Bulletin No. 2004-24June 14, 2004

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. 2004–56, page 1055.Interest rates; underpayments and overpayments. Therate of interest determined under section 6621 of the Codefor the calendar quarter beginning July 1, 2004, will be 4 per-cent for overpayments (3 percent in the case of a corporation),4 percent for underpayments, and 6 percent for large corpo-rate underpayments. The rate of interest paid on the portion ofa corporate overpayment exceeding $10,000 will be 1.5 per-cent.

Rev. Rul. 2004–58, page 1043.Preproduction costs of creative property. This ruling pro-vides that a taxpayer may not deduct as a loss under section165 of the Code the costs of acquiring and developing creativeproperty if the taxpayer does not establish an intention to aban-don the property and an affirmative act of abandonment, or anidentifiable event evidencing a closed and completed transac-tion establishing the worthlessness of the property.

Rev. Rul. 2004–59, page 1050.State law conversion from partnership to corporation.This ruling explains the federal tax consequences when an en-tity classified as a partnership for federal tax purposes con-verts into a state law corporation under a state statute thatdoes not require an actual transfer of the unincorporated en-tity’s assets or interests.

T.D. 9127, page 1042.Final and temporary regulations under section 108 of the Codeclarify that if a taxpayer realizes excluded COD income eitherduring or after the taxable year in which the taxpayer is the dis-tributor or transferor of assets for a transaction described insection 381(a), those attributes to which the acquiring corpo-

ration succeeds, including the basis of property, must reflectthe reductions required by section 108(b).

T.D. 9129, page 1046.REG–148399–02, page 1066.Final, temporary, and proposed regulations under section 263Aof the Code except interest expense incurred by a lessor incertain safe harbor leasing transactions from the requirementto capitalize interest under section 263A.

EMPLOYEE PLANS

Rev. Rul. 2004–57, page 1048.Governmental plan; union; section 457(b). This rulingholds that a deferred compensation plan does not fail to be aneligible governmental plan under section 457(b) of the Codemerely because the plan is created, offered, and administeredby a union, provided adoption of the plan meets certain criteriaset forth in the ruling.

Announcement 2004–52, page 1071.Correction; section 457; Rev. Rul. 2004–57. A transitionrule is set forth for a plan established before June 14, 2004,that does not satisfy the requirements of Rev. Rul. 2004–57solely as a result of being established and maintained by a labororganization instead of being established and maintained by aneligible governmental employer.

(Continued on the next page)

Announcements of Disbarments and Suspensions begin on page 1067.Finding Lists begin on page ii.

EMPLOYMENT TAX

Rev. Rul. 2004–60, page 1051.Federal Insurance Contributions Act (FICA); options anddeferred compensation transfer on divorce. This rulingconcludes that nonqualified stock options and nonqualified de-ferred compensation transferred by an employee to a formerspouse incident to a divorce are subject to the Federal Insur-ance Contributions Act (FICA), the Federal Unemployment TaxAct (FUTA), and income tax withholding to the same extent as ifretained by the employee. The ruling also provides reporting re-quirements applicable to the wage payments. Notice 2002–31modified.

TAX CONVENTIONS

Announcement 2004–54, page 1061.This announcement provides the rates for various types of in-come under a new income tax treaty with Japan. For purposesof withholding, the treaty is generally effective July 1, 2004.The tables in this announcement can be used, depending onthe effective dates, to replace the entries for Japan in Tables1 and 2 in Publication 515, Withholding of Tax on NonresidentAliens and Foreign Entities (For Withholding in 2004).

ADMINISTRATIVE

Rev. Proc. 2004–36, page 1063.This procedure provides a safe harbor method of accountingthat allows film producers to amortize certain creative propertycosts ratably over a period of 15 years beginning in the yearthe creative property costs are written off for book purposesunder AICPA Statement of Position (SOP) 00–2, “Accountingfor Producers or Distributors of Film.” Rev. Proc. 2002–9modified and amplified.

June 14, 2004 2004-24 I.R.B.

The IRS MissionProvide America’s taxpayers top quality service by helpingthem understand 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 Sec-retary (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.

2004-24 I.R.B. June 14, 2004

Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986Section 108.—Income FromDischarge of Indebtedness26 CFR 1.108–7: Reduction of attributes.

T.D. 9127

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Part 1

Reduction of Tax AttributesDue to Discharge ofIndebtedness

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final and temporary regula-tions.

SUMMARY: This document contains fi-nal regulations regarding the reduction oftax attributes under sections 108 and 1017of the Internal Revenue Code. These fi-nal regulations affect taxpayers that real-ize income from the discharge of indebt-edness that is excluded from gross incomepursuant to section 108.

DATES: Effective Date: These final regu-lations are effective May 10, 2004.

Applicability Date: These final regula-tions apply to discharges of indebtednessoccurring on or after May 10, 2004.

FOR FURTHER INFORMATIONCONTACT: Theresa M. Kolish, (202)622–7530, of the Office of AssociateChief Counsel (Corporate) (not a toll-freenumber).

SUPPLEMENTARY INFORMATION:

Background and Explanation ofProvisions

On July 18, 2003, the IRS and Trea-sury Department promulgated temporaryregulations providing guidance regardingthe application of the attribute reductionrules of sections 108 and 1017. Those

temporary regulations clarified that, in thecase of a transaction described in section381(a) that ends a year in which the dis-tributor or transferor corporation excludesincome from the discharge of indebtednessfrom gross income under section 108(a)(excluded COD income), any tax attributesto which the acquiring corporation suc-ceeds, including the basis of property ac-quired by the acquiring corporation in thetransaction, must reflect the reductions re-quired by sections 108 and 1017. Forthis purpose, all attributes listed in section108(b)(2) of the distributor or transferorcorporation immediately prior to the trans-action described in section 381(a), includ-ing the basis of property, but after the de-termination of tax for the year of the dis-charge, are available for reduction undersection 108(b)(2).

The temporary regulations (T.D. 9080,2003–40 I.R.B. 696) were published inthe Federal Register (68 FR 42590) forJuly 18, 2003, and a notice of proposedrulemaking (REG–113112–03, 2003–40I.R.B. 761) cross-referencing the tem-porary regulations was published in theFederal Register for the same day (68FR 42652). No public hearing was re-quested or held. One written commentwas received. The following paragraphsdescribe the written comment receivedand the changes made to the temporaryregulations in these final regulations.

The comment received argued that therules of the temporary regulations arecontrary to the relevant provisions of theInternal Revenue Code. The IRS andTreasury Department continue to believethat the rules of sections 108(b)(4)(A)and 1017 merely prescribe an ordering ofcalculations and that the rules of the tem-porary regulations are consistent with thepolicies underlying sections 108 and 1017and the corporate reorganization provi-sions, including “deferring, but eventuallycollecting within a reasonable period, taxon ordinary income realized from debtdischarge.” S. Rep. No. 96–1035, at 10(1980).

The IRS and Treasury Department,however, have become aware that taxpay-ers are taking the position that the rules

of the temporary regulations do not applyin certain cases to reduce the attributes towhich the acquiring corporation succeededas a result of certain transactions describedin section 381(a). Therefore, these finalregulations make certain modificationsto the rules of the temporary regulationsto ensure that, to the extent possible, thetransferor corporation’s excluded CODincome is applied to reduce attributes in amanner that will effect a deferral, ratherthan a permanent elimination, of income.In that regard, the final regulations applyin cases in which the taxpayer realizes ex-cluded COD income either during or afterthe taxable year in which the taxpayer isthe distributor or transferor of assets in atransaction described in section 381(a). Inaddition, it provides that the basis of stockor securities of the acquiring corporationreceived by the taxpayer in exchange forthe transferred assets in the transactiondescribed in section 381(a) is not availablefor reduction under section 108(b)(2).

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 determinedthat section 553(b) of the AdministrativeProcedure Act (5 U.S.C. chapter 5) doesnot apply to these regulations, and becausethese regulations do not impose a collec-tion of information on small entities, theRegulatory Flexibility Act (5 U.S.C. chap-ter 6) does not apply. Pursuant to sec-tion 7805(f) of the Code, the notice of pro-posed rulemaking preceding these regula-tions was submitted to the Chief Counselfor Advocacy of the Small Business Ad-ministration for comment on its impact onsmall business.

Drafting Information

The principal author of these regula-tions is Theresa M. Kolish, Office of As-sociate Chief Counsel (Corporate). How-ever, other personnel from the IRS andTreasury Department participated in theirdevelopment.

2004-24 I.R.B. 1042 June 14, 2004

* * * * *

Final Amendments to the Regulations

Accordingly, 26 CFR part 1 is amendedas follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by removing the entryfor “1.108–7T” and continues to read, inpart, as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.108–7T is redesig-

nated as §1.108–7 and amended as fol-lows:

1. The language “(temporary)” is re-moved from the section heading.

2. Paragraphs (c) and (e) are revised.The revisions read as follows:

§1.108–7 Reduction of attributes.

* * * * *(c) Transactions to which section 381

applies. If a taxpayer realizes COD in-come that is excluded from gross incomeunder section 108(a) either during or af-ter a taxable year in which the taxpayeris the distributor or transferor of assets ina transaction described in section 381(a),any tax attributes to which the acquiringcorporation succeeds, including the basisof property acquired by the acquiring cor-poration in the transaction, must reflect thereductions required by section 108(b). Forthis purpose, all attributes listed in section108(b)(2) immediately prior to the transac-tion described in section 381(a), but afterthe determination of tax for the year of thedistribution or transfer of assets, includingbasis of property, will be available for re-duction under section 108(b)(2). However,the basis of stock or securities of the ac-quiring corporation, if any, received by thetaxpayer in exchange for the transferredassets shall not be available for reductionunder section 108(b)(2).

* * * * *(e) Effective date. This section applies

to discharges of indebtedness occurring onor after May 10, 2004.

Par. 3. Section 1.1017–1 is amendedby revising paragraph (b)(4) to read as fol-lows:

§1.1017–1 Basis reductions following adischarge of indebtedness.

* * * * *(b) * * *(4) Transactions to which section 381

applies. If a taxpayer realizes COD in-come that is excluded from gross incomeunder section 108(a) either during or af-ter a taxable year in which the taxpayeris the distributor or transferor of assets ina transaction described in section 381(a),the basis of property acquired by the ac-quiring corporation in the transaction mustreflect the reductions required by section1017 and this section. For this purpose, thebasis of property of the distributor or trans-feror corporation immediately prior to thetransaction described in section 381(a), butafter the determination of tax for the yearof the distribution or transfer of assets, willbe available for reduction under section108(b)(2). However, the basis of stock orsecurities of the acquiring corporation, ifany, received by the taxpayer in exchangefor the transferred assets shall not be avail-able for reduction under section 108(b)(2).See §1.108–7. This paragraph (b)(4) ap-plies to discharges of indebtedness occur-ring on or after May 10, 2004.

Par. 4. In section §1.1017–1T, para-graph (b)(4) is removed.

§1.1017–1T Basis reductions following adischarge of indebtedness (temporary).

Paragraphs (a) through (b)(4) [Re-served]. For further guidance, see§1.1017–(a) through (b)(4).

* * * * *

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

Approved May 4, 2004.

Gregory F. Jenner,Acting Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on May 10, 2004,8:45 a.m., and published in the issue of the Federal Registerfor May 11, 2004, 69 F.R. 26038)

Section 165.—Losses26 CFR 1.165–1: Losses.(Also § 1.165–2.)

Preproduction costs of creative prop-erty. This ruling provides that a taxpayermay not deduct as a loss under section 165of the Code the costs of acquiring and de-veloping creative property if the taxpayerdoes not establish an intention to abandonthe property and an affirmative act of aban-donment, or an identifiable event evidenc-ing a closed and completed transaction es-tablishing the worthlessness of the prop-erty.

Rev. Rul. 2004–58

ISSUE

May a taxpayer deduct the cost of ac-quiring and developing creative propertyas a loss under § 165(a) of the Internal Rev-enue Code in the situations described be-low?

FACTS

X is a corporation that files returns ona calendar year basis for federal incometax purposes. X is engaged in the trade orbusiness of producing motion pictures. Aspart of that trade or business, X routinelyincurs costs to acquire and develop cre-ative property such as screenplays, scripts,treatments, story outlines, motion pictureproduction rights to books, plays, andother literary works, and similar propertyfor purposes of potential development,production, and exploitation. The typeof rights X acquires in creative propertyvaries from property to property and mayinclude exclusive rights of ownershipor limited exploitation rights, and mayinclude rights for the entire remainingcopyright term of the property or rights fora limited period of time.

X ultimately sets for production only asmall percentage of the creative propertythat X acquires. Most of the creative prop-erty that X sets for production is set withinthree years of X’s acquisition of the prop-erty. However, X does set some propertyfor production that X has held for longerthan three years. Additionally, X may sellto a third party X’s rights to a creative prop-erty not set for production. X does not dis-card, release to the public domain, or oth-erwise dispose of the creative properties

June 14, 2004 1043 2004-24 I.R.B.

not set for production or sold. Generallythese properties are retained indefinitely.

In order to preserve the properties ina condition that allows for future use, Xmaintains facilities for storing creativeproperty retained but not set for produc-tion. X retains these properties for variousreasons, including, but not limited to, thefollowing:

1. To exercise X’s ownership or othercontractual rights at any time in the futureby, among other things,a. selling or setting a property for pro-

duction if, for example, the subjectmatter becomes more popular or thewriter becomes well known;

b. preventing or defending against apossible future copyright infringe-ment lawsuit; and

c. keeping competitors from developingthe property; and

2. To maintain good relations with theseller of the property.

For financial accounting purposes, Xapplies generally accepted accountingprinciples (GAAP) to the cost of acquir-ing and developing creative property. Forcreative property that has not been set forproduction, X recognizes a loss for finan-cial accounting purposes in the earliest of:(1) the year in which X decides not to setthe property for production; (2) the year inwhich X sells or otherwise disposes of theproperty; or (3) the third year followingthe year in which X acquires the property.

Situation 1

In 2003, X purchases the exclusiverights for the remainder of the copyrightterm to script a. In 2004, an X executivedecides that X will not set script a for pro-duction. In accordance with X’s financialaccounting practice, in 2004 X writes offfor financial accounting purposes the costof acquiring and developing script a. Al-though X writes off the cost of script a forfinancial accounting purposes and doesnot set script a for production, X retains allrights to script a indefinitely.

Situation 2

In 2003, X purchases limited exploita-tion rights to use screenplay b in the pro-duction of a motion picture. Under theterms of the purchase agreement, all ofX’s rights in screenplay b expire if screen-play b is not set for production within four

years from the date of the agreement. Xexecutives do not make a specific decisionnot to set screenplay b for production, butscreenplay b is not set for production bythe time X’s rights in screenplay b expirein 2007. In accordance with X’s finan-cial accounting practice, in 2006 X writesoff for financial accounting purposes thecost of acquiring and developing screen-play b. Although X writes off the cost ofscreenplay b for financial accounting pur-poses and does not set screenplay b for pro-duction, X continues to retain exploitationrights to screenplay b until 2007, at whichtime those rights expire. X does not at-tempt to renew, extend, or otherwise reac-quire any rights to screenplay b.

Situation 3

In 2003, X purchases motion picturerights c, the exclusive rights to producemotion pictures based on a particularnovel, from A, the author of the novel.Under the terms of the contract, A has anoption to reacquire motion picture rightsc if X does not set them for productionwithin two years of acquisition. In 2005,X decides not to set motion picture rightsc for production in the foreseeable future.X informs A that A has the right to reac-quire the rights pursuant to the option. Acontacts other studios to determine if theyare interested in acquiring motion picturerights c, but is unable to find another stu-dio to purchase the rights for a satisfactoryprice. Therefore, A declines to exercisethe option. In accordance with X’s finan-cial accounting practice, in 2005 X writesoff for financial accounting purposes thecost of acquiring and developing motionpicture rights c. X retains motion picturerights c indefinitely.

LAW AND ANALYSIS

Section 165(a) allows a deduction forany loss sustained during the taxable yearand not compensated for by insurance orotherwise. Section 165(b) states that theamount of the deduction for a loss is theadjusted basis as provided in § 1011. Seealso § 1.165–1(c) of the Income Tax Reg-ulations.

Section 1.165–1(b) provides that, to beallowable as a deduction under § 165(a),a loss must be evidenced by a closedand completed transaction, fixed by an

identifiable event, and, except as pro-vided in § 165(h) and § 1.165–11, actuallysustained during the taxable year. Sec-tion 1.165–1(d)(1) provides that a loss istreated as sustained during the taxable yearin which the loss occurs, as evidenced bya closed and completed transaction, and asfixed by an identifiable event occurring insuch taxable year.

Section 1.165–2(a) allows a deductionunder § 165(a) for a loss incurred in a busi-ness or in a transaction entered into forprofit and arising from the sudden termi-nation of the usefulness in such businessor transaction of any nondepreciable prop-erty, when such business or transaction isdiscontinued or when such property is per-manently discarded from use therein. Sec-tion 1.165–2(a) further provides that thetaxable year in which a loss is sustained isnot necessarily the taxable year in whichthe overt act of abandonment, or the lossof title to the property, occurs.

Section 165 losses have been referred toas abandonment losses to reflect that someact is required that evidences a taxpayer’sintent to permanently discard or discon-tinue use. Gulf Oil Corp. v. Commis-sioner, 914 F.2d 396, 402 (3d Cir. 1990).To establish the abandonment of an assetfor purposes of § 165, a taxpayer mustshow both (1) an intention to abandon theasset, and (2) an affirmative act of aban-donment. A.J. Indus., Inc. v. UnitedStates, 503 F.2d 660, 670 (9th Cir. 1974);CRST, Inc. v. Commissioner, 92 T.C.1249, 1257 (1989), aff’d, 909 F.2d 1146(8th Cir. 1990); Rev. Rul. 93–80, 1993–2C.B. 239. A deduction is not allowableif a taxpayer intends to hold and preserveproperty for possible future use or to re-alize potential future value from the prop-erty. A.J. Indus., 503 F.2d at 670. Aban-donment of an intangible property interestshould be accompanied by some expressmanifestation. Citron v. Commissioner, 97T.C. 200, 209 (1991). See also Echols v.Commissioner, 935 F.2d 703, 706–08 (5thCir. 1991) (finding both an intent to aban-don and an affirmative act of abandonmentwhen taxpayers called a partnership meet-ing at which they tendered their 75% part-nership interest to another partner, or any-one else, “gratis,” and announced that theywould contribute no further funds to thepartnership), reh’g denied, 950 F.2d 209(5th Cir. 1991).

2004-24 I.R.B. 1044 June 14, 2004

The “identifiable event” required by§ 1.165–1(b) and (d)(1) “must be observ-able to outsiders and constitute ‘somestep which irrevocably cuts ties to theasset.’” United Dairy Farmers, Inc. v.U.S., 267 F.3d 510, 522 (6th Cir. 2001)(quoting Corra Resources, Ltd. v. Com-missioner, 945 F.2d 224, 226 (7th Cir.1991)). Mere non-use of an asset is notsufficient to establish an act of abandon-ment. Standley v. Commissioner, 99 T.C.259, 272 (1992), aff’d without publishedopinion, 24 F.3d 249 (9th Cir. 1994); JonesBeach Theatre Corp. v. Commissioner,T.C.M. 1966–100. Similarly, internalcommunications or decisions within ataxpayer’s organization are not sufficientaffirmative acts of abandonment. SeeCorra Resources, 945 F.2d at 226.

A taxpayer need not relinquish legaltitle to property in all cases to establishabandonment, provided there is an intentto abandon and an affirmative act of aban-donment. See Echols, 935 F.2d at 706;Middleton v. Commissioner, 77 T.C. 310,322 (1981), aff’d per curiam, 693 F.2d 124(11th Cir. 1982). Retention of bare le-gal title to property does not preclude adeduction under § 165(a) in certain casesin which property has become worthless.See Helvering v. Gordon, 134 F.2d 685,689 (4th Cir. 1943), acq., 1951–1 C.B. 2;Rhodes v. Commissioner, 100 F.2d 966,970 (6th Cir. 1939); Rev. Rul. 54–581,1954–2 C.B. 112. In such cases the courtshave adopted the rule that a taxpayer mayclaim a loss on property without being re-quired to divest legal title if the taxpayerdoes not intend to hold the property andthe taxpayer proves by identifiable eventsthat the property has become worthless.A.J. Indus., 503 F.2d at 670. The tax-payer’s conduct in regarding the propertyas worthless and not intending to preserveor hold it may be the practical equivalent ofabandonment. See id.; Lockwood v. Com-missioner, 94 TC 252, 258 (1990) (leav-ing master recordings on a closet shelf in-stead of storing in a necessary climate-controlled environment was tantamount tothrowing them in the trash).

A deduction for worthlessness under§ 165 is allowable only if there is a closedand completed transaction fixed by identi-fiable events establishing that the propertyis worthless in the taxable year for whichthe deduction is claimed. § 1.165–1(b)and (d)(1). Although the taxpayer is not

required to be an “incorrigible optimist,”United States v. S.S. White Dental Manu-facturing Co., 274 U.S. 398, 403 (1927),a mere diminution in the value of an assetis not sufficient to establish worthless-ness. Proesel v. Commissioner, 77 T.C.992, 1006 (1981). Assets may not beconsidered worthless, even when theyhave no liquidated value, if there is a rea-sonable hope and expectation that theywill become valuable in the future. SeeLawson v. Commissioner, 42 B.T.A. 1103,1108 (1940); Morton v. Commissioner,38 B.T.A. 1270, 1278 (1938), aff’d, 112F.2d 320 (7th Cir. 1940); Rev. Rul. 77–17,1977–1 C.B. 44.

Abandonment and other transactionsthat divest the taxpayer’s title are iden-tifiable events that support a closed andcompleted transaction. Additionally, iden-tifiable events may include “other actsor events which reflect the fact that theproperty is worthless.” Proesel, 77 T.C. at1005. To the extent that the transactionsdo not include divestitures of title or aban-donment, the essential element for tax pur-poses is that a particular event destroyedthe potential value and usefulness of theasset to the taxpayer. See Echols, 950 F.2dat 213 (partnership’s insolvency, thirdparty developer’s default, and inability ofpartners to restructure the underlying debtwere identifiable events that evidencedworthlessness); Corra Resources, 945F.2d at 226–27 (loss realized in the year inwhich coal mining lease expired); GeorgeFreitas Dairy, Inc. v. United States, 582F.2d 500, 502 (9th Cir. 1978) (cancellationof production quota contract was identifi-able event that evidenced the closed andcompleted transaction); Proesel, 77 T.C. at998–99, 1006–07 (finding insufficient evi-dence of worthlessness despite unsuccess-ful attempts to sell or find distributor for amotion picture by contacting all major stu-dios and major independent distributors;however, contract to produce the motionpicture could have been found worthlessupon settled litigation with respect tobreach of contract or demonstration thatlitigation would be fruitless); Oak Har-bor Freight Lines, Inc. v. Commissioner,T.C.M. 1999–291 (an act of Congressrendered motor carrier authorities worth-less because all rights associated withthe authorities were eliminated); Spring-field Productions, Inc. v. Commissioner,T.C.M. 1979–23 (testimony by taxpayer’s

president that film was worthless becausetaxpayer had unsuccessfully submitted itfor sale or distribution to all major stu-dios and small distribution companies wasnot substantial proof of worthlessness);Golden State Towel and Linen Service,Ltd. v. United States, 179 Ct. Cl. 300, 310(1967) (finding that it is only when all or asubstantial, identifiable, vendible portionof a customer list is terminated perma-nently, either through extraneous causesor the sudden and involuntary inability ofthe owner to serve them, that a tax lossmay be claimed, and then only if the lossmay be adequately measured.)

A taxpayer’s treatment of the costs ofacquiring property for financial account-ing purposes does not control the treatmentof those costs for federal income tax pur-poses. See Thor Power Tool Co. v. Com-missioner, 439 U.S. 522, 542–44 (1979).

X has not performed an affirmative actof abandoning creative property merelybecause: (1) an X executive decides notto actively pursue the development orproduction of the property, see Corra Re-sources, 945 F.2d at 226; (2) X does not setthe property for production within threetaxable years of acquiring that property(notwithstanding that it is unlikely thatX will ever set for production propertythat X retains for three years or more),see Standley, 99 T.C. at 272; and (3) Xwrites off for financial accounting pur-poses the cost of acquiring and developingthe property, see Thor Power Tool, 439U.S. at 542–44. Although the above factsmay be relevant factors to consider, anaffirmative act to abandon must be ascer-tained from all the facts and surroundingcircumstances, Citron, 97 T.C. at 210. Xretains creative properties for potentialfuture exercise of ownership or other con-tractual rights, whether by sale or use, orto enforce those rights by preventing X’scompetitors from using the property. Infact, X does sell or set for production somecreative property after writing off the costsof such property for financial accountingpurposes and having made a decision notto set the property for production. Thesefacts are inconsistent with an intent topermanently abandon property and withan affirmative act of abandonment, bothof which are required for an abandonmentloss deduction under § 165(a).

Furthermore, X is not entitled to aworthlessness deduction in the absence

June 14, 2004 1045 2004-24 I.R.B.

of evidence of a closed and completedtransaction fixed by an identifiable eventestablishing worthlessness. A creativeproperty that X acquires may not be pre-sumed worthless simply because X doesnot set that property for production, eitherby a specific internal decision or by inac-tion, as these are not identifiable eventsthat irrevocably cut ties to the asset. SeeCorra Resources, 945 F.2d at 226. In ad-dition, the facts indicate that the creativeproperties that X retains after writing offtheir costs for financial accounting pur-poses are not worthless to X. X maintainsproper storage facilities for the proper-ties, thereby preserving the properties ina condition that allows for future exerciseof ownership or other contractual rights.By retaining its rights in a property, Xcan prevent a competitor from exploitingthat property or prevent or defend againstpotential copyright infringement lawsuits.In some cases, X retains creative propertyto maintain good relations with the sellerfrom whom X acquired the property. Fi-nally, X retains some property in the hopethat the property will have future value ifthe subject matter becomes more popular,if the writer becomes better known, or forvarious other reasons. These facts indicatethat X has an intention to hold and preserveproperty because of a bona fide belief thatthe property has value due to the possibil-ity that the property will be of future use.Thus, without an identifiable event thatdestroys the potential value and usefulnessof the property to X, the property may notbe considered worthless.

In Situation 1, an X executive’s deci-sion in 2004 not to set script a for produc-tion, the write-off for financial accountingpurposes, and the fact that the script hasnot been set for production by the end of2004 do not constitute affirmative acts ofabandonment of script a for purposes of§ 165(a), nor are they identifiable eventsevidencing a closed and completed trans-action establishing worthlessness. To thecontrary, X’s retention of script a in orderto keep the potential to exercise ownershipor other contractual rights in the future isevidence that the script is not worthless.Thus, in the absence of any affirmative actof abandonment or showing of worthless-ness in 2004, X may not deduct in that yearas a loss under § 165(a) the cost of acquir-ing and developing script a.

In Situation 2, the facts do not indi-cate an affirmative act of abandonment oridentifiable events evidencing a closed andcompleted transaction establishing worth-lessness until 2007. X may deduct X’s ad-justed basis in screenplay b under § 165(a)in 2007 because X’s rights to screenplay bexpire in that year. See Rev. Rul. 81–160,1981–1 C.B. 312. In the absence of anyaffirmative act of abandonment or show-ing of worthlessness in an earlier taxableyear, X may not deduct in any earlier tax-able year as a loss under § 165(a) the costof acquiring and developing screenplay b.

In Situation 3, the facts do not indi-cate an affirmative act of abandonment oridentifiable events evidencing a closed andcompleted transaction establishing worth-lessness. X’s notification to A of A’s rightto reacquire motion picture rights c pur-suant to the contract between X and A doesnot constitute an affirmative act of aban-donment by X of motion picture rights c forpurposes of § 165(a). Rather, X is merelycomplying with its contractual obligations.When A declines to exercise its option, Xcontinues to retain motion picture rights cin order to keep the potential to exercise itsownership or other contractual rights in thefuture. Furthermore, A’s failure to exer-cise the option to reacquire motion picturerights c does not establish that those rightsare worthless in 2005. That A was unableto find another studio to purchase motionpicture rights c at a satisfactory price isalso insufficient to establish the worthless-ness of motion picture rights c in 2005. SeeProesel, 77 T.C. at 998–99, 1006–07. Nei-ther of these acts is an identifiable event es-tablishing that motion picture rights c arevalueless in 2005 and without reasonableexpectation of future value. X’s retentionof motion picture rights c in order to keepthe potential to exercise ownership or othercontractual rights in the future is evidencethat the script is not worthless. Thus, in theabsence of any affirmative act of abandon-ment or showing of worthlessness in 2005,X may not deduct in that year as a loss un-der § 165(a) the cost of acquiring and de-veloping motion picture rights c.

HOLDING

A taxpayer may not deduct the costsof acquiring and developing creative prop-erty as a loss under § 165(a) if the taxpayerdoes not establish an intention to abandon

the property and an affirmative act of aban-donment, or identifiable event(s) evidenc-ing a closed and completed transaction es-tablishing worthlessness.

DRAFTING INFORMATION

The principal author of this revenue rul-ing is Joy Spies of the Office of Asso-ciate Chief Counsel (Income Tax and Ac-counting). For further information regard-ing this revenue ruling, contact Ms. Spiesat (202) 622–5020 (not a toll-free call).

Section 263A.—Capital-ization and Inclusion inInventory Costs of Cer-tain Expenses26 CFR 1.263A–9: The avoided cost method.

T.D. 9129

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Part 1

Uniform Capitalization ofInterest Expense in SafeHarbor Sale and LeasebackTransactions

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final and temporary regula-tions.

SUMMARY: This document containsregulations relating to the capitalizationof interest expense incurred in sale andleaseback transactions under the Eco-nomic Recovery Tax Act of 1981 (ERTA)safe harbor leasing provisions. The reg-ulations affect taxpayers that providepurchase money obligations in connec-tion with these transactions. The textof the temporary regulations also servesas the text of the proposed regulations(REG–148399–02) set forth in the noticeof proposed rulemaking on this subjectin this issue of the Bulletin. The finalregulations consist of technical revisionsto reflect the issuance of the temporaryregulations.

2004-24 I.R.B. 1046 June 14, 2004

DATES: Effective Date: These regulationsare effective May 20, 2004.

Applicability Dates: For dates of appli-cability, see §1.263A–15T(a)(3).

FOR FURTHER INFORMATIONCONTACT: Grant Anderson,202–622–4930 (not a toll-free num-ber).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to26 CFR part 1 under section 263A(f) ofthe Internal Revenue Code (Code) relat-ing to the treatment of certain interest ex-pense incurred by the lessor in a sale andleaseback transaction under the ERTA safeharbor leasing provisions (former section168(f)(8), as enacted by section 201(a) ofERTA, Public Law 97–34, 95 Stat. 214).

Section 263A (the uniform capitaliza-tion rules) generally requires the capital-ization of direct costs and indirect costsproperly allocable to real property and tan-gible personal property produced by a tax-payer.

Section 263A(f) and the regulationsthereunder provide special rules for capi-talizing interest to property produced by ataxpayer. In general, section 263A(f) onlyrequires the capitalization of interest thatis paid or incurred during the productionperiod of certain property (referred to asdesignated property). Designated propertyincludes all real property and certain tangi-ble personal property. See §1.263A–8(b)of the Income Tax Regulations.

In general, interest incurred on debt thatis directly attributable to production ex-penditures with respect to designated prop-erty (traced debt) is capitalized first. Seesection 263A(f)(2)(A)(i). If productionexpenditures with respect to designatedproperty exceed the amount of traced debt,interest on any other debt of the taxpayeris capitalized to the extent that the interestcould have been reduced if productionexpenditures had not been incurred. Seesection 263A(f)(2)(A)(ii). The amount ofinterest required to be capitalized undersection 263A(f) is calculated by referenceto eligible debt. See §1.263A–9(a)(4).Eligible debt generally includes all out-standing debt of the taxpayer. Certaintypes of debt (listed in paragraphs (i) to(viii) of § 1.263A–9(a)(4)), however, are

excluded from the definition of eligibledebt.

The ERTA safe harbor leasing provi-sions were intended to permit owners ofproperty to transfer the tax benefits ofownership (depreciation and the invest-ment credit) to other persons. The ERTAsafe harbor leasing provisions operateby guaranteeing that, for federal tax pur-poses, (i) a transaction meeting certainstated qualifications (a qualifying trans-action) will be treated as a lease eventhough the qualifying transaction other-wise would not be considered a lease, and(ii) the nominal lessor will be treated asthe owner of the property even though thenominal lessee is in substance the ownerof the property.

Regulations issued under the ERTAsafe harbor leasing provisions clarify thata qualifying transaction may be part of asale and leaseback transaction, in whichthe nominal lessee sells the underlyingproperty for Federal tax purposes to thenominal lessor for a cash payment andan interest bearing note (purchase moneynote), and the nominal lessor simulta-neously leases the property back to thenominal lessee. See §5c.168(f)(8)–1(e)Example 2. Generally, the nominal lessordeducts, and the nominal lessee includesin income, the interest accruing on thepurchase money note, subject to certainlimitations. See §5c.168(f)(8)–7.

Explanation of Provisions

The temporary regulations providethat eligible debt under section 263A(f)does not include a purchase money obli-gation given by the lessor to the lessee(or a party related to the lessee) in a saleand leaseback transaction under formersection 168(f)(8) as enacted by ERTA. Ac-cordingly, these obligations are excludedfrom the definition of eligible debt, andthe interest accruing on the obligationsis not subject to capitalization with re-spect to designated property under section263A(f).

The temporary regulations apply to in-terest incurred in taxable years beginningon or after May 20, 2004, except that, inthe case of property that is inventory in thehands of the taxpayer, the temporary regu-lations apply to taxable years beginning onor after May 20, 2004. However, taxpay-ers may elect to apply the temporary regu-

lations to interest incurred in taxable yearsbeginning on or after January 1, 1995, or,in the case of property that is inventory inthe hands of the taxpayer, to taxable yearsbeginning on or after January 1, 1995 (thegeneral effective date of the interest capi-talization regulations).

For purposes of §1.263A–15(a)(2), theexclusion of purchase money obligationsgiven by the lessor to the lessee (or aparty related to the lessee) in a sale andleaseback transaction under former sec-tion 168(f)(8) as enacted by ERTA willbe considered to be a reasonable positionfor the application of section 263A(f) intaxable years beginning before January 1,1995. Consequently, a taxpayer changinga method of accounting for property that isnot inventory in the hands of the taxpayerto conform to the temporary regulationsmay elect to include interest incurred afterDecember 31, 1986, in taxable years be-ginning on or after December 31, 1986 (thegeneral effective date of section 263A),and before January 1, 1995, in the deter-mination of its adjustment under section481(a). A taxpayer changing a method ofaccounting for property that is inventoryin the hands of the taxpayer to conform tothe temporary regulations must revalue itsbeginning inventory in the year of changeas if the new method of accounting hadbeen in effect during all prior years.

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 determinedthat section 553(b) of the AdministrativeProcedure Act (5 U.S.C. chapter 5) doesnot apply to these regulations. Please referto the cross-referenced notice of proposedrulemaking published elsewhere in this is-sue of the Bulletin for applicability of theRegulatory Flexibility Act (5 U.S.C. chap-ter 6). Pursuant to section 7805(f) of theCode, these temporary regulations will besubmitted to the Chief Counsel for Advo-cacy of the Small Business Administrationfor comment on their impact on small busi-ness.

Drafting Information

The principal author of these regula-tions is Grant Anderson of the Office of

June 14, 2004 1047 2004-24 I.R.B.

Associate Chief Counsel (Income Tax andAccounting). However, other personnelfrom the IRS and the Treasury Departmentparticipated in their development.

* * * * *

Amendments to the Regulations

Accordingly, 26 CFR part 1 is amendedas 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 1.263A–9 is amended

by revising paragraphs (a)(4)(vii), and(viii) and adding paragraph (a)(4)(ix) toread as follows:

§1.263A–9 The avoided cost method.

(a) * * *(4) * * *(vii) Reserves, deferred tax liabilities,

and similar items that are not treated asdebt for Federal income tax purposes, re-gardless of the extent to which the tax-payer’s applicable financial accounting orother regulatory reporting principles re-quire or support treating these items asdebt;

(viii) Federal, State, and local incometax liabilities, deferred tax liabilities undersection 453A, and hypothetical tax liabili-ties under the look-back method of section460(b) or similar provisions; and

(ix) [Reserved]. For further guidance,see §1.263A–9T(a)(4)(ix).

* * * * *Par. 3. Section 1.263A–9T is added to

read as follows:

§1.263A–9T The avoided cost method(temporary).

(a)(1) through (3) [Reserved]. Forfurther guidance, see §1.263A–9(a)(1)through (3).

(4) Definition of eligible debt. Exceptas provided in this paragraph (a)(4), el-igible debt includes all outstanding debt(as evidenced by a contract, bond, deben-ture, note, certificate, or other evidence ofindebtedness). Eligible debt does not in-clude—

(i) through (viii) [Reserved]. For fur-ther guidance, see §1.263A–9(a)(4)(i)through (viii).

(ix) A purchase money obligation givenby the lessor to the lessee (or a party that isrelated to the lessee) in a sale and lease-back transaction involving an agreementqualifying as a lease under §5c.168(f)(8)–1through §5c.168(f)(8)–11 of this chapter.See §5c.168(f)(8)–1(e) Example (2) of thischapter.

(b) through (g) [Reserved]. For furtherguidance, see §1.263A–9(b) through (g).

Par. 4. Section 1.263A–15T is added toread as follows:

§1.263A–15T Effective dates, transitionalrules, and anti-abuse rule (temporary).

(a)(1) and (2) [Reserved]. For furtherguidance, see §1.263A–15(a)(1) and (2).

(3) Section 1.263A–9T applies to inter-est incurred in taxable years beginning onor after May 20, 2004, except that, in thecase of property that is inventory in thehands of the taxpayer, §1.263A–9T appliesto taxable years beginning on or after May20, 2004. However, taxpayers may electto apply §1.263A–9T to interest incurredin taxable years beginning on or after Jan-uary 1, 1995, or, in the case of property thatis inventory in the hands of the taxpayer,to taxable years beginning on or after Jan-uary 1, 1995. A change in a taxpayer’streatment of interest to a method consistentwith §1.263A–9T is a change in method ofaccounting to which sections 446 and 481apply.

(b) and (c) [Reserved]. For furtherguidance, see §1.263A–15(b) and (c).

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

Approved May 10, 2004.

Gregory F. Jenner,Acting Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on May 19, 2004,8:45 a.m., and published in the issue of the Federal Registerfor May 20, 2004, 69 F.R. 29066)

Section 457.—DeferredCompensation Plansof State and LocalGovernments andTax-Exempt Organizations26 CFR 1.457–2: Definitions.

Governmental plan; union; section457(b). This ruling holds that a deferredcompensation plan does not fail to be aneligible governmental plan under section457(b) of the Code merely because theplan is created, offered, and administeredby a union, provided adoption of the planmeets certain criteria set forth in the ruling.

Rev. Rul. 2004–57

ISSUE

Does a plan fail to be an eligible govern-mental plan under § 457(b) of the InternalRevenue Code solely because the plan isoffered and administered by a labor unionfor the benefit of those State employeeswho are union members?

FACTS

An organization (including its localaffiliates) that is a labor organization de-scribed in § 501(c)(5) (Union) representsprofessional firefighters employed byvarious city, municipal, and other localgovernments in State X (“GovernmentalEmployers”) under collective bargainingagreements between the Union and theGovernmental Employers.

State X maintains an eligible govern-mental § 457(b) plan (Plan A). Plan Ais available to employees of State X andemployees of any political subdivisionof State X, including both unionized andnon-unionized public safety employeesand civilians.

The Union would like to offer an addi-tional eligible governmental § 457(b) plan(Plan B) that is available only to mem-bers of the collective bargaining units rep-resented by the Union who are employedby the Governmental Employers.

Under Plan B, the members of theUnion who are employees of the Govern-mental Employers that adopt Plan B areeligible to participate and elect to havethe Governmental Employers make con-tributions on their behalf to Plan B out

2004-24 I.R.B. 1048 June 14, 2004

of their compensation from the Govern-mental Employers. Plan B states that theplan is established and maintained by theGovernmental Employers and participantsare informed of this. Only investments ap-proved by the Union are offered under PlanB and amounts deferred by employees ofGovernmental Employers that adopt PlanB, plus any amounts transferred directlyfrom any other eligible governmental§ 457(b) plan, provide Plan B’s exclusivesource of funding.

Union members employed by Govern-mental Employers that do not adopt PlanB are not eligible to participate in Plan B,and no contributions may be made on theirbehalf regardless of whether their Govern-mental Employer is part of any collectivebargaining agreement with the Union or itsaffiliates and regardless of whether the em-ployees are union members. Employees ofthe Union are not eligible to participate inPlan B.

Plan B provides that all annual defer-rals for a participant under the plan arecombined with the participant’s annual de-ferrals under Plan A and all other eligi-ble plans of the same employer for pur-poses of the Plan B limitations designedto comply with the limitations of § 457(b),and are combined with annual deferralsunder eligible plans of other employersto the extent information concerning suchplans is provided by the participant. Thus,Plan B treats all deferrals under all eligi-ble plans in which an individual partici-pates by virtue of his or her relationshipwith a single employer as a single plan forpurposes of determining whether deferralsin excess of the § 457(b) limitations havebeen made.

Because both Plan A and Plan B mustcomply with these limitations, they eachinclude terms providing for correction ofany excess deferrals under all plans. PlanB provides that if an excess deferral ariseswhich is only an excess amount as a re-sult of the combined annual deferrals un-der both Plan A and Plan B, then the ex-cess amount will be corrected by Plan B(even though there would be no excess ifonly annual deferrals under Plan B weretaken into account). By adoption of PlanB, each Governmental Employer agreesnot only to forward payroll amounts rep-resenting annual deferrals under Plan B,but also to inform Plan B of the amountof the annual deferrals made under Plan A

by participants in Plan A who also partici-pate in Plan B and such other informationknown to the Governmental Employers asPlan B may need for proper administra-tion. The adoption agreement also requiresthe Union to provide to the GovernmentalEmployers such information from Plan Bas the Governmental Employers may needto complete tax returns for their employeesand to administer Plan A.

In addition, for purposes of Plan B’sspecial catch-up contribution rules for par-ticipants who are within the three-year pe-riod ending before the year they reach nor-mal retirement age, Plan B provides a nor-mal retirement age which is the same as thenormal retirement age under Plan A. Fur-ther, Plan B permits a plan-to-plan trans-fer of assets from Plan A (or any othereligible governmental plan) to Plan B foremployees who have not had a separa-tion from employment only if the follow-ing conditions are satisfied: (i) the trans-fer is from Plan A or any other plan thatis an eligible governmental plan of StateX; (ii) the transferring plan provides forthe transfer; (iii) the participant whose de-ferred amounts are being transferred is per-forming services for a Governmental Em-ployer that has adopted Plan B (and, forthis purpose, Plan B treats the employeras the same employer only if the partici-pant’s compensation is paid by the sameentity); and (iv) the participant or bene-ficiary whose amounts deferred are beingtransferred must have an amount deferredimmediately after the transfer at least equalto the amount deferred with respect to thatparticipant or beneficiary immediately be-fore the transfer.

LAW AND ANALYSIS

Section 457 provides rules for the defer-ral of compensation by an individual par-ticipating in an eligible deferred compen-sation plan as defined in § 457(b). Sec-tion 457(b)(1) provides that the term “el-igible deferred compensation plan” meansa plan “established and maintained by aneligible employer” in which only individu-als who perform services for the employermay be participants. The performance ofservices includes performance of servicesas an employee or as an independent con-tractor. Section 457(e)(2).

Section 457(e)(1) defines an “eligibleemployer” as (A) a State, political subdi-

vision of a State, and any agency or instru-mentality of a State or political subdivisionof a State and (B) any other organization(other than a governmental unit) exemptunder Subtitle A of the Internal RevenueCode. Section 1.457–2(e) of the IncomeTax Regulations further defines the term“eligible employer” as including an entitythat is a State that establishes a plan and§ 1.457–2(l) provides that State means aState (treating the District of Columbia asa State as provided under § 7701(a)(10)),a political subdivision of a State, and anyagency or instrumentality of a State.

Section 1.457–5(b) provides that forpurposes of determining the amount ofannual deferrals under a § 457 plan thatare excluded from a participant’s gross in-come in any taxable year, the participant’sannual deferrals under all § 457 plansmust be determined on an aggregate basis.For example, under § 1.457–5, all annualdeferrals under all eligible plans (whetheror not with the same employer) are com-bined for purposes of determining whetherthe limitations of § 457(b) have been ex-ceeded. In this regard, § 1.457–4(e)(2)treats all deferrals under all eligible plansin which an individual participates byvirtue of his or her relationship with a sin-gle employer as a single plan for purposesof determining excess deferrals.

Under § 1.457–10(b)(4), a plan-to-plantransfer from one eligible governmentalplan to another eligible governmental planof the same employer is permitted with-out a separation from employment if cer-tain conditions are satisfied, including thatthe transfer is from an eligible governmen-tal plan to another eligible governmentalplan of the same employer (and, for thispurpose, the employer is not treated as thesame employer if the participant’s com-pensation is paid by a different entity).

Section 457(g) provides that a planmaintained by an eligible governmentalemployer is not to be treated as an eli-gible deferred compensation plan unlessall amounts of compensation deferredunder the plan, all property and rights pur-chased with such deferred compensationamounts, and all income attributable tosuch amounts, property, or rights of theplan are held in trust for the exclusive ben-efit of participants and their beneficiaries.In order to be an eligible plan of a tax-ex-empt entity, § 457(b)(6) provides that theplan must be unfunded and plan assets

June 14, 2004 1049 2004-24 I.R.B.

must not be set aside for participants ortheir beneficiaries.

An arrangement does not fail to consti-tute a single eligible governmental plan forpurposes of § 457(b) merely because thearrangement is funded through more thanone trustee, custodian, or insurance carrier.See § 1.457–8 of the regulations and No-tice 98–8, 1998–1 C.B. 355.

Under § 457, therefore, different rulesapply depending on whether the entity es-tablishing and maintaining the plan is atax-exempt entity or a State governmententity. A union that is a tax-exempt en-tity may establish and maintain an eligible§ 457(b) plan, but only if the plan is un-funded and is for its employees or otherindividuals who perform services for theunion. A State (including an agency orinstrumentality thereof) may establish andmaintain an eligible § 457(b) plan, but onlyif it is funded and only for employees ofthe State or other individuals who performservices for the State. A union may notestablish and maintain a funded plan forits employees or for individuals who donot perform services for the union. How-ever, an eligible governmental employermay adopt, for its collectively-bargainedemployees, a plan created by the unionfor employees of the governmental em-ployer and offered and administered by theunion, provided that the plan is “estab-lished and maintained by” the governmen-tal employer. Thus, if the plan is estab-lished and maintained by a governmentalemployer, it can qualify as an eligible gov-ernmental § 457(b) plan, assuming that theplan satisfies all of the other requirementsof § 457(b).

If the governmental employer hasadopted the plan in a manner that reflectsthe employer as having established andmaintained the plan, a plan does not failto be an “eligible governmental § 457(b)plan” merely because the plan is created,offered and administered by a union evenif it is in addition to another plan that isoffered and administered by the govern-mental employer.

Under these facts, Plan B includes spe-cial provisions designed to comply withthe rules for eligible governmental § 457plans of the same employer, includingcoordination of limitations and correc-tions under § 1.457–5 and plan-to-plantransfer provisions that comply with§ 1.457–10(b)(4). These facts are con-

sistent with the plan being established andmaintained by the Governmental Employ-ers. The Union’s involvement in adminis-tering the plan to be offered to employeesof the Governmental Employers, such ascoordinating the information necessaryto determine whether any excess contri-butions are made for a participant andresponsibility in providing informationnecessary for completing wage statementsthat reflect Plan B, is comparable to theinvolvement associated with a third partyadministrator who invests annual defer-rals and administers the plan provisionsfor the employer. In this case, the Unionis in effect administering Plan B for theGovernmental Employers, as a plan that isestablished and maintained by the Govern-mental Employers as the actual employersof the union members.

HOLDING

Plan B does not fail to be an eligiblegovernmental plan under § 457(b) solelybecause the plan is offered and adminis-tered by the Union, but only with respect toemployees of the Governmental Employ-ers that have adopted Plan B as describedin these facts.

For § 457(b) plans that do not satisfythe requirements of this revenue ruling, seeAnnouncement 2004–52, page 1071.

DRAFTING INFORMATION

The principal author of this revenueruling is Vernon S. Carter of the Of-fice of the Division Counsel/AssociateChief Counsel (Tax Exempt and Govern-ment Entities). For further informationregarding this revenue ruling contactVernon S. Carter at (202) 622–6060 (not atoll-free call).

Section 708.—Continuationof Partnership26 CFR 1.708–1: Continuation of a partnership.(Also: §§ 7701, 301.7701–1, 301.7701–2,301.7701–3.)

State law conversion from partner-ship to corporation. This ruling explainsthe federal tax consequences when an en-tity classified as a partnership for federaltax purposes converts into a state law cor-poration under a state statute that does not

require an actual transfer of the unincorpo-rated entity’s assets or interests.

Rev. Rul. 2004–59

ISSUE

If an unincorporated state law entitythat is classified as a partnership for fed-eral tax purposes (partnership) converts toa state law corporation under a state statutethat does not require an actual transfer ofthe unincorporated entity’s assets or in-terests (state law formless conversionstatute), how is the conversion treated forfederal tax purposes?

FACTS

On January 1, 2003, A is organized inState as an unincorporated entity that isclassified as a partnership for federal taxpurposes. A elects to convert under a statelaw formless conversion statute into a statelaw corporation, effective January 1, 2004.As a result of the conversion, A is classifiedas a corporation for federal tax purposes.

LAW AND ANALYSIS

Section 7701(a)(2) of the Internal Rev-enue Code provides that the term part-nership includes a syndicate, group, pool,joint venture, or other unincorporated or-ganization, through or by means of whichany business, financial operation, or ven-ture is carried on, and which is not, withinthe meaning of this title, a trust or estate ora corporation.

Section 7701(a)(3) provides that theterm corporation includes associations,joint-stock companies, and insurancecompanies.

Section 301.7701–2(b)(1) defines theterm corporation to include a businessentity organized under a federal or statestatute, or under a statute of a federallyrecognized Indian tribe, if the statutedescribes or refers to the entity as incorpo-rated or as a corporation, body corporate,or body politic.

Section 301.7701–3(a) provides that abusiness entity that is not classified as acorporation under § 301.7701–2(b)(1), (3),(4), (5), (6), (7) or (8) (an eligible entity),can elect its classification for federal taxpurposes.

Section 301.7701–3(g)(1)(i) providesthat, if an eligible entity classified as a part-

2004-24 I.R.B. 1050 June 14, 2004

nership elects under § 301.7701–3(c)(1)(i)to be classified as an association, the fol-lowing is deemed to occur: the partnershipcontributes all its assets and liabilities tothe association in exchange for stock in theassociation, and immediately thereafter,the partnership liquidates, distributing thestock of the association to its partners.

Rev. Rul. 84–111, 1984–2 C.B. 88, de-scribes the tax consequences when stepsare taken as parts of a plan to transferpartnership operations to a corporation or-ganized for valid business reasons. Foreach of three methods of incorporating apartnership, Rev. Rul. 84–111 describesthe differences in the basis and holdingperiods of the various assets received bythe corporation and the basis and holdingperiods of the stock received by the for-mer partners provided the steps describedare actually undertaken and the underly-ing assumptions and purposes for the con-clusions in the revenue ruling are appli-cable. If the partnership converts into acorporation in accordance with a state lawformless conversion statute, however, Rev.Rul. 84–111 does not apply.

For federal tax purposes, a partner-ship that converts to a corporation undera state law formless conversion statutewill be treated in the same manner as onethat makes an election to be treated as anassociation under § 301.7701–3(c)(1)(i).Therefore, when unincorporated entity Aconverts, under state law, to corporation A,the following steps are deemed to occur:unincorporated entity A contributes all ofits assets and liabilities to corporation A inexchange for stock in corporation A, andimmediately thereafter, unincorporatedentity A liquidates, distributing the stockof corporation A to its partners.

HOLDING

If an unincorporated state law entitythat is classified as a partnership for federaltax purposes converts into a state law cor-poration under a state law formless conver-sion statute, the following is deemed to oc-cur: the partnership contributes all its as-sets and liabilities to the corporation in ex-change for stock in such corporation, andimmediately thereafter, the partnership liq-uidates distributing the stock of the corpo-ration to its partners.

DRAFTING INFORMATION

The principal author of this revenue rul-ing is Christopher L. Trump of the Officeof Associate Chief Counsel (Passthroughsand Special Industries). For further in-formation regarding this revenue ruling,contact Christopher L. Trump at (202)622–3080 (not a toll-free call).

Section 3121.—Definitions26 CFR 31.3121(a)–1: Wages.(Also: 31.3306(b)–1, 31.3401(a)–1.)

Federal Insurance Contributions Act(FICA); options and deferred compen-sation transfer on divorce. This rulingconcludes that nonqualified stock optionsand nonqualified deferred compensationtransferred by an employee to a formerspouse incident to a divorce are subjectto the Federal Insurance Contributions Act(FICA), the Federal Unemployment TaxAct (FUTA), and income tax withholdingto the same extent as if retained by the em-ployee. The ruling also provides reportingrequirements applicable to the wage pay-ments. Notice 2002–31 modified.

Rev. Rul. 2004–60

ISSUES:

(1) What is the effect upon taxationunder the Federal Insurance ContributionsAct (FICA), the Federal UnemploymentTax Act (FUTA), and the Collection of In-come Tax at Source on Wages (income taxwithholding) of a transfer of interests in anonstatutory stock option and in nonqual-ified deferred compensation to a formerspouse incident to a divorce?

(2) What is the appropriate reportingof income and/or wages recognized withrespect to nonstatutory stock options andnonqualified deferred compensation trans-ferred to a former spouse incident to a di-vorce?

FACTS

The facts are the same as in Rev. Rul.2002–22, 2002–1 C.B. 849, and are re-stated here for convenience.

Prior to their divorce in 2002, A and Bwere married individuals residing in State

X who used the cash receipts and disburse-ments method of accounting.

A is employed by Corporation Y. Priorto the divorce, Y issued nonstatutory stockoptions to A as part of A’s compensation.The nonstatutory stock options did nothave a readily ascertainable fair marketvalue within the meaning of § 1.83–7(b)of the Income Tax Regulations at the timegranted to A, and thus no amount was in-cluded in A’s gross income with respect tothose options at the time of grant.

Y maintains two unfunded, deferredcompensation plans under which A earnsthe right to receive post-employment pay-ments from Y. Under one of the deferredcompensation plans, participants are enti-tled to payments based on the balance ofindividual accounts of the kind describedin § 31.3121(v)(2)–1(c)(1)(ii) of the Em-ployment Tax Regulations. By the timeof A’s divorce from B, A had an accountbalance of $100x under that plan. Underthe second deferred compensation planmaintained by Y, participants are entitledto receive single sum or periodic paymentsfollowing separation from service basedon a formula reflecting their years of ser-vice and compensation history with Y. Bythe time of A’s divorce from B, A hadaccrued the right to receive a single sumpayment of $50x under the plan follow-ing A’s termination of employment withY. A’s contractual rights to the deferredcompensation benefits under these planswere not contingent on A’s performanceof future services for Y.

Under the law of State X, stock op-tions and unfunded deferred compensationrights earned by a spouse during the periodof marriage are marital property subjectto equitable division between the spousesin the event of divorce. Pursuant to theproperty settlement incorporated into theirjudgment of divorce, A transferred to B(1) one-third of the nonstatutory stock op-tions issued to A by Y, (2) the right toreceive deferred compensation paymentsfrom Y under the account balance planbased on $75x of A’s account balance un-der the plan at the time of the divorce, and(3) the right to receive a single sum pay-ment of $25x from Y under the other de-ferred compensation plan upon A’s termi-nation of employment with Y.

In 2006, B exercises all of the trans-ferred stock options and receives Y stock

June 14, 2004 1051 2004-24 I.R.B.

with a fair market value in excess of theexercise price of the options. In 2011, Aterminates employment with Y, and B re-ceives a single sum payment of $150x fromthe account balance plan and a single sumpayment of $25x from the other deferredcompensation plan.

LAW AND ANALYSIS

Rev. Rul. 2002–22 concludes that ataxpayer who transfers interests in non-statutory stock options and nonqualifieddeferred compensation to the taxpayer’sformer spouse incident to divorce is not re-quired to include an amount in gross in-come upon the transfer. The ruling alsoconcludes that the former spouse, ratherthan the taxpayer, is required to include anamount in gross income when the formerspouse exercises the stock options or whenthe deferred compensation is paid or madeavailable to the former spouse.

FICA Wages

Sections 3101 and 3111 impose FICAtaxes on “wages” as that term is defined in§ 3121(a). FICA taxes consist of the Old-Age, Survivors and Disability Insurancetax (social security tax) and the HospitalInsurance tax (Medicare tax). These taxesare imposed on both the employer and em-ployee. Sections 3101(a) and 3101(b) im-pose the employee portions of the socialsecurity tax and the Medicare tax, respec-tively. Sections 3111(a) and (b) impose theemployer portions of the social security taxand the Medicare tax, respectively.

Section 3102(a) provides that the em-ployee portion of FICA taxes must becollected by the employer of the tax-payer by deducting the amount of thetax from wages as and when paid. Sec-tion 31.3102(a)–1(a) provides that theemployer is required to collect the tax,notwithstanding that wages are paid insomething other than money. Section3102(b) provides that every employer re-quired to deduct the FICA employee taxis liable for the payment of that tax, andis indemnified against the claims and de-mands of any person for the amount of anysuch payment made by such employer.

The term “wages” is defined in§ 3121(a) for FICA purposes as all re-muneration for employment, including thecash value of all remuneration (includingbenefits) paid in any medium other than

cash, with certain specific exceptions.Section 3121(b) defines “employment” asany service, of whatever nature, performedby an employee for the person employinghim, with certain specific exceptions.

Section 31.3121(a)–1(e) provides thatin general the medium in which the remu-neration is paid is immaterial. It may bepaid in cash or other than in cash. Re-muneration paid in any medium other thancash is computed on the basis of the fairmarket value of such items at the time ofpayment.

Under § 3121(v)(2), amounts deferredunder a nonqualified deferred compensa-tion plan generally are to be taken into ac-count when the services are performed or,if later, when there is no substantial riskof forfeiture. To the extent benefit pay-ments under a nonqualified deferred com-pensation plan are attributable to amountsdeferred under the plan that have beentaken into account for FICA tax purposes,the benefit payments are not treated asFICA wages. To the extent benefit pay-ments are attributable to an amount de-ferred that has not been taken into accountfor FICA tax purposes, then the benefitpayments are treated as FICA wages. See§ 31.3121(v)(2)–1(d)(1)(ii).

In the Social Security Amendments of1983, Public Law No. 98–21, 1983–2 C.B.309, Congress added language to § 3121(a)providing that nothing in the income taxwithholding regulations that provides anexclusion from wages for income tax with-holding purposes is to be construed to re-quire a similar exclusion from wages forFICA purposes. The legislative history inconnection with this provision states that“[s]ince the [social] security system hasobjectives which are significantly differentfrom the objective underlying the incometax withholding rules, the committee be-lieves that amounts exempt from incometax withholding should not be exempt fromFICA tax unless Congress provides an ex-plicit tax exclusion.” S. Rep. No. 23, 98thCong., 1st Sess. at 42 (1983).

The fact that payments are includiblein the gross income of an individual otherthan an employee does not remove thepayments from FICA wages. See Rev.Rul. 71–116, 1971–1 C.B. 277, holdingthat payments of wages to an employeein a community property state are FICAwages although one-half of the wagesis includible in the gross income of the

nonemployee spouse. See also Rev. Rul.86–109, 1986–2 C.B. 196, which holdsthat payments of remuneration for employ-ment made after the death of an employeeand in the calendar year of the death arewages for FICA tax purposes, although theamounts are includible in the gross incomeof the recipient and not the employee.

Rev. Rul. 2002–22 holds that, upon theexercise of a nonstatutory stock option ob-tained by a nonemployee spouse pursuantto divorce, the property transferred to thenonemployee spouse by the employer hasthe same character and is includible in theincome of the nonemployee spouse under§ 83(a) to the same extent as the prop-erty would have been includible in the in-come of the employee spouse had the op-tion been retained and exercised by the em-ployee spouse. Rev. Rul. 2002–22 furtherholds that nonqualified deferred compen-sation, the right to which is obtained by anonemployee spouse pursuant to divorce,paid or made available to the nonemployeespouse has the same character and is in-cludible in the income of the nonemployeespouse to the same extent as the compen-sation would have been includible in theincome of the employee spouse had thecompensation been paid or made avail-able to the employee spouse. Nothing in§ 1041, pertaining to transfers of propertybetween spouses or incident to divorce,excludes payments to a person other thanan employee from wages for purposes ofFICA. In the absence of a specific pro-vision that would exclude these paymentsfrom FICA wages, the compensation real-ized on the exercise of the stock options bythe nonemployee spouse and the deferredcompensation paid or made available tothe nonemployee spouse retain their char-acter as wages of the employee spouse forpurposes of FICA. Thus, the payment ofsuch remuneration is subject to FICA tothe same extent as if paid to the employeespouse.

At the same time that the Servicepublished Rev. Rul. 2002–22, it alsopublished Notice 2002–31, 2002–1 C.B.908, which included a proposed revenueruling addressing the application of FICA,FUTA, and income tax withholding, andreporting of income and wages, with re-spect to nonstatutory stock options andnonqualified deferred compensation trans-ferred to a former spouse incident to adivorce (as described in the Facts above),

2004-24 I.R.B. 1052 June 14, 2004

and requested comments on the proposal.In general, the proposed ruling includedthe conclusion that the exercise of theoptions and the nonqualified deferredcompensation remain subject to FICAand FUTA taxes to the same extent as ifthey had been retained by the employee,and that the income recognized by thenonemployee spouse with respect to theexercise of the options and distributionsof nonqualified deferred compensationare wages for purposes of income taxwithholding. The proposed ruling alsoconcluded that any employee FICA taxesand income tax withholding applicable tothe exercise of the options or distributionof the nonqualified deferred compensationwould be deducted from the payments tothe nonemployee spouse.

Accordingly, the nonqualified deferredcompensation paid or made available tothe former spouse remains subject to therules of § 3121, including § 3121(v)(2)and the regulations thereunder, to deter-mine when and whether FICA tax is ap-plicable. Thus, to the extent the amountdeferred has been previously taken into ac-count for FICA purposes, the distributionto the former spouse of the proceeds of theaccount balance plan would not be treatedas wages for FICA tax purposes. How-ever, to the extent the amount deferred hasnot been previously taken into account forFICA tax purposes, the distribution to theformer spouse of the proceeds of the ac-count balance plan would be wages of theemployee for FICA tax purposes. Sim-ilarly, under § 3121 and the regulationsthereunder, a former spouse’s exercise of anonstatutory stock option results in FICAwages of the employee to the extent thatthe fair market value of the stock receivedpursuant to the exercise of the option ex-ceeds the option exercise price.

To the extent the distributed paymentsare FICA wages, the employee FICA taxis deducted from the payment made to thetransferee. The amount includible in thegross income of the transferee is not re-duced by any FICA withholding from thepayments (including transfers of property)to the transferee. See Rev. Rul. 86–109and Rev. Rul. 71–116.

Because A was the service performerand the remuneration relates to A’s ser-vice in employment with Y, the wages, al-though paid to B, are FICA wages of A. SeeRev. Rul. 71–116. Thus, because the pay-

ments are wages for FICA tax purposes,the payments are reportable by Y as socialsecurity wages and Medicare wages on aForm W–2, Wage and Tax Statement, is-sued to A, and the social security tax with-held and Medicare tax withheld are alsoreportable on the Form W–2 to A. Y maytake into account other wages previouslypaid to A in that calendar year in deter-mining whether these distributions are ex-cepted from social security wages under§ 3121(a)(1), the maximum social secu-rity wage base exception. The employeeFICA tax for these wages should be de-ducted from the payment of these wages.Finally, these payments should not be in-cluded in Box 1, Wages, tips, other com-pensation, nor should any amount be re-flected in Box 2, Federal income tax with-held, of the Form W–2 issued to A with re-spect to these payments.

FUTA

The FUTA taxation provisions applica-ble with respect to nonstatutory stock op-tions and nonqualified deferred compensa-tion plans are similar to the FICA provi-sions, except that only the employer paysthe tax imposed under FUTA. See §§ 3301,3306(b), and 3306(r)(2) and the regula-tions thereunder. Because of the similarstatutory provisions, FUTA taxation ap-plies at the same time and in the same man-ner as FICA. To the extent wage taxationapplies, the wages are FUTA wages of theemployee A, subject to the maximum wagebase contained in § 3306(b)(1). As withFICA, wages previously paid to the em-ployee during the calendar year may betaken into account in determining whetherthese amounts qualify for the FUTA max-imum wage base exception.

Income Tax Withholding

Section 3402(a), relating to incometax withholding, generally requires everyemployer making a payment of wages todeduct and withhold upon those wages atax determined in accordance with pre-scribed tables or computational proce-dures.

Section 3401(a) provides that “wages”for income tax withholding purposesmeans all remuneration for services per-formed by an employee for his employer,including the cash value of all remuner-ation (including benefits) paid in any

medium other than cash, with certain ex-ceptions not pertinent to this ruling.

Under § 31.3402(a)–1(c), an employeris required to deduct and withhold the taxnotwithstanding that the wages are paid insomething other than money (for example,wages paid in stock or bonds) and to payover the tax in money. If the wages are paidin property other than money, the employershould make necessary arrangements to in-sure that the amount of the tax requiredto be withheld is available for payment inmoney.

Section 31 provides that the amountwithheld from wages as income tax with-holding will be allowed to the “recipientof the income” as a credit against the in-come taxes imposed by Subtitle A. Section1.31–1(a) of the Income Tax Regulationsprovides that the “recipient of the income”for purposes of the § 31 credit is the indi-vidual who is subject to income taxes uponthe wages from which the tax was with-held. For example, if an employee spouseand nonemployee spouse are domiciled ina community property state and file sep-arate income tax returns, each reportingfor income tax purposes one-half of thewages received by the employee spouse,each spouse is entitled to one-half of thecredit allowable for the tax withheld at thesource with respect to the wages.

Because the compensatory intereststransferred under §1041 to the nonem-ployee spouse pursuant to the divorce re-main taxable for employment tax purposesto the same extent as if retained by theemployee spouse, the income recognizedby the nonemployee spouse with respectto the exercise of the nonstatutory stockoptions and the distributions from the non-qualified deferred compensation plans areremuneration for employment and wagesfor purposes of income tax withholdingunder § 3402. Pursuant to §1.31–1(a), be-cause the income recognized with respectto this compensation is includible in thegross income of the nonemployee spouse,the nonemployee spouse is entitled to thecredit for the income tax withheld withrespect to these wage payments.

Employers are not required to col-lect Form W–4, Employee’s WithholdingAllowance Certificate, from the nonem-ployee spouse, and should not base with-holding on a Form W–4 submitted by thenonemployee spouse. Employers maytreat the compensation includible in the

June 14, 2004 1053 2004-24 I.R.B.

income of the nonemployee spouse assupplemental wages and apply the flatrate withholding method on supplementalwages in withholding income tax on thesewages. The flat rate for withholding onsupplemental wages is currently 25 per-cent. See § 101(c)(11) of the EconomicGrowth and Tax Relief Reconciliation Actof 2001 (Pub. L. No. 107–16), whichprovides that the flat rate for withholdingon supplemental wages is the third low-est rate of tax applicable under § 1(c) ofthe Code, and §§ 1(c), 1(i)(1)(A)(i), and1(i)(2) of the Code, which provide that thethird lowest rate of tax applicable under§ 1(c) is 25 percent.

Reporting of payments

Section 6051 requires payors of remu-neration to an employee to report thosepayments on Form W–2, Wage and TaxStatement. Because the former spouse isnot an employee, the reporting require-ments of § 6051 do not apply.

Section 6041(a) and the accompanyingregulations generally require that all per-sons engaged in a trade or business whomake a payment to a third party during thecourse of such business must file an infor-mation return with the IRS, reporting allpayments totaling $600 or more in a tax-able year, of rent, salaries, wages, premi-ums, annuities, compensations, remuner-ations, emoluments, or other fixed or de-terminable gains, profits and income. Inthis case, pursuant to § 6041(a), Y mustfile an information return reporting boththe income B realized from B’s exercise ofthe nonstatutory stock options and the pay-ments made to B from the deferred com-pensation plans.

Under § 31.6051–1(a)(1), the wages ofan employee that are subject to social se-curity and Medicare taxes are included inthe appropriate boxes on the Form W–2 is-sued to the employee. See also Rev. Rul.71–116.

Because there is no provision for theissuance of Form W–2 in the name of anonemployee spouse, the income real-ized upon the exercise of the nonstatutorystock options would be reportable tothe nonemployee spouse by Y on Form1099–MISC, Miscellaneous Income, is-sued to the nonemployee spouse, in Box 3,Other income, with the income tax with-held reported in Box 4, Federal income

tax withheld. The payments to the nonem-ployee spouse B from the nonqualifieddeferred compensation plans and the with-holding thereon would also be reportableby Y on a Form 1099–MISC in Box 3,with the income tax withheld reported inBox 4.

Social security wages, social securitytax withheld, Medicare wages, and Medi-care taxes withheld, if applicable, arereported on the employee spouse’s FormW–2 as described above.

Employers would report the income taxwithholding on wages paid to the nonem-ployee spouse on Form 945, Annual Re-turn of Withheld Federal Income Tax. Thesocial security and Medicare tax paid withrespect to these wages of the employeespouse would be reported on Form 941,Employer’s Quarterly Federal Tax Return.FUTA tax with respect to wages of the em-ployee spouse would be reported on Form940, Employer’s Annual Federal Unem-ployment (FUTA) Tax Return.

HOLDINGS

(1) The transfer of interests in nonstatu-tory stock options and in nonqualified de-ferred compensation from the employeespouse to the nonemployee spouse inci-dent to a divorce does not result in a pay-ment of wages for FICA and FUTA taxpurposes.

The nonstatutory stock options are sub-ject to FICA and FUTA taxes at the timeof exercise by the nonemployee spouse tothe same extent as if the options had beenretained by the employee spouse and exer-cised by the employee spouse. The non-qualified deferred compensation also re-mains subject to FICA and FUTA taxes tothe same extent as if the rights to the com-pensation had been retained by the em-ployee spouse. To the extent FICA andFUTA taxation apply, the wages are thewages of the employee spouse. The em-ployee portion of the FICA taxes is de-ducted from the wages as and when thewages are taken into account for FICA taxpurposes. The employee portion of theFICA taxes is deducted from the paymentto the nonemployee spouse.

The income recognized by the nonem-ployee spouse with respect to the exerciseof the nonstatutory stock options is sub-ject to withholding under § 3402. Theamounts distributed to the nonemployee

spouse from the nonqualified deferredcompensation plans are also subject towithholding under § 3402. The amountsto be withheld for income tax withholdingare deducted from the payments to thenonemployee spouse. The supplementalwage flat rate may be used to determinethe amount of income tax withholding.Pursuant to § 31, the nonemployee spouseis entitled to the credit allowable for theincome tax withheld at the source on thesewages.

(2) The social security wages, Medicarewages, social security taxes withheld, andMedicare taxes withheld, if applicable, arereportable on a Form W–2 with the name,address, and social security number of theemployee spouse. However, no amount isincludible in Box 1 and Box 2 of the em-ployee’s Form W–2 with