Bulletin No. 2008-18 HIGHLIGHTS OF THIS ISSUEthe Code. Notice 2008–13 supplemented. Notice...

Bulletin No. 2008-18May 5, 2008

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 2008–23, page 852.Employee leasing arrangements. This ruling addresseswhich party is subject to the Code section 274(n) limitationwhen a trucking company leases truck drivers from a leasingcompany and the leasing company reimburses the drivers formeal and incidental expenses they incur in the course of per-forming services.

Rev. Rul. 2008–24, page 861.Federal rates; adjusted federal rates; adjusted federallong-term rate and the long-term exempt rate. For pur-poses of sections 382, 642, 1274, 1288, and other sectionsof the Code, tables set forth the rates for May 2008.

REG–168745–03, page 871.Proposed regulations explain how section 263(a) of the Codeapplies to amounts paid to acquire, produce, or improve tan-gible property. The regulations clarify what amounts must becapitalized, rather than deducted currently, and how those cap-italized amounts should be treated. The regulations withdrawand replace the proposed regulations issued in August 2006under section 263(a). A public hearing is scheduled for June24, 2008.

Notice 2008–46, page 868.This notice provides guidance regarding implementation of thetax return preparer penalty provisions under section 6694 ofthe Code. Notice 2008–13 supplemented.

Notice 2008–47, page 869.The Department of Treasury and the Service invite public com-ments on recommendations for items that should be includedon the 2008–2009 Guidance Priority List. Taxpayers may sub-

mit recommendations for guidance at any time during the year.Recommendations submitted by May 31, 2008, will be re-viewed for possible inclusion on the original 2008–2009 Guid-ance Priority List. Recommendations received after May 31,2008, will be reviewed for inclusion in the next periodic up-date.

EMPLOYEE PLANS


Notice 2008–47, page 869.The Department of Treasury and the Service invite public com-ments on recommendations for items that should be includedon the 2008–2009 Guidance Priority List. Taxpayers may sub-mit recommendations for guidance at any time during the year.Recommendations submitted by May 31, 2008, will be re-viewed for possible inclusion on the original 2008–2009 Guid-ance Priority List. Recommendations received after May 31,2008, will be reviewed for inclusion in the next periodic up-date.

(Continued on the next page)

Finding Lists begin on page ii.

EXEMPT ORGANIZATIONS

T.D. 9390, page 855.Final regulations amend the existing regulations under sections501(c)(3) and 4958 of the Code and clarify the relationship be-tween the substantive requirements for tax exemption for pub-lic charities described in section 501(c)(3) and the impositionof section 4958 excise taxes on excess benefit transactionsbetween public charities and their insiders. Specifically, theregulations set forth a non-exhaustive list of factors the IRS willconsider in deciding whether to revoke the tax-exempt statusof organizations that have engaged in excess benefit transac-tion(s). The regulations also add several examples to illustratethe requirement that an organization serve a public rather thana private interest. Furthermore, the regulations clarify that sec-tion 4958 does not apply at the time of the initial determinationof exempt status.



ESTATE TAX



GIFT TAX



EMPLOYMENT TAX



SELF-EMPLOYMENT TAX


(Continued on the next page)

May 5, 2008 2008–18 I.R.B.

EXCISE TAX

T.D. 9390, page 855.Final regulations amend the existing regulations under sections501(c)(3) and 4958 of the Code and clarify the relationship be-tween the substantive requirements for tax exemption for pub-lic charities described in section 501(c)(3) and the impositionof section 4958 excise taxes on excess benefit transactionsbetween public charities and their insiders. Specifically, theregulations set forth a non-exhaustive list of factors the IRS willconsider in deciding whether to revoke the tax-exempt statusof organizations that have engaged in excess benefit transac-tion(s). The regulations also add several examples to illustratethe requirement that an organization serve a public rather thana private interest. Furthermore, the regulations clarify that sec-tion 4958 does not apply at the time of the initial determinationof exempt status.



TAX CONVENTIONS

Announcement 2008–39, page 867.This announcement provides interim guidance concerning the“commencement date” for Mutual Agreement Procedure (MAP)cases eligible for arbitration under the December 28, 2007,Protocol to the U.S.-Germany Tax Treaty.

ADMINISTRATIVE

T.D. 9389, page 863.REG–114942–07, page 901.Temporary and proposed regulations under section 6103 ofthe Code describe the circumstances by which officers andemployees of the Treasury Department may disclose return in-formation to whistleblowers and, if applicable, their legal rep-resentatives in connection with written contracts for servicesrelating to the detection of violations of the internal revenuelaws or related statutes.


2008–18 I.R.B. May 5, 2008

The IRS MissionProvide America’s taxpayers top quality service by helping themunderstand and meet their tax responsibilities and by applying

the tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly and may be obtained from theSuperintendent of Documents on a subscription basis. Bulletincontents 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 ofthe 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 internalpractices and procedures that affect the rights and duties oftaxpayers are published.

Revenue rulings represent the conclusions of the Service on theapplication of the law to the pivotal facts stated in the revenueruling. In those based on positions taken in rulings to taxpayersor technical advice to Service field offices, identifying detailsand information of a confidential nature are deleted to preventunwarranted invasions of privacy and to comply with statutoryrequirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered,and Service personnel and others concerned are cautionedagainst reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A,Tax Conventions and Other Related Items, and Subpart B, Leg-islation and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the Treasury’s Office of the Assistant Secre-tary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative indexfor the matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the last Bulletin of each semiannual period.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

May 5, 2008 2008–18 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986Section 42.—Low-IncomeHousing Credit

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof May 2008. See Rev. Rul. 2008-24, page 861.

Section 62.—AdjustedGross Income Defined26 CFR 1.62–2: Reimbursements and other expenseallowance arrangements.

A revenue ruling addresses which party is subjectto the section 274(n) limitation when a trucking com-pany leases truck drivers from a leasing company andthe leasing company reimburses the drivers for mealand incidental expenses they incur in the course ofperforming services. See Rev. Rul. 2008-23, page852.

Section 274.—Disallowanceof Certain Entertainment,etc., Expenses26 CFR 1.274–2: Disallowance of deductions forcertain expenses for entertainment, amusement,recreation, or travel.(Also §§ 62, 1.62–2.)

Employee leasing arrangements.This ruling addresses which party is sub-ject to the Code section 274(n) limitationwhen a trucking company leases truckdrivers from a leasing company and theleasing company reimburses the driversfor meal and incidental expenses they in-cur in the course of performing services.

Rev. Rul. 2008–23

ISSUE

If a Client leases employees froma Leasing Company, and the LeasingCompany reimburses the employees formeal and incidental expenses (M&IE)they incur in the course of performingservices, which party’s deduction for re-imbursement of the M&IE is subject to thelimitation under § 274(n) of the InternalRevenue Code?

FACTS

Leasing Company and Client, who areunrelated parties, enter into a written em-

ployee leasing contract under which Leas-ing Company leases drivers to Client tohaul products in exchange for Client’s pe-riodic payments to Leasing Company. Theemployee leasing contract provides thatLeasing Company will calculate Client’speriodic payments to cover Leasing Com-pany’s expenditures (wages due to drivers,payments of the M&IE to drivers undera reimbursement arrangement betweenLeasing Company and the drivers, andother expenses) plus a profit.

Each driver (Driver) performs servicesas an employee in the trucking indus-try. Driver incurs M&IE while travelingovernight away from home in connectionwith Driver’s employment. In additionto receiving wages, Driver receives aseparately stated reimbursement at theM&IE rate from Leasing Company. Allthe reimbursements paid to Driver arepaid under a “reimbursement or other ex-pense allowance arrangement,” within themeaning of § 274(e)(3), between LeasingCompany and Driver.

Neither Leasing Company nor Clientdeducts the M&IE amounts as compen-sation on its originally filed income taxreturn, nor does either treat the M&IEamounts as wages for purposes of with-holding under Chapter 24. The employeeleasing contract does not address whichparty reimburses the drivers’ M&IE forpurposes of applying the § 274(n) limita-tion. In each situation described below,either Leasing Company or Client maybe the Driver’s employer under the usualcommon law rules applicable to determin-ing the employer-employee relationship.See § 31.3121(d)–1 of the EmploymentTax Regulations.

Situation 1. Driver adequately accountsto Leasing Company for the M&IE tosatisfy the substantiation requirements of§ 274(d) pursuant to an annually updatedrevenue procedure, Rev. Proc. 2007–63,2007–42 I.R.B. 809 (or any successor).After calculating Driver’s wages and anyM&IE payments that may be due, LeasingCompany sends Client a billing invoicefor a periodic payment due. The invoiceis for a lump-sum and does not itemizefor the amount of any M&IE reimburse-ment. Client pays Leasing Company the

lump-sum periodic payment. Upon receiv-ing Client’s periodic payment, LeasingCompany pays both Driver’s wages andM&IE reimbursement.

Situation 2. Driver adequately accountsto Leasing Company for the M&IE tosatisfy the substantiation requirements of§ 274(d) pursuant to Rev. Proc. 2007–63(or any successor). After Driver accountsto Leasing Company for M&IE, LeasingCompany calculates Driver’s wages andany M&IE payments that may be due.Leasing Company sends Client a billinginvoice for a periodic payment due. Theinvoice is for a lump-sum and does notitemize for the amount of any M&IE reim-bursement. Client pays Leasing Companythe lump-sum periodic payment. Uponreceiving Client’s periodic payment, Leas-ing Company pays both Driver’s wagesand M&IE reimbursement. Immediatelyafter Leasing Company pays Driver, Leas-ing Company sends Client a statementindicating the amount paid to Driver as areimbursement of Driver’s M&IE. LeasingCompany also accounts for that amountby delivering to Client a copy of all of thesubstantiation that Driver had originallysubmitted to Leasing Company. Clientaccepts the substantiation submitted byLeasing Company and acknowledges thatthe portion of its periodic payment equal tothe amount that Leasing Company paid toreimburse Driver’s M&IE is paid under areimbursement arrangement with LeasingCompany and is subject to the § 274(n)limitation.

Situation 3. Driver is paid an allowanceat the applicable M&IE rate by LeasingCompany, but substantiates the expensesto Client. Client then immediately deliv-ers to Leasing Company a copy of all ofthe information that Driver had originallysubmitted to Client to substantiate Driver’sexpenses, and Client informs Driver thatit has done so. Leasing Company acceptsthe substantiation. Driver adequately ac-counts for the M&IE to satisfy the substan-tiation requirements of § 274(d) pursuantto Rev. Proc. 2007–63 (or any successor).

After receiving Driver’s substantiation,Leasing Company calculates Driver’swages and any M&IE reimbursementsthat may be due. Leasing Company sends

2008–18 I.R.B. 852 May 5, 2008

Client a billing invoice for a periodic pay-ment due. The invoice is for a lump-sumand does not itemize for the amount ofany M&IE reimbursement. Client paysLeasing Company the lump-sum periodicpayment. Upon receiving Client’s periodicpayment, Leasing Company pays bothDriver’s wages and M&IE reimbursement.Immediately after Leasing Company paysDriver, Leasing Company sends Clienta statement indicating the amount paidto Driver as a reimbursement of Driver’sM&IE. Leasing Company also accountsto Client by referring to the substantiationClient had received from Driver and hadsubmitted (via a copy) to Leasing Com-pany. Client accepts the substantiationsubmitted by Leasing Company and ac-knowledges that the portion of its periodicpayment equal to the amount that Leas-ing Company paid to reimburse Driver’sM&IE is paid under a reimbursement ar-rangement with Leasing Company and issubject to the § 274(n) limitation.

LAW

Section 162(a)(2) allows a deductionfor all the ordinary and necessary expensespaid or incurred during the taxable year incarrying on any trade or business, includ-ing traveling expenses (such as M&IE)while away from home in the pursuit of atrade or business.

In general, § 274(d)(1) provides thatno deduction is allowed under § 162 to ataxpayer for traveling expenses (includingM&IE) unless the taxpayer substanti-ates the expenses. If the taxpayer is anemployee and is reimbursed for M&IEby a payor (whether the employer, theemployer’s agent, or a third party), theemployee satisfies § 274(d) by account-ing to the payor with adequate recordssubstantiating the amount of the expense,the time and place of the expense, andthe business purpose of the expense. Sec-tion 1.274–5(f)(4)(i) (last sentence) and(f)(4)(iii) of the Income Tax Regulations.With some exceptions, an employee whoadequately accounts for the M&IE isnot again required to substantiate the ex-penses. Section 1.274–5T(f)(5) of thetemporary Income Tax Regulations. Ifthe payor and employee use the annuallyupdated revenue procedure to substantiatethe expenses, the M&IE amount (to theextent reimbursed and substantiated) is

treated as an expense for food or beveragesand is subject to § 274(n). See section 6.05of Rev. Proc. 2007–63. If the taxpayer isan independent contractor and receives apayment for M&IE under a reimbursementor other expense allowance arrangementfrom a client, § 274(d) requires that the in-dependent contractor account to the clientwith adequate records, or other sufficientevidence corroborating the independentcontractor’s own statement, substantiat-ing the amount of the expense, the timeand place of the expense, and the busi-ness purpose of the expense. Section1.274–5T(h)(3). Unlike an employee,however, an independent contractor mustmaintain a copy of the records, or othersufficient evidence, to substantiate the ex-penses. Section 274(d); § 1.274–5T(h)(2).

Section 274(n)(1) generally limits theamount allowed as a deduction for anyexpense for food or beverages to 50 per-cent of the expense, although § 274(n)(3)generally imposes a lesser limitation ondeductions for truck drivers’ expenses.However, § 274(n)(2) excepts expensesdescribed in § 274(e)(3) from the limita-tion imposed by § 274(n)(1).

Section 274(e)(3) expenses are thosepaid or incurred by a taxpayer in con-nection with the performance of servicesfor another person (whether or not thatother person is the taxpayer’s employer)under a reimbursement or other expenseallowance arrangement with that other per-son. If the payment is made to an em-ployee, the § 274(e)(3)(A) exception ap-plies to the employee only to the extent theemployer does not report the payment ascompensation to the employee on the em-ployer’s originally filed income tax returnand as wages to the employee for purposesof withholding under Chapter 24. Sec-tion 1.274–2(f)(2)(iv)(b). If the paymentis made to an independent contractor, the§ 274(e)(3)(B) exception applies to the in-dependent contractor to the extent the in-dependent contractor accounts for the ex-penses to the payor in a manner satisfying§ 274(d). Section 1.274–2(f)(2)(iv)(c).

For purposes of § 274(e)(3), a“reimbursement or other expense al-lowance arrangement” includes, but isnot limited to, an “accountable plan”as that term is defined for purposes of§ 62(c). See § 1.62–2(c)(1). Since 1963,§ 1.274–2(f)(2)(iv)(a) has provided thatthe term “reimbursement or other expense

allowance arrangement” in § 274(e)(3)has the same meaning it has “in section62(2)(A), but without regard to whetherthe taxpayer is the employee of a personfor whom services are performed.” T.D.6659, 1963–2 C.B. 113. The subsequentaddition of § 62(c) in 1988 and its ac-companying regulations did not changethe meaning of “reimbursement or otherexpense allowance arrangement” for pur-poses of § 274(e)(3). Thus, the applicationof § 274(e)(3) does not require the exis-tence of an accountable plan within themeaning of § 62(c) and the regulationsunder that section.

Section 274(n)(1) limits certain de-ductions allowable under § 162. If anemployee or independent contractor incursM&IE in connection with the performanceof services for another person and is not re-imbursed, § 274(n) limits any § 162(a)(2)deduction claimed by the employee orindependent contractor. If an employeeaccounts for the expenses under § 274(d)to the payor, is reimbursed under a re-imbursement or other expense allowancearrangement, and the payment is nottreated both as additional compensationand as wages for income tax withholdingpurposes, then under § 274(e)(3)(A), theemployee is not subject to § 274(n). See§ 274(n)(2)(A) and § 1.274–2(f)(2)(iv)(a).The party initially making the reim-bursement (“initial payor”) bears theexpenses, and § 274(n) limits thatparty’s § 162(a)(2) deduction, unlessthat party also satisfies § 274(e)(3)(B).Sections 1.274–2(f)(2)(iv)(b) and1.274–5(f)(4)(iii). If the initial payor,in connection with its performance ofservices for a third party, is reimbursedunder a reimbursement or other expenseallowance arrangement with the thirdparty, and the initial payor accountsto the third party in the same mannerthat the employee accounted for the ex-penses to the initial payor, then the initialpayor satisfies § 274(e)(3)(B). Section1.274–2(f)(2)(iv)(c)(1). In that case,the third party bears the expenses, and§ 274(n) limits the § 162(a)(2) deductionthat the third party claims for those ex-penses.

In Transport Labor Contract/Leasing,Inc. v. Commissioner, 461 F.3d 1030 (8th

Cir. 2006), rev’g 123 T.C. 154 (2004)(TLC), the question was the applicationof § 274(n) for taxable years ending in

May 5, 2008 853 2008–18 I.R.B.

1993 through 1996 to an employee leasingarrangement that provided for the pay-ment to employees of per diem allowancesfor M&IE. The Court of Appeals for theEighth Circuit found that the truckingcompany clients, not the leasing company(TLC), actually bore the per diem expensesunder the reimbursement arrangement be-tween the parties. The appellate court heldthat TLC qualified for the exception in§ 274(e)(3)(B) and, therefore, that TLC’s§ 162(a)(2) deduction for the per diemexpenses was not limited by § 274(n).

The appellate court reversed the TaxCourt, which had held that § 274(n) lim-ited TLC’s § 162(a)(2) deduction becauseTLC was the drivers’ common law em-ployer. Under the Tax Court’s analysis,the § 274(n) limitation necessarily appliesto the employees’ common law employer.Compare Beech Trucking Co. v. Commis-sioner, 118 T.C. 428, 443 (2002) (relyingon common law employer factor and iden-tity of party ultimately bearing the expenseto determine incidence of § 274(n) limita-tion). The appellate court opined that theTax Court had erroneously failed to exam-ine whether TLC qualified for the excep-tion in § 274(e)(3)(B).

In TLC, the Court of Appeals for theEighth Circuit determined that TLC’s§ 162 deduction ultimately was not lim-ited by § 274(n) because TLC was notthe party that ultimately bore the per diemexpenses. The appellate court concludedthat status as a common law employer isnot dispositive in the § 274(n) analysis,but did not explicitly reject that status asa relevant factor. The Internal RevenueService acquiesces in the result in TLC andagrees with the appellate court’s opinionthat the § 274(n) limitation should apply tothe party that ultimately bears the per diemexpenses. However, the Internal RevenueService does not agree with the opinion tothe extent that it could be read to implythat status as a common law employer isrelevant to the § 274(n) analysis.

ANALYSIS

In each situation below, Driver is anemployee who incurs M&IE in connec-tion with the performance of services foranother person, receives a reimbursementat the M&IE rate, and accounts for thereimbursement under a “reimbursementor other expense allowance arrangement”

within the meaning of § 274(e)(3). Nei-ther Leasing Company nor Client deductsthe M&IE amounts as compensation paidto Driver on its originally filed incometax return, nor treats the M&IE amountsas wages paid to Driver for purposes ofwithholding under Chapter 24. Therefore,under § 274(e)(3)(A), Driver is not subjectto § 274(n).

Situation 1. Leasing Company, aspayor of the substantiated M&IE reim-bursement to Driver, must determine if itsdeduction of the expenses under § 162(a)is subject to the § 274(n) limitation. Al-though Leasing Company pays the M&IEof each driver in connection with its per-formance of services for Client, LeasingCompany has provided Client only aninvoice for a lump-sum periodic pay-ment due. Therefore, Leasing Companydoes not satisfy § 274(e)(3)(B) because ithas not accounted to Client in a mannersatisfying § 274(d) and does not have a re-imbursement or other expense allowancearrangement with Client. Under thesecircumstances, Leasing Company bearsthe expense of the M&IE, and § 274(n)limits Leasing Company’s § 162(a)(2)deduction for the M&IE, regardless ofwhether Leasing Company or Client isDriver’s employer under the usual com-mon law rules. Even if Leasing Com-pany had provided an itemized invoiceto Client designating a portion of the pe-riodic payment as a reimbursement ofDriver’s M&IE, Leasing Company stilldoes not satisfy § 274(e)(3)(B) because ithas not accounted to Client in a mannersatisfying § 274(d) and does not have a re-imbursement or other expense allowancearrangement with Client.

Situation 2. Leasing Company, aspayor of the substantiated M&IE reim-bursement to Driver, must determine if itsdeduction of the expenses under § 162(a) issubject to the § 274(n) limitation. LeasingCompany has the information Driver orig-inally submitted to account for Driver’sM&IE. Immediately after Leasing Com-pany pays Driver, Leasing Company sendsClient a statement indicating the amountpaid to Driver that was a reimbursementof Driver’s M&IE. Leasing Company alsoaccounts to Client by delivering to Clienta copy of the substantiation that Driverhad originally provided to Leasing Com-pany. Client accepts the substantiationsubmitted by Leasing Company and ac-

knowledges that the portion of its periodicpayment equal to the amount that Leas-ing Company paid to reimburse Driver’sM&IE is paid under a reimbursement ar-rangement and is subject to the § 274(n)limitation. Leasing Company meets therequirements of § 274(e)(3)(B) because(1) under the employee leasing contractand as indicated by their course of dealing,Leasing Company can prove that it hasestablished a reimbursement or other ex-pense allowance arrangement with Clientwithin the meaning of § 274(e)(3), and (2)Leasing Company accounts to Client bydelivering a copy of the substantiation thatDriver had provided to Leasing Company(i.e., in a manner satisfying § 274(d)).Therefore, Leasing Company is not sub-ject to § 274(n), Client bears the expenseof the M&IE, and § 274(n) limits Client’s§ 162(a)(2) deduction for the M&IE, re-gardless of whether Leasing Companyor Client is Driver’s employer under theusual common law rules.

Situation 3. Leasing Company has acopy of the information Driver originallysubmitted to Client to account for Driver’sM&IE. Leasing Company, as payor ofthe substantiated M&IE reimbursement toDriver, must determine if its deduction ofthe expenses under § 162(a) is subject tothe § 274(n) limitation. Immediately afterLeasing Company pays Driver, LeasingCompany sends Client a statement indi-cating the amount paid to Driver that wasa reimbursement of Driver’s M&IE. Leas-ing Company also accounts to Client byreferring to the substantiation Client hadreceived from Driver and had submitted(via a copy) to Leasing Company. Clientaccepts the substantiation submitted byLeasing Company, and acknowledges thatthe portion of its periodic payment equalto the amount that Leasing Company paidto reimburse Driver’s M&IE is paid un-der a reimbursement arrangement and issubject to the § 274(n) limitation. Leas-ing Company meets the requirements of§ 274(e)(3)(B) because (1) under the em-ployee leasing contract and as indicated bytheir course of dealing, Leasing Companycan prove that it has established a reim-bursement or other expense allowance ar-rangement with Client within the meaningof § 274(e)(3), and (2) Leasing Companyaccounts to Client by referring to the sub-stantiation that Driver originally submittedto Client (i.e., in a manner satisfying

2008–18 I.R.B. 854 May 5, 2008

§ 274(d)). Therefore, Leasing Companyis not subject to § 274(n), Client bearsthe expense of the M&IE, and § 274(n)limits Client’s § 162(a)(2) deduction forthe M&IE, regardless of whether LeasingCompany or Client is Driver’s employerunder the usual common law rules.

HOLDINGS

(1) In Situation 1, Leasing Company’sdeduction for reimbursement of the M&IEto Driver is subject to the § 274(n) limita-tion.

(2) In Situation 2, Client’s deductionfor reimbursement of the M&IE to LeasingCompany is subject to the § 274(n) limita-tion.

(3) In Situation 3, Client’s deductionfor reimbursement of the M&IE to LeasingCompany is subject to the § 274(n) limita-tion.

DRAFTING INFORMATION

The principal author of this revenueruling is Jeffrey T. Rodrick of the Officeof Associate Chief Counsel (Income Tax& Accounting). For further informationregarding this revenue ruling, contactMr. Rodrick at (202) 622–4930 (not atoll-free call).

Section 280G.—GoldenParachute Payments

Federal short-term, mid-term, and long-term ratesare set forth for the month of May 2008. See Rev.Rul. 2008-24, page 861.

Section 382.—Limitationon Net Operating LossCarryforwards and CertainBuilt-In Losses FollowingOwnership Change

The adjusted applicable federal long-term rate isset forth for the month of May 2008. See Rev. Rul.2008-24, page 861.

Section 412.—MinimumFunding Standards


Section 467.—CertainPayments for the Use ofProperty or Services


Section 468.—SpecialRules for Mining and SolidWaste Reclamation andClosing Costs


Section 482.—Allocationof Income and DeductionsAmong Taxpayers


Section 483.—Interest onCertain Deferred Payments


Section 501.—ExemptionFrom Tax on Corporations,Certain Trusts, etc.26 CFR 1.501(c)(3)–1: Organizations organized andoperated for religious, charitable, scientific, testingfor public safety, literary, or educational purposes, orfor the prevention of cruelty to children or animals.

T.D. 9390

DEPARTMENT OF THETREASURYInternal Revenue Service26 CFR Parts 1 and 53

Standards for Recognitionof Tax-Exempt Status ifPrivate Benefit Exists or ifan Applicable Tax-ExemptOrganization Has Engaged inExcess Benefit Transaction(s)

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains fi-nal regulations that clarify the substan-tive requirements for tax exemption undersection 501(c)(3) of the Internal RevenueCode (Code). This document also containsprovisions that clarify the relationship be-tween the substantive requirements for taxexemption under section 501(c)(3) and theimposition of section 4958 excise taxes onexcess benefit transactions. These regula-tions affect organizations described in sec-tion 501(c)(3) of the Code and organiza-tions applying for exemption as organiza-tions described in section 501(c)(3) of theCode.

DATES: Effective Date: These regulationsare effective March 28, 2008.

FOR FURTHER INFORMATIONCONTACT: Galina Kolomietz, (202)622–7971 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On September 9, 2005, a notice ofproposed rulemaking (REG–111257–05,2005–2 C.B. 759) clarifying the sub-stantive requirements for tax exemptionunder section 501(c)(3) of the Code, andthe relationship between the substantiverequirements for tax exemption undersection 501(c)(3) and the imposition ofsection 4958 excise taxes was published inthe Federal Register (70 FR 53599). TheIRS received several written commentsresponding to this notice. After consider-ation of all comments received, the pro-posed regulations under sections 501(c)(3)and 4958 are revised and published in finalform. The major areas of comments andrevisions are discussed in the followingpreamble. See §601.601(d)(2)(ii)(b)).

Explanation and Summary ofComments

Private Benefit

The proposed regulations added severalexamples to illustrate the requirement in§1.501(c)(3)–1(d)(1)(ii) that an organiza-tion serve a public rather than a privateinterest. The purpose of the examples is

May 5, 2008 855 2008–18 I.R.B.

to illustrate that prohibited private bene-fit may involve non-economic benefits aswell as economic benefits and that prohib-ited private benefit may arise regardless ofwhether payments made to private inter-ests are reasonable or excessive.

One comment suggested that, ratherthan add three isolated examples on pri-vate benefit to the regulations, the IRSconsider a broader revision of the regula-tions under section 501(c)(3) to provide amore detailed discussion of the underlyingprinciples of the private benefit doctrine.In particular, this comment suggested thatthe regulations address the relative quan-tity of private benefit that could precludeexemption. The IRS and the TreasuryDepartment are not revising the existingregulations under section 501(c)(3) at thistime. The new examples in the proposedregulations clarify the principles of theprivate benefit doctrine under current law.In §1.501(c)(3)–1(d)(1)(iii), Example 1illustrates that private benefit may in-volve non-economic benefits. Example 2illustrates that private benefit is inconsis-tent with tax-exempt status under section501(c)(3) if it is substantial and not merelyincidental to the accomplishment of theorganization’s exempt purposes. Example3 illustrates that private benefit may existeven though the transaction is at fair mar-ket value. Moreover, these examples areintended to illustrate the principle that pri-vate benefit remains an independent basisfor revocation even if it does not involveeconomic benefit or raise fair market valueissues. Accordingly, these examples areadopted in final form without revision.

Revocation Standards

The proposed regulations providedguidance on certain factors that the IRSwill consider in determining whether anapplicable tax-exempt organization de-scribed in section 501(c)(3) that engagesin one or more excess benefit transac-tions continues to be described in section501(c)(3). The comments received inresponse to the proposed regulations arediscussed below. Overall, the commen-tators reacted favorably to the factors setforth in the proposed regulations. The fac-tors described in the proposed regulationsare finalized without major revisions. Theapplication of the factors is refined by the

addition of a new example to the finalregulations.

a. Interaction with determination ofexistence of excess benefit transaction

Two comments suggested that the finalregulations clarify the interaction betweenthe determination of the organization’s tax-exempt status and the determination of theexistence of an excess benefit transaction.One of these comments specifically re-quested that the final regulations state thatthe IRS will not take any action to re-move an organization’s tax exemption onexcess benefit transaction grounds whilethe IRS’s determination of the existence ofan excess benefit transaction is itself beingcontested in court. The final regulations donot adopt this comment. The determina-tion of an organization’s tax-exempt statusand the determination of the existence ofan excess benefit transaction are separatedeterminations, involving distinct parties,different legal elements, and separate pro-cesses, even though they may relate to thesame facts.

b. Clarification of terms

Two comments voiced the need to clar-ify the terms “significant” and “de min-imis” as they are used in the proposedregulations. One of these comments sug-gested adding an example of a safe harborbased on specific amounts the IRS wouldconsider clearly insignificant, perhaps asa percentage of overall expenditures. Be-cause the determination of whether an ac-tivity or an amount is “significant” or “deminimis” depends on the facts and circum-stances, the final regulations do not adoptthis comment.

One comment suggested adding exam-ples combining potential de minimis val-ues with other abating or negative factorsand/or examples containing values that arenot de miminis. The final regulations con-tain a new example that illustrates the ap-plication of the revocation factors to anexcess benefit transaction that is neithersignificant in comparison to the size andscope of the organization’s exempt activi-ties nor de minimis.

One comment requested clarification ofthe term “repeated” as used in Example 3of §1.501(c)(3)–1(g) of the proposed reg-ulations. The term was used in that ex-ample to correspond to the third factor

in the proposed regulations, which lookedto “whether the organization has been in-volved in repeated excess benefit transac-tions.” In response to this comment, thethird factor of the proposed regulations isrevised to substitute the term “multiple”for the word “repeated.” The term “multi-ple” refers to both (1) repeated instances ofthe same (or substantially similar) excessbenefit transaction, regardless of whetherthe transaction involves the same or dif-ferent persons; and (2) the presence ofmore than one excess benefit transaction,regardless of whether the transactions arethe same or substantially similar and re-gardless of whether they involve the sameor different persons.

Another comment requested guidanceregarding when the IRS would considerthe presence of a single excess benefittransaction to jeopardize an organization’stax-exempt status. Because such a deter-mination would depend on the facts andcircumstances, the final regulations do notadopt the comment.

c. Due diligence and safeguards

One comment requested that evidencethat an organization’s board of directorsconducted appropriate due diligence orfollowed certain safeguards in connec-tion with the excess benefit transactionbe treated as a factor weighing in favorof continuing to recognize exemption.The IRS and the Treasury Departmentagree that the organization’s reliance onobjectively reasonable internal controlsand procedures, such as the procedures forestablishing a rebuttable presumption ofreasonableness, in approving a transactionthat is later determined to be an excessbenefit transaction, should be treated asa factor weighing in favor of continuingto recognize exemption. Accordingly, thefourth factor under the proposed regula-tions is revised to make clear that imple-mentation by an organization of safeguardsthat are reasonably calculated to preventexcess benefit transactions will be treatedas a factor weighing in favor of continu-ing to recognize exemption regardless ofwhether such safeguards are implementedin direct response to the excess bene-fit transaction(s) at issue or as a generalmatter of corporate governance or fiscalmanagement. Thus, an organization maybe treated as having implemented safe-

2008–18 I.R.B. 856 May 5, 2008

guards reasonably calculated to preventexcess benefit transactions even thoughthe organization is contesting the exis-tence of the excess benefit transaction(s)at issue. An example is added to illus-trate how implementation of safeguards,including preexisting safeguards, will betaken into account in determining whetherto continue to recognize an organization’stax-exempt status.

One comment suggested that an organ-ization’s good faith attempt to establisha rebuttable presumption of reasonable-ness within the meaning of §53.4958–6be treated as a factor weighing in favorof continuing to recognize exemption.Another comment suggested that a goodfaith attempt by an organization’s boardof directors to determine fair market valuebe treated as a factor precluding revoca-tion even if the IRS disagrees with theboard’s fair market value analysis. Thefourth factor, as revised in these final reg-ulations, takes into account whether theorganization has implemented safeguardsthat are reasonably calculated to preventexcess benefit transactions. This factortakes safeguards into account, regardlessof whether they were implemented beforeor after an excess benefit transaction oc-curred. The comments raise the questionof how this factor will apply where stepshave been taken to avoid an excess benefittransaction, but nonetheless have failedto prevent the excess benefit transaction.The weight afforded to this particular cir-cumstance will depend upon the specificfacts and circumstances.

d. Requests for additional examples

Two comments suggested adding to theproposed regulations an example specifi-cally addressing reasonable compensation.In response to these comments, the new ex-ample added by these final regulations ad-dresses reasonable compensation.

One comment suggested that the regu-lations include examples involving healthcare organizations. The IRS and the Trea-sury Department note that the applicationof sections 501(c)(3) and 4958 to healthcare organizations is not unique. Theexamples in these regulations, althoughnot specifically involving health careorganizations, apply to health care organi-zations in the same manner as they apply

to other organizations described in section501(c)(3).

One comment criticized the examplesin the proposed regulations as too “black-and-white” and suggested that the regula-tions be supplemented with examples thatdiscuss less clear facts. Specifically, thiscomment requested guidance on situationsinvolving more than de minimis amountsin which an applicable tax-exempt organ-ization does not seek correction from thedisqualified person involved. The new ex-ample added by these final regulations il-lustrates that, in some situations, even inthe absence of correction of non-de min-imis excess benefit transactions, an organ-ization may retain its tax-exempt status ifthe other factors, in combination, warrantcontinued exemption. Under the fifth fac-tor, the IRS will take into account the or-ganization’s good faith with respect to cor-rection. Accordingly, the reasons behindthe organization’s failure to seek correc-tion will be examined.

One comment suggested adding an ex-ample that would illustrate what factors, inaddition to post-audit correction, would besufficient to avoid revocation. The exam-ple that has been added illustrates a casewhere factors other than correction supportcontinued exemption. The IRS and theTreasury Department may consider publi-cation of future guidance on the applica-tion of the factors based on other specificfact patterns that the IRS encounters in thecourse of tax administration.

One comment requested adding an ex-ample discussing the effect of “automaticexcess benefit transactions” that are notde minimis on the organization’s tax-ex-empt status. The term “automatic excessbenefit transaction” refers to a transactionin which a disqualified person providesservices to an organization and receiveseconomic benefits from the organizationthat are not substantiated, contempora-neously and in writing, as compensationwithin the meaning of §53.4958–4(c). Af-ter the enactment of the Pension ProtectionAct of 2006, Public Law 109–280 (120Stat. 780 (2006)), the term “automatic ex-cess benefit transaction” also refers to anygrant, loan, compensation or other similarpayment from a donor advised fund toa donor or donor advisor with respect tosuch fund and from a supporting organi-zation to any of its disqualified persons.See section 4958(c)(2) and (3). Although

not in the context of an automatic excessbenefit transaction, the new example inthe final regulations involves an excessbenefit transaction that is not de minimis.

e. Removal of disqualified person

One comment suggested that the reg-ulations address whether and under whatcircumstances removal of a disqualifiedperson may be necessary to avoid revo-cation. The new example added by thesefinal regulations illustrates that removalof a disqualified person is not a neces-sary condition for continued exemption.In the example, the organization imple-mented safeguards designed to prevent fu-ture excess benefit transactions involvingthe same disqualified persons.

f. Best practices

One comment described specific ac-tions that boards of applicable tax-exemptorganizations should be required to taketo improve governance and to preventexcess benefit transactions at their orga-nizations. This comment was not adoptedbecause the purpose of these regulationsis to set forth an analytical framework fordetermining whether to revoke tax-exemptstatus if an organization engages in one ormore excess benefit transactions.

Special Analyses

It has been determined that this regu-lation is not a significant regulatory ac-tion as defined in Executive Order 12866.Therefore, a regulatory assessment is notrequired. It also has been determined thatsection 553(b) of the Administrative Pro-cedure Act (5 U.S.C. chapter 5) does notapply to this regulation, and because thisregulation does not impose a collection ofinformation on small entities, the Regula-tory Flexibility Act (5 U.S.C. chapter 6)does not apply. Pursuant to section 7805(f)of the Code, the notice of proposed rule-making preceding this regulation was sub-mitted to the Chief Counsel for Advocacyof the Small Business Administration forcomment on its impact on small business.

Drafting Information

The principal authors of these reg-ulations are Galina Kolomietz andPhyllis Haney, Office of DivisionCounsel/Associate Chief Counsel (Tax

May 5, 2008 857 2008–18 I.R.B.

Exempt and Government Entities).However, other personnel from the IRSand the Treasury Department participatedin their development.

* * * * *

Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 53 areamended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.501(c)(3)–1 is revised

by:1. Redesignating paragraph (d)(1)(iii)

as paragraph (d)(1)(iv) and adding a newparagraph (d)(1)(iii).

2. Redesignating paragraph (f) as para-graph (g) and adding a new paragraph (f).

The additions read as follows:

§1.501(c)(3)–1 Organizations organizedand operated for religious, charitable,scientific, testing for public safety,literary, or educational purposes, or forthe prevention of cruelty to children oranimals.

* * * * *(d) * * *(1) * * *(iii) Examples. The following exam-

ples illustrate the requirement of paragraph(d)(1)(ii) of this section that an organiza-tion serve a public rather than a private in-terest:

Example 1. (i) O is an educational organizationthe purpose of which is to study history and immi-gration. O’s educational activities include sponsor-ing lectures and publishing a journal. The focus ofO’s historical studies is the genealogy of one fam-ily, tracing the descent of its present members. O ac-tively solicits for membership only individuals whoare members of that one family. O’s research is di-rected toward publishing a history of that family thatwill document the pedigrees of family members. Amajor objective of O’s research is to identify and lo-cate living descendants of that family to enable thosedescendants to become acquainted with each other.

(ii) O’s educational activities primarily serve theprivate interests of members of a single family ratherthan a public interest. Therefore, O is operated for thebenefit of private interests in violation of the restric-tion on private benefit in paragraph (d)(1)(ii) of thissection. Based on these facts and circumstances, Ois not operated exclusively for exempt purposes and,therefore, is not described in section 501(c)(3).

Example 2. (i) O is an art museum. O’s prin-cipal activity is exhibiting art created by a group of

unknown but promising local artists. O’s activity, in-cluding organized tours of its art collection, promotesthe arts. O is governed by a board of trustees un-related to the artists whose work O exhibits. All ofthe art exhibited is offered for sale at prices set bythe artist. Each artist whose work is exhibited hasa consignment arrangement with O. Under this ar-rangement, when art is sold, the museum retains 10percent of the selling price to cover the costs of oper-ating the museum and gives the artist 90 percent.

(ii) The artists in this situation directly benefitfrom the exhibition and sale of their art. As a result,the principal activity of O serves the private interestsof these artists. Because O gives 90 percent of theproceeds from its sole activity to the individual artists,the direct benefits to the artists are substantial and O’sprovision of these benefits to the artists is more thanincidental to its other purposes and activities. Thisarrangement causes O to be operated for the benefitof private interests in violation of the restriction onprivate benefit in paragraph (d)(1)(ii) of this section.Based on these facts and circumstances, O is not oper-ated exclusively for exempt purposes and, therefore,is not described in section 501(c)(3).

Example 3. (i) O is an educational organizationthe purpose of which is to train individuals in a pro-gram developed by P, O’s president. The program isof interest to academics and professionals, represen-tatives of whom serve on an advisory panel to O. Allof the rights to the program are owned by CompanyK, a for-profit corporation owned by P. Prior to theexistence of O, the teaching of the program was con-ducted by Company K. O licenses, from Company K,the right to conduct seminars and lectures on the pro-gram and to use the name of the program as part of O’sname, in exchange for specified royalty payments.Under the license agreement, Company K provides Owith the services of trainers and with course materialson the program. O may develop and copyright newcourse materials on the program but all such materialsmust be assigned to Company K without considera-tion if and when the license agreement is terminated.Company K sets the tuition for the seminars and lec-tures on the program conducted by O. O has agreednot to become involved in any activity resembling theprogram or its implementation for 2 years after thetermination of O’s license agreement.

(ii) O’s sole activity is conducting seminars andlectures on the program. This arrangement causes Oto be operated for the benefit of P and Company K inviolation of the restriction on private benefit in para-graph (d)(1)(ii) of this section, regardless of whetherthe royalty payments from O to Company K for theright to teach the program are reasonable. Based onthese facts and circumstances, O is not operated ex-clusively for exempt purposes and, therefore, is notdescribed in section 501(c)(3).

* * * * *(f) Interaction with section 4958—(1)

Application process. An organization thatapplies for recognition of exemption un-der section 501(a) as an organization de-scribed in section 501(c)(3) must establishits eligibility under this section. The Com-missioner may deny an application for ex-emption for failure to establish any of sec-tion 501(c)(3)’s requirements for exemp-

tion. Section 4958 does not apply to trans-actions with an organization that has failedto establish that it satisfies all of the re-quirements for exemption under section501(c)(3). See §53.4958–2.

(2) Substantive requirements for ex-emption still apply to applicable tax-ex-empt organizations described in section501(c)(3)—(i) In general. Regardless ofwhether a particular transaction is subjectto excise taxes under section 4958, the sub-stantive requirements for tax exemptionunder section 501(c)(3) still apply to anapplicable tax-exempt organization (as de-fined in section 4958(e) and §53.4958–2)described in section 501(c)(3) whosedisqualified persons or organization man-agers are subject to excise taxes under sec-tion 4958. Accordingly, an organizationwill no longer meet the requirements fortax-exempt status under section 501(c)(3)if the organization fails to satisfy the re-quirements of paragraph (b), (c) or (d) ofthis section. See §53.4958–8(a).

(ii) Determination of whether revoca-tion of tax-exempt status is appropriatewhen section 4958 excise taxes also ap-ply. In determining whether to continueto recognize the tax-exempt status of anapplicable tax-exempt organization (as de-fined in section 4958(e) and §53.4958–2)described in section 501(c)(3) that engagesin one or more excess benefit transac-tions (as defined in section 4958(c) and§53.4958–4) that violate the prohibitionon inurement under section 501(c)(3), theCommissioner will consider all relevantfacts and circumstances, including, but notlimited to, the following—

(A) The size and scope of the organi-zation’s regular and ongoing activities thatfurther exempt purposes before and afterthe excess benefit transaction or transac-tions occurred;

(B) The size and scope of the excessbenefit transaction or transactions (collec-tively, if more than one) in relation to thesize and scope of the organization’s regularand ongoing activities that further exemptpurposes;

(C) Whether the organization has beeninvolved in multiple excess benefit trans-actions with one or more persons;

(D) Whether the organization has im-plemented safeguards that are reasonablycalculated to prevent excess benefit trans-actions; and

2008–18 I.R.B. 858 May 5, 2008

(E) Whether the excess benefit transac-tion has been corrected (within the mean-ing of section 4958(f)(6) and §53.4958–7),or the organization has made good faith ef-forts to seek correction from the disquali-fied person(s) who benefited from the ex-cess benefit transaction.

(iii) All factors will be considered incombination with each other. Dependingon the particular situation, the Commis-sioner may assign greater or lesser weightto some factors than to others. The factorslisted in paragraphs (f)(2)(ii)(D) and (E)of this section will weigh more heavily infavor of continuing to recognize exemp-tion where the organization discovers theexcess benefit transaction or transactionsand takes action before the Commissionerdiscovers the excess benefit transactionor transactions. Further, with respect tothe factor listed in paragraph (f)(2)(ii)(E)of this section, correction after the excessbenefit transaction or transactions are dis-covered by the Commissioner, by itself, isnever a sufficient basis for continuing torecognize exemption.

(iv) Examples. The following exam-ples illustrate the principles of paragraph(f)(2)(ii) of this section. For purposes ofeach example, assume that O is an appli-cable tax-exempt organization (as definedin section 4958(e) and §53.4958–2) de-scribed in section 501(c)(3). The examplesread as follows:

Example 1. (i) O was created as a museum forthe purpose of exhibiting art to the general public. InYears 1 and 2, O engages in fundraising and in se-lecting, leasing, and preparing an appropriate facilityfor a museum. In Year 3, a new board of trustees iselected. All of the new trustees are local art dealers.Beginning in Year 3 and continuing to the present, Ouses a substantial portion of its revenues to purchaseart solely from its trustees at prices that exceed fairmarket value. O exhibits and offers for sale all ofthe art it purchases. O’s Form 1023, “Application forRecognition of Exemption Under Section 501(c)(3) ofthe Internal Revenue Code,” did not disclose the pos-sibility that O would purchase art from its trustees.

(ii) O’s purchases of art from its trustees atmore than fair market value constitute excess ben-efit transactions between an applicable tax-exemptorganization and disqualified persons under section4958. Therefore, these transactions are subject tothe applicable excise taxes provided in that section.In addition, O’s purchases of art from its trustees atmore than fair market value violate the proscriptionagainst inurement under section 501(c)(3) and para-graph (c)(2) of this section.

(iii) The application of the factors in paragraph(f)(2)(ii) of this section to these facts is as follows.Beginning in Year 3, O does not engage primarilyin regular and ongoing activities that further exempt

purposes because a substantial portion of O’s activ-ities consists of purchasing art from its trustees anddealing in such art in a manner similar to a commer-cial art gallery. The size and scope of the excess bene-fit transactions collectively are significant in relationto the size and scope of any of O’s ongoing activitiesthat further exempt purposes. O has been involvedin multiple excess benefit transactions, namely, pur-chases of art from its trustees at more than fair mar-ket value. O has not implemented safeguards thatare reasonably calculated to prevent such improperpurchases in the future. The excess benefit transac-tions have not been corrected, nor has O made goodfaith efforts to seek correction from the disqualifiedpersons who benefited from the excess benefit trans-actions (the trustees). The trustees continue to con-trol O’s Board. Based on the application of the fac-tors to these facts, O is no longer described in section501(c)(3) effective in Year 3.

Example 2. (i) The facts are the same as in Ex-ample 1, except that in Year 4, O’s entire board oftrustees resigns, and O no longer offers all exhibitedart for sale. The former board is replaced with mem-bers of the community who are not in the business ofbuying or selling art and who have skills and expe-rience running charitable and educational programsand institutions. O promptly discontinues the prac-tice of purchasing art from current or former trustees,adopts a written conflicts of interest policy, adoptswritten art valuation guidelines, hires legal counselto recover the excess amounts O had paid its formertrustees, and implements a new program of activitiesto further the public’s appreciation of the arts.

(ii) O’s purchases of art from its former trusteesat more than fair market value constitute excess ben-efit transactions between an applicable tax-exemptorganization and disqualified persons under section4958. Therefore, these transactions are subject tothe applicable excise taxes provided in that section.In addition, O’s purchases of art from its trustees atmore than fair market value violate the proscriptionagainst inurement under section 501(c)(3) and para-graph (c)(2) of this section.

(iii) The application of the factors in paragraph(f)(2)(ii) of this section to these facts is as follows. InYear 3, O does not engage primarily in regular and on-going activities that further exempt purposes. How-ever, in Year 4, O elects a new board of trustees com-prised of individuals who have skills and experiencerunning charitable and educational programs and im-plements a new program of activities to further thepublic’s appreciation of the arts. As a result of theseactions, beginning in Year 4, O engages in regularand ongoing activities that further exempt purposes.The size and scope of the excess benefit transactionsthat occurred in Year 3, taken collectively, are sig-nificant in relation to the size and scope of O’s regu-lar and ongoing exempt function activities that wereconducted in Year 3. Beginning in Year 4, however,as O’s exempt function activities grow, the size andscope of the excess benefit transactions that occurredin Year 3 become less and less significant as com-pared to the size and scope of O’s regular and ongoingexempt function activities. O was involved in multi-ple excess benefit transactions in Year 3. However,by discontinuing its practice of purchasing art fromits current and former trustees, by replacing its formerboard with independent members of the community,and by adopting a conflicts of interest policy and art

valuation guidelines, O has implemented safeguardsthat are reasonably calculated to prevent future vio-lations. In addition, O has made a good faith effortto seek correction from the disqualified persons whobenefited from the excess benefit transactions (its for-mer trustees). Based on the application of the factorsto these facts, O continues to meet the requirementsfor tax exemption under section 501(c)(3).

Example 3. (i) O conducts educational programsfor the benefit of the general public. Since its forma-tion, O has employed its founder, C, as its Chief Exec-utive Officer. Beginning in Year 5 of O’s operationsand continuing to the present, C caused O to divertsignificant portions of O’s funds to pay C’s personalexpenses. The diversions by C significantly reducedthe funds available to conduct O’s ongoing educa-tional programs. The board of trustees never autho-rized C to cause O to pay C’s personal expenses fromO’s funds. Certain members of the board were awarethat O was paying C’s personal expenses. However,the board did not terminate C’s employment and didnot take any action to seek repayment from C or toprevent C from continuing to divert O’s funds to payC’s personal expenses. C claimed that O’s paymentsof C’s personal expenses represented loans from O toC. However, no contemporaneous loan documenta-tion exists, and C never made any payments of prin-cipal or interest.

(ii) The diversions of O’s funds to pay C’s per-sonal expenses constitute excess benefit transactionsbetween an applicable tax-exempt organization anda disqualified person under section 4958. Therefore,these transactions are subject to the applicable excisetaxes provided in that section. In addition, thesetransactions violate the proscription against inure-ment under section 501(c)(3) and paragraph (c)(2) ofthis section.

(iii) The application of the factors in paragraph(f)(2)(ii) of this section to these facts is as follows. Ohas engaged in regular and ongoing activities that fur-ther exempt purposes both before and after the excessbenefit transactions occurred. However, the size andscope of the excess benefit transactions engaged inby O beginning in Year 5, collectively, are significantin relation to the size and scope of O’s activities thatfurther exempt purposes. Moreover, O has been in-volved in multiple excess benefit transactions. O hasnot implemented any safeguards that are reasonablycalculated to prevent future diversions. The excessbenefit transactions have not been corrected, nor hasO made good faith efforts to seek correction from C,the disqualified person who benefited from the excessbenefit transactions. Based on the application of thefactors to these facts, O is no longer described in sec-tion 501(c)(3) effective in Year 5.

Example 4. (i) O conducts activities that furtherexempt purposes. O uses several buildings in the con-duct of its exempt activities. In Year 1, O sold oneof the buildings to Company K for an amount thatwas substantially below fair market value. The salewas a significant event in relation to O’s other ac-tivities. C, O’s Chief Executive Officer, owns all ofthe voting stock of Company K. When O’s board oftrustees approved the transaction with Company K,the board did not perform due diligence that couldhave made it aware that the price paid by Company Kto acquire the building was below fair market value.Subsequently, but before the IRS commences an ex-amination of O, O’s board of trustees determines that

May 5, 2008 859 2008–18 I.R.B.

Company K paid less than the fair market value forthe building. Thus, O concludes that an excess ben-efit transaction occurred. After the board makes thisdetermination, it promptly removes C as Chief Ex-ecutive Officer, terminates C’s employment with O,and hires legal counsel to recover the excess benefitfrom Company K. In addition, O promptly adopts aconflicts of interest policy and new contract reviewprocedures designed to prevent future recurrences ofthis problem.

(ii) The sale of the building by O to Company Kat less than fair market value constitutes an excessbenefit transaction between an applicable tax-exemptorganization and a disqualified person under section4958 in Year 1. Therefore, this transaction is subjectto the applicable excise taxes provided in that section.In addition, this transaction violates the proscriptionagainst inurement under section 501(c)(3) and para-graph (c)(2) of this section.

(iii) The application of the factors in paragraph(f)(2)(ii) of this section to these facts is as follows.O has engaged in regular and ongoing activities thatfurther exempt purposes both before and after the ex-cess benefit transaction occurred. Although the sizeand scope of the excess benefit transaction were sig-nificant in relation to the size and scope of O’s activi-ties that further exempt purposes, the transaction withCompany K was a one-time occurrence. By adoptinga conflicts of interest policy and new contract reviewprocedures and by terminating C, O has implementedsafeguards that are reasonably calculated to preventfuture violations. Moreover, O took corrective ac-tions before the IRS commenced an examination ofO. In addition, O has made a good faith effort to seekcorrection from Company K, the disqualified personwho benefited from the excess benefit transaction.Based on the application of the factors to these facts,O continues to be described in section 501(c)(3).

Example 5. (i) O is a large organization withsubstantial assets and revenues. O conducts activitiesthat further its exempt purposes. O employs C asits Chief Financial Officer. During Year 1, O pays$2,500 of C’s personal expenses. O does not makethese payments pursuant to an accountable plan, asdescribed in §53.4958–4(a)(4)(ii). In addition, Odoes not report any of these payments on C’s FormW–2, “Wage and Tax Statement,” or on a Form1099–MISC, “Miscellaneous Income,” for C for Year1, and O does not report these payments as com-pensation on its Form 990, “Return of OrganizationExempt From Income Tax,” for Year 1. Moreover,none of these payments can be disregarded as non-taxable fringe benefits under §53.4958–4(c)(2) andnone consisted of fixed payments under an initialcontract under §53.4958–4(a)(3). C does not reportthe $2,500 of payments as income on his individualFederal income tax return for Year 1. O does notrepeat this reporting omission in subsequent yearsand, instead, reports all payments of C’s personalexpenses not made under an accountable plan asincome to C.

(ii) O’s payment in Year 1 of $2,500 of C’s per-sonal expenses constitutes an excess benefit trans-action between an applicable tax-exempt organiza-tion and a disqualified person under section 4958.Therefore, this transaction is subject to the applica-ble excise taxes provided in that section. In addition,this transaction violates the proscription against in-

urement in section 501(c)(3) and paragraph (c)(2) ofthis section.

(iii) The application of the factors in paragraph(f)(2)(ii) of this section to these facts is as follows.O engages in regular and ongoing activities that fur-ther exempt purposes. The payment of $2,500 of C’spersonal expenses represented only a de minimis por-tion of O’s assets and revenues; thus, the size andscope of the excess benefit transaction were not sig-nificant in relation to the size and scope of O’s ac-tivities that further exempt purposes. The reportingomission that resulted in the excess benefit transac-tion in Year 1 occurred only once and is not repeatedin subsequent years. Based on the application of thefactors to these facts, O continues to be described insection 501(c)(3).

Example 6. (i) O is a large organization withsubstantial assets and revenues. O furthers its ex-empt purposes by providing social services to thepopulation of a specific geographic area. O has asizeable workforce of employees and volunteers toconduct its work. In Year 1, O’s board of directorsadopted written procedures for setting executivecompensation at O. O’s executive compensationprocedures were modeled on the procedures forestablishing a rebuttable presumption of reasonable-ness under §53.4958–6. In accordance with theseprocedures, the board appointed a compensationcommittee to gather data on compensation levelspaid by similarly situated organizations for func-tionally comparable positions. The members of thecompensation committee were disinterested withinthe meaning of §53.4958–6(c)(1)(iii). Based on itsresearch, the compensation committee recommendeda range of reasonable compensation for several ofO’s existing top executives (the Top Executives).On the basis of the committee’s recommendations,the board approved new compensation packagesfor the Top Executives and timely documented thebasis for its decision in board minutes. The boardmembers were all disinterested within the meaningof §53.4958–6(c)(1)(iii). The Top Executives werenot involved in setting their own compensation. InYear 1, even though payroll expenses represented asignificant portion of O’s total operating expenses,the total compensation paid to O’s Top Executivesrepresented only an insubstantial portion of O’s totalpayroll expenses. During a subsequent examination,the IRS found that the compensation committeerelied exclusively on compensation data from or-ganizations that perform similar social services toO. The IRS concluded, however, that the organi-zations were not similarly situated because theyserved substantially larger geographic regions withmore diverse populations and were larger than Oin terms of annual revenues, total operating budget,number of employees, and number of beneficiariesserved. Accordingly, the IRS concluded that thecompensation committee did not rely on “appropri-ate data as to comparability” within the meaningof §53.4958–6(c)(2) and, thus, failed to establishthe rebuttable presumption of reasonableness under§53.4958–6. Taking O’s size and the nature of thegeographic area and population it serves into ac-count, the IRS concluded that the Top Executives’compensation packages for Year 1 were excessive.As a result of the examination, O’s board added newmembers to the compensation committee who have

expertise in compensation matters and also amendedits written procedures to require the compensationcommittee to evaluate a number of specific factors,including size, geographic area, and populationcovered by the organization, in assessing the compa-rability of compensation data. O’s board renegotiatedthe Top Executives’ contracts in accordance with therecommendations of the newly constituted compen-sation committee on a going forward basis. To avoidpotential liability for damages under state contractlaw, O did not seek to void the Top Executives’employment contracts retroactively to Year 1 and didnot seek correction of the excess benefit amountsfrom the Top Executives. O did not terminate any ofthe Top Executives.

(ii) O’s payments of excessive compensation tothe Top Executives in Year 1 constituted excess ben-efit transactions between an applicable tax-exemptorganization and disqualified persons under section4958. Therefore, these payments are subject to theapplicable excise taxes provided under that section,including second-tier taxes if there is no correction bythe disqualified persons. In addition, these paymentsviolate the proscription against inurement under sec-tion 501(c)(3) and paragraph (c)(2) of this section.

(iii) The application of the factors in paragraph(f)(2)(ii) of this section to these facts is as follows. Ohas engaged in regular and ongoing activities that fur-ther exempt purposes both before and after the excessbenefit transactions occurred. The size and scope ofthe excess benefit transactions, in the aggregate, werenot significant in relation to the size and scope ofO’s activities that further exempt purposes. O en-gaged in multiple excess benefit transactions. Nev-ertheless, prior to entering into these excess benefittransactions, O had implemented written proceduresfor setting the compensation of its top managementthat were reasonably calculated to prevent the occur-rence of excess benefit transactions. O followed thesewritten procedures in setting the compensation of theTop Executives for Year 1. Despite the board’s fail-ure to rely on appropriate comparability data, the factthat O implemented and followed these written pro-cedures in setting the compensation of the Top Execu-tives for Year 1 is a factor favoring continued exemp-tion. The fact that O amended its written proceduresto ensure the use of appropriate comparability dataand renegotiated the Top Executives’ compensationpackages on a going forward basis are also factors fa-voring continued exemption, even though O did notvoid the Top Executives’ existing contracts and didnot seek correction from the Top Executives. Basedon the application of the factors to these facts, O con-tinues to be described in section 501(c)(3).

(3) Applicability. The rules in para-graph (f) of this section will apply with re-spect to excess benefit transactions occur-ring after March 28, 2008.

* * * * *

PART 53—FOUNDATION ANDSIMILAR EXCISE TAXES

Par. 3. The authority citation for part53 continues to read, in part, as follows:

2008–18 I.R.B. 860 May 5, 2008

Authority: 26 U.S.C. 7805 * * *Par. 4. In §53.4958–2, paragraph (a)(6)

is added to read as follows:

§53.4958–2 Definition of applicabletax-exempt organization.

(a) * * *(6) Examples. The following exam-

ples illustrate the principles of this section,which defines an applicable tax-exempt or-ganization for purposes of section 4958:

Example 1. O is a nonprofit corporation formedunder state law. O filed its application for recognitionof exemption under section 501(c)(3) within the timeprescribed under section 508(a). In its application,O described its plans for purchasing property fromsome of its directors at prices that would exceed fairmarket value. After reviewing the application, theIRS determined that because of the proposed prop-erty purchase transactions, O failed to establish thatit met the requirements for an organization describedin section 501(c)(3). Accordingly, the IRS deniedO’s application. While O’s application was pending,O engaged in the purchase transactions described inits application at prices that exceeded the fair mar-ket values of the properties. Although these transac-tions would constitute excess benefit transactions un-der section 4958, because the IRS never recognizedO as an organization described in section 501(c)(3),O was never an applicable tax-exempt organizationunder section 4958. Therefore, these transactions arenot subject to the excise taxes provided in section4958.

Example 2. O is a nonprofit corporation formedunder state law. O files its application for recogni-tion of exemption under section 501(c)(3) within thetime prescribed under section 508(a). The IRS is-sues a favorable determination letter in Year 1 thatrecognizes O as an organization described in section501(c)(3). Subsequently, in Year 5 of O’s operations,O engages in certain transactions that constitute ex-cess benefit transactions under section 4958 and vio-late the proscription against inurement under section501(c)(3) and §1.501(c)(3)–1(c)(2). The IRS exam-ines the Form 990, “Return of Organization ExemptFrom Income Tax”, that O filed for Year 5. After con-sidering all the relevant facts and circumstances in ac-cordance with §1.501(c)(3)–1(f), the IRS concludesthat O is no longer described in section 501(c)(3) ef-fective in Year 5. The IRS does not examine theForms 990 that O filed for its first four years of op-erations and, accordingly, does not revoke O’s ex-

empt status for those years. Although O’s tax-ex-empt status is revoked effective in Year 5, under thelookback rules in paragraph (a)(1) of this section and§53.4958–3(a)(1) of this chapter, during the five-yearperiod prior to the excess benefit transactions that oc-curred in Year 5, O was an applicable tax-exempt or-ganization and O’s directors were disqualified per-sons as to O. Therefore, the transactions between Oand its directors during Year 5 are subject to the ap-plicable excise taxes provided in section 4958.

* * * * *

Linda E. Stiff,Deputy Commissioner forServices and Enforcement.

Approved March 19, 2008.

Eric Solomon,Assistant Secretary of

the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on March 27,2008, 8:45 a.m., and published in the issue of the FederalRegister for March 28, 2008, 73 F.R. 16519)

Section 642.—SpecialRules for Credits andDeductions


Section 807.—Rules forCertain Reserves


Section 846.—DiscountedUnpaid Losses Defined


Section 1274.—Determi-nation of Issue Price in theCase 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 thelong-term exempt rate. For purposes ofsections 382, 642, 1274, 1288, and othersections of the Code, tables set forth therates for May 2008.

Rev. Rul. 2008–24

This revenue ruling provides vari-ous prescribed rates for federal incometax purposes for May 2008 (the currentmonth). Table 1 contains the short-term,mid-term, and long-term applicable fed-eral rates (AFR) for the current monthfor purposes of section 1274(d) of theInternal Revenue Code. Table 2 containsthe short-term, mid-term, and long-termadjusted applicable federal rates (adjustedAFR) for the current month for purposesof section 1288(b). Table 3 sets forth theadjusted federal long-term rate and thelong-term tax-exempt rate described insection 382(f). Table 4 contains the ap-propriate percentages for determining thelow-income housing credit described insection 42(b)(2) for buildings placed inservice during the current month. Finally,Table 5 contains the federal rate for deter-mining the present value of an annuity, aninterest for life or for a term of years, ora remainder or a reversionary interest forpurposes of section 7520.

May 5, 2008 861 2008–18 I.R.B.

REV. RUL. 2008–24 TABLE 1

Applicable Federal Rates (AFR) for May 2008

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-term

AFR 1.64% 1.63% 1.63% 1.62%110% AFR 1.80% 1.79% 1.79% 1.78%120% AFR 1.97% 1.96% 1.96% 1.95%130% AFR 2.13% 2.12% 2.11% 2.11%

Mid-term

AFR 2.74% 2.72% 2.71% 2.70%110% AFR 3.01% 2.99% 2.98% 2.97%120% AFR 3.29% 3.26% 3.25% 3.24%130% AFR 3.57% 3.54% 3.52% 3.51%150% AFR 4.12% 4.08% 4.06% 4.05%175% AFR 4.82% 4.76% 4.73% 4.71%

Long-term

AFR 4.21% 4.17% 4.15% 4.13%110% AFR 4.64% 4.59% 4.56% 4.55%120% AFR 5.06% 5.00% 4.97% 4.95%130% AFR 5.49% 5.42% 5.38% 5.36%


Adjusted AFR for May 2008

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-term adjustedAFR

2.07% 2.06% 2.05% 2.05%

Mid-term adjusted AFR 3.17% 3.15% 3.14% 3.13%

Long-term adjustedAFR

4.71% 4.66% 4.63% 4.62%


Rates Under Section 382 for May 2008

Adjusted federal long-term rate for the current month 4.71%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjustedfederal long-term rates for the current month and the prior two months.) 4.71%


Appropriate Percentages Under Section 42(b)(2) for May 2008

Appropriate percentage for the 70% present value low-income housing credit 7.80%

Appropriate percentage for the 30% present value low-income housing credit 3.34%

2008–18 I.R.B. 862 May 5, 2008


Rate Under Section 7520 for May 2008

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 interest 3.2%

Section 1288.—Treatmentof Original Issue Discounton Tax-Exempt Obligations


Section 6103.—Confi-dentiality and Disclosureof Returns and ReturnInformation26 CFR 301.6103(n)–2T: Disclosure of return infor-mation in connection with written contracts amongthe IRS, whistleblowers, and legal representatives ofwhistleblowers (temporary).

T.D. 9389

DEPARTMENT OF THETREASURYInternal Revenue Service26 CFR Part 301

Disclosure of ReturnInformation in ConnectionWith Written Contracts Amongthe IRS, Whistleblowers, andLegal Representatives ofWhistleblowers


ACTION: Temporary regulations.

SUMMARY: This document contains tem-porary regulations relating to the disclo-sure of return information, pursuant to sec-tion 6103(n) of the Internal Revenue Code(Code), by an officer or employee of theTreasury Department, to a whistleblowerand, if applicable, the legal representativeof the whistleblower, to the extent nec-essary in connection with a written con-tract among the IRS, the whistleblowerand, if applicable, the legal representative

of the whistleblower, for services relat-ing to the detection of violations of theinternal revenue laws or related statutes.The temporary regulations will affect of-ficers and employees of the Treasury De-partment who disclose return informationto whistleblowers, or their legal represen-tatives, in connection with written con-tracts among the IRS, whistleblowers and,if applicable, their legal representatives,for services relating to the detection of vi-olations of the internal revenue laws or re-lated statutes. The temporary regulationswill also affect any whistleblower, or le-gal representative of a whistleblower, whoreceives return information in connectionwith a written contract among the IRS, thewhistleblower and, if applicable, the le-gal representative of the whistleblower, forservices relating to the detection of viola-tions of the internal revenue laws or relatedstatutes. The text of the temporary regula-tions also serves as the text of the proposedregulations (REG–114942–07) set forth inthe notice of proposed rulemaking on thissubject in this issue of the Bulletin.

DATES: Effective Date: These temporaryregulations are effective on March 25,2008.

Applicability Date: For dates of appli-cability, see §301.6103(n)–2T(f).

FOR FURTHER INFORMATIONCONTACT: Helene R. Newsome,202–622–7950 (not a toll-free number).


Background

This document contains amendments tothe Procedure and Administration Regu-lations (26 CFR part 301) under section6103(n) relating to the disclosure of re-turn information in connection with writ-ten contracts among the IRS, whistleblow-ers and, if applicable, their legal represen-tatives.

The Tax Relief and Health Care Actof 2006, Public Law 109–432 (120 Stat.2958), (the Act) was enacted on December

20, 2006. Section 406 of the Act amendssection 7623, concerning the payment ofawards to whistleblowers, and establishesa Whistleblower Office within the IRSthat has responsibility for the adminis-tration of a whistleblower program. TheWhistleblower Office, in connection withadministering a whistleblower program,will analyze information provided by awhistleblower, and either investigate thematter itself or assign it to the appropriateIRS office for investigation. In analyzinginformation provided by a whistleblower,or investigating a matter, the Whistle-blower Office may determine that it re-quires the assistance of the whistleblower,or the legal representative of the whistle-blower. The legislative history of section406 of the Act states that “[t]o the extentthe disclosure of returns or return infor-mation is required [for the whistlebloweror his or her legal representative] to ren-der such assistance, the disclosure mustbe pursuant to an IRS tax administrationcontract.” Joint Committee on Taxation,Technical Explanation of H.R. 6408, The“Tax Relief and Health Care Act of 2006,”as Introduced in the House on December7, 2006, at 89 (JCX–50–06), December 7,2006. The legislative history further statesthat “[i]t is expected that such disclosureswill be infrequent and will be made onlywhen the assigned task cannot be properlyor timely completed without the returninformation to be disclosed.” Id.

Under section 6103(a), returns and re-turn information are confidential unlessthe Internal Revenue Code (Code) au-thorizes disclosure. Section 6103(n) isthe authority by which returns and returninformation may be disclosed pursuantto a tax administration contract. Section6103(n) authorizes, pursuant to regula-tions prescribed by the Secretary, returnsand return information to be disclosedto any person, including any person de-scribed in section 7513(a), for purposes oftax administration, to the extent necessaryin connection with: (1) the processing,storage, transmission, and reproductionof returns and return information; (2) the

May 5, 2008 863 2008–18 I.R.B.

programming, maintenance, repair, test-ing, and procurement of equipment; and(3) the providing of other services. Thesetemporary regulations describe the cir-cumstances, pursuant to section 6103(n),under which officers and employees ofthe Treasury Department may disclosereturn information to whistleblowers and,if applicable, their legal representatives,in connection with written contracts forservices relating to the detection of vi-olations of the internal revenue laws orrelated statutes.

Explanation of Provisions

General Rule

The temporary regulations, at§301.6103(n)–2T(a)(1), provide that anofficer or employee of the TreasuryDepartment may, pursuant to sections6103(n) and 7623, disclose return informa-tion to a whistleblower and, if applicable,the legal representative of the whistle-blower, to the extent necessary in connec-tion with a written contract among the IRS,the whistleblower and, if applicable, thelegal representative of the whistleblower,for services relating to the detection ofviolations of the internal revenue laws orrelated statutes. If a whistleblower hasretained the services of a legal representa-tive, then, in addition to the whistleblower,the whistleblower’s legal representativemust be a party to the written contract withthe IRS. These temporary regulations donot provide for the disclosure of returns towhistleblowers or their legal representa-tives.

The temporary regulations, at§301.6103(n)–2T(a)(2), provide that theCommissioner has the discretion to de-termine whether to enter into a writtencontract with the whistleblower and, ifapplicable, the legal representative of thewhistleblower, for services as described in§301.6103(n)–2T(a)(1). The IRS expectsto enter into these contracts only infre-quently, and any contract that is enteredinto, and any disclosures made pursuantto this type of contract, will be carefullytailored to the specific facts of the case.

Limitations

The temporary regulations, at§301.6103(n)–2T(b)(1), set forth thecondition that the disclosure of return

information in connection with a writ-ten contract for services described in§301.6103(n)–2T(a)(1) may be made onlyto the extent the IRS deems it necessary inconnection with the reasonable or properperformance of the contract. In this re-gard, disclosures should relate to relevanttaxable years and types of tax. The tempo-rary regulations, at §301.6103–2T(b)(2),set forth the additional condition that ifthe IRS determines that the services ofa whistleblower and, if applicable, thelegal representative of the whistlebloweras described in §301.6103(n)–2T(a)(1)can be performed reasonably or properlyby disclosure of only parts or portions ofreturn information, then only the parts orportions of the return information are tobe disclosed.

The temporary regulations, at§301.6103(n)–2T(b)(3), provide that,upon written request by a whistleblower,or a legal representative of a whistle-blower, with whom the IRS has enteredinto a written contract for services asdescribed in §301.6103(n)–2T(a)(1), theDirector of the Whistleblower Office, ordesignee of the Director, may inform thewhistleblower and, if applicable, the le-gal representative of the whistleblower,of the status of the whistleblower’s claimfor award under section 7623, includingwhether the claim is being evaluated forpotential investigative action, or is pend-ing due to an ongoing examination, appeal,collection action, or litigation. This in-formation may be disclosed only if theCommissioner determines that the disclo-sure would not seriously impair Federaltax administration.

The temporary regulations, at§301.6103(n)–2T(b)(4), impose the con-dition that return information disclosedto a whistleblower and, if applicable, alegal representative of a whistleblower,may not be disclosed or otherwise used bythe whistleblower or a legal representativeof a whistleblower, except as expresslyauthorized by the IRS.

Penalties

The temporary regulations, at§301.6103(n)–2T(c), set forth the civiland criminal penalties to which whistle-blowers and their legal representatives aresubject for unauthorized inspection or dis-closure of return information by operation

of sections 7431(a)(2), 7213(a)(1), and7213A(a)(1)(B).

Safeguards

The temporary regulations, at§301.6103(n)–2T(d)(1), provide thatwhistleblowers and their legal representa-tives who receive return information underthese regulations must comply with allapplicable conditions and requirements asthe IRS may prescribe from time to time(prescribed requirements) for the purposesof protecting the confidentiality of thereturn information and preventing unau-thorized disclosures and inspections ofthe return information (e.g., requirementspertaining to computer security, physicalsecurity of return information, methods ofdestruction of return information).

The temporary regulations, at§301.6103(n)–2T(d)(2), provide that anywritten contract for services as describedin §301.6103(n)–2T(a)(1) must providethat any whistleblower and, if applicable,the legal representative of a whistleblower,who has access to return information un-der these regulations shall comply withthe prescribed requirements.

The temporary regulations, at§301.6103(n)–2T(d)(3), impose the re-quirement that whistleblowers, and theirlegal representatives who receive returninformation under these regulations, mustagree in writing, before any disclosureof return information is made, to permitan inspection of their premises by theIRS relative to the maintenance of the re-turn information disclosed to them underthese regulations and, upon completionof services as described in the writtencontract with the IRS, to dispose of allreturn information by returning the returninformation, including any and all copiesor notes made, to the IRS, or to the extentthat it cannot be returned, by destroyingthe information in a manner consistentwith security guidelines and other safe-guards for protecting return information inguidance published by the IRS.

The temporary regulations, at§301.6103(n)–2T(d)(4), provide that if theIRS determines that any whistleblower, orthe legal representative of a whistleblower,who has access to return information un-der these regulations, has failed to, or doesnot, satisfy the prescribed requirements,the IRS, using the procedures described in

2008–18 I.R.B. 864 May 5, 2008

the regulations under section 6103(p)(7),may take any action it deems necessaryto ensure that the prescribed requirementsare or will be satisfied.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessmentis not required. It also has been deter-mined that section 553(b) of the Admin-istrative Procedure Act (5 U.S.C. chapter5) does not apply to these regulations. Forthe applicability of the Regulatory Flexi-bility Act (5 U.S.C. chapter 6) refer to theSpecial Analyses section of the preambleto the cross-reference notice of proposedrulemaking published in this issue of theBulletin. Pursuant to section 7805(f) ofthe Code, these regulations have been sub-mitted to the Chief Counsel for Advocacyof the Small Business Administration forcomment on its impact on small business.


The principal author of these regula-tions is Helene R. Newsome, Office ofthe Associate Chief Counsel (Procedure &Administration).

* * * * *

Amendments to the Regulations

Accordingly, 26 CFR part 301 isamended as follows:

PART 301—PROCEDURE ANDADMINISTRATION

Paragraph 1. The authority citation forpart 301 is amended by adding an entry innumerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *Section 301.6103(n)–2T also issued un-

der 26 U.S.C. 6103(n); * * *Par. 2. Section 301.6103(n)–2T is

added to read as follows:

§301.6103(n)–2T Disclosure ofreturn information in connection withwritten contracts among the IRS,whistleblowers, and legal representativesof whistleblowers (temporary).

(a) General rule. (1) Pursuant to theprovisions of sections 6103(n) and 7623of the Internal Revenue Code and subject

to the conditions of this section, an offi-cer or employee of the Treasury Depart-ment is authorized to disclose return infor-mation (as defined in section 6103(b)(2))to a whistleblower and, if applicable, thelegal representative of the whistleblower,to the extent necessary in connection witha written contract among the Internal Rev-enue Service (IRS), the whistleblower and,if applicable, the legal representative of thewhistleblower, for services relating to thedetection of violations of the internal rev-enue laws or related statutes.

(2) The Commissioner shall have thediscretion to determine whether to enterinto a written contract pursuant to section7623 with the whistleblower and, if ap-plicable, the legal representative of thewhistleblower for services described inparagraph (a)(1) of this section.

(b) Limitations. (1) Disclosure of re-turn information in connection with a writ-ten contract for services described in para-graph (a)(1) of this section shall be madeonly to the extent the IRS deems it neces-sary in connection with the reasonable orproper performance of the contract. Dis-closures may include, but are not limitedto, disclosures to accomplish properly anypurpose or activity of the nature describedin section 6103(k)(6) and the regulationsthereunder.

(2) If the IRS determines that the ser-vices of a whistleblower and, if applica-ble, the legal representative of the whistle-blower, as described in paragraph (a)(1) ofthis section can be performed reasonablyor properly by disclosure of only parts orportions of return information, then onlythe parts or portions of the return informa-tion shall be disclosed.

(3) Upon written request by a whistle-blower, or a legal representative of awhistleblower, with whom the IRS hasentered into a written contract for ser-vices as described in paragraph (a)(1) ofthis section, the Director of the Whistle-blower Office, or designee of the Director,may inform the whistleblower and, if ap-plicable, the legal representative of thewhistleblower, of the status of the whistle-blower’s claim for award under section7623, including whether the claim is be-ing evaluated for potential investigativeaction, or is pending due to an ongoing ex-amination, appeal, collection action, or lit-igation. The information may be disclosedonly if the Commissioner determines that

the disclosure would not seriously impairFederal tax administration.

(4) Return information disclosed to awhistleblower and, if applicable, a legalrepresentative of a whistleblower, underthis section, shall not be disclosed or other-wise used by the whistleblower or a legalrepresentative of a whistleblower, exceptas expressly authorized in writing by theDirector of the Whistleblower Office.

(c) Penalties. Any whistleblower, or le-gal representative of a whistleblower, whoreceives return information under this sec-tion, is subject to the civil and criminalpenalty provisions of sections 7431, 7213,and 7213A for the unauthorized inspectionor disclosure of the return information.

(d) Safeguards. (1) Any whistleblower,or the legal representative of a whistle-blower, who receives return informationunder this section, shall comply with allapplicable conditions and requirements asthe IRS may prescribe from time to time(prescribed requirements) for the purposesof protecting the confidentiality of the re-turn information and preventing any dis-closure or inspection of the return informa-tion in a manner not authorized by this sec-tion.

(2) Any written contract for services asdescribed in paragraph (a)(1) of this sec-tion shall provide that any whistleblowerand, if applicable, the legal representativeof a whistleblower, who has access to re-turn information under this section, shallcomply with the prescribed requirements.

(3) Any whistleblower, or the legal rep-resentative of a whistleblower, who mayreceive return information under this sec-tion, shall agree in writing, before any dis-closure of return information is made, topermit an inspection of his or her premisesby the IRS relative to the maintenanceof the return information disclosed underthese regulations and, upon completion ofservices as described in the written con-tract with the IRS, to dispose of all re-turn information by returning the return in-formation, including any and all copies ornotes made, to the IRS, or to the extent thatit cannot be returned, by destroying the in-formation in a manner consistent with se-curity guidelines and other safeguards forprotecting return information in guidancepublished by the IRS.

(4) If the IRS determines that anywhistleblower, or the legal representa-tive of a whistleblower, who has access

May 5, 2008 865 2008–18 I.R.B.

to return information under this section,has failed to, or does not, satisfy the pre-scribed requirements, the IRS, using theprocedures described in the regulationsunder section 6103(p)(7), may take anyaction it deems necessary to ensure thatthe prescribed requirements are or will besatisfied, including—

(i) Suspension of further disclosuresof return information by the IRS to thewhistleblower and, if applicable, the legalrepresentative of the whistleblower, untilthe IRS determines that the conditions andrequirements have been or will be satis-fied; and

(ii) Suspension or termination of anyduty or obligation arising under a contractwith the IRS.

(e) Definitions. For purposes of thissection—

(1) The term Treasury Department in-cludes the IRS and the Office of the ChiefCounsel for the IRS.

(2) The term whistleblower means anindividual who provides information to theIRS regarding violations of the tax laws orrelated statutes and submits a claim for anaward under section 7623 with respect tothe information.

(3) The term legal representative meansany individual who is a member in goodstanding in the bar of the highest court ofany state, possession, territory, common-wealth, or the District of Columbia, andwho has a written power of attorney exe-cuted by the whistleblower.

(f) Effective/applicability date. Thissection is applicable on March 25, 2008.

(g) Expiration date. This section willexpire on March 23, 2011.


Approved March 12, 2008.

Eric Solomon,Assistant Secretary of

the Treasury (Tax Policy).


Section 7520.—ValuationTables


Section 7872.—Treatmentof Loans With Below-MarketInterest Rates


2008–18 I.R.B. 866 May 5, 2008

Part II. Treaties and Tax LegislationSubpart A.—Tax Conventions and Other Related Items

German Mutual AgreementProcedure ArbitrationAnnouncement

Announcement 2008–39

Following is a copy of the announce-ment posted by the LMSB Deputy Com-missioner (International) on the InternalRevenue Service LMSB Website on April3, 2008.1

Announcement Concerning MutualAgreement Procedure Arbitrationunder the Recent Protocol Between

the United States and Germany

Background

On December 28, 2007, the ProtocolAmending the Convention Between theUnited States and the Federal Republicof Germany for the Avoidance of Dou-ble Taxation and the Prevention of FiscalEvasion With Respect to Taxes on Incomeand Capital and to Certain Other Taxes(the 2006 Protocol) entered into force.The 2006 Protocol modified certain pro-visions of the Convention between theUnited States and the Federal Republicof Germany for the Avoidance of Dou-ble Taxation and the Prevention of FiscalEvasion With Respect to Taxes on In-come and Capital and to Certain OtherTaxes (the Convention). Among otherthings, the 2006 Protocol revises Article25 (Mutual Agreement Procedure) of theConvention to provide for mandatory ar-bitration of certain cases in the mutualagreement procedure (MAP). The com-petent authorities of the United Statesand Germany are jointly developing pro-cedures for implementing the arbitrationprocess. Information regarding the rele-vant procedures will be incorporated intoa mutual agreement at a future date. ThisAnnouncement provides interim guidanceconcerning the “commencement date” forMAP cases for purposes of the arbitration

process until a formal mutual agreementis published.

Commencement date

New paragraph 6(c)(aa) of Article 25of the Convention provides that arbitra-tion proceedings generally shall begin twoyears after the commencement date of aMAP case. Under paragraph 4 of ArticleXVII of the 2006 Protocol, the commence-ment date for a MAP case that was alreadyunder consideration by the competent au-thorities as of December 28, 2007, shall beDecember 28, 2007.

For requests for competent authority as-sistance received on or after December 28,2007, new paragraph 6(b) of Article 25of the Convention provides that the com-mencement date of such a MAP case is theearliest date on which the information nec-essary to undertake substantive considera-tion for a mutual agreement has been re-ceived by both competent authorities. Forpurposes of a competent authority requestin the United States, the information nec-essary to undertake substantive consider-ation for a mutual agreement is the infor-mation required to be submitted to the U.S.competent authority under Revenue Proce-dure 2006–54, Section 4.05. For purposesof a competent authority request in Ger-many, the information necessary to under-take substantive consideration for a mu-tual agreement is the information requiredto be submitted to the German competentauthority under Memorandum IV B 6 – B1300- 340/06. See paragraph 22(p) of Ar-ticle XVI of the 2006 Protocol.

The competent authorities of the UnitedStates and Germany agree that, within 45days after receipt of a request for compe-tent authority assistance, each competentauthority shall determine whether the tax-payer’s request provides information nec-essary to undertake substantive considera-tion. The agreement will also provide that,if the necessary information has been pro-vided, then the relevant competent author-ity will advise the taxpayer and the other

competent authority that the informationsubmitted with the taxpayer’s request issufficient to undertake substantive consid-eration of the request.

If the necessary information is notprovided, the relevant competent author-ity will inform the taxpayer and othercompetent authority of what additionalinformation is needed. After the relevantcompetent authority has determined thatit has the necessary information it will in-form the taxpayer and the other competentauthority of its determination.

The agreement will also provide that thecompetent authorities shall inform taxpay-ers in writing of the commencement dateconsistent with new paragraph 6(b) of Ar-ticle 25 of the Convention.

A case initially submitted to the compe-tent authorities as a request for an AdvancePricing Agreement (APA) is eligible for ar-bitration, but only to the extent tax returnshave been filed with respect to all taxableyears at issue. For purposes of establishinga commencement date for cases initiallysubmitted as a request for an APA, para-graph 22(p)(aa) of Article XVI of the 2006Protocol provides that the information nec-essary to undertake substantive considera-tion for a mutual agreement is the informa-tion required to be submitted to the Inter-nal Revenue Service under Revenue Pro-cedure 2006–9, section 4 (or any applica-ble successor provisions). The competentauthorities agree that they will modify thisrule pursuant to paragraph 22(q) of Arti-cle XVI of the 2006 Protocol to take intoaccount the procedures related to process-ing APA requests. Such agreement willindicate that the commencement date forcases initially submitted as a request foran APA shall be the earlier of, the datethe countries exchange position papers, ortwo years from the date the taxpayer sub-mits the information required by RevenueProcedure 2006–9, section 4. The compe-tent authorities shall inform the taxpayersin writing of the commencement date.

1 http://www.irs.gov/businesses/international/article/0,,id=181003,00.html

May 5, 2008 867 2008–18 I.R.B.

Part III. Administrative, Procedural, and MiscellaneousSupplemental GuidanceUnder the PreparerPenalty Provisions of theSmall Business and WorkOpportunity Tax Act of 2007

Notice 2008–46

This notice provides guidance regard-ing implementation of the tax return pre-parer penalty provisions under section6694 of the Internal Revenue Code, asamended by the Small Business and WorkOpportunity Tax Act of 2007, Pub. L.No. 110–28, 121 Stat. 190, by adding cer-tain returns and documents supplementingExhibits 1, 2, and 3 of Notice 2008–13,2008–3 I.R.B. 282.

A. Returns and Claims for Refund Subjectto 6694 Penalty

Notice 2008–13 describes categories ofreturns and other documents to which sec-tion 6694 could apply. Notice 2008–13provides that, solely for purposes of sec-tion 6694, a return or claim for refund in-cludes the tax returns listed in Exhibit 1 ora claim for refund with respect to any suchreturn. The notice further provides that a

person who for compensation prepares allor a substantial portion of any of the taxreturns listed on Exhibit 1 is a tax returnpreparer who is subject to section 6694.

Notice 2008–13 also provides thatsolely for purposes of section 6694, aninformation return or document listed onExhibit 2 that includes information that isor may be reported on a taxpayer’s tax re-turn or claim for refund is a return to whichsection 6694 could apply if the informationreported constitutes a substantial portionof that taxpayer’s tax return or claim forrefund. A person who for compensationprepares any of the information returnsor documents listed on Exhibit 2, whichreturn or document does not report a taxliability but affects an entry or entries ona tax return and constitutes a substantialportion of the tax return or claim for re-fund that does report a tax liability, is a taxreturn preparer who is subject to section6694.

Notice 2008–13 also provides thatsolely for purposes of section 6694, a doc-ument listed on Exhibit 3 that includesinformation that is or may be reported ona taxpayer’s tax return or claim for refund(and that constitutes a substantial portionof such tax return or claim for refund) will

not subject the preparer to a penalty undersection 6694(a). A document listed on Ex-hibit 3, however, may subject the preparerto a willful or reckless conduct penaltyunder section 6694(b) if the informationreported on the document constitutes asubstantial portion of the tax return orclaim for refund and is prepared willfullyin any manner to understate the liability oftax on a tax return or claim for refund, orin reckless or intentional disregard of rulesor regulations. A person who for compen-sation prepares all or a substantial portionof any of the documents listed on Exhibit3 is not a tax return preparer subject tosection 6694(a) unless the document wasprepared willfully in any manner to un-derstate the liability of tax on a tax returnor claim for refund or in reckless or inten-tional disregard of rules or regulations.

Notice 2008–13 also provides that theTreasury Department and the Internal Rev-enue Service may add or remove forms ordocuments from any of the categories orexhibits to Notice 2008–13 in future guid-ance. Accordingly, the following returnsand documents are added to Exhibits 1, 2,and 3 of Notice 2008–13:

Exhibit 1 — Tax Returns Reporting Tax Liability

(1) Form 1040–C, U.S. Departing Alien Income Tax Return;

(2) Form 1040NR, U.S. Nonresident Alien Income Tax Return;

(3) Form 1040NR–EZ, U.S. Income Tax Return for Certain Nonresident Aliens With No Dependents;

(4) Form 1041–N, U.S. Income Tax Return for Electing Alaska Native Settlement Trusts;

(5) Form 1041–QFT, U.S. Income Tax Return for Qualified Funeral Trusts;

(6) Form 1120–FSC, U.S. Income Tax Return of a Foreign Sales Corporation;

(7) Form 1120–H, U.S. Income Tax Return for Homeowners Associations;

(8) Form 1120–L, U.S. Life Insurance Company Income Tax Return;

(9) Form 1120–ND, Return for Nuclear Decommissioning Funds and Certain Related Persons;

(10) Form 1120–PC, U.S. Property and Casualty Insurance Company Income Tax Return;

(11) Form 1120–POL, U.S. Income Tax Return for Certain Political Organizations;

(12) Form 1120–REIT, U.S. Income Tax Return for Real Estate Investment Trusts;

(13) Form 1120–RIC, U.S. Income Tax Return for Regulated Investment Companies;

(14) Form 1120–SF, U.S. Income Tax Return for Settlement Funds (Under Section 468B);

(15) Form 1040–SS, U.S. Self-Employment Tax Return (Incuding the Additional Child Tax Credit for Bona Fide Residents ofPuerto Rico);

2008–18 I.R.B. 868 May 5, 2008

(16) Form 2438, Undistributed Capital Gains Tax Return;

(17) Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests;

(18) Form 8752, Required Payment or Refund Under Section 7519; and

(19) Form 8804, Annual Return for Partnership Withholding Tax (Section 1446).

Exhibit 2 — Information Returns That Report Information That is or May be Reported on Another Tax Return ThatMay Subject a Tax Return Preparer to the Section 6694(a) Penalty if the Information Reported Constitutes a SubstantialPortion of the Other Tax Return

(1) Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts;

(2) Form 3520–A, Annual Information Return of Foreign Trust With a U.S. Owner (Under section 6048(b));

(3) Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations;

(4) Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S.Trade or Business (Under Sections 6038A and 6038C of the Internal Revenue Code);

(5) Form 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax;

(6) Form 8858, Information Return of U.S. Persons With Respect To Foreign Disregarded Entities; and

(7) Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships.

Exhibit 3 — Forms That Would Not Subject a Tax Return Preparer to the Section 6694(a) Penalty Unless PreparedWillfully in any Manner to Understate the Liability of Tax on a Return or Claim for Refund or in Reckless or IntentionalDisregard of Rules or Regulations

(1) Form 8288–A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests; and

(2) Form 8288–B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests.

EFFECTIVE DATE

This notice is effective as of April 16,2008.

EFFECT ON OTHER DOCUMENTS

Notice 2008–13, 2008–3 I.R.B. 282, issupplemented.

CONTACT INFORMATION

The principal authors of this notice areMatthew S. Cooper and Michael E. Haraof the Office of Associate Chief Coun-sel (Procedure and Administration). Forfurther information regarding this notice,contact Mr. Cooper at (202) 622–4940 orMr. Hara at (202) 622–4910 (not toll-freecalls).

Public Comment Invitedon Recommendations for2008–2009 Guidance PriorityList

Notice 2008–47

The Department of Treasury and Inter-nal Revenue Service invite public com-ment on recommendations for items thatshould be included on the 2008–2009Guidance Priority List.

The Treasury Department’s Office ofTax Policy and the Service use the Guid-ance Priority List each year to identifyand prioritize the tax issues that shouldbe addressed through regulations, revenuerulings, revenue procedures, notices, andother published administrative guidance.The 2008–2009 Guidance Priority Listwill establish the guidance that the Trea-sury Department and the Service intend toissue from July 1, 2008, through June 30,2009. The Treasury Department and theService recognize the importance of pub-lic input to formulate a Guidance PriorityList that focuses resources on guidance

items that are most important to taxpayersand tax administration. Published guid-ance plays an important role in increasingvoluntary compliance by helping to clarifyambiguous areas of the tax law.

As is the case whenever significantlegislation is enacted, the Treasury De-partment and the Service have continuedto dedicate substantial resources duringthe current plan year to published guid-ance projects necessary to implement theprovisions of the American Jobs CreationAct of 2004, Pub. L. No. 108–357, 118Stat. 1418, which was enacted on Oc-tober 22, 2004; the Energy Policy Actof 2005, Pub. L. No. 109–58, 119 Stat.594, which was enacted on August 8,2005; the Gulf Opportunity Zone Act of2005, Pub. L. No. 109–135, 119 Stat.2577, which was enacted on December21, 2005; the Tax Increase Preventionand Reconciliation Act of 2005, Pub. L.No. 109–222, 120 Stat. 345, which wasenacted on May 17, 2006; the PensionProtection Act of 2006, Pub. L. No.109–280, 120 Stat. 780, which wasenacted on August 17, 2006; the Tax Relief

May 5, 2008 869 2008–18 I.R.B.

and Health Care Act of 2006, Pub. L.No. 109–432, 120 Stat. 2921, whichwas enacted on December 20, 2006; theMortgage Forgiveness Debt Relief Act of2007, Pub. L. No. 110–142, 121 Stat.1803, which was enacted on December20, 2007; and the Economic StimulusAct of 2008, Pub. L. No. 110–185, 122Stat. 613, which was enacted on February13, 2008. The Treasury Department andthe Service will continue to evaluate thepriority of each guidance project in lightof the above-mentioned tax legislation andother developments occurring during the2008–2009 plan year.

In reviewing recommendations andselecting projects for inclusion on the2008–2009 Guidance Priority List, theTreasury Department and the Service willconsider the following:

1. Whether the recommended guidanceresolves significant issues relevant tomany taxpayers;

2. Whether the guidance may be appro-priate for enhanced public involve-ment through the process described inNotice 2007–17, 2007–12 I.R.B. 748;

3. Whether the recommended guidancepromotes sound tax administration;

4. Whether the recommended guidancecan be drafted in a manner that willenable taxpayers to easily understandand apply the guidance;

5. Whether the Service can administerthe recommended guidance on a uni-form basis; and

6. Whether the recommended guidancereduces controversy and lessens theburden on taxpayers or the Service.

Taxpayers may submit recommenda-tions for guidance at any time during theyear. Please submit recommendations byMay 31, 2008, for possible inclusion onthe original 2008–2009 Guidance Prior-ity List. The Treasury Department andthe Service plan to update the 2008–2009Guidance Priority List periodically to re-flect additional guidance that the TreasuryDepartment and the Service intend to pub-lish during the plan year. The periodicupdates allow the Treasury Departmentand the Service to respond to the need foradditional guidance that may arise duringthe plan year. Recommendations for guid-ance received after May 31, 2008, will bereviewed for inclusion in the next periodicupdate.

Taxpayers are not required to submitrecommendations for guidance in any par-ticular format. Taxpayers should, how-ever, briefly describe the recommendedguidance and explain the need for the guid-ance. In addition, taxpayers may includean analysis of how the issue should be re-solved. It would be helpful if taxpayerssuggesting more than one guidance projectprioritize the projects by order of impor-tance. If a large number of projects are be-ing suggested, it also would be helpful ifthe projects were grouped in terms of high,medium or low priority.

Taxpayers should send written com-ments to:

Internal Revenue ServiceAttn: CC:PA:LPD:PR

(Notice 2008–47)Room 5203P.O. Box 7604Ben Franklin StationWashington, D.C. 20044

or hand deliver comments Mondaythrough Friday between the hours of8 a.m. and 4 p.m. to:

Courier’s DeskInternal Revenue ServiceAttn: CC:PA:LPD:PR

(Notice 2008–47)1111 Constitution Avenue, N.W.Washington, D.C. 20224

Alternatively, taxpayers may sub-mit comments electronically viae-mail to the following address:[email protected] should include “Notice2008–47” in the subject line. Allcomments will be available for publicinspection and copying in their entirety.

For further information regarding thisnotice, contact Henry Schneiderman ofthe Office of Associate Chief Counsel(Procedure and Administration) at (202)622–3400 (not a toll-free call).

2008–18 I.R.B. 870 May 5, 2008

Part IV. Items of General InterestNotice of ProposedRulemaking, a Noticeof Public Hearing, andWithdrawal of PreviouslyProposed Regulations

Guidance RegardingDeduction and Capitalizationof Expenditures Related toTangible Property

REG–168745–03


ACTION: Notice of proposed rulemaking,a notice of public hearing, and withdrawalof previously proposed regulations.

SUMMARY: This document containsproposed regulations that explain howsection 263(a) of the Internal RevenueCode (Code) applies to amounts paid toacquire, produce, or improve tangibleproperty. The proposed regulations clarifyand expand the standards in the currentregulations under section 263(a), as wellas provide some bright-line tests (for ex-ample, a de minimis rule for acquisitions).The proposed regulations will affect alltaxpayers that acquire, produce, or im-prove tangible property. This documentalso provides a notice of public hearing onthe proposed regulations and withdrawsthe proposed regulations published in theFederal Register on August 21, 2006(71 FR 161).

DATES: Written or electronic commentsmust be received by June 9, 2008. Out-lines of topics to be discussed at the pub-lic hearing scheduled for June 24, 2008, at10 a.m., must be received by June 3, 2008.

ADDRESSES: Send submissions to:CC:PA:LPD:PR (REG–168745–03), room5203, Internal Revenue Service, PO Box7604, Ben Franklin Station, Washington,DC 20044. Submissions may be hand-de-livered Monday through Friday betweenthe hours of 8:00 a.m. and 4:00 p.m.to CC:PA:LPD:PR (REG–168745–03),Courier’s Desk, Internal Revenue Ser-vice, 1111 Constitution Avenue, NW,

Washington, DC 20224, or sent elec-tronically, via the Federal eRulemak-ing Portal at www.regulations.gov (IRSREG–168745–03). The public hearingwill be held in the auditorium of the Inter-nal Revenue Building, 1111 ConstitutionAvenue, NW, Washington, DC.

FOR FURTHER INFORMATIONCONTACT: Concerning the proposedregulations, Merrill D. Feldstein orMon L. Lam, (202) 622–4950; concerningsubmission of comments, the hearing,and/or to be placed on the buildingaccess list to attend the hearing,[email protected].


Background

On August 21, 2006, the IRS and Trea-sury Department published in the FederalRegister (71 FR 161) proposed amend-ments to the regulations under section263(a) (2006 proposed regulations) relat-ing to amounts paid to acquire, produce,or improve tangible property. The IRSand Treasury Department received numer-ous written comments. A public hearingwas held on December 19, 2006. Afterconsidering the comment letters and thestatements at the public hearing, the IRSand Treasury Department are withdrawingthe 2006 proposed regulations and areproposing new regulations.

Summary of Comments andExplanation of Provisions

I. Overview

These new proposed regulations in-clude many of the provisions contained inthe 2006 proposed regulations, includingthe proposed format changes in which§1.263(a)–1 provides general rules forcapital expenditures, §1.263(a)–2 providesrules for amounts paid for the acquisitionor production of tangible property, and§1.263(a)–3 provides rules for amountspaid for the improvement of tangibleproperty. However, these new proposedregulations provide many additional rulesthat were not included in the 2006 pro-posed regulations. For example, these newproposed regulations provide a definition

of materials and supplies under §1.162–3(including a special 12-month rule anda $100 de minimis rule), a book confor-mity de minimis rule for acquisitions ofunits of property under §1.263(a)–2, asafe harbor for routine maintenance under§1.263(a)–3, and an optional simplifiedmethod for regulated taxpayers under§1.263(a)–3. Additionally, these newproposed regulations provide significantchanges to the rules relating to unit ofproperty and restorations, and allow forindustry-specific repair allowance meth-ods in future Internal Revenue Bulletinguidance. These new proposed regula-tions generally will apply to taxable yearsbeginning on or after the date that finalregulations are published in the FederalRegister.

II. Withdrawal and Re-Proposal ofRegulations

In addition to providing specific com-ments, many commentators suggestedthat, given the broad scope and effect ofthe regulations and the numerous com-ments received on the 2006 proposedregulations, consideration should be givento re-proposing the regulations in theirentirety. This suggestion has been adoptedand the 2006 proposed regulations arewithdrawn and replaced with these newproposed regulations.

III. Materials and Supplies under§1.162–3

Various commentators thought that the2006 proposed regulations failed to fullyaddress the relationship between the rulesfor capitalization of tangible property un-der section 263(a) and the materials andsupplies rules provided in §1.162–3 of thecurrent regulations because the 2006 pro-posed regulations did not provide specialrules for the interaction between the twoprovisions. Specifically, commentatorsnoted that under the 2006 proposed reg-ulations, tangible property with a usefullife of 12 months or less was not treatedas a material and supply, which treatmentwas inconsistent with existing authorities,particularly with regard to the timing ofwhen to deduct amounts paid to acquirethe property with a useful life of 12 months

May 5, 2008 871 2008–18 I.R.B.

or less. Commentators pointed out thatthe 2006 proposed regulations were incon-sistent with §1.162–3 and would createuncertainty with regard to which provisionshould be applied to which property. Inresponse, the IRS and Treasury Depart-ment decided to revise §§1.162–3 and1.263(a)–2 to provide clear and consistenttreatment for those items that traditionallyhave been considered to be materials andsupplies and to provide distinct, but co-ordinated, treatment for those items thatshould be addressed under section 263(a).

The new proposed regulations provideadditional guidance under §1.162–3 withrespect to the definition of materials andsupplies. Specifically, the proposed rulesdefine a material and supply as tangibleproperty that (a) is not a unit of property,(b) is a unit of property with an economicuseful life of 12 months or less, (c) is a unitof property that costs $100 or less, or (d) isidentified as a material and supply in futureguidance.

Under the existing regulations, thecosts of non-incidental materials and sup-plies are deducted as the materials andsupplies are used or consumed, and thecosts of incidental materials and suppliesare deducted as the costs are incurred.These new proposed regulations retainthis treatment of materials and supplies,except with respect to rotable and tem-porary spare parts. These new proposedregulations provide that rotable or tem-porary spare parts treated as materialsand supplies will be considered used orconsumed in the taxable year in whichthe taxpayer disposes of the parts. Thisrule prevents taxpayers from prematurelydeducting the cost of a unit of property bysystematically replacing components withrotable spare parts. The IRS and TreasuryDepartment anticipate that taxpayers withrotable or temporary spare parts that arenot discarded after their original use gen-erally will prefer to capitalize their costsand treat those parts as depreciable assets.These new proposed regulations providefor an election to capitalize these costs.

Taxpayers should recognize that theused or consumed standard for non-in-cidental materials and supplies generallyis met later than the placed in servicestandard used for depreciation. In addi-tion, taxpayers are reminded that after amaterial or supply is used or consumed,

capitalization of the material or supplycost to another property may be required.For example, amounts paid for materialsand supplies used in the production ofinventory or a self-constructed asset gen-erally are required to be capitalized undersection 263A. Similarly, amounts paid toproduce materials and supplies generallyare required to be capitalized as part ofthe production costs of the materials andsupplies. Nothing in these new proposedregulations is intended to change this treat-ment.

First, these new proposed regulationsprovide that property that is not a unit ofproperty as defined in §1.263(a)–3 will beconsidered a material and supply. In gen-eral, this definition is intended to describespare and replacement parts and is con-sistent with the current characterization ofthese items.

Second, these new proposed regula-tions provide that property that has aneconomic useful life of 12 months or lesswill be considered a material and supply.Commentators requested clarification con-cerning the application of the 12-monthrule provided in the 2006 proposed reg-ulations. For purposes of applying the12-month rule, these new proposed reg-ulations generally adopt the economicuseful life definition in §1.167(a)–1(b)and provide that, for purposes of thesenew proposed materials and suppliesregulations, the measurement period foreconomic useful life begins when the itemis first used or consumed in the taxpayer’strade or business. Therefore, the timeprior to when an item is used or consumedis not taken into consideration in deter-mining the economic useful life of theasset for purposes of these new proposedregulations, notwithstanding the fact thatthe item may have been placed in service(ready and available for its intended use)for depreciation.

In addition, these new proposed reg-ulations provide a special economic use-ful life test under the 12-month rule fortaxpayers with applicable financial state-ments (AFS). Under this rule, taxpayerswith AFS are required to determine theeconomic useful life in a manner consis-tent with the economic useful life usedfor purposes of determining deprecia-tion in the books and records supportingtheir AFS. An exception is provided if a

taxpayer does not assign a useful life tocertain property in its AFS (for example,the item is currently expensed in the tax-payer’s AFS because it is considered deminimis).

The 2006 proposed regulations did notprovide a de minimis rule for the acqui-sition or production of property but re-quested comments on whether a de min-imis rule should be adopted. Commenta-tors generally agreed that the regulationsshould include a de minimis rule but var-ied on how that rule should be structured.

Third, these new proposed regulationsprovide a $100 de minimis rule within thedefinition of materials and supplies. Mate-rials and supplies include a unit of propertythat has a production or acquisition cost of$100 or less, without regard to the treat-ment of the item in the taxpayer’s financialstatements. Allowing small items to betreated as materials and supplies resolvesuncertainty with respect to whether thoseitems represent a depreciable asset or a ma-terial and supply, and $100 is a low enoughthreshold to alleviate concerns about thepotential distortion of income. However,treating a small unit of property as a ma-terial and supply may affect the timing ofthe deduction for the material and supplycost because expensing an amount paid fora non-incidental material and supply willonly occur in the period in which the itemis used or consumed.

Various commentators pointed out thattaxpayer burden may be reduced by al-lowing taxpayers to capitalize amountspaid for items that otherwise would qual-ify as materials and supplies and treatthe items as depreciable assets. For ex-ample, many taxpayers currently treatrotable spare parts as capital expendituresdepreciable over the life of the unit ofproperty in which the rotables are used.See Rev. Rul. 69–200, 1969–1 C.B. 60.See §601.601(d)(2)(ii)(b).

Under these new proposed regulations,taxpayers may elect to treat an amount paidfor a material and supply as a capital ex-penditure. In general, the election is madeseparately for each material and supplyand is revocable only with the consent ofthe Commissioner. The election is madeby capitalizing the cost of the material andsupply in the year the cost is incurred andbeginning depreciation of the item in theyear it is placed in service.

2008–18 I.R.B. 872 May 5, 2008

IV. Repairs under §1.162–4

The 2006 proposed regulations revised§1.162–4 (the repair rules), to providerules consistent with the improvementrules under §1.263(a)–3 of the 2006 pro-posed regulations. Commentators ex-pressed concern that the proposed changeswould result in challenges to the de-ductibility of costs that the IRS has longagreed with taxpayers are deductible. TheIRS and Treasury Department do not thinkthat the proposed change to §1.162–4 cre-ates a burden of proof higher than thatwhich exists under current law or requirescapitalization of costs that are not requiredto be capitalized under current law. There-fore, these new proposed regulations donot propose any specific changes to therules proposed in the 2006 proposed reg-ulations. However, a routine maintenancesafe harbor is provided in these new pro-posed regulations in §1.263(a)–3.

V. Professional Expenses under §1.162–6

The existing regulations under§1.162–6 provide rules for professionalexpenses. These new proposed regula-tions propose to remove §1.162–6. Ingeneral, the treatment of the items listed in§1.162–6 is adequately addressed in thesenew proposed regulations and other exist-ing regulations. The proposed removal of§1.162–6 is not intended to result in anysubstantive changes in the treatment ofprofessional expenses.

VI. Capital Expenditures

A. Amounts Paid to Sell Property

The 2006 proposed regulations pro-vided rules for the capitalization of sellingexpenses, except in the case of dealers,under §1.263(a)–1. The 2006 proposedregulations included an example that re-quired the capitalization of advertisingcosts as a selling expense that must beoffset against the sale proceeds. Variouscommentators questioned this treatmentof advertising costs. In general, adver-tising costs are not capital expenditures.Therefore, these new proposed regulationsretain the general rule but remove the ref-erences to advertising costs provided inthe 2006 proposed regulations and updatethe examples accordingly.

B. Interests in Land

The 2006 proposed regulations did notprovide a specific capitalization rule foramounts paid to acquire or create intangi-ble interests in land. The 2006 proposedregulations specifically requested com-ments on this issue, but no commentswere received. These new proposed reg-ulations provide that amounts paid toacquire or create interests in land, such aseasements, life estates, mineral interests,timber rights, zoning variances, or otherinterests in land, are examples of capitalexpenditures. Comments are specificallyrequested on this proposed rule.

VII. Amounts Paid to Acquire or ProduceTangible Property

The 2006 proposed regulations pro-vided rules for the capitalization ofamounts paid to acquire or produce tan-gible property under §1.263(a)–2. Thesenew proposed regulations generally retainthe same format, but make some modifica-tions to the 2006 proposed regulations. Forexample, modifications have been madeto clarify the interaction of §1.263(a)–2of these new proposed regulations withthe materials and supplies rules under§1.162–3. Significant modifications andclarifications are discussed further in thispreamble.

A. Definition of Produce

Commentators asked whether the term“produce” as used in the 2006 proposedregulations had the same meaning as theterm “produce” under section 263A. Thesenew proposed regulations clarify that thedefinition of the term produce for purposesof §1.162–3 and §1.263(a)–2 generally isthe same as the definition of the term pro-duce for section 263A purposes. The soledifference is that the term “improve” isnot included in §1.162–3 and §1.263(a)–2because “improve” under section 263Ais specifically defined in §1.263(a)–3 ofthese new proposed regulations, relatingto the improvement of tangible property.

B. Transaction Costs

The 2006 proposed regulations gen-erally required a taxpayer to capitalizeamounts paid to facilitate the acquisitionof real or personal property, and included

a list of typical transaction costs. Com-mentators suggested that with respect tothe rules requiring the capitalization offacilitative transaction costs, an excep-tion should be provided for transactioncosts for pre-decisional investigatorycosts, similar to the exception providedwith respect to certain intangibles in§1.263(a)–4(e)(1)(iii) (creation of certaincontract rights) and §1.263(a)–5(e) (acqui-sition of a trade or business). These newproposed regulations provide a generalrule similar to the rules in the intangiblesregulations requiring that taxpayers capi-talize all costs that facilitate an acquisitionof tangible property, including the costsof investigating the acquisition, but adoptthe commentators’ suggestion in part byproviding an exception for certain costs in-curred in the investigation of real propertyacquisitions. The IRS and Treasury De-partment think it is appropriate to providean exception for real property acquisitionsbecause these types of transactions mostoften raise the issue of whether the in-vestigatory costs are deductible businessexpansion costs rather than capital expen-ditures to acquire a specific asset. Theexception provides that costs relating toactivities performed in the process of de-termining whether to acquire real propertyand which real property to acquire gen-erally are deductible pre-decisional costs.Under this exception, capitalization willnot be required for certain pre-decisionalinvestigative activities, such as marketingstudies, that are not specifically identifiedin these regulations as being inherently fa-cilitative. These new proposed regulationsprovide that inherently facilitative costsmust be capitalized and list the costs, suchas transportation and shipping costs, thatare inherently facilitative.

A commentator pointed out that sec-tion 263A does not apply to acquisitionsof property that are not intended for re-sale, and thus, taxpayers should not be re-quired to capitalize overhead costs to thistype of property. These new proposed reg-ulations address this comment by provid-ing a simplifying convention for employeecompensation and overhead costs similarto the rules provided for intangible prop-erty. However, the new proposed regula-tions reiterate that section 263A does applyto the production of real or personal prop-erty. Section 263A contains rules for cer-tain costs incurred prior to production.

May 5, 2008 873 2008–18 I.R.B.

Under current law, if a taxpayer en-gages in multiple separate and distincttransactions, the taxpayer may allocatetransaction costs to the separate trans-actions and recover the allocable trans-action costs as each distinct transactionis abandoned. Sibley, Lindsay & CurrCo. v. Commissioner, 15 T.C. 106,110 (1950), acq., 1951–1 C.B. 3. See§601.601(d)(2)(ii)(b). However, if thetransactions are viewed as alternatives,only one of which the taxpayer can com-plete, the courts have held that the tax-payer must capitalize all the transactioncosts to the one transaction ultimatelycompleted. United Dairy Farmers, Inc.v. United States, 267 F.3d 510 (6th Cir.2001); Nicolazzi v. Commissioner, 79 T.C.109 (1982), aff’d, 722 F.2d 324 (6th Cir.1983). To avoid the difficulty inherentin administering this rule, including as-certaining the intent of the taxpayer, thenew proposed regulations provide a moreobjective rule. This rule allows taxpay-ers to allocate inherently facilitative costsamong the separate and distinct propertiesconsidered, regardless of the taxpayer’sultimate intent or plan. The taxpayer cap-italizes the allocable transaction costs toeach property, including properties notacquired, and recovers the costs as ap-propriate under the applicable provisionof the Code (for example, section 165,167, or 168). Examples are provided todemonstrate the application of these rules.

In addition, a commentator noted thatthe rule contained in the 2006 proposedregulations with respect to costs incurredprior to placing property in service is reallya rule for acquisition costs, not improve-ment costs. The IRS and Treasury Depart-ment agree that activities occurring prior toplacing the property in service are concep-tually more related to the acquisition of theproperty than to the improvement of prop-erty. Therefore, these new proposed reg-ulations move to the acquisition cost sec-tion of these regulations the requirementto capitalize amounts paid for work per-formed prior to placing property in service.

C. De Minimis Rule

The 2006 proposed regulations did notprovide a specific de minimis rule for theacquisition or production of property, butthe preamble provided a detailed proposalof what might be an appropriate de min-

imis rule and requested comments fromtaxpayers on this issue. Numerous com-ments supported the adoption of a de min-imis rule to the extent such a proposalwould not alter the current understandingsbetween taxpayers and examining agentswith respect to what type of transactionsare considered de minimis on examinationfor purposes of evaluating risk. Therefore,to reduce burden and provide simplifica-tion, these new proposed regulations pro-vide a de minimis rule. With respect to theconcerns raised by commentators as to theadoption of a de minimis rule, the IRS andTreasury Department want to make clearthat the adoption of such a rule is not in-tended to alter the general risk analysiscurrently employed by examining agents.Therefore, the de minimis rule proposedin these regulations should not affect anycurrent understandings between examin-ing agents and taxpayers with respect tothe size and character of transactions thatwill be the focus of examinations.

The proposed de minimis rule is basedprimarily on a qualifying taxpayer’s finan-cial statement standards. A qualifying tax-payer is a taxpayer that: (a) has an AFS,(b) has written accounting procedures forthe expensing of de minimis items, and (c)recognizes de minimis costs as expenseson its AFS. Under the rule provided inthese new proposed regulations, a qualify-ing taxpayer can use the de minimis stan-dard adopted in its AFS to the extent theAFS de minimis standard does not result ina distortion of income. Although commen-tators varied regarding whether it is appro-priate to require conformity with AFS toqualify for a de minimis rule, the IRS andTreasury Department think that it providessimplification and reduces burden only toallow deductions for de minimis amountspaid for property (other than the $100 rulefor materials and supplies) that are alreadybeing deducted for AFS purposes.

The primary concern with the adoptionof a de minimis rule is that expensing itemsunder a de minimis rule may not clearlyreflect income under section 446, partic-ularly for aggregate or bulk purchases ofde minimis items. In general, the IRSand Treasury Department recognize thataccounting for an item using generallyaccepted accounting principles will notresult in a distortion of income. Nonethe-less, a distortion of income standard hasbeen adopted in an effort to avoid inten-

tional manipulations of the de minimisrule. These new proposed regulations pro-vide a safe harbor in which the use of anAFS de minimis standard will be deemednot to distort income. Specifically, thesafe harbor provides that an amount de-ducted under the AFS de minimis rule forthe taxable year will be deemed not todistort income if that amount, added to theamounts deducted in the taxable year asmaterials and supplies for units of propertycosting $100 or less, is less than or equalto the lesser of (i) 0.1 percent of the tax-payer’s gross receipts for the taxable year,or (ii) 2 percent of the taxpayer’s total de-preciation and amortization for the taxableyear as determined in its AFS. The safeharbor provided in these new proposedregulations is based upon percentages andcomparisons provided in case law. SeeAlacare Home Health Services, Inc. v.Commissioner, T.C. Memo. 2001–149;Cincinnati, New Orleans & Tex. Pac. Ry.Co. v. United States, 424 F.2d 563 (Ct. Cl.1970). This safe harbor is not intended tobe used in other contexts as a bright-linerule of an amount that distorts income.Whether amounts above the safe harborresult in a distortion of income dependsupon the taxpayer’s facts and circum-stances.

These new proposed regulations alsoprovide that gain on the sale or disposi-tion of property accounted for under the deminimis rule is not treated as gain resultingfrom the sale or disposition of a capital as-set under section 1221 or as property usedin the trade or business under section 1231.These new proposed regulations also clar-ify that property accounted for under thede minimis rule is not a material or supplyunder §1.162–3.

Moreover, these new proposed regula-tions provide that taxpayers may elect tocapitalize items that might otherwise bewithin the scope of the de minimis rule. Ingeneral, this election to capitalize is madeseparately for each asset by treating theamount paid as a capital expenditure on thetax return.

These new proposed regulations alsomake a conforming change to the regu-lations under section 263A to ensure thatamounts paid for property produced by thetaxpayer also qualify under the de minimisrule, because there is no basis for distin-guishing between acquired and producedproperty for this purpose. This change

2008–18 I.R.B. 874 May 5, 2008

is provided in §1.263A–1(b)(14) of thesenew proposed regulations. The rule pro-vides that the cost of property to whicha taxpayer properly applies the de min-imis rule contained in §1.263(a)–2(d)(4) ofthese new proposed regulations (includingthe requirement that it not distort income)is not required to be capitalized under sec-tion 263A as a separate unit of property,but may be required to be capitalized as acost incurred by reason of the productionof other property. This change is neces-sary because without a conforming changeto section 263A, property produced by thetaxpayer that qualified under the de min-imis rule would be capitalized under sec-tion 263A despite the de minimis rule un-der section 263(a).

These new proposed regulations donot impose any specific record keepingrequirements for the use of the de min-imis rule. However, under section 6001,taxpayers are required to keep booksand records sufficient to establish theireligibility to use the de minimis rule.Specifically, taxpayers must maintainbooks and records reasonably sufficientto determine (1) the total amounts paidand deducted as materials and suppliespursuant to §1.162–3(d)(1)(iii) of thesenew proposed regulations; (2) the totalamounts paid and not capitalized pursuantto §1.263(a)–2(d)(4)(i) of these new pro-posed regulations; (3) the computationof the safe harbor amount provided by§1.263(a)–2(d)(4)(iii) of these new pro-posed regulations; (4) that income hasnot been distorted by the aggregate ofthe deductions under §§1.162–3(d)(1)(iii)and 1.263(a)–2(d)(4)(i) of these newproposed regulations if the aggre-gate amount exceeds the safe har-bor amount determined pursuant to§1.263(a)–2(d)(4)(iii) of these new pro-posed regulations; and (5) that the require-ments of §1.263(a)–2(d)(4)(i)(A)–(C) ofthese new proposed regulations have beenmet.

VIII. Improvements

In general, these proposed regula-tions are intended to reduce controversyand provide clarity on how to determinewhether an amount paid must be capital-ized under section 263(a) as an improve-ment cost. Consistent with that intent, the2006 proposed regulations contained rules

with respect to improvements, includingrules to determine whether an amount paidresults in a material increase in value orprolonged useful life. As described below,these regulations modify the rules set forthin the 2006 proposed regulations to reflectcomments received. While these pro-posed regulations attempt to provide morecertainty in an area of law that currentlyrequires a subjective analysis, the IRS andTreasury Department request commentson whether the improvement rules in theseregulations are consistent with the overrid-ing goal of providing clarity and certaintyin this area.

The IRS and Treasury Department re-ceived numerous comments regarding theimprovement rules provided in the 2006proposed regulations. Many of the com-ments received included a general requestthat consideration be given to providingmore bright-line rules and clarifying def-initions as well as providing greater con-sistency with other provisions of the Code.The rules contained in these new proposedregulations attempt to address these con-cerns.

Section 1.263(a)–3 of the 2006 pro-posed regulations provided that taxpayersare required to capitalize amounts paidto improve a unit of property. Under thegeneral rule in the 2006 proposed regula-tions, a unit of property is improved if theamounts paid (i) materially increase thevalue of the unit of property; or (ii) restorethe unit of property. Under the 2006 pro-posed regulations, amounts paid to adapta unit of property to a new or differentuse were considered to materially increasethe value of a unit of property. The 2006proposed regulations also contained rulesfor determining the appropriate unit ofproperty.

These new proposed regulations re-move the new or different use standardfrom the material increase in value rulesand provide a separate category for newor different use. Additionally, the materialincrease in value standard has been re-named the “betterment” standard becausethe betterment standard more closely re-flects the manner in which section 263(a)has been interpreted and applied undercurrent law. Therefore, these new pro-posed regulations identify three categoriesof costs that result in an improvement toproperty. Taxpayers under the new pro-

posed regulations must capitalize amountspaid that:

(i) Result in a betterment to a unit ofproperty;

(ii) Restore a unit of property; or(iii) Adapt a unit of property to a new or

different use.These new proposed regulations continueto include rules for defining the unit ofproperty to be used in making these deter-minations.

The 2006 proposed regulations did notprescribe a plan of rehabilitation doctrineas traditionally described in the case law.That judicially-created doctrine providesthat a taxpayer must capitalize otherwisedeductible repair costs if they are incurredas part of a general plan of rehabilitationto the property. See Norwest Corp. v.Commissioner, 108 T.C. 265 (1997); Mossv. Commissioner, 831 F.2d 833 (9th Cir.1987); United States v. Wehrli, 400 F.2d686 (10th Cir. 1968). Commentators re-quested that the regulations specificallystate that the plan of rehabilitation doctrineeither is eradicated or is limited to clearlydefined circumstances.

Section 263A requires that all directcosts of an improvement and all indirectcosts that directly benefit or are incurredby reason of the improvement must becapitalized. See section 263A(b)(1),which states that section 263A applies toreal or tangible property produced by thetaxpayer, and section 263A(g)(1), whichstates that the definition of “produce” in-cludes improve. See also §1.263A–1(e),which requires the capitalization of directcosts and of all indirect costs that directlybenefit or are incurred by reason of theperformance of production activities. Sec-tion 263A, therefore, requires a taxpayerto capitalize otherwise deductible repaircosts as part of an improvement if the tax-payer improves a unit of property and theotherwise deductible repair costs directlybenefit or are incurred by reason of the im-provement to the property. Thus, section263A has eliminated the need for a planof rehabilitation doctrine to determine theallocable costs that must be capitalized aspart of an improvement. Although somecommentators requested that the circum-stances in which otherwise deductiblerepair costs must be capitalized as part ofan improvement be limited, for example,to property that is totally dysfunctionaland unsuitable for its intended purpose,

May 5, 2008 875 2008–18 I.R.B.

there is no authority for doing so becausesection 263A specifically applies to im-provements. The legislative history tothe Tax Reform Act of 1986, P.L. 99–514(100 Stat. 2085) also indicates that Con-gress intended section 263A to apply toimprovements to property. See, for exam-ple, S. Rep. No. 99–313, 99th Cong., 2dSess. 133–152 (1986), which states thatthe uniform capitalization rules will applyto assets or improvements to assets con-structed by a taxpayer for its own use in atrade or business or in an activity engagedin for profit, and that the rules are notintended to apply to expenditures properlytreated as repair costs under present lawthat do not relate to the manufacture, re-manufacture, or production of property.

Section 263A does not require other-wise deductible repair costs to be capital-ized if the repairs do not directly benefit orare not incurred by reason of a productionactivity (for example, an improvement).The judicially-created plan of rehabili-tation doctrine, however, has been citedto require capitalization of otherwise de-ductible repair costs solely because thetaxpayer has a plan (written or otherwise)to perform periodic repairs or mainte-nance, or solely because the taxpayerperforms several repairs to the same prop-erty at one time even though the propertyis not improved. As stated in the preambleto the 2006 proposed regulations, the IRSand Treasury Department do not think thischaracterization is appropriate. These newproposed regulations specifically providethat repairs that are made at the same timeas an improvement, but that do not directlybenefit or are not incurred by reason ofthe improvement, are not required to becapitalized under section 263(a). Thesenew proposed regulations do not prescribea plan of rehabilitation doctrine. There-fore, when these new proposed regulationsare finalized, the judicially-created planof rehabilitation doctrine will be obsolete,particularly with regard to the assertionthat the doctrine transforms otherwisedeductible repair costs into capital im-provement costs solely because the repairsare performed at the same time as animprovement, or are pursuant to a mainte-nance plan, even though the repairs do notimprove the property under §1.263(a)–3.However, section 263A continues to re-quire a taxpayer to capitalize otherwisedeductible repair costs if the taxpayer im-

proves a unit of property and the otherwisedeductible repair costs directly benefit orare incurred by reason of the improvementto the property.

A. Unit of Property

The 2006 proposed regulations beganwith an initial unit of property determina-tion of all components that are function-ally interdependent to define the largestunit of property as a starting point for theanalysis. Special rules applied to build-ings and their structural components andto property used in certain regulated indus-tries. Network assets were excluded fromthe definition of unit of property. The unitof property determination for other per-sonal property employed a facts and cir-cumstances test based on the applicationof four exclusive factors—(1) marketplacetreatment; (2) industry practice and finan-cial accounting; (3) treatment as a rotablespare part; and (4) functional use. An over-riding rule required taxpayers to treat prop-erty as a unit of property for purposes ofsection 263 if the taxpayer did so for anyother Federal income tax purpose.

The IRS and Treasury Departmentreceived multiple comments on the defini-tion of a unit of property provided in the2006 proposed regulations. The commen-tators generally expressed dissatisfactionwith the unit of property rules providedin the 2006 proposed regulations, particu-larly with respect to the regulated industryrules and the rule for rotable spare parts.Commentators generally agreed with theunit of property rules for a building, butraised objections that the remaining rulesprovided in the 2006 proposed regulationswere overly complex and ambiguous.Many commentators recommended thatthe determination of a unit of propertybe based primarily on the functional in-terdependence test, similar to that usedfor depreciation and section 263A pur-poses, with no further factors, while othercommentators recommended that the de-termination be based on the factors usedin FedEx Corp. v. United States, 291F. Supp. 2d 699 (W.D. Tenn. 2003), aff’d,412 F.3d 617 (6th Cir. 2005).

The IRS and Treasury Departmentthink that most of the factors listed in the2006 proposed regulations were the sameas the factors used in FedEx. However,commentators generally criticized the

manner in which the 2006 proposed regu-lations applied these factors. Nonetheless,the IRS and Treasury Department agreethat some factors, such as the rotable spareparts factor, may be overly burdensome,particularly for taxpayers that use smallcomponents in their businesses. Addition-ally, although some taxpayers in regulatedindustries favored the ability to conformto regulatory reporting, many that are notsubject to regulatory accounting for allassets objected to the conformity rule asinappropriate and a potential source foruncertainty and controversy. Therefore,these new proposed regulations substan-tially modify the unit of property definitioncontained in the 2006 proposed regula-tions.

These new proposed regulations pro-vide unit of property rules that generallyare based on the functional interdepen-dence standard, and include special rulesfor buildings, plant property, and networkassets. Additional rules are provided thatmay require a smaller unit of propertycharacterization in certain circumstances.Generally, improvements to a unit of prop-erty are not considered separate units ofproperty even though the improvementsare treated as separate assets for deprecia-tion purposes.

These new proposed regulations gener-ally provide the same rule for buildings asthe 2006 proposed regulations. A buildingand its structural components are treated asa single unit of property. However, a spe-cial rule for condominiums and coopera-tives is provided. Additionally, a leaseholdimprovement that is section 1250 propertyand is made by a lessee is a separate unitof property.

For property other than a building, thesenew proposed regulations provide that, ingeneral, a single unit of property includesall components that are functionally inter-dependent. However, a number of spe-cial rules are provided that may require asmaller unit of property to be considered.The IRS and Treasury Department do notthink that applying solely a functional in-terdependence test results in the appropri-ate unit for all types of property. For sometypes of property, such as machinery andequipment in a manufacturing plant, thefunctional interdependence test often re-sults in a very expansive unit of property.The IRS and Treasury Department thinkit is inappropriate to use such a large unit

2008–18 I.R.B. 876 May 5, 2008

of property for making a determination re-garding improvements.

These new proposed regulations pro-vide a special rule for plant property, whichis defined as “functionally interdependentmachinery or equipment . . . used to per-form an industrial process . . . .” Thisdefinition is not intended to include alltypes of property used in a taxpayer’s tradeor business, but is intended only to cap-ture the functionally interdependent ma-chinery and equipment used in industrialprocesses like manufacturing, electric gen-eration, distribution, warehousing, as wellas equipment used in providing industrialservices such as automated materials han-dling equipment. This special rule requiresthat the functionally interdependent ma-chinery and equipment be separated into acomponent or a group of components thatperforms a discrete and major function oroperation. These new proposed regula-tions provide various examples to illustrateactivities that will constitute a discrete andmajor function.

These new proposed regulations pro-vide the same definition of network assetsas the 2006 proposed regulations and con-tinue to reserve on providing a special rulefor networks assets. The IRS and Trea-sury Department think that in many sit-uations, the unit of property for networkassets should be smaller than the unit ofproperty determined under the functionalinterdependence test. The IRS and Trea-sury Department generally think that theunit of property rules for network assetsshould be addressed on an industry by in-dustry basis in Internal Revenue Bulletinguidance. Industries are invited to submitrequests for guidance under the IndustryIssue Resolution (IIR) program after theseregulations are finalized.

These new proposed regulations alsoprovide two additional rules that mayrequire a smaller unit of property deter-mination than that provided under thegeneral rule. The first rule is triggered ifthe taxpayer has assigned different eco-nomic useful lives for financial statementor regulatory purposes to components ofa single unit of property at the time theunit of property is placed in service by thetaxpayer. Simply accounting for compo-nents separately (for example, recordingthe property separately in depreciation orother asset-tracking books and records)does not trigger this rule. However, as-

signing a different economic useful life tocomponents will require that the unit ofproperty determination be limited to thosecomponents that have been assigned thesame useful life for financial statementpurposes. The second rule applies whencomponents of a single unit of property aredepreciated by the taxpayer under differ-ent MACRS classes (including a differentMACRS class that results from a changein method of accounting). This secondrule also applies if components of a singleunit of property are depreciated by thetaxpayer using different recovery methods(for example, double-declining balanceversus unit-of-production). Again, simplyrecording various components separatelyin the taxpayer’s depreciation books andrecords will not trigger the rule.

These rules are intended to preventoverly broad unit of property determi-nations that are inconsistent with thetaxpayer’s characterization of the unit ofproperty for depreciation purposes. Ingeneral, the IRS and Treasury Departmentanticipate that these limiting rules willapply only in unique circumstances. TheIRS and Treasury Department encouragetaxpayers to provide comments on theapplication of these limiting rules and toidentify situations (if any) in which thelimiting rules may not operate as intended.

B. Routine Maintenance Safe Harbor

The 2006 proposed regulations did notcontain a routine maintenance safe harbor.Various commentators requested that theregulations provide guidance to clarifywhen the cost of a routine maintenanceactivity will be considered a deductibleexpense. In addition, commentators ex-pressed concern that under the rules pro-vided in the 2006 proposed regulations,routine maintenance activities are requiredto be capitalized if performed near the endof the economic useful life of the property,regardless that identical activities wereconsidered deductible if performed earlierin the useful life.

To address this concern, these new pro-posed regulations provide a routine main-tenance safe harbor under which qualify-ing activities will be deemed to not im-prove the unit of property. Under this safeharbor, routine maintenance activities in-clude recurring activities that a taxpayerexpects to perform more than once over the

class life of the unit of property as a resultof the taxpayer’s use of the unit of propertyto keep the unit of property in its ordinar-ily efficient operating condition. Amountspaid for betterments do not keep the unitof property in an ordinarily efficient oper-ating condition; however, the replacementof minor parts with improved but compara-ble parts generally does not result in a bet-terment. Thus, for example, the safe har-bor includes amounts paid for replacementparts that the taxpayer expects to replacemore than once during the class life of theunit of property, even if the replacementpart is an improved but comparable part.As part of the safe harbor provisions, thesenew proposed regulations provide a list ofrelevant considerations to be taken into ac-count in determining whether an amountis paid for routine maintenance. Theseconsiderations include the recurring natureof the activity, industry practice, manufac-turer recommendations, taxpayer experi-ence and the treatment of the activity onthe taxpayer’s AFS. The safe harbor main-tenance rule specifically applies to main-tenance activities performed on rotable ortemporary spare parts, but reminds tax-payers that under the rules proposed in§1.162–3(b) of these new proposed regula-tions, the capitalized costs associated withrotable and temporary spare parts (that is,acquisition costs) may be deducted onlyin the taxable year in which the rotable ortemporary spare part is discarded.

One concern with establishing a main-tenance safe harbor that includes the costsof replacement parts is creating an incen-tive for taxpayers to componentize assetsin an effort to recover basis upon the re-moval of a component while deducting thereplacement cost as a repair or mainte-nance expense. Therefore, the safe harbordoes not apply to the cost of replacementcomponents in situations in which the tax-payer has taken into account the basis ofthe component being replaced in determin-ing gain or loss resulting from a sale orexchange of the replacement component,has taken a loss related to the retirementof the component, or has taken a basis ad-justment related to a casualty event undersection 165.

The safe harbor is intended to operateonly as a safe harbor in which qualify-ing costs will be deemed not to consti-tute an improvement. The IRS and Trea-sury Department recognize that many ac-

May 5, 2008 877 2008–18 I.R.B.

tivities that do not qualify for the safe har-bor nonetheless may be activities that donot give rise to capitalization of costs un-der section 263(a). Additionally, costs de-ductible under the maintenance safe har-bor may be required to be capitalized undersection 263A to other property produced oracquired for resale.

C. Betterments

1. Overview

The 2006 proposed regulations usedthe term “material increase in value” togenerally describe the concept of a better-ment. In general, commentators agreedwith the standards outlined in the 2006proposed regulations to determine whetheran amount paid materially increases thevalue of property. However, commenta-tors differed on whether taxpayers shouldbe allowed to override the material in-crease in value test by proving that theactivity did not actually increase fair mar-ket value. Consistent with the preambleto the 2006 proposed regulations, theIRS and Treasury Department continue tothink that whether an amount paid shouldbe capitalized as a betterment to a unitof property depends upon the purpose,the physical nature, and the effect of thework for which the amounts were paid,and not upon an analysis of the fair marketvalue of the property before and after thework. Therefore, to clarify this distinction,these new proposed regulations change thename of the material increase in value testto the betterment test. The general rulefocuses on betterments to the condition ofthe property, the costs of which should becapitalized as an improvement if the bet-terment is material, regardless of whetherthe betterment increases the fair marketvalue.

Commentators noted that the generalconcept of a betterment is difficult to applyand suggested that the language in the reg-ulations better define what types of eventswould give rise to a betterment. Addition-ally, commentators pointed out that someof the betterment tests were redundant.The IRS and Treasury Department agreethat the general concept of a bettermentor improvement can be difficult to apply.In developing these new proposed regula-tions, consideration was given to retainingthe rules provided in the current regula-

tions without providing clarification ofmaterial increase in value, prolong usefullife, and new or different use. The prin-cipal concern in providing detailed ruleson the concept of an improvement is thepotential to create controversy in areaswhere none currently exists, which wouldundermine one of the primary purposes ofthe project.

Nonetheless, because commentatorsgenerally did not oppose the tests pro-vided for material increase in value underthe 2006 proposed regulations, these newproposed regulations continue to providean exclusive list of tests that determinewhether an amount paid results in a bet-terment in an attempt to further solicitcomments in this area. The IRS andTreasury Department specifically requestcomments as to whether the exclusive listof tests with respect to improvements pro-vides additional certainty in this area andif not, why. Given the continuing eval-uation of this area, taxpayers should beparticularly aware that no reliance shouldbe placed on the rules provided in thesenew proposed regulations until such rulesare finalized.

The tests included in the original pro-posed regulations have been reorganized inthese new proposed regulations in an at-tempt to provide additional clarification.Under these new proposed regulations, anamount paid results in a betterment if it:

(i) Ameliorates a material condition ormaterial defect that existed prior to the ac-quisition or arose during the production ofthe property,

(ii) Results in a material addition to theunit of property (including a physical en-largement, expansion, or extension), or

(iii) Results in a material increase in thecapacity, productivity, efficiency, strength,or quality of the unit of property or its out-put.

2. Ameliorates a Material Condition orDefect

This rule generally follows the rule con-tained in the 2006 proposed regulationsbut clarifies, in response to comments re-ceived, that capitalization is only requiredto the extent the condition or defect is con-sidered material. Commentators noted thata taxpayer may not know of a condition ordefect that exists at the time property is ac-quired and that requiring capitalization of

costs in this situation would create a hard-ship for those taxpayers. Although taxpay-ers may not be aware of defects that existat the time of acquisition, the remedial ac-tivity being performed necessarily resultsin a betterment, regardless of whether theactivity actually increases the fair marketvalue of the property. The rule providedin these proposed regulations is consis-tent with established case law. See UnitedDairy Farmers, Inc. v. United States, 267F.3d 510 (6th Cir. 2001); Dominion Re-sources, Inc. v. United States, 219 F.3d359 (4th Cir. 2000).

Moreover, adopting a rule based on ataxpayer’s knowledge at the time of acqui-sition or production would be difficult toadminister. The IRS and Treasury Depart-ment recognize that application of this ruleto used property acquired by a taxpayerwill result in some costs that would oth-erwise be deductible as repair costs beingcapitalized the first time the repairs are per-formed (if the condition or defect is ma-terial) if the nature of the activities is tocorrect the effects of wear and tear thatwas not caused by the taxpayer’s use ofthe property. This result is consistent withthe routine maintenance safe harbor, whichrequires the activities under that safe har-bor to be performed as a result of the tax-payer’s own use of the property.

The IRS and Treasury Department un-derstand that certain cases exist in whicha taxpayer contaminates property duringits operations, the taxpayer disposes of theproperty, and the taxpayer reacquires theproperty to clean up the contamination.Under the proposed rule, a taxpayer wouldbe required to capitalize the costs incurredto clean up the property even though it wasthe taxpayer’s own activities that contam-inated the property. The IRS and TreasuryDepartment request comments regardingthe appropriate treatment of environmentalremediation costs in these circumstances,considering that the remediation is per-formed as a result of the taxpayer’s ownuse of the property. The IRS and Trea-sury Department also request commentsregarding how to determine whether thecontamination was due solely to the tax-payer’s prior operations or, if an interimowner may have added to the contami-nation, how to determine the appropriatetreatment of remediation costs in that cir-cumstance.

2008–18 I.R.B. 878 May 5, 2008

3. Results in a Material Increase in theCapacity, etc.

This rule applies both to materialincreases in the capacity, efficiency,strength, or quality of the unit of propertyitself as well as to material increases in thecapacity, efficiency, strength, or quality ofthe output of the unit of property.

4. Application of Betterments Rule

Commentators requested that, to the ex-tent possible, additional guidance be pro-vided with respect to how the bettermentsrules, including materiality, should be ap-plied. The IRS and Treasury Departmentconsidered various possible bright-linerules with respect to materiality, but de-termined that each rule was inappropriateunder certain circumstances. For example,the IRS and Treasury Department con-sidered a rule that presumed materialityif the amounts paid are capitalized in thetaxpayer’s financial statements as a perma-nent improvement, that is, the bettermentis capitalized in the taxpayer’s financialstatements over the remaining economicuseful life of the unit of property or longer.The IRS and Treasury Department thinkthat financial statement treatment is an im-portant factor in determining materiality,because if the activity is material enoughto treat as an improvement for financialstatements, then generally it should be amaterial improvement for tax purposes.However, this bright-line rule was notadopted because the IRS and TreasuryDepartment recognize that the standardsused for financial statement purposes forcapitalization of improvements do not co-incide with the rules for capitalization ofimprovements in these proposed regula-tions. For example, some taxpayers maydefer major maintenance expenses andamortize the expenses over the period untilthe next maintenance cycle rather than im-mediately expensing the costs for financialstatement purposes. The taxpayer’s reasonfor not immediately expensing the costfor financial statement purposes (that is,treating the cost as a deferred expense oras a material capital expenditure) may notbe readily apparent to the IRS, creating ad-ministrative burden and a potential sourceof controversy. Therefore, under thesenew proposed regulations, materiality willbe based upon the facts and circumstances

in each case. Examples are provided toillustrate to the application of materiality.

5. Appropriate Comparison forBetterments

The 2006 proposed regulations specif-ically provided that the appropriatecomparison for determining whether anamount paid results in a betterment is madeby comparing the condition of the unitof property immediately after the expen-diture with the condition of the propertyprior to the circumstances necessitatingthe expenditure. These new proposed reg-ulations retain the same comparison test.

D. Restorations

1. Overview

The 2006 proposed regulations pro-vided that, consistent with section263(a)(2), a taxpayer must capitalizeamounts paid that restore a unit of prop-erty. The 2006 proposed regulationsprovided that amounts paid restore a unitof property only if they substantially pro-long the economic useful life of the unitof property, and provided four rules formaking that determination. The restora-tion of property rules contained in the2006 proposed regulations were criticizedby commentators as being overbroad anddifficult to apply. In particular, the AFSdefinition of economic useful life and thebright-line one-year rule were denouncedas providing inappropriate results. In re-sponse, these new proposed regulationsmake numerous modifications to the 2006proposed regulations.

These new proposed regulations con-tinue to require a taxpayer to capitalizeamounts paid to restore a unit of property.However, the one-year rule and the AFSconformity requirement for economic use-ful life have been removed. These newproposed regulations provide a series ofbright-line rules to determine when anamount paid is deemed to restore property.Although some commentators criticizedrules that deem the cost of certain activ-ities to be capitalized as restorations, theIRS and Treasury Department think thatbright lines under this test will reducecontroversy and help ease administration.These rules also expand on the rules pro-vided in the 2006 proposed regulations

with regard to the restoration of propertyafter a casualty loss.

Section 263(a)(2) states that no deduc-tion is allowed for any amount paid inrestoring property or in making good theexhaustion thereof for which an allowanceis or has been made. The IRS and Trea-sury Department think that this languagerequires capitalization of a replacementcomponent if the taxpayer removes thebasis of the replaced component from itsbooks and records and takes the basis ofthe replaced component into account in itstax return. If a taxpayer takes into accountthe basis of a replaced component in itstax return, then the replacement of thatcomponent “makes good the exhaustionthereof for which an allowance has beenmade.” Therefore, these new proposedregulations provide that if the taxpayer hasproperly taken a portion of the existingadjusted basis of the restored asset into ac-count in the computation of gain or loss ona sale or exchange, or as a retirement lossor other loss under the Code, the replace-ment of that component will be deemed torestore the unit of property.

2. Restoration of Property Destroyed in aCasualty

The 2006 proposed regulations requireda taxpayer to capitalize amounts paid to re-pair property if the taxpayer properly de-ducted a casualty loss under section 165with respect to a unit of property and theamounts paid restore the unit of propertyto a condition that is the same or betterthan before the casualty. The casualty lossrule provided in the 2006 proposed reg-ulations was criticized. In general, com-mentators thought there should be no linkbetween the recognition of a casualty lossunder section 165 and the determinationof whether the cost to replace the prop-erty destroyed (in part or in whole) aftera casualty event constitutes a capital ex-penditure. However, significant authorityimplies that a casualty-type event gener-ally may only be characterized either as anextraordinary event (thus giving rise to a“loss” under section 165), or as an ordi-nary and necessary event in the operationof a trade or business (thus giving rise toan ordinary and necessary deduction un-der section 162). See, e.g., R. R. Hensler,Inc. v. Commissioner, 73 T.C. 168, 179(1979), acq., (1980–2 C.B. 1); Hubinger

May 5, 2008 879 2008–18 I.R.B.

v. Commissioner, 36 F.2d 724, 726 (2dCir. 1929), cert. denied, 281 U.S. 741(1930). Thus, a casualty is not an ordinaryevent, and the cost to repair property dam-aged by a casualty is not an ordinary ex-pense. Stated differently, a loss under sec-tion 165 represents a destruction of prop-erty necessitating a replacement, which iscapital, while an ordinary event generallyrepresents damage to property necessitat-ing a repair, which may or may not be cap-ital. Because the restoration cost resultingfrom a loss is not ordinary, it is not allowedas an ordinary and necessary expense un-der section 162, but is treated as a capi-tal expenditure under section 263(a). Al-though it is clear that a casualty event gen-erally results in two economic costs to thetaxpayer (the destruction of the previouslyinvested capital and the costs to replace thedestruction), the event giving rise to bothof these costs is the same.

These new proposed regulations gen-erally require consistent characterizationof all costs arising from a single event.Therefore, under the rules provided inthese new proposed regulations, a tax-payer that experiences an extraordinaryloss event sufficiently destructive to in-voke the provisions of section 165 will berequired to treat the resulting restorationcosts as a capitalized replacement of thedestroyed property. This rule is requiredto ensure consistency in tax treatmentamong similarly situated taxpayers. Forexample, a taxpayer whose property iscompletely destroyed by a casualty eventis required to capitalize the restoration ofthe loss because the restoration results inthe replacement of the destroyed prop-erty with an entirely new unit of property.However, without a consistency rule, ataxpayer who experiences the same casu-alty event but only has part of a unit ofproperty destroyed might argue that thecost to replace the destroyed portion ofthe unit of property is deductible becauseit simply returns the unit of property asa whole to its pre-casualty state. Allow-ing this type of disparity in tax treatmentwould provide an incentive to characterizedestructions of property as partial destruc-tions in order to leave open the positionthat a deduction may be taken for boththe destruction of property resulting fromthe casualty event, as well as the ordinaryand necessary expense of replacing the de-stroyed property. This rule also eliminates

the dual characterization of minor costsincurred for items such as broken windowsor blown-off shingles as both a casualtyloss under section 165 and an ordinary andnecessary expense under section 162.

Commentators noted that a rule requir-ing the capitalization of restoration costsfollowing the recognition of a casualtyloss would unfairly burden taxpayers thatroutinely experience extraordinary lossevents in their trade or business. However,it should be noted that under these newproposed regulations, capitalization is re-quired only if a loss or basis adjustment tothe property is recognized by the taxpayerwith respect to the event.

Various judicial authorities have heldthat events that generally are viewed as ex-traordinary loss events may nonetheless beconsidered ordinary occurrences in a par-ticular industry. See Atlantic GreyhoundCorp. v. United States, 111 F. Supp. 953(Ct. Cl. 1953). In this situation, thecosts to replace property destroyed in whatwould normally be characterized as a ca-sualty event may result in an ordinary andnecessary expenditure under section 162rather than a loss under section 165. In thisregard, the IRS and Treasury Departmentwill consider providing guidance on whattypes of events may be considered ordi-nary in a particular industry. Taxpayers areencouraged to provide comments on thisissue.

Commentators also noted that the ruleprovided in the 2006 proposed regulationscreated a disparity between taxpayers thatrecognized a loss under section 165 andtaxpayers that received untaxed insuranceproceeds as a result of a casualty eventand adjusted the basis of the damaged assetaccordingly. These new proposed regula-tions eliminate this disparity.

3. Other Restorations

Similar to the 2006 proposed regula-tions, these new proposed regulations pro-vide additional circumstances in which arestoration is deemed to occur. Capitaliza-tion is required for amounts paid to returna unit of property to its ordinarily efficientoperating condition if the property has de-teriorated to a state of disrepair and can nolonger function for its intended purpose.The IRS and Treasury Department antic-ipate that these types of restorations willoccur either as a result of lack of mainte-

nance by the taxpayer or after the end ofthe property’s useful life. A unit of prop-erty that is damaged by a casualty is notconsidered to be deteriorated to a state ofdisrepair.

These new proposed regulations alsorequire capitalization of amounts paid torebuild a unit of property to a like-newcondition after the end of its economic use-ful life. The IRS and Treasury Departmentanticipate that this standard will apply tothe traditional rebuilding of a unit of prop-erty to return it to a like-new condition. Ingeneral, a restoration under this rule willnot result from routine maintenance activ-ities, even if performed near the end of theuseful life of the property, but instead rep-resents a fundamental renewal of the eco-nomic useful life of the asset.

Similar to the 2006 proposed regula-tions, the new proposed regulations requirecapitalization of amounts paid to replace amajor component or substantial structuralpart of a unit of property. In response tocomments regarding the uncertainty in ap-plying this standard, these new proposedregulations define the term “major compo-nent or substantial structural part.” Specif-ically, these new proposed regulations pro-vide that the replacement of a major com-ponent or substantial structural part will bedeemed to occur only if (a) the replace-ment costs constitute 50 percent or moreof the replacement cost of the unit of prop-erty or (b) the replacement part or partsconstitute 50 percent or more of the physi-cal structure of the unit of property. These50 percent thresholds apply solely for pur-poses of the restoration rules and are notintended to be applied to the betterment ornew or different use rules.

E. New or Different Use

In general, these new proposed regu-lations contain the rules set forth in the2006 proposed regulations with respectto the capitalization of amounts paid toadapt property to a new or different use.However, these new proposed regula-tions remove the parenthetical containedin the 2006 proposed regulations relat-ing to “structural alterations to the unitof property.” Commentators noted that,although permanent structural alterationsmay result in adapting property to a new ordifferent use, those alterations also couldresult in betterments to the unit of prop-

2008–18 I.R.B. 880 May 5, 2008

erty and, in certain circumstances, couldconstitute routine maintenance. Commen-tators also noted that adapting property toa new or different use does not necessarilymake the property better or increase itsvalue, but nevertheless is a capital expen-diture. Therefore, the new or differentuse rules are provided separately from thebetterment rules in these new proposedregulations.

These new proposed regulations alsoclarify that amounts paid will be deemedto adapt property to a new or different useonly if the new use is not consistent withthe taxpayer’s intended use of the propertyat the time the property is placed in serviceby the taxpayer. Additional examples havebeen added to clarify the application of thisrule.

F. Repair Allowance

The 2006 proposed regulations pro-vided a repair allowance similar to theCLADR repair allowance, but did notspecify different repair allowance percent-ages for different industries. Commenta-tors generally favored the idea of a repairallowance; however, they widely criti-cized the lack of percentages tailored tospecific industries. Some commentatorsin regulated industries requested that theybe allowed to determine their deductiblerepair costs and their capital improvementcosts for tax purposes based on conformitywith regulatory accounting reporting.

These new proposed regulations adoptthe request by certain regulated industriesto conform the tax treatment of amountspaid to maintain, repair, or improve tan-gible property to their regulatory account-ing treatment. An optional regulatory ac-counting method is proposed for amountspaid to maintain, repair, or improve tangi-ble property subject to regulatory account-ing. For purposes of this method, regu-lated accounting industries include indus-tries regulated by the Federal Energy Reg-ulatory Commission (FERC), the FederalCommunications Commission (FCC), andthe Surface Transportation Board (STB).The IRS and Treasury Department recog-nize that conformity with the regulatoryaccounting rules in these industries fre-quently may result in the overcapitaliza-tion of costs, and sometimes the undercap-italization of costs, as compared to the gen-eral rules for improvements under these

new proposed regulations. The regulatoryaccounting method is not intended to beused as a definitive test of what should becapitalized for taxpayers that do not electto use the method.

These new proposed regulations do notpropose a detailed repair allowance likethe one that was provided in the 2006 pro-posed regulations. Some commentatorsstated that very large taxpayers will wantto have a repair allowance, because apply-ing the general rules asset-by-asset is tooburdensome because of their numerous as-sets. The commentators made clear, how-ever, that taxpayers would not widely usea one-size-fits-all approach and that anyrepair allowance must be tailored to in-dividual industries. Therefore, these newproposed regulations provide authority forissuing industry-specific repair allowanceguidance in the future.

IX. Accounting Method Changes

These new proposed regulations do notprovide any specific rules for changes inmethod of accounting. Because these pro-posed regulations are not effective untilthey are published as final regulations,taxpayers may not change their account-ing method to conform to a method ofaccounting provided in these proposedregulations. Generally, a taxpayer’s treat-ment of an amount paid to conform withthese proposed regulations will be achange in method of accounting undersection 446(e). For example, a changeto the routine maintenance safe harborin §1.263(a)–3(e) of these proposed reg-ulations or to the optional regulatoryaccounting method in §1.263(a)–3(i) ofthese proposed regulations is a changein method of accounting. The IRS andTreasury Department request commentson whether a change to or from the use ofthe de minimis rule in §1.263(a)–2(d)(4)of these proposed regulations is a changein method of accounting under section446(e).

Proposed Effective Date

These regulations are proposed to ap-ply to taxable years beginning on or af-ter the date the final regulations are pub-lished in the Federal Register. The finalregulations will provide rules applicable totaxpayers that seek to change a method ofaccounting to comply with the rules con-

tained in the final regulations. Taxpay-ers may not change a method of account-ing in reliance upon the rules contained inthese new proposed regulations until therules are published as final regulations inthe Federal Register.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a significantregulatory action as defined in ExecutiveOrder 12866. Therefore, a regulatoryassessment is not required. It also hasbeen determined that section 553(b) of theAdministrative Procedure Act (5 U.S.C.chapter 5) does not apply to these regu-lations, and, because the regulation doesnot impose a collection of information onsmall entities, the Regulatory FlexibilityAct (5 U.S.C. chapter 6) does not apply.Pursuant to section 7805(f), this notice ofproposed rulemaking will be submittedto the Chief Counsel for Advocacy ofthe Small Business Administration forcomment on its impact on small business.

Comments and Public Hearing

Before the proposed regulations areadopted as final regulations, considerationwill be given to any written comments (asigned original and eight (8) copies) orelectronic comments that are submittedtimely to the IRS. Comments are requestedon all aspects of the proposed regulations.In addition, the IRS and Treasury Depart-ment specifically request comments onthe clarity of the proposed rules and howthey may be made easier to understand.All comments will be available for publicinspection and copying.

A public hearing has been scheduledfor June 24, 2008, at 10 a.m. in the Audi-torium, Internal Revenue Building, 1111Constitution Avenue, NW, Washington,DC. Due to building security procedures,visitors must enter at the Constitution Av-enue entrance. In addition, all visitorsmust present photo identification to enterthe building. Because of access restric-tions, visitors will not be admitted beyondthe immediate entrance area more than 30minutes before the hearing starts. For in-formation about having your name placedon the building access list to attend thehearing, see the “FOR FURTHER IN-FORMATION CONTACT” section of thispreamble.

May 5, 2008 881 2008–18 I.R.B.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments at the hearing mustsubmit electronic or written comments byJune 9, 2008 and an outline of the topicsto be discussed and the time to be devotedto each topic (signed original and eight (8)copies) by June 3, 2008. A period of 10minutes will be allotted to each person formaking comments. An agenda showingthe scheduling of the speakers will be pre-pared after the deadline for receiving out-lines has passed. Copies of the agenda willbe available free of charge at the hearing.


The principal author of these regula-tions is Merrill D. Feldstein, Office of theAssociate Chief Counsel (Income Tax andAccounting). However, other personnelfrom the IRS and Treasury Departmentparticipated in their development.

Withdrawal of Proposed Amendmentsto the Regulations

Accordingly, under the authority of 26U.S.C. 7805, the notice of proposed rule-making (REG–168745–03) published inthe Federal Register on August 21, 2006,(71 FR 161) is withdrawn.

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 1 is proposedto be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.162–3 is revised to

read as follows:

§1.162–3 Materials and supplies.

(a) In general—(1) Non-incidental ma-terials and supplies. Amounts paid to ac-quire or produce materials and supplies aredeductible in the taxable year in which thematerials and supplies are used or con-sumed in the taxpayer’s operations.

(2) Incidental materials and supplies.Amounts paid to acquire or produce inci-dental materials and supplies that are car-ried on hand and for which no record of

consumption is kept or physical invento-ries at the beginning and end of the yearare not taken, are deductible in the taxableyear in which these amounts are paid, pro-vided taxable income is clearly reflected.

(b) Rotable and temporary spare parts.For purposes of this section, rotable spareparts are parts that are removable fromthe unit of property, generally repaired orimproved, and either reinstalled on otherproperty, or stored for later installation.Temporary spare parts are parts that areused temporarily until a new or repairedpart can be installed, and then removed andstored for later (emergency or temporary)installation. For purposes of paragraph(a)(1) of this section, rotable and tempo-rary spare parts are used or consumed inthe taxpayer’s business in the taxable yearin which the taxpayer disposes of the parts.

(c) Coordination with other provisionsof the Internal Revenue Code. Nothing inthis section changes the treatment of anyamount that is specifically provided for un-der any provision of the Internal RevenueCode (Code) or regulations other than sec-tion 162(a) or section 212 and the regula-tions under those sections. For example,see §1.263(a)–3, which requires taxpayersto capitalize amounts paid to improve unitsof property and section 263A and the regu-lations under section 263A, which requiretaxpayers to capitalize the direct and al-locable indirect costs, including the costof materials and supplies, to property pro-duced or to property acquired for resale.

(d) Definitions—(1) Materials and sup-plies. For purposes of this section, materi-als and supplies means tangible propertythat is used or consumed in the taxpayer’soperations and that—

(i) Is not a unit of property (as deter-mined under §1.263(a)–3(d)(2)) and is notacquired as part of a single unit of prop-erty;

(ii) Is a unit of property (as determinedunder §1.263(a)–3(d)(2)) that has an eco-nomic useful life of 12 months or less, be-ginning when the property is used or con-sumed in the taxpayer’s operations;

(iii) Is a unit of property (as determinedunder §1.263(a)–3(d)(2)) that has an ac-quisition cost or production cost (as deter-mined under section 263A) of $100 or less;or

(iv) Is identified in published guid-ance in the Federal Register or inthe Internal Revenue Bulletin (see

§601.601(d)(2)(ii)(b) of this chapter) asmaterials and supplies for which treatmentis permitted under this section.

(2) Economic useful life—(i) Generalrule. The economic useful life of a unit ofproperty is not necessarily the useful lifeinherent in the property but is the periodover which the property may reasonably beexpected to be useful to the taxpayer or, ifthe taxpayer is engaged in a trade or busi-ness or an activity for the production of in-come, the period over which the propertymay reasonably be expected to be usefulto the taxpayer in its trade or business orfor the production of income, as applica-ble. See §1.167(a)–1(b) for the factors tobe considered in determining this period.

(ii) Taxpayers with an applicable finan-cial statement. For taxpayers with an ap-plicable financial statement (as defined inparagraph (d)(2)(iii) of this section), theeconomic useful life of a unit of property,solely for the purposes of applying the pro-visions of paragraph (d)(1)(ii) of this sec-tion, is the useful life initially used by thetaxpayer for purposes of determining de-preciation in its applicable financial state-ment, regardless of any salvage value ofthe property. If a taxpayer does not have anapplicable financial statement for the tax-able year in which the property was origi-nally acquired or produced, the economicuseful life of the unit of property mustbe determined under paragraph (d)(2)(i) ofthis section. Further, if a taxpayer treatsamounts paid for a unit of property as anexpense in its applicable financial state-ment on a basis other than the useful lifeof the property or if a taxpayer does not de-preciate the unit of property on its applica-ble financial statement, the economic use-ful life of the unit of property must be de-termined under paragraph (d)(2)(i) of thissection. For example, if a taxpayer has apolicy of treating as an expense on its ap-plicable financial statement amounts paidfor property costing less than a certain dol-lar amount, notwithstanding that the prop-erty has a useful life of more than oneyear, the economic useful life of the prop-erty must be determined under paragraph(d)(2)(i) of this section.

(iii) Definition of applicable finan-cial statement. The taxpayer’s applicablefinancial statement is the taxpayer’s fi-nancial statement listed in paragraphs(d)(2)(iii)(A) through (C) of this sectionthat has the highest priority (including

2008–18 I.R.B. 882 May 5, 2008

within paragraph (d)(2)(iii)(B) of this sec-tion). The financial statements are, indescending priority—

(A) A financial statement required tobe filed with the Securities and ExchangeCommission (SEC) (the 10-K or the An-nual Statement to Shareholders);

(B) A certified audited financial state-ment that is accompanied by the report ofan independent CPA (or in the case of aforeign entity, by the report of a similarlyqualified independent professional), that isused for—

(1) Credit purposes;(2) Reporting to shareholders, partners,

or similar persons; or(3) Any other substantial non-tax pur-

pose; or(C) A financial statement (other than

a tax return) required to be provided tothe Federal or a state government or anyFederal or state agencies (other than theSEC or the Internal Revenue Service).

(3) Amount paid. For purposes of thissection, in the case of a taxpayer usingan accrual method of accounting, theterms amount paid and payment mean aliability incurred (within the meaning of§1.446–1(c)(1)(ii)). A liability may notbe taken into account under this sectionprior to the taxable year during which theliability is incurred.

(4) Produce. For purposes of thissection, produce means construct, build,install, manufacture, develop, create, raiseor grow. See also §1.263(a)–2(b)(4).This definition is intended to have thesame meaning as the definition usedfor purposes of section 263A(g)(1) and§1.263A–2(a)(1)(i), except that improve-ments are excluded from the definition inthis paragraph (d)(4) and are separatelydefined and addressed in §1.263(a)–3.Amounts paid to produce materials andsupplies must be capitalized under section263A.

(e) Election to capitalize. A taxpayermay elect to treat as a capital expenditurethe cost of any material or supply as de-fined in paragraph (d)(1) of this section,unless the material or supply is a com-ponent of a unit of property as describedin paragraph (d)(1)(i) of this section, andthe unit of property is a material or sup-ply under paragraph (d)(1)(ii)–(iv) of thissection, rather than a capital expenditure.An election made under this paragraph (e)applies to amounts paid during the tax-

able year to acquire or produce any ma-terial or supply to which paragraph (a)of this section would apply (but for theelection under this paragraph (e)). A tax-payer makes the election by capitalizingthe amounts paid to acquire or produce amaterial or supply in the taxable year theamounts are paid and by recovering thecosts when the material or supply is placedin service by the taxpayer for the purposesof determining depreciation under the ap-plicable Code and regulation provisions.A taxpayer must make this election in itstimely filed original Federal income tax re-turn (including extensions) for the taxableyear the material or supply is placed in ser-vice by the taxpayer for purposes of deter-mining depreciation. See §1.263(a)–2 forthe treatment of amounts paid to acquire orproduce real or personal tangible property.In the case of a pass-through entity, theelection is made by the pass-through entity,and not by the shareholders, partners, etc.An election must be made for each mate-rial and/or supply. A taxpayer may revokean election made under this paragraph (e)with respect to a material or supply onlyby filing a request for a private letter rulingand obtaining the Commissioner’s consentto revoke the election. An election maynot be made or revoked through the filingof an application for change in accountingmethod or by an amended Federal incometax return. A taxpayer that revokes an elec-tion may not re-elect to capitalize the ma-terial or supply for a period of at least 60months, beginning with the taxable year ofrevocation.

(f) Examples. The rules of this sectionare illustrated by the following examples,in which it is assumed (unless otherwisestated) that the property is not an inciden-tal material or supply, that the taxpayer isa calendar year, accrual method taxpayer,and that the taxpayer has not elected tocapitalize under paragraph (e) of this sec-tion.

Example 1. Not a unit of property; componentof personal property. X operates a fleet of aircraft.In 2008, X purchases a stock of spare parts, whichit uses to maintain and repair its aircraft. The spareparts are not units of property as determined under§1.263(a)–3(d)(2) and are not rotable or temporaryspare parts. In 2009, X uses the spare parts in a repairand maintenance activity that does not improve theproperty under §1.263(a)–3. Under paragraph (a)(1)of this section, the amounts paid for the spare partsare deductible as materials and supplies in 2009, thetaxable year in which the spare parts are used to repairand maintain the aircraft.

Example 2. Not a unit of property; rotable spareparts. X operates a fleet of specialized vehicles thatit uses in its service business. At the time that it ac-quires a new type of vehicle, X also acquires a sub-stantial number of rotable spare parts that will be kepton hand to quickly replace similar parts in X’s vehi-cles as those parts break down or wear out. Theserotable replacement parts are not units of property asdetermined under §1.263(a)–3(d)(2), are removablefrom the vehicles, and are repaired or reconditioned,so that they can be reinstalled on the same or simi-lar vehicles. In 2008, X acquires several vehicles andassociated rotable spare parts. In 2009, X makes re-pairs to several vehicles by using these rotable spareparts to replace worn or damaged parts. In 2010, Xremoves these rotable spare parts from its vehicles,repairs them and reinstalls them on other similar ve-hicles. In 2012, X can no longer use the rotable partsit acquired in 2008 and disposes of them as scrap.Under paragraph (d)(1) of this section, the rotablespare parts acquired in 2008 are materials and sup-plies. However, under paragraph (b) of this section,these parts are not used or consumed until the taxableyear in which X disposes of the parts. Therefore, un-der paragraph (a)(1) of this section, X may deduct theamounts paid for the rotable spare parts in 2012, thetaxable year in which X disposes of the parts.

Example 3. Not a unit of property; part of a singleunit of real property. X owns an apartment buildingand discovers that a window in one of the apartmentsis broken. In 2008, X pays for the acquisition, de-livery, and installation of a new window to replacethe broken window. In the same year, the new win-dow is installed. The window is not a unit of propertyas determined under §1.263(a)–3(d)(2), and the re-placement of the window does not improve the prop-erty under §1.263(a)–3. Under paragraph (a)(1) ofthis section, the amounts paid for the acquisition, de-livery, and installation of the window are deductibleas materials and supplies in 2008, the taxable year inwhich the window is installed in the apartment build-ing.

Example 4. Economic useful life of 12 monthsor less. X operates a fleet of aircraft that carriesfreight for its customers. X owns a storage tank onits premises, which can hold a one-month supply ofjet fuel for its aircraft. On December 31, 2008, Xpurchases a one-month supply of jet fuel. In 2009, Xuses the jet fuel purchased on December 31, 2008, tofuel the aircraft used in its business. Under paragraph(a)(1) of this section, the amounts paid for the jet fuelare deductible as materials and supplies in 2009, thetaxable year in which the jet fuel is used or consumedin the operation of X’s aircraft.

Example 5. Unit of property that costs $100 orless. X operates a rental business that rents out a va-riety of small individual items to customers (rentalitems). X maintains a supply of rental items on handto replace worn or damaged items. In 2008, X pur-chases a large quantity of rental items to use in itsrental business. Each of these rental items is a unitof property that costs $100 or less. In 2009, X be-gins using all of the rental items purchased in 2008by providing them to customers of its rental business.X does not sell or exchange these items on establishedretail markets at any time after the items are used inthe rental business. Under paragraph (a)(1) of thissection, the amounts paid for the rental items are de-ductible as materials and supplies in 2009, the taxable

May 5, 2008 883 2008–18 I.R.B.

year in which the rental items are used in X’s busi-ness.

Example 6. Unit of property that costs $100 orless. X provides billing services to its customers. In2008, X incurs costs to purchase 50 facsimile ma-chines to be used by its employees. Each facsimilemachine is a unit of property that costs less than $100.In 2008, X’s employees begin using 35 of the facsim-ile machines, and X stores the remaining 15 machinesfor use in a later taxable year. Under paragraph (a)(1)of this section, the amounts paid for 35 of the fac-simile machines are deductible as materials and sup-plies in 2008, the taxable year in which X uses thosemachines. The amounts paid for each of the remain-ing 15 machines are deductible in the taxable year inwhich each machine is used.

Example 7. Materials and supplies used in im-provements; coordination with §1.263(a)–3. X ownsvarious machines that are used in its business. In2008, X purchases a supply of spare parts for its ma-chines. The spare parts are not units of property as de-termined under §1.263(a)–3(d)(2) and are not rotableor temporary spare parts. The spare parts may be usedby X in the repair or maintenance of a machine under§1.162–4 or in the improvement of a machine under§1.263(a)–3. In 2009, X uses all of these spare partsin an activity that improves the unit of property under§1.263(a)–3. Under paragraph (d)(1)(i) of this sec-tion, the spare parts purchased by X in 2008 are ma-terials and supplies. Under paragraph (a)(1) of thissection, the amounts paid for the spare parts are oth-erwise deductible as materials and supplies in 2009,the taxable year in which X uses those parts. How-ever, because these materials and supplies are used toimprove X’s property, X is required to capitalize theamounts paid for those spare parts under §1.263(a)–3.See also section 263A requiring taxpayers to capital-ize the direct and allocable indirect costs of propertyproduced or acquired for resale.

Example 8. Cost of producing materials and sup-plies; coordination with section 263A. X is a manu-facturer that produces liquid waste as part of its oper-ations. X determines that its current liquid waste dis-posal process is inadequate. To remedy the problem,in 2008, X constructs a leaching pit to provide a drain-ing area for the liquid waste. The leaching pit has aneconomic useful life of less than 12 months, startingon the date that X begins to use the leaching pit asa draining area. At the end of this period, X’s fac-tory will be connected to the local sewer system. In2009, X starts using the leaching pit in its operations.The amounts paid to construct the leaching pit (in-cluding the direct and allocable indirect costs of prop-erty produced under section 263A) are amounts paidfor a material or supply under paragraph (d)(1)(ii) ofthis section. Under paragraph (a)(1) of this section,the amounts paid for the leaching pit are otherwisedeductible as materials and supplies in 2009, the tax-able year in which X uses the leaching pit. However,because the amounts paid to construct the leachingpit are incurred by reason of X’s manufacturing oper-ations, X is required to capitalize the amounts paid toconstruct the leaching pit to X’s property produced.See §1.263A–1(e)(3)(ii)(E).

Example 9. Costs of acquiring materials and sup-plies for production of property; coordination withsection 263A. In 2008, X purchases jigs, dies, molds,and patterns for use in the manufacture of X’s prod-ucts. The economic useful life of each jig, die, mold,

and pattern is 12 months or less, beginning wheneach item is used in the manufacturing process. Xbegins using the purchased items in 2009 to manu-facture its products. These items are materials andsupplies under paragraph (d)(1)(ii) of this section.Under paragraph (a)(1) of this section, the amountspaid for the items are otherwise deductible as mate-rials and supplies in 2009, the taxable year in whichX uses those items. However, because the amountspaid for these materials and supplies directly benefitor are incurred by reason of the taxpayer’s produc-tion activities, X is required to capitalize the amountspaid for these items to X’s property produced. See§1.263A–1(e)(3)(ii)(E).

Example 10. Election to capitalize. X operatesa rental business that rents out a variety of items(rental items) to its customers, each of which isa separate unit of property as determined under§1.263(a)–3(d)(2). X does not sell or exchange theseitems on established retail markets at any time afterthe items are used in the rental business. In 2008,X incurs costs to purchase various rental items, allof which cost less than $100 or have an economicuseful life of less than 12 months, beginning whenused or consumed. X begins using the rental itemsin its business in 2008. Under paragraph (a)(1) ofthis section, the amounts paid for each rental itempurchased in 2008 are deductible as a material orsupply in the taxable year in which the item is used.However, for administrative reasons, X would preferto treat all of its rental items as capital expendituressubject to depreciation. Under paragraph (e) of thissection, X may elect not to apply the rule containedin paragraph (a)(1) of this section to the rental items.X makes this election by capitalizing the amountspaid for each rental item in the taxable year the costsare incurred and by beginning to recover the costsof each item on its timely filed Federal income taxreturn for the taxable year that the item is placedin service by X for purposes of determining depre-ciation under the applicable Code and regulationprovisions. See §1.263(a)–2(e) for the treatment ofcapital expenditures.

Example 11. Election to capitalize. X is an elec-tric utility. In 2008, X acquires certain temporaryspare parts, which it keeps on hand to avoid opera-tional time loss in the event it must make emergencyrepairs to a unit of property that is subject to depre-ciation. These parts are not units of property as de-termined under §1.263(a)–3(d)(2) and are not usedto improve property under §1.263(a)–3(d)(1). Thesetemporary spare parts are used until a new or repairedpart can be installed, and then removed and storedfor later emergency installation. Under paragraphs(a)(1) and (b) of this section, the amounts paid forthe temporary spare parts are deductible as materi-als and supplies in the taxable year in which they aredisposed of by the taxpayer. However, because it isunlikely that the temporary spare parts will be dis-posed of in the near future, X would prefer to treat thespare parts as capital expenditures subject to depreci-ation. Accordingly, X may elect under paragraph (e)of this section not to apply the rule contained in para-graph (a)(1) of this section to each of its temporaryspare parts. X makes this election by capitalizing theamounts paid for each spare part in the taxable yearthe costs are incurred and by beginning to recover thecosts of each part on its timely filed Federal incometax return for the taxable year that the part is placed

in service by X for purposes of determining depreci-ation under the applicable Code and regulation pro-visions. See §1.263(a)–2(e) for the treatment of cap-ital expenditures and section 263A requiring taxpay-ers to capitalize the direct and allocable indirect costsof property produced or acquired for resale.

Par. 3. Section 1.162–4 is revised toread as follows:

§1.162–4 Repairs.

Amounts paid for repairs and mainte-nance to tangible property are deductibleif the amounts paid are not required to becapitalized under §1.263(a)–3.

§1.162–6 [Removed]

Par. 4. Section 1.162–6 is removed.Par. 5. Section 1.263(a)–0 is amended

by revising the entries for §§1.263(a)–1,1.263(a)–2 and 1.263(a)–3 to read as fol-lows:

§1.263(a)–0 Table of contents.

* * * * *

§1.263(a)–1 Capital expenditures; ingeneral.

(a) General rule for capital expendi-tures.

(b) Coordination with section 263A.(c) Examples of capital expenditures.(d) Amounts paid to sell property.(1) In general.(2) Treatment of capitalized amount.(3) Examples.(e) Amount paid.(f) [Reserved](g) Effective/applicability date.

§1.263(a)–2 Amounts paid to acquire orproduce tangible property.

(a) Overview.(b) Definitions.(1) Amount paid.(2) Personal property.(3) Real property.(4) Produce.(c) Coordination with other provisions

of the Internal Revenue Code.(1) In general.(2) Materials and supplies.(d) Acquired or produced tangible prop-

erty.(1) In general.(i) Requirement of capitalization.(ii) Examples.

2008–18 I.R.B. 884 May 5, 2008

(2) Defense or perfection of title toproperty.

(i) In general.(ii) Examples.(3) Transaction costs.(i) In general.(ii) Scope of facilitate.(A) In general.(B) Inherently facilitative amounts.(C) Special rule for acquisitions of real

property.(D) Employee compensation and over-

head costs.(1) In general.(2) Election to capitalize.(iii) Treatment of transaction costs.(iv) Examples.(4) De minimis rule.(i) In general.(ii) Exceptions to de minimis rule.(iii) Safe harbor.(iv) Additional rules.(v) Election to capitalize.(vi) Definition of applicable financial

statement.(vii) Examples.(e) Treatment of capital expenditures.(f) Recovery of capitalized amounts.(1) In general.(2) Examples.(g) [Reserved](h) Effective/applicability date.

§1.263(a)–3 Amounts paid to improvetangible property.

(a) Overview.(b) Definitions.(1) Amount paid.(2) Personal property.(3) Real property.(4) Applicable financial statement.(c) Coordination with other provisions

of the Internal Revenue Code.(1) In general.(2) Example.(d) Improved property.(1) Capitalization rule.(2) Determining the unit of property.(i) In general.(ii) Building and structural compo-

nents.(iii) Property other than buildings.(A) In general.(B) Plant property.(1) Definition.(2) Unit of property for plant property.(C) Network assets.

(1) Definition.(2) [Reserved](D) Additional rules.(iv) Examples.(3) Compliance with regulatory re-

quirements.(4) Repairs and maintenance performed

during an improvement.(i) In general.(ii) Exception for individuals.(5) Aggregate of related amounts.(e) Safe harbor for routine maintenance.(1) In general.(2) Exceptions.(3) Rotable or temporary spare parts.(4) Class life.(5) Examples.(f) Capitalization of betterments.(1) In general.(2) Application of general rule.(i) Facts and circumstances.(ii) Unavailability of replacement parts.(iii) Appropriate comparison.(A) In general.(B) Normal wear and tear.(C) Particular event.(3) Examples.(g) Capitalization of restorations.(1) In general.(2) Rebuild to like-new condition.(i) In general.(A) Like-new condition.(B) Economic useful life.(ii) Exception.(3) Replacement of a major component

or substantial structural part.(i) In general.(ii) Exception.(4) Examples.(h) Capitalization of amounts to adapt

property to a new or different use.(1) In general.(2) Examples.(i) Optional regulatory accounting

method.(1) In general.(2) Eligibility for regulatory accounting

method.(3) Description of regulatory account-

ing method.(4) [Reserved](5) Examples.(j) Repair allowance.(k) Treatment of capital expenditures.(l) Recovery of capitalized amounts.(m) [Reserved](n) Effective/applicability date.

Par. 6. Section 1.263(a)–1 is revised toread as follows:

§1.263(a)–1 Capital expenditures; ingeneral.

(a) General rule for capital expendi-tures. Except as provided in chapter 1 ofthe Internal Revenue Code (Code), no de-duction is allowed for—

(1) Any amount paid for new buildingsor for permanent improvements or better-ments made to increase the value of anyproperty or estate, or

(2) Any amount paid in restoring prop-erty or in making good the exhaustionthereof for which an allowance is or hasbeen made.

(b) Coordination with section 263A.Section 263(a) generally requires taxpay-ers to capitalize an amount paid to acquire,produce, or improve real or personal tan-gible property. Section 263A generallyprescribes the direct and indirect costs thatmust be capitalized to property producedor improved by the taxpayer and propertyacquired for resale.

(c) Examples of capital expenditures.The following amounts paid are examplesof capital expenditures:

(1) An amount paid to acquire or pro-duce real or personal tangible property.See §1.263(a)–2.

(2) An amount paid to improve realor personal tangible property. See§1.263(a)–3.

(3) An amount paid to acquire or createintangibles. See §1.263(a)–4.

(4) An amount paid or incurred to facil-itate an acquisition of a trade or business,a change in capital structure of a businessentity, and certain other transactions. See§1.263(a)–5.

(5) An amount paid to acquire or createinterests in land, such as easements, life es-tates, mineral interests, timber rights, zon-ing variances, or other interests in land.

(6) An amount assessed and paid un-der an agreement between bondholders orshareholders of a corporation to be used ina reorganization of the corporation or vol-untary contributions by shareholders to thecapital of the corporation for any corporatepurpose. See section 118 and §1.118–1.

(7) An amount paid by a holding com-pany to carry out a guaranty of dividendsat a specified rate on the stock of a sub-sidiary corporation for the purpose of se-

May 5, 2008 885 2008–18 I.R.B.

curing new capital for the subsidiary andincreasing the value of its stockholdings inthe subsidiary. This amount must be addedto the cost of the stock in the subsidiary.

(d) Amounts paid to sell property—(1)In general. Except in the case of dealers inproperty, commissions and other transac-tion costs paid to facilitate the sale of prop-erty generally must be capitalized. How-ever, in the case of dealers in property,amounts paid to facilitate the sale of prop-erty are treated as ordinary and necessarybusiness expenses. See §1.263(a)–5(g) forthe treatment of amounts paid to facilitatethe disposition of assets that constitute atrade or business.

(2) Treatment of capitalized amount.Amounts capitalized under paragraph(d)(1) of this section are treated as a reduc-tion in the amount realized and generallyare taken into account either in the taxableyear in which the sale occurs or in thetaxable year in which the sale is aban-doned if a loss deduction is permissible.The capitalized amount is not added to thebasis of the property and is not treated asan intangible under §1.263(a)–4.

(3) Examples. The following examples,which assume the sale is not an installmentsale under section 453, illustrate the rulesof this paragraph (d):

Example 1. Sales costs of real property. X ownsa parcel of real estate. X sells the real estate and payslegal fees, recording fees, and sales commissions tofacilitate the sale. X must capitalize the fees and com-missions and, in the taxable year of the sale, offsetthe fees and commissions against the amount realizedfrom the sale of the real estate.

Example 2. Sales costs of dealers. Assume thesame facts as in Example 1, except that X is a dealerin real estate. The commissions and fees paid to facil-itate the sale of the real estate are treated as ordinaryand necessary business expenses under section 162.

Example 3. Sales costs of personal property usedin a trade or business. X owns a truck for use inX’s trade or business. X decides to sell the truck andon November 15, 2008, X pays for an appraisal todetermine a reasonable asking price. On February 15,2009, X sells the truck to Y. X is required to capitalizein 2008 the amount paid to appraise the truck and, in2009, is required to offset the amount paid against theamount realized from the sale of the truck.

Example 4. Costs of abandoned sale of personalproperty used in a trade or business. Assume thesame facts as in Example 3, except that, instead ofselling the truck on February 15, 2009, X decides onthat date not to sell the truck and takes the truck offthe market. X is required to capitalize in 2008 theamount paid to appraise the truck. However, X maytreat the amount paid to appraise the truck as a lossunder section 165 in 2009 when the sale is abandoned.

Example 5. Sales costs of personal property notused in a trade or business. Assume the same facts as

in Example 3, except that X does not use the truck inX’s trade or business, but instead uses it for personalpurposes. X decides to sell the truck and on Novem-ber 15, 2008, X pays for an appraisal to determinea reasonable asking price. On February 15, 2009, Xsells the truck to Y. X is required to capitalize in 2008the amount paid to appraise the truck and, in 2009, isrequired to offset the amount paid against the amountrealized from the sale of the truck.

Example 6. Costs of abandoned sale of personalproperty not used in a trade or business. Assume thesame facts as in Example 5, except that, instead ofselling the truck on February 15, 2009, X decides onthat date not to sell the truck and takes the truck offthe market. X is required to capitalize in 2008 theamount paid to appraise the truck. Although the saleis abandoned in 2009, X may not treat the amountpaid to appraise the truck as a loss under section 165because the truck was not used in X’s trade or busi-ness or in a transaction entered into for profit.

(e) Amount paid. In the case of a tax-payer using an accrual method of account-ing, the terms amount paid and paymentmean a liability incurred (within the mean-ing of §1.446–1(c)(1)(ii)). A liability maynot be taken into account under this sectionprior to the taxable year during which theliability is incurred.

(f) [Reserved](g) Effective/applicability date. The

rules in this section apply to taxable yearsbeginning on or after the date of publi-cation of the Treasury decision adoptingthese rules as final regulations in the Fed-eral Register.


§1.263(a)–2 Amounts paid to acquire orproduce tangible property.

(a) Overview. This section providesrules for applying section 263(a) toamounts paid to acquire or produce a unitof real or personal property. Paragraph(b) of this section contains definitions.Paragraph (c) of this section contains therules for coordinating this section withother provisions of the Internal RevenueCode (Code). Paragraph (d) of this sec-tion provides the rules for determining thetreatment of amounts paid to acquire orproduce a unit of real or personal property,including amounts paid to defend or per-fect title to real or personal property andamounts paid to facilitate the acquisitionof property. Paragraph (d) also provides ade minimis rule.

(b) Definitions. For purposes of thissection, the following definitions apply:

(1) Amount paid. In the case of a tax-payer using an accrual method of account-ing, the terms amount paid and paymentmean a liability incurred (within the mean-ing of §1.446–1(c)(1)(ii)). A liability maynot be taken into account under this sectionprior to the taxable year during which theliability is incurred.

(2) Personal property means tangiblepersonal property as defined in §1.48–1(c).

(3) Real property means land and im-provements thereto, such as buildings orother inherently permanent structures (in-cluding items that are structural compo-nents of the buildings or structures) that arenot personal property as defined in para-graph (b)(2) of this section. Any propertythat constitutes other tangible property un-der §1.48–1(d) is treated as real propertyfor purposes of this section. Local lawis not controlling in determining whetherproperty is real property for purposes ofthis section.

(4) Produce means construct, build, in-stall, manufacture, develop, create, raise,or grow. This definition is intended to havethe same meaning as the definition usedfor purposes of section 263A(g)(1) and§1.263A–2(a)(1)(i), except that improve-ments are excluded from the definition inthis paragraph (b)(4) and are separately de-fined and addressed in §1.263(a)–3.

(c) Coordination with other provisionsof the Internal Revenue Code—(1) In gen-eral. Nothing in this section changes thetreatment of any amount that is specifi-cally provided for under any provision ofthe Code or regulations other than section162(a) or section 212 and the regulationsunder those sections. For example, seesection 263A requiring taxpayers to cap-italize the direct and certain indirect costsof producing property or acquiring prop-erty for resale.

(2) Materials and supplies. Nothingin this section changes the treatment ofamounts paid to acquire or produce prop-erty that is properly treated as materialsand supplies under §1.162–3.

(d) Acquired or produced tangibleproperty—(1) In general—(i) Require-ment of capitalization. Except as pro-vided in paragraph (d)(4) of this section(relating to the de minimis rule) and in§1.162–3(d)(1)(ii), (iii), and (iv) (relat-ing to certain materials and supplies), ataxpayer must capitalize amounts paidto acquire or produce a unit of real or

2008–18 I.R.B. 886 May 5, 2008

personal property (as determined under§1.263(a)–3(d)(2)), including leaseholdimprovement property, land and land im-provements, buildings, machinery andequipment, and furniture and fixtures.Amounts paid to acquire or produce aunit of real or personal property includethe invoice price, transaction costs as de-termined under paragraph (d)(3) of thissection, and costs for work performedprior to the date that the unit of propertyis placed in service by the taxpayer (with-out regard to any applicable conventionunder section 168(d)). A taxpayer alsomust capitalize amounts paid to acquirereal or personal property for resale andto produce real or personal property. Seesection 263A for the costs required to becapitalized to property produced by thetaxpayer or to property acquired for resale.

(ii) Examples. The rules of this sectionare illustrated by the following examples,in which it is assumed that the taxpayerdoes not apply the de minimis rule underparagraph (d)(4) of this section:

Example 1. Acquisition of personal property. In2008, X purchases new cash registers for use in its re-tail store located in leased space in a shopping mall.Assume each cash register is a unit of property as de-termined under §1.263(a)–3(d)(2), and is not a mate-rial or supply under §1.162–3. X must capitalize un-der this paragraph (d)(1) the amount paid to purchaseeach cash register.

Example 2. Relocation of personal property. As-sume the same facts as in Example 1, except that X’slease expires in 2009 and X decides to relocate its re-tail store to a different building. In addition to variousother costs, X pays $5,000 to move the cash registers.X is not required to capitalize under this paragraph(d)(1) the $5,000 amount paid for moving the cashregisters.

Example 3. Acquisition of personal propertythat is not a unit of property; coordination with§1.162–3. X operates a fleet of aircraft. In 2008,X purchases a stock of spare parts, which it uses tomaintain and repair its aircraft. Assume that the spareparts are not units of property as determined under§1.263(a)–3(d)(2). X does not make elections under§1.162–3(e) to treat the materials and supplies ascapital expenditures. In 2009, X uses the spare partsin a repair and maintenance activity that does notimprove the property under §1.263(a)–3. Becausethe parts are not units of property, X is not requiredto capitalize the amounts paid for the parts underthis paragraph (d)(1). Rather, X must apply the rulesin §1.162–3, governing the treatment of materialsand supplies, to determine the treatment of theseamounts.

Example 4. Acquisition of unit of personal prop-erty; coordination with §1.162–3. X operates a rentalbusiness that rents out a variety of small individualitems to customers (rental items). X maintains asupply of rental items on hand to replace worn ordamaged items. In 2008, X purchases a large quan-

tity of rental items to be used in its business. Assumethat each of these items is a unit of property under§1.263(a)–3(d)(2) and that several of these rentalitems are materials and supplies under the definitionprovided in §1.162–3(d). Therefore, X must applythe rules in §1.162–3 to determine the treatment ofthe amounts paid to acquire rental items that arematerials and supplies. Under this paragraph (d)(1),X must capitalize the amounts paid for the rentalitems that are units of property and do not otherwisequalify as materials and supplies under §1.162–3(d).

Example 5. Acquisition or production cost. Xpurchases or produces jigs, dies, molds, and patternsfor use in the manufacture of X’s products. Assumethat each of these items is a unit of property as deter-mined under §1.263(a)–3(d)(2), and is not a materialand supply under §1.162–3(d). X is required to cap-italize under this paragraph (d)(1) the amounts paidto produce or purchase the jigs, dies, molds, and pat-terns. See section 263A for the costs to be capitalizedto property produced by X.

Example 6. Acquisition of land. X purchases aparcel of undeveloped real estate. X must capitalizeunder this paragraph (d)(1) the amount paid to acquirethe real estate. See §1.263(a)–2(d)(3) for the treat-ment of amounts paid to facilitate the acquisition ofreal property.

Example 7. Acquisition of building. X purchasesa building. X must capitalize under this paragraph(d)(1) the amount paid to acquire the building. See§1.263(a)–2(d)(3) for the treatment of amounts paidto facilitate the acquisition of real property.

Example 8. Acquisition of property for resale. Xpurchases goods for resale. X must capitalize underthis paragraph (d)(1) the amounts paid to acquire thegoods. See section 263A for the costs to be capital-ized to property acquired for resale.

Example 9. Production of property for sale. Xproduces goods for sale. X must capitalize underthis paragraph (d)(1) the amount paid to produce thegoods. See section 263A for the costs to be capital-ized to property produced by X.

Example 10. Production of building. X con-structs a building. X must capitalize under this para-graph (d)(1) the amount paid to construct the build-ing. See section 263A for the costs to be capitalizedto real property produced by X.

Example 11. Acquisition of assets constituting atrade or business. Y owns tangible and intangible as-sets that constitute a trade or business. X purchasesall the assets of Y in a taxable transaction. X mustcapitalize under this paragraph (d)(1) the amount paidfor the tangible assets of Y. See §1.263(a)–4 for thetreatment of amounts paid to acquire intangibles and§1.263(a)–5 for the treatment of amounts paid to fa-cilitate the acquisition of assets that constitute a tradeor business. See section 1060 for special allocationrules for certain asset acquisitions.

Example 12. Work performed prior to placing theproperty in service. In 2008, X purchases a buildingfor use as a business office. The building is in a stateof disrepair. Prior to placing the building in service, Xincurs costs to repair cement steps, shore up parts ofthe first and second floors, replace electrical wiring,remove and replace old plumbing, and paint the out-side and inside of the building. All the work was per-formed on the building or its structural components.In 2010, X places the building in service and beginsusing the building as its business office. Assume the

building and its structural components is the unit ofproperty. The amounts paid must be capitalized ascosts of acquiring the building because they were forwork performed prior to X’s placing the building inservice.

Example 13. Work performed prior to placing theproperty in service. In January 2008, X purchases anew machine for use in an existing production line ofits manufacturing business. Assume that the machineis a unit of property under §1.263(a)–3(d)(2). Afterthe machine is installed, X performs critical testingon the machine to ensure that it is operational. OnNovember 1, 2008, the critical testing is completeand X places the machine in service on the productionline. X continues to perform testing for quality con-trol. The amounts paid for the installation and criti-cal testing must be capitalized as costs of acquiringthe machine because they were for work performedprior to X’s placing the machine in service. However,amounts paid for quality control testing after the ma-chine is placed in service by X are not required to becapitalized as a cost of acquiring the machine.

(2) Defense or perfection of title toproperty—(i) In general. Amounts paid todefend or perfect title to real or personalproperty are amounts paid to acquire orproduce property within the meaning ofthis section and must be capitalized. Seesection 263A for the costs required to becapitalized to property produced by thetaxpayer or to property acquired for resale.

(ii) Examples. The following examplesillustrate the rule of this paragraph (d)(2):

Example 1. Amounts paid to contest condemna-tion. X owns real property located in County. Countyfiles an eminent domain complaint condemning a por-tion of X’s property to use as a roadway. X hires anattorney to contest the condemnation. Amounts paidby X to the attorney must be capitalized because theywere to defend X’s title to the property.

Example 2. Amounts paid to invalidate or-dinance. X is in the business of quarrying andsupplying for sale sand and stone in a certain munic-ipality. Several years after X establishes its business,the municipality in which it is located passes an or-dinance that prohibits the operation of X’s business.X incurs attorney’s fees in a successful prosecutionof a suit to invalidate the municipal ordinance. Xprosecutes the suit to preserve its business activitiesand not to defend X’s title in the property. Therefore,attorney’s fees paid by X are not required to be capi-talized under this paragraph (d)(2). However, undersection 263A, all indirect costs, including otherwisedeductible costs, that directly benefit or are incurredby reason of the taxpayer’s production activitiesmust be capitalized to the property produced forsale. See §1.263A–1(e)(3)(i). Therefore, because theamounts paid to invalidate the ordinance are incurredby reason of X’s production activities, the amountspaid must be capitalized under section 263A to theproperty produced for sale by X.

Example 3. Amounts paid to challenge buildingline. The board of public works of a municipality es-tablishes a building line across X’s business property,adversely affecting the value of the property. X in-curs legal fees in unsuccessfully litigating the estab-lishment of the building line. Amounts paid by X to

May 5, 2008 887 2008–18 I.R.B.

the attorney must be capitalized because they were todefend X’s title to the property.

(3) Transaction costs—(i) In general.A taxpayer must capitalize amounts paidto facilitate the acquisition or productionof real or personal property. See section263A for the costs required to be capital-ized to property produced by the taxpayeror to property acquired for resale. See§1.263(a)–5 for the treatment of amountspaid to facilitate the acquisition of assetsthat constitute a trade or business.

(ii) Scope of facilitate—(A) In general.Except as otherwise provided in this sec-tion, an amount is paid to facilitate the ac-quisition of real or personal property if theamount is paid in the process of investi-gating or otherwise pursuing the acquisi-tion. Whether an amount is paid in theprocess of investigating or otherwise pur-suing the acquisition is determined basedon all of the facts and circumstances. Indetermining whether an amount is paid tofacilitate an acquisition, the fact that theamount would (or would not) have beenpaid but for the acquisition is relevant, butis not determinative. These amounts in-clude, but are not limited to, inherently fa-cilitative amounts specified in paragraph(d)(3)(ii)(B) of this section.

(B) Inherently facilitative amounts. Anamount paid in the process of investigat-ing or otherwise pursuing the acquisitionof real or personal property facilitates theacquisition if the amount is inherently fa-cilitative. An amount is inherently facili-tative if the amount is paid for—

(1) Transporting the property (for ex-ample, shipping fees and moving costs);

(2) Securing an appraisal or determin-ing the value or price of property;

(3) Negotiating the terms or structure ofthe acquisition and obtaining tax advice onthe acquisition;

(4) Application fees, bidding costs, orsimilar expenses;

(5) Preparing and reviewing the docu-ments that effectuate the acquisition of theproperty (for example, preparing the bid,offer, sales contract, or purchase agree-ment);

(6) Examining and evaluating the titleof property;

(7) Obtaining regulatory approval of theacquisition or securing permits related tothe acquisition, including application fees;

(8) Conveying property between theparties, including sales and transfer taxes,and title registration costs;

(9) Finders’ fees or brokers’ commis-sions, including amounts paid that are con-tingent on the successful closing of the ac-quisition;

(10) Architectural, geological, engi-neering, environmental or inspection ser-vices pertaining to particular properties;and

(11) Services provided by a qualifiedintermediary or other facilitator of an ex-change under section 1031.

(C) Special rule for acquisitions of realproperty. Except as provided in paragraph(d)(3)(ii)(B) of this section (relating to in-herently facilitative amounts), an amountpaid by the taxpayer in the process of in-vestigating or otherwise pursuing the ac-quisition of real property does not facili-tate the acquisition if it relates to activitiesperformed in the process of determiningwhether to acquire real property and whichreal property to acquire.

(D) Employee compensation and over-head costs—(1) In general. For purposesof this paragraph (d)(3), amounts paid foremployee compensation (within the mean-ing of §1.263(a)–4(e)(4)(ii)) and overheadare treated as amounts that do not facilitatethe acquisition of real or personal property.See section 263A for the treatment of em-ployee compensation and overhead costsrequired to be capitalized to property pro-duced by the taxpayer or to property ac-quired for resale.

(2) Election to capitalize. A tax-payer may elect to treat amounts paidfor employee compensation or overheadas amounts that facilitate the acquisitionof property. The election is made sepa-rately for each acquisition and applies toemployee compensation or overhead, orboth. For example, a taxpayer may electto treat overhead, but not employee com-pensation, as amounts that facilitate theacquisition of property. A taxpayer makesthe election by treating the amounts towhich the election applies as amounts thatfacilitate the acquisition in the taxpayer’stimely filed original Federal income taxreturn (including extensions) for the tax-able year during which the amounts arepaid. In the case of an S corporation orpartnership, the election is made by theS corporation or by the partnership, andnot by the shareholders or partners. A

taxpayer may revoke an election madeunder this paragraph (d)(3)(ii)(D)(2) withrespect to each acquisition only by filinga request for a private letter ruling andobtaining the Commissioner’s consent torevoke the election. An election may notbe made or revoked through the filing ofan application for change in accountingmethod or by an amended Federal incometax return.

(iii) Treatment of transaction costs. Allamounts paid to facilitate the acquisitionor production of real or personal propertyare capital expenditures. Inherently facil-itative amounts allocable to real or per-sonal property are capital expenditures re-lated to such property even if the propertyis not eventually acquired or produced. Fa-cilitative amounts allocable to real or per-sonal property actually acquired or pro-duced must be included in the basis of theproperty acquired or produced. See para-graph (f) of this section for the recovery ofcapitalized amounts.

(iv) Examples. The following examplesillustrate the rules of this paragraph (d)(3):

Example 1. Broker’s fees to facilitate an acquisi-tion. X decides to purchase a building in which to re-locate its offices and hires a real estate broker to finda suitable building. X pays fees to the broker to findproperty for X to acquire. Under paragraph (d)(3)(i)of this section, X must capitalize the amounts paid tothe broker because these costs are inherently facilita-tive of the acquisition of real property.

Example 2. Inspection and survey costs to facil-itate an acquisition. X decides to purchase build-ing A and pays amounts to third-party contractors fora termite inspection and an environmental survey ofbuilding A. Under paragraph (d)(3)(i) of this section,X must capitalize the amounts paid for the inspectionand the survey of the building because these costs areinherently facilitative of the acquisition of real prop-erty.

Example 3. Moving costs to facilitate an acqui-sition. X purchases all the assets of Y and, in con-nection with the purchase, hires a transportation com-pany to move storage tanks from Y’s plant to X’splant. Under paragraph (d)(3)(i) of this section, Xmust capitalize the amount paid to move the storagetanks from Y’s plant to X’s plant because this cost isinherently facilitative to the acquisition of personalproperty.

Example 4. Scope of facilitate. X is in the busi-ness of providing legal services to clients. X is inter-ested in acquiring a new conference table for its of-fice. X hires and incurs fees for an interior designerto shop for, evaluate, and make recommendations toX regarding which new table to acquire. Under para-graph (d)(3)(i) of this section, X must capitalize theamounts paid to the interior designer to provide theseservices because they are paid in the process of in-vestigating or otherwise pursuing the acquisition ofpersonal property.

2008–18 I.R.B. 888 May 5, 2008

Example 5. Transaction costs allocable to otherproperty. X, a retailer, wants to acquire land for thepurpose of building a new distribution facility for itsproducts. X considers various properties on highwayA in state B. In evaluating the feasibility of severalsites, X incurs fees for the services of an architectto advise and prepare preliminary plans for a facil-ity that X is reasonably likely to construct at one ofthe sites. The architect’s fees are not inherently fa-cilitative to the acquisition of land, but are inherentlyfacilitative to the acquisition of a building under para-graph (d)(3)(ii)(B)(10) of this section. In addition,these costs are allocable as construction costs of thebuilding under section 263A. Therefore, X does notcapitalize these fees as amounts to acquire the build-ing under paragraph (d)(3)(ii)(B) of this section, butinstead must capitalize these costs as indirect costsallocable to the production of property under section263A.

Example 6. Special rule for acquisitions of realproperty. X owns several retail stores. X decidesto examine the feasibility of opening a new store inCity A. In October 2008, X hires and incurs costsfor a development consulting firm to study City Aand perform market surveys, evaluate zoning and en-vironmental requirements, and make preliminary re-ports and recommendations as to areas that X shouldconsider for purposes of locating a new store. In De-cember 2008, X continues to consider whether to pur-chase real property in City A and which property toacquire. X hires, and incurs fees for, an appraiser toperform appraisals on two different sites to determinea fair offering price for each site. In March 2009, Xdecides to acquire one of these two sites for the lo-cation of its new store. At the same time, X deter-mines not to acquire the other site. Under paragraph(d)(3)(ii)(C) of this section, X is not required to cap-italize amounts paid to the development consultantin 2008 because the amounts relate to activities per-formed in the process of determining whether to ac-quire real property and which real property to acquireand the amounts are not inherently facilitative costsunder paragraph (d)(3)(ii)(B) of this section. How-ever, X must capitalize amounts paid to the appraiserin 2008 because the appraisal costs are inherentlyfacilitative costs under paragraph (d)(3)(ii)(B)(2) ofthis section. In 2009, X must include the appraisalcosts allocable to property acquired in the basis of theproperty acquired and may recover the appraisal costsallocable to the property not acquired in accordancewith paragraph (f) of this section.

Example 7. Employee compensation and over-head. X, a freight carrier, maintains an acquisitiondepartment whose sole function is to arrange for thepurchase of vehicles and aircraft from manufacturersor other parties to be used in its freight carrying busi-ness. As provided in paragraph (d)(3)(ii)(D)(1) ofthis section, X is not required to capitalize any portionof the compensation paid to employees in its acqui-sition department or any portion of its overhead allo-cable to its acquisition department. However, underparagraph (d)(3)(ii)(D)(2) of this section, X may electto capitalize the compensation and overhead costs al-locable to the acquisition of a vehicle or aircraft bytreating these amounts as costs that facilitate the ac-quisition of that property in its timely filed originalFederal income tax return for the year the amountsare paid.

(4) De minimis rule—(i) In general.Except as otherwise provided in this para-graph (d)(4), a taxpayer is not required tocapitalize under paragraph (d) of this sec-tion amounts paid for the acquisition orproduction (including any amounts paid tofacilitate the acquisition or production) ofa unit of property (as determined under§1.263(a)–3(d)(2)) if—

(A) The taxpayer has an applica-ble financial statement (as defined in§1.263(a)–2(d)(4)(vi));

(B) The taxpayer has at the beginningof the taxable year, written accounting pro-cedures treating as an expense for non-taxpurposes the amounts paid for propertycosting less than a certain dollar amount;

(C) The taxpayer treats the amountspaid during the taxable year as an expenseon its applicable financial statement inaccordance with its written accountingprocedures; and

(D) The total aggregate of amountspaid and not capitalized under paragraphs(d)(4)(i)(A), (B), and (C) of this sectionfor the taxable year do not distort the tax-payer’s income for the taxable year.

(ii) Exceptions to de minimis rule. Thede minimis rule in paragraph (d)(4)(i) ofthis section does not apply to the follow-ing:

(A) Amounts paid to improve propertyunder §1.263(a)–3.

(B) Amounts paid for property that isor is intended to be included in propertyproduced or acquired for resale.

(C) Amounts paid for land.(iii) Safe harbor. The total aggregate

amount that is not required to be capital-ized under the de minimis rule of para-graphs (d)(4)(i)(A), (B) and (C) of this sec-tion for the taxable year is deemed to notdistort the taxpayer’s income under para-graph (d)(4)(i)(D) of this section if thisamount, added to the amount the taxpayerdeducts in the taxable year as materials andsupplies under the definition provided un-der §1.162–3(d)(1)(iii) (relating to certainproperty costing $100 or less), is less thanor equal to the lesser of—

(A) 0.1 percent of the taxpayer’s grossreceipts for the taxable year; or

(B) 2 percent of the taxpayer’s totaldepreciation and amortization expense forthe taxable year as determined in its appli-cable financial statement.

(iv) Additional rules. Property to whicha taxpayer applies the de minimis rule

contained in paragraph (d)(4) of this sec-tion is not treated upon sale or dispositionas a capital asset under section 1221 oras property used in the trade or businessunder section 1231. Property to which ataxpayer applies the de minimis rule con-tained in paragraph (d)(4) of this section isnot a material or supply under §1.162–3.The cost of property to which a taxpayerproperly applies the de minimis rule con-tained in paragraph (d)(4) of this sectionis not required to be capitalized under sec-tion 263A to a separate unit of property,but may be required to be capitalized as acost of other property if incurred by reasonof the production of the other property.See, for example, §1.263A–1(e)(3)(ii)(O)requiring taxpayers to capitalize repair andmaintenance costs allocable to propertyproduced or acquired for resale.

(v) Election to capitalize. A taxpayermay elect not to apply the de minimis rulecontained in paragraph (d)(4)(i) of this sec-tion. An election made under this para-graph (d)(4)(v) applies to any unit of prop-erty during the taxable year to which para-graphs (d)(4)(i)(A), (B), and (C) of thissection would apply (but for the electionunder this paragraph (d)(4)(v)). A tax-payer makes the election by treating theamount paid as a capital expenditure in itstimely filed original Federal income taxreturn (including extensions) for the tax-able year in which the amount is paid. Inthe case of an S corporation or partner-ship, the election is made by the S cor-poration or by the partnership, and notby the shareholders or partners. A tax-payer may revoke an election made un-der this paragraph (d)(4)(v) with respectto a unit of property only by filing a re-quest for a private letter ruling and obtain-ing the Commissioner’s consent to revokethe election. An election may not be madeor revoked through the filing of an appli-cation for change in accounting method orby an amended Federal income tax return.

(vi) Definition of applicable financialstatement. For purposes of this paragraph(d)(4), the taxpayer’s applicable financialstatement is the taxpayer’s financial state-ment listed in paragraphs (d)(4)(vi)(A)through (C) of this section that has thehighest priority (including within para-graph (d)(4)(vi)(B) of this section). Thefinancial statements are, in descendingpriority—

May 5, 2008 889 2008–18 I.R.B.

(A) A financial statement required tobe filed with the Securities and ExchangeCommission (SEC) (the 10-K or the An-nual Statement to Shareholders);

(B) A certified audited financial state-ment that is accompanied by the report ofan independent CPA (or in the case of aforeign entity, by the report of a similarlyqualified independent professional), that isused for—

(1) Credit purposes;(2) Reporting to shareholders, partners,

or similar persons; or(3) Any other substantial non-tax pur-

pose; or(C) A financial statement (other than

a tax return) required to be provided tothe Federal or a state government or anyFederal or state agencies (other than theSEC or the Internal Revenue Service).

(vii) Examples. The following exam-ples illustrate the rule of this paragraph(d)(4):

Example 1. De minimis rule. X purchases 10printers at $200 each for a total cost of $2000. As-sume that each printer is a unit of property under§1.263(a)–3(d)(2). X has an applicable financialstatement. X has a written policy at the beginning ofthe taxable year to expense amounts paid for propertycosting less than $500. X treats the amounts paid forthe printers as an expense on its applicable financialstatement. Assuming the total aggregate amountsnot capitalized under the de minimis rule for thetaxable year do not distort the taxpayer’s income, Xis not required to capitalize the amounts paid for theprinters.

Example 2. De minimis rule safe harbor notmet. X is a member of an affiliated group that filesa consolidated return. In 2008, X purchases 300computers at $400 each for a total cost of $120,000.Assume that each computer is a unit of propertyunder §1.263(a)–3(d)(2). X has a written policy atthe beginning of the taxable year to expense amountspaid for property costing less than $500. X treatsthe amounts paid for the computers as an expenseon its applicable financial statement. In addition,in 2008 X purchases 300 desk chairs for $50 eachfor a total cost of $15,000. X intends to deduct theamounts paid for the desk chairs when used or con-sumed as non-incidental materials and supplies under§1.162–3(a)(1) and §1.162–3(d)(1)(iii) becausethey are units of property costing less than $100.For its 2008 taxable year, X has gross receipts of$125,000,000 and reports $7,000,000 of depreciationand amortization on its applicable financial state-ment. Thus, in order to meet the de minimis rule safeharbor for 2008, the sum of the amounts not requiredto be capitalized under the de minimis rule for 2008($120,000) plus the amounts X intends to deductas materials and supplies under §1.162–3(a)(1) and§1.162–3(d)(1)(iii) for 2008 ($15,000), must beless than or equal to $125,000 (0.1% of X’s totalgross receipts of $125,000,000), which is less than$140,000 (2% of X’s total deprecation and amortiza-tion of $7,000,000). Because $135,000 ($120,000 +

$15,000) exceeds $125,000, X will not meet the deminimis rule safe harbor for its 2008 taxable year. Asa result, to apply the de minimis rule to the $120,000paid to acquire the computers, X will have to other-wise establish that this amount does not distort thetaxpayer’s income in 2008.

Example 3. De minimis rule safe harbor met. As-sume the same facts as in Example 2, except X makesan election under paragraph (d)(4)(v) of this sectionto capitalize the $10,000 paid to acquire 25 of the 300computers at $400 each. In this case, X is not requiredto capitalize the $110,000 paid to acquire the remain-ing 275 computers under paragraph (d)(4)(i) becausethis amount, when added to the $15,000 that X in-tends to deduct in 2008 as materials and supplies un-der §1.162–3(a)(1) and §1.162–3(d)(1)(iii), does notexceed the de minimis rule safe harbor of $125,000for 2008.

Example 4. De minimis rule safe harbor; elec-tion to capitalize. Assume the same facts as in Ex-ample 2, except X does not otherwise establish thatthe deduction of amounts in excess of the $125,000safe harbor do not distort X’s income in 2008. Rather,X makes an election under §1.162–3(e) to capitalize$10,000 paid to acquire 200 of the 300 desk chairs at$50 each. In this case, X is not required to capital-ize the $120,000 paid to acquire the 300 computersunder paragraph (d)(4)(i) of this section because thisamount, when added to the $5000 (the remaining 100desk chairs at $50 each) that X intends to deduct in2008 as materials and supplies under §1.162–3(a)(1)and §1.162–3(d)(1)(iii), does not exceed the de min-imis rule safe harbor of $125,000 for 2008.

(e) Treatment of capital expenditures.Amounts required to be capitalized un-der this section are capital expendituresand must be taken into account througha charge to capital account or basis, or inthe case of property that is inventory inthe hands of a taxpayer, through inclusionin inventory costs. See section 263A forthe treatment of amounts referred to inthis section as well as other amounts paidin connection with the production of realproperty and personal property, includ-ing films, sound recordings, video tapes,books, or similar properties.

(f) Recovery of capitalizedamounts—(1) In general. Amounts thatare capitalized under this section arerecovered through depreciation, cost ofgoods sold, or by an adjustment to basis atthe time the property is placed in service,sold, used, or otherwise disposed of bythe taxpayer. Cost recovery is determinedby the applicable Code and regulationprovisions relating to the use, sale, ordisposition of property.

(2) Examples. The following examplesillustrate the rule of this paragraph (f)(1).Assume that X does not apply the de min-imis rule under paragraph (d)(4) of thissection.

Example 1. Recovery when property placed inservice. X owns a 10-unit apartment building. Therefrigerator in one of the apartments stops function-ing and X purchases a new refrigerator to replace theold one. X pays for the acquisition, delivery, and in-stallation of the new refrigerator to replace the old re-frigerator. Assume that the refrigerator is the unit ofproperty, as determined under §1.263(a)–3(d)(2), andis not a material or supply under §1.162–3. Underparagraph (d) of this section, X is required to capital-ize the amounts paid for the acquisition, delivery, andinstallation of the refrigerator. Under this paragraph(f), the capitalized amounts are recovered through de-preciation when the refrigerator is placed in serviceby X.

Example 2. Recovery when property used in theproduction of property. X operates a plant where itmanufactures widgets. X purchases a tractor/loaderto move raw materials into and around the plant foruse in the manufacturing process. Assume that thetractor/loader is a unit of property, as determined un-der §1.263(a)–3(d)(2), and is not a material or sup-ply under §1.162–3. Under paragraph (d) of this sec-tion, X is required to capitalize the amounts paid toacquire the tractor/loader. Under this paragraph (f),the capitalized amounts are recovered through depre-ciation when the tractor/loader is placed in serviceby X. However, because the tractor/loader is used inthe production of property, under section 263A thecost recovery (that is, the depreciation) on the capi-talized amounts must be capitalized to X’s propertyproduced, and consequently, recovered through costof goods sold. See §1.263A–1(e)(3)(ii)(I).

(g) [Reserved](h) Effective/applicability date. The



§1.263(a)–3 Amounts paid to improvetangible property.

(a) Overview. This section providesrules for applying section 263(a) toamounts paid to improve tangible prop-erty. Paragraph (b) of this section providesdefinitions. Paragraph (c) of this sectionprovides rules for coordinating this sec-tion with other provisions of the InternalRevenue Code (Code). Paragraph (d) ofthis section provides rules for determiningthe treatment of amounts paid to improvetangible property, including rules for de-termining the appropriate unit of property.Paragraph (e) of this section provides asafe harbor for routine maintenance costs.Paragraph (f) of this section provides rulesfor determining whether amounts paid re-sult in betterments to the unit of property.

2008–18 I.R.B. 890 May 5, 2008

Paragraph (g) of this section provides rulesfor determining whether amounts paidrestore the unit of property. Paragraph (h)of this section provides rules for amountspaid to adapt the unit of property to anew or different use. Paragraph (i) of thissection provides an optional regulatoryaccounting method safe harbor. Paragraph(j) of this section provides an optionalrepair allowance. Paragraphs (k) through(m) of this section provide additional rulesrelated to these provisions. Paragraph (n)of this section provides the applicabilitydate of the rules in this section.

(b) Definitions. For purposes of thissection, the following definitions apply:

(1) Amount paid. In the case of a tax-payer using an accrual method of account-ing, the terms amounts paid and paymentmean a liability incurred (within the mean-ing of §1.446–1(c)(1)(ii)). A liability maynot be taken into account under this sectionprior to the taxable year during which theliability is incurred.

(2) Personal property means tangiblepersonal property as defined in §1.48–1(c).

(3) Real property means land and im-provements thereto, such as buildings orother inherently permanent structures (in-cluding items that are structural compo-nents of the buildings or structures) that arenot personal property as defined in para-graph (b)(2) of this section. Any propertythat constitutes other tangible property un-der §1.48–1(d) is also treated as real prop-erty for purposes of this section. Local lawis not controlling in determining whetherproperty is real property for purposes ofthis section.

(4) Applicable financial statement. Theapplicable financial statement is the tax-payer’s financial statement listed in para-graphs (b)(4)(i) through (iii) of this sec-tion that has the highest priority (includingwithin paragraph (b)(4)(ii) of this section).The financial statements are, in descend-ing priority—

(i) A financial statement required tobe filed with the Securities and ExchangeCommission (SEC) (the 10-K or the An-nual Statement to Shareholders);

(ii) A certified audited financial state-ment that is accompanied by the report ofan independent CPA (or in the case of aforeign entity, by the report of a similarlyqualified independent professional), that isused for—

(A) Credit purposes;

(B) Reporting to shareholders, partners,or similar persons; or

(C) Any other substantial non-tax pur-pose; or

(iii) A financial statement (other thana tax return) required to be provided tothe Federal or a state government or anyFederal or state agencies (other than theSEC or the Internal Revenue Service).

(c) Coordination with other provisionsof the Internal Revenue Code—(1) In gen-eral. Nothing in this section changes thetreatment of any amount that is specifi-cally provided for under any provision ofthe Code or regulations (other than sec-tion 162(a) or section 212 and the regula-tions under those sections). See, for exam-ple, §1.263A–1(e)(3), requiring taxpayersto capitalize costs that directly benefit orare incurred by reason of the performanceof production or resale activities, includingrepair and maintenance costs allocable toproperty produced or acquired for resale.

(2) Example. The following exampleillustrates the rules of this paragraph (c):

Example. Railroad rolling stock. X is a railroadthat properly treats amounts paid for the rehabilitationof railroad rolling stock as deductible expenses un-der section 263(d). X is not required to capitalize theamounts paid because nothing in this section changesthe treatment of amounts specifically provided for un-der section 263(d).

(d) Improved property—(1) Capital-ization rule. Except as provided in theoptional regulatory accounting methodin paragraph (i) of this section or underany repair allowance method publishedin accordance with paragraph (j) of thissection, a taxpayer must capitalize the ag-gregate of related amounts paid to improvea unit of property, whether the improve-ments are made by the taxpayer or by athird party, and whether the taxpayer isan owner or lessee of the property. Forpurposes of this section, a unit of prop-erty includes units of property for whichthe acquisition or production costs werededucted as materials and supplies under§1.162–3(a)(1) or under the de minimisrule in §1.263(a)–2(d)(4). See section263A for the costs required to be capital-ized to property produced by the taxpayeror to property acquired for resale; section1016 for adding capitalized amounts to thebasis of the unit of property; and section168 for the treatment of additions or im-provements for depreciation purposes. Forpurposes of this section, a unit of propertyis improved if the amounts paid for activi-

ties performed after the property is placedin service by the taxpayer—

(i) Result in a betterment to the unit ofproperty (see paragraph (f) of this section);or

(ii) Restore the unit of property (seeparagraph (g) of this section); or

(iii) Adapt the unit of property to a newor different use (see paragraph (h) of thissection).

(2) Determining the appropriate unitof property—(i) In general. The unit ofproperty rules in this paragraph (d)(2) ap-ply only for purposes of section 263(a) and§§1.263(a)–1, 1.263(a)–2, 1.263(a)–3, and1.162–3(d). In general, the unit of prop-erty determination is based upon the func-tional interdependence standard providedin paragraph (d)(2)(iii)(A) of this section.However, special rules are provided forbuildings (see paragraph (d)(2)(ii) of thissection), plant property (see paragraph(d)(2)(iii)(B) of this section), and networkassets (see paragraph (d)(2)(iii)(C) of thissection). Additional rules are provided ifa taxpayer has assigned different finan-cial statement economic useful lives orMACRS classes or depreciation methodsto components of property (see paragraph(d)(2)(iii)(D) of this section). Propertythat is aggregated and subject to a generalasset account election or accounted for ina multiple asset account (that is, pooled)may not be treated as a single unit of prop-erty. In addition, an improvement to a unitof property as determined under this sec-tion, other than a leasehold improvement,is not a unit of property separate from theunit of property improved.

(ii) Buildings and structural compo-nents. In the case of a building (as de-fined in §1.48–1(e)(1)), the building andits structural components (as defined in§1.48–1(e)(2)) are a single unit of property.In the case of a leasehold improvementmade by a lessee and that is section 1250property, the leasehold improvement is aseparate unit of property. In the case of ataxpayer that owns or occupies an individ-ual unit in a building with multiple units(such as a condominium or cooperative),the unit of property is the individual unitowned and/or occupied by the taxpayer.

(iii) Property other than buildings—(A)In general. Except as provided in para-graphs (d)(2)(iii)(B), (C) and (D) of thissection, in the case of real or personal prop-erty other than property described in para-

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graph (d)(2)(ii) of this section, all the com-ponents that are functionally interdepen-dent comprise a single unit of property.Components of property are functionallyinterdependent if the placing in service ofone component by the taxpayer is depen-dent on the placing in service of the othercomponent by the taxpayer.

(B) Plant property—(1) Definition. Forpurposes of this paragraph (d)(2) of thissection, the term plant property meansfunctionally interdependent machinery orequipment, other than network assets, usedto perform an industrial process, such asmanufacturing, generation, warehousing,distribution, automated materials handlingin service industries, or other similar ac-tivities.

(2) Unit of property for plant property.In the case of plant property, a unit of prop-erty is comprised of each component (orgroup of components) within the unit ofproperty determined under the general ruleof paragraph (d)(2)(iii)(A) of this sectionthat performs a discrete and major functionor operation within the functionally inter-dependent machinery or equipment.

(C) Network assets—(1) Definition.For purposes of this paragraph (d)(2), theterm network assets means railroad track,oil and gas pipelines, water and sewagepipelines, power transmission and distri-bution lines, and telephone and cable linesthat are owned or leased by taxpayers ineach of those respective industries. Theterm includes, for example, trunk andfeeder lines, pole lines, and buried conduit.It does not include property that wouldbe included as a structural component ofa building under paragraph (d)(2)(ii) ofthis section, nor does it include separateproperty that is adjacent to, but not part ofa network asset, such as bridges, culverts,or tunnels.

(2) [Reserved](D) Additional rules. Notwithstanding

the unit of property determination underparagraphs (d)(2)(iii)(A), (B), and (C) ofthis section, a component (or a group ofcomponents) of a unit property must betreated as a separate unit of property if—

(1) At the time the unit of prop-erty (as determined under paragraphs(d)(2)(iii)(A), (B), and (C) of this section)is placed in service by the taxpayer (with-out regard to subsequent improvements),the taxpayer has recorded on its booksand records for financial or regulatory

accounting purposes an economic usefullife for the component that is differentfrom the economic useful life of the unitof property of which the component is apart; or

(2) The taxpayer has properly treatedthe component as being within a differ-ent class of property under section 168(e)(MACRS classes) than the class of the unitof property of which the component is apart or, the taxpayer, at the time the compo-nent was placed in service by the taxpayer,has properly depreciated the componentusing a different depreciation method un-der section 167 or section 168 than the de-preciation method of the unit of propertyof which the component is a part.

(iv) Examples. The rules of this para-graph (d)(2) are illustrated by the follow-ing examples, in which it is assumed thatthe taxpayer has not made a general assetaccount election with regard to property oraccounted for property in a multiple assetaccount.

Example 1. Buildings and structural compo-nents; plant property. X owns a building containingvarious types of manufacturing equipment that arenot structural components of the building. Becausethe property is a building, as defined in §1.48–1(e)(1),the unit of property for the building must be de-termined under paragraph (d)(2)(ii) of this section.Under the rules of that paragraph, X must treat thebuilding and all its structural components as a singleunit of property. In addition, because the manu-facturing equipment contained within the buildingconstitutes property other than a building, the unitsof property for the manufacturing equipment areinitially determined under the general rule in para-graph (d)(2)(iii)(A) of this section and are thereforecomprised of all the components that are functionallyinterdependent. Moreover, because the manufac-turing equipment is plant property, under paragraph(d)(2)(iii)(B) of this section, the units of propertyunder the general rule are further divided into smallerunits of property by determining the components(or groups of components) that perform discrete andmajor functions within the plant. Finally, X must ap-ply the additional rules in paragraph (d)(2)(iii)(D) ofthis section to determine whether any of the units ofproperty determined under paragraphs (d)(2)(iii)(A)and (B) of this section contain components that mustbe treated as separate units of property.

Example 2. Buildings and structural compo-nents; property other than plants. X, a manufacturer,owns a building adjacent to its manufacturing facil-ity that contains office space and related facilitiesfor X’s employees that manage and administer X’smanufacturing operations. The office building con-tains equipment, such as desks, chairs, computers,telephones, and bookshelves, that are not structuralcomponents of the building. Because the officebuilding is a building, as defined in §1.48–1(e)(1), theunit of property for the building must be determinedunder paragraph (d)(2)(ii) of this section. Under the

rules of that paragraph, X must treat the office build-ing and all its structural components as a single unitof property. In addition, because the equipment con-tained within the office building constitutes propertyother than a building, the units of property for theoffice equipment are initially determined under thegeneral rule in paragraph (d)(2)(iii)(A) of this sectionand are comprised of the groups of components thatare functionally interdependent. X then must applythe additional rules in paragraph (d)(2)(iii)(D) ofthis section to determine whether any of the units ofproperty determined under paragraph (d)(2)(iii)(A)of this section contain components that must betreated as separate units of property.

Example 3. Plant property; discrete and majorfunction. X is an electric utility company that oper-ates a power plant to generate electricity. The powerplant includes a structure that is not a building un-der §1.48–1(e)(1), four pulverizers that grind coal,one boiler that produces steam, one turbine that con-verts the steam into mechanical energy, and one gen-erator that converts mechanical energy into electricalenergy. In addition, the turbine contains a series ofblades that cause the turbine to rotate when affectedby the steam. When X placed the plant into service,X recorded all the components of the plant as hav-ing the same economic useful life on its books andrecords for financial and regulatory accounting pur-poses. X also treated all the components of the plantas being within the same class of property under sec-tion 168(e) and has depreciated all the componentsusing the same depreciation methods. Because theplant is composed of real and personal tangible prop-erty other than a building, the unit of property forthe generating equipment is initially determined un-der the general rule in paragraph (d)(2)(iii)(A) of thissection and is comprised of all the components thatare functionally interdependent. Under this rule, theinitial unit of property is the entire plant because thecomponents of the plant are functionally interdepen-dent. However, because the power plant is plant prop-erty under paragraph (d)(2)(iii)(B) of this section, theinitial unit of property is further divided into smallerunits of property by determining the components (orgroups of components) that perform discrete and ma-jor functions within the plant. Under this paragraph,X must treat the structure, the boiler, the turbine, andthe generator each as a separate unit of property, andeach of the four pulverizers as a separate unit of prop-erty because each of these components performs adiscrete and major function within the power plant.X is not required to treat components, such as theturbine blades, as separate units of property becauseeach of these components does not perform a discreteand major function within the plant.

Example 4. Plant property; discrete and majorfunction. X is engaged in a uniform and linen rentalbusiness that operates a plant to treat and launderitems used in its business. Within the plant, X utilizesan assembly line-like process that incorporates manydifferent machines and equipment to launder andprepare the items to be returned to customers. X uti-lizes two laundering lines in its plant, each of whichcan operate independently. One line is used for uni-forms and another line is used for linens. Both linesincorporate several sorters, boilers, washers, dryers,ironers, folders, and waste water treatment systems.Because the laundering equipment contained withinthe plant is personal property, the unit of property

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for the laundering equipment is initially determinedunder the general rule in paragraph (d)(2)(iii)(A) ofthis section and is comprised of all the componentsthat are functionally interdependent. Under this rule,the initial units of property are each laundering linebecause each line is functionally independent and iscomprised of components that are functionally inter-dependent. However, because each line is comprisedof plant property under paragraph (d)(2)(iii)(B) ofthis section, the initial units of property are furtherdivided into smaller units of property by determin-ing the components (or groups of components) thatperform discrete and major functions within the line.Under paragraph (d)(2)(iii)(B) of this section, Xmust treat each sorter, boiler, washer, dryer, ironer,folder, and waste water treatment system in each lineas a separate unit of property because each of thesecomponents performs a discrete and major functionwithin the line. Finally, X must apply the additionalrules in paragraph (d)(2)(iii)(D) of this section todetermine whether any of the units of property deter-mined under paragraph (d)(2)(iii)(B) of this sectioncontain components that must be treated as separateunits of property.

Example 5. Plant property; industrial process. Xoperates a restaurant that prepares and serves food toretail customers. Within its restaurant, X has a largepiece of equipment that uses an assembly line-likeprocess to prepare and cook tortillas that X serves toits customers. Because the tortilla-making equipmentis personal property, the unit of property for the equip-ment is initially determined under the general rule inparagraph (d)(2)(iii)(A) of this section and is com-prised of all the components that are functionally in-terdependent. Under this rule, the initial unit of prop-erty is the entire tortilla-making equipment becausethe various components of the equipment are func-tionally interdependent. Although the equipment isused to perform a manufacturing process, the equip-ment is not being used in an industrial process, asit performs a small-scale function as part of X’s re-tail restaurant operations. Therefore, the equipmentis not plant property under paragraph (d)(2)(iii)(B)of this section. Finally, X must apply the additionalrules in paragraph (d)(2)(iii)(D) of this section to de-termine whether the equipment contains componentsthat must be treated as separate units of property.

Example 6. Personal property. X owns locomo-tives that it uses in its railroad business. Each loco-motive consists of various components, such as an en-gine, generators, batteries and trucks. X acquired alocomotive with all its components and recorded allthe components as having the same economic usefullife on its books and records for financial and regu-latory accounting. X also treated all the componentsof the locomotive as being within the same class ofproperty under section 168(e) and has depreciated allthe components using the same depreciation meth-ods. Because X’s locomotive is property other thana building, the initial unit of property is determinedunder paragraph (d)(2)(iii)(A) of this section. Underthis paragraph, the locomotive is a single unit of prop-erty because it consists entirely of components thatare functionally interdependent. Because the addi-tional rules under paragraph (d)(2)(iii)(D) of this sec-tion do not apply under these facts, the locomotive isa single unit of property.

Example 7. Personal property. X is engaged inthe business of transporting freight throughout the

United States. To conduct its business, X owns afleet of tractors and trailers. Each tractor and traileris comprised of various components, including tires.X purchases a truck trailer with all of its components,including 16 tires. At the time the trailer was placedin service by X, X treated the trailer and the tires asbeing within the same class of property under sec-tion 168(e) and has depreciated all the componentsusing the same depreciation methods. However, onits books and records for financial accounting pur-poses, X recorded economic useful lives for the tiresthat were different from the economic useful life thatit recorded for the trailer. Because X’s trailer is prop-erty other than a building, the initial units of prop-erty for the trailer are determined under the generalrule in paragraph (d)(2)(iii)(A) of this section and arecomprised of all the components that are functionallyinterdependent. Under this rule, the truck trailer, in-cluding its 16 tires, is a single unit of property be-cause the trailer and the tires are functionally interde-pendent (that is, the placing in service of the tires isdependent upon the placing in service of the trailer).X then must apply the additional rules in paragraph(d)(2)(iii)(D) of this section to determine whether theinitial unit of property determined under paragraph(d)(2)(iii)(A) of this section contains components thatmust be treated as separate units of property. Underparagraph (d)(2)(iii)(D)(1) of this section, because Xrecorded on its books and records economic usefullives for the tires that are different from the economicuseful lives that it recorded for the trailer, the tiresmust be treated as separate units of property.

Example 8. Personal property. X provides legalservices to customers. X purchased a laptop com-puter and a printer to be used by its employees in pro-viding services. When X placed the computer andprinter into service, X recorded both items and alltheir components as having the same economic use-ful life on its books and records for financial account-ing purposes. X also treated the computer and printerand all their components as being within the sameclass of property under section 168(e) and has depre-ciated all the components using the same depreciationmethods. Because the computer and printer are prop-erty other than a building, the initial units of prop-erty are determined under the general rule in para-graph (d)(2)(iii)(A) of this section and are comprisedof the components that are functionally interdepen-dent. Under this paragraph (d)(2)(iii)(A), the com-puter and the printer are separate units of propertybecause the computer and the printer are not compo-nents that are functionally interdependent (that is, theplacing in service of the computer is not dependent onthe placing in service of the printer). The additionalrules in paragraph (d)(2)(iii)(D) of this section do notapply under these facts. Accordingly, the computerand the printer each constitute separate units of prop-erty.

(3) Compliance with regulatory re-quirements. For purposes of this section,a Federal, state, or local regulator’s re-quirement that a taxpayer perform certainrepairs or maintenance on a unit of prop-erty to continue operating the property isnot relevant in determining whether theamount paid improves the unit of property.

(4) Repairs and maintenance per-formed during an improvement—(i) Ingeneral. A taxpayer must capitalize allthe direct costs of an improvement and allthe indirect costs (including otherwise de-ductible repair costs) that directly benefitor are incurred by reason of an improve-ment in accordance with the rules undersection 263A. Repairs and maintenancethat do not directly benefit or are not in-curred by reason of an improvement arenot required to be capitalized under sec-tion 263(a), regardless of whether they aremade at the same time as an improvement.

(ii) Exception for individuals’ resi-dences. A taxpayer who is an individualmay capitalize amounts paid for repairsand maintenance that are made at the sametime as substantial capital improvementsto property not used in the taxpayer’s tradeor business or for the production of in-come if the repairs are done as part of aremodeling of the taxpayer’s residence.

(5) Aggregate of related amounts. Forpurposes of paragraph (d)(1) of this sec-tion, the aggregate of related amounts paidto improve a unit of property may be in-curred over a period of more than one tax-able year. Whether amounts are relatedto the same improvement depends on thefacts and circumstances of the activitiesbeing performed and whether the costs areincurred by reason of a single improve-ment or directly benefit a single improve-ment.

(e) Safe harbor for routine mainte-nance—(1) In general. An amount paidfor routine maintenance performed on aunit of property is deemed to not improvethat unit of property. Routine mainte-nance is the recurring activities that ataxpayer expects to perform as a result ofthe taxpayer’s use of the unit of propertyto keep the unit of property in its ordinar-ily efficient operating condition. Routinemaintenance activities include, for exam-ple, the inspection, cleaning, and testingof the unit of property, and the replace-ment of parts of the unit of property withcomparable and commercially availableand reasonable replacement parts. Theactivities are routine only if, at the timethe unit of property is placed in serviceby the taxpayer, the taxpayer reasonablyexpects to perform the activities more thanonce during the class life (as defined inparagraph (e)(4) of this section) of the unitof property. Among the factors to be con-

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sidered in determining whether a taxpayeris performing routine maintenance are therecurring nature of the activity, industrypractice, manufacturers’ recommenda-tions, the taxpayer’s experience, and thetaxpayer’s treatment of the activity on itsapplicable financial statement (as definedin paragraph (b)(4) of this section). Withrespect to a taxpayer that is a lessor of aunit of property, the taxpayer’s use of theunit of property includes the lessee’s useof the unit of property.

(2) Exceptions. Routine maintenancedoes not include the following—

(i) Amounts paid for the replacement ofa component of a unit of property if thetaxpayer has properly deducted a loss forthat component (other than a casualty lossunder §1.165–7);

(ii) Amounts paid for the replacementof a component of a unit of property if thetaxpayer has properly taken into accountthe adjusted basis of the component in re-alizing gain or loss resulting from the saleor exchange of the component;

(iii) Amounts paid for the repair of dam-age to a unit of property for which the tax-payer has taken a basis adjustment as a re-sult of a casualty loss under section 165or relating to a casualty event described insection 165; and

(iv) Amounts paid to return a unit ofproperty to its former ordinarily efficientoperating condition, if the property has de-teriorated to a state of disrepair and is nolonger functional for its intended use.

(3) Rotable or temporary spare parts.For purposes of paragraph (e)(1) of thissection, amounts paid for routine main-tenance include routine maintenance per-formed on (and with regard to) rotableand temporary spare parts. But see§1.162–3(b), which provides that rotableand temporary spare parts are used or con-sumed by the taxpayer in the taxable yearin which the taxpayer disposes of the part.

(4) Class life. The class life of a unit ofproperty is the recovery period prescribedfor the property under section 168(g)(2)and (3) for purposes of the alternative de-preciation system, regardless of whetherthe property is depreciated under sec-tion 168(g). For purposes of determiningclass life under this paragraph (e), section168(g)(3)(A) (relating to tax-exempt useproperty subject to lease) does not apply.

(5) Examples. The following examplesillustrate the rules of this paragraph (e).

Example 1. Routine maintenance on rotable com-ponent. (i) X is a commercial airline engaged inthe business of transporting passengers and freightthroughout the United States and abroad. To conductits business, X owns or leases various types of air-craft. As a condition of maintaining its airworthinesscertification for these aircraft, X is required by theFederal Aviation Administration (FAA) to establishand adhere to a continuous maintenance program foreach aircraft within its fleet. These programs, whichare designed by X and the aircraft’s manufacturer andapproved by the FAA, are incorporated into each air-craft’s maintenance manual. The maintenance man-uals require a variety of periodic maintenance visitsat various intervals. One type of maintenance visitis an engine shop visit (ESV), which X expects toperform on its aircraft engines approximately every4 years in order to keep its aircraft in its ordinarilyefficient operating condition. In 2004, X purchaseda new aircraft and four new engines to use in thataircraft and later, in other aircraft in its fleet. Theaircraft engines are rotable spare parts because theyare removable from the aircraft, and repaired and re-installed on other aircraft or stored for later installa-tion on other aircraft. See §1.162–3(b) (treatment ofmaterials and supplies). In 2008, X performs its firstESV on the aircraft engines. The ESV includes disas-sembly, cleaning, inspection, repair, replacement, re-assembly, and testing of the engine and its componentparts. During the ESV, the engine is removed fromthe aircraft and shipped to an outside vendor who per-forms the ESV. If inspection or testing discloses a dis-crepancy in a part’s conformity to the specificationsin X’s maintenance program, the part is repaired, orif necessary, replaced with a comparable and com-mercially available and reasonable replacement part.After the ESVs, the engines are returned to X to be re-installed on another aircraft or stored for later instal-lation. Assume the unit of property for X’s aircraft isthe entire aircraft, including the aircraft engines, andthat the class life for X’s aircraft is 12 years. Assumethat none of the exceptions set out in paragraph (e)(2)of this section applies to the costs of performing theESVs.

(ii) Because the ESVs involve the recurring ac-tivities that X expects to perform as a result of itsuse of the aircraft to keep the aircraft in ordinarilyefficient operating condition, and consist of mainte-nance activities that X expects to perform more thanonce during the 12 year class life of the aircraft, X’sESVs are within the routine maintenance safe harborunder paragraph (e) of this section. Accordingly,the amounts paid by X for the ESVs are deemed notto improve the aircraft and are not required to becapitalized under paragraph (d)(1) of this section.For the treatment of costs to acquire the engines, see§1.162–3.

Example 2. Routine maintenance after economicuseful life. Assume the same facts as in Example 1,except that X incurs costs to perform an ESV on oneof its aircraft engines in 2024, after the end of the eco-nomic useful life that X anticipated for the aircraft.Because this ESV involves the same routine mainte-nance activities that were performed on aircraft en-gines in Example 1, this ESV also is within the rou-tine maintenance safe harbor under paragraph (e) ofthis section. Accordingly, the amounts paid by X forthis ESV, even though performed after the economicuseful life of the aircraft, are deemed not to improve

the aircraft and are not required to be capitalized un-der paragraph (d)(1) of this section.

Example 3. Routine maintenance resulting fromprior owner’s use. (i) In January 2008, X purchasesa used machine for use its manufacturing operations.Assume that the machine is the unit of property andhas a class life of 10 years. The machine is fully op-erational at the time it is purchased by X and is im-mediately placed in service in X’s business. At thetime it is placed in service by X, X expects to performmanufacturer recommended scheduled maintenanceon the machine approximately every three years. Thescheduled maintenance includes the cleaning and oil-ing of the machine, the inspection of parts for defects,and the replacement of minor items such as springs,bearings, and seals with comparable and commer-cially available and reasonable replacement parts. Atthe time the machine is purchased, it is approachingthe end of a three-year scheduled maintenance pe-riod. As a result, in February 2008, X incurs coststo perform the manufacturer recommended scheduledmaintenance. Assume that none of the exceptions setout in paragraph (e)(2) of this section apply to theamounts paid for the scheduled maintenance.

(ii) The majority of the costs incurred by X do notqualify under the routine maintenance safe harbor inparagraph (e) of this section because the costs wereprimarily incurred as a result of the prior owner’s useof the property and not X’s use. The condition of themachine at the time that it was placed in service by Xwas that of a machine nearing the end of a scheduledmaintenance period. Accordingly, the amounts paidby X for the scheduled maintenance resulting fromthe prior owner’s use of the property must be capi-talized if those amounts result in a betterment underparagraph (f) of this section, including the ameliora-tion of a material condition or defect, or otherwise re-sult in an improvement under paragraph (d)(1) of thissection. See also section 263A requiring taxpayersto capitalize the direct and allocable share of indirectcosts of property produced or acquired for resale.

Example 4. Routine maintenance resulting fromnew owner’s use. Assume the same facts as in Exam-ple 3, except that after X incurs costs for the mainte-nance in 2008, X continues to operate the machine inits manufacturing business. In 2011, X incurs coststo perform the next scheduled manufacturer recom-mended maintenance on the machine. Assume thatthe scheduled maintenance activities performed arethe same as those performed in Example 3 and thatnone of the exceptions set out in paragraph (e)(2) ofthis section apply to the amounts paid for the sched-uled maintenance. Because the scheduled mainte-nance performed in 2011 involves the recurring ac-tivities that X performs as a result of its use of themachine, keeps the machine in an ordinarily efficientoperating condition, and consists of maintenance ac-tivities that X expects to perform more than once dur-ing the 10 year class life of the machine, X’s sched-uled maintenance costs are within the routine main-tenance safe harbor under paragraph (e) of this sec-tion. Accordingly, the amounts paid by X for thescheduled maintenance in 2011 are deemed not to im-prove the machine and are not required to be capital-ized under paragraph (d)(1) of this section. However,because the amounts paid for the scheduled mainte-nance are incurred by reason of X’s manufacturingoperations, X is required to capitalize the amounts

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paid for the maintenance to products produced by X.See §1.263A–1(e)(3)(ii).

Example 5. Routine maintenance; replacementof substantial structural part. X is in the business ofproducing commercial products for sale. As part ofthe production process, X places raw materials intolined containers in which a chemical reaction is usedto convert raw materials into the finished product.The lining is a substantial structural part of the con-tainer, and comprises 60% of the total physical struc-ture of the container. Assume that each container, in-cluding its lining, is the unit of property and that acontainer has a class life of 12 years. At the time thatX placed the container into service, X was aware thatapproximately every three years, X would be requiredto replace the lining in the container with comparableand commercially available and reasonable replace-ment materials. At the end of that period, the con-tainer will continue to function, but will become lessefficient and the replacement of the lining will be nec-essary to keep the container in an ordinarily efficientoperating condition. In 2003, X acquired 10 new con-tainers and placed them into service. In 2006, 2009,2011, and 2014, X pays amounts to replace the con-tainers’ linings with comparable and commerciallyavailable and reasonable replacement parts. Assumethat none of the exceptions set out in paragraph (e)(2)of this section apply to the amounts paid for the re-placement linings. Because the replacement of thelinings involves recurring activities that X expects toperform as a result of its use of the containers to keepthe containers in their ordinarily efficient operatingcondition, and consists of maintenance activities thatX expects to perform more than once during the 12year class lives of the containers, X’s lining replace-ment costs are within the routine maintenance safeharbor under paragraph (e) of this section. Accord-ingly, the amounts paid by X for the replacement ofthe container linings are deemed not to improve thecontainers and are not required to be capitalized un-der paragraph (d)(1) of this section. However, be-cause the amounts paid to replace the container lin-ings are incurred by reason of X’s manufacturing op-erations, X is required to capitalize the amounts paidfor the replacements to products produced by X. See§1.263A–1(e)(3)(ii).

Example 6. Routine maintenance once duringclass life. X is a Class I railroad that owns a fleet offreight cars. Assume that a freight car, including allits components, is a unit of property and has a classlife of 14 years. At the time that X places a freight carinto service, X expects to perform cyclical recondi-tioning to the car every 8 to 10 years in order to keepthe freight car in ordinarily efficient operating con-dition. During this reconditioning, X incurs costs todisassemble, inspect, and recondition and/or replacecomponents of the freight car with comparable andcommercially available and reasonable replacementparts. Ten years after the freight car is placed in ser-vice by X, X incurs costs to perform a cyclical recon-ditioning on the car. Because X expects to performthe reconditioning only once during the 14 year classlife of the freight car, the costs incurred for recon-ditioning do not qualify for the routine maintenancesafe harbor under paragraph (e) of this section. Ac-cordingly, X must capitalize the amounts paid for thereconditioning of the freight car if these amounts re-sult in an improvement under paragraph (d)(1) of thissection.

Example 7. Routine maintenance on non-rotablepart. X is a towboat operator that owns and leases afleet of towboats. Each towboat is equipped with twodiesel-powered engines. Assume that each towboat,including its engines, is the unit of property and thata towboat has a class life of 18 years. At the timethat X places its towboats into service, X is awarethat approximately every three to four years, X willneed to perform scheduled maintenance on the twotowboat engines to keep the engines in their ordinar-ily efficient operating condition. This maintenanceis completed while the engines are attached to thetowboat and involves the cleaning and inspectingof the engines to determine which parts are withinacceptable operating tolerances and can continue tobe used, which parts must be reconditioned to bebrought back to acceptable tolerances, and whichparts must be replaced. Engine parts replaced duringthese procedures are replaced with comparable andcommercially available and reasonable replacementparts. Assume the towboat engines are not rotablespare parts under §1.162–3(b). In 2005, X acquireda new towboat, including its two engines, and placedthe towboat into service. In 2009, X incurs amountsto perform scheduled maintenance on both enginesin the towboat. Assume that none of the exceptionsset out in paragraph (e)(2) of this section apply to thescheduled maintenance costs. The scheduled main-tenance involves recurring activities that X expectsto perform more than once during the 18 year classlife of the towboat. Because this maintenance resultsfrom X’s use of the towboat, and is performed tokeep the towboat in an ordinarily efficient operatingcondition, the scheduled maintenance on X’s tow-boat is within the routine maintenance safe harborunder paragraph (e) of this section. Accordingly, theamounts paid by X for the scheduled maintenanceto its towboat engines in 2009 are deemed not toimprove the towboat and are not required to be capi-talized under paragraph (d)(1) of this section.

Example 8. Routine maintenance with better-ments. Assume the same facts as Example 7, exceptthat in 2013, X’s towboat engines are due for anotherscheduled maintenance visit. At this time X decidesto upgrade the engines to increase their horsepowerand propulsion, which would permit the towboatsto tow heavier loads. Accordingly, in 2013 X in-curs costs to perform many of the same activitiesthat it would perform during the typical scheduledmaintenance activities such as cleaning, inspecting,reconditioning, and replacing minor parts, but at thesame time, X incurs costs to upgrade certain engineparts to increase the towing capacity of the boats inexcess of the capacity when the boats were placedin service by X. Both the scheduled maintenanceprocedures and the replacement of parts with newand upgraded parts are necessary to increase thehorsepower of the engines and the towing capacityof the boat. Thus, the work done on the enginesencompasses more than the recurring activities thatX expected to perform as a result of its use of thetowboats and did more than keep the towboat inits ordinarily efficient operating condition. In addi-tion, the scheduled maintenance procedures directlybenefit and are incurred by reason of the upgrades.Therefore, the amounts paid by X in 2013 for themaintenance and upgrade of the engines do not qual-ify for the routine maintenance safe harbor describedunder paragraph (e) of this section. These amounts

must be capitalized if they result in a bettermentunder paragraph (f) of this section, including a ma-terial increase in the capacity of the towboat, orotherwise result in an improvement under paragraph(d)(1) of this section. See also section 263A requir-ing taxpayers to capitalize all the direct costs of animprovement to property and all the indirect coststhat directly benefit or are incurred by reason of animprovement to property.

Example 9. Exceptions to routine maintenance.X owns and operates a farming and cattle ranch withan irrigation system that provides water for crops.Assume that each canal in the irrigation system is asingle unit of property and has a class life of 20 years.When X placed the canals into service, X expected tohave to perform major maintenance on the canals ev-ery 3 years to keep the canals in their ordinarily effi-cient operating condition. This maintenance includeddraining the canals, and then cleaning, inspecting, re-pairing, reconditioning or replacing parts of the canalwith comparable and commercially available and rea-sonable replacement parts. X placed the canals intoservice in 2005 and did not perform any maintenanceon the canals until 2010. At that time, the canals hadfallen into a state of disrepair and no longer func-tioned for irrigation. In 2010, X paid amounts todrain the canals, and do extensive cleaning, repair-ing, reconditioning and replacing parts of the canalswith comparable and commercially available and rea-sonable replacement parts. Although the work per-formed on X’s canals was similar to the activities thatX expected to perform, but did not perform, everythree years, the costs of these activities do not fallwithin the routine maintenance safe harbor. Specifi-cally, under paragraph (e)(2)(iv) of this section, rou-tine maintenance does not include amounts paid toreturn a unit of property to its former ordinarily effi-cient operating condition if the property has deterio-rated to a state of disrepair and is no longer functionalfor its intended use. Accordingly, amounts paid byX for work performed on the canals in 2010 must becapitalized if they result in improvements under para-graph (d)(1) of this section (for example, restorationsunder paragraph (g) of this section).

(f) Capitalization of betterments—(1)In general. A taxpayer must capitalizeamounts paid that result in the bettermentof a unit of property. An amount paid re-sults in the betterment of a unit of propertyonly if it—

(i) Ameliorates a material condition ordefect that either existed prior to the tax-payer’s acquisition of the unit of propertyor arose during the production of the unitof property, whether or not the taxpayerwas aware of the condition or defect at thetime of acquisition or production;

(ii) Results in a material addition (in-cluding a physical enlargement, expan-sion, or extension) to the unit of property;or

(iii) Results in a material increase incapacity (including additional cubic orsquare space), productivity, efficiency,

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strength, or quality of the unit of propertyor the output of the unit of property.

(2) Application of general rule—(i)Facts and circumstances. To determinewhether an amount paid results in a better-ment described in paragraph (f)(1) of thissection, it is appropriate to consider all thefacts and circumstances including, but notlimited to, the purpose of the expenditure,the physical nature of the work performed,the effect of the expenditure on the unit ofproperty, and the taxpayer’s treatment ofthe expenditure on its applicable financialstatement (as defined in paragraph (b)(4)of this section).

(ii) Unavailability of replacement parts.If a taxpayer needs to replace part of a unitof property that cannot practicably be re-placed with the same type of part (for ex-ample, because of technological advance-ments or product enhancements), the re-placement of the part with an improved butcomparable part does not, by itself, resultin a betterment to the unit of property.

(iii) Appropriate comparison—(A) Ingeneral. In cases in which a particularevent necessitates an expenditure, the de-termination of whether an expenditure re-sults in a betterment of the unit of propertyis made by comparing the condition of theproperty immediately after the expenditurewith the condition of the property immedi-ately prior to the circumstances necessitat-ing the expenditure.

(B) Normal wear and tear. If the ex-penditure is made to correct the effects ofnormal wear and tear to the unit of property(including the amelioration of a conditionor defect that existed prior to the taxpayer’sacquisition of the unit of property result-ing from normal wear and tear), the con-dition of the property immediately prior tothe circumstances necessitating the expen-diture is the condition of the property af-ter the last time the taxpayer corrected theeffects of normal wear and tear (whetherthe amounts paid were for maintenance orimprovements) or, if the taxpayer has notpreviously corrected the effects of normalwear and tear, the condition of the propertywhen placed in service by the taxpayer.

(C) Particular event. If the expenditureis made as a result of a particular event,the condition of the property immediatelyprior to the circumstances necessitating theexpenditure is the condition of the propertyimmediately prior to the particular event.

(3) Examples. The following examplesillustrate solely the rules of this paragraph(f). Even if capitalization is not requiredin an example under this paragraph (f), theamounts paid in the example may be sub-ject to capitalization under a different pro-vision of this section.

Example 1. Amelioration of pre-existing materialcondition or defect. In 2008, X purchases a store lo-cated on a parcel of land that contained undergroundgasoline storage tanks left by prior occupants. As-sume that the parcel of land is the unit of property.The tanks had leaked, causing soil contamination. Xis not aware of the contamination at the time of pur-chase. In 2009, X discovers the contamination andincurs costs to remediate the soil. The remediationcosts incurred by X result in a betterment to the landunder paragraph (f)(1)(i) of this section because thecosts were incurred to ameliorate a material conditionor defect that existed prior to the taxpayer’s acquisi-tion of the land.

Example 2. Not amelioration of pre-existing con-dition or defect. X owned a building that was con-structed with insulation that contained asbestos. Thehealth dangers of asbestos were not widely knownwhen the building was constructed. In 2008, X deter-mined that certain areas of asbestos-containing insu-lation had begun to deteriorate and could eventuallypose a health risk to employees. Therefore, X decidedto remove the asbestos-containing insulation from thebuilding and replace it with new insulation that wassafer to employees, but no more efficient or effectivethan the asbestos insulation. Assume the building andits structural components (including the asbestos in-sulation) is the unit of property. The amounts paidto remove and replace the asbestos insulation are notrequired to be capitalized as a betterment under para-graphs (f)(1)(i) and (f)(2)(i) of this section becausethe asbestos, although later determined to be unsafeunder certain circumstances, was not an inherent andmaterial defect to the property. In addition, the re-moval and replacement of the asbestos did not re-sult in any material additions to the building or ma-terial increases in capacity, productivity, efficiency,strength or quality of the building or the output of thebuilding under paragraphs (f)(1)(ii) and (f)(1)(iii) ofthis section.

Example 3. Not amelioration of pre-existing ma-terial condition or defect. (i) In January 2008, X pur-chases a used machine for use in its manufacturingoperations. Assume that the machine is a unit of prop-erty and it has a class life of 10 years. The machine isfully operational at the time it is purchased by X and isimmediately placed in service in X’s business. At thetime it is placed in service by X, X expects to performmanufacturer recommended scheduled maintenanceon the machine every three years. The scheduledmaintenance includes the cleaning and oiling of themachine, the inspection of parts for defects, and thereplacement of minor items such as springs, bearings,and seals with comparable and commercially avail-able and reasonable replacement parts. The sched-uled maintenance does not result in any material ad-ditions or material increases in capacity, productiv-ity, efficiency, strength or quality of the machine orthe output of the machine. At the time the machineis purchased, it is approaching the end of a three-yearscheduled maintenance period. As a result, in Feb-

ruary 2008, X incurs costs to perform the manufac-turer recommended scheduled maintenance to keepthe machine in its ordinarily efficient operating con-dition.

(ii) The majority of the costs incurred by X do notqualify under the routine maintenance safe harbor inparagraph (e) of this section because the costs wereprimarily incurred as a result of the prior owner’s useof the property and not the taxpayer’s use. The con-dition of the machine at the time that it was placedin service by X was that of a machine nearing theend of a scheduled maintenance period. Accordingly,the amounts paid by X for the scheduled maintenanceresulting from the prior owner’s use of the propertyameliorate conditions or defects that existed prior toX’s ownership of the machine. Nevertheless, con-sidering the facts and circumstances under paragraph(f)(2)(i) of this section, including the purpose and mi-nor nature of the work performed, those amounts donot ameliorate a material condition or defect underparagraph (f)(1)(i) of this section and accordingly donot result in a betterment that must be capitalized un-der this paragraph (f).

Example 4. Not amelioration of pre-existing ma-terial condition or defect. In 2008, X purchases aused ice resurfacing machine for use in the operationof its ice skating rink. To comply with local regula-tions, X is required to routinely monitor the air qual-ity in the ice skating rink. One week after X placesthe machine into service, during a routine air qualitycheck, X discovers that the operation of the machineis adversely affecting the air quality in the skatingrink. As a result, X incurs costs to inspect and retunethe machine, which includes replacing minor compo-nents of the engine, which had worn out prior to X’sacquisition of the machine. Assume the resurfacingmachine, including the engine, is the unit of property.The routine maintenance safe harbor in paragraph (e)of this section does not apply to the amounts paid be-cause the activities performed do more than return themachine to the condition that existed at the time itwas placed in service by X. The amounts paid by Xto inspect, retune, and replace minor components ofthe ice resurfacing machine ameliorated a conditionor defect that existed prior to X’s acquisition of theequipment. Nevertheless, considering the facts andcircumstances under paragraph (f)(2)(i) of this sec-tion, including the purpose and minor nature of thework performed, these amounts do not ameliorate amaterial condition or defect under paragraph (f)(1)(i)of this section, result in a material addition to the ma-chine under paragraph (f)(1)(ii) of this section, or re-sult in a material increase in the capacity, productiv-ity, efficiency, strength or quality of the machine orthe output of the machine. Accordingly, the amountspaid by X to inspect, retune, and replace minor com-ponents of the machine do not result in a bettermentthat must be capitalized under this paragraph (f).

Example 5. Amelioration of material conditionor defect; increase in quality. (i) In January 2009,X acquires a building for use in its business of pro-viding assisted living services. Before and after thepurchase, the building functions as an assisted livingfacility. However, at the time of the purchase, X isaware that the building is in a condition that is be-low the standards that X requires for facilities usedin its business. Beginning in 2009 and over the nexttwo years, while X continues to use the building asan assisted living facility, X incurs costs for repairs,

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maintenance, and the acquisition of new property tobring the facility into the high-quality condition forwhich X’s facilities are known. The work includes re-painting; replacing flooring materials, windows, andtiling and fixtures in bathrooms; replacing windowtreatments, furniture, and cabinets; and repairing orreplacing roofing materials, heating and cooling sys-tems. On its applicable financial statements, X capi-talizes the costs of the repairs, maintenance, and ac-quisitions over the remaining economic useful liferecorded for the building. Assume that the building,including its structural components, is a single unit ofproperty and that each section 1245 property is a sep-arate unit of property.

(ii) Considering the facts and circumstancesunder paragraph (f)(2)(i) of this section, includingthe purpose of the expenditures, the effect of theexpenditures on the building, and the treatment of theexpenditures in X’s applicable financial statements,the amounts paid by X for repairs and maintenanceto the building and its structural components ame-liorated material conditions and defects that existedprior to X’s acquisition of the building. In addition,these amounts materially increased the quality of thebuilding as compared to the condition of the buildingwhen it was placed in service by X. Accordingly, theamounts paid by X for repairs and maintenance tothe building and its structural components (that is,repainting, replacing windows, replacing bathroomfixtures, repairing and replacing roofing materialsand heating and cooling systems) result in better-ments that must be capitalized under this paragraph(f). Moreover, X is required to capitalize the amountspaid to acquire and install each section 1245 property,including the flooring materials, tiling, each windowtreatment, each item of furniture, and each cabinet,in accordance with §1.263(a)–2(d).

Example 6. Not a betterment. (i) X owns a na-tionwide chain of retail stores that sell a wide varietyof items. To remain competitive in the industry, Xperiodically changes the layout and appearance of itsstores. These changes include the reconfiguration ofthe stores to provide better exposure of the merchan-dise and cosmetic alterations to keep the store modernand attractive to customers. The work is not under-taken for the purpose of repairing damaged propertybut rather to renew the appearance of the property.X incurs costs to update 50 stores during the taxableyear. In its applicable financial statement, X capi-talizes all the costs of the updates over a 5 year pe-riod until which X anticipates it would have to updateagain. Assume that each store building, including itsstructural components, is a unit of property and thateach section 1245 property within the store is a sepa-rate unit of property. Also assume that the work per-formed did not ameliorate any material conditions ordefects that existed when X acquired the store build-ings or result in any material additions to the storebuildings.

(ii) Considering the facts and circumstances un-der paragraph (f)(2)(i) of this section, including thepurpose of the expenditure, the nature of the workperformed, and the treatment of the work on X’sapplicable financial statements, the amounts paid byX for updates to its store buildings (including theirstructural components) do not result in material in-creases in capacity, productivity, efficiency, strengthor quality of the store buildings. Accordingly, theamounts paid by X for the updates on the store

buildings (including their structural components)do not result in betterments that must be capitalizedunder this paragraph (f). However, X is requiredto capitalize the amounts paid to acquire and in-stall each section 1245 property in accordance with§1.263(a)–2(d).

Example 7. Betterment; regulatory requirement.X owns a hotel in City that includes five foot highunreinforced terra cotta and concrete parapets withoverhanging cornices around the entire roof perime-ter. The parapets and cornices are in good condi-tion. In 2008, City passes an ordinance setting highersafety standards for parapets and cornices because ofthe hazardous conditions caused by earthquakes. Tocomply with the ordinance, X replaces the old para-pets and cornices with new ones made of glass fiberreinforced concrete, which makes them lighter andstronger than the original ones. They are attached tothe hotel using welded connections instead of wiresupports, making them more resistant to damage fromlateral movement. Assume the hotel building and itsstructural components are the unit of property. Theevent necessitating the expenditure was the 2008 Cityordinance. Prior to the ordinance, the old parapetsand cornices were in good condition, but were de-termined by City to create a potential hazard. Af-ter the expenditure, the new parapets and cornicesmaterially increased the structural soundness (that is,the strength) of the hotel building. Therefore, theamounts paid by X to replace the parapets and cor-nices must be capitalized because they resulted in abetterment to the hotel. City’s requirement that X cor-rect the potential hazard to continue operating the ho-tel is not relevant in determining whether the amountpaid improved the hotel. See paragraph (d)(3) of thissection.

Example 8. Not a betterment; regulatory require-ment. X owns a meat processing plant. In 2008, Xdiscovers that oil was seeping through the concretewalls of the plant, creating a fire hazard. Federal meatinspectors advise X that it must correct the seepageproblem or shut down its plant. To correct the prob-lem, X incurs costs to add a concrete lining to thewalls from the floor to a height of about four feet andalso to add concrete to the floor of the plant. Assumethe plant building and its structural components arethe unit of property. The event necessitating the ex-penditure was the seepage of the oil. Prior to the seep-age, the plant did not leak and was functioning for itsintended use. The expenditure did not result in a ma-terial addition or material increase in capacity, pro-ductivity, efficiency, strength or quality of the plant orits output compared to the condition of the plant priorto the seepage of the oil. Therefore, the amounts paidby X to correct the seepage do not result in a better-ment to the plant. X is not required to capitalize as animprovement under this paragraph (f) amounts paidto correct the seepage problem. The Federal meat in-spectors’ requirement that X correct the seepage tocontinue operating the plant is not relevant in deter-mining whether the amount paid improved the plant.See paragraph (d)(3) of this section.

Example 9. Not a betterment; replacement withsame part. X owns a small retail shop. In 2008, astorm damages the roof of X’s shop by displacing nu-merous wooden shingles. X decides to replace all thewooden shingles on the roof and hires a contractor toreplace all the shingles on the roof with new woodenshingles. Assume the shop building and its structural

components are the unit of property. The event ne-cessitating the expenditure was the storm. Prior to thestorm, the retail shop was functioning for its intendeduse. The expenditure did not result in a material addi-tion, or material increase in the capacity, productiv-ity, efficiency, strength or quality of the shop or theoutput of the shop compared to the condition of theshop prior to the storm. Therefore, the amounts paidby X to reshingle the roof with wooden shingles donot result in betterment to the shop building. X is notrequired to capitalize as an improvement under thisparagraph (f) amounts paid to replace the shingles.

Example 10. Not a betterment; replacementwith comparable part. Assume the same facts asin Example 9, except that wooden shingles are notavailable on the market. X decides to replace allthe wooden shingles with comparable asphalt shin-gles. The amounts paid by X to reshingle the roofwith asphalt shingles do not result in a bettermentto the shop, even though the asphalt shingles maybe stronger than the wooden shingles. Because thewooden shingles could not practicably be replacedwith new wooden shingles, the replacement of theold shingles with comparable asphalt shingles doesnot, by itself, result in an improvement to the shop.X is not required to capitalize as an improvementunder this paragraph (f) amounts paid to replace theshingles.

Example 11. Betterment; replacement with im-proved parts. Assume the same facts as in Example9, except that, instead of replacing the wooden shin-gles with asphalt shingles, X decides to replace all thewooden shingles with shingles made of lightweightcomposite materials that are maintenance-free and donot absorb moisture. The new shingles have a 50-yearwarranty and a Class A fire rating. The expenditurefor these shingles resulted in a material increase inthe quality of the shop building as compared to thecondition of the shop building prior to the storm. Xmust capitalize amounts paid to reshingle the roof asan improvement under this paragraph (f) because theyresult in a betterment to the shop.

Example 12. Material increase in capacity. Xowns a factory building with a storage area on thesecond floor. In 2008, X replaces the columns andgirders supporting the second floor to permit storageof supplies with a gross weight 50 percent greaterthan the previous load-carrying capacity of the stor-age area. Assume the factory building and its struc-tural components are the unit of property. X mustcapitalize as an improvement amounts paid for thecolumns and girders because they result in a materialincrease in the load-carrying capacity of the building.The comparison rule in paragraph (f)(2)(iii) of thissection does not apply to these amounts paid becausethe expenditure was not necessitated by a particularevent.

Example 13. Material increase in capacity. In2008, X purchases harbor facilities consisting of aslip for the loading and unloading of barges and achannel leading from the slip to the river. At thetime of purchase, the channel is 150 feet wide, 1,000feet long, and 10 feet deep. To allow for ingress andegress and for the unloading of its barges, X needsto deepen the channel to a depth of 20 feet. X hires acontractor to dredge the channel to the required depth.Assume the channel is the unit of property. X mustcapitalize as an improvement amounts paid for thedredging because it resulted in a material increase in

May 5, 2008 897 2008–18 I.R.B.

the capacity of the channel. The comparison rule inparagraph (f)(2)(iii) of this section does not apply tothese amounts paid because the expenditure was notnecessitated by a particular event.

Example 14. Not a material increase in capac-ity. Assume the same facts as in Example 13, exceptthat the channel was susceptible to siltation and, by2009, the channel depth had been reduced to 18 feet.X hired a contractor to redredge the channel to a depthof 20 feet. The event necessitating the expenditurewas the siltation of the channel. Both prior to the sil-tation and after the redredging, the depth of the chan-nel was 20 feet. Therefore, the amounts paid by Xfor redredging the channel did not result in a materialaddition to the unit of property or a material increasein the capacity, productivity, efficiency, strength orquality of the unit of property or the output of the unitof property. X is not required to capitalize as a bet-terment under paragraph (f) of this section amountspaid to redredge the channel.

Example 15. Not a material increase in capacity.X owns a building used in its trade or business. Thefirst floor has a drop-ceiling. X decides to remove thedrop-ceiling and repaint the original ceiling. Assumethe building and its structural components are the unitof property. The removal of the drop-ceiling does notcreate additional capacity in the building that was notthere prior to the removal. Therefore, the amountspaid by X to remove the drop-ceiling and repaint theoriginal ceiling did not result in a material additionor a material increase to the capacity, productivity,efficiency, strength or quality of the unit of propertyor output of the unit of property. X is not requiredto capitalize as a betterment under this paragraph (f)amounts paid related to removing the drop-ceiling.The comparison rule in paragraph (f)(2)(iii) of thissection does not apply to these amounts paid becausethe expenditure was not necessitated by a particularevent.

(g) Capitalization of restorations—(1)In general. A taxpayer must capitalizeamounts paid to restore a unit of property,including amounts paid in making goodthe exhaustion for which an allowance isor has been made. An amount is paid torestore a unit of property if it—

(i) Is for the replacement of a compo-nent of a unit of property and the taxpayerhas properly deducted a loss for that com-ponent (other than a casualty loss under§1.165–7);

(ii) Is for the replacement of a com-ponent of a unit of property and the tax-payer has properly taken into account theadjusted basis of the component in realiz-ing gain or loss resulting from the sale orexchange of the component;

(iii) Is for the repair of damage to aunit of property for which the taxpayer hasproperly taken a basis adjustment as a re-sult of a casualty loss under section 165,or relating to a casualty event described insection 165;

(iv) Returns the unit of property to itsordinarily efficient operating condition ifthe property has deteriorated to a state ofdisrepair and is no longer functional for itsintended use;

(v) Results in the rebuilding of the unitof property to a like-new condition afterthe end of its economic useful life (seeparagraph (g)(2) of this section); or

(vi) Is for the replacement of a ma-jor component or a substantial structuralpart of the unit of property (see paragraph(g)(3) of this section).

(2) Rebuild to like-new condition—(i)In general. For purposes of paragraph(g)(1)(v) of this section, the following def-initions apply:

(A) Like-new condition. A unit of prop-erty is rebuilt to a like-new condition if itis brought to the status of new, rebuilt, re-manufactured, or similar status under theterms of any Federal regulatory guidelineor the manufacturer’s original specifica-tions.

(B) Economic useful life. The economicuseful life of a unit of property is not nec-essarily the useful life inherent in the prop-erty but is the period over which the prop-erty may reasonably be expected to be use-ful to the taxpayer or, if the taxpayer is en-gaged in a trade or business or an activ-ity for the production of income, the periodover which the property may reasonably beexpected to be useful to the taxpayer in itstrade or business or for the production ofincome, as applicable. See §1.167(a)–1(b)for the factors to be considered in deter-mining this period.

(ii) Exception. An amount paid is notrequired to be capitalized under paragraph(g)(1)(v) of this section if it is paid duringthe recovery period prescribed in section168(c) (taking into account the applicableconvention) for the property, regardless ofwhether the property is depreciated undersection 168(a).

(3) Replacement of a major compo-nent or a substantial structural part—(i)In general. For purposes of paragraph(g)(1)(vi) of this section, the replacementof a major component or a substantialstructural part means the replacement of—

(A) A part or a combination of parts ofthe unit of property, the cost of which com-prises 50 percent or more of the replace-ment cost of the unit of property; or

(B) A part or a combination of partsof the unit of property that comprise 50

percent or more of the physical structureof the unit of property.

(ii) Exception. An amount paid is notrequired to be capitalized under paragraph(g)(1)(vi) of this section if it is paid duringthe recovery period prescribed in section168(c) (taking into account the applicableconvention) for the property, regardless ofwhether the property is depreciated undersection 168(a).

(4) Examples. The following examplesillustrate solely the rules of this paragraph(g). Even if capitalization is not required inan example under the cited subparagraphunder this paragraph (g), the amounts paidin the example may be subject to capital-ization under a different provision of thissection, or under a different subparagraphin this paragraph (g).

Example 1. Replacement of loss component. Xowns a manufacturing building containing varioustypes of manufacturing equipment. X does a costsegregation study of the manufacturing building andproperly determines that a walk-in freezer in the man-ufacturing equipment is section 1245 property as de-fined in section 1245(a)(3). The freezer is not part ofthe HVAC system that relates to the general operationor maintenance of the building. The components ofthe walk-in freezer cease to function and X decidesto replace them. X abandons the freezer componentsand properly recognizes a loss from the abandonmentof the components. X replaces the abandoned freezercomponents with new components and incurs coststo acquire and install the new components. Underparagraph (g)(1)(i) of this section, X must capital-ize the amounts paid to acquire and install the newfreezer components because X replaced componentsfor which it had properly deducted a loss.

Example 2. Replacement of sold component. As-sume the same facts as in Example 1 except that X didnot abandon the components, but instead sold themto another party and properly recognized a loss onthe sale. Under paragraph (g)(1)(ii) of this section,X must capitalize the amounts paid to acquire and in-stall the new freezer components because X replacedcomponents for which it had properly taken into ac-count the adjusted basis of the components in realiz-ing a loss from the sale of the components.

Example 3. Restoration after casualty loss. Xowns an office building that it uses in its trade orbusiness. A storm damages the office building ata time when the building has an adjusted basis of$500,000. X deducts under section 165 a casualtyloss in the amount of $50,000 and properly reducesits basis in the office building to $450,000. X hires acontractor to repair the damage to the building andpays the contractor $50,000 for the work. Underparagraph (g)(1)(iii) of this section, X must capital-ize the $50,000 amount paid to the contractor becauseX properly adjusted its basis as a result of a casualtyloss under section 165.

Example 4. Restoration after casualty event. As-sume the same facts as in Example 3, except that Xreceives insurance proceeds of $50,000 after the ca-sualty to compensate for its loss. X cannot deduct a

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casualty loss under section 165 because its loss wascompensated by insurance. However, X properly re-duces its basis in the property by the amount of the in-surance proceeds. Under paragraph (g)(1)(iii) of thissection, X must capitalize the $50,000 amount paidto the contractor because X has properly taken a ba-sis adjustment relating to a casualty event describedin section 165.

Example 5. Restoration of property in a state ofdisrepair. X owns and operates a farm with severalbarns and outbuildings. One of the outbuildings is notused or maintained by X on a regular basis and fallsinto a state of disrepair. The outbuilding previouslywas used for storage but can no longer be used forthat purpose because the building is not structurallysound. X decides to restore the outbuilding and incurscosts to shore up the walls and replace the siding.Under paragraph (g)(1)(iv) of this section, X mustcapitalize the amounts paid to restore the outbuildingbecause they return the outbuilding to its ordinarilyefficient operating condition after it had deterioratedto a state of disrepair and was no longer functional forits intended use.

Example 6. Rebuild of property to like-new con-dition before end of economic useful life. X is a ClassI railroad that owns a fleet of freight cars. Freightcars have a recovery period of 7 years under section168(c) and an economic useful life of 30 years. Ev-ery 8 to 10 years, X rebuilds its freight cars. Tenyears after the freight car is placed in service by X,X performs a rebuild, which includes a complete dis-assembly, inspection, and reconditioning and/or re-placement of components of the suspension and draftsystems, trailer hitches, and other special equipment.X modifies the car to upgrade various components tothe latest engineering standards. The freight car es-sentially is stripped to the frame, with all of its sub-stantial components either reconditioned or replaced.The frame itself is the longest-lasting part of the carand is reconditioned. The walls of the freight carare replaced or are sandblasted and repainted. Newwheels are installed on the car. All the remainingcomponents of the car are restored before they arereassembled. At the end of the rebuild, the freightcar has been restored to a rebuilt condition under themanufacturer’s specifications. Assume the freight caris the unit of property. X is not required to capitalizeunder paragraph (g)(1)(v) of this section the amountspaid to rebuild the freight car because, although theamounts paid restore the freight car to a like-new con-dition, the amounts were not paid after the end of theeconomic useful life of the freight car.

Example 7. Rebuild of property to like-new con-dition after end of economic useful life. Assume thesame facts as in Example 6, except that X rebuildsthe freight car 40 years after it is placed in service byX. Under paragraph (g)(1)(v) of this section, X mustcapitalize the amounts paid to rebuild the freight carbecause the amounts paid restore the freight car to alike-new condition after the end of the economic use-ful life of the freight car.

Example 8. Replacement of major component. Xis a common carrier that owns a fleet of petroleumhauling trucks. X replaces the existing engine, cab,and petroleum tank with a new engine, cab, and tank.The new engine and cab cost $25,000; the new tankcosts $10,000. The cost of a new tractor is $50,000and the cost of a new trailer is $30,000. Assume thetractor of the truck (which includes the cab and the

engine) is a separate unit of property from the rest ofthe truck, and that the trailer (which contains the pe-troleum tank) is a separate unit of property from therest of the truck. Also assume that X replaced thecomponents after the end of the recovery periods un-der section 168(c) for the tractor and the trailer. Theamounts paid for the new engine and cab comprise50% of the cost of a new tractor and must be capital-ized under paragraph (g)(1)(vi) of this section. Theamounts paid for the new petroleum tank do not com-prise 50% or more of the cost of a new trailer; how-ever, the tank comprises more than 50% of the phys-ical structure of the trailer. Therefore, the amountspaid for the new tank also must be capitalized underparagraph (g)(1)(vi) of this section.

Example 9. Repair performed during a restora-tion. Assume the same facts as in Example 8, ex-cept that, at the same time the engine and cab of thetractor are replaced, X paints the cab of the tractorwith its company logo and fixes a broken taillighton the tractor. The repair of the broken taillight andthe painting of the cab generally are deductible ex-penses under §1.162–4. However, under paragraph(d)(4)(i) of this section, a taxpayer must capitalize allthe direct costs of an improvement and all the indi-rect costs that directly benefit or are incurred by rea-son of an improvement in accordance with the rulesunder section 263A. Repairs and maintenance thatdo not directly benefit or are not incurred by reasonof an improvement are not required to be capitalizedunder section 263(a), regardless of whether they aremade at the same time as an improvement. Therefore,all amounts paid that directly benefit or are incurredby reason of the tractor restoration must be capital-ized, including amounts paid for activities that usu-ally would be deductible maintenance expenses, suchas the painting of the cab. Amounts paid to repair thebroken taillight, however, are not incurred by reasonof the restoration of the tractor, nor do the amountspaid directly benefit the tractor restoration, despitethat the repair was performed at the same time as therestoration. Thus, X must capitalize to the restorationof the tractor the amounts paid to paint the cab, but Xis not required to capitalize to the restoration of thetractor the amounts paid to repair the broken taillight.

Example 10. Not a replacement of substantialstructural part. X owns a large retail store. X discov-ers a leak in the roof of the store and hires a contractorto inspect and fix the roof. The contractor discoversthat a major portion of the sheathing and rafters hasrotted, and recommends the replacement of the entireroof. X pays the contractor to replace the roof. As-sume the store and its structural components are theunit of property and that the roof does not comprise50% or more of the physical structure of the store.Also assume the cost of the roof does not comprise50% or more of the cost to acquire a new store. Con-sequently, the new roof is not a major component orsubstantial structural part of the store. Therefore, X isnot required to capitalize under paragraph (g)(1)(vi)of this section the amounts paid to replace the roof.

Example 11. Related amounts to replace majorcomponent. (i) X owns a retail gasoline station, con-sisting of a paved area used for automobile accessto the pumps and parking areas, a building used tomarket gasoline, and a canopy covering the gasolinepumps. The premises also consist of undergroundstorage tanks (USTs) that are connected by piping tothe pumps and are part of the machinery used in the

immediate retail sale of gas. To comply with regula-tions issued by the Environmental Protection Agency,X is required to remove and replace leaking USTs.In 2008, X hires a contractor to perform the removaland replacement, which consists of removing the oldtanks and installing new tanks with leak detectionsystems. The removal of the old tanks includes re-moving the paving material covering the tanks, exca-vating a hole large enough to gain access to the oldtanks, disconnecting any strapping and pipe connec-tions to the old tanks, and lifting the old tanks out ofthe hole. Installation of the new tanks includes place-ment of a liner in the excavated hole, placement ofthe new tanks, installation of a leak detection system,installation of an overfill system, connection of thetanks to the pipes leading to the pumps, backfillingof the hole, and replacement of the paving. Assumethe new tanks comprise 50% or more of the physicalstructure of the gasoline distribution system. X alsois required to pay a permit fee to the county to under-take the installation of the new tanks.

(ii) X pays the permit fee to the county on October15, 2008. The contractor performs all of the requiredwork and, on November 1, 2008, bills X for the costsof removing the old USTs. On November 15, 2008,the contractor bills X for the remainder of the work.Assume the gasoline distribution system is the unitof property. The USTs are major components of thegasoline distribution system. Therefore, under para-graphs (d)(5) and (g)(1)(vi) of this section, X mustcapitalize as an improvement to the distribution sys-tem the aggregate of related amounts paid to replacethe USTs, which related amounts include the amountpaid to the county, the amount paid to remove the oldUSTs, and the amount paid to install the new USTs(regardless that the amounts were separately invoicedand paid to two different parties).

Example 12. Minor part replacement; coordina-tion with section 263A. X is in the business of smelt-ing aluminum. X’s aluminum smelting facility in-cludes a plant where molten aluminum is poured intomolds and allowed to solidify. Because of the poten-tial of fire from a molten metal explosion, the plant’sroof must be made of fire-resistant material. The roofmust also be without leaks because rain water hit-ting the molten aluminum could cause an explosion.During 2008, X removed and replaced a major por-tion of the plant’s roof decking and roofing material.Assume the plant building and its structural compo-nents are the unit of property and that the portion ofthe roof that is replaced is not a major component orsubstantial structural part of the building. X is not re-quired to capitalize under paragraph (g)(1)(vi) of thissection the amounts paid to remove and replace theroof decking and materials. However, under section263A, all direct and indirect costs, including other-wise deductible costs, that directly benefit or are in-curred by reason of X’s manufacturing activities mustbe capitalized to the property produced by X. There-fore, because the amounts paid for the roof deckingand materials are incurred by reason of X’s manufac-turing operations, the amounts paid must be capital-ized under section 263A to the property produced byX.

(h) Capitalization of amounts to adaptproperty to a new or different use—(1)In general. Taxpayers must capitalizeamounts paid to adapt a unit of property

May 5, 2008 899 2008–18 I.R.B.

to a new or different use. In general, anamount is paid to adapt a unit of propertyto a new or different use if the adaptationis not consistent with the taxpayer’s in-tended ordinary use of the unit of propertyat the time originally placed in service bythe taxpayer.

(2) Examples. The following examplesillustrate solely the rules of this paragraph(h). Even if capitalization is not requiredin an example under this paragraph (h),the amounts paid in the example may besubject to capitalization under a differentprovision of this section.

Example 1. New or different use. X is a man-ufacturer and owns a manufacturing facility that ithas used for manufacturing since 1970, when it wasplaced in service by X. Assume the manufacturing fa-cility is a unit of property. In 2008, X incurred coststo convert its manufacturing facility into a showroomfor its business. To convert the facility, X replacesvarious structural components to provide a better lay-out for the showroom and its offices. X also rewiresand repaints the building as part of the conversion.None of the materials used, such as the wiring, arebetter than existing materials in the building. Underthis paragraph (h), the amounts paid by X to convertthe manufacturing facility into a showroom are paidto adapt the building to a new or different use becausethe conversion is not consistent with X’s intended or-dinary use of the property at the time it was placed inservice. Therefore, X is required to capitalize theseamounts under paragraph (h)(1) of this section.

Example 2. Not a new or different use. X ownsa building, which is a unit of property, consisting oftwenty retail spaces. The space was designed to bereconfigured; that is, adjoining spaces could be com-bined into one space. In 2008, one of the tenants ex-panded its occupancy to include two adjoining retailspaces. To facilitate the new lease, X incurred coststo remove the walls between the three retail spaces.Under this paragraph (h), the amounts paid by X toconvert three retail spaces into one larger space for anexisting tenant do not adapt X’s building to a new ordifferent use because the combination of retail spacesis consistent with X’s intended, ordinary use of thebuilding. Therefore, the costs are not required by thisparagraph (h) to be capitalized.

Example 3. Not a new or different use. X ownsa building, which is a unit of property, consistingof twenty retail spaces. X decides to sell the build-ing. In anticipation of selling the building, X repaintsthe interior walls and refinishes the hardwood floors.Preparing the building for sale does not constitutea new or different use for the building. Therefore,amounts paid in preparing the building for sale arenot required by this paragraph (h) to be capitalized.

Example 4. New or different use. Since 1930, Xhas owned a parcel of land on which it previouslyoperated a manufacturing facility. Assume that theland is the unit of property. During the course ofX’s operation of the manufacturing facility, the landbecame contaminated with wastes from its manufac-turing processes. In 1995, X discontinued manufac-turing operations at the site. In 2008, X decides tosell the property to a developer that intends to use the

property for residential housing. In anticipation ofselling the land, X pays amounts to clean up the landto a standard that is required for the land to be used forresidential purposes. In addition, X pays amounts toregrade the land so that it can be used for residentialpurposes. Amounts paid by X to clean up wastes thatwere discharged in the course of X’s manufacturingoperations do not adapt the land to a new or differentuse, regardless of the extent to which the land wascleaned. However, amounts to regrade the land sothat it can be used for residential purposes adapts theland to a new or different use that is inconsistent withX’s intended ordinary use of the property at the timeit was placed in service. Accordingly, the amountspaid by X to regrade the land must be capitalized un-der paragraph (h)(1) of this section.

(i) Optional regulatory accountingmethod—(1) In general. This paragraph(i) provides an optional simplified method(the regulatory accounting method) forregulated taxpayers to determine whetheramounts paid to repair, maintain, or im-prove tangible property are to be treatedas deductible expenses or capital expen-ditures. A taxpayer that elects to use theregulatory accounting method describedin paragraph (i)(3) of this section must usethat method for property subject to regu-latory accounting instead of determiningwhether amounts paid to repair, maintain,or improve property are capital expen-ditures or deductible expenses under thegeneral principles of sections 162(a), 212,and 263(a). Thus, the capitalization rulesin §1.263(a)–3(d) (and the routine mainte-nance safe harbor described in paragraph(e) of this section) do not apply to amountspaid to repair, maintain, or improve prop-erty subject to regulatory accounting bytaxpayers that elect to use the regulatoryaccounting method under this paragraph(i). However, section 263A continues toapply to costs required to be capitalized toproperty produced by the taxpayer or toproperty acquired for resale.

(2) Eligibility for regulatory account-ing method. A taxpayer that is engagedin a trade or business in a regulated in-dustry may use the regulatory accountingmethod under this paragraph (i). For pur-poses of this paragraph (i), a taxpayer in aregulated industry is a taxpayer that is sub-ject to the regulatory accounting rules ofthe Federal Energy Regulatory Commis-sion (FERC), the Federal CommunicationsCommission (FCC), or the Surface Trans-portation Board (STB).

(3) Description of regulatory account-ing method. Under the regulatory account-ing method, a taxpayer must follow its

method of accounting for regulatory ac-counting purposes in determining whetheran amount paid improves property underthis section. Therefore, a taxpayer mustcapitalize for Federal income tax purposesan amount paid that is capitalized as an im-provement for regulatory accounting pur-poses. A taxpayer must not capitalize forFederal income tax purposes under thissection an amount paid that is not capital-ized as an improvement for regulatory ac-counting purposes. A taxpayer that usesthe regulatory accounting method must usethat method for all of its tangible prop-erty that is subject to regulatory account-ing rules. The method does not apply totangible property that is not subject to reg-ulatory accounting rules.

(4) [Reserved](5) Examples. The rules of this para-

graph (i) are illustrated by the followingexamples.

Example 1. Taxpayer subject to regulatory ac-counting rules of FERC. X is an electric utility com-pany that operates a power plant to generate electric-ity. X is subject to the regulatory accounting rules ofFERC and X chooses to use the regulatory accountingmethod under this paragraph (i). X does not capital-ize on its books and records for regulatory account-ing purposes the cost of repairs made to its turbines.Under the regulatory accounting method, X must notcapitalize for Federal income tax purposes amountspaid for repairs made to its turbines.

Example 2. Taxpayer not subject to regulatory ac-counting rules of FERC. X is an electric utility com-pany that operates a power plant to generate electric-ity. X previously was subject to the regulatory ac-counting rules of FERC but, for various reasons, Xis no longer required to use FERC’s regulatory ac-counting rules. X cannot use the regulatory account-ing method provided in this paragraph (i).

Example 3. Taxpayer subject to regulatory ac-counting rules of FCC. X is a telecommunicationscompany that is subject to the regulatory accountingrules of the FCC. X chooses to use the regulatory ac-counting method under this paragraph (i). The assetsof X include a telephone central office switching cen-ter, which contains numerous switches and variousswitching equipment. X capitalizes on its books andrecords for regulatory accounting purposes the cost ofreplacing each switch. Under the regulatory account-ing method, X is required to capitalize for Federalincome tax purposes amounts paid to replace eachswitch.

Example 4. Taxpayer subject to regulatory ac-counting rules of STB. X is a Class I railroad that issubject to the regulatory accounting rules of the STB.X chooses to use the regulatory accounting methodunder this paragraph (i). X capitalizes on its booksand records for regulatory accounting purposes thecost of locomotive rebuilds. Under the regulatory ac-counting method, X is required to capitalize for Fed-eral income tax purposes amounts paid to rebuild itslocomotives.

2008–18 I.R.B. 900 May 5, 2008

(j) Repair allowance. A taxpayer mayuse a repair allowance method of ac-counting that is identified in publishedguidance in the Federal Register orin the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter).

(k) Treatment of capital expenditures.Amounts required to be capitalized un-der this section are capital expendituresand must be taken into account througha charge to capital account or basis, or inthe case of property that is inventory inthe hands of a taxpayer, through inclusionin inventory costs. See section 263A forthe treatment of amounts referred to inthis section as well as other amounts paidin connection with the production of realproperty and personal property, includ-ing films, sound recordings, video tapes,books, or similar properties.

(l) Recovery of capitalized amounts.Amounts that are capitalized under thissection are recovered through deprecia-tion, cost of goods sold, or by an adjust-ment to basis at the time the property isplaced in service, sold, used, or otherwisedisposed of by the taxpayer. Cost recoveryis determined by the applicable Code andregulation provisions relating to the use,sale, or disposition of property.

(m) [Reserved](n) Effective/applicability date. The


Par. 9. Section 1.263A–1 is amendedby adding paragraph (b)(14) as follows:

§1.263A–1 Uniform capitalization ofcosts.

* * * * *(b) * * *(14) Property subject to de minimis

rule. Section 263A does not apply to thecosts of property produced by a taxpayerto which the taxpayer properly applies thede minimis rule under §1.263(a)–2(d)(4).However, the cost of property to which ataxpayer properly applies the de minimisrule under §1.263(a)–2(d)(4) may be re-quired to be capitalized to other propertyas a cost incurred by reason of the produc-tion of the other property that is subject tosection 263A.

* * * * *


(Filed by the Office of the Federal Register on March 7, 2008,8:45 a.m., and published in the issue of the Federal Registerfor March 10, 2008, 73 F.R. 12837)

Notice of ProposedRulemaking byCross-Reference toTemporary Regulations

Disclosure of ReturnInformation in ConnectionWith Written Contracts Amongthe IRS, Whistleblowers, andLegal Representatives ofWhistleblowers

REG–114942–07


ACTION: Notice of proposed rulemakingby cross-reference to temporary regula-tions.

SUMMARY: In this issue of the Bulletin,the IRS is issuing temporary regulations(T.D. 9389) relating to the disclosure ofreturn information, pursuant to section6103(n), to whistleblowers and their legalrepresentatives. The temporary regula-tions describe the circumstances by whichan officer or employee of the Treasury De-partment may disclose return informationto a whistleblower and, if applicable, thelegal representative of the whistleblower,to the extent necessary in connection witha written contract among the IRS, thewhistleblower and, if applicable, the le-gal representative of the whistleblower,for services relating to the detection ofviolations of the internal revenue laws orrelated statutes. The temporary regula-tions will affect officers and employeesof the Treasury Department who disclosereturn information to whistleblowers, ortheir legal representatives, in connectionwith written contracts among the IRS,whistleblowers and, if applicable, theirlegal representatives, for services relat-ing to the detection of violations of theinternal revenue laws or related statutes.The temporary regulations will also affect

any whistleblower, or legal representativeof a whistleblower, who receives returninformation in connection with a writtencontract among the IRS, the whistleblowerand, if applicable, the legal representativeof the whistleblower, for services relatingto the detection of violations of the inter-nal revenue laws or related statutes.

DATES: Written or electronic commentsand requests for a public hearing must bereceived by June 23, 2008.

ADDRESSES: Send submissions toCC:PA:LPD:PR (REG–114942–07),room 5203, Internal Revenue Service,PO Box 7604, Ben Franklin Station,Washington, DC 20044. Submissions maybe hand-delivered Monday through Fridaybetween the hours of 8 a.m. and 4 p.m.to CC:PA:LPD:PR (REG–114942–07),Courier’s Desk, Internal RevenueService, 1111 Constitution Avenue, NW,Washington, DC, or sent electronically,via the Federal eRulemakingPortal at www.regulations.gov (IRSREG–114942–07).

FOR FURTHER INFORMATIONCONTACT: Helene R. Newsome,202–622–7950 (not a toll-free number).


Background and Explanation ofProvisions

Temporary regulations in this issueof the Bulletin amend the Procedure andAdministration Regulations (26 CFR part301) under section 6103(n) relating to thedisclosure of return information in con-nection with written contracts among theIRS, whistleblowers and, if applicable,their legal representatives.

The Tax Relief and Health Care Actof 2006, Public Law 109–432 (120 Stat.2958), (the Act) was enacted on December20, 2006. Section 406 of the Act amendssection 7623, concerning the payment ofawards to whistleblowers, and establishesa Whistleblower Office within the IRSthat has responsibility for the adminis-tration of a whistleblower program. TheWhistleblower Office, in connection withadministering a whistleblower program,will analyze information provided by awhistleblower, and either investigate thematter itself or assign it to the appropriate

May 5, 2008 901 2008–18 I.R.B.

IRS office for investigation. In analyzinginformation provided by a whistleblower,or investigating a matter, the Whistle-blower Office may determine that it re-quires the assistance of the whistleblower,or the legal representative of the whistle-blower. The legislative history of section406 of the Act states that “[t]o the extentthe disclosure of returns or return infor-mation is required [for the whistlebloweror his or her legal representative] to ren-der such assistance, the disclosure mustbe pursuant to an IRS tax administrationcontract.” Joint Committee of Taxation,Technical Explanation of H.R. 6408, The“Tax Relief and Health Care Act of 2006,”as Introduced in the House on December7, 2006, at 89 (JCX–50–06), December 7,2006. The legislative history further statesthat “[i]t is expected that such disclosureswill be infrequent and will be made onlywhen the assigned task cannot be properlyor timely completed without the returninformation to be disclosed.” Id.

Under section 6103(a), returns and re-turn information are confidential unlessthe Internal Revenue Code (Code) au-thorizes disclosure. Section 6103(n) isthe authority by which returns and returninformation may be disclosed pursuantto a tax administration contract. Section6103(n) authorizes, pursuant to regula-tions prescribed by the Secretary, returnsand return information to be disclosedto any person, including any person de-scribed in section 7513(a), for purposes oftax administration, to the extent necessaryin connection with: (1) the processing,storage, transmission, and reproductionof returns and return information; (2) theprogramming, maintenance, repair, test-ing, and procurement of equipment; and(3) the providing of other services. Theseproposed regulations describe the cir-cumstances, pursuant to section 6103(n),by which officers and employees of theTreasury Department may disclose re-

turn information to whistleblowers and, ifapplicable, their legal representatives, inconnection with written contracts for ser-vices relating to the detection of violationsof the internal revenue laws or relatedstatutes.

The text of the temporary regulationsalso serves as the text of these proposedregulations. The preamble to the tempo-rary regulations explains these proposedregulations.

Special Analyses

It has been determined that this noticeof 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 hasbeen determined that section 553(b) of theAdministrative Procedure Act (5 U.S.C.chapter 5) does not apply to these reg-ulations, and because the regulations donot impose a collection of information onsmall entities, the Regulatory FlexibilityAct (5 U.S.C. chapter 6) does not apply.Pursuant to section 7805(f) of the Code,these regulations have been submitted tothe Chief Counsel of the Small BusinessAdministration for comment on its impacton small businesses.

Comments and Request for a PublicHearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any electronic and writ-ten comments (a signed original and eight(8) copies) that are submitted timely to theIRS. The IRS and Treasury Department re-quest comments on the clarity of the pro-posed rule and how it may be made eas-ier to understand. All comments will beavailable for public inspection and copy-ing. A public hearing may be scheduled ifrequested in writing by a person that timelysubmits written comments. If a public

hearing is scheduled, notice of the date,time, and place of the hearing will be pub-lished in the Federal Register.


The principal author of these regula-tions is Helene R. Newsome, Office ofthe Associate Chief Counsel (Procedure &Administration).

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 301 is pro-posed to be amended as follows:

PART 301—PROCEDURE ANDADMINISTRATION

Paragraph 1. The authority citation forpart 301 is amended by adding an entry innumerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *Section 301.6103(n)–2 also issued un-

der 26 U.S.C. 6103(n); * * *Par. 2. Section 301.6103(n)–2 is added

to read as follows:

§301.6103(n)–2 Disclosure of returninformation in connection withwritten contracts among the IRS,whistleblowers, and legal representativesof whistleblowers.

[The text of this proposed section is thesame as the text of §301.6103(n)–2T pub-lished elsewhere in this issue of the Bul-letin].



2008–18 I.R.B. 902 May 5, 2008

Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as “rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe the ef-fect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position is be-ing extended to apply to a variation of thefact situation set forth therein. Thus, ifan earlier ruling held that a principle ap-plied to A, and the new ruling holds that thesame principle also applies to B, the earlierruling is amplified. (Compare with modi-fied, below).

Clarified is used in those instanceswhere the language in a prior ruling is be-ing made clear because the language hascaused, or may cause, some confusion.It is not used where a position in a priorruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previously pub-lished ruling and points out an essentialdifference between them.

Modified is used where the substanceof a previously published position is beingchanged. Thus, if a prior ruling held that aprinciple applied to A but not to B, and thenew ruling holds that it applies to both A

and B, the prior ruling is modified becauseit corrects a published position. (Comparewith amplified and clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly used ina ruling that lists previously published rul-ings that are obsoleted because of changesin laws or regulations. A ruling may alsobe obsoleted because the substance hasbeen included in regulations subsequentlyadopted.

Revoked describes situations where theposition in the previously published rulingis not correct and the correct position isbeing stated in a new ruling.

Superseded describes a situation wherethe 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 the1986 Code and regulations the same po-sition published under the 1939 Code andregulations. The term is also used whenit is desired to republish in a single rul-ing a series of situations, names, etc., thatwere previously published over a period oftime in separate rulings. If the new rul-ing does more than restate the substance

of a prior ruling, a combination of termsis used. For example, modified and su-perseded describes a situation where thesubstance of a previously published rulingis being changed in part and is continuedwithout change in part and it is desired torestate the valid portion of the previouslypublished ruling in a new ruling that is selfcontained. In this case, the previously pub-lished ruling is first modified and then, asmodified, is superseded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further names insubsequent rulings. After the original rul-ing has been supplemented several times, anew ruling may be published that includesthe list in the original ruling and the ad-ditions, and supersedes all prior rulings inthe series.

Suspended is used in rare situations toshow that the previous published rulingswill not be applied pending some futureaction such as the issuance of new oramended regulations, the outcome of casesin litigation, or the outcome of a Servicestudy.

AbbreviationsThe following abbreviations in current useand formerly used will appear in materialpublished in the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.E.O.—Executive Order.

ER—Employer.ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contributions Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—Grantor.IC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.PHC—Personal Holding Company.PO—Possession of the U.S.PR—Partner.

PRS—Partnership.PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statement of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D. —Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z —Corporation.

May 5, 2008 i 2008–18 I.R.B.

Numerical Finding List1

Bulletins 2008–1 through 2008–18

Announcements:

2008-1, 2008-1 I.R.B. 246

2008-2, 2008-3 I.R.B. 307

2008-3, 2008-2 I.R.B. 269

2008-4, 2008-2 I.R.B. 269

2008-5, 2008-4 I.R.B. 333

2008-6, 2008-5 I.R.B. 378

2008-7, 2008-5 I.R.B. 379

2008-8, 2008-6 I.R.B. 403

2008-9, 2008-7 I.R.B. 444

2008-10, 2008-7 I.R.B. 445

2008-11, 2008-7 I.R.B. 445

2008-12, 2008-7 I.R.B. 446

2008-13, 2008-8 I.R.B. 480

2008-14, 2008-8 I.R.B. 481

2008-15, 2008-9 I.R.B. 511

2008-16, 2008-9 I.R.B. 511

2008-17, 2008-9 I.R.B. 512

2008-18, 2008-12 I.R.B. 667

2008-19, 2008-11 I.R.B. 624

2008-20, 2008-11 I.R.B. 625

2008-21, 2008-13 I.R.B. 691

2008-22, 2008-13 I.R.B. 692

2008-23, 2008-14 I.R.B. 731

2008-24, 2008-13 I.R.B. 692

2008-25, 2008-14 I.R.B. 732

2008-26, 2008-13 I.R.B. 693

2008-27, 2008-15 I.R.B. 751

2008-28, 2008-14 I.R.B. 733

2008-29, 2008-15 I.R.B. 786

2008-30, 2008-16 I.R.B. 825

2008-31, 2008-15 I.R.B. 787

2008-32, 2008-16 I.R.B. 826

2008-33, 2008-16 I.R.B. 826

2008-34, 2008-17 I.R.B. 849

2008-35, 2008-17 I.R.B. 849

2008-36, 2008-16 I.R.B. 827

2008-37, 2008-17 I.R.B. 850

2008-38, 2008-17 I.R.B. 851

2008-39, 2008-18 I.R.B. 867

Court Decisions:

2085, 2008-17 I.R.B. 828

Notices:

2008-1, 2008-2 I.R.B. 251

2008-2, 2008-2 I.R.B. 252

2008-3, 2008-2 I.R.B. 253

2008-4, 2008-2 I.R.B. 253

2008-5, 2008-2 I.R.B. 256

2008-6, 2008-3 I.R.B. 275

2008-7, 2008-3 I.R.B. 276

Notices— Continued:

2008-8, 2008-3 I.R.B. 276

2008-9, 2008-3 I.R.B. 277

2008-10, 2008-3 I.R.B. 277

2008-11, 2008-3 I.R.B. 279

2008-12, 2008-3 I.R.B. 280

2008-13, 2008-3 I.R.B. 282

2008-14, 2008-4 I.R.B. 310

2008-15, 2008-4 I.R.B. 313

2008-16, 2008-4 I.R.B. 315

2008-17, 2008-4 I.R.B. 316

2008-18, 2008-5 I.R.B. 363

2008-19, 2008-5 I.R.B. 366

2008-20, 2008-6 I.R.B. 406

2008-21, 2008-7 I.R.B. 431

2008-22, 2008-8 I.R.B. 465

2008-23, 2008-7 I.R.B. 433

2008-24, 2008-8 I.R.B. 466

2008-25, 2008-9 I.R.B. 484

2008-26, 2008-9 I.R.B. 487

2008-27, 2008-10 I.R.B. 543

2008-28, 2008-10 I.R.B. 546

2008-29, 2008-12 I.R.B. 637

2008-30, 2008-12 I.R.B. 638

2008-31, 2008-11 I.R.B. 592

2008-32, 2008-11 I.R.B. 593

2008-33, 2008-12 I.R.B. 642

2008-34, 2008-12 I.R.B. 645

2008-35, 2008-12 I.R.B. 647

2008-36, 2008-12 I.R.B. 650

2008-37, 2008-12 I.R.B. 654

2008-38, 2008-13 I.R.B. 683

2008-39, 2008-13 I.R.B. 684

2008-40, 2008-14 I.R.B. 725

2008-41, 2008-15 I.R.B. 742

2008-42, 2008-15 I.R.B. 747

2008-43, 2008-15 I.R.B. 748

2008-44, 2008-16 I.R.B. 799

2008-45, 2008-17 I.R.B. 835

2008-46, 2008-18 I.R.B. 868

2008-47, 2008-18 I.R.B. 869

Proposed Regulations:

REG-168745-03, 2008-18 I.R.B. 871

REG-147290-05, 2008-10 I.R.B. 576

REG-153589-06, 2008-14 I.R.B. 730

REG-104713-07, 2008-6 I.R.B. 409

REG-104946-07, 2008-11 I.R.B. 596

REG-110136-07, 2008-17 I.R.B. 838

REG-111583-07, 2008-4 I.R.B. 319

REG-114126-07, 2008-6 I.R.B. 410

REG-114942-07, 2008-18 I.R.B. 901

REG-119518-07, 2008-17 I.R.B. 844

REG-124590-07, 2008-16 I.R.B. 801

REG-127391-07, 2008-13 I.R.B. 689

REG-136701-07, 2008-11 I.R.B. 616

Proposed Regulations— Continued:

REG-137573-07, 2008-15 I.R.B. 750

REG-139236-07, 2008-9 I.R.B. 491

REG-141399-07, 2008-8 I.R.B. 470

REG-143468-07, 2008-17 I.R.B. 848

REG-147832-07, 2008-8 I.R.B. 472

REG-149475-07, 2008-9 I.R.B. 510

REG-151135-07, 2008-16 I.R.B. 815

Revenue Procedures:

2008-1, 2008-1 I.R.B. 1

2008-2, 2008-1 I.R.B. 90

2008-3, 2008-1 I.R.B. 110

2008-4, 2008-1 I.R.B. 121

2008-5, 2008-1 I.R.B. 164

2008-6, 2008-1 I.R.B. 192

2008-7, 2008-1 I.R.B. 229

2008-8, 2008-1 I.R.B. 233

2008-9, 2008-2 I.R.B. 258

2008-10, 2008-3 I.R.B. 290

2008-11, 2008-3 I.R.B. 301

2008-12, 2008-5 I.R.B. 368

2008-13, 2008-6 I.R.B. 407

2008-14, 2008-7 I.R.B. 435

2008-15, 2008-9 I.R.B. 489

2008-16, 2008-10 I.R.B. 547

2008-17, 2008-10 I.R.B. 549

2008-18, 2008-10 I.R.B. 573

2008-19, 2008-11 I.R.B. 594

2008-21, 2008-12 I.R.B. 657

2008-22, 2008-12 I.R.B. 658

2008-23, 2008-12 I.R.B. 664

2008-24, 2008-13 I.R.B. 684

2008-25, 2008-13 I.R.B. 686

Revenue Rulings:

2008-1, 2008-2 I.R.B. 248

2008-2, 2008-2 I.R.B. 247

2008-3, 2008-2 I.R.B. 249

2008-4, 2008-3 I.R.B. 272

2008-5, 2008-3 I.R.B. 271

2008-6, 2008-3 I.R.B. 271

2008-7, 2008-7 I.R.B. 419

2008-8, 2008-5 I.R.B. 340

2008-9, 2008-5 I.R.B. 342

2008-10, 2008-13 I.R.B. 676

2008-11, 2008-10 I.R.B. 541

2008-12, 2008-10 I.R.B. 520

2008-13, 2008-10 I.R.B. 518

2008-14, 2008-11 I.R.B. 578

2008-15, 2008-12 I.R.B. 633

2008-16, 2008-11 I.R.B. 585

2008-17, 2008-12 I.R.B. 626

2008-18, 2008-13 I.R.B. 674

2008-19, 2008-13 I.R.B. 669

2008-20, 2008-14 I.R.B. 716

1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2007–27 through 2007–52 is in Internal Revenue Bulletin2007–52, dated December 26, 2007.

2008–18 I.R.B. ii May 5, 2008

Revenue Rulings— Continued:

2008-21, 2008-15 I.R.B. 734

2008-22, 2008-16 I.R.B. 796

2008-23, 2008-18 I.R.B. 852

2008-24, 2008-18 I.R.B. 861

Tax Conventions:

2008-8, 2008-6 I.R.B. 403

2008-39, 2008-18 I.R.B. 867

Treasury Decisions:

9368, 2008-6 I.R.B. 382

9369, 2008-6 I.R.B. 394

9370, 2008-7 I.R.B. 428

9371, 2008-8 I.R.B. 447

9372, 2008-8 I.R.B. 462

9373, 2008-8 I.R.B. 463

9374, 2008-10 I.R.B. 521

9375, 2008-5 I.R.B. 344

9376, 2008-11 I.R.B. 587

9377, 2008-11 I.R.B. 578

9378, 2008-14 I.R.B. 720

9379, 2008-14 I.R.B. 715

9380, 2008-14 I.R.B. 718

9381, 2008-14 I.R.B. 694

9382, 2008-9 I.R.B. 482

9383, 2008-15 I.R.B. 738

9384, 2008-16 I.R.B. 792

9385, 2008-15 I.R.B. 735

9386, 2008-16 I.R.B. 788

9387, 2008-16 I.R.B. 789

9388, 2008-17 I.R.B. 832

9389, 2008-18 I.R.B. 863

9390, 2008-18 I.R.B. 855

May 5, 2008 iii 2008–18 I.R.B.

Finding List of Current Actions onPreviously Published Items1

Bulletins 2008–1 through 2008–18

Announcements:

2006-88

Clarified and superseded by

Notice 2008-35, 2008-12 I.R.B. 647Notice 2008-36, 2008-12 I.R.B. 650

2008-6

Superseded by

Ann. 2008-19, 2008-11 I.R.B. 624

Notices:

2001-16

Modified by

Notice 2008-20, 2008-6 I.R.B. 406

2001-60

Modified and superseded by

Notice 2008-31, 2008-11 I.R.B. 592

2002-44

Superseded by

Notice 2008-39, 2008-13 I.R.B. 684

2003-51

Superseded by

Rev. Proc. 2008-24, 2008-13 I.R.B. 684

2006-27


Notice 2008-35, 2008-12 I.R.B. 647

2006-28


Notice 2008-36, 2008-12 I.R.B. 650

2006-52

Clarified and amplified by

Notice 2008-40, 2008-14 I.R.B. 725

2006-77


Notice 2008-25, 2008-9 I.R.B. 484

2006-107

Modified by

Notice 2008-7, 2008-3 I.R.B. 276

2007-30


Notice 2008-14, 2008-4 I.R.B. 310

2007-54

Clarified by

Notice 2008-11, 2008-3 I.R.B. 279

2008-13

Supplemented by

Notice 2008-46, 2008-18 I.R.B. 868

Notices— Continued:

2008-27

Clarified, amended, supplemented, and

superseded by

Notice 2008-41, 2008-15 I.R.B. 742

Proposed Regulations:

REG-209020-86

Corrected by

Ann. 2008-11, 2008-7 I.R.B. 445

REG-107592-00

Partial withdrawal by

Ann. 2008-25, 2008-14 I.R.B. 732

REG-149856-03

Hearing scheduled by

Ann. 2008-26, 2008-13 I.R.B. 693

REG-113891-07


Ann. 2008-4, 2008-2 I.R.B. 269

REG-114126-07

Corrected by

Ann. 2008-36, 2008-16 I.R.B. 827

REG-127770-07


Ann. 2008-24, 2008-13 I.R.B. 692

REG-133300-07


Ann. 2008-34, 2008-17 I.R.B. 849

REG-141399-07

Hearing cancelled by

Ann. 2008-31, 2008-15 I.R.B. 787

Revenue Procedures:

97-36

Modified by

Rev. Proc. 2008-23, 2008-12 I.R.B. 664

2001-23

Modified by

Rev. Proc. 2008-23, 2008-12 I.R.B. 664

2002-9

Modified by

Rev. Proc. 2008-18, 2008-10 I.R.B. 573

Modified and amplified by

Rev. Proc. 2008-25, 2008-13 I.R.B. 686

2007-1

Superseded by

Rev. Proc. 2008-1, 2008-1 I.R.B. 1

2007-2

Superseded by

Rev. Proc. 2008-2, 2008-1 I.R.B. 90

Revenue Procedures— Continued:

2007-3

Superseded by

Rev. Proc. 2008-3, 2008-1 I.R.B. 110

2007-4

Superseded by

Rev. Proc. 2008-4, 2008-1 I.R.B. 121

2007-5

Superseded by

Rev. Proc. 2008-5, 2008-1 I.R.B. 164

2007-6

Superseded by

Rev. Proc. 2008-6, 2008-1 I.R.B. 192

2007-7

Superseded by

Rev. Proc. 2008-7, 2008-1 I.R.B. 229

2007-8

Superseded by

Rev. Proc. 2008-8, 2008-1 I.R.B. 233

2007-26

Obsoleted in part by

Rev. Proc. 2008-17, 2008-10 I.R.B. 549

2007-31

Obsoleted in part by

Rev. Proc. 2008-19, 2008-11 I.R.B. 594

2007-39

Superseded by

Rev. Proc. 2008-3, 2008-1 I.R.B. 110

2007-52

Superseded by

Rev. Proc. 2008-9, 2008-2 I.R.B. 258

2008-13

Corrected by

Ann. 2008-15, 2008-9 I.R.B. 511

Revenue Rulings:

58-612


Rev. Rul. 2008-15, 2008-12 I.R.B. 633

64-250

Amplified by

Rev. Rul. 2008-18, 2008-13 I.R.B. 674

89-42


Rev. Rul. 2008-17, 2008-12 I.R.B. 626

92-19

Supplemented in part by

Rev. Rul. 2008-19, 2008-13 I.R.B. 669

97-31


Rev. Rul. 2008-17, 2008-12 I.R.B. 626

1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2007–27 through 2007–52 is in Internal Revenue Bulletin 2007–52, dated December 26,2007.

2008–18 I.R.B. iv May 5, 2008

Revenue Rulings— Continued:

2001-48


Rev. Rul. 2008-17, 2008-12 I.R.B. 626

2007-4

Supplemented and superseded by

Rev. Rul. 2008-3, 2008-2 I.R.B. 249

Treasury Decisions:

8697

Corrected by

Ann. 2008-38, 2008-17 I.R.B. 851

9273

Corrected by

Ann. 2008-33, 2008-16 I.R.B. 826

9362

Corrected by

Ann. 2008-9, 2008-7 I.R.B. 444Ann. 2008-12, 2008-7 I.R.B. 446

9363

Corrected by

Ann. 2008-10, 2008-7 I.R.B. 445

9368

Corrected by

Ann. 2008-29, 2008-15 I.R.B. 786Ann. 2008-30, 2008-16 I.R.B. 825

9375

Corrected by

Ann. 2008-16, 2008-9 I.R.B. 511

9386

Corrected by

Ann. 2008-35, 2008-17 I.R.B. 849

May 5, 2008 v 2008–18 I.R.B.

2008–18 I.R.B. May 5, 2008

May 5, 2008 2008–18 I.R.B.

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