an agent; rather, an agency relationship is established when it appears, based on all the facts and circumstances, that the payer of the income is looking directly to the order, rather than to the individual member, for the performance of services.

Ordinarily, a religious order is not engaged in the performance of services as a principal where the legal relationship of employer and employee exists between the member and a third party with respect to the performance of such services. Accordingly, although the chaplain was required by the order to enter the Armed Forces, to perform religious work while in the Armed Forces, and to turn over to the order the wages earned, the direct relationship between the Armed Forces and the individual chaplain establishes an employer-employee and an agency relationship between them so that the service performed by the member as a chaplain is not considered the exercise of duties required by such order. HOLDINGS

1. The chaplain is required to inIclude in gross income the entire remuneration received to the extent such remuneration is not excludable from gross income under any provision of the Code.

2. The remuneration is subject to income tax withholding.

3. The services of the chaplain are not excepted from "employment" by section 3121 (b) (8) of the Code.

EFFECT ON OTHER REVENUE RULINGS

Revenue Ruling 77-290, 1977-2 C.B. 26, is amplified.

26 CFR 1.61-3: Gross income derived from business.

Whether a taxpayer that is adopting a full absorption method of inventory costing as required by section 1.471-11 of the regulations has a right to change from a method of accounting that does not provide for the inclusion in inventory of a cost(s) listed in section 1.471-11 (c) (2) (ii) to a

method that provides for such inclusion. See Rev. Rul. 79-25, page 186.

26 CFR 1.61-4: Gross income of farmers.

Rev. Proc. 78-22, 1978-2 C.B. 499, setting forth procedures for certain farmers, nurserymen, and florists to change their method of accounting to the cash receipts and disbursements method of accounting is revoked. See Rev. Proc. 79-16, page 516.

26 CFR 1.61-4: Gross income of farmers.

Farmers, nurserymen, and florists are not required to inventory growing crops, trees or plants. Rev. Rul. 76-242, 1976-1 C.B. 132 and Rev. Rul. 77-64, 1977-1 C.B. 136, modifying Rev. Rul. 76-242, are revoked. See Rev. Rul. 79-102, page 184.

26 CFR 1.61-4: Gross income of farmers.

Whether livestock raised and purchased for breeding purposes are "inventory assets" as defined in section 312(b) of the Code when the cost of raising and purchasing the breeding stock is properly capitalized and depreciated, rather than included in inventory, for federal income tax purposes. See Rev. Rul. 79-149, page 132.

26 CFR 1.61-7: Interest.

Whether interest that a lender receives on its loan to a city is exempt from tax. See Rev. Rul. 79-108, page 75.

26 CFR 1.61-7: Interest.

Whether interest to be paid on obligations of a political subdivision of a state will be exempt from tax. See Rev. Rul. 79135, page 78.

26 CFR 1.61-7: Interest.

Whether interest paid on obligations of a city is exempt from tax. See Rev. Rul. 79-172, page 79.

Section 63.-Taxable Income
Defined

The zero bracket amount, general tax credit, and use of tax rate schedules and tax tables of a United States citizen or resident married to a nonresident alien in 1977. See Rev. Rul. 79-23, page 3.

26 CFR 1.63-1: Change of treatment with respect to the zero bracket amount and itemized deductions.

(Also Section 6654; 1.6654-2.)

T.D. 7585 TITLE

26.-INTERNAL REVENUE. CHAPTER I, SUBCHAPTER A, PART 1.-INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Change of treatment with respect to itemized deductions; annualization of taxable income for purposes of estimated tax rules.

AGENCY: Internal Revenue Service, Treasury.

ACTION: Final regulations.

SUMMARY: This document provides final regulations on two matters: a change of treatment with respect to the zero bracket amount and itemized deductions after the taxpayer has filed a return for the taxable year, and the annualization of taxable income for purposes of determining whether an addition to tax is imposed for underpayment of estimated tax. The Tax Reduction and Simplification Act of 1977 [Pub. L. 95-30, 1977-1 C.B. 451] amended the applicable tax law. These regulations provide the public with the necessary guidance on these two

matters.

EFFECTIVE DATE: The regulations are effective for taxable years beginning after 1976.

FOR FURTHER INFORMATION CONTACT: Paul A. Francis 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) (202566-6640).

SUPPLEMENTARY INFORMATION:

BACKGROUND

On August 30, 1978, the Federal Register published proposed amendments to the Income Tax Regulations (26 CFR Part 1) under sections 63

and 6654 of the Internal Revenue Code of 1954 (43 F.R. 38725). The amendments were proposed to conform the regulations to section 102(a) and (b)(16) of the Tax Reduction and Simplification Act of 1977 (91 Stat. 135, 139). No written comments were submitted regarding the proposed regulations, and no public hearing was requested or held. The proposed amendments are adopted without change by this Treasury decision.

CHANGE OF TREATMENT WITH RESPECT TO ITEMIZED DEDUCTIONS

The Tax Reduction and Simplification Act of 1977 redefined the term "taxable income" and eliminated the concept "standard deduction" from the Internal Revenue Code. For taxable years beginning after 1976, a taxpayer generally may elect to itemize deductions only if the taxpayer has itemized deductions in excess of the taxpayer's zero bracket amount. Certain taxpayers who were prohibited from taking the standard deduction or whose standard deduction was subject to special restrictions under prior law are treated as having elected to itemize deductions under the new law.

New Code section 63(g) (5) provides that a taxpayer may change a decision with respect to itemizing deductions after the taxpayer has filed a return for the taxable year. This privilege is subject to restrictions similar to those that applied to changes with respect to the standard deduction under prior law.

In addition to the general rule that taxpayers may change the treatment of itemized deductions, new § 1.63-1 sets forth the special requirements applicable to spouses filing separate returns. The new regulations also state the exception to the general rule for taxable years for which the tax liability of either the taxpayer or the taxpayer's spouse has been compromised. The new regulations were adapted from § 1.144-2 which dealt

with changes of election with respect to the standard deduction under prior law.

ANNUALIZATION OF TAXABLE INCOME IN CONNECTION WITH UNDERPAYMENT OF

ESTIMATED TAX

Section 6654 of the Code imposes an addition to tax on individuals who fail to make sufficient estimated income tax payments. There is no addition to tax, however, if the payments made by an individual equal or exceed any of several amounts specified in section 6654(d). In order to determine one of those amounts, it is necessary to place the taxable income for a given period on an annualized basis. For taxable years beginning before 1977, section 6654 and § 1.6654-2 (a) (2) set forth the method by which taxable income had to be annualized.

The redefinition of the term "taxable income" by the Tax Reduction and Simplification Act of 1977 makes a revision of that method necessary for taxable years beginning after 1976. That Act amended section 6654(d) (2) to provide that the regulations should prescribe the new method for annualizing taxable income. The report of the Senate Finance Committee indicated the method intended by Congress. S. Rep. No. 95-66, 95th Cong., 1st Sess. 59 (1977) [1977-1 C.B. 469].

The regulations, as amended by this Treasury decision, provide that an affected taxpayer first annualize the adjusted gross income and itemized deductions for the months in question. The taxpayer then determines any excess itemized deductions or unused zero bracket amount and computes annualized tax table income. If the taxpayer is unable to use the tax tables to determine tax at this point, the taxpayer deducts personal exemptions from annualized tax table income to arrive at annualized taxable income. The amendment adds two new examples to § 1.6654-2 (c) to illustrate these computations.

DRAFTING INFORMATION

The principal author of these regulations is Paul A. Francis 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.

MISCELLANEOUS MATTERS

The regulations adopted by this Treasury decision impose no new reporting burdens or recordkeeping requirements. The principal effect of the final regulations is to conform the Income Tax Regulations under sections 63 and 6654 of the Code to changes made by the Tax Reduction and Simplification Act of 1977. The Treasury Department will review these regulations from time to time in light of comments received from offices within the Treasury Department and Internal Revenue Service or from the public.

Adoption of amendments of the regulations

The following amendments to 26 CFR Part 1 are hereby adopted: Paragraph 1. Section 1.63 is deleted. Par. 2. The following new section is added immediately after § 1.62-1:

§ 1.63-1 Change of treatment with re

spect to the zero bracket amount and itemized deductions.

(a) In general. An individual who files a return on which the individual itemizes deductions in accordance with section 63(g) may later make a change of treatment by recomputing taxable income for the taxable year to which that return relates without itemizing deductions. Similarly, an individual who files a return on which the individual computes taxable income without itemizing deductions may later make a change of treatment by itemizing deductions in accordance

with section 63(g) in recomputing taxable income for the taxable year to which that return relates.

(b) No extension of time for claiming credit or refund. A change of treatment described in paragraph (a) of this section does not extend the period of time prescribed in section 6511 within which the taxpayer may make a claim for credit or refund of tax.

(c) Special requirements if spouse filed separate return (1) Requirements. If the spouse of the taxpayer filed a separate return for a taxable year corresponding to the taxable year of the taxpayer, the taxpayer may not make a change of treatment described in paragraph (a) of this section for that year unless

(i) The spouse makes a change of treatment on the separate return consistent with the change of treatment sought by the taxpayer; and

(ii) The taxpayer and the taxpayer's spouse file a consent in writing to the assessment of any deficiency of either spouse to the extent attributable to the change of treatment, even though the assessment of the deficiency would otherwise be prevented by the operation of any law or rule of law. The consent must be filed with the district director for the district in which the taxpayer applies for the change of treatment, and the period during which a deficiency may be assessed shall be established by agreement of the spouses and the district director.

(2) Corresponding taxable year. A taxable year of one spouse corresponds to a taxable year of the other spouse if both taxable years end in the same calendar year. If the taxable of year one spouse ends with death, however, the corresponding taxable year of the surviving spouse is that in which the death occurs.

(d) Inapplicable if tax liability has been compromised. The taxpayer may not make a change of treatment described in paragraph (a) of this section for any taxable year if—

Par. 3. Section 1.6654 is deleted.

Par. 4. Section 1.6654-2 is amended by revising paragraph (a) (2) (i), by revising the last sentence of paragraph (a)(2)(ii), and by adding new examples (8) and (9) at the end of paragraph (c). These revised and added provisions read as follows:

§ 1.6654-2 Exceptions to imposition of the addition to the tax in the case of individuals.

(a) In general. * *
(2) ***

(i) Taxable income shall be placed on an annualized basis

(A) For taxable years beginning after 1976, by

(1) Multiplying by 12 (or the number of months in the taxable year if less than 12) the adjusted gross income and the itemized deductions for the calendar months in the taxable year ending before the month in which the installment is required to be paid,

(2) Dividing the resulting amounts by the number of such calendar months,

(3) Increasing the amount of the annualized adjusted gross income by the unused zero bracket amount, if any, determined by reference to the annualized itemized deductions, or decreasing the amount of the annualized adjusted gross income by the excess itemized deductions, if any, determined by reference to the annualized itemized deductions (the amount resulting under this step is annualized tax table income), and

(4) Deducting from the annualized

tax table income the deduction for personal exemptions (such personal exemptions being determined as of the date prescribed for payment of the installment).

If the taxpayer would be eligible to use the tax tables on the basis of annualized tax table income, the amount which would have been required to be paid for purposes of this subparagraph may be determined by applying the tax tables to annualized tax table income, the amount resulting under (3).

(B) For taxable years beginning before 1977, by

(1) Multiplying by 12 (or the number of months in the taxable year if less than 12) the taxable income (computed without the standard deduction and without the deduction for personal exemptions), or the adjusted gross income if the standard deduction is to be used, for the calendar months in the taxable year ending before the month in which the installment is required to be paid,

(2) Dividing the resulting amount by the number of such calendar

months, and

eral tax credit. C filed a declaration of estimated tax on April 15, 1977, and on or before September 15, 1977, makes estimated tax payments for 1977 which total $460. For purposes of determining whether the exception described in paragraph (a) (2) of this section applies, the following computations are necessary:

Adjusted gross income for the pe-
riod ending August 31, 1977,
on an annual basis ($4,000 ×
128)
Itemized deductions for the pe-
riod ending August 31, 1977,
on an annual basis ($300 X
12 ÷ 8)
Unused zero bracket amount
computation required under
section 63 (e) (1) (D)

Zero bracket amount-- $2,200

Annualized itemized

$6,000

$ 450

450

$1,750

come

$6,000

$ 757

Amount specified in paragraph

(a) (2) of this section (34 X
80% x $757)

$ 454.20 The exception described in paragraph (a) (2) applies, and no addition to tax will be imposed.

Example (9). D, an unmarried taxpayer entitled to one exemption, has adjusted gross income of $16,000 and itemized deductions of $2,000 for the period January 1, 1977, through August 31, 1977. D has no net earnings from self-employment and is entitled to no credits other than the general tax credit. D files a declaration of estimated tax on April 15, 1977, and on or before September 15, 1977, makes estimated tax payments for 1977 which total $3,000. For purposes of determining whether the exception in paragraph (a) (2) of this section applies, the following computations are necessary:

Adjusted gross income for the period ending August 31, 1977, on an annual basis ($16,000 × 12 ÷ 8)

$24,000

PART 20.-ESTATE TAX; ES-
TATES OF DECEDENTS DY-
ING AFTER AUGUST 16, 1954

Group-term life insurance AGENCY: Internal Revenue Service, Treasury.

ACTION: Final regulations.

SUMMARY: This document provides final regulations relating to group-term life insurance purchased for employees. Questions have arisen concerning the tax treatment of insurance provided employees under policies that include permanent benefits. These regulations help employers and others determine when insurance is group-term life insurance the cost of which may be excludable from the income of insured employees.

DATES: The regulations are generally effective for taxable years beginning on or after January 1, 1977 or January 1, 1978, depending on when the employer entered into an arrangement to provide insurance.

FOR FURTHER INFORMATION CONTACT: John H. Parcell of the Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC 20224, Attention: CC: LR:T, 202-566-3828, not a toll-free call.

SUPPLEMENTARY INFORMATION

BACKGROUND

On January 5, 1978, the Federal Register published proposed amendments to the Income Tax Regulations (26 CFR Part 1) under section 79 of the Internal Revenue Code of 1954 (43 FR 976). The proposed amendments also contained nonsubstantive revisions of certain cross-references in the Income Tax Regulations under sections 61 and 6052 of the Code and the Estate Tax Regulations (26 CFR Part 20) under section 2042 of the

Code. The amendments were proposed to prescribe rules for the tax treatment of life insurance provided employees under policies that include permanent benefits. A public hearing was held on April 26, 1978. After consideration of all comments regarding the proposed amendments, those amendments are adopted as revised by this Treasury decision. The preamble to the notice of proposed rulemaking summarizes and explains the proposed amendments. The remainder of this preamble discusses the major comments from the public and changes to the proposed regulations and sets. forth additional information_required by paragraph 13(c) of Executive Order 12044.

PERMANENT BENEFITS

The proposed regulations required that an employee must be able to decline or drop the permanent benefit without affecting the amount of groupterm life insurance provided. Approximately 200 comments objected. to the effect of this requirement on certain group paid-up life insurance plans. The commenters consider this requirement inappropriate because they believe it is inconsistent with past administrative practice, it would impose additional administrative burdens, it would lead to individual selection, it would discourage employees from purchasing permanent insurance, and it might cause employers to reduce the benefits provided to employees. In addition, the commenters suggested that there is no need for this requirement because the amount included in an employee's income under the proposed regulations is determined without regard to the allocation of premiums in the policy. However, the comments do not establish any significant distinction between policies that do not permit an employee to decline or drop the permanent benefit and other forms of permanent insurance. Therefore, the Treasury decision retains a modified

version of this rule. Under the rule in the proposed regulations, if an employee who declines or drops the permanent benefit receives a greater amount of current life insurance than an employee who accepts the permanent benefit, the excess does not qualify under section 79. The Treasury decision modifies this rule to permit the excess to qualify under section 79.

OTHER BENEFITS

A similar issue has arisen in connection with benefits other than permanent benefits. The issue, which was not considered in the proposed regulations, is whether an employee can be required to purchase these other benefits to obtain group-term life insurance. It arises because insurance does not qualify under section 79 unless it is provided to a group of employees membership in which is determined on the basis of age, marital status, or factors related to employment. The Treasury decision provides that the purchase of any benefit (other than certain tax-favored employee benefits) is not a factor related to employment. Thus, life insurance generally does not qualify under section. 79 if an employee must purchase any other benefit to obtain the insurance. However, participation in an employer's contributory pension, profitsharing, or accident and health plan is considered a factor related to employment.

DEFINITION OF POLICY

A number of comments were received on the definition of "policy". The proposed regulations treated as a single policy two or more obligations of an insurer that are interrelated or sold in conjunction. Some comments suggested that the term and permanent portion of a combination policy be treated as separate policies if they are actuarially independent and separate in form. If this suggestion had been adopted, the permanent portion of such a policy would not have been

subject to the formula for determining the cost of permanent benefits. This Treasury decision retains a modified version of the rule in the proposed regulations because the Service is unable to determine when obligations that are sold in conjunction are economically independent of each other. The Treasury decision provides that obligations sold in conjunction are a policy and clarifies the meaning of "sold in conjunction". The Treasury decision states that obligations are sold in conjunction when they are offered or available because of the employment relationship.

DIFFERENT INSURERS

A similar issue arose in connection with insurance provided by different insurers. Under the proposed regulations it was not clear whether insurance provided by different insurers could be aggregated for purposes of determining whether the insurance is subject to the special rules applicable to groups of fewer than 10 employees and otherwise satisfies the requirements of the regulations. Several comments pointed out that aggregation is permitted under the current regulations. This issue is more appropriately addressed in connection with the regulations project dealing with evidence of insurability (LR-42-78). Accordingly, this Treasury decision makes it clear that aggregation is still permitted. For the same reason, a number of comments suggesting changes in the rules applicable to groups of fewer than 10 employees are being considered in connection with LR-42-78.

BENEFITS AVAILABLE
TO EMPLOYEE

A number of comments were received on the definition of "permanent benefit." Some comments suggested limiting permanent benefits to benefits available to the employee. This suggestion is adopted in the Treasury decision.