Td 8901

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Section 110.—Qualified Lessee
Construction Allowances for
Short-Term Leases
26 CFR 1.110–1: Qualified lessee construction
allowances.

T.D. 8901
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Qualified Lessee Construction
Allowances for Short-Term
Leases
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains
final regulations concerning an exclusion
from gross income for qualified lessee
construction allowances provided by a
lessor to a lessee for the purpose of constructing long-lived property to be used
by the lessee pursuant to a short-term
lease. The final regulations affect a lessor
and a lessee paying and receiving, respectively, qualified lessee construction allowances that are depreciated by a lessor
as nonresidential real property and excluded from the lessee’s gross income.
The final regulations provide guidance on
the exclusion, the information required to
be furnished by the lessor and the lessee,
and the time and manner for providing
that information to the IRS.
DATES: Effective Date: These regulations are effective October 5, 2000.
Date of Applicability: For date of applicability of §1.110–1, see §1.110–1(d).
FOR FURTHER INFORMATION CONTACT: Paul Handleman, (202) 622-3040
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in these final regulations have been
reviewed and approved by the Office of
Management and Budget in accordance
with the Paperwork Reduction Act of

September 18, 2000

1995 (44 U.S.C. 3507) under control
number 1545-1661. Responses to these
collections of information are mandatory.
An agency may not conduct or sponsor,
and a person is not required to respond to,
a collection of information unless the collection of information displays a valid
control number.
The estimated annual burden per respondent varies from .5 hours to 1.5
hours, depending on individual circumstances, with an estimated average of 1
hour.
Comments concerning the accuracy of
these burden estimates and suggestions
for reducing these burdens should be sent
to the Internal Revenue Service, Attn:
IRS Reports Clearance Officer,
OP:FS:FP, Washington, DC 20224, and to
the Office of Management and Budget,
Attn: Desk Officer for the Department of
the Treasury, Office of Information and
Regulatory Affairs, Washington, DC
20503.
Books or records relating to this collection of information must be retained as
long as their contents may become material in the administration of any internal
revenue law. Generally, tax returns and
tax return information are confidential, as
required by 26 U.S.C. 6103.
Background
On September 20, 1999, the IRS published proposed regulations (REG–
106010–98, 1999–40 I.R.B. 493) in the
Federal Register (64 F.R. 50783) inviting comments under section 110. A public hearing was held January 19, 2000.
Numerous comments have been received.
After consideration of all the comments,
the proposed regulations are adopted as
revised by this Treasury decision.
Public Comments
In accordance with section 110(a), the
proposed regulations provided that
amounts provided to a lessee by a lessor
for property to be constructed and used by
the lessee pursuant to a lease are not includible in the lessee’s gross income if the
amount is a qualified lessee construction
allowance. The proposed regulations defined a qualified lessee construction allowance as any amount received in cash

272

(or treated as a rent reduction) by a lessee
from a lessor under a short-term lease of
retail space, provided the purpose and expenditure requirements are met.
Expenditure Requirement
The proposed regulations required that
a qualified lessee construction allowance
be expended by the lessee in the taxable
year received on the construction or improvement of qualified long-term real
property for use in the lessee’s trade or
business at the retail space. However, the
proposed regulations deemed an amount
to have been expended by a lessee in the
taxable year in which the construction allowance was received by the lessee if the
amount is expended within 8 1/2 months
after the close of that taxable year.
Several commentators maintained that
the proposed rule prescribing a time limit
for making the expenditure is not required
by the statute or the legislative history and
should be eliminated. One commentator,
for example, pointed out the absence of
an explicit expenditure requirement in
section 110 like the one found in section
118(c)(2)(B), which requires that an expenditure relating to a nontaxable contribution in aid of construction be made before the end of the second taxable year
after the year in which such amount was
received.
Section 110 does not provide an explicit expenditure time limit, but it also
does not toll the statute of limitations until
the taxpayer notifies the Secretary that the
amount has been expended as does section 118. The lack of a statute of limitation tolling provision in section 110
would be troublesome if there was no limitation on the time period to make the
qualified expenditure. In addition, section 110(a) provides that an amount may
be excluded only to the extent that such
amount does not exceed the amount expended by the lessee for the construction
or improvement of qualified long-term
real property.
The IRS and Treasury Department believe that the absence of an extension of
the statute of limitations and use of the
term “expended” in the past tense indicate
that the amount must be expended by the
end of the taxable year it is received. Ac-

2000–38 I.R.B.

cordingly, the final regulations retain the
expenditure time limitation. However, in
recognition that a lessee may not be able
to expend the amount in the same taxable
year the lessee receives the construction
allowance from the lessor, the final regulations also retain the 8 1/2 month rule
provided in the proposed regulations.
This 8 1/2 month rule, which grants the
lessee an additional 8 1/2 months after the
close of the taxable year in which the construction allowance was received to expend the amount, is consistent with the
time period, including extensions, that a
corporate taxpayer has to file its return for
the taxable year in which the construction
allowance is received.
Commentators requested that to the extent the final regulations retain the expenditure requirement, the requirement
should be modified to include construction allowances used to reimburse lessee
expenditures made in a prior year. In response to these comments, the final regulations clarify that, provided the lessee
has not depreciated the expenditures, reimbursements received in a taxable year
after the year in which the expenditures
are made by the lessee are timely for purposes of the expenditure requirement.
Purpose Requirement
Consistent with section 110(a), the proposed regulations provided that a qualified lessee construction allowance must
be under a short-term lease of retail space
and for the purpose of constructing or improving qualified long-term real property
for use in the lessee’s trade or business at
the retail space. The proposed regulations
required that the lease agreement for the
retail space expressly provide that the
construction allowance is for the purpose
of constructing or improving qualified
long-term real property for use in the
lessee’s trade or business at that retail
space. The purpose requirement was intended to further Congressional intent of
ensuring consistency in the treatment of
the construction allowance by both the
lessor and the lessee.
Commentators suggested deleting the
requirement in the proposed regulations
that the lease agreement “expressly provides” that a construction allowance be
for the purpose of constructing or improving qualified long-term real property.
Other commentators suggested changing

2000–38 I.R.B.

this language to “substantially provides”
or using a standard that would lead a reasonable person to conclude that the purpose of the construction allowance
amount is for the construction or improvement of qualified long-term real
property. The final regulations do not
adopt these suggestions. The IRS and the
Treasury Department believe that this express language is consistent with the requirements of section 110(a) and is necessary to help ensure that the lessor and the
lessee take consistent tax positions.
In addition, commentators noted that
lease agreements do not necessarily address construction allowances. The construction allowance provisions may be
contained in another document executed
contemporaneously with the lease agreement or executed during the lease term.
For example, the lessor may provide a
construction allowance during the lease
term for the remodeling of the retail space
by the lessee. In response to these comments, the final regulations clarify that an
ancillary agreement executed contemporaneously with the payment of a construction allowance, whether executed with the
lease or during the term of the lease, is
considered a provision of the lease agreement for this purpose.
Definition of Retail Space
Section 110(c)(3) defines the term “retail space” as real property leased, occupied, or otherwise used by a lessee in its
trade or business of selling tangible personal property or services to the general
public. The proposed regulations specifically requested comments on whether the
definition of “retail space” needs to be
clarified.
In response to comments, the final regulations clarify that offices for hair stylists, tailors, shoe repairmen, doctors,
lawyers, accountants, insurance agents,
financial advisors, stock brokers, securities dealers (including dealers who sell securities out of inventory), and bankers are
included in the definition of retail space.
The final regulations also clarify that a
taxpayer is selling to the general public if
the products or services for sale are made
available to everyone even though only
certain customers or clients are targeted.
A commentator suggested that retail
space should include back-office support
functions that are contiguous to the retail

273

sales area and not be limited only to areas
where customers purchase products and
services. Section 110(c)(3) and the proposed regulations only require that the
property be used “in the trade or business”
of selling tangible personal property or
services to the general public. In response
to these comments, the final regulations
state that the term “retail space” includes
not only the space where the retail sales
are made, but also space where activities
supporting the retail activity are performed (such as an administrative office, a
storage area, and an employee lounge).
Definition of Lease Term
Consistent with section 110(c)(2), the
proposed regulations defined a short-term
lease as a lease (or other agreement for
occupancy or use) of retail space for 15
years or less (as determined pursuant to
section 168(i)(3)). Section 168(i)(3) provides rules on determining when renewal
options will be considered part of the
lease term. Section 168(i)(3)(B) provides
that, in the case of nonresidential real
property or residential rental property,
any option to renew at fair market value,
determined at the time of renewal, is not
taken into account for purposes of determining the lease term.
A commentator suggested that the final
regulations stipulate that certain common
renewal options will be considered to be
at fair market value. For example, the
commentator suggested that if a lease sets
rent at a certain percentage of sales for the
original lease term and uses that same
percentage of sales for renewal options,
the renewals should be considered to be at
fair market value. As the comment relates
to the determination of lease term under
section 168 and would affect other provisions in addition to section 110 that reference section 168(i)(3), such as sections
142 and 280F, the comment is beyond the
scope of this regulation. Accordingly, the
final regulations do not adopt the suggested comment.
Information Requirement
The proposed regulations required
qualified lessee construction allowance
information to be furnished by the lessor
and the lessee to the IRS, and described
the time and manner for providing that information to the IRS. The proposed regulations also provided that a lessor or a

September 18, 2000

lessee that fails to furnish the required information may be subject to a penalty
under section 6721.
A commentator suggested that the required information to be furnished should
be the information that is current at the time
the lease is executed. According to the
commentator, it would not be unusual for a
lease to be executed years prior to the payment and receipt of the construction allowance. One of the parties to the lease
may have been acquired by another taxpayer or its name and address may have
changed.
The final regulations do not adopt the
suggestion. The purpose of the information
reporting by the lessor and the lessee is to
ensure consistent treatment of the construction allowance as nonresidential property
owned by the lessor. Accordingly, it is imperative that the identity of the persons paying and receiving the construction allowance amount and relevant information
provided be correct.
A commentator suggested that the information requirement should absolve the
party filing the information statement from
any penalty under section 6721 if the party
relied upon incorrect information received
from the other party or if the information
cannot be obtained from the other party
after reasonable efforts. Section 6724(a)
provides that no penalty shall be imposed
under section 6721 with respect to any failure if it is shown that such failure is due to
reasonable cause and not willful neglect.
Thus, no penalty under section 6721 will
apply to a lessor (or a lessee) if the failure
to furnish qualified lessee construction allowance information resulted from the
lessee (or the lessor) providing incorrect information to the other party to the lease
upon which the lessor (or the lessee) relied
in good faith.
Another commentator suggested that the
information to be furnished by a lessor is
duplicative because the lessee is required to
furnish the same information to the IRS.
According to the commentator, the lessee
should bear the entire burden of filing the
required information because the lessee is
the primary beneficiary of section 110. The
final regulations do not adopt the commentator’s suggestion. The information provided by the lessor is helpful in corroborating the information provided by the lessee
and ensures that the lessor treats the amount
as nonresidential real property on its return.

September 18, 2000

Moreover, the reporting requirement in section 110(d) specifically provides that both
the lessor and the lessee should furnish information.
Effective Date
The proposed regulations proposed an
effective date applicable to leases entered
into on or after the date final regulations are
published in the Federal Register. A commentator suggested delaying the effective
date of the final regulations to allow businesses a short period to conform their business practices to the final regulations. The
final regulations adopt this suggestion by
making the regulations effective 30 days
after the date the final regulations are published in the Federal Register.
Although the final regulations do not
provide for an election to apply the regulations retroactively, taxpayers who comply with the rules set forth in the regulations for leases entered into after August
5, 1997, and prior to the effective date of
the regulations (other than the reporting
requirement) will be treated as meeting
the requirements of section 110.
Special Analyses
It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations. It is hereby certified that the collection of information in these regulations
will not have a significant economic impact on a substantial number of small entities. This certification is based upon the
fact that any burden on taxpayers is minimal. Accordingly, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not
required. Pursuant to section 7805(f) of
the Internal Revenue Code, the notice of
proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact
on small business.
Drafting Information
The principal author of these regulations
is Paul F. Handleman, Office of the Associ-

274

ate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.
* * * * *
Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding an entry in
numerical order to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.110–1 also issued under 26
U.S.C. 110(d); * * *
Par. 2. Section 1.110–1 is added to
read as follows:
§1.110–1 Qualified lessee construction
allowances.
(a) Overview. Amounts provided to a
lessee by a lessor for property to be constructed and used by the lessee pursuant
to a lease are not includible in the lessee’s
gross income if the amount is a qualified
lessee construction allowance under paragraph (b) of this section.
(b) Qualified lessee construction allowance—(1) In general. A qualified
lessee construction allowance means any
amount received in cash (or treated as a
rent reduction) by a lessee from a lessor—
(i) Under a short-term lease of retail
space;
(ii) For the purpose of constructing or
improving qualified long-term real property for use in the lessee’s trade or business at that retail space; and
(iii) To the extent the amount is expended by the lessee in the taxable year
received on the construction or improvement of qualified long-term real property
for use in the lessee’s trade or business at
that retail space.
(2) Definitions—(i) Qualified longterm real property is nonresidential real
property under section 168(e)(2)(B) that
is part of, or otherwise present at, the retail space referred to in paragraph
(b)(1)(i) of this section and which reverts
to the lessor at the termination of the
lease. Thus, qualified long-term real
property does not include property qualifying as section 1245 property under section 1245(a)(3).

2000–38 I.R.B.

(ii) Short-term lease is a lease (or other
agreement for occupancy or use) of retail
space for 15 years or less (as determined
pursuant to section 168(i)(3)).
(iii) Retail space is nonresidential real
property under section 168(e)(2)(B) that
is leased, occupied, or otherwise used by
the lessee in its trade or business of selling tangible personal property or services
to the general public. The term retail
space includes not only the space where
the retail sales are made, but also space
where activities supporting the retail activity are performed (such as an administrative office, a storage area, and employee lounge). Examples of services
typically sold to the general public include services provided by hair stylists,
tailors, shoe repairmen, doctors, lawyers,
accountants, insurance agents, stock brokers, securities dealers (including dealers
who sell securities out of inventory), financial advisors and bankers. For purposes of this paragraph (b)(2)(iii), a taxpayer is selling to the general public if the
products or services for sale are made
available to the general public, even if the
product or service is targeted to certain
customers or clients.
(3) Purpose requirement. An amount
will meet the requirement in paragraph
(b)(1)(ii) of this section only to the extent
that the lease agreement for the retail
space expressly provides that the construction allowance is for the purpose of
constructing or improving qualified longterm real property for use in the lessee’s
trade or business at the retail space. An
ancillary agreement between the lessor
and the lessee providing for a construction allowance, executed contemporaneously with the lease or during the term of
the lease, is considered a provision of the
lease agreement for purposes of the preceding sentence, provided the agreement
is executed before payment of the construction allowance.
(4) Expenditure requirement—(i) In
general. Expenditures referred to in paragraph (b)(1)(iii) of this section may be
treated as being made first from the
lessee’s construction allowance. Tracing
of the construction allowance to the actual
lessee expenditures for the construction or
improvement of qualified long-term real
property is not required. However, the
lessee should maintain accurate records of
the amount of the qualified lessee con-

2000–38 I.R.B.

struction allowance received and the expenditures made for qualified long-term
real property.
(ii) Time when expenditures deemed
made. For purposes of paragraph
(b)(1)(iii) of this section, an amount is
deemed to have been expended by a
lessee in the taxable year in which the
construction allowance was received by
the lessee if—
(A) The amount is expended by the
lessee within 8 1/2 months after the close
of the taxable year in which the amount
was received; or
(B) The amount is a reimbursement
from the lessor for amounts expended by
the lessee in a prior year and for which the
lessee has not claimed any depreciation
deductions.
(5) Consistent treatment by lessor.
Qualified long-term real property constructed or improved with any amount excluded from a lessee’s gross income by
reason of paragraph (a) of this section
must be treated as nonresidential real
property owned by the lessor (for purposes of depreciation under 168(e)(2)(B)
and determining gain or loss under section 168(i)(8)(B)). For purposes of the
preceding sentence, the lessor must treat
the construction allowance as fully expended in the manner required by paragraph (b)(1)(iii) of this section unless the
lessor is notified by the lessee in writing
to the contrary. General tax principles
apply for purposes of determining when
the lessor may begin depreciation of its
nonresidential real property. The lessee’s
exclusion from gross income under paragraph (a) of this section, however, is not
dependent upon the lessor’s treatment of
the property as nonresidential real property.
(c) Information required to be furnished—(1) In general. The lessor and
the lessee described in paragraph (b) of
this section who are paying and receiving
a qualified lessee construction allowance,
respectively, must furnish the information
described in paragraph (c)(3) of this section in the time and manner prescribed in
paragraph (c)(2) of this section.
(2) Time and manner for furnishing information. The requirement to furnish information under paragraph (c)(1) of this
section is met by attaching a statement
with the information described in paragraph (c)(3) of this section to the lessor’s

275

or the lessee’s, as applicable, timely filed
(including extensions) Federal income tax
return for the taxable year in which the
construction allowance was paid by the
lessor or received by the lessee (either in
cash or treated as a rent reduction), as applicable. A lessor or a lessee may report
the required information for several qualified lessee construction allowances on a
combined statement. However, a lessor’s
or a lessee’s failure to provide information with respect to each lease will be
treated as a separate failure to provide information for purposes of paragraph
(c)(4) of this section.
(3) Information required—(i) Lessor.
The statement provided by the lessor must
contain the lessor’s name (and, in the case
of a consolidated group, the parent’s
name), employer identification number,
taxable year and the following information for each lease:
(A) The lessee’s name (in the case of a
consolidated group, the parent’s name).
(B) The address of the lessee.
(C) The employer identification number of the lessee.
(D) The location of the retail space (including mall or strip center name, if applicable, and store name).
(E) The amount of the construction allowance.
(F) The amount of the construction allowance treated by the lessor as nonresidential real property owned by the lessor.
(ii) Lessee. The statement provided by
the lessee must contain the lessee’s name
(and, in the case of a consolidated group,
the parent’s name), employer identification number, taxable year and the following information for each lease:
(A) The lessor’s name (in the case of a
consolidated group, the parent’s name).
(B) The address of the lessor.
(C) The employer identification number of the lessor.
(D) The location of the retail space (including mall or strip center name, if applicable, and store name).
(E) The amount of the construction allowance.
(F) The amount of the construction allowance that is a qualified lessee construction allowance under paragraph (b)
of this section.
(4) Failure to furnish information. A
lessor or a lessee that fails to furnish the
information required in this paragraph (c)

September 18, 2000

may be subject to a penalty under section
6721.
(d) Effective date. This section is applicable to leases entered into on or after
October 5, 2000.
PART 602—OMB CONTROL
NUMBERS UNDER THE
PAPERWORK REDUCTION ACT
Par. 3. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.

Par. 4. In §602.101, paragraph (b) is
amended by adding an entry for 1.110–1
to the table in numerical order to read as
follows:

Approved August 29, 2000.
Jonathan Talisman,
Acting Assistant Secretary
of the Treasury.

§602.101 OMB Control numbers.
(Filed by the Office of the Federal Register on September 1, 2000, 8:45 a.m., and published in the issue
of the Federal Register for September 5, 2000, 65
F.R. 53584)

*****
(b) * * *
Robert E. Wenzel,
Deputy Commissioner
of Internal Revenue.

CFR part or section where
identified and described

Current OMB
control No.

*****
1.110–1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1545-1661

*****

Section 368.—Definitions
Relating to Corporate
Reorganizations
26 CFR 1.368–1: Purpose and scope of exception of
reorganization exchanges.

T.D. 8898
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Continuity of Interest
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains
final regulations providing guidance regarding the continuity of interest requirement for corporate reorganizations. The
final regulations affect corporations and
their shareholders. The final regulations
provide that distributions and redemptions by a target corporation prior to a potential reorganization are taken into account for continuity of interest purposes
to the extent that the consideration received by the target shareholder in the redemption or distribution is treated as
other property or money under section
356 of the Internal Revenue Code, or to
the extent that the consideration would be
treated as other property or money if the
target shareholder also had received stock

September 18, 2000

of the issuing corporation in exchange for
stock owned by the shareholder in the target corporation.
DATES: Effective Dates: These regulations are effective August 30, 2000.
Applicability Dates: For dates of applicability of these regulations, see the
“Effective Dates” portion of the Supplementary Information of the preamble.
FOR FURTHER INFORMATION CONTACT: Marie Byrne, (202) 622-7750 (not
a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information in these
final regulations has been reviewed and,
pending receipt and evaluation of public
comments, approved by the Office of
Management and Budget (OMB) under
44 U.S.C. 3507 and assigned control
number 1545-1691.
The collection of information in these
regulations is in §1.368–1(e)(7). The information is a private letter ruling request
to apply the final regulations to a transaction in which a taxpayer has entered into a
binding agreement on or after January 28,
1998 (the effective date of §1.368–1T),
and before the effective date of the final
regulations. This information will be
used to ensure that all parties to the transaction take consistent positions for Federal tax purposes. The collection of infor-

276

mation is elective. If §1.368–1T would
apply to a transaction, but the taxpayer
would prefer to apply the final regulations, the taxpayer may elect to submit the
information. The likely respondents are
businesses or other for-profit institutions.
Comments concerning the collection of
information should be sent to the Office
of Management and Budget, Attn: Desk
Officer for the Department of Treasury,
Office of Information and Regulatory Affairs, Washington, DC 20503, with copies
to the Internal Revenue Service, Attn:
IRS Reports Clearance Officer,
OP:FS:FP, Washington, DC 20224. Any
such comments should be submitted not
later than October 30, 2000.
Comments are specifically requested
concerning:
(a) Whether the collection of information is necessary for the proper performance of the functioning of the Internal
Revenue Service, including whether the
information will have practical utility;
(b) The accuracy of the estimated burden associated with the collection of information (see below);
(c) How the quality, utility, and clarity of
the information requested may be enhanced;
(d) How the burden of complying with
the collection of information may be minimized, including through the application of
automated collection techniques or other
forms of information technology; and
(e) Estimates of capital or start-up
costs, and costs of operation, mainte-

2000–38 I.R.B.