utable directly to C's interest in the partnership (50% of the net capital gain that would result from offsetting the $6,000 net long-term capital gain and the $2,000 net short-term capital loss that are attributable to C's interest in the partnership). Since the remaining $1,000 deduction under section 1202 cannot be attributed directly to either C's income from the partnership or any other specific activity, it must be treated as a deduction not attributable to a specific activity. (e) Deductions not attributable to a specific activity-(1) "Specific activity" defined. A "specific activity" means a course of continuous conduct involving a particular line of endeavor, whether or not the activity is carried on for profit. Examples of a specific activity are: (i) A trade or business carried on by the taxpayer; (ii) A trade or business carried on by an entity in which the taxpayer has an interest; (iii) An activity with respect to which the taxpayer is entitled to a deduction under section 212; (iv) The operation of a farm as a hobby. (2) Types of deductions not attributable to a specific activity. Examples of deductions not attributable to a specific activity include charitable contributions made by the partner, beneficiary, or shareholder; medical expenses; alimony; interest on personal debts of the partner, beneficiary, or shareholder; and real estate taxes on the personal residence of the partner, beneficiary, or shareholder. For purposes of this section, in cases in which deductions are not itemized, the zero bracket amount is considered to be a deduction not attributable to a specific activity. (f) Carryback or carryover of credit subject to separate limitation. A credit subject to the separate limitation under section 53(b) that is carried back or carried over to another taxable year is also subject to the separate limitation in the carryback or carryover year. The taxpayer to whom the credit has been passed through shall not be prevented from applying the unused portion in a carryback or carryover year merely because the entity that earned the credit changes its form of conducting business if the nature of its trade or business essentially remains the same. The computation of the separate limitation in such a case shall reflect the income attributable to the taxpayer's interest in the entity in its revised form. Thus, a shareholder carrying over a credit from a subchapter S corporation may include dividends declared by that corporation after the subchapter S election had been terminated as income attributable to that person's interest in the entity. Similarly, if a partnership incorporates in a carryover year, any income attributable to an interest in the corporation will be regarded, for purposes of computing the separate limitation under section 53(b), as income attributable to an interest in the entity. This Treasury decision is issued under the authority contained in sections 44B (b) and 7805 of the Internal Revenue Code of 1954 (68A Stat. 917; 91 Stat. 141, 26 U.S.C. 44B(b), 7805). JEROME KURTZ, Approved August 11, 1978. DONALD C. LUBICK, Assistant Secretary of the Treasury. (Filed by the Office of the Federal Register on Aug. 22, 1978 and Dec. 27, 1978, at 8:45 a.m., and published in the issues of the Federal Register for Aug. 23, 1978, 43 F.R. 37450 and Dec. 28, 1978, 43 F.R. 60445.) Part VI.-Minimum Tax for Tax Preferences Section 56.-Imposition of Tax 26 CFR 1.56-1: Imposition of tax. (Also Sections 57, 58; 1.57-1, 1.58-1.) T.D. 7564 1 TITLE NUE. 26.-INTERNAL REVECHAPTER I, SUBCHAPTER A, PART 1.-INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953; SUBCHAPTER F, PART 301.-PROCEDURE AND ADMINISTRATION Minimum tax for tax preferences AGENCY: Internal Revenue Service, Treasury. ACTION: Final regulations. SUMMARY: This document provides final regulations relating to the imposition of a minimum tax on tax preferences of both individuals and corporations. Changes to the applicable tax law were made by the Tax Reform Act of 1969 [Pub. L. 91-172, 1969-3 C.B. 10] and the Excise, Estate, and Gift Tax Adjustment Act of 1970 [Pub. L. 91-614, 1971-1 C.B. 533]. These regulations provide necessary guidance to the public for compliance with the law and affect all taxpayers who may have any items of tax pref erence. DATE: The regulations are generally effective for taxable years ending after December 31, 1969. FOR FURTHER INFORMATION CONTACT: Robert Coplan of the Legislation and Regulations Division, Office of the Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224, Attention: CC: LR:T, 202566-3287), not a toll-free call. SUPPLEMENTARY INFORMA TION: BACKGROUND On December 30, 1970, the Federal Register published proposed amendments to the Income Tax Regulations (26 CFR Part 1) under sections 56 'This publication of the Treasury Decision contains the complete text of the regulations. The individual instructions for modifying the notices of proposed rulemaking have been omitted. through 58 of the Internal Revenue Code of 1954 (35 FR 19757). The amendments were proposed to conform the regulations to section 301 of the Tax Reform Act of 1969 (83 Stat. 580). On June 24, 1971, the Federal Register published a notice of proposed rulemaking which withdrew portions of the previously proposed regulations (36 FR 12020). Revised provisions were proposed at that time. In addition, a new section of the regulations (§ 1.56-5) was proposed to reflect the amendment made to section 56 of the Code by section 501 of the Excise, Estate, and Gift Tax Adjustment Act of 1970 (84 Stat. 1846). A public hearing was held on August 10, 1971. After consideration of all comments regarding the proposed amendments, those amendments are adopted as revised by this Treasury decision. LEGISLATIVE CHANGES REFLECTED IN REGULATIONS These amendments only reflect changes made by the Tax Reform Act of 1969 and the Excise, Estate, and Gift Tax Adjustment Act of 1970. In addition, changes have been made in § 1.56-1(b) and § 1.56-5(b) to reflect the addition of certain credits by the Revenue Act of 1971 (85 Stat. 497) [Pub. L. 92-178, 1972-1 C.B. 443]. Amendments to conform the regulations to changes made by other legislation, including the Tax Reform Act of 1976 [Pub. L. 94-455, 1976-3 C.B. (Vol. 1) 1], will be contained in separate documents. NATURE OF MINIMUM TAX The minimum tax for tax preferences is in addition to the regular income tax and is imposed with respect to specified items of tax preference. These items of tax preference represent income which is either (a) not subject to current taxation by reason of temporary exclusion or an acceleration of deductions or (b) not subject to full taxation by reason of certain deductions or a special rate of tax. IMPOSITION AND COMPUTATION OF MINIMUM TAX Section 1.56-1 of the regulations sets forth the general rules for the imposition and computation of the minimum tax for tax preferences. The rate of the minimum tax is 10 percent. The base of the tax for a taxable year is the sum of taxpayer's items of tax preference (to the extent they exceed $30,000), reduced by his liability for the year for income tax and certain special taxes. DEFERRAL OF MINIMUM TAX Section 1.56-2 of the regulations sets forth rules for the deferral of minimum tax liability in the case of certain net operating losses. Under these rules (which implement section 56(b) of the Code), if a taxpayer has a net operating loss for a taxable year, his liability for minimum tax is deferred to the year (or years) in which the net operating loss is applied to reduce taxable income. EFFECTIVE DATE AND CROSS-REFERENCES Section 1.56-3 of the regulations sets forth the effective date of the minimum tax provisions. In general, the minimum tax is applicable to taxable years ending after December 31, 1969. Section 1.56-4 cross-refers to § 1.58-2 through 1.58-6 for rules relating to certain "conduit" entities (estates, trusts, partnerships, and the like). CARRYOVER OF MINIMUM Under section 56(c) and § 1.56-5, a taxpayer may carry forward the excess of its income tax liability for a taxable year (except taxes imposed by sections 56, 72(m) (5) (B), 402(e), 408(f), 531 and 541) over the amount by which its items of tax preference exceed the $30,000 exemption. This excess tax liability may be carried forward for up to seven years to re duce the taxpayer's minimum tax base for those subsequent years. REGULATIONS UNDER No material change has been made in the final regulations under section 56 from the provisions proposed in 1970 and 1971. ITEMS OF TAX PREFERENCE Section 1.57-1 of the regulations gives detailed definitions for 8 of the 9 items of tax preference listed in section 57 (a) as originally enacted. These 8 items are: accelerated depreciation on real property; accelerated depreciation on personal property subject to a net lease; amortization of certified pollution control facilities; amortization of railroad rolling stock; stock options; additions to reserves for losses on bad debts of financial institutions; depletion; and capital gains. The ninth item, excess investment interest, was repealed by the Tax Reform Act of 1976. Proposed § 1.57-2 deals with that item, but is not being adopted at this time for reasons discussed later in this preamble. CHANGES MADE IN § 1.57-1 IN RESPONSE TO COMMENTS Comments were received from the public suggesting that various changes be made to proposed § 1.57-1. The most significant changes made in 1.57-1 of the final regulations in response to these comments are as follows: 1. Under the proposed regulations, the determination of the depreciation items of tax preference under section 57 (a) (2) and (3) is made with respect to each item of section 1250 property or section 1245 property. The final regulations now provide that a taxpayer who uses group, classified, or composite depreciation accounts will determine the amount of this tax preference in the aggregate with respect to all property in the account, provided that the account contains only property placed in service during a single year. 2. For several tax preference items, it is necessary to determine the amount of depreciation which would have been allowable if only the straight line method had been used. The final regulations add rules specifying the useful life to be used in determining the amount of this hypothetical depreciation where the taxpayer elects to apply an asset depreciation period or an asset guideline period to eligible property. 3. The final regulations provide that, where a qualified or restricted stock option is exercised by an estate or heir, the option price of the stock for minimum tax purposes includes all or part of the basis of the option. The rule in § 1.57-1(f) (5) (i) has been expanded to provide that no stock option preference item arises if there is a disposition of the stock in the same taxable year the option is exercised. 4. The preference item in section 57(a) (7) is the amount by which the deduction allowed to financial institutions under section 585 or 593 for a reasonable addition to a reserve for bad debts exceeds the amount that would have been allowable had the institution maintained its bad debt reserve for all taxable years on the basis of actual experience. The last sentence of proposed § 1.57-1 (g) (4) (i) did not allow a bank to claim a deduction smaller than that permitted by section 585(b) (3) (A), and then recoup the unclaimed amount in a later year. If a bank in a subsequent year claimed all or part of such an unclaimed deduction, a tax preference item would have been imposed equal to the recouped amount. The final regulations have been changed to permit such a recoupment. The minimum addition to the reserve for bad debts imposed by the regulations under section 585 reduce the effect of this change for taxable years beginning after December 31, 1976. An example has been added to § 1.57-1 (g) (4) (i) which generally illustrates the computation of this preference item. RECOMMENDATIONS NOT Several recommendations made in the public comments were not adopted in the final regulations. These recommendations were not followed primarily because of conflicts with the statutory language of section 57 and other sections of the Code or administrative problems raised by the application of these recommendations. The more significant suggestions were as follows: 1. Under § 1.57-1(f) (3), stock received pursuant to the exercise of a qualified or restricted stock option is valued in a manner consistent with the principles applicable under section 83(a) (1). Section 83(a) (1) requires that the stock be valued without regard to restrictions (other than restrictions which by their terms will never lapse). One comment urged that the stock should be valued with regard to restrictions or that the taxpayer be allowed an option to defer minimum tax liability until the restrictions lapse. This recommendation was not adopted. The use of section 83 is proper for valuation purposes since it measures the amount of income that would be subject to immediate tax, and therefore the amount that is subject to preferential deferral, but for the benefit provided by section 421. Clarifying language was added to § 1.57-1 (f) (3) to indicate that the timing rule of section 83(a) (1) is not being used. For purposes of section 57 (a) (6), the fair market value of the stock is determined as of the time the option is exercised. 2. Comments were received recommending that if a taxpayer claims a deduction for depletion smaller than the deduction allowable under section 611, the amount treated as an item of tax preference should be determined on the basis of the deduction claimed, rather than the maximum deduction allowable. This suggestion has not been adopted since section 57(a) (8) defines the depletion item of tax preference as "***the excess of the deduction for depletion allowable under section 611 for the taxable year over the adjusted basis of the property at the end of the taxable year***" (emphasis added). EXCESS INVESTMENT INTEREST AND NET LEASE PROVISIONS NOT ADOPTED Sections 1.57-2 and 1.57-3 relating to excess investment interest and net leases, respectively, are not being adopted at this time. These sections have been left outstanding because amendments made to sections 57 (b) and (c) by the Revenue Act of 1971 were made effective for taxable years beginning after December 31, 1969, the effective date of the Tax Reform Act of 1969. In view of the retroactive nature of these amendments, any necessary changes in §§ 1.57-2 and 1.57-3 will be made in a notice of proposed rulemaking. Because of the similarity of the subject matter, such changes may be incorporated in a notice of proposed rulemaking which will be issued containing proposed regulations under section 163(d). TAX BENEFIT RULE ADOPTED FOR TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1976 Section 1.57-4 of the proposed regulations, relating to a limitation on amounts treated as items of tax preference, is being adopted, but will only be effective for taxable years beginning before January 1, 1976, the effective date of the Tax Reform Act of 1976. For taxable years beginning after this date, new regulations will be proposed in a separate document which will implement the tax benefit rule of section 58(h), added by section 301 of the Tax Reform Act of 1976. These new regulations will not necessarily follow all the provisions in § 1.57.4. RECORDS TO BE RETAINED BY TAXPAYER Section 1.57-5 of the regulations prescribes the records which are to be maintained and retained to permit a determination of a taxpayer's minimum tax base. MINIMUM TAX EXEMPTION Section 1.58-1 of the regulations sets forth rules concerning the minimum tax exemption. In general, a taxpayer's first $30,000 of items of tax preference is exempt from the minimum tax. A married person filing a separate return is entitled to a minimum tax exemption of only $15,000. In the case of a controlled group of corporations, the $30,000 exemption is divided equally among the component members unless they consent to an unequal allocation of the $30,000 exemption. APPLICATION OF MINIMUM TAX TO CONDUIT ENTITIES Section 1.58-2 of the regulations contains general rules for conduit entities and special rules for partnerships and partners. Since a partnership as such is not subject to the income tax, it is not itself subject to the minimum tax for tax preferences. However, each partner in computing his items of tax preference, must take into account separately his allocable share of those items of income and deduction of the partnership that enter into the computation of his items of tax preference. Section 1.58-3 of the regulations, which implements section 58(c) (1) of the Code, contains rules relating to estates and trusts. Code section 58(c) (1) provides that the sum of the items of tax preference of an estate or trust is to be apportioned between the estate or trust and its beneficiaries on the basis of the income of the estate or trust allocable to each. The regulations provide that, for this purpose, "income" is the income received or accrued by the trust or estate which is not subject to current taxation in the hands of the trust or estate or the beneficiary by reason of an item of tax preference. In response to a comment § 1.58-3 (a) (4) has been revised in the final regulations. This section establishes the year in which a beneficiary is to take into account items of tax preference of a trust that are apportioned to him. As proposed, this provision would have required the beneficiary to report his allocable share of tax preference items in the same taxable year in which he receives the income upon which the apportionment of tax preferences is based. The final regulations provide that items of tax preference apportioned to a beneficiary are to be taken into account by him in his taxable year within or with which ends the taxable year of the estate or trust during which it has such items of tax preference. This revision conforms these regulations to the rules set forth in section 652(c) and 662(c) for the reporting of income by a beneficiary. Section 1.58-4 contains rules for the apportionment of the items of tax preference of an electing small business corporation (sometimes referred to as a "tax-option corporation" or a "subchapter S corporation"). With one exception, the items of tax preference of the corporation are not subject to minimum tax at the level of the corporation. The exception to the general rule pertains to certain capital gains, which are subject to tax at the corporate level under Code section 1378. The corporation is subject to the minimum tax with respect to such capital gains. The items of tax preference not subject to minimum tax at the corporate level are apportioned pro rata among the shareholders. In addition, each shareholder must treat as a capital gain preference item, his distributive share of the corporation's net section 1201 gain less the taxes paid by the corporation under sections 56 and 1378. made to the formula contained in § 1.58-4(c) (2) for computing a Subchapter S corporation's capital gain preference item. The final regulations indicate that only one of the two exclusions in §1.58-4(c) (2) (i) could apply to a given computation because of the limitation imposed by section 1378(c), relating to capital gain attributable to property with a substituted basis. Section 1.58-5 of the regulations provides that participants in a common trust fund are to take into account their proportionate share of the items of tax preference of the fund. The items of tax preference to be apportioned are to be determined as if the fund itself were subject to the minimum tax. The participant's proportionate share of such item of tax preference is determined in a manner consistent with §1.584-2(c) (relating to income of participants in a common trust fund). Section 1.58-6 provides rules for the apportionment of items of tax preference of a regulated investment company or real estate investment trust to their shareholders or holders of beneficial interest. In general, the items of tax preference are computed at the entity level and apportioned to the shareholders or holders of beneficial interest in the same proportion as the dividends (other than capital gains dividends and, in the case of a real estate investment trust, accelerated depreciation on section 1250 property) paid to each such shareholder or holder of beneficial interest bear to the taxable income of the company or trust, determined without regard to the devidends paid deduction. PREFERENCE ITEMS ATTRIBUTABLE TO FOREIGN SOURCES Sections 1.58-7 and 1.58-8 of the regulations contain special rules concerning items of tax preference at1.58-7 relates to foreign source items of tax preference (other than capital gains and stock options). Such items of tax preference are taken into account for minimum tax purposes only to the extent that they reduce the taxpayer's income tax on income derived from sources within the United States. Under the regulations, foreign-source items of tax preference are considered to reduce the taxpayer's income tax on income from sources within the United States to the extent that the deductions relating to such preferences, in combination with other foreign deductions, exceed the income from such foreign sources and, in effect, offset income from sources within the United States. Under the Code and regulations, items of tax preference are treated as reducing United States income tax before items which are not items of tax preference. A minor clarifying change has been tributable to foreign sources. Section Section 1.58-8 contains rules relating to foreign-source capital gains and stock options. Such items are subject to the minimum tax for tax preferences only if they are accorded preferential treatment under the tax laws of the foreign country (or possession of the United States) to which they are attributable. In prescribing rules for determining whether a foreign country accords preferential treatment of such items, the final regulations follow the rules proposed on June 24, 1971, rather than the rules originally proposed on December 30, 1970. Several comments objected to the change of position in § 1.58-8 of the proposed regulations published on June 24, 1971. These provisions concern the applicability of the minimum tax to capital gains whose source was a country which imposes no income tax. The amendment of section 58(g) with retroactive application by the Revenue Act of 1971 has statutorily ratified the position taken in the final regulations. MINOR COMMENTS SUGGESTING CLARIFICATIONS A number of changes of a clarifying nature were made in the final regulations in response to public comments received which identified particular sections in need of clarification. REGULATIONS LEFT For the convenience of the reader, the sections of the proposed regulations being left outstanding are listed below: § 1.57-2 and § 1.57-3. As part of the effort to reduce the bulk of the Code of Federal Regulations, these sections of the proposed regulations which merely reproduced various provisions of the Internal Revenue Code are deleted. For the same reason, several such sections are deleted from the Code of Federal Regulations by this document. DRAFTING INFORMATION was The principal author of these proposed regulations Robert B. Coplan of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulation, both on matters of substance and style. Adoption of amendments to the regulations Accordingly, the following amendments are hereby adopted: Paragraph 1. Section 1.5 is deleted. Par. 4. Section 1.46-1 is amended by revising paragraph (c) to read as follows: § 1.46-1 Determination of amount. pose of computing the limitation based on the amount of tax, section 46(a) defines the liability for tax as the income tax imposed for the taxable year by chapter 1, reduced by the sum of certain credits listed in section 46(a). In addition, an increase in tax resulting from the application of section 47 (relating to certain dispositions, etc., of section 38 property) shall not be treated as tax imposed by chapter 1 for purposes of computing the liability for tax. See section 47(c). Par. 5. Section 1.51 is deleted. Par. 6. The following sections are inserted immediately before § 1.61: § 1.56-1 Imposition of tax. (a) In general. Section 56(a) imposes an income tax on the items of tax preference (as defined in § 1.57-1) of all persons other than persons specifically exempt from the taxes imposed by chapter 1. The items of tax preference represent income of a person which either is not subject to current taxation by reason of temporary exclusion (such as stock options) or by reason of an acceleration of deductions (such as accelerated depreciation) or is sheltered from full taxation by reason of certain deductions (such as percentage depletion) or by reason of a special rate of tax (such as the rate of tax on corporate capital gains). The tax imposed by section 56 is in addition to the other taxes imposed by chapter 1. (b) Computation of tax. The amount of such tax is 10 percent of the excess (referred to herein as "the minimum tax base") of (1) The sum of the taxpayer's items of tax preference for such year in excess of the taxpayer's minimum tax exemption (determined under § 1.581) for such year, over (2) The sum of: (i) The taxes imposed for such year under chapter 1 other than the taxes imposed by section 56 (relating to minimum tax for tax preferences), by |