A political subdivision of a state proposes to issue industrial development bonds as defined in section 103 (b)(2) of the Code in the amount of $4,500,000 to finance the acquisition of land, factory building, and equip ment located in county M to be used by X corporation, a nonexempt person. Prior to the issuance of the bonds, the political subdivision plans to make an election to have the bonds treated as a $5,000,000 exempt small issue under section 103(b)(6)(D). There will be no prior exempt small issues outstanding at the time the bonds will be issued. X currently owns and operates a manufacturing facility in city N, an incorporated municipality located in county M. During the three years prior to the issuance of the bonds, X will have expended $550,000 for research and experimentation with respect to the proposed facility to be located in county M. The research and development activities will consist of experimentation with respect to the products to be produced in the new facility and the development of equipment to be used in the manufacture of such products. X will elect to treat the research and experimental expenditures as deductible expenses under the provisions of section 174 of the Code. Section 103(a)(1) of the Code provides that gross income does not include interest on the obligations of a state, a territory, or a possession of the United States, or any political subdivision of any of the foregoing, or of the District of Columbia. Section 103(b) (1) of the Code provides that, except as otherwise provided in section 103(b), any industrial development bond shall be treated as an obligation that is not an obligation described in section 103(a)(1). Section 103(b) (6) (A) of the Code provides that section 103(b) (1) shall not apply to any obligation issued as part of an issue the aggregate authorized face amount of which is $1,000,000 or less and substantially all of the proceeds of which are to be used for the acquisition, construction, reconstruction, or improvement of land or property of a character subject to the allowance for depreciation, or to redeem part or all of a prior issue that was issued for such purposes. Section 103(b) (6) (D) of the Code provides, in part, that the issuer may elect to issue an exempt small issue of $5,000,000 or less in lieu of the $1,000,000 described in section 103(b) (6)(A). For purposes of determining the aggregate face amount of such issue, there must be taken into account the face amount of the bonds to be issued, the outstanding face amount of any prior exempt small issues, and the aggregate amount of capital expenditures with respect to facilities paid or incurred during the 6-year period beginning three years before the date of such issue and ending three years after such date (and financed otherwise than out of the proceeds of outstanding issues to which section 103(b) (6) (A) applied). The facilities to be taken into account are those located in the same incorporated municipality or located in the same county (but not in any incorporated municipality) the principal user of which is or will be the same person or two or more related persons. Section 1.103-10(b) (2) (ii) (e) of the Income Tax Regulations provides, in part, that an expenditure is a section 103(c) (6)(D) (now section 103(b) (6) (D)) capital expenditure if the capital expenditure is properly chargeable to the capital account of any person or State or local governmental unit (whether or not such person is the principal user of the facility or a related person) determined, for this purpose, without regard to any rule of the Code that permits expenditures properly chargeable to capital account to be treated as current expenses. Section 174 of the Code provides, in general, that a taxpayer may treat research or experimental expenditures in connection with a trade or business as expenses that are not charge able to the taxpayer's capital account. Such expenditures are allowable as a deduction in the taxable year paid or incurred or, under certain circumstances, they may be deferred and amortized. Although, in the instant case, X will elect to treat its expenditures for research and experimentation with respect to the proposed manufacturing facility as deductible expenses under section 174 of the Code, the provisions of section 1.103-10(b) (2) (ii) (e) of the regulations will apply for purposes of determining whether such expenditures are capital expenditures under section 103(b)(6)(D). Accordingly, the expenditures by X for research and experimentation will be capital expenditures within the meaning of section 103(b) (6) (D) of the Code. Since the sum of the face amount of the proposed bond issue ($4,500,000) and the aggregate amount of the capital expenditures ($550,000) will exceed the $5,000,000 limitation for an exempt small issue, the political subdivision may not elect to have the bonds treated as an exempt small issue under section 103 (b) (6) (D). 26 CFR 1.103-10: Exemption for certain small issues of industrial development bonds. Industrial development bonds; exempt small issue; property contributed to partnership. Property contributed to a partnership in exchange for an interest in the partnership that did not result in the recognition of a gain or loss under section 721 of the Code will not be considered a capital expenditure by the partnership for purposes of determining whether the $5,000,000 small issue limitation provided in section 103(b)(6)(D) has been exceeded. Rey Rul 77,146 son user of the the per- nersnge for an in partnershi Propert In 1977, city M proposes to issue industrial development bonds as de the purphe city for tilmed in 1976, to a conock or securitiof the Income fined in section 103(b)(2) of the whether the small issue limitation of Code, for the purpose of constructing Internal Revenue Code of 1954, for $5,000,000 provided in section 103 an industrial facility for the use of X, the purpose of constructing facilities (b) (6) (D) has been exceeded. For a plastic products manufacturing corwithin the city for the use of part- similar treatment where section 351 poration that is not an exempt person nership X that was formed in 1976. M (a) applies to a transfer of property within the meaning of section 103(b) proposes to make the election pro- to a corporation solely in exchange (3). M made the election provided in vided in section 103(b) (6) (D) for for its stock or securities, see section section 103(b) (6)(D) to treat the the $5,000,000 small issue exemption, 1.103-10(b)(2) (v) (c) of the Income bonds as an exempt small issue of so that the bonds will qualify for Tax Regulations, as limited by sec- $5,000,000 or less. the interest exclusion provision of sec- tion 1.103-10(b) (2) (v) (d) of the Prior to issuance of the bonds and tion 103(a)(1). In 1976 Y, also a regulations. the opening of the plant in M, X, in partnership, contributed land, which other political subdivisions where it it acquired in 1971, to X in exchange had plants, had charged customers a for a 30 percent interest in partner- 26 CFR 1.103-10: Exemption for certain unit price for a plastic product and a ship X. The bond-financed facilities small issues of industrial development separate charge for the cost of the bonds. will be constructed on that land. mold. The mold for which the cusUnder section 721, the contribution of Industrial development bonds; tomer had paid became the property land by Y to X did not result in recog. exempt small issue; capital ex of the customer but was retained by nition of gain or loss. penditures. Costs were incurred by X. After the bonds were issued and X After the bonds To determine whether the $5,000.- a plastic product manufacturing after the beginning of operations in 000 limit under section 103(b) (6) (D) corporation for molds that custo the plant in M, X began charging of the Code has been exceeded, it is eeded. it is mers had been charged separately customers a price per unit for each necessary to take into account any for and became the property of the plastic product that included the mold capital expenditures made with respect customers. After bonds had been charge. Under this new method, X to facilities described in section 103(b) issued by a political subdivision to paid for the mold and retained title to (6)(E), that are paid or incurred durconstruct a facility for the corpora it. This new method resulted from ining the 6-year period beginning 3 years tion's use and operations had be quiries from potential customers as to fore and ending 3 vears after the gun, the method of cost recovery the feasibility of adopting the method issuance of the bonds in question and was changed by including a mold under which the customer could avoid financed otherwise than out of a prior charge in the price of the plastic problems relative to financing, purexempt issue already being taken into units and transfer of ownership chasing, responsibility for mold quality account. was discontinued. The costs of the and maintenance, insurance and perThe facilities described in section molds under both methods of sonal property taxes. Although X had 103(b) (6) (E) of the Code are those charging the customers are capital not previously foreseen it, a substanin which the principal user is the same expenditures within the meaning tial additional amount of business person as the principal user of the of section 103(b)(6)(D) of the Code could be obtained by X by adopting facilities financed by the bonds in for purposes of the $5,000,000 the new method thus allowing X to question or a related person, proexempt small issue limitation. increase its production. vided that both facilities are located Rev. Rul. 77-224 Although section 103(a)(1) of the in the same incorporated municipality Code provides, in part, that gross inor located in the same county but not Advice has been requested whether, come does not include interest on the in any incorporated municipality. under the circumstances described be obligations of a state, section 103(b) Held, under the circumstances de- low, the costs of certain molds to be (1) provides, in part, that industrial scribed above, since the contribution incurred by a manufacturing corpo development bonds shall not be of land by Y to X in exchange for an ration for the manufacture of custom treated as obligations of a state. interest in partnership X represents molded plastic products will be con- Therefore, the general rule in regard a change in the form of Y's ownership sidered as excludable capital expendi to industrial development bonds is of the land that does not result in tures under section 103(b) (6) (F) (ii) that gross income does include the iner sec. of the Internal Revenue Code ofterest on industrial development tion 721 of the Code, the contribution 1954. bonds. However, section 103(b) proof land by Y to X in exchange for an In January 1976, City M, a political vides certain exceptions to this general interest in partnership X is not a sec- subdivision, issued $4,000,000 of in- rule. tion 103(b) (6) (D) capital expendi- dustrial development bonds, as de One of these exceptions is provided ture by X for purposes of determining scribed in section 103(b) (2) of the in section 103(b) (6) (D). of the Code an employee of the United ces as molds paid by the customers for the gregate face amount is made, the ag section periods before mall issues had al expenas in the matche whereby at the election of the issuer a small issue exemption is available to an issuance of $5,000,000 or less of industrial development bonds. However, if the election is made, the aggregate face amount of the bond issue will be determined, for purposes of resolving whether the $5,000,000 limit has been exceeded, by taking into account any capital expenditures made with respect to facilities of the type described in section 103(b) (6) (E) and paid or incurred during the six year period beginning three years before and ending three years after the issuance of the bonds in question and financed otherwise than out of the proceeds of a prior exempt issue already being taken into account. The facilities described in section 103(b) (6) (E) of the Code are those in which the principal user is the same duri cilities financed by the bonds in question or a person related thereto, provided that both facilities are located in the same incorporated municipality or located in the same county (but not in any incorporated municipality). Section 103(b) (6) (F) (iii) of the Code provides, in part, that a capital expenditure will not be taken into account in determining whether the $5,000,000 limit has been exceeded if the expenditure is required by circumstances that could not be reasonably foreseen on the date of issue of the obligations. In the instant case, X could have reasonably foreseen that an increase in production might result from nego tiations with customers and the adoption of the new method of charging for the costs of the molds. Accordingly, the costs of the molds are not excludable capital expenditures described in section 103(b) (6) (F) (iii) of the Code and must be taken into account in determining whether the $5,000,000 limit has been exceeded within the applicable six year period described in section 103 (b) (6) (D). In addition, if X had continued to employ at the new plant its original Internal Revenue Code of 1954 when disability is no longer "absent from provided by section 105(d) of the Section 105.—Amounts Received Code when the member performs Under Accident and Health Plans services as an employee of the United States, whether such services are per26 CFR 1.105-4: Wage continuation plans. formed in the same department or in Sick pay; Federal disability re another department, agency, or branch tiree employed by Postal Service. of the United States Government. For periods prior to 1976, a Fed- The Postal Reorganization Act, eral employee who retired on dis- Pub. L. No. 91-375, 91st Cong., 2d ability (including members of the Sess. (August 12, 1970), created the Armed Forces on the retired list for United States Postal Service as an inphysical disability) was not "absent dependent establishment of the execufrom work" for purposes of the sick tive branch of the Government of the pay exclusion when that individual United States (39 U.S.C. section 201 performed services as an employee (1970)), to be operated as a service of the U.S. Postal Service. to the people by the Government of the United States (39 U.S.C. section Rev. Rul. 77-15 " 101(a) (1970)). Thus, an officer or Advice has been requested whether employee of the United States Postal an individual retired for disability Service is an employee of the Governfrom an agency of the United States ment of the United States and, thereGovernment (including members of fore, comes within the purview of the Armed Forces of the United States Rev. Rul. 58-599. on the retired list for physical dis- Accordingly, an individual retired ability) is "absent from work” for for disability from an agency of the purposes of the sick pay exclusion United States Government (including provided by section 105(d) of the members of the Armed Forces of the United States on the retired list for ernment who retired prior to January on provided by section 55. after 30 years of service, on a regu 105(d) of the Code when that in lar annuity of $12,200 per annum, dividual performs services as an em ices as an em- even though on that date A was actu even though on that date A was actı ployee of the United States Postal ally disabled. A's initial retirement age Service for which payments were re was 55 and mandatory retirement age ceived in 1975 and earlier years. was 70. In timely filed Federal income For the exclusion of disability pay- tax returns for the calendar years 1974 ments received subsequent to Decem- and 1975. A excluded $18.300 of the ber 31, 1975, see section 105(d) of annuity payments received during the Code as amended by section 505 such years as recoveries of the annuity (a), (c) and (d) of the Tax Reform cost under the 3-year rule of section Act of 1976, Pub. L. No. 94-455, 94th 72(d) of the Internal Revenue Code Cong., 2d Sess. (October 4, 1976) of 1954. Prior to retirement A had [1976-3 C.B. (Vol. 1) 42]. requested to be placed on a disability status. On May 3, 1976, after A's in26 CFR 1.105-4: Wage continuation plans. come tax return for the calendar year (Also Section 72; 1.72-1.) 1975 had been filed, the United States Sick pay exclusion for civil serv Civil Service Commissioner certified A's eligibility for wage continuation ice retiree; pre-1976. A Federal benefits because of personal injuries or Civil Service employee retired be sickness from the date of A's retirefore the mandatory retirement age ment until A reaches mandatory reon a regular annuity. After filing tirement age. If, on July 1, 1974, A 1974 and 1975 income tax returns had retired on disability A would have and excluding retirement payments been entitled to exclude as sick pay as recovery of cost, the employee under section 105(d) $2.200 of the was certified as eligible for disabil amount received during the remainder ity retirement. If the employee of 1974. timely files Form 5401 (Agreement to Apply Sick Pay Exclusion to Re For taxable years prior to January 1, tirement Annuity) electing to have 1976, section 105(d) of the Code the 1974 retirement payments provides, in part, that gross income treated in part as sick pay, the does not include amounts (within cerexcess retirement payments over tain dollar limitations) that are wages the sick pay exclusion will be a re or payments in lieu of wages for a covery of cost. The sick pay exclu period during which the employee is absent from work on account of persion must also be claimed in an sonal injury or sickness. amended return for 1975 but the excess of the retirement payments Section 1.105-6(a) of the Income Tax Regulations provides, in part, that for that year over the sick pay ex an employee who retired before Januclusion must be included in the ary 27, 1975, on a regular annuity (alemployee's gross income. though actually disabled) may, as of Rev. Rul. 77-28 the date of retirement, apply the sick pay exclusion to the annuity payments Advice has been requested regard until the employee reaches mandaing the Federal income tax treatment tory retirement age if the following of payments received during the calen- requirements are met; dar years 1974 and 1975, under a wage (1) The employer had in operation continuation plan by a retired civilian at the time of the employee's retireemployee of the United States Gov- ment a program providing accident and health benefits under a wage continuation plan; (2) The employer certifies, under procedures approved in advance by the Internal Revenue Service, that the employee would have been eligible for disability retirement under the plan because of personal injuries or sickness; (3) At the time of the employee's retirement there was no substantive difference between the benefits actually received and the benefits the employee would have received had the employee retired under the employer's wage continuation plan; and (4) The employee agrees to the adjustments and conditions required by the Commissioner with respect to amounts excluded under section 72(b) or (d) of the Code in taxable years ending before January 27, 1975. The certification required in paragraph (a)(2) and the agreement required in (a) (4) of section 1.105-6 of the regulation are to be filed on or before April 15, 1977, with the return, or in a timely filed amended. or claim, made for the taxable year in which the employee reached retirement age (initial retirement age), or for the first taxable year for which the taxpayer files an income tax return claiming an exclusion under section 105(d) of the Code. Form 5401, Agreement to Apply Sick Pay Exclusion (Section 105(d)) to Retirement Annuity, may be used for this purpose. Section 1.72-15(i) (1) of the regulations provides, in part, that a taxpayer, who reaches initial retirement age before January 27, 1975, and under a pension plan established by the employer, received payments that qualify as wage-continuation benefits pursuant to section 105(d) of the Code, is entitled to an exclusion for taxable years ending before January 27, 1975, with respect to payments received after initial retirement age but before mandatory retirement age. The amount of such exclusion is the greater of the amount actually excluded under section 72(b) or (d) as a recovery of whereby at the election of the issuer a small issue exemption is available to an issuance of $5,000,000 or less of industrial development bonds. However, if the election is made, the aggregate face amount of the bond issue will be determined, for purposes of resolving whether the $5,000,000 limit has been exceeded, by taking into account any capital expenditures made with respect to facilities of the type described in section 103(b) (6) (E) and paid or incurred during the six year period beginning three years before and ending three years after the issuance of the bonds in question and financed otherwise than out of the proceeds of a prior exempt issue already being taken into account. The facilities described in section 103(b) (6) (E) of the Code are those in which the principal user is the same person as the principal user of the fa cilities financed by the bonds in question or a person related thereto, provided that both facilities are located in the same incorporated municipality or located in the same county (but not in any incorporated municipality). Section 103(b) (6)(F) (iii) of the Code provides, in part, that a capital expenditure will not be taken into account in determining whether the $5,000,000 limit has been exceeded if the expenditure is required by circumstances that could not be reasonably foreseen on the date of issue of the obligations. In the instant case, X could have reasonably foreseen that an increase in production might result from nego tiations with customers and the adoption of the new method of charging for the costs of the molds. Accordingly, the costs of the molds are not excludable capital expenditures described in section 103(b) (6) (F) (iii) of the Code and must be taken into account in determining whether the $5,000,000 limit has been exceeded within the applicable six year period described in section 103 (b) (6) (D). In addition, if X had continued to employ at the new plant its original Internal Revenue Code of 1954 when disability is no longer "absent from provided by section 105(d) of the Section 105.-Amounts Received Code when the member performs Under Accident and Health Plans service services as an employee of the United States, whether such services are per26 CFR 1.105-4: Wage continuation plans formed in the same department or in Sick pay; Federal disability re- another department, agency, or branch tiree employed by Postal Service, of the United States Government. For periods prior to 1976, a Fed- The Postal Reorganization A eral employee who retired on dis- Pub. L. No. 91-375, 91st Cong.. ability (including members of the Sess. (August 12, 1970), created Armed Forces on the retired list for United States Postal Service as a physical disability) was not "absent dependent establishment of the from work" for purposes of the sick tive branch of the Governmer pay exclusion when that individual United States (39 U.S.C. sec performed services as an employee (1970) ), to be operated as of the U.S. Postal Service. to the people by the Gove the United States (39 U. 101(a) (1970)). Thus, a |