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Restricted stock: The Tax Impact On Employers and Employees - Part 4 of 4

G. Edgar Adkins, Jr., and Jeffrey A. Martin of Grant Thornton LLP


Dividends

Some employers choose to pay dividends on restricted stock. In that event, income must be recognized by the employee. The question is whether it is compensation income (i.e., subject to ordinary income tax rates) or dividend income (i.e., subject to the favorable tax treatment of qualified dividends under Section 1(h)(11)). The answer depends on whether a Section 83(b) election has been made. If no Section 83(b) election has been made, then the dividend is compensation income (i.e., ordinary income) and is deductible by the employer as compensation expense.[37] If a Section 83(b) election has been made, however, the dividends are treated as dividend income rather than compensation.[38]

Withholding and employment taxes

The income derived by an employee from restricted stock is treated as compensation. Thus, income tax withholding is required, as well as the payment of FICA and FUTA taxes. These obligations occur at the same time that the employee recognizes income. Thus, for restricted stock, the obligations arise when the stock becomes vested.[39] If, however, a Section 83(b) election is made, the obligations arise when the election is made rather than on the vesting date.

For purposes of determining the amount of income tax withholding, the employer may treat the income associated with restricted stock as regular wages. If the income associated with the restricted stock is a relatively large amount, however, this treatment may result in a large amount of withholding. Employees may find the withholding amount excessive. As an alternative to treating the restricted stock income as regular wages, the employer may treat the income as supplemental wages, subject to a flat (and perhaps lower) withholding rate.[40]

The withholding rate for supplemental wages is 25% on the first $1 million paid to the employee during the calendar year, and 35% on the amounts in excess of $1 million.[41] All supplemental wages paid to the employee by the employer and related employers during the calendar year must be aggregated in order to determine whether the $1 million threshold has been reached. The flat rates are applied without regard to the number of withholding allowances claimed by the employee on Form W-4.[42]

The total FICA tax rate is 7.65%, payable by both the employer and the employee (i.e., a combined tax rate of 15.3%).[43] Of this amount, 6.2% is paid on a limited amount of inflation-adjusted income ($97,500 in 2007), and many employees will reach this limit without regard to any income attributable to restricted stock. The remaining 1.45% is applied to total income with no limitation and can be a significant amount with respect to restricted stock.

The FUTA tax rate is generally only 0.8% and is payable on a limited amount of inflation-adjusted income ($7,000 in 2007).[44] Thus, FUTA taxes rarely will have any impact on employees with respect to restricted stock.

Tax withholding may be a challenge, since the compensation related to restricted stock is not paid in cash. This raises the issue of how the withholding obligation from the employee will be satisfied. The easiest approach is for the employer to withhold from the employer's regular cash compensation. Where there is a relatively large amount of income related to the restricted stock, however, the employee's regular compensation may not be adequate to meet the withholding obligation. In that event, the employee and employer must make other arrangements to meet the withholding obligation. One approach is for the employee to provide the cash to the employer to satisfy the withholding obligation. This approach may be burdensome for the employee, who may not have the cash on hand to make the payment.

Another approach involves the employee's transferring some of the stock to the employer in order to satisfy the withholding obligation. Presumably, an employer would permit this only for stock that is vested. The transfer of the stock would be treated as a sale by the employee, which itself would generate an additional income tax liability; the additional income is not compensation income, so it would not be subject to withholding. Yet another approach is for the employer to gross-up the employee for the taxes. This is expensive for the employer, because the gross-up itself is taxable to the employee, which in turn leads to an additional income tax liability. Thus, gross-ups have a pyramiding effect. For example, at a 35% rate the gross-up for $1,000 of income is $538.[45]

A Section 83(b) election can create interesting timing issues with respect to withholding and employment taxes, as illustrated below.

Example 3: An employee receives restricted stock on Dec. 15, 2007. The employee submits a Section 83(b) election to the employer on Jan. 12, 2008 (i.e., within the 30-day election period). The employee will recognize income as of the grant date, which occurred in 2007. Thus, if the employer has already prepared the employee's Form W-2, a corrected form (i.e., Form W-2C) will have to be prepared. Nevertheless, it will be too late to withhold and pay taxes in 2007.

There is no IRS guidance on how to handle this particular situation, and employers have taken various approaches. Regardless of the specific approach taken, the income to the employee must be reported in the proper year, and the FICA taxes ultimately must be paid. Some employers argue that the withholding of income taxes is less important in this situation, since the employee ultimately will pay the income taxes on filing the income tax return.

Tax treatment when vested stock becomes nonvested

It is possible that vested stock may become nonvested at some point in the future (i.e., the opposite of what usually happens with respect to restricted stock). This is most likely to occur in connection with a corporate transaction. In Rev. Rul. 2007-49, the IRS recently addressed the tax impact of three specific situations where this occurs.

In the first situation, new investors in a corporation reach an agreement with an employee under which vested stock that the employee previously received in connection with his services will become nonvested for a period of two years (as an incentive for the employee to remain with the company). The IRS concluded that neither the agreement to change the vested status of the stock nor the subsequent vesting of the stock in two years will have any tax effect, since for tax purposes the employee already has recognized income with respect to the stock and is treated as the owner of the stock for tax purposes.

In the second situation, the employer is acquired by another corporation in a Section 368(a) tax-free reorganization. The employee exchanges his vested stock in the employer for nonvested stock in the acquiring corporation. The employee timely files a Section 83(b) election in connection with the nonvested stock. The IRS concluded that the Section 83(b) election is valid, and that for purposes of the election, the amount paid by the employee for the nonvested stock is the FMV of the employer's vested stock that was exchanged for the acquiring corporation's nonvested stock. Since the FMV of the acquiring corporation's stock and the employer's stock is the same at the time of the exchange, the amount of gross income recognition in connection with the Section 83(b) election is zero. The employee's basis in the new stock is his basis in the original employer stock.

In the third situation, the facts are the same as in the second situation except that the employer is acquired by another corporation in a fully taxable transaction. The employee recognizes a capital gain equal to the difference between the value of the acquiring corporation's stock and his basis in the employer stock, despite the fact that his stock in the acquiring corporation is not vested. The employee's basis in the acquiring corporation's stock will be equal to the FMV of the employer's stock on the exchange date. The employee will recognize compensation income when he vests in the acquiring corporation's stock, in an amount equal to the appreciation in the stock value between the date it was issued and the vesting date. The employee may make a Section 83(b) election in connection with the nonvested stock of the acquiring corporation. If he does so, there will be no income recognized on making the election, for the same reasons as described above for the second situation. In addition, there will be no income recognized on the vesting of the stock, due to the fact that the Section 83(b) election was made.

Deduction by the employer

Section 83(h) provides that the employer receives an income tax deduction with respect to restricted stock in "an amount equal to the amount included" in income by the employee. Thus, the employer receives a deduction on the vesting of the stock, unless the employee makes a Section 83(b) election. In the latter instance, the employer obtains a deduction on the granting of the stock.

Some employers choose to issue restricted stock units rather than restricted stock, because employees cannot make a Section 83(b) election in connection with restricted stock units. Employers who make this choice typically do so because they do not want to keep track of whether employees have made the election, and they do not want the employees' decisions to determine the timing and amount of their tax deduction (especially when they believe that the value of the stock will increase significantly in the future).

The statute uses "included" rather than "includable." Tax practitioners generally interpret this to mean that the employee must actually include the amount in income in order for the employer to obtain a deduction. Of course, the employer is usually in no position to know whether the employee actually includes the amount in income. Fortunately, the regulations provide that if the employer reports the income on the employee's Form W-2, then the employee is deemed to have included the amount in income.[46]

The Federal Circuit has held that "included" means that the employee was legally required to report an amount in income.[47] Thus, according to the court, the employee's actual inclusion of an amount in income is not required in order for the employer to obtain a deduction. Despite this interpretation, it seems prudent for employers to issue a Form W-2 to employees to report the income, in order to ensure a proper deduction, regardless of how the word "included" is interpreted.

If the employer's and employee's tax years coincide (i.e., a calendar year), the employer obtains the deduction in the same tax year that the employee includes the amount in income. If the employer's and employee's tax years do not coincide, the employer obtains the deduction in the tax year in which the employee's tax year ends.

Example 4: The employer's tax year ends on June 30. The employee's restricted stock vests on May 31, 2008. The employee will recognize the amount in income in the tax year that ends on Dec. 31, 2008. The December 31 date falls within the employer's tax year that ends on June 30, 2009, which thus is the year in which the employer takes the deduction.

Parent stock. An issue that arises when restricted stock in a parent corporation is granted to employees of a subsidiary corporation is who gets the deduction, the parent or the subsidiary? This is important when the parent and subsidiary do not file a consolidated income tax return (e.g., a foreign parent and a U.S. domestic subsidiary). The transfer of the stock is treated as a two-step transaction, as follows:

(1) A contribution of the stock by the parent to the capital of the subsidiary, and

(2) A transfer of the stock by the subsidiary to the employee.

Thus, the subsidiary is entitled to the deduction, because it is the subsidiary that has transferred the stock to the employee.[48]

Impact on other areas of tax law

The primary tax impact of restricted stock relates to the employee's inclusion of the value in gross income and the employer's deduction. Restricted stock also affects other areas of tax law, including the Section 162(m) deduction limit on compensation, the Section 280G golden parachute rules, the Section 409A nonqualified deferred compensation plan rules and special considerations related to S corporations.

$1 million deduction limitation

A public company's deduction for compensation paid to a "covered employee" is limited to $1 million per year under Section 162(m)(1). "Covered employee" includes the company's chief executive officer (CEO) and its three highest-paid officers other than the CEO and chief financial officer.[49] Equity-based compensation, including restricted stock, may significantly contribute to a covered employee's compensation, causing it to exceed $1 million. Performance-based compensation (e.g., a bonus that meets certain conditions) is deductible without regard to the $1 million limit.[50]

Restricted stock is not performance-based compensation, however. Reg. 1.162-27(e)(2)(vi)(A) provides that "if the amount of compensation the employee will receive under the grant or award is not based solely on an increase in the value of the stock after the date of grant or award (e.g., in the case of restricted stock ...), none of the compensation attributable to the grant or award is qualified performance-based compensation...." (Emphasis added.)

Fortunately, the regulation provides a clear way for restricted stock to qualify as performance-based compensation. Specifically, if the restricted stock is granted or becomes vested as a result of the attainment of a performance goal, then the restricted stock qualifies as performance-based compensation. Several requirements must be met in order for compensation to be treated as performance-based compensation:

  • The grant or vesting must be contingent on attaining pre-established performance goals determined by the compensation committee;
  • The compensation committee must be made up solely of two or more outside directors;
  • The material terms of the restricted stock plan must be disclosed and approved by a shareholder vote; and
  • The compensation committee must certify that the performance goals were met before the restricted stock is granted or vested.

Golden parachute payments

Restricted stock also can affect the application of the golden parachute rules under Section 280G. These rules apply to corporations that undergo a change in ownership or effective control of the corporation or in the ownership of a substantial portion of the corporation's assets, except for corporations that qualify as a "small business corporation" under Section 1361.[51] If payments made to certain individuals in connection with a change in control exceed three times the average of their annual compensation for the prior five years, the payments are "excess parachute payments." Payments made by a private company that have been approved by more than 75% of the shareholders are not treated as parachute payments.[52] The excess parachute payments are nondeductible by the employer and are subject to a 20% excise tax on the part of the individual.[53]

These rules apply to payments that are contingent on a change in control and are known as parachute payments.[54] Restricted stock agreements often provide for accelerated vesting on a change in control. This accelerated vesting causes the restricted stock to be treated as a parachute payment. The amount of the parachute payment consists of two components.

The first component measures the time-value difference between receiving money at the time of the change in control vs. receiving it later (on the normal vesting date).[55] The second component places a somewhat arbitrary value on the fact that the vesting period has been cut short; the value attributable to this component is equal to 1% of the stock's value for each month that the vesting is accelerated.[56] This second component can be a significant amount when the change in control occurs long before the regular vesting date. If the vesting conditions associated with the restricted stock involve more than simply continued employment, such as the satisfaction of performance conditions discussed above, then the two components described above are ignored and the entire value of the stock is treated as a parachute payment.[57]

A question arises when the stock for which vesting is accelerated on a change in control already has been included in income due to a Section 83(b) election in a tax year prior to the change in control. Logically, one might conclude that this stock is not a parachute payment because it has already been included in the employee's income. The regulations provide, however, that the restricted stock will be treated as a parachute payment when the stock actually vests, rather than when the Section 83(b) election was made.[58] Thus, the calculations described above for determining the parachute payment amount apply even when a Section 83(b) election has been made.

For purposes of the Section 280G rules, a change in ownership or control occurs when a person, or group of persons acting as a group, acquires stock that, together with stock already held by the person or group, causes them to possess more than 50% of the total FMV or voting power of the stock.[59] A change in control also occurs if a person, or a group of persons acting as a group, acquires ownership of stock within the last 12 months possessing 20% or more of the total voting power of the corporation.[60] Restricted stock is generally not treated as outstanding stock for purposes of determining whether a change in control has occurred. If an employee has made a Section 83(b) election, however, the stock is treated as outstanding.[61]

The individuals to whom the golden parachute rules apply are known as "disqualified individuals." The term includes officers, shareholders who own stock with an FMV in excess of 1% of the value of all outstanding shares of the employer and individuals who are among the highest paid 1% of the employer's employees.[62] When determining whether an employee-shareholder has reached the 1% ownership threshold, restricted stock generally is not taken into account. If the individual has made a Section 83(b) election with respect to her restricted stock, however, those shares are treated as outstanding and are included in the employee's total shares owned.[63]

Nonqualified deferred compensation plans

Section 409A places restrictions on arrangements that defer compensation. These restrictions apply to elections to defer compensation, the funding of the deferred compensation and distributions of the deferred compensation.[64] If the arrangement fails to comply with these restrictions, the deferred compensation is subject to income tax immediately on vesting, along with a 20% additional tax and interest.[65]

Restricted stock is specifically exempt from Section 409A.[66] Some types of restricted stock units, however, are subject to Section 409A. Specifically, if the stock that will be transferred in connection with the restricted stock unit is vested at the time of the transfer, then the restricted stock unit is subject to Section 409A.[67] In contrast, a restricted stock unit that will result in the transfer of nonvested stock is not subject to Section 409A (presumably because this is equivalent to a transfer of restricted stock, and restricted stock is exempt from Section 409A).[68] For a restricted stock unit that is subject to Section 409A, the primary impact is that the stock's transfer date or triggering event (such as on a change of control) must be specified at the time the restricted stock unit is granted. (A further discussion of the impact of the Section 409A requirements on restricted stock units is beyond the scope of this article.)

S corporations

Several requirements must be met in order for S corporation status to be available. Two of these warrant special attention when the corporation issues restricted stock, i.e., the corporation (1) may have no more than 100 shareholders and (2) may have only one class of stock.[69]

Restricted stock is ignored for S corporation purposes until it becomes vested.[70] Thus, the individuals who hold restricted stock are not counted towards the 100-shareholder limit, and the restricted stock is ignored for purposes of determining whether there is more than one class of stock. When the restricted stock vests, however, the individuals who hold the stock will count towards the 100-shareholder limit and the restricted stock will be taken into account in determining whether there is more than one class of stock. Thus, if there is a desire to preserve S corporation treatment, care must be taken to limit the number of individuals to whom restricted stock is granted and to ensure that the characteristics of the stock do not create an additional class of stock.

The general rule is that a corporation is treated as having only one class of stock if all outstanding shares of the corporation confer identical rights to distribution and liquidation proceeds. It is, however, acceptable for the stock to have differences in voting rights and still qualify as an S corporation.[71] This is particularly useful for employers who wish to grant stock to employees, but who do not wish to convey any voting rights.

On making a Section 83(b) election, the employee is treated as an actual shareholder. Thus, the employee is counted as a shareholder for purposes of the 100-shareholder limit, and the stock is treated as outstanding stock for purposes of the single class of stock requirement.[72] The fact that the stock is subject to a vesting schedule does not cause it to be treated as a second class of stock. The employee will be taxed on her share of the corporation's income, based on relative stock ownership. Thus, an employee who is contemplating a Section 83(b) election should inquire as to whether distributions will be made each year to fund the taxes on this income.

S corporations that maintain an employee stock ownership plan (ESOP) should be aware of the impact that restricted stock may have on the ESOP. Under Section 409(p), employees who own at least 10% of the S corporation's stock held by the ESOP (or 20% with family members) may not receive a contribution allocation under the ESOP when these employees own 50% or more of the S corporation shares. Restricted stock is taken into account when determining this ownership threshold.

Conclusion

The rules regarding the taxation of restricted stock are relatively straightforward. Several complex issues may arise, however, in some situations, such as the appropriate determination of the grant date and the vesting date. The determination of the stock's FMV is a particularly challenging task for private companies.

Before restricted stock is issued, care should be taken to understand the full impact of the stock on various aspects of the tax law, such as the $1 million deduction limit under Section 162(m) and the golden parachute rules under Section 280G. Despite these complexities, restricted stock serves as a valuable compensation tool, and its popularity is likely to continue and perhaps even grow in the future.

Practice notes

In order to determine the proper timing and amount of the employee's income and the employer's deduction, care must be taken to accurately determine the grant date, vesting date and FMV. An employee includes the FMV of the restricted stock in income on vesting. If a Section 83(b) election is made, then the employee recognizes income earlier - on the grant of the stock. The employer obtains a deduction at the same time, and in the amount, as the employee includes the income.

The Federal Circuit has held that "includes" means that the employee was legally required to report an amount in income. Thus, according to the court, the employee's actual inclusion of an amount in income is not required in order for the employer to obtain a deduction. Despite this interpretation, it seems prudent for employers to issue a Form W-2 to employees to report the income, in order to ensure a proper deduction, regardless of how the word "included" is interpreted.

Read the entire article in chapter 7.1.2.a: Restricted stock: The Tax Impact On Employers and Employees of the Encyclopedia of Private Equity.


Eddie Adkins is Grant Thornton LLP's Compensation and Benefits Technical Practice Leader, based in the firm's National Tax Office in Washington, D.C. Previously, he spent 17 years at a Big 4 accounting firm, including 12 years as a partner. He has served as COO of a regional pension consulting firm and controller for a privately held company, as well as operated his own CPA firm. He serves on the AICPA Employee Benefits Technical Resource Panel. He received his Master of Accountancy from Virginia Tech.

Jeffrey A. Martin is a manager with the National Tax Office of Grant Thornton LLP located in Washington D.C., specializing in compensation and benefits. Since receiving his Masters in Professional Accountancy from West Virginia University, Jeff has spent the last four years with Grant Thornton practicing both federal taxation as well as compensation and benefits

Grant Thornton LLP is the U.S. member firm of Grant Thornton International, one of the six global accounting, tax and business advisory organizations. Through member firms in 110 countries, including 50 offices in the United States, the partners and employees of Grant Thornton member firms provide personalized attention and the highest quality service to public and private clients around the globe.

[1] Restricted stock also may be issued to compensate non-employees, such as independent contractors and directors. The tax treatment for non-employees generally is the same as for employees.

[2] APB 25, ô10.

[3] Large public employers were required to adopt SFAS 123(R) in the first quarter of fiscal years beginning after June 15, 2005. Small public employers (annual revenues or market capitalization less than $25 million) were required to adopt in the first quarter of fiscal years beginning after Dec. 15, 2005. Privately held employers were required to adopt in the first fiscal year beginning after Dec. 15, 2005.

[4] Some compensation planners argue that restricted stock is a less effective incentive for employees than stock options, because employees typically make no investment in the stock, and the stock has value to them even if the stock value goes down after the grant date.

[5] Section 83(c)(2).

[6] Reg. 1.83-3(b) states that property, e.g., stock, is "vested" when it is either transferable or not subject to a substantial risk of forfeiture. The term "vested" is commonly used in practice, however, in a manner that means simply that there is no substantial risk of forfeiture.

[7] Reg. 1.83-2(a).

[8] Id. See also Alves, 54 AFTR 2d 84-5281, 734 F2d 478 (CA-9, 1984), aff'g 79 TC 864 (1982).

[9] Reg. 1.83-2(e).

[10] See, e.g., Ltr. Ruls. 8452116 and 8833015.

[11] Section 83(b)(2).

[12] Reg. 1.83-2(f) and Rev. Proc. 2006-31, 2006-27 IRB 13.

[13] Reg. 1.83-3(c)(1).

[14] Reg. 1.83-3(c)(2).

[15] Reg. 1.83-3(c)(1).

[16] Reg. 1.83-3(c)(4), Example 1.

[17] Section 83(c)(3).

[18] Rev. Rul. 2005-28, 2005-19 IRB 997.

[19] Reg. 1.421-1(c)(1).

[20] Reg. 1.409A-1(b)(5)(vi)(B)(1). For more on these rules generally, see Hirsh and Schoonmaker, "Section 409A Final Regs. Provide Comprehensive Guidance for Post-Transition Period," 107 JTAX 150 (September 2007).

[21] Reg. 1.409A-1(b)(5)(vi)(B)(2).

[22] Reg. 1.83-5 contemplates the possibility that a restriction that was intended to be permanent may be cancelled in the future and provides that compensation income will arise as a result of the cancellation.

[23] Reg. 1.83-3(h).

[24] Reg. 1.83-5(a).

[25] Reg. 1.83-3(i).

[26] Section 422(b)(4).

[27] Reg. 1.409A-1(b)(5)(i)(A)(1).

[28] Regs. 1.421-1(e) and 1.409A-1(b)(5)(iv)(B)(1).

[29] Regs. 1.422-2(e)(2)(iii) and 1.421-1(e)(2).

[30] Reg. 20.2031-2.

[31] Reg. 1.422-2(e)(2)(iii).

[32] Reg. 1.409A-1(b)(5)(iv)(B)(1).

[33 ]Reg. 1.409A-1(b)(5)(iv)(B)(2).

[34] Reg. 1.409A-1(b)(5)(iv)(B)(2)(i).

[35] Reg. 1.409A-1(b)(5)(iv)(B)(2)(iii).

[36] Reg. 1.409A-1(b)(5)(iv)(B)(2)(ii).

[37] Reg. 1.83-1(f), Example 1.

[38] Rev. Rul. 83-22, 1983-1 CB 17; Rev. Proc. 83-38, 1983-1 CB 773.

[39] Rev. Rul. 79-305, 1979-2 CB 350.

[40] Reg. 31.3402(g)-1(a) defines supplemental wages to include "wage income recognized on the lapse of a restriction on restricted property transferred from an employer to an employee."

[41] Regs. 31.3402(g)-1(a)(2) and (a)(7)(iii)(F).

[42] Reg. 31.3402(g)-1(a)(2).

[43] Section 3101.

[44] Sections 3301 and 3302.

[45] The income tax liability on $1,000 of income at a 35% rate is $350. The gross-up calculation is as follows: $350 ž [1 ö (1 − .35)].

[46] Reg. 1.83-6(a)(2).

[47] Robinson, 92 AFTR 2d 2003-5349, 335 F3d 1365 (CA-F.C., 2003).

[48] Reg. 1.83-6(d).

[49] Notice 2007-49, 2007-25 IRB 1429. Due to the interaction between the statutory language of Section 162(m) and the recently changed SEC rules, the chief financial officer is not a covered employee.

[50] Section 162(m)(4)(C).

[51] Section 280G(b)(2).

[52] Section 280G(b)(5)(B).

[53] Sections 280G and 4999.

[54] Section 280G(b)(2)(A).

[55] Reg. 1.280G-1, Q&A-22(c) and -24(c)(1).

[56] Id., Q&A-24(c)(4).

[57] Id., Q&A-24(d)(3).

[58] Id., Q&A-12(b).

[59] Id., Q&A-27(a).

[60] Id., Q&A-28(a)(1). There are other circumstances under which a change in control may occur, but restricted stock has no impact on these circumstances.

[61] Rev. Rul. 2005-39, 2005-2 CB 1.

[62] Section 280G(c); Reg. 1.280G-1, Q&A-15 through -19.

[63] Rev. Rul. 2005-39, supra note 61.

[64] Sections 409A(a)(2), (a)(4), and (b).

[65] Section 409A(a)(1).

[66] Reg. 1.409A-1(b)(6).

[67] Reg. 1.409A-1(b)(6)(ii).

[68] Id.

[69] Sections 1361(b)(1)(A) and (D).

[70] Reg. 1.1361-1(b)(3). Stock existing on the effective date of the regulations (tax years beginning after May 27, 1992) that has been treated as outstanding by the corporation, even though it is substantially nonvested, continues to be treated as outstanding for purposes of Subchapter S. A history of issuing a Schedule K-1 with respect to the stock is evidence that the corporation has treated the nonvested stock as outstanding.

[71] Reg. 1.1361-1(l)(1).

[72] Reg. 1.1361-1(b)(3).