Internal Revenue Bulletin 2004-36 (PDF rendition): IRS Revenue Rulings

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

Bulletin No. 200
4-36
September 7, 200
4
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. 2004–69, page 445.
Federal rates; adjusted federal rates; adjusted federal
long-term rate and the long-term exempt rate.For pur-
poses of sections 382, 642, 1274, 1288, and other sections
of the Code, tables set forth the rates for September 2004.
T.D. 9143,
page 442.
REG–20824
6–90, page 450.
Temporary
, final, and proposed regulations under section 861
of the Code
provide that deductions for charitable contributions
(as define
d in section 170(c)) are definitely related and alloca-
ble to all o
f the taxpayer’s gross income and are apportioned on
the basis
of income from sources within the United States. The
final reg
ulations, which provide that deductions for charitable
contribu
tions are not definitely related to any gross income and
therefor
e are ratably apportioned between or among the statu-
tory and
residual groupings, are removed. The proposed regu-
lations
withdraw proposed regulations, INTL-116–90, 1991–1
C.B. 949
. A public hearing on the proposed regulations is
schedul
ed for December 2, 2004. INTL-116–90 withdrawn.
T.D. 9144, page 413.
Final regulations under section 421 of the Code provide guid-
ance to taxpayers who are granted statutory stock options (i.e.,
incentive stock options and options granted under an employee
stock purchase plan) and corporations who grant such options.
The regulations also provide rules for the creation and opera-
tion of a statutory stock option plan.
T.D. 9146, page 408.
REG–152549–03, page 451.
Final, temporary, and proposed regulations under section 179
of the Code provide rules for making and revoking elections
to expense the cost of certain depreciable business property.
The regulations apply for property placed in service in taxable
years beginning after 2002 and before 2006. A public hearing
on the proposed regulations is scheduled for November 30,
2004.
REG–129771–04, page 453.
Proposed regulations under section 951(a) of the Code provide
guidance for determining a United States shareholder’spro rata
share of a controlled foreign corporation’s (CFC’s) subpart F in-
come, previously excluded subpart F income withdrawn from
investment in less developed countries, previously excluded
subpartFincomewithdrawnfromforeignbasecompanyship-
ping operations, and amounts determined under section 956.
A public hearing is scheduled for November 18, 2004.
Announcement 2004–67, page 459.
This document contains corrections to A-14 in Notice 2004–2,
2004–2 I.R.B. 269, relating to Health Savings Accounts.
Notice 2004–2 corrected.
EMPLOYEE PLANS
Notice 2004–59, page 447.
Alternative deficit reduction election; amendment fol-
lowing election.This notice provides guidance on the restric-
tions that are placed on plan amendments following an em-
ployer’s election of the alternative deficit reduction contribution
under § 412(l)(12) of the Code and section 302(d)(12) of the
Employee Retirement Income Security Act of 1974, as added
by section 102 of the Pension Funding Equity Act of 2004.
Fi
nding Lists begin on page ii.

The IRS Mission
Provide America’s taxpayers top quality service by helping
them understand and meet their tax responsibilities and by
applying the tax law with integrity and fairness to all.
Introduction
The Internal Revenue Bulletin is the authoritative instrument of
the Commissioner of Internal Revenue for announcing official
rulings and procedures of the Internal Revenue Service and for
publishing Treasury Decisions, Executive Orders, Tax Conven-
tions, legislation, court decisions, and other items of general
interest. It is published weekly and may be obtained from the
Superintendent of Documents on a subscription basis. Bulletin
contents are compiled semiannually into Cumulative Bulletins,
which are sold on a single-copy basis.
It is the policy of the Service to publish in the Bulletin all sub-
stantive rulings necessary to promote a uniform application of
the tax laws, including all rulings that supersede, revoke, mod-
ify, or amend any of those previously published in the Bulletin.
All published rulings apply retroactively unless otherwise indi-
cated. Procedures relating solely to matters of internal man-
agement are not published; however, statements of internal
practices and procedures that affect the rights and duties of
taxpayers are published.
Revenue rulings represent the conclusions of the Service on the
application of the law to the pivotal facts stated in the revenue
ruling. In those based on positions taken in rulings to taxpayers
or technical advice to Service field offices, identifying details
and information of a confidential nature are deleted to prevent
unwarranted invasions of privacy and to comply with statutory
requirements.
Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be
relied on, used, or cited as precedents by Service personnel in
the disposition of other cases. In applying published rulings and
procedures, the effect of subsequent legislation, regulations,
court decisions, rulings, and procedures must be considered,
and Service personnel and others concerned are cautioned
against reaching the same conclusions in other cases unless
the facts and circumstances are substantially the same.
The Bulletin is divided into four parts as follows:
Part I.—19
86 Code.
This part i
ncludes rulings and decisions based on provisions of
the Intern
al Revenue Code of 1986.
Part II.—Treaties and Tax Legislation.
This part is divided into two subparts as follows: Subpart A,
Tax Conventions and Other Related Items, and Subpart B, Leg-
islation and Related Committee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to these
subjects are contained in the other Parts and Subparts. Also
included in this part are Bank Secrecy Act Administrative Rul-
ings. Bank Secrecy Act Administrative Rulings are issued by
the Department of the Treasury’s Office of the Assistant Sec-
retary (Enforcement).
Part IV
.—Items of General Interest.
This par
t includes notices of proposed rulemakings, disbar-
ment an
d suspension lists, and announcements.
The last Bulletin for each month includes a cumulative index
for the matters published during the preceding months. These
monthly indexes are cumulated on a semiannual basis, and are
published in the last Bulletin of each semiannual period.
The c
ontents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.
For sale by the Superintendent of Documents, U.S.Government Printing Office, Washington, DC 20402.
September 7, 20042004–36 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Code
of 1986
Section 42.—Low-Income
Housing Credit
The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of September 2004. See Rev. Rul. 2004-69, page
445.
Section 179.—Election
to Expense Certain
Depreciable Business
Assets
26 CFR 1.179–2: Limitations on amount subject to
section 179 election.
T.D. 9146
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Part 1
Section 179 Elections
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final and temporary regula-
tions.
SUMMARY: This document contains tem-
porary regulations relating to the election
to expense the cost of property subject to
section 179 of the Internal Revenue Code.
The regulations reflect changes to the
law made by section 202 of the Jobs and
Growth Tax Relief Reconciliation Act of
2003. The text of these temporary regula-
tions also serves as the text of the proposed
regulations (REG–152549–03) set forth in
the notice of proposed rulemaking in this
issue of the Bulletin.
DATES:Effective Dates:These regula-
tions are effective August 4, 2004.
Applicability Dates:For dates of appli-
cability, see §1.179–6T.
FOR FURTHER INFORMATION
CONTACT: Winston H. Douglas, (202)
622–3110 (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 Administra-
tive Procedure Act (5 U.S.C. 553). For
this reason, the collection of information
contained in these regulations has been
reviewed and, pending receipt and eval-
uation of public comments, approved by
theOffice of Management and Budget
under control number 1545–1201. Re-
sponses to this collection of information
are required to obtain a benefit.
An agency may not conduct or sponsor,
and a person is not required to respond
to, a collection of information unless the
collection of information displays a valid
OMB control number.
For further information concerning this
collection of information, where to submit
comments on the collection of information
and the accuracy of the estimated burden,
and suggestions for reducing this burden,
please refer to the preamble to the cross-
referencing notice of proposed rulemaking
published in this issue of the Bulletin.
Books or records relating to a collection
of information must be retained as long as
their contents may become material in the
administration of any internal revenue law.
Generally, Federal tax returns and tax re-
turn information are confidential pursuant
to 26 U.S.C. 6103.
Background
This document contains amendments to
26 CFR part 1 to provide regulations un-
der section 179 of the Internal Revenue
Code (Code). These amendments reflect
the changes to the law made by section 202
of the Jobs and Growth Tax Relief Recon-
ciliation Act of 2003, Public Law 108–27
(117 Stat. 752).
Prior to the enactment of the Jobs and
Growth Tax Relief Reconciliation Act of
2003 (JGTRRA) (117 Stat. 752), section
179 provided that, in lieu of depreciation
under section 168 (MACRS depreciation)
for taxable years beginning in 2003 and
thereafter, a taxpayer with a sufficiently
small amount of current year investment in
section 179 property could elect to deduct
up to $25,000 of the cost of section 179
property placed in service by the taxpayer
for the taxable year. In general, section 179
property was defined as depreciable tangi-
ble personal property that was purchased
for use in the active conduct of a trade
or business. The $25,000 amount was re-
duced (but not below zero) by the amount
by which the cost of section 179 property
placed in service by the taxpayer during
the taxable year exceeded $200,000. The
election under section 179 generally was
made on the taxpayer’s original Federal
tax return for the taxable year to which the
election related, required specific informa-
tion to be provided at the time the election
was made, and could only be revoked with
the consent of the Commissioner of Inter-
nal Revenue.
The changes made to section 179 by
section 202 of JGTRRA are applicable
for section 179 property placed in service
by a taxpayer in taxable years beginning
after 2002 and before 2006. Section 202
of JGTRRA expands the definition of sec-
tion 179 property to include off-the-shelf
computer software (a category of intan-
gible property) and increases the $25,000
and $200,000 amounts to $100,000 and
$400,000, respectively. In addition, the
$100,000 and $400,000 amounts are in-
dexed annually for inflation for taxable
years beginning after 2003 and before
2006. JGTRRA also modifies section 179
to provide that any election or specifica-
tion for taxable years beginning after 2002
and before 2006 may be revoked by the
taxpayer with respect to any section 179
property, and that such revocation, once
made, shall be irrevocable. The confer-
ence agreement (H.R. Conf. Rep. No.
108–126, at 35 (2003)) states that a tax-
payer may make or revoke an expensing
election on an amended Federal tax return
without the consent of the Commissioner.
Explanation of Provisions
For taxable years beginning after 2002
and before 2006, the regulations reflect
the change to section 179(d)(1) by in-
cluding off-the-shelf computer software
in the definition of section 179 property,
2004–36 I.R.B.408September 7, 2004

and the changes to sections 179(b)(1) and
(2) by increasing the respective amounts
to $100,000 and $400,000. The regula-
tions also provide guidance for making
and revoking elections under section 179
for those taxable years. Several examples
areprovidedtoillustrate how taxpayers
may make and revoke their section 179
elections. Additionally, each year the IRS
will publish the annual inflation indexed
amounts for sections 179(b)(1) and (2).
For the inflation indexed amounts for tax-
able years beginning in 2004, see Rev.
Proc. 2003–85, 2003–49 I.R.B. 1184.
Making or Revoking Section 179 Elections
on Amended Federal Tax Returns
Prior to the enactment of JGTRRA, an
election to expense the cost of property
under section 179 generally was made on
the taxpayer’s original federal tax return
for the taxable year to which the election
applied. An election could only be re-
voked with the consent of the Commis-
sioner. The section 179 regulations (pre-
JGTRRA) provided that a revocation of an
election would only be granted in extraor-
dinary circumstances.
Small business taxpayers are often un-
aware of the advantages or disadvantages
of section 179 expensing. Some taxpay-
ers may not have been aware of the sec-
tion 179 election until after filing an orig-
inal Federal tax return. In addition, mak-
ing the section 179 election is not always
to a taxpayer’s advantage. For example,
the section 179 election may prevent the
taxpayer from fully using exemptions and
deductions, reduce a taxpayer’s coverage
under the social security system, and make
various tax credits unusable. See Internal
Revenue Service, Publication 946,“How
to Depreciate Property (For use in prepar-
ing 2003 Returns)”,p. 14,and“General
Explanations of the Administration’s Fis-
cal Year 2004 Revenue Proposals”, De-
partment of the Treasury, p. 23 (February
2003).
Permitting taxpayers to make or revoke
section 179 elections on amended Federal
tax returns without the consent of the Com-
missioner reflects Congress’ intent “that
the process of making and revoking sec-
tion 179 elections should be made simpler
and more efficient for taxpayers.” H.R.
Rep. No. 108–94, at 25 and 26 (2003) and
S. Prt. No. 108–26, at 10 (2003). Such
a process will provide flexibility to small
business taxpayers in determining whether
the section 179 election is to their advan-
tage or disadvantage.
Section 1.179–5T(c)(1) establishes the
time period during which a taxpayer may
make or revoke a section 179 election on
an amended Federal tax return.
Section 1.179–5T(c)(2) provides that a
section 179 election made on an amended
Federal tax return must specify the item
of section 179 property to which the elec-
tion applies and the portion of the cost of
each such item to be taken into account
under section 179. Further, if a taxpayer
elected to expense only a portion of the
cost basis of an item of section 179 prop-
erty for a particular taxable year (or did
not elect to expense any portion of the cost
basis of an item of section 179 property),
§1.179–5T(c)(2) allows the taxpayer to file
an amended Federal tax return and expense
any portion of the cost basis of an item of
section 179 property that was not expensed
pursuant to a prior section 179 election.
Any such increase in the amount expensed
under section 179 is not deemed to be a re-
vocation of the prior election for that par-
ticular taxable year.
Section 1.179–5T(c)(3) provides that
any election under section 179, or speci-
fication of such election, for any taxable
year beginning after 2002 and before 2006
for any item of section 179 property may
be revoked by the taxpayer on an amended
Federal tax return without the Commis-
sioner’s consent and that such revocation,
once made, is irrevocable. For this pur-
pose, aspecificationrefers to both the
selected specific item of section 179 prop-
erty subject to a section 179 election and
a selected dollar amount allocable to the
specific item of section 179 property. In
addition, §1.179–5T(c)(3) describes the
circumstances under which partial and
entire revocations of elections and spec-
ifications occur. Section 1.179–5T(c)(3)
also discusses the effect of a revocation of
an election under section 179 or a revoca-
tion of any specification of such election.
Section 1.179–5T(c)(4) sets forth ex-
amples illustrating the rules of paragraphs
(c)(1), (2), and (3).
Section 1.179–6T provides the ap-
plicability dates for the provisions of
§§1.179–2T, 1.179–4T, and 1.179–5T.
Special Analyses
It has been determined that this Trea-
sury decision is not asignificant regula-
tory action as defined in Executive Order
12866. Therefore, a regulatory assessment
is not required. It also has been deter-
mined that section 553(b) of the Admin-
istrative Procedure Act (5 U.S.C. chapter
5) does not apply to these regulations. For
the applicability of the Regulatory Flexi-
bility Act (5 U.S.C. chapter 6), refer to the
Special Analyses section of the preamble
to the cross-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 Advo-
cacy of the Small Business Administration
for comment on its impact on small busi-
ness.
Drafting Information
The principal author of these regula-
tions is Winston H. Douglas, Office of As-
sociate Chief Counsel (Passthroughs and
Special Industries). However, other per-
sonnel from the IRS and Treasury Depart-
ment participated in their development.
*****
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR part 1 is amended
as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.179–0 is amended as
follows:
1. Paragraphs (b)(1) and (b)(2) of
§1.179–2 are revised.
2. Section 1.179–2T is added.
3. Paragraph (a) of §1.179–4 is revised.
4. Section 1.179–4T is added.
5. Paragraph (c) of §1.179–5 is added.
6. Section 1.179–5T is added.
7. Section 1.179–6T is added.
The revisions and additions read as fol-
lows:
§1.179–0 Table of contents for section
179 expensing rules.
*****
September 7, 20044092004–36 I.R.B.

§1.179–2 Limitations on amount subject
to section 179 election.
*****
(b) * * *
(1) [Reserved].
(2) [Reserved].
*****
§1.179–2T Limitations on amount subject
to section 179 election (temporary).
(a) [Reserved].
(b) Dollar Limitation.
(1) In general.
(2) Excess section 179 property.
(3) through (d) [Reserved].
*****
§1.179–4 Definitions.
(a) Section 179 property [Reserved].
*****
§1.179–4T Definitions.
(a) Section 179 property.
(b) through (f) [Reserved].
§1.179–5 Time and manner of making
election.
*****
(c) Section 179 property placed in ser-
vice by the taxpayer in a taxable year be-
ginning after 2002 and before 2006.
§1.179–5T Time and manner of making
election.
(a) and (b) [Reserved].
(c) Section 179 property placed in ser-
vice by the taxpayer in a taxable year be-
ginning after 2002 and before 2006.
*****
§1.179–6T Effective dates.
(a) In general.
(b) Section 179 property placed in ser-
vice by the taxpayer in a taxable year be-
ginning after 2002 and before 2006.
Par. 3. Section 1.179–2 is amended by
revising paragraphs (b)(1) and (b)(2)(ii) to
read as follows:
§1.179–2 Limitations on amount subject
to section 179 election.
*****
(b) * * *
(1) [Reserved]. For further guidance,
see §1.179–2T(b)(1).
(2) * * *
(i) * * *
(ii) [Reserved]. For further guidance,
see §1.179–2T(b)(2)(ii).
*****
Par. 4. Section 1.179–2T is added to
read as follows:
§1.179–2T Limitations on amount subject
to section 179 election (temporary).
(a) [Reserved]. For further guidance,
see §1.179–2(a).
(b)Dollar limitation—(1)In general.
The aggregate cost of section 179 prop-
erty that a taxpayer may elect to expense
under section 179 for any taxable year be-
ginning in 2003 and thereafter is $25,000
($100,000 in the case of taxable years be-
ginning after 2002 and before 2006 un-
der section 179(b)(1), indexed annually for
inflation under section 179(b)(5) for tax-
able years beginningafter 2003 and before
2006), reduced (but not below zero) by the
amount of any excess section 179 property
(described in paragraph (b)(2) of this sec-
tion) placed in service during the taxable
year.
(b)(2) and (b)(2)(i) [Reserved]. For
further guidance, see §1.179–2(b)(2) and
(b)(2)(i).
(ii) $200,000 ($400,000 in the case of
taxable years beginning after 2002 and
before 2006 under section 179(b)(2), in-
dexed annually for inflation under section
179(b)(5) for taxable years beginning after
2003 and before 2006).
(b)(3) through (d) [Reserved]. For fur-
ther guidance, see §1.179–2(b)(3) through
(d).
Par. 5. Section 1.179–4 is amended by
revising paragraph (a) to reads as follows:
§1.179–4 Definitions.
*****
(a) [Reserved]. For further guidance,
see §1.179–4T(a).
*****
Par. 6. Section 1.179–4T is added to
read as follows:
§1.179–4T Definitions (temporary).
The following definitions apply for pur-
poses of section 179, §§1.179–1 through
1.179–6, and §§1.179–2T, 5T, and 6T:
(a)Section 179 property.Thetermsec-
tion 179 propertymeans any tangible prop-
erty described in section 179(d)(1) that is
acquired by purchase for use in the active
conduct of the taxpayer’s trade or business
(as described in §1.179–2(c)(6)). For tax-
able years beginning after 2002 and be-
fore 2006, the termsection 179 property
includes computer software described in
section 179(d)(1) that is placed in service
by the taxpayer in a taxable year begin-
ning after 2002 and before 2006 and is ac-
quired by purchase for use in the active
conduct of the taxpayer’s trade or business
(as described in §1.179–2(c)(6)). For pur-
poses of this paragraph (a), the termtrade
or businesshas the same meaning as in sec-
tion 162 and the regulations thereunder.
(b) through (f) [Reserved]. For further
guidance, see §1.179–4(b) through (f).
Par. 7. Section 1.179–5 is amended by
adding paragraph (c) to read as follows:
§1.179–5 Time and manner of making
election.
*****
(c)Section 179 property placed in ser-
vice by the taxpayer in a taxable year
beginning after 2002 and before 2006.
[Reserved]. For further guidance, see
§1.179–5T(c).
Par. 8. Section 1.179–5T is added to
read as follows:
§1.179–5T Time and manner of making
election (temporary).
(a) and (b) [Reserved]. For further
guidance, see §1.179–5(a) and (b).
(c)Section 179 property placed in ser-
vice by the taxpayer in a taxable year be-
ginning after 2002 and before 2006—(1)
In general. For any taxable year begin-
ning after 2002 and before 2006, a tax-
payer is permitted to make or revoke an
election under section 179 without the con-
sent of the Commissioner on an amended
Federal tax return for that taxable year.
This amended return must be filed within
the time prescribed by law for filing an
amended return for such taxable year.
(2)Election—(i)In general.Forany
taxable year beginning after 2002 and
2004–36 I.R.B.410September 7, 2004

before 2006, a taxpayer is permitted to
make an election under section 179 on an
amended Federal tax return for that taxable
year without the consent of the Commis-
sioner. Thus, the election under section
179 and §1.179–1 to claim a section 179
expense deduction for section 179 prop-
erty may be made on an amended Federal
tax return for the taxable year to which the
election applies. The amended Federal tax
return must include the adjustment to tax-
able income for the section 179 election
and any collateral adjustments to taxable
income or to the tax liability (for example,
the amount of depreciation allowed or al-
lowable in that taxable year for the item of
section 179 property to which the election
pertains). Such adjustments must also be
made on amended Federal tax returns for
any affected succeeding taxable years.
(ii)Specifications of election.Any
election under section 179 must specify
the items of section 179 property and the
portion of the cost of each such item to be
taken into account under section 179(a).
Any election under section 179 must com-
ply with the specification requirements
of section 179(c)(1)(A), §1.179–1(b), and
§1.179–5(a). If a taxpayer elects to ex-
pense only a portion of the cost basis
of an item of section 179 property for
a taxable year beginning after 2002 and
before 2006 (or did not elect to expense
any portion of the cost basis of the item
of section 179 property), the taxpayer is
permittedtofileanamendedFederaltax
return for that particular taxable year and
increase the portion of the cost of the item
of section 179 property to be taken into
account under section 179(a) (or elect to
expense any portion of the cost basis of
the item of section 179 property if no prior
election was made) without the consent of
the Commissioner. Any such increase in
the amount expensed under section 179 is
not deemed to be a revocation of the prior
election for that particular taxable year.
(3)Revocation—(i)In general. Section
179(c)(2) permits the revocation of an en-
tire election or specification, or a portion
of the selected dollar amount of a specifi-
cation. The termspecificationin section
179(c)(2) refers to both the selected spe-
cific item of section 179 property subject
to a section 179 election and the selected
dollar amount allocableto the specific item
of section 179 property. Any portion of the
cost basis of an item of section 179 prop-
erty subject to an election under section
179 for a taxable year beginning after 2002
and before 2006 may be revoked by the
taxpayer without the consent of the Com-
missioner by filing an amended Federal tax
return for that particular taxable year. The
amended Federal tax return must include
the adjustment to taxable income for the
section 179 revocation and any collateral
adjustments to taxable income or to the tax
liability (for example, allowable depreci-
ation in that taxable year for the item of
section 179 property to which the revoca-
tion pertains). Such adjustments must also
be made on amended Federal tax returns
for any affected succeeding taxable years.
Reducing or eliminating a specified dollar
amount for any item of section 179 prop-
erty with respect to any taxable year begin-
ning after 2002 and before 2006 results in a
revocation of that specified dollar amount.
(ii)Effect of revocation. Such revoca-
tion, once made, shall be irrevocable. If
the selected dollar amount reflects the en-
tire cost of the item of section 179 property
subject to the section 179 election, a revo-
cation of the entire selected dollar amount
is treated as a revocation of the section 179
election for that item of section 179 prop-
erty and the taxpayer is unable to make a
new section 179 election with respect to
that item of property. If the selected dol-
lar amount is a portion of the cost of the
item of section 179 property, revocation of
a selected dollar amount shall be treated
as a revocation of only that selected dol-
lar amount. The revoked dollars cannot be
the subject of a new section 179 election
for the same item of property.
(4)Examples. The following examples
illustrate the rules of this paragraph (c):
Example 1. Taxpayer, a sole proprietor, owns
and operates a jewelry store. During 2003, Taxpayer
purchased and placed in service two items of sec-
tion 179 property — a cash register costing $4,000
(5-year MACRS property) and office furniture cost-
ing $10,000 (7-year MACRS property). On his 2003
Federal tax return filed on April 15, 2004, Taxpayer
elected to expense under section 179 the full cost of
the cash register and, with respect to the office furni-
ture, claimed the depreciation allowable. In Novem-
ber 2004, Taxpayer determines it would have been
more advantageous to have made an election under
section 179 to expense the full cost of the office fur-
niture rather than the cash register. Pursuant to para-
graph (c)(1) of this section, Taxpayer is permitted to
file an amended Federal tax return for 2003 revoking
the section 179 election for the cash register, claiming
the depreciation allowable in 2003 for the cash regis-
ter, and making an election to expense under section
179 the cost of the office furniture. The amended re-
turn must include an adjustment for the depreciation
previously claimed in 2003 for the office furniture,
an adjustment for the depreciation allowable in 2003
for the cash register, and any other collateral adjust-
ments to taxable income or to the tax liability. In addi-
tion, once Taxpayer revokes the section 179 election
for the entire cost basis of the cash register, Taxpayer
can no longer expense under section 179 any portion
of the cost of the cash register.
Example 2. Taxpayer, a sole proprietor, owns
and operates a machine shop that does specialized
repair work on industrial equipment. During 2003,
Taxpayer purchased and placed in service one item
of section 179 property — a milling machine cost-
ing $135,000. On Taxpayer’s 2003 Federal tax return
filedonApril15,2004,Taxpayerelectedtoexpense
under section 179 $5,000 of the cost of the milling
machine and claimed allowable depreciation on the
remaining cost. Subsequently, Taxpayer determines
it would have been to Taxpayer’s advantage to have
elected to expense $100,000 of the cost of the milling
machine on Taxpayer’s 2003 Federal tax return. In
November 2004, Taxpayer files an amended Federal
tax return for 2003, increasing the amount of the cost
of the milling machine that is to be taken into account
under section 179(a) to $100,000, decreasing the de-
preciation allowable in 2003 for the milling machine,
and making any other collateral adjustments to tax-
able income or to the tax liability. Pursuant to para-
graph (c)(2)(ii) of this section, increasing the amount
of the cost of the milling machine to be taken into ac-
count under section 179(a) supplements the portion of
the cost of the milling machine that was already taken
into account by the original section 179 election made
on the 2003 Federal tax return and no revocation of
any specification with respect to the milling machine
has occurred.
Example 3. Taxpayer, a sole proprietor, owns and
operates a real estate brokerage business located in
a rented storefront office. During 2003, Taxpayer
purchases and places in service two items of section
179 property — a laptop computer costing $2,500
and a desktop computer costing $1,500. On Tax-
payer’s 2003 Federal tax return filed on April 15,
2004, Taxpayer elected to expense under section 179
the full cost of the laptop computer and the full cost
of the desktop computer. Subsequently, Taxpayer de-
termines it would have been to Taxpayer’s advantage
to have originally elected to expense under section
179 only $1,500 of the cost of the laptop computer
on Taxpayer’s 2003 Federal tax return. In November
2004, Taxpayer files an amended Federal tax return
for 2003 reducing the amount of the cost of the laptop
computer that was taken into account under section
179(a) to $1,500, claiming the depreciation allowable
in 2003 on the remaining cost of $1,000 for that item,
and making any other collateral adjustments to tax-
able income or to the tax liability. Pursuant to para-
graph (c)(3)(ii) of this section, the $1,000 reduction
represents a revocation of a portion of the selected
dollar amount and no portion of those revoked dol-
lars may be the subject of a new section 179 election
for the laptop computer.
Example 4. Taxpayer, a sole proprietor, owns and
operates a furniture making business. During 2003,
Taxpayer purchases and places in service one item
of section 179 property — an industrial-grade cabi-
net table saw costing $5,000. On Taxpayer’s 2003
Federal tax return filed on April 15, 2004, Taxpayer
September 7, 20044112004–36 I.R.B.

elected to expense under section 179 $3,000 of the
cost of the saw and, with respect to the remaining
$2,000 of the cost of the saw, claimed the depreci-
ation allowable. In November 2004, Taxpayer files
an amended Federal tax return for 2003 revoking the
selected $3,000 amount for the saw, claiming the de-
preciation allowable in 2003 on the $3,000 cost of the
saw, and making any other collateral adjustments to
taxable income or to the tax liability. Subsequently,
in December 2004, Taxpayer files a second amended
Federal tax return for 2003 selecting a new dollar
amount of $2,000 for the saw, including an adjust-
ment for the depreciation previously claimed in 2003
on the $2,000, and making any other collateral adjust-
ments to taxable income or to the tax liability. Pur-
suant to paragraph (c)(2)(ii) of this section, Taxpayer
is permitted to select a new selected dollar amount to
expense under section 179 encompassing all or a part
of the initially non-elected portion of the cost of the
elected item of section 179 property. However, no
portion of the revoked $3,000 may be the subject of a
new section 179 dollar amount selection for the saw.
In December 2005, Taxpayer files a third amended
Federal tax return for 2003 revoking the entire se-
lected $2,000 amount with respect to the saw, claim-
ing the depreciation allowable in 2003 for the $2,000,
and making any other collateral adjustments to tax-
able income or to the tax liability. Because Taxpayer
elected to expense, and subsequently revoke, the en-
tire cost basis of the saw, the section 179 election for
the saw has been revoked and Taxpayer is unable to
make a new section 179 election with respect to the
saw.
Par. 9. Section 1.179–6T is added to
read as follows:
§1.179–6T Effective dates.
(a)In general. Except as provided in
paragraph (b) of this section, the provi-
sions of §§1.179–1 through 1.179–5 apply
for property placed in service by the tax-
payer in taxable years ending after January
25, 1993. However, a taxpayer may ap-
ply the provisions of §§1.179–1 through
1.179–5 to property placed in service by
the taxpayer after December 31, 1986, in
taxable years ending on or before January
25, 1993. Otherwise, for property placed
in service by the taxpayer after Decem-
ber 31, 1986, in taxable years ending on
or before January 25, 1993, the final regu-
lations under section179 as in effect for
the year the property was placed in ser-
vice apply, except to the extent modified
by the changes made to section 179 by the
Tax Reform Act of 1986 (100 Stat. 2085),
the Technical and Miscellaneous Revenue
Act of 1988 (102 Stat. 3342) and the
Revenue Reconciliation Act of 1990 (104
Stat. 1388–400). For that property, a tax-
payer may apply any reasonable method
that clearly reflects income in applying the
changes to section 179, provided the tax-
payer consistently applies the method to
the property.
(b)Section 179 property placed in ser-
vice by the taxpayer in a taxable year be-
ginning after 2002 and before 2006.The
provisions of §§1.179–2T, 1.179–4T, and
1.179–5T, reflecting changes made to sec-
tion179bytheJobsandGrowthTaxRe-
lief Reconciliation Act of 2003 (117 Stat.
752), apply for property placed in service
in taxable years beginning after 2002 and
before 2006.
PART 602—OMB CONTROL
NUMBERS UNDER THE PAPERWORK
REDUCTION ACT
Par. 10. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 11. In §602.101, paragraph (b) is
amended by adding the following entries
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.
*****
1.179–2T........................................................... 1545–1201
*****
1.179–5T........................................................... 1545–1201
*****
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
Approved July 21, 2004.
Gregory F. Jenner,
Acting Assistant Secretary of the
Treasury (Tax Policy).
(Filed by the Office of the Federal Register on August 3,
2004, 8:45 a.m., and published in the issue of the Federal
Register for August 4, 2004, 69 F.R. 46982)
Section 280G.—Golden
Parachute Payments
Federal short-term, mid-term, and long-term rates
are set forth for the month of September 2004. See
Rev. Rul. 2004-69, page 445.
Section 382.—Limitation
on Net Operating Loss
Carryforwards and Certain
Built-In Losses Following
Ownership Change
The adjusted applicable federal long-term rate is
set forth for the month of September 2004. See Rev.
Rul. 2004-69, page 445.
Section 412.—Minimum
Funding Standards
The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of September 2004. See Rev. Rul. 2004-69, page
445.
2004–36 I.R.B.412September 7, 2004

Section 421.—General
Rules
26 CFR 1.421–1: Meaning and use of certain terms.
T.D. 9144
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Part 1 and 14a
Statutory Options
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains final
regulations relating to statutory options.
These final regulations affect certain tax-
payers who participate in the transfer of
stock pursuant to the exercise of incentive
stock options and the exercise of options
granted pursuant to an employee stock pur-
chase plan (statutoryoptions). These reg-
ulations provide guidance to assist these
taxpayers in complying with the law in ad-
dition to clarifying rules regarding statu-
tory options.
DATES:Effective Date:These regulations
are effective on August 3, 2004. For rules
concerning reliance and transition pe-
riod, see §§1.421–1(j)(2), 1.421–2(f)(2),
1.422–5(f)(2), and 1.424–1(g)(2).
FOR FURTHER INFORMATION
CONTACT: Concerning the regulations,
please contact Erinn Madden at (202)
622–6030 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained
in these final regulations (see §1.6039–1)
has been reviewed and approved by the Of-
fice of Management and Budget in accor-
dance with the Paperwork Reduction Act
(44 U.S.C. 3507) under control number
1545–0820. Responses to this collection
of information are required to assist tax-
payers with the completion of their income
tax returns for the taxable year in which
a disposition of statutory option stock oc-
curs.
An agency may not conduct or sponsor,
and a person is not required to respond
to, a collection of information unless the
collection of information displays a valid
control number assigned by the Office of
Management and Budget.
The estimated annual burden per re-
spondent varies from 15 minutes to 25
minutes, depending on individual circum-
stances, with an estimated average of 20
minutes.
Comments concerning the accuracy
of this burden estimate and sugges-
tions for reducing this burden should
be sent to the Internal Revenue Service,
Attn: IRS Reports Clearance Officer,
SE:W:CAR:MP:T:T:SP, Washington, DC
20224, and to the Office of Manage-
ment and Budget, Attn: Desk Officer for
the Department of the Treasury, Office
of Information and Regulatory Affairs,
Washington, DC 20503.
Books or records relating to this col-
lection 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 re-
quired by 26 U.S.C. 6103.
Background
This document contains amendments to
26 CFR part 1 under sections 421, 422, and
424 of the Internal Revenue Code (Code).
Changes to the applicable tax law con-
cerning section 421 were made by sections
11801 and 11821 of the Omnibus Budget
Reconciliation Act of 1990 (OBRA 90),
Public Law 101–508 (104 Stat. 1388).
Changes to the applicable tax law con-
cerning section 424 were made by sec-
tion 1003 of the Technical and Miscella-
neous Revenue Act of 1988 (TAMRA),
Public Law 100–647 (102 Stat. 3342),
sections 11801 and 11821 of OMBRA 90,
which included re-designating section 425
as section 424 of the Code, and section
1702(h) of the Small Business Job Pro-
tection Act of 1996, Public Law 104–88
(110 Stat. 1755). Changes concerning
section 422 were made by section 251 of
the Economic Recovery Tax Act of 1981,
Public Law 97–34 (95 Stat. 172), which
added section 422A to the Code. Re-
lated changes to section 422A were made
by section 102(j) of the Technical Correc-
tions Act of 1982, Public Law 97–448 (96
Stat. 2365), section 321(a) of Tax Re-
form Act of 1986, Public Law 99–514 (100
Stat. 2085), section 1003(d) of TAMRA,
and sections 11801 and 11821 of OBRA
90, which included re-designating section
422A as section 422 of the Code.
Regulations under section 421 govern-
ing the requirements for restricted stock
options and qualified stock options, as
well as options granted under an employee
stock purchase plan, were published in the
Federal Registeron December 9, 1957
(T.D. 6276, 1957–2 C.B. 271), November
26, 1960 (T.D. 6500), January 19, 1961
(T.D. 6527, 1961–1 C.B. 153), January 20,
1961 (T.D. 6540, 1961–1 C.B. 161), De-
cember 12, 1963 (T.D. 6696, 1963–2 C.B.
23), June 24, 1966 (T.D. 6887, 1966–2
C.B. 129), July 24, 1978 (T.D. 7554,
1981–1 C.B. 56), and November 3, 1980
(T.D. 7728, 1980–2 C.B. 236). Temporary
regulations under section 422A providing
guidance and transitional rules related to
incentive stock options were published in
theFederal Registeron December 17,
1981 (T.D. 7799, 1982–1 C.B. 67) and
September 18, 1992 (T.D. 8435, 1992–2
C.B. 324). Final regulations under section
422 related to stockholder approval were
published in theFederal Registeron De-
cember 1, 1988 (T.D. 8235, 1989–1 C.B.
117) and November 29, 1991 (T.D. 8374,
1991–2 C.B. 320). Regulations under sec-
tion 425 were published in theFederal
Registeron June 23, 1966 (T.D. 6887,
1966–2 C.B. 129).
Proposed changes to the final reg-
ulations under sections 421, 424, and
6039 and proposed regulations under
section 422A were previously published
in theFederal Registerat 49 FR 4504
(LR–279–81, 1984–1 C.B. 714) on Feb-
ruary 7, 1984 (the 1984 proposed regu-
lations). With the exception of certain
stockholder approval rules, the 1984 pro-
posed regulations provided a comprehen-
sive set of rules under section 422 of the
Code. The 1984 proposed regulations and
the temporary regulations have been with-
drawn. See 68 FR 34344.
On June 9, 2003, a notice of proposed
rulemaking (REG–122917–02, 2003–27
I.R.B. 15) was published in theFed-
eral Registerat 68 FR 34344 (the 2003
proposed regulations). No hearing con-
cerning the 2003 proposed regulations was
held; however, the IRS received written
and electronic comments responding to
September 7, 20044132004–36 I.R.B.

this notice. After consideration of these
comments, the 2003 proposed regulations
are adopted as amended by this Treasury
decision. The significant revisions are
discussed below.
Explanation of Provisions
Overview
In general, the income tax treatment of
the grant of an option to purchase stock
in connection with the performance of ser-
vices and of the transfer of stock pursuant
to the exercise of such option is determined
under section 83 of the Code and the reg-
ulations thereunder. However, section 421
of the Code provides special rules for de-
termining the income tax treatment of the
transfer of shares of stock pursuant to the
exercise of an option if the requirements of
section 422(a) or 423(a), as applicable, are
met. Section 422 applies to incentive stock
options, and section 423 applies to options
granted under an employee stock purchase
plan (collectively,statutory options).
Under section 421, if a share of stock is
transferred to an individual pursuant to the
exercise of a statutory option, there is no
income at the time of exercise of the op-
tion with respect to such transfer, and no
deduction under section 162 is allowed to
the employer corporation with respect to
such transfer. However, pursuant to sec-
tion 56(b)(3), section 421 does not apply
with respect to the exercise of an incentive
stock option for purposes of the individual
alternative minimum tax.
Section 422(a) of the Code provides
that section 421 applies to the transfer of
stock to an individual pursuant to the ex-
ercise of an incentive stock option if (i) no
disposition of the share is made within 2
years from the date of grant of the option
or within 1 year from the date of trans-
fer of the share, and (ii) at all times dur-
ing the period beginning on the date of
grant and ending on the day 3 months be-
fore the exercise of the option, the indi-
vidual is an employee of either the corpo-
ration granting the option or a parent or
subsidiary of such corporation, or a cor-
poration (or a parent or subsidiary of such
corporation) issuing or assuming a stock
option in a transaction to which section
424(a) applies. Section 422(b) provides
several requirements that must be met for
an option to qualify as an incentive stock
option. Section 422(c) provides special
rules applicable to incentive stock options,
and section 422(d) provides a $100,000 per
year limitation with respect to incentive
stock options.
Section 424 of the Code provides spe-
cial rules applicable to statutory options,
including rules concerning the modifica-
tion of statutory options and the substitu-
tion or assumption of an option by reason
of a corporate merger, consolidation, ac-
quisition of property or stock, separation,
reorganization, or liquidation. Section 424
also contains definitions of certain terms,
includingdisposition,parent corporation,
andsubsidiary corporation. Finally, sec-
tion 424 provides special rules related to
attribution of stock ownership and the ef-
fect of stockholder approval on the date of
grant of a statutory option.
These final regulations provide com-
prehensive rules governing incentive stock
options that, as did the 2003 proposed reg-
ulations, incorporate many of the rules
contained in the 1984 proposed regu-
lations. However, the 2003 proposed
regulations are re-numbered, and these
final regulations adopt that reorganization.
These final regulations also make changes
to the final regulations under sections 421
and 424 to provide additional guidance,
as discussed below, in certain areas, to
reflect the new organizational structure of
the statutory option rules (including the
re-designation of §1.425–1 as §1.424–1),
and to remove obsolete rules and cross-ref-
erences.
Section 421: General Rules
Sections 422 and 423 provide that a
statutory option may be granted to an in-
dividual who is an employee of the cor-
poration granting the option, a parent or
subsidiary of such corporation, or a cor-
poration or a parent or subsidiary of such
corporation issuing or assuming a stock
option in a transaction to which section
424(a) applies.
Section 1.421–1(h) of the 2003 pro-
posed regulations further describes the
requisite employment relationship for pur-
poses of a statutory option. The 2003
proposed regulations provide that an op-
tion is a statutory option only if, at the
time the option is granted, the optionee is
an employee of the corporation granting
the option or a related corporation of such
corporation. In the case of an assumption
or substitution under §1.424–1(a), the op-
tionee must, at the time of the assumption
or substitution, be an employee of the
corporation assuming or substituting the
option or a related corporation of such
corporation. In response to comments,
these final regulations provide that in the
case of an assumption or substitution un-
der §1.424–1(a) an option also will be
treated as granted to an employee of the
granting corporation if the optionee is an
individual who is in the 3-month period
following termination of the employment
relationship.
Section §1.421–1(h)(2) of the 2003
proposed regulations also provides that
the employment relationship is considered
to continue intact while an individual is on
military leave, sick leave, or otherbona
fideleave of absence if the period of leave
does not exceed 3 months, or if longer,
so long as the individual’s right to reem-
ployment with the corporation granting
the option (or a related corporation of such
corporation) or a corporation assuming or
substituting an option under §1.424–1(a)
is guaranteed by statute or contract. Com-
mentors requested clarificationinthefinal
regulations concerning whether the right
to reemployment must be absolute and
whether the right to reemployment pro-
vided by the Family Medical Leave Act or
the Uniformed Services Employment and
Reemployment Rights Act satisfies the
requirements of this section. These final
regulations provide that the right to reem-
ployment must be provided by statute or
contract. Thus, for example, if an optionee
is on leave pursuant to the Family Med-
ical Leave Act, the Uniformed Services
Employment and Reemployment Rights
Act, or any similar statute providing for
continued employment rights for an ex-
tended period of time, the employment
relationship is considered intact.
Section 422: Incentive Stock Options
1. Special rules regarding disqualifying
dispositions
The general rules concerning dis-
qualifying dispositions are described in
§1.421–2(b) of the 2003 proposed regula-
tions. Under these rules, if there is a dis-
qualifying disposition of a share of stock,
the special tax treatment provided by sec-
2004–36 I.R.B.414September 7, 2004

tion 421 and §1.421–2(a) does not apply
to the transfer of the share. The effects of
a disqualifying disposition are determined
under section 83(a). Thus, in the taxable
year in which the disqualifying disposi-
tion occurs, the individual must recognize
compensation income equal to the fair
market value of the stock (determined
without regard to any lapse restriction and
without regard to any reduction for any
brokerage fees or other costs paid in con-
nection with the disposition) on the date
the stock is substantially vested less the
exercise price. (See section 422(c)(2) con-
cerning special rules that are applicable
where the amount realized in a disposition
is less than this difference.) A deduction
is allowable for the taxable year in which
such disqualifying disposition occurs to
the employer corporation, its parent or
subsidiary corporation, or a corporation
substituting or assuming an option in a
transaction to which §1.424–1(a) applies.
Section 422(c)(2) and §1.422–1(b) of the
2003 proposed regulations provide special
rules concerning disqualifying disposi-
tions.
The application of the disqualifying
disposition rules is described in several
examples in §1.422–1(b)(3) of the 2003
proposed regulations. InExample 1of
§1.422–1(b)(3) of the 2003 proposed reg-
ulations, on exercise of an incentive stock
option, the optionee receives vested stock
and disposes of the stock before meet-
ing the applicable holding period. In this
example, the amount of compensation in-
come is based on the fair market value of
thestockonthedateofexerciselessthe
exercise price, and the section 422(a)(1)
holding period is based on the date of
exercise.
However, inExample 2of §1.422–1
(b)(3) of the 2003 proposed regulations,
the optionee receives nonvested stock on
exercise of an incentive stock option. This
example retains the same holding period
for the receipt of nonvested stock, but
computes the amountof compensation
income based on the date of vesting of the
underlying stock (rather than the date of
exercise).
Several commentors suggested that if
the option is exercised for nonvested stock
the compensation income should not be
calculated on the date of vesting because
section 83 does not apply to a transaction
to which section 421 applies (and section
421(b) applies to a disqualifying disposi-
tion). Instead, the compensation income
should be computed on the date of exer-
cise. Alternatively, if the proposed rule is
retained, commentors suggest that the fi-
nal regulations and examples provide that
an optionee may make a protective section
83(b) election on exercise of the option.
These final regulations retain the
rules described in the 2003 proposed
regulations, however, the examples in
§1.422–1(b)(3) of the final regulations
more fully describe the application of the
disqualifying disposition rules. Specifi-
cally,Example 2indicates that pursuant to
section 83(e)(1) of the Code, section 83
does not apply to a transaction to which
section 421 applies. Thus, on exercise of a
statutory option section 83 does not apply,
and an optionee cannot make an effective
election under section 83(b) for purposes
of the income tax consequences on the
date of exercise. However, an effective
election under section 83(b) may be made
forpurposesofthealternativeminimum
tax, which calculates income as if section
83 applies.Example 2also illustrates that
on a disqualifying disposition, the rules of
section 83 and the regulations thereunder
(rather than section 422 and the regula-
tions thereunder) are used to determine
the amount of compensation includible
in income. Applying the rules under sec-
tion 83(a), the amount of compensation
includible is the difference between the
fair market value of the stock on the date
the substantial risk of forfeiture lapses
less the fair market value on the date of
exercise. Additionally,Example 2demon-
strates that there is a transfer (as defined in
§1.421–1(g) of the final regulations) of the
stock on the date of exercise for purposes
of the holding period requirement of sec-
tion 422(a)(1). Thus, the holding period
for the transfer of the stock for purposes
of section 422 and the holding period re-
quirements begins on the date of exercise
(rather than the date of vesting). See also,
§1.422–1(b)(3),Example 3. However, in
the event of a disqualifying disposition,
the amount of capital gain (if any) and the
holding period for purposes of determin-
ing capital gain is computed from the date
of vesting.
2. Shareholder approval
Among other requirements, to qualify
as an incentive stock option, the option
must be granted pursuant to a plan which is
approved by the stockholders of the grant-
ing corporation within 12 months before
or after the date the plan is adopted. See
section 422(b) and §1.422–2(b)(2)(i) of the
2003 proposed regulations.
These final regulations retain the
rules contained in the 2003 proposed
regulations concerning shareholder ap-
proval. However, an additional example
in §1.422–2(b)(6) illustrates the share-
holder approval requirements where an
incentive stock option plan is assumed in
connection with a corporate transaction.
See §1.422–2(b)(6),Example 3.
InExample 3of §1.422–2(b)(6) of
these final regulations, Corporation X
maintains an incentive stock option plan,
but Corporation Y does not maintain such
a plan. The companies combine to form
one corporation that will be named Y, the
plan will be continued by Y, and future
grants under the plan will be made by
Y (the new combined entity). The con-
solidation agreement describes the plan,
including the maximum aggregate number
of shares available for issuance pursuant
to incentive stock options under the plan
after the consolidation and the employees
eligible to receive options under the plan.
Because there is a change in the granting
corporation under §1.422–2(b)(3)(iii), Y
is considered to have adopted a new plan
that must satisfy the shareholder approval
requirements. In this example, because
the consolidation agreement describes the
plan and indicates that it will continue
after the consolidation, the shareholder
approval requirements of §1.422–2(b)(3)
are satisfied, and the plan is considered
adopted and approved on the date the con-
solidation agreement is approved. See
Rev. Rul. 68–233, 1968–1 C.B. 187.
3. Maximum aggregate number of shares
Section 422(b)(1) provides that an in-
centive stock option must be granted pur-
suant to a plan that includes the aggre-
gate number of shares which may be issued
under options. Section 1.422–2(b)(3)(i)
of the 2003 proposed regulations provides
that the plan must designate the maximum
aggregate number of shares that may be
September 7, 20044152004–36 I.R.B.

issued under the plan through incentive
stock options, nonstatutory options, and all
other stock-based awards to be granted un-
der the plan.
In response to comments, these final
regulations provide that the plan must des-
ignate the maximum aggregate number of
shares that may be issued under the plan
through incentive stock options. Thus,
for example, if a corporation maintains
an omnibus plan under which incentive
stock options, nonstatutory options, and
other stock-based awards may be made,
the plan must contain a maximum number
of shares that may be issued as incentive
stock options under the plan. Such a num-
ber may be expressed as a limit specific to
incentive stock options or as a limit on all
awards under the plan, including incentive
stock options. These final regulations do
not require the plan to include the maxi-
mum number of shares that may be issued
pursuant to nonstatutory options or other
stock-based awards.
Commentators also asked whether the
maximum aggregate number of shares that
may be issued under an incentive stock
option plan is affected by the use of out-
standing shares used to exercise an option.
Under these final regulations, only the net
number of shares that are issued pursuant
to the exercise of a statutory option are
counted against the maximum aggregate
number of shares. For example, if the ex-
ercise price of an option to purchase 100
shares equals the value of 20 shares, and
the corporation permits the employee to
use those 20 of the 100 shares to pay the
exercise price of the option, and the cor-
poration only issues 80 shares to the op-
tionee, then 80 shares are counted against
the maximum aggregate number of shares
(rather than 100).
4. Option price
Under section 422(b)(4), the option
price of an incentive stock option must
not be less than the fair market value of
the stock at the time the option is granted.
The 2003 proposed regulations retain this
rule, but also provide that the option price
may be determined in any reasonable
manner, including the valuation methods
permitted under §20.2031–2 (Estate Tax
Regulations), so long as the minimum
price possible under the terms of the op-
tion is not less than the fair market value
of the stock on the date of grant.
Section 1.422–2(e)(2)(i) of the 2003
proposed regulations provides that if a
share of stock is transferred to an individ-
ual pursuant to the exercise of an incentive
stock option, which fails to qualify as an
incentive stock option because the exer-
cise price is less than the fair market value
of the underlying stock on the date of
grant, such requirement is still considered
to have been met if there was an attempt,
made in good faith, to meet the option
price requirements of §1.422–2(e)(1).
For nonpublicly traded stock, §1.422–
2(e)(2)(iii) provides that if it is demon-
strated that the fair market value of the
stock on the date of grant was based on
an average of the fair market values as of
such date set forth in the opinions of com-
pletely independent and well-qualified
experts, such a determination establishes
that a good-faith attempt to meet the op-
tion price requirements of §1.422–2(e) was
made. Taxpayers are required to retain ad-
equate books and records to demonstrate
that the option price requirements are sat-
isfied. See section 6001.
Commentors suggested that the fi-
nal regulations be revised to provide
that a good-faith attempt to meet the op-
tion price requirements is demonstrated
if the value of the stock is determined
by a qualified appraiser (as defined in
§1.170A–13(c)(5)), by an individual
(rather than more than one individual)
who is not a qualified appraiser, or by the
corporation at the date of grant. Because
of concerns that the value determined
under these approaches may not reliably
reflect the fair market value of the stock
on the date of grant, these final regulations
retain the rules described in the 2003 pro-
posed regulations.
5. $100,000 limitation
Section 422(d)(1) provides that, to the
extent that the aggregate fair market value
of stock with respect to which incentive
stock options (determined without regard
to section 422(d)) are exercisable for the
first time by an individual during the cal-
endar year (under all of the plans of the
employer corporation and any related cor-
poration) exceeds $100,000, such options
are not treated as incentive stock options.
Under section 422(d)(2), options are taken
into account in the order in which they are
granted. Section 422(d)(3) provides that
the fair market value of stock is determined
at the time the option is granted.
Section 1.422–4(b)(5)(ii) of the 2003
proposed regulations provides that if the
option is not canceled, modified, or trans-
ferred prior to the year in which it would
first become exercisable, it is treated as
outstanding until the end of the year in
which it first becomes exercisable. Com-
mentors suggested that the final regula-
tions permit an individual to cancel, mod-
ify, or transfer an option at any time prior
to the date of exercise (rather than the year
it first becomes exercisable). Because of
concerns about the administrability of a
rule that, for purposes of the $100,000 lim-
itation, would permit an individual to de-
termine the status of an option as statutory
or nonstatutory until the date of exercise,
these final regulations retain the rule de-
scribed in the 2003 proposed regulations.
Section 1.422–4(c) of the 2003 pro-
posed regulations provides that the ap-
plication of the $100,000 limitation may
result in an option being treated, in part,
as an incentive stock option and, in part,
as a nonstatutory option. In response to
comments, these final regulations provide
additional guidance concerning the treat-
ment of options (and the stock purchasable
thereunder) that are bifurcated into an in-
centive stock option and nonstatutory
option as a result of the application of the
$100,000 limitation.
These final regulations provide that a
corporation may issue a separate certifi-
cate for incentive stock option stock or
designate such stock as incentive stock
option stock in the corporation’s transfer
records or the plan records. The issuance
of separate certificates or designation in
plan records is not considered a modifica-
tion under §1.424–1(e). However, in the
absence of such an issuance or designation,
shares are deemed purchased under an in-
centive stock option first to the extent of
the $100,000 limitation, and then the ex-
cess shares are deemed purchased under a
nonstatutory option.
2004–36 I.R.B.416September 7, 2004

Section 424: Definitions and Special
Rules
1. Substitution, Assumption, and
Modification of Options
Section 424(h)(1) provides that if the
terms of an option are modified, extended,
or renewed, such modification, renewal,
or extension is treated as the grant of a
new option. Under section 424(h)(3), the
termmodification(with certain excep-
tions) means any change in the terms of an
option which gives the optionee additional
benefits under the option. One exception
to this definition is that a change in the
terms of an option attributable to a sub-
stitution or an assumption that meets the
requirements of section 424(a) is not a
modification of an option.
The 2003 proposed regulations provide
that aneligible corporation(as defined
in §1.424–1(a)(2)) may, by reason of
acorporate transaction(as defined in
§1.424–1(a)(3)), substitute a new statu-
tory option (new option) for an outstanding
statutory option (old option) or assume an
old option without the substitution or as-
sumption being considered a modification
of the old option under section 424(h).
These final regulations retain most of the
rules contained in the 2003 proposed reg-
ulations, with certain changes.
Under the 2003 proposed regulations,
acorporate transactionis (i) a corporate
merger, consolidation, acquisition of prop-
erty or stock, separation, reorganization,
or liquidation; (ii) a distribution (exclud-
ing ordinary dividends), or change in the
terms or number of outstanding shares of
such corporation, such as a stock split or
stock dividend (a change in capital struc-
ture); (iii) a change in the name of a cor-
poration whose stock is purchasable under
the old option; and (iv) such other corpo-
rate events as may be prescribed by the
Commissioner in published guidance.
In response to comments, these final
regulations provide that a “distribution”
does not include a stock dividend or stock
split (including a reverse stock split) that
merely changes the number of outstand-
ing shares of a corporation. Thus, an out-
standing option is not treated as substi-
tuted or assumed under section 424(a) and
§1.424–1(a) in connection with a stock
dividend or stock split that merely changes
the number of outstanding shares. Instead,
the exercise price of an outstanding option
maybeproportionallyadjustedtoreflect
a stock dividend or stock split that merely
changes the number of outstanding shares
of a corporation under §1.424–1(e). This
adjustment is not a modification of the op-
tion, and because the stock dividend or
stock split is not a corporate transaction,
the requirements of §1.424–1(a), including
the spread and ratio tests, do not have to be
satisfied.
The 2003 proposed regulations also
provide that a new or assumed option
must otherwise qualify as a statutory op-
tion. See §1.424–1(a)(5)(vi) of the 2003
proposed regulations. The 2003 pro-
posed regulations provide that, except
as necessary to comply with the specific
requirements regarding substitution or as-
sumption, such as the rules concerning
ratio and spread, the option must comply
with the requirements of §1.422–2 of the
2003 proposed regulations or 1.423–2, as
applicable. Thus, under the 2003 proposed
regulations, for example, the new option
must be substituted, or the old option must
be assumed, under a plan approved by the
stockholders of the corporation substitut-
ing or assuming the option.
In Rev. Rul. 71–474, 1971–2 C.B.
215, involving qualified stock options,
the IRS held that qualified stock options
assumedbyacorporationinamergerwith
the granting corporation retained their
status as qualified stock options without
approval of the assuming corporation’s
stockholders. In the ruling, the IRS in-
dicated that approval of the persons who
owned stock of the granting corporation at
the time the plan originally was approved
was sufficient to satisfy the stockholder
approval requirements.
In response to comments, these fi-
nal regulations refrain from imposing an
additional stockholder approval require-
ment for statutory options that have been
granted and are outstanding at the time
of a corporate transaction. Thus, the re-
quirement in §1.424–1(a)(5)(vi) of the
2003 proposed regulations is removed.
Further, the examples in §1.424–1(a)(10)
of these final regulations demonstrate that
if the shareholder approval requirements
are met on the date of grant, a subsequent
substitution or assumption of an outstand-
ing option (old option) by an acquiring
corporation does not require additional
stockholder approval for the substituted
or assumed option (new option) to con-
tinue to qualify as a statutory option. See,
§1.424–1(a)(10),Example 9. For exam-
ple, assume Corporation X maintains an
incentive stock option plan that meets the
requirements of §1.422–2 on the date of
grant. E, an employee of X, holds out-
standing incentive stock options to acquire
X stock on exercise of the options. If
Corporation Y acquires X and substitutes
new options to acquire Y stock for the old
options to acquire X stock held by E, the
substitution of the new Y options does not
require new stockholder approval. The re-
sultisthesameiftheoptionsareassumed
by Y. However, for future options granted
under the plan to qualify as incentive stock
options, the plan must be approved by the
Y shareholders. (See, §1.422–2(b)(6)Ex-
ample 3, for guidance concerning future
grants under an option plan that is assumed
in a corporate transaction.)
Finally, commentors requested guid-
ance concerning the treatment of earn-out
payments received by option holders in
connection with a corporate transaction.
Because of the factual nature of these
transactions, these final regulations do not
address the issues raised by these trans-
actions. However, this area is currently
under study and may be the subject of
future guidance of general applicability
under § 601.601(d)(2).
2. Modification, extension, or renewal of
option
Section 424(h)(3) provides that a mod-
ification is any change in the terms of
an option which gives the optionee addi-
tional benefits underthe option, with cer-
tain specified exceptions.
Under §1.424–1(e)(4)(iii) of the 2003
proposed regulations, a change to an op-
tion providing that the optionee may re-
ceive an additional benefit under the op-
tion at the future discretion of the granting
corporation is a modification of the option
at the time the option is changed to pro-
vide the discretion. Additionally, the exer-
cise of such discretion is a modification of
the option. Although several commentors
suggested that the final regulations provide
that the later exercise of the discretion is
not a modification of the option, these fi-
nal regulations retain the rule contained in
the 2003 proposed regulations.
September 7, 20044172004–36 I.R.B.

However, as under the 2003 proposed
regulations, it is not a modification for the
granting corporation to exercise discretion
specifically reservedunder an option re-
lated to the payment of a bonus at the time
of the exercise of the option, the availabil-
ity of a loan at exercise, or the right to ten-
der previously-owned stock for the stock
purchasable under the option. A change to
an option adding such discretion, however,
is a modification.
Commentors suggested broadening this
rule to include the exercise of any reserved
discretion under the option. These final
regulations, however, only expand this
rule to provide that it is not a modifi-
cation to exercise discretion specifically
reserved under an option with respect to
the payment of employment taxes and/or
withholding taxes resulting from the exer-
cise of a statutory option.
The 2003 proposed regulations also
provide that an option is not modified
merely because an optionee is offered a
change in the terms of the option if the
change is not made. These final regula-
tions retain this rule, but also provide that
if an offer to change the terms of the option
remains outstanding for less than 30 days,
the option is not modified. However, if
the offer to change the terms of the option
remains outstanding for 30 days or more,
the option is treated as modified as of the
date the offer to change the terms of the
option is made.
Finally, commentors suggested that
these final regulations provide an ex-
ception to the modification rule for an
inadvertent change to a statutory option
where the change is promptly reversed. In
response, these final regulations provide
that any inadvertent modification of an op-
tion is not treated as a modification to the
extent the modification is reversed by the
earlier of the date the option is exercised
or the last day of the calendar year during
which such change occurred.
Section 6039
Under section 1.6039–1(f) of the 2003
proposed regulations, the issue of furnish-
ing electronic statements was reserved.
These final regulations provide that the
furnishing of statements in electronic form
is permitted, provided the recipient con-
sents to that means of delivery.
Effective date and reliance
These final regulations are effective on
August 3, 2004. However, these final reg-
ulations provide special transitional and
reliance rules.
For statutory options granted on or
before June 9, 2003, taxpayers may
rely on the 1984 proposed regulations
LR–279–81, 49 FR 4504, the 2003 pro-
posed regulations REG–122917–02, 68
FR 34344, or these final regulations un-
til the earlier of January 1, 2006, or the
first regularly scheduled stockholders
meeting of the granting corporation oc-
curring 6 months after August 3, 2004.
For statutory options granted after June
9, 2003, and before the earlier of January
1, 2006, or the first regularly scheduled
stockholders meeting of the granting cor-
poration occurring at least 6 months after
August 3, 2004, taxpayers may rely on
either the REG–122917–02 or the fi-
nal regulations. Taxpayers may not rely
on LR–279–81 or REG–122917–02 af-
ter December 31, 2005. Reliance on
LR–279–81, REG–122917–02, or the fi-
nal regulations must bein its entirety, and
all statutory options granted during the re-
liance period must be treated consistently.
Special Analyses
It has been determined that these regu-
lations are not a significant regulatory ac-
tion as defined in Executive Order 12866.
Therefore, a regulatory assessment is not
required. It is hereby certified that the col-
lection of information in these regulations
will not have a significant economic im-
pact on a substantial number of small enti-
ties. This certification is based on the fact
that the provision ofemployee statements
provided under these proposed regulations
will impose a minimal paperwork burden
on most small entities (see the discussion
under the heading “Paperwork Reduction
Act” earlier in this preamble). Therefore,
an analysis under the Regulatory Flexibil-
ity Act (5 U.S.C. chapter 6) is not required.
Pursuant to section 7805(f) of the Code,
the notice of proposed rulemaking preced-
ing these final regulations is being sub-
mitted to the Chief Counsel for Advocacy
of the Small Business Administration for
comment on its impact on small business.
Drafting Information
The principal author of these proposed
regulations is Erinn Madden, Office of the
Division Counsel/Associate Chief Coun-
sel (Tax Exempt and Government Enti-
ties). However, other personnel from the
IRS and Treasury Department participated
in their development.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 14a
are amended as follows:
PART 1 — INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
§§1.421–1 through 1.421–6 [Removed]
Par. 2. Sections 1.421–1 through
1.421–6 are removed.
Par. 3. Section 1.421–7 is re-desig-
nated as §1.421–1 and is amended as fol-
lows:
1. In paragraph (a)(1), first sentence,
the language “sections 421 through 425”
is removed and “this §§1.421–1 through
1.424–1” is added in its place.
2. In paragraph (a)(1), first sentence,
the language “includes” is removed, and
“means” is added in its place.
3. In paragraph (a)(1), removing the
second sentence.
4. Removing the last sentence of para-
graph (a)(1) and adding two sentences in
its place.
5. Revising paragraph (a)(3).
6. Revising paragraphs (b)(1) and
(b)(2).
7. In paragraph (b)(3)(i), third sen-
tence, removing the language “1.425–1”
and inserting “1.424–1” in its place.
8. In the list below, for each section
indicated in the left column, remove the
language in the middle column and add the
language in the right column:
2004–36 I.R.B.418September 7, 2004

Newly Designated
Section
RemoveAdd
1.421-1(b)(3)(ii)
Example 1, first, second, third, and fourth
sentences
S-1X
1.421-1(b)(3)(ii)
Example 1, second sentence
19642004
1.421-1(b)(3)(ii)
Example 1, third and fourth sentences
19652005
1.421-1(b)(3)(ii),
Example 2, first and second sentences
19642004
1.421-1(b)(3)(ii)
Example 2,first,third,andfourth
sentences
S-1X
1.421-1(b)(3)(ii)
Example 2, third and fourth sentences
19652005
9. Revising the last sentence of para-
graph (b)(3)(ii)Example 1.
10. Removing the last sentence of para-
graph (b)(3)(ii)Example 2, and adding two
sentences in its place.
11. Removing the first sentence of
paragraph (c)(1) and adding two new sen-
tences in its place.
12. In paragraph (c)(2), second sen-
tence, the language “425” is removed and
“424” is added in its place.
13. In paragraph (c)(3), second and last
sentences, the language “1964” is removed
and “2004” is added in its place.
14. In paragraph (c)(3), second sen-
tence, the language “1965” is removed
wherever it appears and “2005” is added
in its place.
15. Revising paragraphs (d) and (e).
16. In paragraph (f), in the first sen-
tence, the language “sections 421 through
425” is removed and “this section and
§§1.421–2 through 1.424–1” is added in
its place.
17. Revising the last sentence of para-
graph (f).
18. In paragraph (g), first sentence, the
language “sections 421 through 425” is re-
moved and “this section and §§1.421–2
through 1.424–1” is added in its place.
19. Adding a new third, fourth, and
fifth sentences to paragraph (g).
20. Revising the first, second, and third
sentences of paragraph (h)(1).
21. Revising paragraph (h)(2).
22. In paragraph (h)(3), first sentence,
the language “425” is removed and “424”
is added in its place.
23. In paragraph (h)(3), last sentence,
the language “or assuming” is removed
and “the option or substituting or assum-
ing the option” is added in its place.
24. In the list below, for each section
indicated in the left column, remove the
language in the middle column and add the
language in the right column:
Newly Designated
Section
RemoveAdd
1.421-1(h)(4)
Example 1, first sentence
19642004
1.421-1(h)(4)
Example 1, second and last sentences
19652005
1.421-1(h)(4)
Example 2, first sentence
425424
1.421-1(h)(4)
Example 2, first sentence
issuingsubstituting
1.424-1(h)(4)
Example 2, last sentence
19652005
September 7, 20044192004–36 I.R.B.

Newly Designated
Section
RemoveAdd
1.421-1(h)(4)
Example 2, last sentence
for A is then employedbyacorporation
which issued an option under section
425(a).
to the transfer of the M stock because,
at all times during the period beginning
with the date of grant of the X option
and ending with the date of exercise of
the M option, A was an employee of
the corporation granting the option or
substituting or assuming the option under
§1.424-1(a).
1.421-1(h)(4)
Example 3, second sentence
19642004
1.421-1(h)(4)
Example 3, third, fourth, and fifth
sentences
19652005
1.421-1(h)(4)
Example 4, first sentence
425(a)424(a)
1.421-1(h)(4)
Example 5, first sentence
qualified stockstatutory
1.421-1(h)(4)
Example 6, first sentence
an employment contract with M which
provides that upon the termination of any
military duty E may be required to serve,
E will be entitled to reemployment with
M or a parent or subsidiary of M.
a right to reemployment with M or a
related corporation on the termination
of any military duty E may be required
to serve.
1.421-1(h)(4)
Example 6, third sentence
of Mof M or a related corporation
1.421-1(h)(4)
Example 6, last sentence
can applyapplies
1.421-1(h)(4)
Example 7, first and last sentences
a qualified stockan incentive
1.421-1(h)(4)
Example 7, first sentence
parent or subsidiaryrelated corporation
1.421-1(h)(4)
Example 7, last sentence
its parent and subsidiary corporationrelatedcorporations
1.421-1(h)(4)
Example 7, last sentence
terminateddeemed terminated
25. Revising paragraph (i).
26. Adding paragraph (j).
The additions and revisions read as fol-
lows:
§1.421–1 Meaning and use of certain
terms.
(a)***(1)***Whilenoparticu-
lar form of words is necessary, the option
must express, among other things, an of-
fer to sell at the option price, the maxi-
mum number of shares purchasable under
the option, and the period of time during
which the offer remains open. The term
optionincludes a warrant that meets the re-
quirements of this paragraph (a)(1).
*****
(3)Anoptionmustbeinwriting(in
paper or electronic form), provided that
such writing is adequate to establish an
option right or privilege that is enforceable
under applicable law.
(b)Statutory options.(1)Theterm
statutory option, for purposes of this sec-
tion and §§1.421–2 through 1.424–1,
means anincentive stock option,asde-
fined in §1.422–2(a), or an option granted
under anemployee stock purchase plan,as
defined in §1.423–2.
(2) An option qualifies as a statutory
option only if the option is not transfer-
able (other than by will or by the laws of
descent and distribution) by the individ-
ual to whom the option was granted, and
is exercisable, during the lifetime of such
individual, only by such individual. See
§§1.422–2(a)(2)(v) and 1.423–2(j). Ac-
cordingly, an option which is transferable
or transferred by the individual to whom
the option is granted during such individ-
ual’s lifetime, or is exercisable during such
individual’s lifetime by another person, is
not a statutory option. However, if the op-
tion or the plan under which the option
2004–36 I.R.B.420September 7, 2004

was granted contains a provision permit-
ting the individual to designate the person
who may exercise theoption after such in-
dividual’s death, neither such provision,
nor a designation pursuant to such provi-
sion, disqualifies the option as a statutory
option. A pledge of the stock purchasable
under an option as security for a loan that is
used to pay the option price does not cause
the option to violate the nontransferability
requirements of this paragraph (b). Also,
the transfer of an option to a trust does not
disqualify the option as a statutory option
if, under section 671 and applicable State
law, the individual is considered the sole
beneficial owner of the option while it is
held in the trust. If an option is transferred
incident to divorce (within the meaning of
section 1041) or pursuant to a domestic re-
lations order, the option does not qualify
as a statutory option as of the day of such
transfer. For the treatment of nonstatutory
options, see §1.83–7.
(3) * * *
(ii) * * *
Example 1. * * * Because X was a subsidiary
of P on the date of the grant of the statutory option,
the option does not fail to be a statutory option even
though X ceases to be a subsidiary of P.
Example 2. * * * Because X was not a subsidiary
of S or P on the date of the grant of the option, the
option is not a statutory option even though X later
becomes a subsidiary of P. See §§1.422–2(a)(2) and
1.423–2(b).
(c)Time and date of granting op-
tion. (1) For purposes of this section and
§§1.421–2 through 1.424–1, the language
“the date of the granting of the option”
and “the time such option is granted,” and
similar phrases refer to the date or time
when the granting corporation completes
the corporate action constituting an offer
of stock for sale to an individual under the
terms and conditions of a statutory option.
A corporate action constituting an offer
of stock for sale is not considered com-
plete until the date on which the maximum
number of shares that can be purchased
under the option and the minimum option
price are fixed or determinable. * * *
*****
(d)Stock and voting stock.(1)For
purposes of this section and §§1.421–2
through 1.424–1, the termstockmeans
capital stock of any class, including voting
or nonvoting common or preferred stock.
Except as otherwise provided, the term
includes both treasury stock and stock of
original issue. Special classes of stock
authorized to be issued to and held by em-
ployees are within the scope of the term
stockas used in such sections, provided
such stock otherwise possesses the rights
and characteristics of capital stock.
(2) For purposes of determining what
constitutes voting stock in ascertain-
ing whether a plan has been approved
by stockholders under §1.422–2(b) or
1.423–2(c) or whether the limitations
pertaining to voting power contained in
§§1.422–2(f) and 1.423–2(d) have been
met, stock which does not have voting
rights until the happening of an event,
such as the default in the payment of div-
idends on preferred stock, is not voting
stock until the happening of the specified
event. Generally, stock which does not
possess a general voting power, and may
vote only on particular questions, is not
voting stock. However, if such stock is
entitled to vote on whether a stock option
plan may be adopted, it is voting stock.
(3) In general, for purposes of this sec-
tion and §§1.421–2 through 1.424–1, own-
ership interests other than capital stock are
considered stock.
(e)Option price. (1) For purposes
of this section and §§1.421–2 through
1.424–1, the termoption price,price
paid under the option,orexercise price
means the consideration in cash or prop-
erty which, pursuant to the terms of the
option, is the price at which the stock sub-
ject to the option is purchased. The term
option pricedoes not include any amounts
paid as interest under a deferred payment
arrangement or treated as interest.
(2) Any reasonable valuation method
may be used to determine whether, at the
time the option is granted, the option price
satisfies the pricing requirements of sec-
tions 422(b)(4), 422(c)(5), 422(c)(7), and
423(b)(6) with respect to the stock subject
to the option. Such methods include, for
example, the valuation method described
in §20.2031–2 of this chapter (Estate Tax
Regulations).
(f)Exercise. * * * An agreement or un-
dertaking by the employee to make pay-
ments under a stock purchase plan does
not constitute the exercise of an option to
the extent the payments made remain sub-
ject to withdrawal by or refund to the em-
ployee.
(g)Transfer.***Forpurposesofsec-
tion 422, a transfer may occur even if a
share of stock is subject to a substantial
risk of forfeiture or is not otherwise trans-
ferable immediately after the date of exer-
cise. See §1.422–1(b)(3)Example 2.A
transfer does not fail to occur merely be-
cause, under the terms of the arrangement,
the individual may not dispose of the share
for a specified period of time, or the share
is subject to a right of first refusal or a right
to reacquire the share at the share’s fair
market value at the time of sale.
(h)Employment relationship.(1)An
option is a statutory option only if, at the
time the option is granted, the optionee
is an employee of the corporation grant-
ing the option, or a related corporation of
such corporation. Ifthe option has been
assumed or a new option has been substi-
tuted in its place under §1.424–1(a), the
optionee must, at the time of such sub-
stitution or assumption, be an employee
(or a former employee within the 3-month
period following termination of the em-
ployment relationship) of the corporation
so substituting or assuming the option, or
a related corporation of such corporation.
The determination of whether the optionee
is an employee at the time the option is
granted (or at the time of the substitution
or assumption under §1.424–1(a)) is made
in accordance with section 3401(c) and the
regulations thereunder. * * *
(2) In addition, §1.421–2(a) is applica-
ble to the transfer of a share pursuant to the
exercise of the statutory option only if the
optionee is, at all times during the period
beginning with the date of the granting
of such option and ending on the day 3
months before the date of such exercise,
an employee of either the corporation
granting such option, a related corporation
of such corporation, or a corporation (or
a related corporation of such corporation)
substituting or assuming a stock option in a
transaction to which §1.424–1(a) applies.
For purposes of the preceding sentence,
the employment relationship is treated
as continuing intactwhile the individual
is on military leave, sick leave, or other
bona fideleave of absence (such as tem-
porary employment by the Government)
if the period of such leave does not ex-
ceed 3 months, or if longer, so long as the
individual’s right to reemployment with
the corporation granting the option (or a
related corporation of such corporation)
or a corporation (or a related corporation
of such corporation) substituting or as-
suming a stock option in a transaction to
September 7, 20044212004–36 I.R.B.

which §1.424–1(a) applies, is provided
either by statute or by contract. If the
period of leave exceeds 3 months and the
individual’s right to reemployment is not
provided either by statute or by contract,
the employment relationship is deemed
to terminate on the first day immedi-
ately following suchthree-month period.
Thus, if the option is not exercised before
such deemed termination of employment,
§1.421–2(a) applies to the transfer of a
share pursuant to an exercise of the option
only if the exercise occurs within 3 months
fromthedatetheemployment relationship
is deemed terminated.
****
(i)Additional definitions.(1)Corpo-
ration. For purposes of this section and
§§1.421–2 through 1.424–1, the termcor-
porationhas the meaning prescribed by
section 7701(a)(3) and §301.7701–2(b) of
this chapter. For example, acorporation
for purposes of the preceding sentence in-
cludes an S corporation (as defined in sec-
tion 1361), a foreign corporation (as de-
fined in section 7701(a)(5)), and a limited
liability company that is treated as a cor-
poration for all Federal tax purposes.
(2)Parent corporation and subsidiary
corporation. For the definition of the
termsparent corporation(andparent)and
subsidiary corporation(andsubsidiary),
for purposes of this section and §§1.421–2
through 1.424–1, see §1.424–1(f)(i) and
(ii), respectively.Related corporation
as used in this section and in §§1.421–2
through 1.424–1 means either a parent
corporation or subsidiary corporation.
(j)Effective date—(1)In general.
These regulations are effective on August
3, 2004.
(2)Reliance and transition period.For
statutory options granted on or before
June 9, 2003, taxpayers may rely on the
1984 proposed regulations LR–279–81
(49 FR 4504), the 2003 proposed regu-
lations REG–122917–02 (68 FR 34344),
or this section until the earlier of January
1, 2006, or the first regularly scheduled
stockholders meeting of the granting cor-
poration occurring 6 months after August
3, 2004. For statutory options granted
after June 9, 2003, and before the earlier
of January 1, 2006, or the first regularly
scheduled stockholders meeting of the
granting corporation occurring at least 6
months after August 3, 2004, taxpayers
may rely on either the REG–122917–02
or this section. Taxpayers may not rely
on LR–279–81 or REG–122917–02 af-
ter December 31, 2005. Reliance on
LR–279–81, REG–122917–02, or this
section must be in its entirety, and all
statutory options granted during the re-
liance period must be treated consistently.
Par. 4. Section 1.421–8 is re-desig-
nated as 1.421–2 and is amended by:
1. Revising paragraphs (a)(1), (b), and
(c)(1).
2. In paragraph (c)(2), first sentence,
add the phrase “for purposes of section
423(c)” at the end of the first sentence.
3. In the list below, for each section
indicated in the left column, remove the
language in the middle column and add the
language in the right column:
Newly Designated
Section
RemoveAdd
1.421-2(c)(2),
second sentence
, or 424(c)(1)
1.421-2(c)(2),
third sentence
or 424(c)(1)
1.421-2(c)(3)(i),
first, second, and third sentences
422(c)(1), 423(c), or 424(c)(1)423(c)
1.421-2(c)(3)(ii)
Example, first sentence
19642004
1.421-2(c)(3)(ii)
Example, third, fifth, and sixth sentences
19662006
4. Removing paragraph (c)(4)(i) and re-
designating paragraphs (c)(4)(ii) through
(c)(4)(iv) as paragraphs (c)(4)(i) through
(c)(4)(iii), respectively.
5. In newly designated paragraph
(c)(4)(i)(a), first sentence, removing the
phrase “In the case of an employee dying
after December 31, 1956” and adding “In
the case of the death of an optionee” in its
place.
6. RemovingExample (1)in newly des-
ignated paragraph (c)(4)(iii) and redesig-
natingExamples (2)through (5) asExam-
ples (1)through (4), respectively.
7. In the list below, for each section
indicated in the left column, remove the
language in the middle column and add the
language in the right column:
2004–36 I.R.B.422September 7, 2004

Newly Designated
Section
RemoveAdd
1.421-2(c)(4)(i)(a),
last sentence
422(c)(1), 423(c), or 424(c)(1)423(c)
1.421-2(c)(4)(i)(b),
first, second, and last sentences
422(c)(1), 423(c), or 424(c)(1)423(c)
1.421-2(c)(4)(i)(c),
first sentence
422(c)(1), 423(c), or 424(c)(1)423(c)
1.421-2(c)(4)(iii)
Example 1, first sentence
19642005
1.421-2(c)(4)(iii),
Example 1,eighthsentence
subdivision (ii)(b) of this subparagraph paragraph (c)(4)(i)(b) of this section
1.421-2(c)(4)(iii),
Example 1, third and fifth sentences
19662006
1.421-2(c)(4)(iii)
Example 1, ninth sentence
subdivision (ii)(c) of this subparagraph paragraph (c)(4)(i)(c)ofthissection
1.421-2(c)(4)(iii)
Example 2, second and fifth sentences
subdivision (ii)(a) of this subparagraph paragraph (c)(4)(i)(a) of this section
1.421-2(c)(4)(iii)
Example 2, fifth sentence
subdivision (ii)(b) of this subparagraph paragraph (c)(4)(i)(b) of this section
1.421-2(c)(4)(iii)
Example 2, first sentence
example (2)Example 1
1.421-2(c)(4)(iii)
Example 3, first sentence
example (2)Example 1
1.421-2(c)(4)(iii),
Example 3, second and fourth sentences
subdivision (ii)(a) of this subparagraph paragraph (c)(4)(i)(a) of this section
1.421-2(c)(4)(iii)
Example 3,fourthsentence
subdivision (ii)(c) of this subparagraph paragraph (c)(4)(i)(c)ofthissection
1.421-2(c)(4)(iii)
Example 4, first sentence
example (2)Example 1
1.421-2(c)(4)(iii)
Example 4, first sentence
19662006
1.421-2(c)(4)(iii)
Example 4, first and second sentences
19672007
1.421-2(c)(iii)
Example 4, third, fifth, and sixth sentences
subdivision (ii)(a) of this subparagraph paragraph (c)(4)(i)(a) of this section
1.421-2(c)(4)(iii)
Example 4, fifth and sixth sentences
subdivision (ii)(b) of this subparagraph paragraph (c)(4)(i)(b) of this section
1.421-2(c)(4)(iii)
Example 4, sixth sentence
subdivision (ii)(c) of this subparagraph paragraph (c)(4)(i)(c)ofthissection
8. Revising paragraph (d).
9. Adding paragraph (f).
The revisions read as follows:
§ 1.421–2 General rules.
(a)Effect of qualifying transfer.(1)If
a share of stock is transferred to an indi-
vidual pursuant to the individual’s exercise
of a statutory option, and if the require-
ments of §1.422–1(a) (relating to incentive
stock options) or §1.423–1(a) (relating to
employee stock purchase plans) whichever
is applicable, are met, then—
(i) No income results under section 83
at the time of the transfer of such share
to the individual upon the exercise of the
option with respect to such share;
(ii) No deduction under sections 83(h)
or 162 or the regulations thereunder (relat-
ing to trade or business expenses) is allow-
able at any time with respect to the share so
transferred; and
September 7, 20044232004–36 I.R.B.

(iii) No amount other than the price paid
under the option is considered as received
by the employer corporation, a related cor-
poration of such corporation, or a corpo-
ration substituting or assuming a stock op-
tion in a transaction to which §1.424–1(a)
(relating to corporate reorganizations, liq-
uidations, etc.) applies, for the share so
transferred.
*****
(b)Effect of disqualifying disposi-
tion. (1)(i) The disposition (as defined in
§1.424–1(c)) of a share of stock acquired
by the exercise of a statutory option before
the expiration of the applicable holding
periods as determined under §1.422–1(a)
or 1.423–1(a) is a disqualifying dispo-
sition and makes paragraph (a) of this
section inapplicable to the transfer of such
share. See section 83(a) to determine
the amount includible on a disqualifying
disposition. The income attributable to
such transfer (determined without reduc-
tion for any brokerage fees or other costs
paid in connection with the disposition)
is treated by the individual as compensa-
tion income received in the taxable year
in which such disqualifying disposition
occurs. A deduction attributable to such
transfer is allowable, to the extent other-
wise allowable under section 162, for the
taxable year in which such disqualifying
disposition occurs to the employer cor-
poration, or a relatedcorporation of such
corporation, or a corporation substituting
or assuming an option in a transaction
to which §1.424–1(a) applies. Addition-
ally, the amount allowed as a deduction
must be determined as if the requirements
of section 83(h) and §1.83–6(a) apply.
No amount is treated as income, and no
amount is allowed as a deduction, for any
taxable year other than the taxable year
in which the disqualifying disposition
occurs. If the amount realized on the dis-
position exceeds (or is less than) the sum
of the amount paid for the share and the
amount of compensation income recog-
nized as a result of such disposition, the
extent to which the difference is treated as
gain (or loss) is determined under the rules
of section 302 or 1001, as applicable.
(ii) The following examples illustrate
the principles of this paragraph (b):
Example 1. On June 1, 2006, X Corporation
grants an incentive stock option to A, an employee
of X, entitling A to purchase 100 shares of X stock
at $10 per share. On August 1, 2006, A exercises the
option when the fair market value of X stock is $20
per share, and 100 shares of X stock are transferred
to A on that date. On December 15, 2007, A sells
the stock for $20 per share. Because A disposed of
the stock before June 2, 2008, A did not satisfy the
holding period requirements of §1.422–1(a). Under
paragraph (b)(1)(i) of this section, A therefore made
a disqualifying disposition of the stock. Thus, para-
graph (a) of this section is inapplicable to the transfer
of the shares, and A must include the compensation
income attributable to the transfer of the shares in
gross income in the year of the disqualifying dispo-
sition. The amount of compensation income A must
include in income is $1,000 ($2,000, the fair market
value of X stock on transfer less $1,000, the exercise
price per share). If the requirements of §83(h) and
§1.83–6(a) are satisfied and otherwise allowable un-
der section 162, X is allowed a deduction of $1,000
for its taxable year in which the disqualifying dispo-
sition occurs.
Example 2. Y Corporation grants an incentive
stockoptionfor100sharesofitsstocktoE,anem-
ployee of Y. The option has an exercise price of $10
per share. E exercises the option and is transferred
the shares when the fair market value of a share of Y
stock is $30. Before the applicable holding periods
are met, Y redeems the shares for $70 per share. Be-
cause the holding period requirements of §1.422–1(a)
are not met, the redemption of the shares is a dis-
qualifying disposition of the shares. Under paragraph
(b)(1)(i) of this section, A made a disqualifying dis-
position of the stock. Thus, paragraph (a) of this sec-
tion is inapplicable to the transfer of the shares, and
E must include the compensation income attributable
to the transfer of the shares in gross income in the
year of the disqualifying disposition. The amount of
compensation income that E must include in income
is $2,000 ($3,000, the fair market value of Y stock
on transfer, less $1,000, the exercise price paid by E).
The character of the additional gain that is includible
in E’s income as a result of the redemption is deter-
mined under the rules of section 302. If the require-
ments of §83(h) and §1.83–6(a) are satisfied and oth-
erwise allowable under section 162, Y is allowed a
deduction for the taxable year in which the disquali-
fying disposition occurs for the compensation income
of $2,000. Y is not allowed a deduction for the addi-
tional gain includible in E’s income as a result of the
redemption.
(2) If an optionee transfers stock ac-
quired through the optionee’s exercise of
a statutory option prior to the expiration of
the applicable holding periods, paragraph
(a) of this section continues to apply to
the transfer of the stock pursuant to the
exercise of the option if such transfer is
not a disposition of the stock as defined in
§1.424–1(c) (for example, a transfer from
a decedent to the decedent’s estate or a
transfer by bequest or inheritance). Sim-
ilarly, a subsequent transfer by the execu-
tor, administrator, heir, or legatee is not a
disqualifying disposition by the decedent.
If a statutory option is exercised by the es-
tate of the optionee or by a person who ac-
quired the option by bequest or inheritance
or by reason of the death of such optionee,
see paragraph (c) of this section. If a statu-
tory option is exercised by the individual
to whom the option was granted and the
individual dies before the expiration of the
holding periods, see paragraph (d) of this
section.
(3) For special rules relating to the
disqualifying disposition of a share of
stock acquired by exercise of an incen-
tive stock option, see §§1.422–5(b)(2) and
1.424–1(c)(3).
(c)Exercise by estate. (1) If a statutory
option is exercised by the estate of the indi-
vidual to whom the option was granted (or
by any person who acquired such option by
bequest or inheritance or by reason of the
death of such individual), paragraph (a) of
this section applies to the transfer of stock
pursuant to such exercise in the same man-
ner as if the option had been exercised by
the deceased optionee. Consequently, nei-
ther the estate nor such person is required
to include any amount in gross income as
a result of a transfer of stock pursuant to
the exercise of the option. Paragraph (a)
of this section applies even if the executor,
administrator, or such person disposes of
the stock so acquired before the expiration
of the applicable holding periods as de-
termined under §1.422–1(a) or 1.423–1(a).
This special rule does not affect the appli-
cability of section 423(c), relating to the
estate’s or other qualifying person’s recog-
nition of compensation income, or sec-
tion 1222, relating to what constitutes a
short-term and long-term capital gain or
loss. Paragraph (a) of this section also ap-
plies even if the executor, administrator, or
such person does not exercise the option
within three months after the death of the
individual or is not employed as described
in §1.421–1(h), either when the option is
exercised or at any time. However, para-
graph (a) of this section does not apply to a
transfer of shares pursuant to an exercise of
the option by the estate or by such person
unless the individual met the employment
requirements described in §1.421–1(h) ei-
ther at the time of the individual’s death or
within three months before such time (or, if
applicable, within the period described in
§1.422–1(a)(3)). Additionally, paragraph
(a) of this section does not apply if the op-
tion is exercised by a person other than the
executor or administrator, or other than a
person who acquired the option by bequest
or inheritance or by reason of the death of
2004–36 I.R.B.424September 7, 2004

such deceased individual. For example, if
theoptionissoldbytheestate,paragraph
(a) of this section does not apply to the
transfer of stock pursuant to an exercise of
the option by the buyer, but if the option is
distributed by the administrator to an heir
as part of the estate, paragraph (a) of this
section applies to the transfer of stock pur-
suant to an exercise of the option by such
heir.
*****
(d)Option exercised by the individual
to whom the option was granted if the in-
dividual dies before expiration of the ap-
plicable holding periods. If a statutory op-
tion is exercised by the individual to whom
the option was granted and such individ-
ual dies before the expiration of the ap-
plicable holding periods as determined un-
der §1.422–1(a) or 1.423–1(a), paragraph
(a) of this section does not become inap-
plicable if the executor or administrator of
the estate of such individual, or any person
who acquired such stock by bequest or in-
heritance or by reason of the death of such
individual, disposes of such stock before
the expiration of such applicable holding
periods. This rule does not affect the ap-
plicability of section 423(c), relating to the
individual’s recognition of compensation
income, or section 1222, relating to what
constitutes a short-term and long-term cap-
ital gain or loss.
*****
(f)Effective date—(1)In general.
These regulations are effective on August
3, 2004.
(2)Reliance and transition period.For
statutory options granted on or before
June 9, 2003, taxpayers may rely on the
1984 proposed regulations LR–279–81
(49 FR 4504), the 2003 proposed regu-
lations REG–122917–02 (68 FR 34344),
or this section until the earlier of January
1, 2006, or the first regularly scheduled
stockholders meeting of the granting cor-
poration occurring 6 months after August
3, 2004. For statutory options granted
after June 9, 2003, and before the earlier
of January 1, 2006, or the first regularly
scheduled stockholders meeting of the
granting corporation occurring at least 6
months after August 3, 2004, taxpayers
may rely on either the REG–122917–02
or this section. Taxpayers may not rely
on LR–279–81 or REG–122917–02 af-
ter December 31, 2005. Reliance on
LR–279–81, REG–122917–02, or this
section must be in its entirety, and all
statutory options granted during the re-
liance period must be treated consistently.
Par. 5. Section 1.422–1 is added to read
as follows:
§1.422–1 Incentive stock options; general
rules.
(a)Applicability of section 421(a).
(1)(i) Section 1.421–2(a) applies to the
transfer of a share of stock to an individual
pursuant to the individual’s exercise of
an incentive stock option if the following
conditions are satisfied—
(A) The individual makes no disposi-
tion of such share before the later of the ex-
piration of the 2-year period from the date
of grant of the option pursuant to which
such share was transferred, or the expira-
tion of the 1-year period from the date of
transfer of such share to the individual; and
(B) At all times during the period be-
ginning on the date of grant of the option
and ending on the day 3 months before the
date of exercise, the individual was an em-
ployee of either the corporation granting
the option, a related corporation of such
corporation, or a corporation (or a related
corporation of such corporation) substitut-
ing or assuming a stock option in a trans-
action to which §1.424–1(a) applies.
(ii) For rules relating to the disposi-
tion of shares of stock acquired pursuant
to the exercise of a statutory option, see
§1.424–1(c). For rules relating to the
requisite employment relationship, see
§1.421–1(h).
(2)(i) The holding period requirement
of section 422(a)(1), described in para-
graph (a)(1)(i)(A) of this section, does not
apply to the transfer of shares by an insol-
vent individual described in this paragraph
(a)(2). If an insolvent individual holds a
share of stock acquired pursuant to the in-
dividual’s exercise of an incentive stock
option, and if such share is transferred to
a trustee, receiver, or other similar fidu-
ciary in any proceeding under the Bank-
ruptcy Act or any other similar insolvency
proceeding, neither such transfer, nor any
other transfer of such share for the benefit
of the individual’s creditors in such pro-
ceeding is a disposition of such share for
purposes of this paragraph (a). For pur-
poses of this paragraph (a)(2), an individ-
ual is insolvent only if the individual’s li-
abilities exceed the individual’s assets or
the individual is unable to satisfy the in-
dividual’s liabilities as they become due.
See section 422(c)(3).
(ii) A transfer by the trustee or other
fiduciary that is not treated as a disposition
for purposes of this paragraph (a) may be
a sale or exchange for purposes of recog-
nizing capital gain or loss with respect to
the share transferred. For example, if the
trustee transfers the share to a creditor in an
insolvency proceeding, capital gain or loss
must be recognized by the insolvent indi-
vidual to the extent of the difference be-
tween the amount realized from such trans-
fer and the adjusted basis of such share.
(iii) If any transfer by the trustee or
other fiduciary (other than a transfer back
to the insolvent individual) is not for the
exclusive benefit of the creditors in an in-
solvency proceeding, then whether such
transfer is a disposition of the share by the
individual for purposes of this paragraph
(a) is determined under §1.424–1(c). Sim-
ilarly, if the trustee or other fiduciary trans-
fers the share back to the insolvent individ-
ual, any subsequent transfer of the share by
such individual which is not made in re-
spect of the insolvency proceeding may be
a disposition of the share for purposes of
this paragraph (a).
(3) If the employee exercising an option
ceased employment because of permanent
and total disability, within the meaning of
section 22(e)(3), 1 year is used instead of 3
months in the employment period require-
ment of paragraph (a)(1)(i)(B) of this sec-
tion.
(b)Failure to satisfy holding period re-
quirements—(1)General rule. For general
rules concerning a disqualifying disposi-
tion of a share of stock acquired pursuant
to the exercise of an incentive stock option,
see §1.421–2(b)(1).
(2)(i)Special rule. If an individual
makes a disqualifying disposition of a
share of stock acquired by the exercise of
an incentive stock option, and if such dis-
position is a sale or exchange with respect
to which a loss (if sustained) would be rec-
ognized to the individual, then, under this
paragraph (b)(2)(i), the amount includible
(determined without reduction for broker-
age fees or other costs paid in connection
with the disposition) in the gross income
of such individual, and deductible from
the income of the employer corporation
(or a related corporation of such corpo-
September 7, 20044252004–36 I.R.B.

ration, or of a corporation substituting or
assuming the option in a transaction to
which §1.424–1(a) applies) as compen-
sation attributable to the exercise of such
option, shall not exceed the excess (if any)
of the amount realized on such sale or
exchange over the adjusted basis of such
share. Subject to the special rule provided
by this paragraph (b)(2)(i), the amount of
compensation attributable to the exercise
of the option is determined under section
83(a); see §1.421–2(b)(1)(i).
(ii)Limitation to special rule.Thespe-
cial rule described in paragraph (b)(2)(i) of
this section does not apply if the disposi-
tion is a sale or exchange with respect to
which a loss (if sustained) would not be
recognized by the individual. Thus, for ex-
ample, if a disqualifying disposition is a
sale described in section 1091 (relating to
loss from wash sales of stock or securities),
a gift (or any other transaction which is not
at arm’s length), or a sale described in sec-
tion 267(a)(1) (relating to sales between
related persons), the special rule described
in paragraph (b)(2)(i) of this section does
not apply because a loss sustained in any
such transaction would not be recognized.
(3)Examples. The following examples
illustrate the principles of this paragraph
(b):
Example 1.Disqualifying disposition of vested
stock. On June 1, 2006, X Corporation grants an in-
centive stock option to A, an employee of X Corpo-
ration, entitling A to purchase one share of X Cor-
poration stock. On August 1, 2006, A exercises the
option, and the share of X Corporation stock is trans-
ferred to A on that date. The option price is $100
(the fair market value of a share of X Corporation
stock on June 1, 2006), and the fair market value of
a share of X Corporation stock on August 1, 2006
(the date of transfer), is $200. The share transferred
to A is transferable and not subject to a substantial
risk of forfeiture. A makes a disqualifying disposi-
tion by selling the share on June 1, 2007, for $250.
The amount of compensation attributable to A’s ex-
ercise is $100 (the difference between the fair market
value of the share at the date of transfer, $200, and the
amount paid for the share, $100). Because the amount
realized ($250) is greater than the value of the share
at transfer ($200), paragraph (b)(2)(i) of this section
does not apply and thus does not affect the amount in-
cludible as compensation in A’s gross income and de-
ductible by X. A must include in gross income for the
taxable year in which the sale occurred $100 as com-
pensation and $50 as capital gain ($250, the amount
realized from the sale, less A’s basis of $200 (the $100
paid for the share plus the $100 increase in basis re-
sulting from the inclusion of that amount in A’s gross
income as compensation attributable to the exercise
of the option)). If the requirements of section 83(h)
and §1.83–6(a) are satisfied and the deduction is oth-
erwise allowable under section 162, for its taxable
year in which the disqualifying disposition occurs, X
Corporation is allowed a deduction of $100 for com-
pensation attributable to A’s exercise of the incentive
stock option.
Example 2.Disqualifying disposition of unvested
stock. Assume the same facts as inExample 1, except
that the share of X Corporation stock received by A is
subject to a substantial risk of forfeiture and not trans-
ferable for a period of six months after such exercise.
Assume further that the fair market value of X Corpo-
rationstockis$225onFebruary1,2007,thedateon
which the six-month restriction lapses. Because sec-
tion 83 does not apply for ordinary income tax pur-
poses on the date of exercise, A cannot make an ef-
fective section 83(b) election at that time (although
such an election is permissible for alternative mini-
mum tax purposes). Additionally, at the time of the
disposition, section 422 and §1.422–1(a) no longer
apply, and thus, section 83(a) is used to measure the
consequences of the disposition, and the holding pe-
riod for capital gain purposes begins on the vesting
date, six months earlier. The amount of compensa-
tion attributable to A’s exercise of the option and dis-
qualifying disposition of the share is $125 (the differ-
ence between the fair market value of the share on the
date that the restriction lapsed, $225, and the amount
paid for the share, $100). Because the amount re-
alized ($225) is greater than the value of the share
at transfer ($200), paragraph (b)(2)(i) of this section
does not apply and thus does not affect the amount
includible as compensation in A’s gross income and
deductible by X. A must include $125 of compensa-
tion income and $25 of capital gain in gross income
for the taxable year in which the disposition occurs
($250, the amount realized from the sale, less A’s ba-
sis of $225 (the $100 paid for the share plus the $125
increase in basis resulting from the inclusion of that
amount of compensation in A’s gross income)). If the
requirements of section 83(h) and §1.83–6(a) are sat-
isfied and the deduction is otherwise allowable under
section 162, for its taxable year in which the disqual-
ifying disposition occurs, X Corporation is allowed a
deduction of $125 for the compensation attributable
to A’s exercise of the option.
Example 3.(i)Disqualifying disposition and ap-
plication of special rule. Assume the same facts as in
Example 1, except that A sells the share for $150 to
M.
(ii) If the sale to M is a disposition that meets the
requirements of paragraph (b)(2)(i) of this section, in-
stead of $100 which otherwise would have been in-
cludible as compensation under §1.83–7, under para-
graph (b)(2)(i) of this section, A must include only
$50 (the excess of the amount realized on such sale,
$150, over the adjusted basis of the share, $100) in
gross income as compensation attributable to the ex-
ercise of the incentive stock option. Because A’s ba-
sis for the share is $150 (the $100 which A paid for the
share, plus the $50 increase in basis resulting from the
inclusion of that amount in A’s gross income as com-
pensation attributable to the exercise of the option), A
realizes no capital gain or loss as a result of the sale.
If the requirements of section 83(h) and §1.83–6(a)
are satisfied and the deduction is otherwise allowable
under section 162, for its taxable year in which the
disqualifying disposition occurs, X Corporation is al-
lowed a deduction of $50 for the compensation attrib-
utable to A’s exercise of the option and disqualifying
disposition of the share.
(iii) Assume the same facts as in paragraph (i) of
thisExample 3, except that 10 days after the sale to M,
A purchases substantiallyidentical stock. Because
under section 1091(a) a loss (if it were sustained on
the sale) would not be recognized on the sale, under
paragraph (b)(2)(ii) of this section, the special rule de-
scribed in paragraph (b)(2)(i) of this section does not
apply. A must include $100 (the difference between
thefairmarketvalueoftheshareonthedateoftrans-
fer, $200, and the amount paid for the share, $100)
in gross income as compensation attributable to the
exercise of the option forthe taxable year in which
the disqualifying disposition occurred. A recognizes
no capital gain or loss on the transaction. If the re-
quirements of section 83(h) and §1.83–6(a) are satis-
fied and the deduction is otherwise allowable under
section 162, for its taxable year in which the disqual-
ifying disposition occurs X Corporation is allowed a
$100 deduction for compensation attributable to A’s
exercise of the option and disqualifying disposition
of the share.
(iv) Assume the same facts as in paragraph (ii)
of thisExample 3, except that A sells the share for
$50. Under paragraph (b)(2)(i) of this section, A is
not required to include any amount in gross income
as compensation attributable to the exercise of the op-
tion. A is allowed a capital loss of $50 (the difference
between the amount realized on the sale, $50, and the
adjusted basis of the share, $100). X Corporation is
not allowed any deduction attributable to A’s exer-
cise of the option and disqualifying disposition of the
share.
(c)Failure to satisfy employment re-
quirement. Section 1.421–2(a) does not
apply to the transfer of a share of stock pur-
suant to the exercise of an incentive stock
option if the employment requirement, as
determined under paragraph (a)(1)(i)(B) of
this section, is not met at the time of the
exercise of such option. Consequently, the
effects of such a transfer are determined
under the rules of §1.83–7. For rules re-
lating to the employment relationship, see
§1.421–1(h).
Par. 6. Section 1.422–2 is added to read
as follows:
§1.422–2 Incentive stock options defined.
(a)Incentive stock option defined—(1)
In general.Thetermincentive stock option
means an option that meets the require-
ments of paragraph (a)(2) of this section
on the date of grant. An incentive stock
option is also subject to the $100,000 lim-
itation described in §1.422–4. An incen-
tive stock option may contain a number
of permissible provisions that do not af-
fect the status of the option as an incentive
stock option. See §1.422–5 for rules relat-
ing to permissible provisions of an incen-
tive stock option.
2004–36 I.R.B.426September 7, 2004

(2)Option requirements. To qualify as
an incentive stock option under this sec-
tion, an option must be granted to an indi-
vidual in connection with the individual’s
employment by the corporation granting
such option (or by a related corporation
as defined in §1.421–1(i)(2)), and granted
only for stock of any of such corporations.
In addition, the option must meet all of the
following requirements—
(i) It must be granted pursuant to a plan
that meets the requirements described in
paragraph (b) of this section;
(ii) It must be granted within 10 years
from the date of the adoption of the plan
or the date such plan is approved by the
stockholders, whichever is earlier (see
paragraph (c) of this section);
(iii) It must not be exercisable after the
expiration of 10 years from the date of
grant (see paragraph (d) of this section);
(iv) It must provide that the option price
per share is not less than the fair market
value of the share on the date of grant (see
paragraph (e) of this section);
(v) By its terms, it must not be trans-
ferrable by the individual to whom the
option is granted other than by will or
the laws of descent and distribution, and
must be exercisable,during such individ-
ual’s lifetime, only by such individual (see
§§1.421–1(b)(2) and 1.421–2(c)); and
(vi) Except as provided in paragraph
(f) of this section, it must be granted to
an individual who, at the time the option
is granted, does not own stock possessing
more than 10 percent of the total combined
voting power of all classes of stock of the
corporation employing such individual or
of any related corporation of such corpo-
ration.
(3)Amendment of option terms.Ex-
cept as otherwise provided in §1.424–1,
the amendment of the terms of an incen-
tive stock option may cause it to cease to
be an option described in this section. If
the terms of an option that has lost its sta-
tus as an incentive stock option are subse-
quently changed with the intent to re-qual-
ify the option as an incentive stock op-
tion, such change results in the grant of a
new option on the date of the change. See
§1.424–1(e).
(4)Terms provide option not an incen-
tive stock option. If the terms of an option,
when granted, provide that it will not be
treated as an incentive stock option, such
option is not treated as an incentive stock
option.
(b)Option plan—(1)In general.An
incentive stock option must be granted
pursuant to a plan that meets the require-
ments of this paragraph (b). The author-
ity to grant other stock options or other
stock-based awards pursuant to the plan,
where the exercise of such other options
or awards does not affect the exercise of
incentive stock options granted pursuant
to the plan, does not disqualify such in-
centive stock options. The plan must be
in writing or electronic form, provided
that such writing or electronic form is ad-
equate to establish the terms of the plan.
See §1.422–5 for rules relating to per-
missible provisions of an incentive stock
option.
(2)Stockholder approval.(i)Theplan
required by this paragraph (b) must be ap-
proved by the stockholders of the corpo-
ration granting the incentive stock option
within 12 months before or after the date
such plan is adopted. Ordinarily, a plan is
adopted when it is approved by the grant-
ing corporation’s board of directors, and
the date of the board’s action is the refer-
ence point for determining whether stock-
holder approval occurs within the appli-
cable 24-month period. However, if the
board’s action is subject to a condition
(such as stockholder approval) or the hap-
pening of a particular event, the plan is
adopted on the date the condition is met or
the event occurs, unless the board’s resolu-
tion fixes the date of approval as the date
of the board’s action.
(ii) For purposes of paragraph (b)(2)(i)
of this section, the stockholder approval
must comply with the rules described in
§1.422–3.
(iii) The provisions relating to the max-
imum aggregate number of shares to be
issued under the plan (described in para-
graph (b)(3) of this section) and the em-
ployees (or class or classes of employees)
eligible to receive options under the plan
(described in paragraph (b)(4) of this sec-
tion) are the only provisions of a stock op-
tion plan that, if changed, must be re-ap-
proved by stockholders for purposes of
section 422(b)(1). Any increase in the
maximum aggregate number of shares that
may be issued under the plan (other than
an increase merely reflecting a change in
the number of outstanding shares, such as
a stock dividend or stock split), or change
in the designation of the employees (or
class or classes of employees) eligible to
receive options under the plan is consid-
ered the adoption of a new plan requiring
stockholder approval within the prescribed
24-month period. In addition, a change in
the granting corporation or the stock avail-
able for purchase or award under the plan
is considered the adoption of a new plan
requiring new stockholder approval within
the prescribed 24-month period. Any other
changes in the terms of an incentive stock
option plan are not considered the adop-
tion of a new plan and, thus, do not require
stockholder approval.
(3)Maximum aggregate number of
shares. (i)Theplanrequiredbythis
paragraph (b) must designate the max-
imum aggregate number of shares that
may be issued under the plan through
incentive stock options. If nonstatutory
options or other stock-based awards may
be granted, the plan may separately des-
ignate terms for each type of option or
other stock-based awards and designate
the maximum number of shares that may
be issued under such option or other
stock-based awards. Unless otherwise
specified, all terms of the plan apply to all
options and other stock-based awards that
may be granted under the plan.
(ii) A plan that merely provides that
the number of shares that may be issued
as incentive stock options under such plan
may not exceed a stated percentage of the
shares outstanding at the time of each of-
fering or grant under such plan does not
satisfy the requirement that the plan state
the maximum aggregate number of shares
that may be issued under the plan. How-
ever, the maximum aggregate number of
shares that may be issued under the plan
may be stated in terms of a percentage
of the authorized, issued, or outstanding
shares at the date of the adoption of the
plan. The plan may specify that the maxi-
mum aggregate number of shares available
for grants under the plan may increase an-
nually by a specified percentage of the au-
thorized, issued, or outstanding shares at
the date of the adoption of the plan. A plan
which provides that the maximum aggre-
gate number of shares that may be issued
as incentive stock options under the plan
may change based on any other specified
circumstances satisfies the requirements of
this paragraph (b)(3) only if the stockhold-
ers approve an immediately determinable
September 7, 20044272004–36 I.R.B.

maximum aggregate number of shares that
may be issued under the plan in any event.
(iii) It is permissible for the plan to
provide that, shares purchasable under the
plan may be supplied to the plan through
acquisitions of stock on the open market;
shares purchased under the plan and for-
feited back to the plan; shares surrendered
in payment of the exercise price of an op-
tion; shares withheld for payment of appli-
cable employment taxes and/or withhold-
ing obligations resulting from the exercise
of an option.
(iv) If there is more than one plan un-
der which incentive stock options may be
granted and stockholders of the granting
corporation merely approve a maximum
aggregate number of shares that are avail-
able for issuance under such plans, the
stockholder approval requirements de-
scribed in paragraph (b)(2) of this section
are not satisfied. A separate maximum
aggregate number of shares available for
issuance pursuant to incentive stock op-
tions must be approved for each plan.
(4)Designation of employees.The
plan described in this paragraph (b), as
adopted and approved, must indicate the
employees (or class or classes of employ-
ees) eligible to receive the options or other
stock-based awards to be granted under
the plan. This requirement is satisfied by
a general designation of the employees (or
the class or classes of employees) eligible
to receive options or other stock-based
awards under the plan. Designations such
as “key employees of the grantor corpo-
ration”; “all salaried employees of the
grantor corporation and its subsidiaries,
including subsidiaries which become such
after adoption of the plan;” or “all em-
ployees of the corporation” meet this
requirement. This requirement is consid-
ered satisfied even though the board of
directors, another group, or an individual
is given the authority to select the particu-
lar employees who are to receive options
or other stock-based awards from a de-
scribed class and to determine the number
of shares to be optioned or granted to
each such employee. If individuals other
than employees may be granted options or
other stock-based awards under the plan,
the plan must separately designate the em-
ployees or classes of employees eligible to
receive incentive stock options.
(5)Conflicting option terms.Anoption
on stock available for purchase or grant
under the plan is treated as having been
granted pursuant to a plan even if the terms
of the option conflict with the terms of the
plan, unless such option is granted to an
employee who is ineligible to receive op-
tions under the plan, options have been
granted on stock in excess of the aggregate
number of shares which may be issued un-
der the plan, or the option provides other-
wise.
(6) The following examples illustrate
the principles of this paragraph (b):
Example 1.Stockholder approval. (i) S Corpora-
tion is a subsidiary of P Corporation, a publicly traded
corporation. On January 1, 2006, S adopts a plan
under which incentive stock options for S stock are
granted to S employees.
(ii) To meet the requirements of paragraph (b)(2)
of this section, the plan must be approved by the
stockholders of S (in this case, P) within 12 months
before or after January 1, 2006.
(iii) Assume the same facts as in paragraph (i) of
thisExample 1. Assume further that the plan was
approved by the stockholders of S (in this case, P)
on March 1, 2006. On January 1, 2008, S changes
the plan to provide that incentive stock options for P
stock will be granted to S employees under the plan.
Because there is a change in the stock available for
grant under the plan, the change is considered the
adoption of a new plan that must be approved by the
stockholders of P within 12 months before or after
January 1, 2008.
Example 2.Stockholder approval. (i) Assume the
same facts as in paragraph (i) ofExample 1, except
that on March 15, 2007, P completely disposes of its
interest in S. Thereafter, S continues to grant options
for S stock to S employees under the plan.
(ii) The new S options are granted under a plan
that meets the stockholder approval requirements
of paragraph (b)(2) of this section without regard
to whether S seeks approval of the plan from the
stockholders of S after P disposes of its interest in S.
(iii) Assume the same facts as in paragraph (i) of
thisExample 2, except that under the plan as adopted
on January 1, 2006, only options for P stock are
granted to S employees. Assume further that after
P disposes of its interest in S, S changes the plan
to provide for the grant of options for S stock to S
employees. Because there is a change in the stock
available for purchase or grant under the plan, under
paragraph (b)(2)(iii) of this section, the stockholders
of S must approve the plan within 12 months before
or after the change to the plan to meet the stock-
holder approval requirements of paragraph (b) of this
section.
Example 3.Stockholder approval. (i) Corpo-
ration X maintains a plan under which incentive
stock options may be granted to all eligible employ-
ees. Corporation Y does not maintain an incentive
stock option plan. On May 15, 2006, Corporation
X and Corporation Y consolidate under state law to
form one corporation. The new corporation will be
named Corporation Y. The consolidation agreement
describes the Corporation X plan, including the
maximum aggregate number of shares available for
issuance pursuant to incentive stock options after the
consolidation and the employees eligible to receive
options under the plan. Additionally, the consolida-
tion agreement states that the plan will be continued
by Corporation Y after the consolidation and incen-
tive stock options will be issued by Corporation Y.
The consolidation agreement is unanimously ap-
proved by the shareholders of Corporations X and
Y on May 1, 2006. Corporation Y assumes the plan
formerly maintained by Corporation X and contin-
ues to grant options under the plan to all eligible
employees.
(ii) Because there is a change in the granting cor-
poration (from Corporation X to Corporation Y), un-
der paragraph (b)(2)(iii) of this section, Corporation
Y is considered to have adopted a new plan. Be-
cause the plan is fully described in the consolidation
agreement, including the maximum aggregate num-
ber of shares available for issuance pursuant to incen-
tive stock options and employees eligible to receive
options under the plan, the approval of the consoli-
dation agreement by the shareholders constitutes ap-
proval of the plan. Thus, the shareholder approval of
the consolidation agreement satisfies the shareholder
approval requirements of paragraph (b)(2) of this sec-
tion, and the plan is considered to be adopted by Cor-
poration Y and approved by its shareholders on May
1, 2006.
Example 4.Maximum aggregate number of
shares. X Corporation maintains a plan under which
statutory options and nonstatutory options may be
granted. The plan designates the number of shares
that may be used for incentive stock options. Be-
cause the maximum aggregate number of shares that
will be used for incentive stock options is designated
in the plan, the requirements of paragraph (b)(3) of
this section are satisfied.
Example 5.Maximum aggregate number of
shares. Y Corporation adopts an incentive stock op-
tion plan on November 1, 2006. On that date, there
are two million outstanding shares of Y Corporation
stock. The plan provides that the maximum aggre-
gate number of shares that may be issued under the
plan may not exceed 15% of the outstanding number
of shares of Y Corporation on November 1, 2006.
Because the maximum aggregate number of shares
that may be issued under the plan is designated in
the plan, the requirements of paragraph (b)(3) of this
section are met.
Example 6.Maximum aggregate number of
shares. (i) B Corporation adopts an incentive stock
option plan on March 15, 2005. The plan provides
that the maximum aggregate number of shares avail-
able for issuance under theplan is 50,000, increased
on each anniversary date of the adoption of the plan
by 5 percent of the then-outstanding shares.
(ii) Because the maximum aggregate number of
shares is not designated under the plan, the require-
ments of paragraph (b)(3) of this section are not met.
(iii) Assume the same facts as in paragraph (i)
of thisExample 6, except that the plan provides that
the maximum aggregate number of shares available
under the plan is the lesser of (a) 50,000 shares, in-
creased each anniversary date of the adoption of the
plan by 5 percent of the then-outstanding shares, or
(b) 200,000 shares. Becausethe maximum aggregate
number of shares that may be issued under the plan is
designated as the lesser of one of two numbers, one
of which provides an immediately determinable max-
imum aggregate number of shares that may be issued
2004–36 I.R.B.428September 7, 2004

under the plan in any event, the requirements of para-
graph (b)(3) of this section are met.
(c)Duration of option grants under
the plan. An incentive stock option must
be granted within 10 years from the date
that the plan under which it is granted is
adopted or the date such plan is approved
by the stockholders, whichever is earlier.
To grant incentive stock options after the
expiration of the 10-year period, a new
plan must be adopted and approved.
(d)Period for exercising options.An
incentive stock option, by its terms, must
not be exercisable after the expiration of 10
years from the date such option is granted,
or 5 years from the date such option is
granted to an employee described in para-
graph (f) of this section. An option that
does not contain such a provision when
granted is not an incentive stock option.
(e)Option price. (1) Except as provided
by paragraph (e)(2) of this section, the op-
tion price of an incentive stock option must
not be less than the fair market value of the
stock subject to the option at the time the
option is granted. The option price may
be determined in any reasonable manner,
including the valuation methods permitted
under §20.2031–2 of this chapter, so long
as the minimum price possible under the
terms of the option is not less than the fair
market value of the stock on the date of
grant. For general rules relating to the op-
tion price, see §1.421–1(e). For rules relat-
ingtothedeterminationofwhenanoption
is granted, see §1.421–1(c).
(2)(i) If a share of stock is transferred
to an individual pursuant to the exercise of
an option which fails to qualify as an in-
centive stock option merely because there
was a failure of an attempt, made in good
faith, to meet the option price requirements
of paragraph (e)(1) of this section, the re-
quirements of such paragraph are consid-
ered to have been met. Whether there was
a good-faith attempt to set the option price
at not less than the fair market value of the
stock subject to the option at the time the
option was granted depends on the relevant
facts and circumstances.
(ii) For publicly held stock that is ac-
tively traded on an established market at
the time the option is granted, determin-
ing the fair market value of such stock
by the appropriate method described in
§20.2031–2 of this chapter establishes that
a good-faith attempt to meet the option
price requirements of this paragraph (e)
was made.
(iii) For non-publicly traded stock, if
it is demonstrated, for example, that the
fair market value of the stock at the date
of grant was based upon an average of
the fair market values as of such date set
forth in the opinions of completely inde-
pendent and well-qualified experts, such
a demonstration generally establishes that
there was a good-faith attempt to meet
the option price requirements of this para-
graph (e). The optionee’s status as a major-
ity or minority stockholder may be taken
into consideration.
(iv) Regardless of whether the stock of-
fered under an option is publicly traded, a
good-faith attempt to meet the option price
requirements of this paragraph (e) is not
demonstrated unless the fair market value
ofthestockonthedateofgrantisde-
termined with regard tononlapse restric-
tions(as defined in §1.83–3(h)) and with-
out regard tolapse restrictions(as defined
in §1.83–3(i)).
(v) Amounts treated as interest and
amounts paid as interest under a de-
ferred payment arrangement are not in-
cludible as part of the option price. See
§1.421–1(e)(1). An attempt to set the
option price at not less than fair market
value is not regarded as made in good
faith where an adjustment of the option
price to reflect amounts treated as interest
results in the option price being lower than
the fair market value on which the option
price was based.
(3) Notwithstanding that the option
price requirements of paragraphs (e)(1)
and (2) of this section are satisfied by
an option granted to an employee whose
stock ownership exceeds the limitation
provided by paragraph (f) of this section,
such option is not an incentive stock option
when granted unless it also complies with
paragraph (f) of this section. If the op-
tion, when granted, does not comply with
the requirements described in paragraph
(f) of this section, such option can never
become an incentive stock option, even if
the employee’s stock ownership does not
exceed the limitation of paragraph (f) of
this section when such option is exercised.
(f)Options granted to certain stock-
holders. (1) If, immediately before an op-
tion is granted, an individual owns (or is
treated as owning) stock possessing more
than 10 percent of the total combined vot-
ing power of all classes of stock of the
corporation employing the optionee or of
any related corporation of such corpora-
tion, then an option granted to such indi-
vidual cannot qualify as an incentive stock
option unless the option price is at least
110 percent of the stock’s fair market value
on the date of grant and such option by its
terms is not exercisable after the expiration
of 5 years from the date of grant. For pur-
poses of determining the minimum option
price for purposes of this paragraph (f), the
rules described in paragraph (e)(2) of this
section, relating to the good-faith determi-
nation of the option price, do not apply.
(2) For purposes of determining the
stock ownership of the optionee, the stock
attribution rules of §1.424–1(d) apply.
Stock that the optionee may purchase un-
der outstanding options is not treated as
stock owned by the individual. The de-
termination of the percentage of the total
combined voting power of all classes of
stock of the employer corporation (or of
its related corporations) that is owned by
the optionee is made with respect to each
suchcorporationintherelatedgroupby
comparing the voting power of the shares
owned (or treated as owned) by the op-
tionee to the aggregate voting power of all
shares of each such corporation actually
issued and outstanding immediately be-
fore the grant of the option to the optionee.
The aggregate voting power of all shares
actually issued and outstanding immedi-
ately before the grant of the option does
not include the voting power of treasury
shares or shares authorized for issue under
outstanding options held by the individual
or any other person.
(3)Examples. The rules of this para-
graph (f) are illustrated by the following
examples:
Example 1. (i) E, an employee of M Corporation,
owns 15,000 shares of M Corporation common stock,
which is the only class of stock outstanding. M has
100,000 shares of its common stock outstanding. On
January 1, 2005, when the fair market value of M
stock is $100, E is granted an option with an option
price of $100 and an exercise period of 10 years from
thedateofgrant.
(ii) Because E owns stock possessing more than
10 percent of the total combined voting power of all
classes of M Corporation stock, M cannot grant an in-
centive stock option to E unless the option is granted
at an option price of at least 110 percent of the fair
market value of the stock subject to the option and
the option, by its terms, expires no later than 5 years
from its date of grant. The option granted to E fails
to meet the option-price and term requirements de-
September 7, 20044292004–36 I.R.B.

scribed in paragraph (f)(1) of this section and, thus,
the option is not an incentive stock option.
(iii) Assume the same facts as in paragraph (i)
of thisExample 1, except that E’s father and brother
each owns 7,500 shares of M Corporation stock, and
EownsnoMstockinE’sownname. Becauseun-
der the attribution rules of §1.424–1(d), E is treated
as owning stock held by E’s parents and siblings, M
cannot grant an incentive stock option to E unless the
option price is at least 110 percent of the fair market
value of the stock subject to the option, and the op-
tion, by its terms, expires no later than 5 years from
thedateofgrant.
Example 2. Assume the same facts as in para-
graph (i) of thisExample 1. Assume further that
M is a subsidiary of P Corporation. Regardless of
whether E owns any P stock and the number of P
shares outstanding, if P Corporation grants an option
to E which purports to be an incentive stock option,
but which fails to meet the 110-percent-option-price
and 5-year-term requirements, the option is not an in-
centive stock option because E owns more than 10
percent of the total combined voting power of all
classes of stock of a related corporation of P Corpo-
ration (i.e., M Corporation). An individual who owns
(or is treated as owning) stock in excess of the own-
ership specified in paragraph (f)(1) of this section, in
any corporation in a group of corporations consist-
ing of the employer corporation and its related corpo-
rations, cannot be granted an incentive stock option
by any corporation in the group unless such option
meets the 110-percent-option-price and 5-year-term
requirements of paragraph (f)(1) of this section.
Example 3. (i) F is an employee of R Corpora-
tion. R has only one class of stock, of which 100,000
shares are issued and outstanding. F owns no stock
in R Corporation or any related corporation of R Cor-
poration. On January 1, 2005, R grants a 10-year in-
centive stock option to F to purchase 50,000 shares
of R stock at $3 per share, the fair market value of R
stock on the date of grant of the option. On April 1,
2005, F exercises half of the January option and re-
ceives 25,000 shares of R stock that previously were
not outstanding. On July 1, 2005, R grants a second
50,000 share option to F which purports to be an in-
centive stock option. The terms of the July option are
identical to the terms of the January option, except
that the option price is $3.25 per share, which is the
fair market value of R stock on the date of grant of
the July option.
(ii) Because F does not own more than 10% of the
total combined voting power of all classes of stock
of R Corporation or any related corporation on the
date of the grant of the January option and the pric-
ing requirements of paragraph (e) of this section are
satisfied on the date of grant of such option, the unex-
ercised portion of the January option remains an in-
centive stock option regardless of the changes in F’s
percentage of stock ownership in R after the date of
grant. However, the July option is not an incentive
stock option because, on the date that it is granted, F
owns 20 percent (25,000 shares owned by F divided
by 125,000 shares of R stock issued and outstanding)
of the total combined voting power of all classes of R
Corporation stock and, thusthe pricing requirements
of paragraph (f)(1) of this section are not met.
(iii) Assume the same facts as in paragraph (i) of
thisExample 3except that the partial exercise of the
January incentive stock option on April 1, 2003, is
for only 10,000 shares. Under these circumstances,
the July option is an incentive stock option, because,
on the date of grant of the July option, F does not own
more than 10 percent of the total combined voting
power (10,000 shares owned by F divided by 110,000
shares of R issued and outstanding) of all classes of
R Corporation stock.
§1.422–4 [Removed]
Par. 7. Section 1.422–4 is removed.
§1.422–5 [Redesignated as §1.422–3]
Par. 8. Section 1.422–5 is re-desig-
nated as §1.422–3.
Par. 9. New §1.422–4 is added to read
as follows:
§1.422–4 $100,000 limitation for
incentive stock options.
(a)$100,000 per year limitation—(1)
General rule. Anoptionthatotherwise
qualifies as an incentive stock option nev-
ertheless fails to bean incentive stock op-
tion to the extent that the $100,000 limi-
tation described in paragraph (a)(2) of this
section is exceeded.
(2)$100,000 per year limitation.Tothe
extent that the aggregate fair market value
of stock with respect to which an incen-
tive stock option (determined without re-
gard to this section) is exercisable for the
first time by any individual during any cal-
endar year (under all plans of the employer
corporation and related corporations) ex-
ceeds $100,000, such option is treated as a
nonstatutory option. See §1.83–7 for rules
applicable to nonstatutory options.
(b)Application. To determine whether
the limitation described in paragraph (a)(2)
of this section has been exceeded, the fol-
lowing rules apply:
(1) An option that does not meet the re-
quirements of §1.422–2 when granted (in-
cluding an option which, when granted,
contains terms providing that it will not be
treated as an incentive stock option) is dis-
regarded. See §1.422–2(a)(4).
(2) The fair market value of stock is
determined as of the date of grant of the
option for such stock.
(3) Except as otherwise provided in
paragraph (b)(4) of this section, options
are taken into account in the order in which
they are granted.
(4) For purposes of this section, an op-
tion is considered to be first exercisable
during a calendar year if the option will
become exercisable at any time during the
year assuming that any condition on the
optionee’s ability to exercise the option re-
lated to the performance of services is sat-
isfied. If the optionee’s ability to exer-
cise the option in the year is subject to
an acceleration provision, then the option
is considered first exercisable in the cal-
endar year in which the acceleration pro-
vision is triggered. After an acceleration
provision is triggered, the options subject
to such provision are then taken into ac-
count in accordance with paragraph (b)(3)
of this section for purposes of applying the
limitation described in paragraph (a)(2) of
this section to all options first exercisable
during a calendar year. However, because
an acceleration provision is not taken into
account prior to its triggering, an incen-
tive stock option that becomes exercisable
for the first time during a calendar year by
operation of such a provision does not af-
fect the application of the $100,000 limi-
tation with respect to any option (or por-
tion thereof) exercised prior to such ac-
celeration. For purposes of this paragraph
(b)(4), an acceleration provision includes,
for example, a provision that accelerates
the exercisability of an option on a change
in ownership or control or a provision that
conditions exercisability on the attainment
of a performance goal. See paragraph (d),
Example 4of this section.
(5)(i) An option (or portion thereof) is
disregarded if, prior to the calendar year
during which it would otherwise have
become exercisable for the first time, the
option (or portion thereof) is modified
and thereafter ceases to be an incentive
stock option described in §1.422–2, is
canceled, or is transferred in violation of
§1.421–1(b)(2).
(ii) If an option (or portion thereof) is
modified, canceled, or transferred at any
other time, such option (or portion thereof)
is treated as outstanding according to its
original terms until the end of the calendar
year during which it would otherwise have
become exercisable for the first time.
(6) A disqualifying disposition has no
effect on the determination of whether an
option exceeds the $100,000 limitation.
(c)Bifurcation—(1)Options.Theap-
plication of the rules described in para-
graph (b) of this section may result in an
option being treated, in part, as an incen-
tive stock option and, in part, as a nonstatu-
2004–36 I.R.B.430September 7, 2004

tory option. See §1.83–7 for the treatment
of nonstatutory options.
(2)Stock. A corporation may issue
a separate certificate for incentive option
stock or designate such stock as incen-
tive stock option stock in the corporation’s
transfer records or plan records. In such a
case, the issuance of separate certificates
or designation in the corporation’s trans-
fer records or plan records is not a modi-
fication under §1.424–1(e). In the absence
of such an issuance ordesignation, shares
are treated as first purchased under an in-
centive stock option to the extent of the
$100,000 limitation, and the excess shares
are treated as purchased under a nonstatu-
tory option. See §1.83–7 for the treatment
of nonstatutory options.
(d)Examples. The following examples
illustrate the principles of this section. In
each of the following examples E is an
employee of X Corporation. The examples
are as follows:
Example 1.General rule. Effective January 1,
2004, X Corporation adopts a plan under which in-
centive stock options may be granted to its employ-
ees. On January 1, 2004, and each succeeding Jan-
uary 1 through January 1, 2013, E is granted imme-
diately exercisable options for X Corporation stock
with a fair market value of $100,000 determined on
the date of grant. The options qualify as incentive
stock options (determined without regard to this sec-
tion). On January 1, 2014, E exercises all of the op-
tions. Because the $100,000 limitation has not been
exceeded during any calendar year, all of the options
are treated as incentive stock options.
Example 2.Order of grant. X Corporation is a
parent corporation of Y Corporation, which is a par-
ent corporation of Z Corporation. Each corporation
has adopted its own separate plan, under which an
employee of any member of the corporate group may
be granted options for stock of any member of the
group. On January 1, 2004, X Corporation grants E
an incentive stock option (determined without regard
to this section) for stock of Y Corporation with a fair
market value of $100,000 on the date of grant. On De-
cember 31, 2004, Y Corporation grants E an incentive
stock option (determined without regard to this sec-
tion) for stock of Z Corporation with a fair market
value of $75,000 as of the date of grant. Both of the
options are immediately exercisable. For purposes of
this section, options are taken into account in the or-
der in which granted using the fair market value of
stock as of the date on the option is granted. During
calendar year 2004, the aggregate fair market value of
stock with respect to which E’s options are exercis-
able for the first time exceeds $100,000. Therefore,
the option for Y Corporation stock is treated as an in-
centive stock option, and the option for Z Corporation
stock is treated as a nonstatutory option.
Example 3.Acceleration provision. (i) In 2004,
X Corporation grants E three incentive stock options
(determined without regard to this section) to acquire
stock with an aggregate fair market value of $150,000
on the date of grant. The dates of grant, the fair mar-
ket value of the stock (as of the applicable date of
grant) with respect to which the options are exercis-
able, and the years in which the options are first ex-
ercisable (without regard to acceleration provisions)
are as follows:
Date of GrantFair Market
Value of Stock
First
Exercisable
Option 1April 1, 2004
$60,000
2004
Option2May1,2004
$50,000
2006
Option 3June 1, 2004
$40,000
2004
(ii) In July of 2004, a change in control of X
Corporation occurs, and, under the terms of its op-
tion plan, all outstanding options become immedi-
ately exercisable. Under the rules of this section, Op-
tion 1 is treated as an incentive stock option in its
entirety; Option 2 exceeds the $100,000 aggregate
fair market value limitation for calendar year 2004 by
$10,000 (Option 1’s $60,000 + Option 2’s $50,000 =
$110,000) and is, therefore,bifurcated into an incen-
tive stock option for stock with a fair market value of
$40,000 as of the date of grant and a nonstatutory op-
tion for stock with a fair market value of $10,000 as
of the date of grant. Option 3 is treated as a nonstatu-
tory option in its entirety.
Example 4.Exercise of option and acceleration
provision. (i) In 2004, X Corporation grants E three
incentive stock options (determined without regard to
this section) to acquire stock with an aggregate fair
market value of $120,000 on the date of grant. The
dates of grant, the fair market value of the stock (as
of the applicable date of grant) with respect to which
the options are exercisable, and the years in which the
options are first exercisable (without regard to accel-
eration provisions) are as follows:
Date of GrantFair Market
Value of Stock
First
Exercisable
Option 1April 1, 2004
$60,000
2005
Option2May1,2004
$40,000
2006
Option 3June 1, 2004
$20,000
2005
(ii) On June 1, 2005, E exercises Option 3. At
the time of exercise of Option 3, the fair market
value of X stock (at the time of grant) with respect
to which options held by E are first exercisable in
2005 does not exceed $100,000. On September 1,
2005, a change of control of X Corporation occurs,
and, under the terms of its option plan, Option 2
becomes immediately exercisable. Under the rules
of this section, because E’s exercise of Option 3
occurs before the change of control and the effects
of an acceleration provision are not taken into ac-
count until it is triggered, Option 3 is treated as an
incentive stock option in its entirety. Option 1 is
treated as an incentive stock option in its entirety.
Option 2 is bifurcated into an incentive stock option
for stock with a fair market value of $20,000 on the
date of grant and a nonstatutory option for stock with
a fair market value of $20,000 on the date of grant
because it exceeds the $100,000 limitation for 2003
by $20,000 (Option 1 for $60,000 + Option 3 for
$20,000 + Option 2 for $40,000 = $120,000).
(iii) Assume the same facts as in paragraph (ii) of
thisExample 4, except that the change of control oc-
curs on May 1, 2005. Because options are taken into
account in the order in which they are granted, Option
1 and Option 2 are treated as incentive stock options
in their entirety. Because the exercise of Option 3 (on
June 1, 2005) takes place after the acceleration provi-
sion is triggered, Option 3 is treated as a nonstatutory
option in its entirety.
Example 5.Cancellation of option. (i) In 2004,
X Corporation grants E three incentive stock options
(determined without regard to this section) to acquire
stock with an aggregate fair market value of $140,000
as of the date of grant. The dates of grant, the fair
market value of the stock (as of the applicable date of
grant) with respect to which the options are exercis-
able, and the years in which the options are first ex-
ercisable (without regard to acceleration provisions)
are as follows:
September 7, 20044312004–36 I.R.B.

Date of GrantFair Market
Value of Stock
First
Exercisable
Option 1April 1, 2004
$60,000
2005
Option2May1,2004
$40,000
2005
Option 3June 1, 2004
$40,000
2005
(ii) On December 31, 2004, Option 2 is canceled.
Because Option 2 is canceledbefore the calendar year
during which it would have become exercisable for
the first time, it is disregarded. As a result, Option 1
and Option 3 are treated as incentive stock options in
their entirety.
(iii) Assume the same facts as in paragraph (ii)
of thisExample 5, except that Option 2 is canceled
on January 1, 2005. Because Option 2 is not can-
celed prior to the calendar year during which it would
have become exercisable for the first time (2005), it
is treated as an outstanding option for purposes of de-
termining whether the $100,000 limitation for 2005
has been exceeded. Becauseoptions are taken into
account in the order in which granted, Option 1 is
treated as an incentive stock option in its entirety. Be-
cause Option 3 exceeds the $100,000 limitation by
$40,000 (Option 1 for $60,000 + Option 2 for $40,000
+ Option 3 for $40,000 = $140,000), it is treated as a
nonstatutory option in its entirety.
(iv) Assume the same facts as in paragraph (i) of
thisExample 5, except that on January 1, 2005, E ex-
ercises Option 2 and immediately sells the stock in
a disqualifying disposition. A disqualifying dispo-
sition has no effect on the determination of whether
the underlying option is considered outstanding dur-
ing the calendar year during which it is first exercis-
able. Because options are taken into account in the
order in which granted, Option 1 is treated as an in-
centive stock option in its entirety. Because Option 3
exceeds the $100,000 limitation by $40,000 (Option
1 for $60,000 + Option 2 for $40,000 + Option 3 for
$40,000 = $140,000), it is treated as a nonstatutory
option in its entirety.
Example 6.Designation of stock. On January 1,
2004, X grants E an immediately exercisable incen-
tive stock option (determined without regard to this
section) to acquire X stock with a fair market value
of $150,000 on that date. Under the rules of this sec-
tion, the option is bifurcated and treated as an incen-
tive stock option for X stock with a fair market value
of $100,000 and a nonstatutory option for X stock
with a fair market value of $50,000. In these cir-
cumstances, X may designate the stock that is treated
as stock acquired pursuant to the exercise of an in-
centive stock option by issuing a separate certificate
(or certificates) for $100,000 of stock and identifying
such certificates as Incentive Stock Option Stock in
its transfer records. In the absence of such a desig-
nation (or a designation in the corporation’s transfer
records or the plan records) shares with a fair market
value of $100,000 are deemed purchased first under
an incentive stock option, and shares with a fair mar-
ket value of $50,000 are deemed purchased under a
nonstatutory option.
Par. 10. Section 1.422–5 is added to
read as follows:
§1.422–5 Permissible provisions.
(a)General rule. An option that other-
wise qualifies as an incentive stock option
does not fail to be an incentive stock op-
tion merely because such option contains
one or more of the provisions described in
paragraphs (b), (c), and (d) of this section.
(b)Cashless exercise. (1) An option
does not fail to be an incentive stock op-
tion merely because the optionee may ex-
ercise the option with previously acquired
stock of the corporation that granted the
option or stock of the corporation whose
stock is being offered for purchase under
the option. For special rules relating to the
use of statutory option stock to pay the op-
tion price of an incentive stock option, see
§1.424–1(c)(3).
(2) All shares acquired through the
exercise of an incentive stock option are
individually subject to the holding period
requirements described in §1.422–1(a)
and the disqualifying disposition rules of
§1.422–1(b), regardless of whether the op-
tion is exercised with previously acquired
stock of the corporation that granted the
option or stock of the corporation whose
stock is being offered for purchase under
the option. If an incentive stock option
is exercised with such shares, and the
exercise results in the basis allocation de-
scribed in paragraph (b)(3) of this section,
the optionee’s disqualifying disposition
of any of the stock acquired through such
exercise is treated as a disqualifying dispo-
sition of the shares with the lowest basis.
(3) If the exercise of an incentive stock
option with previously acquired shares is
comprisedinpartofanexchangetowhich
section1036(andsomuchofsection1031
as relates to section 1036) applies, then:
(i) The optionee’s basis in the incen-
tive stock option shares received in the
section 1036 exchange is the same as the
optionee’s basis in the shares surrendered
in the exchange, increased, if applicable,
byanyamountincludedingrossincome
as compensation pursuant to sections 421
through 424 or section 83. Except for pur-
poses of §1.422–1(a), the holding period
of the shares is determined under section
1223. For purposes of §1.422–1 and sec-
tions 421(b) and 83 and the regulations
thereunder, the amount paid for the shares
purchased under the option is the fair mar-
ket value of the shares surrendered on the
date of the exchange.
(ii) The optionee’s basis in the incen-
tive stock option shares not received pur-
suant to the section 1036 exchange is zero.
For all purposes, the holding period of such
shares begins as of the date that such shares
are transferred to the optionee. For pur-
poses of §1.422–1(b) and sections 421(b)
and 83 and the regulations thereunder, the
amount paid for the shares is considered to
be zero.
(c)Additional compensation. An op-
tion does not fail to be an incentive stock
option merely because the optionee has
the right to receive additional compensa-
tion, in cash or property, when the op-
tion is exercised, provided such additional
compensation is includible in income un-
der section 61 or section 83. The amount
of such additional compensation may be
determined in any manner, including by
reference to the fair market value of the
stock at the time of exercise or to the op-
tion price.
(d)Option subject to a condition.(1)
An option does not fail to be an incentive
stock option merely because the option is
subject to a condition, or grants a right, that
is not inconsistent with the requirements of
§§1.422–2 and 1.422–4.
(2) An option that includes an alterna-
tive right is not an incentive stock option
if the requirements of §1.422–2 are effec-
tively avoided by the exercise of the alter-
native right. For example, an alternative
right extending the option term beyond
ten years, setting an option price below
fair market value, or permitting transfer-
ability prevents an option from qualifying
as an incentive stock option. If either
of two options can be exercised, but not
both, each such option is a disqualifying
alternative right with respect to the other,
2004–36 I.R.B.432September 7, 2004

even though one or both options would
individually satisfy the requirements of
§§1.422–2, 1.422–4, and this section.
(3) An alternative right to receive a tax-
able payment of cash and/or property in
exchange for the cancellation or surrender
of the option does not disqualify the option
as an incentive stock option if the right is
exercisable only when the then fair mar-
ket value of the stockexceeds the exercise
price of the option and the option is oth-
erwise exercisable, the right is transferable
only when the option is otherwise transfer-
able, and the exercise of the right has eco-
nomic and tax consequences no more fa-
vorable than the exercise of the option fol-
lowed by an immediate sale of the stock.
For this purpose, the exercise of the alter-
native right does not have the same eco-
nomic and tax consequences if the pay-
ment exceeds the difference between the
then fair market value of the stock and the
exercise price of the option.
(e)Examples. The principles of this
section are illustrated by the following ex-
amples:
Example 1. On June 1, 2004, X Corporation
grants an incentive stock option to A, an employee
of X Corporation, entitling A to purchase 100 shares
of X Corporation common stock at $10 per share.
The option provides that A may exercise the option
with previously acquired shares of X Corporation
common stock. X Corporation has only one class
of common stock outstanding. Under the rules of
section 83, the shares transferable to A through the
exercise of the option are transferable and not subject
to a substantial risk of forfeiture. On June 1, 2005,
when the fair market value of an X Corporation share
is $25, A uses 40 shares of X Corporation common
stock, which A had purchased on the open market
on June 1, 2002, for $5 per share, to pay the full
option price. After exercising the option, A owns
100 shares of incentive stock option stock. Under
section 1036 (and so much of section 1031 as relates
to section 1036), 40 of the shares have a $200 ag-
gregate carryover basis (the $5 purchase price x 40
shares) and a three-year holding period for purposes
of determining capital gain, and 60 of the shares have
a zero basis and a holding period beginning on June
1, 2005, for purposes of determining capital gain. All
100 shares have a holding period beginning on June
1, 2005, for purposes of determining whether the
holding period requirements of §1.422–1(a) are met.
Example 2. Assume the same facts as inExam-
ple 1. Assume further that, on September 1, 2005, A
sells 75 of the shares that A acquired through exer-
cise of the incentive stock option for $30 per share.
Because the holding period requirements were not
satisfied, A made a disqualifying disposition of the
75 shares on September 1, 2005. Under the rules of
paragraph (b)(2) and (b)(3) of this section, A has sold
all 60 of the non-section-1036 shares and 15 of the
40 section-1036 shares. Therefore, under paragraph
(b)(3) of this section and section 83(a), the amount of
compensation attributable to A’s exercise of the op-
tion and subsequent disqualifying disposition of 75
shares is $1,500 (the difference between the fair mar-
ket value of the stock on the date of transfer, $1,875
(75 shares at $25 per share), and the amount paid
for the stock, $375 (60 shares at $0 per share plus
15 shares at $25 per share)). In addition, A must
recognize a capital gain of $675, which consists of
$375 ($450, the amount realized from the sale of 15
shares, less A’s basis of $75) plus $300 ($1,800, the
amount realized from the sale of 60 shares, less A’s
basis of $1,500 resulting from the inclusion of that
amount in income as compensation). Accordingly,
A must include in gross income for the taxable year
in which the sale occurs $1,500 as compensation and
$675 as capital gain. For its taxable year in which
the disqualifying disposition occurs, if otherwise al-
lowable under section 162 and if the requirements of
§1.83–6(a) are met, X Corporation is allowed a de-
duction of $1,500 for the compensation paid to A.
Example 3. Assume the same facts as inExample
2, except that, instead of selling the 75 shares of in-
centive stock option stock on September 1, 2005, A
uses those shares to exercise a second incentive stock
option. The second option was granted to A by X Cor-
poration on January 1, 2005, entitling A to purchase
100 shares of X Corporation common stock at $22.50
per share. As inExample 2, A has made a disqualify-
ing disposition of the 75 shares of stock pursuant to
§1.424–1(c). Under paragraph (b) of this section, A
has disposed of all 60 of the non-section-1036 shares
and 15 of the 40 section-1036 shares. Therefore, pur-
suant to paragraph (b)(3) ofthis section and section
83(a), the amount of compensation attributable to A’s
exercise of the first option and subsequent disqualify-
ing disposition of 75 shares is $1,500 (the difference
between the fair market value of the stock on the date
of transfer, $1,875 (75 shares at $25 per share), and
the amount paid for the stock, $375 (60 shares at $0
per share plus 15 shares at $25 per share)). UnlikeEx-
ample 2, A does not recognize any capital gain as a
result of exercising the second option because, for all
purposes other than the determination of whether the
exercise is a disposition pursuant to section 424(c),
the exercise is considered an exchange to which sec-
tion 1036 applies. Accordingly, A must include in
gross income for the taxable year in which the dis-
qualifying disposition occurs $1,500 as compensa-
tion. If the requirements of §83(h) and §1.83–6(a)
are satisfied and the deduction is otherwise allowable
under section 162, for its taxable year in which the
disqualifying disposition occurs, X Corporation is al-
lowed a deduction of $1,500 for the compensation
paid to A. After exercising the second option, A owns
a total of 125 shares of incentive stock option stock.
Under section 1036 (and so much of section 1031 as
relates to section 1036), the 100 “new” shares of in-
centive stock option stock have the following bases
and holding periods: 15 shares have a $75 carry-
over basis and a three-year-and-three-month holding
period for purposes of determining capital gain, 60
shares have a $1,500 basis resulting from the inclu-
sion of that amount in income as compensation and a
three-month holding period for purposes of determin-
ing capital gain, and 25 shares have a zero basis and
a holding period beginning on September 1, 2005,
for purposes of determining capital gain. All 100
shares have a holding period beginning on Septem-
ber 1, 2005, for purposes of determining whether the
holding period requirements of §1.422–1(a) are met.
Example 4. Assume the same facts as inExam-
ple 2, except that, instead of selling the 75 shares of
incentive stock option stock on September 1, 2005,
A uses those shares to exercise a nonstatutory option.
The nonstatutory option was granted to A by X Cor-
poration on January 1, 2005, entitling A to purchase
100 shares of X Corporation common stock at $22.50
per share. UnlikeExample 3, A has not made a dis-
qualifying disposition of the 75 shares of stock. Af-
ter exercising the nonstatutory option, A owns a total
of 100 shares of incentive stock option stock and 25
shares of nonstatutory stock option stock. Under sec-
tion 1036 (and so much of section 1031 as relates to
section 1036), the 75 new shares of incentive stock
option stock have the same basis and holding period
as the 75 old shares used to exercise the nonstatutory
option. The additional 25 shares of stock received
upon exercise of the nonstatutory option are taxed un-
der the rules of section 83(a). Accordingly, A must
include in gross income for the taxable year in which
the transfer of such shares occurs $750 (25 shares at
$30 per share) as compensation. A’s basis in such
shares is the same as the amount included in gross
income. For its taxable year in which the transfer oc-
curs, X Corporation is allowed a deduction of $750
for the compensation paid to A to the extent the re-
quirements of section 83(h) and §1.83–6(a) are satis-
fied and the deduction is otherwise allowable under
section 162.
Example 5. Assume the same facts inExample
1, except that the shares transferred pursuant to the
exercise of the incentive stock option are subject to a
substantial risk of forfeiture and not transferable (sub-
stantially nonvested) for a period of six months after
such transfer. Assume further that the shares that A
uses to exercise the incentive stock option are sim-
ilarly restricted. Such shares were transferred to A
on January 1, 2005, through A’s exercise of a non-
statutory stock option which was granted to A on Jan-
uary 1, 2004. A paid $5 per share for the stock when
its fair market value was $22.50 per share. A did
not file a section 83(b) election to include the $700
spread (the difference between the option price and
the fair market value of the stock on date of exer-
cise of the nonstatutory option) in gross income as
compensation. After exercising the incentive stock
option with the 40 substantially-nonvested shares, A
owns 100 shares of substantially-nonvested incentive
stockoptionstock.Section1036(andsomuchofsec-
tion 1031 as relates to section 1036) applies to the 40
shares exchanged in exercise of the incentive stock
option. However, pursuant to section 83(g), the stock
received in such exchange, because it is incentive
stock option stock, is not subject to restrictions and
conditions substantially similar to those to which the
stock given in such exchange was subject. For pur-
poses of section 83(a) and §1.83–1(b)(1), therefore,
A has disposed of the 40 shares of substantially-non-
vested stock on June 1, 2005, and must include in
gross income as compensation $800 (the difference
between the amount realized upon such disposition,
$1,000, and the amount paid for the stock, $200).
Accordingly, 40 shares of the incentive stock option
stock have a $1,000 basis (the $200 original basis plus
the $800 included in income as compensation) and 60
shares of the incentive stock option stock have a zero
basis. For its taxable year in which the disposition of
September 7, 20044332004–36 I.R.B.

the substantially-nonvested stock occurs, X Corpora-
tion is allowed a deduction of $800 for the compen-
sationpaidtoA,providedtherequirementsofsection
83(h) and §1.83–6(a) are satisfied and the deduction
is otherwise allowable under section 162.
(f)Effective date—(1)In general.
These regulations are effective on August
3, 2004.
(2)Reliance and transition period.For
statutory options granted on or before
June 9, 2003, taxpayers may rely on the
1984 proposed regulations LR–279–81
(49 FR 4504), the 2003 proposed regu-
lations REG–122917–02 (68 FR 34344),
or this section until the earlier of January
1, 2006, or the first regularly scheduled
stockholders meeting of the granting cor-
poration occurring 6 months after August
3, 2004. For statutory options granted
after June 9, 2003, and before the earlier
of January 1, 2006, or the first regularly
scheduled stockholders meeting of the
granting corporation occurring at least 6
months after August 3, 2004, taxpayers
may rely on either the REG–122917–02
or this section. Taxpayers may not rely
on LR–279–81 or REG–122917–02 af-
ter December 31, 2005. Reliance on
LR–279–81, REG–122917–02, or this
section must be in its entirety, and all
statutory options granted during the re-
liance period must be treated consistently.
§1.423–1 [Amended]
Par. 11. Section 1.423–1 is amended as
follows:
1. In paragraph (a)(2), the language
“425(a)” is removed and “424(a)” is added
in its place.
2. In paragraph (b), first sentence,
the language “§1.421–7” is removed and
“§1.421–1” is added in its place.
3. In paragraph (b), second sentence,
the language “§1.421–8” is removed and
“§1.421–2” is added in its place.
4. In paragraph (b), last sentence,
the language “425(c)” is removed and
“424(c)” is added in its place.
5. In paragraph (b), last sentence,
the language “§1.425–1” is removed and
“§1.424–1” is added in its place.
§1.423–2 [Amended]
Par. 12. Section 1.423–2 is amended
by:
1. In paragraph (b), last sentence,
the language “§1.421–7” is removed and
“§1.421–1” is added in its place.
2. In paragraph (d)(1), second sen-
tence, the language “425(d)” is removed
and “424(d)” is added in its place.
3. In paragraph (d)(3),Example 1,
fourth sentence, the language “425(d)”
is removed and “424(d)” is added in its
place.
4. In paragraph (e)(2), the language
“§1.421–7” is removed and “§1.421–1” is
added in its place.
5. In paragraph (g)(1), the first sen-
tence of the concluding text, the language
“§1.421–7” is removed and “§1.421–1” is
added in its place.
6. In paragraph (g)(1), the second sen-
tence of the concluding text, the language
“§1.421–7” is removed and “§1.421–1” is
added in its place.
7. In paragraph (j), second sentence,
the language “§1.421–7” is removed and
“§1.421–1” is added in its place.
8. In paragraph (j), last sentence, the
language “425” is removed and “424” is
added in its place.
9. In paragraph (k)(2), second sentence,
the language “§1.421–8” is removed and
“§1.421–2” is added in its place.
§1.425–1 [Redesignated as §1.424–1]
Par. 13. Section 1.425–1 is redesig-
nated as §1.424–1 and is amended by:
1. Revising paragraphs (a)(1) through
(a)(6).
2. Redesignating paragraph (a)(7) as
paragraph (a)(9).
3. Adding a new paragraph (a)(7).
4. Revising paragraph (a)(8).
5. Adding paragraph (a)(10).
6. In paragraph (b)(1), first, second,
and last sentences, the language “425” is
removed wherever it appears, and “424” is
added in their places.
7. In paragraph (c)(1), first sentence,
the language “425” is removed and “424”
is added in its place.
8. In paragraph (c)(1), first sentence,
the language “disposition” is removed and
“disposition of stock” is added in its place.
9. Adding paragraph (c)(1)(iv).
10. Redesignating paragraph (c)(3) as
(c)(4).
11. Adding new paragraph (c)(3).
12. Adding newly designated para-
graph (c)(4)Examples 7through9.
13. In the list below, for each section
indicated in the left column, remove the
language in the middle column and add the
language in the right column:
Newly Designated
Section
RemoveAdd
1.424-1(c)(4)
Example 1, first sentence
19642004
1.424-1(c)(4)
Example 1, first sentence
qualified stock optionstatutory option
1.424-1(c)(4)
Example 1, second and fourth sentences
19652005
1.424-1(c)(4)
Example 1, third sentence
19682006
1.424-1(c)(4)
Example 2, first sentence
19682006
2004–36 I.R.B.434September 7, 2004

Newly Designated
Section
RemoveAdd
1.424-1(c)(4)
Example 2, last sentence
long-term
1.424-1(c)(4)
Example 3, first sentence
19682006
1.424-1(c)(4)
Example 4, first sentence
1968, two years and 11 months after the
transfer of shares to him
2006
1.424-1(c)(4)
Example 4, last sentence
three years from the datetwo years from the date the options were
granted and within one year of the date
that
1.424-1(c)(4)
Example 5, first sentence
19652005
1.424-1(c)(4)Example 5, first sentencequalified stock optionstatutory option
1.424-1(c)(4)
Example 6, first sentence
19652005
1.424-1(c)(4)
Example 6, third sentence
three years2 years
1.424-1(c)(4)
Example 6, third sentence
incomecompensation income
1.424-1(c)(4)
Example 6, third sentence
a qualified stock optionthe option
1.424-1(c)(4)
Example 6, last sentence
paragraph (b)(2) of §1.421-8§1.421-2(b)(2)
14. Revising paragraph (d).
15. Revising paragraphs (e)(1) and
(e)(2).
16. In paragraph (e)(3), first sentence,
remove the phrase “Except as otherwise
provided in subparagraph (4) of this para-
graph” and add “If section 423(c) applies
to an option then,”.
17. In paragraph (e)(3), first sentence,
remove the language “, and 424(b)(1).”
18. Removing paragraph (e)(4).
19. Redesignating paragraph (e)(5) as
paragraph (e)(4).
20. Revising newly designated para-
graph (e)(4).
21. Redesignating paragraph (e)(6) as
paragraph (e)(5) and removing the second
and third sentences.
22. Adding and reserving a new para-
graph (e)(6).
23. In list below, for each section indi-
cated in the left column, remove the lan-
guage in the middle column and add the
language in the right column:
SectionRemoveAdd
1.424-1(e)(7)
Example 1, first and sixth sentences
19642004
1.424-1(e)(7)
Example 1, first sentence
19662006
1.424-1(e)(7)
Example 1, third, fourth, fifth, sixth and
last sentences
19652005
1.424-1(e)(7)
Example 1, fifth sentence
425(h)424(h)
1.424-1(e)(7)
Example 1, last sentence
The exercise of suchBecause the requirements of
§1.424-1(e)(3) and §1.423-2(g)
have not been met, the exercise of such
September 7, 20044352004–36 I.R.B.

SectionRemoveAdd
1.424-1(e)(7)
Example 2,first,second,andfifth
sentences
19642004
1.424-1(e)(7)
Example 2,first,third,fourth,andfifth
sentences, wherever it appears
19652005
1.424-1(e)(7)
Example 2, first and third sentences
19662006
1.424-1(e)(7)
Example 2, fifth sentence
425(h)424(h)
1.424-1(e)(7)
Example 2, last sentence
The exercise of suchBecause the requirements of
§1.424-1(e)(3) and §1.423-2(g)
have not been met, the exercise of such
1.424-1(e)(7)
Example 3, first, second, and last sentences
19652005
24. In paragraph (e)(7), removeExam-
ple 4.
25. Adding paragraphs (f) and (g).
The additions and revisions are as fol-
lows:
§ 1.424–1 Definitions and special rules
applicable to statutory options.
(a)Substitutions and assumptions of op-
tions—(1)In general. (i) This paragraph
(a) provides rules under which aneligi-
ble corporation(as defined in paragraph
(a)(2) of this section) may, by reason of a
corporate transaction(as defined in para-
graph (a)(3) of this section), substitute a
new statutory option (new option) for an
outstanding statutory option (old option)
or assume an old option without such sub-
stitution or assumption being considered a
modification of the old option. For the def-
inition ofmodification, see paragraph (e)
of this section.
(ii) For purposes of §§1.421–1 through
1.424–1, the phrase “substituting or as-
suming a stock option in a transaction to
which section 424 applies,” “substituting
or assuming a stock option in a transaction
to which §1.424–1(a) applies,” and simi-
lar phrases means a substitution of a new
option for an old option or an assumption
of an old option that meets the require-
ments of this paragraph (a). For a substi-
tution or assumption to qualify under this
paragraph (a), the substitution or assump-
tion must meet all of the requirements de-
scribed in paragraphs (a)(4) and (a)(5) of
this section.
(2)Eligible corporation. For purposes
of this paragraph (a), the termeligible cor-
porationmeans a corporation that is the
employer of the optionee or a related cor-
poration of such corporation. For purposes
of this paragraph (a), the determination of
whether a corporation is the employer of
the optionee or a related corporation of
such corporation is based upon all of the
relevant facts and circumstances existing
immediately after the corporate transac-
tion. See §1.421–1(h) for rules concerning
the employment relationship.
(3)Corporate transaction. For pur-
poses of this paragraph (a), the termcor-
porate transactionincludes—
(i) A corporate merger, consolidation,
acquisition of property or stock, separa-
tion, reorganization, or liquidation;
(ii) A distribution (excluding an ordi-
nary dividend or a stock split or stock div-
idend described in §1.424–1(e)(4)(v)) or
change in the terms or number of outstand-
ing shares of such corporation; and
(iii) Such other corporate events pre-
scribed by the Commissioner in published
guidance.
(4)By reason of. (i) For a change in
an option or issuance of a new option to
qualify as a substitution or assumption un-
der this paragraph (a), the change must be
made by aneligible corporation(as de-
fined in paragraph (a)(2) of this section)
and occur by reason of acorporate trans-
action(as defined in paragraph (a)(3) of
this section).
(ii) Generally, a change in an option or
issuance of a new option is considered to
be by reason of a corporate transaction, un-
less the relevant facts and circumstances
demonstrate that such change or issuance
is made for reasons unrelated to such cor-
porate transaction. For example, a change
in an option or issuance of a new option
will be considered to be made for reasons
unrelated to a corporate transaction if there
is an unreasonable delay between the cor-
porate transaction and such change in the
option or issuance of a new option, or if
the corporate transaction serves no sub-
stantial corporate business purpose inde-
pendent of the change in options. Simi-
larly, a change in the number or price of
shares purchasable under an option merely
to reflect market fluctuations in the price
of the stock purchasable under an option is
not by reason of a corporate transaction.
(iii) A change in an option or issuance
of a new option is by reason of a distri-
bution or change in the terms or number
of the outstanding shares of a corporation
(as described in paragraph (a)(3)(ii) of this
section) only if the option as changed, or
the new option issued, is an option on the
same stock as under the old option (or if
such class of stock is eliminated in the
change in capital structure, on other stock
of the same corporation).
(5)Other requirements. For a change
in an option or issuance of a new option
to qualify as a substitution or assumption
under this paragraph (a), all of the require-
ments described in this paragraph (a)(5)
must be met.
(i) In the case of an issuance of a new
option (or a portion thereof) in exchange
2004–36 I.R.B.436September 7, 2004

for an old option (or portion thereof), the
optionee’s rights under the old option (or
portion thereof) must be canceled, and the
optionee must lose all rights under the old
option (or portion thereof). There cannot
be a substitution of a new option for an
old option within the meaning of this para-
graph (a) if the optionee may exercise both
the old option and the new option. It is not
necessary to have a complete substitution
of a new option for the old option. How-
ever, any portion of such option which is
not substituted or assumed in a transaction
to which this paragraph (a) applies is an
outstanding option to purchase stock or, to
the extent paragraph (e) of this section ap-
plies, a modified option.
(ii) The excess of the aggregate fair
market value of the shares subject to the
new or assumed option immediately after
the change in the option or issuance of a
new option over the aggregate option price
of such shares must not exceed the excess
of the aggregate fair market value of all
shares subject to the old option (or portion
thereof) immediately before the change in
the option or issuance of a new option over
the aggregate option price of such shares.
(iii) On a share by share comparison,
the ratio of the option price to the fair mar-
ket value of the shares subject to the option
immediately after the change in the option
or issuance of a new option must not be
more favorable to the optionee than the ra-
tio of the option price to the fair market
value of the stock subject to the old op-
tion (or portion thereof) immediately be-
fore the change in the option or issuance
of a new option. The number of shares
subject to the new orassumed option may
be adjusted to compensate for any change
in the aggregate spread between the ag-
gregate option price and the aggregate fair
market value of the shares subject to the
option immediately after the change in the
option or issuance of the new option as
compared to the aggregate spread between
the option price and theaggregate fair mar-
ket value of the shares subject to the option
immediately before the change in the op-
tion or issuance of the new option.
(iv)Theneworassumedoptionmust
contain all terms of the old option, except
to the extent such terms are rendered inop-
erative by reason of the corporate transac-
tion.
(v) The new option or assumed option
must not give the optionee additional ben-
efits that the optionee did not have under
the old option.
(6)Obligation to substitute or assume
not necessary. For a change in the op-
tion or issuance of a new option to meet
the requirements of this paragraph (a), it
is not necessary to show that the corpora-
tion changing an option or issuing a new
option is under any obligation to do so.
In fact, this paragraph (a) may apply even
when the option that is being replaced or
assumed expressly provides that it will ter-
minate upon the occurrence of certain cor-
porate transactions. However, this para-
graph (a) cannot be applied to revive a
statutory option which, for reasons not re-
lated to the corporate transaction, expires
before it can properly be replaced or as-
sumed under this paragraph (a).
(7)Issuance of stock without meeting
the requirements of this paragraph (a).A
change in the terms of an option resulting
in a modification of such option occurs if
an optionee’s new employer (or a related
corporation of the new employer) issues
its stock (or stock of a related corporation)
upon exercise of such option without sat-
isfying all of the requirements described in
paragraphs (a)(4) and (5) of this section.
(8)Date of grant. For purposes of ap-
plying the rules of this paragraph (a), a sub-
stitution or assumption is considered to oc-
cur on the date that the optionee would,
but for this paragraph (a), be considered to
have been granted the option that the eligi-
ble corporation is substituting or assuming.
A substitution or an assumption that occurs
by reason of a corporate transaction may
occur before or after the corporate transac-
tion.
*****
(10)Examples. The principles of this
paragraph (a) are illustrated by the follow-
ing examples:
Example 1.Eligible corporation.XCorpora-
tion acquires a new subsidiary, Y Corporation, and
transfers some of its employees to Y. Y Corporation
wishes to grant to its new employees and to the em-
ployees of X Corporation new options for Y shares in
exchange for old options for X shares that were pre-
viously granted by X Corporation. Because Y Cor-
poration is an employer with respect to its own em-
ployees and a related corporation of X Corporation,
Y Corporation is an eligible corporation under para-
graph (a)(2) of this section with respect to both the
employees of X and Y Corporations.
Example 2.Corporate transaction.(i)OnJan-
uary 1, 2004, Z Corporation grants E, an employee
of Z, an option to acquire 100 shares of Z common
stock. At the time of grant, the fair market value of Z
common stock is $200 per share. E’s option price is
$200 per share. On July 1, 2005, when the fair market
value of Z common stock is $400, Z declares a stock
dividend of preferred stock distributed on common
stock that causes the fair market value of Z common
stock to decrease to $200 per share. On the same day,
Z grants to E a new option to acquire 200 shares of
Z common stock in exchangefor E’s old option. The
new option has an exercise price of $100 per share.
(ii) A stock dividend other than that described
in §1.424–1(e)(4)(v) is a corporate transaction under
paragraph (a)(3)(ii) of this section. Generally, the is-
suance of a new option is considered to be by reason
of a corporate transaction. None of the facts in this
Example 2indicate that the new option is not issued
by reason of the stock dividend. In addition, the new
option is issued on the same stock as the old option.
Thus, the substitution occurs by reason of the corpo-
rate transaction. Assuming the other requirements of
this section are met, the issuance of the new option
is a substitution that meets the requirements of this
paragraph (a) and is not a modification of the option.
(iii) Assume the same facts as in paragraph (i) of
thisExample 2. Assume further that on December 1,
2005, Z declares an ordinary cash dividend. On the
same day, Z grants E a new option to acquire Z stock
in substitution for E’s old option. Under paragraph
(a)(3)(ii) of this section, an ordinary cash dividend is
not a corporate transaction. Thus, the exchange of
the new option for the old option does not meet the
requirements of this paragraph (a) and is a modifica-
tion of the option.
Example 3.Corporate transaction. On March 15,
2004, A Corporation grants E, an employee of A, an
option to acquire 100 shares of A stock at $50 per
share, the fair market value of A stock on the date
of grant. On May 2, 2005, A Corporation transfers
several employees, including E, to B Corporation, a
related corporation. B Corporation arranges to pur-
chase some assets from A on the same day as E’s
transfer to B. Such purchase is without a substan-
tial business purpose independent of making the ex-
change of E’s old options for the new options appear
to be by reason of a corporate transaction. The fol-
lowing day, B Corporation grants to E, one of its new
employees, an option to acquire shares of B stock in
exchangefortheoldoptionheldbyEtoacquireA
stock. Under paragraph (a)(3)(i) of this section, the
purchase of assets is a corporate transaction. Gener-
ally, the substitution of an option is considered to oc-
cur by reason of a corporate transaction. However, in
this case, the relevant facts and circumstances demon-
strate that the issuance of the new option in exchange
for the old option occurred by reason of the change
in E’s employer rather than a corporate transaction
and that the sale of assets is without a substantial cor-
porate business purpose independent of the change in
the options. Thus, the exchange of the new option for
the old option is not by reason of a corporate transac-
tion that meets the requirements of this paragraph (a)
andisamodificationoftheoldoption.
Example 4.Corporate transaction. (i) E, an em-
ployee of Corporation A, holds an option to acquire
100 shares of Corporation A stock. On September
1, 2006, Corporation A has one class of stock out-
standing and declares a stock dividend of one share
of common stock for each outstanding share of com-
mon stock. The rights associated with the common
stock issued as a dividend are the same as the rights
September 7, 20044372004–36 I.R.B.

under existing shares of stock. In connection with the
stock dividend, E’s option is exchanged for an op-
tion to acquire 200 shares of Corporation A stock.
The per-share exercise price is equal to one half of
the per-share exercise price of the original option.
The stock dividend merely changes the number of
shares of Corporation A outstanding and effects no
other change to the stock of Corporation A. The op-
tion is proportionally adjusted and the aggregate ex-
ercise price remains the same and therefore satisfies
the requirements described in §1.424–1(e)(4)(v).
(ii) The stock dividend is not a corporate trans-
action under paragraph (a)(3) of this section, and the
declaration of the stock dividend is not a modification
of the old option under paragraph (a) of this section.
Pursuant to §1.424–1(e)(4)(v), the exercise price of
the old option may be adjusted proportionally with
the change in the number of outstanding shares of
Corporation A such that the ratio of the aggregate ex-
ercise price of the option to the number of shares cov-
ered by the option is the same both before and after
the stock dividend. The adjustment of E’s option is
not treated as a modification of the option.
Example 5.Additional benefit. On June 1, 2004,
P Corporation acquires 100 percent of the shares of
S Corporation and issuesa new option to purchase
P shares in exchange for an old option to purchase
SsharesthatisheldbyE,anemployeeofS.Onthe
date of the exchange, E’s old option is exercisable for
3 more years, and, after the exchange, E’s new option
is exercisable for 5 years. Because the new option is
exercisable for an additional period of time beyond
the time allowed under the old option, the effect of
the exchange of the new option for the old option is
to give E an additional benefit that E did not enjoy
under the old option. Thus, the requirements of para-
graph (a)(5) of this section are not met, and this para-
graph (a) does not apply to the exchange of the new
option for the old option. Therefore, the exchange is
a modification of the old options.
Example 6.Spread and ratio tests. E is an em-
ployee of S Corporation. E holds an old option that
was granted to E by S to purchase 60 shares of S at
$12 per share. On June 1, 2005, S Corporation is
merged into P Corporation, and on such date P issues
a new option to purchase Pshares in exchange for
E’s old option to purchase S shares. Immediately be-
fore the exchange, the fair market value of an S share
is $32; immediately after the exchange, the fair mar-
ket value of a P share is $24. The new option enti-
tles E to buy P shares at $9 per share. Because, on a
share-by-share comparison, the ratio of the new op-
tion price ($9 per share) to the fair market value of a P
share immediately after the exchange ($24 per share)
is not more favorable to E than the ratio of the old
option price ($12 per share) to the fair market value
of an S share immediately before the exchange ($32
per share) (9/24 = 12/32), the requirements of para-
graph (a)(5)(iii) of this section are met. The number
of shares subject to E’s option to purchase P stock is
set at 80. Because the excess of the aggregate fair
market value over the aggregate option price of the
shares subject to E’s new option to purchase P stock,
$1,200 (80 x $24 minus 80 x $9), is not greater than
the excess of the aggregate fair market value over the
aggregate option price of the shares subject to E’s old
option to purchase S stock, $1,200 (60 x $32 minus
60 x $12), the requirements of paragraph (a)(5)(ii) of
this section are met.
Example 7.Ratio test and partial substitution.
Assume the same facts as inExample 6, except that
the fair market value of an S share immediately before
the exchange of the new option for the old option is
$8, that the option price is $10 per share, and that the
fair market value of a P share immediately after the
exchange is $12. P sets the new option price at $15
per share. Because, on a share-by-share comparison,
the ratio of the new option price ($15 per share) to
the fair market value of a P share immediately after
the exchange ($12) is not more favorable to E than
the ratio of the old option price ($10 per share) to the
fair market value of an S share immediately before
the substitution ($8 per share) (15/12 = 10/8), the re-
quirements of paragraph (a)(5)(iii) of this section are
met. Assume further that the number of shares sub-
ject to E’s P option is set at 20, as compared to 60
shares under E’s old option to buy S stock. Imme-
diately after the exchange, 2 shares of P are worth
$24, which is what 3 shares of S were worth immedi-
ately before the exchange (2 x $12 = 3 x $8). Thus,
to achieve a complete substitution of a new option for
E’s old option, E would need to receive a new option
to purchase 40 shares of P (i.e., 2 shares of P for each
3 shares of S that E could have purchased under the
old option (2/3 = 40/60)). Because E’s new option is
for only 20 shares of P, P has replaced only
1
/2of E’s
old option, and the other
1
/2is still outstanding.
Example 8.Partial substitution. X Corporation
forms a new corporation, Y Corporation, by a trans-
fer of certain assets and, in a spin-off, distributes the
shares of Y Corporation to the stockholders of X Cor-
poration. E, an employee of X Corporation, is there-
after an employee of Y. Y wishes to substitute a new
option to purchase some of its stock for E’s old option
to purchase 100 shares of X. E’s old option to pur-
chase shares of X, at $50 a share, was granted when
the fair market value of an X share was $50, and an X
share was worth $100 just before the distribution of
the Y shares to X’s stockholders. Immediately after
the spin-off, which is also the time of the substitution,
each share of X and each share of Y is worth $50.
Based on these facts, a new option to purchase 200
shares of Y at an option price of $25 per share could
be granted to E in complete substitution of E’s old op-
tion. In the alternative, it would also be permissible
in connection with a spinoff to grant E a new option
to purchase 100 shares of Y, at an option price of $25
per share, and for E to retain an option to purchase
100 shares of X under the old option, with the op-
tion price adjusted to $25. However, because X is no
longer a related corporation with respect to Y, E must
exercise the option for 100 shares of X within three
months from the date of the spinoff for the option to
be treated as a statutory option. See §1.421–1(h).
Example 9.Stockholder approval requirements.
(i) X Corporation, a publicly traded corporation,
adopts an incentive stock option plan that meets the
requirements of §1.422–2. Under the plan, options to
acquire X stock are granted to X employees. X Cor-
poration is acquired by Y Corporation and becomes
a subsidiary corporation of Y Corporation. After the
acquisition, X employees remain employees of X.
In connection with the acquisition, Y Corporation
substitutes new options to acquire Y stock for the old
options to acquire X stock previously granted to the
employees of X. As a result of this substitution, on
exercise of the new options, X employees receive Y
Corporation stock.
(ii) Because the requirements of §1.422–2 were
met on the date of grant, the substitution of the new
Y options for the old X options does not require new
stockholder approval. If the other requirements of
paragraphs (a)(4) and (5) of this section are met, the
issuance of new options for Y stock in exchange for
the old options for X stock meets the requirements of
this paragraph (a) and is not a modification of the old
options.
(iii) Assume the same facts as in paragraphs (i)
and (ii) of thisExample 9. Assume further that as part
of the acquisition, X amends its plan to allow future
grants under the plan to be grants to acquire Y stock.
Because the amendment of the plan to allow options
on a different stock is considered the adoption of a
new plan under §1.422–2(b)(2)(iii), the stockholders
of Y must approve the plan within 12 months before
or after the date of the amendment of the plan. If the
stockholders of Y timely approve the plan, the future
grants to acquire Y stock will be incentive stock op-
tions (assuming the other requirements of §1.422–2
have been met).
Example 10.Modification. X Corporation
merges into Y Corporation. Y Corporation retains
employees of X who hold old options to acquire X
Corporation stock. When the former employees of
X exercise the old options, Y Corporation issues Y
stock to the former employees of X. Under paragraph
(a)(7) of this section, because Y issues its stock on
exercise of the old options for X stock, there is a
change in the terms of the old options for X stock.
Thus, the issuance of Y stock on exercise of the old
options is a modification of the old options.
Example 11.Eligible corporation. (i) D Corpora-
tion grants an option to acquire 100 shares of D Cor-
poration stock to E, an employee of D Corporation.
S Corporation is a subsidiary of D Corporation. On
March 1, 2005, D Corporation spins off S Corpora-
tion. E remains an employee of D Corporation. In
connection with the spin off, D Corporation substi-
tutes a new option to acquire D Corporation stock and
a new option to acquire S Corporation stock for the
old option in a manner that meets the requirements of
paragraph (a) of this section.
(ii) The substitution of the new option to acquire
S and D stock for the old option to acquire D stock is
not a modification of the old option. However, be-
cause S is no longer a related corporation with re-
spect to D Corporation, E must exercise the option
for S stock within three months from March 1, 2005,
for the option to be treated as a statutory option. See
§1.421–1(h).
(iii) Assume the same facts as in paragraph (i)
of thisExample 11except that E’s employment with
D Corporation is terminated on February 20, 2005.
The substitution of the new option to acquire S and
D stock for the old option to acquire D stock is not
a modification of the old option. However, because
the employment relationship between E and D Corpo-
ration terminated on February 20, 2005, E must ex-
ercise the option for the D and S stock within three
months from February 20, 2005, for the option to be
treated as a statutory option. See §1.421–1(h).
*****
(c)***(1)***
(iv) A transfer between spouses or in-
cident to divorce (described in section
1041(a)). The special tax treatment of
2004–36 I.R.B.438September 7, 2004

§1.421–2(a) with respect to the transferred
stock applies to the transferee. However,
see §1.421–1(b)(2) for the treatment of the
transfer of a statutory option incident to
divorce.
*****
(3) If an optionee exercises an incentive
stock option with statutory option stock
and the applicable holding period require-
ments (under §1.422–1(a) or §1.423–1(a))
with respect to such statutory option stock
are not met before such transfer, then sec-
tions 354, 355, 356, or 1036 (or so much
of 1031 as relates to 1036) do not apply to
determine whether there is a disposition of
those shares. Therefore, there is a disposi-
tion of the statutory option stock, and the
special tax treatment of § 1.421–2(a) does
not apply to such stock.
(4) * * *
Example 7. On January 1, 2004, X Corporation
grants to E, an employee of X Corporation, an incen-
tive stock option to purchase 100 shares of X Corpo-
ration stock at $100 per share (the fair market value
of an X Corporation share on that date). On Jan-
uary 1, 2005, when the fair market value of a share
of X Corporation stock is $200, E exercises half of
the option, pays X Corporation $5,000 in cash, and
is transferred 50 shares of X Corporation stock with
an aggregate fair market value of $10,000. E makes
no disposition of the shares before January 2, 2006.
Under §1.421–2(a), no income is recognized by E on
the transfer of shares pursuant to the exercise of the
incentive stock option, and X Corporation is not en-
titled to any deduction at any time with respect to its
transfer of the shares to E. E’s basis in the shares is
$5,000.
Example 8. Assume the same facts as inExample
7, except that on December 1, 2005, one year and 11
months after the grant of the option and 11 months af-
ter the transfer of the 50 shares to E, E uses 25 of those
shares, with a fair market value of $5,000, to pay for
the remaining 50 shares purchasable under the option.
On that day, X Corporation transfers 50 of its shares,
with an aggregate fair market value of $10,000, to E.
Because E disposed of the 25 shares before the expi-
ration of the applicable holding periods, §1.421–2(a)
does not apply to the January 1, 2005, transfer of the
25 shares used by E to exercise the remainder of the
option. As a result of the disqualifying disposition of
the 25 shares, E recognizes compensation income un-
der the rules of §1.421–2(b).
Example 9. On January 1, 2005, X Corporation
grants an incentive stock option to E, an employee of
X Corporation. The exercise price of the option is
$10 per share. On June 1, 2005, when the fair market
value of an X Corporation share is $20, E exercises
the option and purchases 5 shares with an aggregate
fair market value of $100. On January 1, 2006, when
the fair market value of an X Corporation share is
$50, X Corporation is acquired by Y Corporation in
a section 368(a)(1)(A) reorganization. As part of the
acquisition, all X Corporation shares are converted
into Y Corporation shares. After the conversion, if
an optionee holds a fractional share of Y Corpora-
tion stock, Y Corporation will purchase the fractional
share for cash equal to its fair market value. After ap-
plying the conversion formula to the shares held by
E, E has 10
1
/2Y Corporation shares. Y Corporation
purchases E’s one-half share for $25, the fair mar-
ket value of one-half of a Y Corporation share on the
conversion date. Because E sells the one-half share
prior to expiration of the holding periods described
in §1.422–1(a), the sale is a disqualifying disposition
of the one-half share. Thus, in 2006, E must recog-
nize compensation income of $5 (one-half of the fair
market value of an X Corporation share on the date
of exercise of the option, or $10, less one-half of the
exercise price per share, or $5). For purposes of com-
puting any additional gain, E’s basis in the one-half
share increases to $10 (reflecting the $5 included in
income as compensation). Erecognizes an additional
gain of $15 ($25, the fair market value of the one-half
share, less $10, the basisin such share). The extent
to which the additional $15 of gain is treated as a re-
demption of Y Corporation stock is determined under
section 302.
(d)Attribution of stock ownership.To
determine the amount of stock owned by
an individual for purposes of applying the
percentage limitations relating to certain
stockholders described in §§1.422–2(f)
and 1.423–2(d), shares of the employer
corporation or of a related corporation
that are owned (directly or indirectly) by
or for the individual’s brothers and sis-
ters (whether by the whole or half blood),
spouse, ancestors, and lineal descendants,
are considered to be owned by the individ-
ual. Also, for such purposes, if a domestic
or foreign corporation, partnership, estate,
or trust owns (directly or indirectly) shares
of the employer corporation or of a related
corporation, the shares are considered to
be owned proportionately by or for the
stockholders, partners, or beneficiaries
of the corporation, partnership, estate, or
trust. The extent to which stock held by
the optionee as a trustee of a voting trust
is considered owned by the optionee is
determined under all of the facts and cir-
cumstances.
(e)Modification, extension, or renewal
of option. (1) This paragraph (e) provides
rules for determining whether a share of
stock transferred to an individual upon the
individual’s exercise of an option after the
terms of the option have been changed is
transferred pursuant to the exercise of a
statutory option.
(2) Any modification, extension, or re-
newal of the terms of an option to purchase
shares is considered the granting of a new
option. The new option may or may not be
a statutory option. To determine the date
of grant of the new option for purposes of
section 422 or 423, see §1.421–1(c).
*****
(4)(i) For purposes of §§1.421–1
through 1.424–1 the termmodification
means any change in the terms of the op-
tion (or change in the terms of the plan
pursuant to which the option was granted
or in the terms of any other agreement
governing the arrangement) that gives the
optionee additional benefits under the op-
tion regardless of whether the optionee
in fact benefits from the change in terms.
In contrast, for example, a change in the
terms of the option shortening the period
during which the option is exercisable is
not a modification. However, a change
providing an extension of the period dur-
ing which an option may be exercised
(such as after termination of employment)
or a change providing an alternative to
the exercise of the option (such as a stock
appreciation right) is a modification re-
gardless of whether the optionee in fact
benefits from such extension or alternative
right. Similarly, a change providing an ad-
ditional benefit upon exercise of the option
(such as the payment of a cash bonus) or
a change providing more favorable terms
for payment for the stock purchased under
the option (such as the right to tender pre-
viously acquired stock) is a modification.
(ii) If an option is not immediately exer-
cisable in full, a change in the terms of the
option to accelerate the time at which the
option (or any portion thereof) may be ex-
ercised is not a modification for purposes
of this section. Additionally, no modifica-
tion occurs if a provision accelerating the
time when an option may first be exercised
is removed prior to the year in which it
would otherwise be triggered. For exam-
ple, if an acceleration provision is timely
removed to avoid exceeding the $100,000
limitation described in §1.422–4, a modi-
fication of the option does not occur.
(iii) A change to an option which pro-
vides, either by its terms or in substance,
that the optionee mayreceive an additional
benefit under the option at the future dis-
cretion of the grantor, is a modification
at the time that the option is changed to
provide such discretion. In addition, the
exercise of discretion to provide an addi-
tional benefit is a modification of the op-
tion. However, it is not a modification for
the grantor to exercise discretion specif-
September 7, 20044392004–36 I.R.B.

ically reserved under an option with re-
spect to the payment of a cash bonus at the
time of exercise, the availability of a loan
at exercise, the right to tender previously
acquired stock for the stock purchasable
under the option, or the payment of em-
ployment taxes and/or required withhold-
ing taxes resulting from the exercise of a
statutory option. An option is not modi-
fied merely because an optionee is offered
a change in the terms of an option if the
change to the option is not made. An offer
to change the terms of an option that re-
mains open less than 30 days is not a modi-
fication of the option. However, if an offer
to change the terms of an option remains
outstanding for 30 days or more, there is
a modification of the option as of the date
the offer to change the option is made.
(iv) A change in the terms of the stock
purchasable under the option that increases
the value of the stock is a modification
of such option, except to the extent that a
new option is substituted for such option
by reason of the change in the terms of the
stock in accordance with paragraph (a) of
this section.
(v) If an option is amended solely to
increase the number of shares subject to
the option, the increase is not considered a
modification of the option but is treated as
the grant of a new option for the additional
shares. Notwithstanding the previous sen-
tence, if the exercise price and number of
shares subject to an option are proportion-
ally adjusted to reflecta stock split (includ-
ing a reverse stock split) or stock dividend,
and the only effect of the stock split or
stock dividend is to increase (or decrease)
on apro ratabasis the number of shares
owned by each shareholder of the class of
stock subject to the option, then the option
is not modified if it is proportionally ad-
justed to reflect the stock split or stock div-
idend and the aggregate exercise price of
the option is not less than the aggregate ex-
ercise price before the stock split or stock
dividend.
(vi)Anychangeinthetermsofanop-
tion made in an attempt to qualify the op-
tion as a statutory option grants additional
benefits to the optionee and is, therefore, a
modification.
(vii) An extension of an option refers
to the granting by the corporation to the
optionee of an additional period of time
within which to exercise the option be-
yond the time originally prescribed. A re-
newal of an option is the granting by the
corporation of the same rights or privi-
leges contained in the original option on
the same terms and conditions. The rules
of this paragraph apply as well to suc-
cessive modifications, extensions, and re-
newals.
(viii) Any inadvertent change to the
terms of an option (or change in the terms
of the plan pursuant to which the option
was granted or in the terms of any other
agreement governing the arrangement)
that is treated as a modification under this
paragraph (e) is not considered a modifica-
tion of the option to the extent the change
in the terms of the option is removed by
the earlier of the date the option is exer-
cised or the last day of the calendar year
during which such change occurred. Thus,
for example, if the terms of an option are
inadvertently changed on March 1 to ex-
tend the exercise period and the change
is removed on November 1, then if the
option is not exercised prior to November
1, the option is not considered modified
under this paragraph (e).
*****
(6) [Reserved.]
*****
(f)Definitions. The following defi-
nitions apply for purposes of §§1.421–1
through 1.424–1:
(1)Parent corporation.Thetermpar-
ent corporation,orparent, means any cor-
poration (other than the employer corpora-
tion) in an unbroken chain of corporations
ending with the employer corporation if, at
the time of the granting of the option, each
of the corporations other than the employer
corporation owns stock possessing 50 per-
cent or more of the total combined voting
powerofallclassesofstockinoneofthe
other corporations in such chain.
(2)Subsidiary corporation.Theterm
subsidiary corporation,orsubsidiary,
means any corporation (other than the em-
ployer corporation) in an unbroken chain
of corporations beginning with the em-
ployer corporation if, at the time of the
granting of the option, each of the corpo-
rations other than the last corporation in
an unbroken chain owns stock possessing
50 percent or more of the total combined
voting power of all classes of stock in one
of the other corporations in such chain.
(g)Effective date—(1)In general.
These regulations are effective on August
3, 2004.
(2)Reliance and transition period.For
statutoryoptionsgrantedonorbefore
June 9, 2003, taxpayers may rely on the
1984 proposed regulations LR–279–81
(49 FR 4504), the 2003 proposed regu-
lations REG–122917–02 (68 FR 34344),
or this section until the earlier of January
1, 2006, or the first regularly scheduled
stockholders meeting of the granting cor-
poration occurring 6 months after August
3, 2004. For statutory options granted
after June 9, 2003, and before the earlier
of January 1, 2006, or the first regularly
scheduled stockholders meeting of the
granting corporation occurring at least 6
months after August 3, 2004, taxpayers
may rely on either the REG–122917–02
or this section. Taxpayers may not rely
on LR–279–81 or REG–122917–02 af-
ter December 31, 2005. Reliance on
LR–279–81, REG–122917–02, or this
section must be in its entirety, and all
statutory options granted during the re-
liance period must be treated consistently.
§1.6039–1 and 1.6039–2 [Removed]
Par. 14. Section 1.6039–1 and
1.6039–2 are removed.
Par. 15. A new §1.6039–1 is added to
read as follows:
§1.6039–1 Statements to persons with
respect to whom information is furnished.
(a)Requirement of statement with re-
spect to incentive stock options under sec-
tion 6039(a)(1). Every corporation which
transfers stock to any person pursuant to
such person’s exercise of an incentive
stock option described in section 422(b)
must furnish to such transferee, for each
calendar year in which such a transfer
occurs, a written statement with respect
to the transfer or transfers made during
such year. This statement must include the
following information—
2004–36 I.R.B.440September 7, 2004

(1) The name, address, and employer
identification number of the corporation
transferring the stock;
(2) The name, address, and identifying
number of the person to whom the share or
shares of stock were transferred;
(3) The name and address of the cor-
poration the stock of which is the subject
of the option (if other than the corporation
transferring the stock);
(4) The date the option was granted;
(5) The date the shares were transferred
to the person exercising the option;
(6) The fair market value of the stock at
the time the option was exercised;
(7) The number of shares of stock trans-
ferred pursuant to the option;
(8) The type of option under which the
transferred shares were acquired; and
(9) The total cost of all the shares.
(b)Requirement of statement with re-
spect to stock purchased under an em-
ployee stock purchase plan under section
6039(a)(2). (1) Every corporation which
records, or has by its agent recorded, a
transfer of the title to stock acquired by the
transferor pursuant to the transferor’s ex-
ercise on or after January 1, 1964, of an
option granted under an employee stock
purchase plan which meets the require-
ments of section 423(b), and with respect
to which the special rule of section 423(c)
applied, must furnish to such transferor,
for each calendar year in which such a
recorded transfer of title to such stock oc-
curs, a written statement with respect to the
transfer or transfers containing the infor-
mation required by paragraph (b)(2) of this
section.
(2) The statement required by para-
graph (b)(1) of this section must contain
the following information—
(i) The name and address of the corpo-
ration whose stock is being transferred;
(ii) The name, address, and identifying
number of the transferor;
(iii) The date such stock was transferred
to the transferor;
(iv) The number of shares to which title
is being transferred; and
(v) The type of option under which the
transferred shares were acquired.
(3) If the statement required by this
paragraph is made by the authorized trans-
fer agent of the corporation, it is deemed
to have been made by the corporation. The
termtransfer agent,asusedinthissection,
means any designee authorized to keep the
stock ownership records of a corporation
and to record a transfer of title of the stock
of such corporation on behalf of such cor-
poration.
(4) A statement is required by reason of
a transfer described in section 6039(a)(2)
of a share only with respect to the first
transfer of such share by the person who
exercised the option. Thus, for example,
if the owner has record title to a share or
shares of stock transferred to a recognized
broker or financial institution and the stock
is subsequently sold by such broker or in-
stitution (on behalf of the owner), the cor-
poration is only required to furnish a writ-
ten statement to the owner relating to the
transfer of record title to the broker or fi-
nancial institution. Similarly, a written
statement is required when a share of stock
istransferredbytheoptioneetohimself
and another person (or persons) as joint
tenants, tenants by the entirety or tenants
in common. However, when stock is orig-
inally issued to the optionee and another
person (or persons) as joint tenants, or as
tenants by the entirety, the written state-
ment required by this paragraph shall be
furnished (at such time and in such manner
as is provided by this section) with respect
to the first transfer of the title to such stock
by the optionee.
(5) Every corporation which transfers
any share of stock pursuant to the exercise
of an option described in this paragraph
shall identify such stock in a manner suffi-
cient to enable the accurate reporting of the
transfer of record title to such shares. Such
identification may be accomplished by as-
signing to the certificates of stock issued
pursuant to the exercise of such options a
special serial number or color.
(c)Time for furnishing statements—
(1)In general. Each statement required by
this section to be furnished to any person
for a calendar year must be furnished to
such person on or before January 31 of
the year following the year for which the
statement is required.
(2)Extension of time. For good cause
shown upon written application of the cor-
poration required to furnish statements un-
der this section, the Director, Martinsburg
Computing Center, may grant an extension
of time not exceeding 30 days in which to
furnish such statements. The application
must contain a full recital of the reasons
for requesting an extension to aid the Di-
rector in determining the period of the ex-
tension, if any, which will be granted and
must be sent to the Martinsburg Comput-
ing Center (Attn: Extension of Time Co-
ordinator). Such a request in the form of a
letter to the Martinsburg Computing Cen-
ter, 250 Murall Drive, Kearneysville, West
Virginia 25430, signed by the applicant (or
its agent) will suffice as an application.
The application must be filed on or before
the date prescribed in paragraph (c)(1) of
this section for furnishing the statements
required by this section, and must contain
the employer identification number of the
corporation required to furnish statements
under this section.
(3)Last day for furnishing statement.
For provisions relating to the time for
performance of an act when the last day
prescribed for performance falls on Sat-
urday, Sunday, or a legal holiday, see
§301.7503–1 of this chapter (Regulations
on Procedure and Administration).
(d)Statements furnished by mail.For
purposes of this section, a statement is con-
sidered to be furnished to a person if it
is mailed to such person’s last known ad-
dress.
(e)Penalty. For provisions relating to
the penalty provided for failure to furnish
a statement under this section, see section
6722.
(f)Electronic furnishing of statements.
The statements required to be furnished
pursuant to this section may be provided
in an electronic format in lieu of a paper
format, with the consent of the recipient.
See §31.6051–1(j) of the Regulations on
Employment Taxes and Collection of In-
come Tax at the Source for further guid-
ance regarding the manner in which such
electronic statements must be furnished.
(g)Effective date—(1)In general.
These regulations are effective on August
3, 2004.
(2)Reliance and transition period.For
statutory options transferred on or before
June 9, 2003, taxpayers may rely on the
1984 proposed regulations LR–279–81
(49 FR 4504), the 2003 proposed regu-
lations REG–122917–02 (68 FR 34344),
or this section until the earlier of January
1, 2006, or the first regularly scheduled
stockholders meeting of the granting cor-
poration occurring 6 months after August
3, 2004. For statutory options transferred
after June 9, 2003, and before the earlier
of January 1, 2006, or the first regularly
scheduled stockholders meeting of the
September 7, 20044412004–36 I.R.B.

granting corporation occurring at least 6
months after August 3, 2004, taxpayers
may rely on either the REG–122917–02
or this section. Taxpayers may not rely
on LR–279–81 or REG–122917–02 af-
ter December 31, 2005. Reliance on
LR–279–81, REG–122917–02, or this
section must be in its entirety, and all
statutory options granted during the re-
liance period must be treated consistently.
PART 14a—TEMPORARY INCOME
TAX REGULATIONS RELATING TO
INCENTIVE STOCK OPTIONS
Part 14a [Removed]
Par. 16. Part 14a is removed.
PART 602—OMB CONTROL
NUMBERS UNDER THE PAPERWORK
REDUCTION ACT
Par. 17. 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.
*****
1.422–1........................................................... 1545–0820
*****
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
Approved July 20, 2004.
Gregory Jenner,
Acting Assistant Secretary of Treasury.
(Filed by the Office of the Federal Register on August 2,
2004, 8:45 a.m., and published in the issue of the Federal
Register for August 3, 2004, 69 F.R. 46401)
Section 467.—Certain
Payments for the Use of
Property or Services
The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of September 2004. See Rev. Rul. 2004-69, page
445.
Section 468.—Special
Rules for Mining and Solid
Waste Reclamation and
Closing Costs
The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of September 2004. See Rev. Rul. 2004-69, page
445.
Section 482.—Allocation
of Income and Deductions
Among Taxpayers
Federal short-term, mid-term, and long-term rates
are set forth for the month of September 2004. See
Rev. Rul. 2004-69, page 445.
Section 483.—Interest on
Certain Deferred Payments
The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of September 2004. See Rev. Rul. 2004-69, page
445.
Section 642.—Special
Rules for Credits and
Deductions
Federal short-term, mid-term, and long-term rates
are set forth for the month of September 2004. See
Rev. Rul. 2004-69, page 445.
Section 807.—Rules for
Certain Reserves
The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of September 2004. See Rev. Rul. 2004-69, page
445.
Section 846.—Discounted
Unpaid Losses Defined
The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of September 2004. See Rev. Rul. 2004-69, page
445.
Section 861.—Income
From Sources Within the
United States
26 CFR 1.861–8: Computation of taxable income
from sources within the United States and from other
sources and activities.
T.D. 9143
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Part 1
Allocation and Apportionment
of Deductions for Charitable
Contributions
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Temporary and final regula-
tions.
SUMMARY: This document contains
temporary regulations relating to the allo-
cation and apportionment of the deduction
for charitable contributions allowed by
sections 170, 873(b)(2), and 882(c)(1)(B).
These regulations change the method
of allocating and apportioning these de-
ductions from ratable apportionment on
the basis of gross income to apportion-
ment on the basis of income from sources
within the United States. The temporary
regulations will affect individuals and
corporations that make contributions to
2004–36 I.R.B.442September 7, 2004

charitable organizations and that have for-
eign source income and calculate their
foreign tax credit limitations under section
904. The text of the temporary regulations
also serves as the text of the proposed
regulations (REG–208246–90) set forth in
this issue of the Bulletin. This document
also contains final regulations that remove
the existing regulations concerning allo-
cation and apportionment of charitable
contribution deductions.
DATES:Effective Date:These regulations
are effective on July 28, 2004.
Applicability Dates:For dates of
applicability,see §§1.861–8(a)(5),
1.861–8T(e)(12)(iv), and 1.861–14T(e)
(6)(ii). The regulations are applicable to
charitable contributions made on or after
July 28, 2004. Taxpayers may elect to
apply these regulations to contributions
made before July 28, 2004, but during a
taxable year ending after July 28, 2004.
FOR FURTHER INFORMATION
CONTACT: Teresa Burridge Hughes
(202) 622–3850 (not a toll-free call).
SUPPLEMENTARY INFORMATION:
Background
This document contains amendments
to the regulations under section 861 relat-
ing to the allocation and apportionment of
the deduction for charitable contributions
allowed under sections 170, 873(b)(2),
and 882(c). Currently, regulations un-
der §1.861–8(e)(9)(iv) provide that such
deductions generally are not definitely
related to any gross income and therefore
are ratably apportioned to the statutory and
residual groupings on the basis of gross
income.
In 1991, the Treasury Department and
the IRS issued proposed regulations (the
1991 proposed regulations) that would
have changed the ratable apportionment
rule of the final regulations to a rule that,
assuming certain requirements are met,
generally would apportion the deduction
for a charitable contribution based on
where the contribution would be used.
Prop. Treas. Reg. §1.861–8(e)(12), 56
Fed. Reg. 10,395 (1991). More specifi-
cally, the 1991 proposed regulations pro-
vided that the deduction for a charitable
contribution would have been apportioned
solely to foreign source gross income if
the taxpayer, at the time of the contribu-
tion, knows or has reason to know that the
contribution will be used solely outside
the United States or that the contribution
may necessarily be used only outside the
United States. The 1991 proposed regu-
lations also provided that the deduction
for a charitable contribution would have
been apportioned solely to U.S. source
gross income if the taxpayer, at the time
of the contribution, both designates the
contribution for use solely in the United
States and reasonably believes that the
contribution will be so used. Under the
1991 proposed regulations, a deduction
for a charitable contribution that is not
apportionable to United States or foreign
source gross income under the foregoing
rules would have been ratably apportioned
on the basis of gross income.
The preamble to the 1991 proposed reg-
ulations requested comments on the ef-
fects of the proposed rules on U.S. char-
ities with significant international activi-
ties. Numerous comments were received
on the 1991 proposed regulations, most
of which recommended that the proposed
rules not be adopted. The principal rea-
son given was that the 1991 proposed reg-
ulations would reduce funding for foreign
charitable activities generally. In addi-
tion, the designation and place of use re-
quirements were seen as generating sig-
nificant paperwork and accountability bur-
dens for both the contributors and the re-
cipient charities. Many comments sug-
gested that, instead of the bifurcated allo-
cation and apportionment in the proposed
regulations, the deduction for a charita-
ble contribution should be allocated solely
to income from sources within the United
States.
In response to the comments received,
and upon further consideration of the is-
sue, the 1991 proposed regulations are
being withdrawn. See Notice of Proposed
Rulemaking (REG–208246–90) published
in this issue of the Bulletin. In addition,
the notice of proposed rulemaking in-
cludes proposed regulations which cross
reference these temporary regulations and
proposed regulations with respect to de-
ductions for charitable contributions that
are allowed under a U.S. income tax treaty
(rather than under sections 170, 873(b)(2),
and 882(c)(1)(B)).
Explanation of Provisions
The temporary regulations provide
that the deduction for charitable contribu-
tions allowed by sections 170, 873(b)(2),
and 882(c)(1)(B) is definitely related and
allocable to all of the taxpayer’s gross
income and is apportioned between the
statutory grouping (or among the statutory
groupings) of gross income and the resid-
ual grouping on the basis of the relative
amounts of gross income from sources in
the United States in each grouping. For
example, where a deduction for charitable
contributions is allocated and apportioned
for purposes of the foreign tax credit
limitation, the charitable contribution de-
duction is allocated toall of the taxpayer’s
gross income and apportioned solely to
the residual grouping consisting of U.S.
source gross income. This revision of the
regulations is consistent with the policy of
the section 170 contribution rules. The re-
vision is intended to ensure that a taxpayer
is not discouraged from making a chari-
table contribution that is deductible under
section 170 simply because the allocation
and apportionment rules would reduce the
taxpayer’s foreign source income and, ac-
cordingly, the taxpayer’s foreign tax credit
limitation as a result of the deduction.
The temporary regulations also provide
that, where a charitable contribution is
made by a member of an affiliated group,
the deduction for the charitable contri-
bution is related to and allocated to the
income of all of the members of the affil-
iated group and not to any subset of the
group. This rule is consistent with the
provisions of Notice 89–91, 1989–2 C.B.
408. Finally, the provisions of the final
regulations under §1.861–8(e)(9)(iv) and
§1.861–8(g),Example 18, which provide
for ratable allocation and apportionment
of deductions for charitable contributions,
are removed.
The regulations are effective for char-
itable contributionsmade on or after July
28, 2004. Taxpayers may elect to apply
these regulations to contributions made be-
fore July 28, 2004, but during a taxable
year ending on or after July 28, 2004.
Special Analyses
It has been determined that this Trea-
sury decision is not asignificant regula-
tory action as defined in Executive Order
September 7, 20044432004–36 I.R.B.

12866. Therefore, a regulatory assessment
is not required. It also has been deter-
mined that section 553(b) of the Admin-
istrative Procedure Act (5 U.S.C. chapter
5) does not apply to these regulations. For
the applicability of the Regulatory Flexi-
bility Act (5 U.S.C. chapter 6), refer to the
Special Analyses section of the preamble
to the cross-referenced notice of proposed
rulemaking published in this issue of the
Bulletin. Pursuant to section 7805(f) of
the Internal Revenue Code, these tempo-
rary regulations will be submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment on
their impact on small businesses.
Drafting Information
The princip
al author of these regula-
tionsisTer
esa Burridge Hughes, Office of
Associate
Chief Counsel (International).
However, o
ther personnel from the IRS
and Treasu
ry Department participated in
their deve
lopment.
*****
Amendments to the Regulations
According
ly, 26 CFR part 1 is amended
as follow
s:
PART 1 — INCOME TAXES
Paragraph. 1. The authority for part 1
continues to read in part:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section §1.861–8 is amended as
follows:
1. Remove the language “paragraphs
(c)(2)” from paragraph (a)(2) and add the
language “paragraphs (c)(3)” in its place.
2. Add a new second sentence to para-
graph (a)(5)(i).
3. Revise paragraph (e)(1).
4. Remove the language “paragraph
(c)(2)” from the paragraph (e)(9) introduc-
tory text and add the language “paragraph
(c)(3)” in its place.
5. Add the word “and” at the end of
paragraph (e)(9)(iii).
6. Remove paragraphs (e)(9)(iv) and
(g)Example 18(iv).
7. Redesignate paragraph (e)(9)(v) as
paragraph (e)(9)(iv).
8. Add new paragraph (e)(12).
9. Redesignate paragraph (g)Example
18(i) as paragraph (g)Example 18(i)(A).
10. Remove the last three entries in the
table following the language “Total gross
income ....40,000,000” from newly desig-
nated paragraph (g)Example 18(i)(A).
11. Add new paragraph (g)Example 18
(i)(B) immediately following the table in
newly designated paragraph (g)Example
18(i)(A).
12. Designate the undesignated text
following new paragraph (g)Example 18
(i)(B) as paragraph (g)Example 18(i)(C).
The revisions and additions read as fol-
lows:
§1.861–8 Computation of taxable income
from sources within the United States and
from other sources and activities.
(a)***(1)***
(5)***(i)***Paragraph(g)Exam-
ple 18(i)(B) applies to charitable contribu-
tions made on or after July 28, 2004. * * *
*****
(e)Allocation and apportionment of
certain deductions—(1)In general. Para-
graphs (e)(2) and (e)(3) of this section
contain rules with respect to the allocation
and apportionment of interest expense
and research and development expen-
ditures, respectively. Paragraphs (e)(4)
through (e)(8) of this section contain rules
with respect to the allocation of certain
other deductions. Paragraph (e)(9) of this
section lists those deductions which are
ordinarily considered as not being defi-
nitely related to any class of gross income.
Paragraph (e)(10) of this section lists spe-
cial deductions of corporations which
must be allocated and apportioned. Para-
graph (e)(11) of this section lists personal
exemptions which are neither allocated
nor apportioned. Paragraph (e)(12) of
this section contains rules with respect
to the allocation and apportionment of
deductions for charitable contributions.
Examples of allocation and apportionment
are contained in paragraph (g) of this sec-
tion.
*****
(12) [Reserved]. For further guidance,
see §1.861–8T(e)(12).
*****
(g)General examples.***
Example 18.***(i)(A)***
(i)(B) In addition, X incurs expenses of
its supervision department of $1,600,000.
*****
Par. 3. Section 1.861–8T is amended as
follows:
1. Add new paragraph (e)(12).
2. Add a new second sentence to para-
graph (h).
The additions read as follows:
§1.861–8T Computation of taxable
income from sources within the United
States and from other sources and
activities (temporary).
*****
(e)***(1)***
(12)Deductions for certain charitable
contributions—(i)In general. The deduc-
tion for charitable contributions that is al-
lowed under sections 170, 873(b)(2), and
882(c)(1)(B) is definitely related and al-
locable to all of the taxpayer’s gross in-
come. The deduction allocated under this
paragraph (e)(12)(i) shall be apportioned
between the statutory grouping (or among
the statutory groupings) of gross income
and the residual grouping on the basis of
the relative amounts of gross income from
sources in the United States in each group-
ing.
(ii)Coordination with §1.861–14T.A
deduction for a charitable contribution by
amemberofanaffiliatedgroupshallbe
allocated and apportioned under the rules
of this section and §1.861–14T(c)(1).
(iii)Treaty provisions. [Reserved].
(iv)Effective date.(A)Therulesof
paragraphs (e)(12)(i) and (ii) shall apply
to charitable contributions made on or af-
ter July 28, 2004. Taxpayers may apply
the provisions of paragraphs (e)(12)(i) and
(ii) to charitable contributions made before
July 28, 2004, but during the taxable year
ending on or after July 28, 2004.
(B) The applicability of this section ex-
pires on or before July 27, 2007.
*****
(h)***However,seeparagraph
(e)(12)(iv) of this section and
§1.861–14T(e)(6)(ii) for rules con-
cerning the allocation and apportionment
of deductions for charitable contributions.
***
*****
Par. 4. Section 1.861–14T is amended
by revising the section heading and adding
paragraph (e)(6) to read as follows:
§1.861–14T Special rules for allocating
and apportioning certain expenses (other
2004–36 I.R.B.444September 7, 2004

than interest expense) of an affiliated
group of corporations (temporary).
*****
(e)***(1)***(i)***
(6)Charitable contribution ex-
penses—(i)In general.Adeduction
for a charitable contribution by a mem-
ber of an affiliated group shall be allo-
cated and apportioned under the rules of
§1.861–8T(e)(12) and paragraph (c)(1) of
this section.
(ii)Effective date. (A) The rules of this
paragraph shall apply to charitable contri-
butions made on or after July 28, 2004,
and, for taxpayers applying the second sen-
tence of §1.861–8T(e)(12)(iv)(A), to char-
itable contributions made during the tax-
able year ending on or after July 28, 2004.
(B) The applicability of this section ex-
pires on or before July 27, 2007.
*****
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
Approved July 20, 2004.
Gregory Jenner,
Acting Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on July 27, 2004,
8:45 a.m., and published in the issue of the Federal Register
for July 28, 2004, 69 F.R. 44930)
Section 1274.—Determi-
nation of Issue Price in the
Case of Certain Debt Instru-
ments Issued for Property
(Also, Sections 42, 280G, 382, 412, 467, 468, 482,
483, 642, 807, 846, 1288, 7520, 7872.)
Federal rates; adjusted federal rates;
adjusted federal long-term rate and the
long-term exempt rate.For purposes of
sections 382, 642, 1274, 1288, and other
sections of the Code, tables set forth the
rates for September 2004.
Rev. Rul. 2004–69
This revenue ruling provides various
prescribed rates for federal income tax
purposes for September 2004 (the current
month). Table 1 contains the short-term,
mid-term, and long-term applicable fed-
eral rates (AFR) for the current month
for purposes of section 1274(d) of the
Internal Revenue Code. Table 2 contains
the short-term, mid-term, and long-term
adjusted applicable federal rates (adjusted
AFR) for the current month for purposes
of section 1288(b). Table 3 sets forth the
adjusted federal long-term rate and the
long-term tax-exempt rate described in
section 382(f). Table 4 contains the ap-
propriate percentages for determining the
low-income housing credit described in
section 42(b)(2) for buildings placed in
service during the current month. Finally,
Table 5 contains the federal rate for de-
termining the present value of annuity, an
interest for life or for a term of years, or
a remainder or a reversionary interest for
purposes of section 7520.
REV. RUL. 2004–69 TABLE 1
Applicable Federal Rates (AFR) for September 2004
Period for Compounding
AnnualSemiannualQuarterlyMonthly
Short-Term
AFR2.34%2.33%2.32%2.32%
110% AFR2.58%2.56%2.55%2.55%
120% AFR2.82%2.80%2.79%2.78%
130% AFR3.05%3.03%3.02%3.01%
Mid-Term
AFR3.84%3.80%3.78%3.77%
110% AFR4.22%4.18%4.16%4.14%
120% AFR4.61%4.56%4.53%4.52%
130% AFR5.00%4.94%4.91%4.89%
150% AF
R
5.78%5.70%5.66%5.63%
175% AFR6.76%6.65%6.60%6.56%
Long-
Term
AFR5.03%4.97%4.94%4.92%
110% AFR5.54%5.47%5.43%5.41%
120% AFR6.05%5.96%5.92%5.89%
130% AFR6.56%6.46%6.41%6.37%
September 7, 20044452004–36 I.R.B.

REV. RUL. 2004–69 TABLE 2
Adjusted AFR for September 2004
Period for Compounding
AnnualSemiannualQuarterlyMonthly
Short-term adjusted
AFR
1.65%1.64%1.64%1.63%
Mid-term adjusted AFR3.16%3.14%3.13%3.12%
Long-term a
djusted
AFR
4.51%4.46%4.44%4.42%
REV. RUL. 2004–69 TABLE 3
Rates Under Section 382 for September 2004
Adjusted f
ederal long-term rate for the current month
4.51%
Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted
federal long-term rates for the current month and the prior two months.)4.72%
REV. RUL. 2004–69 TABLE 4
Appropr
iate Percentages Under Section 42(b)(2) for September 2004
Appropriate percentage for the 70% present value low-income housing credit8.03%
Appropriate percentage for the 30% present value low-income housing credit3.44%
REV. RU
L. 2004–69 TABLE 5
Rate Under Section 7520 for September 2004
Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years,
or a remainder or reversionary interest4.6%
Section 1288.—Treatment
of Original Issue Discount
on Tax-Exempt Obligations
The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of September 2004. See Rev. Rul. 2004-69, page
445.
Section 7520.—Valuation
Tables
The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of September 2004. See Rev. Rul. 2004-69, page
445.
Section 7872.—Treatment
of Loans With Below-Market
Interest Rates
The adjusted applicable federal short-term, mid-
term, and long-term rates are set forth for the month
of September 2004. See Rev. Rul. 2004-69, page
445.
2004–36 I.R.B.446September 7, 2004

Part III. Administrative, Procedural, and Miscellaneous
Plan Amendments Following
Election of Alternative Deficit
Reduction Contribution
Notice 2004–59
This notice provides guidance on the re-
strictions that are placed on plan amend-
ments following an employer’s election
of the alternative deficit reduction contri-
bution under § 412(l)(12) of the Internal
Revenue Code (the “Code”) and section
302(d)(12) of the Employee Retirement
Income Security Act of 1974 (“ERISA”),
as added by section 102 of the Pension
Funding Equity Act of 2004, Pub. L.
108–218 (“PFEA ’04”).
I. Background
Section 102 of PFEA ’04, which
was enacted on April 10, 2004, added
§ 412(l)(12) to the Code and section
302(d)(12) to ERISA.Section 412(l)(12)
of the Code permits certain employers
who are required to make additional con-
tributions under § 412(l) to elect a reduced
amount of those contributions (“alterna-
tive deficit reduction contributions”) for
certain plan years. An employer is eligible
to make such an election if it is (1) a com-
mercial passenger airline, (2) primarily
engaged in the production or manufacture
of a steel mill product or the processing
of iron ore pellets, or (3) an organization
described in § 501(c)(5) that established a
plan on June 30, 1955, to which § 412 now
applies. On April 12, 2004, the Internal
Revenue Service (the “Service”) issued
Announcement 2004–38, 2004–18 I.R.B.
878, which provides guidance for making
the election for an alternative deficit re-
duction contribution. On May 6, 2004, the
Service issued Announcement 2004–43,
2004–21 I.R.B. 955 (corrected by An-
nouncement 2004–51, 2004–23 I.R.B.
1041), which provides further guidance
for making the election for the alternative
deficit reduction contribution and provides
guidance regarding notices that must be
provided to participants, beneficiaries, and
the Pension Benefit Guaranty Corporation
following the making of the election.
Section 412(l)(12)(B) provides that
no amendment that increases the liabili-
ties of the plan by reason of any increase
in benefits, any change in the accrual
of benefits, or any change in the rate at
which benefits becomenonforfeitable un-
der the plan shall be adopted during any
applicable plan year, unless (1) the plan’s
enrolled actuary certifies (in such form
and manner prescribed by the Secretary)
that the amendment provides for an in-
crease in annual contributions that will
exceed the increase in annual charges to
the funding standard account attributable
to such amendment, or (2) the amend-
ment is required by a collective bargaining
agreement that is in effect on April 10,
2004. Section 412(l)(12)(B) further pro-
vides that, if a plan is amended during any
applicable plan year (i.e., a plan year for
which the § 412(l)(12) election is made)
in violation of the preceding sentence, any
election under § 412(l)(12) shall not apply
to any applicable plan year ending on or
after the date on which the amendment is
adopted.
Section 302 of ERISA contains mini-
mum funding standard requirements that
are parallel to those under § 412 of the
Code, and section 302(d)(12) of ERISA
provides an election that is identical to the
election under § 412(l)(12) of the Code.
Under section 101 of Reorganization Plan
No. 4 of 1978, 1979–1 C.B. 480, the Sec-
retary of the Treasury has sole interpretive
authority over the interpretation of sec-
tion 302(d)(12) of ERISA. Accordingly,
the guidance set forth in this notice ap-
plies as well under section 302(d)(12) of
ERISA.
Section 412(c)(12) of the Code pro-
vides that, in determining projected bene-
fits, the funding method of a collectively
bargained plan (other than a multiem-
ployer plan) shall anticipate benefit in-
creases scheduled to take effect during the
term of the collective bargaining agree-
ment applicable to the plan.
Section 1.412(c)(3)–1(d)(1)(i) of the
Income Tax Regulations provides that,
except as otherwise provided by the Com-
missioner, a reasonable funding method
does not anticipate changes in plan bene-
fits that become effective, whether or not
retroactively, in a future plan year or that
become effective after the first day of, but
during, a current plan year.
Rev. Rul. 77–2, 1977–1 C.B. 120,
provides guidance regarding the minimum
funding requirements with respect to a
change in the benefit structure of a qual-
ified pension plan that becomes effective
during a plan year. Section 2.02 of Rev.
Rul. 77–2 provides that, in the case of
a change in the benefit structure that be-
comes effective as of a date during a plan
year (but subsequent to the first day in
such plan year), the charges and credits
to the funding standard account shall not
reflect the change in such benefit structure
for the portion of such plan year prior to
the effective date of such change, and shall
reflect the change in such benefit structure
for the portion of the plan year subsequent
to the effective date of the change. Sec-
tion 3 of Rev. Rul. 77–2 provides that, in
determining the charges and credits for the
plan year, in lieu of using the rule of sec-
tion 2.02, a plan is permitted to disregard a
change in benefit structure that is adopted
after the valuation date for the year.
Section 412(c)(8) provides that any
amendment applying to a plan year that is
adopted after the close of the plan year but
no later than 2
1
/2months after the close of
the plan year and that does not reduce the
accrued benefit of any participant deter-
mined as of the beginning of the first plan
year to which the amendment relates shall,
at the election of the plan administrator, be
deemed to have been made on the first day
of such plan year (subject to additional re-
strictions on plan amendments that reduce
benefits). Pursuant to Rev. Proc. 94–42,
1994–1 C.B. 717 and Rev. Rul. 79–325,
1979–2 C.B. 190, § 412(c)(8) also applies
to plan amendments adopted during the
plan year to which the amendment relates.
II. Questions and Answers Regarding
Plan Amendments Following a
§ 412(l)(12) Election
Q–1. Which plan amendments are sub-
ject to the requirements of § 412(l)(12)(B)
(regarding plan amendments increasing
benefits)?
A–1. Plan amendments that are subject
to the requirements of § 412(l)(12)(B)
are referred to in this notice as “restricted
amendments”. A plan amendment is a re-
stricted amendment if it is adopted during
a plan year for which an election for an
September 7, 20044472004–36 I.R.B.

alternative deficit reduction contribution
is in effect, is not required by a collective
bargaining agreement in effect on April
10, 2004, and increases benefits (including
an increase in an early retirement benefit
or retirement-type subsidy), changes the
accrual of benefits in a manner that results
in increased accruals, or changes the rate
at which benefits become nonforfeitable
in a manner that results in faster vesting.
Thus, for example, with respect to a plan
not maintained pursuant to a collective
bargaining agreement, a plan amendment
adopted February 1, 2004, and providing a
benefit increase effective during the 2004
calendar plan year is a restricted amend-
ment if the employer makes an election for
an alternative deficit reduction contribu-
tion for the 2004 plan year. Furthermore,
if that employer makes an election for the
alternative deficit reduction contribution
for the 2005 plan year, the plan amend-
ment adopted in 2004 will continue to
be a restricted amendment for the 2005
plan year. For purposes of determining
whether a plan amendment is a restricted
amendment, a plan amendment is con-
sidered adopted at the later of the time
it is adopted or made effective. Thus, a
plan amendment with different benefit
increases that become effective during
different plan years is considered adopted
during each plan year in which each bene-
fit increase becomes effective (if no earlier
than the date on which the amendment is
addedtotheplan).
A plan amendment adopted during a
plan year for which the employer did not
make an election for the alternative deficit
reduction contribution (or a plan amend-
ment considered adopted during such a
plan year) is not a restricted amendment
for the plan year adopted or for the sub-
sequent plan year, even if the employer
makes an election for an alternative deficit
reduction contribution for the subsequent
plan year. However, such a plan amend-
ment will be considered adopted during the
subsequent plan year for purposes of de-
termining whether the amendment is a re-
stricted amendment unless an election is
made under § 412(c)(8) to treat the plan
amendment as made on the first day of the
plan year in which adopted and unless the
amendment is treated as effective as of the
beginning of the plan year.
Annual cost-of-living adjustments to
statutory limits that are implemented
pursuant to plan terms that are adopted
and in effect before the beginning of
the plan year for which the alternative
deficit reduction contribution election is
made are not treated as plan amendments
that are subject to the requirements of
§ 412(l)(12)(B). Thus, annual cost-of-liv-
ing adjustments to the § 401(a)(17) limit
and the § 415(b)(1)(A) dollar limit that are
automatically put into effect pursuant to
plan terms that are adopted and in effect
before the beginning of the plan year are
not treated as restricted amendments.
Q–2. What plan terms must a restricted
amendment include?
A–2. A restricted amendment must
include terms that require that contribu-
tions to the plan for all plan years in which
the alternative deficit reduction contri-
bution election is in effect will exceed
the § 412(l)(12)(B) amount described in
Q&A–3 of this notice. A restricted amend-
ment may satisfy this requirement by re-
flecting the formula for the § 412(l)(12)(B)
amount set forth in Q&A–3 of this notice.
Alternatively, a restricted amendment may
satisfy this requirement by providing for a
dollar amount of contributions or for some
other method of determining contributions
if the amount of contributions specified
in the plan exceeds the § 412(l)(12)(B)
amount. For this purpose, the terms of a
collective bargaining agreement pursuant
to which a plan is maintained are deemed
included in plan terms.
If a restricted amendment is adopted
prior to August 31, 2004, the plan com-
plies with this Q&A–2 if, no later than
October 31, 2004, the plan is amended to
provide for contributions that exceed the
§ 412(l)(12)(B) amount.
Q–3. How is the § 412(l)(12)(B)
amount determined?
A–3. The § 412(l)(12)(B) amount is
equal to the sum of the minimum required
contribution under § 412 determined as
if the restricted amendment had not been
made (taking into account the alternative
deficit reduction contribution election)
plus the incremental amendment amount.
The incremental amendment amount is
equal to the difference between the re-
quired minimum contribution under § 412
that would have been due taking into ac-
count the restricted amendment and the
required minimum contribution under
§ 412 that would have been due disre-
garding the restricted amendment. These
two calculations are made as if the al-
ternative deficit reduction contribution
had not been elected. The calculation of
the required minimum contribution under
§ 412 that would have been due taking
into account the restricted amendment
generally is made as if the amendment
had been adopted and made effective on
the first day of the plan year (i.e.,the
amendment must be fully reflected in plan
costs for this purpose). However, if the
amendment does not provide for benefit
increases attributable to service prior to
the beginning of the plan year, and is not
effective as of the first day of the plan year,
the amendment may instead be treated in
accordance with the rules of section 2.02
of Rev. Rul. 77–2. In addition, the rules
of § 412(c)(12) apply to the determination
of the § 412(l)(12)(B) amount. For rules
regarding the treatment of a credit balance
generated as a result of contributions made
with respect to the § 412(l)(12)(B) amount
for the prior plan year, see Q&A–5.
The § 412(l)(12)(B) amount is com-
puted without regard to any funding
waiver for the plan year. Accordingly,
the terms of a restricted amendment do
not comply with § 412(l)(12)(B) if, under
the terms of the plan as amended by the
restricted amendment, any portion of the
contribution in excess of the incremental
amendment need not be made if a funding
waiver is granted.
Q–4. How does the § 412(l)(12)(B)
amount affect the application of the min-
imum funding requirements of § 412?
A–4. The § 412(l)(12)(B) amount does
not affect the computation of minimum
required contributions under § 412. Thus,
for example, quarterly contributions under
§ 412(m) are not required to reflect the
minimum contribution required to main-
tain the applicability of the alternative
deficit reduction contribution election. If
an amount in excess of minimum required
contributions is contributed for a plan year
on account of the § 412(l)(12)(B) amount,
the plan’s funding standard account will
reflect a credit balance on account of the
excess. In addition, even if an amendment
is considered adopted in a later year or
years for purposes of determining whether
an amendment is a restricted amendment
for a plan year for purposes of applying
§ 412(l)(12)(B), the rules of § 412(c)(12)
(requiring the funding method of a collec-
tively bargained plan to take into account
2004–36 I.R.B.448September 7, 2004

certain anticipated benefit increases) may
require the amendment to be taken into
account at an earlier time for purposes of
computing minimum required contribu-
tions under § 412.
Q–5: How does a credit balance gener-
ated as a result of contributions made with
respect to the § 412(l)(12)(B) amount for
the prior plan year affect the computation
of the § 412(l)(12)(B) amount for the plan
year?
A–5: If a restricted amendment was
adopted in a prior plan year for which
the alternative deficit reduction con-
tribution election was made, the credit
balance resulting from the excess of the
§ 412(l)(12)(B) amount for the prior plan
year over the minimum required contribu-
tion for the prior plan year must be disre-
garded in computing the § 412(l)(12)(B)
amount for the current plan year. Thus, for
example, assume that an employer elects
the alternative deficit reduction contribu-
tion for both the 2004 and 2005 calendar
plan years, adopts a restricted amendment
during the 2004 plan year, and contributes
the § 412(l)(12)(B) amount for the 2004
plan year, creating a credit balance as of
the end of the 2004 plan year. The deter-
mination of the § 412(l)(12)(B) amount
for the 2005 plan year (which reflects the
restricted amendment adopted in 2004 as
well as any restricted amendments adopted
in 2005) is made as if there were no credit
balance resulting from the excess of the
§ 412(l)(12)(B) amount for the 2004 plan
year over the minimum required contribu-
tion for the 2004 plan year. However, if
the contributions made for the 2004 plan
year exceed the § 412(l)(12)(B) amount
for that plan year, the credit balance at-
tributable to that excess can be taken into
account in determining the § 412(l)(12)(B)
amount for 2005.
Q–6. How does the plan’s enrolled ac-
tuary certify that a restricted amendment
provides for an increase in annual contri-
butions that will exceed the increase in an-
nual charges to the funding standard ac-
count attributable to such amendment?
A–6. The plan’s enrolled actuary certi-
fies that a restricted amendment provides
for an increase in annual contributions that
will exceed the increase in annual charges
to the funding standard account attribut-
able to such amendment by filing a cer-
tification with the Service that, following
the adoption of the plan amendment, the
plan includes terms to the effect that con-
tributions to the plan while the alternative
deficit reduction contribution election is
in effect will exceed the § 412(l)(12)(B)
amount described in Q&A–3 of this notice.
The certification may be based either on
plan terms incorporating the formula de-
scribed in Q&A–3 or on plan terms pro-
viding for either an amount of contribu-
tions or an alternative formula for contri-
butions under which contributions for the
plan year will exceed the § 412(l)(12)(B)
amount. The certification must also pro-
vide the derivation of the § 412(l)(12)(B)
amount as well as the amount of contri-
butions required under the terms of the
plan (if determined under an alternative
formula).
The certification with respect to a re-
stricted amendment made during a plan
year must be filed on or before the due date
for the filing of Form 5500 for the plan
year at the following address:
Internal Revenue Service
Commissioner, Tax Exempt and
Government Entities Division
Attention: SE:T:EP:RA:T
Alternative DRC Election Amendment
Certification
P.O. Box 27063
McPherson Station
Washington, D.C. 20038
Q–7. What are the consequences of
failure to include the plan terms required
under § 412(l)(12)(B) as part of a restricted
amendment?
A–7. If a restricted amendment does
not contain the plan terms required un-
der § 412(l)(12)(B) in a plan year, then
the alternative deficit reduction contribu-
tion election is no longer valid for the plan
year and cannot be made in any succeed-
ing plan year.
Q–8. What are the consequences of
failure to contribute the amount required
under a restricted amendment that includes
plan terms that satisfies the plan language
requirements of § 412(l)(12)(B)?
A–8. If the contribution required under
the terms of a restricted amendment is not
made on or before the due date for contri-
butions for the plan year, then the alterna-
tive deficit reduction contribution election
is no longer valid for the plan year and can-
not be made in any succeeding plan year.
Paperwork Reduction Act
The collection of information contained
in this notice has been reviewed and ap-
proved by the Office of Management and
Budget in accordance with the Paperwork
Reduction Act (44 U.S.C. 3507) under
control number 1545–1889.
An agency may not conduct or sponsor,
and a person is not required to respond
to, a collection of information unless the
collection of information displays a valid
OMB control number.
The collection of information in this no-
tice is in Q&A–6. This information is re-
quired to meet the requirements of section
102 of the Pension Funding Equity Act
of 2004 to monitor and make valid deter-
minations with respect to employers that
elect an alternative deficit reduction con-
tribution for certain plans and make re-
stricted amendments. As a result of such
elections, an employer’s deficit reduction
contribution for certain plans will be based
on amounts specified under § 412(l)(12) of
the Code. The likely respondents are busi-
nesses or other for-profit institutions, and
nonprofit institutions.
The estimated total annual reporting
and/or recordkeeping burden is 400 hours.
The estimated annual burden per re-
spondent/recordkeeper varies from 3 to 5
hours, depending on individual circum-
stances, with an estimated average of 4
hours. The estimated number of respon-
dents and/or recordkeepers is 100.
The estimated frequency of responses is
occasional.
Books or records relating to a collection
of information must be retained as long
as their contents may become material in
the administration of any internal revenue
law. Generally tax returns and tax return
information are confidential, as required
by 26 U.S.C. § 6103.
Drafting Information
The principal authors of this notice are
James E. Holland of the Employee Plans,
Tax Exempt and Government Entities Di-
vision and Linda S. F. Marshall of the
Office of the Division Counsel/Associate
Chief Counsel (Tax Exempt and Gov-
ernment Entities). Mr. Holland may be
reached at 202–283–9699(not a toll-free
number).
September 7, 20044492004–36 I.R.B.

Part IV. Items of General Interest
Withdrawal of Notice of
Proposed Rulemaking,
Notice of Proposed
Rulemaking, Notice of
Proposed Rulemaking
by Cross-Reference to
Temporary Regulations, and
Notice of Public Hearing
Allocation and Apportionment
of Deductions for Charitable
Contributions
REG–208246–90
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Withdrawal of notice of pro-
posed rulemaking, notice of proposed rule-
making, notice of proposed rulemaking by
cross-reference to temporary regulations,
and notice of public hearing.
SUMMARY: This document withdraws
the notice of proposed rulemaking pub-
lished on March 12, 1991 (the 1991 pro-
posed regulations), relating to the allo-
cation and apportionment of charitable
deductions. In addition, in this issue of
the Bulletin, the Treasury Department and
the IRS are issuing temporary regulations
(T.D. 9143) providing that the deduction
for a charitable contribution (as defined
in section 170(c)) is to be allocated to
all of the taxpayer’s gross income and
apportioned on the basis of income from
sources within the United States. The
text of the temporary regulations also
serves as the text of these proposed regu-
lations. Further, regulations are proposed
in this document, without cross-reference
to temporary regulations, with respect to
deductions for charitable contributions
that are provided by an income tax treaty
rather than by sections 170, 873(b)(2),
and 882(c)(1)(B). This document also pro-
vides a notice of public hearing on these
proposed regulations.
DATES: Written or electronic comments
must be received by October 26, 2004.
Outlines of topics to be discussed at the
public hearing scheduled for December 2,
2004, at 10 a.m. must be received by
November 12, 2004.
ADDRESSES: Send submissions to:
CC:PA:LPD:PR(REG–208246–90),
Room 5203, Internal Revenue Service,
POB 7604, Ben Franklin Station, Wash-
ington, DC 20044. Submissions may
be hand-delivered between the hours of
8a.m. and4p.m. toCC:PA:LPD:PR
(REG–208246–90), Courier’s Desk, In-
ternal Revenue Service, 1111 Constitution
Ave., NW, Washington, DC, or sent elec-
tronically, via the IRS internet site at
www.irs.gov/regsor Federal eRulemaking
Portal atwww.regulations.gov(IRS and
REG–208246–90). The public hearing
will be held in the Auditorium, Inter-
nal Revenue Building, 1111 Constitution
Ave., NW, Washington, DC.
FOR FURTHER INFORMATION
CONTACT: Concerning the withdrawal
of the 1991 proposed regulations and the
proposed regulations, Teresa Burridge
Hughes, (202) 622–3850 (not a toll-free
number); concerning the submission of
comments, the hearing, and/or placement
on the building access list to attend the
hearing, Treena Garrett, (202) 622–7180
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background and Explanation of
Provisions
Section 1.861–8(e)(9) provides that
the deduction for charitable contributions
allowed by sections 170, 873(b)(2), and
882(c)(1)(B) is generally considered as
not definitely related to any gross income
and therefore is ratably apportioned to
all of a taxpayer’s gross income. On
March 12, 1991, Treasury and the IRS
published in theFederal Register(56
FR 10395) a notice of proposed rulemak-
ing (INTL–116–90, 1991–1 C.B. 949,
REG–208246–90) that would have mod-
ified the allocation and apportionment of
the deduction for charitable contributions.
The 1991 proposed regulations generally
would have provided for the allocation
and apportionment of a deduction for a
charitable contributiontosourceswithin
or without the United States based on
where the contribution was used. Where
the deduction for a charitable contribution
would not have been allocable to United
States or foreign source gross income
based on the new test, it would have been
ratably apportioned to all gross income.
Written comments were received and a
public hearing on the 1991 proposed reg-
ulations was held on August 1, 1991. In
response to comments received, and after
further consideration of the issue, the 1991
proposed regulations are withdrawn.
Contemporaneously with the with-
drawal of the 1991 proposed regulations,
the Treasury Department and the IRS are
issuingaTreasurydecision containing
temporary regulations that are published
in this issue of the Bulletin. The temporary
regulations provide for the allocation and
apportionment of the deduction for chari-
table contributions to U.S. source income.
The text of the temporary regulations also
serves as the text of these proposed reg-
ulations. The preamble to the temporary
regulations discusses the comments re-
ceived on the 1991 proposed regulations,
the reasons for the withdrawal of the 1991
proposed regulations, and the approach of
the temporary regulations.
This document also proposes a rule for
the allocation and apportionment of deduc-
tions for charitable contributions that are
allowed under a U.S. income tax treaty
(rather than under sections 170, 873(b)(2),
and 882(c)(1)(B)) that limits the amount of
the deduction based on a percentage of in-
come that arises from sources within the
treaty partner. In such case, these pro-
posed regulations would provide that the
deduction is definitely related and alloca-
ble to all of the taxpayer’s gross income.
The deduction would be apportioned be-
tween the statutory grouping (or among
the statutory groupings) of gross income
and the residual grouping on the basis of
the relative amounts of gross income from
sources within the treaty partner within
each grouping This rule is proposed to be
effective for taxable years beginning on
or after the date final regulations are pub-
lished in theFederal Register.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant
regulatory action as defined in Executive
2004–36 I.R.B.450September 7, 2004

Order 12866. Therefore, a regulatory as-
sessment is not required. It also has been
determined that section 553(b) of the Ad-
ministrative Procedure Act (5 U.S.C. chap-
ter 5) does not apply to these regulations,
and because the regulations do not im-
pose a collection of information on small
entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursuant
to section 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 their impact on
small businesses.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any written (a signed origi-
nal and eight (8) copies) or electronic com-
ments that are submitted timely to the IRS.
The IRS and the Treasury Department re-
quest comments on the clarity of the pro-
posed rules and how they can be made eas-
ier to understand. All comments will be
available for public inspection and copy-
ing.
A public hearing has been scheduled for
December 2, 2004, beginning at 10 a.m.
in the IRS Auditorium of the Internal Rev-
enue Building, 1111 Constitution Avenue,
NW, Washington, DC. Due to building se-
curity procedures, visitors must enter at
the Constitution Avenue entrance. In addi-
tion, all visitors must present photo iden-
tification to enter the building. Because
of access restrictions, visitors will not be
admitted beyond the immediate entrance
area more than 30 minutes before the hear-
ing starts. For more information about
having your name placed on the build-
ing access list to attend the hearing, see
theFOR FURTHER INFORMATION
CONTACTsection of this preamble.
The rules of 26 CFR 601.601(a)(3) ap-
ply to the hearing. Persons who wish
to present oral comments at the hearing
must submit electronic or written com-
ments by October 26, 2004, and an out-
line of the topics to be discussed and the
time to be devoted to each topic (signed
original and eight (8) copies) by Novem-
ber 12, 2004. A period of 10 minutes will
be allotted to each person for making com-
ments. 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.
Drafting Information
The principal author of this document is
Teresa Burridge Hughes, Office of Asso-
ciate Chief Counsel (International). How-
ever, other personnel from the Treasury
Department and the IRS participated in its
development.
*****
Withdrawal of a Notice of Proposed
Rulemaking
Under the authority of 26 U.S.C. 7805,
§1.861–8(e) and (g) of the notice of pro-
posed rulemaking (INTL–116–90) pub-
lished in theFederal Registeron March
12, 1991, (56 FR 10395) is withdrawn.
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
PART 1 — INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding an entry in
numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.861–8(e)(12) is added
to read as follows:
§1.861–8 Computation of taxable income
from sources within the United States and
from other sources and activities.
*****
(e)***(1)***
(e)(12)(i) and (ii) [The text of the pro-
posed addition of §1.861–8(e)(12)(i) and
(ii) is the same as §1.861–8T(e)(12)(i) and
(ii) published elsewhere in this issue of the
Bulletin.]
(e)(12)(iii)Treaty provisions.(A)In
general. If a deduction for charitable con-
tributions not otherwise permitted by sec-
tions 170, 873(b)(2), and 882(c)(1)(B) is
allowed under a U.S. income tax treaty,
and such treaty limits the amount of the de-
duction based on a percentage of income
arising from sources within the treaty part-
ner, the deduction is definitely related and
allocable to all of the taxpayer’s gross in-
come. The deduction allocated under this
paragraph (e)(12)(iii) shall be apportioned
between the statutory grouping (or among
the statutory groupings) of gross income
and the residual grouping on the basis of
the relative amounts of gross income from
sources within the treaty partner within
each grouping.
(B) The rules of this paragraph
(e)(12)(iii) are applicable for charitable
contributions made on or after the date
of publication of this document as a final
regulation in theFederal Register.
(e)(12)(iv)(A) [The text of the pro-
posed addition of §1.861–8(e)(12)(iv)(A)
is the same as §1.861–8T(e)(12)(iv)(A)
published elsewhere in this issue of the
Federal Register.]
(e)(12)(iv)(B) [Reserved].
Par. 4. Section 1.861–14(e)(6) is re-
vised to read as follows:
§1.861–14 Special rules for allocating
and apportioning certain expenses (other
than interest expense) of an affiliated
group of corporations.
*****
(e)***(1)***
(e)(6) [The text of the proposed revi-
sion of §1.861–14(e)(6) is the same as
§1.861–14T(e)(6) through (e)(6)(ii)(A)
published elsewhere in this issue of the
Bulletin.]
*****
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on July 27, 2004,
8:45 a.m., and published in the issue of the Federal Register
for July 28, 2004, 69 F.R. 44988)
Notice of Proposed
Rulemaking by
Cross-Reference to
Temporary Regulations
and Notice of Public Hearing
Section 179 Elections
REG–152549–03
AGENCY: Internal Revenue Service
(IRS), Treasury.
September 7, 20044512004–36 I.R.B.

ACTION: Notice of proposed rulemaking
by cross-reference to temporary regula-
tions and notice of public hearing.
SUMMARY: In this issue of the Bulletin,
the IRS is issuing temporary regulations
(T.D. 9146) under section 179 of the In-
ternal Revenue Code relating to the elec-
tion to expense the cost of property sub-
ject to section 179. The temporary regu-
lations reflect changes to the law made by
the Jobs and Growth Tax Relief Reconcil-
iation Act of 2003. The text of those tem-
porary regulations also serves as the text
of these proposed regulations. This docu-
ment also provides notice of a public hear-
ing on these proposed regulations.
DATES: Written or electronic comments
must be received by November 2, 2004.
Requests to speak with outlines of topics
to be discussed at the public hearing sched-
uled for Tuesday, November 30, 2004, at
10 a.m., must be received by November 9,
2004.
ADDRESSES: Send submissions to
CC:PA:LPD:PR (REG–152549–03), room
5203, Internal Revenue Service, PO Box
7604, Ben Franklin Station, Washing-
ton, DC, 20044. Submissions may be
hand-delivered Monday through Friday
between the hours of 8 a.m. and 4 p.m.
to CC:PA:LPD:PR (REG–152549–03),
Courier’s Desk, Internal Revenue Service,
1111 Constitution Avenue, NW, Washing-
ton, DC, or sent electronically, via the IRS
Internet site at:www.irs.gov/regsor via the
Federal eRulemaking Portal atwww.regu-
lations.gov(IRS - REG–152549–03). The
public hearing will be held in room 4718,
Internal Revenue Building, 1111 Constitu-
tion Avenue, NW, Washington, DC.
FOR FURTHER INFORMATION
CONTACT: Concerning the proposed
regulations, Winston Douglas, (202)
622–3110; concerning submissions of
comments, the hearing, and/or to be placed
on the building access list to attend the
hearing, Robin Jones, (202) 622–7180
(not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained
in this notice of proposed rulemaking has
been submitted to the Office of Manage-
ment and Budget for review in accordance
with the Paperwork Reduction Act of 1995
(44 U.S.C. 3507(d)). Comments on the
collection of information should be sent to
theOffice of Management and Budget,
Attn: Desk Officer for the Department
of the Treasury, Office of Information
and Regulatory Affairs, Washington, DC
20503, with copies to theInternal Rev-
enue Service, Attn: IRS Reports Clear-
ance Officer, SE:W:CAR:MP:T:T:SP,
Washington, DC 20224. Comments on
the collection of information should be
received by October 4, 2004. Comments
are specifically requested concerning:
Whether the proposed collection of in-
formation is necessary for the proper per-
formance of the functions of theInternal
Revenue Service, including whether the
information 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 en-
hanced;
How the burden of complying with the
proposed collection of information may be
minimized, including through the appli-
cation of automated collection techniques
or other forms of information technology;
and
Estimates of capital or start-up costs
and costs of operation, maintenance, and
purchase of service to provide information.
The collections of information in this
proposed regulation are in §§1.179–2T and
1.179–5T. This information is required by
§1.179–2T to insure that married individu-
als filing separate returns properly allocate
the cost of section 179 property elected
to be expensed in a taxable year and that
the dollar limitation is properly allocated
among the component members of a con-
trolled group. Also, this information is re-
quired by §1.179–5T to insure the specific
identification of each piece of acquired
section 179 property and reflect how and
from whom such property was placed in
service. This information will be used for
audit and examination purposes. The col-
lection of information is required to obtain
a benefit. The likely respondents and/or
recordkeepers are individuals, farms, and
small businesses.
Estimated total annual reporting and/or
recordkeeping burden: 3,015,000 hours.
The estimated annual burden per re-
spondent/recordkeeper varies from .50 to
1 hour, depending on individual circum-
stances, with an estimated average of .75
hour.
Estimated number of respondents
and/or recordkeepers: 4,025,000
Estimated frequency of responses: An-
nually
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 control number assigned by the Of-
fice of Management and Budget.
Books or records relating to a collection
of information must be retained as long
as their contents may become material in
the administration of any internal revenue
law. Generally, tax returns and tax return
information are confidential, as required
by 26 U.S.C. 6103.
Background
Temporary regulations in this issue of
the Bulletin amend 26 CFR part 1 relat-
ing to section 179 of the Internal Rev-
enue Code (Code). The temporary regula-
tions provide guidance under section 179
for making and revoking elections to ex-
pense the cost of property subject to sec-
tion 179. The text of those temporary reg-
ulations also serves as the text of these pro-
posed regulations. The preamble to the
temporary regulations explains the tempo-
rary regulations and these proposed regu-
lations.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in Exec-
utive Order 12866. Therefore, a regula-
tory 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 regu-
lations. It is hereby certified that the col-
lection of information in these regulations
will not have a significant economic im-
pact on a substantial number of small en-
tities. This certification is based upon the
fact, as discussed earlier in this preamble,
that the amount of time necessary to record
and retain the required information will
be minimal for those taxpayers electing to
expense the cost of section 179 property.
2004–36 I.R.B.452September 7, 2004

Therefore, a Regulatory Flexibility Anal-
ysis under the Regulatory Flexibility Act
(5 U.S.C. chapter 6) is not required. Pur-
suant to section 7805(f) of the Code, this
notice of proposed rulemaking will be sub-
mitted to the Chief Counsel for Advocacy
of the Small BusinessAdministration 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 written comments
(a signed original and eight (8) copies)
or electronic comments that are submitted
timely to the IRS. The IRS and Treasury
Department specifically request comments
on the clarity of the proposed rules and
how they can be made easier to understand.
All comments will be available for public
inspection and copying.
A public hearing has been scheduled for
November 30, 2004, beginning at 10 a.m.,
in room 4718, Internal Revenue Building,
1111 Constitution Avenue, NW, Washing-
ton, DC. Due to building security proce-
dures, visitors must enter at the Consti-
tution Avenue entrance. In addition, all
visitors must presentphoto identification
to enter the building. Because of access
restrictions, visitors will not be admitted
beyond the immediate entrance area more
than 30 minutes before the hearing starts.
For information about having your name
placed on the building access list to attend
the hearing, see the “FOR FURTHER IN-
FORMATION CONTACT” section of this
preamble.
The rules of 26 CFR 601.601(a)(3) ap-
ply to the hearing. Persons who wish to
present oral comments at the hearing must
submit an outline of the topics to be dis-
cussed and the time to be devoted to each
topic (signed original and eight (8) copies)
by November 9, 2004. A period of 10
minutes will be allotted to each person for
making comments. An agenda showing
the scheduling of the speakers will be pre-
pared after the deadline for receiving out-
lines has passed. Copies of the agenda will
be available free of charge at the hearing.
Drafting Information
The principal author of these regula-
tions is Winston H. Douglas, Office of As-
sociate Chief Counsel (Passthroughs and
Special Industries). However, other per-
sonnel from the IRS and Treasury Depart-
ment participated in their development.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part1readsasfollows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.179–2 is amended by
revising paragraphs (b)(1) and (b)(2)(ii) to
read as follows:
§1.179–2 Limitations on amount subject
to section 179 election.
*****
(b) * * *
(1) [The text of the proposed amend-
ment to §1.179–2(b)(1) is the same as the
text of §1.179–2T(b)(1) published else-
whereinthisissueoftheBulletin].
(2) * * *
(i) * * *
(ii) [The text of the proposed amend-
ment to §1.179–2(b)(2)(ii) is the same as
the text of §1.179–2T(b)(2)(ii) published
elsewhere in this issue of the Bulletin].
Par. 3. Section 1.179–4 is amended by
revising paragraph (a) to read as follows:
§1.179–4 Definitions.
*****
(a) [The text of the proposed amend-
ment to §1.179–4(a) is the same as the
text of §1.179–4T(a) published elsewhere
in this issue of the Bulletin].
*****
Par. 4. Section 1.179–5 is amended by
adding paragraph (c) to read as follows:
§1.179–5 Time and manner of making
election.
*****
(c) [The text of the proposed amend-
ment of §1.179–5(c) is the same as the
text of §1.179–5T(c) published elsewhere
in this issue of the Bulletin].
Par. 5. Section 1.179–6 is revised to
read as follows:
§1.179–6 Effective date.
[The text of the proposed amendment
to §1.179–6 is the same as the text of
§1.179–6T published elsewhere in this is-
sue of the Bulletin].
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on August 3,
2004, 8:45 a.m., and published in the issue of the Federal
Register for August 4, 2004, 69 F.R. 47043)
Notice of Proposed
Rulemaking and Notice of
Public Hearing
Guidance Under Section 951
for DeterminingPro Rata
Share
REG–129771–04
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking
and notice of public hearing.
SUMMARY: This document contains pro-
posed regulations under section 951(a) of
the Internal Revenue Code (Code) that
provide guidance for determining a United
States shareholder’spro ratashare of a
controlled foreign corporation’s (CFC’s)
subpart F income, previously excluded
subpart F income withdrawn from in-
vestment in less developed countries,
previously excluded subpart F income
withdrawn from foreign base company
shipping operations, and amounts deter-
mined under section 956.
DATES: Written or electronic comments
must be received by November 4, 2004.
Requests to speak and outlines of topics to
be discussed at the public hearing sched-
uled for November 18, 2004, at 10 a.m.
must be received by November 4, 2004.
ADDRESSES: Send submissions to:
CC:PA:LPD:PR (REG–129771–04), room
5203, Internal Revenue Service, PO Box
September 7, 20044532004–36 I.R.B.

7604, Ben Franklin Station, Washing-
ton, DC 20044. Submissions may be
hand-delivered between the hours of 8
a.m. and 4 p.m. to CC:PA:LPD:PR
(REG–129771–04), Courier’s Desk, In-
ternal Revenue Service, 1111 Constitution
Avenue, NW, Washington, DC, or sent
electronically, via the IRS Internet site at
www.irs.gov/regsor via the Federal eRule-
making Portal atwww.regulations.gov
(IRS and REG–129771–04). If a public
hearing is scheduled, notice of the date,
time, and place for the hearing will be
published in theFederal Register.
FOR FURTHER INFORMATION
CONTACT: Concerning the proposed
regulations, Jonathan A. Sambur, (202)
622–3840; concerning submissions of
comments, the hearing, and/or to be placed
on the building access list to attend the
hearing, Sonya Cruse (202) 622–4693
(not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
This document contains proposed
amendments to 26 CFR part 1 under
section 951(a) of the Code relating to the
determination of a United States share-
holder’spro ratashare of a CFC’s subpart
F income, previously excluded subpart F
income withdrawn from investment in less
developed countries, previously excluded
subpart F income withdrawn from foreign
base company shipping operations, and
amounts determined under section 956
(collectively, section 951(a)(1) amounts).
In general, section 951(a)(1) requires a
United States shareholder that owns stock
in a CFC to include itspro ratashare of
such section 951(a)(1) amounts in its gross
income.Pro ratashare is defined in sec-
tion 951(a)(2) of the Code as the amount:
(A) which would have been distributed
with respect to the stock which such
shareholder owns (within the meaning
of section 958(a)) in such corporation
if on the last day, in its taxable year, on
which the corporation is a [CFC] it had
distributedpro ratato its shareholders
an amount (i) which bears the same ra-
tio to its subpart F income for the tax-
able year, as (ii) the part of such year
during which the corporation is a [CFC]
bears to the entire year, reduced by
(B) the amount of distributions received
by any other person during such year as
a dividend with respect to such stock,
but only to the extent of the dividend
which would have been received if
the distribution by the corporation had
been the amount (i) which bears the
same ratio to the subpart F income of
such corporation for the taxable year, as
(ii) the part of such year during which
such shareholder did not own (within
the meaning of section 958(a)) such
stock bears to the entire year.
The current regulations provide rules
for determining a United States share-
holder’spro ratashare of a CFC’s section
951(a)(1) amounts in the case where the
CFC has more than one class of stock
outstanding. These regulations have re-
mained unchanged since 1965. In the 39
years since the rules were issued, interna-
tional business arrangements have become
much more complex than contemplated in
1965, reflecting in particular more com-
plex structures for determining return on
capital. The current regulations do not
take into account these developments.
The IRS and Treasury, therefore, believe
that updated guidance is necessary to en-
sure results that are more consistent with
the economic interests of shareholders in
aCFC.
Explanation of Provisions
A.In General
Section 1.951–1(e) definespro rata
shareforpurposesofsection951(a)of
the Code. These proposed regulations
replace existing §1.951–1(e)(2) through
(4) and are intended to provide allocations
that are more consistent with the eco-
nomic interests of shareholders in a CFC.
The proposed regulations also include a
conforming change to §1.951–1(e)(1) to
reflect the 1993 legislative amendment to
section 956 of the Code.
B.ProRataShareRulesforCFCswith
Only One Class of Stock
Proposed §1.951–1(e)(2) adds an ex-
plicit rule to clarify the method by which a
United States shareholder’spro ratashare
of a CFC’s section 951(a)(1) amounts is
determined in the case where the CFC
has only one class of stock outstand-
ing. In such a case, each United States
shareholder’s share of the CFC’s section
951(a)(1) amounts shall be determined on
a per share basis.Example 1of proposed
§1.951–1(e)(6) illustrates the application
of this rule.
C.Pro Rata Share Rules for CFCs with
More than One Class of Stock
1.In General
Proposed §1.951–1(e)(3) provides rules
for determining a United States share-
holder’spro ratashare of a CFC’s section
951(a)(1) amounts in the case where the
CFC has more than one class of stock
outstanding. Proposed §1.951–1(e)(3)(i)
retains the general rule in the current reg-
ulations, which provides that the amount
of subpart F income, withdrawals, or
amounts determined under section 956
which shall be taken into account with
respect to any one class of stock shall be
that amount which bears the same ratio to
the total of such subpart F income, with-
drawals, or amounts determined under
section 956 for such year as the earnings
and profits which would be distributed
with respect to such class of stock if all
earnings and profits of such corporation
for such year were distributed on the last
day of such corporation’s taxable year
on which such corporation is a CFC (the
hypothetical distribution date) bear to the
total earnings and profits of such corpora-
tion for such taxable year.Examples 2and
8of proposed §1.951–1(e)(6) illustrate the
application of this general rule.
This general rule applies in cases where
a CFC has more than one class of stock
outstanding and where the allocation of the
amount of the CFC’s earnings and prof-
its between or among different classes of
stock does not depend upon the exercise of
discretion by the board of directors or sim-
ilar governing body of the CFC. The IRS
and Treasury Department believe that this
general rule, in practice, will apply in most
cases in which a CFC has more than one
class of stock outstanding.
2.Discretionary Power to Allocate
Earnings to Different Classes of Stock
In the case where the allocation of the
amount of a CFC’s earnings and profits
for the taxable year between two or more
classes of stock depends upon the exer-
2004–36 I.R.B.454September 7, 2004

cise of discretion by the board of directors
or a similar governing body of the CFC,
proposed §1.951–1(e)(3)(ii)(A) provides
a new general rule that determines thepro
ratashare of the CFC’s section 951(a)(1)
amounts. This new general rule allocates
earnings and profits to classes of shares
with discretionary distribution rights by
reference to the relative values of such
classes of shares on the hypothetical dis-
tribution date. Under this new rule, the
allocation of earnings and profits to each
class of stock with discretionary distribu-
tion rights generally will be the amount
of earnings and profits that bears the
same ratio to the total earnings and profits
allocated to all classes of stock with dis-
cretionary distribution rights as the value
of all shares of such class determined on
the hypothetical distribution date bears
to the total value of all classes of stock
with discretionary distribution rights. This
allocation approach is analogous to the
approach used for allocating adjustments
among classes of stock for consolidated
return purposes. See §1.1502–32(c). For
guidance with respect to the valuation
of stock, see,e.g.,Framatome Connec-
tors USA, Inc. v. Comm’r, 118 T.C. 32
(2002) (establishing factors to be used
to value stock of a CFC for purposes of
determining whether the foreign corpora-
tion was a CFC pursuant to the value test
in section 957(a)(2)); compare Rev. Rul.
59–60, 1959–1 C.B. 237 (valuing privately
held stock for estate tax purposes). See
§601.601(d)(2)(ii)(b). In cases where the
value of each share of two or more classes
of stock with discretionary distribution
rights is substantially the same, the alloca-
tion of earnings and profits to each class
of stock shall be made as if such classes
constituted one class of stock.Examples
3and4of proposed §1.951–1(e)(6) illus-
trate the application of these rules.
The general rules of proposed
§1.951–1(e)(3)(i) and (ii)(A) both apply in
certain cases where a CFC has more than
two classes of stock outstanding. Specifi-
cally, these rules both apply where a CFC
has at least two classes of stock with dis-
cretionary distribution rights and at least
one class of stock with non-discretionary
distribution rights. In general, a United
States shareholder’spro ratashare of a
CFC’s section 951(a)(1) amounts is deter-
mined by allocating earnings and profits
to classes of shares with non-discretionary
distribution rights (e.g., nonparticipating
preferred stock) in accordance with the
rules of proposed paragraph (e)(3)(i), and
then allocating the remaining earnings and
profits, if any, to each remaining class of
stock in accordance with the relative value
rules of proposed paragraph (e)(3)(ii)(A).
The new rule in proposed
§1.951–1(e)(3)(ii)(A) is intended to
ensure that the determination of a United
States shareholder’spro ratashare of a
CFC’s section 951(a)(1) amounts in cases
where the United States shareholder’s
stock has discretionary distribution rights
properly reflects the true economics of the
shareholder’s investment in the CFC. The
IRS and Treasury Department believe that
in the case of multiple classes of stock
with discretionary distribution rights, the
relative value of the classes of stock better
reflects the economics of the investment
in a CFC, and thus provides a better
mechanism for determining a United
States shareholder’spro ratashare of a
CFC’s section 951(a)(1) amounts.
Proposed §1.951–1(e)(3)(ii)(B) pro-
vides that the right to redeem stock of
a CFC will not be considered a discre-
tionary distribution right for purposes of
determining a shareholder’spro ratashare
under proposed §1.951–1(e)(3)(ii)(A),
even if the resulting redemption would
be treated as a distribution of property
to which section 301 applies pursuant to
section 302(d).Example 7of proposed
§1.951–1(e)(6) illustrates the application
of this rule.
3.Special Allocation Rule for Stock with
Mixed Distribution Rights
Proposed §1.951–1(e)(3)(iii) provides a
specific rule that applies the general rules
of proposed §1.951–1(e)(3)(i) and (ii)(A)
in cases where a class of stock provides for
both non-discretionary distribution rights
and discretionary distribution rights (e.g.,
participating preferred stock). In such a
case, the proposed regulations require sep-
arate allocations of earnings and profits
based upon the non-discretionary distribu-
tion rights and the relative value of the dis-
cretionary distribution rights.Example 5
of proposed §1.951–1(e)(6) illustrates the
application of this rule.
4.Dividend Arrearages
Proposed §1.951–1(e)(3)(iv) retains the
existing rule with respect to arrearages in
dividends with respect to classes of pre-
ferred stock of the CFC. The earnings and
profits for the taxable year shall be attribut-
able to such arrearage only to the extent the
arrearage exceeds theearnings and profits
remaining from prior taxable years begin-
ning after December 31, 1962.
D.Scope of Deemed Distribution.
Proposed §1.951–1(e)(4) sets forth a
special rule that provides that no amount
shall be considered to be distributed with
respect to a particular class of stock under
proposed §1.951–1(e)(3) to the extent that
such a distribution would constitute a dis-
tribution in redemption of stock, a distri-
bution in liquidation, or a return of capital.
This rule would apply notwithstanding the
terms of any class of stock of the CFC or
any arrangement involving the CFC. Thus,
for purposes of determining the allocation
of earnings and profits to a class of stock
of a CFC based on the earnings and prof-
its which would be distributed with re-
spect to such class of stock if all earnings
and profits were distributedpro ratato its
shareholders on the hypothetical distribu-
tion date, taxpayers may not consider any
part of the hypothetical distribution as a
distribution in redemption of stock (even if
such redemption would be treated as a dis-
tribution of property to which section 301
applies pursuant to section 302(d)), a dis-
tribution in liquidation, or a return of capi-
tal. The IRS and Treasury Department be-
lieve that such characterizations of the hy-
pothetical distribution would not properly
reflect a United States shareholder’s eco-
nomic interest in the CFC and thus should
not be considered in determining a United
States shareholder’spro ratashare of sec-
tion 951(a)(1) amounts.Example 7of pro-
posed §1.951–1(e)(6) illustrates the appli-
cation of this rule.
E.Restrictions or Other Limitations on
Distributions of Earnings and Profits by
aCFC
Proposed §1.951–1(e)(5) provides that,
except in the case of a governmental re-
striction described in section 964(b) of the
Code, a restriction or other limitation on
the distribution of earnings and profits to
September 7, 20044552004–36 I.R.B.

a United States shareholder by a CFC will
not be taken into account for purposes of
determining the amount of earnings and
profits allocated to a class of stock of a
CFC or the amount of the United States
shareholder’spro ratashare of the CFC’s
section 951(a)(1) amounts. This rule ap-
plies in all cases, including cases where
the restriction or limitation is the result
of an arrangement between unrelated par-
ties or an arrangement that has a non-tax
motivated business purpose and economic
substance. The IRS and Treasury Depart-
ment believe that taking into account such
restrictions or limitations in determining
a United States shareholder’spro rata
share is contrary to the purpose of section
951(a) and would not properly reflect a
United States shareholder’s economic in-
terest in the CFC.Example 6of proposed
§1.951–1(e)(6) illustrates the application
of this rule.
Proposed §1.951–1(e)(5)(ii) provides
a broad definition ofrestrictions or
other limitations on distributionsthat
are covered by this rule. Under proposed
§1.951–1(e)(5)(iii), the right to receive
a preferred dividend is not considered
a restriction or other limitation on the
distribution of earnings and profits with
respect to other classes of stock. Proposed
§1.951–1(e)(5)(iv) lists some instances
where restrictions or other limitations will
not be taken into account.
Proposed Effective Date
These regulations are proposed to apply
for taxable years of a controlled foreign
corporation beginning on or after January
1, 2005.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant
regulatory action as defined in Executive
Order 12866. Therefore, a regulatory as-
sessment is not required. It also has been
determined that section 553(b) of the Ad-
ministrative Procedure Act (5 U.S.C. chap-
ter 5) does not apply to these regulations,
and because the regulation does not im-
pose a collection of information on small
entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursuant
to section 7805(f) of the Code, this notice
of proposed rulemaking will be submitted
to the Chief Counsel for Advocacy of the
Small Business Administration for com-
ment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, considera-
tion will be given to any written (a signed
original and eight (8) copies) or electronic
comments that are submitted timely to
the IRS. The IRS and Treasury Depart-
ment request comments on the clarity of
the proposed rules and how they can be
made easier to understand. All comments
will be available for public inspection
and copying. A public hearing has been
scheduled for November 18, 2004, at 10
a.m. in the auditorium, Internal Revenue
Building, 1111 Constitution Avenue, NW,
Washington, DC. Due to building security
procedures, visitors must enter at the Con-
stitution Avenue entrance. In addition, all
visitors must presentphoto identification
to enter the building. Because of access
restrictions, visitors will not be admitted
beyond the immediate entrance area more
than 30 minutes before the hearing starts.
For information about having your name
placed on the building access list to attend
the hearing, see the “FOR FURTHER IN-
FORMATION CONTACT” section of this
preamble.
The rules of 26 CFR 601.601(a)(3) ap-
ply to the hearing. Persons who wish to
present oral comments at the hearing must
submit written or electronic comments and
an outline of the topics to be discussed and
the time to be devoted to each topic (signed
original and eight (8) copies) by Novem-
ber 4, 2004. A period of 10 minutes will
be allotted to each person for making com-
ments. 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.
Comments are requested on all aspects
of the proposed regulations, including
those aspects for which specific requests
for comments are set forth above.
Drafting Information
The principal author of these regula-
tions is Jonathan A. Sambur, Office of
Associate Chief Counsel (International).
However, other personnel from the IRS
and Treasury Department participated in
their development.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.951–1 is amended by:
1. Removing the language “increase
in earnings invested in United States
property” in paragraph (e)(1) and adding
“amount determined under section 956” in
its place.
2. Revising paragraphs (e)(2) through
(e)(4) and adding paragraphs (e)(5)
through (e)(7) to read as follows:
§1.951–1 Amounts included in gross
income of United States shareholders.
*****
(e) * * *
(2)One class of stock. If a controlled
foreign corporation for a taxable year has
only one class of stock outstanding, each
United States shareholder’spro ratashare
of such corporation’s subpart F income,
withdrawal, or amount determined under
section 956, for the taxable year under
paragraph (e)(1) of this section shall be de-
termined by allocating the controlled for-
eign corporation’s earnings and profits on
a per share basis.
(3)More than one class of stock—(i)In
general. Subject to paragraphs (e)(3)(ii)
and (e)(3)(iii) of this section, if a con-
trolled foreign corporation for a taxable
year has more than one class of stock out-
standing, the amount of such corporation’s
subpart F income, withdrawal, or amount
determined under section 956, for the tax-
able year taken into account with respect
to any one class of stock for purposes of
paragraph (e)(1) of this section shall be
that amount which bears the same ratio to
the total of such subpart F income, with-
drawal, or amount determined under sec-
tion 956 for such year as the earnings and
profits which would be distributed with re-
spect to such class of stock if all earnings
and profits of such corporation for such
year were distributed on the last day of
such corporation’s taxable year on which
2004–36 I.R.B.456September 7, 2004

such corporation is acontrolled foreign
corporation (the hypothetical distribution
date), bear to the total earnings and profits
of such corporation for such taxable year.
(ii)Discretionary power to allocate
earnings to different classes of stock—(A)
In general. Subject to paragraph (e)(3)(iii)
of this section, the rules of this paragraph
apply for purposes of paragraph (e)(1)
if the allocation of a controlled foreign
corporation’s earnings and profits for the
taxable year between two or more classes
of stock depends upon the exercise of
discretion by that body of persons which
exercises with respect to such corporation
the powers ordinarily exercised by the
board of directors of a domestic corpo-
ration (discretionary distribution rights).
First, the earnings and profits of the cor-
poration are allocated under paragraph
(e)(3)(i) of this section to any class or
classes of stock with non-discretionary
distribution rights (e.g., preferred stock
entitled to a fixed return). Second, the
amount of earnings and profits allocated
to a class of stock with discretionary dis-
tribution rights shall be that amount which
bears the same ratio to the remaining earn-
ings and profits of such corporation for
such taxable year as the value of all shares
of such class of stock, determined on the
hypothetical distribution date, bears to
the total value of all shares of all classes
of stock with discretionary distribution
rights of such corporation, determined on
the hypothetical distribution date. For
purposes of the preceding sentence, in
the case where the value of each share of
two or more classes of stock with discre-
tionary distribution rights is substantially
the same on the hypothetical distribution
date, the allocation of earnings and profits
to such classes shall be made as if such
classes constituted one class of stock in
which each share has the same rights to
dividends as any other share.
(B)Special rule for redemption rights.
For purposes of paragraph (e)(3)(ii)(A)
of this section, discretionary distribution
rights do not include rights to redeem
shares of a class of stock (even if such
redemption would be treated as a distri-
bution of property to which section 301
applies pursuant to section 302(d)).
(iii)Special allocation rule for stock
with mixed distribution rights. For pur-
poses of paragraphs (e)(3)(i) and (e)(3)(ii)
of this section, in the case of a class of
stock with both discretionary and non-dis-
cretionary distribution rights, earnings and
profits shall be allocated to the non-discre-
tionary distribution rights under paragraph
(e)(3)(i) of this section and to the discre-
tionary distribution rights under paragraph
(e)(3)(ii) of this section. In such a case,
paragraph (e)(3)(ii) of this section will be
applied such that the value used in the ra-
tio will be the value of such class of stock
solely attributable to the discretionary dis-
tribution rights of such class of stock.
(iv)Dividend arrearages. For purposes
of paragraph (e)(3)(i) of this section, if
an arrearage in dividends for prior taxable
years exists with respect to a class of pre-
ferred stock of such corporation, the earn-
ings and profits for the taxable year shall
be attributed to such arrearage only to the
extent such arrearage exceeds the earnings
and profits of such corporation remaining
from prior taxable years beginning after
December 31, 1962.
(4)Scope of deemed distribution.Not-
withstanding the terms of any class of
stock of the controlled foreign corporation
or any agreement or arrangement with
respect thereto, no amount shall be con-
sidered to be distributed with respect to a
particular class of stock for purposes of
paragraph (e)(3) of this section to the ex-
tent that such distribution would constitute
a distribution in redemption of stock (even
if such redemption would be treated as a
distributionofpropertytowhichsection
301 applies pursuant to section 302(d)), as
a distribution in liquidation, or as a return
of capital.
(5)Restrictions or other limitations on
distributions—(i)In general.Arestric-
tion or other limitation on distributions of
earnings and profits by a controlled for-
eign corporation will not be taken into ac-
count, for purposes of this section, in deter-
mining the amount of earnings and profits
that shall be allocated to a class of stock
of the controlled foreign corporation or the
amount of the United States shareholder’s
pro ratashare of the controlled foreign cor-
poration’s subpart F income, withdrawal,
or amounts determined under section 956
for the taxable year.
(ii)Definition. For purposes of this sec-
tion, arestriction or other limitation on
distributionsincludes any limitation that
has the effect of limiting the allocation or
distribution of earnings and profits by a
controlled foreign corporation to a United
States shareholder, other than currency or
other restrictions or limitations imposed
under the laws of any foreign country as
provided in section 964(b).
(iii)Exception for certain preferred dis-
tributions. The right to receive periodi-
cally a fixed amount (whether determined
by a percentage of par value, a reference
to a floating coupon rate, a stated return
expressed in terms of a certain amount of
dollars or foreign currency, or otherwise)
with respect to a class of stock the distri-
bution of which is a condition precedent to
a further distribution of earnings or prof-
its that year with respect to any class of
stock (not including a distribution in par-
tial or complete liquidation) is not a restric-
tion or other limitation on the distribution
of earnings and profits by a controlled for-
eign corporation under paragraph (e)(5) of
this section.
(iv)Illustrative list of restrictions and
limitations. Except as provided in para-
graph (e)(5)(iii) of this section, restric-
tions or other limitations on distributions
include, but are not limited to—
(A) An arrangement that restricts the
ability of the controlled foreign corpora-
tion to pay dividends on a class of shares
of the corporation owned by United States
shareholders until a condition or condi-
tions are satisfied (e.g., until another class
of stock is redeemed);
(B) A loan agreement entered into by
a controlled foreign corporation that re-
stricts or otherwise affects the ability to
make distributions on its stock until certain
requirements are satisfied; or
(C) An arrangement that conditions the
ability of the controlled foreign corpora-
tion to pay dividends to its shareholders
on the financial condition of the controlled
foreign corporation.
(6)Examples. The application of this
section may be illustrated by the following
examples:
Example 1.(i)Facts. FC1, a controlled foreign
corporation within the meaning of section 957(a), has
outstanding 100 shares of one class of stock. Corp
E, a domestic corporation and a United States share-
holder of FC1, within the meaning of section 951(b),
owns 60 shares. Corp H, a domestic corporation and
a United States shareholder of FC1, within the mean-
ing of section 951(b), owns 40 shares. FC1, Corp E,
and Corp H each use the calendar year as a taxable
year. Corp E and Corp H are shareholders of FC1 for
its entire 2004 taxable year. For 2004, FC1 has $100x
of earnings and profits, and income of $100x with re-
spect to which amounts are required to be included
in gross income of United States shareholders under
September 7, 20044572004–36 I.R.B.

section 951(a). FC1 makes no distributions during
that year.
(ii)Analysis. FC1 has one class of stock. There-
fore, under paragraph (e)(2) of this section, FC1’s
earnings and profits are allocated on a per share basis.
Accordingly, for the taxable year 2004, Corp E’spro
ratashare of FC1’s subpart F income is $60x (60/100
x $100x) and Corp H’spro ratashare of FC1’s sub-
part F income is $40x (40/100 x $100x).
Example 2.(i)Facts. FC2, a controlled foreign
corporation within the meaning of section 957(a),
has outstanding 70 shares of common stock and 30
shares of 4-percent, nonparticipating, voting, pre-
ferred stock with a par value of $10x per share. The
common shareholders are entitled to dividends when
declared by the board of directors of FC2. Corp A, a
domestic corporation and a United States shareholder
of FC2, within the meaning of section 951(b), owns
all of the common shares. Individual B, a foreign
individual, owns all of the preferred shares. FC2 and
Corp A each use the calendar year as a taxable year.
Corp A and Individual B are shareholders of FC2 for
its entire 2004 taxable year. For 2004, FC1 has $50x
of earnings and profits, and income of $50x with
respect to which amounts are required to be included
in gross income of United States shareholders under
section 951(a). In 2004, FC2 distributes as a dividend
$12x to Individual B with respect to Individual B’s
preferred shares. FC2 makes no other distributions
during that year.
(ii)Analysis. FC2 has two classes of stock, and
there are no restrictions or other limitations on distri-
butions within the meaning of paragraph (e)(5) of this
section. If the total $50x of earnings were distributed
on December 31, 2004, $12x would be distributed
with respect to Individual B’s preferred shares and the
remainder, $38x, would be distributed with respect to
Corp A’s common shares. Accordingly, under para-
graph (e)(3)(i) of this section, Corp A’spro ratashare
of FC1’s subpart F income is $38x for taxable year
2004.
Example 3.(i)Facts. The facts are the same as
inExample 2, except that the shares owned by Indi-
vidual B are Class B common shares and the shares
owned by Corp A are Class A common shares and the
board of directors of FC2 may declare dividends with
respect to one class of stock without declaring divi-
dends with respect to the other class of stock. The
value of the Class A common shares on the last day
of FC2’s 2004 taxable year is $680x and the value
of the Class B common shares on that date is $300x.
The board of directors of FC2 determines that FC2
will not make any distributions in 2004 with respect
to the Class A and B common shares of FC2.
(ii)Analysis. The allocation of FC2’s earnings
and profits between its Class A and Class B common
shares depends solely on the exercise of discretion by
the board of directors of FC2. Therefore, under para-
graph (e)(3)(ii)(A) of this section, the allocation of
earnings and profits between the Class A and Class
B common shares will depend on the value of each
class of stock on the last day of the controlled for-
eign corporation’s taxable year. On the last day of
FC2’s taxable year 2004, the Class A common shares
had a value of $9.71x/share and the Class B common
shares had a value of $10x/share. Because each share
of the Class A and Class B common stock of FC2 has
substantially the same value on the last day of FC2’s
taxable year, under paragraph (e)(3)(ii)(A) of this sec-
tion, for purposes of allocating the earnings and prof-
its of FC2, the Class A and Class B common shares
will be treated as one class of stock. Accordingly, for
FC2’s taxable year 2004, the earnings and profits of
FC2 are allocated $35x (70/100 x $50x) to the Class
A common shares and $15x (30/100 x $50x) to the
Class B common shares. For its taxable year 2004,
Corp A’spro ratashare of FC2’s subpart F income
will be $35x.
Example 4.(i)Facts. FC3, a controlled foreign
corporation within the meaning of section 957(a), has
outstanding 100 shares of Class A common stock,
100 shares of Class B common stock and 10 shares
of 5-percent nonparticipating, voting preferred stock
with a par value of $50x per share. The value of the
Class A shares on the last day of FC3’s 2004 taxable
year is $800x. The value of the Class B shares on
that date is $200x. The Class A and Class B share-
holders each are entitled to dividends when declared
by the board of directors of FC3, and the board of
directors of FC3 may declare dividends with respect
to one class of stock without declaring dividends with
respect to the other class of stock. Corp D, a domestic
corporation and a United States shareholder of FC3,
within the meaning of section 951(b), owns all of the
Class A shares. Corp N, a domestic corporation and
a United States shareholder of FC3, within the mean-
ing of section 951(b), owns all of the Class B shares.
Corp S, a domestic corporation and a United States
shareholder of FC3, within the meaning of section
951(b), owns all of the preferred shares. FC3, Corp
D, Corp N, and Corp S each use the calendar year as a
taxable year. Corp D, Corp N, and Corp S are share-
holders of FC3 for all of 2004. For 2004, FC3 has
$100x of earnings and profits, and income of $100x
with respect to which amounts are required to be in-
cluded in gross income of United States shareholders
under section 951(a). In 2004, FC3 distributes as a
dividend $25x to Corp S with respect to the preferred
shares. The board of directors of FC3 determines that
FC3 will make no other distributions during that year.
(ii)Analysis. The distribution rights of the pre-
ferred shares are not a restriction or other limitation
within the meaning of paragraph (e)(5) of this section.
Pursuant to paragraph (e)(3)(i) of this section, if the
total $100x of earnings were distributed on Decem-
ber 31, 2004, $25x would be distributed with respect
to Corp S’s preferred shares and the remainder, $75x
would be distributed with respect to Corp D’s Class
A shares and Corp N’s Class B shares. The allocation
of that $75x between its Class A and Class B shares
depends solely on the exercise of discretion by the
board of directors of FC3. The value of the Class A
shares ($8x/share) and the value of the Class B shares
($2x/share) are not substantially the same on the last
day of FC3’s taxable year 2004. Therefore for FC3’s
taxable year 2004, under paragraph (e)(3)(ii)(A) of
this section, the earnings and profits of FC3 are al-
located $60x ($800/$1,000 x $75x) to the Class A
shares and $15x ($200/$1,000 x $75x) to the Class B
shares. For the 2004 taxable year, Corp D’spro rata
share of FC3’s subpart F income will be $60x, Corp
N’spro ratashare of FC3’s subpart F income will be
$15x and Corp S’spro ratashare of FC3’s subpart F
income will be $25x.
Example 5.(i)Facts. FC4, a controlled foreign
corporation within the meaning of section 957(a), has
outstanding 40 shares of participating, voting, pre-
ferred stock and 200 shares of common stock. The
owner of a share of preferred stock is entitled to an an-
nual dividend equal to 0.5-percent of FC4’s retained
earnings for the taxable year and also is entitled to
additional dividends when declared by the board of
directors of FC4. The common shareholders are en-
titled to dividends when declared by the board of di-
rectors of FC4. The board of directors of FC4 has
discretion to pay dividends to the participating por-
tion of the preferred shares (after the payment of the
preference) and the common shares. The value of the
preferred shares on the last day of FC4’s 2004 taxable
year is $600x ($100x of this value is attributable to the
discretionary distribution rights of these shares) and
the value of the common shares on that date is $400x.
Corp E, a domestic corporation and United States
shareholder of FC4, within the meaning of section
951(b), owns all of the preferred shares. FC5, a for-
eign corporation that is not a controlled foreign cor-
poration within the meaning of section 957(a), owns
all of the common shares. FC4 and Corp E each use
the calendar year as a taxable year. Corp E and FC5
are shareholders of FC4 for all of 2004. For 2004,
FC4 has $100x of earnings and profits, and income
of $100x with respect to which amounts are required
to be included in gross income of United States share-
holders under section 951(a). In 2004, FC4’s retained
earnings are equal to its earnings and profits. FC4 dis-
tributes as a dividend $20x to Corp E that year with
respect to Corp E’s preferred shares. The board of
directors of FC4 determines that FC4 will not make
any other distributions during that year.
(ii)Analysis. The non-discretionary distribution
rights of the preferred shares are not a restriction
or other limitation within the meaning of paragraph
(e)(5) of this section. The allocation of FC4’s earn-
ings and profits between its preferred shares and
common shares depends, in part, on the exercise of
discretion by the board of directors of FC4 because
the preferred shares are shares with both discre-
tionary distribution rights and non-discretionary
distribution rights. Paragraph (e)(3)(i) of this sec-
tion is applied first to determine the allocation of
earnings and profits of FC4 to the non-discretionary
distribution rights of the preferred shares. If the total
$100x of earnings were distributed on December
31, 2004, $20x would be distributed with respect to
the non-discretionary distribution rights of Corp E’s
preferred shares. Accordingly, $20x would be allo-
cated to such shares under paragraphs (e)(3)(i) and
(iii) of this section. The remainder, $80x, would be
allocated under paragraph (e)(3)(ii)(A) and (e)(3)(iii)
of this section between the preferred and common
shareholders by reference to the value of the dis-
cretionary distribution rights of the preferred shares
and the value of the common shares. Therefore, the
remaining $80x of earnings and profits of FC4 are
allocated $16x ($100x/$500x x $80x) to the preferred
shares and $64x ($400x/$500x x $80) to the common
shares. For its taxable year 2004, Corp E’spro rata
share of FC4’s subpart F income will be $36x ($20x
+ $16x) .
Example 6.(i)Facts. FC6, a controlled foreign
corporation within the meaning of section 957(a),
has outstanding 10 shares of common stock and 400
shares of 2-percent nonparticipating, voting, pre-
ferred stock with a par value of $1x per share. The
common shareholders are entitled to dividends when
declared by the board of directors of FC6. Corp M, a
domestic corporation and a United States shareholder
2004–36 I.R.B.458September 7, 2004

of FC6, within the meaning of section 951(b), owns
all of the common shares. FC7, a foreign corpo-
ration that is not a controlled foreign corporation
within the meaning of section 957(a), owns all of the
preferred shares. Corp M and FC7 cause the govern-
ing documents of FC6 to provide that no dividends
may be paid to the common shareholders until FC6
cumulatively earns $100,000x of income. FC6 and
Corp M each use the calendar year as a taxable year.
Corp M and FC7 are shareholders of FC6 for all
of 2004. For 2004, FC6 has $50x of earnings and
profits, and income of $50x with respect to which
amounts are required to be included in gross income
of United States shareholders under section 951(a).
In 2004, FC6 distributes as a dividend $8x to FC7
with respect to FC7’s preferred shares. FC6 makes
no other distributions during that year.
(ii)Analysis. The agreement restricting FC6’s
ability to pay dividends to common shareholders un-
til FC6 cumulatively earns $100,000x of income is
a restriction or other limitation, within the meaning
of paragraph (e)(5) of this section, and will be disre-
garded for purposes of calculating Corp M’spro rata
share of subpart F income. The non-discretionary
distribution rights of the preferred shares are not a
restriction or other limitation within the meaning of
paragraph (e)(5) of this section. If the total $50x of
earnings were distributed on December 31, 2004, $8x
would be distributed with respect to FC7’s preferred
shares and the remainder, $42x, would be distributed
with respect to Corp M’s common shares. Accord-
ingly, under paragraph (e)(3)(i) of this section, Corp
M’spro ratashare of FC6’s subpart F income is $42x
for taxable year 2004.
Example 7.(i)Facts. FC8, a controlled foreign
corporation within the meaning of section 957(a), has
outstanding 40 shares of common stock and 10 shares
of 4-percent voting preferred stock with a par value
of $50x per share. Pursuant to the terms of the pre-
ferred stock, FC8 has the right to redeem at any time,
in whole or in part, the preferred stock. FP, a foreign
corporation, owns all of the preferred shares. Corp
G, a domestic corporation wholly owned by FP and
a United States shareholder of FC8, within the mean-
ing of section 951(b), owns all of the common shares.
FC8 and Corp G each use the calendar year as a tax-
able year. FP and Corp G are shareholders of FC8 for
all of 2004. For 2004, FC8 has $100x of earnings and
profits, and income of $100x with respect to which
amounts are required to be included in gross income
of United States shareholder under section 951(a). In
2004, FC8 distributes as a dividend $20x to FP with
respect to FP’s preferred shares. FC8 makes no other
distributions during that year.
(ii)Analysis. Pursuant to paragraph (e)(3)(ii)(B)
of this section, the redemption rights of the preferred
shares will not be treated asa discretionary distribu-
tion right under paragraph (e)(3)(ii)(A) of this sec-
tion. Further, if FC8 were treated as having redeemed
any preferred shares under paragraph (e)(3)(i) of this
section, the redemption would be treated as a distribu-
tion to which section 301 applies under section 302(d)
due to FP’s constructive ownership of the common
shares. However, pursuant to paragraph (e)(4) of this
section, no amount of earnings and profits would be
allocated to the preferred shareholders on the hypo-
thetical distribution date, under paragraph (e)(3)(i) of
this section, as a result of FC8’s right to redeem, in
whole or in part, the preferred shares. FC8’s redemp-
tion rights with respect to the preferred shares can-
not affect the allocation of earnings and profits be-
tween FC8’s shareholders. Therefore, the redemption
rights are not restrictions or other limitations within
the meaning of paragraph (e)(5) of this section. Ad-
ditionally, the non-discretionary distribution rights of
the preferred shares are not restrictions or other limi-
tations within the meaning of paragraph (e)(5) of this
section. Therefore, if the total $100x of earnings were
distributed on December 31, 2004, $20x would be
distributed with respect to FP’s preferred shares and
the remainder, $80x, would be distributed with re-
spect to Corp G’s common shares. Accordingly, un-
der paragraph (e)(3)(i) of this section, Corp G’spro
ratashare of FC8’s subpart F income is $80 for tax-
able year 2004.
Example 8.(i)Facts. FC9, a controlled foreign
corporation within the meaning of section 957(a), has
outstanding 40 shares of common stock and 60 shares
of 6-percent, nonparticipating, nonvoting, preferred
stock with a par value of $100x per share. Individ-
ual J, a United States shareholder of FC9, within the
meaning of section 951(b), who uses the calendar
year as a taxable year, owns 30 shares of the common
stock, and 15 shares of the preferred stock during tax
year 2004. The remaining 10 common shares and 45
preferred shares of FC9 are owned by Foreign Indi-
vidual N, a foreign individual. Individual J and Indi-
vidual N are shareholders of FC9 for all of 2004. For
taxable year 2004, FC9 has $1,000x of earnings and
profits, and income of $500x with respect to which
amounts are required to be included in gross income
of United States shareholders under section 951(a).
(ii)Analysis. The non-discretionary distribution
rights of the preferred shares are not a restriction
or other limitation within the meaning of paragraph
(e)(5) of this section. If the total $1,000x of earnings
and profits were distributed on December 31, 2004,
$360x (0.06 x $100x x 60) would be distributed with
respect to FC9’s preferred stock and $640x ($1,000x
minus $360x) would be distributed with respect to
its common stock. Accordingly, of the $500x with
respect to which amounts are required to be included
in gross income of United States shareholders under
section 951(a), $180x ($360x/$1,000x x $500x)
is allocated to the outstanding preferred stock and
$320x ($640x/$1,000x x $500x) is allocated to the
outstanding common stock. Therefore, under para-
graph (e)(3)(i) of this section, Individual J’spro rata
share of such amounts for 2004 is $285x [($180x x
15/60)+($320x x 30/40)].
(7)Effective date. These regulations
apply for taxable years of a controlled for-
eign corporation beginning on or after Jan-
uary 1, 2005.
Nancy Jardini,
Acting Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on August 5,
2004, 8:45 a.m., and published in the issue of the Federal
Register for August 6, 2004, 69 F.R. 47822)
Health Savings Accounts
(HSAs); Correction
Announcement 2004–67
PURPOSE
This document contains corrections to
A–14 in Notice 2004–2, 2004–2 I.R.B.
269, relating to Health Savings Accounts.
As published, A–14 of the notice contains
errors that may prove to be misleading and
are in need of clarification.
CORRECTIONS
The last sentence in A–14 of Notice
2004–2 which currently reads, “After an
individual has attained age 65 (the Medi-
care eligibility age), contributions, includ-
ing catch-up contributions, cannot be made
to an individual’s HSA”, is corrected to
read as follows: “After an individual has
attained age 65 and becomes enrolled in
Medicare benefits, contributions, includ-
ing catch-up contributions, cannot be made
to an individual’s HSA.” Additionally, the
terms “becomes eligible for” in the first
sentence of the Example in A–14 of Notice
2004–2 are replaced by “becomes enrolled
in”.
FOR FURTHER INFORMATION
CONTACT:
Shoshanna Tanner at (202) 622–6080
(not a toll-free number).
September 7, 20044592004–36 I.R.B.

Definition of Terms
Revenue rulings and revenue procedures
(hereinafter referred to as “rulings”) that
have an effect on previous rulings use the
following defined terms to describe the ef-
fect:
Amplifieddescribes a situation where
no change is being made in a prior pub-
lished position, but the prior position is be-
ingextendedtoapplytoavariationofthe
fact situation set forth therein. Thus, if
an earlier ruling held that a principle ap-
plied to A, and the new ruling holds that the
same principle also applies to B, the earlier
ruling is amplified. (Compare withmodi-
fied,below).
Clarifiedis used in those instances
where the language in a prior ruling is be-
ing made clear because the language has
caused, or may cause, some confusion.
It is not used where a position in a prior
ruling is being changed.
Distinguisheddescribes a situation
where a ruling mentions a previously pub-
lished ruling and points out an essential
difference between them.
Modifiedis used where the substance
of a previously published position is being
changed. Thus, if a prior ruling held that a
principle applied to A but not to B, and the
new ruling holds that it applies to both A
and B, the prior ruling is modified because
it corrects a published position. (Compare
withamplifiedandclarified, above).
Obsoleteddescribes a previously pub-
lished ruling that is not considered deter-
minative with respect to future transac-
tions. This term is most commonly used in
a ruling that lists previously published rul-
ings that are obsoleted because of changes
in laws or regulations. A ruling may also
be obsoleted because the substance has
been included in regulations subsequently
adopted.
Revokeddescribes situations where the
position in the previously published ruling
is not correct and the correct position is
beingstatedinanewruling.
Supersededdescribes a situation where
the new ruling does nothing more than re-
state the substance and situation of a previ-
ously published ruling (or rulings). Thus,
the term is used to republish under the
1986 Code and regulations the same po-
sition published under the 1939 Code and
regulations. The term is also used when
it is desired to republish in a single rul-
ing a series of situations, names, etc., that
were previously published over a period of
time in separate rulings. If the new rul-
ing does more than restate the substance
of a prior ruling, a combination of terms
is used. For example,modifiedandsu-
persededdescribes a situation where the
substance of a previously published ruling
is being changed in part and is continued
without change in part and it is desired to
restate the valid portion of the previously
published ruling in a new ruling that is self
contained. In this case, the previously pub-
lished ruling is first modified and then, as
modified, is superseded.
Supplementedis used in situations in
which a list, such as a list of the names of
countries, is published in a ruling and that
list is expanded by adding further names in
subsequent rulings. After the original rul-
ing has been supplemented several times, a
new ruling may be published that includes
the list in the original ruling and the ad-
ditions, and supersedes all prior rulings in
the series.
Suspendedis used in rare situations
to show that the previous published rul-
ings will not be applied pending some
future action such as the issuance of new
or amended regulations, the outcome of
cases in litigation, or the outcome of a
Service study.
Abbreviations
The fol
lowing abbreviations in current use
and for
merly used will appear in material
publis
hedintheBulletin.
A—Individual.
Acq.—A
cquiescence.
B—Individual.
BE—Beneficiary.
BK—Bank
.
B.T.A.—Board of Tax Appeals.
C—Individual.
C.B.—Cu
mulative Bulletin.
CFR—Code of Federal Regulations.
CI—City.
COOP—Coo
perative.
Ct.D.—Court Decision.
CY—County.
D—Decede
nt.
DC—Dummy Corporation.
DE—Donee.
Del. Order
—Delegation Order.
DISC—Domestic International Sales Corporation.
DR—Donor.
E—Estate.
EE—Employee.
E.O.—Executive Order.
ER—Emp
loyer.
ERISA—Employee Retirement Income Security Act.
EX—Executor.
F—Fiduc
iary.
FC—Foreign Country.
FICA—Federal Insurance Contributions Act.
FISC—Fo
reign International Sales Company.
FPH—Foreign Personal Holding Company.
F.R.—Federal Register.
FUTA—Fed
eral Unemployment Tax Act.
FX—Foreign corporation.
G.C.M.—Chief Counsel’s Memorandum.
GE—Grante
e.
GP—General Partner.
GR—Grantor.
IC—Insura
nce Company.
I.R.B.—Internal Revenue Bulletin.
LE—Lessee.
LP—Limited
Partner.
LR—Lessor.
M—Minor.
Nonacq.—No
nacquiescence.
O—Organization.
P—Parent Corporation.
PHC—Persona
l Holding Company.
PO—Possession of the U.S.
PR—Partner.
PRS—Pa
rtnership.
PTE—Prohibited Transaction Exemption.
Pub. L.—Public Law.
REIT—Re
al Estate Investment Trust.
Rev. Proc.—Revenue Procedure.
Rev. Rul.—Revenue Ruling.
S—Subsi
diary.
S.P.R.—Statement of Procedural Rules.
Stat.—Statutes at Large.
T—Target
Corporation.
T.C.—Tax Court.
T.D.—Treasury Decision.
TFE—Trans
feree.
TFR—Transferor.
T.I.R.—Technical Information Release.
TP—Taxpay
er.
TR—Trust.
TT—Trustee.
U.S.C.—Uni
ted States Code.
X—Corporation.
Y—Corporation.
Z—Corporat
ion.
2004–36 I.R.B.iSeptember 7, 2004

Numerical Finding List
1
Bulletins 2004–27 through 2004–36
Announcements:
2004-55, 2004-27 I.R.B.15
2004-56, 2004-28 I.R.B.41
2004-57, 2004-27 I.R.B.15
2004-58, 2004-29 I.R.B.66
2004-59, 2004-30 I.R.B.94
2004-60, 2004-29 I.R.B.43
2004-61, 2004-29 I.R.B.67
2004-62, 2004-30 I.R.B.103
2004-63, 2004-31 I.R.B.149
2004-64, 2004-35 I.R.B.402
2004-65, 2004-33 I.R.B.300
2004-66, 2004-35 I.R.B.402
2004-67, 2004-36 I.R.B.459
Notices:
2004-41, 2004-28 I.R.B.31
2004-43, 2004-27 I.R.B.10
2004-44, 2004-28 I.R.B.32
2004-45, 2004-28 I.R.B.33
2004-46, 2004-29 I.R.B.46
2004-47, 2004-29 I.R.B.48
2004-48, 2004-30 I.R.B.88
2004-49, 2004-30 I.R.B.88
2004-50, 2004-33 I.R.B.196
2004-51, 2004-30 I.R.B.89
2004-52, 2004-32 I.R.B.168
2004-53, 2004-33 I.R.B.209
2004-54, 2004-33 I.R.B.209
2004-55, 2004-34 I.R.B.319
2004-56, 2004-35 I.R.B.375
2004-57, 2004-35 I.R.B.376
2004-59, 2004-36 I.R.B.447
Proposed Regulations:
REG-208246-90, 2004-36 I.R.B.450
REG-153841-02, 2004-31 I.R.B.145
REG-163679-02, 2004-35 I.R.B.390
REG-124405-03, 2004-35 I.R.B.394
REG-131486-03, 2004-28 I.R.B.36
REG-150562-03, 2004-32 I.R.B.175
REG-152549-03, 2004-36 I.R.B.451
REG-101447-04, 2004-34 I.R.B.344
REG-117307-04, 2004-28 I.R.B.39
REG-129771-04, 2004-36 I.R.B.453
Revenue Procedures:
2004-38, 2004-27 I.R.B.10
2004-39, 2004-29 I.R.B.49
2004-40, 2004-29 I.R.B.50
2004-41, 2004-30 I.R.B.90
2004-42, 2004-31 I.R.B.121
Revenue Procedures— Continued:
2004-43, 2004-31 I.R.B.124
2004-44, 2004-31 I.R.B.134
2004-45, 2004-31 I.R.B.140
2004-46, 2004-31 I.R.B.142
2004-47, 2004-32 I.R.B.169
2004-48, 2004-32 I.R.B.172
2004-49, 2004-33 I.R.B.210
2004-50, 2004-33 I.R.B.211
2004-51, 2004-33 I.R.B.294
2004-52, 2004-34 I.R.B.319
2004-53, 2004-34 I.R.B.320
2004-54, 2004-34 I.R.B.325
2004-55, 2004-34 I.R.B.343
2004-56, 2004-35 I.R.B.376
Revenue Rulings:
2004-63, 2004-27 I.R.B.6
2004-64, 2004-27 I.R.B.7
2004-65, 2004-27 I.R.B.1
2004-66, 2004-27 I.R.B.4
2004-67, 2004-28 I.R.B.28
2004-68, 2004-31 I.R.B.118
2004-69, 2004-36 I.R.B.445
2004-71, 2004-30 I.R.B.74
2004-72, 2004-30 I.R.B.77
2004-73, 2004-30 I.R.B.80
2004-74, 2004-30 I.R.B.84
2004-75, 2004-31 I.R.B.109
2004-76, 2004-31 I.R.B.111
2004-77, 2004-31 I.R.B.119
2004-78, 2004-31 I.R.B.108
2004-79, 2004-31 I.R.B.106
2004-80, 2004-32 I.R.B.164
2004-81, 2004-32 I.R.B.161
2004-82, 2004-35 I.R.B.350
2004-83, 2004-32 I.R.B.157
2004-84, 2004-32 I.R.B.163
2004-85, 2004-33 I.R.B.189
2004-86, 2004-33 I.R.B.191
2004-87, 2004-32 I.R.B.154
2004-88, 2004-32 I.R.B.165
2004-89, 2004-34 I.R.B.301
2004-90, 2004-34 I.R.B.317
2004-91, 2004-35 I.R.B.357
Tax Conventions:
2004-60, 2004-29 I.R.B.43
Treasury Decisions:
9131, 2004-27 I.R.B.2
9132, 2004-28 I.R.B.16
9133, 2004-28 I.R.B.25
9134, 2004-30 I.R.B.70
9135, 2004-30 I.R.B.69
9136, 2004-31 I.R.B.112
Treasury Decisions— Continued:
9137, 2004-34 I.R.B.308
9138, 2004-32 I.R.B.160
9140, 2004-32 I.R.B.159
9141, 2004-35 I.R.B.359
9142, 2004-34 I.R.B.302
9143, 2004-36 I.R.B.442
9144, 2004-36 I.R.B.413
9146, 2004-36 I.R.B.408
1
A cumulative list of all revenue rulings, revenueprocedures, Treasury decisions, etc., publishedin Internal Revenue Bulletins 2004–1 through 2004–26 is in Internal Revenue Bulletin
2004–26, dated June 28, 2004.
September 7, 2004ii2004–36 I.R.B.

Findings List of Current Actions on
Previously Published Items
1
Bulletins 2004–27 through 2004–36
Notices:
98-65
Superseded by
Rev. Proc. 2004-40, 2004-29 I.R.B.50
2001-50
Modified by
Rev. Proc. 2004-46, 2004-31 I.R.B.142
2004-2
Modified by
Notice 2004-50, 2004-33 I.R.B.196
Corrected by
Ann. 2004-67, 2004-36 I.R.B.459
Proposed Regulations:
INTL-116-90
Withdrawn by
REG-208246-90, 2004-36 I.R.B.450
REG-104683-00
Partially withdrawn by
Ann. 2004-64, 2004-35 I.R.B.402
Revenue Procedures:
79-61
Superseded by
Rev. Proc. 2004-44, 2004-31 I.R.B.134
89-37
Obsoleted by
Rev. Rul. 2004-90, 2004-34 I.R.B.317
94-64
Superseded by
Rev. Proc. 2004-38, 2004-27 I.R.B.10
96-18
Obsoleted by
Rev. Rul. 2004-90, 2004-34 I.R.B.317
96-53
Superseded by
Rev. Proc. 2004-40, 2004-29 I.R.B.50
96-60
Superseded by
Rev. Proc. 2004-53, 2004-34 I.R.B.320
98-41
Superseded by
Rev. Proc. 2004-56, 2004-35 I.R.B.376
2000-37
Modified by
Rev. Proc. 2004-51, 2004-33 I.R.B.294
Revenue Procedures— Continued:
2002-9
Modified and amplified by
Rev. Proc. 2004-41, 2004-30 I.R.B.90
2003-30
Superseded by
Rev. Proc. 2004-54, 2004-34 I.R.B.325
2003-52
Superseded by
Rev. Proc. 2004-50, 2004-33 I.R.B.211
2004-4
Modified by
Rev. Proc. 2004-44, 2004-31 I.R.B.134
Revenue Rulings:
54-379
Superseded by
Rev. Rul. 2004-68, 2004-31 I.R.B.118
58-120
Obsoleted by
Rev. Rul. 2004-90, 2004-34 I.R.B.317
62-60
Amplified by
Rev. Proc. 2004-53, 2004-34 I.R.B.320
70-58
Obsoleted by
Rev. Rul. 2004-90, 2004-34 I.R.B.317
73-354
Obsoleted by
Rev. Rul. 2004-76, 2004-31 I.R.B.111
78-371
Distinguished by
Rev. Rul. 2004-86, 2004-33 I.R.B.191
79-64
Obsoleted by
Rev. Rul. 2004-90, 2004-34 I.R.B.317
80-7
Amplified and clarified by
Rev. Rul. 2004-71, 2004-30 I.R.B.74
Rev. Rul. 2004-72, 2004-30 I.R.B.77
Rev. Rul. 2004-73, 2004-30 I.R.B.80
Rev. Rul. 2004-74, 2004-30 I.R.B.84
80-366
Obsoleted by
Rev. Rul. 2004-90, 2004-34 I.R.B.317
81-100
Clarified and modified by
Rev. Rul. 2004-67, 2004-28 I.R.B.28
Revenue Rulings— Continued:
85-70
Amplified and clarified by
Rev. Rul. 2004-71, 2004-30 I.R.B.74
Rev. Rul. 2004-72, 2004-30 I.R.B.77
Rev. Rul. 2004-73, 2004-30 I.R.B.80
Rev. Rul. 2004-74, 2004-30 I.R.B.84
92-105
Distinguished by
Rev. Rul. 2004-86, 2004-33 I.R.B.191
1
A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2004–1 through 2004–26 is in Internal Revenue Bulletin 2004–26, dated June 28, 2004.
2004–36 I.R.B.iiiSeptember 7, 2004
*U.S. G.P.O.: 2004—304–778/60151