Internal Revenue Bulletin 2003-9 (PDF rendition): IRS Notices

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.

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
T.D. 9035, page 528.
Final regulations under section 1041 of the Code relate to the
tax treatment of redemptions, during marriage or incident to di-
vorce, of stock in a corporation owned by a spouse or a former
spouse.
T.D. 9038, page 524.
REG–126485–01, page 542.
Temporary and proposed regulations under section 368 of the
Code provide guidance with respect to statutory mergers and con-
solidations. These regulations also provide that the merger of a
domestic corporation into a domestic disregarded entity can
qualify as a statutory merger or consolidation. A public hearing
on the proposed regulations is scheduled for May 21, 2003.
REG–103580–02, page 543.
Proposed regulations under section 721 of the Code describe
the tax consequences of certain noncompensatory options and
convertible instruments issued by partnerships. The regula-
tions provide that section 721 generally applies to the exer-
cise of a noncompensatory option. The regulations also modify
the rules under section 704(b) regarding the determination of the
partners’ distributive shares of partnership items, and provide that
the holder of a noncompensatory option is treated as a part-
ner under certain circumstances. A public hearing is sched-
uled for May 20, 2003.
Notice 2003–15, page 540.
Finality of foreign adoptions.This notice provides a pro-
posed revenue procedure that would establish certain safe har-
bors for determining the finality of the adoption of eligible foreign-
born children for purposes of the adoption credit and the exclusion
for employer-provided assistance for qualified adoption ex-
penses. Comments are requested by June 2, 2003.
ADMINISTRATIVE
T.D. 9036, page 533.
Final regulations under section 6103 of the Code permit the IRS
to authorize agencies with access to returns and return infor-
mation to redisclose returns and return information, with the ap-
proval of the Commissioner, to any authorized recipient set forth
in section 6103, subject to the same restrictions and condi-
tions, and for the same purposes, as if the recipient had re-
ceived the information from the IRS directly.
T.D. 9037, page 535.
Final regulations under section 6103 of the Code authorize the
disclosure of additional tax information to the Bureau of the Cen-
sus to better meet the Bureau’s program objectives, which in-
clude the Longitudinal Employer-Household Dynamics (LEHD)
project and the Survey of Income and Program Participation (SIPP)
project.
Bulletin No. 2003–9
March 3, 2003
Finding Lists begin on page ii.
Index for January and February begins on page iv.

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 rul-
ings and procedures of the Internal Revenue Service and for pub-
lishing Treasury Decisions, Executive Orders, Tax Conventions,
legislation, court decisions, and other items of general inter-
est. It is published weekly and may be obtained from the Super-
intendent of Documents on a subscription basis. Bulletin contents
are consolidated 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, modify,
or amend any of those previously published in the Bulletin. All pub-
lished rulings apply retroactively unless otherwise indicated. Pro-
cedures relating solely to matters of internal management are
not published; however, statements of internal practices and pro-
cedures that affect the rights and duties of taxpayers are pub-
lished.
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 taxpay-
ers or technical advice to Service field offices, identifying de-
tails 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 re-
lied on, used, or cited as precedents by Service personnel in the
disposition of other cases. In applying published rulings and pro-
cedures, the effect of subsequent legislation, regulations, court
decisions, rulings, and procedures must be considered, and Ser-
vice personnel and others concerned are cautioned against reach-
ing 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.—1986 Code.
This part includes rulings and decisions based on provisions of
the Internal 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, Legisla-
tion and Related Committee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to these sub-
jects are contained in the other Parts and Subparts. Also in-
cluded in this part are Bank Secrecy Act Administrative Rulings.
Bank Secrecy Act Administrative Rulings are issued by the De-
partment of the Treasury’s Office of the Assistant Secretary (En-
forcement).
Part IV.—Items of General Interest.
This part includes notices of proposed rulemakings, disbar-
ment and suspension lists, and announcements.
The first 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 first Bulletin of the succeeding semiannual pe-
riod, respectively.
The contents 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.
March 3, 20032003–9 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Section 368.—Definitions
Relating to Corporate
Reorganizations
26 CFR 1.368–2: Definitions of terms.
T.D. 9038
DEPARTMENT OF THE
TREASURY
Internal Revenue Service
26 CFR Part 1
Statutory Mergers and
Consolidations
AGENCY: Internal Revenue Service (IRS),
Treasury.
ACTION: Final and temporary regulations.
SUMMARY: This document contains tem-
porary regulations that define the termstatu-
tory merger or consolidationas that term
is used in section 368(a)(1)(A). These regu-
lations affect corporations engaging in statu-
tory mergers and consolidations, and their
shareholders. The text of the temporary
regulations also serves as the text of the pro-
posed regulations set forth in the notice of
proposed rulemaking (REG–126485–01) on
this subject on page 542 of this Bulletin.
DATES:Effective Date:These regulations
are effective January 24, 2003.
FOR FURTHER INFORMATION CON-
TACT: Richard M. Heinecke or Reginald
Mombrun at (202) 622–7930 (not a toll-
free number).
SUPPLEMENTARY INFORMATION:
Background
A.Section 368(a) Generally
The Internal Revenue Code of 1986
(Code) provides general nonrecognition
treatment for reorganizations specifically de-
scribed in section 368(a). Section
368(a)(1)(A) provides that the termreor-
ganizationincludes “a statutory merger or
consolidation.” Section 1.368–2(b)(1) cur-
rently provides that a statutory merger or
consolidation must be “effected pursuant to
the corporation laws of the United States
or a State or Territory or the District of Co-
lumbia.”
B.Disregarded Entities Generally
A business entity (as defined in
§301.7701–2(a)) that has only one owner
may be disregarded as an entity separate
from its owner for federal tax purposes. Ex-
amples of disregarded entities include a do-
mestic single member limited liability
company that does not elect to be classi-
fied as a corporation for federal tax pur-
poses, a corporation (as defined in
§301.7701–2(b)) that is a qualified REIT
subsidiary (within the meaning of section
856(i)(2)) (hereinafter referred to as “QRS”),
and a corporation that is a qualified sub-
chapter S subsidiary (within the meaning
of section 1361(b)(3)(B)) (hereinafter some-
times referred to as “QSub”).
Because a QRS and QSub are corpora-
tions under state law, state merger laws gen-
erally permit them to merge with other
corporations. In addition, many state merger
laws permit a limited liability company
(LLC) to merge with another LLC or with
a corporation.
C.Previous Proposals of Regulations
On May 16, 2000, the IRS and Trea-
sury issued a notice of proposed rulemak-
ing (REG–106186–98, 2000–1 C.B. 1226
[65 FR 31115]) (hereinafter referred to as
the 2000 proposed regulations) providing
that neither the merger of a disregarded en-
tity into a corporation nor the merger of a
corporation into a disregarded entity would
qualify as a reorganization under section
368(a)(1)(A). While commentators gener-
ally agreed that the merger of a disregarded
entity into a corporation should not qualify
as a reorganization under section
368(a)(1)(A), commentators asserted that the
merger of a corporation into a disregarded
entity with a corporate owner should be able
to qualify as a reorganization under sec-
tion 368(a)(1)(A).
On November 15, 2001, after consid-
eration of the comments received regard-
ing the 2000 proposed regulations, the IRS
and Treasury withdrew the 2000 proposed
regulations (REG–106186–98; Announce-
ment 2001–121, 2001–2 C.B. 584 [66 FR
57400]) and issued another notice of pro-
posed rulemaking (REG–126485–01,
2001–2 C.B. 555 [66 FR 57400]) (herein-
after referred to as the 2001 proposed regu-
lations).
The 2001 proposed regulations provide
that, for purposes of section 368(a)(1)(A),
a statutory merger or consolidation must be
effected pursuant to the laws of the United
States or a State or the District of Colum-
bia. Pursuant to such laws, the following
events must occur simultaneously at the ef-
fective time of the transaction: (1) all of the
assets (other than those distributed in the
transaction) and liabilities (except to the ex-
tent satisfied or discharged in the transac-
tion) of each member of one or more
combining units (each a transferor unit) be-
come the assets and liabilities of one or
more members of one other combining unit
(the transferee unit); and (2) the combin-
ing entity of each transferor unit ceases its
separate legal existence for all purposes. For
this purpose, a combining entity is a busi-
ness entity that is a corporation (as de-
fined in §301.7701–2(b)) that is not a
disregarded entity) and a combining unit is
a combining entity and all of its disre-
garded entities.
The 2001 proposed regulations provide
that the merger of a disregarded entity into
a corporation will not qualify as a statu-
tory merger or consolidation under sec-
tion 368(a)(1)(A) because all of the
transferor unit’s assets may not be trans-
ferred to the transferee unit and the sepa-
rate legal existence of the combining entity
of the transferor unit does not terminate as
a matter of law. The 2001 proposed regu-
lations, however, generally provide that the
merger of a corporation into a disregarded
entity will qualify as a statutory merger or
consolidation if it satisfies the require-
ments of the regulations.
No public hearing regarding the 2001
proposed regulations was requested or held.
Nonetheless, a number of written com-
ments were received.
Explanation of Provisions
The IRS and Treasury have studied the
comments received regarding the 2001 pro-
posed regulations. Although the IRS and
Treasury are continuing to study a num-
ber of the comments received regarding the
proposed regulations, in response to a num-
ber of comments requesting immediate
guidance in this area upon which taxpay-
ers may rely, the IRS and Treasury are pro-
mulgating these regulations as temporary
regulations in this Treasury Decision. The
2003–9 I.R.B.524March 3, 2003

temporary regulations retain the general
framework of the 2001 proposed regula-
tions, but make certain modifications in re-
sponse to comments received. The following
sections describe a number of the most sig-
nificant comments and the extent to which
they have been incorporated in these tem-
porary regulations. Further changes to the
temporary regulations, however, are pos-
sible before these regulations are final-
ized.
A.Definition of Combining Entity
As described above, the 2001 proposed
regulations define a combining entity as a
business entity that is a corporation that is
not a disregarded entity. Although the pre-
amble to the 2001 proposed regulations
clarifies that, for this purpose, the term cor-
poration is defined as provided in
§301.7701–2(b), commentators requested
that clarification also be provided in the text
of the regulations. In response to these com-
ments, the temporary regulations provide
that a combining entity is a corporation (as
defined in§301.7701–2(b)) that is not a dis-
regarded entity.
B.The All of the Assets Requirement
As stated above, the 2001 proposed
regulations require that all of the assets of
a transferor unit become the assets of a
transferee unit. A number of comments were
received regarding this requirement. The fol-
lowing paragraphs describe these com-
ments and the extent to which the temporary
regulations reflect them.
One comment suggested that the regu-
lations be amended to clarify that whether
the all of the assets requirement is satis-
fied is determined by reference to the as-
sets of the transferor unit immediately prior
to the merger. These temporary regula-
tions add an example that illustrates that a
transaction that is preceded by a distribu-
tion by the transferor unit to its sharehold-
ers may qualify as a statutory merger under
these temporary regulations, even if the
“substantially all”requirement applicable
to certain other types of reorganizations
would not be satisfied. The example is pro-
vided solely to illustrate the meaning of the
all of the assets requirement. No infer-
ence is intended regarding the shareholder
level and other tax consequences of the
transaction described therein.
Another comment stated that the pro-
posed regulations are unclear as to whether
a transaction in which an entity that is dis-
regarded as an entity separate from the com-
bining entity of the transferor unit becomes
an entity that is disregarded as an entity
separate from the combining entity of the
transferee unit satisfies the all of the as-
sets requirement. These temporary regula-
tions amendExample 2of the 2001
proposed regulations, as described below,
to clarify that this transaction may satisfy
the all of the assets requirement and, there-
fore, qualify as a statutory merger or con-
solidation.
C.The Cessation of Separate Legal
Existence Requirement
The 2001 proposed regulations require
that the combining entity of each trans-
feror unit“ceases its separate legal exist-
ence for all purposes.”One comment re-
quested that the phrase“for all purposes”
be deleted from this requirement. The com-
ment suggested that under some corpo-
rate laws a merged corporation may
continue its existence for a specified time
period and for certain limited purposes, such
as bringing and defending against law-
suits. This limited continued existence of
a combining entity of a transferor unit, the
comment suggested, should not prevent a
transaction from being treated as failing to
satisfy the requirement that the combin-
ing entity of each transferor unit cease its
separate legal existence for all purposes.
The IRS and Treasury do not believe that
the deletion of“for all purposes”from the
regulation will alter the terms of the re-
quirement. Nonetheless, these temporary
regulations provide that this requirement will
be satisfied even if, pursuant to the laws of
the United States or a State or the Dis-
trict of Columbia, after the effective time
of the transaction, the combining entity of
the transferor unit (or its officers, direc-
tors, or agents) may act or be acted against,
or a member of the transferee unit (or its
officers, directors, or agents) may act or be
acted against in the name of the combin-
ing entity of the transferor unit, provided
that such actions relate to assets or obli-
gations of the combining entity of the trans-
feror unit that arose, or relate to activities
engaged in by such entity, prior to the ef-
fective time of the transaction, and such ac-
tions are not inconsistent with the all of the
assets requirement.
D.Example 2 of the 2001 Proposed
Regulations
A number of comments were received
regardingExample 2of the 2001 proposed
regulations, which involves the merger of
a target corporation into a disregarded en-
tity. The last sentence of the facts ofEx-
ample 2states that,“[p]rior to the
transaction, [the combining entity of the
transferor unit] is not treated as owning any
assets of an entity that is disregarded as an
entity separate from its owner for federal
tax purposes.”One commentator indicated
that it is not clear why this fact is rel-
evant to the conclusion that the transac-
tion qualifies as a statutory merger or
consolidation and suggested either delet-
ing or clarifying this fact.
As described above, in order to qualify
as a statutory merger or consolidation, all
of the assets of a transferor unit must be-
come assets of the transferee unit. In or-
der to determine whether this requirement
has been satisfied, it is necessary to know
whether the combining entity of the trans-
feror unit owns the interests of any entity
that is disregarded as an entity separate from
its owner for federal tax purposes. The last
sentence of the facts ofExample 2was
merely intended to convey the fact that the
only assets of the transferor unit were those
that the combining entity owned directly.
To clarify the significance of this fact, the
temporary regulations amend the analysis
inExample 2to indicate that the transac-
tion would still qualify as a statutory merger
or consolidation even if the combining en-
tity of the transferor unit were treated as
owning assets of an entity that is disre-
garded as an entity separate from the com-
bining entity of the transferor unit for
federal tax purposes, provided that those as-
sets become assets of the transferee unit.
E.Additional Examples
One commentator suggested that the
scope of the proposed regulations be clari-
fied through additional examples. The fol-
lowing paragraphs describe the suggested
examples and the extent to which they have
been incorporated in these temporary regu-
lations.
1.QSub that becomes a C corporation
A QSub may cease to be a disregarded
entity because of an event that renders the
subsidiary ineligible for QSub status, such
as a merger into an entity owned by a C
corporation. For example, suppose Z, an S
corporation, owns all of the stock of B, a
QSub, and Z merges with and into X, an
March 3, 20035252003–9 I.R.B.

entity that is disregarded as an entity sepa-
rate from Y, a C corporation. B’s status as
a QSub will terminate at the end of the day
on which the merger occurs. See Treas. Reg.
§1.1361–5(a)(1)(iii). A commentator sug-
gested that, in this case, it is not clear
whether B is a member of the transferor
unit. If B were treated as a member of the
transferor unit, the transaction may not
qualify as a statutory merger or consolida-
tion because the assets of B may not be-
come assets of the transferee unit. If,
however, B were not treated as a member
of the transferor unit, the transaction may
qualify as a statutory merger or consolida-
tion. The commentator suggested that B
should not be treated as a member of the
transferor unit. Alternatively, the commen-
tator suggested that the principles ofEx-
ample 9of§1.1361–5(b)(3) could be
applied to this case. InExample 9of
§1.1361–5(b)(3), the acquisition of the stock
of a QSub is treated as a transfer of the
QSub’s assets followed by the transfer of
those assets by the acquirer to a new cor-
poration.
The IRS and Treasury agree with the
commentator that the principles illustrated
byExample 9of§1.1361–5(b)(3) apply to
determine whether the merger of Z into X
qualifies as a statutory merger or consoli-
dation. In particular, the transaction should
be treated as a transfer of B’s assets to X
followed by a transfer of such assets by X
to a new corporation. Accordingly, the trans-
action may qualify as a statutory merger or
consolidation provided that the other re-
quirements of a statutory merger or con-
solidation are satisfied. These temporary
regulations include an example illustrat-
ing this result.
2.Transitory surviving disregarded en-
tity
One commentator suggested that the
2001 proposed regulations be amended to
provide an example in which the surviv-
ing disregarded entity in an otherwise quali-
fying statutory merger or consolidation is
transitory. For example, suppose corpora-
tion Z merges into X, an entity that is dis-
regarded as separate from corporation Y. In
the transaction, the shareholders of Z ex-
change their Z stock for Y stock. Immedi-
ately after the merger of Z into X and as
part of a plan that includes that merger, X
merges into Y. The commentator noted that,
in Rev. Rul. 72–405, 1972–2 C.B. 217, the
IRS held that a forward triangular merger
of a target corporation into a newly formed
controlled corporation of a parent corpo-
ration followed by the liquidation of the
controlled corporation into the parent cor-
poration would be treated as a reorganiza-
tion under section 368(a)(1)(C) rather than
a reorganization under sections 368(a)(1)(A)
and 368(a)(2)(D). The commentator sug-
gested that the principles of Revenue Rul-
ing 72–405 should not be applied to prevent
the merger of Z into X from qualifying as
a reorganization under section 368(a)(1)(A).
The IRS and Treasury agree that the
merger of Z into X followed by the merger
of X into Y does not implicate the prin-
ciples of Revenue Ruling 72–405. Because
the merger of X into Y does not alter the
identity of the tax owner of the former as-
sets of X, that merger would be disregarded.
The IRS and Treasury do not believe that
an additional example is necessary to il-
lustrate this result.
F.The Domestic Entity Requirement
The 2001 proposed regulations provide
that a transaction in which any of the as-
sets and liabilities of a combining entity of
a transferor unit become assets and liabili-
ties of one or more disregarded entities of
the transferee unit cannot qualify as a statu-
tory merger or consolidation unless such
combining entity, the combining entity of
the transferee unit, such disregarded enti-
ties, and each business entity through which
the combining entity of the transferee unit
holds its interests in such disregarded en-
tities is organized under the laws of the
United States or a State or the District of
Columbia. One commentator suggested that
where an entity that is disregarded as an en-
tity separate from the combining entity of
the transferor unit becomes an entity that
is disregarded as an entity separate from the
combining entity of the transferee unit,
whether such disregarded entity is orga-
nized under the laws of the United States
or a State or the District of Columbia is not
relevant to whether the transaction quali-
fies as a statutory merger or consolida-
tion. The IRS and Treasury agree and have
clarified the domestic entity requirement to
exclude such disregarded entities.
Another comment suggested that the do-
mestic entity requirement be eliminated for
the disregarded entity into which a target
corporation is merged and each business en-
tity through which the combining entity
holds its interests in the disregarded en-
tity into which a target corporation is
merged. Although these temporary regula-
tions retain that requirement for those en-
tities, as described in the preamble to the
2001 proposed regulations, the IRS and
Treasury are continuing to consider fur-
ther revisions to the regulations under sec-
tion 368(a)(1)(A) to address statutory
mergers and consolidations that involve one
or more foreign corporations, including
transactions involving a disregarded en-
tity.
Special Analyses
It also has been determined that sec-
tion 553(b) of the Administrative Proce-
dure Act (5 U.S.C. chapter 5) does not
apply to these regulations, and because the
regulation does not impose a collection of
information on small entities, the Regula-
tory Flexibility Act (5 U.S.C. chapter 6)
does not apply. Pursuant to section 7805(f)
of the Code, these temporary regulations
will be submitted to the Chief Counsel for
Advocacy of the Small Business Admin-
istration for comment on its impact on small
business.
Drafting Information
The principal author of these tempo-
rary regulations is Richard M. Heinecke,
Office of Associate Chief Counsel (Cor-
porate). However, other personnel from the
IRS and Treasury Department participated
in their development.
*****
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR part 1 is amended
as follows:
PA RT 1—INCOME TAXES
Paragraph 1.The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805***
Par.2.In§1.368–2, paragraph (b)(1) is
revised to read as follows:
§1.368–2 Definition of terms.
*****
(b)(1) For rules regarding statutory merg-
ers or consolidations on or after January 24,
2003, see§1.368–2T(b)(1). For rules re-
garding statutory mergers or consolida-
tions before January 24, 2003, see§1.368–
2003–9 I.R.B.526March 3, 2003

2(b)(1) as in effect before January 24, 2003
(See 26 CFR part 1, revised April 1, 2002).
*****
Par. 3. Section 1.368–2T is added to read
as follows:
§1.368–2T Definition of terms
(temporary).
(a) [Reserved]. For further guidance, see
§1.368–2(a).
(b)(1)(i)Definitions.For purposes of this
paragraph (b)(1), the following terms shall
have the following meanings:
(A)Disregarded entity.A disregarded en-
tity is a business entity (as defined in
§301.7701–2(a) of this chapter) that is dis-
regarded as an entity separate from its
owner for federal tax purposes. Examples
of disregarded entities include a domestic
single member limited liability company
that does not elect to be classified as a cor-
poration for federal tax purposes, a corpo-
ration (as defined in§301.7701–2(b) of this
chapter) that is a qualified REIT subsid-
iary (within the meaning of section
856(i)(2)), and a corporation that is a quali-
fied subchapter S subsidiary (within the
meaning of section 1361(b)(3)(B)).
(B)Combining entity.A combining en-
tity is a business entity that is a corpora-
tion (as defined in§301.7701–2(b) of this
chapter) that is not a disregarded entity.
(C)Combining unit.A combining unit
is composed solely of a combining entity
and all disregarded entities, if any, the as-
sets of which are treated as owned by such
combining entity for federal tax purposes.
(ii)Statutory merger or consolidation
generally.For purposes of section
368(a)(1)(A), a statutory merger or con-
solidation is a transaction effected pursu-
ant to the laws of the United States or a
State or the District of Columbia, in which,
as a result of the operation of such laws,
the following events occur simultaneously
at the effective time of the transaction—
(A) All of the assets (other than those
distributed in the transaction) and liabili-
ties (except to the extent satisfied or dis-
charged in the transaction) of each member
of one or more combining units (each a
transferor unit) become the assets and li-
abilities of one or more members of one
other combining unit (the transferee unit);
and
(B) The combining entity of each trans-
feror unit ceases its separate legal exist-
ence for all purposes; provided, however,
that this requirement will be satisfied even
if, pursuant to the laws of the United States
or a State or the District of Columbia, af-
ter the effective time of the transaction, the
combining entity of the transferor unit (or
its officers, directors, or agents) may act or
be acted against, or a member of the trans-
feree unit (or its officers, directors, or
agents) may act or be acted against in the
name of the combining entity of the trans-
feror unit, provided that such actions re-
late to assets or obligations of the combining
entity of the transferor unit that arose, or
relate to activities engaged in by such en-
tity, prior to the effective time of the trans-
action, and such actions are not inconsistent
with the requirements of paragraph
(b)(1)(ii)(A) of this section.
(iii)Statutory merger or consolidation
involving disregarded entities.A transac-
tion effected pursuant to the laws of the
United States or a State or the District of
Columbia in which any of the assets and
liabilities of a combining entity of a trans-
feror unit become assets and liabilities of
one or more disregarded entities of the
transferee unit is not a statutory merger or
consolidation within the meaning of sec-
tion 368(a)(1)(A) and paragraph (b)(1)(ii)
of this section unless such combining en-
tity, the combining entity of the transferee
unit, such disregarded entities other than en-
tities that were disregarded entities of the
transferor unit immediately prior to the
transaction, and each business entity through
which the combining entity of the trans-
feree unit holds its interests in such disre-
garded entities is organized under the laws
of the United States or a State or the Dis-
trict of Columbia.
(iv)Examples.The following examples
illustrate the rules of paragraph (b)(1) of this
section. In each of the examples, except as
otherwise provided, each of V, Y, and Z is
a domestic C corporation. X is a domes-
tic limited liability company. Except as oth-
erwise provided, X is wholly owned by Y
and is disregarded as an entity separate from
Y for federal tax purposes. The examples
are as follows:
Example 1. Divisive transaction pursuant to a
merger statute.(i) Under State W law, Z transfers some
of its assets and liabilities to Y, retains the remain-
der of its assets and liabilities, and remains in exist-
ence following the transaction. The transaction qualifies
as a merger under State W corporate law. Prior to the
transaction, Y is not treated as owning any assets of
an entity that is disregarded as an entity separate from
its owner for federal tax purposes.
(ii) The transaction does not satisfy the require-
ments of paragraph (b)(1)(ii)(A) of this section be-
cause all of the assets and liabilities of Z, the
combining entity of the transferor unit, do not be-
come the assets and liabilities of Y, the combining en-
tity and sole member of the transferee unit. In addition,
the transaction does not satisfy the requirements of
paragraph (b)(1)(ii)(B) of this section because the sepa-
rate legal existence of Z does not cease for all pur-
poses. Accordingly, the transaction does not qualify
as a statutory merger or consolidation under section
368(a)(1)(A).
Example 2. Merger of a target corporation into a
disregarded entity in exchange for stock of the owner.
(i) Under State W law, Z merges into X. Pursuant to
such law, the following events occur simultaneously
at the effective time of the transaction: all of the as-
sets and liabilities of Z become the assets and liabili-
ties of X and Z’s separate legal existence ceases for
all purposes. In the merger, the Z shareholders ex-
change their stock of Z for stock of Y. Prior to the
transaction, Z is not treated as owning any assets of
an entity that is disregarded as an entity separate from
its owner for federal tax purposes.
(ii) The transaction satisfies the requirements of para-
graph (b)(1)(ii) of this section because the transac-
tion is effected pursuant to State W law and the
following events occur simultaneously at the effec-
tive time of the transaction: all of the assets and li-
abilities of Z, the combining entity and sole member
of the transferor unit, become the assets and liabili-
ties of one or more members of the transferee unit that
is comprised of Y, the combining entity of the trans-
feree unit, and X, a disregarded entity the assets of
which Y is treated as owning for federal tax pur-
poses, and Z ceases its separate legal existence for all
purposes. Paragraph (b)(1)(iii) of this section does not
apply to prevent the transaction from qualifying as a
statutory merger or consolidation for purposes of sec-
tion 368(a)(1)(A) because each of Z, Y, and X is a do-
mestic entity. Accordingly, the transaction qualifies as
a statutory merger or consolidation for purposes of sec-
tion 368(a)(1)(A). The result would be the same if Z
were treated as owning assets of an entity that is dis-
regarded as an entity separate from Z, regardless of
whether such disregarded entity became an entity dis-
regarded as an entity separate from Y as a result of
the transaction, or merged into X or a domestic en-
tity disregarded as an entity separate from Y.
Example 3. Merger of a target S corporation that
owns a QSub into a disregarded entity.(i) The facts
are the same as inExample 2,except that Z is an S
corporation and owns all of the stock of U, a QSub.
(ii) The deemed formation by Z of U pursuant to
§1.1361–5(b)(1) (as a consequence of the termina-
tion of U’s QSub election) is disregarded for fed-
eral income tax purposes. The transaction is treated
as a transfer of the assets of U to X, followed by X’s
transfer of these assets to U in exchange for stock of
U. See§1.1361–5(b)(3),Example 9.The transac-
tion will, therefore, satisfy the requirements of para-
graph (b)(1)(ii) of this section because the transaction
is effected pursuant to State W law and the follow-
ing events occur simultaneously at the effective time
of the transaction: all of the assets and liabilities of
Z and U, the sole members of the transferor unit, be-
come the assets and liabilities of one or more mem-
bers of the transferee unit that is comprised of Y, the
combining entity of the transferee unit, and X, a dis-
regarded entity the assets of which Y is treated as own-
March 3, 20035272003–9 I.R.B.

ing for federal tax purposes, and Z ceases its separate
legal existence for all purposes. Paragraph (b)(1)(iii)
of this section does not apply to prevent the transac-
tion from qualifying as a statutory merger or consoli-
dation for purposes of section 368(a)(1)(A) because
each of Z, Y, and X is a domestic entity. Moreover,
the deemed transfer of the assets of U in exchange for
U stock does not cause the transaction to fail to qualify
as a statutory merger or consolidation. See
§368(a)(2)(C). Accordingly, the transaction quali-
fies as a statutory merger or consolidation for pur-
poses of section 368(a)(1)(A).
Example 4. Triangular merger of a target corpo-
ration into a disregarded entity.(i) The facts are the
sameasinExample 2,except that V owns 100 per-
cent of the outstanding stock of Y and, in the merger
of Z into X, the Z shareholders exchange their stock
of Z for stock of V. In the transaction, Z transfers sub-
stantially all of its properties to X.
(ii) The transaction is not prevented from qualify-
ing as a statutory merger or consolidation under sec-
tion 368(a)(1)(A), provided the requirements of section
368(a)(2)(D) are satisfied. Because the assets of X are
treated for federal tax purposes as the assets of Y, Y
will be treated as acquiring substantially all of the prop-
erties of Z in the merger for purposes of determin-
ing whether the merger satisfies the requirements of
section 368(a)(2)(D). As a result, the Z shareholders
that receive stock of V will be treated as receiving
stock of a corporation that is in control of Y, the com-
bining entity of the transferee unit that is the acquir-
ing corporation for purposes of section 368(a)(2)(D).
Accordingly, the merger will satisfy the require-
ments of section 368(a)(2)(D).
Example 5. Merger of a target corporation into a
disregarded entity owned by a partnership.(i) The facts
are the same as inExample 2,except that Y is orga-
nized as a partnership under the laws of State W and
is classified as a partnership for federal tax pur-
poses.
(ii) The transaction does not satisfy the require-
ments of paragraph (b)(1)(ii)(A) of this section. All
of the assets and liabilities of Z, the combining en-
tity and sole member of the transferor unit, do not be-
come the assets and liabilities of one or more members
of a transferee unit because neither X nor Y quali-
fies as a combining entity. Accordingly, the transac-
tion cannot qualify as a statutory merger or
consolidation for purposes of section 368(a)(1)(A).
Example 6. Merger of a disregarded entity into a
corporation.(i) Under State W law, X merges into Z.
Pursuant to such law, the following events occur si-
multaneously at the effective time of the transaction:
all of the assets and liabilities of X (but not the as-
sets and liabilities of Y other than those of X) be-
come the assets and liabilities of Z and X’s separate
legal existence ceases for all purposes.
(ii) The transaction does not satisfy the require-
ments of paragraph (b)(1)(ii)(A) of this section be-
cause all of the assets and liabilities of a transferor
unit do not become the assets and liabilities of one
or more members of the transferee unit. The trans-
action also does not satisfy the requirements of para-
graph (b)(1)(ii)(B) of this section because X does not
qualify as a combining entity. Accordingly, the trans-
action cannot qualify as a statutory merger or con-
solidation for purposes of section 368(a)(1)(A).
Example 7. Merger of a corporation into a disre-
garded entity in exchange for interests in the disre-
garded entity.(i) Under State W law, Z merges into
X. Pursuant to such law, the following events occur
simultaneously at the effective time of the transaction:
all of the assets and liabilities of Z become the as-
sets and liabilities of X and Z’s separate legal exist-
ence ceases for all purposes. In the merger of Z into
X, the Z shareholders exchange their stock of Z for
interests in X so that, immediately after the merger,
X is not disregarded as an entity separate from Y for
federal tax purposes. Following the merger, pursu-
ant to§301.7701–3(b)(1)(i) of this chapter, X is clas-
sified as a partnership for federal tax purposes.
(ii) The transaction does not satisfy the require-
ments of paragraph (b)(1)(ii)(A) of this section be-
cause immediately after the merger X is not
disregarded as an entity separate from Y and, conse-
quently, all of the assets and liabilities of Z, the com-
bining entity of the transferor unit, do not become the
assets and liabilities of one or more members of a
transferee unit. Accordingly, the transaction cannot
qualify as a statutory merger or consolidation for pur-
poses of section 368(a)(1)(A).
Example 8. Merger transaction preceded by dis-
tribution.(i) Z operates two unrelated businesses, Busi-
ness P and Business Q, each of which represents 50
percent of the value of the assets of Z. Y desires to
acquire and continue operating Business P, but does
not want to acquire Business Q. Pursuant to a single
plan, Z sells Business Q for cash to parties unre-
lated to Z and Y in a taxable transaction, and then dis-
tributes the proceeds of the salepro ratato its
shareholders. Then, pursuant to State W law, Z merges
into Y. Pursuant to such law, the following events oc-
cur simultaneously at the effective time of the
transaction: all of the assets and liabilities of Z re-
lated to Business P become the assets and liabilities
of Y and Z’s separate legal existence ceases for all pur-
poses. In the merger, the Z shareholders exchange their
Z stock for Y stock. Prior to the transaction, Z is not
treated as owning any assets of an entity that is dis-
regarded as an entity separate from its owner for fed-
eral tax purposes.
(ii) The transaction satisfies the requirements of para-
graph (b)(1)(ii) of this section because the transac-
tion is effected pursuant to State W law and the
following events occur simultaneously at the effec-
tive time of the transaction: all of the assets and li-
abilities of Z, the combining entity and sole member
of the transferor unit, become the assets and liabili-
ties of Y, the combining entity and sole member of
the transferee unit, and Z ceases its separate legal ex-
istence for all purposes. Paragraph (b)(1)(iii) of this
section does not apply to prevent the transaction from
qualifying as a statutory merger or consolidation for
purposes of section 368(a)(1)(A) because each of Z
and Y is a domestic entity. Accordingly, the transac-
tion qualifies as a statutory merger or consolidation
for purposes of section 368(a)(1)(A).
(v)Effective dates.This paragraph (b)(1)
applies to transactions occurring on or af-
ter January 24, 2003. Taxpayers, however,
may apply these regulations in whole, but
not in part, to transactions occurring be-
fore January 24, 2003, provided that, if the
taxpayer is the acquiring corporation (or a
shareholder of the acquiring corporation
whose tax treatment of the transaction re-
flects the tax treatment by the acquiring cor-
poration, such as a shareholder of an
acquiring S corporation), the target corpo-
ration (and the shareholders of the target
corporation whose tax treatment of the
transaction reflects the tax treatment by the
target corporation) also applies these regu-
lations in whole, but not in part, to the
transaction, and if the taxpayer is the tar-
get corporation (or a shareholder of the tar-
get corporation whose tax treatment of the
transaction reflects the tax treatment by the
target corporation), the acquiring corpora-
tion (and the shareholders of the acquir-
ing corporation whose tax treatment of the
transaction reflects the tax treatment by the
acquiring corporation) also applies these
regulations in whole, but not in part, to the
transaction. For all other transactions, see
§1.368–2(b)(1) as in effect before Janu-
ary 24, 2003 (See 26 CFR part 1, revised
April 1, 2002).
(b)(2) through (k) [Reserved]. For fur-
ther guidance, see§1.368–2(b)(2) through
(k).
David A. Mader,
Assistant Deputy Commissioner of
Internal Revenue.
Approved January 17, 2003.
Pamela F. Olson,
Assistant Secretary of
the Treasury (Tax Policy).
(Filed by the Office of the Federal Register on January 23,
2003, 8:45 a.m., and published in the issue of the Federal Reg-
ister for January 24, 2003, 68 F.R. 3384)
Section 1041.—Transfers of
Property Between Spouses or
Incident to Divorce
26 CFR 1.1041–1T: Treatment of transfers of
property between spouses or incident to divorce
(temporary).
T.D. 9035
DEPARTMENT OF THE
TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Constructive Transfers and
Transfers of Property to a
Third Party on Behalf of a
Spouse
AGENCY: Internal Revenue Service (IRS),
Treasury.
2003–9 I.R.B.528March 3, 2003

ACTION: Final and temporary regulations.
SUMMARY: This document contains fi-
nal and temporary regulations relating to the
tax treatment of redemptions, during mar-
riage or incident to divorce, of stock in a
corporation owned by a spouse or former
spouse.
DATE:Effective Date:These regulations are
effective January 13, 2003.
Applicability Date:These regulations are
applicable to redemptions of stock on or af-
ter January 13, 2003, that are pursuant to
instruments in effect after January 13, 2003.
These regulations are also applicable to re-
demptions before January 13, 2003, or that
are pursuant to instruments in effect be-
fore January 13, 2003, if the spouses or
former spouses execute a written agree-
ment on or after August 3, 2001, that sat-
isfies the requirements of§1.1041–2(c)(1)
or (2).
FOR FURTHER INFORMATION CON-
TACT: Edward C. Schwartz at (202) 622–
4960 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained
in these final regulations has been reviewed
and approved by the Office of Manage-
ment and Budget in accordance with the Pa-
perwork Reduction Act (44 U.S.C. 3507)
under control number 1545–1751. Re-
sponses to this collection of information are
required for certain taxpayers to redeem
stock in a corporation and utilize the spe-
cial rule in§1.1041–2(c) of these regula-
tions.
An agency may not conduct or spon-
sor, and a person is not required to re-
spond to, a collection of information unless
the collection of information displays a valid
control number assigned by the Office of
Management and Budget.
The estimated annual burden per
respondent/recordkeeper varies from 20
minutes to one hour, depending on indi-
vidual circumstances, with an estimated av-
erage of 30 minutes.
Comments concerning the accuracy of
this burden estimate and suggestions for re-
ducing this burden should be sent to theIn-
ternal Revenue Service, Attn: IRS Reports
Clearance Officer, W:CAR:MP:FP:S, Wash-
ington, DC 20224, and to theOffice of
Management and Budget, Attn: Desk Of-
ficer for the Department of the Treasury, Of-
fice of Information and Regulatory Affairs,
Washington, DC 20503.
Books or records relating to this collec-
tion of information must be retained as long
as their contents may become material in
the administration of any internal revenue
law. Generally, tax returns and tax return
information are confidential, as required by
26 U.S.C. 6103.
Background
On August 3, 2001, the IRS and Trea-
sury Department published in theFed-
eral Registera notice of proposed
rulemaking under section 1041 relating to
certain redemptions, during marriage or in-
cident to divorce, of stock in a corpora-
tion owned by a spouse or former spouse
(REG–107151–00, 2001–2 C.B. 370 [66 FR
40659]). Written and electronic comments
were solicited, and a public hearing was
scheduled for December 14, 2001. Sev-
eral comments were received and are dis-
cussed below. Because no requests to speak
were timely received, the public hearing was
cancelled. After consideration of all com-
ments received, the proposed regulations un-
der section 1041 are adopted as revised by
this Treasury decision.
Explanation and Summary of
Comments
1.Special Rules in Cases of Written
Agreements Between the Spouses
The proposed regulations provided gen-
erally that if a corporation redeemed stock
owned by a transferor spouse and the re-
demption resulted in a constructive distri-
bution to the nontransferor spouse under
applicable tax law, then the redemption
would be taxable to the nontransferor
spouse as if the nontransferor spouse had
actually received the redemption proceeds.
The proposed regulations contained a spe-
cial rule in§1.1041–2(c) allowing the
spouses the option of treating the redemp-
tion as resulting in a constructive distribu-
tion to the nontransferor spouse, and
therefore taxable to the nontransferor
spouse, even if the redemption would not
result in a constructive distribution to the
nontransferor spouse under applicable tax
law. The proposed regulations provided that
the spouses could elect the special rule by
providing in the divorce or separation in-
strument, or other written agreement, that
the spouses must file their federal income
tax returns in a manner that reflects that the
transferor spouse transferred the redeemed
stock to the nontransferor spouse in ex-
change for the redemption proceeds and the
corporation redeemed the stock from the
nontransferor spouse in exchange for the re-
demption proceeds. The proposed regula-
tions also provided that the special rule
would be effective for written agreements
executed on or after August 3, 2001, that
met these requirements.
Commentators expressed concern that the
proposed regulations contained no provi-
sion addressing the situation where the
redemption results in a constructive distri-
bution to the nontransferor spouse under ap-
plicable tax law, but the spouses never-
theless would like to agree that the
redemption will be treated as a redemp-
tion distribution to the transferor spouse.
They suggested that the final regulations ex-
pand the special rule in§1.1041–2(c) to al-
low the spouses to agree in the divorce or
separation instrument, or other valid writ-
ten agreement, that the redemption will be
taxable to the transferor spouse notwith-
standing that the redemption might other-
wise result in a constructive distribution to
the nontransferor spouse under applicable
tax law.
The IRS and Treasury Department be-
lieve that this suggestion is consistent with
the policy of section 1041 and its legisla-
tive history, which is to provide flexibil-
ity to spouses and former spouses
concerning the structuring of their prop-
erty transfers during marriage and inci-
dent to divorce. Accordingly, this suggestion
has been adopted in§1.1041–2(c) of the fi-
nal regulations. NewExample 2in§1.1041–
2(d) illustrates the application of this new
special rule.
The manner of electing the special rule
also has been modified somewhat in the fi-
nal regulations. Under the final regula-
tions, the spouses can elect the special rule
by expressly providing, in a divorce or sepa-
ration instrument or other valid written
agreement, that expressly supersedes any
other instrument or agreement concern-
ing the purchase, sale, redemption, or other
disposition of the stock that is the subject
of the redemption, their mutual intent con-
cerning whether the redemption should be
treated as a redemption distribution to the
transferor spouse or to the nontransferor
spouse. The IRS and Treasury Department
March 3, 20035292003–9 I.R.B.

will treat a divorce or separation instru-
ment or other valid written agreement ex-
ecuted on or after August 3, 2001, and
before May 13, 2003, that meets the re-
quirements of the special rule of the pro-
posed regulations as also meeting the
requirements of the special rule in para-
graph (c)(2) of the final regulations.
2.Constructive Distribution Standard
Some commentators also expressed con-
cern that taxpayers and divorce practitio-
ners may not be aware of the situations in
which a redemption of stock owned by the
transferor spouse could result in a con-
structive distribution to the nontransferor
spouse under applicable tax law. They there-
fore suggested that the final regulations ei-
ther provide that the redemption will be
treated as a redemption distribution to the
transferor spouse regardless of applicable
tax law, unless the spouses provide other-
wise in a written agreement and file their
federal income tax returns accordingly, or
provide specific definitions and examples
of situations in which a redemption would
result in a constructive distribution to the
nontransferor spouse under applicable tax
law.
The IRS and Treasury Department con-
tinue to believe that the approach in the pro-
posed regulations is appropriate. Under
existing tax law, a redemption of stock
owned by one shareholder may result in a
constructive distribution to another share-
holder if such nonredeeming shareholder has
a primary and unconditional obligation to
purchase the redeeming shareholder’s stock.
See Rev. Rul. 69–608, 1969–2 C.B. 42,
Wall v. United States, 164 F.2d 462 (4th Cir.
1947), andSullivan v. United States, 363
F.2d 724 (8th Cir. 1966). This“primary and
unconditional obligation”standard applies
to all redemptions, including those involv-
ing stock of closely held corporations by
spouses or former spouses. A rule that pro-
vides that a redemption of stock owned by
the transferor spouse will always be treated
as a redemption distribution to the trans-
feror spouse would be inconsistent with this
established law. Furthermore, if taxpayers
and divorce practitioners are uncertain about
the application of the“primary and uncon-
ditional obligation”standard, they may take
advantage of the special rules of§1.1041–
2(c), which permit spouses to avoid any
question of whether a redemption results in
a constructive distribution to the nontrans-
feror spouse under applicable tax law re-
lating to the primary and unconditional
obligation standard by providing in a writ-
ten agreement which spouse will bear the
tax consequences of the redemption.
3.Withdrawal of§1.1041–1T(c), Q&A–9
Section 1.1041–1T(c), Q&A–9, of the
temporary Income Tax Regulations pro-
vides that there are three situations in which
a transfer of property to a third party on be-
half of a spouse or former spouse will
qualify under section 1041 (provided all
other requirements of that section are met):
(1) if such transfer is required by the di-
vorce or separation instrument; (2) if the
transfer is pursuant to a written request of
the other spouse; and (3) where the trans-
feror spouse receives a written consent or
ratification from the nontransferor spouse.
Under Q&A–9, a transfer of property made
to a third party on behalf of a spouse is
treated first as a deemed transfer of the
property made directly to the nontrans-
feror spouse in a transfer to which sec-
tion 1041 applies, and then as a deemed
transfer of the property from the nontrans-
feror spouse to the third party in a trans-
action to which section 1041 does not apply.
Two commentators recommended that
Q&A–9 be withdrawn. They suggested that
retaining that provision would lead to con-
fusion since it would apply to all trans-
fers of property other than stock
redemptions while this final regulation
would apply only to stock redemptions. An-
other commentator advocated replacing ex-
isting Q&A–9 with a single standard
applicable to all transfers of property to third
parties under which the tax consequences
of the transfer would follow the trans-
fer’s form unless the spouses agreed in writ-
ing otherwise.
The“on behalf of”standard has not led
to the same confusion and litigation out-
side the area of stock redemptions because,
in such cases, it does not conflict with any
other standard of tax law. See,e.g.,
Ingham v. United States, 167 F.3d 1240 (9th
Cir. 1999). In addition, as discussed above,
a single standard applicable to all trans-
fers of property to third parties under which
the tax consequences of the transfer would
follow the transfer’s form would be incon-
sistent with the primary and unconditional
obligation standard applicable to stock re-
demptions under existing tax law. Conse-
quently, the IRS and Treasury Department
continue to believe that the final regula-
tions should be limited to stock redemp-
tions and that Q&A–9 should not be
withdrawn.
4.Use of IRS Form to Designate Intent
One commentator proposed that the fi-
nal regulations include a requirement that
the spouses or former spouses attach a form
to their federal income tax returns show-
ing which spouse or former spouse has the
tax consequences of the redemption. Af-
ter careful consideration, the IRS and Trea-
sury Department have concluded that
requiring spouses, and particularly spouses
who have divorced or are divorcing, to
complete and file an additional form in or-
der to obtain the result of the special rules
would unnecessarily increase the adminis-
trative burden on taxpayers and on the IRS.
The divorce or separation instrument, or
other valid written agreement of the
spouses, provides adequate evidence of the
spouses’intent regarding which spouse has
the tax consequences of the redemption.
5.Legal Guardians and/or Executors of
Estates of Spouses
One commentator suggested that the fi-
nal regulations provide specific authority for
a legal guardian of a spouse or former
spouse or the executor of a spouse’sor
former spouse’s estate to elect the appli-
cation of one of the special rules of
§1.1041–2(c). However, a legal guardian,
custodian, or executor of an estate that has
the general authority to act on behalf of a
spouse or former spouse (or his or her es-
tate) for federal income tax purposes needs
no additional or special authority to elect
one of the special rules under§1.1041–
2(c). Accordingly, this suggestion has not
been adopted.
6.Other Changes
In an effort to improve the clarity of the
final regulations, the order of the two para-
graphs in§1.1041–2(a) has been reversed
and conforming changes have been made
in the remainder of the final regulations.
Also, the final regulations remove the pro-
vision of the proposed regulations that
would have limited their application to
transactions in which both spouses or
former spouses own stock immediately be-
fore or after the redemption. On further re-
flection, the IRS and Treasury Department
believe it is appropriate to apply the regu-
2003–9 I.R.B.530March 3, 2003

lations to all stock redemptions, regard-
less of whether both spouses own stock of
the corporation before or after the redemp-
tion.
7.Effective Date
One comment was received suggest-
ing that the effective date provision of the
final regulations be changed to include all
stock redemptions that were pending on the
day the proposed regulations were issued
(August 2, 2001) and to include all cases
involving stock redemptions at issue on that
date at any level of audit, review, appeal,
or collection by the IRS or before the Tax
Court or any other federal court. It was ar-
gued that this proposal would be consis-
tent with the current state of the law and
would resolve numerous cases involving
taxpayers and the IRS. Adopting this sug-
gestion would have the effect of making the
application of the final regulations retro-
active. Apart from the special rules of
§1.1041–2(c), which are based upon the
stated intent of the spouses, the IRS and
Treasury do not believe it is appropriate to
apply the final regulations retroactively.
Therefore, the final regulations do not adopt
this suggestion.
Special Analysis
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 determined
that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does not
apply to these regulations, and because the
regulations do not impose a collection of
information on small entities, a Regula-
tory Flexibility Analysis under the Regu-
latory Flexibility Act (5 U.S.C. chapter 6)
is not required. Pursuant to section 7805(f)
of the Internal Revenue Code, the notice of
proposed rulemaking preceding these regu-
lations was submitted to the Chief Coun-
sel for Advocacy of the Small Business
Administration for comment on its im-
pact on small business.
Drafting Information
The principal author of these regula-
tions is Edward C. Schwartz of the Of-
fice of the Associate Chief Counsel (Income
Tax and Accounting). However, other per-
sonnel from the IRS and Treasury Depart-
ment participated in their development.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602 are
amended as follows:
PA RT 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805***
Par.2.In§1.1041–1T, paragraph (c) is
amended by adding a sentence at the end
of A–9 to read as follows:
§1.1041–1T Treatment of transfers of
property between spouses or incident to
divorce (temporary).
*****
(c)***
A–9:***This A–9 shall not apply to
transfers to which§1.1041–2 applies.
*****
Par. 3. Section 1.1041–2 is added to read
as follows:
§1.1041–2 Redemptions of stock.
(a)In general—(1)Redemptions of stock
not resulting in constructive distributions.
Notwithstanding Q&A–9of§1.1041–1T(c),
if a corporation redeems stock owned by
a spouse or former spouse (transferor
spouse), and the transferor spouse’sre-
ceipt of property in respect of such re-
deemed stock is not treated, under
applicable tax law, as resulting in a con-
structive distribution to the other spouse or
former spouse (nontransferor spouse), then
the form of the stock redemption shall be
respected for federal income tax purposes.
Therefore, the transferor spouse will be
treated as having received a distribution
from the corporation in redemption of stock.
(2)Redemptions of stock resulting in
constructive distributions.Notwithstand-
ing Q&A–9of§1.1041–1T(c), if a corpo-
ration redeems stock owned by a transferor
spouse, and the transferor spouse’s re-
ceipt of property in respect of such re-
deemed stock is treated, under applicable
tax law, as resulting in a constructive dis-
tribution to the nontransferor spouse, then
the redeemed stock shall be deemed first
to be transferred by the transferor spouse
to the nontransferor spouse and then to be
transferred by the nontransferor spouse to
the redeeming corporation. Any property ac-
tually received by the transferor spouse from
the redeeming corporation in respect of the
redeemed stock shall be deemed first to be
transferred by the corporation to the non-
transferor spouse in redemption of such
spouse’s stock and then to be transferred
by the nontransferor spouse to the trans-
feror spouse.
(b)Tax consequences—(1)Transfers de-
scribed in paragraph (a)(1) of this sec-
tion.Section 1041 will not apply to any of
the transfers described in paragraph (a)(1)
of this section. See section 302 for rules re-
lating to the tax consequences of certain re-
demptions; redemptions characterized as
distributions under section 302(d) will be
subject to section 301 if received from a
Subchapter C corporation or section 1368
if received from a Subchapter S corpora-
tion.
(2)Transfers described in paragraph
(a)(2) of this section.The tax consequences
of each deemed transfer described in para-
graph (a)(2) of this section are determined
under applicable provisions of the Inter-
nal Revenue Code as if the spouses had ac-
tually made such transfers. Accordingly,
section 1041 applies to any deemed trans-
fer of the stock and redemption proceeds
between the transferor spouse and the non-
transferor spouse, provided the require-
ments of section 1041 are otherwise
satisfied with respect to such deemed trans-
fer. Section 1041, however, will not ap-
ply to any deemed transfer of stock by the
nontransferor spouse to the redeeming cor-
poration in exchange for the redemption
proceeds. See section 302 for rules relat-
ing to the tax consequences of certain re-
demptions; redemptions characterized as
distributions under section 302(d) will be
subject to section 301 if received from a
Subchapter C corporation or section 1368
if received from a Subchapter S corpora-
tion.
(c)Special rules in case of agreements
between spouses or former spouses—(1)
Transferor spouse taxable.Notwithstand-
ing applicable tax law, a transferor spouse’s
receipt of property in respect of the re-
deemed stock shall be treated as a distri-
bution to the transferor spouse in
redemption of such stock for purposes of
paragraph (a)(1) of this section, and shall
not be treated as resulting in a construc-
tive distribution to the nontransferor spouse
for purposes of paragraph (a)(2) of this sec-
tion, if a divorce or separation instrument,
March 3, 20035312003–9 I.R.B.

or a valid written agreement between the
transferor spouse and the nontransferor
spouse, expressly provides that—
(i) Both spouses or former spouses in-
tend for the redemption to be treated, for
federal income tax purposes, as a redemp-
tion distribution to the transferor spouse; and
(ii) Such instrument or agreement su-
persedes any other instrument or agree-
ment concerning the purchase, sale,
redemption, or other disposition of the stock
that is the subject of the redemption.
(2)Nontransferor spouse taxable.Not-
withstanding applicable tax law, a trans-
feror spouse’s receipt of property in re-
spect of the redeemed stock shall be treated
as resulting in a constructive distribution to
the nontransferor spouse for purposes of
paragraph (a)(2) of this section, and shall
not be treated as a distribution to the trans-
feror spouse in redemption of such stock
for purposes of paragraph (a)(1) of this sec-
tion, if a divorce or separation instrument,
or a valid written agreement between the
transferor spouse and the nontransferor
spouse, expressly provides that—
(i) Both spouses or former spouses in-
tend for the redemption to be treated, for
federal income tax purposes, as resulting in
a constructive distribution to the nontrans-
feror spouse; and
(ii) Such instrument or agreement su-
persedes any other instrument or agree-
ment concerning the purchase, sale,
redemption, or other disposition of the stock
that is the subject of the redemption.
(3)Execution of agreements.For pur-
poses of this paragraph (c), a divorce or
separation instrument must be effective, or
a valid written agreement must be executed
by both spouses or former spouses, prior to
the date on which the transferor spouse (in
the case of paragraph (c)(1) of this sec-
tion) or the nontransferor spouse (in the case
of paragraph (c)(2) of this section) files such
spouse’s first timely filed federal income
tax return for the year that includes the date
of the stock redemption, but no later than
the date such return is due (including ex-
tensions).
(d)Examples.The provisions of this sec-
tion may be illustrated by the following
examples:
Example 1.Corporation X has 100 shares outstand-
ing. A and B each own 50 shares. A and B divorce.
The divorce instrument requires B to purchase A’s
shares, and A to sell A’s shares to B, in exchange for
$100x. Corporation X redeems A’s shares for $100x.
Assume that, under applicable tax law, B has a pri-
mary and unconditional obligation to purchase A’s
stock, and therefore the stock redemption results in
a constructive distribution to B. Also assume that the
special rule of paragraph (c)(1) of this section does
not apply. Accordingly, under paragraphs (a)(2) and
(b)(2) of this section, A shall be treated as transfer-
ring A’s stock of Corporation X to B in a transfer to
which section 1041 applies (assuming the require-
ments of section 1041 are otherwise satisfied), B shall
be treated as transferring the Corporation X stock B
is deemed to have received from A to Corporation X
in exchange for $100x in an exchange to which sec-
tion 1041 does not apply and sections 302(d) and 301
apply, and B shall be treated as transferring the $100x
to A in a transfer to which section 1041 applies.
Example 2.Assume the same facts asExample 1,
except that the divorce instrument provides as follows:
“A and B agree that the redemption will be treated for
federal income tax purposes as a redemption distri-
bution to A.”The divorce instrument further pro-
vides that it“supersedes all other instruments or
agreements concerning the purchase, sale, redemp-
tion, or other disposition of the stock that is the sub-
ject of the redemption.”By virtue of the special rule
of paragraph (c)(1) of this section and under para-
graphs (a)(1) and (b)(1) of this section, the tax con-
sequences of the redemption shall be determined in
accordance with its form as a redemption of A’s shares
by Corporation X and shall not be treated as result-
ing in a constructive distribution to B. See section 302.
Example 3.Assume the same facts asExample 1,
except that the divorce instrument requires A to sell
A’s shares to Corporation X in exchange for a note.
B guarantees Corporation X’s payment of the note.
Assume that, under applicable tax law, B does not have
a primary and unconditional obligation to purchase A’s
stock, and therefore the stock redemption does not re-
sult in a constructive distribution to B. Also assume
that the special rule of paragraph (c)(2) of this sec-
tion does not apply. Accordingly, under paragraphs
(a)(1) and (b)(1) of this section, the tax consequences
of the redemption shall be determined in accordance
with its form as a redemption of A’s shares by Cor-
poration X. See section 302.
Example 4.Assume the same facts asExample 3,
except that the divorce instrument provides as follows:
“A and B agree the redemption shall be treated, for
federal income tax purposes, as resulting in a con-
structive distribution to B.”The divorce instrument fur-
ther provides that it“supersedes any other instrument
or agreement concerning the purchase, sale, redemp-
tion, or other disposition of the stock that is the sub-
ject of the redemption.”By virtue of the special rule
of paragraph (c)(2) of this section, the redemption is
treated as resulting in a constructive distribution to B
for purposes of paragraph (a)(2) of this section. Ac-
cordingly, under paragraphs (a)(2) and (b)(2) of this
section, A shall be treated as transferring A’s stock of
Corporation X to B in a transfer to which section 1041
applies (assuming the requirements of section 1041
are otherwise satisfied), B shall be treated as trans-
ferring the Corporation X stock B is deemed to have
received from A to Corporation X in exchange for a
note in an exchange to which section 1041 does not
apply and sections 302(d) and 301 apply, and B shall
be treated as transferring the note to A in a transfer
to which section 1041 applies.
(e)Effective date.Except as otherwise
provided in this paragraph, this section is
applicable to redemptions of stock on or af-
ter January 13, 2003, except for redemp-
tions of stock that are pursuant to
instruments in effect before January 13,
2003. For redemptions of stock before Janu-
ary 13, 2003, and redemptions of stock that
are pursuant to instruments in effect be-
fore January 13, 2003, see§1.1041–1T(c),
A–9. However, these regulations will be ap-
plicable to redemptions described in the pre-
ceding sentence of this paragraph (e) if the
spouses or former spouses execute a writ-
ten agreement on or after August 3, 2001,
that satisfies the requirements of one of the
special rules in paragraph (c) of this sec-
tion with respect to such redemption. A di-
vorce or separation instrument or valid
written agreement executed on or after Au-
gust 3, 2001, and before May 13, 2003, that
meets the requirements of the special rule
in Regulations Project REG–107151–00
published in 2001–2 C.B. 370 (see
§601.601(d)(2) of this chapter) will be
treated as also meeting the requirements of
the special rule in paragraph (c)(2) of this
section.
PART 602—OMB CONTROL
NUMBERS UNDER THE
PAPERWORK REDUCTION ACT
Par. 4. The authority citation for part 602
continues to read as follows:
Authority: 26 U.S.C. 7805.
Par.5.In§602.101, paragraph (b) is
amended by adding an entry in numerical
order to the table to read as follows:
§602.101 OMB Control numbers.
*****
(b)***
2003–9 I.R.B.532March 3, 2003

CFR part or section where
identified and described
Current OMB
control No.
*****
1.1041–2 ......................................................................................................................................................... 1545–1751
*****
David A. Mader,
Assistant Deputy Commissioner of
Internal Revenue.
Approved December 30, 2002.
Pamela F. Olson,
Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on January 10,
2003, 8:45 a.m., and published in the issue of the Federal Reg-
ister for January 13, 2003, 68 F.R. 1534)
Section 6103.—Confiden-
tiality and Disclosure of
Returns and Return
Information
26 CFR 301.6103(p)(2)(B)–1: Disclosure of returns
and return information by other agencies.
T.D. 9036
DEPARTMENT OF THE
TREASURY
Internal Revenue Service
26 CFR Parts 301 and 602
Disclosure of Returns and
Return Information by Other
Agencies
AGENCY: Internal Revenue Service (IRS),
Treasury.
ACTION: Final regulations.
SUMMARY: This document contains a fi-
nal regulation relating to the disclosure of
returns and return information by federal,
state, and local agencies other than the IRS.
The final regulation permits the IRS to au-
thorize agencies with access to returns and
return information under section 6103 of the
Internal Revenue Code (Code) to redis-
close returns and return information, with
the approval of the Commissioner of In-
ternal Revenue (Commissioner), to any au-
thorized recipient set forth in section 6103,
subject to the same conditions and restric-
tions, and for the same purposes, as if the
recipient had received the information from
the IRS directly.
DATES: This regulation is effective Janu-
ary 21, 2003.
FOR FURTHER INFORMATION CON-
TACT: Julie C. Schwartz, 202–622–4570
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained
in this final regulation has been reviewed
and approved by the Office of Manage-
ment and Budget in accordance with the Pa-
perwork Reduction Act of 1995 (44 U.S.C.
4507(d)) under control number 1545–1757.
The collection of information in this regu-
lation is in§301.6103(p)(2)(B)–1. This in-
formation is required for the Commissioner
to authorize the disclosure of returns and
return information from agencies with ac-
cess to returns and return information un-
der section 6103 to other authorized
recipients of returns and return informa-
tion in accordance with section 6103.
An agency may not conduct or spon-
sor, and a person is not required to re-
spond to, a collection of information unless
the collection of information displays a valid
OMB control number.
The estimated annual burden per re-
spondent varies from one half-hour to two
hours, depending on individual circum-
stances, with an estimated average of one
hour.
Comments concerning the accuracy of
this burden estimate and suggestions for re-
ducing this burden should be sent to theIn-
ternal Revenue Service,Attn: IRS Reports
Clearance Officer, W:CAR:MP:FP:S, Wash-
ington, DC 20224, and to theOffice of
Management and Budget,Attn: Desk Of-
ficer for the Department of the Treasury, Of-
fice of Information and Regulatory Affairs,
Washington, DC 20503.
Books or records relating to a collec-
tion of information must be retained as long
as their contents may become material in
the administration of any internal revenue
law. Generally, tax returns and return in-
formation are confidential, as required by
26 U.S.C. 6103.
Background
This document contains amendments to
26 CFR parts 301 and 602. On December
13, 2001, a notice of proposed rulemak-
ing (REG–105344–01, 2002–2 I.R.B. 302
[66 FR 64386]) was published in theFed-
eral Register. No comments were received
from the public in response to the notice of
proposed rulemaking. No public hearing
was requested or held. The proposed regu-
lations are adopted by this Treasury deci-
sion.
Explanation of Provisions
The final regulation expands the num-
ber of agencies that may redisclose re-
turns and return information if authorized
by the Commissioner to any federal, state,
or local agency that receives such infor-
mation under section 6103. Similarly, it ex-
pands the universe of authorized recipients
of returns and return information pursu-
ant to this redisclosure authority to any re-
cipient authorized to receive returns and
return information in accordance with sec-
tion 6103. All redisclosures by agencies pur-
suant to this regulation will be made subject
to the same conditions, restrictions, safe-
guards, recordkeeping requirements, and
civil and criminal penalties that would ap-
ply if the disclosure were made by the IRS.
Federal, state and local agencies making dis-
closures of return information under the fi-
nal regulation will continue to provide to
the IRS certain information regarding dis-
closures made pursuant to this authority, in
order for the IRS to fulfill its reporting re-
quirements under section 6103(p).
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
March 3, 20035332003–9 I.R.B.

is not required. It has also been determined
that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does not
apply to these regulations. Pursuant to the
Regulatory Flexibility Act (5 U.S.C. chap-
ter 6), it is hereby certified that this final
rule will not have a significant economic
impact on a substantial number of small en-
tities. The disclosure authorized by the rule
is voluntary on the part of small govern-
mental jurisdictions and, as discussed ear-
lier in this preamble, the burden associated
with requesting authorization from the Com-
missioner to disclose returns and return in-
formation, and to maintain the necessary
records concerning the disclosure of re-
turn information, is minimal. Accordingly,
a Regulatory Flexibility Analysis is not re-
quired. Pursuant to section 7805(f) of the
Code, the proposed regulations preceding
these regulations were submitted to the
Chief Counsel of the Small Business Ad-
ministration for comment on their impact
on small businesses.
Drafting Information
The principal author of these regula-
tions is Julie C. Schwartz, Office of the As-
sociate Chief Counsel (Procedure and
Administration), Disclosure and Privacy
Law Division.
*****
Amendments to the Regulations
Accordingly, 26 CFR parts 301 and 602
are amended as follows:
PART 301—PROCEDURE AND
ADMINISTRATION
Paragraph 1. The authority citation for
part 301 is amended by adding an entry in
numerical order to read as follows:
Authority: 26 U.S.C. 7805***
Section 301.6103(p)(2)(B)–1 also is-
sued under 26 U.S.C. 6103(p)(2);***
Par. 2. Section 301.6103(p)(2)(B)–1is
added to read as follows:
§301.6103(p)(2)(B)–1 Disclosure of
Returns and Return Information by
Other Agencies.
(a)General rule.Subject to the require-
ments of paragraphs (b), (c), and (d) of this
section, returns or return information that
have been obtained by a federal, state, or
local agency, or its agents or contractors,
in accordance with section 6103 (the first
recipient) may be disclosed by the first re-
cipient to another recipient authorized to re-
ceive such returns or return information
under section 6103 (the second recipient).
(b)Approval by Commissioner.A dis-
closure described in paragraph (a) of this
section may be made if the Commissioner
of Internal Revenue (the Commissioner) de-
termines, after receiving a written request
under this section, that such returns or re-
turn information are more readily avail-
able from the first recipient than from the
Internal Revenue Service (IRS). The dis-
closure authorization by the Commissioner
shall be directed to the head of the first re-
cipient and may contain such conditions or
restrictions as the Commissioner may pre-
scribe. The disclosure authorization may be
revoked by the Commissioner at any time.
(c)Requirements and restrictions.The
second recipient may receive only returns
or return information as authorized by the
provision of section 6103 applicable to such
second recipient. Any returns or return in-
formation disclosed may be used by the sec-
ond recipient only for a purpose authorized
by and subject to any conditions imposed
by section 6103 and the regulations there-
under, including, if applicable, safeguards
imposed by section 6103(p)(4).
(d)Records and reports of disclosure.
The first recipient shall maintain to the sat-
isfaction of the IRS a permanent system of
standardized records regarding such dis-
closure authorization described in para-
graph (a) of this section and any disclosure
of returns and return information made pur-
suant to such authorization, and shall pro-
vide such information as prescribed by the
Commissioner in order to enable the IRS
to comply with its obligations under sec-
tion 6103(p)(3) to keep accountings for dis-
closures and to make annual reports of
disclosures to the Joint Committee on Taxa-
tion. The information required for reports
to the Joint Committee on Taxation must
be provided within 30 days after the close
of each calendar year. The requirements of
this paragraph do not apply to the disclo-
sure of returns and return information as
provided by paragraph (a) of this section
which, had such disclosures been made di-
rectly by the IRS, would not have been sub-
ject to the recordkeeping requirements
imposed by section 6103(p)(3)(A).
(e)Effective date.This section is appli-
cable on January 21, 2003.
§301.6103(p)(2)(B)–1T [Removed]
Par. 3. Section 301.6103(p)(2)(B)–1T is
removed.
PART 602—OMB CONTROL
NUMBERS UNDER THE
PAPERWORK REDUCTION ACT
Paragraph 4. The authority citation for
part 602 continues to read as follows:
Authority: 26 U.S.C. 7805***
Paragraph 5. In§602.101, paragraph (b)
is amended by removing the entry
“301.6103(p)(2)(B)–1T”from the table and
adding the entry“301.6103(p)(2)(B)–1”in
numerical order to read as follows:
§602.101 OMB Control numbers.
*****
(b)***
CFR part or section where
identified and described
Current OMB
control No.
*****
301.6103(p)(2)(B)–1 ....................................................................................................................................1545–1757
*****
2003–9 I.R.B.534March 3, 2003

David A. Mader,
Assistant Deputy Commissioner of
Internal Revenue.
Approved December 20, 2002.
Pamela F. Olson,
Assistant Secretary of
the Treasury (Tax Policy).
(Filed by the Office of the Federal Register on January 17,
2003, 8:45 a.m., and published in the issue of the Federal Reg-
ister for January 21, 2003, 68 F.R. 2695)
26 CFR 301.6103(j)(1)–1: Disclosures of return
information reflected on returns to officers and
employees of the Department of Commerce for cer-
tain statistical purposes and related activities.
T.D. 9037
DEPARTMENT OF THE
TREASURY
Internal Revenue Service
26 CFR Part 301
Disclosure of Return
Information to the Bureau of
the Census
AGENCY: Internal Revenue Service (IRS),
Treasury.
ACTION: Final regulations and removal of
temporary regulations.
SUMMARY: This document contains regu-
lations relating to the list of items of tax in-
formation disclosed to the Bureau of the
Census. These regulations reflect an agree-
ment between the IRS and the Bureau of
the Census as to items of tax information
needed to more effectively meet the Bu-
reau of the Census’program objectives as
authorized under chapter 5 of title 13,
United States Code (U.S.C.), including the
Longitudinal Employer-Household Dynam-
ics (LEHD) project and the Survey of In-
come and Program Participation (SIPP)
project.
DATES:Effective Date:These regulations
are effective January 21, 2003.
FOR FURTHER INFORMATION CON-
TACT: Christine Irwin, (202) 622–4570 (not
a toll-free number).
Background
This document contains amendments to
26 CFR part 301 under section 6103(j) of
the Internal Revenue Code (Code). On Feb-
ruary 13, 2001, theFederal Registerpub-
lished temporary regulations (T.D. 8943,
2001–15 I.R.B. 1054 [66 FR 9957]) re-
garding tax information disclosed to the Bu-
reau of the Census for use in the LEHD and
SIPP projects, and a notice of proposed rule-
making (REG–121109–00, 2001–15 I.R.B.
1064 [66 FR 9991]) cross-referencing the
temporary regulations. A correction to the
notice of proposed rulemaking by cross-
reference to the temporary regulations was
published on March 23, 2001 (66 FR
16161). Three comments on these tempo-
rary regulations were received and consid-
ered, but no public hearing was requested
or held. After consideration of the com-
ments, the Treasury decision adopts the
regulations as proposed with certain changes
and removes the corresponding tempo-
rary regulations.
The changes include corrections to punc-
tuation and clarification of certain terms
used in the regulations,e.g., references to
Form SS–4asa“form”as opposed to a tax
“return.”Additional changes include adopt-
ing the generic term“location code”to re-
fer to locations of IRS offices from which
tax information is retrieved. Changes also
include using the terms“area/district of-
fice”and“campus/service”center as ex-
amples of location codes. The tax
information disclosed to the Bureau of the
Census is retrieved from older files, as well
as current files. The older information is re-
trieved from files which contain the terms
“district offices”and“service centers”as
the location codes, while the more recent
information is retrieved from files that use
the terms“area offices”and“campuses”(in
addition to other location codes). Although
the terms“district offices”and“service cen-
ters”are no longer used by the IRS, hav-
ing been replaced by the terms“area
offices”and“campuses”respectively, as a
result of the IRS reorganization mandated
by section 1001 of the IRS Restructuring
and Reform Act of 1998, the regulations’
reference to“location code”will encom-
pass all of these terms to ensure that tax in-
formation may be retrieved from both older
and more current files.
Also, the final regulations narrow the tax
information to be disclosed to the Bureau
of the Census under§301.6103(j)(1)–
1(b)(3)(xxviii) pertaining to“Gross Distri-
butions from Form 1099–R.”Although the
temporary regulations authorized the dis-
closure of all gross distributions from
Form 1099–R under§301.6103(j)(1)–
1T(b)(3)(xxviii), the Bureau of the Cen-
sus needs only tax information related to
distributions from employer-sponsored and
individual retirement plans, according to a
letter sent to the IRS from the Secretary of
Commerce dated October 4, 2002. There-
fore, the final regulations authorize the dis-
closure only of distributions from employer-
sponsored and individual retirement
plans from the Forms 1099-R under
§301.6103(j)(1)–1(b)(3)(xxviii).
The final regulations also clarify the
phrase“return information reflected on re-
turns”—language that was incorporated
into§301.6103(j)(1)–1 when the regula-
tions were first promulgated in 1980 (see
T.D. 7724, 1980–2 C.B. 360 [45 FR
65561]). The phrase“return information re-
flected on returns”is used in the regula-
tions to describe the type of return
information that may be disclosed to agen-
cies under sections 6103(j)(1)(A) and (B)
of the Code. (The phrase“return informa-
tion reflected on returns”encompasses the
phrases used in the statute under section
6103(j)(1)(A) and (B) of the Code that re-
fer to“return information reflected thereon”
and“return information reflected on re-
turns of corporations.”) The legislative his-
tory of section 6103(j)(1)(A) of the Code,
authorizing the disclosure of“returns”and
“return information reflected thereon”to of-
ficers and employees of the Bureau of the
Census, does not specifically define the
phrase“return information reflected
thereon.”Nor does the legislative history
of section 6103(j)(1)(B) of the Code, au-
thorizing the disclosure of“return infor-
mation reflected on returns of corporations”
to officers and employees of the Bureau of
Economic Analysis, define the phrase“re-
turn information reflected on returns of cor-
porations.”These final regulations clarify
the concept of“return information reflected
on returns.”Although the legislative his-
tory does not explicitly define the con-
cept of“return information reflected on
returns,”it does use the term“informa-
tion from tax returns”and expresses Con-
gress’intent that only“limited information”
for statistical purposes should be provided
to the Bureau of the Census and the Bu-
reau of Economic Analysis. The legisla-
March 3, 20035352003–9 I.R.B.

tive history does describe the type of in-
formation that the IRS provided to agen-
cies when section 6103(j)(1) and (2) of the
Code was enacted in the Tax Reform Act
of 1976. This information included IRS
transcript cards that summarized informa-
tion from 500 to 1,000 returns of the larg-
est corporations, taxpayer names, addresses,
employer identification numbers, gross re-
ceipts, accounting periods, industry codes,
and sample codes. (See Staff of Joint Com-
mittee on Internal Revenue Taxation, 94th
Cong., 2d Sess., Tax Revision Issues—
1976 (H.R. 10612), No. 6: Administra-
tive Matters, at 40–41 (Comm. Print, April
14, 1976) (Joint Committee Report)). Ac-
cording to the legislative history, the
“sample code”provided the“sampling pro-
cess used by the IRS with respect to its Sta-
tistics of Income (not with respect to audit,
etc.)....”See Joint Committee Report at
41. These sample codes were not informa-
tion submitted by taxpayers on tax returns
filed with the IRS. Rather, these codes were
information generated by the IRS in con-
junction with returns and disclosed by the
IRS to at least one agency for statistical pur-
poses. Therefore, when Congress enacted
section 6103(j)(1)(A) and (B) of the Code
in 1976, adopting the language“return in-
formation reflected thereon”and“such re-
turn information reflected on returns of
corporations”to describe the type of in-
formation that could be disclosed to agen-
cies for statistical purposes, the information
described includes not only information on
returns, but also information derived from
the processing of such returns, and/or in-
formation related to the establishment and
maintenance of taxpayer information in IRS
data bases, such as sample codes. There-
fore, these final regulations clarify the
phrase“return information reflected on re-
turns”by stating that it includes, but is not
limited to, information on returns, infor-
mation derived from processing such re-
turns, and information derived from the
Social Security Administration (SSA) and
other sources for the purposes of establish-
ing and maintaining taxpayer information
relating to returns. This includes informa-
tion derived from returns and Forms SS–4,
“Application for Employer Identification
Number,”monthly corrections of, and ad-
ditions to, taxpayer information contained
in IRS and SSA databases (e.g., taxpayer
address and name changes) that are ob-
tained from SSA and other sources, and
computer codes compiled by the IRS and
the SSA derived from returns and/or tax
forms and integrated within taxpayer data
bases.
Further, these final regulations clarify a
restriction that was imposed by the tem-
porary regulations with respect to the dis-
closure of tax information to the Bureau of
the Census. Specifically, the explanation of
provisions section to the temporary regu-
lations stated that information will be fur-
nished under the temporary regulations only
for the purposes of conducting the LEHD
project and/or SIPP/SSA project as speci-
fied in the request letters and with the un-
derstanding that the information will be used
strictly in accordance with the provisions
of the Code pertaining to confidentiality (see
66 FR 9958 under“Explanation of Provi-
sions”of the preamble). These tax disclo-
sure restrictions to the LEHD and SIPP
projects were included during the incep-
tion of an agreement entered into between
the IRS and the Bureau of the Census that
provides detailed criteria for the review and
approval by the IRS of Census Bureau
projects that use federal tax information.
This inter-agency agreement between the
IRS and the Bureau of the Census dated
September 15, 2000, is entitled“Criteria for
the Review and Approval of Census
Projects that Use Federal Tax Informa-
tion”(inter-agency agreement) and pro-
vides detailed procedures for imple-
menting the requirements set forth in
§301.6103(j)(1)–1(d) of the regulations. Ac-
cording to§301.6103(j)(1)–1(d) of the regu-
lations and the inter-agency agreement, the
IRS must approve the proposed uses for tax
information disclosed on a project-by-project
basis. The implementation of this inter-
agency agreement has strengthened the IRS’
review process for approving proposed uses
for tax information disclosed to the Bu-
reau of the Census. It has also improved the
ability of the IRS and the Bureau of the
Census to ensure that appropriate proce-
dures, especially relating to safeguards and
approved usage documentation, are em-
ployed for access to, and use of, federal tax
information.
Although the explanation of provisions
section to the temporary regulations stated
that the additional tax information autho-
rized for disclosure under the temporary
regulations under§301.6103(j)(1)–1T(b)(2),
(3), and (5) would be disclosed only for
purposes of conducting the LEHD and/or
SIPP projects, the actual language of the
temporary regulations under§301.6103(j)
(1)–1T(b)(2), (3), and (5) did not contain
such a limitation. Rather, the temporary
regulations adopted the same language de-
scribing the authorized use of the tax in-
formation by the Bureau of the Census that
appeared in§301.6103(j)(1)–1(b)(2), (3),
and (5) of the previous regulations (prior
to the implementation of the temporary
regulations). This language authorizes a
broader use of the disclosed tax informa-
tion by the Bureau of the Census for de-
mographicandeconomicstatistics
programs, censuses, and surveys autho-
rized by chapter 5 of title 13, U.S.C. These
final regulations do not change this lan-
guage pertaining to the authorized uses of
the tax information by the Bureau of the
Census in§301.6103(j)(1)–1(b)(2), (3), and
(5). Accordingly, these final regulations per-
mit the disclosure of tax information to the
Bureau of the Census, not only for the
LEHD and SIPP projects, but also to the ex-
tent necessary in conducting and prepar-
ing demographic and economic statistics
programs, censuses, and surveys, as autho-
rized by chapter 5 of title 13, U.S.C., and
as approved for these purposes by the IRS
according to procedures reflected in the
September 15, 2000, inter-agency agree-
ment described above and§301.6103(j)(1)–
1(d) of the regulations.
Summary of Comments
With respect to the three comments re-
ceived in response to the temporary regu-
lations, two strongly supported, and one
objected to, the additional disclosure of tax
information to the Bureau of the Census.
Specifically, two of the comments sup-
ported the additions to the list of items of
tax information disclosed to the Bureau of
the Census for use in the SIPP project. One
comment stated that these additional dis-
closures to the Census Bureau will make
it possible to provide an accurate mea-
sure of prospective pension benefits that is
critically important in providing estimates
of the future economic well-being of an in-
creasingly large segment of the popula-
tion and will provide legislators, policy
analysts, and researchers with a much more
2003–9 I.R.B.536March 3, 2003

useful measure of the net government trans-
fers to different households than that pro-
vided by the current SIPP. These additional
disclosures will also provide a crucial source
of information for assessing potential re-
forms of the Social Security System, ac-
cording to the comment.
The third comment expressed opposi-
tion to the compiling of data by the Bu-
reau of Census beyond that necessary to
determine population distribution for the
purpose of legislative redistricting. This ob-
jection does not recognize that the Bu-
reau of the Census is authorized under
chapter 5 of title 13, U.S.C., to conduct
various demographic, economic, and agri-
cultural statistics programs and censuses and
related program evaluation that includes the
LEHD and SIPP projects. Therefore, the
comment was not adopted.
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 determined
that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does not
apply to these regulations, and because the
regulations do not impose a collection of
information on small entities, the Regula-
tory Flexibility Act (5 U.S.C. chapter 6)
does not apply. Pursuant to section 7805(f)
of the Code, the notice of proposed rule-
making preceding these regulations was
submitted to the Chief Counsel for Advo-
cacy of the Small Business Administra-
tion for comment on its impact on small
business.
Drafting Information
The principal author of these regula-
tions is Christine Irwin, Office of the As-
sociate Chief Counsel, Procedure &
Administration (Disclosure & Privacy Law
Division).
*****
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR part 301 is
amended as follows:
PART 301—PROCEDURE AND
ADMINISTRATION
Paragraph 1. The authority citation for
part 301 is amended by removing the en-
try for“Section 301.6103(j)(1)–lT”and con-
tinues to read in part as follows:
Authority: 26 U.S.C. 7805***
Par. 2. Section 301.6103(j)(1)–1isre-
vised to read as follows:
§301.6103(j)(1)–1 Disclosures of return
information reflected on returns to
officers and employees of the
Department of Commerce for certain
statistical purposes and related
activities.
(a)General rule.Pursuant to the pro-
visions of section 6103(j)(1) of the Inter-
nal Revenue Code and subject to the
requirements of paragraph (d) of this sec-
tion, officers or employees of the Internal
Revenue Service will disclose return in-
formation (as defined by section 6103(b)(2)
but not including return information de-
scribed in section 6103(o)(2)) reflected on
returns to officers and employees of the De-
partment of Commerce to the extent, and
for such purposes as may be, provided by
paragraphs (b) and (c) of this section. Fur-
ther, in the case of any disclosure of re-
turn information reflected on returns so
provided by paragraphs (b) and (c) of this
section, the tax period or accounting pe-
riod to which such information relates will
also be disclosed.“Return information re-
flected on returns”includes, but is not lim-
ited to, information on returns, information
derived from processing such returns, and
information derived from the Social Secu-
rity Administration and other sources for the
purposes of establishing and maintaining
taxpayer information relating to returns.
(b)Disclosure of return information re-
flected on returns to officers and employ-
ees of the Bureau of the Census.
(1) Officers or employees of the Inter-
nal Revenue Service will disclose the fol-
lowing return information reflected on
returns of individual taxpayers to officers
and employees of the Bureau of the Cen-
sus for purposes of, but only to the ex-
tent necessary in, conducting and preparing,
as authorized by chapter 5 of title 13,
United States Code, intercensal estimates
of population and income for all geographic
areas included in the population estimates
program and demographic statistics pro-
grams, censuses, and related program
evaluation:
(i) Taxpayer identity information (as de-
fined in section 6103(b)(6) of the Internal
Revenue Code), validity code with respect
to the taxpayer identifying number (as de-
scribed in section 6109), and taxpayer iden-
tity information of spouse and dependents,
if reported.
(ii) Location codes (including area/district
office and campus/service center codes).
(iii) Marital status.
(iv) Number and classification of re-
ported exemptions.
(v) Wage and salary income.
(vi) Dividend income.
(vii) Interest income.
(viii) Gross rent and royalty income.
(ix) Total of—
(A) Wages, salaries, tips, etc.;
(B) Interest income;
(C) Dividend income;
(D) Alimony received;
(E) Business income;
(F) Pensions and annuities;
(G) Income from rents, royalties, part-
nerships, estates, trusts, etc.;
(H) Farm income;
(I) Unemployment compensation; and
(J) Total Social Security benefits.
(x) Adjusted gross income.
(xi) Type of tax return filed.
(xii) Entity code.
(xiii) Code indicators for Form 1040,
Form 1040 (Schedules A, C, D, E, F, and
SE), and Form 8814.
(xiv) Posting cycle date relative to fil-
ing.
(xv) Social Security benefits.
(2) Officers or employees of the Inter-
nal Revenue Service will disclose to offic-
ers and employees of the Bureau of the
Census for purposes of, but only to the ex-
tent necessary in, conducting, as autho-
rized by chapter 5 of title 13, United States
Code, demographic, economic, and agri-
cultural statistics programs and censuses and
related program evaluation—
(i) From the business master files of the
Internal Revenue Service—the taxpayer
name directory and entity records consist-
ing of taxpayer identity information (as de-
fined in section 6103(b)(6)) with respect to
taxpayers engaged in a trade or business,
the principal industrial activity code, the fil-
ing requirement code, the employment code,
the physical location, the location codes (in-
cluding area/district office and campus/
service center codes), and monthly
corrections of, and additions to, such en-
tity records;
(ii) From Form SS–4—all information
reflected on such form;
(iii) From an employment tax return—
March 3, 20035372003–9 I.R.B.

(A) Taxpayer identifying number (as de-
scribed in section 6109) of the employer;
(B) Total compensation reported;
(C) Master file tax account code (MFT);
(D) Taxable period covered by such re-
turn;
(E) Employer code;
(F) Document locator number;
(G) Record code;
(H) Total number of individuals em-
ployed in the taxable period covered by the
return;
(I) Total taxable wages paid for pur-
poses of chapter 21; and
(J) Total taxable tip income reported for
purposes of chapter 21;
(iv) From Form 1040 (Schedule SE)—
(A) Taxpayer identifying number of self-
employed individual;
(B) Business activities subject to the tax
imposed by chapter 21;
(C) Net earnings from farming;
(D) Net earnings from nonfarming ac-
tivities;
(E) Total net earnings from self-
employment; and
(F) Taxable self-employment income for
purposes of chapter 2;
(v) Total Social Security taxable earn-
ings; and
(vi) Quarters of Social Security cover-
age.
(3) Officers or employees of the Inter-
nal Revenue Service will disclose the fol-
lowing business related return information
reflected on returns of taxpayers to offic-
ers and employees of the Bureau of the
Census for purposes of, but only to the ex-
tent necessary in, conducting and prepar-
ing, as authorized by chapter 5 of title 13,
United States Code, demographic and eco-
nomic statistics programs, censuses, and sur-
veys. (The“returns of taxpayers”include,
but are not limited to: Form 941; Form 990
series; Form 1040 series and Schedules C
and SE; Form 1065 and all attending sched-
ules and Form 8825; Form 1120 series and
all attending schedules and Form 8825;
Form 851; Form 1096; and other busi-
ness returns, schedules and forms that the
Internal Revenue Service may issue.):
(i) Taxpayer identity information (as de-
fined in section 6103(b)(6)) including par-
ent corporation, shareholder, partner, and
employer identity information.
(ii) Gross income, profits, or receipts.
(iii) Returns and allowances.
(iv) Cost of labor, salaries, and wages.
(v) Total expenses or deductions.
(vi) Total assets.
(vii) Beginning- and end-of-year inven-
tory.
(viii) Royalty income.
(ix) Interest income, including portfo-
lio interest.
(x) Rental income, including gross rents.
(xi) Tax-exempt interest income.
(xii) Net gain from sales of business
property.
(xiii) Other income.
(xiv) Total income.
(xv) Percentage of stock owned by each
shareholder.
(xvi) Percentage of capital ownership of
each partner.
(xvii) End-of-year code.
(xviii) Months actively operated.
(xix) Principal industrial activity code,
including the business description.
(xx) Total number of documents and the
total amount reported on the Form 1096
transmitting Forms 1099–MISC.
(xxi) Form 941 indicator and business
address on Form 1040 (Schedule C).
(xxii) Consolidated return indicator.
(xxiii) Wages, tips, and other compen-
sation.
(xxiv) Social Security wages.
(xxv) Deferred wages.
(xxvi) Social Security tip income.
(xxvii) Total Social Security taxable
earnings.
(xxviii) Gross distributions from
employer-sponsored and individual retire-
ment plans from Form 1099–R.
(4) Officers or employees of the Inter-
nal Revenue Service will disclose return in-
formation reflected on returns of taxpayers
contained in the exempt organization mas-
ter files of the Internal Revenue Service to
officers and employees of the Bureau of the
Census for purposes of, but only to the ex-
tent necessary in, conducting and prepar-
ing, as authorized by chapter 5 of title 13,
United States Code, economic censuses.
This return information reflected on re-
turns of taxpayers consists of taxpayer iden-
tity information (as defined in section
6103(b)(6)), activity codes, and filing re-
quirement code, and monthly corrections of,
and additions to, such information.
(5) Subject to the requirements of para-
graph (d) of this section and§301.6103(p)
(2)(B)–1, officers or employees of the So-
cial Security Administration to whom the
following return information reflected on re-
turns has been disclosed as provided by sec-
tion 6103(l)(1)(A) or (l)(5) may disclose
such information to officers and employ-
ees of the Bureau of the Census for nec-
essary purposes described in paragraph
(b)(2) or (3) of this section:
(i) From Form SS–4—all information re-
flected on such form.
(ii) From Form 1040 (Schedule SE)—
(A) Taxpayer identifying number of self-
employed individual;
(B) Business activities subject to the tax
imposed by chapter 21;
(C) Net earnings from farming;
(D) Net earnings from nonfarming ac-
tivities;
(E) Total net earnings from self-
employment; and
(F) Taxable self-employment income for
purposes of chapter 2.
(iii) From Form W–2, and related forms
and schedules—
(A) Social Security number;
(B) Employer identification number;
(C) Wages, tips, and other compensa-
tion;
(D) Social Security wages; and
(E) Deferred wages.
(iv) Total Social Security taxable earn-
ings.
(v) Quarters of Social Security cover-
age.
(6)(i) Officers or employees of the In-
ternal Revenue Service will disclose the fol-
lowing return information (but not including
return information described in section
6103(o)(2)) reflected on returns of corpo-
rations with respect to the tax imposed by
chapter 1 to officers and employees of the
Bureau of the Census for purposes of, but
only to the extent necessary in, develop-
ing and preparing, as authorized by law, the
Quarterly Financial Report:
(A) From the business master files of the
Internal Revenue Service—
(1) Taxpayer identity information (as de-
fined in section 6103(b)(6)), including par-
ent corporation identity information;
(2) Document code;
(3) Location codes (including area/district
office and campus/service center codes);
(4) Consolidated return and final re-
turn indicators;
(5) Principal industrial activity code;
(6) Partial year indicator;
(7) Annual accounting period;
(8) Gross receipts less returns and al-
lowances; and
2003–9 I.R.B.538March 3, 2003

(9) Total assets.
(B) From Form SS–4—
(1) Month and year in which such form
was executed;
(2) Taxpayer identity information; and
(3) Principal industrial activity, geo-
graphic, firm size, and reason for applica-
tion codes.
(ii) Subject to the requirements of
paragraph (d) of this section and
§301.6103(p)(2)(B)–1, officers or employ-
ees of the Social Security Administration
to whom return information reflected on re-
turns of corporations described in para-
graph (b)(6)(i)(B) of this section has been
disclosedasprovidedbysection
6103(l)(1)(A) or (l)(5) may disclose such
information to officers and employees of the
Bureau of the Census for a purpose de-
scribed in this paragraph (b)(6).
(iii) Return information reflected on em-
ployment tax returns disclosed pursuant to
paragraphs (b)(2)(iii)(A), (B), (D), (I) and
(J) of this section may be used by offi-
cers and employees of the Bureau of the
Census for the purpose described in and
subject to the limitations of this paragraph
(b)(6).
(c)Disclosure of return information re-
flected on returns of corporations to offi-
cers and employees of the Bureau of
Economic Analysis.(1) Officers or em-
ployees of the Internal Revenue Service will
disclose to officers and employees of the
Bureau of Economic Analysis for purposes
of, but only to the extent necessary in, con-
ducting and preparing, as authorized by law,
statistical analyses return information con-
sisting of Statistics of Income transcript-
edit sheets containing return information
reflected on returns of designated classes
or categories of corporations with respect
to the tax imposed by chapter 1 of the In-
ternal Revenue Code and microfilmed
records of return information reflected on
such returns where needed for further use
in connection with such conduct or prepa-
ration.
(2) Subject to the requirements of
paragraph (d) of this section and
§301.6103(p)(2)(B)–1, officers and em-
ployees of the Social Security Administra-
tion to whom the following return
information reflected on returns of desig-
nated classes or categories of corpora-
tions has been disclosed as provided by
section 6103(l)(1)(A) or (l)(5) may dis-
close such information to officers and em-
ployees of the Bureau of Economic Analysis
for necessary purposes described in para-
graph (c)(1) of this section:
(i) From Form SS–4—Principal indus-
trial activity and geographic codes.
(ii) From an employment tax return—
(A) Total compensation reported; and
(B) Taxable wages paid for purposes of
chapter 21 to each employee.
(d)Procedures and restrictions.Disclo-
sure of return information reflected on re-
turns by officers or employees of the
Internal Revenue Service or the Social Se-
curity Administration as provided by para-
graphs (b) and (c) of this section will be
made only upon written request to the Com-
missioner of Internal Revenue by the Sec-
retary of Commerce describing—
(1) The particular return information re-
flected on returns to be disclosed;
(2) The taxable period or date to which
such return information reflected on re-
turns relates; and
(3)(i) The particular purpose for which
the return information reflected on returns
is to be used, and designating by name and
title the officers and employees of the Bu-
reau of the Census or the Bureau of Eco-
nomic Analysis to whom such disclosure is
authorized.
(ii) No such officer or employee to
whom return information reflected on re-
turns is disclosed pursuant to the provi-
sions of paragraph (b) or (c) of this section
shall disclose such information to any per-
son, other than the taxpayer to whom such
return information reflected on returns re-
lates or other officers or employees of such
bureau whose duties or responsibilities re-
quire such disclosure for a purpose de-
scribed in paragraph (b) or (c) of this
section, except in a form which cannot be
associated with, or otherwise identify, di-
rectly or indirectly, a particular taxpayer. If
the Internal Revenue Service determines that
the Bureau of the Census or the Bureau of
Economic Analysis, or any officer or em-
ployee thereof, has failed to, or does not,
satisfy the requirements of section
6103(p)(4) of the Internal Revenue Code or
regulations or published procedures there-
under (see§601.601(d)(2) of this chap-
ter), the Internal Revenue Service may take
such actions as are deemed necessary to en-
sure that such requirements are or will be
satisfied, including suspension of disclo-
sures of return information reflected on re-
turns otherwise authorized by section 6103
(j)(1) and paragraph (b) or (c) of this sec-
tion, until the Internal Revenue Service de-
termines that such requirements have been
or will be satisfied.
(e)Effective date.This section is appli-
cable to the Bureau of the Census on Janu-
ary 21, 2003.
§301.6103(j)(1)–1T [Removed]
Par. 3. Section 301.6103(j)(1)–1T is re-
moved.
David A. Mader,
Assistant Deputy Commissioner of
Internal Revenue.
Approved December 20, 2002.
Pamela F. Olson,
Assistant Secretary of the
Treasury (Tax Policy).
(Filed by the Federal Register on January 17, 2003, 8:45 a.m.,
and published in the issue of the Federal Register for Janu-
ary 21, 2003, 68 F.R. 2691)
March 3, 20035392003–9 I.R.B.

Part III. Administrative, Procedural, and Miscellaneous
Proposed Revenue Procedure
Regarding Finality of
Adoptions
Notice 2003–15
This notice provides a proposed rev-
enue procedure that would establish cer-
tain safe harbors for determining the finality
of the adoption of a foreign-born child for
purposes of the adoption credit and the ex-
clusion for employer-provided assistance for
qualified adoption expenses.
The proposed revenue procedure ap-
plies to qualified adoption expenses paid or
incurred in connection with the adoption of
a foreign-born child who has received an
“immediate relative”(IR) visa from the De-
partment of State. The Department of State
issues an IR visa only to a foreign-born
child who enters the United States pursu-
ant to a decree of adoption or guardian-
ship granted by a court or other
governmental agency (“competent author-
ity”) with jurisdiction over child welfare
matters in a foreign-sending country. Thus,
the proposed revenue procedure does not
apply to the adoption of a child who is a
citizen or resident of the United States at
the time the adoption proceedings com-
mence.
The proposed revenue procedure pro-
vides that a taxpayer may treat an adop-
tion of a foreign-born child who receives
an IR–3 visa as final for federal income tax
purposes in the taxable year in which the
competent authority enters a decree of adop-
tion. The adoption of a foreign-born child
who receives an IR–4 visa and enters the
United States under a guardianship or le-
gal custody arrangement may be treated as
final for federal income tax purposes in the
taxable year in which a court of the home
state enters a decree of adoption. A tax-
payer who adopts a foreign-born child who
receives an IR–2 visa, or who receives an
IR–4 visa and enters the United States un-
der a decree of simple adoption, may treat
the adoption as final for federal income tax
purposes in the taxable year in which a
home state court enters a decree of re-
adoption or the home state otherwise rec-
ognizes the adoption decree of the foreign-
sending country.
The Service requests general comments
on the proposed revenue procedure. The
Service also requests specific comments on
the following matters:
(1) Whether other specified events (such
as the date on which a foreign-born child
obtains United States citizenship) should be
treated as safe harbors, either in addition to
or in lieu of events provided in the pro-
posed revenue procedure;
(2) Whether the term“enters a decree of
adoption”is sufficiently precise (in light of
variations in the laws of foreign countries
and of states within the United States, and
of the possibility that a decree of adop-
tion might be appealed or otherwise con-
tested) to establish a reliable date for
determining the finality of an adoption, and
if not, what term is more precise; and
(3) Whether the phrase“the taxable year
in which a home state court enters a de-
cree of re-adoption or the home state oth-
erwise recognizes the adoption decree of the
foreign-sending country”is sufficiently
broad to encompass the manner in which
various states acknowledge the existence of
a parent-child relationship and, if not, what
phrase is more encompassing.
Comments should be submitted by June
2, 2003, either to:
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044
Attn: CC:PA:T:CRU (ITA)
Room 5529
or electronically at:Notice.Comments@
irscounsel.treas.gov(the Service’s com-
ments e-mail address). All comments are
available for public inspection and copy-
ing.
Although the revenue procedure is in
proposed form, the Internal Revenue Ser-
vice will not challenge the finality of adop-
tions by taxpayers who apply the proposed
revenue procedure in any taxable years for
which the period of limitation under§6511
of the Internal Revenue Code has not ex-
pired on February 11, 2003.
Rev. Proc. 2003—
SECTION 1. PURPOSE
This revenue procedure provides cer-
tain safe harbors for establishing the final-
ity of the adoption of a foreign-born child
for federal income tax purposes.
SECTION 2. BACKGROUND
.01 Section 23 of the Internal Revenue
Code allows a credit for qualified adop-
tion expenses paid or incurred by an indi-
vidual in connection with the adoption of
an eligible child. Section 137 allows an ex-
clusion from an employee’s gross income
for qualified adoption expenses paid or in-
curred by the employer under an adop-
tion assistance program. See Notice 97–9,
1997–1 C.B. 365, for general guidance con-
cerning the credit under§23 and the ex-
clusion under§137.
.02 Section 23(d)(2) provides that an eli-
gible child includes any individual who has
not attained age 18, or who is physically
or mentally incapable of caring for him-
self. However, under§23(d)(1)(C), no credit
or exclusion is allowed for the adoption of
a stepchild.
.03 Section 23(a)(2) provides the gen-
eral rule that, for qualified adoption ex-
penses paid or incurred in a taxable year
before the adoption is final, the credit is al-
lowed in the next taxable year after the tax-
able year in which the qualified adoption
expenses are paid or incurred. For quali-
fied adoption expenses paid or incurred dur-
ing or after the taxable year in which the
adoption is final, the credit is allowed in the
taxable year in which the qualified adop-
tion expenses are paid or incurred.
.04 Section 23(e) provides, in the case
of an adoption of an otherwise eligible child
who is not a citizen or resident of the
United States at the time the adoption com-
mences (“foreign adoption”), that: (1) the
credit is allowed only if the adoption be-
comes final, and (2) qualified adoption ex-
penses paid or incurred in any taxable year
before the taxable year in which the adop-
tion becomes final are treated as paid or in-
curred in the taxable year in which the
adoption becomes final. Similar rules ap-
ply for purposes of the exclusion under
§137 for employer-provided adoption as-
sistance.
.05 Therefore, for a foreign adoption,
qualified adoption expenses paid or in-
curred before the taxable year in which the
adoption becomes final, or during the tax-
able year in which the adoption becomes
final, are allowed as a credit under§23 in
the taxable year in which the adoption be-
comes final. Similarly, the exclusion un-
der§137 for amounts furnished by an emp-
2003–9 I.R.B.540March 3, 2003

loyer before or during the taxable year in
which a foreign adoption becomes final is
allowed for the taxable year in which the
adoption becomes final.
SECTION 3. SCOPE
This revenue procedure applies to tax-
payers who claim the adoption credit or ex-
clusion for qualified adoption expenses
related to a foreign-born child. This rev-
enue procedure does not apply to taxpay-
ers who adopt or attempt to adopt an
eligible child who is a United States citi-
zen or resident at the time the adoption pro-
cedure commences.
SECTION 4. DEFINITIONS
.01Foreign-born child.An individual
who is not a citizen or resident of the
United States at the time the adoption com-
mences but who is otherwise an eligible
child within the meaning of§23(d)(2).
.02Orphan.A foreign-born child un-
der the age of 16 at the time an immigra-
tion petition is filed on the child’s behalf
who has suffered the death or disappear-
ance of, abandonment or desertion by, or
separation or loss from, both parents, or for
whom the sole or surviving parent is in-
capable of providing the proper care and has
in writing irrevocably released the foreign-
born child for emigration and adoption.
.03Foreign-sending country.The coun-
try of citizenship of a foreign-born child,
or if the foreign-born child is not perma-
nently residing in the country of citizen-
ship, the country of the child’s habitual
residence before adoption.
.04Competent authority.A court or gov-
ernmental agency of the foreign-sending
country with jurisdiction and authority to
make decisions in matters of child wel-
fare, including adoption (as provided in 8
C.F.R.§204.3 (2001)).
.05Home state.The state (including the
District of Columbia and possessions) in
which the adopted child and adoptive par-
ents make their habitual residence in the
United States.
.06Full and final adoption.An adop-
tion of an orphan in which the competent
authority of the foreign-sending country en-
ters a decree of adoption establishing a
parent-child relationship and both adop-
tive parents (in adoptions by two parents)
or the sole adoptive parent (in adoptions by
one parent) see the orphan before or dur-
ing the adoption proceeding.
.07Simple adoption.An adoption of a
foreign-born child in which the compe-
tent authority of the foreign-sending coun-
try enters a decree of adoption establishing
a parent-child relationship under the laws
of that foreign-sending country, but in which
either (1) one or both of the adoptive par-
ents do not see the foreign-born child be-
fore or during the adoption proceeding (in
the case of an orphan receiving an IR–4
visa), or (2) the foreign-born child receives
an IR–2 visa.
.08Re-adoption.An adoption or other
recognition proceeding under home state
law occurring subsequent to the entry of a
foreign-born child into the United States on
an IR–4orIR–2 visa.
.09IR–2 visa.A visa issued to a foreign-
born child adopted while under the age of
16 years who has been in the legal cus-
tody of, and has resided with, the adop-
tive parent or parents for at least 2 years.
.10IR–3 visa.A visa issued to an or-
phan after a full and final adoption of the
orphan has occurred in the foreign-sending
country. An IR–3 visa is issued if: (1) the
competent authority of the foreign-sending
country severs the parental rights of the bio-
logical or any previous adoptive parents and
establishes a parent-child relationship be-
tween the orphan and the adoptive parent
or parents, and (2) both adoptive parents (in
adoptions by two parents) or the sole adop-
tive parent (in adoptions by one parent) see
the orphan before or during the adoption
proceeding.
.11IR–4 visa.An IR–4 visa issued to an
orphan if: (1) the competent authority of the
foreign-sending country grants legal guard-
ianship or custody either to the prospec-
tive adoptive parent or parents or to an
individual or agency acting on behalf of the
prospective adoptive parent or parents, or
(2) a simple adoption occurs in the foreign-
sending country.
SECTION 5. APPLICATION
.01IR–3 visa.If a taxpayer adopts an or-
phan in a full and final adoption and the or-
phan receives an IR–3 visa, the taxpayer
may treat the adoption as final for federal
income tax purposes in the taxable year in
which the competent authority enters the de-
cree of adoption.
.02IR–4 visa.A taxpayer who adopts an
orphan who receives an IR–4 visa and en-
ters the United States under a guardian-
ship or legal custody arrangement may treat
the adoption as final for federal income tax
purposes in the taxable year in which a
home state court enters a decree of adop-
tion. A taxpayer who adopts an orphan who
receives an IR–4 visa and enters the United
States under a decree of simple adoption
may treat the adoption as final for federal
income tax purposes in the taxable year in
which a home state court enters a decree
of re-adoption or the home state other-
wise recognizes the adoption decree of the
foreign-sending country.
.03IR–2 visa.A taxpayer who adopts a
foreign-born child who receives an IR–2
visa may treat the adoption as final for fed-
eral income tax purposes in the taxable year
in which a home state court enters a de-
cree of re-adoption or the home state oth-
erwise recognizes the adoption decree of the
foreign-sending country.
SECTION 6. EFFECTIVE DATE
This revenue procedure is effective for
expenses paid or incurred after [date of pub-
lication of final revenue procedure]. How-
ever, the Service will not challenge the
finality of adoptions by taxpayers who ap-
ply this revenue procedure in any taxable
year for which the period of limitation un-
der§6511 has not expired.
DRAFTING INFORMATION
The principal author of this notice is
Marilyn E. Brookens of the Office of As-
sociate Chief Counsel (Income Tax & Ac-
counting). For further information regarding
this notice, contact Ms. Brookens at (202)
622–4920 (not a toll-free call).
March 3, 20035412003–9 I.R.B.

Part IV. Items of General Interest
Notice of Proposed Rulemak-
ing by Cross-Reference to
Temporary Regulations; No-
tice of Public Hearing; and
Withdrawal of Previous Notice
of Proposed Rulemaking
Statutory Mergers and
Consolidations
REG–126485–01
AGENCY: Internal Revenue Service (IRS),
Treasury.
ACTION: Notice of proposed rulemak-
ing by cross-reference to temporary regu-
lations; notice of public hearing; and
withdrawal of previous notice of proposed
rulemaking.
SUMMARY: In T.D. 9038 on page 524 of
this issue of the Bulletin, the IRS is issu-
ing temporary regulations relating to trans-
actions involving corporations engaging in
statutory mergers and consolidations. The
text of those regulations also serves as the
text of these proposed regulations. This
document also provides notice of a pub-
lic hearing on these proposed regulations.
This document also withdraws the notice
of proposed rulemaking published in the
Federal Register(REG–126485–01,
2001–2 C.B. 555 [66 FR 57400]) on No-
vember 15, 2001.
DATES: Written or electronic comments
and outlines of topics to be discussed at the
public hearing scheduled for May 21, 2003,
at 10 a.m. must be received by April 24,
2003.
ADDRESSES: Send submissions to:
CC:ITA:RU (REG–126485–01), room 5226,
Internal Revenue Service, POB 7604, Ben
Franklin Station, Washington, DC 20044.
Submissions may be hand delivered Mon-
day through Friday between the hours of
8 a.m. and 5 p.m. to: CC:ITA:RU (REG–
126485–01), Courier’s Desk, Internal Rev-
enue Service,1111Constitution Avenue
NW, Washington, DC. Alternatively, tax-
payers may submit electronic comments di-
rectly to the IRS Internet site at
www.irs.gov/regs.The public hearing will
be held in room 4718 of the Internal Rev-
enue Building,1111Constitution Avenue
NW, Washington, DC.
FOR FURTHER INFORMATION CON-
TACT: Concerning the proposed regula-
tions, Richard M. Heinecke or Reginald
Mombrun at (202) 622–7930; concerning
submissions of comments, the hearing,
and/or to be placed on the building ac-
cess list to attend the hearing, Guy R.
Traynor, (202) 622–7180 (not toll-free num-
bers).
SUPPLEMENTARY INFORMATION:
Background and Explanation of
Provisions
On November 15, 2001, the IRS and
Treasury published in theFederal Regis-
terat 66 FR 57400 a notice of proposed
rulemaking (REG–126485–01) under sec-
tion 368(a)(1)(A) of the Internal Revenue
Code of 1986 (Code). Those proposed regu-
lations are withdrawn.
Temporary regulations on page 524 of
this issue of the Bulletin amend the In-
come Tax Regulations (26 CFR part 1) re-
lating to section 368(a)(1)(A). The
temporary regulations set forth certain defi-
nitions and explanations with respect to cer-
tain transactions that qualify as statutory
mergers and consolidations. The text of
those regulations also serves as the text of
these proposed regulations. The preamble
to the temporary regulations explains the
amendments.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in Ex-
ecutive Order 12866. Therefore, a regulatory
assessment 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,
and because these regulations do not im-
pose a collection of information on small
entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursu-
ant to section 7805(f) of the Code, this no-
tice of proposed rulemaking will be
submitted to the Chief Counsel for Advo-
cacy of the Small Business Administra-
tion for comment on their impact.
Comments and Requests for a Public
Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any written comments (a
signed original and eight (8) copies) or elec-
tronic comments that are submitted timely
to the IRS. The IRS and Treasury Depart-
ment specifically request comments on the
clarity of the proposed rule and how it may
be made easier to understand. All com-
ments will be available for public inspec-
tion and copying.
A public hearing has been scheduled for
May 21, 2003, beginning at 10 a.m. in room
4718 of the Internal Revenue Building,1111
Constitution Avenue, NW, Washington, DC.
Due to building security procedures, visi-
tors must enter at the Constitution Av-
enue entrance. In addition, all visitors must
present photo identification to enter the
building. Because of access restrictions, visi-
tors will not be admitted beyond the im-
mediate entrance area more than 30 minutes
before the hearing starts. For information
about having your name placed on the
building access 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 April 24, 2003. A
period 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 receiv-
ing 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 Richard M. Heinecke, Office of As-
sociate Chief Counsel (Corporate). However,
other personnel from the IRS and Trea-
sury Department participated in their de-
velopment.
*****
2003–9 I.R.B.542March 3, 2003

Withdrawal of Proposed Amendments
Accordingly, under the authority of 26
U.S.C. 7805, the proposed amendment to
26 CFR part 1 that was published in the
Federal Registeron Thursday, Novem-
ber 15, 2001 (66 FR 57400) is withdrawn.
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
PA RT 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805***
Par.2.In§1.368–2, paragraph (b)(1) is
revised to read as follows:
§1.368–2 Definition of terms.
[The text of proposed§1.368–2isthe
same as the text of§1.368–2T published
elsewhere in this issue of theFederal Reg-
ister.]
David A. Mader,
Assistant Deputy Commissioner
of Internal Revenue.
(Filed by the Office of the Federal Register on January 23,
2003, 8:45 a.m., and published in the issue of the Federal Reg-
ister for January 24, 2003, 68 F.R. 3477)
Notice of Proposed Rulemak-
ing and Notice of Public
Hearing
Noncompensatory
Partnership Options
REG–103580–02
AGENCY: Internal Revenue Service (IRS),
Treasury.
ACTION: Notice of proposed rulemak-
ing and notice of public hearing.
SUMMARY: This document contains pro-
posed regulations relating to the tax treat-
ment of noncompensatory options and
convertible instruments issued by a part-
nership. The proposed regulations gener-
ally provide that the exercise of a
noncompensatory option does not cause the
recognition of immediate income or loss by
either the issuing partnership or the op-
tion holder. The proposed regulations also
modify the regulations under section 704(b)
regarding the maintenance of the partners’
capital accounts and the determination of
the partners’distributive shares of partner-
ship items. Additionally, the proposed regu-
lations contain a characterization rule
providing that the holder of a noncompen-
satory option is treated as a partner under
certain circumstances. This document also
provides a notice of public hearing on these
proposed regulations.
DATES: Written or electronic comments
must be received by April 29, 2003. Re-
quests to speak and outlines of oral com-
ments to be discussed at the public hearing
scheduled for May 20, 2003, at 10 a.m.
must be received by April 29, 2003.
ADDRESSES: Send submissions to:
CC:ITA:RU (REG–103580–02), room 5226,
Internal Revenue Service, POB 7604, Ben
Franklin Station, Washington, DC 20044.
Submissions may be hand delivered Mon-
day through Friday between the hours of
8 a.m. and 4 p.m. to: CC:ITA:RU (REG–
103580–02), Courier’s Desk, Internal Rev-
enue Service,1111Constitution Avenue,
NW, Washington, DC. Alternatively, tax-
payers may submit comments electroni-
cally directly to the IRS internet site at
www.irs.gov/regs.The public hearing will
be held in room 4718, Internal Revenue
Building,1111Constitution Avenue, NW,
Washington, DC.
FOR FURTHER INFORMATION CON-
TACT: Concerning the regulations,
Audrey W. Ellis, (202) 622–3060; concern-
ing submissions, the hearing, and/or to be
placed on the building access list to at-
tend the hearing, Treena Garrett, (202) 622–
7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
In a variety of situations, partnerships is-
sue options or convertible instruments that
allow the holder to acquire by purchase or
conversion an equity interest in the part-
nership. On June 5, 2000, Treasury and the
IRS issued Notice 2000–29, 2000–1 C.B.
1241, inviting public comment on the fed-
eral income tax treatment of the exercise
of an option to acquire a partnership inter-
est, the exchange of convertible debt for a
partnership interest, and the exchange of a
preferred interest in a partnership for a com-
mon interest in that partnership.
In response to Notice 2000–29, Trea-
sury and the IRS received a number of
comments. Many commentators requested
guidance on the treatment of options and
other instruments that are issued by part-
nerships in connection with the perfor-
mance of services (compensatory options).
These proposed regulations apply to cer-
tain call options, warrants, convertible debt,
and convertible preferred equity that are not
issued in connection with the performance
of services (noncompensatory options). To
expedite the issuance of guidance, these
regulations do not address compensatory op-
tions. Nothing in the proposed regulations
should be construed as creating any infer-
ence regarding the proper federal income
tax treatment of compensatory options.
However, Treasury and the IRS are work-
ing on future guidance that will address the
federal income tax consequences of com-
pensatory options and invite comments. In
particular, Treasury and the IRS request
comments on the proposed amendment to
§1.721–1(b)(1) that was published in the
Federal Registeron June 3, 1971 (36 FR
10787), and, more particularly, on the ap-
plication of section 83 to the issuance of
compensatory options and partnership capi-
tal interests in connection with the perfor-
mance of services. In addition, Treasury and
the IRS request comments on how to co-
ordinate the tax treatment of partnership
profits interests issued in connection with
the performance of services (see Rev. Proc.
93–27, 1993–2 C.B. 343, as clarified in Rev.
Proc. 2001–43, 2001–2 C.B. 191) with the
tax treatment of options to acquire part-
nership capital interests issued in connec-
tion with the performance of services.
Explanation of Provisions
1. Scope of Proposed Regulations
The proposed regulations describe cer-
tain of the income tax consequences of is-
suing,transferring,andexercising
noncompensatory options. These proposed
regulations apply only if the call option,
warrant, or conversion right entitles the
holder to the right to acquire an interest in
the issuer (or to cash or property having a
value equal to the value of such an inter-
est).
The proposed regulations generally pro-
vide that the exercise of a noncompensa-
tory option does not cause recognition of
March 3, 20035432003–9 I.R.B.

gain or loss to either the issuing partner-
ship or the option holder. In addition, the
proposed regulations modify the regula-
tions under section 704(b) regarding the
maintenance of the partners’capital ac-
counts and the determination of the part-
ners’distributive shares of partnership items.
Finally, the proposed regulations contain a
characterization rule providing that the
holder of a call option, warrant, convert-
ible debt, or convertible preferred equity is-
sued by a partnership (or an eligible entity,
as defined in§301.7701–3(a), that would
become a partnership if the option holder
were treated as a partner) is treated as a
partner under certain circumstances.
The rule providing for nonrecognition of
gain or loss on the exercise of a noncom-
pensatory option does not apply to any call
option, warrant, or convertible debt is-
sued by an eligible entity, as defined in
§301.7701–3(a), that would become a part-
nership under§301.7701–3(f)(2) if the op-
tion, warrant, or conversion right were
exercised. Treasury and the IRS request
comments on whether the nonrecognition
rule should be extended to such instru-
ments.
2. Issuance, Exercise, and Lapse of
Noncompensatory Options
Section 721(a) and§1.721–1 provide
that, with certain exceptions, no gain or loss
is recognized to a partnership or any of its
partners on the contribution of property to
a partnership in exchange for an interest in
the partnership. However,§1.721–1 does not
provide clear guidance as to the tax con-
sequences to the holder of a noncompen-
satory option and the partnership upon the
issuance, lapse, and exercise of a noncom-
pensatory option to acquire a partnership in-
terest. Many taxpayers have requested
guidance clarifying the tax consequences of
these transactions.
Generally, the proposed regulations do
not treat the issuance of a noncompensa-
tory option as a transaction described in sec-
tion 721. Therefore, the issuance of a
noncompensatory option is taxed under gen-
eral tax principles. Under these principles,
the issuance of a noncompensatory call op-
tion or warrant (stand-alone option) is gen-
erally an open transaction for the issuer. The
issuer’s income or loss from the noncom-
pensatory stand-alone option does not be-
come fixed and determinable until the lapse,
exercise, repurchase, or other termination
of the option. For the holder of the non-
compensatory stand-alone option, the pur-
chase of the option is merely an investment
in the option—a capital expenditure that
is neither taxable to nor deductible by the
holder. See Rev. Rul 78–182, 1978–1 C.B.
265. However, if the holder uses appreci-
ated or depreciated property (property with
a value greater or less than the holder’s ba-
sis in the property) to acquire the noncom-
pensatory stand-alone option, then the
holder recognizes gain or loss in accor-
dance with the provisions of section 1001,
subject to the generally applicable rules gov-
erning the allowance of losses, such as sec-
tion 707(b).
The proposed regulations do not change
the rules relating to the issuance of con-
vertible debt or convertible equity. Under
general tax principles, the conversion right
embedded in convertible debt or convert-
ible equity typically is taken into account
for tax purposes as part of the underlying
instrument.
The proposed regulations also provide
guidance on the tax consequences result-
ing from the exercise of a noncompensa-
tory option. Section 1.721–1(b) provides
that, to the extent that a partner gives up
his right to be repaid all or a portion of his
capital contribution in favor of another part-
ner“as compensation for services (or in sat-
isfaction of an obligation),”section 721 does
not apply. Some commentators have ex-
pressed a concern that this regulation could
be read to exclude from the application of
section 721 a shift in partnership capital
from the historic partners to the holder of
the noncompensatory option in satisfac-
tion of the partnership’s option obligation
upon exercise of the option. If this were the
case, the partnership could be deemed to
have sold a portion of each of its assets to
the holder in a taxable exchange. Alterna-
tively, the partnership could be deemed to
have sold a partnership interest with a $0
basis to the option holder in a taxable ex-
change.
Despite these concerns, most commen-
tators believe that§1.721–1(b)(1) should not
cause the issuance of a partnership inter-
est upon exercise of a noncompensatory op-
tion to be taxable. They assert that the
exercise of such an option should be non-
taxable to the holder and the partnership,
both under general tax principles appli-
cable to noncompensatory options and un-
der the policy of section 721 to facilitate
business combinations through the pool-
ing of capital.
Treasury and the IRS agree that, in gen-
eral, the issuance of a partnership interest
to the holder of a noncompensatory op-
tion should not be taxable to the holder or
the partnership. Upon exercise, the op-
tion holder may be viewed as contribut-
ing property in the form of the premium,
the exercise price, and the option privi-
lege to the partnership in exchange for the
partnership interest. Generally, this is a
transaction to which section 721 should ap-
ply—a transaction through which per-
sons join together in order to conduct a
business or make investments. Accord-
ingly, the proposed regulations generally
provide that section 721 applies to the
holder and the partnership upon the exer-
cise of a noncompensatory option issued by
the partnership.
The proposed regulations do not de-
scribe the tax consequences (to the part-
nership or the holder) of a right to convert
partnership debt into an interest in the is-
suing partnership to the extent of any ac-
crued but unpaid interest on the debt
(including accrued original issue discount).
On the one hand, based onCarman v. Com-
missioner, 189 F.2d 363 (2d Cir. 1951), it
might be argued that the interest obliga-
tion is inseparable from the debt and that
both are property for purposes of section
721. On the other hand, it may be appro-
priate to require a partnership to recog-
nize gain to the extent of the accrued but
unpaid interest, because the issuance of the
partnership interest satisfies a deductible (or
capital) expense of the partnership. As this
issue is closely related to the tax treat-
ment of the exercise of compensatory op-
tions, Treasury and the IRS have decided
to consider this issue in the course of pre-
paring guidance on compensatory options.
Treasury and the IRS request comments on
the proper treatment of the exercise of con-
vertible debt to the extent of accrued, but
unpaid, interest (including original issue dis-
count) on the debt.
The proposed regulations also clarify that
section 721 does not apply to the lapse of
a noncompensatory option. If a noncom-
pensatory option lapses, the former op-
tion holder does not contribute property to
the partnership in exchange for an inter-
est in the partnership. Accordingly, con-
sistent with general tax principles, the lapse
2003–9 I.R.B.544March 3, 2003

of a noncompensatory option generally re-
sults in the recognition of income by the
partnership and the recognition of loss by
the former option holder.
3. Accounting for Noncompensatory
Options
The proposed regulations also contain
rules to assist partnerships in properly ac-
counting for any shifts in capital that may
result from the exercise of noncompensa-
tory options.
Generally, upon the exercise of a non-
compensatory option, the option holder re-
ceives a partnership interest with a value
that is greater or less than the aggregate
value of the premium and exercise price that
the option holder contributes to the part-
nership. In other words, the option privi-
lege represents an asset with built-in gain
or loss,i.e., an asset to which section 704(c)
would apply. However, because the op-
tion privilege terminates upon its contri-
bution to the partnership, the partnership
cannot allocate gain or loss from the op-
tion privilege to the option holder under sec-
tion 704(c)(1)(A). To address this problem,
the proposed regulations generally allow
partnerships to substitute built-in gain or loss
in the partnership’s assets for the built-in
gain or loss in the option.
The proposed regulations achieve this re-
sult by providing that a noncompensatory
option holder’s initial capital account is
equal to the consideration paid to the part-
nership to acquire the noncompensatory op-
tion and the fair market value of any
property (other than the option) contrib-
uted to the partnership on the exercise of
the noncompensatory option. The proposed
regulations then require the partnership to
revalue its property immediately follow-
ing the exercise of the noncompensatory op-
tion, when the holder has become a partner.
Under the proposed regulations, the part-
nership must allocate the unrealized in-
come, gain, loss, and deduction from this
revaluation, first, to the noncompensatory
option holder, to the extent necessary to re-
flect the holder’s right to share in partner-
ship capital under the partnership agreement,
and, then, to the historic partners, to re-
flect the manner in which the unrealized in-
come, gain, loss, or deduction in partnership
property would be allocated among those
partners if there were a taxable disposi-
tion of such property for its fair market
value on that date. To the extent that un-
realized appreciation or depreciation in the
partnership’s assets has been allocated to
the capital account of the noncompensa-
tory option holder, the holder will, under
section 704(c) principles, recognize any in-
come or loss attributable to that apprecia-
tion or depreciation as the underlying assets
are sold, depreciated, or amortized.
In some cases, the built-in gain or loss
in the option will exceed the unrealized ap-
preciation or depreciation in the partner-
ship’s assets (that has not been reflected in
the partners’capital accounts previously).
In those cases, even after all of the unre-
alized appreciation or depreciation in the
partnership’s assets has been allocated to
the option holder, a disparity may remain
between the noncompensatory option hold-
er’s right to share in partnership capital and
the value of money and other property con-
tributed by the partner. Most commenta-
tors have recommended and Treasury and
the IRS agree that the partnership never-
theless should be allowed to shift capital be-
tween the historic partners and the
noncompensatory option holder on the ex-
ercise of the noncompensatory option.
Some commentators also have suggested
that the historic partners and the noncom-
pensatory option holder should be allo-
cated notional tax items over the recovery
period for partnership assets similar to the
remedial allocations that are permitted, but
not required, under the regulations issued
under section 704(c)(1)(A). Although the
use of section 704(c) notional tax items
would ensure that the noncompensatory op-
tion holder and the historic partners re-
ceive the proper amount of income and loss
over time, Treasury and the IRS believe that
implementing such a system would be un-
duly complex where the built-in gain or loss
to be allocated to the noncompensatory op-
tion holder exceeds the built-in gain or loss
in the partnership’s assets.
Instead, the proposed regulations re-
quire that the partnership make corrective
allocations of gross income or loss to the
partners in the year in which the option is
exercised so as to take into account any shift
in the partners’capital accounts that oc-
curs as a result of the exercise of a non-
compensatory option. These corrective
allocations are allocations of tax items that
differ from the partnership’s allocations of
book items. If there are not sufficient ac-
tual partnership items in the year of exer-
cise to conform the partnership’s tax
allocations to the capital shift, additional
corrective allocations are required in suc-
ceeding taxable years until the capital shift
has been fully taken into account.
The proposed regulations also provide
rules for revaluing the partners’capital ac-
counts while a noncompensatory option is
outstanding. Section 1.704–1(b)(2)(iv) con-
tains rules for maintaining a partnership’s
capital accounts. Section 1.704–1(b)(2)(iv)(f)
provides that a partnership may, upon the
occurrence of certain events (including the
contribution of money to the partnership by
a new or existing partner), increase or de-
crease the partners’capital accounts to re-
flect a revaluation of partnership property.
If one or more options are outstanding when
a revaluation occurs, and the revaluation
does not account for the value associated
with the outstanding options, the partners’
capital accounts will not reflect the true eco-
nomic value of their interests. For example,
in partnerships with appreciated property,
the historic partners’capital accounts of-
ten would overstate the distributions that
would be made to the partners if the part-
nership were liquidated, because a por-
tion of the partnership’s assets may
ultimately be paid to the option holder.
Therefore, the proposed regulations modify
§1.704–1(b)(2)(iv)(f) and (h) to provide that
any revaluation during the period in which
there are outstanding noncompensatory op-
tions generally must take into account the
fair market value, if any, of outstanding op-
tions.
4. Characterization Rule
Under section 704(b), a partner’s dis-
tributive share of income, gain, loss, de-
duction, or credit (or item thereof) is
determined under the partnership agree-
ment if the allocation under the agree-
ment has substantial economic effect. If the
allocation does not have substantial eco-
nomic effect, or the partnership agree-
ment does not provide for the allocation,
then the allocation must be made in accor-
dance with the partner’s interest in the part-
nership (determined by taking into account
all facts and circumstances). Section 1.704–
1(b)(2)(ii)(h) provides in part that, for this
purpose, the partnership agreement in-
cludes all agreements among the partners,
or between one or more partners and the
partnership, concerning affairs of the part-
nership and responsibilities of partners,
whether oral or written, and whether or not
March 3, 20035452003–9 I.R.B.

embodied in a document referred to by the
partners as the partnership agreement, in-
cluding puts, options, and buy-sell agree-
ments. Currently, there is some uncertainty
about the extent to which these rules re-
quire a partnership to take into account a
noncompensatory option to acquire an in-
terest in a partnership when making its an-
nual allocations.
Treasury and the IRS believe that it is
appropriate to clarify these rules with re-
spect to noncompensatory options addressed
in this project. As these proposed regula-
tions are limited to noncompensatory op-
tions, nothing in these proposed regulations
provides any inference as to the opera-
tion of this rule for compensatory options
or other types of agreements.
Given the uncertainty of the exercise of
most noncompensatory options, Treasury
and the IRS believe that noncompensa-
tory options generally should not be treated
as entitling the holder to a fixed right to
share in partnership income until the op-
tion is exercised. However, if a noncom-
pensatory option provides the holder with
rights that are substantially similar to the
rights afforded to a partner, then the holder
should be treated as a partner and the op-
tion should be taken into account in allo-
cating partnership income. At the same time,
Treasury and the IRS recognize that treat-
ing a noncompensatory option holder as a
partner may, in some circumstances, frus-
trate the intent of the parties without sub-
stantially altering their aggregate tax
liabilities.
For these reasons, the proposed regula-
tions generally respect noncompensatory op-
tions as such and do not characterize them
as partnership equity. However, the pro-
posed regulations contain a rule that char-
acterizes the holder of a noncompensatory
option as a partner if the option holder’s
rights are substantially similar to the rights
afforded to a partner. This rule applies only
if, as of the date that the noncompensa-
tory option is issued, transferred, or modi-
fied, there is a strong likelihood that the
failure to treat the option holder as a part-
ner would result in a substantial reduc-
tion in the present value of the partners’and
the option holder’s aggregate tax liabili-
ties.
The proposed regulations use a facts and
circumstances test to determine whether a
noncompensatory option holder’s rights are
substantially similar to the rights afforded
to a partner, including whether the option
is reasonably certain to be exercised and
whether the option holder has partner at-
tributes. The proposed regulations list a
number of factors that are used to deter-
mine whether a noncompensatory option is
reasonably certain to be exercised, includ-
ing the premium paid for the option, the ex-
ercise price of the option, the term of the
option, the predictability and stability of the
value of the underlying partnership inter-
est, and whether the partnership is expected
to make distributions during the term of the
option. If a noncompensatory option is rea-
sonably certain to be exercised, then the
holder of the option ordinarily has rights
that are substantially similar to the rights
afforded to a partner. Partner attributes in-
clude the extent to which the option holder
shares in the economic benefit and detri-
ment of partnership income and loss and the
extent to which the option holder has the
right to participate in the management of
the partnership.
If the holder of a noncompensatory op-
tion is treated as a partner under the pro-
posed regulations, then the holder’s
distributive share of the partnership’s in-
come, gain, loss, deduction, or credit (or
items thereof) generally must be deter-
mined in accordance with such partner’s in-
terest in the partnership (taking into account
all facts and circumstances) as determined
under§1.704–1(b)(3). For this purpose, the
partner’s interest in the partnership gener-
ally must reflect the economic differences
between holding an option to acquire a part-
nership interest and holding the partner-
ship interest itself. For example, unlike a
partner, a noncompensatory option holder
is not required initially to contribute to the
partnership the full amount of the pur-
chase price for the partnership interest. In-
stead, the noncompensatory option holder
generally pays an option premium that is
considerably smaller than the purchase price
and may wait until the option is about to
expire to decide whether to exercise the op-
tion and pay the exercise price. The com-
putation of the noncompensatory option
holder’s share of partnership items should
reflect this lesser amount of capital invest-
ment to the extent appropriate in a particu-
lar case. In addition, a noncompensatory
option holder’s cumulative distributive share
of partnership losses and deductions may
be limited under sections 704(b) and (d) to
the amount paid by the holder to the part-
nership for the option.
5. Original Issue Discount Provisions
The final regulations under the origi-
nal issue discount (OID) provisions pro-
vide special rules for debt instruments
convertible into the stock of the issuer. See
§§1.1272–1(e), 1.1273–2(j), and 1.1275–
4(a)(4). In response to Notice 2000–29,
commentators requested that these spe-
cial rules be extended to apply to debt in-
struments convertible into partnership
interests. Treasury and the IRS agree with
the commentators. Treating convertible debt
issued by partnerships and corporations dif-
ferently for purposes of these special rules
could create unjustified distinctions be-
tween the taxation of instruments that are
economically equivalent. Accordingly, the
proposed regulations amend the OID pro-
visions to treat partnership interests as stock
for purposes of the special rules for con-
vertible debt instruments.
Proposed Effective Date
These regulations are proposed to ap-
ply to noncompensatory options that are is-
sued on or after the date final regulations
are published in theFederal Register.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in Ex-
ecutive Order 12866. Therefore, a regulatory
assessment 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,
and because the regulations do not im-
pose a collection of information on small
entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursu-
ant to section 7805(f) of the Internal Rev-
enue Code, this notice of proposed
rulemaking will be submitted to the Chief
Counsel for Advocacy of the Small Busi-
ness Administration for comment on its im-
pact on small businesses.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any written comments (a
signed original and eight (8) copies) that are
submitted timely to the IRS. Alternatively,
2003–9 I.R.B.546March 3, 2003

taxpayers may submit comments electroni-
cally directly to the IRS Internet site at
www.irs.gov/regs.The IRS and Treasury
Department request comments on the clar-
ity of the proposed rules and how they can
be made easier to understand. All com-
ments will be available for public inspec-
tion and copying.
A public hearing has been scheduled for
May 20, 2003, beginning at 10 a.m. in room
4718, Internal Revenue Building,1111Con-
stitution Avenue, NW, Washington, DC. Due
to building security procedures, visitors must
enter at the Constitution Avenue entrance.
In addition, all visitors must present photo
identification to enter the building. Be-
cause of access restrictions, visitors will not
be admitted beyond the immediate entrance
area more than 30 minutes before the hear-
ing starts. For information about having
your name placed on the building access list
to attend the hearing, see the FOR FUR-
THER INFORMATION CONTACT por-
tion of this preamble.
The rules of 26 CFR 601.601(a)(3) ap-
ply to the hearing. Persons who wish to
present oral comments must submit writ-
ten comments and an outline of the top-
ics to be discussed and the time to be
devoted to each topic (a signed original and
eight (8) copies) by April 29, 2003. 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 review-
ing outlines has passed. Copies of the
agenda will be available free of charge at
the hearing.
Drafting Information
The principal author of these proposed
regulations is Audrey W. Ellis of the Of-
fice of the Associate Chief Counsel
(Passthroughs and Special Industries). How-
ever, other personnel from the IRS and
Treasury participated in their development.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
PA RT 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805***
Par. 2. Section 1.704–1 is amended as
follows:
1. Paragraph (b)(0) is amended by add-
ing entries for 1.704–1(b)(2)(iv)(d)(4),
1.704–1(b)(2)(iv)(h)(1), 1.704–1(b)(2)(iv)(h)
(2), 1.704–1(b)(2)(iv)(s), 1.704–1(b)(4)(ix),
and 1.704–1(b)(4)(x).
2. Paragraph (b)(1)(ii) is amended by
adding a sentence at the end of the para-
graph.
3. Paragraph (b)(2)(iv)(d)(4) is added.
4. Paragraph (b)(2)(iv)(f)(1) is revised.
5. Paragraphs (b)(2)(iv)(h)(1) and (2) are
redesignated as paragraphs (b)(2)(iv)(h)(1)(i)
and (ii), respectively; the text of paragraph
(b)(2)(iv)(h) is redesignated as paragraph
(b)(2)(iv)h)(1); a heading is added to new
paragraph (b)(2)(iv)(h)(1); and paragraph
(b)(2)(iv)(h)(2) is added.
6. Paragraph (b)(2)(iv)(s) is added im-
mediately after the undesignated paragraph
that follows paragraph (b)(2)(iv)(r)(2).
7. Paragraphs (b)(4)(ix) and (b)(4)(x) are
added.
8. Paragraph (b)(5) is amended by add-
ingExample 20,Example 21,Example 22,
Example 23, andExample 24.
The additions and revisions read as
follows:
§1.704–1 Partner’s distributive share.
*****
(b) (0)***
Exercise of noncompensatory options .................................................................................. 1.704–1(b)(2)(iv)(d)(4)
*****
In general ............................................................................................................................... 1.704–1(b)(2)(iv)(h)(1)
*****
Adjustments for noncompensatory options........................................................................... 1.704–1(b)(2)(iv)(h)(2)
*****
Adjustments on the exercise of a noncompensatory option ................................................ 1.704–1(b)(2)(iv)(s)
*****
Allocations with respect to noncompensatory options......................................................... 1.704–1(b)(4)(ix)
Corrective allocations ............................................................................................................ 1.704–1(b)(4)(x)
March 3, 20035472003–9 I.R.B.

*****
(1)***
(ii)***In addition, paragraph
(b)(2)(iv)(d)(4), paragraph (b)(2)(iv)(h)(2),
paragraph (b)(2)(iv)(s), paragraph (b)(4)(ix),
paragraph (b)(4)(x), andExamples 20
through24in paragraph (b)(5) of this sec-
tion apply to noncompensatory options (as
defined in§1.721–2(d)) that are issued on
or after the date final regulations are pub-
lished in theFederal Register.
*****
(2)***
(iv)***
(d)***
(4)Exercise of noncompensatory op-
tions.Forpurposesofparagraph
(b)(2)(iv)(b)(2) of this section, the fair mar-
ket value of the property contributed on the
exercise of a noncompensatory option (as
defined in§1.721–2(d)) does not include the
fair market value of the option privilege, but
does include the consideration paid to the
partnership to acquire the option and the fair
market value of any property (other than the
option) contributed to the partnership on the
exercise of the option. With respect to con-
vertible equity, the fair market value of the
property contributed to the partnership on
the exercise of the option includes the con-
verting partner’s capital account immedi-
ately before the conversion. With respect to
convertible debt, the fair market value of
the property contributed on the exercise of
the option includes the adjusted basis and
the accrued but unpaid qualified stated in-
terest on the debt immediately before the
conversion. SeeExamples 20through24of
paragraph (b)(5) of this section.
*****
(f)***
(1) The adjustments are based on the fair
market value of partnership property (tak-
ing section 7701(g) into account) on the
date of adjustment, as determined under
paragraph (b)(2)(iv)(h) of this section, re-
duced by the consideration paid to the part-
nership to acquire any outstanding
noncompensatory options (as defined in
§1.721–2(d)) that are issued on or after the
date final regulations are published in the
Federal Register. SeeExample 22of para-
graph (b)(5) of this section.*****
(h)Determinations of fair market
value—(1)In general.***
(2)Adjustments for noncompensatory op-
tions.The fair market value of partner-
ship property must be adjusted to account
for any outstanding noncompensatory op-
tions (as defined in§1.721–2(d)) at the time
of a revaluation of partnership property un-
der paragraph (b)(2)(iv)(f)or(s) of this sec-
tion. If the fair market value of outstanding
noncompensatory options (as defined in
§1.721–2(d)) as of the date of the adjust-
ment exceeds the consideration paid by the
option holders to acquire the options, then
the fair market value of partnership prop-
erty must be reduced by that excess to the
extent of the unrealized income or gain in
partnership property (that has not been re-
flected in the capital accounts previously).
This reduction is allocated only to proper-
ties with unrealized appreciation in pro-
portion to their respective amounts of
unrealized appreciation. If the price paid by
the option holders to acquire the outstand-
ing noncompensatory options (as defined in
§1.721–2(d)) exceeds the fair market value
of such options as of the date of the ad-
justment, then the value of partnership prop-
erty must be increased by that excess to the
extent of the unrealized deduction or loss
in partnership property (that has not been
reflected in the capital accounts previ-
ously). This increase is allocated only to
properties with unrealized depreciation in
proportion to their respective amounts of
unrealized depreciation.
*****
(s)Adjustments on the exercise of a non-
compensatory option.A partnership agree-
ment may grant a partner, on the exercise
of a noncompensatory option (as defined in
§1.721–2(d)), a right to share in partner-
ship capital that exceeds (or is less than) the
sum of the consideration paid by the part-
ner to acquire and exercise such option.
Where such an agreement exists, capital ac-
counts will not be considered to be deter-
mined and maintained in accordance with
the rules of this paragraph (b)(2)(iv)
unless—
(1) In lieu of revaluing partnership prop-
erty under paragraph (b)(2)(iv)(f) of this sec-
tion immediately before the exercise of the
option, the partnership revalues partner-
ship property in accordance with the pro-
visions of paragraphs (b)(2)(iv)(f)(1) through
(4) of this section immediately after the ex-
ercise of the option;
(2) In determining the capital accounts
of the partners (including the exercising
partner) under paragraph (b)(2)(iv)(s)(1)of
this section, the partnership first allocates
any unrealized income, gain, loss, or de-
duction in partnership assets (that has not
been reflected in the capital accounts pre-
viously) to the exercising partner to the ex-
tent necessary to reflect that partner’s right
to share in partnership capital under the
partnership agreement, and then allocates
any remaining unrealized income gain, loss,
or deduction (that has not been reflected in
the capital accounts previously) to the ex-
isting partners, to reflect the manner in
which the unrealized income, gain, loss, or
deduction in partnership property would be
allocated among those partners if there were
a taxable disposition of such property for
its fair market value on that date;
(3) If, after making the allocations de-
scribed in paragraph (b)(2)(iv)(s)(2) of this
section, the exercising partner’s capital ac-
count still does not reflect that partner’s
right to share in partnership capital under
the partnership agreement, then the part-
nership reallocates partnership capital be-
tween the existing partners and the
exercising partner so that the exercising
partner’s capital account does reflect the ex-
ercising partner’s right to share in partner-
ship capital under the partnership agreement
(a capital account reallocation). Any in-
crease or reduction in the capital accounts
of existing partners that occurs as a result
of a capital account reallocation under this
paragraph (b)(2)(iv)(s)(3)mustbeallo-
cated among the existing partners in ac-
cordance with the principles of this section;
and
(4) The partnership agreement requires
corrective allocations so as to take into ac-
count all capital account reallocations made
under paragraph (b)(2)(iv)(s)(3)ofthissec-
tion (see paragraph (b)(4)(x) of this sec-
tion). SeeExamples 20through24of
paragraph (b)(5) of this section.
*****
(4)***
(ix)Allocations with respect to noncom-
pensatory options.A partnership agree-
ment may grant to a partner that exercises
a noncompensatory option a right to share
in partnership capital that exceeds (or is less
than) the sum of the amounts paid by the
partner to acquire and exercise such op-
tion. In such a case, allocations of income,
gain, loss, and deduction to the partners
while the noncompensatory option is out-
standing cannot have economic effect, be-
2003–9 I.R.B.548March 3, 2003

cause, if the noncompensatory option is
exercised, the exercising partner, rather than
the existing partners, may receive the eco-
nomic benefit or bear the economic detri-
ment associated with that income, gain, loss,
or deduction. Allocations of partnership in-
come, gain, loss, and deduction to the part-
ners while the noncompensatory option is
outstanding will be deemed to be in accor-
dance with the partners’interests in the part-
nership only if—
(a) The holder of the noncompensa-
tory option is not treated as a partner un-
der§1.761–3;
(b) The partnership agreement requires
that, on the exercise of the noncompensa-
tory option, the partnership comply with the
rules of paragraph (b)(2)(iv)(s) of this sec-
tion; and
(c) All material allocations and capital
account adjustments under the partner-
ship agreement not pertaining to noncom-
pensatory options are recognized under
section 704(b). SeeExamples 20through
24of paragraph (b)(5) of this section.
(x)Corrective allocations.If partner-
ship capital is reallocated between exist-
ing partners and a partner exercising a
noncompensatory option under paragraph
(b)(2)(iv)(s)(3) of this section (a capital ac-
count reallocation), the partnership must, be-
ginning with the taxable year of the exercise
and in all succeeding taxable years until the
allocations required are fully taken into ac-
count, make corrective allocations so as to
take into account the capital account real-
location. A corrective allocation is an al-
location (consisting of apro rataportion
of each item) for tax purposes of gross in-
come and gain, or gross loss and deduc-
tion, that differs from the partnership’s
allocation of the corresponding book item.
SeeExample 21of paragraph (b)(5) of this
section.
*****
(5)***
Example 20.(i) In Year 1, TM and PK each con-
tribute cash of $10,000 to LLC, a newly formed lim-
ited liability company, classified as a partnership for
federal tax purposes, in exchange for 100 units in LLC.
Under the LLC agreement, each unit is entitled to par-
ticipate equally in the profits and losses of LLC. LLC
uses the cash contributions to purchase a non-
depreciable property, Property A, for $20,000. Also
in Year 1, at a time when Property A is still valued
at $20,000, LLC issues an option to DH. The op-
tion allows DH to buy 100 units in LLC for an ex-
ercise price of $15,000 in Year 2. DH pays $1,000 to
the LLC for the issuance of the option. Assume that
the LLC agreement requires that, on the exercise of
a noncompensatory option, LLC comply with the rules
of paragraph (b)(2)(iv)(s) of this section, and that all
material allocations and capital account adjustments
under the LLC agreement not pertaining to noncom-
pensatory options are recognized under section 704(b).
Also assume that DH’s option is a noncompensa-
tory option under§1.721–2(d), and that DH is not
treated as a partner with respect to the option. In Year
2, DH exercises the option, contributing the $15,000
exercise price to the partnership. At the time the op-
tion is exercised, the value of Property A is $35,000.
AssetsLiabilities and Capital
BasisValueBasisValue
Property A$20,000$35,000TM$10,000$17,000
CashPK$10,000$17,000
Premium$ 1,000$ 1,000DH$16,000
$17,000
Exercise Price$15,000$15,000
Total$36,000$51,000$36,000$51,000
(ii) Under paragraphs (b)(2)(iv)(b)(2) and (b)(2)(iv)(d)(4) of this section, DH’s capital account is credited with the amount paid for the option ($1,000) and the
exercise price of the option ($15,000). Under the LLC agreement, however, DH is entitled to LLC capital corresponding to 100 units of LLC (
1
⁄3of LLC’s capital).
Immediately after the exercise of the option, LLC’s assets are cash of $16,000 ($1,000 premium and $15,000 exercise price contributed by DH) and Property A,
which has a value of $35,000. Thus, the total value of LLC’s assets is $51,000. DH is entitled to LLC capital equal to
1
⁄3of this value, or $17,000. As DH is en-
titled to $1,000 more LLC capital than DH’s capital contributions to LLC, the provisions of paragraph (b)(2)(iv)(s) of this section apply.
(iii) Under paragraph (b)(2)(iv)(s) of this section, LLC must increase DH’s capital account from $16,000 to $17,000 by, first, revaluing LLC property in accor-
dance with the principles of paragraph (b)(2)(iv)(f) of this section and allocating the first $1,000 of book gain to DH. The net gain in LLC’s assets (Property A) is
$15,000 ($35,000 value less $20,000 basis). The first $1,000 of this gain must be allocated to DH, and the remaining $14,000 of this gain is allocated equally to
TM and PK in accordance with the LLC agreement. Because the revaluation of LLC assets under paragraph (b)(2)(iv)(s)(2) of this section increases DH’s capital
account to the amount agreed on by the members, LLC is not required to make a capital account reallocation under paragraph (b)(2)(iv)(s)(3) of this section. Under
paragraph (b)(2)(iv)(f)(4) of this section, the tax items from the revalued property must be allocated in accordance with section 704(c) principles.
TMPKDH
TaxBookTaxBookTaxBook
Capital account after exercise ................... $10,000$10,000$10,000$10,000$16,000$16,000
Revaluation amount ................................... ----------$ 7,000----------$ 7,000----------$ 1,000
Capital account after revaluation .............. $10,000$17,000$10,000$17,000$16,000$17,000
Example 21.(i) Assume the same facts as inExample 20, except that, in Year 1, LLC sells Property A for $40,000, recognizing gain of $20,000. LLC does not
distribute the sale proceeds to its partners and it has no other earnings in Year 1. With the proceeds ($40,000), LLC purchases Property B, a nondepreciable prop-
erty. Also assume that DH exercises the noncompensatory option at the beginning of Year 2 and that, at the time DH exercises the option, the value of Property B
is $41,000. In Year 2, LLC has gross income of $3,000 and deductions of $1,500.
March 3, 20035492003–9 I.R.B.

AssetsLiabilities and Capital
BasisValueBasisValue
Property B$40,000$41,000TM$20,000$19,000
Cash$16,000
$16,000PK$20,000$19,000
DH$16,000
$19,000
Total$56,000$57,000$56,000$57,000
(ii) Under paragraphs (b)(2)(iv)(b)(2) and (b)(2)(iv)(d)(4) of this section, DH’s capital account is credited with the amount paid for the option ($1,000) and the
exercise price of the option ($15,000). Under the LLC agreement, however, DH is entitled to LLC capital corresponding to 100 units of LLC (
1
⁄3of LLC’s capital).
Immediately after the exercise of the option, LLC’s assets are $16,000 cash ($1,000 option premium and $15,000 exercise price contributed by DH) and Property
B, which has a value of $41,000. Thus, the total value of LLC’s assets is $57,000. DH is entitled to LLC capital equal to
1
⁄3of this amount, or $19,000. As DH is
entitled to $3,000 more LLC capital than DH’s capital contributions to LLC, the provisions of paragraph (b)(2)(iv)(s) of this section apply.
(iii) Under paragraph (b)(2)(iv)(s) of this section, LLC must increase DH’s capital account from $16,000 to $19,000 by, first, revaluing LLC property in accor-
dance with the principles of paragraph (b)(2)(iv)(f) of this section, and allocating the $1,000 of book gain from the revaluation to DH. This brings DH’s capital ac-
count to $17,000. Second, under paragraph (b)(2)(iv)(s)(3) of this section, LLC must reallocate $2,000 of capital from the existing partners (TM and PK) to DH to
bring DH’s capital account to $19,000 (the capital account reallocation). As TM and PK share equally in all items of income, gain, loss, and deduction of LLC,
each member’s capital account is reduced by
1
⁄2of the $2,000 reduction ($1,000).
(iv) Under paragraph (b)(2)(iv)(s)(4) of this section, beginning in the year in which the option is exercised, LLC must make corrective allocations so as to take
into account the capital account reallocation. In Year 2, LLC has gross income of $3,000 and deductions of $1,500. The book gross income of $3,000 is shared equally
by TM, PK, and DH. For tax purposes, however, LLC must allocate all of its gross income ($3,000) to DH. LLC’s deductions ($1,500) must be allocated equally
among TM, PK, and DH. Under paragraph (b)(2)(iv)(f)(4) of this section, the tax items from Property B must be allocated in accordance with section 704(c) prin-
ciples.
TMPKDH
TaxBookTaxBookTaxBook
Capital account after exercise ................... $20,000$20,000$20,000$20,000$16,000$16,000
Revaluation ................................................ --------------------------------------------------$ 1,000
Capital account after revaluation .............. $20,000$20,000$20,000$20,000$16,000$17,000
Capital account reallocation ...................... ----------($1,000)----------($1,000)----------$ 2,000
Capital account after capital account
reallocation................................................. $20,000$19,000$20,000$19,000$16,000$19,000
Income allocation (Yr. 2)----------$ 1,000----------$ 1,000$ 3,000$ 1,000
Deduction allocation (Yr. 2)($ 500)($ 500)($ 500)($ 500)($ 500)($ 500)
Capital account at end of year 2............... $19,500$19,500$19,500$19,500$18,500$19,500
Example 22.(i) In Year 1, AC and NE each contribute cash of $10,000 to LLC, a newly formed limited liability company classified as a partnership for federal
tax purposes, in exchange for 100 units in LLC. Under the LLC agreement, each unit is entitled to participate equally in the profits and losses of LLC. LLC uses
the cash contributions to purchase two non-depreciable properties, Property A and Property B, for $10,000 each. Also in Year 1, at a time when PropertyA and Prop-
erty B are still valued at $10,000 each, LLC issues an option to DR. The option allows DR to buy 100 units in LLC for an exercise price of $15,000 in Year 2. DR
pays $1,000 to LLC for the issuance of the option. Assume that the LLC agreement requires that, on the exercise of a noncompensatory option, LLC comply with
the rules of paragraph (b)(2)(iv)(s) of this section, and that all material allocations and capital account adjustments under the LLC agreement not pertaining to non-
compensatory options are recognized under section 704(b). Also assume that DR’s option is a noncompensatory option under§1.721–2(d), and that DR is not treated
as a partner with respect to the option.
(ii) Prior to the exercise of DR’s option, ML contributes $17,000 to LLC for 100 units in LLC. At the time of ML’s contribution, Property A has a value of $30,000
and a basis of $10,000, Property B has a value of $5,000 and a basis of $10,000, and the fair market value of DR’s option is $2,000.
(iii) Upon ML’s admission to the partnership, the capital accounts of AC and NE (which were $10,000 each prior to ML’s admission) are, in accordance with
paragraph (b)(2)(iv)(f) of this section, adjusted upward to reflect their shares of the unrealized appreciation in the partnership’s assets. Under paragraph (b)(2)(iv)(f)(1)
of this section, those adjustments must be based on the fair market value of LLC property (taking section 7701(g) into account) on the date of the adjustment. The
fair market value of partnership property ($36,000) must be reduced by the consideration paid by DR to the partnership to acquire the option ($1,000) (under para-
graph (b)(2)(iv)(f)(1) of this section), and the excess of the fair market value of the option as of the date of the adjustment over the consideration paid by DR to
acquire the option ($1,000) (under paragraph (b)(2)(iv)(h)(2) of this section), but only to the extent of the unrealized appreciation in LLC property ($15,000). There-
fore, the revaluation adjustments must be based on a value of $34,000. Accordingly, AC and NE’s capital accounts must be increased to $17,000. This $1,000 re-
duction is allocated entirely to Property A, the only asset having unrealized appreciation. Therefore, the book value of Property A is $29,000. The $19,000 of built-in
gain in Property A and the $5,000 of built-in loss in Property B must be allocated equally between AC and NE in accordance with section 704(c) principles.
2003–9 I.R.B.550March 3, 2003

Assets
BasisValueOption Adjustment704(c) Book
Property A$10,000$30,000($1,000)$29,000
Property B$10,000$ 5,0000$ 5,000
Cash$ 1,000$ 1,0000$ 1,000
Subtotal$21,000$36,000($1,000)$35,000
Cash contributed
by ML$17,000$17,0000
$17,000
Total$38,000$53,000($1,000)$52,000
Liabilities and Capital
TaxValue
AC$10,000$17,000
NE$10,000$17,000
ML$17,000$17,000
Option$ 1,000$ 2,000
Total$38,000$53,000
(iv) After the admission of ML, when Property A still has a value of $30,000 and a basis of $10,000 and Property B still has a value of $5,000 and a basis of
$10,000, DR exercises the option. On the exercise of the option, DR’s capital account is credited with the amount paid for the option ($1,000) and the exercise price
of the option ($15,000). Under the LLC agreement, however, DR is entitled to LLC capital corresponding to 100 units of LLC (
1
⁄4of LLC’s capital). Immediately
after the exercise of the option, LLC’s assets are worth $68,000 ($15,000 contributed by DR, plus the value of LLC assets prior to the exercise of the option, $53,000).
DR is entitled to LLC capital equal to
1
⁄4of this value, or $17,000. As DR is entitled to $1,000 more LLC capital than DR’s capital contributions to LLC, the pro-
visions of paragraph (b)(2)(iv)(s) of this section apply.
(v) Under paragraph (b)(2)(iv)(s) of this section, the LLC must increase DR’s capital account from $16,000 to $17,000 by, first, revaluing LLC property in ac-
cordance with the principles of paragraph (b)(2)(iv)(f) of this section and allocating the first $1,000 of book gain to DR. The net increase in the value of LLC prop-
erties since the previous revaluation is $1,000 (the difference between the actual value of Property A, $30,000, and the book value of Property A, $29,000). The
entire $1,000 of book gain is allocated to DR. Because the revaluation of LLC assets under paragraph (b)(2)(iv)(s)(2) of this section increases DR’s capital account
to the amount agreed on by the members, the LLC is not required to make a capital account reallocation under paragraph (b)(2)(iv)(s)(3) of this section. Under para-
graph (b)(2)(iv)(f)(4) of this section, the tax items from Properties A and B must be allocated in accordance with section 704(c) principles.
ACNEMLDR
TaxBookTaxBookTaxBookTaxBook
Capital account after admission of ML .... $10,000 $17,000$10,000 $17,000$17,000 $17,000---------- ----------
Capital account after exercise of DH’s
option ..................................................... $10,000 $17,000$10,000 $17,000$17,000 $17,000$16,000 $16,000
Revaluation ................................................---------- -------------------- -------------------- -------------------- $ 1,000
Capital account after revaluation .............. $10,000 $17,000$10,000 $17,000$17,000 $17,000$16,000 $17,000
Example 23.(i) On the first day of Year 1, MS, VH, and SR form LLC, a limited liability company classified as a partnership for federal tax purposes. MS and
VH each contribute $10,000 cash to LLC for 100 units of common interest in LLC. SR contributes $10,000 cash for a convertible preferred interest in LLC.SR’s
convertible preferred interest entitles SR to receive an annual allocation and distribution of cumulative LLC net profits in an amount equal to 10 percent of SR’s
unreturned capital. SR’s convertible preferred interest also entitles SR to convert, in year 3, SR’s preferred interest into 100 units of common interest. If SR con-
verts, SR has the right to the same share of LLC capital as SR would have had if SR had held the 100 units of common interest since the formation of LLC. Under
the LLC agreement, each unit of common interest has an equal right to share in any LLC net profits that remains after payment of the preferred return. Assume
that the LLC agreement requires that, on the exercise of a noncompensatory option, LLC comply with the rules of paragraph (b)(2)(iv)(s) of this section, and that
all material allocations and capital account adjustments under the LLC agreement not pertaining to noncompensatory options are recognized under section 704(b).
Also assume that SR’s right to convert the preferred interest into a common interest qualifies as a noncompensatory option under§1.721–2(d), and that, prior to
the exercise of the conversion right, SR is not treated as a partner with respect to the conversion right.
(ii) LLC uses the $30,000 to purchase Property Z, a property that is depreciable on a straight-line basis over 15 years. In each of Years 1 and 2, LLC has net
income of $2,500, comprised of $4,500 of gross receipts and $2,000 of depreciation. It allocates and distributes $1,000 of this net income to SR in eachyear. LLC
allocates, but does not distribute, the remaining $1,500 of net income equally to MS and VH in each year.
March 3, 20035512003–9 I.R.B.

MSVHSR
TaxBookTaxBookTaxBook
Capital account upon formation.................... $10,000$10,000$10,000$10,000$10,000$10,000
Allocation of income Years 1 and 2 ............. $ 1,500$ 1,500$ 1,500$ 1,500$ 2,000$ 2,000
Distributions Years 1 and 2...........................----($2,000)($2,000)
Capital account end of Year 2 ...................... $11,500$11,500$11,500$11,500$10,000$10,000
(iii) At the beginning of Year 3, when Property Z has a value of $38,000 and a basis of $26,000 ($30,000 original basis less $4,000 of depreciation) and LLC
has accumulated undistributed cash of $7,000 ($9,000 gross receipts less $2,000 distributions), SR converts SR’s preferred interest into a common interest. Under
paragraphs (b)(2)(iv)(b)(2) and (b)(2)(iv)(d)(4) of this section, SR’s capital account after the conversion equals SR’s capital account before the conversion, $10,000.
On the conversion of the preferred interest, however, SR is entitled to LLC capital corresponding to 100 units of common interest in LLC (
1
⁄3of LLC’s capital). At
the time of the conversion, the total value of LLC assets is $45,000. SR is entitled to LLC capital equal to
1
⁄3of this value, or $15,000. As SR is entitled to $5,000
more LLC capital than SR’s capital account immediately after the conversion, the provisions of paragraph (b)(2)(iv)(s) of this section apply.
AssetsLiabilities and Capital
BasisValueBasisValue
Property Z$26,000$38,000MS$11,500$15,000
Undistributed
Income
VH$11,500$15,000
$ 7,000
$ 7,000SR$10,000$15,000
Total $33,000$45,000Total$33,000$45,000
(iv) Under paragraph (b)(2)(iv)(s) of this section, LLC must increase SR’s capital account from $10,000 to $15,000 by, first, revaluing LLC property in accor-
dance with the principles of paragraph (b)(2)(iv)(f) of this section, and allocating the first $5,000 of book gain from that revaluation to SR. The net unrealized gain
in LLC’s assets (Property Z) is $12,000 ($38,000 value less $26,000 basis). The first $5,000 of this gain must be allocated to SR. The remaining $7,000 of that
gain must be allocated equally to MS and VH in accordance with the LLC agreement. Because the revaluation of LLC assets under paragraph (b)(2)(iv)(s)(2)of
this section increases SR’s capital account to the amount agreed on by the members, LLC is not required to make a capital account reallocation under paragraph
(b)(2)(iv)(s)(3) of this section. Under paragraph (b)(2)(iv)(f)(4) of this section, the tax items from the revalued property must be allocated in accordance with sec-
tion 704(c) principles.
MSVHSR
TaxBookTaxBookTaxBook
Capital account prior to conversion .......... $11,500$11,500$11,500$11,500$10,000$10,000
Revaluation on conversion ........................ ----------$ 3,500----------$ 3,500----------$ 5,000
Capital account after conversion............... $11,500$15,000$11,500$15,000$10,000$15,000
Example 24.(i) On the first day of Year 1, AK and JP each contribute cash of $10,000 to LLC, a newly formed limited liability company classified as a partner-
ship for federal tax purposes, in exchange for 100 units in LLC. Immediately after its formation, LLC borrows $10,000 from JS. Under the terms of the debtin-
strument, interest of $1,000 is payable annually and principal is repayable in five years. Throughout the term of the indebtedness, JS has the right toconvert the
debt instrument into 100 units in LLC. If JS converts, JS has the right to the same share of LLC capital as JS would have had if JS had held 100 units in LLC since
the formation of LLC. Under the LLC agreement, each unit participates equally in the profits and losses of LLC and has an equal right to share in LLC capital.
Assume that the LLC agreement requires that, on the exercise of a noncompensatory option, LLC comply with the rules of paragraph (b)(2)(iv)(s) of this section,
and that all material allocations and capital account adjustments not pertaining to noncompensatory options are recognized under section 704(b). Also assume that
JS’s right to convert the debt into an interest in LLC qualifies as a noncompensatory option under§1.721–2(d), and that, prior to the exercise of the conversion right,
JS is not treated as a partner with respect to the convertible debt.
(ii) LLC uses the $30,000 to purchase Property D, property that is depreciable on a straight-line basis over 15 years. In each of Years 1, 2, and 3, LLC hasnet
income of $2,000, comprised of $5,000 of gross receipts, $2,000 of depreciation, and interest expense (representing payments of interest on the loanfrom JS) of
$1,000. LLC allocates, but does not distribute, this income equally to AK and JP.
AKJPJS
TaxBookTaxBookTaxBook
Initial capital account$10,000$10,000$10,000$10,000--------------------
Year 1 net income$ 1,000$ 1,000$ 1,000$ 1,000--------------------
Year 2 net income$ 1,000$ 1,000$ 1,000$ 1,000--------------------
Year 3 net income$ 1,000
$ 1,000$ 1,000$ 1,000
--------------------
Year 4 initial capital account .................... $13,000$13,000$13,000$13,00000
2003–9 I.R.B.552March 3, 2003

(iii) At the beginning of year 4, at a time when Property D, the LLC’s only asset, has a value of $33,000 and basis of $24,000 ($30,000 original basis less $6,000
depreciation in Years 1 through 3), and LLC has accumulated undistributed cash of $12,000 ($15,000 gross receipts less $3,000 of interest payments) in LLC, JS
converts the debt into a
1
⁄3interest in LLC. Under paragraphs (b)(2)(iv)(b)(2) and (b)(2)(iv)(d)(4) of this section, JS’s capital account after the conversion is the ad-
justed basis of the debt immediately before JS’s conversion of the debt, $10,000, plus any accrued but unpaid qualified stated interest on the debt, $0. On the con-
version of the debt, however, JS is entitled to receive LLC capital corresponding to 100 units of LLC (
1
⁄3of LLC’s capital). At the time of the conversion, the total
value of LLC’s assets is $45,000. JS is entitled to LLC capital equal to
1
⁄3of this value, or $15,000. As JS is entitled to $5,000 more LLC capital than JS’s capital
contribution to LLC ($10,000), the provisions of paragraph (b)(2)(iv)(s) of this section apply.
AssetsLiabilities and Capital
BasisValueBasisValue
Property D$24,000$33,000AK$13,000$15,000
Cash$12,000
$12,000JP$13,000$15,000
JS$10,000$15,000
Total$36,000$45,000$36,000$45,000
(iv) Under paragraph (b)(2)(iv)(s) of this section, LLC must increase JS’s capital account from $10,000 to $15,000 by, first, revaluing LLC property in accor-
dance with the principles of paragraph (b)(2)(iv)(f) of this section, and allocating the first $5,000 of book gain from that revaluation to JS. The net unrealized gain
in LLC’s assets (Property D) is $9,000 ($33,000 value less $24,000 basis). The first $5,000 of this gain must be allocated to JS, and the remaining $4,000 of that
gain must be allocated equally to AK and JP in accordance with the LLC agreement. Because the revaluation of LLC assets under paragraph (b)(2)(iv)(s)(2) of this
section increases JS’s capital account to the amount agreed upon by the members, LLC is not required to make a capital account reallocation under paragraph (b)(2)(iv)(s)(3)
of this section. Under paragraph (b)(2)(iv)(f)(4) of this section, the tax items from the revalued property must be allocated in accordance with section 704(c) prin-
ciples.
AKJPJS
TaxBookTaxBookTaxBook
Year 4 capital account prior to exercise ... $13,000$13,000$13,000$13,00000
Capital account after exercise ................... $13,000$13,000$13,000$13,000$10,000$10,000
Revaluation ................................................ ----------$ 2,000----------$ 2,000----------$ 5,000
Capital account after revaluation .............. $13,000$15,000$13,000$15,000$10,000$15,000
Par. 3. Section 1.704–3 is amended by
revising the first sentence of paragraph
(a)(6)(i) to read as follows:
§1.704–3 Contributed property.
(a)***
(6)Other applications of section 704(c)
principles—(i)Revaluations under sec-
tion 704(b).The principles of this section
apply to allocations with respect to prop-
erty for which differences between book
value and adjusted tax basis are created
when a partnership revalues partnership
property pursuant to§1.704–1(b)(2)(iv)(f)
or 1.704–1(b)(2)(iv)(s) (reverse section
704(c) allocations).***
*****
Par. 4. Section 1.721–2 is added to read
as follows:
§1.721–2 Noncompensatory options.
(a)Exercise of a noncompensatory op-
tion.Notwithstanding§1.721–1(b)(1), sec-
tion 721 applies to the exercise (as defined
in paragraph (e)(4) of this section) of a non-
compensatory option (as defined in para-
graph (d) of this section). However, if the
exercise price (as defined in paragraph (e)(5)
of this section) of a noncompensatory op-
tion exceeds the capital account received by
the option holder on the exercise of the non-
compensatory option, the transaction will
be given tax effect in accordance with its
true nature.
(b)Transfer of property in exchange for
a noncompensatory option.Section 721
does not apply to a transfer of property to
a partnership in exchange for a noncom-
pensatory option. For example, if a per-
son purchases a noncompensatory option
with appreciated property, the person rec-
ognizes income or gain to the extent that
the fair market value of the noncompen-
satory option exceeds the person’s basis in
the surrendered property.
(c)Lapse of a noncompensatory op-
tion.Section 721 does not apply to the lapse
of a noncompensatory option.
(d)Scope.The provisions of this sec-
tion apply only to noncompensatory op-
tions and do not apply to any interest on
convertible debt that has been accrued by
the partnership (including accrued origi-
nal issue discount). For purposes of this sec-
tion, the term noncompensatory option
means an option (as defined in paragraph
(e)(1) of this section) issued by a partner-
ship (the issuing partnership), other than an
option issued in connection with the per-
formance of services.
(e)Definitions.The following defini-
tions apply for the purposes of this sec-
tion.
(1)Optionmeans a call option or war-
rant to acquire an interest in the issuing
partnership, the conversion feature of con-
vertible debt (as defined in paragraph (e)(2)
of this section), or the conversion feature
of convertible equity (as defined in para-
graph (e)(3) of this section). A contract that
otherwise constitutes an option shall not fail
to be treated as such for purposes of this
March 3, 20035532003–9 I.R.B.

section merely because it may or must be
settled in cash or property other than a part-
nership interest.
(2)Convertible debtis any indebted-
ness of a partnership that is convertible into
an interest in that partnership.
(3)Convertible equityis preferred eq-
uity in a partnership that is convertible into
common equity in that partnership. For this
purpose, preferred equity is any interest in
the issuing partnership that entitles the part-
ner to a preferential return on capital and
common equity is any interest in the issu-
ing partnership that is not preferred eq-
uity.
(4)Exercisemeans the exercise of an op-
tion or warrant or the conversion of con-
vertible debt or convertible equity.
(5)Exercise pricemeans, in the case of
a call option or warrant, the exercise price
of the call option or warrant; in the case of
convertible equity, the converting part-
ner’s capital account with respect to that
convertible equity, increased by the fair mar-
ket value of cash or other property con-
tributed to the partnership in connection
with the conversion; and, in the case of con-
vertible debt, the adjusted issue price (within
the meaning of§1.1275–1(b)) of the debt
converted, increased by accrued but un-
paid qualified stated interest and by the fair
market value of cash or other property con-
tributed to the partnership in connection
with the conversion.
(f)Example.The following example il-
lustrates the provisions of this section:
Example.In Year 1, L and M form general part-
nership LM with cash contributions of $5,000 each,
which are used to purchase land, Property D, for
$10,000. In that same year, the partnership issues an
option to N to buy a one-third interest in the part-
nership at any time before the end of Year 3. The ex-
ercise price of the option is $5,000, payable in either
cash or property. N transfers Property E with a ba-
sis of $600 and a value of $1,000 to the partnership
in exchange for the option. N provides no other con-
sideration for the option. Assume that N’s option is
a noncompensatory option under paragraph (d) of this
section and that N is not treated as a partner with re-
spect to the option. Under paragraph (b) of this sec-
tion, section 721(a) does not apply to N’s transfer of
Property E to LM in exchange for the option. In ac-
cordance with§1.1001–2, upon N’s transfer of Prop-
erty E to the partnership in exchange for the option,
N recognizes $400 of gain. Under open transaction
principles applicable to noncompensatory options, the
partnership does not recognize any gain upon re-
ceipt of appreciated property in exchange for the op-
tion. The partnership has a basis of $1,000 in Property
E. In Year 3, when the partnership property is val-
ued at $16,000, N exercises the option, contributing
Property F with a basis of $3,000 and a fair market
value of $5,000 to the partnership. Under paragraph
(a) of this section, neither the partnership nor N rec-
ognizes gain upon N’s contribution of property to the
partnership upon the exercise of the option. Under sec-
tion 723, the partnership has a basis of $3,000 in Prop-
erty F. See§1.704–1(b)(2)(iv)(d)(4) and (s) for special
rules applicable to capital account adjustments on the
exercise of a noncompensatory option.
(g)Effective Date.This section applies
to noncompensatory options that are is-
sued on or after the date final regulations
are published in theFederal Register.
Par. 5. Section 1.761–3 is added to read
as follows.
§1.761–3 Certain option holders treated
as partners.
(a)In general.A noncompensatory op-
tion (as defined in paragraph (b) of this sec-
tion) is treated as a partnership interest if
the option (and any rights associated with
it) provides the holder with rights that are
substantially similar to the rights afforded
to a partner. This paragraph applies only if,
as of the date that the noncompensatory op-
tion is issued, transferred, or modified, there
is a strong likelihood that the failure to treat
the holder of the noncompensatory op-
tion as a partner would result in a substan-
tial reduction in the present value of the
partners’and the holder’s aggregate tax li-
abilities. If the holder of a noncompensa-
tory option is treated as a partner under this
section, such partner’s distributive share of
the partnership’s income, gain, loss, de-
duction or credit (or items thereof) is de-
termined in accordance with that partner’s
interest in the partnership (taking into ac-
count all facts and circumstances) in ac-
cordance with§1.704–1(b)(3).
(b)Definitions—(1)Noncompensatory
option.For purposes of this section, a non-
compensatory option means an option (as
defined in paragraph (b)(2) of this sec-
tion) issued by a partnership, other than an
option issued in connection with the per-
formance of services. A noncompensatory
option issued by an eligible entity (as de-
fined in§301.7701–3(a)) that would be-
come a partnership under§301.7701–3(f)(2)
of this chapter if the option holder were
treated as a partner under this section is also
a noncompensatory option for purposes of
this section. If a noncompensatory option
is issued by such an eligible entity, then the
eligible entity is treated as a partnership for
purposes of applying this section.
(2)Option.For purposes of this sec-
tion, a call option or warrant to acquire an
interest in the issuing partnership is an op-
tion. In addition, convertible debt (as de-
fined in§1.721–2(e)(2)) and convertible
equity (as defined in§1.721–2(e)(3)) are op-
tions for purposes of this section. A con-
tract that otherwise constitutes an option
shall not fail to be treated as such for pur-
poses of this section merely because it may
or must be settled in cash or property other
than a partnership interest.
(c)Rights taken into account.(1) In de-
termining whether a noncompensatory op-
tion provides the holder with rights that are
substantially similar to the rights afforded
to a partner, all facts and circumstances are
considered, including whether the option is
reasonably certain to be exercised (as of the
time that the option is issued, transferred
or modified) and whether the option holder
possesses partner attributes. For purposes
of this section, if a noncompensatory op-
tion is reasonably certain to be exercised,
then the holder of the option ordinarily has
rights that are substantially similar to the
rights afforded to a partner.
(2)Reasonable certainty of exercise.The
following factors are relevant in determin-
ing whether a noncompensatory option is
reasonably certain to be exercised (as of the
time that the noncompensatory option is is-
sued, transferred, or modified)—
(i) The fair market value of the partner-
ship interest that is the subject of the op-
tion;
(ii) The exercise price of the option;
(iii) The term of the option;
(iv) The volatility, or riskiness, of the
partnership interest that is the subject of the
option;
(v) The fact that the option premium and,
if the option is exercised, the option exer-
cise price, will become assets of the part-
nership;
(vi) Anticipated distributions by the part-
nership during the term of the option;
(vii) Any other special option features,
such as an exercise price that declines over
time or declines contingent on the happen-
ing of specific events;
(viii) The existence of related options,
including reciprocal options; and
(ix) Any other arrangements (express or
implied) affecting the likelihood that the op-
tion will be exercised.
(3)Partner attributes.Partner attributes
include the extent to which the holder of
the option will share in the economic ben-
efit of partnership profits (including dis-
tributed profits) and in the economic
detriment associated with partnership losses.
2003–9 I.R.B.554March 3, 2003

Partner attributes also include the exist-
ence of any arrangement (either within the
option agreement or in a related agree-
ment) that, directly or indirectly, allows the
holder of a noncompensatory option to con-
trol or restrict the activities of the partner-
ship. For this purpose, rights in the
partnership possessed by the option holder
solely by virtue of owning a partnership in-
terest and not by virtue of holding a non-
compensatory option are not taken into
account, provided that those rights are no
greater than rights granted to other part-
ners owning similar interests in the part-
nership.
(d)Examples.The following examples
illustrate the provisions of this section. For
the following examples, assume that:
(1) Each option agreement provides that
the partnership cannot make distributions
to its partners while the option remains out-
standing; and
(2) The option holders do not have any
significant rights to control or restrict the
activities of the partnership (other than re-
stricting distributions and dilutive issu-
ances of partnership equity).
Example 1. Active trade or business.PRS is a part-
nership engaged in a telecommunications business. In
exchange for a premium of $8x, PRS issues a non-
compensatory option to A to acquire a 10 percent in-
terest in PRS for $17x at any time during a 7-year
period commencing on the date on which the op-
tion is issued. At the time of the issuance of the op-
tion, a 10 percent interest in PRS has a fair market
value of $16x. Due to the riskiness of PRS’s busi-
ness, the value of a 10 percent PRS interest in 7 years
is not reasonably predictable as of the time the op-
tion is issued. Therefore, it is not reasonably certain
that A’s option will be exercised. Furthermore, al-
though the option provides A with substantially the
same economic benefit of partnership profits as would
a direct investment in PRS, A does not share in sub-
stantially the same economic detriment of partner-
ship losses as would a partner in PRS. Given these
facts, the option to acquire a PRS interest does not pro-
vide A with rights that are substantially similar to the
rights afforded to a partner. Therefore, A is not treated
as a partner under this section.
Example 2. Option issued by partnership with rea-
sonably predictable earnings.PRS owns rental real
property. The property is 95 percent rented to corpo-
rate tenants with a mid-investment grade bond rat-
ing or better and is expected to remain so for the next
20 years. The tenants of the building are respon-
sible for paying all real estate taxes, insurance, and
maintenance expenses relating to the property. Oc-
cupancy rates in properties of a similar character are
high in the geographic area in which the property is
located, and it is reasonably predictable that proper-
ties in that area will retain their value during the next
10 years. In exchange for a premium of $6.5x, PRS
issues a noncompensatory option to B to acquire a 10
percent interest in PRS for $17x at the end of a 7-year
period commencing on the date of the issuance of the
option. At the time the option is issued, a 10 per-
cent interest in PRS has a fair market value of $16.5x.
Given the stability of PRS’s rental property, PRS can
reasonably predict that its net cash flow for each of
the 7 years during which the option is outstanding will
be $10x ($70x over the 7 years), and that there will
be no decline in the value of the property during that
time. In light of the reasonably predictable earnings
of PRS and the fact that PRS will make no distribu-
tions to its partners during the 7 years that the op-
tion is outstanding, it is reasonably certain that the
value of a 10 percent interest in PRS at the end of the
option’s 7-year term will significantly exceed the ex-
ercise price of the option. Therefore, the option is rea-
sonably certain to be exercised. Because the option
is reasonably certain to be exercised, under these facts,
B has rights that are substantially similar to the rights
afforded to a partner. Therefore, if there is a strong
likelihood that failure to treat B as a partner would
result in a substantial reduction in the partners’and
B’s aggregate tax liabilities, B will be treated as a part-
ner. In such a case, B’s distributive share of PRS’s
income, gain, loss, deduction, or credit (or items
thereof) is determined in accordance with B’s inter-
est in the partnership (taking into account all facts and
circumstances) in accordance with§1.704–1(b)(3).
Example 3. Deep in the money options.(i) LP is a
limited partnership engaged in an internet start-up ven-
ture. In exchange for a premium of $14x, LP issues
a noncompensatory option to C to acquirea5per-
cent interest in LP for $6x at any time during a 10-
year period commencing on the date on which the
option is issued. At the time of the issuance of the op-
tion, a 5 percent interest in LP has a fair market value
of $15x. Because of the riskiness of LP’s business,
the option is not reasonably certain to be exercised.
Nevertheless, because C has paid a $14x premium for
a partnership interest that has a fair market value of
$15x, C has substantially the same economic ben-
efits and detriments as a result of purchasing the op-
tion as C would have had if C had purchased a
partnership interest. Therefore, the option provides C
with rights that are substantially similar to the rights
afforded to a partner (partner attributes). See para-
graph (c)(3) of this section. If there is a strong like-
lihood that failure to treat C as a partner would result
in a substantial reduction in the partners’and C’s ag-
gregate tax liabilities, C will be treated as a partner.
In such a case, C’s distributive share of LP’s in-
come, gain, loss, deduction, or credit (or items thereof)
is determined in accordance with C’s interest in the
partnership (taking into account all facts and circum-
stances) in accordance with§1.704–1(b)(3).
(ii) The facts are the same as in paragraph (i) of this
Example 3, except that C transfers $150x to LP in ex-
change for a note from LP that matures 10 years from
the date of issuance and a warrant to acquirea5per-
cent interest in LP for an exercise price of $6x. The
warrant issued with the debt is exercisable at any time
during the 10-year term of the debt. The debt instru-
ment and the warrant comprise an investment unit with
the meaning of section 1273(c)(2). Under§1.1273–
2(h), the issue price of the investment unit, $150x, is
allocated $136x to the debt instrument and $14x to
the warrant. As in paragraph (i), C has substantially
the same economic benefits and detriments as a re-
sult of purchasing the warrant as C would have had
if C had purchased a partnership interest. Therefore,
the warrant provides C with rights that are substan-
tially similar to the rights afforded to a partner. If there
is a strong likelihood that failure to treat C as a part-
ner would result in a substantial reduction in the part-
ners’and C’s aggregate tax liabilities, then C will be
treated as a partner. In such a case, C’s distributive
share of LP’s income, gain, loss, deduction, or credit
(or items thereof) is determined in accordance with
C’s interest in the partnership (taking into account all
facts and circumstances) in accordance with§1.704–
1(b)(3).
(e)Effective Date.This section applies
to noncompensatory options that are is-
sued on or after the date final regulations
are published in theFederal Register.
Par. 6. Section 1.1272–1 is amended by
adding a sentence at the end of paragraph
(e) to read as follows:
§1.1272–1 Current inclusion of OID in
income.
*****
(e)***For debt instruments issued on
or after the date final regulations are pub-
lished in theFederal Register, the term
stockin the preceding sentence means an
equity interest in any entity that is classi-
fied, for federal tax purposes, as either a
partnership or a corporation.
*****
Par. 7. Section 1.1273–2 is amended by
adding a sentence at the end of paragraph
(j) to read as follows:
§1.1273–2 Determination of issue price
and issue date.
*****
(j)***For debt instruments issued on
or after the date final regulations are pub-
lished in thefederal Register, the term
stockin the preceding sentence means an
equity interest in any entity that is classi-
fied, for federal tax purposes, as either a
partnership or a corporation.
*****
Par. 8. Section 1.1275–4 is amended by
adding a sentence at the end of paragraph
(a)(4) to read as follows:
§1.1275–4 Contingent payment debt
instruments.
(a)***
(4)***For debt instruments issued on
or after the date final regulations are pub-
lished in theFederal Register, the term
stockin the preceding sentence means an
equity interest in any entity that is classi-
fied, for federal tax purposes, as either a
partnership or a corporation.
March 3, 20035552003–9 I.R.B.

*****
David A. Mader,
Assistant Deputy Commissioner of
Internal Revenue.
(Filed by the Office of the Federal Register on January 21,
2003, 8:45 a.m., and published in the issue of the Federal Reg-
ister for January 22, 2003, 68 F.R. 2930)
2003–9 I.R.B.556March 3, 2003

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
effect:
Amplifieddescribes a situation where
no change is being made in a prior pub-
lished position, but the prior position is
being extended to apply to a variation of
the fact situation set forth therein. Thus, if
an earlier ruling held that a principle
applied to A, and the new ruling holds
that the same principle also applies to B,
the earlier ruling is amplified. (Compare
withmodified, below).
Clarifiedis used in those instances
where the language in a prior ruling is
being made clear because the language
has caused, or may cause, some confu-
sion. It is not used where a position in a
prior ruling is being changed.
Distinguisheddescribes a situation
where a ruling mentions a previously
published ruling and points out an essen-
tial 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 pub-
lished position. (Compare withamplified
andclarified, 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
rulings that are obsoleted because of
changes in law or regulations. A ruling
may also be obsoleted because the sub-
stance has been included in regulations
subsequently adopted.
Revokeddescribes situations where the
position in the previously published rul-
ing is not correct and the correct position
is being stated in the new ruling.
Supersededdescribes a situation where
the new ruling does nothing more than
restate the substance and situation of a
previously published ruling (or rulings).
Thus, the term is used to republish under
the 1986 Code and regulations the same
position published under the 1939 Code
and regulations. The term is also used
when it is desired to republish in a single
ruling a series of situations, names, etc.,
that were previously published over a
period of time in separate rulings. If the
new ruling does more than restate the
substance of a prior ruling, a combination
of terms is used. For example,modified
andsupersededdescribes a situation
where the substance of a previously pub-
lished 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 published ruling is first
modified and then, as modified, is super-
seded.
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
ruling has been supplemented several
times, a new ruling may be published that
includes the list in the original ruling and
the additions, and supersedes all prior rul-
ings in the series.
Suspendedis used in rare situations to
show that the previous published rulings
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 following abbreviations in current
use and formerly used will appear in
material published in the Bulletin.
A—Individual.
Acq.—Acquiescence.
B—Individual.
BE—Beneficiary.
BK—Bank.
B.T.A.—Board of Tax Appeals.
C—Individual.
C.B.—Cumulative Bulletin.
CFR—Code of Federal Regulations.
CI—City.
COOP—Cooperative.
Ct.D.—Court Decision.
CY—County.
D—Decedent.
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—Employer.
ERISA—Employee Retirement Income Security Act.
EX—Executor.
F—Fiduciary.
FC—Foreign Country.
FICA—Federal Insurance Contributions Act.
FISC—Foreign International Sales Company.
FPH—Foreign Personal Holding Company.
F. R .—Federal Register.
FUTA—Federal Unemployment Tax Act.
FX—Foreign Corporation.
G.C.M.—Chief Counsel’s Memorandum.
GE—Grantee.
GP—General Partner.
GR—Grantor.
IC—Insurance Company.
I.R.B.—Internal Revenue Bulletin.
LE—Lessee.
LP—Limited Partner.
LR—Lessor.
M—Minor.
Nonacq.—Nonacquiescence.
O—Organization.
P—Parent Corporation.
PHC—Personal Holding Company.
PO—Possession of the U.S.
PR—Partner.
PRS—Partnership.
PTE—Prohibited Transaction Exemption.
Pub. L.—Public Law.
REIT—Real Estate Investment Trust.
Rev. Proc.—Revenue Procedure.
Rev. Rul.—Revenue Ruling.
S—Subsidiary.
S.P.R.—Statements of Procedural Rules.
Stat.—Statutes at Large.
T—Target Corporation.
T.C.—Tax Court.
T.D.—Treasury Decision.
TFE—Transferee.
TFR—Transferor.
T.I.R.—Technical Information Release.
TP—Taxpayer.
TR—Trust.
TT—Trustee.
U.S.C.—United States Code.
X—Corporation.
Y—Corporation.
Z—Corporation.
March 3, 2003i2003–9 I.R.B.

Numerical Finding List
1
Bulletins 2003–1 through 2003–8
Announcements:
2003–1, 2003–2 I.R.B.281
2003–2, 2003–3 I.R.B.301
2003–3, 2003–4 I.R.B.361
2003–4, 2003–5 I.R.B.396
2003–5, 2003–5 I.R.B.397
2003–6, 2003–6 I.R.B.450
2003–7, 2003–6 I.R.B.450
2003–8, 2003–6 I.R.B.451
2003–9, 2003–7 I.R.B.490
2003–10, 2003–7 I.R.B.490
Notices:
2003–1, 2003–2 I.R.B.257
2003–2, 2003–2 I.R.B.257
2003–3, 2003–2 I.R.B.258
2003–4, 2003–3 I.R.B.294
2003–5, 2003–3 I.R.B.294
2003–6, 2003–3 I.R.B.298
2003–7, 2003–4 I.R.B.310
2003–8, 2003–4 I.R.B.310
2003–9, 2003–5 I.R.B.369
2003–10, 2003–5 I.R.B.369
2003–11, 2003–6 I.R.B.422
2003–12, 2003–6 I.R.B.422
2003–13, 2003–8 I.R.B.513
2003–14, 2003–8 I.R.B.515
Proposed Regulations:
REG–209500–86, 2003–2 I.R.B.262
REG–116641–01, 2003–8 I.R.B.518
REG–125638–01, 2003–5 I.R.B.373
REG–126016–01, 2003–7 I.R.B.486
REG–124069–02, 2003–7 I.R.B.488
REG–138882–02, 2003–8 I.R.B.522
REG–151043–02, 2003–3 I.R.B.300
REG–164464–02, 2003–2 I.R.B.262
Revenue Procedures:
2003–1, 2003–1 I.R.B.1
2003–2, 2003–1 I.R.B.76
2003–3, 2003–1 I.R.B.113
2003–4, 2003–1 I.R.B.123
2003–5, 2003–1 I.R.B.163
2003–6, 2003–1 I.R.B.191
2003–7, 2003–1 I.R.B.233
2003–8, 2003–1 I.R.B.236
2003–9, 2003–8 I.R.B.516
2003–10, 2003–2 I.R.B.259
2003–11, 2003–4 I.R.B.311
2003–12, 2003–4 I.R.B.316
2003–13, 2003–4 I.R.B.317
2003–14, 2003–4 I.R.B.319
2003–15, 2003–4 I.R.B.321
2003–16, 2003–4 I.R.B.359
2003–17, 2003–6 I.R.B.427
2003–18, 2003–6 I.R.B.439
2003–19, 2003–5 I.R.B.371
2003–20, 2003–6 I.R.B.445
2003–21, 2003–6 I.R.B.448
Revenue Rulings:
2003–1, 2003–3 I.R.B.291
2003–2, 2003–2 I.R.B.251
2003–3, 2003–3 I.R.B.252
2003–4, 2003–4 I.R.B.253
2003–5, 2003–5 I.R.B.254
2003–6, 2003–3 I.R.B.286
2003–7, 2003–5 I.R.B.363
2003–8, 2003–3 I.R.B.290
2003–9, 2003–4 I.R.B.303
2003–10, 2003–3 I.R.B.288
2003–11, 2003–3 I.R.B.285
2003–12, 2003–3 I.R.B.283
2003–13, 2003–4 I.R.B.305
2003–14, 2003–4 I.R.B.302
2003–15, 2003–4 I.R.B.302
2003–16, 2003–6 I.R.B.401
2003–17, 2003–6 I.R.B.400
2003–18, 2003–7 I.R.B.467
2003–19, 2003–7 I.R.B.468
2003–20, 2003–7 I.R.B.465
2003–21, 2003–8 I.R.B.509
2003–22, 2003–8 I.R.B.494
2003–23, 2003–8 I.R.B.511
Treasury Decisions:
9024, 2003–5 I.R.B.365
9025, 2003–5 I.R.B.362
9026, 2003–5 I.R.B.366
9027, 2003–6 I.R.B.413
9028, 2003–6 I.R.B.415
9029, 2003–6 I.R.B.403
9030, 2003–8 I.R.B.495
9031, 2003–8 I.R.B.504
9032, 2003–7 I.R.B.471
9033, 2003–7 I.R.B.483
9034, 2003–7 I.R.B.453
9041, 2003–8 I.R.B.510
1
A cumulative list of all revenue rulings, revenue
procedures, Treasury decisions, etc., published in
Internal Revenue Bulletins 2002–26 through 2002–52 is
in Internal Revenue Bulletin 2003–1, dated January 6, 2003.
2003–9 I.R.B.iiMarch 3, 2003

Finding List of Current Actions
on Previously Published Items
2
Bulletins 2003–1 through 2003–8
Notices:
97–19
Modified by
Rev. Proc. 2003–1, 2003–1 I.R.B.1
2001–26
Obsoleted by
T.D. 9032, 2003–7 I.R.B.471
2001–46
Modified by
Notice 2003–6, 2003–3 I.R.B.298
2001–69
Modified and superseded by
Notice 2003–1, 2003–2 I.R.B.257
2002–27
Clarified by
Notice 2003–3, 2003–2 I.R.B.258
2002–46
Modified by
Notice 2003–10, 2003–5 I.R.B.369
Proposed Regulations:
REG–209500–86
Corrected by
Ann. 2003–6, 2003–6 I.R.B.450
REG–164464–02
Corrected by
Ann. 2003–6, 2003–6 I.R.B.450
Revenue Procedures:
83–23
Supplemented by
Rev. Proc. 2003–21, 2003–6 I.R.B.448
84–37
Modified by
Rev. Proc. 2003–1, 2003–1 I.R.B.1
93–38
Obsoleted by
Rev. Proc. 2003–15, 2003–4 I.R.B.321
97–31
Modified by
Rev. Proc. 2003–9, 2003–8 I.R.B.516
98–13
Obsoleted by
T.D. 9032, 2003–7 I.R.B.471
2002–1
Superseded by
Rev. Proc. 2003–1, 2003–1 I.R.B.1
2002–2
Superseded by
Rev. Proc. 2003–2, 2003–1 I.R.B.76
Revenue Procedures—Continued:
2002–3
Superseded by
Rev. Proc. 2003–3, 2003–1 I.R.B.113
2002–4
Superseded by
Rev. Proc. 2003–4, 2003–1 I.R.B.123
2002–5
Superseded by
Rev. Proc. 2003–5, 2003–1 I.R.B.163
2002–6
Superseded by
Rev. Proc. 2003–6, 2003–1 I.R.B.191
2002–7
Superseded by
Rev. Proc. 2003–7, 2003–1 I.R.B.233
2002–8
Superseded by
Rev. Proc. 2003–8, 2003–1 I.R.B.236
2002–9
Modified and amplified by
Rev. Proc. 2003–20, 2003–6 I.R.B.445
Rev. Rul. 2003–3, 2003–2 I.R.B.252
2002–22
Modified by
Rev. Proc. 2003–3, 2003–1 I.R.B.113
2002–29
Modified by
Rev. Proc. 2003–10, 2003–2 I.R.B.259
2002–52
Modified by
Rev. Proc. 2003–1, 2003–1 I.R.B.1
2002–67
Supplemented by
Ann. 2003–3, 2003–4 I.R.B.361
2002–75
Superseded by
Rev. Proc. 2003–3, 2003–1 I.R.B.113
2003–3
Amplified by
Rev. Proc. 2003–14, 2003–4 I.R.B.319
2003–7
Corrected by
Ann. 2003–4, 2003–5 I.R.B396
Revenue Rulings:
53–131
Modified by
Rev. Rul. 2003–12, 2003–3 I.R.B.283
57–190
Obsoleted by
Rev. Rul. 2003–18, 2003–7 I.R.B.467
65–190
Revoked by
Rev. Rul. 2003–3, 2003–2 I.R.B.252
Revenue Rulings—Continued:
69–372
Revoked by
Rev. Rul. 2003–3, 2003–2 I.R.B.252
2003–2
Revoked by
Rev. Rul. 2003–22, 2003–8 I.R.B.494
Treasury Decisions:
9002
Corrected by
Ann. 2003–8, 2003–6 I.R.B.451
9022
Supplemented by
Ann. 2003–7, 2003–6 I.R.B.450
2
A cumulative list of current actions on previously
published items in Internal Revenue Bulletins
2002–26 through 2002–52 is in Internal Revenue
Bulletin 2003–1, dated January 6, 2003.
March 3, 2003iii2003–9 I.R.B.

INDEX
Internal Revenue Bulletins
2003–1 through 2003–8
The abbreviation and number in paren-
thesis following the index entry refer to
the specific item; numbers in roman and
italic type following the parenthesis refer
to the Internal Revenue Bulletin in which
the item may be found and the page num-
ber on which it appears.
Key to Abbreviations:
AnnAnnouncement
CDCourt Decision
DODelegation Order
EOExecutive Order
PLPublic Law
PTEProhibited Transaction
Exemption
RPRevenue Procedure
RRRevenue Ruling
SPRStatement of Procedural
Rules
TCTax Convention
TDTreasury Decision
TDOTreasury Department Order
EMPLOYEE PLANS
Advance letter rulings and determination
letters, areas which will not be issued
from:
Associates Chief Counsel and Division
Counsel/Associate Chief Counsel
(TE/GE) (RP 3) 1,113
Associate Chief Counsel (Interna-
tional) (RP 7) 1,233; correction
(Ann 4) 5,396
Contacts with third parties for determina-
tion or collection of taxes (TD 9028)
6,415
Defined benefit plans, required minimum
distributions (Notice 2) 2,257
Determination letters, issuing procedures
(RP 6) 1,191
Employee stock ownership plans, delayed
effective date, abuse (RR 6) 3,286
Full funding limitations, weighted aver-
age interest rate for:
January 2003 (Notice 7) 4,310
February 2003 (Notice 14) 8,515
Individual retirement arrangements:
Deemed IRAs (RP 13) 4,317
Required minimum distributions
(Notice 3) 2,258
EMPLOYEE PLANS—
Cont.
Letter rulings:
Determination letters and information
letters issued by Associates Chief
Counsel and Division Counsel/
Associate Chief Counsel (TE/GE)
(RP 1) 1,1
Information letters, etc. (RP 4) 1,123
Limitation on annual compensation, non-
discrimination (RR 11) 3,285
Nondiscrimination, governmental plans
(Notice 6) 3,298
Practice before the Internal Revenue Ser-
vice (Ann 5) 5,397
Proposed Regulations:
26 CFR 1.401(a)(4)–3,–9, revised;
1.411(b)–2, revised; reductions of
accruals and allocations because of
the attainment of any age; applica-
tion of nondiscrimination cross-
testing rules to cash balance plans
(REG–209500–86, REG–164464–
02) 2,262; correction (Ann 6)
6,450
Qualified retirement plans:
Age discrimination (REG–209500–86,
REG–164464–02) 2,262; correc-
tion (Ann 6) 6,450
Definition of early retirement benefits
and retirement-type subsidies, con-
tingent benefits (Notice 10) 5,369
Distributions, rollover, waiver of
60-day requirement (RP 16) 4,359
Minimum distributions, delayed
amendment date (RP 10) 2,259
Regulations:
26 CFR 301.7602–2, added; third
party contacts (TD 9028) 6,415
Technical advice:
Proposed cash balance regulations, age
discrimination issues (Ann 1) 2,281
To directors and chiefs, appeals
offices, from Associates Chief
Counsel and Division Counsel/
Associate Chief Counsel (TE/GE)
(RP 2) 1,76
To IRS employees (RP 5) 1,163
User fees, request for letter rulings (RP 8)
1,236
EMPLOYMENT TAX
Contacts with third parties for determina-
tion or collection of taxes (TD 9028)
6,415
EMPLOYMENT TAX—
Cont.
Levy restrictions during installment
agreements (TD 9027) 6,413
Practice before the Internal Revenue Ser-
vice (Ann 5) 5,397
Regulations:
26 CFR 301.6331–3,–4, added; levy
restrictions during installment agree-
ments (TD 9027) 6,413
26 CFR 301.7602–2, added; third
party contacts (TD 9028) 6,415
ESTATE TAX
Contacts with third parties for determina-
tion or collection of taxes (TD 9028)
6,415
Levy restrictions during installment
agreements (TD 9027) 6,413
Practice before the Internal Revenue Ser-
vice (Ann 5) 5,397
Regulations:
26 CFR 301.6331–3,–4, added; levy
restrictions during installment agree-
ments (TD 9027) 6,413
26 CFR 301.7602–2, added; third
party contacts (TD 9028) 6,415
EXCISE TAX
Contacts with third parties for determina-
tion or collection of taxes (TD 9028)
6,415
Insurance premium excise tax, liability
for (TD 9024) 5,365
Levy restrictions during installment
agreements (TD 9027) 6,413
Practice before the Internal Revenue Ser-
vice (Ann 5) 5,397
Regulations:
26 CFR 46.4374–1, revised; liability
for insurance premium excise tax
(TD 9024) 5,365
26 CFR 301.6331–3,–4, added; levy
restrictions during installment agree-
ments (TD 9027) 6,413
26 CFR 301.7602–2, added; third
party contacts (TD 9028) 6,415
2003–9 I.R.B.ivMarch 3, 2003

EXEMPT
ORGANIZATIONS
Advance letter rulings and determination
letters, areas which will not be issued
from Associates Chief Counsel and
Division Counsel/Associate Chief
Counsel (TE/GE) (RP 3) 1,113
Contacts with third parties for determina-
tion or collection of taxes (TD 9028)
6,415
Dissolution clause requirements for sec-
tion 501(c)(3) entities seeking a section
115(1) letter ruling (RP 12) 4,316
Form 990, Return of Organization
Exempt From Income Tax, U.S. posses-
sions, relief from filing (RP 21) 6,448
Letter rulings:
Determination letters and information
letters issued by Associates Chief
Counsel and Division Counsel/
Associate Chief Counsel (TE/GE)
(RP 1) 1,1
Information letters, etc. (RP 4) 1,123
List of organizations classified as private
foundations (Ann 10) 7,490
Practice before the Internal Revenue Ser-
vice (Ann 5) 5,397
Private foundations, termination, transfer
of assets (RR 13) 4,305
Regulations:
26 CFR 301.7602–2, added; third
party contacts (TD 9028) 6,415
Technical advice to:
Directors and chiefs, appeals offices,
from Associates Chief Counsel and
Division Counsel/Associate Chief
Counsel (TE/GE) (RP 2) 1,76
IRS employees (RP 5) 1,163
U.S. possessions, relief from filing Form
990 (RP 21) 6,448
User fees, request for letter rulings (RP 8)
1,236
GIFT TAX
Contacts with third parties for determina-
tion or collection of taxes (TD 9028) 6,
415
Practice before the Internal Revenue Ser-
vice (Ann 5) 5,397
Regulations:
26 CFR 301.7602–2, added; third
party contacts (TD 9028) 6,415
INCOME TAX
Accuracy-related penalty, defenses avail-
able to the imposition (REG–126016–
01) 7,486
Accrual of income (RR 10) 3,288
Advance letter rulings and determination
letters, areas which will not be issued
from:
Associates Chief Counsel and Division
Counsel/Associate Chief Counsel
(TE/GE) (RP 3) 1,113
Associate Chief Counsel (Interna-
tional) (RP 7) 1,233; correction
(Ann 4) 5,396
Basis of redeemed stock when a distribu-
tion in redemption of stock is treated as
a dividend (Ann 9) 7,490
Capitalization of amounts paid to acquire,
create, or enhance intangible assets
(REG–125638–01) 5,373
Consolidated income tax return, common
parent as agent for consolidated group,
substitute agent, tentative carryback
adjustments (Ann 8) 6,451
Constructive sales treatment for appreci-
ated financial positions (RR 1) 3,291
Contacts with third parties for determina-
tion or collection of taxes (TD 9028)
6,415
Contingent liability transaction cases, list
of arbitrators (Ann 3) 4,361
Corporations:
Acquisitions, auto dealer expansion
(RR 18) 7,467
Foreign tax credit limitation, dividends
from a noncontrolled section 902
corporation (Notice 5) 3,294
Transactions involving deemed sale of
corporate assets under section 338,
new Form 8883 (Ann 2) 3,301
Cost-share payments, Agricultural Man-
agement Assistance Program (AMA)
(RR 15) 4,302
Costa Rican withholding taxes, noncredit-
ability (RR 8) 3,290
Credits:
Education tax credit (TD 9034) 7,453
Low-income housing credit:
Satisfactory bond,“bond factor”
amounts for the period:
January through March 2003 (RR
2) 2,251; correction (RR 22)
8,494
New markets tax credit (RR 20) 7,
465; extension of deadline (Notice
9) 5,369
INCOME TAX—Cont.
Election to treat trust as part of an estate
(TD 9032) 7,471
Estimated tax, application of the addition
to the tax for underpayment (RR 23)
8,511
Exclusion of gain from the sale or
exchange of a principal residence (TD
9030) 8,495
Form 8883, Asset Allocation Statement
Under Section 338, new (Ann 2) 3,301
Information reporting:
On Form 1099–B for securities futures
contracts (Notice 8) 4,310
Payment card transactions, information
reporting and backup withholding
(REG–116641–01) 8,518
Requirements for qualified tuition and
related expenses under section
6050S, filing information returns on
magnetic media (TD 9029) 6,403
Transition rules for acquisitions of
control and substantial changes in
capital structure (Ann 7) 6,450
Innocent spouse relief, nonrequesting
spouse administrative appeal rights (RP
19) 5,371
Insurance companies:
Corporate reorganization and mergers,
demutualization (RR 19) 7,468
Determination of effectively connected
income of foreign insurance compa-
nies (RR 17) 6,400
Loss payment patterns and discount
factors for the 2002 accident year
(RP 17) 6,427
Recomputed differential earnings rate
for 2000 and the differential earn-
ings rate for 2001 for mutual life
insurance companies (RR 4) 2,253
Salvage discount factors for the 2002
accident year (RP 18) 6,439
Interest:
Investment:
Federal short-term, mid-term, and
long-term rates for:
January 2003 (RR 5) 2,254
February 2003 (RR 16) 6,401
Inventory:
LIFO, price indexes used by depart-
ment stores for:
November 2002 (RR 9) 4,303
December 2002 (RR 21) 8,509
March 3, 2003v2003–9 I.R.B.

INCOME TAX—Cont.
Valuation of vehicle parts cores (RP
20) 6,445
Leave-based donation programs (Notice
1) 2,257
Letter rulings, determination letters and
information letters issued by Associates
Chief Counsel and Division Counsel/
Associate Chief Counsel (TE/GE) (RP
1) 1,1
Levy restrictions during installment
agreements (TD 9027) 6,413
LIFO recapture installment payments
(Notice 4) 3,294
Low-income taxpayer clinics, income tax
return preparer (TD 9026) 5,366
Methods of accounting, nonaccrual expe-
rience (NAE) method (Notice 12)
6,422
Offshore Voluntary Compliance Initiative
(RP 11) 4,311
Partnerships, section 6038, returns
required with respect to controlled for-
eign partnerships (TD 9033) 7,483;
(REG–124069–02) 7,488
Practice before the Internal Revenue Ser-
vice (Ann 5) 5,397
Presidentially declared disaster, gross
income, disaster relief payments (RR
12) 3,283
Private foundations, organizations now
classified as (Ann 10) 7,490
Proposed Regulations:
26 CFR 1.61–8, revised; rents and roy-
alties (REG–151043–02) 3,300
26 CFR 1.121–3, amended; reduced
maximum exclusion of gain from
sale or exchange of principal resi-
dence (REG–138882–02) 8,522
26 CFR 1.167(a)–3, amended;
1.263(a)–4, added; 1.446–5, added;
guidance regarding deduction and
capitalization of expenditures
(REG–125638–01) 5,373
26 CFR 1.302–5, 1.304–3; redemp-
tions taxable as dividends (REG–
150313–01); correction (Ann 9) 7,
490
26 CFR 1.6038–3, amended; returns
required with respect to controlled
foreign partnerships (REG–124069–
02) 7,488
26 CFR 1.6662–3, amended;
1.6664–0,–4, amended; establishing
defenses to the imposition of the
accuracy-related penalty (REG–
126016–01) 7,486
INCOME TAX—Cont.
26 CFR 31.3406(g)–1, (j)–1, amended;
301.6724–1, amended; information
reporting and backup withholding
for payment card transactions
(REG–116641–01) 8,518
Qualified census tracts, issuers of quali-
fied mortgage bonds and mortgage
credit certificates (RP 15) 4,321
Qualified Payment Card Agent (QPCA),
proposed revenue procedure to request
a determination (Notice 13) 8,513
Regulations:
26 CFR 1.25A–0 through–5, added;
602.101, revised; education tax
credit (TD 9034) 7,453
26 CFR 1.121–1 through–4, amended;
1.121–5, removed; 1.1398–3, added;
exclusion of gain from sale or
exchange of principal residence (TD
9030) 8,495
26 CFR 1.121–3T, added; reduced
maximum exclusion of gain from
sale or exchange of principal resi-
dence (TD 9031) 8,504
26 CFR 1.446–1, amended; 1.1502–
13, revised; intercompany transac-
tions: conforming amendments to
section 446 (TD 9025) 5,362
26 CFR 1.641(b)–3, amended;
1.642(c)–1,–6A, revised; 1.645–1,
added; 1.671–4, amended; 1.6012–3,
amended; 1.6072–1, amended;
301.6109–1, amended; 602.101,
amended; election to treat trust as
part of an estate (TD 9032) 7,471
26 CFR 1.1502–77T, 602.101; agent
for consolidated group (TD 9002);
correction (Ann 8) 6,451
26 CFR 1.6038–3, amended; 1.6038–
3T, added; 602.101, amended;
returns required with respect to con-
trolled foreign partnerships (TD
9033) 7,483
26 CFR 1.6050S–0, amended;
1.6050S–1, added; 301.6011–2,
amended; 602.101, amended; infor-
mation reporting for qualified tuition
and related expenses; magnetic
media filing requirements for infor-
mation returns (TD 9029) 6,403
26 CFR 31.3406(j)–1, amended;
31.3406(j)–1T, added; Taxpayer
Identification Number (TIN) Match-
ing Program (TD 9041) 8,510
INCOME TAX—Cont.
26 CFR 301.6331–3,–4, added; levy
restrictions during installment agree-
ments (TD 9027) 6,413
26 CFR 301.7602–2, added; third
party contacts (TD 9028) 6,415
26 CFR 301.7701–15, amended; low-
income taxpayer clinics-definition of
income tax return preparer (TD
9026) 5,366
Rents and royalties, inclusion of advance
rentals in gross income (REG–151043–
02) 3,300
Sale or exchange of a principal residence,
reduced maximum exclusion of gain
(TD 9031) 8,504; (REG–138882–02)
8,522
Soil and Water Conservation Assistance
Program (SWCA) (RR 14) 4,302
State tax refunds, accrual of income (RR
3) 2,252
Stocks, determination and recognition of
gain or loss (RR 7) 5,363
Tax shelter registrations, effective date
(Notice 11) 6,422
Taxpayer Indentification Number (TIN)
Matching Program:
Expanded to online matching for all
payors and authorized agents (RP 9)
8,516
Expansion (TD 9041) 8,510
Technical advice to:
Directors and chiefs, appeals offices,
from Associates Chief Counsel and
Divison Counsel/Associate Chief
Counsel (TE/GE) (RP 2) 1,76
IRS employees (RP 5) 1,163
Timing rules of intercompany transaction
(TD 9025) 5,362
Trusts for minors, Indian Gaming Regula-
tory Act (IGRA) (RP 14) 4,319
SELF-EMPLOYMENT
TAX
Contacts with third parties for determina-
tion or collection of taxes (TD 9028) 6,
415
Levy restrictions during installment
agreements (TD 9027) 6,413
Practice before the Internal Revenue Ser-
vice (Ann 5) 5,397
2003–9 I.R.B.viMarch 3, 2003

SELF-EMPLOYMENT
TAX—Cont.
Regulations:
26 CFR 301.6331–3,–4, added; levy
restrictions during installment agree-
ments (TD 9027) 6,413
26 CFR 301.7602–2, added; third
party contacts (TD 9028) 6,415
March 3, 2003vii*U.S. Government Printing Office:2003–9 I.R.B.2003—496-919/60072