Internal Revenue Bulletin 2002-4 (PDF rendition): IRS Revenue Procedures

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
Rev. Rul. 2002–4, page 389.
LIFO; price indexes; department stores.The November
2001 Bureau of Labor Statistics price indexes are accepted for
use by department stores employing the retail inventory and
last-in, first-out inventory methods for valuing inventories for
tax years ended on, or with reference to, November 30, 2001.
T.D. 8973, page 391.
Final regulations under section 865(j)(1) of the Code relate to
the allocation of loss recognized on the disposition of stock
and other personal property.
T.D. 8975, page 379.
REG–142299–01, REG–209135–88, page 418.
Temporary and proposed regulations apply to certain transac-
tions or events that result in a Regulated Investment Company
(RIC) or a Real Estate Investment Trust (REIT) owning property
that has a basis determined by reference to a C corporation’s
basis in the property. These regulations clarify the tax treat-
ment of transfers of C corporation property to a RIC or REIT.
Notice 2002–8, page 398.
Split-dollar life insurance arrangements.This notice
announces that the Treasury and the Service intend to publish
proposed regulations providing comprehensive guidance on
the Federal tax treatment of split-dollar life insurance arrange-
ments. In addition, this notice indicates that any regulations will
not be effective until the publication date of the final regula-
tions, and provides information on the tax treatment of split-
dollar life insurance arrangements entered into prior to the
effective date of final regulations. Notice 2001–10 revoked.
Rev. Rul. 55–747 revoked, Rev. Ruls. 64–328 and 66–110
modified.
REG–112991–01, page 404.
Proposed regulations modify the following provisions of T.D.
8930: (1) that qualified research be undertaken for the purpose
of discovering information that is technological in nature; (2)
the process of experimentation; (3) the type of computer soft-
ware constituting internal use software; (4) the first part of the
three-part high threshold of innovation test for internal-use soft-
ware to be excepted from the exclusion from qualified
research; and (5) the documentation required to substantiate
the research credit. A public hearing is scheduled for March
27, 2002.
EMPLOYEE PLANS
Rev. Proc. 2002–10, page 401.
Opinion letters; prototype SEPs, SIMPLEs, and IRAs. This
revenue procedure describes the opinion letter program for all
prototype plans within the meaning of sections 408(a), (b), (k),
and (p) and 408A of the Code. Rev. Proc. 87–50 modified.
ADMINISTRATIVE
Announcement 2002–5, page 420.
Inflation-adjusted items; expatriation to avoid tax.This
annoucement provides corrections to Rev. Proc. 2001–13
(2001–3 I.R.B. 337), which sets forth inflation-adjusted items
for 2001. The corrections relate to amounts used to determine
whether taxpayers are subject to section 877 of the Code
regarding expatriation to avoid tax.
Finding Lists begin on page ii.
Bulletin No. 2002–4
January 28, 2002

The IRS Mission
Provide America’s taxpayers top quality service by helping
them understand and meet their tax responsibilities and by
applying the tax law with integrity and fairness to all.
Introduction
The Internal Revenue Bulletin is the authoritative instrument of
the Commissioner of Internal Revenue for announcing official
rulings and procedures of the Internal Revenue Service and for
publishing Treasury Decisions, Executive Orders, Tax Conven-
tions, legislation, court decisions, and other items of general
interest. It is published weekly and may be obtained from the
Superintendent of Documents on a subscription basis. Bulletin
contents are consolidated semiannually into Cumulative Bulle-
tins, 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 Bul-
letin. All published rulings apply retroactively unless otherwise
indicated. Procedures relating solely to matters of internal
management are not published; however, statements of inter-
nal practices and procedures that affect the rights and duties
of taxpayers are published.
Revenue rulings represent the conclusions of the Service on
the application of the law to the pivotal facts stated in the rev-
enue ruling. In those based on positions taken in rulings to tax-
payers or technical advice to Service field offices, identifying
details and information of a confidential nature are deleted to
prevent unwarranted invasions of privacy and to comply with
statutory requirements.
Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be
relied on, used, or cited as precedents by Service personnel in
the disposition of other cases. In applying published rulings and
procedures, the effect of subsequent legislation, regulations,
court decisions, rulings, and procedures must be considered,
and Service personnel and others concerned are cautioned
against reaching the same conclusions in other cases unless
the facts and circumstances are substantially the same.
The Bulletin is divided into four parts as follows:
Part I.—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
subjects are contained in the other Parts and Subparts. Also
included in this part are Bank Secrecy Act Administrative Rul-
ings. Bank Secrecy Act Administrative Rulings are issued by
the Department of the Treasury’s Office of the Assistant Secre-
tary (Enforcement).
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
period, 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.
January 28, 20022002–4 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Section 61.—Gross Income
Defined.
This notice announces that the Treasury and the
Service intend to publish proposed regulations pro-
viding comprehensive guidance on the Federal tax
treatment of split-dollar life insurance arrangements.
In addition, this notice indicates that any regulations
will not be effective until the publication date of the
final regulations, and provides information on the
tax treatment of split-dollar life insurance arrange-
ments entered into prior to the effective date of final
regulations. Notice 2001–10 (2001–5 I.R.B. 459) is
revoked. Notwithstanding that revocation, Rev. Rul.
55–747 (1955–2 C.B. 228) remains revoked, and
Rev. Rul. 64–328 (1964–2 C.B. 11) and Rev. Rul.
66–110 (1966–1 C.B. 12) remain modified to the
extent that those rulings indicate that an employer’s
premium payments under a split-dollar life insur-
ance arrangement may not be treated as loans. See
Notice 2002–8, page 398.
Section 337.—Nonrecognition
for Property Distributed to
Parent in Complete
Liquidation of Subsidiary
26 CFR 1.337(d)–5T: Tax on C assets becoming RIC
or REIT assets (temporary).
T.D. 8975
DEPARTMENT OF THE
TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Certain Transfers of Property
to Regulated Investment
Companies [RICs] and Real
Estate Investment Trusts
[REITs]
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Temporary regulations.
SUMMARY: This document contains
temporary regulations that apply to cer-
tain transactions or events that result in a
Regulated Investment Company [RIC] or
a Real Estate Investment Trust [REIT]
owning property that has a basis deter-
mined by reference to a C corporation’s
basis in the property. These regulations
affect RICs, REITs, and C corporations
and clarify the tax treatment of transfers
of C corporation property to a RIC or
REIT. The text of the temporary regula-
tions also serves as the text of the pro-
posed regulations set forth in the notice of
proposed rulemaking on this subject in
this issue of the Bulletin (REG–142299–
01, REG–209135–88, page 418).
DATES:Effective Date: These regula-
tions are effective January 2, 2002.
Applicability Dates: For dates of appli-
cability, see §§1.337(d)–6T(e) and
1.337(d)–7T(f).
FOR FURTHER INFORMATION CON-
TACT: Lisa A. Fuller (202) 622–7750
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
These temporary regulations are being
issued without prior notice and public
procedure pursuant to the Administrative
Procedure Act (5 U.S.C. 553). For this
reason, the collection of information con-
tained in these regulations has been
reviewed and, pending receipt and evalu-
ation of public comments, approved by
the Office of Management and Budget
under control number 1545–1672.
Responses to this collection of informa-
tion are required to obtain a benefit,i.e.,
to elect to recognize gain as if the C cor-
poration had sold the property at fair mar-
ket value or to elect section 1374 treat-
ment.
An agency may not conduct or spon-
sor, and a person is not required to
respond to, a collection of information
unless the collection of information dis-
plays a valid control number.
For further information concerning
this collection of information, and where
to submit comments on the collection of
information and the accuracy of the esti-
mated burden, and suggestions for reduc-
ing this burden, please refer to the pre-
amble to the cross-referencing notice of
proposed rulemaking published elsewhere
in this issue of the Bulletin.
Books or records relating to a collec-
tion of information must be retained as
long as their contents may become mate-
rial in the administration of any internal
revenue law. Generally, tax returns and
tax return information are confidential, as
required by 26 U.S.C. section 6103.
Background
Sections 631 and 633 of the Tax
Reform Act of 1986 (the 1986 Act) (Pub-
lic Law 99–514, 100 Stat. 2085, 2272), as
amended by section 1006(e) and (g) of
the Technical and Miscellaneous Revenue
Act of 1988 (the 1988 Act) (Public Law
100–647, 102 Stat. 3342, 3400–01),
amended the Internal Revenue Code
(Code) to repeal theGeneral Utilities
doctrine. In particular, the 1986 Act
amended sections 336 and 337 to require
corporations to recognize gain or loss on
the distribution of property in connection
with complete liquidations other than cer-
tain subsidiary liquidations. Section
337(d) directs the Secretary to prescribe
regulations as may be necessary to carry
out the purposes ofGeneral Utilities
repeal, including rules to “ensure that
such purposes may not be circum-
vented...through the use of a regulated
investment company, a real estate invest-
ment trust, or tax-exempt entity....”
Absent special rules, the transfer of prop-
erty owned by a C corporation to a RIC
or REIT could result in permanently
removing the property’s built-in gain
from tax at the corporate level, because
RICs and REITs generally are not subject
to tax on income that is distributed to
their shareholders.
On February 4, 1988, the IRS issued
Notice 88–19 (1988–1 C.B. 486)
announcing its intention to promulgate
regulations under the authority of section
337(d) with respect to transactions or
events that result in a RIC or REIT own-
ing property that has a basis determined
by reference to a C corporation’s basis (a
carryover basis). Notice 88–19 provided
that the regulations would apply with
respect to the net built-in gain of C cor-
poration assets that become assets of a
RIC or REIT by the qualification of a C
corporation as a RIC or REIT or by the
transfer of assets of a C corporation to a
RIC or REIT (a conversion transaction).
The Notice further provided that, where
the regulations apply, the C corporation
2002–4 I.R.B.379January 28, 2002

would be treated, for all purposes, as if it
had sold all of its assets at their respective
fair market values and immediately liqui-
dated. The Notice provided, however, that
the regulations would not allow the rec-
ognition of a net loss and that, except as
provided in the Notice, the regulations
would not affect the characterization for
tax purposes of, or the tax treatment of
parties to, any transactions to which they
apply. For example, shareholders of a C
corporation who received RIC shares in a
transaction that qualified as a reorganiza-
tion under section 368(a)(1)(C) would not
recognize gain or loss solely because the
C corporation was subject to tax. The
Notice also provided that immediate gain
recognition could be avoided if the C cor-
poration that qualified as a RIC or REIT
or the transferee RIC or REIT, as the case
may have been, elected to be subject to
tax under section 1374 with respect to the
C corporation property. Notice 88–19 also
indicated that the regulations would apply
retroactively to June 10, 1987. Notice
88–96 (1988–2 C.B. 420) amplifies
Notice 88–19 by providing that the regu-
lations described in Notice 88–19 would
provide an exception to the general gain
recognition rules for any C corporation
that qualified to be taxed as a RIC for at
least one taxable year, then failed to so
qualify for one taxable year, and then
requalified to be taxed as a RIC in the
next taxable year.
On February 7, 2000, Treasury and the
IRS published temporary regulations
(T.D. 8872, 2000–8 I.R.B. 639) (the 2000
temporary regulations) reflecting the prin-
ciples set forth in Notice 88–19 and
Notice 88–96, a notice of proposed rule-
making by cross-reference to temporary
regulations, and a notice of public hearing
(REG–209135–88, 2000–8 I.R.B. 681).
The 2000 temporary regulations apply
retroactively to June 10, 1987.
Treasury and the IRS have received a
number of comments, both written and
oral, on the 2000 temporary regulations.
A public hearing was held on May 10,
2000. After considering these comments,
Treasury and the IRS have decided to
issue two new sets of temporary regula-
tions, one that will apply to conversion
transactions occurring on or after June 10,
1987, and before January 2, 2002 (the
–6T regulations), and another that will
apply to conversion transactions occur-
ring on or after January 2, 2002 (the–7T
regulations). Alternatively, taxpayers gen-
erally may apply the 2000 temporary
regulations in lieu of the–6T regulations
to any conversion transaction that
occurred on or after June 10, 1987, and
before January 2, 2002. However, RICs
and REITs that rely on the 2000 tempo-
rary regulations and that are subject to
section 1374 treatment may not rely on
certain provisions in the 2000 temporary
regulations, but instead must apply cer-
tain provisions of the–6T regulations,
with respect to built-in gains and losses
recognized in taxable years beginning on
or after January 2, 2002. Furthermore,
taxpayers are not prevented from relying
on the 2000 temporary regulations merely
because they elect section 1374 treatment
in the manner described in the–6T regu-
lations rather than in the manner
described in the 2000 temporary regula-
tions.
Explanation of Provisions
This preamble first discusses the–6T
regulations and how the–6T regulations
differ from the 2000 temporary regula-
tions. This preamble then explains the
differences between the–7T regulations
and the–6T regulations.
Summary of–6T Regulations
The–6T regulations provide that, if
property of a C corporation that is not a
RIC or REIT becomes the property of a
RIC or REIT in a conversion transaction,
then the C corporation is subject to
deemed sale treatment, unless the RIC or
REIT elects to be subject to section 1374
treatment. Thus, the C corporation gener-
ally recognizes gain and loss as if it sold
the property converted to RIC or REIT
property or transferred to the RIC or
REIT (the converted property) to an unre-
lated party at fair market value immedi-
ately before the conversion transaction. If
the C corporation recognizes net gain on
the deemed sale, then the basis of the
converted property in the hands of the
RIC or REIT is adjusted to its fair market
value immediately before the conversion
transaction. The–6T regulations do not
permit a C corporation to recognize a net
loss on the deemed sale. For this purpose,
net loss is defined as the excess of aggre-
gate losses over aggregate gains (includ-
ing items of income), without regard to
character. Where there is a net loss, the C
corporation recognizes no gain or loss on
the deemed sale, and the C corporation’s
basis in the converted property carries
over to the RIC or REIT.
Clarification of Deemed Sale Treatment
The 2000 temporary regulations pro-
vide that, unless a section 1374 election is
made, a C corporation that elects RIC or
REIT status or transfers property to a RIC
or REIT is“treated for all purposes,
including recognition of net built-in gain,
as if it had sold all of its assets at their
respective fair market values on the
deemed liquidation date...andimmedi-
ately liquidated.”Commentators objected
to this provision on two grounds. First,
they argued that the provision is overly
broad, because it treats the C corporation
that is transferring property to a RIC or
REIT as having sold all of its property,
even where all of its property may not
have been transferred to the RIC or REIT.
Second, they argued that the“for all pur-
poses”language could be read to suggest
that the deemed liquidation results in the
imposition of a shareholder tax, a result
that they view as inconsistent with Notice
88–19 and the purposes of section 337(d).
Commentators also argued that deemed
liquidation treatment would inappropri-
ately eliminate the C corporation’s tax
attributes, such as net operating loss car-
ryforwards and earnings and profits, to
which the RIC or REIT might otherwise
succeed.
Treasury and the IRS agree with these
comments. Accordingly, the–6T regula-
tions clarify that the C corporation is
treated as having sold only that property
actually transferred to the RIC or REIT
and that a shareholder-level tax is not
imposed. In addition, the deemed liquida-
tion construct has been eliminated.
Deemed Sale Loss Disallowance
The 2000 temporary regulations do not
permit a C corporation to recognize a net
loss on a conversion transaction. Some
commentators argued that loss disallow-
ance is inappropriate, noting that a net
loss can be recognized under sections 336
and§1.337(d)–4, which govern certain
transfers of property from taxable to tax-
exempt entities.
January 28, 20023802002–4 I.R.B.

Treasury and the IRS believe that loss
disallowance is appropriate in the context
of the–6T regulations for two reasons.
First, Treasury and the IRS are concerned
that a C corporation may selectively con-
tribute loss property to a RIC or REIT in
a section 351 transaction, generating an
immediate loss. Because sections 336 and
§1.337(d)–4 apply only where a C corpo-
ration transfers substantially all of its
assets, selective contribution concerns are
minimal in those contexts. Second, sec-
tions 336 and§1.337(d)–4 require C cor-
porations to recognize both gains and
losses immediately, whereas the–6T
regulations allow taxpayers to defer the
recognition of net gain on a conversion
transaction by making an election to be
subject to tax under section 1374. Allow-
ing immediate net loss recognition while
allowing deferral of net gain would pro-
vide C corporations engaging in conver-
sion transactions with an inappropriate
degree of selectivity. Taxpayers that oth-
erwise would recognize a net gain on a
conversion transaction would likely elect
section 1374 treatment. Taxpayers that
would recognize a net loss on a conver-
sion transaction would likely choose
deemed sale treatment. For these reasons,
the–6T regulations disallow recognition
of a net loss on a conversion transaction.
Section 1374 Double Tax Issue
Some commentators argued that con-
version transactions do not implicate con-
cerns regarding avoidance ofGeneral
Utilitiesrepeal to the extent that the RIC
or REIT has C corporations as sharehold-
ers after the conversion transaction. The
commentators explained that, if a C cor-
poration continues to own stock in the
RIC or REIT after a conversion transac-
tion, then the built-in gain attributable to
the transferred property is preserved in
the basis of the C corporation’s RIC or
REIT stock. Further, the C corporation
generally will be fully taxable on divi-
dends distributed by the RIC or REIT,
even where the RIC or REIT pays tax on
built-in gains. Accordingly, the commen-
tators requested that the 2000 temporary
regulations be modified to mitigate the
combined impact of tax at the RIC or
REIT level under section 1374 and tax at
the C corporation shareholder level on
RIC and REIT dividends.
Treasury and the IRS considered sev-
eral approaches suggested by commenta-
tors for mitigating this double corporate
tax. These approaches include: (1)
exempting section 351 transfers of prop-
erty by a C corporation to a RIC or REIT
from the scope of these regulations, (2)
removing the requirement that RICs and
REITs distribute recognized built-in
gains, and (3) allowing C corporation
shareholders of RICs and REITs to claim
a dividends received deduction for
built-in gains distributed by the RIC or
REIT.
After consideration, Treasury and the
IRS decided that it could not accept any
of these approaches. The first two
approaches were not accepted because
they could create opportunities to avoid
corporate-level tax on built-in gains. The
third approach was not accepted because
the dividends received deduction is only
available for distributions characterized
as ordinary income, not distributions
characterized as capital gains. As
explained below, under the–6T regula-
tions, RICs and REITs may characterize
most distributions of built-in gains as
capital gain dividends. Moreover, all
three approaches would give rise to
administrative difficulties that could be
addressed only through extensive rule-
making.
Section 1374 OperationalRules
The 2000 temporary regulations pro-
vide that the built-in gain of a RIC or
REIT electing section 1374 treatment and
the corporate-level tax imposed on that
gain are subject to rules similar to the
rules relating to net income from foreclo-
sure property (NIFP) of REITs. The com-
ments pointed out certain differences
between the section 1374 rules and the
NIFP rules. For example, under section
1374, any recognized built-in gain retains
its character as capital gain or ordinary
income. In contrast, NIFP is always
treated as ordinary income. In addition,
net operating losses of a C corporation
can offset recognized built-in gains of an
S corporation but cannot offset NIFP.
Similarly, business credit carryforwards
from a C corporation can reduce the tax
on the net recognized built-in gain of an
S corporation but cannot reduce the tax
on NIFP.
In light of these differences, Treasury
and the IRS have adopted an alternative
approach that does not rely on the NIFP
rules for coordinating the built-in gains
tax imposed by this section with the pro-
visions of subchapter M. Unlike the NIFP
rules, this approach generally preserves
the character of recognized built-in gains
and recognized built-in losses. Under this
approach, recognized built-in gains and
recognized built-in losses that have been
taxed in accordance with these regula-
tions are treated like other gains and
losses of RICs and REITs that are not
subject to tax under these regulations.
Thus, they are included in computing
investment company taxable income for
purposes of section 852(b)(2), real estate
investment trust taxable income for pur-
poses of section 857(b)(2), net capital
gain for purposes of sections 852(b)(3)
and 857(b)(3), gross income derived from
sources within any foreign country or
possession of the United States for pur-
poses of section 853, and the dividends
paid deduction for purposes of sections
852(b)(2)(D), 852(b)(3)(A), 857(b)(2)(B),
and 857(b)(3)(A).
In addition, consistent with section
1374, the–6T regulations generally allow
RICs and REITs to use loss carryforwards
and credits and credit carryforwards aris-
ing in taxable years for which the corpo-
ration that generated the attribute was a C
corporation (and not a RIC or REIT) to
reduce net recognized built-in gain and
the tax thereon, subject to the limitations
imposed by sections 1374(b)(2) and
(b)(3) and§§1.1374–5 and 1.1374–6. In
addition, the–6T regulations provide an
ordering rule for applying loss carryfor-
wards, credits, and credit carryforwards
to reduce net recognized built-in gain
(and the tax thereon) and RIC or REIT
taxable income (and the tax thereon).
Under this ordering rule, loss carryfor-
wards of a RIC or REIT must be used to
reduce net recognized built-in gain for a
taxable year to the greatest extent pos-
sible before such losses can be used to
reduce investment company taxable
income for purposes of section 852(b) or
real estate investment trust taxable
income for purposes of section 857(b) for
that taxable year. Similarly, credits and
credit carryforwards of a RIC or REIT
must be used to reduce the tax on net rec-
ognized built-in gain imposed under this
2002–4 I.R.B.381January 28, 2002

section for the taxable year to the greatest
extent possible before such credits and
credit carryforwards can be used to
reduce the tax, if any, on investment com-
pany taxable income for purposes of sec-
tion 852(b) or on real estate investment
trust taxable income for purposes of sec-
tion 857(b) for that taxable year.
The–6T regulations also make adjust-
ments to the taxable income limitation of
section 1374 to take into account items
that are unique to REITs. Under the–6T
regulations, taxable income of a RIC or
REIT is initially computed under sections
1374(d)(2) and 1375(b)(1)(B) as if the
RIC or REIT were an S corporation.
Thus, the RIC’s or REIT’s taxable income
is its taxable income under section 63(a)
without regard to—(i) deductions
allowed by part VIII of subchapter B
(other than the deduction allowed by sec-
tion 248, relating to organizational expen-
ditures), and (ii) the deduction under sec-
tion 172. In addition, the RIC or REIT
would not be allowed a deduction for
dividends paid, as the dividends paid
deduction is not available to S corpora-
tions. Under the–6T regulations, this
amount is then reduced for REITs by cer-
tain items that are subject to a 100-
percent penalty tax. Items subject to a
100-percent penalty tax, along with net
income from foreclosure property, are
also excluded in computing a REIT’s net
recognized built-in gain.
In response to comments, the–6T
regulations also provide that the entity-
level tax imposed on net recognized
built-in gain is treated as a loss that
reduces the RIC’s or REIT’s taxable
income and earnings and profits. The
character of the loss attributable to the tax
on net recognized built-in gain is deter-
mined by allocating the tax proportion-
ately (based on recognized built-in gain)
among the items of recognized built-in
gain included in net recognized built-in
gain. With respect to RICs, the tax
imposed on net recognized built-in gain is
treated as attributable to the portion of the
RIC’s taxable year occurring after Octo-
ber 31.
Commentators also requested that
built-in gain recognized by a RIC or
REIT that is subject to section 1374 treat-
ment generate subchapter M earnings and
profits. They explained that a RIC or
REIT cannot qualify as such under sub-
chapter M if it retains any subchapter C
earnings and profits. Thus, if earnings and
profits attributable to recognized built-in
gain were subchapter C earnings and
profits, a RIC or REIT would retain its
qualification only if it distributed 100 per-
cent of the net recognized built-in gain in
excess of the entity-level tax. In response
to these comments, the examples in the
–6T regulations clarify that earnings and
profits attributable to built-in gain recog-
nized by a RIC or REIT are subchapter M
earnings and profits.
Electing Section 1374 Treatment
The 2000 temporary regulations pro-
vide that a RIC or REIT makes a section
1374 election by attaching a statement to
its Federal income tax return for the first
taxable year in which the assets of a C
corporation become assets of the RIC or
REIT. The 2000 temporary regulations
also provide a special rule for making a
section 1374 election where the first tax-
able year in which the assets of a C cor-
poration became the assets of a RIC or
REIT ends after June 10, 1987, but before
March 8, 2000 (an interim period elec-
tion). Under the 2000 temporary regula-
tions, a RIC or REIT may file an interim
period election with its first Federal
income tax return filed after March 8,
2000.
Commentators expressed concern that
the rule applicable to interim period elec-
tions required a RIC or REIT to make an
election on its first Federal income tax
return filed after March 8, 2000, even if
the RIC or REIT previously had made a
section 1374 election. They also
expressed concern that RICs and REITs
were not given sufficient time after the
promulgation of the 2000 temporary
regulations to make interim period elec-
tions. In response to these comments, the
–6T regulations allow a RIC or REIT that
converted from a C corporation or
acquired property with a carryover basis
from a C corporation before January 2,
2002, to make a section 1374 election
with any Federal income tax return filed
by the RIC or REIT on or before March
15, 2003, provided that the RIC or REIT
has reported consistently with such elec-
tion for all periods. In addition, under the
–6T regulations, an interim period elec-
tion is not necessary if the RIC or REIT
can demonstrate that it has previously
informed the IRS of its intent to make a
section 1374 election.
Some commentators also requested
that Treasury and the IRS clarify that a
RIC or REIT must make a separate sec-
tion 1374 election for each conversion
transaction in which it participates. The
–6T regulations make this clarification.
Thus, a RIC or REIT can elect section
1374 treatment for one conversion trans-
action and not elect section 1374 treat-
ment for another conversion transaction.
Exception for Re-Election of RIC or
REIT Status
Under the 2000 temporary regulations,
the rule requiring recognition of gain on a
conversion transaction does not apply to a
C corporation that qualified to be a RIC
for at least one taxable year, then failed to
so qualify for a period not in excess of
one taxable year, and then requalifies as a
RIC. Although this exception implements
Notice 88–96, the language of the 2000
temporary regulations differs slightly
from the language used in Notice 88–96.
Some commentators have noted that the
change in language might be misinter-
preted as a substantive change where
none was intended. In response to these
comments, this language has been clari-
fied in the–6T regulations.
In addition, some commentators
requested that the exception be expanded
to cover periods longer than one taxable
year. They argued that a corporation that
fails to meet the RIC qualification
requirements for as short a period as 6
months could be taxed as a C corporation
for two taxable years. This could happen
where a RIC fails the quarterly diversifi-
cation test for the last quarter of one cal-
endar year and the first quarter of the sub-
sequent calendar year.
Other commentators requested that
this exception be expanded to cover
REITs. They noted that Congress gener-
ally treats RICs and REITs similarly and
that there is no justification for excluding
REITs from the benefit of this exception.
The–6T regulations incorporate these
comments by extending the exception to
REITs and the maximum period for loss
of RIC or REIT status from one taxable
year to two taxable years.
January 28, 20023822002–4 I.R.B.

Retention of Retroactive Effective Date
Commentators argued that, due to the
12-year gap between the promulgation of
Notice 88–19 and the issuance of the
regulations implementing Notice 88–19,
the regulations should not apply retroac-
tively.
Notice 88–19 notified taxpayers that
the section 337(d) regulations would
apply as of June 10, 1987. The 2000 tem-
porary regulations, which were published
on February 7, 2000, do, in fact, apply as
of June 10, 1987. Moreover, since Febru-
ary 7, 2000, taxpayers have relied on the
2000 temporary regulations. For these
reasons, the 2000 temporary regulations
and the–6T regulations retain the June
10, 1987, applicability date.
Summary of–7T Regulations
The–7T regulations follow the–6T
regulations in most respects. However,
certain changes were included in the–7T
regulations that were not included in the
–6T regulations, because Treasury and the
IRS were concerned that these changes, if
made retroactively, could have an adverse
impact on taxpayers that have relied on
the 2000 temporary regulations. The fol-
lowing sections highlight these differ-
ences between the–6T regulations and
the–7T regulations.
Section 1374 Treatment as Default Rule
A number of commentators, particu-
larly REIT commentators, expressed the
view that, when a C corporation engages
in a conversion transaction, section 1374
treatment should apply automatically and
taxpayers that desire deemed sale treat-
ment should be allowed to elect such
treatment. They pointed out that the auto-
matic application of a section 1374
regime is consistent with the treatment of
C corporations that elect S status. Further,
they argued that most taxpayers would
prefer to be subject to section 1374 treat-
ment than to deemed sale treatment. If
section 1374 treatment is the default treat-
ment, then the incidence of inadvertent
failures to make elections will be
reduced. However, to protect the expecta-
tions of taxpayers that engaged in conver-
sion transactions prior to the promulga-
tionoftheseregulations,the
commentators recommended that section
1374 treatment be adopted as the default
treatment on a prospective basis. In
accordance with these comments, the–7T
regulations provide that section 1374
treatment applies unless the C corporation
elects deemed sale treatment.
Anti-Stuffing Rule for Taxpayers Electing
Deemed Sale Treatment
Treasury and the IRS are concerned
that taxpayers electing deemed sale treat-
ment might attempt to decrease net gains
on conversion transactions by stuffing
loss property into a C corporation prior to
a conversion transaction. Treasury and the
IRSnotethatsections336and
§1.337(d)–4 both have anti-stuffing
rules. Accordingly, the–7T regulations
include an anti-stuffing rule applicable to
transactions taxed under the deemed sale
approach. The anti-stuffing rule is similar
to those contained in section 336 and
§1.337(d)–4.
Aggregate Principles to Apply to
Partnership Transactions
Treasury and the IRS believe that a
partnership with C corporation partners
should be treated as an aggregate for pur-
poses of applying these regulations.
Accordingly, the–7T regulations provide
that these regulations apply to property
transferred by a partnership to a RIC or
REIT to the extent of any C corporation
partner’s proportionate share of the trans-
ferred property. For example, if a C cor-
poration owns a 20 percent interest in a
partnership and that partnership contrib-
utes an asset to a REIT in a section 351
transaction, then the partnership shall be
treated as a C corporation with respect to
20 percent of the asset contributed to the
REIT. If the partnership were to elect
deemed sale treatment with respect to
such transfer, then any gain recognized by
the partnership on the deemed sale must
be specially allocated to the C corporation
partner.
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 assess-
ment 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 regula-
tions. For the applicability of the Regula-
tory Flexibility Act (5 U.S.C. chapter 6)
refer to the Special Analyses section of
the preamble to the cross-reference notice
of proposed rulemaking published in this
issue of the Bulletin. Pursuant to section
7805(f) of the Code, these temporary
regulations will be submitted to the Chief
Counsel for Advocacy of the Small Busi-
ness Administration for comment on their
impact on small business.
Drafting Information
The principal author of these regula-
tions is Lisa A. Fuller of the Office of
Associate Chief Counsel (Corporate).
Other personnel from Treasury Depart-
ment and the IRS participated in their
development.
****
Adoption of 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 is amended by adding an entry in
numerical order to read in part as follows:
Authority: 26 U.S.C. 7805***
Section 1.337(d)–6T also issued under
26 U.S.C. 337.
Section 1.337(d)–7T also issued under
26 U.S.C. 337.***
Par. 2.§1.337(d)–5T is amended by:
1. Revising the section heading.
2. Revising paragraph (d).
The revisions read as follows:
§1.337(d)–5T Old transitional rules
imposing tax on property owned by a C
corporation that becomes property of a
RIC or REIT (temporary).
*****
(d)Effective date. In the case of carry-
over basis transactions involving the
transfer of property of a C corporation to
a RIC or REIT, the regulations apply to
transactions occurring on or after June 10,
1987, and before January 2, 2002. In the
case of a C corporation that qualifies to
be taxed as a RIC or REIT, the regula-
tions apply to such qualifications that are
effective for taxable years beginning on
2002–4 I.R.B.383January 28, 2002

or after June 10, 1987, and before January
2, 2002. However, RICs and REITs that
are subject to section 1374 treatment
under this section may not rely on
§1.337(d)–5T(b)(1), but must apply para-
graphs (c)(1)(i), (c)(2)(i), (c)(2)(ii), and
(c)(3) of§1.337(d)–6T, with respect to
built-in gains and losses recognized in
taxable years beginning on or after Janu-
ary 2, 2002. In lieu of applying this sec-
tion,taxpayersmayrelyon
§1.337(d)–6T to determine the tax conse-
quences (for all taxable years) of any con-
version transaction. For transactions and
qualifications that occur on or after Janu-
ary 2, 2002, see§1.337(d)–7T.
Par. 3. Sections 1.337(d)–6T and
1.337(d)–7T are added immediately after
§1.337(d)–5T to read as follows:
§1.337(d)–6T New transitional rules
imposing tax on property owned by a C
corporation that becomes property of a
RIC or REIT (temporary).
(a)General Rule—(1)Property owned
by a C corporation that becomes property
of a RIC or REIT. If property owned by a
C corporation (as defined in paragraph
(a)(2)(i) of this section) becomes the
property of a RIC or REIT (the converted
property) in a conversion transaction (as
defined in paragraph (a)(2)(ii) of this sec-
tion), then deemed sale treatment will
apply as described in paragraph (b) of this
section, unless the RIC or REIT elects
section 1374 treatment with respect to the
conversion transaction as provided in
paragraph (c) of this section. See para-
graph (d) of this section for exceptions to
this paragraph (a).
(2)Definitions—(i)C corporation. For
purposes of this section, the term C cor-
poration has the meaning provided in sec-
tion 1361(a)(2) except that the term does
not include a RIC or REIT.
(ii)Conversion transaction. For pur-
poses of this section, the term conversion
transaction means the qualification of a C
corporation as a RIC or REIT or the
transfer of property owned by a C corpo-
ration to a RIC or REIT.
(b)Deemed Sale Treatment—(1)In
general. If property owned by a C corpo-
ration becomes the property of a RIC or
REIT in a conversion transaction, then
the C corporation recognizes gain and
loss as if it sold the converted property to
an unrelated party at fair market value on
the deemed sale date (as defined in para-
graph (b)(3) of this section). This para-
graph (b) does not apply if its application
would result in the recognition of a net
loss. For this purpose,net lossis the
excess of aggregate losses over aggregate
gains (including items of income), with-
out regard to character.
(2)Basis adjustment. If a corporation
recognizes a net gain under paragraph
(b)(1) of this section, then the converted
property has a basis in the hands of the
RIC or REIT equal to the fair market
value of such property on the deemed sale
date.
(3)Deemed sale date—(i)RIC or
REIT qualifications. If the conversion
transaction is a qualification of a C corpo-
ration as a RIC or REIT, then the deemed
sale date is the end of the last day of the
C corporation’s last taxable year before
the first taxable year in which it qualifies
to be taxed as a RIC or REIT.
(ii)Other conversion transactions.If
the conversion transaction is a transfer of
property owned by a C corporation to a
RIC or REIT, then the deemed sale date is
the end of the day before the day of the
transfer.
(4)Example. The rules of this para-
graph (b) are illustrated by the following
example:
Example. Deemed sale treatment on merger into
RIC. (i) X, a calendar-year taxpayer, has qualified as
a RIC since January 1, 1991. On May 31, 1994, Y,
a C corporation and calendar-year taxpayer, trans-
fers all of its property to X in a transaction that
qualifies as a reorganization under section
368(a)(1)(C). X does not elect section 1374 treat-
ment under paragraph (c) of this section and chooses
not to rely on§1.337(d)–5T. As a result of the
transfer, Y is subject to deemed sale treatment under
this paragraph (b) on its tax return for the short tax-
able year ending May 31, 1994. On May 31, 1994,
Y’s only assets are Capital Asset, which has a fair
market value of $100,000 and a basis of $40,000 as
of the end of May 30, 1994, and $50,000 cash. Y
also has an unrestricted net operating loss carryfor-
ward of $12,000 and accumulated earnings and
profits of $50,000. Y has no taxable income for the
short taxable year ending May 31, 1994, other than
gain recognized under this paragraph (b). In 1997, X
sells Capital Asset for $110,000. Assume the appli-
cable corporate tax rate is 35%.
(ii) Under this paragraph (b), Y is treated as if it
sold the converted property (Capital Asset and
$50,000 cash) at fair market value on May 30, 1994,
recognizing $60,000 of gain ($150,000 amount real-
ized - $90,000 basis). Y must report the gain on its
tax return for the short taxable year ending May 31,
1994. Y may offset this gain with its $12,000 net
operating loss carryforward and will pay tax of
$16,800 (35% of $48,000).
(iii) Under section 381, X succeeds to Y’s accu-
mulated earnings and profits. Y’s accumulated earn-
ings and profits of $50,000 increase by $60,000 and
decrease by $16,800 as a result of the deemed sale.
Thus, the aggregate amount of subchapter C earn-
ings and profits that must be distributed to satisfy
section 852(a)(2)(B) is $93,200 ($50,000 + $60,000
- $16,800). X’s basis in Capital Asset is $100,000.
On X’s sale of Capital Asset in 1997, X recognizes
$10,000 of gain, which is taken into account in com-
puting X’s net capital gain for purposes of section
852(b)(3).
(c)Electionofsection1374
treatment—(1)In general—(i)Property
owned by a C corporation that becomes
property of a RIC or REIT. Paragraph (b)
of this section does not apply if the RIC
or REIT that was formerly a C corpora-
tion or that acquired property from a C
corporation makes the election described
in paragraph (c)(4) of this section. A RIC
or REIT that makes such an election will
be subject to tax on the net built-in gain
in the converted property under the rules
of section 1374 and the regulations there-
under, as modified by this paragraph (c),
as if the RIC or REIT were an S corpora-
tion.
(ii)Property subject to the rules of
section 1374 owned by a RIC, REIT, or S
corporation that becomes property of a
RIC or REIT. If property subject to the
rules of section 1374 owned by a RIC, a
REIT, or an S corporation (the predeces-
sor) becomes the property of a RIC or
REIT (the successor) in a continuation
transaction, the rules of section 1374
apply to the successor to the same extent
that the predecessor was subject to the
rules of section 1374 with respect to such
property, and the 10-year recognition
period of the successor with respect to
such property is reduced by the portion of
the 10-year recognition period of the pre-
decessor that expired before the date of
the continuation transaction. For this pur-
pose, a continuation transaction means
the qualification of the predecessor as a
RIC or REIT or the transfer of property
from the predecessor to the successor in a
transaction in which the successor’s basis
in the transferred property is determined,
in whole or in part, by reference to the
predecessor’s basis in that property.
(2)Modification of section 1374 treat-
ment—(i)Net recognized built-in gain for
REITs—(A)Prelimitation amount. The
prelimitation amount determined as pro-
vided in§1.1374–2(a)(1) is reduced by
the portion of such amount, if any, that is
January 28, 20023842002–4 I.R.B.

subject to tax under section 857(b)(4),
(5), (6), or (7). For this purpose, the
amount of a REIT’s recognized built-in
gain that is subject to tax under section
857(b)(5) is computed as follows:
(1) Where the tax under section
857(b)(5) is computed by reference to
section 857(b)(5)(A), the amount of a
REIT’s recognized built-in gain that is
subject to tax under section 857(b)(5) is
the tax imposed by section 857(b)(5) mul-
tiplied by a fraction the numerator of
which is the amount of recognized
built-in gain (without regard to recog-
nized built-in loss and recognized built-in
gain from prohibited transactions) that is
not derived from sources referred to in
section 856(c)(2) and the denominator of
which is the gross income (without regard
to gross income from prohibited transac-
tions) of the REIT that is not derived
from sources referred to in section
856(c)(2).
(2) Where the tax under section
857(b)(5) is computed by reference to
section 857(b)(5)(B), the amount of a
REIT’s recognized built-in gain that is
subject to tax under section 857(b)(5) is
the tax imposed by section 857(b)(5) mul-
tiplied by a fraction the numerator of
which is the amount of recognized
built-in gain (without regard to recog-
nized built-in loss and recognized built-in
gain from prohibited transactions) that is
not derived from sources referred to in
section 856(c)(3) and the denominator of
which is the gross income (without regard
to gross income from prohibited transac-
tions) of the REIT that is not derived
from sources referred to in section
856(c)(3).
(B)Taxable income limitation. The
taxable income limitation determined as
provided in§1.1374–2(a)(2) is reduced
by an amount equal to the tax imposed
under sections 857(b)(5), (6), and (7).
(ii)Loss carryforwards, credits and
credit carryforwards—(A)Loss carryfor-
wards. Consistent with paragraph (c)(1)(i)
of this section, net operating loss carry-
forwards and capital loss carryforwards
arising in taxable years for which the cor-
poration that generated the loss was not
subject to subchapter M of chapter 1 of
the Code are allowed as a deduction
against net recognized built-in gain to the
extent allowed under section 1374 and the
regulations thereunder. Such loss carry-
forwards must be used as a deduction
against net recognized built-in gain for a
taxable year to the greatest extent pos-
sible before such losses can be used to
reduce investment company taxable
income for purposes of section 852(b) or
real estate investment trust taxable
income for purposes of section 857(b) for
that taxable year.
(B)Credits and credit carryforwards.
Consistent with paragraph (c)(1)(i) of this
section, minimum tax credits and busi-
ness credit carryforwards arising in tax-
able years for which the corporation that
generated the credit was not subject to
subchapter M of chapter 1 of the Internal
Revenue Code are allowed to reduce the
tax imposed on net recognized built-in
gain under this paragraph (c) to the extent
allowed under section 1374 and the regu-
lations thereunder. Such credits and credit
carryforwards must be used to reduce the
tax imposed under this paragraph (c) on
net recognized built-in gain for a taxable
year to the greatest extent possible before
such credits and credit carryforwards can
be used to reduce the tax, if any, on
investment company taxable income for
purposes of section 852(b) or on real
estate investment trust taxable income for
purposes of section 857(b) for that tax-
able year.
(iii)10-year recognition period.Inthe
case of a conversion transaction that is a
qualification of a C corporation as a RIC
or REIT, the 10-year recognition period
described in section 1374(d)(7) begins on
the first day of the RIC’s or REIT’s first
taxable year. In the case of other conver-
sion transactions, the 10-year recognition
period begins on the day the property is
acquired by the RIC or REIT.
(3)Coordination with subchapter M
rules—(i)Recognized built-in gains and
losses subject to subchapter M. Recog-
nized built-in gains and losses of a RIC or
REIT are included in computing invest-
ment company taxable income for pur-
poses of section 852(b)(2), real estate
investment trust taxable income for pur-
poses of section 857(b)(2), capital gains
for purposes of sections 852(b)(3) and
857(b)(3), gross income derived from
sources within any foreign country or
possession of the United States for pur-
poses of section 853, and the dividends
paid deduction for purposes of sections
852(b)(2)(D), 852(b)(3)(A), 857(b)(2)(B),
and 857(b)(3)(A).
(ii)Treatment of tax imposed. The
amount of tax imposed under this para-
graph (c) on net recognized built-in gain
for a taxable year is treated as a loss sus-
tained by the RIC or the REIT during
such taxable year. The character of the
loss is determined by allocating the tax
proportionately (based on recognized
built-in gain) among the items of recog-
nized built-in gain included in net recog-
nized built-in gain. With respect to RICs,
the tax imposed under this paragraph (c)
on net recognized built-in gain is treated
as attributable to the portion of the RIC’s
taxable year occurring after October 31.
(4)Making the section 1374 election—
(i)In general. A RIC or REIT makes a
section 1374 election with the following
statement:“[Insert name and employer
identification number of electing RIC or
REIT] elects under§1.337–6T(c) to be
subject to the rules of section 1374 and
the regulations thereunder with respect to
its property that formerly was held by a C
corporation, [insert name and employer
identification number of the C corpora-
tion, if different from name and employer
identification number of the RIC or
REIT].”However, a RIC or REIT need
not file an election under this paragraph
(c), but will be deemed to have made
such an election if it can demonstrate that
it informed the IRS prior to January 2,
2002, of its intent to make a section 1374
election. An election under this paragraph
(c) is irrevocable.
(ii)Time for making the election.An
election under this paragraph (c) may be
filed by the RIC or REIT with any Fed-
eral income tax return filed by the RIC or
REIT on or before March 15, 2003, pro-
vided that the RIC or REIT has reported
consistently with such election for all
periods.
(5)Example. The rules of this para-
graph (c) are illustrated by the following
example:
Example. Section 1374 treatment on REIT elec-
tion. (i) X, a C corporation that is a calendar-year
taxpayer, elects to be taxed as a REIT on its 1994
tax return, which it files on March 15, 1995. As a
result, X is a REIT for its 1994 taxable year and
would be subject to deemed sale treatment under
paragraph (b) of this section but for X’s timely elec-
tion of section 1374 treatment under this paragraph
(c). X chooses not to rely on§1.337(d)–5T. As of
the beginning of the 1994 taxable year, X’s property
consisted of Real Property, which is not section
2002–4 I.R.B.385January 28, 2002

1221(a)(1) property and which had a fair market
value of $100,000 and an adjusted basis of $80,000,
and $25,000 cash. X also had accumulated earnings
and profits of $25,000, unrestricted net operating
loss carryforwards of $3,000, and unrestricted busi-
ness credit carryforwards of $2,000. On July 1,
1997, X sells Real Property for $110,000. For its
1997 taxable year, X has net income other than rec-
ognized built-in gain. Assume the highest corporate
tax rate is 35%.
(ii) Upon its election to be taxed as a REIT, X
retains its $80,000 basis in Real Property and its
$25,000 accumulated earnings and profits. X retains
its $3,000 of net operating loss carryforwards and its
$2,000 of business credit carryforwards. To satisfy
section 857(a)(2)(B), X must distribute $25,000, an
amount equal to its earnings and profits accumu-
lated in non-REIT years, to its shareholders by the
end of its 1994 taxable year.
(iii) Upon X’s sale of Real Property in 1997, X
recognizes gain of $30,000 ($110,000 - $80,000).
X’s recognized built-in gain for purposes of apply-
ing section 1374 is $20,000 ($100,000 fair market
value as of the beginning of X’s first taxable year as
a REIT - $80,000 basis). Because X has net income
other than recognized built-in gain for its 1997 tax-
able year, the taxable income limitation does not
apply. X, therefore, has $20,000 net recognized
built-in gain for the year. Assuming that X has not
used its $3,000 of net operating loss carryforwards
in a prior taxable year and that their use is allowed
under section 1374(b)(2) and§1.1374–5,Xis
allowed a $3,000 deduction against the $20,000 net
recognized built-in gain. X would owe tax of $5,950
(35% of $17,000) on its net recognized built-in gain,
except that X may use its $2,000 of business credit
carryforwards to reduce this tax, assuming that X
has not used the credit carryforwards in a prior tax-
able year and that their use is allowed under sections
1374(b)(3) and§1.1374–6. Thus, X owes tax of
$3,950 under this paragraph (c). For purposes of
subchapter M, X’s earnings and profits for the year
increase by $26,050 ($30,000 capital gain on the
sale of Real Property - $3,950 tax under this para-
graph (c)).
(iv) To compute X’s net capital gain for pur-
poses of section 857(b)(3) for the taxable year, the
$20,000 of net recognized built-in gain less the
$3,950 of tax imposed on that gain is added to X’s
capital gain (or loss), if any, that is not recognized
built-in gain (or loss).
(d)Exceptions—(1)Gain otherwise
recognized. Paragraph (a) of this section
does not apply to any conversion transac-
tion to the extent that gain or loss other-
wise is recognized on such conversion
transaction. See, for example, sections
336, 351(b), 356, 357(c), 367, and 1001.
(2)Re-election of RIC or REIT
status—(i)Generally. Except as provided
in paragraphs (d)(2)(ii) and (iii) of this
section, paragraph (a)(1) of this section
does not apply to any corporation that—
(A) Immediately prior to qualifying to
be taxed as a RIC or REIT was subject to
tax as a C corporation for a period not
exceeding two taxable years; and
(B) Immediately prior to being subject
to tax as a C corporation was subject to
tax as a RIC or REIT for a period of at
least one taxable year.
(ii)Property acquired from another
corporation while a C corporation. The
exception described in paragraph (d)(2)(i)
of this section does not apply to property
acquired by the corporation while it was
subject to tax as a C corporation from
another corporation (whether or not a C
corporation) in a transaction that results
in the acquirer’s basis in the property
being determined by reference to a C cor-
poration’s basis in the property.
(iii)RICs and REITs previously subject
to section 1374 treatment. If the RIC or
REIT had property subject to paragraph
(c) of this section before the RIC or REIT
became subject to tax as a C corporation
as described in paragraph (d)(2)(i) of this
section, then paragraph (c) of this section
applies to the RIC or REIT upon its
requalification as a RIC or REIT, except
that the 10-year recognition period with
respect to such property is reduced by the
portion of the 10-year recognition period
that expired before the RIC or REIT
became subject to tax as a C corporation
and by the period of time that the corpo-
ration was subject to tax as a C corpora-
tion.
(e)Effective date. This section applies
to conversion transactions that occur on
or after June 10, 1987, and before January
2, 2002. In lieu of applying this section,
taxpayersgenerallymayapply
§1.337(d)–5T to determine the tax conse-
quences (for all taxable years) of any con-
version transaction that occurs on or after
June 10, 1987, and before January 2,
2002, except that RICs and REITs that are
subject to section 1374 treatment with
respect to a conversion transaction may
not rely on§1.337(d)–5T(b)(1), but must
apply paragraphs (c)(1)(i), (c)(2)(i),
(c)(2)(ii), and (c)(3) of this section, with
respect to built-in gains and losses recog-
nized in taxable years beginning on or
after January 2, 2002. Taxpayers are not
prevented from relying on§1.337(d)–5T
merely because they elect section 1374
treatment in the manner described in
paragraph (c)(4) of this section instead of
in the manner described in§1.337(d)–
5T(b)(3) and (c). For conversion transac-
tions that occur on or after January 2,
2002, see§1.337(d)–7T. This section
expires on December 31, 2004.
§1.337(d)–7T Tax on property owned by
a C corporation that becomes property of
a RIC or REIT (temporary).
(a)General Rule—(1)Property owned
by a C corporation that becomes property
of a RIC or REIT. If property owned by a
C corporation (as defined in paragraph
(a)(2)(i) of this section) becomes the
property of a RIC or REIT (the converted
property) in a conversion transaction (as
defined in paragraph (a)(2)(ii) of this sec-
tion), then section 1374 treatment will
apply as described in paragraph (b) of this
section, unless the C corporation elects
deemed sale treatment with respect to the
conversion transaction as provided in
paragraph (c) of this section. See para-
graph (d) of this section for exceptions to
this paragraph (a).
(2)Definitions—(i)C corporation. For
purposes of this section, the term C cor-
poration has the meaning provided in sec-
tion 1361(a)(2) except that the term does
not include a RIC or REIT.
(ii)Conversion transaction. For pur-
poses of this section, the term conversion
transaction means the qualification of a C
corporation as a RIC or REIT or the
transfer of property owned by a C corpo-
ration to a RIC or REIT.
(b)Section 1374 treatment—(1)In
general—(i)Property owned by a C cor-
poration that becomes property of a RIC
or REIT. If property owned by a C corpo-
ration becomes the property of a RIC or
REIT in a conversion transaction, then
the RIC or REIT will be subject to tax on
the net built-in gain in the converted
property under the rules of section 1374
and the regulations thereunder, as modi-
fied by this paragraph (b), as if the RIC or
REIT were an S corporation.
(ii)Property subject to the rules of
section 1374 owned by a RIC, REIT, or S
corporation that becomes property of a
RIC or REIT. If property subject to the
rules of section 1374 owned by a RIC, a
REIT, or an S corporation (the predeces-
sor) becomes the property of a RIC or
REIT (the successor) in a continuation
transaction, the rules of section 1374
apply to the successor to the same extent
that the predecessor was subject to the
rules of section 1374 with respect to such
property, and the 10-year recognition
period of the successor with respect to
January 28, 20023862002–4 I.R.B.

such property is reduced by the portion of
the 10-year recognition period of the pre-
decessor that expired before the date of
the continuation transaction. For this pur-
pose, a continuation transaction means
the qualification of the predecessor as a
RIC or REIT or the transfer of property
from the predecessor to the successor in a
transaction in which the successor’s basis
in the transferred property is determined,
in whole or in part, by reference to the
predecessor’s basis in that property.
(2)Modification of section 1374
treatment—(i)Net recognized built-in
gainforREITs—(A)Prelimitation
amount. The prelimitation amount deter-
mined as provided in§1.1374–2(a)(1) is
reduced by the portion of such amount, if
any, that is subject to tax under section
857(b)(4), (5), (6), or (7). For this pur-
pose, the amount of a REIT’s recognized
built-in gain that is subject to tax under
section 857(b)(5) is computed as follows:
(1) Where the tax under section
857(b)(5) is computed by reference to
section 857(b)(5)(A), the amount of a
REIT’s recognized built-in gain that is
subject to tax under section 857(b)(5) is
the tax imposed by section 857(b)(5) mul-
tiplied by a fraction the numerator of
which is the amount of recognized
built-in gain (without regard to recog-
nized built-in loss and recognized built-in
gain from prohibited transactions) that is
not derived from sources referred to in
section 856(c)(2) and the denominator of
which is the gross income (without regard
to gross income from prohibited transac-
tions) of the REIT that is not derived
from sources referred to in section
856(c)(2).
(2) Where the tax under section
857(b)(5) is computed by reference to
section 857(b)(5)(B), the amount of a
REIT’s recognized built-in gain that is
subject to tax under section 857(b)(5) is
the tax imposed by section 857(b)(5) mul-
tiplied by a fraction the numerator of
which is the amount of recognized
built-in gain (without regard to recog-
nized built-in loss and recognized built-in
gain from prohibited transactions) that is
not derived from sources referred to in
section 856(c)(3) and the denominator of
which is the gross income (without regard
to gross income from prohibited transac-
tions) of the REIT that is not derived
from sources referred to in section
856(c)(3).
(B)Taxable income limitation. The
taxable income limitation determined as
provided in§1.1374–2(a)(2) is reduced
by an amount equal to the tax imposed
under sections 857(b)(5), (6), and (7).
(ii)Loss carryforwards, credits and
credit carryforwards—(A)Loss carryfor-
wards. Consistent with paragraph
(b)(1)(i) of this section, net operating loss
carryforwards and capital loss carryfor-
wards arising in taxable years for which
the corporation that generated the loss
was not subject to subchapter M of chap-
ter 1 of the Code are allowed as a deduc-
tion against net recognized built-in gain
to the extent allowed under section 1374
and the regulations thereunder. Such loss
carryforwards must be used as a deduc-
tion against net recognized built-in gain
for a taxable year to the greatest extent
possible before such losses can be used to
reduce investment company taxable
income for purposes of section 852(b) or
real estate investment trust taxable
income for purposes of section 857(b) for
that taxable year.
(B)Credits and credit carryforwards.
Consistent with paragraph (b)(1)(i) of this
section, minimum tax credits and busi-
ness credit carryforwards arising in tax-
able years for which the corporation that
generated the credit was not subject to
subchapter M of chapter 1 of the Internal
Revenue Code are allowed to reduce the
tax imposed on net recognized built-in
gain under this paragraph (b) to the extent
allowed under section 1374 and the regu-
lations thereunder. Such credits and credit
carryforwards must be used to reduce the
tax imposed under this paragraph (b) on
net recognized built-in gain for a taxable
year to the greatest extent possible before
such credits and credit carryforwards can
be used to reduce the tax, if any, on
investment company taxable income for
purposes of section 852(b) or on real
estate investment trust taxable income for
purposes of section 857(b) for that tax-
able year.
(iii)10-year recognition period.Inthe
case of a conversion transaction that is a
qualification of a C corporation as a RIC
or REIT, the 10-year recognition period
described in section 1374(d)(7) begins on
the first day of the RIC’s or REIT’s first
taxable year. In the case of other conver-
sion transactions, the 10-year recognition
period begins on the day the property is
acquired by the RIC or REIT.
(3)Coordination with subchapter M
rules—(i)Recognized built-in gains and
losses subject to subchapter M. Recog-
nized built-in gains and losses of a RIC or
REIT are included in computing invest-
ment company taxable income for pur-
poses of section 852(b)(2), real estate
investment trust taxable income for pur-
poses of section 857(b)(2), capital gains
for purposes of sections 852(b)(3) and
857(b)(3), gross income derived from
sources within any foreign country or
possession of the United States for pur-
poses of section 853, and the dividends
paid deduction for purposes of sections
852(b)(2)(D), 852(b)(3)(A), 857(b)(2)(B),
and 857(b)(3)(A).
(ii)Treatment of tax imposed. The
amount of tax imposed under this para-
graph (b) on net recognized built-in gain
for a taxable year is treated as a loss sus-
tained by the RIC or the REIT during
such taxable year. The character of the
loss is determined by allocating the tax
proportionately (based on recognized
built-in gain) among the items of recog-
nized built-in gain included in net recog-
nized built-in gain. With respect to RICs,
the tax imposed under this paragraph (b)
on net recognized built-in gain is treated
as attributable to the portion of the RIC’s
taxable year occurring after October 31.
(4)Example. The rules of this para-
graph (b) are illustrated by the following
example:
Example. Section 1374 treatment on REIT elec-
tion. (i) X, a C corporation that is a calendar-year
taxpayer, elects to be taxed as a REIT on its 2004
tax return, which it files on March 15, 2005. As a
result, X is a REIT for its 2004 taxable year and is
subject to section 1374 treatment under this para-
graph (b). X does not elect deemed sale treatment
under paragraph (c) of this section. As of the begin-
ning of the 2004 taxable year, X’s property con-
sisted of Real Property, which is not section
1221(a)(1) property and which had a fair market
value of $100,000 and an adjusted basis of $80,000,
and $25,000 cash. X also had accumulated earnings
and profits of $25,000, unrestricted net operating
loss carryforwards of $3,000, and unrestricted busi-
ness credit carryforwards of $2,000. On July 1,
2007, X sells Real Property for $110,000. For its
1997 taxable year, X has net income other than rec-
ognized built-in gain. Assume the highest corporate
tax rate is 35%.
2002–4 I.R.B.387January 28, 2002

(ii) Upon its election to be taxed as a REIT, X
retains its $80,000 basis in Real Property and its
$25,000 accumulated earnings and profits. X retains
its $3,000 of net operating loss carryforwards and its
$2,000 of business credit carryforwards. To satisfy
section 857(a)(2)(B), X must distribute $25,000, an
amount equal to its earnings and profits accumu-
lated in non-REIT years, to its shareholders by the
end of its 2004 taxable year.
(iii) Upon X’s sale of Real Property in 2007, X
recognizes gain of $30,000 ($110,000 - $80,000).
X’s recognized built-in gain for purposes of apply-
ing section 1374 is $20,000 ($100,000 fair market
value as of the beginning of X’s first taxable year as
a REIT - $80,000 basis). Because X has net income
other than recognized built-in gain for its 2007 tax-
able year, the taxable income limitation does not
apply. X, therefore, has $20,000 net recognized
built-in gain for the year. Assuming that X has not
used its $3,000 of net operating loss carryforwards
in a prior taxable year and that their use is allowed
under section 1374(b)(2) and§1.1374–5,Xis
allowed a $3,000 deduction against the $20,000 net
recognized built-in gain. X would owe tax of $5,950
(35% of $17,000) on its net recognized built-in gain,
except that X may use its $2,000 of business credit
carryforwards to reduce the tax, assuming that X has
not used the credit carryforwards in a prior taxable
year and that their use is allowed under section
1374(b)(3) and§1.1374–6. Thus, X owes tax of
$3,950 under this paragraph (b). For purposes of
subchapter M, X’s earnings and profits for the year
increase by $26,050 ($30,000 capital gain on the
sale of Real Property - $3,950 tax under this para-
graph (b)).
(iv) To compute X’s net capital gain for pur-
poses of section 857(b)(3) for the taxable year, the
$20,000 of net recognized built-in gain less the
$3,950 of tax imposed on that gain is added to X’s
capital gain (or loss), if any, that is not recognized
built-in gain (or loss).
(c)Election of deemed sale treat-
ment—(1)In general. Paragraph (b) of
this section does not apply if the C corpo-
ration that qualifies as a RIC or REIT or
transfers property to a RIC or REIT
makes the election described in paragraph
(c)(5) of this section. A C corporation that
makes such an election recognizes gain
and loss as if it sold the converted prop-
erty to an unrelated party at fair market
value on the deemed sale date (as defined
in paragraph (c)(3) of this section). See
paragraph (c)(4) of this section concern-
ing limitations on the use of loss in com-
puting gain. This paragraph (c) does not
apply if its application would result in the
recognition of a net loss. For this purpose,
net lossis the excess of aggregate losses
over aggregate gains (including items of
income), without regard to character.
(2)Basis adjustment. If a corporation
recognizes a net gain under paragraph
(c)(1) of this section, then the converted
property has a basis in the hands of the
RIC or REIT equal to the fair market
value of such property on the deemed sale
date.
(3)Deemed sale date—(i)RIC or
REIT qualifications. If the conversion
transaction is a qualification of a C corpo-
ration as a RIC or REIT, then the deemed
sale date is the end of the last day of the
C corporation’s last taxable year before
the first taxable year in which it qualifies
to be taxed as a RIC or REIT.
(ii)Other conversion transactions.If
the conversion transaction is a transfer of
property owned by a C corporation to a
RIC or REIT, then the deemed sale date is
the end of the day before the day of the
transfer.
(4)Anti-stuffing rule. A C corporation
must disregard converted property in
computing gain or loss recognized on the
conversion transaction under this para-
graph (c), if—
(i) The converted property was
acquired by the C corporation in a trans-
action to which section 351 applied or as
a contribution to capital;
(ii) Such converted property had an
adjusted basis immediately after its acqui-
sition by the C corporation in excess of
its fair market value on the date of acqui-
sition; and
(iii) The acquisition of such converted
property by the C corporation was part of
a plan a principal purpose of which was
to reduce gain recognized by the C corpo-
ration in connection with the conversion
transaction. For purposes of this para-
graph (c)(4), the principles of section
336(d)(2) apply.
(5)Making the deemed sale election.A
C corporation makes the deemed sale
election with the following statement:
“[Insert name and employer identification
number of electing corporation] elects
deemed sale treatment under§1.337(d)–
7T(c) with respect to its property that was
converted to property of, or transferred to,
a RIC or REIT, [insert name and
employer identification number of the
RIC or REIT, if different from the name
and employer identification number of
the C corporation].”This statement must
be attached to the Federal income tax
return of the C corporation for the taxable
year in which the deemed sale occurs. An
election under this paragraph (c) is irrevo-
cable.
(6)Examples. The rules of this para-
graph (c) are illustrated by the following
examples:
Example 1. Deemed sale treatment on merger
into RIC. (i) X, a calendar-year taxpayer, has quali-
fied as a RIC since January 1, 2001. On May 31,
2004, Y, a C corporation and calendar-year taxpayer,
transfers all of its property to X in a transaction that
qualifies as a reorganization under section
368(a)(1)(C). As a result of the transfer, Y would be
subject to section 1374 treatment under paragraph
(b) of this section but for its timely election of
deemed sale treatment under this paragraph (c). As
a result of such election, Y is subject to deemed sale
treatment on its tax return for the short taxable year
ending May 31, 2004. On May 31, 2004, Y’s only
assets are Capital Asset, which has a fair market
value of $100,000 and a basis of $40,000 as of the
end of May 30, 2004, and $50,000 cash. Y also has
an unrestricted net operating loss carryforward of
$12,000 and accumulated earnings and profits of
$50,000. Y has no taxable income for the short tax-
able year ending May 31, 2004, other than gain rec-
ognized under this paragraph (c). In 2007, X sells
Capital Asset for $110,000. Assume the applicable
corporate tax rate is 35%.
(ii) Under this paragraph (c), Y is treated as if it
sold the converted property (Capital Asset and
$50,000 cash) at fair market value on May 30, 2004,
recognizing $60,000 of gain ($150,000 amount real-
ized - $90,000 basis). Y must report the gain on its
tax return for the short taxable year ending May 31,
2004. Y may offset this gain with its $12,000 net
operating loss carryforward and will pay tax of
$16,800 (35% of $48,000).
(iii) Under section 381, X succeeds to Y’s accu-
mulated earnings and profits. Y’s accumulated earn-
ings and profits of $50,000 increase by $60,000 and
decrease by $16,800 as a result of the deemed sale.
Thus, the aggregate amount of subchapter C earn-
ings and profits that must be distributed to satisfy
section 852(a)(2)(B) is $93,200 ($50,000 + $60,000
- $16,800). X’s basis in Capital Asset is $100,000.
On X’s sale of Capital Asset in 2007, X recognizes
$10,000 of gain which is taken into account in com-
puting X’s net capital gain for purposes of section
852(b)(3).
Example 2. Loss limitation. (i) Assume the facts
are the same as those described inExample 1, but
that, prior to the reorganization, a shareholder of Y
contributed to Y a capital asset, Capital Asset 2,
which has a fair market value of $10,000 and a basis
of $20,000, in a section 351 transaction.
(ii) Assuming that Y’s acquisition of Capital
Asset 2 was made pursuant to a plan a principal
purpose of which was to reduce the amount of gain
that Y would recognize in connection with the con-
version transaction, Capital Asset 2 would be disre-
garded in computing the amount of Y’s net gain on
the conversion transaction.
(d)Exceptions—(1)Gain otherwise
recognized. Paragraph (a) of this section
does not apply to any conversion transac-
tion to the extent that gain or loss other-
wise is recognized on such conversion
transaction. See, for example, sections
336, 351(b), 356, 357(c), 367, and 1001.
January 28, 20023882002–4 I.R.B.

(2)Re-election of RIC or REIT
status—(i)Generally. Except as provided
in paragraphs (d)(2)(ii) and (d)(2)(iii) of
this section, paragraph (a)(1) of this sec-
tion does not apply to any corporation
that—
(A) Immediately prior to qualifying to
be taxed as a RIC or REIT was subject to
tax as a C corporation for a period not
exceeding two taxable years; and
(B) Immediately prior to being subject
to tax as a C corporation was subject to
tax as a RIC or REIT for a period of at
least one taxable year.
(ii)Property acquired from another
corporation while a C corporation. The
exception described in paragraph (d)(2)(i)
of this section does not apply to property
acquired by the corporation while it was
subject to tax as a C corporation from
another corporation (whether or not a C
corporation) in a transaction that results
in the acquirer’s basis in the property
being determined by reference to a C cor-
poration’s basis in the property.
(iii)RICs and REITs previously subject
to section 1374 treatment. If the RIC or
REIT had property subject to paragraph
(b) of this section before the RIC or REIT
became subject to tax as a C corporation
as described in paragraph (d)(2)(i) of this
section, then paragraph (b) of this section
applies to the RIC or REIT upon its
requalification as a RIC or REIT, except
that the 10-year recognition period with
respect to such property is reduced by the
portion of the 10-year recognition period
that expired before the RIC or REIT
became subject to tax as a C corporation
and by the period of time that the corpo-
ration was subject to tax as a C corpora-
tion.
(e)Special rule for partnerships. The
principles of this section apply to prop-
erty transferred by a partnership to a RIC
or REIT to the extent of any C corpora-
tion partner’s proportionate share of the
transferred property. For example, if a C
corporation owns a 20 percent interest in
a partnership and that partnership contrib-
utes an asset to a REIT in a section 351
transaction, then the partnership shall be
treated as a C corporation with respect to
20 percent of the asset contributed to the
REIT. If the partnership were to elect
deemed sale treatment under paragraph
(c) of this section with respect to such
transfer, then any gain recognized by the
partnership on the deemed sale must be
specially allocated to the C corporation
partner.
(f)Effective date. This section applies
to conversion transactions that occur on
or after January 2, 2002. For conversion
transactions that occurred on or after June
10, 1987, and before January 2, 2002, see
§1.337(d)–5T and§1.337(d)–6T. This
section expires on December 31, 2004.
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)***
CFR Part or section where
identified and described
Current OMB
control No.
*****
1.337(d)–6T.............................................................................................................................................................. 1545–1672
1.337(d)–7T.............................................................................................................................................................. 1545-1672
*****
Robert E. Wenzel,
Deputy Commissioner of
Internal Revenue.
Approved December 20, 2001.
Mark Weinberger,
Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on
December 31, 2001, 8:45 a.m., and published in the
issue of the Federal Register for January 2, 2002, 67
F.R. 8)
Section 408.—Individual
Retirement Arrangements
26 CFR 1.408–2: Individual retirement accounts.
A revenue procedure describes the process for
amending prototype and model IRAs, SEPs, and
SIMPLE IRA plans. See Rev. Proc. 2002–10, page
401.
Section 408A.—Roth IRAs
26 CFR 1.408A–2: Establishing Roth IRAs.
A revenue procedure describes the process for
amending prototype and model Roth IRAs. See Rev.
Proc. 2002–10, page 401.
Section 472.—Last-in, First-
out Inventories
26 CFR 1.472–1: Last-in, first-out inventories.
LIFO; price indexes; department
stores. The November 2001 Bureau of
Labor Statistics price indexes are
accepted for use by department stores
employing the retail inventory and last-in,
first-out inventory methods for valuing
inventories for tax years ended on, or
with reference to November 30, 2001.
Rev. Rul. 2002–4
The following Department Store
Inventory Price Indexes for November
2001 were issued by the Bureau of Labor
Statistics. The indexes are accepted by
the Internal Revenue Service, under
§1.472–1(k) of the Income Tax Regula-
tions and Rev. Proc. 86–46 (1986–2
2002–4 I.R.B.389January 28, 2002

C.B. 739) for appropriate application to
inventories of department stores employ-
ing the retail inventory and last-in, first-
out inventory methods for tax years ended
on, or with reference to, November 30,
2001.
The Department Store Inventory Price
Indexes are prepared on a national basis
and include (a) 23 major groups of
departments, (b) three special combina-
tions of the major groups—soft goods,
durable goods, and miscellaneous goods,
and (c) a store total, which covers all
departments, including some not listed
separately, except for the following:
candy, food, liquor, tobacco, and contract
departments.
BUREAU OF LABOR STATISTICS,
DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS
(January 1941 = 100, unless otherwise noted)
Groups
Nov.
2000
Nov.
2001
Percent Change
from Nov. 2000
to Nov. 2001
1
1. Piece Goods.....................................................................................................499.6492.1-1.5
2. Domestics and Draperies ................................................................................610.2597.2-2.1
3. Women’s and Children’s Shoes ......................................................................664.0659.0-0.8
4. Men’s Shoes ....................................................................................................911.2877.2-3.7
5. Infants’Wear ...................................................................................................648.0641.4-1.0
6. Women’s Underwear .......................................................................................577.3574.5-0.5
7. Women’s Hosiery ............................................................................................347.0355.02.3
8. Women’s and Girls’Accessories ....................................................................555.4562.21.2
9. Women’s Outerwear and Girls’Wear .............................................................402.0385.3-4.2
10. Men’s Clothing................................................................................................598.8582.7-2.7
11. Men’s Furnishings ...........................................................................................639.2625.4-2.2
12. Boys’Clothing and Furnishings .....................................................................501.3490.1-2.2
13. Jewelry.............................................................................................................936.0907.3-3.1
14. Notions ............................................................................................................798.0806.51.1
15. Toilet Articles and Drugs ................................................................................973.8979.80.6
16. Furniture and Bedding ....................................................................................696.6629.5-9.6
17. Floor Coverings...............................................................................................625.6627.30.3
18. Housewares......................................................................................................775.6762.5-1.7
19. Major Appliances ............................................................................................227.9226.5-0.6
20. Radio and Television.......................................................................................57.552.3-9.0
21. Recreation and Education
2
..............................................................................92.388.4-4.2
22. Home Improvements
2
.....................................................................................129.2124.2-3.9
23. Auto Accessories
2
...........................................................................................107.6110.42.6
Groups 1—15: Soft Goods .................................................................................604.6592.1-2.1
Groups 16—20: Durable Goods ...........................................................................435.6418.8-3.9
Groups 21—23: Misc. Goods
2
.............................................................................100.197.6-2.5
Store Total
3
.......................................................................................................541.4528.0-2.5
1
Absence of a minus sign before the percentage change in this column signifies a price increase.
2
Indexes on a January 1986=100 base.
3
The store total index covers all departments, including some not listed separately, except for the following: candy, food, liquor,
tobacco, and contract departments.
January 28, 20023902002–4 I.R.B.

DRAFTING INFORMATION
The principal author of this revenue
ruling is Michael Burkom at the Office of
Associate Chief Counsel (Income Tax and
Accounting). For further information
regarding this revenue ruling, contact Mr.
Burkom at (202) 622–7718 (not a toll-
free call).
Section 865.—Source Rules
for Personal Property Sales
26 CFR 1.865–1: Loss with respect to personal
property other than stock.
T.D. 8973
DEPARTMENT OF THE
TREASURY
Internal Revenue Service
26 CFR Part 1
Allocation of Loss With
Respect to Stock and Other
Personal Property
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations and removal
of temporary regulations.
SUMMARY: This document contains
final Tax Regulations which remove tem-
porary regulations relating to the alloca-
tion of loss recognized on the disposition
of stock and other personal property. The
loss allocation regulations primarily will
affect taxpayers that claim the foreign tax
credit and that incur losses with respect to
personal property and are necessary to
modify existing guidance with respect to
loss allocation.
DATES:Effective Dates: These regula-
tions are effective January 8, 2002.
Applicability Dates: For dates of appli-
cability, see§§1.865–1(f) and 1.865–
2(e).
FOR FURTHER INFORMATION CON-
TACT: David A. Juster (202) 622–3850
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
This document contains amendments
to 26 CFR part 1. On January 11, 1999,
final regulations (T.D. 8805 (1999–1 C.B.
371) the 1999 final regulations) address-
ing the allocation of loss on the disposi-
tion of stock (§1.865–2) and amending
the foreign tax credit passive limitation
grouping rules under§1.904–4(c) were
published in theFederal Register(64 FR
1505), together with temporary regula-
tions relating to the allocation of loss on
the disposition of personal property other
than stock (§1.865–1T) and providing a
special matching rule with respect to the
allocationofcertainstocklosses
(§1.865–2T). A notice of proposed rule-
making (REG–106905–98, 1999–1 C.B.
768) cross-referencing the temporary
regulations was published in theFederal
Registerfor the same day (64 FR 1571).
No public hearing was requested or held.
One written comment responding to the
notice of proposed rulemaking was
received. After consideration of the com-
ment, the regulations are finalized sub-
stantially as proposed, and the corre-
sponding temporary regulations are
removed. This Treasury decision also
contains minor clarifying amendments to
§1.865–2 of the 1999 final regulations.
The revisions are discussed below.
Explanation of Provisions
§1.865–1: Loss with Respect to Personal
Property Other Than Stock
§1.865–1(a): general rules
Taxpayers have inquired whether the
regulations apply to section 166 bad debt
deductions. Section 1.865–1 is intended
to apply to all recognized losses with
respect to personal property, unless other-
wise excepted, whether or not the loss
results from an actual sale or disposition.
Although section 166 does not use the
termlossin the context of describing
worthless debts giving rise to a deduction
under the statute, worthlessness deduc-
tions reflect economically sustained
losses similar to losses described in sec-
tion 165(g) with respect to worthless
securities. Section 1.865–1(a)(1) of the
final regulations clarifies that the loss
allocation rules of§1.865–1 apply to sec-
tion 166 bad debt deductions, as well as
losses on property that is marked-to-
market (such as under section 475) and
not excluded from the scope of these
regulations (as are inventory property and
certain derivative contracts).
One commentator requested that the
final regulations clarify the proper alloca-
tion of a loss from the disposition of a
partnership interest. Treasury and the Ser-
vice do not believe that a special rule is
required. Instead, loss on the disposition
of a partnership interest is subject to the
general rule of§1.865–1(a) that allocates
loss to the class of gross income to which
gain from the sale of such property would
give rise in the seller’s hands,i.e.,ona
reciprocal-to-gain basis.
§1.865–1(b)(2): contingent payment debt
instruments
Section 1.865–1(b)(2), explaining the
particular application of the reciprocal-to-
gain loss allocation rule to contingent
payment debt instruments, provides that
loss on an instrument to which§1.1275–
4(b) applies is allocated and apportioned
to the class of interest income to which
the instrument would give rise. The final
regulation adopts the rule of the tempo-
rary regulation, reworded to clarify the
interaction of this section with§1.1275–
4(b)(9)(iv)(A).
§1.865–1(c)(4): unamortized bond pre-
mium
Section 1.865–1(c)(4) provides an
exception from the general reciprocal-to-
gain rule with respect to unamortized
bond premium. The final regulations
modify the text and add a newExample 3
in§1.865–1(e) to clarify that loss on a
debt instrument is allocated against inter-
est only to the extent of the amount of
bond premium that could have been, but
was not, amortized by the taxpayer before
the loss was recognized.
§1.865–1(c)(6)(iii): matching rule
For discussion of modifications to the
matching rule in response to comments,
see the discussion below in connection
with the stock loss matching rule of
§1.865–2(b)(4)(iii).
2002–4 I.R.B.391January 28, 2002

§1.865–1(f): effective dates
The final regulations apply to losses
recognized on or after January 8, 2002. A
taxpayer may apply the regulations, how-
ever, to loss recognized in taxable years
beginning on or after January 1, 1987,
subject to certain conditions.
§1.865–2: Loss with Respect to Stock
§1.865–2(a)(1): general rules
A sentence is added to§1.865–2(a)(1)
to clarify that the loss allocation rules of
§1.865–2 apply to loss on stock (other
than inventory) that is marked-to-market
(such as under section 475).
§1.865–2(a)(3)(ii): bona fide residents of
Puerto Rico
Under section 933, a U.S. citizen or
resident alien that is abona fideresident
of Puerto Rico is generally exempt from
U.S. tax with respect to Puerto Rican
source income, but remains subject to
U.S. tax with respect to income derived
from other sources. Consistent with the
general rule of the 1999 final regulations
allocating losses against gains and taking
account of the special source rule of sec-
tion 865(g)(3),§1.865–2(a)(3)(ii) pro-
vides that a loss recognized by a U.S. citi-
zen or resident alien that is abona fide
resident of Puerto Rico with respect to
stock of a corporation that is engaged in
a trade or business within Puerto Rico
shall be allocated to reduce foreign source
income. The final regulation, however,
did not specifically state whether the
stock loss is allocated against Puerto
Rican source income that is exempt from
tax under section 933 or against all of the
bona fideresident’s foreign source
income. Section 1.865–2(a)(3)(ii) is clari-
fied to provide that if gain from the sale
of such stock would be Puerto Rican
source income that is exempt from tax
under section 933, the loss with respect to
such stock shall be allocated to Puerto
Rican source income. Under section
933(1), a loss allocated to Puerto Rican
source income that is excluded from gross
income under section 933 is not allowed
as a deduction. See§1.933–1(c).
§§1.865–1(c)(6)(iii) and 1.865–
2(b)(4)(iii): matching rule
The temporary regulations provided
that, to the extent a taxpayer recognizes
foreign source income for tax purposes
that results in the creation of a corre-
sponding loss with respect to stock or
other personal property, as the case may
be, the loss shall be allocated and appor-
tioned against such income. The preamble
to the temporary regulations explained
that this rule is intended to prevent tax-
payers from avoiding the dividend recap-
ture rule of§1.865–2(b)(1) or from
accelerating foreign source income and
recognizing an offsetting U.S. loss.
One commenter characterized the rule
as overly broad and the examples as unre-
alistic. The commenter recommended that
the matching rule be eliminated from the
final regulations or revised to target iden-
tified abuses more narrowly.
Taking these considerations into
account,§§1.865–1(c)(6)(iii) and 1.865–
2(b)(4)(iii) are modified to provide that
the matching rule will only apply if a tax-
payer engages in a transaction or series of
transactions with a principal purpose of
recognizing foreign source income that
results in the creation of a corresponding
loss. As an anti-abuse rule, the matching
rule targets transactions that are designed
to produce an artificial or accelerated rec-
ognition of income that directly results in
the creation of a corresponding built-in
loss. The step-down preferred transac-
tions described inExamples 4and5of
§1.865–2T(b)(4)(iv) are transactions of
this type; however, because those transac-
tions are now expressly addressed by
regulations at§1.7701(l)–3, the final
regulations omitExamples 4and5.In
addition,Example 6of§1.865–
2T(b)(4)(iv) is revised and redesignated
asExample 6of paragraph (b)(1)(iv) of
§1.865–2 to illustrate an amendment to
the definition of the recapture period in
§1.865–2(d)(3) discussed below.
Section 1.865–2(b)(4)(iii) is also
revised to clarify the interaction of the
matching rule and the exceptions to the
dividend recapture rule forde minimisor
passive dividends. In the temporary regu-
lations, the matching rule applied to
amounts that otherwise were exempted
from the dividend recapture rule under
the passive orde minimisexceptions only
if the taxpayer held the stock with a prin-
cipal purpose of producing foreign source
income and corresponding loss. Because
the final regulations revise the matching
rule to incorporate a principal purpose
test in all instances, the specific require-
ment of a principal purpose to apply the
matching rule tode minimisor passive
dividends is no longer necessary.
§1.865–2(d)(3): recapture period
The dividend recapture period set forth
in§1.865–2(d)(3) is revised to provide
that the 24-month period ends on the date
on which a taxpayer recognizes a loss
with respect to stock. In addition, in con-
nection with the revisions to the matching
rule discussed above, the definition of the
recapture period in§1.865–2(d)(3) is
expanded to provide that the recapture
period is extended if the assets of the cor-
poration are converted to low-risk invest-
ments with a principal purpose of
enabling the taxpayer to hold the stock
without significant risk of loss until the
recapture period has expired. As noted
above,Example 6of§1.865–2T(b)(4)(iv)
has been redesignated asExample 6of
§1.865–2(b)(1)(iv) and revised to illus-
trate the operation of this change to the
definition of the recapture period. Finally,
§1.865–2(d)(3) is revised to clarify that
the dividend recapture rule applies to a
dividend paid after the date a loss is rec-
ognized, if the loss is incurred after the
dividend was declared (i.e., when the
stock is sold ex-dividend).
§1.865–2(e): effective dates
The final regulations retain the January
11, 1999, effective date of the identical
provisions of the temporary regulations
and provide that the amendments made
by the final regulations apply to losses
recognized on or after January 8, 2002. A
taxpayer may apply the regulations, how-
ever, to loss recognized in any taxable
year beginning on or after January 1,
1987, subject to certain conditions.
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 assess-
ment is not required. A final regulatory
flexibility analysis under 5 U.S.C. 604
has been prepared for the portion of this
January 28, 20023922002–4 I.R.B.

Treasury decision with respect to regula-
tions issued under section 865 of the
Internal Revenue Code. This analysis is
set forth below.
Pursuant to section 7805(f) of the
Internal Revenue Code, the notice of pro-
posed rulemaking preceding this regula-
tion was submitted to the Small Business
Administration for comment on its impact
on small business.
Regulatory Flexibility Analysis
It has been determined that a final
regulatory flexibility analysis is required
under 5 U.S.C. 604 with respect to this
Treasury decision issued under section
865 of the Internal Revenue Code. These
regulations will affect small entities such
as small businesses but not other small
entities, such as local government or tax
exempt organizations, which do not pay
taxes. The IRS and Treasury Department
are not aware of any federal rules that
duplicate, overlap or conflict with these
regulations. The final regulations address
the allocation of loss with respect to stock
and other personal property. These regu-
lations are necessary primarily for the
proper computation of the foreign tax
credit limitation under section 904 of the
Internal Revenue Code. With respect to
U.S. resident taxpayers, the regulations
generally allocate losses against U.S.
source income. Generally, this allocation
simplifies the computation of the foreign
tax credit limitation. None of the signifi-
cant alternatives considered in drafting
the regulations would have significantly
altered the economic impact of the regu-
lations on small entities. There are no
alternative rules that are less burdensome
to small entities but that accomplish the
purposes of the statute.
Drafting Information
Various personnel from the Office of
Associate Chief Counsel (International)
within the Office of Chief Counsel, the
IRS and Treasury Department partici-
pated in developing these regulations.
*****
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 is amended by removing the entries
for“1.865–1T”and“1.865–2T”, revising
the entry for“1.865–2”, and adding
entries in numerical order to read in part
as follows:
Authority: 26 U.S.C. 7805***
Section 1.861–8 also issued under 26
U.S.C. 882(c).***
Section 1.865–1 also issued under 26
U.S.C. 863(a) and 865(j)(1).
Section 1.865–2 also issued under 26
U.S.C. 863(a) and 865(j)(1).***
Par. 2. Section 1.861–8 is amended by:
1. Revising paragraphs (e)(7)(iii) and
(e)(8).
2. Removing the authority citation at
the end of the section.
The revisions read as follows:
§1.861–8 Computation of taxable income
from sources within the United States and
from other sources and activities.
*****
(e)***
(7)***
(iii)Allocation of loss recognized in
taxable years after 1986. See§§1.865–1
and 1.865–2 for rules regarding the allo-
cation of certain loss recognized in tax-
able years beginning after December 31,
1986.
(8)Net operating loss deduction. A net
operating loss deduction allowed under
section 172 shall be allocated and appor-
tioned in the same manner as the deduc-
tions giving rise to the net operating loss
deduction.
*****
Par. 3. Section 1.861–8T is amended
as follows:
1. Paragraphs (e)(1) and (e)(3) through
(e)(11) are revised.
2. Paragraph (h) is amended by remov-
ing the last sentence of the concluding
text.
3. The authority citation at the end of
the section is removed.
The revisions read as follows:
§1.861–8T Computation of taxable
income from sources within the United
States and for other sources and activities
(temporary).
*****
(e)***
(1) [Reserved]. For further guidance,
see§1.861–8(e)(1).
*****
(3) through (11) [Reserved]. For fur-
ther guidance, see§1.861–8(e)(3) through
(e)(11).
*****
Par. 4. Section 1.865–1 is added to
read as follows:
§1.865–1 Loss with respect to personal
property other than stock.
(a)General rules for allocation of
loss—(1)Allocation against gain. Except
as otherwise provided in§1.865–2 and
paragraph (c) of this section, loss recog-
nized with respect to personal property
shall be allocated to the class of gross
income and, if necessary, apportioned
between the statutory grouping of gross
income (or among the statutory group-
ings) and the residual grouping of gross
income, with respect to which gain from
a sale of such property would give rise in
the hands of the seller. For purposes of
this section, loss includes bad debt deduc-
tions under section 166 and loss on prop-
erty that is marked-to-market (such as
under section 475) and subject to the
rules of this section. Thus, for example,
loss recognized by a United States resi-
dent on the sale or worthlessness of a
bond generally is allocated to reduce
United States source income.
(2)Loss attributable to foreign office.
Exceptasotherwiseprovidedin
§1.865–2 and paragraph (c) of this sec-
tion, and except with respect to loss sub-
ject to paragraph (b) of this section, in the
case of loss recognized by a United States
resident with respect to property that is
attributable to an office or other fixed
place of business in a foreign country
within the meaning of section 865(e)(3),
the loss shall be allocated to reduce for-
eign source income if a gain on the sale
of the property would have been taxable
by the foreign country and the highest
marginal rate of tax imposed on such
gains in the foreign country is at least 10
percent. However, paragraph (a)(1) of this
section and not this paragraph (a)(2) will
apply if gain on the sale of such property
would be sourced under section 865(c),
(d)(1)(B), or (d)(3).
2002–4 I.R.B.393January 28, 2002

(3)Loss recognized by United States
citizen or resident alien with foreign tax
home. Except as otherwise provided in
§1.865–2 and paragraph (c) of this sec-
tion, and except with respect to loss sub-
ject to paragraph (b) of this section, in the
case of loss with respect to property rec-
ognized by a United States citizen or resi-
dent alien that has a tax home (as defined
in section 911(d)(3)) in a foreign country,
the loss shall be allocated to reduce for-
eign source income if a gain on the sale
of such property would have been taxable
by a foreign country and the highest mar-
ginal rate of tax imposed on such gains in
the foreign country is at least 10 percent.
(4)Allocation for purposes of section
904. For purposes of section 904, loss
recognized with respect to property that is
allocated to foreign source income under
this paragraph (a) shall be allocated to the
separate category under section 904(d) to
which gain on the sale of the property
would have been assigned (without
regard to section 904(d)(2)(A)(iii)(III)).
For purposes of§1.904–4(c)(2)(ii)(A),
any such loss allocated to passive income
shall be allocated (prior to the application
of§1.904–4(c)(2)(ii)(B)) to the group of
passive income to which gain on a sale of
the property would have been assigned
had a sale of the property resulted in the
recognition of a gain under the law of the
relevant foreign jurisdiction or jurisdic-
tions.
(5)Loss recognized by partnership.A
partner’s distributive share of loss recog-
nized by a partnership with respect to per-
sonal property shall be allocated and
apportioned in accordance with this sec-
tion as if the partner had recognized the
loss. If loss is attributable to an office or
other fixed place of business of the part-
nership within the meaning of section
865(e)(3), such office or fixed place of
business shall be considered to be an
office of the partner for purposes of this
section.
(b)Special rules of application—(1)
Depreciable property. In the case of a
loss recognized with respect to depre-
ciable personal property, the gain referred
to in paragraph (a)(1) of this section is the
gain that would be sourced under section
865(c)(1) (depreciation recapture).
(2)Contingent payment debt instru-
ment. Loss described in the last sentence
of§1.1275–4(b)(9)(iv)(A) that is recog-
nized with respect to a contingent pay-
ment debt instrument to which§1.1275–
4(b) applies (instruments issued for
money or publicly traded property) shall
be allocated to the class of gross income
and, if necessary, apportioned between
the statutory grouping of gross income (or
among the statutory groupings) and the
residual grouping of gross income, with
respect to which interest income from the
instrument (in the amount of the loss sub-
ject to this paragraph (b)(2)) would give
rise.
(c)Exceptions—(1)Foreign currency
and certain financial instruments. This
section does not apply to loss governed
by section 988 and loss recognized with
respect to options contracts or derivative
financial instruments, including futures
contracts, forward contracts, notional
principal contracts, or evidence of an
interest in any of the foregoing.
(2)Inventory. This section does not
apply to loss recognized with respect to
property described in section 1221(a)(1).
(3)Interest equivalents and trade
receivables. Loss subject to§1.861–
9T(b) (loss equivalent to interest expense
and loss on trade receivables) shall be
allocated and apportioned under the rules
of§1.861–9T and not under the rules of
this section.
(4)Unamortized bond premium.Ifa
taxpayer recognizing loss with respect to
a bond (within the meaning of§1.171–
1(b)) did not amortize bond premium to
the full extent permitted by section 171
and the regulations thereunder, then, to
the extent of the amount of bond pre-
mium that could have been, but was not,
amortized by the taxpayer, loss recog-
nized with respect to the bond shall be
allocated to the class of gross income
and, if necessary, apportioned between
the statutory grouping of gross income (or
among the statutory groupings) and the
residual grouping of gross income, with
respect to which interest income from the
bond was assigned.
(5)Accrued interest. Loss attributable
to accrued but unpaid interest on a debt
obligation shall be allocated to the class
of gross income and, if necessary, appor-
tioned between the statutory grouping of
gross income (or among the statutory
groupings) and the residual grouping of
gross income, with respect to which inter-
est income from the obligation was
assigned. For purposes of this section,
whether loss is attributable to accrued but
unpaid interest (rather than to principal)
shall be determined under the principles
of§§1.61–7(d) and 1.446–2(e).
(6)Anti-abuse rules—(i)Transactions
involving built-in losses. If one of the
principal purposes of a transaction is to
change the allocation of a built-in loss
with respect to personal property by
transferring the property to another per-
son, qualified business unit, office or
other fixed place of business, or branch
that subsequently recognizes the loss, the
loss shall be allocated by the transferee as
if it were recognized by the transferor
immediately prior to the transaction. If
one of the principal purposes of a change
of residence is to change the allocation of
a built-in loss with respect to personal
property, the loss shall be allocated as if
the change of residence had not occurred.
If one of the principal purposes of a trans-
action is to change the allocation of a
built-in loss on the disposition of personal
property by converting the original prop-
erty into other property and subsequently
recognizing loss with respect to such
other property, the loss shall be allocated
as if it were recognized with respect to
the original property immediately prior to
the transaction. Transactions subject to
this paragraph shall include, without limi-
tation, reorganizations within the meaning
of section 368(a), liquidations under sec-
tion 332, transfers to a corporation under
section 351, transfers to a partnership
under section 721, transfers to a trust, dis-
tributions by a partnership, distributions
by a trust, transfers to or from a qualified
business unit, office or other fixed place
of business, or branch, or exchanges
under section 1031. A person may have a
principal purpose of affecting loss alloca-
tion even though this purpose is out-
weighed by other purposes (taken
together or separately).
(ii)Offsetting positions. If a taxpayer
recognizes loss with respect to personal
property and the taxpayer (or any person
described in section 267(b) (after applica-
tion of section 267(c)), 267(e), 318, or
482 with respect to the taxpayer) holds
(or held) offsetting positions with respect
to such property with a principal purpose
of recognizing foreign source income and
United States source loss, the loss shall
be allocated and apportioned against such
January 28, 20023942002–4 I.R.B.

foreign source income. For purposes of
this paragraph (c)(6)(ii), positions are off-
setting if the risk of loss of holding one or
more positions is substantially diminished
by holding one or more other positions.
(iii)Matching rule. If a taxpayer (or a
person described in section 1059(c)(3)(C)
with respect to the taxpayer) engages in a
transaction or series of transactions with a
principal purpose of recognizing foreign
source income that results in the creation
of a corresponding loss with respect to
personal property (as a consequence of
the rules regarding the timing of recogni-
tion of income, for example), the loss
shall be allocated and apportioned against
such income to the extent of the recog-
nized foreign source income. For an
example illustrating a similar rule with
respect to stock loss, see§1.865–
2(b)(4)(iv)Example 3.
(d)Definitions—(1)Contingent pay-
ment debt instrument. A contingent pay-
ment debt instrument is any debt instru-
ment that is subject to§1.1275–4.
(2)Depreciable personal property.
Depreciable personal property is any
propertydescribedinsection
865(c)(4)(A).
(3)Terms defined in§1.861–8. See
§1.861–8 for the meaning ofclass of
gross income,statutory grouping of gross
income, andresidual grouping of gross
income.
(e)Examples. The application of this
section may be illustrated by the follow-
ing examples:
Example 1. On January 1, 2000,A, a domestic
corporation, purchases for $1,000 a machine that
produces widgets, whichAsells in the United States
and throughout the world. ThroughoutA’s holding
period, the machine is located and used in Country
X. DuringA’s holding period,Aincurs depreciation
deductions of $400 with respect to the machine.
Under§1.861–8,Aallocates and apportions depre-
ciation deductions of $250 against foreign source
general limitation income and $150 against U.S.
source income. On December 12, 2002,Asells the
machine for $100 and recognizes a loss of $500.
Because the machine was used predominantly out-
side the United States, under sections 865(c)(1)(B)
and 865(c)(3)(B)(ii) gain on the disposition of the
machine would be foreign source general limitation
income to the extent of the depreciation adjust-
ments. Therefore, under paragraph (b)(1) of this sec-
tion, the entire $500 loss is allocated against foreign
source general limitation income.
Example 2. On January 1, 2002,A, a domestic
corporation, loans $2,000 toN, its wholly-owned
controlled foreign corporation, in exchange for a
contingent payment debt instrument subject to
§1.1275–4(b). During 2002 through 2004,A
accrues and receives interest income of $630, $150
of which is foreign source general limitation income
and $480 of which is foreign source passive income
under section 904(d)(3). Assume there are no posi-
tive or negative adjustments pursuant to§1.1275–
4(b)(6) in 2002 through 2004. On January 1, 2005,
Adisposes of the debt instrument and recognizes a
$770 loss. Under§1.1275–4(b)(8)(ii), $630 of the
loss is treated as ordinary loss and $140 is treated as
capital loss. Assume that $140 of interest income
earned in 2005 with respect to the debt instrument
would be foreign source passive income under sec-
tion 904(d)(3). Under§1.1275–4(b)(9)(iv), $150 of
the ordinary loss is allocated against foreign source
general limitation income and $480 of the ordinary
loss is allocated against foreign source passive
income. Under paragraph (b)(2) of this section, the
$140 capital loss is allocated against foreign source
passive income.
Example 3. (i) On January 1, 2003,A, a domes-
tic corporation, purchases for $1,200 a taxable bond
maturing on December 31, 2008, with a stated prin-
cipal amount of $1,000, payable at maturity. The
bond provides for unconditional payments of inter-
est of $100, payable December 31 of each year. The
issuer of the bond is a foreign corporation and inter-
est on the bond is thus foreign source. Interest pay-
ments for 2003 and 2004 are timely made.Adoes
not elect to amortize its bond premium under sec-
tion 171 and the regulations thereunder, which
would have permittedAto offset the $100 of inter-
est income by $28.72 of bond premium in 2003, and
by $30.42 in 2004. On January 1, 2005,Asells the
bond and recognizes a $100 loss. Under paragraph
(c)(4) of this section, $59.14 of the loss is allocated
against foreign source income. Under paragraph
(a)(1) of this section, the remaining $40.86 of the
loss is allocated against U.S. source income.
(ii) The facts are the same as in paragraph (i) of
thisExample 3, except thatAmade the election to
amortize its bond premium effective for taxable year
2004 (see§1.171–4(c)). Under paragraph (c)(4) of
this section, $28.72 of the loss is allocated against
foreign source income. Under paragraph (a)(1) of
this section, the remaining $71.28 of the loss is allo-
cated against U.S. source income.
Example 4. On January 1, 2002,A, a domestic
corporation, purchases for $1,000 a bond maturing
December 31, 2014, with a stated principal amount
of $1,000, payable at maturity. The bond provides
for unconditional payments of interest of $100, pay-
able December 31 of each year. The issuer of the
bond is a foreign corporation and interest on the
bond is thus foreign source. Between 2002 and
2006,Aaccrues and receives foreign source interest
income of $500 with respect to the bond. On Janu-
ary 1, 2007,Asells the bond and recognizes a $500
loss. Under paragraph (a)(1) of this section, the
$500 loss is allocated against U.S. source income.
Example 5. On January 1, 2002,A, a domestic
corporation on the accrual method of accounting,
purchases for $1,000 a bond maturing December 31,
2012, with a stated principal amount of $1,000, pay-
able at maturity. The bond provides for uncondi-
tional payments of interest of $100, payable Decem-
ber 31 of each year. The issuer of the bond is a
foreign corporation and interest on the bond is thus
foreign source. On June 10, 2002, afterAhas
accrued $44 of interest income, but before any inter-
est has been paid, the issuer suddenly becomes
insolvent and declares bankruptcy.Asells the bond
(including the accrued interest) for $20. Assuming
thatAproperly accrued $44 of interest income,A
treats the $20 proceeds from the sale of the bond as
payment of interest previously accrued and recog-
nizes a $1,000 loss with respect to the bond princi-
pal and a $24 loss with respect to the accrued inter-
est. See§1.61–7(d). Under paragraph (a)(1) of this
section, the $1,000 loss with respect to the principal
is allocated against U.S. source income. Under para-
graph (c)(5) of this section, the $24 loss with respect
to accrued but unpaid interest is allocated against
foreign source interest income.
(f)Effective date—(1)In general.
Except as provided in paragraph (f)(2) of
this section, this section is applicable to
loss recognized on or after January 8,
2002. For purposes of this paragraph (f),
loss that is recognized but deferred (for
example, under section 267 or 1092) shall
be treated as recognized at the time the
loss is taken into account.
(2)Application to prior periods. A tax-
payer may apply the rules of this section
to losses recognized in any taxable year
beginning on or after January 1, 1987,
and all subsequent years, provided that—
(i) The taxpayer’s tax liability as
shown on an original or amended tax
return is consistent with the rules of this
section for each such year for which the
statute of limitations does not preclude
the filing of an amended return on June
30, 2002; and
(ii) The taxpayer makes—appropriate
adjustments to eliminate any double ben-
efit arising from the application of this
section to years that are not open for
assessment.
(3)Examples. See§1.865–2(e)(3) for
examples illustrating an applicability date
provision similar to the applicability date
provided in this paragraph (f).
§ 1.865–1T [Removed]
Par. 5. Section 1.865–1T is removed.
Par. 6. Section 1.865–2 is amended by:
1. Adding a sentence after the first sen-
tence of paragraph (a)(1).
2. Adding two sentences at the end of
paragraph (a)(3)(ii).
3. AddingExample 6to paragraph
(b)(1)(iv).
4. Revising paragraph (b)(4)(iii).
5. AddingExample 3to paragraph
(b)(4)(iv).
6. Revising paragraphs (d)(3), (e)(1),
and (e)(2)(i).
The revisions and additions read as
follows:
2002–4 I.R.B.395January 28, 2002

§1.865–2 Loss with respect to stock.
(a)(1)***Forpurposes of this sec-
tion, loss includes loss on property that is
marked-to-market (such as under section
475) and subject to the rules of this sec-
tion.***
(3)***
(ii)***Ifgain from a sale of such
stock would give rise to income exempt
from tax under section 933, the loss with
respect to such stock shall be allocated to
amounts that are excluded from gross
income under section 933(1) and there-
fore shall not be allowed as a deduction
from gross income. See section 933(1)
and§1.933–1(c).
*****
(b)***
(1)***
(iv)***
Example 6. (i) On January 1, 1998,P, a domes-
tic corporation, purchasesN, a foreign corporation,
for $1,000. On March 1, 1998,PcausesNto sell its
operating assets, distribute a $400 general limitation
dividend toP, and invest its remaining $600 in
short-term government securities.Pconverted theN
assets into low-risk investments with a principal
purpose of holding theNstock without significant
risk of loss until the recapture period expired.N
earns interest income from the securities. The
income constitutes subpartFincome that is included
inP’s income under section 951, increasingP’s
basis in theNstock under section 961(a). On March
1, 2002,PsellsNand recognizes a $400 loss.
(ii) Pursuant to paragraph (d)(3) of this section,
the recapture period is increased by the period in
whichN’s assets were held as low-risk investments
becausePcausedN’s assets to be converted into and
held as low-risk investments with a principal pur-
pose of enablingPto hold theNstock without sig-
nificant risk of loss. Accordingly, under paragraph
(b)(1)(i) of this section the $400 loss is allocated
against foreign source general limitation income.
*****
(4)***
(iii)Matching rule. If a taxpayer (or a
person described in section 1059(c)(3)(C)
with respect to the taxpayer) engages in a
transaction or series of transactions with a
principal purpose of recognizing foreign
source income that results in the creation
of a corresponding loss with respect to
stock (as a consequence of the rules
regarding the timing of recognition of
income, for example), the loss shall be
allocated and apportioned against such
income to the extent of the recognized
foreign source income. This paragraph
(b)(4)(iii) applies to any portion of a loss
that is not allocated under paragraph
(b)(1)(i) of this section (dividend recap-
ture rule), including a loss in excess of
the dividend recapture amount and a loss
that is related to a dividend recapture
amount described in paragraph (b)(1)(ii)
(de minimisexception) or (b)(1)(iii) (pas-
sive dividend exception) of this section.
(iv)Examples.***
*****
Example 3. (i)Facts. On January 1, 2002,Pand
Q, domestic corporations, formR, a domestic part-
nership. The corporations and partnership use the
calendar year as their taxable year.Pcontributes
$900 toRin exchange for a 90–percent partnership
interest andQcontributes $100 toRin exchange for
a10–percent partnership interest.Rpurchases a
dance studio in countryXfor $1,000. On January 2,
2002,Renters into contracts to provide dance les-
sons in CountryXfora5–year period beginning
January 1, 2003. These contracts are prepaid by the
dance studio customers on December 31, 2002, and
Rrecognizes foreign source taxable income of $500
from the prepayments (R’s only income in 2002).P
takes into income its $450 distributive share of part-
nership taxable income. On January 1, 2003,P’s
basis in its partnership interest is $1,350 ($900 from
its contribution under section 722, increased by its
$450 distributive share of partnership income under
section 705). On September 22, 2003,Pcontributes
itsRpartnership interest toS, a newly-formed
domestic corporation, in exchange for all the stock
ofS. Under section 358,P’s basis in S is $1,350. On
December 1, 2003,PsellsSto an unrelated party
for $1050 and recognizes a $300 loss.
(ii)Loss allocation.Precognized foreign source
income for tax purposes before the income had eco-
nomically accrued, and the accelerated recognition
of income increasedP’s basis inRwithout increas-
ing its value by a corresponding amount, which
resulted in the creation of a built-in loss with respect
to theSstock. Under paragraph (b)(4)(iii) of this
section the $300 loss is allocated against foreign
source income ifPhad a principal purpose of rec-
ognizing foreign source income and corresponding
loss.
*****
(d)***
(3)Recapture period. A recapture
period is the 24-month period ending on
the date on which a taxpayer recognized a
loss with respect to stock. For example, if
a taxpayer recognizes a loss on March 15,
2002, the recapture period begins on and
includes March 16, 2000, and ends on
and includes March 15, 2002. A recapture
period is increased by any period of time
in which the taxpayer has diminished its
risk of loss in a manner described in sec-
tion 246(c)(4) and the regulations there-
under and by any period in which the
assets of the corporation are hedged
against risk of loss (or are converted into
and held as low-risk investments) with a
principal purpose of enabling the tax-
payer to hold the stock without significant
risk of loss until the recapture period has
expired. In the case of a loss recognized
after a dividend is declared but before
such dividend is paid, the recapture
period is extended through the date on
which the dividend is paid.
*****
(e)Effective date—(1)In general. This
section is applicable to loss recognized on
or after January 11, 1999, except that
paragraphs (a)(3)(ii), (b)(1)(iv)Example
6, (b)(4)(iii), (b)(4)(iv)Example 3, and
(d)(3) of this section are applicable to loss
recognized on or after January 8, 2002.
For purposes of this paragraph (e), loss
that is recognized but deferred (for
example, under section 267 or 1092) shall
be treated as recognized at the time the
loss is taken into account.
(2)***
(i) The taxpayer’s tax liability as
shown on an original or amended tax
return is consistent with the rules of this
section for each such year for which the
statute of limitations does not preclude
the filing of an amended return on June
30, 2002; and
*****
§1.865–2T [Removed]
Par. 7. Section 1.865–2T is removed.
§1.904–4 [Amended]
Par.8.In§1.904–4, paragraph
(c)(2)(ii)(A), remove the language
“1.865–1T through 1.865–2T”at the end
of the first sentence and add“1.865–1
and 1.865–2”in its place.
Robert E. Wenzel,
Deputy Commissioner of
Internal Revenue.
Approved December 19, 2001.
Mark Weinberger,
Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on
December 27, 2001, 8:45 a.m., and published in the
issue of the Federal Register for December 28,
2001, 66 F.R. 67081)
January 28, 20023962002–4 I.R.B.

Section 7872.—Treatment of
Loans With Below-Market
Interest Rates.
This notice announces that the Treasury and the
Service intend to publish proposed regulations pro-
viding comprehensive guidance on the Federal tax
treatment of split-dollar life insurance arrangements.
In addition, this notice indicates that any regulations
will not be effective until the publication date of the
final regulations, and provides information on the
tax treatment of split-dollar life insurance arrange-
ments entered into prior to the effective date of final
regulations. Notice 2001–10 (2001–5 I.R.B. 459) is
revoked. Notwithstanding that revocation, Rev. Rul.
55–747 (1955–2 C.B. 228) remains revoked, and
Rev. Rul. 64–328 (1964–2 C.B. 11) and Rev. Rul.
66–110 (1966–1 C.B. 12) remain modified to the
extent that those rulings indicate that an employer’s
premium payments under a split-dollar life insur-
ance arrangement may not be treated as loans. See
Notice 2002–8, page 398.
2002–4 I.R.B.397January 28, 2002

Part III. Administrative, Procedural, and Miscellaneous
Split-Dollar Life Insurance
Arrangements
Notice 2002–8
I. PURPOSE AND OVERVIEW
On January 29, 2001, the Treasury
Department and Internal Revenue Service
issued Notice 2001–10 (2001–5 I.R.B.
459) to provide interim guidance regard-
ing the tax treatment of parties entering
into split-dollar life insurance arrange-
ments and to revise standards for valuing
current life insurance protection. This
Notice 2002–8:
•Revokes Notice 2001–10;
•Announces that the Treasury and the
Service intend to publish proposed
regulations providing comprehensive
guidance regarding the Federal tax
treatment of split-dollar life insurance
arrangements;
•Outlines rules expected to be included
in the forthcoming proposed regula-
tions and the expected effective date
of those regulations; and
•Provides guidance regarding the valu-
ation of current life insurance protec-
tion under a split-dollar life insurance
arrangement, under qualified retire-
ment plans and under employee annu-
ity contracts.
II. EXPECTED PROPOSED
REGULATIONS
Treasury and the Service intend to
issue proposed regulations requiring the
taxation of parties to a split-dollar life
insurance arrangement under one of two
mutually exclusive regimes. Under one
regime, the economic benefits of a split-
dollar life insurance arrangement gener-
ally are treated as transfers to the ben-
efited party. Under the other regime,
payments by the sponsor (i.e., the party
providing life insurance benefits to the
other party under the arrangement) pursu-
ant to a split-dollar life insurance arrange-
ment generally are treated as a series of
loans to the benefited party.
The proposed regulations are expected
to provide that, in an employment-related
split-dollar life insurance arrangement, if
the employer is formally designated as
the owner of the life insurance contract,
then the benefits provided to the
employee under the arrangement are sub-
ject to tax under the first regime. Under
this regime, the employer is treated for
Federal tax purposes as the owner of the
life insurance contract prior to termina-
tion of the arrangement, and is treated as
providing current life insurance protec-
tion and other economic benefits to the
employee, which are taxable under sec-
tion 61 of the Internal Revenue Code. A
transfer of the life insurance contract to
the employee is taxed under section 83.
The proposed regulations will not treat an
employer as having made a transfer of a
portion of the cash surrender value of a
life insurance contract to an employee for
purposes of section 83 solely because the
interest or other earnings credited to the
cash surrender value of the contract cause
the cash surrender value to exceed the
portion thereof payable to the employer.
The proposed regulations are expected
to provide that if the employee is for-
mally designated as the owner of the life
insurance contract under a split-dollar
arrangement, then the premiums paid by
the employer are treated as a series of
loans by the employer to the employee if
the employee is obligated to repay the
employer, whether out of contract pro-
ceeds or otherwise. Under this second
regime, the loans are subject to the prin-
ciples, where applicable, of sections
1271–1275 (regarding the taxation of
original issue discount) and section 7872
(in the case of a compensation-related
below-market loan, section 7872 deems
an interest payment by the employee to
the employer, which is funded by deemed
additional compensation paid by the
employer to the employee). If the
employee is not obligated to repay the
premiums paid by the employer, then
such amounts are treated as compensation
income to the employee at the time the
premiums are paid by the employer.
The same principles are expected to
govern the Federal tax treatment of split-
dollar life insurance arrangements in
other contexts, including arrangements
that provide benefits in gift and
corporation-shareholder contexts.
The proposed regulations addressing
the Federal tax treatment of split-dollar
life insurance arrangements will be effec-
tive for arrangements entered into after
the date of publication of final regula-
tions.
III. REVISED STANDARDS FOR
VALUING CURRENT LIFE
INSURANCE PROTECTION
Pending the consideration of com-
ments and publication of further guid-
ance, the following interim guidance is
provided on the valuation of current life
insurance protection:
1. Rev. Rul. 55–747 (1955–2 C.B.
228), remains revoked, as provided in and
with the transitional relief for 2001
described in Part IV.B.1 of Notice 2001–
10. Notwithstanding such revocation, for
a split-dollar life insurance arrangement
entered into before January 28, 2002, in
which a contractual arrangement between
an employer and employee provides that
the P.S. 58 rates will be used to determine
the value of current life insurance protec-
tion provided to the employee (or to the
employee and one or more additional per-
sons), the employer and employee may
continue to use the P.S. 58 rates set forth
in Rev. Rul. 55–747 to determine the
value of current life insurance protection.
2. For arrangements entered into
before the effective date of future guid-
ance, taxpayers may use the premium rate
table set forth at the end of this notice to
determine the value of current life insur-
ance protection on a single life that is
provided under a split-dollar life insur-
ance arrangement, in a qualified retire-
ment plan, or under employee annuity
contracts. (This table is captioned as
Table 2001 and was originally published
in Notice 2001–10.) Taxpayers should
make appropriate adjustments to these
premium rates if the life insurance protec-
tion covers more than one life.
3. For arrangements entered into
before the effective date of future guid-
ance, to the extent provided by Rev. Rul.
66–110 (1966–1 C.B. 12) as amplified by
Rev. Rul. 67–154 (1967–1 C.B. 11) tax-
payers may continue to determine the
value of current life insurance protection
by using the insurer’s lower published
premium rates that are available to all
standard risks for initial issue one-year
term insurance. However, for arrange-
ments entered into after January 28, 2002,
January 28, 20023982002–4 I.R.B.

and before the effective date of future
guidance, for periods after December 31,
2003, the Service will not consider an
insurer’s published premium rates to be
available to all standard risks who apply
for term insurance unless (i) the insurer
generally makes the availability of such
rates known to persons who apply for
term insurance coverage from the insurer,
and (ii) the insurer regularly sells term
insurance at such rates to individuals who
apply for term insurance coverage
through the insurer’s normal distribution
channels.
IV. SPLIT-DOLLAR LIFE
INSURANCE ARRANGEMENTS
ENTERED INTO BEFORE THE DATE
OF PUBLICATION OF FINAL
REGULATIONS
1. For split-dollar life insurance
arrangements entered into before the date
of publication of final regulations, the
Service will not treat a service recipient
as having made a transfer of a portion of
the cash surrender value of a life insur-
ance contract to a service provider for
purposes of section 83 solely because the
interest or other earnings credited to the
cash surrender value of the contract cause
the cash surrender value to exceed the
portion thereof payable to the service
recipient.
2. For split-dollar life insurance
arrangements entered into before the date
of publication of final regulations, in
cases where the value of current life
insurance protection is treated as an eco-
nomic benefit provided by a sponsor to a
benefited person under a split-dollar life
insurance arrangement, the Service will
not treat the arrangement as having been
terminated (and thus will not assert that
there has been a transfer of property to
the benefited person by reason of termi-
nation of the arrangement) for so long as
the parties to the arrangement continue to
treat and report the value of the life insur-
ance protection as an economic benefit
provided to the benefited person. This
treatment will be accepted without regard
to the level of the remaining economic
interest that the sponsor has in the life
insurance contract.
3. For split-dollar life insurance
arrangements entered into before the date
of publication of final regulations, the
parties to the arrangement may treat pre-
mium or other payments by the sponsor
as loans. In such cases, the Service will
not challenge reasonable efforts to com-
ply with the requirements of sections
1271–1275 and section 7872. All pay-
ments by the sponsor from the inception
of the arrangement (reduced by any
repayments to the sponsor) before the
first taxable year in which such payments
are treated as loans for Federal tax pur-
poses must be treated as loans entered
into at the beginning of that first year in
which such payments are treated as loans.
4. For split-dollar life insurance
arrangements entered into before January
28, 2002, under which a sponsor has
made premium or other payments under
the arrangement and has received or is
entitled to receive full repayment of all of
its payments, the Service will not assert
that there has been a taxable transfer of
property to a benefited person upon ter-
mination of the arrangement if (i) the
arrangement is terminated before January
1, 2004, or (ii) for all periods beginning
on or after January 1, 2004, all payments
by the sponsor from inception of the
arrangement (reduced by any repayments
to the sponsor) are treated as loans for
Federal tax purposes, and the parties to
the arrangement report the tax treatment
in a manner consistent with this loan
treatment, including sections 1271–1275
and section 7872. Any such payments by
the sponsor before the first taxable year in
which such payments are treated as loans
for Federal tax purposes must be treated
as loans entered into at the beginning of
that first year in which such payments are
treated as loans.
V. REQUEST FOR COMMENTS
The proposed regulations will provide
an opportunity for comment. In addition,
Treasury and the Service request com-
ments on this notice, in particular on both
the appropriate rates for valuing current
life insurance protection and the stan-
dards that should be required for use of
the insurer’s published premium rates for
valuing current life insurance protection.
Comments are specifically invited on (i)
whether one or more premium rate tables
should be prescribed as the exclusive
basis for valuing current life insurance
protection for Federal tax purposes, and
(ii) if one or more premium rate tables are
prescribed for these purposes, how such
tables should be determined and whether
premium rates charged by life insurance
companies can be used for this determina-
tion.
Written comments on this notice are
requested to be submitted no later than
April 28, 2002, to CC:ITA:RU (Notice
2002–8 [NOT–168656–01]), room 5226,
Internal Revenue Service, POB 7604,
Ben Franklin Station, Washington, DC
20044. Comments may be hand delivered
Monday through Friday between the
hours of 8 a.m. and 5 p.m. to CC:ITA:RU
(Notice 2002–8 [NOT–168656–01]),
Courier’s Desk, Internal Revenue Ser-
vice,1111Constitution Avenue NW,
Washington, DC, or submitted electroni-
cally to:Notice.Comments@irscounsel.
treas.gov. All comments will be available
for public inspection and copying.
VI. EFFECT ON OTHER
DOCUMENTS
Notice 2001–10 is revoked. Notwith-
standing that revocation, Rev. Rul.
55–747 remains revoked, and Rev. Rul.
64–328 (1964–2 C.B. 11) and Rev. Rul.
66–110 remain modified to the extent that
those rulings indicate that an employer’s
premium payments under a split-dollar
life insurance arrangement may not be
treated as loans.
Except for Part III (Revised Standards
for Valuing Current Life Insurance Pro-
tection), no inference should be drawn
from this notice regarding the appropriate
Federal income, employment and gift tax
treatment of split-dollar life insurance
arrangements entered into before the date
of publication of final regulations. How-
ever, taxpayers may rely on this notice
(including a reasonable application of the
rules to be proposed as described in Part
II) or Notice 2001–10 for split-dollar life
insurance arrangements entered into
before the date of publication of final
regulations.
VII. CONTACT INFORMATION
For further information regarding this
notice, contact Rebecca Asta of the Office
of Associate Chief Counsel (Financial
Institutions and Products) at (202) 622–
3930, or Erinn Madden of the Office of
Associate Chief Counsel (Tax Exempt
and Government Entities) at (202) 622–
6030 (not toll-free calls).
2002–4 I.R.B.399January 28, 2002

TABLE 2001
INTERIM TABLE OF ONE-YEAR TERM PREMIUMS
FOR $1,000 OF LIFE INSURANCE PROTECTION
Attained
Age
Section 79
Extended and
Interpolated
Annual Rates
Attained
Age
Section 79
Extended and
Interpolated
Annual Rates
Attained
Age
Section 79
Extended and
Interpolated
Annual Rates
0$ 0.7035$ 0.9970$ 20.62
1$ 0.4136$ 1.0171$ 22.72
2$ 0.2737$ 1.0472$ 25.07
3$ 0.1938$ 1.0673$ 27.57
4$ 0.1339$ 1.0774$ 30.18
5$ 0.1340$ 1.1075$ 33.05
6$ 0.1441$ 1.1376$ 36.33
7$ 0.1542$ 1.2077$ 40.17
8$ 0.1643$ 1.2978$ 44.33
9$ 0.1644$ 1.4079$ 49.23
10$ 0.1645$ 1.5380$ 54.56
11$ 0.1946$ 1.6781$ 60.51
12$ 0.2447$ 1.8382$ 66.74
13$ 0.2848$ 1.9883$ 73.07
14$ 0.3349$ 2.1384$ 80.35
15$ 0.3850$ 2.3085$ 88.76
16$ 0.5251$ 2.5286$ 99.16
17$ 0.5752$ 2.8187$ 110.40
18$ 0.5953$ 3.2088$ 121.85
19$ 0.6154$ 3.6589$ 133.40
20$ 0.6255$ 4.1590$ 144.30
21$ 0.6256$ 4.6891$ 155.80
22$ 0.6457$ 5.2092$ 168.75
23$ 0.6658$ 5.6693$ 186.44
24$ 0.6859$ 6.0694$ 206.70
25$ 0.7160$ 6.5195$ 228.35
26$ 0.7361$ 7.1196$ 250.01
27$ 0.7662$ 7.9697$ 265.09
28$ 0.8063$ 9.0898$ 270.11
29$ 0.8364$ 10.4199$ 281.05
30$ 0.8765$ 11.90
31$ 0.9066$ 13.51
32$ 0.9367$ 15.20
33$ 0.9668$ 16.92
34$ 0.9869$ 18.70
January 28, 20024002002–4 I.R.B.

26 CFR 601.201: Rulings and determination letters.
(Also, Part I,§§408, 408A.)
Rev. Proc. 2002–10
SECTION 1. PURPOSE
This revenue procedure provides (1)
guidance to drafters of IRAs, SEPs and
SIMPLE IRA plans; (2) guidance to users
of Internal Revenue Service model IRAs
and plans; and (3) transitional relief for
users of IRAs and plans that have not
been approved by the Service.
SECTION 2. BACKGROUND AND
GENERAL INFORMATION
.01 The Economic Growth and Tax
Relief Reconciliation Act of 2001
(“EGTRRA”), Pub. L. 107–16, made sev-
eral changes to the Internal Revenue
Code, affecting IRAs (traditional, Roth,
and SIMPLE IRAs), SEPs (including sal-
ary reduction SEPs,“SARSEPs”) and
SIMPLE IRA plans, that are effective
beginning January 1, 2002.
.02 On January 17, 2001, proposed
regulations concerning required minimum
distributions from retirement plans were
published in the Federal Register. These
proposed regulations can be used to fig-
ure required minimum distributions from
IRAs beginning with the 2001 distribu-
tion calendar year. Final regulations are
expected to be issued in the near future.
.03 Rev. Proc. 87–50 (1987–2 C.B.
647) provides the procedures for a spon-
soring organization or a mass submitter (a
“prototype sponsor”) to apply to the Ser-
vice for an opinion letter on whether a
prototype traditional IRA or a prototype
SEP meets the requirements of§408(a)
or (b), or§408(k), respectively. Rev.
Proc. 87–50 also contains procedures for
employers and employee associations to
apply for a ruling on a§408(c) IRA and
for employers to apply for a ruling on
whether a SEP, in combination with a ter-
minated defined benefit plan, satisfies the
requirements of§415.
.04 Rev. Proc. 91–44 (1991–2 C.B.
733) modified Rev. Proc. 87–50 to permit
prototype sponsors to apply to the service
for an opinion letter on whether a proto-
type SARSEP meets the requirements of
§408(k)(6). The Small Business Job Pro-
tection Act of 1996 (Pub. L. 104–188)
prohibited the establishment of SARSEPs
after December 31, 1996.
.05 Rev. Proc. 97–29 (1997–1 C.B.
698) modified Rev. Proc. 87–50 to permit
prototype sponsors to apply to the Service
for an opinion letter on whether a proto-
type SIMPLE IRA or a SIMPLE IRA
plan meets the requirements of§408(p).
.06 Rev. Proc. 98–59 (1998–2 C.B.
727) modified Rev. Proc. 87–50 to permit
prototype sponsors to apply to the Service
for an opinion letter on whether a proto-
type Roth IRA meets the requirements of
§408A.
.07 In Announcement 2001–96
(2001–41 I.R.B. 317) (October 9, 2001),
the Service announced that opinion letters
would not be issued covering EGTRRA
changes to SEPs and SIMPLE IRA plans
until further notice.
.08 Model forms are available for tax-
payers who want to use a pre-approved
document to establish an IRA or a SEP or
SIMPLE IRA plan without using a proto-
type document. The model forms refer-
enced in the preceding sentence are: Form
5305,IndividualRetirementTrust
Account; Form 5305–A,Individual
Retirement Custodial Account;Form
5305–R,Roth Individual Retirement Trust
Account; Form 5305–RA,Roth Individual
Retirement Custodial Account;Form
5305–RB,Roth Individual Retirement
Annuity Endorsement; Form 5305–S,
SIMPLEIndividualRetirementTrust
Account; Form 5305–SA,SIMPLE Indi-
vidual Retirement Custodial Account;
Form 5304–SIMPLE,Savings Incentive
Match Plan for Employees of Small
Employers (SIMPLE)—(Not Subject to
the Designated Financial Institution
Rules); Form 5305–SIMPLE,Savings
Incentive Match Plan for Employees of
Small Employers (SIMPLE)—(For Use
With a Designated Financial Institution);
Form 5305–SEP,Simplified Employee
Pension; and Form 5305A-SEP,Salary
Reduction and Other Elective Simplified
Employee Pension.
SECTION 3. OPINION LETTERS FOR
IRAS AND SEP AND SIMPLE IRA
PLANS
.01Mandatory submission. Beginning
April 1, 2002, prototype sponsors can
apply for opinion letters on prototype
documents that incorporate EGTRRA
changes and the final required minimum
distribution rules. All prototype sponsors
with currently approved prototype IRAs,
SEPs, and SIMPLE IRA plans must
amend these documents and submit an
application for opinion letters on the
amended documents no later than Decem-
ber 31, 2002, in order to remain a proto-
type sponsor of such documents. Drafters
of§408(c) IRAs must also amend such
§408(c) IRA documents and submit an
application for opinion letters on the
amended documents no later than Octo-
ber 1, 2002. The documents must be sub-
mitted using the appropriate application
form and following the instructions on
that form. Form 5306,Application for
Approval of Prototype or Employer Spon-
sored Individual Retirement Arrangement
(IRA), is used for prototype IRA submis-
sions, and Form 5306–A,Application for
Approval of Prototype Simplified
Employee Pension (SEP) or Savings
Incentive Match Plan for Employees of
Small Employees (SIMPLE IRA plan),is
used for prototype SEP and SIMPLE IRA
plan submissions.
.02Sample language. A Listing of
Required Modifications, or LRMs, that
the Service finds acceptable for prototype
IRAs, SEPs, and SIMPLE IRA plans will
be available shortly on the Service’sWeb
Site atwww.irs.gov. Click on“Tax Info
For Business,”then“Employee Plans
Corner,”then“Listing of Required Modi-
fications (LRMs).”In order to receive a
favorable opinion letter, prototype docu-
ments must include language that
addresses every point in the LRMs,
unless clearly inapplicable. Identical lan-
guage is not necessary, but LRM concepts
may not be abbreviated by using refer-
ences to Code sections or such phrases as
“in accordance with the law.”
.03Annuities. In the case of a proto-
type sponsor that is an issuer of indi-
vidual retirement annuities described in
§408(b) and that must apply to one or
more state insurance departments for
approval of amended IRA documents, the
Service will grant expedited review of
Service-approved EGTRRA prototype
IRA documents amended for changes
required by a state insurance department,
provided: (1) the Service-approved
EGTRRA document is submitted to the
state insurance department within 90 days
of the date the Service issues a favorable
EGTRRA opinion letter on the document
2002–4 I.R.B.401January 28, 2002

and; (2) the prototype sponsor resubmits
the document, as amended to comply
with changes required by the state insur-
ance department, to the Service within 90
days after it is approved by such state
insurance department.
SECTION 4. ADOPTION OF REVISED
IRAS, SEPS, AND SIMPLE IRA
PLANS
.01Model IRAs. The Service expects
to issue revised model IRAs in early 2002
containing EGTRRA changes and
required minimum distribution rules that
comply with the final regulations. Exist-
ing model IRAs may not be used to estab-
lish new IRAs after June 1, 2002. An
individual using an existing model IRA
who wants to take advantage of the 2002
EGTRRA changes to IRAs in 2002 must
adopt a revised model IRA (or an appro-
priate amended prototype IRA) by the
end of 2002.
.02Prototype IRAs. An individual
using a currently approved prototype IRA
must adopt either (1) the prototype spon-
sor’s amended document within 180 days
after the date the Service issues a favor-
able EGTRRA opinion letter on the
amended document or (2) an appropriate
model IRA by the end of 2002.
.03Section 408(c) IRAs. An employer
or employee association using a currently
approved§408(c) IRA must adopt an
amended§408(c) IRA within 30 days
after the date the Service issues a favor-
able EGTRRA opinion letter on the
amended document.
.04Disclosure statements. A financial
institution that serves as a trustee, issuer,
or custodian for a model or prototype
IRA must change the corresponding dis-
closure statement, required pursuant to
§408(i), to reflect the contents of the
revised IRA. The financial institution
must distribute the amended disclosure
statement to each individual using the
revised IRA.
.05Model SEPs and SIMPLE IRA
plans. The Service expects to issue
revised model SEP and SIMPLE IRA
forms, also in early 2002, containing
EGTRRA changes. Existing model SEPs
and SIMPLE IRA plans may not be used
to establish new SEPs or SIMPLE IRA
plans after June 1, 2002. An employer
using an existing model SEP who wants
to take advantage of the EGTRRA
changes to such plans for the first plan
year beginning after December 31, 2001,
must adopt a revised model plan (or an
appropriate amended prototype plan) by
the end of such first plan year. An
employer using an existing model
SIMPLE IRA plan, must adopt a revised
model plan (or an appropriate amended
prototype plan) by the end of 2002. How-
ever, notwithstanding the preceding two
sentences or otherwise applicable notice
requirements, participating employees
must be notified of the increased
EGTRRA contribution limits by October
1, 2002.
.06Prototype SEPs and SIMPLE IRA
plans. An employer using a currently
approved prototype SEP who wants to
take advantage of the EGTRRA changes
to such plans for the first plan year begin-
ning after December 31, 2001, must adopt
the prototype sponsor’s amended docu-
ment within 180 days after the date the
Service issues a favorable opinion letter
on the amended document. An employer
using a currently approved prototype
SIMPLE IRA plan must adopt the proto-
type sponsor’s amended document within
180 days after the date the Service issues
a favorable opinion letter on the amended
document. However, notwithstanding the
preceding two sentences or otherwise
applicable notice requirements, participat-
ing employees must be notified of the
increased EGTRRA contribution limits by
October 1, 2002.
.07SEPs with§415 rulings.An
employer using a SEP that has a favorable
ruling because participants also partici-
pated in the employer’s terminated
defined benefit plan must adopt an
amended SEP in accordance with section
4.05 above. Because the aggregation rules
under§415(e) have been repealed, the
Service will no longer issue rulings on
whether a SEP, in combination with a ter-
minated defined benefit plan, satisfies the
requirements of§415.
SECTION 5. TRANSITIONAL RELIEF
FOR PROTOTYPE ADOPTERS
.01IRAs. An individual and financial
institution who establish a trust, custodial
account or annuity contract as an IRA
after 2001 using a document that has not
received an EGTRRA opinion letter are
deemed to have established an IRA using
an EGTRRA-approved document pro-
vided the conditions in (1) through (4)
below are satisfied:
(1) The individual and financial insti-
tution used a document provided by a
prototype sponsor to establish the“IRA.”
(2) No later than December 31, 2002,
the prototype sponsor applies to the Ser-
vice for an opinion letter on the document
described in section 5.01(1).
(3) The individual and financial insti-
tution adopt the approved document
within 180 days after the date the Service
issues a favorable opinion letter on the
document to the prototype sponsor.
(4) The individual and financial insti-
tution comply in operation with appli-
cable statutory requirements for the
period beginning on the date the“IRA”
was established under the original docu-
ment through the date the Service-
approved document is adopted.
.02SEPs and SIMPLE IRA plans.An
employer who establishes a plan as a SEP
or SIMPLE IRA plan after 2001 using a
document that has not received an
EGTRRA opinion letter is deemed to
have established such a plan using an
EGTRRA-approved document provided
the conditions in (1) through (4) below
are satisfied:
(1) The employer used a document
provided by a prototype sponsor to estab-
lish the“SEP”or“SIMPLE IRA plan.”
(2) No later than December 31, 2002,
the prototype sponsor applies to the Ser-
vice for an opinion letter on the document
described in section 5.02(1).
(3) Within 180 days after the Service
issues a favorable opinion letter on the
document to the prototype sponsor, the
employer adopts the approved document.
(4) The employer complies in opera-
tion with applicable statutory require-
ments for the period beginning on the
date the“SEP”or“SIMPLE IRA plan”
was established under the original docu-
ment through the date the Service-
approved document is adopted.
January 28, 20024022002–4 I.R.B.

SECTION 6. EFFECT ON OTHER
DOCUMENTS
Section 4.01 of Rev. Proc. 87–50 is
modified by section 4.07 of this revenue
procedure.
SECTION 7. EFFECTIVE DATE
This revenue procedure is effective on
January 28, 2002.
SECTION 8. PAPERWORK
REDUCTION ACT
The collections of information con-
tained in this revenue procedure have
been reviewed and approved by the
Office of Management and Budget in
accordance with the Paperwork Reduc-
tion Act (44 U.S.C. section 3507) under
control number 1545–1769.
An agency may not conduct or spon-
sor, and a person is not required to
respond to, a collection of information
unless the collection of information dis-
plays a valid control number.
The collections of information in this
revenue procedure are in sections 4.04,
4.05, and 4.06. This information is
required to inform IRA owners and plan
participants of the new rules applicable to
their retirement savings. The likely
respondents are (1) businesses or other
for-profit institutions and (2) not-for-
profit institutions.
The estimated total annual reporting
burden is 7,371,000 hours.
The estimated annual burden per
respondent varies from 0.1 hours to 1,000
hours, depending on individual circum-
stances, with an estimated average of 19.5
hours. The estimated number of respon-
dents is 378,000.
The estimated annual frequency of
responses is one.
Books or records relating to a collec-
tion of information must be retained as
long as their contents may become mate-
rial in the administration of any internal
revenue law.
DRAFTING INFORMATION
The principal author of this revenue
procedure is Roger Kuehnle of the
Employee Plans, Tax Exempt and Gov-
ernment Entities Division. For further
information regarding this revenue proce-
dure, please contact Employee Plans’tax-
payer assistance telephone service at
1–877–829–5500 (a toll-free number),
between the hours of 8:00 a.m. and 6:30
p.m. Eastern Time, Monday through Fri-
day.
2002–4 I.R.B.403January 28, 2002

Part IV. Items of General Interest
Notice of Proposed
Rulemaking and Notice of
Public Hearing
Credit for Increasing
Research Activities
REG–112991–01
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking
and notice of public hearing.
SUMMARY: This document contains
proposed regulations relating to the com-
putation of the research credit under sec-
tion 41(c) and the definition of qualified
research under section 41(d). In addition,
this document contains proposed regula-
tions describing when computer software
that is developed by (or for the benefit of)
a taxpayer primarily for the taxpayer’s
internal use is excepted from the internal-
use software exclusion contained in sec-
tion 41(d)(4)(E). These proposed regula-
tions reflect changes to section 41 made
by the Tax Reform Act of 1986, the Rev-
enue Reconciliation Act of 1989, the
Small Business Job Protection Act of
1996, the Taxpayer Relief Act of 1997,
the Tax and Trade Relief Extension Act of
1998, and the Tax Relief Extension Act of
1999. This document also provides notice
of a public hearing on these proposed
regulations.
DATES: Written and electronic comments
and requests to speak (with outlines of
oral comments) at the public hearing
scheduled for March 27, 2002, must be
received no later than March 6, 2002.
ADDRESSES: Send submissions to:
CC:IT&A:RU (REG–112991–01), room
5226, Internal Revenue Service, POB
7604, Ben Franklin Station, Washington,
DC 20044. Submissions may also be
hand delivered Monday through Friday
between the hours of 8 a.m. and 5 p.m.
to: CC:IT&A:RU (REG–112991–01),
Courier’s Desk, Internal Revenue Ser-
vice,1111Constitution Avenue NW,
Washington, DC. Alternatively, taxpayers
may submit comments electronically via
the Internet by selecting the“Tax Regs”
option of the IRS Home Page, or by sub-
mitting comments directly to the IRS
Internet site at:http://www.irs.gov/
tax_regs/reglist.html. The public hearing
will be held in the IRS Auditorium (7th
Floor), Internal Revenue Building,1111
Constitution Avenue, NW, Washington,
DC.
FOR FURTHER INFORMATION CON-
TACT: Concerning the regulations, Lisa
J. Shuman, 202–622–3120; concerning
submissions of comments and the hear-
ing, LaNita VanDyke 202–622–7180 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information con-
tained in this proposed regulation have
been previously reviewed and approved
by theOffice of Management and Bud-
get(OMB) in accordance with the Paper-
work Reduction Act of 1995 (44 U.S.C.
3507(d)) and assigned OMB Control
Number 1545–1625. An agency may not
conduct or sponsor, and a person is not
required to respond to, a collection of
information unless it displays a valid con-
trol number assigned by OMB.
Books or records relating to a collec-
tion of information must be retained as
long as their contents may become mate-
rial 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 January 3, 2001, Treasury and the
IRS published in theFederal Register
(66 FR 280) final regulations (T.D. 8930,
2001–5 I.R.B.433) relating to the compu-
tation of the credit for increasing research
activities (the research credit) under sec-
tion 41(c) and the definition of qualified
research under section 41(d). In response
to taxpayer concerns regarding T.D. 8930,
on January 31, 2001, Treasury and the
IRS published Notice 2001–19 (2001–10
I.R.B. 784), announcing that Treasury and
the IRS would review T.D. 8930 and
reconsider comments previously submit-
ted in connection with the finalization of
T.D. 8930. Comments were requested on
all aspects of T.D. 8930 with specific
comments requested on whether modifi-
cations should be made to the documen-
tation requirement contained in§1.41–
4(d).
Notice 2001–19 also provided that,
upon the completion of this review, Trea-
sury and the IRS would announce
changes to the regulations, if any, in the
form of proposed regulations. Notice
2001–19 stated that T.D. 8930 would be
revised so that the provisions of the regu-
lations, including any changes to T.D.
8930, would be effective no earlier than
the date when the completion of this
review was announced, except that the
provisions relating to internal-use com-
puter software (including any revisions)
generally would be applicable for taxable
years beginning after December 31, 1985.
Explanation of Provisions
This document amends 26 CFR part 1
to provide additional rules under section
41. Section 41 contains the rules for the
research credit. After consideration of the
statute and legislative history, the court
decisions, T.D. 8930 and the comments
previously submitted in connection with
the finalization of T.D. 8930, and the
comments submitted in response to
Notice 2001–19, Treasury and the IRS
have revised T.D. 8930 to provide rules
regarding:
(i) the requirement in section
41(d)(1)(B)(i) that qualified research be
“undertaken for the purpose of discover-
ing information which is technological in
nature”;
(ii) the requirement in section
41(d)(1)(C) that qualified research be
research“substantially all of the activities
of which constitute elements of a process
of experimentation”;
(iii) the type of computer software
constituting software“which is developed
by (or for the benefit of) the taxpayer pri-
marily for internal use by the taxpayer”
for purposes of section 41(d)(4)(E); and
(iv) the documentation required to sub-
stantiate the research credit.
These and other changes to T.D. 8930
are discussed below.
January 28, 20024042002–4 I.R.B.

I. Research that is Undertaken for the
Purpose of Discovering Information
which is Technological in Nature
Section 41(d)(1)(B)(i) requires that
qualified research must be“undertaken
for the purpose of discovering informa-
tion which is technological in nature.”
T.D. 8930 provided that“research is
undertaken for the purpose of discovering
information only if it is undertaken to
obtain knowledge that exceeds, expands,
or refines the common knowledge of
skilled professionals in a particular field
of science or engineering”and that
“information is technological in nature if
the process of experimentation used to
discover such information fundamentally
relies on principles of the physical or bio-
logical sciences, engineering, or computer
science.”
With respect to the phrase“undertaken
for the purpose of discovering informa-
tion,”commentators noted that§1.174–
2(a)(1) imposes a requirement that a tax-
payer’s activities must be“intended to
discover information”in order to give rise
to research and experimental expenditures
under section 174, and that section
41(d)(1)(A) incorporates this requirement
because an expenditure must qualify
under section 174 in order to give rise to
the research credit. Commentators argued
that the enactment of the section
41(d)(1)(B)“undertaken for the purpose
of discovering information”language
should not necessarily be viewed as
imposing a different standard than that
imposed under section 174 because the
section 174“intended to discover infor-
mation”language was promulgated in
regulations after section 41(d)(1)(B) was
enacted.
Commentators also stated that the
requirement that qualified research be
“undertaken for the purpose of discover-
ing information which is technological in
nature”reflects Congress’concern that
the research credit had been claimed for
non-technological research. These com-
mentators note that in 1984 hearings to
evaluate the operation of the research
credit prior to the changes of the Tax
Reform Act of 1986, Public Law 99–514,
100 Stat. 2085, 2186 (the 1986 Act),
members of the Subcommittee on Over-
sight of the House Committee on Ways
and Means and Treasury officials cited
research credit claims by fast food restau-
rants, fashion designers and hair stylists
as examples of activities that should not
be credit eligible. These commentators
argue that the 1986 Act modifications to
the research credit were intended to target
research that relies upon principles of the
physical or biological sciences, engineer-
ing, or computer science.
Based upon their review of these com-
ments, the statute and legislative history,
Treasury and the IRS have determined
that the definition of qualified research
set out in T.D. 8930 does not fully
address Congress’concerns regarding the
importance of research activities to the
U.S. economy. Accordingly, Treasury and
the IRS have eliminated in these proposed
regulations the requirement that qualified
research must be undertaken to obtain
knowledge that exceeds, expands, or
refines the common knowledge of skilled
professionals in a particular field of sci-
ence or engineering. Rather, Treasury and
the IRS believe that the requirement that
qualified research be“undertaken for the
purpose of discovering information which
is technological in nature”is intended to
distinguish technological research, which
may qualify for the research credit, from
non-technological research, which does
not.
When the research credit rules were
amended by the 1986 Act, Congress
explained the requirement in section
41(d)(1)(B)(i) as follows:
[t]he determination of whether the
research is undertaken for the purpose
of discovering information that is
technological in nature depends on
whether the process of experimenta-
tion utilized in the research funda-
mentally relies on principles of the
physical or biological sciences, engi-
neering, or computer science/3/—in
which case the information is deemed
technological in nature—or on other
principles, such as those of
economics—in which case the infor-
mation is not to be treated as techno-
logical in nature. For example, infor-
mation relating to financial services
or similar products (such as new types
of variable annuities or legal forms)
or advertising does not qualify as
technological in nature.
H.R. Conf. Rep. No. 99–841, at II–71
(1986) (footnote omitted). This explana-
tion of section 41(d)(1)(B)(i) focuses on
the distinction between information
derived from a process of experimenta-
tion that fundamentally relies on prin-
ciples of physical or biological sciences,
engineering, or computer science, and
information derived by other means. This
and other changes to the research credit
by the 1986 Act were driven by Congres-
sional concerns that the research credit
had been applied“too broadly”and that
“[m]any taxpayers claiming the credit
were not in industries that involved high
technology or its application in develop-
ing new and improved products or meth-
ods of production.”H.R. Rep. No.
99–426, at 177–78; S. Rep. No. 99–313,
at 694–95. The examples provided by
Congress illustrate this point. Information
relating to financial services, variable
annuities, legal forms and advertising all
involve information derived from non-
technological research. This distinction
between technological and non-
technological research is further empha-
sized by other changes made to the defi-
nition of qualified research by the 1986
Act. For example, section 41(d)(4)(D)
specifically excludes from the definition
of qualified research certain non-technical
activities including efficiency surveys,
activities relating to management function
or technique, market research testing,
routine data collection and quality control
testing. Similarly, section 41(d)(3)(B)
generally provides that if the purpose of
research relates to style, taste, cosmetic or
seasonal design factors, then that research
cannot constitute qualified research. The
1986 Act also expanded the list of social
science exclusions contained in section
41(d)(4)(G).
In contrast, the 1986 legislative history
does not indicate that section
41(d)(1)(B)(i) was enacted to impose a
scientific discovery requirement. The leg-
islative history does not contain a defini-
tion of the termdiscovery. The footnote 3
referenced in the above quoted legislative
history does state:
Research does not rely on the prin-
ciples of computer science merely
because a computer is employed.
Research may be treated as under-
taken to discover information that is
technological in nature, however, if
the research is intended to expand or
refine existing principles of computer
science.
2002–4 I.R.B.405January 28, 2002

H.R. Conf. Rep. No. 99–841, at II–71, n.3
(1986). This footnote, however, does not
set forth a rule of general application, but
instead merely illustrates a clear example
of research satisfying the requirement that
qualified research be technological in
nature.
For all of these reasons, Treasury and
the IRS have concluded that there should
be no“discovery”requirement in the
research credit regulations separate and
apart from that already required under
§1.174–2(a)(1), which states, in part:
Expenditures represent research and
development costs in the experimental
or laboratory sense if they are for
activities intended to discover infor-
mation that would eliminate uncer-
tainty concerning the development or
improvement of a product. Uncer-
tainty exists if the information avail-
able to the taxpayer does not establish
the capability or method for develop-
ing or improving the product or the
appropriate design of the product.
Accordingly, these proposed regulations
do not retain from T.D. 8930 the require-
ment that qualified research must be
undertaken to obtain knowledge that
exceeds, expands, or refines the common
knowledge of skilled professionals in a
particular field of science or engineering.
Instead, the proposed regulations repeat
the requirement from§1.174–2(a)(1) by
stating that research is undertaken for the
purpose of discovering information if it is
intended to eliminate uncertainty con-
cerning the development or improvement
of a business component. Uncertainty, for
purposes of this requirement, exists if the
information available to the taxpayer does
not establish the capability or method of
developing or improving the business
component, or the appropriate design of
the business component.
These proposed regulations expand on
the definition oftechnological in nature
set out in T.D. 8930. As under T.D. 8930,
information is technological in nature if
the process of experimentation used to
discover such information fundamentally
relies on principles of the physical or bio-
logical sciences, engineering, or computer
science. As in T.D. 8930, these proposed
regulations clarify the definition of tech-
nological in nature by stating that a tax-
payer may employ existing technologies
and may rely on existing principles of the
physical or biological sciences, engineer-
ing, or computer science to satisfy this
requirement.
T.D. 8930 contained a patent safe har-
bor providing that a taxpayer is conclu-
sively presumed to have obtained knowl-
edge that exceeds, expands, or refines the
common knowledge of skilled profession-
als in the relevant field of science or engi-
neering, if that taxpayer was awarded a
patent (other than a patent for design
issued under the provisions of 35 U.S.C.
171) for the business component. These
proposed regulations contain a similar
rule that conforms to the underlying
requirement for credit eligibility in sec-
tion 41(d)(1)(B)(i) that research must be
undertaken for the purpose of discovering
information that is technological in
nature. Accordingly, these proposed regu-
lations provide that a taxpayer is conclu-
sively presumed to have discovered infor-
mation that is technological in nature that
is intended to eliminate uncertainty con-
cerning the development or improvement
of a business component if that taxpayer
was awarded a patent (other than a patent
for design issued under the provisions of
35 U.S.C. 171) for the business compo-
nent.
II. Process of Experimentation
Together with the requirements of sec-
tion 41(d)(1)(A) and (B), section
41(d)(1)(C) provides that qualified
research means research substantially all
of the activities of which constitute ele-
ments of a process of experimentation
related to a new or improved function,
performance, or reliability or quality. In
T.D. 8930, Treasury and the IRS clarified
how the process of experimentation
required by section 41(d)(1)(C) differs
from research and development in the
experimental or laboratory sense required
by§1.174–2(a). Specifically, T.D. 8930
provided that a process of experimenta-
tion is a process to evaluate more than
one alternative designed to achieve a
result where the capability or method of
achieving that result is uncertain at the
outset, but does not include the evaluation
of alternatives to establish the appropriate
design of a business component when the
capability and method for developing or
improving the business component are
not uncertain. Several commentators
objected to any distinction regarding the
design of a business component and cited
examples from the legislative history
which these commentators contend show
that the determination of the appropriate
design of a business component involved
a process of experimentation.
Treasury and the IRS continue to
believe that the requirements for a pro-
cess of experimentation under section 41
are more stringent than the requirements
for research and development in the
experimental or laboratory sense under
§1.174–2(a)(1). However, Treasury and
the IRS have determined that a process of
experimentation may exist if a taxpayer
performs research to establish the appro-
priate design of a business component
when the capability and method for
developing or improving the business
component are not uncertain. As is dis-
cussed in more detail below, not all
research to arrive at the appropriate
design of a business component will be
credit eligible.
These proposed regulations provide
that a process of experimentation is a pro-
cess designed to evaluate one or more
alternatives to achieve a result where the
capability or the method of achieving that
result, or the appropriate design of that
result, is uncertain as of the beginning of
the taxpayer’s research activities.
Whether a taxpayer has undertaken a pro-
cess of experimentation is a facts and cir-
cumstances determination. The proposed
regulations provide factors that are
indicative of a process of experimenta-
tion. The factors listed are not exclusive,
and no one factor is dispositive.
A taxpayer’s activities do not consti-
tute elements of a process of experimen-
tation where the capability and method of
achieving the desired new or improved
business component, and the appropriate
design of the desired new or improved
business component, are readily discern-
ible and applicable as of the beginning of
the taxpayer’s research activities so that
true experimentation in the scientific or
laboratory sense would not have to be
undertaken to test, analyze, and choose
among viable alternatives. Similarly, a
process of experimentation does not
include merely selecting among several
alternatives that are readily discernible
and applicable. The fact that a taxpayer
conducts only rudimentary or non-
technological testing in order to develop
January 28, 20024062002–4 I.R.B.

or improve a business component tends to
indicate that the appropriate design of the
business component was readily discern-
ible and applicable at the outset within
the meaning of these rules.
T.D. 8930 provided that the substan-
tially all requirement of section
41(d)(1)(C) is satisfied only if 80 percent
or more of the research activities, mea-
sured on a cost or other consistently
applied reasonable basis (and without
regard to§1.41–2(d)(2)), constitute ele-
ments of a process of experimentation for
a purpose described in section 41(d)(3).
The substantially all requirement is
applied separately to each business com-
ponent. These proposed regulations retain
the same rule. Treasury and the IRS, how-
ever, request comments on the application
of the substantially all rule. Treasury and
the IRS are specifically interested in com-
ments on whether research expenses
incurred for non-qualified purposes are
includible in the credit computation pro-
vided that substantially all of the research
expenses constitute elements of a process
of experimentation.
III. Internal Use Software
Section 41(d)(4)(E) provides that,
except to the extent provided by regula-
tions, research with respect to“computer
software which is developed by (or for
the benefit of) the taxpayer primarily for
internal use by the taxpayer”(i.e.,
internal-use software) is excluded from
the definition of qualified research. T.D.
8930 provided that the development of
internal-use software constitutes qualified
research only if the research satisfies both
the general requirements for credit eligi-
bility under section 41 (including that the
research not be otherwise excluded) and
an additional, three-part high threshold of
innovation test. T.D. 8930 defined
internal-use software as software that is to
be used internally, such as software used
in general and administrative functions of
the taxpayer, or in providing noncomputer
services. Noncomputer services are ser-
vices offered by a taxpayer to customers
who do business with the taxpayer prima-
rily to obtain a service other than a com-
puter service, even if such other service is
enabled, supported, or facilitated by com-
puter or software technology. T.D. 8930,
however, contained an exception to this
rule that provides that internal-use soft-
ware does not include software that is
designed to provide customers with a new
feature, not available from the taxpayer’s
competitors, with respect to a noncom-
puter service and that the taxpayer rea-
sonably anticipates will give rise to
increased customer demand for the non-
computer service.
The high threshold of innovation test
in T.D. 8930 generally required that (i)
the internal-use software be innovative;
(ii) the development of the internal-use
software involve significant economic
risk; and (iii) the internal-use software not
be commercially available. The high
threshold of innovation test, however,
does not apply with respect to the devel-
opment of software (i) for use in conduct-
ing qualified research; (ii) for use in a
production process; (iii) for use as part of
a package of hardware and software
developed concurrently; and (iv) for use
in providing computer services to cus-
tomers. Computer services are services
offered by a taxpayer to customers who
do business with the taxpayer primarily
for the use of the taxpayer’s computer or
software technology.
In response to Notice 2001–19, several
commentators objected to the internal-use
software provisions of T.D. 8930. After
reviewing the legislative history to the
1986 Act, the Tax and Trade Relief
Extension Act of 1998, Public Law 105–
277, 112 Stat. 2681, 2681–888 (the 1998
Act), and the Tax Relief Extension Act of
1999, Public Law 106–170, 113 Stat.
1860, 1919, together with the comment
letters, Treasury and the IRS made sev-
eral changes to the internal-use software
rules. These proposed regulations clarify
the definition of internal-use software
contained in T.D. 8930 as well as the
exceptions to this definition and the types
of software that are not required to satisfy
the high threshold of innovation test.
These changes are discussed below.
Internal-use software defined
Under these proposed regulations,
software that is developed by (or for the
benefit of) the taxpayer primarily to be
commercially sold, leased, licensed, or
otherwise marketed, for separately stated
consideration to unrelated third parties is
not treated as internal use software. All
other software is presumed to be devel-
oped by (or for the benefit of) the tax-
payer primarily for the taxpayer’s internal
use. This distinction reflects the view that
software that is sold, leased, licensed, or
otherwise marketed, for separately stated
consideration to unrelated third parties is
software that is intended to be used pri-
marily by the customers of the taxpayer,
whereas software that does not satisfy this
requirement is software that is intended to
be used primarily by the taxpayer for its
internal use or in connection with a non-
computer service provided by the tax-
payer.
These proposed regulations retain the
provision in T.D. 8930 that excluded
from the definition ofinternal-use soft-
warecomputer software and hardware
developed as a single product. This rule,
however, has been modified in response
to a commentator’s suggestion that some
purchasers of combined software and
hardware packages may develop their
own computer software to operate the
package or modify the imbedded com-
puter software. Because the computer
software is an integral part of the hard-
ware, these commentators urged that the
computer software/hardware rule should
be extended to these development costs.
Treasury and the IRS agree that, provided
the computer software is developed to be
used with hardware as a single product
and the activities are otherwise credit-
eligible and not excluded under another
provision (e.g., section 41(d)(4)(B)), the
computer software/hardware rule should
extend to these development costs. Thus,
under these proposed regulations,
internal-use software does not include a
new or improved package of computer
software and hardware developed
together by the taxpayer as a single prod-
uct (or to the costs to modify an acquired
computer software and hardware pack-
age), of which the software is an integral
part, that is used directly by the taxpayer
in providing services in its trade or busi-
ness to customers.
High threshold of innovation test
These proposed regulations retain the
general rule contained in T.D. 8930 that
internal-use software must satisfy the
general requirements for credit eligibility
(and not be excluded from the definition
of qualified research under any other
exclusion) and the three-part high thresh-
old of innovation test. These proposed
2002–4 I.R.B.407January 28, 2002

regulations clarify the first prong of the
three-part test by providing that internal-
use software is innovative if the software
is intended to be unique or novel and is
intended to differ in a significant and
inventive way from prior software imple-
mentations or methods. This change is
being proposed pursuant to the authority
provided in section 41(d)(4)(E) and the
legislative history thereunder in order to
update the definition of innovative con-
tained in T.D. 8930. The T.D. 8930 defi-
nition was derived from the legislative
history to the 1986 Act and required that
the software be intended to result in a
reduction in cost, improvement in speed,
or other improvement, that is substantial
and economically significant. Treasury
and the IRS became concerned that the
elements of the T.D. 8930 definition,
while perhaps reflecting innovations in
computer software in the mid–1980s, did
not adequately reflect the factors that
indicate that software is innovative today.
The proposed change, therefore, is an
attempt both to update the definition of
innovative, and to provide a more flexible
definition with continuing application.
Several examples were added to these
proposed regulations to illustrate the
application of this proposed rule. The sec-
ond and third prongs of the high threshold
of innovation test (i.e., significant eco-
nomic risk and commercial availability)
remain unchanged from T.D. 8930.
Software not required to satisfy the high
threshold of innovation test
Like T.D. 8930, these proposed regula-
tions provide that software is not required
to satisfy the high threshold of innovation
test if the software was developed by the
taxpayer for use in an activity that consti-
tutes qualified research (other than the
development of the internal-use software
itself), a production process that meets
the requirements of section 41(d)(1), or in
providing computer services to custom-
ers. These proposed regulations, however,
eliminate the special rule contained in
T.D. 8930 for software used to deliver
noncomputer services to customers with
features that are not yet offered by a tax-
payer’s competitors. Several commenta-
tors stated that this rule is too limited and
subjective in its application to have sig-
nificant value to taxpayers. Due to other
revisions contained in these proposed
regulations, Treasury and the IRS believe
that the computer software targeted by
this rule generally would be credit eli-
gible without this rule.
Several commentators objected to the
distinction between computer services
and noncomputer services and urged that
the definition of internal-use software
exclude any software used to deliver a
service to customers or any software that
includes an interface with customers or
the public. An exclusion for software that
includes an interface with customers or
the public would entail substantial admin-
istrative difficulties and may inappropri-
ately permit certain categories of costs
(e.g., certain web site development costs)
to constitute qualified research expenses
without having to satisfy the high thresh-
old of innovation test.
With respect to software developed by
a taxpayer for use in a production process
satisfying the requirements of section
41(d)(1), comments from service provid-
ers urged Treasury and the IRS to give
service providers the same benefits as
manufacturing companies. Congress pro-
vided an explicit exclusion for software
developed for use in a production pro-
cess; however, it did not provide a similar
exclusion for software used in the provi-
sion of noncomputer services. Therefore,
Treasury and the IRS conclude that soft-
ware used in the provision of noncom-
puter services generally should be subject
to the internal-use software requirements.
Effective date
Treasury and the IRS propose the revi-
sions to the internal-use software rules to
be effective for taxable years beginning
after December 31, 1985. Treasury and
the IRS believe that the proposed rule is
consistent with the legislative history and
the legislative mandate for retroactive
application of the rule. Taxpayers, how-
ever, may continue to rely on T.D. 8930
until regulations are finalized.
IV. Shrinking-back Rule
T.D. 8930 contained a special
shrinking-back rule. These proposed
regulations revise the shrinking-back rule
to conform it to the rule in the legislative
history to the 1986 Act. These proposed
regulations also reiterate that the
shrinking-back rule may not itself be
applied as a reason to exclude research
activities from credit eligibility.
V. Other Exclusions
Several commentators raised issues
concerning activities excluded from the
definition of qualified research. In par-
ticular, the commentators were concerned
about the research after commercial pro-
duction exclusion. Because the rules con-
tained in§1.41–4(c) of T.D. 8930 closely
reflected the legislative history regarding
post-research activities, these proposed
regulations retain the rules contained in
T.D. 8930. See H.R. Conf. Rep. No.
99–841, at II–74–75. However, new
examples are included to illustrate the
application of the exclusions. Treasury
and the IRS request comments concern-
ing the application of the exclusions and
the extent to which additional guidance
concerning the exclusions may be helpful.
VI. Gross Receipts
When Congress revised the computa-
tion of the research credit to incorporate a
taxpayer’s gross receipts, neither the stat-
ute nor the legislative history defined the
termgross receipts, other than to provide
that gross receipts for any taxable year
are reduced by returns and allowances
made during the tax year, and, in the case
of a foreign corporation, that only gross
receipts effectively connected with the
conduct of a trade or business within the
United States are taken into account. See
section 41(c)(6).
T.D. 8930 adopted a broad definition
of the termgross receiptsfor purposes of
computing the research credit. T.D. 8930
generally defined gross receipts as the
total amount derived by a taxpayer from
all activities and sources. In addition,
because certain extraordinary gross
receipts might not be taken into account
when a business determines its research
budget, T.D. 8930 provided that certain
items (e.g., receipts from the sale or
exchange of capital assets, or repayments
of loans or similar instruments) would be
excluded from the computation of gross
receipts. Further, T.D. 8930 excluded
from the definition of gross receipts any
income derived by a taxpayer in a taxable
year that precedes the first taxable year in
which the taxpayer derives more than
January 28, 20024082002–4 I.R.B.

$25,000 in gross receipts other than
investment income.
In response to Notice 2001–19, some
commentators suggested that the defini-
tion of gross receipts created an adminis-
trative burden to the extent that taxpayers
would be obligated to apply the definition
of the term for the four years preceding
the determination years as well as to the
1984 through 1988 base years.
These proposed regulations retain the
definition of gross receipts contained in
T.D. 8930. Treasury and the IRS continue
to believe that the definition of gross
receipts should be construed broadly and
that the definition of gross receipts in
T.D. 8930 is appropriate for purposes of
computing the research credit. Further,
Treasury and the IRS believe that the
administrative burden referred to by com-
mentators is due to the incremental nature
of the credit and the statutorily deter-
mined base years, and not to the defini-
tion of gross receipts.
VII. Recordkeeping for the Research
Credit
Under T.D. 8930, taxpayers were
required to prepare and retain written
documentation before or during the early
stages of the research project that
describes the principal questions to be
answered and the information the tax-
payer seeks to obtain that exceeds,
expands, or refines the common knowl-
edge of skilled professionals in the rel-
evant field of science or engineering.
These proposed regulations eliminate this
recordkeeping requirement.
Treasury and the IRS recognize that
the research credit presents a particular
burden for taxpayers because tracking eli-
gible expenditures may necessitate tax-
payers preparing and keeping records
unlikely to be prepared or kept for other
business purposes. The fact that the
records are not prepared or kept for other
business purposes has made administra-
tion of the research credit burdensome for
the IRS. Moreover, section 41 often
requires an allocation between qualifying
and non-qualifying costs that is difficult
for taxpayers to make and for the IRS to
administer.
Nevertheless, when the research credit
was extended in 1999, Congress made
clear that the credit should not impose
unreasonable recordkeeping require-
ments:
The conferees also are concerned
about unnecessary and costly taxpayer
recordkeeping burdens and reaffirm
that eligibility for the credit is not
intended to be contingent on meeting
unreasonable recordkeeping require-
ments.
H.R. Conf. Rep. No. 106–478, at 132
(1999). Treasury and the IRS have
re-evaluated whether a research credit-
specific documentation requirement is
warranted and have concluded that the
high degree of variability in the objec-
tives and conduct of research activities in
the United States compels a conclusion
that taxpayers must be provided reason-
able flexibility in the manner in which
they substantiate their research credits.
Accordingly, Treasury and the IRS have
concluded that the failure to keep records
in a particular manner (so long as such
records are in sufficiently usable form
and detail to substantiate that the expen-
ditures claimed are eligible for the credit)
cannot serve as a basis for denying the
credit. Treasury and the IRS have decided
that the rules generally applicable under
section 6001 provide sufficient detail
about required documentary substantia-
tion for purposes of the research credit.
Consequently, no separate research credit-
specific documentation requirement is
included in these proposed regulations.
Section 1.6001–1 requires the keeping
of records“sufficient to establish the
amount of...credits, . . required to be
shown....”The consequence of failing
to keep sufficient records substantiating a
claimed credit may be denial of the
credit. To address any ongoing record-
keeping concerns regarding the research
credit, Treasury and the IRS propose to
use pre-filing processes, including indus-
try issue resolution, pre-filing agree-
ments, determination letters, and record
retention agreements, to provide certainty
to taxpayers about the records that must
be kept and to ensure the availability to
the IRS of the records necessary to exam-
ine taxpayers’returns expeditiously. Trea-
sury and the IRS solicit comments from
taxpayers on establishing recordkeeping
rules that will facilitate compliance and
administration, including whether pre-
filing agreements should extend to the
qualification of particular cost centers or
to the procedures established by the tax-
payer for determining the expenditures
qualifying for the credit. Treasury and the
IRS also solicit comments from taxpayers
on the extent to which guidelines may be
developed on an industry-by-industry
basis.
Proposed Effective Dates
Except as specifically provided in
§1.41–4(c)(6)(ix), the proposed amend-
ments to§1.41–4 are proposed to apply
to taxable years ending on or after
December 26, 2001. Notwithstanding this
prospective effective date, Treasury and
the IRS believe that these rules prescribe
the proper treatment of the expenditures
they address, and the IRS generally will
not challenge return positions consistent
with the proposed regulations. Therefore,
taxpayers may rely on these proposed
regulations until the date final regulations
under§1.41–4 are published in theFed-
eral Register.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in
Executive Order 12866. It also has been
determined that section 533(b) of the
Administrative Procedures Act (5 U.S.C.
chapter 5) does not apply to these regula-
tions, and because these regulations do
not impose a collection of information on
small entities, the Regulatory Flexibility
Act (5 U.S.C. chapter 6) does not apply.
Therefore, a Regulatory Flexibility
Analysis is not required. Pursuant to sec-
tion 7805(f) of the Internal Revenue
Code, this notice of proposed rulemaking
will be submitted to the Chief Counsel for
Advocacy of the Small Business Admin-
istration for comment on its impact on
small business.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any electronic and writ-
ten comments (a signed original and eight
2002–4 I.R.B.409January 28, 2002

(8) copies) that are submitted timely to
the IRS. The IRS and the Treasury
Department specifically request com-
ments on the clarity of the proposed regu-
lations and how they may be made easier
to understand. All comments will be
available for public inspection and copy-
ing. All comments will be available for
public inspection and copying.
A public hearing has been scheduled
for March 27, 2002, at 10 a.m. in the IRS
Auditorium (7th Floor), Internal Revenue
Building,1111Constitution Avenue, NW,
Washington, DC. Because of access
restrictions, visitors will not be admitted
beyond the building lobby more than 15
minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons that wish to present oral com-
ments at the hearing must submit (in the
manner described in the ADDRESSES
portion of this preamble) comments and
an outline of the topics to be discussed
and the time to be devoted to each topic
by March 6, 2002.
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 receiving outlines has
passed. Copies of the agenda will be
available free of charge at the hearing.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is pro-
posed 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 1.41–0 is amended as
follows:
1. Revising the entry for§1.41–3.
2. Revising the entries for§1.41–4.
3. Revising the entry for§1.41–8.
The revisions read as follow:
§1.41–0 Table of contents.
*****
§1.41–3 Base amount for taxable years
ending on or after December 26, 2001.
*****
§1.41–4 Qualified research for expendi-
tures paid or incurred in taxable years
ending on or after December 26, 2001.
(a) Qualified research.
(1) General rule.
(2) Requirements of section 41(d)(1).
(3) Undertaken for the purpose of discov-
ering information.
(i) In general.
(ii) Application of the discovering infor-
mation requirement.
(iii) Patent safe harbor.
(4) Technological in nature.
(5) Process of experimentation.
(i) In general.
(ii) Readily discernible capability, method
and appropriate design.
(iii) Qualified purpose.
(iv) Factors tending to indicate that the
taxpayer has engaged in a process of
experimentation.
(6) Substantially all requirement.
(i) General rule.
(ii) Illustrations. [Reserved]
(7) Use of computers and information
technology.
(8) Illustrations.
(b) Application of requirements for quali-
fied research.
(1) In general.
(2) Shrinking-back rule.
(3) Illustration.
(c) Excluded activities.
(1) In general.
(2) Research after commercial produc-
tion.
(i) In general.
(ii) Certain additional activities related to
the business component.
(iii) Activities related to production pro-
cess or technique.
(iv) Clinical testing.
(3) Adaptation of existing business com-
ponents.
(4) Duplication of existing business com-
ponent.
(5) Surveys, studies, research relating to
management functions, etc.
(6) Internal use software for taxable years
beginning on or after December 31, 1985.
(i) General rule.
(ii) Requirements.
(iii) Computer software and hardware
developed as a single product.
(iv) Primarily for internal use.
(v) Software used in the provision of ser-
vices.
(A) Computer services.
(B) Noncomputer services.
(vi) High threshold of innovation test.
(vii) Application of high threshold of
innovation test.
(viii) Illustrations.
(ix) Effective date.
(7) Activities outside the United States,
Puerto Rico, and other possessions.
(i) In general.
(ii) Apportionment of in-house research
expenses.
(iii) Apportionment of contract research
expenses.
(8) Research in the social sciences, etc.
(9) Research funded by any grant, con-
tract, or otherwise.
(10) Illustrations.
(d) Recordkeeping for the research credit.
(e) Effective dates.
*****
§1.41–8 Special rules for taxable years
ending on or after December 26, 2001.
Par. 3. Section 1.41–3 is amended by:
1. Revising the section heading.
2. Revising paragraph (e).
The revisions read as follows:
§1.41–3 Base amount for taxable years
ending on or after December 26, 2001.
*****
(e)Effective date. The rules of this
section are applicable for taxable years
ending on or after December 26, 2001.
Par. 4. Section 1.41–4 is revised to
read as follows:
§1.41–4 Qualified research for expendi-
tures paid or incurred in taxable years
ending on or after December 26, 2001.
(a)Qualified research—(1)General
rule. Research activities related to the
development or improvement of a busi-
ness component constitute qualified
research only if the research activities
meet all of the requirements of section
41(d)(1) and this section, and are not oth-
erwiseexcludedundersection
41(d)(3)(B) or (d)(4), or this section.
(2)Requirements of section 41(d)(1).
Research constitutes qualified research
only if it is research—
(i) With respect to which expenditures
may be treated as expenses under section
174, see§1.174–2;
(ii) That is undertaken for the purpose
of discovering information that is techno-
logical in nature, and the application of
January 28, 20024102002–4 I.R.B.

which is intended to be useful in the
development of a new or improved busi-
ness component of the taxpayer; and
(iii) Substantially all of the activities
of which constitute elements of a process
of experimentation that relates to a new
or improved function, performance, reli-
ability or quality.
(3)Undertaken for the purpose of dis-
covering information—(i)In general. For
purposes of section 41(d) and this section,
research must be undertaken for the pur-
pose of discovering information that is
technological in nature. Research is
undertaken for the purpose of discovering
information if it is intended to eliminate
uncertainty concerning the development
or improvement of a business component.
Uncertainty exists if the information
available to the taxpayer does not estab-
lish the capability or method for develop-
ing or improving the business component,
or the appropriate design of the business
component.
(ii)Application of the discovering
information requirement. A determination
that research is undertaken for the pur-
pose of discovering information that is
technological in nature does not require
the taxpayer be seeking to obtain infor-
mation that exceeds, expands or refines
the common knowledge of skilled profes-
sionals in the particular field of science or
engineering in which the taxpayer is per-
forming the research. In addition, a deter-
mination that research is undertaken for
the purpose of discovering information
that is technological in nature does not
require that the taxpayer succeed in
developing a new or improved business
component.
(iii)Patent safe harbor. For purposes
of section 41(d) and paragraph (a)(3)(i) of
this section, the issuance of a patent by
the Patent and Trademark Office under
the provisions of 35 U.S.C. 151 (other
than a patent for design issued under the
provisions of 35 U.S.C. 171) is conclu-
sive evidence that a taxpayer has discov-
ered information that is technological in
nature that is intended to eliminate uncer-
tainty concerning the development or
improvement of a business component.
However, the issuance of such a patent is
not a precondition for credit availability.
(4)Technological in nature. For pur-
poses of section 41(d) and this section,
information is technological in nature if
the process of experimentation used to
discover such information fundamentally
relies on principles of the physical or bio-
logical sciences, engineering, or computer
science. A taxpayer may employ existing
technologies and may rely on existing
principles of the physical or biological
sciences, engineering, or computer sci-
ence to satisfy this requirement.
(5)Process of experimentation—(i)In
general. For purposes of section 41(d)
and this section, a process of experimen-
tation is a process designed to evaluate
one or more alternatives to achieve a
result where the capability or the method
of achieving that result, or the appropriate
design of that result, is uncertain as of the
beginning of the taxpayer’s research
activities. Thus, a taxpayer may undertake
a process of experimentation if there is no
uncertainty concerning the taxpayer’s
capability or method of achieving the
desired result so long as the appropriate
design of the desired result is uncertain as
of the beginning of the taxpayer’s
research activities. However, a process of
experimentation does not include the
evaluation of alternatives to achieve the
desired result if the capability and method
of achieving the desired result, and the
appropriate design of the desired result,
are readily discernible and applicable as
of the beginning of the taxpayer’s
research activities. A process of experi-
mentation may include developing one or
more hypotheses designed to achieve the
desired result, designing and conducting
an experiment to test and analyze those
hypotheses, and refining or discarding the
hypotheses as part of a design process to
develop or improve the business compo-
nent. For purposes of this paragraph
(a)(5), factors that tend to indicate that
the taxpayer has engaged in a process of
experimentation are listed in paragraph
(a)(5)(iv) of this section.
(ii)Readily discernible capability,
method and appropriate design. A taxpay-
er’s activities do not constitute elements
of a process of experimentation where the
capability and method of achieving the
desired new or improved business com-
ponent, and the appropriate design of the
desired new or improved business com-
ponent, are readily discernible and appli-
cable as of the beginning of the taxpay-
er’s research activities, so that true
experimentation in the scientific or labo-
ratory sense would not have to be under-
taken to test, analyze, and choose among
viable alternatives. A process of experi-
mentation does not include any activities
to select among several alternatives that
are readily discernible and applicable.
(iii)Qualified purpose. For purposes
of section 41(d) and this section, a pro-
cess of experimentation is undertaken for
a qualified purpose if it relates to a new
or improved function, performance, reli-
ability or quality of the business compo-
nent. Research will not be treated as con-
ducted for a qualified purpose if it relates
to style, taste, cosmetic, or seasonal
design factors.
(iv)Factors tending to indicate that
the taxpayer has engaged in a process of
experimentation. For purposes of section
41(d) and this section, in determining
whether a taxpayer has undertaken a pro-
cess of experimentation, all facts and cir-
cumstances with respect to a taxpayer’s
research activities are taken into account.
No one factor is dispositive in making
this determination. Further, it is not
intended that only the factors described in
this paragraph are to be taken into
account in making the determination.
Thus, no inference should be drawn from
the taxpayer’s failure to satisfy any or all
of the factors. Among the factors that
tend to indicate that the taxpayer has
engaged in a process of experimentation
are—
(A) The taxpayer tests and analyzes
numerous alternative hypotheses to
develop a new or improved business com-
ponent;
(B) The taxpayer engages in extensive,
comprehensive, intricate or complex sci-
entific or laboratory testing; or
(C) The taxpayer evaluates numerous
or complex specifications related to the
function, performance, reliability or qual-
ity of a new or improved business compo-
nent.
(6)Substantially all requirement—(i)
General rule. The substantially all
requirement of section 41(d)(1)(C) and
paragraph (a)(2)(iii) of this section is sat-
isfied only if 80 percent or more of the
research activities, measured on a cost or
other consistently applied reasonable
basis (and without regard to§1.41–
2(d)(2)), constitute elements of a process
2002–4 I.R.B.411January 28, 2002

of experimentation for a purpose
described in section 41(d)(3). The sub-
stantially all requirement is applied sepa-
rately to each business component.
(ii)Illustrations. [Reserved]
(7)Use of computers and information
technology. The employment of comput-
ers or information technology, or the reli-
ance on principles of computer science or
information technology to store, collect,
manipulate, translate, disseminate, pro-
duce, distribute, or process data or infor-
mation, and similar uses of computers
and information technology does not
itself establish that qualified research has
been undertaken.
(8)Illustrations. The following
examples illustrate the application of
paragraph (a)(5) of this section:
Example 1. (i)Facts. X is engaged in the busi-
ness of developing and manufacturing widgets. X
wants to change the color of its blue widget to
green. X obtains from various suppliers several dif-
ferent shades of green paint. X paints several sample
widgets, and surveys X’s customers to determine
which shade of green X’s customers prefer.
(ii)Conclusion.X’s activities to change the
color of its blue widget to green are not qualified
research under section 41(d)(1) and paragraph (a)(5)
of this section because substantially all of X’s
activities are not undertaken for a qualified purpose.
All of X’s research activities are related to style,
taste, cosmetic, or seasonal design factors.
Example 2. (i)Facts. X is engaged in the busi-
ness of manufacturing widgets and wants to change
the color of its blue widget to green. X obtains
samples of green paint from a supplier and deter-
mines that X must modify its painting process to
accommodate the green paint because the green
paint has different characteristics from other paints
X has used. X obtains detailed data on the green
paint from X’s paint supplier. X also consults with
the manufacturer of X’s paint spraying machines
and determines that X must acquire new nozzles that
are designed to operate with paints similar to the
green paint X wants to use. X installs the new
nozzles on its paint spraying machines and tests the
nozzles to ensure that they work as specified by the
manufacturer of the paint spraying machines.
(ii)Conclusion.X’s activities to modify its
painting process is a separate business component
under section 41(d)(2)(A). X’s activities to modify
its painting process by installing new nozzles on its
paint spraying machines to change the color of its
blue widget to green are not qualified research under
section 41(d)(1) and paragraph (a)(5) of this section.
The capability, method and appropriate design of the
changes to X’s painting process are readily discern-
ible and applicable to X as of the beginning of X’s
activities. X’s activities to test the nozzles to deter-
mine if the nozzles work as specified by the manu-
facturer of the paint spraying machines are not the
type of testing activities that tend to indicate that a
process of experimentation was undertaken.
Example 3. (i)Facts. X is engaged in the busi-
ness of manufacturing food products and currently
manufactures a large-shred version of a product.
Because X’s competitors manufacture both a large-
shred and fine-shred version of comparable food
products, X seeks to modify its current production
line to permit it to manufacture both a large-shred
version and fine-shred version of one of its own
food products. A shredding blade capable of produc-
ing a fine-shred version of the food product is not
commercially available. Thus, X must develop a
new shredding blade that can be fitted onto X’s cur-
rent production line. X must test and analyze numer-
ous alternative hypotheses to determine whether a
new shredding blade must be constructed of a differ-
ent material from that of its existing shredding
blade. In addition, X must engage in comprehensive
and complex scientific or laboratory testing to
ensure that its modified production process, with the
newly-developed shredding blade, can accommo-
date the manufacture of both the large-shred and
fine-shred versions of X’s food products.
(ii)Conclusion.X’s activities to modify its cur-
rent production line meet the requirements of quali-
fied research as set forth in paragraph (a)(2) of this
section. Substantially all of X’s activities constitute
elements of a process of experimentation because X
must evaluate more than one alternative to achieve
a result where the method and appropriate design
are uncertain as of the beginning of the taxpayer’s
research activities. X must test and analyze numer-
ous alternative hypotheses and engage in compre-
hensive and complex scientific or laboratory testing
to ensure that its modified production process, with
a newly-developed shredding blade, can accommo-
date the manufacture of both the large-shred and
fine-shred versions of X’s food products.
Example 4. (i)Facts. X operates wireless net-
works in several U.S. cities. X discovers in City a
service problem and collects data on the nature of
the problem. X analyzes the data and knows, based
on its previous experience with wireless networks in
other cities, that the installation of a new type of
gateway will eliminate the problem. X installs the
new gateway in its City network.
(ii)Conclusion.X’s activities to determine a
solution to its service problem are not qualified
research under section 41(d)(1) and paragraph (a)(5)
of this section. Substantially all of X’s research
activities do not constitute elements of a process of
experimentation because the solution to the service
problem is readily discernible and applicable by X
as of the beginning of X’s research activities.
Example 5. (i)Facts. X is engaged in the busi-
ness of manufacturing and selling automobiles. X
incorporated into one of its new vehicles a new
exhaust system that it designed. After X offered the
vehicle for sale, X received complaints of a rattling
noise that could be heard in the passenger compart-
ment. X’s engineers determined that the cause of the
noise was the exhaust system coming into contact
with the undercarriage of the vehicle. Based on pre-
vious experience with similar noise problems, X’s
engineers knew of two safe, effective, reliable solu-
tions that would eliminate the noise. X’s engineers
selected one of the solutions based on cost studies
that indicated it would be the less expensive alterna-
tive.
(ii)Conclusion.X’s activities to eliminate the
rattling noise are not qualified research under sec-
tion 41(d)(1) and paragraph (a)(5) of this section.
Substantially all of X’s research activities do not
constitute elements of a process of experimentation
because the solution is readily discernible and appli-
cable to X as of the beginning of X’s activities.
Example 6. (i)Facts. X is in the business of
designing, developing, and manufacturing automo-
biles and decides to update one of its current model
vehicles. In response to government-mandated fuel
economy requirements, X undertakes to improve
aerodynamics by lowering the hood of the current
model vehicle. X determines that lowering the hood
changes the air flow under the hood, which changes
the rate at which air enters the engine through the
air intake system, and which reduces the functional-
ity of the cooling system. X designs, models, tests,
refines, and re-tests proposed modifications to both
the air intake system and cooling system until modi-
fications are developed that meet X’s requirements.
X then integrates the modified air intake and cool-
ing systems into a current model vehicle with a
lower hood, modifying in the process the new air
intake and cooling systems as well as the underhood
wiring, brake lines and fuel line. X conducts exten-
sive and complex scientific or laboratory testing to
determine if the current model vehicle meets X’s
requirements. X conducts extensive and complex
scientific or laboratory testing (including simula-
tions and crash tests) to determine if the current
model vehicle meets X’s requirements.
(ii)Conclusion.X’s activities to update its
vehicle meet the requirements of qualified research
as set forth in paragraph (a)(2) of this section. X
must test and analyze numerous alternative hypoth-
eses, engage in extensive testing and analysis, and
evaluate complex specifications related to the func-
tionality of several of the vehicle’s underhood sys-
tems and to the vehicle’s overall performance.
These activities indicate that X undertook a process
of experimentation to achieve the appropriate design
of the updated vehicle.
(b)Application of requirements for
qualified research—(1)In general. The
requirements for qualified research in
section 41(d)(1) and paragraph (a) of this
section, must be applied separately to
each business component, as defined in
section 41(d)(2)(B). In cases involving
development of both a product and a
manufacturing or other commercial pro-
duction process for the product, research
activities relating to development of the
process are not qualified research unless
the requirements of section 41(d) and this
section are met for the research activities
relating to the process without taking into
account the research activities relating to
development of the product. Similarly,
research activities relating to develop-
ment of the product are not qualified
research unless the requirements of sec-
tion 41(d) and this section are met for the
research activities relating to the product
without taking into account the research
activities relating to development of the
manufacturing or other commercial pro-
duction process.
January 28, 20024122002–4 I.R.B.

(2)Shrinking-back rule. The require-
ments of section 41(d) and paragraph (a)
of this section are to be applied first at the
level of the discrete business component,
that is, the product, process, computer
software, technique, formula, or invention
to be held for sale, lease, or license, or
used by the taxpayer in a trade or busi-
ness of the taxpayer. If the requirements
for credit eligibility are met at that first
level, then some or all of the taxpayer’s
qualified research expenses are eligible
for the credit. If all aspects of such
requirements are not met at that level, the
test applies at the most significant subset
of elements of the product, process, com-
puter software, technique, formula, or
invention to be held for sale, lease, or
license. This shrinking back of the prod-
uct is to continue until either a subset of
elements of the product that satisfies the
requirements is reached, or the most basic
element of the product is reached and
such element fails to satisfy the test. This
shrinking-back rule is applied only if a
taxpayer does not satisfy the requirements
of section 41(d)(1) and paragraph (a)(2)
of this section with respect to the overall
business component. The shrinking-back
rule is not itself applied as a reason to
exclude research activities from credit eli-
gibility.
(3)Illustration. The following
example illustrates the application of this
paragraph (b):
Example. X, a motorcycle engine builder, devel-
ops a new carburetor for use in a motorcycle engine.
X also modifies an existing engine design for use
with the new carburetor. Under the shrinking-back
rule, the requirements of section 41(d)(1) and para-
graph (a) of this section are applied first to the
engine. If the modifications to the engine when
viewed as a whole, including the development of the
new carburetor, do not satisfy the requirements of
section 41(d)(1) and paragraph (a) of this section,
those requirements are applied to the next most sig-
nificant subset of elements of the business compo-
nent. Assuming that the next most significant subset
of elements of the engine is the carburetor, the
research activities in developing the new carburetor
may constitute qualified research within the mean-
ing of section 41(d)(1) and paragraph (a) of this
section.
(c)Excluded activities—(1)In gen-
eral. Qualified research does not include
any activity described in section 41(d)(4)
and paragraph (c) of this section.
(2)Researchaftercommercial
production—(i)In general. Activities
conducted after the beginning of commer-
cial production of a business component
are not qualified research. Activities are
conducted after the beginning of commer-
cial production of a business component
if such activities are conducted after the
component is developed to the point
where it is ready for commercial sale or
use, or meets the basic functional and
economic requirements of the taxpayer
for the component’s sale or use.
(ii)Certain additional activities
related to the business component. The
following activities are deemed to occur
after the beginning of commercial pro-
duction of a business component—
(A) Preproduction planning for a fin-
ished business component;
(B) Tooling-up for production;
(C) Trial production runs;
(D) Trouble shooting involving detect-
ing faults in production equipment or pro-
cesses;
(E) Accumulating data relating to pro-
duction processes; and
(F) Debugging flaws in a business
component.
(iii)Activities related to production
process or technique. In cases involving
development of both a product and a
manufacturing or other commercial pro-
duction process for the product, the
exclusiondescribedinsection
41(d)(4)(A) and paragraphs (c)(2)(i) and
(ii) of this section applies separately for
the activities relating to the development
of the product and the activities relating
to the development of the process. For
example, even after a product meets the
taxpayer’s basic functional and economic
requirements, activities relating to the
development of the manufacturing pro-
cess still may constitute qualified
research, provided that the development
of the process itself separately satisfies
the requirements of section 41(d) and this
section, and the activities are conducted
before the process meets the taxpayer’s
basic functional and economic require-
ments or is ready for commercial use.
(iv)Clinical testing. Clinical testing of
a pharmaceutical product prior to its com-
mercial production in the United States is
not treated as occurring after the begin-
ning of commercial production even if the
product is commercially available in
other countries. Additional clinical testing
of a pharmaceutical product after a prod-
uct has been approved for a specific
therapeutic use by the Food and Drug
Administration and is ready for commer-
cial production and sale is not treated as
occurring after the beginning of commer-
cial production if such clinical testing is
undertaken to establish new functional
uses, characteristics, indications, combi-
nations, dosages, or delivery forms for the
product. A functional use, characteristic,
indication, combination, dosage, or deliv-
ery form shall be considered new only if
such functional use, characteristic, indica-
tion, combination, dosage, or delivery
form must be approved by the Food and
Drug Administration.
(3)Adaptation of existing business
components. Activities relating to adapt-
ing an existing business component to a
particular customer’s requirement or need
are not qualified research. This exclusion
does not apply merely because a business
component is intended for a specific cus-
tomer.
(4)Duplication of existing business
component. Activities relating to repro-
ducing an existing business component
(in whole or in part) from a physical
examination of the business component
itself or from plans, blueprints, detailed
specifications, or publicly available infor-
mation about the business component are
not qualified research. This exclusion
does not apply merely because the tax-
payer examines an existing business com-
ponent in the course of developing its
own business component.
(5)Surveys, studies, research relating
to management functions, etc. Qualified
research does not include activities relat-
ing to—
(i) Efficiency surveys;
(ii) Management functions or tech-
niques, including such items as prepara-
tion of financial data and analysis, devel-
opment of employee training programs
and management organization plans, and
management-based changes in production
processes (such as rearranging work sta-
tions on an assembly line);
(iii) Market research, testing, or devel-
opment (including advertising or promo-
tions);
(iv) Routine data collections; or
(v) Routine or ordinary testing or
inspections for quality control.
(6)Internal use software for taxable
years beginning on or after the December
31, 1985—(i)General rule. Research
with respect to computer software that is
2002–4 I.R.B.413January 28, 2002

developed by (or for the benefit of) the
taxpayer primarily for the taxpayer’s
internal use is eligible for the research
credit only if the software satisfies the
requirements of paragraph (c)(6)(ii) of
this section.
(ii)Requirements. The requirements of
this paragraph (c)(6)(ii) are—
(A) The software satisfies the require-
ments of section 41(d)(1);
(B) The software is not otherwise
excluded under section 41(d)(4) (other
than section 41(d)(4)(E)); and
(C) One of the following conditions is
met—
(1) The taxpayer develops the software
for use in an activity that constitutes
qualified research (other than the devel-
opment of the internal-use software
itself);
(2) The taxpayer develops the software
for use in a production process that satis-
fies the requirements of section 41(d)(1);
(3) The taxpayer develops the software
for use in providing computer services to
customers; or
(4) The software satisfies the high
threshold of innovation test of paragraph
(c)(6)(vi) of this section.
(iii)Computer software and hardware
developed as a single product. This para-
graph (c)(6) does not apply to the devel-
opment costs of a new or improved pack-
age of computer software and hardware
developed together by the taxpayer as a
single product (or to the costs to modify
an acquired computer software and hard-
ware package), of which the software is
an integral part, that is used directly by
the taxpayer in providing services in its
trade or business to customers. In these
cases, eligibility for the research credit is
to be determined by examining the com-
bined software-hardware product as a
single product.
(iv)Primarily for internal use. Unless
computer software is developed to be
commercially sold, leased, licensed, or
otherwise marketed, for separately stated
consideration to unrelated third parties,
computer software is presumed developed
by (or for the benefit of) the taxpayer pri-
marily for the taxpayer’s internal use. For
example, the computer software may
serve general and administrative func-
tions of the taxpayer, or may be used in
providing a noncomputer service. General
and administrative functions include, but
are not limited to, functions such as pay-
roll, bookkeeping, financial management,
financial reporting, personnel manage-
ment, sales and marketing, fixed asset
accounting, inventory management, and
cost accounting. Computer software that
is developed to be commercially sold,
leased, licensed or otherwise marketed,
for separately stated consideration to
unrelated third parties is not developed
primarily for the taxpayer’s internal use.
The requirements of this paragraph (c)(6)
apply to computer software that is devel-
oped primarily for the taxpayer’s internal
use even though the taxpayer subse-
quently sells, leases, licenses, or other-
wise markets the computer software for
separately stated consideration to unre-
lated third parties.
(v)Software used in the provision of
services—(A)Computer services. For
purposes of this section, a computer ser-
vice is a service offered by a taxpayer to
customers who conduct business with the
taxpayer primarily for the use of the tax-
payer’s computer or software technology.
A taxpayer does not provide a computer
service merely because customers interact
with the taxpayer’s software.
(B)Noncomputer services. For pur-
poses of this section, a noncomputer ser-
vice is a service offered by a taxpayer to
customers who conduct business with the
taxpayer primarily to obtain a service
other than a computer service, even if
such other service is enabled, supported,
or facilitated by computer or software
technology.
(vi)High threshold of innovation test.
Computer software satisfies this para-
graph (c)(6)(vi) only if the taxpayer can
establish that—
(A) The software is innovative in that
the software is intended to be unique or
novel and is intended to differ in a sig-
nificant and inventive way from prior
software implementations or methods;
(B) The software development
involves significant economic risk in that
the taxpayer commits substantial
resources to the development and there is
substantial uncertainty, because of techni-
cal risk, that such resources would be
recovered within a reasonable period; and
(C) The software is not commercially
available for use by the taxpayer in that
the software cannot be purchased, leased,
or licensed and used for the intended pur-
pose without modifications that would
satisfy the requirements of paragraphs
(c)(6)(v)(A) and (B) of this section.
(vii)Application of high threshold of
innovation test. The costs of developing
internal use software are eligible for the
research credit only if the software satis-
fies the high threshold of innovation test
of paragraph (c)(6)(vi) of this section.
This test takes into account only the
results attributable to the development of
the new or improved software indepen-
dent of the effect of any modifications to
related hardware or other software.
(viii)Illustrations. The following
examples illustrate provisions contained
in this paragraph (c)(6) of this section. No
inference should be drawn from these
examples concerning the application of
section 41(d)(1) and paragraph (a) of this
section to these facts. The examples are
as follows:
Example 1. (i)Facts. X, an insurance company,
has increased its number of insurance policies in
force. In recent years, regulatory and financial
accounting rules for computing actuarial reserves on
these insurance policies have changed several times.
In order to compute actuarial reserves in a more
timely and cost-effective manner, X undertakes to
create an improved reserve valuation software that
will generate data for regulatory and financial
accounting purposes.
(ii)Conclusion. The improved reserve valuation
software created by X is internal use software
because the software is not developed to be com-
mercially sold, leased, licensed, or otherwise mar-
keted, for separately stated consideration to unre-
lated third parties. The improved reserve valuation
software was developed by X to serve X’s general
and administrative functions. X’s costs of develop-
ing the reserve valuation software are eligible for
the research credit only if the software satisfies the
high threshold of innovation test of paragraph
(c)(6)(vi) of this section.
Example 2. (i)Facts. Assume the same facts as
inExample 1. Also assume that in order to create an
improved reserve valuation software, X purchases
updated hardware with a new operating system to
build the new software system. Several other insur-
ance companies using the same updated hardware
and new operating system have in place software
systems that can handle the volume of transactions
that X seeks to handle, provide reserve computa-
tions within a similar time frame, and accommodate
the most current regulatory and financial accounting
requirements.
(ii)Conclusion.X’s reserve valuation software
system is internal use software that does not satisfy
the high threshold of innovation test of paragraph
(c)(6)(vi) of this section. The software is not
intended to be unique or novel in that it is intended
to be merely comparable to software developed by
other insurance companies. The software does not
differ in a significant or inventive way from prior
software implementations because X’s reserve valu-
ation software system was developed using the same
January 28, 20024142002–4 I.R.B.

technologies and methods that were employed by
other insurance companies. Further, X’s reserve
valuation software is not excluded from the applica-
tion of paragraph (c)(6) of this section by the rule of
paragraph (c)(6)(iii) of this section.
Example 3. (i)Facts. In 1986, X, a large
regional bank with hundreds of branch offices,
maintained separate software systems for each of its
customer’s accounts, including checking, deposit,
loan, lease, and trust. X determined that improved
customer service could be achieved by redesigning
its disparate systems into one customer-centric sys-
tem. X also determined that commercially available
database management systems did not meet all of
the critical requirements of the proposed system.
Specifically, available relational database manage-
ment systems were well suited for the proposed sys-
tem’s data modeling requirements but not the data
integrity and transaction throughput (transactions-
per-second) requirements. Rather than waiting sev-
eral years for vendor offerings to mature and
become viable for its purpose, X decided to embark
upon the project utilizing older technology that sat-
isfied the data integrity and transaction throughput
requirements but that was severely challenged with
respect to the data modeling capabilities. X commits
substantial resources to this project and, because of
technical risk, X cannot determine if it will recover
its resources in a reasonable period. Early in the
course of the project, industry analysts observed that
the project appeared highly ambitious and risky. The
limitations of the technology X was attempting to
utilize required that X develop a new database archi-
tecture that could accommodate transaction volumes
unheard-of in the industry. X was unable to success-
fully develop the system and X abandoned the
project.
(ii)Conclusion. X intended to develop a com-
puter software system primarily for X’s internal use
because X did not intend to commercially sell,
lease, license, or otherwise market the software, for
separately stated consideration to unrelated third
parties, and X intended to use the software in pro-
viding noncomputer services to its customers. X’s
software development activities satisfy the high
threshold of innovation test of paragraph (c)(6)(vi)
of this section because the system was intended to
be innovative in that it was intended to be novel and
it was intended to differ in a significant and inven-
tive way from prior software implementations. In
addition, X’s development activities involved sig-
nificant economic risk in that X committed substan-
tial resources to the development and there was sub-
stantial uncertainty, because of technical risk, that
such resources would be recovered within a reason-
able period. Finally, at the time X undertook the
development of the system, software meeting X’s
requirements was not commercially available for
use by X.
Example 4. (i)Facts. X wishes to improve upon
its capabilities in the area of insurance fraud preven-
tion, detection and control. X believes that it can
exceed the capabilities of current commercial offer-
ings in this area by developing and applying pattern
matching algorithms that are not implemented in
current vendor offerings. X has determined that
many insurance fraud perpetrators can evade detec-
tion because its current system relies too heavily on
exact matches and scrubbed data. Because a com-
puter software system that will accomplish these
objectives is not commercially available, X under-
takes to develop and implement advanced pattern
matching algorithms that would significantly
improve upon the capabilities currently available
from vendors. X commits substantial resources to
the development of the software system and cannot
determine, because of technical risk, if it will
recover its investment within a reasonable period.
(ii)Conclusion.X’s computer software system is
developed primarily for X’s internal use because X
did not intend to sell, lease, license or otherwise
market the software, for separately stated consider-
ation to unrelated third parties. X’s software devel-
opment activities satisfy the high threshold of inno-
vation test of paragraph (c)(6)(vi) of this section
because the software system is innovative in that it
was intended to be novel and it was intended to dif-
fer in a significant and inventive way from prior
software implementations. In addition, X’s develop-
ment activities involved significant economic risk in
that X committed substantial resources to the devel-
opment and there was substantial uncertainty,
because of technical risk, that such resources would
be recovered within a reasonable period. Finally, at
the time X undertook the development of the soft-
ware, software satisfying X’s requirements was not
commercially available for use by X.
Example 5. (i)Facts. X is engaged in the busi-
ness of designing, manufacturing, and selling wid-
gets. X delivers its widgets in the same manner and
time as its competitors. To improve customer ser-
vice, X undertakes to develop computer software
that will monitor the progress of the manufacture
and delivery of X’s widgets to enable X’s custom-
ers to track their widget orders from origination to
delivery, whether by air, land or ship. In addition, at
the request of a customer, X will be able to intercept
and return or reroute packages prior to delivery. At
the time X undertakes its software development
activities, X is uncertain whether it can develop the
real-time communication software necessary to
achieve its objective. None of X’s competitors have
a comparable tracking system. X commits substan-
tial resources to the development of the system and,
because of technical risk, X cannot determine if it
will recover its investment within a reasonable
period.
(ii)Conclusion.X’s computer software is devel-
oped primarily for X’s internal use because the soft-
ware is not developed to be commercially sold,
leased, licensed, or otherwise marketed, for sepa-
rately stated consideration to unrelated third parties.
X’s computer software was developed to be used by
X in providing noncomputer services to its custom-
ers. X’s software satisfies the high threshold of
innovation test of paragraph (c)(6)(vi) of this section
because, at the time the research is undertaken, X’s
software is designed to provide a new tracking capa-
bility that is novel in that none of X’s competitors
have such a capability. Further, the new capability
differs in a significant and inventive way from prior
software implementations. In addition, X’s develop-
ment activities involved significant economic risk in
that X committed substantial resources to the devel-
opment and there was substantial uncertainty,
because of technical risk, that such resources would
be recovered within a reasonable period. Finally, at
the time X undertook the development of the soft-
ware, software satisfying X’s requirements was not
commercially available for use by X.
Example 6. (i)Facts. X, a multinational chemi-
cal manufacturer with different business and finan-
cial systems in each of its divisions, undertakes a
software development project aimed at integrating
the majority of the functional areas of its major soft-
ware systems into a single enterprise resource man-
agement system supporting centralized financial
systems, inventory, and management reporting. This
project involves the detailed analysis of X’s (as well
as each of X’s divisions’) legacy systems to under-
stand the actual current business processes and data
requirements. X also has to develop programs to fill
in the gaps between the software features and X’s
system requirements. X hires Y, a systems consult-
ing firm to assist with this development effort. Y has
experience in developing similar systems. X, work-
ing jointly with Y, evaluates its needs, establishes
goals for the new system, re-engineers the business
processes that will be made concurrently with the
implementation of the new system, and chooses and
purchases a software system upon which to base its
enterprise-wide system.
(ii)Conclusion.X’s enterprise-wide computer
software is developed primarily for internal use
because the software is not developed to be com-
mercially sold, leased, licensed, or otherwise mar-
keted, for separately stated consideration to unre-
lated third parties. X’s computer software was
developed to be used by X to serve X’s general and
administrative functions. However, the development
of X’s enterprise management system does not sat-
isfy the high threshold of innovation test of para-
graph (c)(6)(vi) of this section because the system
that X is seeking to develop is not intended to be
unique or novel. Further, the software does not dif-
fer in a significant or inventive way from software
implemented by other manufacturers.
Example 7. (i)Facts. X, a financial services
company specializing in commercial mortgages,
decides to support its ongoing expansion by upgrad-
ing its information technology infrastructure. In
order to accommodate its expanding efforts to
acquire and maintain corporate borrowers and draw
securitized loan investors, X builds a scalable and
modular enterprise network to run its latest business
applications, including web-based portfolio access
for investors and staff, document imaging for cus-
tomer service personnel, desktop access to informa-
tion services for in-house securities traders and mul-
timedia on-line training and corporate information
delivery for all company personnel. As a result, X is
able to access market information faster and func-
tion more efficiently and effectively than before.
The new network is based on a faster local area net-
work technology which is better able to meet the
higher bandwidth requirements of X’s current mul-
timedia applications.
(ii)Conclusion.X’s software is software devel-
oped primarily for X’s internal use because the soft-
ware is not developed to be commercially sold,
leased, licensed, or otherwise marketed, for sepa-
rately stated consideration to unrelated third parties.
X’s software development activities do not meet the
high threshold of innovation test of paragraph
(c)(6)(vi) of this section because the system is not
intended to be unique or novel. Further, the software
does not differ in a significant or inventive way
from other existing software implementations.
2002–4 I.R.B.415January 28, 2002

Example 8. (i)Facts. X, a corporation, under-
took a software project to rewrite a legacy main-
frame application using an object-oriented program-
ming language, and to move the new application off
the mainframe to a client/server environment. Both
the object-oriented language and client/server tech-
nologies were new to X. This project was under-
taken to develop a more maintainable application,
and to be able to implement new features more
quickly. X had to perform a detailed analysis of the
old legacy application in order to determine the
requirements of the rewritten application. To accom-
plish this task, X had to train the legacy mainframe
programmers in the new object-oriented and client/
server technologies that they would have to utilize.
Several of X’s competitors had successfully imple-
mented similar systems using object-oriented pro-
gramming language and client/server technologies.
(ii)Conclusion.X’s software is developed pri-
marily for internal use because the software is not
developed to be commercially sold, leased, licensed,
or otherwise marketed, for separately stated consid-
eration to unrelated third parties. X’s activities to
rewrite a legacy mainframe application using an
object-oriented programming language, and to move
the application from X’s mainframe to a client/
server environment do not satisfy the high threshold
of innovation test of paragraph (c)(6)(vi) of this sec-
tion. The software developed is not intended to be
either unique or novel and is not intended to differ
in a significant and inventive way from prior soft-
ware implementations or methods.
Example 9. (i)Facts. X, a retail and distribution
company, wants to upgrade its warehouse manage-
ment software. Therefore, X performs an analysis of
the warehouse management products and vendors in
the marketplace. X selects vendor V’s software and,
in turn, develops the software interfaces between
X’s legacy systems and V’s warehouse management
software in order to integrate the new warehouse
management system with X’s financial and inven-
tory systems. The development of these interfaces
requires a detailed understanding of all the input and
output fields and their data formats, and how they
map from the old system to the new system and
vice-versa. Once X develops the interfaces, X has to
perform extensive testing and validation work to
ensure that the interfaces work correctly and accu-
rately.
(ii)Conclusion.X’s software is developed pri-
marily for internal use because the software is not
developed to be commercially sold, leased, licensed,
or otherwise marketed, for separately stated consid-
eration to unrelated third parties. X’s software
development activities do not satisfy the high
threshold of innovation test of paragraph (c)(6)(vi)
of this section because the software development
does not involve significant economic risk in that
there is no substantial uncertainty, because of tech-
nical risk, that such resources will be recovered
within a reasonable period.
Example 10. (i)Facts. X, a credit card company,
knows that its customers are not comfortable with
purchasing products over the Internet because they
feel the Web is not secure. X decides to build a pay-
ment system that provides customers with a single
use, automatically generated, short-term time-based,
transaction number. This single-use transaction
number has a short expiration period that is just long
enough to allow a merchant to process and fill the
customer’s order. Thus, when a customer wishes to
make a purchase over the Internet, the customer
requests X to generate automatically a single-use
transaction number that merchant systems will
accept as a legitimate card number. All purchases
using single-use transaction numbers are automati-
cally linked back to the customer’s credit card
account. X commits substantial resources to the
development of the system and X cannot determine,
because of technical risk, if it will recover its invest-
ment within a reasonable period. At the time of this
project, nothing exists in the market that has these
capabilities.
(ii)Conclusion.X’s software is developed pri-
marily for internal use because the software is not
developed to be commercially sold, leased, licensed,
or otherwise marketed, for separately stated consid-
eration to unrelated third parties. X’s computer soft-
ware is developed primarily for X’s internal use
because it was intended to be used by X in provid-
ing noncomputer services to its customers. X’s soft-
ware satisfies the high threshold of innovation test
of paragraph (c)(6)(vi) of this section because the
system is a novel way to solve the security issue of
making purchases over the Internet. Further, because
of the secure payment capability, the software dif-
fers in a significant and inventive way from prior
software implementations. In addition, X’s develop-
ment activities involved significant economic risk in
that X committed substantial resources to the devel-
opment and there was substantial uncertainty,
because of technical risk, that such resources would
be recovered within a reasonable period. Finally, at
the time X undertook the development of the soft-
ware, software satisfying X’s requirements was not
commercially available for use by X.
Example 11. (i)Facts. X, a corporation, wants to
expand its internal computing power, and is aware
that its PCs and workstations are idle at night, on
the weekends, and for a significant part of any busi-
ness day. Because the corporate computations that X
needs to make could be done on workstations as
well as PCs, X develops a screen-saver like applica-
tion that runs on employee computers. When
employees’computers have been idle for an amount
of time set by each employee, the“screen-saver”
starts to execute. However, instead of displaying
moving lines, like the typical screen-saver, X’s
application goes back to a central server to get a
new job to execute. This job will execute on the idle
employee’s computer until it has either finished, or
the employee resumes working on his computer. X
wants to ensure that it can manage all of the com-
putation jobs distributed across its thousands of PCs
and workstations. In addition, X wants to ensure
that the additional load on its network caused by
downloading the jobs and uploading the results, as
well as in monitoring and managing the jobs, does
not adversely impact the corporate computing infra-
structure. At the time X undertook this software
development project, X was uncertain, because of
technical risk, it could develop a server application
that could schedule and distribute the jobs across
thousands of PCs and workstations, as well as
handle all the error conditions that occur on a user’s
machine. Also, at the time X undertook this project,
there was no commercial application available with
such a capability.
(ii)Conclusion.X’s computer software is devel-
oped primarily for internal use because the software
is not developed to be commercially sold, leased,
licensed, or otherwise marketed, for separately
stated consideration to unrelated third parties. X’s
computer software was developed to be used by X
to serve X’s general and administrative functions.
X’s software satisfies the high threshold of innova-
tion test of paragraph (c)(6)(vi) of this section
because making use of idle corporate computing
resources through what is ostensibly a screen-saver,
was a novel approach to solving X’s need for more
computer intensive processing time. In addition, X’s
software development involves significant economic
risk in that there was substantial uncertainty,
because of technical risk, that the server application
that schedules and distributes the jobs across thou-
sands of PCs and workstations, as well as handles
all the error conditions that can occur on a user’s
machine, amounts to developing a new operating
system with new capabilities. Finally, at the time X
undertook the development of the software, software
satisfying X’s requirements was not commercially
available for use by X.
Example 12. (i)Facts. (A) X, a corporation,
wants to protect its internal documents without
building a large public key infrastructure. In addi-
tion, X needs to implement a new highly secure
encryption algorithm that has a“back-door”such
that X can decrypt and read any document, even
when the employee is on vacation or leaves the
company. X wants to develop a new encryption
algorithm that is both secure, easy to use, and diffi-
cult to break. Current commercial encryption/
decryption products are too slow for high-level
secure encryption processing. Furthermore, no com-
mercial product exists that provides the capability of
having a secure back-door key to decrypt files when
the owner is unavailable.
(B) The development of the encryption/
decryption software requires specialized knowledge
of cryptography and computational methods. Due to
the secret nature of X’s work, the encryption algo-
rithm has to be unbreakable, yet recoverable should
the employee forget his key. X commits substantial
resources to the development of the system and,
because of technical risk, cannot estimate whether it
will recover its investment within a reasonable
period.
(ii)Conclusion.X’s back-door file encryption
software is developed primarily for internal use
because the software is not developed to be com-
mercially sold, leased, licensed, or otherwise mar-
keted, for separately stated consideration to unre-
lated third parties. X’s back-door file encryption
software was developed to be used by X to serve
X’s general and administrative functions. X’s
encryption software satisfies the high threshold of
innovation test of paragraph (c)(6)(vi) of this section
because, at the time the research is undertaken, X’s
software is designed to provide encryption and
back-door decryption capabilities that are unique in
that no other product has these capabilities, which
indicates the software encryption system differs in a
significant way from prior software implementa-
tions. Further, the encryption and back-door decryp-
tion capabilities indicate that the software differs in
a significant and inventive way from prior software
implementations. In addition, X’s development
activities involved significant economic risk in that
X committed substantial resources to the develop-
ment and there was substantial uncertainty, because
January 28, 20024162002–4 I.R.B.

of technical risk, that such resources would be
recovered within a reasonable period. Finally, at the
time X undertook the development of the software,
software satisfying X’s requirements was not com-
mercially available for use by X.
Example 13. (i)Facts. X, a large regional tele-
phone company, is experiencing rapidly increasing
customer demand. X would like to determine
whether evolutionary algorithms such as genetic
algorithms may improve its ability to design cost-
effective networks and extend existing networks. X
would also like to determine whether such adaptive
algorithms may be used to optimize the routing of
call traffic across existing networks in order to use
efficiently the resources available without causing
congestion. X first explores the use of evolutionary
algorithms for the call routing task, because X deter-
mines that this type of complex, unpredictable prob-
lem is most appropriate for an adaptive algorithm
solution. X develops and tests genetic algorithms
until it determines that it has developed a software
system it can test on a pilot basis on its existing net-
works. X commits substantial resources to the
project, and cannot predict, because of technical
risk, whether it will recover its resources within a
reasonable period. Finally, at the time X undertook
the development of the software, software satisfying
X’s requirements was not commercially available
for use by X.
(ii)Conclusion.X’s software is developed pri-
marily for internal use because the software is not
developed to be commercially sold, leased, licensed,
or otherwise marketed, for separately stated consid-
eration to unrelated third parties. X’s computer soft-
ware is intended to be used by X in providing non-
computer services to its customers. X’s software
satisfies the high threshold of innovation test of
paragraph (c)(6)(vi) of this section because the soft-
ware is intended to be novel and is intended to dif-
fer in a significant and inventive way from other
existing software implementations. In addition, X’s
development activities involved significant eco-
nomic risk in that X committed substantial resources
to the development and there was substantial uncer-
tainty, because of technical risk, that such resources
would be recovered within a reasonable period.
Finally, at the time X undertook the development of
the software, software satisfying X’s requirements
was not commercially available.
(ix)Effective date. This paragraph
(c)(6) is applicable for taxable years
beginning after December 31, 1985.
(7)Activities outside the United States,
Puerto Rico, and other possessions—(i)
In general. Research conducted outside
the United States, as defined in section
7701(a)(9), the Commonwealth of Puerto
Rico and other possessions of the United
States does not constitute qualified
research.
(ii)Apportionment of in-house
research expenses. In-house research
expenses paid or incurred for qualified
services performed both in the United
States, the Commonwealth of Puerto Rico
and other possessions of the United States
and outside the United States, the Com-
monwealth of Puerto Rico and other pos-
sessions of the United States must be
apportioned between the services per-
formed in the United States, the Com-
monwealth of Puerto Rico and other pos-
sessions of the United States and the
services performed outside the United
States, the Commonwealth of Puerto Rico
and other possessions of the United
States. Only those in-house research
expenses apportioned to the services per-
formed within the United States, the
Commonwealth of Puerto Rico and other
possessions of the United States are eli-
gible to be treated as qualified research
expenses, unless the in-house research
expenses are wages and the 80 percent
rule of§1.41–2(d)(2) applies.
(iii)Apportionment of contract
research expenses. If contract research is
performed partly in the United States, the
Commonwealth of Puerto Rico and other
possessions of the United States and
partly outside the United States, the Com-
monwealth of Puerto Rico and other pos-
sessions of the United States, only 65 per-
cent (or 75 percent in the case of amounts
paid to qualified research consortia) of
the portion of the contract amount that is
attributable to the research activity per-
formed in the United States, the Com-
monwealth of Puerto Rico and other pos-
sessions of the United States may qualify
as a contract research expense (even if 80
percent or more of the contract amount is
for research performed in the United
States, the Commonwealth of Puerto Rico
and other possessions of the United
States).
(8)Research in the social sciences,
etc. Qualified research does not include
research in the social sciences (including
economics, business management, and
behavioral sciences), arts, or humanities.
(9)Research funded by any grant, con-
tract, or otherwise. Qualified research
does not include any research to the
extent funded by any grant, contract, or
otherwise by another person (or govern-
mental entity). To determine the extent to
which research is so funded,§1.41–
4A(d) applies.
(10)Illustrations. The following
examples illustrate provisions contained
in paragraphs (c)(1) through (9) (except-
ing (c)(6)) of this section. No inference
should be drawn from these examples
concerning the application of section
41(d)(1) and paragraph (a) of this section
to these facts. The examples are as fol-
lows:
Example 1. (i)Facts. X, a tire manufacturer,
develops a new material to use in its tires. X con-
ducts research to determine the changes that will be
necessary for X to modify its existing manufactur-
ing processes to manufacture the new tire. X deter-
mines that the new material retains heat for a longer
period of time than the materials X currently uses
and, as a result, adheres to the manufacturing equip-
ment during tread cooling. X evaluates numerous
options for processing the treads at cooler tempera-
tures. X designs, develops, and conducts sophisti-
cated tests on the numerous options for a new type
of belt to be used in tread cooling. X then manufac-
tures a set of belts for its production equipment,
installs the belts, and tests the belts to make sure
they were manufactured correctly.
(ii)Conclusion.X’s research with respect to the
design of the new belts to be used in its manufactur-
ing of the new tire may be qualified research under
section 41(d)(1) and paragraph (a) of this section.
However, X’s expenses to implement the design,
including the costs to manufacture, install, and test
the belts were incurred after the belts met the tax-
payer’s functional and economic requirements and
are excluded as research after commercial produc-
tion under section 41(d)(4)(A) and paragraph (c)(2)
of this section. In addition, amounts expended on
component materials of the production belts and the
costs of labor or other elements involved in the
manufacture and installation of the production belts
are not qualified research expenses. These expenses
are not for expenditures that may be treated as
expenses under section 174 and thus are not quali-
fied research under section 41(d)(1)(A) and para-
graph (a)(2)(i) of this section. See section 174(c)
and§1.174–2(b). Further, testing or inspection to
determine whether the production belts were manu-
factured correctly is quality control testing under
§1.174–2(a)(4) and thus is not qualified research
under section 41(d)(1)(A) and paragraph (a)(2)(i) of
this section.
Example 2. (i)Facts. For several years, X has
manufactured and sold a particular kind of widget.
X initiates a new research project to develop a new
or improved widget.
(ii)Conclusion.X’s activities to develop a new
or improved widget are not excluded from the defi-
nition of qualified research under section
41(d)(4)(A) and paragraph (c)(2) of this section. X’s
activities relating to the development of a new or
improved widget constitute a new research project
to develop a new business component. X’s research
activities relating to the development of the new or
improved widget, a new business component, are
not considered to be activities conducted after the
beginning of commercial production under section
41(d)(4)(A) and paragraph (c)(2) of this section.
Example 3. (i)Facts. X, a computer software
development firm, owns all substantial rights in a
general ledger accounting software core program
that X markets and licenses to customers. X incurs
expenditures in adapting the core software program
to the requirements of C, one of X’s customers.
(ii)Conclusion. Because X’s activities represent
activities to adapt an existing software program to a
particular customer’s requirement or need, X’s
2002–4 I.R.B.417January 28, 2002

activities are excluded from the definition of quali-
fied research under section 41(d)(4)(B) and para-
graph (c)(3) of this section.
Example 4. (i)Facts. The facts are the same as
inexample 3, except that C pays X to adapt the core
software program to C’s requirements.
(ii)Conclusion. Because X’s activities are
excluded from the definition of qualified research
under section 41(d)(4)(B) and paragraph (c)(3) of
this section, C’s payments to X are not for qualified
research and are not considered to be contract
research expenses under section 41(b)(3)(A).
Example 5. (i)Facts. The facts are the same as
inexample 3, except that C’s own employees adapt
the core software program to C’s requirements.
(ii)Conclusion. Because C’s employees’activi-
ties to adapt the core software program to C’s
requirements are excluded from the definition of
qualified research under section 41(d)(4)(B) and
paragraph (c)(3) of this section, the wages C paid to
its employees do not constitute in-house research
expenses under section 41(b)(2)(A).
Example 6. (i)Facts. X manufacturers and sells
rail cars. Because rail cars have numerous specifica-
tions related to performance, reliability and quality,
rail car designs are subject to extensive, complex
testing in the scientific or laboratory sense. B orders
passenger rail cars from X. B’s rail car requirements
differ from those of X’s other customers in that B
wants fewer seats in its passenger cars and a higher
quality seating material and carpet. X manufactures
rail cars meeting B’s requirements. X does not con-
duct complex testing in the scientific or laboratory
sense on the rail cars manufactured for B.
(ii)Conclusion.X’s activities to manufacture
rail cars for B are excluded from the definition of
qualified research. The rail cars designed for B were
not subject to the type of complex testing that is
indicative of a process of experimentation. Further,
the rail car sold to B was not a new business com-
ponent, but merely an adaptation of an existing busi-
ness component. Thus, X’s activities to manufacture
rail cars for B are excluded from the definition of
qualified research under section 41(d)(4)(B) and
paragraph (c)(3) of this section because X’s activi-
ties represent activities to adapt an existing business
component to a particular customer’s requirement or
need.
Example 7. (i)Facts. X, a manufacturer, under-
takes to create a manufacturing process for a new
valve design. X determines that it requires a special-
ized type of robotic equipment to use in the manu-
facturing process for its new valves. X is unable to
locate robotic equipment that meets X’s precise
specifications, and, therefore, purchases the existing
robotic equipment for the purpose of modifying it to
meet its needs. X’s engineers conduct experiments
using modeling and simulation in modifying the
robotic equipment and conduct extensive scientific
and laboratory testing of design alternatives. As a
result of this process, X’s engineers develop a
design for the robotic equipment that meets X’s
specifications. X constructs and installs the modi-
fied robotic equipment on its manufacturing pro-
cess.
(ii)Conclusion.X’s research activities to deter-
mine how to modify X’s robotic equipment for its
manufacturing process are not excluded from the
definition of qualified research under section
41(d)(4)(B) and paragraph (c)(3) of this section.
Example 8. (i)Facts. An existing gasoline addi-
tive is manufactured by Y using three ingredients, A,
B, and C. X seeks to develop and manufacture its
own gasoline additive that appears and functions in
a manner similar to Y’s additive. To develop its own
additive, X first inspects the composition of Y’s
additive, and uses knowledge gained from the
inspection to reproduce A and B in the laboratory.
Any differences between ingredients A and B that
are used in Y’s additive and those reproduced by X
are insignificant and are not material to the viability,
effectiveness, or cost of A and B. X desires to use
with A and B an ingredient that has a materially
lower cost than ingredient C. Accordingly, X
engages in a process of experimentation to develop,
analyze and test potential alternative formulations of
the additive.
(ii)Conclusion.X’s activities in analyzing and
reproducing ingredients A and B involve duplication
of existing business components and are excluded
from the definition of qualified research under sec-
tion 41(d)(4)(C) and paragraph (c)(4) of this section.
X’s experimentation activities to develop potential
alternative formulations of the additive do not
involve duplication of an existing business compo-
nent and are not excluded from the definition of
qualified research under section 41(d)(4)(C) and
paragraph (c)(4) of this section.
Example 9. (i)Facts. X, a manufacturing corpo-
ration, undertakes to restructure its manufacturing
organization. X organizes a team to design an orga-
nizational structure that will improve X’s business
operations. The team includes X’s employees as
well as outside management consultants. The team
studies current operations, interviews X’s employ-
ees, and studies the structure of other manufacturing
facilities to determine appropriate modifications to
X’s current business operations. The team develops
a recommendation of proposed modifications which
it presents to X’s management. X’s management
approves the team’s recommendation and begins to
implement the proposed modifications.
(ii)Conclusion.X’s activities in developing and
implementing the new management structure are
excluded from the definition of qualified research
under section 41(d)(4)(D) and paragraph (c)(5) of
this section. Qualified research does not include
activities relating to management functions or tech-
niques including management organization plans
and management-based changes in production pro-
cesses.
Example 10. (i)Facts. X, an insurance company,
develops a new life insurance product. In the course
of developing the product, X engages in research
with respect to the effect of pricing and tax conse-
quences on demand for the product, the expected
volatility of interest rates, and the expected mortal-
ity rates (based on published data and prior insur-
ance claims).
(ii)Conclusion.X’s activities related to the new
product represent research in the social sciences
(including economics and business management)
and are thus excluded from the definition of quali-
fied research under section 41(d)(4)(G) and para-
graph (c)(8) of this section.
(d)Recordkeeping for the research
credit. A taxpayer claiming a credit under
section 41 must retain records in suffi-
ciently usable form and detail to substan-
tiate that the expenditures claimed are eli-
gible for the credit. For the rules
governingrecordretention,see
§1.6001–1. To facilitate compliance and
administration, the IRS and taxpayers
may agree to guidelines for the keeping
of specific records for purposes of sub-
stantiating research credits.
(e)Effective dates. In general, the rules
of this section are applicable for taxable
years ending on or after December 26,
2001.
Par. 5. Section 1.41–8 is amended by:
1. Revising the section heading.
2. Revising paragraph (b)(4).
The revisions read as follows:
§1.41–8 Special rules for taxable years
ending on or after December 26, 2001.
*****
(b)***
(4)Effective date. Paragraphs (b)(2)
and (3) of this section are applicable for
taxable years ending on or after Decem-
ber 26, 2001.
Charles O. Rossotti,
Commissioner of Internal Revenue.
(Filed by the Office of the Federal Register on
December 21, 2001, 8:45 a.m., and published in the
issue of the Federal Register for December 26,
2001, 66 F.R. 66362)
Notice of Proposed
Rulemaking by Cross-
Reference to Temporary
Regulations
Certain Transfers of Property
to Regulated Investment
Companies and Real Estate
Investment Trusts
REG–142299–01,
REG–209135–88
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking
by cross-reference to temporary regula-
tions.
SUMMARY: This document contains
proposed regulations that apply to certain
transactions or events that result in a
Regulated Investment Company [RIC] or
January 28, 20024182002–4 I.R.B.

Real Estate Investment Trust [REIT]
owning property that has a basis deter-
mined by reference to a C corporation’s
basis in the property. The text of the tem-
porary regulations published in this issue
of the Bulletin serves as the text of this
proposed regulation.
DATES: Written or electronic comments
must be received by April 2, 2002.
ADDRESSES: Send submissions to:
CC:ITA:RU [REG–142299–01], room
5226, Internal Revenue Service, POB
7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand
delivered Monday through Friday
between the hours of 8 a.m. and 5 p.m. to
CC:ITA:RU [REG–142299–01], Couri-
er’s Desk, Internal Revenue Service,1111
Constitution Avenue NW, Washington,
DC. or sent to the IRS Internet site at:
http://www.irs.gov/tax_regs/reglist.html.
FOR FURTHER INFORMATION CON-
TACT: Concerning the proposed regula-
tions, Lisa A. Fuller (202) 622–7750;
concerning submissions of comments,
Donna Poindexter (202) 622–7180 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information con-
tained in this notice of proposed rulemak-
ing has been submitted to the Office of
Management and Budget for review in
accordance with the Paperwork Reduc-
tion Act of 1995 (44 U.S.C. 3507(d)).
Comments on the collection of informa-
tion should be sent to theOffice of Man-
agement and Budget, Attn: Desk Officer
for the Department of the Treasury, Office
of Information and Regulatory Affairs,
Washington, DC 20503, with copies to
theInternal Revenue Service, Attn: IRS
ReportsClearanceOfficer,W:CAR:
MP:FP:S:O, Washington, DC 20224.
Comments on the collection of informa-
tion should be received by March 4,
2002. Comments are specifically
requested concerning:
Whether the proposed collection of infor-
mation is necessary for the proper perfor-
mance of the functions of the IRS, includ-
ing whether the collection will have
practical utility;
The accuracy of the estimated burden
associated with the proposed collection of
information (see below);
How the quality, utility, and clarity of the
information to be collected may be
enhanced;
How the burden of complying with the
proposed collection of information may
be minimized, including through the
application of automated collection tech-
niques or other forms of information tech-
nology; and
Estimates of capital or start-up costs and
costs of operation, maintenance, and pur-
chase of services to provide information.
The collection of information in this
proposed regulation is in§§1.337(d)–6T
and 1.337(d)–7T. This information is nec-
essary for the IRS to determine whether
section 1374 treatment or deemed sale
treatment is appropriate for the entity for
which the regulation applies. The collec-
tion of information is required to obtain a
benefit,i.e., to elect section 1374 treat-
ment in lieu of deemed sale treatment in
§1.337(d)–6T, or to elect deemed sale
treatment in lieu of section 1374 treat-
ment in§1.337(d)–7T. The likely respon-
dents for deemed sale elections are C cor-
porations. The likely respondents for
section 1374 elections are RICs and
REITs.
Section 1.337(d)–6T provides that a
section 1374 election is made by filing a
statement and attaching it to any Federal
income tax return filed by the RIC or
REIT on or before March 15, 2003, pro-
vided that the RIC or REIT has reported
consistently with such election for all
periods. Alternatively, a RIC or REIT can
also make a section 1374 election by
informing the IRS prior to January 2,
2002, of its intent to make a section 1374
election. Section 1.337(d)–7T provides
that a deemed sale election is made by
filing a statement and attaching it to the C
corporation’s Federal income tax return
for the taxable year in which the deemed
sale occurs.
Estimated total annual reporting bur-
den: 70 hours.
Estimated average annual burden per
respondent: 30 minutes.
Estimated number of respondents:
140.
Estimated annual frequency of
responses: Once.
An agency may not conduct or spon-
sor, and a person is not required to
respond to, a collection of information
unless it displays a valid control number
assigned by the Office of Management
and Budget.
Books or records relating to a collec-
tion of information must be retained as
long as their contents may become mate-
rial 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
Temporary regulations (T.D. 8975) in
this issue of the Bulletin revise and add
the Income Tax Regulations (26 CFR part
1) relating to section 337(d). The tempo-
rary regulations generally provide that, if
property owned by a C corporation or
property subject to section 1374 owned
by a RIC, a REIT, or an S corporation
becomes the property of a RIC or REIT
by (1) the qualification of the C corpora-
tion as a RIC or REIT, or (2) certain
transfers of property to a RIC or REIT,
then the RIC or REIT will be subject
either to section 1374 treatment or the C
corporation will be subject to deemed sale
treatment. The text of those temporary
regulations also serves as the text of these
proposed regulations. The preamble to the
temporary regulations explains the tem-
porary regulations.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory 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 regula-
tions do not impose a collection of infor-
mation on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does
not apply. Therefore, a Regulatory Flex-
ibility Analysis is not required. Pursuant
to section 7805(f) of the Code, these pro-
posed regulations will be submitted to the
Chief Counsel for Advocacy of the Small
2002–4 I.R.B.419January 28, 2002

Business Administration for comment on
their impact on small business.
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) or
electronic comments that are submitted
timely to the IRS. The IRS and Treasury
request comments on the clarity of the
proposed rule and how it may be made
easier to understand. All comments will
be made available for public inspection
and copying. A public hearing may be
scheduled. When a public hearing is
scheduled, notice of the date, time, and
place for the public hearing will be pub-
lished in theFederal Register.
Drafting Information
The principal author of these regula-
tions is Lisa A. Fuller of the Office of
Associate Chief Counsel (Corporate).
Other personnel from Treasury and the
IRS participated in their development.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is pro-
posed to be amended as follows:
PA RT 1—INCOME TAXES
Par. 1. The authority citation for part 1
is amended by adding an entry in numeri-
cal order to read in part as follows:
Authority: 26 U.S.C. 7805***
Section 1.337(d)–6 also issued under
26 U.S.C. 337.
Section 1.337(d)–7 also issued under
26 U.S.C. 337.***
Par. 2. Sections 1.337(d)–6 and
1.337(d)–7 are added to read as follows:
§1.337(d)–6 New transitional rules
imposing tax on property owned by a C
corporation that becomes property of a
RIC or REIT.
[The text of proposed§1.337(d)–6is
the same as the text of§1.337(d)–6T
published elsewhere in this issue of the
Federal Register.]
§1.337(d)–7 Tax on property owned by a
C corporation that becomes property of a
RIC or REIT.
[The text of proposed§1.337(d)–7is
the same as the text of§1.337(d)–7T pub-
lished elsewhere in this issue of theFed-
eral Register.]
Robert E. Wenzel,
Deputy Commissioner of
Internal Revenue.
(Filed by the Office of the Federal Register on
December 31, 2001, 8:45 a.m., and published in the
issue of the Federal Register for January 2, 2002, 67
F.R. 48)
Inflation Adjusted Items for
2001
Announcement 2002–5
This announcement reflects the correc-
tion of an error in Rev. Proc. 2001–13
(2001–3 I.R.B. 337) which sets forth
inflation adjusted items for 2001. In sec-
tion 2.15, regarding expatriation to avoid
tax, the average annual net income tax
figure of $115,000 is changed to
$116,000, and the net worth figure of
$579,000 is changed to $580,000.
January 28, 20024202002–4 I.R.B.

Definition of Terms
Revenue rulings and revenue procedures
(hereinafter referred to as“rulings”) that
have an effect on previous rulings use the
following defined terms to describe the
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.—Intemal 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.
2002–4 I.R.B.iJanuary 28, 2002

Numerical Finding List
1
Bulletins 2002–1 through 2002–3
Announcements:
2002–1, 2002–2 I.R.B.304
2002–2, 2002–2 I.R.B.304
2002–3, 2002–2 I.R.B.305
2002–4, 2002–2 I.R.B.306
Notices:
2002–1, 2002–2 I.R.B.283
2002–2, 2002–2 I.R.B.285
2002–3, 2002–2 I.R.B.289
2002–4, 2002–2 I.R.B.298
2002–5, 2002–3 I.R.B.320
2002–6, 2002–3 I.R.B.327
Proposed Regulations:
REG–105344–01, 2002–2 I.R.B.302
REG–119436–01, 2002–2 I.R.B.376
Revenue Procedures:
2002–1, 2002–1 I.R.B.1
2002–2, 2002–1 I.R.B.82
2002–3, 2002–1 I.R.B.117
2002–4, 2002–1 I.R.B.127
2002–5, 2002–1 I.R.B.173
2002–6, 2002–1 I.R.B.203
2002–7, 2002–1 I.R.B.249
2002–8, 2002–1 I.R.B.252
2002–9, 2002–3 I.R.B.327
2002–12, 2002–3 I.R.B.374
Revenue Rulings:
2002–1, 2002–2 I.R.B.268
2002–2, 2002–2 I.R.B.271
2002–3, 2002–3 I.R.B.316
Treasury Decisions:
8968, 2002–2 I.R.B.274
8969, 2002–2 I.R.B.276
8970, 2002–2 I.R.B.281
8971, 2002–2 I.R.B.308
8974, 2002–2 I.R.B.318
1
A cumulative list of all revenue rulings, revenue
procedures, Treasury decisions, etc., published in
Internal Revenue Bulletins 2001–27 through 2001–53 is
in Internal Revenue Bulletin 2002–1, dated January 7, 2002.
January 28, 2002ii2002–4 I.R.B.

Finding List of Current Actions
on Previously Published Items
2
Bulletins 2002–1 through 2002–3
Notices:
98–43
Modified and superseded by
Notice 2002–5, 2002–3 I.R.B.320
2000–11
Obsoleted by
Notice 2002–3, 2002–2 I.R.B.289
Revenue Procedures:
84–37
Modified by
Rev. Proc. 2002–1, 2002–1 I.R.B.1
96–13
Modified by
Rev. Proc. 2002–1, 2002–1 I.R.B.1
99–49
Modified and superseded by
Rev. Proc. 2002–9, 2002–3 I.R.B.327
2002–6
Modified by
Notice 2002–1, 2002–2 I.R.B.583
2002–8
Modified by
Notice 2002–1, 2002–2 I.R.B.583
2000–20
Modified by
Rev. Proc. 2002–6, 2002–1 I.R.B.203
2001–1
Superseded by
Rev. Proc. 2002–1, 2002–1 I.R.B.1
2001–2
Superseded by
Rev. Proc. 2002–2, 2002–1 I.R.B.82
2001–3
Superseded by
Rev. Proc. 2002–3, 2002–1 I.R.B.117
2001–4
Superseded by
Rev. Proc. 2002–4, 2002–1 I.R.B.127
2001–5
Superseded by
Rev. Proc. 2002–5, 2002–1 I.R.B.173
Revenue Procedures:—Continued
2001–6
Superseded by
Rev. Proc. 2002–6, 2002–1 I.R.B.203
2001–7
Superseded by
Rev. Proc. 2002–7, 2002–1 I.R.B.249
2001–8
Superseded by
Rev. Proc. 2002–8, 2002–1 I.R.B.252
2001–36
Superseded by
Rev. Proc. 2002–3, 2002–1 I.R.B.117
2001–41
Superseded by
Rev. Proc. 2002–2, 2002–1 I.R.B.82
2001–51
Superseded by
Rev. Proc. 2002–3, 2002–1 I.R.B.117
Revenue Rulings:
61–146
Distinguished by
Rev. Rul. 2002–3, 2002–3 I.R.B.316
2
A cumulative list of current actions on previously published
items in Internal Revenue Bulletins 2001–27 through 2001–53 is
in Internal Revenue Bulletin 2002–1, dated January 7, 2002.
2002–4 I.R.B.iiiJanuary 28, 2002