Bulletin No. 2004-6February 9, 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. 2004–9, page 428.Federal rates; adjusted federal rates; adjusted federallong-term rate and the long-term exempt rate. For pur-poses of sections 382, 642, 1274, 1288, and other sectionsof the Code, tables set forth the rates for February 2004.

T.D. 9104, page 406.Final regulations under section 41 of the Code clarify the def-inition of qualified research contained in the credit for increas-ing research activities. In addition, the regulations adopt therecordkeeping requirements and the rules for excluded activi-ties as set forth in the 2001 proposed regulations.

T.D. 9105, page 419.REG–126459–03, page 437.Final, temporary, and proposed regulations under sections167, 446, and 1016 of the Code provide rules for changesin determining depreciation or amortization. The regulationsalso provide guidance as to whether certain changes in depre-ciation or amortization are changes in methods of accounting.The regulations apply to changes made for taxable yearsending on or after December 30, 2003. A public hearing onthe proposed regulations is scheduled for April 7, 2004.

T.D. 9108, page 429.Final regulations under section 6011 of the Code modify andclarify the rules relating to confidential transactions under reg-ulations section 1.6011–4(b)(3), and make minor conformingchanges to the list maintenance rules under regulations section301.6112–1.

Notice 2004–11, page 434.This notice announces a pilot program that permits largeand mid-size business taxpayers to enter into research creditrecordkeeping agreements.

Announcement 2004–9, page 441.This advance notice of proposed rulemaking(REG–153656–03) under section 41 of the Code in-vites comments relating to the definition of internal-usesoftware contained in the credit for increasing researchactivities. In addition, the document provides guidancefor taxpayers regarding the interim effective dates of theinternal-use software rules.

EMPLOYEE PLANS

Rev. Rul. 2004–4, page 414.Employee stock ownership plans; S corporations; listedtransactions. A finding of synthetic equity owned by a dis-qualified person in a nonallocation year of an ESOP, as thoseterms are defined in section 409(p) of the Code and regulationssection 1.409(p)–1T, takes place in three distinct situations.In addition, the transactions described in this ruling, as wellas substantially similar transactions, are designated as “listedtransactions.”

Notice 2004–10, page 433.Electronic delivery of Form 1099 and Form 5498 payeestatements. This notice permits the electronic delivery ofForm 1099–R, Form 1099–MSA, Form 1099–Q, Form 5498,Form 5498–ESA, and Form 5498–MSA payee statements bytheir respective due dates.

(Continued on the next page)

Announcements of Disbarments and Suspensions begin on page 439.Finding Lists begin on page ii.

EXEMPT ORGANIZATIONS

Notice 2004–10, page 433.Electronic delivery of Form 1099 and Form 5498 payeestatements. This notice permits the electronic delivery ofForm 1099–R, Form 1099–MSA, Form 1099–Q, Form 5498,Form 5498–ESA, and Form 5498–MSA payee statements bytheir respective due dates.

ADMINISTRATIVE

T.D. 9108, page 429.Final regulations under section 6011 of the Code modify andclarify the rules relating to confidential transactions under reg-ulations section 1.6011–4(b)(3), and make minor conformingchanges to the list maintenance rules under regulations section301.6112–1.

Notice 2004–10, page 433.Electronic delivery of Form 1099 and Form 5498 payeestatements. This notice permits the electronic delivery ofForm 1099–R, Form 1099–MSA, Form 1099–Q, Form 5498,Form 5498–ESA, and Form 5498–MSA payee statements bytheir respective due dates.

Announcement 2004–8, page 441.This announcement corrects the user fee in Appendix A of Rev.Proc. 2004–1 for a letter ruling request involving an extensionof time to file Form 3115, Application for Change in AccountingMethod. The correct user fee is $1,200, not $1,500.

February 9, 2004 2004-6 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. Bul-letin contents are consolidated semiannually into CumulativeBulletins, 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.

* Beginning with Internal Revenue Bulletin 2003–43, we are publishing the index at the end of the month, rather than at the beginning.

2004-6 I.R.B. February 9, 2004

Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986Section 41.—Credit forIncreasing ResearchActivities

26 CFR 1.41–4: Qualified research for expenditurespaid or incurred in taxable years ending on or afterDecember 31, 2003.

T.D. 9104

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Parts 1 and 602

Credit for Increasing ResearchActivities

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains fi-nal regulations relating to the definition ofqualified research under section 41(d) forthe credit for increasing research activities.These final regulations reflect changes tosection 41(d) made by the Tax Reform Actof 1986.

DATES: Effective Dates: These regula-tions are effective January 2, 2004.

Applicability Dates: For dates of appli-cability of these regulations, see §1.41–4(e) and Effective Dates under SUPPLE-MENTARY INFORMATION.

FOR FURTHER INFORMATIONCONTACT: Nicole R. Cimino at (202)622–3120 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On December 2, 1998, the Treasury De-partment and the IRS published in the Fed-eral Register a notice of proposed rule-making (REG–105170–97, 1998–2 C.B.729 [63 FR 66503]) under section 41 (1998proposed regulations) relating to the creditfor increasing research activities (research

credit). The 1998 proposed regulations ad-dressed, in relevant part, (1) the definitionof qualified research under section 41(d),(2) the application of the exclusions fromthe definition of qualified research, and(3) the application of the shrinking-backrule. Comments responding to the 1998proposed regulations were received and apublic hearing was held on April 29, 1999.

On January 3, 2001, the Treasury De-partment and the IRS published in theFederal Register final regulations re-lating, in relevant part, to the definitionof qualified research under section 41(d)(T.D. 8930, 2001–1 C.B. 433 [66 FR280]). In response to taxpayer concernsregarding T.D. 8930, on January 31, 2001,the Treasury Department and the IRS pub-lished Notice 2001–19, 2001–1 C.B. 784,announcing that the Treasury Departmentand the IRS would review T.D. 8930 andreconsider comments previously submit-ted in connection with the finalizationof T.D. 8930. Notice 2001–19 also pro-vided that, upon the completion of thereview, the Treasury Department and theIRS would announce changes to the reg-ulations, if any, in the form of proposedregulations.

On December 26, 2001, the TreasuryDepartment and the IRS published in theFederal Register a notice of proposedrulemaking (REG–112991–01, 2002–1C. B. 404 [66 FR 66362]) reflecting theTreasury Department and the IRS’ reviewof T.D. 8930 (2001 proposed regulations).Comments responding to the 2001 pro-posed regulations were received and apublic hearing was held on March 27,2002. After considering the commentsreceived and the statements made at thepublic hearing, portions of the 2001 pro-posed regulations are adopted as revisedby this Treasury Decision.

Explanation of Provisions

This document amends 26 CFR part 1to provide revised rules for the researchcredit under section 41. These final regula-tions generally retain the provisions of the2001 proposed regulations but clarify theprovisions relating to the requirement insection 41(d)(1)(C) that qualified research

be research “substantially all of the ac-tivities of which constitute elements of aprocess of experimentation.” These finalregulations, however, do not contain finalrules for research with respect to computersoftware “which is developed by (or for thebenefit of) the taxpayer primarily for in-ternal use by the taxpayer” for purposes ofsection 41(d)(4)(E).

Process of Experimentation—In General

The Tax Reform Act of 1986, PublicLaw 99–514 (100 Stat. 2085) (the 1986Act), which narrowed the definition ofthe term qualified research, amended thedefinition of qualified research by addinga process of experimentation requirement.Section 41(d)(1) provides that in order toconstitute qualified research, substantiallyall of the activities of the research mustconstitute elements of a process of exper-imentation related to a new or improvedfunction, performance, or reliability orquality. The legislative history to the 1986Act explained that “[t]he determinationof whether research is undertaken forthe purpose of discovering informationthat is technological in nature dependson whether the process of experimenta-tion utilized in the research fundamentallyrelies on principles of the physical or bio-logical sciences, engineering, or computerscience.” H.R. Conf. Rep. No. 99–841,at II–71 (1986). The legislative historyfurther explained that the term processof experimentation means, “a processinvolving the evaluation of more thanone alternative designed to achieve a re-sult where the means of achieving thatresult is uncertain at the outset.” Id., atII–72. In addition, a process of experi-mentation may involve developing one ormore hypotheses, testing and analyzingthose hypotheses (through, for example,modeling or simulation), and refining ordiscarding the hypotheses as part of asequential design process to develop theoverall component. Id.

The 1998 proposed regulations defineda process of experimentation as “a processto evaluate more than one alternative de-signed to achieve a result where the meansof achieving that result are uncertain at the

2004-6 I.R.B. 406 February 9, 2004

outset.” Further, the 1998 proposed regu-lations specified that a process of exper-imentation is a four-step process requir-ing that the taxpayer: (i) develop one ormore hypotheses designed to achieve theintended result; (ii) design a scientific ex-periment (that, where appropriate to theparticular field of research, is intended tobe replicable with an established experi-mental control) to test and analyze thosehypotheses (through, for example, model-ing, simulation, or a systematic trial anderror methodology); (iii) conduct the ex-periment and record the results; and (iv)refine or discard the hypotheses as part ofa sequential design process to develop orimprove the business component. Com-mentators generally objected to this pre-scribed four-step test arguing that it wouldnot be appropriate for evaluating the qual-ification of certain commercial and indus-trial research activities.

In response to these comments, theTreasury Department and the IRS inT.D. 8930 provided that taxpayers con-ducting a process of experimentation may,but were not required to, engage in thefour-step process described in the 1998proposed regulations, but eliminated, forthis purpose, the specific recordation re-quirement. (As an addition to the generalrecordkeeping requirement under section6001, T.D. 8930 instead included a con-temporaneous documentation requirementthat was intended to be less burdensomethan the specific recordation requirement.The contemporaneous documentation re-quirement in T.D. 8930 was eliminated inthe 2001 proposed regulations.) Consis-tent with the legislative history, however,T.D. 8930 retained the underlying processof experimentation requirement in the1998 proposed regulations by providingthat a process of experimentation “is aprocess to evaluate more than one alter-native designed to achieve a result wherethe capability or method of achieving thatresult is uncertain at the outset.”

The 2001 proposed regulations furtherclarified the definition of a process of ex-perimentation and provided, in relevantpart, that “a process of experimentation isa process designed to evaluate one or morealternatives to achieve a result where thecapability or the method of achieving thatresult, or the appropriate design of that re-sult, is uncertain as of the beginning ofthe taxpayer’s research activities.” More

specifically, however, the general require-ment was modified in the 2001 proposedregulations to provide, first, that “a processof experimentation is a process designedto evaluate one or more alternatives toachieve a result.” (Emphasis added). The2001 proposed regulations also providedthat a process of experimentation may ex-ist if a taxpayer performs research to es-tablish the appropriate design of a busi-ness component even when the capabil-ity and method for developing or improv-ing the business component are not un-certain. The 2001 proposed regulationsfurther stated that a taxpayer’s activitiesdo not constitute elements of a process ofexperimentation where the capability andmethod of achieving the desired new orimproved business component, and the ap-propriate design of the desired new or im-proved business component, are readilydiscernible and applicable as of the be-ginning of the taxpayer’s research activ-ities so that true experimentation in thescientific or laboratory sense would nothave to be undertaken to test, analyze,and choose among viable alternatives. Fi-nally, the 2001 proposed regulations em-phasized that the determination of whethera taxpayer has engaged in a process of ex-perimentation was dependent on the factsand circumstances of the taxpayer’s re-search activities and, for this purpose, con-tained three non-dispositive and non-ex-clusive factors that tend to indicate that ataxpayer has engaged in a process of ex-perimentation.

In response to the 2001 proposed reg-ulations, a number of commentators ex-pressed concern with the rules for theprocess of experimentation requirement,and, in particular, stated that the rules andterms used (including uncertainty, appro-priate design, and readily discernible andapplicable) did not provide clear guidancefor the requirement. More specifically,commentators stated that the term read-ily discernible and applicable was highlysubjective in nature, and thus arguablycould be construed as a variant of the dis-covery test of T.D. 8930. In addition, onecommentator expressed concern regard-ing the meaning and scope of the termuncertain and suggested adding examplesillustrating the factors that tend to indicatethat a taxpayer has engaged in a process ofexperimentation. Another commentatoralso noted that the 2001 proposed regula-

tions appeared to allow the inclusion of alldesign costs as qualified research expen-ditures to the extent that the appropriatedesign of the desired result is never certainat the outset of the typical design process.

The Treasury Department and the IRScontinue to believe that the process of ex-perimentation test requires an evaluationof the facts and circumstances of a tax-payer’s research activities. As reflectedby the changes made in the 2001 proposedregulations, this requirement is not in-tended to be inflexible or overly narrow.Nevertheless, the Treasury Departmentand the IRS continue to believe that therequirement in the 2001 proposed regu-lations that a process of experimentationis “a process designed to evaluate oneor more alternatives to achieve a result”(emphasis added) implies that researchactivities must contain certain core el-ements in order to constitute a processof experimentation within the meaningof section 41(d)(1)(C). These final reg-ulations, therefore, make the followingclarifications relating to the process ofexperimentation requirement in the 2001proposed regulations.

Process ofExperimentation—Requirements

The final regulations retain, but furtherclarify, the requirement in the 2001 pro-posed regulations that “a process of exper-imentation is a process designed to evalu-ate one or more alternatives to achieve aresult where the capability or the methodof achieving that result, or the appropriatedesign of that result, is uncertain as of thebeginning of the taxpayer’s research activ-ities.” Further, the final regulations empha-size that the taxpayer’s activities must bedirected at resolving uncertainty regardingthe taxpayer’s development or improve-ment of a business component, and thatthe process of experimentation must fun-damentally rely on the principles of thephysical or biological sciences, engineer-ing, or computer science in attempting toresolve the uncertainty. Although theseconcepts are stated explicitly in the 1986legislative history and are implicit in thestatute, they may not have been given ap-propriate or necessary weight in prior pro-posed or final guidance on the process ofexperimentation requirement.

February 9, 2004 407 2004-6 I.R.B.

The final regulations, therefore, set outwhat the Treasury Department and theIRS have concluded to be the core ele-ments of a process of experimentation forpurposes of the research credit. As notedabove and consistent with the statute’swording which requires purposeful activ-ity (i.e., “undertaken for the purpose ofdiscovering information”), a taxpayer isrequired to identify the uncertainty regard-ing the development or improvement ofa business component that is the objectof the taxpayer’s research activities. Ataxpayer is also required to identify oneor more alternatives intended to eliminatethat uncertainty. Additionally, a taxpayeris required to identify and to conduct aprocess of evaluating the alternatives.The final regulations provide that such aprocess may involve, for example, model-ing, simulation, or a systematic trial anderror methodology.

The final regulations further providethat a process of experimentation “must bean evaluative process and generally shouldbe capable of evaluating more than onealternative.” (Emphasis added). Althoughthe identification and evaluation of morethan a single alternative is not requiredto satisfy the process of experimentationrequirement, the Treasury Department andthe IRS believe that a taxpayer’s activities,in order to qualify for the research credit,generally should be capable of evaluat-ing more than one alternative and, in anyevent, must be designed to evaluate thealternative, or alternatives, being consid-ered.

The final regulations state that the mereexistence of uncertainty regarding the de-velopment or improvement of a businesscomponent does not indicate that all of ataxpayer’s activities undertaken to achievethat new or improved business componentconstitute a process of experimentation,even if the taxpayer, in fact, does achievethe new or improved business component.The Treasury Department and the IRSbelieve that the inclusion of a separateprocess of experimentation requirementin the statute makes this proposition clear.However, the Treasury Department andthe IRS have included this clarification inthe final regulations out of concern thattaxpayers have not been giving sufficientweight to the requirement that a taxpayerengage in a process designed to evaluateone or more alternatives to achieve a re-

sult where the capability or the method ofachieving that result, or the appropriatedesign of that result, is uncertain as ofthe beginning of the taxpayer’s researchactivities. In particular, this clarifica-tion is intended to indicate that merelydemonstrating that uncertainty has beeneliminated (e.g., the achievement of theappropriate design of a business compo-nent when such design was uncertain asof the beginning of a taxpayer’s activities)is insufficient to satisfy the process ofexperimentation requirement. A taxpayerbears the burden of demonstrating that itsresearch activities additionally satisfy theprocess of experimentation requirement.

As noted above, all of the facts andcircumstances of a taxpayer’s researchactivities are taken into account to de-termine whether the taxpayer identifieduncertainty concerning the developmentor improvement of a business component,identified one or more alternatives in-tended to eliminate that uncertainty, andidentified and conducted a process of eval-uating the alternatives. Although the finalregulations set out the core elements ofa process of experimentation, how a tax-payer’s qualified research activities willreflect these core elements will depend onthe facts and circumstances. These coreelements will not necessarily occur in astrict, sequential order. A process of ex-perimentation is an evaluative process, andas such, often involves refining through-out much of the process the taxpayer’sunderstanding of the uncertainty the tax-payer is trying to address, modifying thealternatives being evaluated to eliminatethat uncertainty, or modifying the processused to evaluate those alternatives.

Accordingly, the final regulations donot provide detailed guidance as to how theregulatory provisions are to be applied to agiven factual situation. Rather, the Trea-sury Department and the IRS have con-cluded that the application of these pro-visions will depend on the specific activ-ities being claimed by a taxpayer as quali-fied research, the nature of the taxpayer’sbusiness and industry, and the uncertain-ties being addressed by the taxpayer’s re-search activities. The Treasury Depart-ment and the IRS believe that additional,industry-specific guidance may be appro-priate and request comments on the formof such guidance.

The final regulations do not includethe rule contained in the 2001 proposedregulations that a taxpayer’s activities donot constitute a process of experimentationwhere the capability and method of achiev-ing the desired new or improved businesscomponent, and the appropriate designof the desired new or improved businesscomponent, are readily discernible andapplicable as of the beginning of the tax-payer’s research activities. A numberof commentators expressed concern thatthis rule was too vague and susceptibleto conflicting interpretations. In light ofthe clarifications made in these final regu-lations, the Treasury Department and theIRS have concluded that this rule is nolonger necessary because such activitiesdo not constitute a process of experimen-tation under the final regulations.

As noted above, the 2001 proposed reg-ulations do not contain a specific record-keeping requirement beyond the require-ments set out in section 6001 and the reg-ulations thereunder. No change regardingrecordkeeping is being made in these fi-nal regulations. The clarifications beingmade to the process of experimentation re-quirement do not impose any recordkeep-ing requirement on taxpayers beyond therequirements set out in section 6001 andthe regulations thereunder.

Process ofExperimentation—Substantiallyall Requirement

The 2001 proposed regulations retainedthe rule in T.D. 8930 that the “substantiallyall” requirement of section 41(d)(1)(C) issatisfied only if 80 percent or more of theresearch activities, measured on a cost orother consistently applied reasonable ba-sis (and without regard to §1.41–2(d)(2)),constitute elements of a process of exper-imentation for a purpose described in sec-tion 41(d)(3). This requirement is appliedseparately to each business component.

The Treasury Department and the IRSrequested comments on the application ofthe substantially all rule and, in partic-ular, whether research expenses incurredfor non-qualified purposes (i.e., relating tostyle, taste, cosmetic, or seasonal designfactors) are includible in the credit compu-tation provided that substantially all of theresearch activities constitute elements of aprocess of experimentation for a qualified

2004-6 I.R.B. 408 February 9, 2004

purpose. After consideration of the com-ments received, the Treasury Departmentand the IRS have concluded that the sub-stantially all requirement can be satisfiedeven if some portion of a taxpayer’s activ-ities are not for a qualified purpose.

Accordingly, these final regulationsclarify the substantially all rule and pro-vide that the substantially all require-ment is satisfied if 20 percent or less ofa taxpayer’s research activities do notconstitute elements of a process of ex-perimentation for a purpose described insection 41(d)(3), so long as these remain-ing activities satisfy the requirements ofsection 41(d)(1)(A) and are not otherwiseexcluded under section 41(d)(4). Example(6) of §1.41–4(a)(8) of the 2001 proposedregulations has been modified to illustratethe application of this rule, and appears asexample (4) in these final regulations.

Other Issues

Patent Safe Harbor

Section 1.41–4(a)(3)(iii) of the 2001proposed regulations generally providedthat the issuance of certain patents isconclusive evidence that a taxpayer hasdiscovered information that is technologi-cal in nature that is intended to eliminateuncertainty concerning the developmentor improvement of a business compo-nent. Some commentators requested thatthis patent safe harbor be expanded tocover all requirements contained in sec-tions 41(d)(1) and (3). After considerationof these comments, and in light of theclarifications being made in these finalregulations to the provisions relating tothe process of experimentation require-ment, the Treasury Department and theIRS continue to believe that the patentsafe harbor is appropriately limited and,therefore, have not changed the patent safeharbor provision.

Shrinking-Back Rule

Some commentators expressed concernthat the language of the shrinking-backrule in §1.41–4(b)(2) of the 2001 proposedregulations implied that not all of a tax-payer’s qualified research expenses wouldbe eligible for the research credit as a re-sult of the application of the rule. Thisprovision has been revised in these final

regulations to clarify that the rule is notintended to exclude qualified research ex-penses from the credit, but rather is in-tended to ensure that expenses attributableto qualified research activities are eligiblefor the research credit for purposes of sec-tion 41(d)(1).

Research After Commercial Production

Some commentators requested addi-tional clarification regarding the scope ofthe research after commercial production,adaptation, and duplication exclusionsset out in section 41(d)(4)(A), (B) and(C), and §1.41–4(c)(2), (3) and (4) of the2001 proposed regulations. After consid-eration of these comments, the TreasuryDepartment and the IRS believe that themultitude of factual situations to whichthese exclusions might apply make it im-practical to provide additional clarificationthat is both meaningful and of broad appli-cation. The Treasury Department and theIRS believe these three specific exclusionsdo not cover research activities that other-wise satisfy the requirements for qualifiedresearch. Taxpayers, however, shouldcarefully review (including, as appropri-ate, the application of the shrinking-backrule) research activities that might other-wise fall within these exclusions to ensurethat only eligible activities are being in-cluded in their credit computations.

One commentator expressed concernthat the language of §1.41–4(c)(2)(iv), re-lating to the clinical testing of pharmaceu-tical products, could exclude from crediteligibility clinical trials performed underan arrangement where the Food and DrugAdministration has granted conditionalapproval for a pharmaceutical productcontingent upon the results of additionalclinical trials. Another commentator ex-pressed concern that the language wouldexclude otherwise qualifying activitiesbecause the research was not required tobe approved by the Food and Drug Ad-ministration. Section 1.41–4(c)(2)(iv) isnot a rule of exclusion. As stated above,the Treasury Department and the IRS be-lieve that the research after commercialproduction exclusion (as well as the adap-tation and duplication exclusions) do notcover research activities, including theseadditional clinical trials, so long as suchtrials satisfy the requirements for qualifiedresearch.

Gross Receipts

These final regulations retain the broaddefinition of gross receipts contained inT.D. 8930. In response to Notice 2001–19,a number of commentators reiterated ear-lier comments that this definition wasoverly broad. As stated in the preamble tothe 2001 proposed regulations, the Trea-sury Department and the IRS continueto believe that the definition of gross re-ceipts should be construed broadly, and,accordingly, no change has been made inthese final regulations to the definitioncontained in T.D. 8930.

Examples

The examples in the regulations havebeen changed to remove references to“readily discernible and applicable.”While the Treasury Department and theIRS continue to believe that the activitiesin Examples 4 and 5 of §1.41–4(a)(8) ofthe 2001 proposed regulations would notqualify under the final regulations, theseexamples were removed as the only pur-pose of these examples was to illustratethe “readily discernable and applicable”standard. Minor changes to the facts inExample 4 of §1.41–4(a)(8) in the finalregulations (Example 6 of §1.41–4(a)(8) ofthe 2001 proposed regulations) were madeto illustrate more clearly the applicationof the substantially all requirement of§1.41–4(a)(6). These changes do not indi-cate that the Treasury Department and theIRS believe that the integration activitiesremoved from the example, as containedin the 2001 proposed regulations, are orare not qualified activities standing alone.The determination of whether activities arequalified research is based on the specificfacts and circumstances of those activities.

Additionally, minor changes were madeto the examples in §1.41–4(c)(10) to re-move references to “readily discernableand applicable” and to make some clarifi-cations based on comments received. Ex-ample 1 of §1.41–4(c)(10) was modified toremove the conclusion regarding qualifi-cation of expenses under section 174. Al-though the Treasury Department and theIRS continue to believe that the conclu-sion in the 2001 proposed regulations iscorrect, the Treasury Department and theIRS believe that the point illustrated in theremoved portion of the example would be

February 9, 2004 409 2004-6 I.R.B.

more appropriately addressed in guidanceissued under section 174, rather than inguidance under section 41.

Effective Date

Notice 2001–19 stated, in relevant part,that the provisions of T.D. 8930, includ-ing any changes to T.D. 8930, would beeffective no earlier than the date when thecompletion of the Treasury Departmentand the IRS’ review of T.D. 8930 wasannounced. The 2001 proposed regula-tions provided, in relevant part, that finalregulations would apply to taxable yearsending on or after December 26, 2001,the date the proposed regulations werepublished in the Federal Register.

Because these final regulations onlyclarify the provisions of the 2001 pro-posed regulations, these final regulationsapply to taxable years ending on or af-ter December 31, 2003. For taxable yearsending before December 31, 2003, the IRSwill not challenge return positions that areconsistent with these final regulations.

Special Analyses

It has been determined that these reg-ulations are not a significant regulatoryaction as defined in Executive Order12866. It also has been determined thatsection 553(b) of the Administrative Pro-cedure Act (5 U.S.C. chapter 5) does notapply to these regulations, and becausethese regulations do not impose a col-lection of information on small entities,the Regulatory Flexibility Act (5 U.S.C.chapter 6) does not apply. Therefore, aRegulatory Flexibility Act Analysis is notrequired. Pursuant to section 7805(f), thenotice of proposed rulemaking precedingthese regulations was submitted to theChief Counsel for Advocacy of the SmallBusiness Administration for comment onits impact on small business.

Drafting Information

The principal author of these regula-tions is Nicole R. Cimino of the Officeof Associate Chief Counsel (Passthroughsand Special Industries), IRS. However,personnel from other offices of the IRSand the Treasury Department participatedin their development.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR parts 1 and 602are amended as follows:

PART I—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.41–0 is amended by

revising the entries for §1.41–4 to read asfollows:

The revisions and additions read as fol-lows:

§1.41–0 Table of contents.

* * * * *

§1.41–4 Qualified research forexpenditures paid or incurred in taxableyears ending on or after December 31,2003.

(a) Qualified research.(1) General rule.(2) Requirements of section 41(d)(1).(3) Undertaken for the purpose of discov-ering information.(i) In general.(ii) Application of the discovering infor-mation requirement.(iii) Patent safe harbor.(4) Technological in nature.(5) Process of experimentation.(i) In general.(ii) Qualified purpose.(6) Substantially all requirement.(7) Use of computers and informationtechnology.(8) Illustrations.(b) Application of requirements for quali-fied research.(1) In general.(2) Shrinking-back rule.(3) Illustration.(c) Excluded activities.(1) In general.(2) Research after commercial production.(i) In general.(ii) Certain additional activities related tothe business component.(iii) Activities related to productionprocess or technique.(iv) Clinical testing.(3) Adaptation of existing business com-ponents.

(4) Duplication of existing business com-ponent.(5) Surveys, studies, research relating tomanagement functions, etc.(6) Internal use software for taxable yearsbeginning on or after December 31, 1985.[Reserved].(7) Activities outside the United States,Puerto Rico, and other possessions.(i) In general.(ii) Apportionment of in-house researchexpenses.(iii) Apportionment of contract researchexpenses.(8) Research in the social sciences, etc.(9) Research funded by any grant, contract,or otherwise.(10) Illustrations.(d) Recordkeeping for the research credit.(e) Effective dates.

* * * * *Par. 3. Section 1.41–4 is amended as

follows:1. The section heading and paragraphs

(a)(2)(iii), (a)(3), (a)(4), (a)(5), (a)(6),(a)(8), (b)(2), (b)(3), (c)(2)(iv), (c)(4),(c)(7)(ii), (c)(10), (d), and (e) are revised.

2. The heading of paragraph (c)(6) is re-vised and the text is removed and reserved.

The revisions read as follows:

§1.41–4 Qualified research forexpenditures paid or incurred in taxableyears ending on or after December 31,2003.

(a) * * *(2) * * *(iii) Substantially all of the activities of

which constitute elements of a process ofexperimentation that relates to a qualifiedpurpose.

(3) Undertaken for the purpose of dis-covering information—(i) In general. Forpurposes of section 41(d) and this sec-tion, research must be undertaken for thepurpose of discovering information that istechnological in nature. Research is under-taken for the purpose of discovering infor-mation if it is intended to eliminate uncer-tainty concerning the development or im-provement of a business component. Un-certainty exists if the information availableto the taxpayer does not establish the capa-bility or method for developing or improv-ing the business component, or the appro-priate design of the business component.

2004-6 I.R.B. 410 February 9, 2004

(ii) Application of the discovering in-formation requirement. A determinationthat research is undertaken for the purposeof discovering information that is techno-logical in nature does not require the tax-payer be seeking to obtain information thatexceeds, expands or refines the commonknowledge of skilled professionals in theparticular field of science or engineeringin which the taxpayer is performing the re-search. In addition, a determination thatresearch is undertaken for the purpose ofdiscovering information that is technolog-ical in nature does not require that the tax-payer succeed in developing a new or im-proved business component.

(iii) Patent safe harbor. For purposesof section 41(d) and paragraph (a)(3)(i) ofthis section, the issuance of a patent bythe Patent and Trademark Office under theprovisions of 35 U.S.C. 151 (other than apatent for design issued under the provi-sions of 35 U.S.C. 171) is conclusive evi-dence that a taxpayer has discovered infor-mation that is technological in nature thatis intended to eliminate uncertainty con-cerning the development or improvementof a business component. However, the is-suance of such a patent is not a precondi-tion for credit availability.

(4) Technological in nature. For pur-poses of section 41(d) and this section,information is technological in nature ifthe process of experimentation used to dis-cover such information fundamentally re-lies on principles of the physical or bio-logical sciences, engineering, or computerscience. A taxpayer may employ exist-ing technologies and may rely on existingprinciples of the physical or biological sci-ences, engineering, or computer science tosatisfy this requirement.

(5) Process of experimentation—(i) Ingeneral. For purposes of section 41(d) andthis section, a process of experimentationis a process designed to evaluate one ormore alternatives to achieve a result wherethe capability or the method of achievingthat result, or the appropriate design ofthat result, is uncertain as of the begin-ning of the taxpayer’s research activities.A process of experimentation must fun-damentally rely on the principles of thephysical or biological sciences, engineer-ing, or computer science and involves theidentification of uncertainty concerningthe development or improvement of abusiness component, the identification of

one or more alternatives intended to elimi-nate that uncertainty, and the identificationand the conduct of a process of evaluatingthe alternatives (through, for example,modeling, simulation, or a systematic trialand error methodology). A process ofexperimentation must be an evaluativeprocess and generally should be capableof evaluating more than one alternative.A taxpayer may undertake a process ofexperimentation if there is no uncertaintyconcerning the taxpayer’s capability ormethod of achieving the desired resultso long as the appropriate design of thedesired result is uncertain as of the begin-ning of the taxpayer’s research activities.Uncertainty concerning the developmentor improvement of the business compo-nent (e.g., its appropriate design) does notestablish that all activities undertaken toachieve that new or improved businesscomponent constitute a process of experi-mentation.

(ii) Qualified purpose. For purposes ofsection 41(d) and this section, a process ofexperimentation is undertaken for a qual-ified purpose if it relates to a new or im-proved function, performance, reliabilityor quality of the business component. Re-search will not be treated as conducted fora qualified purpose if it relates to style,taste, cosmetic, or seasonal design factors.

(6) Substantially all requirement. Inorder for activities to constitute qualifiedresearch under section 41(d)(1), substan-tially all of the activities must constituteelements of a process of experimentationthat relates to a qualified purpose. Thesubstantially all requirement of section41(d)(1)(C) and paragraph (a)(2)(iii) ofthis section is satisfied only if 80 percentor more of a taxpayer’s research activities,measured on a cost or other consistentlyapplied reasonable basis (and withoutregard to §1.41–2(d)(2)), constitute ele-ments of a process of experimentation fora purpose described in section 41(d)(3).Accordingly, if 80 percent (or more) of ataxpayer’s research activities with respectto a business component constitute ele-ments of a process of experimentation fora purpose described in section 41(d)(3),the substantially all requirement is satis-fied even if the remaining 20 percent (orless) of a taxpayer’s research activitieswith respect to the business componentdo not constitute elements of a process ofexperimentation for a purpose described

in section 41(d)(3), so long as these re-maining research activities satisfy therequirements of section 41(d)(1)(A) andare not otherwise excluded under section41(d)(4). The substantially all requirementis applied separately to each business com-ponent.

* * * * *(8) Illustrations. The following exam-

ples illustrate the application of paragraph(a)(5) of this section:

Example 1. (i) Facts. X is engaged in the businessof developing and manufacturing widgets. X wantsto change the color of its blue widget to green. X ob-tains from various suppliers several different shadesof green paint. X paints several sample widgets, andsurveys X’s customers to determine which shade ofgreen X’s customers prefer.

(ii) Conclusion. X’s activities to change the colorof its blue widget to green are not qualified researchunder section 41(d)(1) and paragraph (a)(5) of thissection because substantially all of X’s activities arenot undertaken for a qualified purpose. All of X’sresearch activities are related to style, taste, cosmetic,or seasonal design factors.

Example 2. (i) Facts. The facts are the sameas in Example 1, except that X chooses one of thegreen paints. X obtains samples of the green paintfrom a supplier and determines that X must modifyits painting process to accommodate the green paintbecause the green paint has different characteristicsfrom other paints X has used. X obtains detailed dataon the green paint from X’s paint supplier. X alsoconsults with the manufacturer of X’s paint sprayingmachines. The manufacturer informs X that X mustacquire a new nozzle that operates with the greenpaint X wants to use. X tests the nozzles to ensurethat they work as specified by the manufacturer of thepaint spraying machines.

(ii) Conclusion. X’s activities to modify its paint-ing process are a separate business component un-der section 41(d)(2)(A). X’s activities to modify itspainting process to change the color of its blue wid-get to green are not qualified research under section41(d)(1) and paragraph (a)(5) of this section. X didnot conduct a process of evaluating alternatives in or-der to eliminate uncertainty regarding the modifica-tion of its painting process. Rather, the manufacturerof the paint machines eliminated X’s uncertainty re-garding the modification of its painting process. X’sactivities to test the nozzles to determine if the noz-zles work as specified by the manufacturer of thepaint spraying machines are in the nature of routineor ordinary testing or inspection for quality control.

Example 3. (i) Facts. X is engaged in the busi-ness of manufacturing food products and currentlymanufactures a large-shred version of a product. Xseeks to modify its current production line to per-mit it to manufacture both a large-shred version anda fine-shred version of one of its food products. Asmaller, thinner shredding blade capable of produc-ing a fine-shred version of the food product, how-ever, is not commercially available. Thus, X mustdevelop a new shredding blade that can be fitted ontoits current production line. X is uncertain concerningthe design of the new shredding blade, because thematerial used in its existing blade breaks when ma-

February 9, 2004 411 2004-6 I.R.B.

chined into smaller, thinner blades. X engages in asystematic trial and error process of analyzing variousblade designs and materials to determine whether thenew shredding blade must be constructed of a differ-ent material from that of its existing shredding bladeand, if so, what material will best meet X’s functionalrequirements.

(ii) Conclusion. X’s activities to modify its cur-rent production line by developing the new shreddingblade meet the requirements of qualified research asset forth in paragraph (a)(2) of this section. Sub-stantially all of X’s activities constitute elements ofa process of experimentation because X evaluated al-ternatives to achieve a result where the method ofachieving that result, and the appropriate design ofthat result, were uncertain as of the beginning of thetaxpayer’s research activities. X identified uncertain-ties related to the development of a business compo-nent, and identified alternatives intended to eliminatethese uncertainties. Furthermore, X’s process of eval-uating identified alternatives was technological in na-ture, and was undertaken to eliminate the uncertain-ties.

Example 4. (i) Facts. X is in the business of de-signing, developing and manufacturing automobiles.In response to government-mandated fuel economyrequirements, X seeks to update its current modelvehicle and undertakes to improve aerodynamics bylowering the hood of its current model vehicle. X de-termines, however, that lowering the hood changesthe air flow under the hood, which changes the rate atwhich air enters the engine through the air intake sys-tem, and which reduces the functionality of the cool-ing system. X’s engineers are uncertain how to de-sign a lower hood to obtain the increased fuel econ-omy, while maintaining the necessary air flow un-der the hood. X designs, models, simulates, tests,refines, and re-tests several alternative designs forthe hood and associated proposed modifications toboth the air intake system and cooling system. Thisprocess enables X to eliminate the uncertainties re-lated to the integrated design of the hood, air intakesystem, and cooling system, and such activities con-stitute eighty-five percent of X’s total activities to up-date its current model vehicle. X then engages inadditional activities that do not involve a process ofevaluating alternatives in order to eliminate uncer-tainties. The additional activities constitute only fif-teen percent of X’s total activities to update its currentmodel vehicle.

(ii) Conclusion. In general, if eighty percent ormore of a taxpayer’s research activities measured ona cost or other consistently applied reasonable basisconstitute elements of a process of experimentationfor a qualified purpose under section 41(d)(3)(A)and paragraph (a)(5)(ii) of this section, then thesubstantially all requirement of section 41(d)(1)(C)and paragraph (a)(2)(iii) of this section is satisfied.Substantially all of X’s activities constitute elementsof a process of experimentation because X evaluatedalternatives to achieve a result where the method ofachieving that result, and the appropriate design ofthat result, were uncertain as of the beginning of X’sresearch activities. X identified uncertainties relatedto the improvement of a business component andidentified alternatives intended to eliminate theseuncertainties. Furthermore, X’s process of evaluat-ing the identified alternatives was technological innature and was undertaken to eliminate the uncer-

tainties. Because substantially all (in this example,eighty-five percent) of X’s activities to update its cur-rent model vehicle constitute elements of a process ofexperimentation for a qualified purpose described insection 41(d)(3)(A), all of X’s activities to update itscurrent model vehicle meet the requirements of qual-ified research as set forth in paragraph (a)(2) of thissection, provided that X’s remaining activities (inthis example, fifteen percent of X’s total activities)satisfy the requirements of section 41(d)(1)(A) andare not otherwise excluded under section 41(d)(4).

(b)* * *(2) Shrinking-back rule. The require-

ments of section 41(d) and paragraph (a)of this section are to be applied first atthe level of the discrete business compo-nent, that is, the product, process, com-puter software, technique, formula, or in-vention to be held for sale, lease, or li-cense, or used by the taxpayer in a trade orbusiness of the taxpayer. If these require-ments are not met at that level, then theyapply at the most significant subset of el-ements of the product, process, computersoftware, technique, formula, or inventionto be held for sale, lease, or license. Thisshrinking back of the product is to con-tinue until either a subset of elements ofthe product that satisfies the requirementsis reached, or the most basic element of theproduct is reached and such element failsto satisfy the test. This shrinking-back ruleis applied only if a taxpayer does not sat-isfy the requirements of section 41(d)(1)and paragraph (a)(2) of this section withrespect to the overall business component.The shrinking-back rule is not itself ap-plied as a reason to exclude research ac-tivities from credit eligibility.

(3) Illustration. The following exampleillustrates the application of this paragraph(b):

Example. X, a motorcycle engine builder, devel-ops a new carburetor for use in a motorcycle engine.X also modifies an existing engine design for use withthe new carburetor. Under the shrinking-back rule,the requirements of section 41(d)(1) and paragraph(a) of this section are applied first to the engine. If themodifications to the engine when viewed as a whole,including the development of the new carburetor, donot satisfy the requirements of section 41(d)(1) andparagraph (a) of this section, those requirements areapplied to the next most significant subset of elementsof the business component. Assuming that the nextmost significant subset of elements of the engine isthe carburetor, the research activities in developingthe new carburetor may constitute qualified researchwithin the meaning of section 41(d)(1) and paragraph(a) of this section.

(c) * * *(2) * * *

(iv) Clinical testing. Clinical testing ofa pharmaceutical product prior to its com-mercial production in the United States isnot treated as occurring after the begin-ning of commercial production even if theproduct is commercially available in othercountries. Additional clinical testing ofa pharmaceutical product after a producthas been approved for a specific therapeu-tic use by the Food and Drug Administra-tion and is ready for commercial produc-tion and sale is not treated as occurring af-ter the beginning of commercial produc-tion if such clinical testing is undertakento establish new functional uses, character-istics, indications, combinations, dosages,or delivery forms for the product. A func-tional use, characteristic, indication, com-bination, dosage, or delivery form shallbe considered new only if such functionaluse, characteristic, indication, combina-tion, dosage, or delivery form must be ap-proved by the Food and Drug Administra-tion.

* * * * *(4) Duplication of existing business

component. Activities relating to repro-ducing an existing business component (inwhole or in part) from a physical exam-ination of the business component itselfor from plans, blueprints, detailed specifi-cations, or publicly available informationabout the business component are notqualified research. This exclusion doesnot apply merely because the taxpayer ex-amines an existing business component inthe course of developing its own businesscomponent.

* * * * *(6) Internal use software for taxable

years beginning on or after December 31,1985. [Reserved].

(7) * * *(ii) Apportionment of in-house research

expenses. In-house research expensespaid or incurred for qualified servicesperformed both in the United States, theCommonwealth of Puerto Rico and otherpossessions of the United States and out-side the United States, the Commonwealthof Puerto Rico and other possessions ofthe United States must be apportioned be-tween the services performed in the UnitedStates, the Commonwealth of Puerto Ricoand other possessions of the United Statesand the services performed outside theUnited States, the Commonwealth of

2004-6 I.R.B. 412 February 9, 2004

Puerto Rico and other possessions ofthe United States. Only those in-houseresearch expenses apportioned to the ser-vices performed within the United States,the Commonwealth of Puerto Rico andother possessions of the United States areeligible to be treated as qualified researchexpenses, unless the in-house research ex-penses are wages and the 80 percent ruleof §1.41–2(d)(2) applies.

* * * * *(10) Illustrations. The following exam-

ples illustrate provisions contained in para-graphs (c)(1) through (9) (excepting para-graphs (c)(6) of this section) of this sec-tion. No inference should be drawn fromthese examples concerning the applicationof section 41(d)(1) and paragraph (a) ofthis section to these facts. The examplesare as follows:

Example 1. (i) Facts. X, a tire manufacturer, de-velops a new material to use in its tires. X conductsresearch to determine the changes that will be neces-sary for X to modify its existing manufacturing pro-cesses to manufacture the new tire. X determines thatthe new tire material retains heat for a longer period oftime than the materials X currently uses for tires, and,as a result, the new tire material adheres to the man-ufacturing equipment during tread cooling. X eval-uates several alternatives for processing the treads atcooler temperatures to address this problem, includ-ing a new type of belt for its manufacturing equip-ment to be used in tread cooling. Such a belt is notcommercially available. Because X is uncertain ofthe belt design, X develops and conducts sophisti-cated engineering tests on several alternative designsfor a new type of belt to be used in tread cooling untilX successfully achieves a design that meets X’s re-quirements. X then manufactures a set of belts for itsproduction equipment, installs the belts, and tests thebelts to make sure they were manufactured correctly.

(ii) Conclusion. X’s research with respect to thedesign of the new belts to be used in its manufacturingof the new tire may be qualified research under sec-tion 41(d)(1) and paragraph (a) of this section. How-ever, X’s expenses to implement the new belts, in-cluding the costs to manufacture, install, and test thebelts were incurred after the belts met the taxpayer’sfunctional and economic requirements and are ex-cluded as research after commercial production un-der section 41(d)(4)(A) and paragraph (c)(2) of thissection.

Example 2. (i) Facts. For several years, X hasmanufactured and sold a particular kind of widget. Xinitiates a new research project to develop a new orimproved widget.

(ii) Conclusion. X’s activities to develop a newor improved widget are not excluded from the defini-tion of qualified research under section 41(d)(4)(A)and paragraph (c)(2) of this section. X’s activities re-lating to the development of a new or improved wid-get constitute a new research project to develop a newbusiness component. X’s research activities relatingto the development of the new or improved widget, anew business component, are not considered to be ac-

tivities conducted after the beginning of commercialproduction under section 41(d)(4)(A) and paragraph(c)(2) of this section.

Example 3. (i) Facts. X, a computer software de-velopment firm, owns all substantial rights in a gen-eral ledger accounting software core program that Xmarkets and licenses to customers. X incurs expen-ditures in adapting the core software program to therequirements of C, one of X’s customers.

(ii) Conclusion. Because X’s activities representactivities to adapt an existing software program to aparticular customer’s requirement or need, X’s activ-ities are excluded from the definition of qualified re-search under section 41(d)(4)(B) and paragraph (c)(3)of this section.

Example 4. (i) Facts. The facts are the same asin Example 3, except that C pays X to adapt the coresoftware program to C’s requirements.

(ii) Conclusion. Because X’s activities are ex-cluded from the definition of qualified research un-der section 41(d)(4)(B) and paragraph (c)(3) of thissection, C’s payments to X are not for qualified re-search and are not considered to be contract researchexpenses under section 41(b)(3)(A).

Example 5. (i) Facts. The facts are the same as inExample 3, except that C’s own employees adapt thecore software program to C’s requirements.

(ii) Conclusion. Because C’s employees’ activ-ities to adapt the core software program to C’s re-quirements are excluded from the definition of qual-ified research under section 41(d)(4)(B) and para-graph (c)(3) of this section, the wages C paid to itsemployees do not constitute in-house research ex-penses under section 41(b)(2)(A).

Example 6. (i) Facts. X manufacturers and sellsrail cars. Because rail cars have numerous specifi-cations related to performance, reliability and qual-ity, rail car designs are subject to extensive, complextesting in the scientific or laboratory sense. B orderspassenger rail cars from X. B’s rail car requirementsdiffer from those of X’s other existing customers onlyin that B wants fewer seats in its passenger cars anda higher quality seating material and carpet that arecommercially available. X manufactures rail carsmeeting B’s requirements.

(ii) Conclusion. X’s activities to manufacturerail cars for B are excluded from the definition ofqualified research. The rail car sold to B was nota new business component, but merely an adapta-tion of an existing business component that did notrequire a process of experimentation. Thus, X’sactivities to manufacture rail cars for B are excludedfrom the definition of qualified research under sec-tion 41(d)(4)(B) and paragraph (c)(3) of this sectionbecause X’s activities represent activities to adaptan existing business component to a particular cus-tomer’s requirement or need.

Example 7. (i) Facts. X, a manufacturer, un-dertakes to create a manufacturing process for a newvalve design. X determines that it requires a special-ized type of robotic equipment to use in the manufac-turing process for its new valves. Such robotic equip-ment is not commercially available, and X, therefore,purchases the existing robotic equipment for the pur-pose of modifying it to meet its needs. X’s engineersidentify uncertainty that is technological in natureconcerning how to modify the existing robotic equip-ment to meet its needs. X’s engineers develop sev-eral alternative designs, and conduct experiments us-

ing modeling and simulation in modifying the roboticequipment and conduct extensive scientific and lab-oratory testing of design alternatives. As a result ofthis process, X’s engineers develop a design for therobotic equipment that meets X’s needs. X constructsand installs the modified robotic equipment on itsmanufacturing process.

(ii) Conclusion. X’s research activities to de-termine how to modify X’s robotic equipment forits manufacturing process are not excluded fromthe definition of qualified research under section41(d)(4)(B) and paragraph (c)(3) of this section,provided that X’s research activities satisfy the re-quirements of section 41(d)(1).

Example 8. (i) Facts. An existing gasoline ad-ditive is manufactured by Y using three ingredients,A, B, and C. X seeks to develop and manufacture itsown gasoline additive that appears and functions ina manner similar to Y’s additive. To develop its ownadditive, X first inspects the composition of Y’s addi-tive, and uses knowledge gained from the inspectionto reproduce A and B in the laboratory. Any differ-ences between ingredients A and B that are used inY’s additive and those reproduced by X are insignif-icant and are not material to the viability, effective-ness, or cost of A and B. X desires to use with A andB an ingredient that has a materially lower cost thaningredient C. Accordingly, X engages in a process ofexperimentation to develop, analyze and test poten-tial alternative formulations of the additive.

(ii) Conclusion. X’s activities in analyzing andreproducing ingredients A and B involve duplicationof existing business components and are excludedfrom the definition of qualified research under section41(d)(4)(C) and paragraph (c)(4) of this section. X’sexperimentation activities to develop potential alter-native formulations of the additive do not involve du-plication of an existing business component and arenot excluded from the definition of qualified researchunder section 41(d)(4)(C) and paragraph (c)(4) of thissection.

Example 9. (i) Facts. X, a manufacturing cor-poration, undertakes to restructure its manufacturingorganization. X organizes a team to design an organi-zational structure that will improve X’s business op-erations. The team includes X’s employees as wellas outside management consultants. The team stud-ies current operations, interviews X’s employees, andstudies the structure of other manufacturing facilitiesto determine appropriate modifications to X’s currentbusiness operations. The team develops a recommen-dation of proposed modifications which it presentsto X’s management. X’s management approves theteam’s recommendation and begins to implement theproposed modifications.

(ii) Conclusion. X’s activities in developing andimplementing the new management structure are ex-cluded from the definition of qualified research un-der section 41(d)(4)(D) and paragraph (c)(5) of thissection. Qualified research does not include activi-ties relating to management functions or techniquesincluding management organization plans and man-agement-based changes in production processes.

Example 10. (i) Facts. X, an insurance company,develops a new life insurance product. In the courseof developing the product, X engages in research withrespect to the effect of pricing and tax consequenceson demand for the product, the expected volatility of

February 9, 2004 413 2004-6 I.R.B.

interest rates, and the expected mortality rates (basedon published data and prior insurance claims).

(ii) Conclusion. X’s activities related to the newproduct represent research in the social sciences (in-cluding economics and business management) andare thus excluded from the definition of qualifiedresearch under section 41(d)(4)(G) and paragraph(c)(8) of this section.

(d) Recordkeeping for the researchcredit. A taxpayer claiming a credit un-der section 41 must retain records insufficiently usable form and detail to sub-stantiate that the expenditures claimed areeligible for the credit. For the rules gov-erning record retention, see §1.6001–1. Tofacilitate compliance and administration,the IRS and taxpayers may agree to guide-lines for the keeping of specific recordsfor purposes of substantiating researchcredits.

(e) Effective dates. This section is ap-plicable for taxable years ending on or af-ter December 31, 2003.

PART 602—OMB CONTROLNUMBERS UNDER THE PAPERWORKREDUCTION ACT

Par. 4. The authority citation for part602 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Par. 5. In §602.101, paragraph (b) is

amended by removing the entry from thetable for §1.41–4(d).

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

Approved December 18, 2003.

Pamela F. Olson,Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on December 31,2003, 8:45 a.m., and published in the issue of the FederalRegister for January 2, 2004, 69 F.R. 22)

Section 42.—Low-IncomeHousing Credit

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the monthof February 2004. See Rev. Rul. 2004-9, page 428.

Section 280G.—GoldenParachute Payments

Federal short-term, mid-term, and long-term ratesare set forth for the month of February 2004. See Rev.Rul. 2004-9, page 428.

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

The adjusted applicable federal long-term rate isset forth for the month of February 2004. See Rev.Rul. 2004-9, page 428.

Section 409.—Qualifi-cations for Tax CreditEmployee Stock Own-ership Plans26 CFR 1.409(p)–1T: Prohibited allocation of secu-rities in an S corporation.(Also, §§ 1361, 4975, 4979A, 6011, 6111, and6112; §§ 54.4975–11, 1.6011–4, 301.6111–2, and301.6112–1.)

Employee stock ownership plans;S corporations; listed transactions. Afinding of synthetic equity owned by adisqualified person in a nonallocation yearof an ESOP, as those terms are defined insection 409(p) of the Code and regulationssection 1.409(p)–1T, takes place in threedistinct situations. In addition, the trans-actions described in this ruling, as wellas substantially similar transactions, aredesignated as “listed transactions.”

Rev. Rul. 2004–4

ISSUES

In the three situations described below,(1) are the individuals disqualified per-sons within the meaning of § 409(p)(4) ofthe Internal Revenue Code (the Code), (2)does the related employee stock ownershipplan (ESOP) have a nonallocation yearwithin the meaning of § 409(p)(3), and(3) are any disqualified persons treated asowning synthetic equity within the mean-ing of § 409(p)(5)?

FACTS

Situation 1

Before 2003, Individuals A and B own,either directly or indirectly, in whole or in

part, a domestic professional services cor-poration. In addition, before 2003, indi-viduals C, D, and E each owns, either di-rectly or indirectly, in whole or in part, hisor her own domestic professional servicescorporation. A, B, C, D, and E (Taxpayers)are employees of their respective domes-tic professional services corporations (Ser-vice Recipient Corporations).

In 2003, a new corporation (S Corp) isformed, and elects to be treated as a sub-chapter S corporation. S Corp forms asubsidiary corporation for each Taxpayer(QSubs A through E), and files a qualifiedsubchapter S subsidiary (QSub) electionfor each subsidiary. S Corp contributescash in exchange for 100 percent of the is-sued and outstanding stock of each QSub.Each Taxpayer is designated as an officerand investment manager for Taxpayer’s re-spective QSub. In addition, each QSubgrants its respective Taxpayer a nonqual-ified stock option to acquire substantiallyall or a majority of the shares of the QSub.

At the same time that S Corp is formed,it establishes a plan (ESOP) which is de-signed to be an employee stock ownershipplan (within the meaning of § 4975(e)(7))and which holds 100 percent of the stock ofS Corp. All the employees of S Corp andthe QSubs participate in the ESOP, with theexception of Taxpayers A through E.

Taxpayers A through E and their sup-port staff terminate their existing employ-ment relationship with their respective Ser-vice Recipient Corporations and becomeemployees of the respective QSub. Thecustomers of Taxpayers A through E stopdoing business with the Service Recipi-ent Corporations and begin doing businesswith the respective QSub of Taxpayers Athrough E.

Taxpayers A through E receive salarypayments from their respective QSub, inan amount substantially less than the in-come to S Corp generated by the busi-ness activities of that Taxpayer after de-duction for expenses. S Corp treats thesubsidiaries as valid QSubs, and treats theincome generated by each QSub each year,and earnings thereon, as earned by S Corp.The payments to the Taxpayers for cur-rent salary are deducted by S Corp as anordinary and necessary business expense.However, since S Corp is wholly ownedby an ESOP holding S corporation stock, SCorp’s net earnings are not taxed currently.

2004-6 I.R.B. 414 February 9, 2004

Amounts of income to S Corp generatedby the business activities of each Taxpayer(net of expenses) but not paid to Taxpayerswithin 21/2 months after the end of the yearaccumulate in each Taxpayer’s respectiveQSub, for example, in a brokerage accountin each subsidiary, over which the respec-tive Taxpayer has investment control as theinvestment manager of the subsidiary. Athrough E can access the amounts accumu-lated in their respective QSub by exercis-ing their option to purchase shares in theQSub. If each Taxpayer’s option to pur-chase shares of QSub stock were syntheticequity of S Corp (determined in accor-dance with § 1.409(p)–1T(f)(4)(ii)), theneach Taxpayer would own at least 10 per-cent of the sum of the outstanding sharesof S Corp plus the synthetic equity sharesof S Corp.

Situation 2

The facts are the same as in Situation 1,except that instead of 5 individuals, thereare 11 individuals (Taxpayers A throughK) each of whom is an employee of aService Recipient Corporation owned ei-ther directly or indirectly, in whole or inpart, by that Taxpayer. As in Situation 1,amounts of income to S Corp generatedby the business activities of each Taxpayer(net of expenses) but not paid to the Tax-payer accumulate in each Taxpayer’s re-spective QSub, and each Taxpayer has theright to acquire stock in that Taxpayer’sQSub under the same terms as described inSituation 1. If each Taxpayer’s option topurchase shares of QSub stock were syn-thetic equity of S Corp, then each Taxpayerwould own less than 10 percent of the sumof the outstanding shares of S Corp plus thesynthetic equity shares of S Corp.

Situation 3

Before 2003, Corporation M is an Scorporation with 200 employees, whollyowned by an ESOP that was establishedafter March 14, 2001, in which substan-tially all of its employees participate. Be-fore 2003, Individual A (Taxpayer) oper-ated a professional services corporation asa separate business. In 2003, CorporationM forms a QSub for A by contributing cashin exchange for 100 percent of the issuedand outstanding stock of the QSub. As inSituation 1, A and A’s support staff ter-minate their existing employment relation-

ship with A’s Service Recipient Corpora-tion and become employees of the QSub;A’s customers become customers of theQSub; amounts of income to S Corp gen-erated by the business activities of A (netof expenses) but not paid to A accumulatein A’s QSub; and A has the right to acquirestock in the QSub under the same terms asdescribed in Situation 1. A does not par-ticipate in the Corporation M ESOP. If A’soption to purchase shares of the QSub weresynthetic equity of S Corp, then A wouldown less than 10 percent of the total of theoutstanding shares of S Corp plus the syn-thetic equity shares of S Corp.

LAW

Section 4975(e)(7) provides that anESOP is a defined contribution plan thatis designed to invest primarily in qual-ifying employer securities and that iseither a stock bonus plan which is qual-ified, or a stock bonus plan and moneypurchase pension plan both of which arequalified, under § 401(a). A plan is nottreated as an ESOP under the Code unlessit meets the following requirements, tothe extent applicable: § 409(h) (relatingto participants’ right to receive employersecurities; put options); § 409(o) (relat-ing to participants’ distribution rights andpayment requirements); § 409(n) (relatingto securities received in transactions towhich § 1042 applies); § 409(p) (relatingto prohibited allocations of securities inan S corporation); § 664(g) (relating toqualified gratuitous transfers of qualifiedemployer securities); and § 409(e) (re-lating to participants’ voting rights if theemployer has a registration-type class ofsecurities). As authorized by § 4975(e)(7),additional requirements are imposed under§ 54.4975–11 of the Excise Tax Regula-tions.

Section 1361(b)(1)(B) provides that anS corporation may not have as a share-holder a person that is not an estate, a trustdescribed in § 1361(c)(2), an organizationdescribed in § 1361(c)(6), or an individual.In 1996, § 1361(c)(6) was amended to per-mit a qualified plan under § 401(a) to bea shareholder in an S corporation. Section1316(a) of the Small Business Job Protec-tion Act of 1996 (SBJPA) (110 Stat. 1755)(1996).

Section 1361(b)(3)(A) provides that,for purposes of title 26 of the U.S. Code, a

corporation that is a qualified SubchapterS subsidiary will not be treated as a sepa-rate corporation and all assets, liabilities,and items of income, deduction and creditof the corporation are treated as assets,liabilities, and such items (as the case maybe) of the S corporation.

Section 511(a)(1) imposes a tax onthe unrelated business taxable income(as defined in § 512(a)) of organizationsdescribed in § 511(a)(2), which includeplans that qualify under § 401(a). Section512(e)(1) provides that if an organizationdescribed in § 1361(c)(6) holds stock in anS corporation, the interest is treated as aninterest in an unrelated trade or businessand, notwithstanding the organization’sgeneral tax-exempt status, all items of in-come, loss, or deduction taken into accountunder § 1366(a) and any gain or loss onthe disposition of the stock in the S corpo-ration are taken into account in computingthe unrelated business taxable income ofthe organization. In 1997, § 512(e) wasamended to provide that § 512(e) does notapply to employer securities (within themeaning of § 409(l)) held by an ESOPdescribed in § 4975(e)(7). Section 1523of the Taxpayer Relief Act of 1997 (TRA’97) (111 Stat. 788) (1997). Accordingly,S corporation income allocable to stockheld by an ESOP is not subject to regularincome or unrelated business income tax.

Congress became aware that the taxexemption for earnings on S corporationstock held by an ESOP may lead to in-appropriate tax deferral or avoidance insome cases. In order to address these con-cerns, Congress enacted § 409(p) as partof the Economic Growth and Tax ReliefReconciliation Act of 2001 (EGTRRA)(115 Stat. 38) (2001). Section 409(p) iseffective for plan years beginning afterDecember 31, 2004. However, pursuant tosection 656(d)(2) of EGTRRA, § 409(p) ofthe Code is effective for plan years endingafter March 14, 2001, for an ESOP thatis established after that date, or if the em-ployer securities held by the plan consistof stock in an S corporation that did nothave an S election in effect on that date.Notice 2002–2, Q&A–15, 2002–1 C.B.285, provides that an S corporation doesnot have an election in effect on March 14,2001, unless a valid election was actuallyfiled on or before that date and is effectivewith respect to such corporation on orbefore that date. Temporary and proposed

February 9, 2004 415 2004-6 I.R.B.

regulations under § 409(p) were issued onJuly 21, 2003 (T.D. 9081, 2003–35 I.R.B.420; REG–129709–03, 2003–35 I.R.B.506, September 2, 2003), effective gen-erally for plan years ending after October20, 2003.

Section 409(p) is intended to limit thetax benefits of ESOPs maintained by S cor-porations unless the ESOP provides mean-ingful benefits to rank-and-file employees.As explained in the legislative history:

The Committee continues to believethat S corporations should be able to en-courage employee ownership throughan ESOP. The Committee does not be-lieve, however, that ESOPs should beused by S corporation owners to obtaininappropriate tax deferral or avoidance.

Specifically, the Committee believesthat the tax deferral opportunities pro-vided by an S corporation ESOP shouldbe limited to those situations in whichthere is broad-based employee cover-age under the ESOP and the ESOP ben-efits rank-and-file employees as well ashighly compensated employees and his-torical owners.

H. R. Rep. No. 107–51, part 1, at 100(2001).

Sections 409(p) and 4979A apply ifa nonallocation year occurs in an em-ployee stock ownership plan, as definedin § 4975(e)(7), that holds shares of stockof an S corporation that are employer se-curities as defined in § 409(l). Section409(p)(1) requires that an ESOP holdingemployer securities consisting of stock inan S corporation must provide that no por-tion of the assets of the plan attributableto (or allocable in lieu of) such employersecurities may, during a nonallocationyear, accrue (or be allocated directly orindirectly under any plan of the employermeeting the requirements of § 401(a)) forthe benefit of any disqualified person, asdefined in § 409(p).

Under § 409(p)(3), (4), and (5), a “non-allocation year” means a plan year ofan ESOP during which, at any time, theESOP holds any employer securities thatare shares of an S corporation and either:1) disqualified persons own at least 50 per-cent of the number of outstanding sharesof stock in the S corporation (includingdeemed-owned ESOP shares), or 2) dis-qualified persons own at least 50 percentof the aggregate number of outstandingshares of stock (including deemed-owned

ESOP shares) and synthetic equity in the Scorporation. For these purposes, the rulesof § 318(a) apply to determine ownershipof shares in the S corporation (includ-ing deemed-owned ESOP shares) andsynthetic equity. However, § 318(a)(4)(relating to options to acquire stock) isdisregarded and, in applying § 318(a)(1),the members of an individual’s familyinclude members of the individual’s fam-ily specified in § 409(p)(4)(D). In addi-tion, an individual is treated as owningdeemed-owned ESOP shares of that indi-vidual notwithstanding the employee trustexception in § 318(a)(2)(B)(i).

As indicated by the legislative historyabove, § 409(p) is intended to limit the taxbenefits of ESOPs maintained by S cor-porations unless the ESOP provides broadbased coverage for, and meaningful bene-fits to, rank-and-file employees. See H.R.Rep. No. 107–51, part 1, at 100 (2001).Accordingly, Congress added § 409(p)(7),recognizing that the structure of § 409(p)was not expected to be sufficient in allcases to ensure broad-based coverage for,and meaningful benefits to, rank-and-fileemployees. Section 409(p)(7)(A) thusauthorizes the Secretary to prescribe suchregulations as may be necessary to carryout the purposes of § 409(p). Section409(p)(7)(B) provides that the Secretarymay, by regulation or other guidance ofgeneral applicability, provide that a nonal-location year occurs in any case in whichthe principal purpose of the ownershipstructure of an S corporation constitutesan avoidance or evasion of § 409(p). Thelegislative history to § 409(p) includes thefollowing with respect to exercise of thisauthority:

For example, this might apply if morethan 10 independent businesses arecombined in an S corporation ownedby an ESOP in order to take advantageof the income tax treatment of S corpo-rations owned by an ESOP.

H. R. Conf. Rep. No. 107–84, at 277(2001).

Pursuant to § 409(p)(7)(B), § 1.409(p)–1T(c)(3) of the Temporary Income TaxRegulations provides that the Commis-sioner, in revenue rulings, notices andother guidance published in the InternalRevenue Bulletin, may provide that anonallocation year occurs in any case inwhich the principal purpose of the owner-ship structure of an S corporation consti-

tutes an avoidance or evasion of § 409(p).For any year that is a nonallocation year,taking into account the legislative his-tory cited above, § 1.409(p)–1T(c)(3) alsoprovides that this exercise of authorityincludes the authority to treat any personas a disqualified person.

Under § 409(p)(4), a disqualified per-son is any person for whom: 1) the numberof such person’s deemed-owned ESOPshares is at least 10 percent of the num-ber of deemed-owned ESOP shares of theS corporation; 2) the aggregate numberof such person’s deemed-owned ESOPshares and synthetic equity shares is atleast 10 percent of the aggregate numberof deemed-owned ESOP and synthetic eq-uity shares of the S corporation; 3) the ag-gregate number of deemed-owned ESOPshares of such person and of the mem-bers of such person’s family is at least 20percent of the number of deemed-ownedESOP shares of the S corporation; or 4)the aggregate number of deemed-ownedESOP shares and synthetic equity sharesof such person and of the members of suchperson’s family is at least 20 percent ofthe aggregate number of deemed-ownedESOP and synthetic equity shares of the Scorporation.

Section 409(p)(4)(C) defines “deemed-owned ESOP shares” to mean, with respectto any person: 1) any shares of stock in theS corporation constituting employer secu-rities that are allocated to such person’s ac-count under the ESOP; and 2) such per-son’s share of the stock in the S corpora-tion that is held by the ESOP but is notallocated to the account of any participantor beneficiary (with such person’s share tobe determined in the same proportion asthe most recent stock allocation under theESOP).

Section 1.409(p)–1T(f)(1), interpreting§ 409(p)(5), provides that the determina-tion of whether someone is a disqualifiedperson and whether a plan year is a non-allocation year is made without regard to“synthetic equity” attributable to that per-son and is also made separately taking intoaccount synthetic equity. For purposes of§ 409(p) and § 1.409(p)–1T, synthetic eq-uity is treated as owned by a person in thesame manner as stock is treated as ownedby a person, directly or under the rules of§ 318(a)(2) and (3).

Section 409(p)(6)(C) defines “syn-thetic equity” to include any stock op-

2004-6 I.R.B. 416 February 9, 2004

tion, warrant, restricted stock, deferredissuance stock right, stock appreciationright payable in stock, or similar interestor right that gives the holder the rightto acquire or receive stock of the S cor-poration in the future. Synthetic equityalso includes a right to a future payment(payable in cash or any other form otherthan stock of the S corporation) from anS corporation that is based on the valueof the stock of the S corporation or ap-preciation in such value, such as a stockappreciation right with respect to stock ofan S corporation that is payable in cash ora phantom stock unit with respect to stockof an S corporation that is payable in cash.

Section 1.409(p)–1T(f)(2)(iv) providesa rule treating nonqualified deferred com-pensation as synthetic equity. Specifically,that section of the temporary regulationsprovides that synthetic equity also includesany remuneration for services rendered tothe S corporation, or a related entity, towhich § 404(a)(5) applies (including re-muneration for which a deduction wouldbe permitted under § 404(a)(5) if separateaccounts were maintained), any right to re-ceive property (to which § 83 applies) in afuture year for the performance of servicesto an S corporation, or related entity, andany transfer of property (to which § 83 ap-plies) in connection with the performanceof services to an S corporation, or a relatedentity, to the extent that the property is notsubstantially vested within the meaning of§ 1.83–3(i) of the Income Tax Regulationsby the end of the plan year in which trans-ferred. Section 1.409(p)–1T(f)(2)(iv) alsoprovides that synthetic equity includes anyother remuneration for services renderedto the S corporation, or a related entity, un-der a plan, method or arrangement, defer-ring the receipt of compensation to a datethat is after the 15th day of the 3d calen-dar month after the end of entity’s taxableyear in which the related services are ren-dered, other than a plan that is an eligi-ble retirement plan within the meaning of§ 402(c)(7)(B).

Pursuant to the authority in § 409(p)(7),§ 1.409(p)–1T(f)(2)(iii)(A) provides thatsynthetic equity also includes a right toacquire stock or other similar interestsin a related entity if such interests in therelated entity are the only significant assetof the S corporation and the S corpora-tion is the only significant owner of therelated entity. Whether an asset is the

only significant asset of the S corporationor the S corporation is the only signifi-cant owner of the related entity dependson the relevant facts and circumstances.Section 1.409(p)–1T(f)(2)(iii)(A)(4) pro-vides that a related entity means anyentity in which the S corporation holdsan interest and which is a partnership,a trust, an eligible entity that is disre-garded as an entity that is separate from itsowner under § 301.7701–3 of the Proce-dure and Administration Regulations or aQualified Subchapter S Subsidiary under§ 1361(b)(3).

Pursuant to the authority in § 409(p)(7),§ 1.409(p)–1T(f)(2)(iii)(C) provides thatthe Commissioner may, if necessary tocarry out the purposes of § 409(p), throughrevenue rulings, notices, and other guid-ance published in the Internal RevenueBulletin, provide that synthetic equity in-cludes a right to acquire stock or othersimilar interests in a related entity in casesin which such interests in the related entityare not the only significant asset of theS corporation or the S corporation is notthe only significant owner of the relatedentity.

Section 1.409(p)–1T(f)(4)(ii) providesthat, in the case of synthetic equity that isdetermined by reference to shares of stock(or other similar interests) in a related en-tity, the person who is entitled to the syn-thetic equity is treated as owning shares ofstock in the S corporation with the sameaggregate value as the number of sharesof stock (or similar interests) of the relatedentity (with such value determined withoutregard to any lapse restriction as defined at§ 1.83–3(i)).

Section 4979A imposes a 50 percent ex-cise tax in