If, on December 31, 1965, X is an organization described in section 501 (c) (3) and exempt from tax under section 501 (a), then only so much of the $3,300 as is not excludable under paragraph (b) of § 1.403 (b)-1 is includible in A's gross income for 1965. Similarly, if, on December 31, 1968, X is an organization described in section 501(c)(3) and exempt from tax under section 501(a), then only so much of the $4,400 as is not excludable under paragraph (b) of § 1.403(b)-1 is includible in A's gross income for 1968. Par. 10. Section 1.404 (a) is deleted. Par. 11. Section 1.404 (a)-12 is amended to read as follows: § 1.404(a)-12 Contributions of an employer under a plan that does not meet the requirements of section 401(a); application of section 404 (a) (5). (a) In general. Section 404 (a) (5) covers all cases for which deductions are allowable under section 404 (a) (for contributions paid by an employer under a stock bonus, pension, profitsharing, or annuity plan or for any compensation paid on account of any employee under a plan deferring the receipt of such compensation) but not allowable under paragraph (1), (2), (3), (4), or (7) of such section. For the rules with respect to the taxability of an employee when rights under a nonexempt trust become substantially vested, see section 402 (b) and the regulations thereunder. (b) Contributions made after August 1, 1969-(1) In general. A deduction is allowable for a contribution paid after August 1, 1969, under section 404 (a) (5) only in the taxable year of the employer in which or with which ends the taxable year of an employee in which an amount attributable to such contribution is includible in his gross income as compensation, and then only to the extent allowable under section 404(a). See § 1.404 (a)-1. For example, if an employer A contributes $1,000 to the account of its employee E for its taxable (calendar) year 1977, but the amount in the account attributable to that contribution is not includible in E's gross income until his taxable (calendar) year 1980 (at which time the includible amount is $1,150), A's deduction for that contribution is $1,000 in 1980 (if allowable under section 404(a)). For purposes of this (1), a contribution is considered to be so includible where the employee or his beneficiary excludes it from his gross income under section. 101 (b) or subchapter N. To the extent that property of the employer is transferred in connection with such a contribution, such transfer will consti tute a disposition of such property by the employer upon which gain or loss is recognized, except as provided in section 1032 and the regulations thereunder. The amount of gain or loss recognized from such disposition shall be the difference between the value of such property used to measure the deduction allowable under this section and the employer's adjusted basis in such property. are (2) Special rule for unfunded pensions and certain death benefits. If unfunded pensions are paid directly to former employees, such payments are includible in their gross income when paid, and accordingly, such amounts deductible under section 404 (a) (5) when paid. Similarly, if amounts are paid as a death benefit to the beneficiaries of an employee (for example, by continuing his salary for a reasonable period), and if such amounts meet the requirements of section 162 or 212, such amounts are deductible under section 404 (a) (5) in any case when they are not includible under the other paragraphs of section 404 (a). (3) Separate accounts for funded plans with more than one employee. In the case of a funded plan under which more than one employee participates, no deduction is allowable under section 404 (a) (5) for any contribution unless separate accounts are maintained for each employee. The requirement of separate accounts does not require that a separate trust be maintained for each employee. However, a separate account must be maintained for each employee to which employer contributions under the plan are allocated, along with any income earned thereon. In addition, such accounts must be sufficiently separate and independent to qualify as separate shares under section 663 (c). Nothing shall preclude a trust which loses its exemption under section 501 (a) from setting up such accounts and meeting the separate account requirement of section 404 (a) (5) with respect to the taxable years in which such accounts are set up and maintained. (c) Contributions paid on or before August 1, 1969. No deduction is allowable under section 404 (a) (5) for any contribution paid on or before August 1, 1969, by an employer under a stock bonus, pension, profit-sharing, or annuity plan, or for any compensation paid on account of any employee under a plan deferring the receipt of such compensation, except in the year when paid, and then only to the extent allowable under section 404(a). See § 1.404(a)-1. If payments are made under such a plan and the amounts are not deductible under the other paragraphs of section 404 (a), they are deductible under section 404 (a) (5) to the extent that the rights of individual employees to, or derived from, such employer's contribution or such compensation are nonforfeitable at the time the contribution or compensation is paid. If unfunded pensions are paid directly to former employees, their rights to such payments are nonforfeitable, and accordingly, such amounts are deductible under section 404 (a) (5) when paid. Similarly, if amounts are paid as a death benefit to the beneficiaries of an employee (for example, by continuing his salary for a reasonable period), and if such amounts meet the requirements of section 162 or 212, such amounts are deductible under section 404 (a) (5) in any case where they are not deductible under the other paragraphs of section 404(a). As to what constitutes nonforfeitable rights of an employee in other cases, see 1.402 (b)-1 (d) (2). If an amount is accrued but not paid during the taxable year, no deduction is allowable for such amount for such year. If an amount is paid during the taxable year to a trust or under a plan and the employee's rights to such amount are forfeitable at the time the amount is paid, no deduction is allowable for such amount for any taxable year. Par. 12. Paragraphs (a) (2) and (c) (3) (ii) of § 1.421-6 are amended to read as follows: § 1.421-6 Options to which section. 421 does not apply. (a) Scope of section. *** (2) This section is applicable to options granted on or after February 26, 1945, and before July 1, 1969 (and thereafter, to the extent that § 1.838(b) applies). For rules relating to options granted after June 30, 1969, see § 1.83-7. This section, however, is not applicable to— (i) Property transferred pursuant to an option exercised before September 25, 1959, if the property is transferred subject to a restriction which has a significant effect on its value, or (ii) Property transferred pursuant to an option granted before September 25, 1959, and exercised on or after such date, if, under the terms of the contract granting such option, the property to be transferred upon the exercise of the option is to be subject to a restriction which has a significant effect on its value and if such property is actually transferred subject to such restriction. However, if an option granted before September 25, 1959, and on or after February 26, 1945, is sold or otherwise disposed of before exercise, the provisions of this section. shall be fully applicable to such disposition. (ii) The option privilege in the case of an option to buy is the opportunity to benefit during the option's exercise period from any increase in the value of property subject to the option during such period, without risking any capital. Similarly, the option privilege in the case of an option to sell is the opportunity to benefit during the exercise period from a decrease in the value of the property subject to the option. For example, if at some time during the exercise period of an option to buy, the fair market value of the property subject to the option is greater than the option's exercise price, a profit may be realized by exercising the option and immediately selling the property so acquired for its higher fair market value. Irrespective of whether any such gain may be realized immediately at the time an option is granted, the fair market value of an option includes the value of the right to benefit from any future increase in the value of the property subject to the option (relative to the option exercise period), without risking any capital. Therefore, the fair market value of an option is not merely the difference that may exist at a particular time between the option's exercise price and the value of the property subject to the option, but also includes the value of the option privilege for the remainder of the exercise period. Accordingly, for purposes of this section, in determining whether the fair market value of an option is readily ascertainable, it is necessary to consider whether the value of the entire option privilege can be measured with reasonable accuracy. In determining whether the value of the option privilege is readily ascertainable, and in determining the amount of such value when such value is readily ascertainable, it is necessary to consider (a) Whether the value of the property subject to the option can be ascertained; (b) The probability of any ascertainable value of such property increasing or decreasing; and (c) The length of the period during which the option can be exercised. Par. 13. Paragraph (b)(3)(i) of § 1.421-7 is amended by adding at the end thereof the following sentence: For rules concerning options that are not statutory options, see § 1.83-7. (This Treasury decision is issued under the authority contained in sections 83 and 7805 of the Internal Revenue Code of 1954 (83 Stat. 588; 68A Stat. 917; 26 U.S.C. 83 and 7805).) JEROME KURTZ, Commissioner of Internal Revenue. Approved July 11, 1978. DONALD C. LUBICK, (Filed by the Office of the Federal Register on July 21, 1978, 8:45 a.m., and published in the issue of the Federal Register for July 24, 1978, 43 F.R. 31911) Part III.-Items Specifically Excluded From Gross Income Section 101.—Certain Death 26 CFR 1.101-1: Exclusion from gross income of proceeds of life insurance contracts payable by reason of death. (Also Sections 61, 451; 1.61-1, 1.451-2.) Armed Forces; missing in action; life insurance proceeds. The recipient beneficiary may exclude from gross income the proceeds of a life insurance policy upon which the insured was a Missing in Action member of the U.S. uniformed services for whom no official finding of death has been made by the Department of Defense; Rev. Rul. 76-468 clarified. Rev. Rul. 78-372 Are proceeds of a life insurance policy excludable from gross income of the recipient beneficiary of the policy as an amount paid by reason of the death of the insured for purposes of section 101 (a) (1) of the Internal Revenue Code of 1954 if the insured is a Missing in Action member of the uniformed services of the United States for whom no official finding of death has been made by the United States Department of Defense? FACTS An individual taxpayer, A, who uses the cash receipts and disbursements method of accounting and files returns on a calendar year basis, is married to B, who is a member of a voluntary nonprofit association formed to provide for the welfare and financial security of its members. The association's most important function is to make available to its members low cost group life insurance, which is underwritten by a commercial insurance company. All members of the association must be active-duty commissioned officers of the uniformed services of the United States upon joining the association. During the Vietnam conflict B, insured under this group life plan, was listed as Missing in Action (MIA) and continued to be listed as missing in action on the records of the Department of Defense after the cessation of hostilities in January of 1973. In August of 1977, in order to relieve further hardship to the beneficiaries of its insured MIA members for whom the death benefits had not been paid only because no official finding of death had been made by the United States Department of Defense, the association requested and authorized the underwriting insurance company to offer the full death benefit payment to each MIA beneficiary as of a specified date in October 1977. The insurance company subsequently determined in good faith under applicable state law that submission of evidence establishing these MIA's as officially missing in action as a result of the Vietnam hostilities would warrant a conclusion of death. The company therefore agreed to pay the full death benefit to each MIA beneficiary who submitted a claim evidencing an official status of MIA, which it accepted as due proof of death. It was also agreed that if a beneficiary should fail to immediately submit an acceptable claim for the death benefit payment, but instead claim payment at some future date, the insurance company would accumulate it with interest at a rate determined by the insurance company from the specified date in 1977 and would pay the accumulation to the beneficiary of record on the date the beneficiary's claim for the insurance is paid. It was further agreed that no addi tional contributions would be due or payable to maintain the insurance. benefits of the MIA's after the specified date in 1977. The beneficiary's claim for death benefits is not taken into account by the Department of Defense in determining whether to continue the MIA in missing status. Later in 1977, the insurance company drew checks in full payment of the group life death benefit for each insured MIA, naming the respective MIA beneficiaries as payees, and delivered the checks to the association for distribution to the payees. The association then notified the payees that the checks were available to them contingent upon submission of due proof of death and execution by the payee an agreement releasing the insurance company and association from further claims for death benefits for the named insured. Upon receipt of this notification in 1977, A submitted the due proof of death and executed the release agreement, and received the check for the proceeds that same year. LAW AND ANALYSIS of Section 61 (a) of the Internal Revenue Code of 1954 and the Income Tax Regulations thereunder provide that, except as otherwise provided by law, gross income means all income from whatever source derived, including in terest. Section 101 (a) (1) of the Code provides that, with certain exceptions not here relevant, gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract if such amounts were paid by reason of the death of the insured. Section 101 (c) of the Code provides that if any amount excluded from gross income as life insurance proceeds, paid by reason of the death of the insured, is held under an agreement to pay interest thereon, the interest payments shall be included in gross income. Secion 451 (a) of the Code provides that the amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period. Section 1.451-2 of the regulations provides, in pertinent part, as follows: (a) General rule. Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. *** If a life insurance policy provides that proceeds will be paid to the beneficiary of record upon receipt of due proof of death, and the insurance company determines in good faith that such a policy is payable (whether that determination is based on facts and circumstances indicating death or on a presumption of death under applicable state law), then the proceeds will be an amount paid by reason of death of the insured for purposes of section 101(a)(1) of the Code. Compare Rev. Rul. 76-468, 1976-2 C.B. 202, which states that for purposes of sections 2(a) (3), 112, 692, 6013, and 7508, the date of death of a member of the Armed Forces or a civilian employee, reported as missing in action or a prisoner of war and later declared to have been killed in action, is the Secretarial determination date of death, unless a later actual date of death is subsequently established. Rev. Rul. 76-468 refers to the Secretarial determination date of death as the date of death determined under 37 U.S.C. section 555 or 556. Rev. Rul. 76-468 is clarified so that any reference therein to the Secretarial determination date of death instead refers to the date on which the determination of death is made under those sections. HOLDING The payment of life insurance proceeds to A in 1977 is fully excludable from A's gross income under the provisions of section 101(a)(1) of the Code. However, if A had deferred claiming the death benefit payment until a later year, any portion of the payment attributable to accumulated interest would be includible in A's gross income under the provisions of sections 61 (a) (4) and 101(c). Pursuant to section 1.451-2 (a) of the regulations, the interest would be includible in the taxable year accumulated to the extent that A could have drawn upon it if A had submitted a claim for the proceeds. See section 101 (d) of the Code and the regulations thereunder with respect to computing the exclusion for proceeds held by an insurer under an agreement provided for in the life insurance contract, and paid other than as a single sum at a date later than death. See section 2042 of the Code and the regulations thereunder with respect to the inclusion of the proceeds of life insurance in the value of a decedent's gross estate. For purposes of the federal estate tax, the date of death is the Secretarial determination date of death unless a later actual date of death is established. EFFECT ON OTHER Section 103.-Interest on Certain Governmental Obligations Arbitrage bonds; fund established for indirect payment of principal or interest. Examples illustrate whether the arbitrage yield restrictions of section 103(c) of the Code apply to amounts accumulated in funds established in connection with the issuance of local government obligations that are not used directly for the payment of principal or interest. Rev. Rul. 78-302 1 ISSUE Will amounts accumulated in certain funds be subject to arbitrage yield restrictions? FACTS Situation 1. Authority A proposes to issue dormitory revenue refunding bonds. The refunding bonds will mature serially over 20 years. The proceeds of the refunding bonds will be deposited in an escrow fund to secure payment of the prior issue and to defease the lien of the prior issue on revenues of the authority. A portion of A's dormitory revenues will be deposited in a “reserve fund." Amounts in the "reserve fund" will be pledged as security for the bonds. Situation 2. City B proposes to issue $5.5 million of 33-year sewer revenue bonds. Two and a half million dollars of the revenue bonds will mature serially over the first 30 years. In addition, $1 million of term bonds will mature in each of the last three years. B's sewer revenue will be used as follows (in order of priority): (1) to pay operating expenses, (2) to pay all debt service on the revenue bonds, and (3) to make deposits in a "renewal fund." B covenants to maintain sewer rates high enough to pay all necessary operating expenses and to make all scheduled payments of debt service and all scheduled deposits in the “renewal fund." However, it would be. impracticable for B to raise sewer rates high enough to meet the balloon payments due in years 31-33 solely out of revenues. 1 Also released as News Release IR-2018, dated July 30, 1978. The "renewal fund" is not pledged as security for the revenue bonds. Moreover, amounts held in the "renewal fund" can in no event be used directly to pay principal or interest on the revenue bonds. However, B's use of the "renewal fund" is restricted by covenants contained in the indenture for the revenue bonds. In particular, B is required to invest the "renewal fund" in Treasury bonds that will mature approximately 30-33 years after the revenue bonds are issued. Further, B will have only one practicable way to meet the balloon payments due in years 31-33. It will have to use the "renewal fund" to pay necessary operating expenses during these years. This will enable B to meet the balloon payments out of current sewer reve nues. Pending use, the amounts in the "renewal fund" will be invested at a yield that is materially higher than the yield on the sewer revenue bonds. Moreover, these amounts will at times exceed 15 percent of the original proceeds of the bonds. Situation 3. City C proposes to issue $10 million of general obligation bonds. While the bonds are outstanding, C will deposit a portion of its tax revenues in a separate "investment fund." The investment fund will be established and maintained at C's discretion solely to enhance C's general credit rating. It will not be specially pledged as security for the general obligation bonds, and C's use of the "investment fund" will in no way be restricted by covenants contained in the bond indenture. Further, C does not reasonably expect to use amounts in the "investment fund" (directly or indirectly) to pay principal or interest on the general obligation bonds. LAW AND ANALYSIS Section 103 (a) (1) of the Internal Revenue Code of 1954 provides that gross income generally does not in clude interest on obligations of a state or a political subdivision thereof. Section 103 (c) (1) of the Code provides that, with certan minor exceptions, the interest on an arbitrage bond is not excludable from gross in come. Section 103 (c) (2) of the Code provides that the term "arbitrage bond" means any obligation all or a major portion (more than 15 percent) of the proceeds of which are reasonably expected to be used directly or indirectly (A) to acquire securities or obligations that may be expected to produce a yield over the term of the governmental issue that is materially higher than the yield on such issue; or (B) to replace funds that were used directly or indirectly to acquire securities or obligations described in (A). Section 1.103-13(g) (2) of the proposed Income Tax Regulations published in the Federal Register on May 8, 1978 (43 FR 19675), provides that amounts accumulated in a sinking fund for an issue are treated as proceeds of the issue. Section 1.103-13 (g) (3) provides that the term "sinking fund" includes a debt service fund, or any similar fund, to the extent that the issuer reasonably expects to use the fund to pay principal or interest on the issue. With certain exceptions, subparagraphs (2) and (3) apply to bonds sold after May 2, 1978. In Situation 1, the "reserve fund" will be pledged as security for the bonds. Therefore, the "reserve fund" will be treated as a sinking fund, and amounts accumulated in the "reserve fund" will be treated as bond proceeds. In Situation 2, the specific amounts accumulated in the "renewal fund" will be used to pay operating expenses rather than to pay principal or interest on the bonds. However, B will use amounts held in the "renewal fund" to replace sewer revenues, and will use the sewer revenues thus freed up to pay principal or interest. Therefore, the amounts accumulated in the "renewal fund" will be used indirectly to pay principal or interest on the bonds. Consequently, the "renewal fund" will be treated as a sinking fund, and the amounts accumulated in the "renewal fund" will be treated as bond proceeds. However, in Situation 3, C will not use the "investment fund" (directly or indirectly) to pay principal or interest on the general obligation bonds. Accordingly, the "investment fund" will not be treated as a sinking fund, and amounts accumulated in the fund will not be treated as bond proceeds. HOLDING Amounts accumulated in the "reserve fund" in Situation 1 and in the "renewal fund" in Situation 2 will be subject to arbitrage yield restrictions as provided by section 103(c) of the Code. Because these amounts will be invested at a materially higher yield, the bonds will be arbitrage bonds and interest received by the bondholders will not be excluded from their gross incomes under section 103 (a) (1). On the other hand, amounts accumulated in the "investment fund" in Situation 3 will not be subject to arbitrage yield restrictions. Arbitrage bonds; third party securities pledged as collateral. Examples illustrate whether the arbitrage yield restrictions of section 103(c) of the Code apply to securities pledged by a third party as collateral for state or local government obligations. Rev. Rul. 78-348 1 ISSUE Will certain securities pledged as collateral for municipal bonds be subject to arbitrage yield restrictions? 1 Also released as News Release IR-2028, dated August 23, 1978. |