Industry Briefs
Banking
Tax Issues
Year Ended December 31, 2002
IRS PUBLISHED RULINGS
must be provided by January 31 of each calendar year
for which an RMD is required.
IRA Required Minimum Distributions Reporting
IRS Notice 2003-2 provides that until further notice,
notwithstanding Question A-12 of Income Tax
Regulations §1.401(a)(9)-6T, in the case of an annuity
contract under an IRA from which annuity payments
have not commenced on an irrevocable basis (except
for acceleration), the IRA trustee may determine the
entire interest under the annuity contract as the dollar
amount credited to the employee or beneficiary under
the annuity contract without regard to the actuarial
value of any other benefits (such as minimum
survivor benefits) that will be provided under the
contract.
On 12/20/02, the IRS issued Notice 2003-3 clarifying
Notice 2002-27 that provides guidance on the reports
that trustees are required to make regarding
minimum distributions from IRAs and annuities
under an IRA. Specifically, Notice 2003-3 provides: (a)
that a trustee can satisfy the requirement to provide
statements regarding RMD to the owners of the IRAs
for which it is the trustee by using one of the two
alternatives provided in Notice 2002-27 for some IRA
owners and the other alternative for other IRA
owners; and (b) guidance on how these statements
can be transmitted electronically.
Background. §408(i), IRC, provides that the trustee of
an IRA must make such reports regarding the IRA to
the IRS and to the IRA owner as the IRS may require.
Form 5498, IRA Contribution Information, is a form
used to satisfy part of this reporting requirement.
Notice 2002-27 provides that the trustee must comply
with either of two reporting alternatives. Under the
first alternative, the trustee must furnish the IRA
owner a statement indicating the RMD amount for
the IRA and the date by which such amount must be
distributed. Under the second alternative, the trustee
must furnish the IRA owner a statement showing that
an RMD is required for the calendar year and the date
by which the RMD must be distributed, and including
an offer to calculate, upon request, the amount of the
RMD. The statement required under either alternative
Notice 2003-3. Notice 2003-3 clarifies Notice 2002-27
as follows:
•
Permitted Inconsistent Use of Alternatives. A trustee
is permitted to satisfy the requirement in Notice
2002-27 that it provide statements regarding the
RMD to the owners of the IRAs for which it is the
trustee by providing statements that satisfy the
first alternative to some IRA owners and
statements that satisfy the second alternative to
the rest of the IRA owners.
•
Permitted Electronic Furnishing of Statements. A
trustee is permitted to transmit electronically the
statements that it is required, under Notice 200227, to provide to IRA owners regarding RMD if
the following requirements are satisfied:
–
For 2003, the electronic transmission must
comply with a reasonable and good-faith
interpretation of applicable law.
–
For calendar years after 2003, the trustee is
permitted to transmit the statements
electronically only if the procedures that apply
to the electronic transmission of Forms W-2,
Wage and Tax Statement, are satisfied,
including the consent requirement described
in the regulations under §6051, IRC. (The IRS
stated that the use of these procedures is a
reasonable, good-faith interpretation of
applicable law for 2003.)
IRA Required Minimum DistributionsValuation
On 10/3/02, the IRS issued Rev. Rul. 2002-62 that is
designed to help taxpayers preserve their retirement
savings when there is an unexpected drop in their
value. Some taxpayers began receiving fixed payments
from their IRA or qualified retirement plan based on
the value of their account at the time they started
receiving payments. Rev. Rul. 2002-62 permits those
taxpayers to switch, without penalty, to a method of
determining the amount of their payments based on
the value of their account as it changes from year to
year (referred to as the required minimum
distribution method).
Background. §72(t)(1) provides that if an employee or
IRA owner receives any amount from a qualified
retirement plan before attaining age 59½, the
employee’s or IRA owners income tax is increased by
an amount equal to 10% of the amount that is
includible in the gross income unless one of the
exceptions in §72(t)(2) applies.
§72(t)(2)(A)(iv) provides, in part, that if distributions
are part of a series of substantially equal periodic
payments (not less frequently than annually) made for
the life (or life expectancy) of the employee or the joint
lives (or joint life expectancy) of the employee and
beneficiary, the tax described in §72(t)(1) will not be
applicable. Pursuant to §72(t)(5), in the case of
distributions from an IRA, the IRA owner is
substituted for the employee for purposes of applying
this exception.
§72(t)(4) provides that if the series of substantially
equal periodic payments that is otherwise excepted
from the 10% tax is subsequently modified (other than
by reason of death or disability) within a 5-year period
beginning on the date of the first payment, or, if later,
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age 59½, the exception to the 10% tax does not apply,
and the taxpayer’s tax for the year of modification is
increased by an amount which, but for the exception,
would have been imposed, plus interest for the
deferral period.
Q&A-12 of IRS Notice 89-25 sets forth three methods
for determining whether payments to individuals
from their IRAs or, if they have separated from
service, from their qualified retirement plans
constitute a series of substantially equal periodic
payments for purposes of §72(t)(2)(A)(iv).
Final Income Tax Regulations that were issued on
4/16/02 under §401(a)(9) provide new life expectancy
tables for determining required minimum
distributions from qualified retirement plans and
IRAs.
Rev. Rul. 2002-62. Two of the safe-harbor methods
described in Notice 89-25 result in a fixed amount that
is required to be distributed and could result in the
premature depletion of the taxpayer’s account in the
event that the value of the assets in the account suffers
a decline in market value. Rev. Rul. 2002-62 provides
relief to taxpayers who selected one of these two
methods by permitting them to change from a
method for determining the payments under which
the amount is fixed to the third method under the
safe-harbor where the amount changes from year to
year based on the value in the account from which the
distributions are being made (i.e., the required
minimum distribution method described in §2.01(a)
of Rev. Rul. 2002-62).
Rev. Rul. 2002-62 states that an individual who
begins distributions in a year using either the fixed
amortization method or the fixed annuitization
method may in any subsequent year switch to the
required minimum distribution method to determine
the payment for the year of the switch and all
subsequent years and the change in method will not
be treated as a modification within the meaning of
§72(t)(4). Once a change is made under Rev. Rul.
2002-62, the required minimum distribution method
must be followed in all subsequent years. Any
subsequent change will be a modification for
purposes of §72(t)(4).
In addition to permitting a one-time switch in
method, Rev. Rul. 2002-62:
•
Clarifies how an individual can satisfy the
permitted method that tracks the required
minimum distribution rules of §401(a)(9) in light
of the recent finalization of regulations regarding
those requirements;
•
Provides guidance on what constitutes a
reasonable rate of interest for determining
payments to satisfy the substantially equal
periodic payment rule; and
•
Provides a choice of mortality tables that can be
used in satisfying the permitted methods.
Effective Date. The guidance in Rev. Rul. 2002-62
replaces the guidance in Q&A-12 of Notice 89-25 for
any series of payments commencing on or after
1/1/03, and may be used for distributions
commencing in 2002. If a series of payments
commenced in a year prior to 2003 that satisfied
§72(t)(2)(A)(iv), the method of calculating the
payments in the series is permitted to be changed at
any time to the required minimum distribution
method described in §2.01(a) of Rev. Rul. 2002-62,
including use of a different life expectancy table.
Nonstatutory Stock Options
On 11/22/02, the IRS issued Announcement 2002-18
reminding taxpayers that, as provided in
Announcement 2001-92, the reporting of
compensation resulting from employer-provided
nonstatutory stock options in box 12 of the Form W-2,
using Code V, is mandatory for Forms W-2 issued for
the year 2003 and subsequent years. Announcement
2002-18 is consistent with the 2003 Form W-2 and
related instructions that the IRS intends to publish in
the near future.
Background. There are two classifications of stock
options: (a) statutory or qualified options (i.e., the tax
treatment of the options is governed by specific IRC
§§421 through 424); and (b) nonstatutory or
nonqualified options (i.e., the tax treatment of the
options is governed under the more general IRC
principles of compensation and the recognition of
income).
When an employee (or former employee) exercises
nonstatutory stock options, employers are required to
report the excess of the fair market value of the stock
received on exercise of the option over the amount
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paid for that stock. That amount is reported on Form
W-2 in boxes 1, 3 (up to the social security wage base),
and 5.
Announcement 2000-97 advised employers that,
beginning for 2001 Forms W-2, income from the
exercise of nonstatutory stock options would also be
required to be reported in box 12 and identified by a
new code, Code V - Income from the exercise of
nonstatutory stock options.
In response to employer concerns, Announcement
2001-7 subsequently provided the relief that the use of
Code V would be optional for the 2001 Forms W-2.
Announcement 2001-92 extended the relief so that
the use of Code V would be optional for the 2002
Forms W-2.
Announcement 2001-92 further requested public
comment and suggestions regarding potential
methods that would enable more efficient and cost
effective means of collecting the information that
would be reported using Code V. Specifically,
Announcement 2001-92 requested proposals for
better and less burdensome methods of collecting the
information about employee income that arises from
the exercise of nonstatutory stock options, including
information about the presence and amount of
nonstatutory stock option income on an employee (or
former employee) basis. Announcement 2001-92
noted that absent further guidance, the Code V
reporting requirement would be mandatory for 2003
Forms W-2.
Announcement 2002-18. The IRS has determined that
none of the alternatives suggested in the comments
received would provide complete and accurate
information of the type that will be reported through
the use of Code V. Accordingly, consistent with
Announcement 2001-92, the reporting of
compensation resulting from employer-provided
nonstatutory stock options in box 12 of the Form W-2,
using Code V, is mandatory for Forms W-2 issued for
the year 2003 and subsequent years in accordance
with the Form W-2 and its related instructions.
Interest Rate Swaps
On 10/16/02, the IRS issued Rev. Rul. 2002-71
addressing the following issue involving the
termination of interest rate swaps: When should a
taxpayer take into account gain or loss on the
with the issuance of the debt instrument, TP also
enters into an NPC with a 5-year term that
converts the fixed rate payments under the debt
instrument into floating rate payments (i.e., the
NPC provides for TP to receive payments equal to
the product of the fixed rate on the debt
instrument and a notional amount equal to the
principal amount of the debt instrument in
exchange for payments by TP equal to the product
of a floating rate and the same notional amount).
Pursuant to §1.1221-2(1), TP properly identifies the
NPC as a hedging transaction covering Year 1
through Year 5 of the debt instrument and
complies with the other requirements necessary
for the NPC to be treated as a hedge under
§§1.1221-2 and 1.446-4. TP terminates the NPC on
the last day of Year 2 and either receives or makes
a termination payment.
termination of a notional principal contract (“NPC”—
i.e., an interest rate swap) that hedges a portion of the
term of a debt instrument issued by the taxpayer? Rev.
Rul 2002-71 addresses the issue in the context of two
factual situations.
Background. §1.446-4(a) provides that a hedging
transaction, as defined in §1.1221-2(b), must be
accounted for under the rules set forth in §1.446-4.
§1.446-4(b) provides that the method of accounting
used by a taxpayer for a hedging transaction must
clearly reflect income. §1.446-4(b) further provides
that to clearly reflect income, the method used for a
hedging transaction must reasonably match the
timing of income, deduction, gain, or loss from the
hedging transaction with timing of income,
deduction, gain, or loss from the item being hedged.
§1.446-4(e)(4) provides that gain or loss from a
transaction that hedges a debt instrument issued or to
be issued by a taxpayer, or a debt instrument held or
to be held by a taxpayer, must be accounted for by
reference to the terms of the debt instrument and the
period or periods to which the hedge relates. A hedge
of an instrument that provides for interest to be paid
at a fixed rate or a qualified floating rate generally is
accounted for using constant yield principles. Thus,
assuming that a fixed rate or qualified floating rate
instrument remains outstanding, hedging gain or loss
is taken into account in the same periods in which it
would be taken into account if it adjusted the yield of
the instrument over the term to which the hedge
relates.
•
Rev. Rul. 2002-71. Based on the above facts, the IRS
arrives at the following conclusions:
•
Situation 1. Unlike the hedging transaction
described in §1.446-4(e)(4) that hedges a fixed rate
borrowing over its entire term, TP’s NPC does not
hedge the entire term of the debt instrument.
Rather, TP’s NPC hedges, and relates only to, Year
1 through Year 5 of the 10-year term of the debt
instrument. Prior to its termination on the last
day of Year 2, the NPC would have continued to
hedge Year 3 through Year 5 of the debt
instrument, and TP generally would have been
required to take into account the remaining
income, deduction, gain, or loss over the period
from Year 3 through Year 5. The termination
payment made or received by TP represents the
present value of the extinguished rights and
obligations under the NPC for Year 3 through
Year 5. Therefore, the gain or loss from the
hedging transaction relates to Year 3 through Year
5. To clearly reflect income in accordance with the
matching requirement of §1.446-4(b), TP must
take into account the gain or loss from
terminating the NPC over the period from Year 3
through Year 5.
•
Situation 2. Following the analysis from Situation
1, TP would have already taken into account in
§1.446-4(e)(4) provides, as an example, that gain or
loss realized on a transaction that hedged an
anticipated fixed rate borrowing for its entire term is
accounted for, solely for purposes of §1.446-4, as if it
decreased or increased the issue price of the debt
instrument. However, in all events, the taxpayer’s
method, as actually applied to the taxpayer’s hedging
transactions, must clearly reflect income by meeting
the matching requirement of §1.446-4(b).
The Facts. Rev. Rul. 2002-71 sets forth two factual
situations as follows:
•
4
Situation 1. Taxpayer TP uses the calendar year as
its taxable year. On the first day of Year 1, TP
issues a debt instrument. The debt instrument
has a 10-year term and provides for interest to be
paid annually at a fixed rate. Contemporaneously
Situation 2. The facts are the same as Situation 1,
but, in addition, TP retires the debt instrument in
Year 4.
Year 3 a portion of the gain or loss from
termination of the NPC in Year 2. However, upon
retiring the debt instrument in Year 4, TP’s
remaining gain or loss from the termination of
the NPC would be recognized in order to match
the timing of income, deduction, gain, or loss
from the hedging transaction with the timing of
income, deduction, gain, or loss from the item
being hedged.
Corporate-Owned Life Insurance Settlements
On 10/4/02, the IRS issued Announcement 2002-96
stating that its Appeals Division settlement initiative
with respect to broad-based COLI plans, purchased
after 6/20/86, will be terminated, and that the IRS
and the Department of Justice will vigorously defend
or prosecute all future COLI litigation. However, the
IRS is providing a 45-day window within which
taxpayers may accept the current IRS settlement offer
before it ends.
Background. In August 2001, the IRS Appeals
Division implemented a coordinated settlement
initiative for broad-based COLI cases that generally
permitted taxpayers to settle if they agreed to concede
80% of the interest deductions claimed with respect to
their COLI plans.
Announcement 2002-96. As a consequence of litigation,
the IRS has determined that the Appeals Division
COLI settlement initiative will be terminated, subject
to a 45-day window within which taxpayers will be
permitted to enter into the current settlement
arrangement. Formal notification of the IRS’s
termination of the settlement initiative has been made
by letter to taxpayers identified with COLI plans by the
Large and Mid-Size Business (“LMSB”) Operating
Division or by the Appeals Office having jurisdiction
over the taxpayer’s case.
In order for taxpayers to qualify for the settlement
initiative, Announcement 2002-96 states that a
written offer to settle must be mailed or delivered to
the IRS within 45 days after the date of the letter. The
written offer to settle must include the following:
•
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Taxpayer’s offer to concede 80% of the claimed
COLI interest deductions; and
•
Taxpayer’s offer to sign a closing agreement
providing that no amount disallowed as an
interest deduction will be allowable as a deduction
under any other provision of the IRC, nor allowed
as an adjustment to the taxpayer’s investment in
the contract (basis) under §72, IRC, nor allowed as
an adjustment to the taxpayer’s basis in any other
asset, in any year.
Detailed instructions for opting into the settlement
initiative are set forth in the IRS’s letter to each
affected taxpayer. Qualifying taxpayers who do not
receive such a letter by 10/18/02, and who want to
make an offer to settle under Announcement 200296 should notify the Appeals Division Coordinator for
COLI in writing on or before 11/18/02.
Announcement 2002-96 states that, under the
procedures outlined therein, the Appeals Divisions
will continue to accommodate taxpayers who wish to
surrender their COLI policies by entering into closing
agreements that finalize the tax consequences of such
surrender transactions. In the event that a taxpayer
fails to comply with the offer procedures set forth in
Announcement 2002-96 or the detailed instructions
contained in the IRS’s notification letter, the Appeals
Division will not entertain further settlement
discussions with the taxpayer relative to its COLI
interest deductions. Furthermore, the IRS and the
Department of Justice will vigorously defend or
prosecute all future COLI litigation that may be
initiated.
Collars and Straddles
On 10/2/02, the IRS issued Rev. Rul. 2002-66
addressing the following issue involving collars and
straddles: If the grantor of a qualified covered call
option holds a put option on the same underlying
equity, is the straddle consisting of the underlying
equity and the written call option part of a larger
straddle and therefore not excluded from straddle
treatment by §1092(c)(4)(A), IRC? Rev. Rul. 2002-66
addresses the issue in the context of three factual
situations.
Background. §1092(a) limits the recognition of losses
on one or more positions in a straddle to the amount
by which the losses exceed the unrecognized gain in
any offsetting positions in that straddle. §1092(c)
defines a straddle as offsetting positions with respect
to personal property, and §1092(d)(3) treats stock as
personal property if the stock is a position in the
straddle and an option on that stock or on
substantially identical stock or securities is an
offsetting position in that straddle.
purchases a 12-month put option on 100 shares of
Y stock with a strike price of $100.
•
§1092(c)(4)(A) provides that a straddle will not be
treated as a straddle for purposes of §§1092 or 263(g)
if:
(i) All of the offsetting positions making up any
straddle consist of one or more qualified
covered call options and the stock to be
purchased from the taxpayer under such
options; and
(ii) Such straddle is not part of a larger straddle.
The two clauses of §1092(c)(4)(A) work together to
delineate the scope of the exemption from straddle
treatment provided by §1092(c)(4). Clause (i) requires
that, in order to obtain the exemption with respect to a
given straddle, the straddle must consist only of one
or more qualified covered call options and the stock to
be purchased from the taxpayer under the options.
Even if this requirement is satisfied, however, clause
(ii) precludes the exemption from applying if the
taxpayer holds at least one other position (i.e., a
position other than qualified covered call options and
the stock to be purchased thereunder) that, when
considered together with the stock and qualified
covered call options described in clause (i), creates a
larger straddle.
The Facts. In the three situations described below, the
presence of a purchased put substantially reduces the
taxpayer’s risk of loss with respect to the stock, and
also reduces any potential for enhancing the
taxpayer’s investment return through premium
income:
•
•
6
Situation 1. On 8/1/02, A purchases 100 shares of
Corporation X stock for $100 per share, writes a
12-month call option an 100 shares of X stock with
a strike price of $110, and purchases a 12-month
put option on 100 shares of X stock with a strike
price of $100.
Situation 2. On 9/3/02, B purchases 100 shares of
Corporation Y stock for $102 per share. On
9/6/02, when the fair market value of Y stock is
$100, B writes a 12-month call option for 100
shares of Y stock with a strike price of $110 and
Situation 3. On 10/1/02, C purchases 100 shares
of Corporation Z stock for $102 per share. On
10/3/02, when the fair market value of Z stock is
$100, C writes a 12-month call option on 100
shares of Z stock with a strike price of $110. On
12/2/02, when the fair market value of the Z stock
remains $100, C purchases a 12-month put option
on 100 shares of Z stock with a strike price of
$100.
Rev. Rul. 2002-66. The IRS concluded that in each of
the three situations, the put option protects against a
decrease in the value of the stock below the exercise
price of the put option and also reduces the impact of
changes in the value of the stock through the inverse
relationship between the value of the stock and the
value of the put option. Both factors substantially
diminish the risk of loss with respect to the holding of
the stock by itself and the risk of loss with respect to
the combination of the stock and the written qualified
covered call option. In addition, when the owner of
the stock acquires the put, the amount of the
premium received from the call option is offset, in
whole or in part, by the amount of the premium paid
for the put option, thus reducing any potential
enhancement of investment return on the stock
resulting from the receipt of the call option premium.
In effect, when the writer of the call option purchases
the put, the writer gives up potential enhancement of
return on investment to acquire additional risk
protection.
Accordingly, in each of the three situations described
below, Rev. Rul. 2002-66 states that the presence of
the purchased put causes the stock and the qualified
covered call option to constitute part of a larger
straddle within the meaning of §1092(c)(4)(A) as
follows:
•
Situation 1. All of the positions in X stock are
treated as part of a larger straddle. §1092(c)(4)
does not apply to any of the positions in X stock.
•
Situation 2. All of the positions in Y stock are part
of a larger straddle beginning on 9/6/02.
§1092(c)(4) does not apply to any of the positions
in Y stock beginning on that date.
•
Situation 3. Prior to 12/2/02, the combination of
the qualified covered call option and the
underlying shares are not treated as a straddle for
purposes of §§1092 and 263(g). However,
beginning on 12/2/02, all of the positions in Z
stock are part of a larger straddle, and §1092(c)(4),
therefore, does not apply to any of the positions in
Z stock beginning on that date.
Note Concerning Subchapter S Straddles. On 9/25/02,
the IRS issued Notice 2002-65 stating that it has
become aware of a type of transaction, generally
described below, that is being used by taxpayers for
the purpose of generating deductions. Notice 2002-65
alerts taxpayers and their representatives that the tax
benefits purportedly generated by these transactions
are not allowable for Federal income tax purposes.
Notice 2002-65 also alerts taxpayers, their
representatives, and promoters of these transactions
of certain responsibilities that may arise from
participating in these transactions.
The transactions described Notice 2002-65 have been
designed to use a straddle of foreign currency, one or
more transitory shareholders, and the rules of
subchapter S to allow a taxpayer to claim an
immediate loss while deferring an offsetting gain in
the taxpayer’s investment in the S corporation. The
IRS stated that it intends to challenge the purported
tax benefits from these transactions on a number of
grounds.
Broker Reporting of Stock Options
On 7/2/02, the IRS issued Rev. Proc. 2002-50 that
provides an exception from reporting on Form 1099B, Proceeds From Broker and Barter Exchange
Transactions, for transactions involving an employee,
former employee, or other service provider (a “service
provider”) who has obtained a stock option in
connection with the performance of services. Rev.
Proc. 2002-50 states that where the service provider
purchases stock through the exercise of the stock
option and sells that stock on the same day through a
broker, the broker executing the sale is not required to
report the sale on Form 1099-B, provided certain
conditions are met. Rev. Proc. 2002-50 is effective for
sales of stock occurring after 12/31/01.
Background. §83, IRC, governs the tax treatment of
nonstatutory stock options granted in connection with
the performance of services. §§421 through 424
govern the tax treatment of statutory stock options
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(i.e., incentive stock options described in §422(b) and
options granted under an employee stock purchase
plan described in §423(b)). A stock option is not
taxable when granted, provided the option either lacks
“a readily ascertainable fair market value” as defined
in §1.83-7(b) of the Income Tax Regulations or meets
the requirements of §422 or §423.
For nonstatutory stock options that lack a readily
ascertainable fair market value, under §83(a) and §1.837, the service provider generally recognizes income at
the time of the exercise of the options, in an amount
generally equal to the fair market value of the stock
received (disregarding lapse restrictions) minus the
amount paid for that stock. The time for recognizing
the income and for determining the fair market value
of the stock is the first day that the transferee’s rights
in the stock are “substantially vested” (i.e., transferable
or not subject to a substantial risk of forfeiture).
Where the individual exercising the options is an
employee, the taxable compensation income
generated by §83(a) constitutes wages for purposes of
§§3121, 3306 and 3401.
For statutory stock options, if the individual receiving
the statutory stock option satisfies the employment
requirements of §422(a) or §423(a), the exercise of the
stock option produces taxable income only when the
stock acquired pursuant to the exercise of the option is
sold or disposed of. If the stock is sold in a
disqualifying disposition (i.e., prior to the later of the
date that is one year after the exercise of the option
and two years after the grant of the option), certain
amounts will be taxable compensation income under
§83(a). In addition, pursuant to §423(c), where the
holding periods are satisfied, and when the stock
options under an employee stock purchase plan are
offered at an exercise price below the fair market value
of the stock at the date of grant, certain amounts may
be included as compensation income at the time of
disposition of the stock acquired at exercise of the
option.
IRS Notice 2002-47 (issued 6/25/02) provided, in
part, that until the IRS issues further guidance, in the
case of a statutory stock option, the IRS will not assess
the Federal Insurance Contributions Act (“FICA”) tax
or Federal Unemployment Tax Act (“FUTA”) tax, or
apply Federal income tax withholding obligations,
upon either the exercise of the option or the
disposition of the stock acquired by an employee
pursuant to the exercise of the option [see below].
§1001, IRC, dictates the tax consequences when
substantially vested stock obtained through the
exercise of an option is sold. Pursuant to §1001(a), the
gain from the sale of the stock is the amount realized
minus the adjusted basis provided in §1011, and the
loss is the adjusted basis provided in §1011 minus the
amount realized. For this purpose, the adjusted basis
of the stock includes the amount included in gross
income under §83(a) upon exercise of an option that
did not have a readily ascertainable fair market value
at grant.
§6045(a) provides that brokers, when required to do
so by the IRS, must make a return in accordance with
regulations that the IRS may prescribe regarding
transactions they carry out for customers. §1.60451(c)(2) of the regulations states, in general, that each
broker must make a return of information with
respect to each sale by a customer effected by the
broker.
§1.6045-1(d)(2) provides, in part, that a broker must
report the gross proceeds of a stock sale.
§1.6045-1(d)(5) provides that the broker may, but is not
required to, take commissions and option premiums
into account in determining gross proceeds provided
the treatment chosen is consistent with the books of
the broker. Form 1099-B is used to report the
information required by §6045 and the regulations
thereunder.
§1.6045-1(c)(3)(ii) states that no return of information
is required with respect to a sale effected by a broker
for a customer if the sale is an excepted sale. This
regulation defines an “excepted sale” as one so
designated and published by the IRS.
Rev. Proc. 2002-50. A broker may treat a sale as an
“excepted sale” for purposes of §1.6045-1(c)(3)(ii) if an
employee, former employee, or other service provider
obtains substantially vested shares of stock from the
exercise of an option and on the same day sells the
shares through a broker and certain other conditions
are met.
The exception provided by Rev. Proc. 2002-50 applies
to a sale of stock acquired by a service provider
through the exercise of an option if numerous detailed
conditions concerning broker commissions and other
8
matters set forth in Rev. Proc. 2002-50 are complied
with (e.g., the service recipient certifies in writing to
the broker that the service recipient will report any
compensation income generated by the exercise of the
option, or disposition of the stock acquired pursuant
to the exercise of the option, in accordance with §6041
(Form 1099) or §6051 (Form W-2), as applicable).
The exception provided by Rev. Proc. 2002-50 does
not apply if the service recipient uses an amount other
than the sale price of the shares to calculate the
compensation income generated to the service
provider by the option exercise. Rev. Proc. 2002-50
also does not apply to the exercise of a stock option if,
at the date of grant, the stock option had a readily
ascertainable fair market value as defined in §1.837(b).
To determine whether the service provider exercised
the option and sold the underlying shares on the same
day, the broker may rely on a receipt or written
statement provided by the service recipient or the
service provider showing the date of exercise. To
determine whether the service recipient uses the sale
price of the shares to calculate the compensation
income generated to service providers by the option
exercise, the broker may rely upon a written statement
from the service recipient certifying that it follows that
practice.
Under the certain circumstances described in Rev.
Proc. 2002-50, the broker must furnish the service
provider with a statement containing certain specified
information (e.g., a description of how gain or loss
with respect to shares obtained through the option
exercise is calculated and the manner in which such
gain or loss should be reported on a Federal income
tax return).
Statutory Stock Options
On 6/25/02, the IRS issued Notice 2002-47
announcing that it will extend the administrative
moratorium on FICA and FUTA taxes for incentive
stock options (“ISOs”) and options issued under
employee stock purchase plans (“ESPPs”). ISOs and
ESPPs are commonly referred to as “statutory stock
options.” Under Notice 2002-47, the IRS will not
assess FICA or FUTA taxes, or impose Federal
income tax withholding, on the exercise of any
statutory stock option or the disposition of any stock
acquired by exercising a statutory stock option. This
moratorium will remain in place until the IRS
completes its review of comments on recent proposed
regulations and issues future guidance, which would
apply only on a prospective basis.
Notice 2002-07 indicates that individuals still must
include any compensation in income on a
disqualifying disposition of stock acquired by
exercising a statutory stock option, and employers are
not relieved of their reporting obligations. Other types
of stock options, “nonqualified” or “nonstatutory”
options, are not affected by Notice 2002-47. The IRS
stated that these options have always been, and
continue to be, subject to FICA and FUTA taxes at
exercise.
Background. Notice 2001-14, issued in January of
2001, imposed an administrative moratorium on the
assessment of FICA and FUTA taxes for statutory
stock options exercised before 1/1/03. In November
2001, the IRS issued proposed Income Tax
Regulations applying FICA and FUTA taxes to
statutory stock options exercised on or after 1/1/03. At
the same time, the IRS issued Notices 2001-72 and
2001-73 that proposed rules of administrative
convenience for employers and employees and
clarified an employer’s income tax withholding and
reporting obligations.
Notice 2002-47. Until the IRS issues further guidance,
in the case of a statutory stock option (i.e., an ISO
described in §422(b), IRC, or an option granted under
an ESPP described in §423(b), IRC), the IRS will not
assess the FICA tax or FUTA tax, or apply Federal
income tax withholding obligations, upon either the
exercise of the option or the disposition of the stock
acquired by an employee pursuant to the exercise of
the option. The IRS anticipates that any final guidance
that would apply employment taxes to statutory stock
options will not apply to any exercise of a statutory
stock option that occurs before the January 1st of the
year that follows the second anniversary of the
publication of the final guidance.
The IRS stated that Notice 2002-47 does not relieve
individual taxpayers of the obligation to include any
compensation in income upon a disposition of stock
acquired pursuant to the exercise of a statutory stock
option and does not relieve employers of any of their
reporting obligations. Regarding the reporting
obligations, §1.6041-2(a)(1) of the Income Tax
9
Regulations requires that, under certain
circumstances, a payment made by an employer to an
employee be reported on Form W-2 even if the
payment is not subject to income tax withholding.
Specifically, §1.6041-2(a)(1) generally requires
reporting of a payment on Form W-2 if the total
amount of the payment, and any other payment of
remuneration (including wages, if any) made to the
employee (or former employee) that are required to be
reported on Form W-2, aggregate at least $600 in a
calendar year. The IRS stated that, therefore, a
disqualifying disposition of stock acquired pursuant to
the exercise of a statutory stock option which results
in ordinary income generally will result in a reporting
obligation on Form W-2.
Short Sales - Realization Date
On 6/24/02, the IRS issued Rev. Rul. 2002-44
addressing the question of when is a gain or a loss on
a short sale realized if a taxpayer enters into a short
sale of stock and directs its broker to purchase the
stock sold short and close out the short sale. The IRS
position differs depending on whether the short sale
is closed out at a gain or at a loss.
Background. §1.1233-1(a)(1) of the Income Tax
Regulations provides that, for income tax purposes, a
short sale is not deemed to be consummated until
delivery of property to close the short sale. Under
§1.1233-1(a)(4), if the short sale is made through a
broker and the broker borrows property to make a
delivery, the short sale is not deemed to be
consummated until the obligation of the seller created
by the short sale is finally discharged by delivery of
property to the broker to replace the property
borrowed by the broker.
In the context of determining holding period, Rev.
Rul. 66-97 stated that both stocks and bonds are
considered acquired or sold on the respective trade
dates. Analogously, Rev. Rul. 93-84 holds that the year
of disposition for a regular-way sale of stock traded on
an established securities market is the year that
includes the trade date. In Rev. Rul. 93-84, the
taxpayer placed a regular-way sale order on stock with
his broker on 12/31/92, but the taxpayer did not
deliver the stock certificates or receive the proceeds
from the sale until 1/8/93. Rev. Rul. 93-84 holds that
the year of disposition and realization was 1992.
§1259(a)(1), IRC, provides that if there is a constructive
sale of an appreciated financial position, the taxpayer
recognizes gain as if such position were sold,
assigned, or otherwise terminated at its fair market
value on the date of the constructive sale. The term
“appreciated financial position” is defined in
§1259(b)(1) to include any position with respect to
stock if there would be gain were such position sold,
assigned, or otherwise terminated at its fair market
value. The term “position” is defined in §1259(b)(3) to
include a short sale. Pursuant to §1259(c)(1)(D), in the
case of an appreciated financial position that is a short
sale, a taxpayer is treated as having made a
constructive sale of the appreciated financial position
if the taxpayer acquires the same or substantially
identical property.
Rev. Rul. 2002-44. Rev. Rul. 2002-44 deals with two
hypothetical short-sale transactions described below,
in general, as follows:
•
•
10
Situation 1. The taxpayer enters into a short sale of
stock (which it does not own) in year 1. On
December 31 of year 1, the taxpayer instructs its
broker to buy the stock (which has appreciated in
value) and close the short sale (at a loss). The
stock is bought (on a regular-way transaction) with
a December 31 of year 1 trade date and a January 4
of year 2 settlement date. Pursuant to §1.12331(a)(1), the short sale is not consummated until
the stock is delivered to close the short sale.
Although the taxpayer is treated as having
acquired the stock on the trade date (see Rev. Rul.
66-97 and Rev. Rul. 93-84), the stock will not be
delivered to close the short sale until January 4 of
Year 2. Therefore, the taxpayer does not realize
the loss on the short sale until January 4 of Year 2.
Situation 2. The facts are the same as in Situation
1 above except that the stock has depreciated in
value and accordingly the short sale is closed out a
gain. The taxpayer is treated as having acquired
the stock on the trade date, December 31 of Year 1.
At that time, unlike in Situation 1, the price of the
stock has decreased. Therefore, the value of the
short sale has increased and the taxpayer holds an
appreciated financial position within the meaning
of §1259(b)(1) (i.e., the short position).
§1259(c)(1)(D) provides that if a taxpayer holds an
appreciated financial position that is a short sale,
the acquisition of the same or substantially
identical stock is a constructive sale transaction.
Therefore, the taxpayer has entered into a
constructive sale transaction by acquiring the
same or substantially identical stock as the stock
underlying the short sale. Pursuant to §1259(a)(1),
the IRS concludes that the taxpayer realizes gain
on the short sale on December 31 of Year 1.
Tax Accrual Workpapers
On 6/17/02, the IRS issued Announcement 2002-63
revising its policy concerning when it will request and,
if necessary, summon tax accrual and other financial
audit workpapers relating to deferred tax liabilities and
relating to footnotes disclosing contingent tax
liabilities (“tax accrual workpapers”) appearing on
audited financial statements. The IRS stated that this
limited expansion of the circumstances in which the
IRS will seek tax accrual workpapers is necessary to
allow the IRS to fulfill its obligation to the public to
curb abusive tax avoidance transactions and to ensure
that taxpayers are in compliance with the tax laws. The
IRS also stated that, in all other respects, the IRS’s
current policy regarding requests for tax accrual
workpapers will continue to apply.
The new IRS policy primarily affects tax returns filed
on or after 7/1/02. For those returns, whether the
request for tax accrual workpapers will be routine or
merely discretionary, or will be limited to the abusive
transaction rather than to all the workpapers, will
depend on several factors, including whether the
abusive transaction was disclosed or whether there are
reported financial accounting irregularities. For tax
returns filed before 7/1/02, the IRS may request tax
accrual workpapers if the taxpayer did not make the
required disclosure of the abusive transactions.
Background. In 1984, the Supreme Court confirmed
the IRS’s right to obtain tax accrual workpapers under
its summons authority. The IRS position is that
because tax accrual workpapers are not generated in
connection with seeking legal or tax advice, but are
developed to evaluate a taxpayer’s deferred or
contingent tax liabilities in connection with a
taxpayer’s disclosure to third parties of the taxpayer’s
financial condition, tax accrual workpapers are not
privileged communications. Neither the attorneyclient privilege nor the tax practitioner privilege
(which is based on, but is more limited than, the
attorney-client privilege) protects tax accrual
workpapers from production upon proper request by
an authorized IRS agent. Despite the broad scope of
authority recognized by the Supreme Court, the IRS
states that it has historically acted with restraint,
declining to request tax accrual workpapers as a
standard examination technique.
Announcement 2002-63. The IRS may request tax
accrual workpapers in the course of examining any tax
return filed on or after 7/1/02, that claims any tax
benefit arising out of a transaction that the IRS has
determined to be a “listed transaction,” at the time of
the request, within the meaning of the Income Tax
Regulations that define listed transactions to include
substantially similar transactions. If the listed
transaction was disclosed, the IRS will routinely
request the tax accrual workpapers pertaining only to
the listed transaction. If the listed transaction was not
disclosed, the IRS will routinely request all tax accrual
workpapers. In addition, if the IRS determines that tax
benefits from multiple investments in listed
transactions are claimed on a tax return, regardless of
whether the listed transactions were disclosed, the
IRS, as a discretionary matter, will request all tax
accrual workpapers. Similarly, if, in connection with
the examination of a tax return claiming tax benefits
from a listed transaction that was disclosed, there are
reported financial accounting irregularities, such as
those requiring restatement of earnings, the IRS, as a
discretionary matter, will request all tax accrual
workpapers.
For a tax return filed prior to 7/1/02, that claims any
tax benefit arising out of a listed transaction, the IRS
may request tax accrual workpapers pertaining to the
listed transaction, if the taxpayer had an obligation to
disclose the transaction under Income Tax
Regulations §1.6011-4T, and failed to do so: (a) on the
return; (b) under Rev. Proc. 94-69, if applicable; or (c)
pursuant to IRS Announcement 2002-2 (1/14/02).
Taxpayer Disaster Relief - Interest and
Penalties
On 5/20/02, the IRS issued Notice 2002-40 that
supplements and expands the relief granted under
§7508A, IRC, in Notice 2001-61 (10/1/01) and Notice
2001-68 (11/19/01), for taxpayers affected by the
9/11/01 Terrorist Attacks. Generally, taxpayers will
11
not owe any interest or penalties for the amount of
time that the IRS earlier extended their filing or
payment deadline, and the IRS will refund such
amounts to affected taxpayers who have already paid
the interest or penalties.
Background. In its earlier actions, the IRS extended
certain tax deadlines to dates ranging from 11/15/01 to
9/12/02, depending on the form or payment involved.
However, at that time the IRC did not provide for the
waiver of some interest and penalty charges. Details
are in Notices 2001-61 and 2001-68 for “affected
taxpayers” [a defined term]. At the time the notices
were issued, the IRC limited the amount of interest
relief the IRS could provide to an affected taxpayer.
Under §6404(h), interest was abated only for income
taxes due from an affected taxpayer located in the
Presidentially declared disaster area and only if both
an extension of time to file under §6081 and an
extension of time to pay under §6161 were granted to
the taxpayer. IRS authority to provide relief under
§7508A was specifically limited to items other than
interest. In addition, §7508A permitted the IRS to
disregard no more than 120 days in the calculation of
penalties.
On 1/23/02, the President signed into law the Victims
of Terrorism Tax Relief Act of 2001 (the “Victims
Act”). §112 of the Victims Act repealed §6404(h) and
amended §7508A (effective 9/11/01), by providing, in
part, that the IRS may disregard up to one year in
determining the amount of any interest or penalty.
Under this increased authority, the IRS is providing
relief from interest and expanded relief from the
failure to pay penalty for certain affected taxpayers.
Notice 2002-40. Notice 2002-40 provides a grant of
relief for specified “affected taxpayers” previously
described in Notices 2001-61 and 2001-68. The relief
pertains to: (a) interest for a specified period of time;
and (b) the failure to pay penalty for a specified period
of time.
The IRS stated that some taxpayers who are now
getting interest and penalty relief may have already
paid these charges. The IRS has identified individual
and business taxpayers located in New York City and
Arlington County, Virginia, and will be sending them
refunds and explanatory notices.
The IRS cannot, however, determine which taxpayers
outside these two covered disaster areas may also be
entitled to this interest and penalty relief. Those
taxpayers located outside New York City and Arlington
County, Virginia who believe that are “affected
taxpayers” covered by Notice 2002-40 should contact
the IRS.
Taxpayer Disaster Relief - NOL Carrybacks
On 2/4/02, the IRS issued Notice 2002-15 that
supplements the tax relief granted in Notice 2001-61
and Notice 2001-68 for taxpayers affected by the
9/11/01 terrorist attacks by providing an additional
postponement of time for certain affected taxpayers to
apply for a tentative carryback adjustment under
§6411, IRC. The relief provided to taxpayers in Notice
2002-15 will apply retroactively to 9/11/01.
Background. To apply for a tentative carryback
adjustment, corporate taxpayers must file Form 1139,
Corporation Application for a Quick Refund, and
noncorporate taxpayers must file Form 1045,
Application for Tentative Refund, on or after the due
date of the return for the taxable year that generates
the NOL, net capital loss, or unused business credit
from which the carryback results and within 12
months after the end of such taxable year. This
procedure allows a taxpayer to obtain a refund without
having to file an amended return for the year to which
the taxpayer carries back the loss or credit. Normally,
the twelve month period for filing for the tentative
carryback falls after the filing due date even if the
filing due date is extended for six months under
§6081.
¶(3) of the Additional Grant of Relief section (§C) of
Notice 2001-68 granted to all “affected taxpayers” (a
defined term) a 120-day postponement of time to
perform the acts listed in Rev. Proc. 2001-53
(11/19/01), if the last day to perform the act would
otherwise fall within the period beginning on 9/11/01
and ending on 11/30/01 (the “window period”). One of
the acts listed in Rev. Proc. 2001-53 is the application
under §6411 for a tentative carryback adjustment of
the tax for a prior taxable year.
Taxpayers affected by the 9/11/01 terrorist attacks that
received a filing extension and/or postponement
under Notice 2001-61, however, now have a due date
for the tax return that falls after the 12-month period
provided by §6411. In cases where the due date for
filing for the tentative carryback under §6411 falls
12
outside the window period provided by ¶(3) of §C of
Notice 2001-68, such taxpayers would have to file for
their tentative carryback before they filed the tax
return for the year the loss or credit arose.
Notice 2002-15. To remedy the above situation, Notice
2002-15 expands the relief provided by ¶(3) of §C of
Notice 2001-68 by providing affected taxpayers with
an additional 120 days in which to file for their
tentative carryback under §6411 if Notice 2001-61
extended and/or postponed the due date of their
income tax return.
For example, an affected individual income taxpayer
who obtained an extension of time to file the 2000 tax
return until 10/15/01, would qualify for a 120-day
postponement of time to file under Notice 2001-61
until 2/12/02. Under §6411, the last day the taxpayer
could file Form 1045 would be 12/31/01. This date is
not within the period provided by Notice 2001-61.
Thus, without Notice 2002-15, the taxpayer would
need to file Form 1045 before the tax return is due.
Under Notice 2002-15, however, the taxpayer will have
an additional 120 days from 12/31/01 (the last day for
applying for the tentative carryback under §6411) to
file Form 1045.
The IRS stated that taxpayers who believe they are
entitled to relief under Notice 2002-15 should mark
“September 11, 2001 Terrorist Attack” in red ink on
the top of their Form 1139 or 1045 submitted to the
IRS. Taxpayers should not put this notation on
envelopes. The IRS stated that doing so may result in
a delay in the delivery or processing of the return or
document.
Contingent Convertible Debt
On 5/6/02, the IRS issued Rev. Rul. 2002-31
providing guidance on the tax treatment of a debt
instrument that is convertible into stock of the issuer
and that also provides for one or more contingent cash
payments (referred to as “contingent convertible debt
instruments”). Rev. Rul. 2002-31 holds that, in the
described circumstances, the noncontingent bond
method described in §1.1275-4(b) of the Income Tax
Regulations applies to these debt instruments. In
addition, Rev. Rul. 2002-31 addresses: (a) how an
issuer determines the comparable yield used to
determine the interest accruals; (b) the effect of
§163(l), IRC, on the accruals; and (c) the consequences
of a conversion of the instrument, including the
application of §249.
than the conversion feature and those contingent
payments are neither remote nor incidental.
Background. §1.1275-4 provides rules for the treatment
of contingent payment debt instruments. In general, if
a contingent payment debt instrument is issued for
cash or publicly traded property, the noncontingent
bond method applies to the instrument. Under the
noncontingent bond method, interest accrues on the
debt instrument as if it were a fixed-payment debt
instrument. This fixed-payment debt instrument is
constructed by using the instrument’s comparable
yield and a projected payment schedule.
Certain provisions of the IRC, such as §163(l) and
§249, may affect an issuer’s ability to deduct the
interest computed under the noncontingent bond
method.
In general, the comparable yield for a contingent
payment debt instrument is the yield at which the
issuer would issue a fixed rate debt instrument with
terms and conditions similar to those of the
contingent payment debt instrument. Relevant terms
and conditions include the level of subordination,
term, timing of payments, and general market
conditions. In determining the comparable yield, no
adjustments are made for the riskiness of the
contingencies or the liquidity of the debt instrument.
In all cases, the yield must be a reasonable yield for
the issuer and may not be less than the applicable
Federal rate (“AFR”). In certain situations, the
comparable yield is presumed to be the AFR. The
projected payment schedule for a debt instrument
includes each noncontingent payment and a projected
amount for each contingent payment.
If the actual amount of a contingent payment is
different from the projected payment, then the
difference is taken into account as either a positive or
negative adjustment in the prescribed manner.
Except as provided in §1.1275-4(a)(2), §1.1275-4 applies
to any debt instrument that provides for one or more
contingent payments. A payment is not a contingent
payment merely because of a contingency that, as of
the issue date, is either remote or incidental.
In addition, a debt instrument does not provide for
contingent payments merely because it provides for
an option to convert the instrument into the stock of
the issuer, into the stock or debt of a related party, or
into cash or other property in an amount equal to the
approximate value of such stock or debt. However,
this exception does not apply when the debt
instrument provides for contingent payments other
13
The Facts. A corporation issued a 20-year debt
instrument that did not pay a stated interest rate but
provided for contingent interest payments. After three
years, the corporate issuer could redeem the
instrument for cash, and the debt holders could
redeem the instrument for cash, common stock, or a
combination of both. Taking into account both the
likelihood of conversion of the debt instrument and
the likelihood that the instrument will be put by the
debt holders, it is not substantially certain that a
substantial amount of the principal or interest on the
debt instrument will be required to be paid in stock or
will be payable in stock at the option of the issuer.
The issuer applied the noncontingent bond method to
the debt instrument and determined that the
comparable yield was 7%, compounded semiannually.
The corporation used the yield at which it would issue
a comparable fixed-rate, nonconvertible debt
instrument, and it projected payments of contingent
interest and payment at maturity, based on a projected
exercise of the conversion privilege.
Rev. Rul. 2002-31. The noncontingent bond method
described in §1.1275-4(b) applies to the convertible
debt instrument issued by the corporation. The yield
at which the corporation would issue a comparable
fixed rate nonconvertible debt instrument is used to
determine the instrument’s comparable yield and,
therefore, the accruals of interest on the instrument.
In addition, the debt instrument is not a disqualified
debt instrument under §163(l). Moreover, §249 does
not affect the corporation’s ability to deduct periodic
interest accruals on the debt instrument. However, if
the debt instrument is converted into the corporation’s
stock having a value in excess of the debt instrument’s
adjusted issue price, the corporation may not be able
to deduct this excess under §249.
Although the debt instrument issued by the
corporation provides for an option described in
§1.1275-4(a)(4), the debt instrument also provides for
one or more contingent payments (the contingent
interest) that are neither remote nor incidental. As a
result, the debt instrument is a contingent payment
debt instrument subject to the noncontingent bond
method described in §1.1275-4(b). Although a
conversion feature alone does not cause a convertible
debt instrument to be subject to the noncontingent
bond method, the possibility of a conversion is
nevertheless a contingency. Therefore, the comparable
yield for a convertible debt instrument subject to the
noncontingent bond method is determined under
§1.1275-4(b) by reference to comparable fixed-rate
nonconvertible debt instruments.
Moreover, the projected payment schedule is
determined by treating the stock received on a
conversion of the debt instrument as a contingent
payment. Under §1.163-7, the amount of interest that
is deductible each year on a contingent payment debt
instrument is determined under §1.1275-4. Therefore,
for purposes of §163(a), the corporation computes its
interest deductions for each year the debt instrument
is outstanding based on the comparable yield of 7%,
compounded semiannually. Based on the facts set
forth above, the OID anti-abuse rule in §1.1275-2(g)
does not apply because the result reached is not
unreasonable in light of the purposes of §163(e),
§§1271 through 1275, or any related section of the IRC.
The anti-abuse rule, therefore, does not affect the
corporation’s ability to compute its interest deductions
based on the comparable yield of 7%, compounded
semiannually.
Notice 2002-36. The IRS also issued Notice 2002-36
that invites comments and suggestions for changes in
the relative tax treatment of straight convertible debt
instruments and contingent convertible debt
instruments to eliminate or reduce the disparity in
treatment of these instruments. The IRS is concerned
whenever significantly different tax results obtain for
economically similar financial instruments, such as:
(a) straight convertible debt; and (b) convertible debt
that provides for contingent payments that, while not
remote or incidental, are relatively insignificant in
amount or in likelihood of occurrence.
Notional Principal Contracts
On 5/6/02, the IRS issued Rev. Rul. 2002-30
providing guidance on the appropriate method for the
inclusion into income or deduction of a nonperiodic
payment made pursuant to an NPC [e.g., an interest
14
rate swap] where the payment is comprised of
noncontingent and contingent components. The IRS
also issued companion Notice 2002-35 describing a
swap transaction that does not comport with Rev. Rul.
2002-30 and will be challenged by the IRS.
Background. §1.446-3 of the Income Tax Regulations
provides rules on the timing of inclusion of income
and deductions for amounts paid or received pursuant
to NPCs. §1.446-3(c)(1)(i) defines an NPC as a
financial instrument that provides for the payment of
amounts by one party to another at specified intervals
calculated by reference to a specified index upon a
notional principal amount, in exchange for specified
consideration or a promise to pay similar amounts.
Payments made pursuant to NPCs are divided into
three categories (periodic, nonperiodic, and
termination payments), and the regulations provide
separate timing regimes for each.
§1.446-3(f)(1) provides that a nonperiodic payment is
any payment made or received with respect to an NPC
that is not a periodic payment or a termination
payment. The recognition rules for nonperiodic
payments are set forth in §1.446-3(f)(2). §1.4463(f)(2)(i) provides that all taxpayers, regardless of their
methods of accounting, must recognize the ratable
daily portion of a nonperiodic payment for the taxable
year to which that portion relates. Generally, a
nonperiodic payment must be recognized over the
term of an NPC in a manner that reflects the
economic substance of the contract.
§1.446-3(f)(2)(ii) provides generally that a nonperiodic
payment must be recognized over the term of the
contract by allocating it in accordance with the
forward rates of a series of cash-settled forward
contracts that reflect the specified index and the
notional principal amount.
§1.446-3(f)(2)(iii)(A) provides that an upfront payment
may be amortized by assuming that the nonperiodic
payment represents the present value of a series of
equal payments made throughout the term of the
swap contract (the “level payment method”).
§1.446-3(f)(2)(iii)(B) provides that nonperiodic
payments other than an upfront payment may be
amortized by treating the contract as if it provided for
a single upfront payment (equal to the present value
of the nonperiodic payments) and a loan between the
parties. The single upfront payment is then amortized
under the level payment method described in §1.4463(f)(2)(iii)(A). The time value component of the loan is
not treated as interest, but together with the amortized
amount of the deemed upfront payment, is
recognized as a periodic payment.
§1.446-3(g)(4) provides that a swap with significant
nonperiodic payments is treated as two separate
transactions consisting of an on-market, level
payment swap and a loan. The loan must be
accounted for by the parties to the contract
independently of the swap. The time value component
associated with the loan is not included in the net
income or net deduction from the swap under §1.4463(d), but is recognized as interest for all purposes of
the IRC.
§1.446-3(d) provides that for all purposes of the IRC,
the net income or net deduction from an NPC for a
taxable year is included in, or deducted from, gross
income for that taxable year. The net income or net
deduction from an NPC for a taxable year equals the
total of all of the periodic payments that are
recognized from that contract for the taxable year
under §1.446-3(e), and all of the nonperiodic payments
that are recognized from that contract for the taxable
year under §1.446-3(f). Each party to the NPC
determines its payments and receipts attributable to
the taxable year and takes into account, as net income
or net deduction, the result of those payments and
receipts.
Rev. Rul. 2002-30. Under the facts set forth, the
amount payable on the expiration of the NPC is a
nonperiodic payment, which the taxpayer and the
counterparty are required to recognize over the term
of the NPC in a manner that reflects the economic
substance of the NPC. In substance, the nonperiodic
payment that the counterparty must pay the taxpayer
on expiration equals the sum of two independent
components, one noncontingent and the other
contingent. The taxpayer and the counterparty must
recognize the noncontingent component of the
nonperiodic payment over the term of the NPC, and
must also account for interest, in a manner consistent
with appropriate provisions of the regulations.
Notice 2002-35. The IRS stated that it has become
aware of a type of transaction that is used by taxpayers
to generate tax losses. In general, the transaction
involves the use of an NPC to claim current
deductions for periodic payments made by a taxpayer
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while disregarding the accrual of a right to receive an
offsetting single payment from the counterparty at the
end of the NPC’s term. Notice 2002-35 alerts
taxpayers and their representatives that the tax
benefits purportedly generated by these transactions
are not allowable for Federal income tax purposes.
Notice 2002-35 also alerts taxpayers, their
representatives, and promoters of these transactions
of certain responsibilities that may arise from
participating in these transactions.
Under the facts, a taxpayer deducts the ratable daily
portion of each periodic payment for the taxable year
to which that portion relates. However, the taxpayer
does not accrue income with respect to the
nonperiodic payment until the year the payment is
received. The taxpayer intends to report as capital gain
any gain it realizes upon the termination of the NPC.
The requirement of §1.446-3(f)(2)(i) that a nonperiodic
payment must be recognized over the term of an NPC
in a manner that reflects the economic substance of
the contract must be applied separately to the
noncontingent component of the contract, whether
that component is based on a fixed or a floating
interest rate.
Rev. Rul. 2002-30 [above] discusses the proper
treatment of the periodic and nonperiodic payments
made pursuant to the interest rate swap if the
noncontingent component is based on a fixed interest
rate. It holds that the nonperiodic payment must be
accrued ratably over the term of the NPC. In addition,
depending on the facts of the particular case, the IRS
may challenge the purported tax results of these
transactions on other grounds, set forth in Notice
2002-35.
Frequent Flyer Miles
On 2/20/02, the IRS issued Announcement 2002-18
concerning the Federal income taxation of frequent
flyer miles attributable to business or official travel
and stated that, in general, it will not presently
attempt to tax miles received for business travel but
used for personal purposes.
Background. Most major airlines offer frequent flyer
programs under which passengers accumulate miles
for each flight. Individuals may also earn frequent
flyer miles or other promotional benefits (e.g., through
rental cars or hotels). These promotional benefits may
generally be exchanged for upgraded seating, free
travel, discounted travel, travel-related services, or
other services or benefits.
Questions have been raised concerning the taxability
of frequent flyer miles or other promotional items that
are received as the result of business travel and used
for personal purposes. There are numerous technical
and administrative issues relating to these benefits on
which no official IRS guidance has been provided,
including issues relating to the timing and valuation
of income inclusions and the basis for identifying
personal use benefits attributable to business (or
official) expenditures versus those attributable to
personal expenditures. Because of these unresolved
issues, the IRS previously has not pursued a tax
enforcement program with respect to promotional
benefits such as frequent flyer miles.
Announcement 2002-18. Consistent with prior practice,
the IRS will not assert that any taxpayer has
understated his or her Federal income tax liability by
reason of the receipt or personal use of frequent flyer
miles or other in-kind promotional benefits
attributable to the taxpayer’s business or official travel.
Any future guidance on the taxability of these benefits
will be applied prospectively.
This relief does not apply to travel or other
promotional benefits that are converted to cash, to
compensation that is paid in the form of travel or
other promotional benefits, or in other circumstances
where these benefits are used for tax avoidance
purposes.
Mortgage Guarantee Fees
On 1/29/02, the IRS Office of Chief Counsel issued
Notice CC-2002-016 to assist Chief Counsel attorneys
in advising field personnel in the development of
cases involving the application of §1286(e)(2), IRC, to
certain fees payable out of mortgage payments
received by mortgage pool trusts.
Background. §1286 provides rules on the treatment of
stripped bonds and stripped coupons. Rev. Rul. 91-46
and three related Rev. Procs. provide guidance on
applying §1286 to certain sales of mortgages when
servicing rights are retained. In particular, Rev. Rul.
91-46 provides guidance on treating certain mortgage
servicing rights as stripped coupons. This results in
gain (or reduced loss) recognition on the sales of
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mortgages to the extent that their basis is reduced by
amounts assigned to stripped coupons.
Previously, the IRS has held that certificate holders in
certain mortgage pool trusts are treated as owning the
entire equitable interests in mortgages that make up
the trust corpus and that the fees paid by the trusts are
deductible by the certificate holders. (See Rev. Rul. 8410, Rev. Rul. 71-399, and Rev. Rul. 70-545). In those
situations, certain entities act as guarantors of the
timely payment of mortgage principal and interest to
the certificate holders and may also act as mortgage
pool trustees. The entities may have held legal
ownership of the mortgages in the mortgage pool on a
transitory basis as part of the procedure for effecting
the guaranty, or they may hold legal ownership as
trustee. In the capacity of guarantor, the entities are
paid a portion of the mortgage interest as a fee for
their guarantee.
Notice CC-2002-016. Because the guarantor entities did
not have an ownership interest in the trust corpus for
tax purposes when the right to payment of fees was
created, the position of the IRS is that the fees they
receive for the guaranty of timely mortgage principal
and interest payments to the certificate holders do not
constitute stripped coupons within the meaning of
§1286(e)(2).
In other situations, a financial institution owning
mortgages may transfer the mortgages to a mortgage
pool trust and retain the right to receive a portion of
mortgage payments as compensation for continuing
to provide mortgage servicing. Whether the retained
right to receive mortgage payments constitutes a right
to stripped coupons is to be determined in accordance
with Rev. Rul. 91-46 and Rev. Proc. 91-50.
Accounting Method Changes
On 1/7/02, the IRS issued Rev. Proc. 2002-9
providing procedures by which a taxpayer may obtain
automatic consent to certain specific changes in
methods of accounting (described in the Appendix to
Rev. Proc. 2002-9) for Federal income tax purposes.
Among the changes in accounting methods to which
the provisions of Rev. Proc. 2002-9 apply are: (a)
accrual of interest income on nonperforming loans;
(b) MTM accounting for securities traders and
commodities traders and dealers; (c) bank reserves for
bad debts; (d) de minimis OID; (e) interest income on
short-term obligations; and (f) stated interest on shortterm loans of cash method banks. Rev. Proc. 2002-9
clarifies, modifies, amplifies and supersedes Rev.
Proc. 99-49 on the same subject.
Background. §1.446-1(e)(2)(ii)(a) of the Income Tax
Regulations provides that a change in a method of
accounting includes a change in the overall plan of
accounting for gross income or deductions, or a
change in the treatment of any material item. A
material item is any item that involves the proper time
for the inclusion of the item in income or the taking
of the item as a deduction. In determining whether a
taxpayer’s accounting practice for an item involves
timing, generally the relevant question is whether the
practice permanently changes the amount of the
taxpayer’s lifetime income. If the practice does not
permanently affect the taxpayer’s lifetime income, but
does or could change the taxable year in which income
is reported, it involves timing and is therefore a
method of accounting.
Although a method of accounting may exist under this
definition without a pattern of consistent treatment of
an item, a method of accounting is not adopted in
most instances without consistent treatment. The
treatment of a material item in the same way in
determining the gross income or deductions in two or
more consecutively filed tax returns (without regard to
any change in status of the method as permissible or
impermissible) represents consistent treatment of that
item for purposes of §1.446-1(e)(2)(ii)(a).
§446(e), IRC, and §1.446-1(e) of the Income Tax
Regulations state that, except as otherwise provided, a
taxpayer must secure the consent of the IRS before
changing a method of accounting for Federal income
tax purposes. §1.446-1(e)(3)(i) requires that, in order
to obtain IRS consent to a method change, a taxpayer
must file a Form 3115, Application for Change in
Accounting Method, during the taxable year in which
the taxpayer wants to make the proposed change.
Rev. Proc. 2002-9. Rev. Proc. 2002-9 consolidates and
supersedes most published automatic consent
guidance for changes in methods of accounting, and
generally provides simplified, uniform procedures and
terms and conditions to obtain automatic consent to
make these changes including the §481(a) adjustment
necessary to avoid the omission or duplication of
amounts. A taxpayer complying with all the applicable
provisions of Rev. Proc. 2002-9 has obtained the
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consent of the IRS to change its method of accounting
under §446(e), IRC, and the Income Tax Regulations
thereunder.
Significant changes to Rev. Proc. 99-49 include the
following:
•
The section of the Appendix pertaining to stated
interest on short-term loans of cash method banks
has been modified to be applicable to all cash
method banks;
•
The following changes in method of accounting
have been added to the Appendix:
•
–
Community Credit Corporation loans;
–
ISO 9000 costs;
–
Computer software expenditures;
–
Distribution fees of open-end regulated
investment companies; and
–
Transactions involving computer programs.
The following changes in method of accounting
have been removed from the Appendix:
–
MTM accounting for nonfinancial customer
paper; and
–
Pools of debt instruments.
Note. The complete text of Rev. Proc. 2002-9 should
be referred to by affected institutions.
Note Concerning Partnership Elections. On 2/13/02, the
IRS issued Rev. Proc. 2002-16 that allows certain
“eligible” partnerships (a defined term) that invest in
assets exempt from taxation under §103, IRC, to make
an election that enables money market fund partners
to take into account monthly the inclusions required
under §§702 and 707(c), IRC.