Treasury (Tax Policy).
(Filed by the Office of the Federal Register on December 16,
2004, 8:45 a.m., and published in the issue of the Federal
Register for December 17, 2004, 69 F.R. 75455)
Section 901.—Taxes
of Foreign Countries
and of Possessions of
United States
Section 901(j)(5) Presidential waiver;
Libya.Pursuant to a section 901(j)(5)
Presidential waiver, section 901(j)(1) of
the Code ceased to apply to Libya effective
December 10, 2004. Section 911(d)(8) is
not applicable to Libya after September 20,
2004, and Iraq after July 29, 2004. Rev.
Ruls. 92–63 and 95–63 modified and su-
perseded. Rev. Rul. 2004–103 super-
seded.
Rev. Rul.
2005–3
This ruling sets forth guidance regard-
ing the application of section 901(j) of
the Internal Revenue Code (Code) with re-
spect to Libya and the application of sec-
tion 911(d)(8) of the Code with respect
to Iraq and Libya. This ruling modifies
and supersedes Rev. Rul. 95–63, 1995–2
C.B. 85, which lists countries subject to
special tax rules undersections 901(j) and
952(a)(5) of the Code, and also supersedes
Rev. Rul. 2004–103, 2004–45 I.R.B. 783,
which modified Rev. Rul. 95–63. This
ruling also modifies and supersedes Rev.
Rul. 92–63, 1992–2 C.B. 195, which lists
countries subject to section 911(d)(8) of
the Code.
SECTION 901(j)
LAW AND ANALYSIS
Sections 901, 902, and 960 of the Code
generally allow U.S. taxpayers to claim a
foreign tax credit for income, war profits,
and excess profits taxes paid or accrued
(or deemed paid or accrued) to any foreign
country or to any possession of the United
States. The foreign tax credit is subject to
various limitations and restrictions under
section 901.
2005–3 I.R.B.334January 18, 2005

Section 901(j)(1) imposes restrictions
in the case of income and taxes attributable
to certain countries. Section 901(j)(1)(A)
denies the credit for taxes paid or accrued
(or deemed paid or accrued under sections
902 or 960) to any country described in
section 901(j)(2)(A) if the taxes are with
respect to income attributable to a period
during which section 901(j) applies. Sec-
tion 901(j)(1)(B) requires taxpayers to ap-
ply subsections (a), (b), and (c) of section
904 and sections 902 and 960 separately
with respect to income attributable to such
a period from sources within such coun-
try. In addition, section 952(a)(5) provides
that subpart F income includes income de-
rivedbyacontrolledforeigncorporation
from any foreign country during any pe-
riod during which section 901(j) applies to
that foreign country.
Pursuant to section 901(j)(5), the re-
strictions of section 901(j)(1) will not ap-
ply with respect to a country if the Pres-
ident determines that a waiver of the ap-
plication of that paragraph is in the na-
tional interest of the United States and will
expand trade and investment opportunities
for U.S. companies in such country. This
provision provides for the President, not
less than 30 days before the date on which
a waiver is granted, to report to Congress
the intention to grant such a waiver and the
reason for the determination under section
901(j)(5)(A)(i).
The President issued Presidential De-
termination 2004–48 on September 20,
2004. In that Presidential Determination,
the President determined that a waiver of
the application of section 901(j)(1) with
respect to Libya is in the national inter-
est of the United States and will expand
trade and investment opportunities for
U.S. companies in Libya. The Presiden-
tial Determination directed the Secretary
of the Treasury to report to Congress, in
accordance with section 901(j)(5)(B), the
President’s intention to grant the waiver
and the reasons for the determination. The
Secretary of the Treasury submitted such
report to Congress on October 7, 2004.
On December 10, 2004, the Presi-
dent issued Presidential Determination
2005–12 which waives the application of
section 901(j)(1) with respect to Libya.
Pursuant to Presidential Determination
2005–12, sections 901(j)(1) and 952(a)(5)
no longer apply to Libya, effective De-
cember 10, 2004. Therefore, United
States taxpayers may be entitled to claim a
foreign tax credit for income, war profits,
and excess profits taxes paid or accrued
(or deemed paid or accrued under sections
902 and 960) to Libya, with respect to in-
come attributable to the period beginning
after December 9, 2004.
HOLDING AND EFFECTIVE DATES
Sections 901(j)(1) and 952(a)(5) apply
to the following countries for the following
periods:
CountryStarting DateEnding Date
AfghanistanJanuary 1, 1987August 4, 1994
AlbaniaJanuary 1, 1987March 15, 1991
AngolaJanuary 1, 1987June 18, 1993
CambodiaJanuary 1, 1987August 4, 1994
CubaJanuary 1, 1987still in effect
IranJanua
ry 1, 1987
still
in effect
IraqFebruary 1, 1991June 27, 2004
LibyaJanuary 1, 1987December 9, 2004
North KoreaJanuary 1, 1987still in effect
South AfricaJanuary 1, 1988July 10, 1991
SudanFebruary 12, 1994still in effect
Sy
ria
Ja
nuary 1, 1987
st
ill in effect
VietnamJanuary 1, 1987July 21, 1995
People’s Democratic
Republic of YemenJanuary 1, 1987May 22, 1990
For guidance on issues arising in a tax-
able year when section 901(j) ceases to ap-
plytoacountry,seeRev. Rul. 92–62,
1992–2 C.B. 193.
SECTION 911
LAW AND ANALYSIS
Section 911(a) of the Code allows a
“qualified individual” to elect to exclude
from gross income his or her “foreign
earned income” (as defined in section
911(b)) and “housing cost amount” (as de-
finedinsection911(c)).Section911(d)(1)
generally defines a “qualified individual”
as a citizen or resident of the United States
whose tax home is in a foreign country
and who meets certain requirements of
residence or presence in a foreign country.
Section 911(d)(8)(A) provides gener-
ally that if travel with respect to any for-
eign country (or any transaction in connec-
tion with such travel) is proscribed by cer-
tain regulations during any period, then:
(1) foreign earned income does not include
income from sources within that country
attributable to services performed during
that period; (2) housing expenses do not
include any expenses allocable to such pe-
riod for housing in that country, or for
housing of the taxpayer’s spouse or depen-
dents in another country while the taxpayer
is present in that country; and (3) an indi-
vidual is not treated as abona fideresident
of, or as present in, a foreign country for
any day during which the individual was
present in that country.
Section 911(d)(8)(B) provides that the
regulations described in section 911(d)(8)
are those that have been adopted pursuant
to the Trading With the Enemy Act, 50
U.S.C. App. 1et seq.,ortheInterna-
January 18, 20053352005–3 I.R.B.

tional Emergency Economic Powers Act,
50 U.S.C. 1701et seq., and that include
provisions generally prohibiting citizens
and residents of the United States from en-
gaging in transactions related to travel to,
from, or within a foreign country. Section
911(d)(8)(C), however, provides that the
limitations of section 911(d)(8)(A) do not
apply to any individual during any period
in which that individual’s activities are not
in violation of the regulations described in
section 911(d)(8)(B).
Rev. Rul. 92–63, 1992–2 C.B. 195,
identifies three countries subject to regu-
lations described in section 911(d)(8)(B):
Cuba (31 CFR 515.560) (1989), Libya (31
CFR 550.207) (1989), and Iraq (31 CFR
575.207) (1991).
On July 29, 2004, the President issued
Executive Order 13350 which effectively
lifted the sanctions against Iraq effective
July 30, 2004. On September 20, 2004,
the President issued Executive Order
13357 which effectively lifted the sanc-
tions against Libya, effective September
21, 2004.
HOLDING AND EFFECTIVE DATES
Section 911(d)(8) applies to the follow-
ing countries for the following periods:
CountryStarting DateEnding Date
CubaJanuary 1, 1987still in effect
LibyaJanuary 1, 1
987
September 2
0, 2004
IraqAugust 2, 1990July 29, 2004
With respect to periods prior to (or end-
ing on) the ending dates listed above for
Libya and Iraq, individuals whose activi-
ties in Libya and Iraq were not in viola-
tion of the regulations described in section
911(d)(8)(B) are not subject to the limita-
tions of section 911(d)(8).See, e.g., Notice
2003–52, 2003–2 C.B. 296, which states
that pursuant to section 911(d)(8)(C), the
limitations of section 911(d)(8)(A) do not
apply to individuals engaged in activities
in Iraq that are permitted by a specific or
general license issued by the United States
Department of Treasury Office of Foreign
Assets Control.
EFFECT ON OTHER
ADMINISTRATIVE GUIDANCE
This ruling modifies and supersedes
Rev. Rul. 95–63, 1995–2 C.B. 85, and
supersedes Rev. Rul. 2004–103, 2004–45
I.R.B. 783, with respect to the list of coun-
tries for which section 901(j) is applicable.
This ruling modifies and supersedes Rev.
Rul. 92–63, 1992–2 C.B. 195, with re-
spect to the list of countries for which
section 911(d)(8) is applicable.
DRAFTING INFORMATION
The principal author of this revenue rul-
ing is Mark R. Pollard of the Office of
Associate Chief Counsel (International).
For further information regarding this rev-
enue ruling, contact Mr. Pollard at (202)
622–3850 (not a toll-free call).
2005–3 I.R.B.336January 18, 2005

Part III. Administrative, Procedural, and Miscellaneous
Election to Determine
Corporate Tax on Certain
International Shipping
Activities Under Tonnage
Tax Regime
Notice 2005–2
This notice provides guidance on the
procedure for making an election to deter-
mine corporate tax on certain international
shipping activities under the tonnage tax
regime.
Code section 1354(a), as added by sec-
tion 248 of the American Jobs Creation
Act of 2004, P.L. 108–357, 118 Stat. 1418
(October 22, 2004), allows a qualifying
vessel operator to elect to be subject to
the tonnage tax regime, under which tax is
imposed on notional income from qualify-
ing shipping activities rather than on actual
income from such activities. A corpora-
tion is a qualifying vessel operator if the
corporation operates one or more qualify-
ing vessels within the meaning of section
1355(a)(4) and meets the shipping activ-
ity requirement of section 1355(c). Pur-
suant to section 1355(c)(2), the shipping
activity requirement is satisfied with re-
spect to the first year for which the elec-
tion is made only if the requirement of sec-
tion 1355(c)(4) is satisfied for the preced-
ing taxable year. Thus, a corporation can-
not be considered a qualifying vessel op-
erator prior to the first day of the first year
for which the election is made.
A corporation making the election is
subject to tax with respect to its income
from qualifying shipping activities at the
maximum corporate income tax rate on a
notional amount based on the net tonnage
of the corporation’s qualifying vessels. An
election made by a member of a controlled
group, as defined in section 1355(a)(2)(B),
applies to all qualifying vessel operators
that are members of such group. The elec-
tion is available for taxable years begin-
ning after October 22, 2004, and is effec-
tive for the taxable year for which it is
made and for all succeeding taxable years
until terminated. If a corporation ceases to
be a qualifying vessel operator, the elec-
tion is terminated effective on or after the
date of such cessation.
The election must be made before the
due date (including extensions) of the in-
come tax return for the year for which the
corporation elects to be subject to the ton-
nage tax regime. An election may be made
prior to the filing of such return by filing a
statement with the Internal Revenue Ser-
vice at the address where the corporation
ordinarily files its income tax return. The
statement must set forth the name, address,
and employer identification number of the
electing corporation and the taxable year
for which the section 1354(a) election is
being made. A copy of the statement must
be attached to the income tax return for the
year for which the corporation elects to be
subject to the tonnage tax regime.
An election to be subject to the tonnage
tax regime is effective only if the corpo-
ration is a qualifying vessel operator for
the taxable year for which the election is
made. If a corporation that files the state-
ment does not satisfy the requirements to
be a qualifying vessel operator, the elec-
tion is not valid.
All electing corporations must provide
such additional information relating to the
tonnage tax as is required by the applica-
ble corporate income tax return and the in-
structions thereto, which will include in-
formation regarding satisfaction of the re-
quirements to be a qualifying vessel oper-
ator.
DRAFTING INFORMATION
The principal author of this notice is
David L. Lundy of the Office of Associate
Chief Counsel (International). For further
information regarding this notice, contact
Mr. Lundy at (202) 622–3880 (not a toll-
free call).
Automatic Rollover
Notice 2005–5
I. PURPOSE
This notice provides guidance relating
to automatic rollover provisions under
§ 401(a)(31)(B) of the Internal Revenue
Code (“Code”) as amended by the Eco-
nomicGrowthandTaxReliefRecon-
ciliation Act of 2001, Pub. L. 107–16
(“EGTRRA”).
II. BACKGROUND
Section 401(a)(31)(A) of the Code and
§1.401(a)(31)–1 of the Income Tax Reg-
ulations provide that a distributee of any
eligible rollover distribution, as defined in
§ 402(f)(2)(A), may elect to have such dis-
tribution paid directly to an eligible retire-
ment plan and that such distribution must
be made in the form of a direct rollover to
the specified eligible retirement plan. Sec-
tion 402(f)(1) requires that the plan admin-
istrator provide a written explanation to the
recipient of the provisions under which the
recipient may have the distribution paid di-
rectly to an eligible retirement plan as de-
fined in § 402(c)(8) in a direct rollover.
Sections 411(a)(11) and 417(e) permit
plans qualified under § 401(a) to include
provisions allowing for the immediate
distribution of a separating participant’s
benefit without such participant’s consent
where the present value of the nonfor-
feitable accrued benefit is less than $5,000.
Section 657 of EGTRRA amended
§ 401(a)(31)(B) of the Code to require
that mandatory distributions of more
than $1,000 from a plan qualified un-
der § 401(a) be paid in a direct rollover
to an individual retirement plan (i.e.,an
individual retirement account as described
in § 408(a) or an individual retirement
annuity described in § 408(b)) of a des-
ignated trustee or issuer if the distributee
does not make an affirmative election to
have the amount paid in a direct rollover
to an eligible retirement plan or to receive
the distribution directly. Section 657(a) of
EGTRRA also added a notice provision
to § 401(a)(31)(B)(i) of the Code which
requires that the plan administrator notify
the distributee in writing (either sepa-
rately or as part of the § 402(f) notice) that
the distribution may be paid in a direct
rollover to an individual retirement plan.
Section 657(c)(2)(A) of EGTRRA di-
rected the Department of Labor to issue
regulations providingsafe harbors under
which 1) a plan administrator’s designa-
tion of an institution to receive the auto-
matic rollover and 2) the initial investment
choice for the rolled-over funds would be
deemed to satisfy the fiduciary responsi-
bility provisions of § 404(a) of the Em-
ployee Retirement Income Security Act of
1974 (“ERISA”).
January 18, 20053372005–3 I.R.B.

Section 657(d) of EGTRRA provided
that the § 401(a)(31)(B) of the Code requir-
ing automatic rollovers of certain manda-
tory distributions to individual retirement
plans will not become effective until the
Department of Labor issues safe harbor
regulations.
On September 28, 2004, the Depart-
ment of Labor issued final regulations
(29 CFR § 2550.404a–2) pursuant to
§ 657(c)(2)(A) of EGTRRA. 69 FR 58017.
Section 2550.404a–2 of those regulations
establishes a safe harbor under which a
fiduciary of an employee pension bene-
fit plan subject to Title I of ERISA will
be deemed to have satisfied his or her
fiduciary duties under § 404(a) of ERISA
in connection with an automatic rollover
of a mandatory distribution described in
§ 401(a)(31)(B) of the Code. Section
2550.404a–2(c) provides the conditions
under which a fiduciary qualifies for the
safe harbor described in the preceding
sentence. The safe harbor contained in
§ 2550.404a–2 applies only to employee
pension benefit plans covered under Title
I of ERISA. The safe harbor contained in
§ 2550.404a–2 also applies to automatic
rollovers of $1,000 or less.
III. QUESTIONS AND ANSWERS
Q–1. To what distributions do the
automatic rollover requirements of
§ 401(a)(31)(B) apply?
A–1. The automatic rollover require-
ments apply to any mandatory distribution
that is more than $1,000 and is an eligi-
ble rollover distribution that is subject to
the direct rollover requirements that are in
§ 401(a)(31). Thus, in order for a plan that
provides for such mandatory distributions
to be qualified under § 401(a), it must sat-
isfy the automatic rollover provisions of
§ 401(a)(31)(B). Pursuant to Q&A–16 of
§ 1.401(a)(31)–1 of the Income Tax Regu-
lations, an eligible rollover distribution in
the form of a plan loan offset amount is
not subject to the automatic rollover pro-
visions of § 401(a)(31)(B).
Q–2. What is a mandatory distribution?
A–2. A mandatory distribution is a
distribution that is made without the par-
ticipant’s consent and that is made to a
participant before the participant attains
the later of age 62 or normal retirement
age. A distribution to a surviving spouse
or alternate payee is not a mandatory dis-
tribution for purposes of the automatic
rollover requirements of § 401(a)(31)(B).
Although § 411(a)(11) generally pro-
hibits mandatory distributions of accrued
benefits attributable to employer contri-
butions with a present value exceeding
$5,000, the automatic rollover provisions
of § 401(a)(31)(B) apply without regard to
the amount of the distribution as long as
the amount exceeds $1,000.
Q–3. How is the automatic rollover
requirement of § 401(a)(31)(B) satisfied?
A–3. In order to satisfy the automatic
rollover requirement of § 401(a)(31)(B),
a plan must provide that, when making
a mandatory distribution that exceeds
$1,000 and that is an eligible rollover
distribution, if, after receiving the notice
describedin§402(f),aparticipantfailsto
elect to receive a mandatory distribution
directly or have it paid in a direct rollover
to an eligible retirement plan, the distribu-
tion will be paid in a direct rollover to an
individual retirement plan.
Q–4. When do the automatic rollover
provisions of § 401(a)(31)(B) become ef-
fective with respect to mandatory distribu-
tions?
A–4. The automatic rollover require-
ments of § 401(a)(31)(B) apply to manda-
tory distributions made on or after March
28, 2005. Thus, the automatic rollover re-
quirements of § 401(a)(31)(B) do not ap-
ply to mandatory distributions made prior
to March 28, 2005. Section 657(d) of
EGTRRA provides that the requirements
of § 401(a)(31)(B) of the Code requiring
automatic rollovers of mandatory distri-
butions to individual retirement plans do
not become effective until the Department
of Labor prescribes final regulations im-
plementing a fiduciary safe harbor related
to automatic rollovers. The final regula-
tions issued by the Department of Labor on
September 28, 2004, provide that the regu-
lations apply to any rollover of mandatory
distributions made on or after March 28,
2005.
Q–5. Do the automatic rollover require-
ments of § 401(a)(31)(B) apply to govern-
mental plans as described in § 414(d)?
A–5. Yes, the automatic rollover re-
quirements apply to governmental plans
(within the meaning of § 414(d)) that are
required to comply with § 401(a)(31),
even though these plans are not subject
to the provisions of § 411. Thus, for
example, in order for a plan of a state
or local government to be qualified un-
der § 401(a), the plan must comply with
§ 401(a)(31)(B). However, governmental
plans will not be treated as failing to sat-
isfy the requirements of § 401(a)(31)(B) if
the automatic rollover provisions are not
applied to mandatorydistributions from
such plans that are made prior to the close
of the first regular legislative session of
the legislative body with the authority to
amend the plan that begins on or after
January 1, 2006.
Q–6. Do the automatic rollover pro-
visions of § 401(a)(31)(B) apply to gov-
ernmental eligible deferred compensation
plans described in § 457(b)?
A–6. Yes, § 457(d)(1)(C) provides
that, in order to satisfy the distribution
requirements of § 457(b)(5), a govern-
mental eligible deferred compensation
plan described in subsection (e)(1)(A)
must meet requirements similar to the
requirements of § 401(a)(31). However,
the delayed compliance date set forth in
Q&A–5 applies. The automatic rollover
requirements of § 401(a)(31)(B) do not ap-
ply to non-governmental § 457(b) plans.
Q–7. Do the automatic rollover provi-
sions of § 401(a)(31)(B) apply to § 403(b)
plans?
A–7. Yes, § 403(b)(10) provides
that rules similar to the rules of
§ 401(a)(31) apply to § 403(b) plans.
Thus, the automatic rollover provisions
of § 401(a)(31)(B) apply to annuity con-
tracts described in § 403(b)(1), custodial
accounts described in § 403(b)(7), and
retirement income accounts described in
§ 403(b)(9). If a § 403(b) plan is a gov-
ernmental plan within the meaning of
§ 414(d), then the delayed compliance
date in A–5 applies.
Q–8. Do the automatic rollover provi-
sions of § 401(a)(31)(B) apply to church
plans within the meaning of § 414(e) with
respect to which the election provided in
§ 410(d) has not been made?
A–8.Yes, the requirements of
§ 401(a)(31)(B) of the Code apply to
non-electing church plans even though
these plans are not subject to the provi-
sions of § 411. However, a non-electing
church plan maintained for which the
authoritytoamendtheplanisheldby
a church convention (within the mean-
ing of § 414(e)(3)) will not be treated
as failing to satisfy the requirements of
§ 401(a)(31)(B) if the automatic rollover
2005–3 I.R.B.338January 18, 2005

provisions are not applied to mandatory
distributions from such plan that are made
prior to the date that is 60 days after the
close of the earliest church convention that
occurs on or after January 1, 2006.
Q–9. If a plan that provides for manda-
tory distributions does not make a distri-
bution to a participant who fails to affir-
matively elect direct payment or a direct
rollover for a mandatory distribution on or
after March 28, 2005, because the plan ad-
ministrator has not sufficiently established
administrative procedures that allow the
plan administrator to accomplish the auto-
matic rollover of a mandatory distribution
by that date, will the plan be treated as fail-
ing to operate in accordance with its terms?
A–9. No, a plan will not be treated as
failing to operate in accordance with its
terms (including the automatic rollover
provisions) with respect to mandatory
distributions merely because it does not
process mandatory distributions for which
the participant does not affirmatively elect
direct rollover or direct payment due to
a lack of sufficient administrative proce-
dures for automatic rollovers, including
establishing individual retirement plans to
accept automatic rollovers, provided the
mandatory distributions are made on or
before December 31, 2005.
Q–10. Can a plan administrator set up
an individual retirement plan for a partic-
ipant who is receiving a mandatory dis-
tribution and who has not elected to have
such distribution paid directly to an eligi-
ble retirement plan in a direct rollover or
to receive the distribution directly?
A–10. Yes, if a participant receiving
a mandatory distribution fails to elect to
have such distribution paid to an eligible
retirement plan in a direct rollover or to
receive the distribution directly, the plan
administrator may execute the necessary
documents to establish an individual re-
tirement plan on the participant’s behalf
with a financial institution selected by
the plan administrator.
1
For this purpose,
the plan administrator may use the par-
ticipant’s most recent mailing address in
the records of the employer and plan ad-
ministrator. The trustee or issuer of the
individual retirement plan must provide a
disclosure statement to the participant and
provide a revocation period as prescribed
in § 1.408–6. The trustee or issuer of
the individual retirement plan will not be
treated as failing to satisfy the disclosure
requirements of § 1.408–6 merely because
the disclosure statement is returned by the
United States Postal Service as undeliver-
able after it was mailed to the participant
using the address for the participant pro-
vided by the plan administrator as the
participant’s most recent mailing address
in the records of the employer and plan
administrator.
Q–11. May a mandatory distribution
be paid to an individual retirement account
under § 408(c) or a deemed individual re-
tirement account under § 408(q) that is part
of the plan that is making the distribution?
A–11. Yes, a mandatory distribution
may be paid to a participant’s individual
retirement account that meets the require-
ments of § 408(c) or to a participant’s
deemed individual retirement account that
meets the requirements of § 408(q).
Q–12. Can a plan sponsor eliminate
mandatory distributions from its plan with-
out violating the anti-cutback provisions of
§ 411(d)(6) of the Code?
A–12. Yes, § 1.411(d)–4, A–2(b)(2)(v),
provides that a plan sponsor may amend
or change a plan to eliminate a provision
which requires the plan to make a manda-
tory single-sum distribution to participants
pursuant to § 411(a)(11) without violating
§ 411(d)(6).
Q–13. If a plan is subject to the
joint and survivor annuity and prere-
tirement survivor annuity requirements of
§ 401(a)(11) and the plan provides that an
accrued benefit greater than $1,000 but not
greater than $5,000 will be distributed to
a participant only with the consent of the
participant, would a distribution of such
an accrued benefit be subject to spousal
consent requirements?
A–13. No. Section 1.417(e)–1(b)(2)(i)
provides that no spousal consent is re-
quired before the annuity starting date
if the present value of the nonforfeitable
benefit is not more than the cash-out limit
in effect under § 411(a)(11).
Q–14. Are amounts attributable to
rollover contributions that exceed $5,000
subject to the automatic rollover provi-
sions of § 401(a)(31)(B)?
A–14. Yes. Section 401(a)(31)(B)
applies to the entire amount of a manda-
tory distribution. Thus, for example, the
portion of the distribution attributable
to a rollover contribution is subject to
the automatic rollover requirements of
§ 401(a)(31)(B), even if that amount is
excludable (under § 411(a)(11)(D)) from
the determination of whether the present
value of the nonforfeitable accrued benefit
exceeds $5,000.
Q–15. Is a plan administrator required
to notify a participant to whom a manda-
tory distribution is going to be made that,
absent the participant’s affirmative elec-
tion, the distribution will automatically be
paid to an individual retirement plan in a
direct rollover?
A–15. Yes. Section 401(a)(31)(B)(i)
requires that the plan administrator notify
the participant in writing (either separately
or as part of the § 402(f) notice) that, ab-
sent an affirmative election by the partici-
pant, the distribution will be paid to an in-
dividual retirement plan. The notice must
identify the trustee or issuer of the individ-
ual retirement plan. A plan administrator
will not be treated as failing to satisfy this
notice requirement merely because the no-
tice is sent using electronic media in ac-
cordance with A–5 of § 1.402(f)–1. Fur-
ther, for an eligible rollover distribution
paid as an automatic direct rollover, a plan
administrator will not be treated as fail-
ing to satisfy this notice requirement or
section 402(f) with respect to an eligible
rollover distribution merely because the
notice is returned as undeliverable by the
United States Postal Service after having
been mailed to the participant using the
participant’s most recent mailing address
in the records of the employer and plan ad-
ministrator.
Q–16. When must a plan that provides
for mandatory distributions be amended to
include a provision that satisfies the re-
quirements of § 401(a)(31)(B)?
A–16. Plans that provide for manda-
tory distributions and that do not already
1
The staffs of the federal functional regulators that issued joint regulations requiring financial institutions to implement customer identification programs (“CIP”) pursuant to § 326 of the
USA PATRIOT Act have interpreted these regulations to require that when a plan administrator transfers funds of a former employee to a financial institution pursuant to § 401(a)(31)(B), the
financial institution will not be required to implement its CIP until the former employee first contacts such institution to assert ownership or exercise control over the account. Accordingly,
CIP compliance is not required at the time an employee benefit plan establishes an account and transfers the funds to the bank or other financial institution for purposes of a complying with
the automatic rollover requirements of § 401(a)(31)(B).
January 18, 20053392005–3 I.R.B.

include the automatic rollover provisions
must adopt a good faith plan amendment
reflecting the automatic rollover require-
ments by the end of the first plan year
ending on or after March 28, 2005 (or
in the case of a governmental plan in
accordance with A–5). Included in the
Appendix is a sample plan amendment
that individual plan sponsors and spon-
sors (or volume submitter practitioners)
of pre-approved plans can adopt or use in
drafting individualized plan amendments.
This sample plan amendment, or a plan
amendment that is materially similar to
this sample, will be a “good faith” plan
amendment. The adoption of this sam-
ple amendment by a sponsor (or volume
submitter practitioner) of a pre-approved
plan will not cause such a plan to be
treated as an individually designed plan.
Ifaplanisamendedbyatimelygood
faith amendment reflecting the automatic
rollover requirements, a plan amendment
to a disqualifying provision related to
the automatic rollover requirements can
be made within the plan’s EGTRRA re-
medial amendment period to the extent
necessary to satisfy the automatic rollover
requirements, as interpreted in published
guidance. See § 2.03, Rev. Proc. 2004–25,
2004–16 I.R.B. 791. To the extent neces-
sary, such a remedial amendment may be
made retroactively effective as of March
28, 2005, or, if later, the date on which
the plan becomes subject to the automatic
rollover requirements of § 401(a)(31)(B).
DRAFTING INFORMATION
The principal authors of this no-
tice are Kathleen J. Herrmann and
Angelique V. Carrington of Employee
Plans, Tax Exempt and Government
Entities Division. Ms. Herrmann and
Ms. Carrington may be reached at (202)
283–9888 (not a toll-free number).
APPENDIX
Section 401(a)(31)(B) Sample
Amendment
“In the event of a mandatory distribu-
tion greater than $1,000 in accordance with
the provisions of section
,ifthe
participant does not elect to have such dis-
tribution paid directly to an eligible retire-
ment plan specified by the participant in
a direct rollover or to receive the distribu-
tion directly in accordance with section(s)
, then the plan administrator will
pay the distribution in a direct rollover to
an individual retirement plan designated
by the plan administrator.”
Section 6043A and Request
for Comments
Notice 2005–7
Background
This notice addresses the new infor-
mation reporting rules provided in section
6043A as enacted by the American Jobs
Creation Act of 2004.
Temporary and Proposed Regulations
under Sections 6043(c) and 6045
Proposed regulations under sections
6043(c) and 6045 provide for information
reporting in the case of an acquisition
of control of a corporation or a substan-
tial change in corporate structure of a
corporation. Pursuant to these proposed
regulations, information reporting would
be required when there is an acquisition
of control of a domestic corporation or a
substantial change in capital structure of
a domestic corporation, and shareholders
are required to recognize gain (if any) from
the transaction. The proposed regulations
would require the reporting corporation
(defined as the acquired corporation in the
case of an acquisition) to file with the IRS
Form 8806 describing the transaction on
or before the 45th day following the trans-
action,andtofilewiththeIRSandfurnish
to shareholders Form 1099-CAP with re-
spect to cash, stock, and other property
received by shareholders. Brokers holding
stock for customers would be required to
file with the IRS and furnish to sharehold-
ers Form 1099-B reporting the amounts
received. Reporting would be required
only with respect to transactions involving
distributions of assets of $100 million or
more, and certain reporting exceptions are
provided with respect to specified share-
holders.
Pursuant to temporary regulations
§§ 1.6043–4T and 1.6045–3T, report-
ing rules have applied to any acquisition
of control and any substantial change in
capital structure occurring after December
31, 2001, if the reporting corporation or
any shareholder is required to recognize
gain (if any) as a result of the application
of section 367(a).
Section 6043A
Section 805 of the American Jobs Cre-
ation Act of 2004, Pub. L. 108–357, 118
Stat. 1418, added section 6043A to the
Internal Revenue Code. Section 6043A
provides for information reporting by an
acquiring corporation in any taxable ac-
quisition, according to forms or regula-
tions prescribed by the Secretary. Sec-
tion 6043A supplements the information
reporting provisions of sections 6043(c)
and 6045.
Reporting and Request for Comments
Treasury and the IRS continue to con-
sider comments regarding the proposed
regulations under sections 6043(c) and
6045. Treasury and the IRS also are con-
sidering the proper implementation of the
additional information reporting provided
in section 6043A.
Treasury and the IRS request public
comments relating to information report-
ing for acquisitions under section 6043A,
including, but not limited to, comments re-
garding:
a. coordination withthe requirements
of the temporary and proposed reg-
ulations under sections 6043(c) and
6045;
b. rules for reporting by nominees;
c. whether dollar thresholds (e.g.,re-
garding the size of the acquisition or
the amount received by a shareholder)
should be adopted and, if so, the ap-
propriate amount of such thresholds;
d. design of forms; and
e. appropriate filing deadlines.
Taxpayers required to report under Treas.
Reg. §§ 1.6043–4T and 1.6045–3T must
continue to report pursuant to those regu-
lations.
Consideration will be given to writ-
ten or electronic comments submitted
by March 1, 2005. All comments will
be made available for public inspec-
tion and copying. Send submissions
to CC:PA:LPD:PR (NOT–156854–04),
room 5203, Internal Revenue Service,
POB 7604, Ben Franklin Station, Wash-
ington, DC 20044. Submissions may be
2005–3 I.R.B.340January 18, 2005

hand delivered Monday through Friday
between the hours of 8 a.m. and 4 p.m.
to CC:PA:LPD:PR (NOT–156854–04),
Courier’s Desk, Internal Revenue Service,
1111 Constitution Avenue, NW, Wash-
ington, DC. Alternatively, taxpayers may
submit electronic comments directly to the
IRS Internet site atwww.irs.gov/regs.
The principal author of this notice is
Michael Hara of the Office of Associate
Chief Counsel (Procedure and Adminis-
tration), Administrative Provisions and Ju-
dicial Practice Division. For further in-
formation regarding this notice, contact
Mr. Hara at (202) 622–4910 (not a toll-free
number).
26 CFR 601.105: Examination of returns and claims
for refund, credit, or abatement; determination of
correct tax liability.
(Also Part I, §§ 62, 162, 267, 274; 1.62–2, 1.162–17,
1.267(a)–1, 1.274–5.)
Rev. Proc. 2005–10
SECTION 1. PURPOSE
This revenue procedure updates Rev.
Proc. 2004–60, 2004–42 I.R.B. 682
(which supersedes Rev. Proc. 2003–80,
2003–2 C.B. 1037), revising the high-low
rates in section 5 to conform to changes to
theper diemrates released by the General
Services Administration (GSA) on Octo-
ber 5, 2004, that are retroactively effective
as of October 1, 2004. See 69 Fed. Reg.
60,152 (Oct. 7, 2004). As a result of these
changes, this revenue procedure revises
the high and low rates contained in section
5.02 from $199 to $204 and from $127
to $129, respectively.In addition, section
5.04 of this revenue procedure describes
changes to the list of high-cost locali-
ties. This revenue procedure also revises
the description of incidental expenses in
section 3.02(3) relating to transportation
between places of lodging or business and
places where meals are taken to conform
to the Federal Travel Regulations as codi-
fied in the Code of Federal Regulations.
This revenue procedure provides rules
under which the amount of ordinary and
necessary business expenses of an em-
ployee for lodging, meal, and incidental
expenses or for meal and incidental ex-
penses incurred whiletraveling away from
home are deemed substantiated under
§ 1.274–5 of the Income Tax Regulations
when a payor (the employer, its agent,
or a third party) provides aper diemal-
lowance under a reimbursement or other
expense allowance arrangement to pay
for the expenses. This revenue procedure
provides an optional method for employ-
ees and self-employed individuals who
pay or incur meal costs to use in com-
puting the deductible costs of business
meal and incidental expenses paid or in-
curred while traveling away from home.
This revenue procedure also provides an
optional method for use in computing
the deductible costs of incidental expenses
paid or incurred while traveling away from
home by employees and self-employed in-
dividuals who do not pay or incur meal
costs and who are not reimbursed for the
incidental expenses. Use of a method de-
scribed in this revenue procedure is not
mandatory, and a taxpayer may use actual
allowable expenses if the taxpayer main-
tains adequate records or other sufficient
evidence for proper substantiation. This
revenue procedure does not provide rules
under which the amount of an employee’s
lodging expenses will be deemed substan-
tiated when a payor provides an allowance
to pay for those expenses but not meal and
incidental expenses.
SECTION 2. BACKGROUND
.01 Section 162(a) of the Internal Rev-
enue Code allows a deduction for all the or-
dinary and necessary expenses paid or in-
curred during the taxable year in carrying
on any trade or business. Under that pro-
vision, an employee or self-employed in-
dividual may deduct expenses paid or in-
curred while traveling away from home in
pursuit of a trade or business. However,
under § 262, no portion of the travel ex-
penses that is attributable to personal, liv-
ing, or family expenses is deductible.
.02 Section 274(n) generally limits the
amount allowable as a deduction under
§ 162 for any expense for food, bever-
ages, or entertainment to 50 percent of
the amount of the expense that otherwise
would be allowable as a deduction. In
the case of any expenses for food or bev-
erages consumed while away from home
(within the meaning of § 162(a)(2)) by an
individual during, or incident to, the pe-
riod of duty subject to the hours of service
limitations of the Department of Trans-
portation, § 274(n)(3) gradually increases
the deductible percentage to 80 percent for
taxable years beginning in 2008. For tax-
able years beginning in 2004 and 2005, the
deductible percentage for these expenses is
70 percent.
.03 Section 274(d) provides, in part,
that no deduction is allowed under § 162
for any travel expense (including meals
and lodging while away from home) unless
the taxpayer complies with certain sub-
stantiation requirements. Section 274(d)
further provides that regulations may pre-
scribe that some or all of the substantiation
requirements do not apply to an expense
that does not exceed an amount prescribed
by the regulations.
.04 Section 1.274–5(g), in part, grants
the Commissioner the authority to pre-
scribe rules relating to reimbursement
arrangements orper diemallowances for
ordinary and necessary expenses paid or
incurred while traveling away from home.
Pursuant to this grant of authority, the
Commissioner may prescribe rules under
which these arrangements or allowances,
if in accordance with reasonable busi-
ness practice, will be regarded (1) as
equivalent to substantiation, by adequate
records or other sufficient evidence, of the
amount of travel expenses for purposes
of § 1.274–5(c), and (2) as satisfying the
requirements of an adequate accounting
to the employer of the amount of travel
expenses for purposes of § 1.274–5(f).
.05 For purposes of determining ad-
justed gross income, § 62(a)(2)(A) allows
an employee a deduction for expenses al-
lowedbyPartVI(§161andfollowing),
subchapter B, chapter 1 of the Code, paid
or incurred by the employee in connection
with the performance of services as an em-
ployee under a reimbursement or other ex-
pense allowance arrangement with a payor.
.06 Section 62(c) provides that an ar-
rangement will not be treated as a reim-
bursement or other expense allowance ar-
rangement for purposes of § 62(a)(2)(A) if
it—
(1) does not require the employee to
substantiate the expenses covered by the
arrangement to the payor, or
(2) provides the employee with the
right to retain any amount in excess of the
substantiated expenses covered under the
arrangement.
Section 62(c) further provides that the sub-
stantiation requirements described therein
January 18, 20053412005–3 I.R.B.

do not apply to any expense to the extent
that, under the grant of regulatory authority
prescribed in § 274(d), the Commissioner
has provided that substantiation is not re-
quired for the expense.
.07 Under § 1.62–2(c)(1) a reimburse-
ment or other expense allowance arrange-
ment satisfies the requirements of § 62(c)
if it meets the requirements of business
connection, substantiation, and returning
amounts in excess of expenses as specified
in the regulations. Section 1.62–2(e)(2)
specifically provides that substantiation of
certain business expenses in accordance
with rules prescribed under the author-
ity of § 1.274–5(g) or 1.274–5(j) will be
treated as substantiation of the amount of
the expenses for purposes of § 1.62–2.
Under § 1.62–2(f)(2), the Commissioner
may prescribe rules under which an ar-
rangement providingper diemallowances
is treated as satisfying the requirement of
returning amounts in excess of expenses,
even though the arrangement does not
require the employee to return the por-
tion of the allowance that relates to days
of travel substantiated and that exceeds
the amount of the employee’s expenses
deemed substantiated pursuant to rules
prescribed under § 274(d), provided the
allowance is reasonably calculated not
to exceed the amount of the employee’s
expenses or anticipated expenses and the
employee is required to return within a
reasonable period of time any portion of
the allowance that relates to days of travel
not substantiated.
.08 Section 1.62–2(h)(2)(i)(B) pro-
vides that, if a payor pays aper diem
allowance that meets the requirements
of § 1.62–2(c)(1), the portion, if any,
of the allowance that relates to days of
travel substantiated in accordance with
§ 1.62–2(e), that exceeds the amount of
the employee’s expenses deemed substan-
tiated for the travel pursuant to rules pre-
scribed under § 274(d) and § 1.274–5(g) or
§ 1.274–5(j), and that the employee is not
required to return, is subject to withhold-
ing and payment of employment taxes.
See §§ 31.3121(a)–3, 31.3231(e)–1(a)(5),
31.3306(b)–2, and 31.3401(a)–4 of the
Employment Tax Regulations. Because
the employee is not required to return this
excess portion, the reasonable period of
time provisions of § 1.62–2(g) (relating to
the return of excess amounts) do not apply
to this portion.
.09 Under § 1.62–2(h)(2)(i)(B)(4), the
Commissioner has the discretion to pre-
scribe special rules regarding the timing of
withholding and payment of employment
taxes onper diemallowances.
.10 Section 1.274–5(j)(1) grants the
Commissioner the authority to establish a
method under which a taxpayer may elect
to use a specified amount for meals paid or
incurred while traveling away from home
in lieu of substantiating the actual cost of
meals.
.11 Section 1.274–5(j)(3) grants the
Commissioner the authority to establish a
method under which a taxpayer may elect
to use a specified amount for incidental
expenses paid or incurred while traveling
away from home in lieu of substantiating
the actual cost of incidental expenses.
.12 On August 31, 2004, GSA pub-
lished the FY 2005 domesticper diem
rates, effective on October 1, 2004. On
October 1, 2004, the Internal Revenue
Service released Rev. Proc. 2004–60, the
annual update of procedures for substanti-
ating the amount of ordinary and necessary
business lodging, meal, and incidental ex-
penses incurred while traveling away from
home. Section 5 of Rev. Proc. 2004–60
includes high-lowper diemrates based
on the GSAper diemrates published on
August 30, 2004.
.13 On October 5, 2004, GSA released
revised FY 2005per diemrates that are
retroactively effective on October 1, 2004.
This revenue procedure revises the high-
lowper diemrates in section 5 based on
GSA’s revised rates.
SECTION 3. DEFINITIONS
.01Per diem allowance.Theterm“per
diem allowance” means a payment under a
reimbursement or other expense allowance
arrangement that meets the requirements
specified in § 1.62–2(c)(1) and that is —
(1) paid with respect to ordinary and
necessary business expenses incurred, or
which the payor reasonably anticipates
will be incurred, by an employee for lodg-
ing, meal, and incidental expenses, or for
meal and incidental expenses for travel
away from home in connection with the
performance of services as an employee
of the employer,
(2) reasonably calculated not to exceed
the amount of the expenses or the antici-
pated expenses, and
(3) paid at or below the applicable fed-
eralper diemrate, a flat rate or stated
schedule, or in accordance with any other
Service-specified rate or schedule.
.02Federal per diem rate and federal
M&IE rate.
(1)In general. The federalper diem
rate is equal to the sum of the applicable
federal lodging expense rate and the appli-
cable federal meal and incidental expense
(M&IE) rate for the day and locality of
travel.
(a)CONUS rates. The rates for lo-
calities in the continental United States
(CONUS) are set forth in Appendix A to
41 C.F.R. ch. 301.
(b)OCONUS rates. The rates for local-
ities outside the continental United States
(OCONUS) are established by the Secre-
tary of Defense (rates for non-foreign lo-
calities, including Alaska, Hawaii, Puerto
Rico, the Northern Mariana Islands, and
the possessions of the United States) and
by the Secretary of State (rates for for-
eign localities), and are published in the
Per DiemSupplement to the Standardized
Regulations (Government Civilians, For-
eign Areas) (updated on a monthly basis).
(c)Internet access to the rates.
The CONUS and OCONUS rates
maybefoundontheInternetat
www.policyworks.gov/perdiem.
(2)Locality of travel.Theterm“lo-
cality of travel” means the locality where
an employee traveling away from home in
connection with the performance of ser-
vices as an employee of the employer stops
for sleep or rest.
(3)Incidental expenses.Theterm“in-
cidental expenses” has the same meaning
as in the Federal Travel Regulations, 41
C.F.R. 300–3.1 (2004). Thus, based on the
current definition of “incidental expenses”
in the Federal Travel Regulations, “inci-
dental expenses” means fees and tips given
to porters, baggage carriers, bellhops, ho-
tel maids, stewards or stewardesses and
others on ships, and hotel servants in for-
eign countries; transportation between
places of lodging or business and places
where meals are taken, if suitable meals
can be obtained at the temporary duty
site; and the mailingcost associated with
filing travel vouchers and payment of em-
ployer-sponsored charge card billings.
.03Flat rate or stated schedule.
(1)In general. Except as provided in
section 3.03(2) of this revenue procedure,
2005–3 I.R.B.342January 18, 2005

an allowance is paid at a flat rate or stated
schedule if it is provided on a uniform
and objective basis with respect to the ex-
penses described in section 3.01 of this
revenue procedure. The allowance may be
paid with respect to the number of days
away from home in connection with the
performance of services as an employee
or on any other basis that is consistently
applied and in accordance with reasonable
business practice. Thus, for example, an
hourly payment to cover meal and inciden-
tal expenses paid to a pilot or flight atten-
dant who is traveling away from home in
connection with the performance of ser-
vices as an employee is an allowance paid
at a flat rate or stated schedule. Likewise,
a payment based on the number of miles
traveled (such as cents per mile) to cover
meal and incidental expenses paid to an
over-the-road truck driver who is traveling
away from home in connection with the
performance of services as an employee is
an allowance paid at a flat rate or stated
schedule.
(2)Limitation. For purposes of this
revenue procedure, an allowance that is
computed on a basis similar to that used
in computing the employee’s wages or
other compensation (such as the number
of hours worked, miles traveled, or pieces
produced) does not meet the business con-
nection requirement of § 1.62–2(d), is not
aper diemallowance, and is not paid at
a flat rate or stated schedule, unless, as
of December 12, 1989, (a) the allowance
was identified by the payor either by mak-
ing a separate payment or by specifically
identifying the amount of the allowance,
or (b) an allowance computed on that ba-
sis was commonly used in the industry
in which the employee is employed. See
§ 1.62–2(d)(3)(ii).
SECTION 4. PER DIEM
SUBSTANTIATION METHOD
.01Per diem allowance. If a payor pays
aper diemallowanceinlieuofreimburs-
ing actual lodging, meal, and incidental ex-
penses incurred or to be incurred by an
employee for travel away from home, the
amount of the expenses that is deemed sub-
stantiated for each calendar day is equal to
the lesser of theper diemallowance for
that day or the amount computed at the
federalper diemrate (see section 3.02 of
this revenue procedure) for the locality of
travel for that day (or partial day, see sec-
tion 6.04 of this revenue procedure).
.02Meal and incidental expenses only
per diem allowance. If a payor pays a
per diemallowance only for meal and in-
cidental expenses in lieu of reimbursing
actual meals and incidental expenses in-
curred or to be incurred by an employee
for travel away from home, the amount of
the expenses that is deemed substantiated
for each calendar day is equal to the lesser
of theper diemallowance for that day or
the amount computed at the federal M&IE
rate for the locality of travel for that day
(or partial day). Aper diemallowance
is treated as paid only for meal and inci-
dental expenses if (1) the payor pays the
employee for actual expenses for lodging
based on receipts submitted to the payor,
(2) the payor provides the lodging in kind,
(3) the payor pays the actual expenses for
lodging directly to the provider of the lodg-
ing, (4) the payor does not have a reason-
able belief that lodging expenses were or
will be incurred by the employee, or (5) the
allowance is computed on a basis similar
to that used in computing the employee’s
wages or other compensation (such as the
number of hours worked, miles traveled,
or pieces produced).
.03Optional method for meal and in-
cidental expenses only deduction.Inlieu
of using actual expenses in computing the
amount allowable as a deduction for or-
dinary and necessary meal and inciden-
tal expenses paid or incurred for travel
away from home, employees and self-em-
ployed individuals who pay or incur meal
expenses may use an amount computed at
the federal M&IE rate for the locality of
travel for each calendar day (or partial day)
the employee or self-employed individual
is away from home. This amount will be
deemed substantiated for purposes of para-
graphs (b)(2) and (c) of § 1.274–5, pro-
vided the employee or self-employed indi-
vidual substantiates the elements of time,
place, and business purpose of the travel
for that day (or partial day) in accordance
with those regulations. See section 6.05(1)
of this revenue procedure for rules related
to the application of the limitation under
§ 274(n) to amounts determined under this
section 4.03. See section 4.05 of this rev-
enue procedure for a method for substanti-
ating incidental expenses that may be used
by employees or self-employed individu-
als who do not pay or incur meal expenses.
.04Special rules for transportation in-
dustry.
(1)In general. Thissection4.04ap-
plies to (a) a payor that pays aper diem
allowance only for meal and incidental ex-
penses for travel away from home as de-
scribed in section 4.02 of this revenue pro-
cedure to an employee in the transportation
industry, or (b) an employee or self-em-
ployed individual in the transportation in-
dustry who computes the amount allow-
able as a deduction for meal and incidental
expenses for travel away from home in ac-
cordance with section 4.03 of this revenue
procedure.
(2)Transportation industry defined.
For purposes of this section 4.04, an em-
ployee or self-employed individual is in
the transportation industry only if the em-
ployee’s or individual’s work (a) is of the
type that directly involves moving people
or goods by airplane, barge, bus, ship,
train, or truck, and (b) regularly requires
travel away from home which, during
anysingletripawayfromhome,usually
involves travel to localities with differ-
ing federal M&IE rates. For purposes
of the preceding sentence, a payor must
determine that an employee or a group of
employees is in the transportation indus-
try by using a method that is consistently
applied and in accordance with reasonable
business practice.
(3)Rates. A taxpayer described in sec-
tion 4.04(1) of this revenue procedure may
treat $41 as the federal M&IE rate for any
CONUS locality of travel, and $46 as the
federal M&IE rate for any OCONUS lo-
cality of travel. A payor that uses either (or
both) of these special rates with respect to
an employee must use the special rate(s)
for all amounts subject to section 4.02 of
this revenue procedure paid to that em-
ployee for travel away from home within
CONUS and/or OCONUS, as the case may
be, during the calendar year. Similarly, an
employee or self-employed individual that
uses either (or both) of these special rates
must use the special rate(s) for all amounts
computed pursuant to section 4.03 of this
revenue procedure for travel away from
home within CONUS and/or OCONUS, as
the case may be, during the calendar year.
(4)Periodic rule. A payor described in
section 4.04(1) of this revenue procedure
may compute the amount of the em-
ployee’s expenses that is deemed substan-
tiated under section 4.02 of this revenue
January 18, 20053432005–3 I.R.B.

procedure periodically (not less frequently
than monthly), rather than daily, by com-
paring the totalper diemallowance paid
for the period to the sum of the amounts
computed either atthe federal M&IE
rate(s) for the localities of travel, or at the
special rate described in section 4.04(3),
for the days (or partial days) the employee
is away from home during the period.
(5)Examples.
(a)Example 1. Taxpayer, an employee in the
transportation industry, travels away from home on
business within CONUS on 17 days (including par-
tial days) during a calendar month and receives aper
diemallowance only for meal and incidental expenses
from a payor that uses the special rule under sec-
tion 4.04(3) of this revenue procedure. The amount
deemed substantiated under section 4.02 of this rev-
enue procedure is equal to the lesser of the totalper
diemallowance paid for the month or $697 (17 days
at $41 per day).
(b)Example 2. Taxpayer, a truck driver employee
in the transportation industry, is paid a “cents-per-
mile” allowance that qualifies as an allowance paid
under a flat rate or stated schedule as defined in sec-
tion 3.03 of this revenue procedure. Taxpayer travels
away from home on business for 10 days. Based on
the number of miles driven by Taxpayer, Taxpayer’s
employer pays an allowance of $400 for the 10 days
of business travel. Taxpayer actually drives for 8
days, and does not drive for the other 2 days Taxpayer
is away from home. Taxpayer is paid under the peri-
odic rule used for transportation industry employers
and employees in accordance with section 4.04(4) of
this revenue procedure. The amount deemed substan-
tiated and excludable from Taxpayer’s income is the
full $400 because that amount does not exceed $410
(ten days away from home at $41 per day).
.05Optional method for incidental ex-
penses only deduction. In lieu of using
actual expenses in computing the amount
allowable as a deduction for ordinary and
necessary incidental expenses paid or in-
curred for travel away from home, employ-
ees and self-employed individuals who do
not pay or incur meal expenses for a calen-
dar day (or partial day) of travel away from
home may use, for each calendar day (or
partial day) the employee or self-employed
individual is away from home, an amount
computed at the rate of $3 per day for any
CONUS or OCONUS locality of travel.
This amount will be deemed substantiated
for purposes of paragraphs (b)(2) and (c)
of § 1.274–5, provided the employee or
self-employed individual substantiates the
elements of time, place, and business pur-
pose of the travel for that day (or partial
day) in accordance with those regulations.
See section 4.03 of this revenue procedure
for a method that may be used by em-
ployees or self-employed individuals who
pay or incur meal expenses. The method
authorized by this section 4.05 may not
be used by payors that use section 4.01,
4.02, or 5.01 of this revenue procedure, or
by employees or self-employed individu-
als who use the method described in sec-
tion 4.03 of this revenue procedure. See
section 6.05(4) of this revenue procedure
for rules related to the application of the
limitation under § 274(n) to amounts de-
termined under this section 4.05.
SECTION 5. HIGH-LOW
SUBSTANTIATION METHOD
.01In general. If a payor pays aper
diemallowance in lieu of reimbursing
actual lodging, meal, and incidental ex-
penses incurred or to be incurred by an
employee for travel away from home and
the payor uses the high-low substantia-
tion method described in this section 5 for
travel within CONUS, the amount of the
expenses that is deemed substantiated for
each calendar day is equal to the lesser
of theper diemallowance for that day or
the amount computed attheratesetforth
in section 5.02 of this revenue procedure
for the locality of travel for that day (or
partial day, see section 6.04 of this revenue
procedure). This high-low substantiation
method may be used in lieu of theper
diemsubstantiation method provided in
section 4.01 of this revenue procedure, but
may not be used in lieu of the meal and
incidental expenses only substantiation
method provided in section 4.02 or 4.03
of this revenue procedure or the inciden-
tal expenses only substantiation method
provided in section 4.05 of this revenue
procedure.
.02Specific high-low rates.Theper
diemrate set forth in this section 5.02 is
$204 for travel to any “high-cost local-
ity” specified in section 5.03 of this rev-
enue procedure, or $129 for travel to any
other locality within CONUS. The high
or low rate, as appropriate, applies as if
it were the federalper diemrate for the
locality of travel. For purposes of ap-
plying the high-low substantiation method
and the § 274(n) limitation on meal ex-
penses (see section 6.05 of this revenue
procedure), the federal M&IE rate shall be
treated as $46 for a high-cost locality and
$36foranyotherlocalitywithinCONUS.
.03High-cost localities. The following
localities have a federalper diemrate of
$167 or more and are high-cost localities
for all of the calendar year or the portion of
the calendar year specified in parentheses
under the key city name:
Key CityCounty or other defined location
Arizona
Phoenix/ScottsdaleMaricopa
(January 1-May 31)
California
MontereyMonterey
(Fe
bruary 1-November 30)
NapaNapa
(May 1-October 31)
Palm SpringsRiverside
(January 1-May 31)
San DiegoSan Diego
S
an Francisco
S
an Francisco
2005–3 I.R.B.344January 18, 2005

Key CityCounty or other defined location
Santa BarbaraSanta Barbara
Santa MonicaCity limits of Santa Monica
South Lake TahoeEl Dorado
(December 1-A
ugust 31)
Colorado
AspenPitkin
Crested ButteCity limits of Crested Butte
(December 1-March 31)(Gunnison County)
Silverthorne/BreckenridgeSummit
(December
1-March 31)
TellurideSan Miguel
(December 1-September 30)
VailEagle
District of Columbia
Washington D.C. (also the cities of Alexandria, Falls Church, and Fairfax, and the counties of Arlington, Loudoun, and
Fairfax, in Virginia; and the counties of Montgomery and Prince George’s in Maryland) (See also Maryland and Virginia)
Delaw
are
LewesSussex
(July 1-August 31)
Florida
Daytona BeachVolusia
(February 1-March 31)
For
t Lauderdale
Bro
ward
(January 1-May 31)
Key WestMonroe
MiamiMiami-Dade
(October 1-May 31)
NaplesCollier
(
January 1-March 31)
Palm Beach
(October 1-May 31)
Palm Beach (also the cities of Boca Raton,
Delray Beach, Jupiter, Palm Beach Gardens,
Palm Beach Shores, Singer Island and West
Palm Beach)
Illinois
ChicagoCook and Lake
Louisiana
New OrleansOrleans and St. Bernard Parishes
(February 1-April 30 and
September 1-November 30)
Maryland
(For the counties of Montgomery and Prince George’s, see District of Columbia)
BaltimoreBaltimore
Cambridge/St. MichaelsDorchester and Talbot
(June 1-August 31)
Ocean CityWorcester
(July 1-August 31)
January 18, 20053452005–3 I.R.B.

Key CityCounty or other defined location
Massachusetts
BostonSuffolk
CambridgeCity limits of Cambridge
HyannisBarnstable
(July 1-August 31)
Martha’s VineyardDukes
(May 1-August 31)
NantucketNantucket
Michigan
Traverse CityGrand Traverse
(July 1-August 31)
New Jers
ey
Atlantic CityAtlantic
(May 1-October 31)
Cape MayCape May (except Ocean City)
(June 1-August 31)
Ocean CityCity limits of Ocean City
(June
1-October 31)
Princeton/TrentonMercer
New Mexico
Santa FeSanta Fe
(July 1-August 31)
New York
Carle Place/Garden City/
Glen Cove/Great Neck/
Plainview/Rockville Centre/
Syosset/Uniondale/Woodbury
Nassau
Lake PlacidEssex
(July 1-August 31)
ManhattanIncludes Richmond and the boroughs of
Manhattan, Brooklyn, Queens and The
Bronx
Riverhead/Ronkonkoma/
Melville
Suffolk
TarrytownWestchester (except White Plains)
White PlainsCity limits of White Plains
North Carolina
Kill DevilDare
(April 1-October 31)
Pennsylvania
HersheyCity limits of Hershey
(May 1-August 31)
PhiladelphiaPhiladelphia
2005–3 I.R.B.346January 18, 2005

Key CityCounty or other defined location
Rhode Island
Jamestown/Middletown/
Newport
Newport
(May 1-October 31)
ProvidenceProvidence
South Carolina
Hilton HeadBeaufort
(April 1-October 31)
Utah
Park CitySummit
(December 1-March 31)
Virginia
(For the cities of Alexandria, Fairfax, and Falls Church, and the counties of Arlington, Fairfax, and Loudoun, see District
of Columbia)
Virginia BeachCities of Virginia Beach, Norfolk,
Portsmouth, Chesapeake, and Suffolk
(June 1-August 31)
Washington
SeattleKing
(May 1-October 31)
.04Changes to high-cost localities in
Rev. Proc. 2004–60. The list of high-cost
localities in section 5.03 of this revenue
procedure differs from the list of high-cost
localities in section 5.03 of Rev. Proc.
2004–60 (changes listed by key cities).
(1) The following locality has been
added to the list of high-cost localities:
Traverse City, Michigan.
(2) The portion of the year for which
the following are high-cost localities has
been changed: Fort Lauderdale, Florida;
New Orleans, Louisiana; and Silver-
thorne/Breckinridge, Colorado;
(3) The following localities have been
removed from the list of high-cost locali-
ties: Las Vegas, Nevada; Mackinac Island,
Michigan; Myrtle Beach, South Carolina;
and Tom’s River, New Jersey.
(4) The boroughs of Brooklyn, Queens,
The Bronx, and Staten Island are no longer
separately listed as a high-cost locality and
are now combined with the borough of
Manhattan.
.05Specific limitation.
(1) Except as provided in section
5.05(2) of this revenue procedure, a
payor that uses the high-low substanti-
ation method with respect to an employee
must use that method for all amounts paid
to that employee for travel away from
home within CONUS during the calendar
year.
(2) With respect to an employee de-
scribed in section 5.05(1) of this revenue
procedure, the payor may reimburse ac-
tual expenses or use the meals onlyper
diemmethod described in section 4.02
of this revenue procedure for any travel
away from home, and may use theper
diemsubstantiation method described in
section 4.01 of this revenue procedure for
any OCONUS travel away from home.
SECTION 6. LIMITATIONS AND
SPECIAL RULES
.01In general. The federalper diem
rate and the federal M&IE rate described in
section 3.02 of this revenue procedure for
the locality of travel will be applied in the
same manner as applied under the Federal
Travel Regulations, 41 C.F.R. Part 301–11
(2004), except as provided in sections 6.02
through 6.04 of this revenue procedure.
.02Federal per diem rate. A receipt
for lodging expenses is not required in de-
termining the amount of expenses deemed
substantiated under section 4.01 or 5.01 of
this revenue procedure. See section 7.01
of this revenue procedure for the require-
ment that the employee substantiate the
time, place, and business purpose of the
expense.
.03Federal per diem or M&IE rate.A
payor is not required to reduce the federal
per diemrate or the federal M&IE rate for
the locality of travel for meals provided in
kind, provided the payor has a reasonable
belief that meal and incidental expenses
were or will be incurred by the employee
during each day of travel.
.04Proration of the federal per diem or
M&IE rate. Pursuant to the Federal Travel
Regulations, in determining the federalper
diemrate or the federal M&IE rate for
the locality of travel, the full applicable
federal M&IE rate is available for a full
day of travel from 12:01 a.m. to 12:00
midnight. The method described in sec-
tion 6.04(1) of this revenue procedure must
be used for purposes of determining the
amount deemed substantiated under sec-
tion 4.03 or 4.05 of this revenue procedure
for partial days of travel away from home.
For purposes of determining the amount
deemed substantiated under section 4.01,
4.02, 4.04, or 5 of this revenue procedure
for partial days of travel away from home,
either of the following methods may be
used to prorate the federal M&IE rate to
January 18, 20053472005–3 I.R.B.

determine the federalper diemrate or the
federal M&IE rate for the partial days of
travel:
(1) The rate may be prorated using the
method prescribed by the Federal Travel
Regulations. Currently the Federal Travel
Regulations allow three-fourths of the ap-
plicable federal M&IE rate for each partial
day during which the employee or self-em-
ployed individual is traveling away from
home in connection with the performance
of services as an employee or self-em-
ployed individual. The same ratio may be
applied to prorate the allowance for inci-
dental expenses described in section 4.05
of this revenue procedure; or
(2) The rate may be prorated using any
method that is consistently applied and in
accordance with reasonable business prac-
tice. For example, if an employee travels
away from home from 9 a.m. one day to
5 p.m. the next day, a method of proration
thatresultsinanamountequaltotwotimes
the federal M&IE rate will be treated as
being in accordance with reasonable busi-
ness practice (even though only one and a
half times the federal M&IE rate would be
allowed under the Federal Travel Regula-
tions).
.05Application of the appropriate
§ 274(n) limitation on meal expenses.Ex-
cept as provided in section 6.05(4), all or
part of the amount of an expense deemed
substantiated under this revenue procedure
is subject to the appropriate limitation un-
der § 274(n) (see section 2.02 of this
revenue procedure) on the deductibility of
food and beverage expenses.
(1) If an amount for meal and incidental
expenses is computed pursuant to section
4.03 of this revenue procedure, the tax-
payer must treat that amount as an expense
for food and beverages.
(2)Ifaper diemallowance is paid only
for meal and incidental expenses, the payor
must treat an amount equal to the lesser of
the allowance or the federal M&IE rate for
the locality of travel for each day (or partial
day, see section 6.04 of this revenue pro-
cedure) as an expense for food and bever-
ages.
(3)Ifaper diemallowance is paid for
lodging, meal, and incidental expenses, the
payor must treat an amount equal to the
federal M&IE rate for the locality of travel
for each calendar day (or partial day) the
employee is away from home as an ex-
pense for food and beverages. For pur-
poses of the preceding sentence, if aper
diemallowance for lodging, meal, and in-
cidental expenses is paid at a rate that is
less than the federalper diemrate for the
locality of travel for each day (or partial
day), the payor may treat an amount equal
to 40 percent of the allowance as the fed-
eral M&IE rate for the locality of travel for
each day (or partial day).
(4) If an amount for incidental expenses
is computed under section 4.05 of this rev-
enue procedure, none of the amount so
computed is subject to limitation under
§ 274(n) on the deductibility of food and
beverage expenses.
.06No double reimbursement or deduc-
tion. If a payor pays aper diemallowance
in lieu of reimbursing actual lodging,
meal, and incidental expenses or for meal
and incidental expenses in accordance
with section 4 or 5 of this revenue proce-
dure, any additional payment with respect
to those expenses is treated as paid un-
der a nonaccountable plan, is included in
the employee’s gross income, is reported
as wages or other compensation on the
employee’s Form W–2, “Wage and Tax
Statement,” and is subject to withhold-
ing and payment of employment taxes.
Similarly, if an employee or self-em-
ployed individual computes the amount
allowable as a deduction for meal and
incidental expenses for travel away from
home in accordance with section 4.03 or
4.04 of this revenue procedure, no other
deduction is allowed to the employee or
self-employed individual with respect to
those expenses. For example, assume an
employee receives aper diemallowance
from a payor for lodging, meal, and inci-
dental expenses or for meal and incidental
expenses incurred while traveling away
from home. During that trip, the employee
pays for dinner for the employee and two
business associates. The payor reimburses
as a business entertainment meal expense
themealexpensefortheemployeeand
the two business associates. Because the
payor also pays aper diemallowance to
cover the cost of the employee’s meals,
the amount paid by the payor for the
employee’s portion of the business enter-
tainment meal expense is treated as paid
under a nonaccountable plan, is reported
as wages or other compensation on the
employee’s Form W–2, and is subject to
withholding and payment of employment
taxes.
.07Related parties. Sections 4.01 and
5 of this revenue procedure do not apply if
a payor and an employee are related within
the meaning of § 267(b), but for this pur-
pose the percentage of ownership interest
referred to in § 267(b)(2) shall be 10 per-
cent.
SECTION 7. APPLICATION
.01 If the amount of travel expenses is
deemed substantiated under the rules pro-
vided in section 4 or 5 of this revenue pro-
cedure, and the employee substantiates to
the payor the elements of time, place, and
business purpose of the travel for that day
(or partial day) in accordance with para-
graphs (b)(2) and (c) (other than subpara-
graph (2)(iii)(A) thereof) of § 1.274–5, the
employee is deemed to satisfy the adequate
accounting requirements of § 1.274–5(f)
as well as the requirement to substantiate
by adequate records or other sufficient ev-
idence for purposes of § 1.274–5(c). See
§ 1.62–2(e)(1) for the rule that an arrange-
ment must require business expenses to be
substantiated to the payor within a reason-
able period of time.
.02 An arrangement providingper diem
allowances will be treated as satisfying the
requirement of § 1.62–2(f)(2) of return-
ing amounts in excess of expenses if the
employee is required to return within a
reasonable period of time (as defined in
§ 1.62–2(g)) any portion of the allowance
that relates to days of travel not substan-
tiated, even though the arrangement does
not require the employee to return the por-
tion of the allowance that relates to days
of travel substantiated and that exceeds
the amount of the employee’s expenses
deemed substantiated. For example, as-
sume a payor provides an employee an ad-
vanceper diemallowance for meal and in-
cidental expenses of $200, based on an an-
ticipated 5 days of business travel at $40
per day to a locality for which the fed-
eral M&IE rate is $31, and the employee
substantiates 3 full days of business travel.
The requirement to return excess amounts
will be treated as satisfied if the employee
is required to return within a reasonable
period of time (as defined in § 1.62–2(g))
the portion of the allowance that is at-
tributable to the 2 unsubstantiated days of
travel ($80), even though the employee is
not required to return the portion of the
allowance ($27) that exceeds the amount
2005–3 I.R.B.348January 18, 2005

of the employee’s expenses deemed sub-
stantiated under section 4.02 of this rev-
enue procedure ($93) for the 3 substanti-
ated days of travel. However, the $27 ex-
cess portion of the allowance is treated as
paid under a nonaccountable plan as dis-
cussed in section 7.04 of this revenue pro-
cedure.
.03 An employee is not required to in-
clude in gross income the portion of a
per diemallowance received from a payor
that is less than or equal to the amount
deemed substantiated under the rules pro-
vided in section 4 or 5 of this revenue pro-
cedure if the employee substantiates the
business travel expenses covered by the
per diemallowance in accordance with
section 7.01 of this revenue procedure. See
§ 1.274–5(f)(2)(i). In addition, that por-
tion of the allowance is treated as paid un-
der an accountable plan, is not reported as
wages or other compensation on the em-
ployee’s Form W–2, and is exempt from
the withholding and payment of employ-
ment taxes. See § 1.62–2(c)(2) and (c)(4).
.04 An employee is required to include
in gross income only the portion of theper
diemallowance received from a payor that
exceeds the amount deemed substantiated
under the rules provided in section 4 or 5
of this revenue procedure if the employee
substantiates the business travel expenses
covered by theper diemallowance in ac-
cordance with section 7.01 of this revenue
procedure. See § 1.274–5(f)(2)(ii). In ad-
dition, the excess portion of the allowance
is treated as paid under a nonaccountable
plan, is reported as wages or other compen-
sation on the employee’s Form W–2, and
is subject to withholding and payment of
employment taxes. See § 1.62–2(c)(3)(ii),
(c)(5), and (h)(2)(i)(B).
.05 If the amount of the expenses that
is deemed substantiated under the rules
provided in section 4.01, 4.02, or 5 of this
revenue procedure is less than the amount
of the employee’s business expenses for
travel away from home, the employee
may claim an itemized deduction for the
amount by which the business travel ex-
penses exceed the amount that is deemed
substantiated, provided the employee sub-
stantiates all the business travel expenses,
includes on Form 2106, “Employee Busi-
ness Expenses,” the deemed substantiated
portion of theper diemallowance received
from the payor, and includes in gross in-
cometheportion(ifany)oftheper diem
allowance received from the payor that
exceeds the amount deemed substantiated.
See § 1.274–5(f)(2)(iii). However, for pur-
poses of claiming this itemized deduction
with respect to meal and incidental ex-
penses, substantiation of the amount of the
expenses is not required if the employee
is claiming a deduction that is equal to or
less than the amount computed under sec-
tion 4.03 of this revenue procedure minus
the amount deemed substantiated under
sections 4.02 and 7.01 of this revenue pro-
cedure. The itemized deduction is subject
to the appropriate limitation (see section
2.02 of this revenue procedure) on meal
and entertainment expenses provided in
§ 274(n) and the 2-percent floor on mis-
cellaneous itemized deductions provided
in § 67.
.06 An employee who pays or incurs
amounts for meal expenses and does not
receive aper diemallowance for meal and
incidental expenses may deduct an amount
computed pursuant to section 4.03 of this
revenue procedure only as an itemized de-
duction. This itemized deduction is sub-
ject to the appropriate limitation on meal
and entertainment expenses provided in
§ 274(n) and the 2-percent floor on miscel-
laneous itemized deductions provided in
§ 67. See section 7.07 of this revenue pro-
cedure for the treatment of an employee
who does not pay or incur amounts for
meal expenses and does not receive aper
diemallowance for incidental expenses.
.07 An employee who does not pay or
incur amounts for meal expenses and does
not receive aper diemallowance for in-
cidental expenses may deduct an amount
computed pursuant to section 4.05 of this
revenue procedure only as an itemized de-
duction. This itemized deduction is sub-
ject to the 2-percent floor on miscellaneous
itemized deductions provided in § 67. See
section 7.06 of this revenue procedure for
the treatment of an employee who pays or
incurs amounts for meal expenses and does
not receive aper diemallowance for meal
and incidental expenses.
.08 A self-employed individual who
pays or incurs meal expenses for a calen-
dar day (or partial day) of travel away from
home may deduct an amount computed
pursuant to section 4.03 of this revenue
procedure in determining adjusted gross
income under § 62(a)(1). This deduction
is subject to the appropriate limitation on
meal and entertainment expenses provided
in § 274(n).
.09 A self-employed individual who
does not pay or incur meal expenses for
a calendar day (or partial day) of travel
away from home may deduct an amount
computed pursuant to section 4.05 of this
revenue procedure in determining adjusted
gross income under § 62(a)(1).
.10 If a payor’s reimbursement or
other expense allowance arrangement ev-
idences a pattern of abuse of the rules of
§ 62(c) and the regulations thereunder,
all payments under the arrangement will
be treated as made under a nonaccount-
able plan. See § 1.62–2(k). Thus, these
payments are included in the employee’s
gross income, are reported as wages or
other compensation on the employee’s
Form W–2, and are subject to withholding
and payment of employment taxes. See
§ 1.62–2(c)(3), (c)(5), and (h)(2).
SECTION 8. WITHHOLDING AND
PAYMENT OF EMPLOYMENT TAXES
.01Theportionofaper diemal-
lowance, if any, that relates to the days
of business travel substantiated and that
exceeds the amount deemed substantiated
for those days under section 4.01, 4.02, or
5 of this revenue procedure is subject to
withholding and payment of employment
taxes. See § 1.62–2(h)(2)(i)(B).
.02 In the case of aper diemallowance
paid as a reimbursement, the excess de-
scribed in section 8.01 of this revenue pro-
cedure is subject to withholding and pay-
ment of employment taxes in the payroll
period in which the payor reimburses the
expenses for the days of travel substanti-
ated. See § 1.62–2(h)(2)(i)(B)(2).
.03 In the case of aper diemallowance
paid as an advance, the excess described
in section 8.01 of this revenue procedure
is subject to withholding and payment of
employment taxes no later than the first
payroll period following the payroll period
in which the days of travel with respect
to which the advance was paid are sub-
stantiated. See § 1.62–2(h)(2)(i)(B)(3). If
some or all of the days of travel with re-
spect to which the advance was paid are
not substantiated within a reasonable pe-
riod of time and the employee does not re-
turn the portion of the allowance that re-
lates to those days within a reasonable pe-
riod of time, the portion of the allowance
January 18, 20053492005–3 I.R.B.

that relates to those days is subject to with-
holding and payment of employment taxes
no later than the first payroll period follow-
ing the end of the reasonable period. See
§ 1.62–2(h)(2)(i)(A).
.04 In the case of aper diemallowance
only for meal and incidental expenses for
travel away from home paid to an em-
ployee in the transportation industry by a
payor that uses the rule in section 4.04(4)
of this revenue procedure, the excess of
theper diemallowance paid for the pe-
riod over the amount deemed substanti-
ated for the period under section 4.02 of
this revenue procedure (after applying sec-
tion 4.04(4) of this revenue procedure),
is subject to withholding and payment of
employment taxes no later than the first
payroll period following the payroll pe-
riod in which the excess is computed. See
§ 1.62–2(h)(2)(i)(B)(4).
.05 For example, assume that an em-
ployer pays an employee aper diemal-
lowance to cover business expenses for
meals and lodging for travel away from
home at a rate of 120 percent of the federal
per diemrate for the localities to which
the employee travels. The employer does
not require the employee to return the 20
percent by which the reimbursement for
those expenses exceeds the federalper
diemrate. The employee substantiates 6
days of travel away from home: 2 days
in a locality in which the federalper diem
rate is $100 and 4 days in a locality in
which the federalper diemrate is $125.
The employer reimburses the employee
$840 for the 6 days of travel away from
home (2 x (120% x $100) + 4 x (120% x
$125)), and does not require the employee
to return the excess payment of $140 (2
days x $20 ($120-$100) + 4 days x $25
($150-$125)). For the payroll period in
which the employer reimburses the ex-
penses, the employer must withhold and
pay employment taxes on $140. See sec-
tion 8.02 of this revenue procedure.
SECTION 9.. EFFECT ON OTHER
DOCUMENTS
Rev. Proc. 2004–60 is superseded (1)
forper diemallowances that are paid both
(a)toanemployeeonorafterJanuary
1, 2005, and (b) with respect to lodging,
meal, and incidental expenses or with
respect to meal and incidental expenses
paid or incurred for travel away from
home on or after January 1, 2005; and
(2) for purposes of computing the amount
allowable as a deduction for meal and inci-
dental expenses or for incidental expenses
only paid or incurred by an employee or
self-employed individual for travel away
from home on or after January 1, 2005.
However, taxpayers may apply Rev. Proc.
2004–60 in lieu of this revenue procedure
(1) forper diemallowances that are paid
both (a) to an employee on or after January
1, 2005, and before March 1, 2005, and (b)
with respect to lodging, meal, and inciden-
tal expenses or with respect to meal and
incidental expenses paid or incurred for
travel away from home on or after January
1, 2005, and before March 1, 2005; and
(2) for purposes of computing the amount
allowable as a deduction for meal and inci-
dental expenses or for incidental expenses
only paid or incurred by an employee or
self-employed individual for travel away
from home on or after January 1, 2005,
and before March 1, 2005.
DRAFTING INFORMATION
The principal author of this revenue
procedure is Christian Wood of the Office
of Associate Chief Counsel (Income Tax
and Accounting). For further information
regarding this revenue procedure, con-
tact Mr. Wood at (202) 622–4930 (not a
toll-free call).
2005–3 I.R.B.350January 18, 2005

Part IV. Items of General Interest
Notice of Proposed
Rulemaking by
Cross-Reference to
Temporary Regulations
and Notice of Public Hearing
Prohibited Allocations of
Securities in an S Corporation
REG–129709–03
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking
by cross-reference to temporary regula-
tions and notice of public hearing.
SUMMARY: In this issue of the Bulletin,
the IRS is issuing temporary regulations
(T.D. 9164) that provide guidance on the
definition and effects of a prohibited allo-
cation under section 409(p), identification
of disqualified persons and determination
of a nonallocation year, calculation of syn-
thetic equity under section 409(p)(5), and
standards for determining whether a trans-
action is an avoidance or evasion of section
409(p). These proposed regulations would
generally affect plan sponsors of, and par-
ticipants in, ESOPs holding stock of Sub-
chapter S corporations. The text of those
temporary regulations also serves as the
text of these proposed regulations. This
document also provides notice of a public
hearing on these proposed regulations.
DATES: Written or electronic comments
must be received by March 17, 2005. Re-
quests to speak (with outlines of oral com-
ments to be discussed) at the public hear-
ing scheduled for April 20, 2005, at 10 a.m.
must be received by March 30, 2005.
ADDRESSES: Send submissions to:
CC:PA:LPD:PR (REG–129709–03), room
5203, Internal Revenue Service, POB
7604, Ben Franklin Station, Washing-
ton, DC 20044. Submissions may be
hand delivered Monday through Friday
between the hours of 8 a.m. and 4 p.m.
to: CC:PA:LPD:PR (REG–129709–03),
Courier’s Desk, Internal Revenue Ser-
vice, 1111 Constitution Avenue, N.W.,
Washington, DC. Alternatively, taxpayers
may submit comments electronically via
the IRS Internet site atwww.irs.gov/regs
or the Federal eRulemaking Portal at
www.regulations.gov(indicate IRS and
REG–129709–03).
FOR FURTHER INFORMATION
CONTACT: Concerning the proposed
regulations, John Ricotta at 622–6060;
concerning submissions of comments,
contact Guy Traynor at 202–622–7180
(not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
Temporary regulations in this issue of
the Bulletin amend the Income Tax Regu-
lations (26 CFR part 1) relating to section
409(p). The temporary regulations contain
rules relating to the definition and effects
of a prohibited allocation under section
409(p), identification of disqualified per-
sons and determination of a nonallocation
year, calculation of synthetic equity under
section 409(p)(5), and standards for deter-
mining whether a transaction is an avoid-
ance or evasion of section 409(p). The text
of those temporary regulations also serves
as the text of these proposed regulations.
The preamble to the temporary regulations
explains the temporary regulations.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant
regulatory action as defined in Executive
Order 12866. Therefore, a regulatory as-
sessment is not required. It also has been
determined that section 553(b) of the Ad-
ministrative Procedure Act (5 U.S.C. chap-
ter 5) does not apply to these regulations.
Because §1.409(p)–1 imposes no new col-
lection of information on small entities, a
Regulatory Flexibility Analysis under the
Regulatory Flexibility Act (5 U.S.C. chap-
ter 6) is not required. Pursuant to section
7805(f) of the Internal Revenue Code, this
notice of proposed rulemaking will be sub-
mitted to the Chief Counsel for Advocacy
of the Small Business Administration for
comment on its impact on small business.
Comments and Requests for a Public
Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any written (a signed orig-
inal and 8 copies) or electronic comments
that are submitted timely to the IRS. All
comments will be available for public in-
spection and copying.
A public hearing has been scheduled
for April 20, 2005, at 10 a.m. in the
IRS Auditorium, Internal Revenue Build-
ing, 1111 Constitution Avenue, NW, Wash-
ington, DC. All visitors must present photo
identification to enter the building. Be-
cause of access restrictions, visitors will
not be admitted beyond the immediate en-
trance area more than 30 minutes before
the hearing starts at the Constitution Av-
enue entrance. For information about hav-
ing your name placed on the building ac-
cess list to attend the hearing, see the "FOR
FURTHER INFORMATION CONTACT"
section of this preamble.
The rules of 26 CFR 601.601(a)(3) ap-
ply to the hearing. Persons who wish to
present oral comments at the hearing must
submit written comments and an outline of
the topics to be discussed and the time to be
devoted to each topic (signed original and
eight (8) copies) by March 30, 2005. A pe-
riod of 10 minutes will be allotted to each
person for making comments. An agenda
showing the scheduling of the speakers
will be prepared after the deadline for re-
ceiving outlines has passed. Copies of the
agenda will be available free of charge at
the hearing.
Drafting Information
The principal author of these regula-
tions is John Ricotta of the Office of the
Division Counsel/Associate Chief Coun-
sel (Tax Exempt and Government Enti-
ties). However, other personnel from the
IRS and Treasury participated in their de-
velopment.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
January 18, 20053512005–3 I.R.B.

PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding an entry in
numerical order to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.409(p)–1 also issued under 26
U.S.C. 409(p)(7)(A). * * *
Par. 2. Section 1.409(p)–1 is added to
read as follows:
§1.409(p)–1 Prohibited allocations of
securities in an S corporation.
[The text of proposed §1.409(p)–1 is
the same as the text of §1.409(p)–1T pub-
lished elsewhere in this issue of the Bul-
letin].
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on December 16,
2004, 8:45 a.m., and published in the issue of the Federal
Register for December 17, 2004, 69 F.R. 75492)
Announcement of Disciplinary Actions Involving
Attorneys, Certified Public Accountants, Enrolled Agents,
and Enrolled Actuaries — Suspensions, Censures,
Disbarments, and Resignations
Announcement 2005-2
Under Title 31, Code of Federal Regu-
lations, Part 10, attorneys, certified public
accountants, enrolled agents, and enrolled
actuaries may not accept assistance from,
or assist, any person who is under disbar-
ment or suspension from practice before
the Internal Revenue Service if the assis-
tance relates to a matter constituting prac-
tice before the Internal Revenue Service
and may not knowingly aid or abet another
person to practice before the Internal Rev-
enue Service during a period of suspen-
sion, disbarment, or ineligibility of such
other person.
To enable attorneys, certified public
accountants, enrolled agents, and enrolled
actuaries to identify persons to whom
these restrictions apply, the Director, Of-
fice of Professional Responsibility, will
announce in the Internal Revenue Bulletin
their names, their city and state, their pro-
fessional designation, the effective date
of disciplinary action, and the period of
suspension. This announcement will ap-
pear in the weekly Bulletin at the earliest
practicable date after such action and will
continue to appear in the weekly Bulletins
for five successive weeks.
Consent Suspensions From Practice Before the Internal
Revenue Service
Under Title 31, Code of Federal Regu-
lations, Part 10, an attorney, certified pub-
lic accountant, enrolled agent, or enrolled
actuary, in order to avoid institution or con-
clusion of a proceeding for his or her dis-
barment or suspension from practice be-
fore the Internal Revenue Service, may of-
fer his or her consent to suspension from
such practice. The Director, Office of Pro-
fessional Responsibility, in his discretion,
may suspend an attorney, certified public
accountant, enrolled agent, or enrolled ac-
tuary in accordance with the consent of-
fered.
The following individuals have been
placed under consent suspension from
practice before the Internal Revenue Ser-
vice:
NameAddressDesignationDate of Suspension
Nadler, HerbertNew York, NYEnrolled ActuaryNovember 1, 2004
to
February 28, 2005
2005–3 I.R.B.352January 18, 2005

New Code Z for the 2005
Form W–2, Box 12
Announcement 2005–5
PurposeThe purpose of this announcement is to advise employers about an additional code for use on the 2005
Form W–2. Similar reporting is required on Form 1099–MISC for nonemployees. This code and other
reporting will be used to identify income recognized due to participation in a nonqualified deferred
compensation plan that fails to meet the requirements of Internal Revenue Code section 409A that
was added by section 885 of the American Jobs Creation Act of 2004. This income is subject to an
additional tax and interest imposed on the individual.
A new code(Code Z-Income under section 409A on a nonqualified deferred compensation plan),
for use in box 12 on the 2005 Form W–2, has been added to the 2005 Form W–2 and the Instructions
for Forms W–2 and W–3.
Employers must use code Z in box 12 of Form W–2 to report the income shown in box 1 that relates
to the recognition of income due to participation in anonqualified deferred compensation plan that
fails to meet the requirements of section 409A.
Reporting of
Income
Recognized
Under a
Nonqualified
Deferred
Compensation
Plan
Report income recognized under section 409A for nonemployees both in box 7 and in box 15b
of Form 1099–MISC.
No Change to
Reporting of
Social Security
and Medicare
Wages
Social security and Medicare wage reporting wasnot changed by section 409A. Nonqualified deferred
compensation for employees is generally subject to social security and Medicare taxes when the related
services are performed. However, the taxability ofwages for social security and Medicare purposes is
delayed during the period when an employee’s right to receive payment of the wages is subject to a
substantial risk of forfeiture. Employers should continue to report social security and Medicare wages
from nonqualified deferred compensation plans in boxes 3, 5, and 11 of Form W–2, as appropriate.
Related
Reporting
As provided by Internal Revenue Code sections 6051(a)(13) and 6041(g), applicable persons must
report employee and nonemployee income deferralsunder a nonqualified deferred compensation plan
using code Y in box 12 of Form W–2 or in box 15a of Form 1099–MISC respectively. Report deferrals
in box 12 or in box 15a even if the payee must recognize income under section 409A during the
same year.
January 18, 20053532005–3 I.R.B.

Definition of Terms
Revenue rulings and revenue procedures
(hereinafter referred to as “rulings”) that
have an effect on previous rulings use the
following defined terms to describe the ef-
fect:
Amplifieddescribes a situation where
no change is being made in a prior pub-
lished position, but the prior position is be-
ingextendedtoapplytoavariationofthe
fact situation set forth therein. Thus, if
an earlier ruling held that a principle ap-
plied to A, and the new ruling holds that the
same principle also applies to B, the earlier
ruling is amplified. (Compare withmodi-
fied,below).
Clarifiedis used in those instances
where the language in a prior ruling is be-
ing made clear because the language has
caused, or may cause, some confusion.
It is not used where a position in a prior
ruling is being changed.
Distinguisheddescribes a situation
where a ruling mentions a previously pub-
lished ruling and points out an essential
difference between them.
Modifiedis used where the substance
of a previously published position is being
changed. Thus, if a prior ruling held that a
principle applied to A but not to B, and the
new ruling holds that it applies to both A
and B, the prior ruling is modified because
it corrects a published position. (Compare
withamplifiedandclarified, above).
Obsoleteddescribes a previously pub-
lished ruling that is not considered deter-
minative with respect to future transac-
tions. This term is most commonly used in
a ruling that lists previously published rul-
ings that are obsoleted because of changes
in laws or regulations. A ruling may also
be obsoleted because the substance has
been included in regulations subsequently
adopted.
Revokeddescribes situations where the
position in the previously published ruling
is not correct and the correct position is
beingstatedinanewruling.
Supersededdescribes a situation where
the new ruling does nothing more than re-
state the substance and situation of a previ-
ously published ruling (or rulings). Thus,
the term is used to republish under the
1986 Code and regulations the same po-
sition published under the 1939 Code and
regulations. The term is also used when
it is desired to republish in a single rul-
ing a series of situations, names, etc., that
were previously published over a period of
time in separate rulings. If the new rul-
ing does more than restate the substance
of a prior ruling, a combination of terms
is used. For example,modifiedandsu-
persededdescribes a situation where the
substance of a previously published ruling
is being changed in part and is continued
without change in part and it is desired to
restate the valid portion of the previously
published ruling in a new ruling that is self
contained. In this case, the previously pub-
lished ruling is first modified and then, as
modified, is superseded.
Supplementedis used in situations in
which a list, such as a list of the names of
countries, is published in a ruling and that
list is expanded by adding further names in
subsequent rulings. After the original rul-
ing has been supplemented several times, a
new ruling may be published that includes
the list in the original ruling and the ad-
ditions, and supersedes all prior rulings in
the series.
Suspendedis used in rare situations
to show that the previous published rul-
ings will not be applied pending some
future action such as the issuance of new
or amended regulations, the outcome of
cases in litigation, or the outcome of a
Service study.
Abbreviations
The fol
lowing abbreviations in current use
and for
merly used will appear in material
publis
hedintheBulletin.
A—Individual.
Acq.—A
cquiescence.
B—Individual.
BE—Beneficiary.
BK—Bank
.
B.T.A.—Board of Tax Appeals.
C—Individual.
C.B.—Cu
mulative Bulletin.
CFR—Code of Federal Regulations.
CI—City.
COOP—Coo
perative.
Ct.D.—Court Decision.
CY—County.
D—Decede
nt.
DC—Dummy Corporation.
DE—Donee.
Del. Order
—Delegation Order.
DISC—Domestic International Sales Corporation.
DR—Donor.
E—Estate.
EE—Employee.
E.O.—Executive Order.
ER—Emp
loyer.
ERISA—Employee Retirement Income Security Act.
EX—Executor.
F—Fiduc
iary.
FC—Foreign Country.
FICA—Federal Insurance Contributions Act.
FISC—Fo
reign International Sales Company.
FPH—Foreign Personal Holding Company.
F.R.—Federal Register.
FUTA—Fed
eral Unemployment Tax Act.
FX—Foreign corporation.
G.C.M.—Chief Counsel’s Memorandum.
GE—Grante
e.
GP—General Partner.
GR—Grantor.
IC—Insura
nce Company.
I.R.B.—Internal Revenue Bulletin.
LE—Lessee.
LP—Limited
Partner.
LR—Lessor.
M—Minor.
Nonacq.—No
nacquiescence.
O—Organization.
P—Parent Corporation.
PHC—Persona
l Holding Company.
PO—Possession of the U.S.
PR—Partner.
PRS—Pa
rtnership.
PTE—Prohibited Transaction Exemption.
Pub. L.—Public Law.
REIT—Re
al Estate Investment Trust.
Rev. Proc.—Revenue Procedure.
Rev. Rul.—Revenue Ruling.
S—Subsi
diary.
S.P.R.—Statement of Procedural Rules.
Stat.—Statutes at Large.
T—Target
Corporation.
T.C.—Tax Court.
T.D.—Treasury Decision.
TFE—Trans
feree.
TFR—Transferor.
T.I.R.—Technical Information Release.
TP—Taxpay
er.
TR—Trust.
TT—Trustee.
U.S.C.—Uni
ted States Code.
X—Corporation.
Y—Corporation.
Z—Corporat
ion.
2005–3 I.R.B.iJanuary 18, 2005

Numerical Finding List
1
Bulletins 2005–1 through 2005–3
Announcements:
2005-1, 2005-1 I.R.B.257
2005-2, 2005-2 I.R.B.319
2005-3, 2005-2 I.R.B.270
2005-4, 2005-2 I.R.B.319
2005-5, 2005-3 I.R.B.353
Notices:
2005-1, 2005-2 I.R.B.274
2005-2, 2005-3 I.R.B.337
2005-4, 2005-2 I.R.B.289
2005-5, 2005-3 I.R.B.337
2005-7, 2005-3 I.R.B.340
Proposed Regulations:
REG-129709-03, 2005-3 I.R.B.351
Revenue Procedures:
2005-1, 2005-1 I.R.B.1
2005-2, 2005-1 I.R.B.86
2005-3, 2005-1 I.R.B.118
2005-4, 2005-1 I.R.B.128
2005-5, 2005-1 I.R.B.170
2005-6, 2005-1 I.R.B.200
2005-7, 2005-1 I.R.B.240
2005-8, 2005-1 I.R.B.243
2005-9, 2005-2 I.R.B.303
2005-10, 2005-3 I.R.B.341
2005-11, 2005-2 I.R.B.307
2005-12, 2005-2 I.R.B.311
Revenue Rulings:
2005-1, 2005-2 I.R.B.258
2005-2, 2005-2 I.R.B.259
2005-3, 2005-3 I.R.B.334
Tax Conventions:
2005-3, 2005-2 I.R.B.270
Treasury Decisions:
9164, 2005-3 I.R.B.320
9167, 2005-2 I.R.B.261
1
A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2004–27 through 2004–52 is in Internal Revenue Bulletin
2004–52, dated December 27, 2004.
January 18, 2005ii2005–3 I.R.B.

Finding List of Current Actions on
Previously Published Items
1
Bulletins 2005–1 through 2005–3
Notices:
88-30
Obsoleted by
Notice 2005-4, 2005-2 I.R.B.289
88-132
Obsoleted by
Notice 2005-4, 2005-2 I.R.B.289
89-29
Obsoleted by
Notice 2005-4, 2005-2 I.R.B.289
89-38
Obsoleted by
Notice 2005-4, 2005-2 I.R.B.289
Revenue Procedures:
98-16
Modified and superseded by
Rev. Proc. 2005-11, 2005-2 I.R.B.307
2001-22
Superseded by
Rev. Proc. 2005-12, 2005-2 I.R.B.311
2002-9
Modified and amplified by
Rev. Proc. 2005-9, 2005-2 I.R.B.303
2004-1
Superseded by
Rev. Proc. 2005-1, 2005-1 I.R.B.1
2004-2
Superseded by
Rev. Proc. 2005-2, 2005-1 I.R.B.86
2004-3
Superseded by
Rev. Proc. 2005-3, 2005-1 I.R.B.118
2004-4
Superseded by
Rev. Proc. 2005-4, 2005-1 I.R.B.128
2004-5
Superseded by
Rev. Proc. 2005-5, 2005-1 I.R.B.170
2004-6
Superseded by
Rev. Proc. 2005-6, 2005-1 I.R.B.200
2004-7
Superseded by
Rev. Proc. 2005-7, 2005-1 I.R.B.240
Revenue Procedures— Continued:
2004-8
Superseded by
Rev. Proc. 2005-8, 2005-1 I.R.B.243
2004-35
Corrected by
Ann. 2005-4, 2005-2 I.R.B.319
2004-60
Superseded by
Rev. Proc. 2005-10, 2005-3 I.R.B.341
Revenue Rulings:
92-63
Modified and superseded by
Rev. Rul. 2005-3, 2005-3 I.R.B.334
95-63
Modified and superseded by
Rev. Rul. 2005-3, 2005-3 I.R.B.334
2004-103
Superseded by
Rev. Rul. 2005-3, 2005-3 I.R.B.334
1
A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2004–27 through 2004–52 is in Internal Revenue Bulletin 2004–52, dated December 27,
2004.
2005–3 I.R.B.iiiJanuary 18, 2005
*U.S.G.P.O.: 2005—310–365/60170